After a few weeks of emotional extremes in the financial markets it is time to reflect on the US economic picture. There are some positive signs. Outside of the financial sector, reported earnings have not been unreasonably bad; the proposed bipartisan fiscal stimulus looks like it will pass through the Senate; and the Federal Reserve has preemptively slashed interest rates by 0.75% with a further 50 basis points last Wednesday.
The foundations for the next bull cycle are well and truly in place; now it’s a question of when the current bear period will end. To search for answers, we can turn to the US bond markets, an economic indicator. We can see from a technical perspective where interest rates are predicted to go.
Interest rates move in the same direction as bond yields and bond yields move in the opposite direction to bond prices. Hence a rising bond price indicates falling interest rates. The regression line on the chart below of the 30-year US bond has a 2.5% upper and lower price envelope, which has been successfully encompassing the upward price action since June 2007. Practitioners of Elliott will also notice that the price target has been reached.
Both these conclusions would suggest a short term hiatus in the current upward price trend and a view that yield falls (and interest rate cuts) are currently complete. This is not to say that the upward trend has now ended, as support from the lower percentage channel could easily lead to a rally in price and further pressure on rates.
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Analysis of the same instrument on a more expansive scale offers some evidence that the current turmoil could be close to an end. Should this prove to be the case, the bond chart points to a new period of prolonged range trading as economic factors play themselves out whilst share investors follow neutral strategies – looking for dividend based yield and index tracking. This is the higher probability outcome, although fear and panic always ignore the fundamentals.
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The low in bond yields (the price high on the left hand side of the chart) coincides with the beginning of the Dow 30s bull run beginning in March 2003 (INDU:CBOT). As we approach those yields again with the 30-year bond, resistance could easily dictate a new trading range illustrated by the two parallel blue lines. This would lead to the aforementioned scenario of sideways moving equity prices.
On the other hand, a future test and successful break of the upper resistance could have serious consequences for the US economy, possibly even a prolonged period of recession as seen in Japan in the 1990s - with the Bank of Japan unable to stimulate the economy because of the ZIRP – zero interest rate policy. By the same token, a successful break of the lower support could be the signal for an inflationary (growth) environment and a new bull term. Time will tell.