What will second quarter profits suggest? As noted yesterday results are expected to decline by 5.7%, the fifth consecutive quarter drop and the longest decline since 2009. The post Brexit rally is the result of promised additional central bank stimulus, not from increased corporate cashflows which is the historical driver of stock valuations.
Speaking of interest rates, the Treasury market was crushed yesterday with the 30-year dropping almost 2 ½ points and the 10-year off almost a point. Treasuries have just experienced their largest two day drop for 2016 after last week’s all time low yields on several of the benchmarks.
As noted many times, the incessant advance in Treasury prices is the result of negative yields in most of the developed world, an environment coupled by extreme complacency of inflationary expectations that has permitted the Treasury to be priced beyond anyone’s wildest expectations. Some now think a change in monetary policy may not occur until late 2017 at the earliest. Six weeks ago the debate was whether or not rates would rise in June of July.
In extremes, wild price fluctuations can occur. Speaking of week, about 4 months ago oil was around $25/barrel. Today it is around $48, after broaching $50 in June. Many thought oil would not see $50 until 2018. The negative narrative was (and still is) intense.
I ask how will equities respond if the 10-year doubles in yield to 3.0% by year end? Wow! I must remind all this was the expected year end yield as forecasted on January 1 by Goldman, PIMCO and was the central tendency of the FOMC.
There are three potential catalysts that I believe can cause a doubling in yield, all of which are in the nascent phases of recovery. The first is oil. I believe oil will be around $65 by year end. Second is rising Owners’ Equivalent Rent. And third is accelerating wages, which has already commenced at either end of the spectrum.
Approximately 95% of Treasury volume is done electronically or via high frequency/algorithmic traders. Few had thought the markets would rally after Brexit, a rally I think is the result of cross correlated trading strategies.
What happens if all three of the above catalysts occur in today’s highly automated trading environment?
Commenting upon yesterday’s market action, as noted above Treasuries did fall sharply but equities advanced on optimism of even more central bank stimulus and the greatest advance in crude since April.
What will happen today? How will the Beige Book be interpreted?
Last night the foreign markets were up. London was up 0.12%, Paris up 0.44% and Frankfurt up 0.16%. China was up 0.82%, Japan up 0.84% and Hang Sang up 0.46%.
The Dow should open little changed. Will there be a reality check regarding the strength of corporate earnings and state of monetary policy, an environment perhaps amplified by an overbought market? The 10-year is up 10/32 to yield 1.49%.
