Libor Increases At Quickest Month-over-Month Pace in Over 12 Months

The 3-month London Interbank Offered Rate, or Libor, has recorded its strongest month-over-month increase from the start of June to the start of July in at least twelve months.

Note: Dates are meant to signify the start of each month, and the first of each month may not necessarily have been a business day.

From the first business day of June to the first business day of July, the 3-month Libor rate increased by 8.266 basis points, from roughly 1.22% to about 1.30%. Previously, the strongest increase in this rate had been from August to September 2016, when the rate saw a rise of 7.657 basis points from ~0.76% to ~0.84%.

The magnitude of increases in that period and the current period may have been similar, but the consequences are different. An increase in the Libor rate to 1.3% at this magnitude of over eight basis points signifies tighter financial conditions, tightening at a respectable pace. To be sure, a Libor rate of 1.30% today is well below the 4.54% rate seen at the start of January 2006, just before financial markets began seizing up as the financial crisis commenced.

Thus, a Libor rate of 1.3% still reflects rather loose monetary conditions - however, these conditions are certainly tighter than those seen in fall 2016, going strictly by the three-month Libor rate. Indicators such as the St. Louis Fed's Financial Stress Index show incredibly accommodative monetary policies, ascertained by a broad variety of financial instruments and indicators. I don't disagree with this, hence the emphasis on how monetary conditions appear somewhat tighter only relative to last fall.

From the start of June 2017 to the start of July 2017, the three-month Libor rate increased at a magnitude not seen in over a year, indicating a quickening pace of tightening monetary conditions. However, when zooming out to broader indicators (e.g. St. Louis Financial Stress Index) and broader timeframes (e.g. 3-month Libor in January 2006), monetary conditions remain quite accommodative. For now, this is merely something to keep an eye on.

Andrew

Yield Curve Continues to Flatten

The yield curve for U.S. Treasuries continues to flatten, reflecting a dimming of expectations on significant economic boosts from President Trump's proposed reforms, continued thirst for yield globally, the Federal Reserve moving to tighten monetary policy, and some investor anxiety about the apparent separation of stock market prices from underlying fundamentals.

A comparison of the yield curves from May 1, 2017 (lighter blue line) and June 23, 2017 (darker blue line) shows the flattening process that began earlier this year and has continued into the summer. The flatter yield curve can be attributed to four primary causes:

I. Dimming of Expectations of Pro-Growth Reforms
After his election as president and through the first couple months of his presidency, Donald Trump advocated an agenda heavy with reforms that, if implemented as promised, would likely give a substantial short- to medium-term boost to the languishing economy. Some of his most notable campaign ideas included repealing and replacing the Affordable Care Act passed under President Barack Obama, significant tax reform, and substantially relaxing regulations on financial institutions (namely the Dodd-Frank Act). Market participants saw the potential bounty of economic growth that these reforms could bring, and have sent all four major stock market indexes skyrocketing in the time since the November 2016 election.

Stock Index Performance since the 2016 Presidential Election (11/8/2016 to 6/23/2017).
From top to bottom: Dow Jones Industrial Average, S&P 500, Nasdaq Composite, Russell 2000
Chart from stockcharts.com

Roughly five months since President Trump's inauguration, these reforms have not been fully realized as investors had hoped. Some progress has been made on easing regulations on financial institutions, but a significant defeat of the initial new health care bill a couple months back, paired with the newly-released health care bill this past week still garnering skepticism from within the Republican Party shows that any significant health care reform will take some time. Tax reform, another potential Congressional flashpoint, has yet to be proposed as legislation. As the year has gone on it has become apparent to many investors that if Trump's reforms are to be fully implemented as promised (still a very big "if"), it will take notably longer than they had expected. As such, any significant economic boost is still a ways off, and thus inflation expectations have dimmed to levels not seen since just before the 2016 presidential election. Bonds then become more attractive to investors, one reason why the yield curve has once again begun flattening.

II. Continued Global Thirst for Yield
This factor is much more long-term than the first factor we discussed. The search for yield has been intense for years now, amidst this global low-interest-rate environment, and while the global economy is beginning to pick up steam, American long-term debt remains much more attractive to foreign investors than those investors' own domestic sovereign debt.

Worldgovernmentbonds.com

Above is a list of major countries' 10-year bond yields. There are countries like Japan, France, Germany and the U.K., all with easy access to the global financial markets but with sovereign debt yields well below the United States' 10-year yield. Consequentially, as we have seen for a few years now, foreign investors are plowing money into long-term U.S. debt to get those higher yields. In turn, this is also helping keep the long end of the yield curve flat.

