Flat Stock Market On Monday

The S&P 500 was up 0.09% as it gave back most of its gains from the morning. The Dow now has an 8 day winning streak. The Russell 2000, which is the closest major index to its all-time high, was down 0.4%. This flat market supports my thesis that the stock market is in ‘wait and see’ mode. The rally last week was justified, but now investors want to see some improvement in the economic data.

One data point which I’ll be looking at closely is the retail sales report on Tuesday. There was a string of negative month over month results until March which saw a 0.6% gain. The consensus is for a 0.3% gain on the headline number and a 0.4% growth rate for the control group. If these results beat expectations, we could see stocks move up further.

The market is overbought in the past week of trading, but can move higher if the fundamentals permit. The 14 day RSI is at 54 which is neither overbought, nor oversold. The CNN Fear and Greed Index is also at 54 which is neutral. Another up day would push those to the highest point they’ve been at in a while, further supporting the notion that the correction is over.

Oil Price Shock Could Lead To The End Of The Cycle

Oil was up 26 cents to $70.96 as the stockpiles which pushed oil into the $30s in 2016 have been eliminated. Oil is a boom and bust commodity. We are now in the boom stages; I admit I have been wrong to be bearish this year. Venezuela is in crisis mode as its government has collapsed. That has lead Venezuelan production to decline to the lowest level in decades. Furthermore, the Iranian sanctions could take out 400,000-500,000 barrels of production per day.

WTI is about $7 below Brent, which is the highest difference since December, because of the potential for more shale production. There are 7,700 drilled but uncompleted wells. Clearly, oil price increases will spur inflation, pushing this expansion to its brink. Either the demand weakens during the summer driving season as price pressures prove to be too much or demand is strong, prices rally further, and then demand starts to falter.

One potential thesis why the expansion has been long, besides the fact that the labor market needed a long time to heal and that growth has been slow, is that commodity prices have been weak. This partially explains why inflation has been low. The chart below shows the rolling 10 year annualized returns of commodities. As you can see, the returns are -6.5% which is the worst since the Great Depression. This rise in oil prices isn’t going to reverse these returns overnight, but even a small improvement will lead to additional inflation which could be problematic. It’s worth mentioning that the CRB commodities ETF is down from $313 in June 2014 to $204 today, but it’s up from $168 last June.

(Click on image to enlarge)

Inflation Curve

The potential rise of commodity prices and some wage inflation are leading the near term breakeven rates to rise much faster than the long term breakevens. This is catalyzing a flattening of the yield curve as it’s pushing up short term treasury yields while long term treasury yields are mostly stationary. As you can see from the chart below, the 2 year breakeven rate has increased by 72 basis points since the start of the year, while the 10 year breakeven inflation rate has only increased 7 basis points.

(Click on image to enlarge)

The economy is headed in the right direction as growth should improve and inflation will come with it. However, the Fed’s reaction to this will be to raise rates which will eventually stop the expansion probably in 2020. On Monday, the yield curve actually steepened a bit as the 10 year yield increased 3.29 basis points to 3%, while the 2 year yield was up 1.26 basis points to 2.55%. The latest difference is 45 basis points. This steepening is a pit stop on the way to an inversion in late 2018 or early 2019.

Fed Expected To Raise Rates In June & September

The increase in breakeven rates is showing the market expects more inflation. This is coupled with the theme I’ve been discussing which is a heightened expectations for growth. The CNBC median consensus for GDP growth in Q2 is 3.7%. I don’t think stocks will fall if growth comes in below that. I think stocks will rally if growth is closer to that rate than the 2.3% growth rate seen last quarter. Just because expectations are set at a certain rate, doesn’t always mean the market is pricing that in.

(Click on image to enlarge)

These points all mean the Fed will raise rates more than 3 times in 2018. Currently, the chance of a rate hike in June is 95% and the chance of at least 2 rate hikes by September is 79.3%. The chart above shows the recent surge in the odds for rates to be between 2% and 2.25% after the September meeting.

It’s interesting to hear that despite this trend towards more rate hikes, St. Louis Fed President, James Bullard, stated rates are already near neutral so there’s no reason to hike them further. On the one hand, he has been a dove for a while, so this isn’t news. If the Fed never raised rates this cycle, it would be a problem because inflation might be higher and the Fed wouldn’t be able to cut them in the next recession. On the other hand, it’s a fair point because rates are very close to core inflation. The Fed funds rate is 1.69% and core PCE is 1.9%. Letting the economy finally grow at the rate seen in historical expansions would help business investment and probably wouldn’t cause inflation get out of hand. After the rate hikes in June and September, the Fed will be in the hawkish category. Each subsequent rate hike could slow the economy, which shouldn’t be the goal yet with Q1 GDP growth at 2.3%.