Let the Risk/Inflation Rally Commence! (SPY,TLT)

The final phase is upon us.

 

And within a few weeks, we’ll be witness to one of the greatest underwritings of risk the human species has ever known.

 

Nor will it be fun.

 

Unless you’re a bit twisted.

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Be prepared to watch men jump from heights and expect to fly.  Watch them attempt to match strength and wits against the wildest of caged animals.  See, as they roll the dice of a life of prudence and surety against fortune’s wheel of chance, grinning all the while, a glass of bourbon in hand.

 

Oh-boy!-oh-boy!-oh-boy! …

 

It’s a’coming.

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Rudyard Kipling’s poem, “If,” spoke of the passage to manhood and the exceptional mental fortitude required to arrive there.  So when we offer above his reference to gambling, we don’t believe he was sanctioning the sort of capricious recklessness that’s going to characterize what’s about to come.

 

Indeed, what we already see coming.

 

Have a look here –

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This is a chart of the iShares iBoxx High Yield Corporate Bond ETF (NYSE:HYG), a stock that’s a proxy for the state of the American junk bond market.

 

And what does it show?

 

Among other things, that we’re now in the midst of a bullish move for the high yield asset class (higher highs and higher lows, in red), a development that carries significant weight for our understanding of investor sentiment.

 

And that sentiment is looking increasingly risk-prone.

 

As high yield gains value, and spreads against Treasuries decrease, investors are informing us that they’re increasingly confident that default risks are shrinking and the overall economic climate is improving.

 

Whether that’s the case in reality is irrelevant.  It’s the perception that drives the action, and that action now is bullish.

 

What’s Behind it?

 

Of course, there are fundamental drivers behind the move in high yield, most formidably a real decline in the number of defaults, particularly in the energy, mines and metals sectors, all of which have been hit hard after plummeting commodity prices tore into revenues like Wanda O’Shaughnessy’s nails in your flesh after a night at the Pumpkin and Brew.

 

Here’s a chart that demonstrates the latest encouraging signs from the junk sector –

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Simply put, defaults in the above named sectors are diminishing because the price of oil and a number of other mineable commodities have gained traction of late, helping with revenues and pulling a great number of would-be defaulters back into the game.

 

The metals and miners have not seen a single issue default in the last five months.

 

Below is a look at oil for the last quarter, and it, too, looks quite promising.

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Crude has jumped by over 40% from its lows at this time last year, and again, higher highs and higher lows indicate an ongoing bullish trend in play.

 

Moreover, at $50 oil is now fetching a price at which most producers stateside can continue to operate and even make money – should their balance sheets not be too lopsided.

 

And that’s good news for investors all round.

 

Oil = Inflation

 

It’s not something you’ll read in most economic textbooks, and it’s certainly not categorically the case, but our radar is telling us that the latest pull off the lows in the crude pits is signaling something more than an interim bounce.  What we’re more likely viewing is a genuine pickup in economic activity after several years of quietude, and enough of a goose to the system that we could see a cold splash of inflation within the next three to six months.

 

That means both a raise in short term interest rates and a coming waterfall selloff in government bonds.

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We’ve discussed that scenario amply over the last couple of years, and though we’ve been premature every time, the inevitability of the thing never diminishes.  The bond market will deflate, and the flow of funds will stream inexorably toward equities and, it now appears, increasingly back toward the commodities.

 

The latest action on the Shanghai market and from a number of quality commodity ETFs all support the view that, after topping in 2008 and turning lower, commodities are now back in play.

 

And that means inflation.

 

We are going to get a good whack of it eventually, and we have our central bankers to thank for it.  They’re the ones, after all, who’ve maintained a zero interest rate policy (ZIRP), encouraging people to borrow and spend at virtually no cost for … how long has it been now?  They’re also the ones who opened the money floodgates that sent us awash in a sea of liquidity that has no precedent and that, by definition, has to make its way back into assets real and paper.

 

The Fed also engaged in outright purchases of Treasury Bonds alongside their Twists and their QEs and ZIRPs and NIRPs, an effort that allows them to maintain a more orderly selloff in the Treasury market when the time to rotate into equities arrives.

 

We’ve droned on about this for years, and it now appears the pesos are coming home to roost.

 

American Equities – The Last Game Played on Earth

 

While we pronounce R.I.P. over the bond market and watch as the appetite for the most dangerous investment instruments is whetted, as commodity prices ratchet up and await the great rotation to begin bloating their prices, a look at the major stock market indexes produces nothing but puzzlement.

 

Why have they traded in such a tight range for the last ten weeks, moving no more than 1.5% higher or lower for the entire period?

 

The Dow, NASDAQ and Russell indices are all stuck between their 50 and 200-day moving averages, on their way to … where.

 

Only the S&P 500’s chart offers clarity as to the market’s next move.

 

Have a look at the SPDR S&P 500 ETF (NYSE:SPY) –

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Here, a clear flag pattern (in red) speaks to a continuation of the bullish trend.  And while it may drift within those confines for another week or two, the eventual break will be higher.

 

RSI and MACD (in green) are floating about their respective waterlines, awaiting the break, and the stock’s moving averages are just about to unfurl for the first time since August of 2015 (in blue).

 

We expect a break above the upper edge of the flag to produce great profits.

 

So we’re buying CALLs.

 

And paying for them with CALLs on the bond market.

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Many happy returns,

 

Matt McAbby

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