III. The Federal Reserve Tightening Monetary Policy
The federal funds rate now stands at a range of 1.00% to 1.25% after three rate increases, each by a quarter of a percentage point, over the last six months by the Federal Open Market Committee. Let's first be clear in recognizing that even despite these increases, a 1.25% federal funds rate is still quite accommodative. It is not the 0.25% that this range ceiling reached at the nadir of this cycle, but a range of 1.00% to 1.25% remains quite accommodative by historic monetary policy standards. The St. Louis Federal Reserve branch's Financial Stress Index also portrays how loose monetary policy remains:

Intriguingly enough, this index has been falling even amidst the FOMC's rate hikes, but that's another discussion for another post. For now, the focus is on the Federal Reserve's tightening of monetary policy (through rate hikes and reducing its $4.5 trillion portfolio of Treasury bonds and mortgage-backed securities, set to begin later this year) sending short-term U.S. Treasury debt yields higher, as typically happens in tightening monetary policy.

It is worth noting that when the Federal Reserve begins allowing its Treasuries to mature and not re-invest to maintain the size of the $4.5 trillion portfolio, longer-term Treasury debt yields are expected to rise somewhat as supply increases in the market without a clear replacement buyer as the FOMC steps away. But again, this is another discussion for another post.

IV. Some Investor Anxiety
Let me first start off and assuage you that this discussion will not be about the CBOE's Volatility Index, or VIX. We are all well aware that the VIX continues to remain incredibly subdued, whether due to complacency or genuine investor confidence in the economy or even a side effect of massive central bank stimulus. There is likely a degree of all three present in where the VIX lies today, but that's not relevant to this section.

Rather, there is some investor anxiety over a culmination of the uncertainty in President Trump's promised reforms from above, weaker economic data as of late that raises questions of if the Federal Reserve may accidentally tighten monetary policy too much and cut off economic growth, very high stock price valuations even in the face of improved corporate earnings, geopolitical tensions (which seem to rise every other day in some aspect), and more. To me, it comes down to substantial risks to the market being at least partially offset by continued strongly accommodative monetary policy by central banks worldwide. I say partially because we have seen some rattled nerves in recent months following bouts of increased uncertainty or tension, but overall this has not been enough to persuade investors to fully dive into haven assets like U.S. Treasuries or gold. Gold is up over $100/ounce from the start of 2017 to 6/23, and the U.S. 10-year Treasury yield has dropped 30 basis points in that same timeframe. Again, these signal some investor anxiety, but not enough to make the stock markets or other riskier assets notably less attractive.

So what's the outlook? Unless Congress can force the most recent health care bill through in the near term, it looks to be more of the same: A gradually flattening yield curve as uncertainty over Trump's promised reforms, tightening monetary policy, an insatiable global thirst for yield, and hints of investor anxiety amidst heightened geopolitical tensions.

Andrew

An Economic Defense of Price Gouging

For my business ethics class this semester, I'm reading Michael Sandel's Justice, a review of the definitions of justice, and how various philosophers evaluate concepts such as freedom, the morally correct and incorrect, and more. The first chapter begins with a look at Hurricane Charley in 2004, and how the storm wasn't finished after the rain and clouds dissipated. With prices for necessary goods surging (Sandel cites a $40 motel room going for $160 per night and $250 generators priced at $2,000), a fierce controversy erupted on the ethics surrounding price gouging. The law quickly became involved, with some plaintiffs winning their lawsuits. As many economists have already done, I'd like to express why price gouging is beneficial, if not necessary, to the free market economy as we know it.

Before diving in, let's make sure we identify price gouging correctly. Legaldictionary.net defines price gouging:

"Price gouging is a term that refers to the practice of raising the price of goods, services, or commodities, to an unreasonable or unfair level. Such an increase in price is often a result of a sudden increase of demand and shortage of goods, such as in the event of a natural disaster or other crisis, and it is illegal in most jurisdictions."

In sum, we'll define price gouging as raising the price of goods, services, and commodities to unreasonably high levels, brought on by sudden demand or supply shocks.

Legaldictionary.net notes that price gouging is illegal in most jurisdictions. This is accurate: Michael Giberson of Knowledge Problem notes that 34 states and the District of Columbia have some form of legislature in place against price gouging (as of November 2012). The Federal Price Gouging Prevention Act of 2013 was introduced to the House of Representatives in 2013 to fight against unreasonably high gasoline prices, though this never became law.

Given that the government is to be the voice of the people, one may assume the people are against price gouging, no matter its economic implications. On the surface, who wouldn't fight against price gouging? I too would be furious if, after a natural disaster, I needed to purchase water for my family and was forced to pay $20 for three bottles of water that typically cost $5. What kind of rotten scumbag hikes the price of necessary goods after a natural disaster, just for profit? How could someone be so evil? The angry disbelief is palpable whenever a situation like this arises. Rather than spring boarding from the buyer's point of view, let's compare and contrast the buyer and seller in a hypothetical situation.

Suppose a massive flood has hit your town, and the waters have just recently receded. Your entire town has been devastated, with cars, homes, and businesses alike all submerged in the floodwaters. You realize you need water for your family, as well as ice, given it's summer. Making your way to an open store, you discover a bottle of water, previously $1.50, is now $10. A bag of ice, previously $4, is now $20.

Buyer's perspective: These prices are outrageous, and the store owner is nothing less than a crook for selling these necessary things at these ridiculous prices. I've already lost most of my things in this natural disaster, and now the owner wants to bankrupt me?!? I have to get these things for my family, though. You pay for the goods.

Seller's perspective: We lost a good chunk of our storage in the flood, the store is damaged, and from the looks of things we won't get a sufficient shipment of water and ice for a few days. If I keep selling these things at the regular prices, there's no way we'll be able to rebuild and repair even a fraction of this store. You sell the goods at the high prices.

It's certainly tempting to blame the seller for being a greedy pig and trying to profit off of someone's despair, but that often isn't the case (or at least the primary case). Recall the focal point of economics: supply and demand.

In a natural disaster, or some other shock to the system, the demand curve for a good will generally shift significantly to the right. This signals an increase in demand for the good, such as bottles of water and bags of ice.

Such a shift in the demand curve is depicted above, shifting from D0 to D1. Note how the new equilibrium price (where the new demand curve and the supply curve intersect) is higher up than the old equilibrium price (where D0 and S1 intersect). From a logical point of view, companies view higher demand (and higher prices) as a profit-booster. The firms boost the supply of the good or service, leading to that higher equilibrium price.
Simultaneously, in a natural disaster, the supply curve shifts to the left.

The supply curve moves from the lighter red line to the darker red line, while the demand curve (in a case where only the supply curve shifts) remains stationary. Recall that shifts in either the supply or demand curve can arise from any number of events, including a natural disaster. The supply curve shifts to the left, raising the equilibrium price and softening demand. Again, however, that is only the case if only the supply curve shifted. In our situation, the supply curve shifts left and the demand curve shifts right. The result? A relatively similar position of quantity demanded and quantity supplied, but with a higher equilibrium quantity. That result is represented somewhat below:

Shifts in the demand and supply curves simultaneously lead to a new equilibrium price in that black circle. These curves may shift to a more or less extreme degree than I have depicted here, but the general sense remains the same. In a natural disaster, or any shock that reduces supply and boosts demand, a higher equilibrium price (and thus market price) will develop. That's just economics in a free market such as ours, not the greediness of shopkeepers.

There's that phrase- free market. Let's define it using Investopedia.com:

"Free market refers to an economy where the government imposes few or no restrictions and regulations on buyers and sellers. In a free market, participants determine what products are produced, how, when and where they are made, to whom they are offered, and at what price—all based on supply and demand."

Free markets go hand in hand with capitalism: free market is a key concept of capitalism, to be precise. The United States is a capitalist economy, there is little doubt of that. As buyers and sellers, we collectively determine market prices, and buy and sell accordingly.

Note the line in our definition above: "the government imposes few or no restrictions and regulations on buyers and sellers". That's the 'free' in free market- in an ideal free market, there are no price floors, no price ceilings, no taxes, no quotas, etc. Buyers and sellers are free to do their business as they please, with minimal intervention that would reduce the optimality of the market. In both Sandel's Hurricane Charley example and my own example above, the free market reigns through the higher equilibrium price as a result of the supply and demand curves shifting. Again, it's the economics of the free market at work.

What would happen if price gouging laws were in play in our above example, namely in the form of a price ceiling?

Consider the supply and demand curves here as the new curves, following the flood from our earlier example. In this area, price gouging laws prevent a market price/equilibrium price above a certain level, depicted here as the yellow line. This is a price ceiling. As we did earlier, let's view this new scenario from a buyer's perspective and a seller's perspective.

Buyer's perspective: Good thing those price gouging laws are in effect, now I'll be able to buy the bottled water and bags of ice for my family. Wait, the store is sold out? How could it be?? You say someone bought all the water and ice earlier?!? You cannot buy the goods due to a shortage.

Seller's perspective: I can't believe all of the water and ice was sold out in under an hour. There's at least 50 people here demanding more water and ice, but there's just no more. Adding to that, thanks to these price gouging laws, I had to take losses on selling the ice and water. You cannot sell the goods due to excess demand and losses incurred.

In our new scenario, with a price ceiling acting as a price gouging prevention device, a shortage in water and ice bags quickly emerges. At this lower price, as shown in the graph above, demand far exceeds the amount supplied. In a free market without any natural disasters, supply is well below demand because the price level of the price ceiling is too low for the firm to make a profit. To minimize losses, firms supply less. Consumers see this as a bargain, and demand more. However,  lower supply in the face of higher demand results in a large shortage. This is no longer a free market economy.

An interesting point was brought up in Sandel's book. In defense of price gouging in the wake of a natural disaster, pro-market writer Jeff Jacoby pointed out how the higher equilibrium price of these goods acts as an incentive for suppliers to produce more of the good. Indeed, a price ceiling provides no incentive for a firm to produce more of a good- they would just incur losses, after all. By permitting higher market prices of goods following disasters such as a hurricane or flood, suppliers are far more willing to increase supply of these goods than if price gouging laws were in place. In the short term, higher prices spells financial pain; this is true. In the longer term, however, increased supply of necessary goods like ice bags and water speeds the recovery of areas hurt in natural disasters.

"The enemy of my enemy is my friend."

I've found the above proverb to be a particularly interesting one. It is often applicable in real life situations, but also realistic in hypothetical situations. In terms of price gouging, it is also quite applicable: The enemy (free-market economy) of my enemy (price gouging) is my friend. Perhaps a little simplistic, but it holds true nevertheless. So long as we permit buyers and sellers to freely find market prices, even in extreme situations like after natural disasters, the most efficient outcome will prevail.

In summary, the higher prices of necessary goods in the aftermath of natural disasters is beneficial and crucial to the structure of our free market economy. Allowing higher prices incentivizes suppliers to provide more of the necessary goods, eventually allowing the market price to move lower again. Enforcing laws to prevent price gouging, particularly through the use of a price ceiling, results in shortages of these necessary goods for buyers, and incurred losses for sellers. In order to provide the most efficient outcome in the end, and maintain the integrity of the capitalist economy, allowance of higher prices in extreme situations is required.

Crude Oil To Be Pressured; Gold On The Rise

It's looking like crude oil prices are positioned to take a fall in the short-term, while gold is aiming for further gains following post-election declines.

StockCharts.com

A look at the last six months for WTI shows a pretty good number of reasons to be bearish. Since about the beginning of December we've been in a bearish pennant, with resistance around $54 reached at the turn of the new year and support now around $52, built around short-term lows throughout the last two months. This pennant is outlined in thin black lines. Tuesday's trading brought us very near a breakout point lower, with session lows right on the line of support on that pennant. What really matters is where we close, though.

Speaking of closing prices, WTI managed to close a hair above the 50-day SMA, prominently shown on the right panel of the above image. As of this typing, crude oil futures for March delivery are down roughly 1.1% to $51.59 a barrel, not only below Tuesday's close but also below Tuesday's session lows. This bodes well for Wednesday being our breakout point lower below the 50-day SMA line and possibly breaking the pennant as well, barring any positive shocks/news.

StockCharts.com

While crude oil looks for a break lower, gold is slowly but surely regaining ground lost after the election, when risk-off was the status quo. With that risk-off sentiment now abating as the new administration starts off on some shaky footing in some cases, gold is back in the crosshairs of investors. Long-term resistance was broken initially on Monday's close, and confirmed by Tuesday's open and close above that black resistance line.

I'm personally expecting the 'Trump trade' to continue slowing as the honeymoon phase ends and investors realize that significant tax reform and fiscal policy changes will not be immediate. This seems like a good time to jump into gold, so long as the dollar rally continues to stall along with the general Trump trade/risk-off sentiment.

Andrew

Dollar Bulls Will Ride Again... If Not Now, Then Soon...

Dollar Bulls Will Ride Again... If Not Now, Then Soon...

MyFxBook

There's some shifting going on in the currency markets, especially in major currency pairs. The first image shows latest readings of the Euro (currency pair EUR/USD), which is currently in the retesting phase of a true 'head-and-shoulders' pattern. This pattern is identified by a rise in the value of a security, followed by a dip, followed by another rise, followed by another dip, and a final rise and a final dip to give the appearance of a head and two shoulders.
In the finance world, this is a 'bearish' pattern, a pattern that anticipates the value of the security will fall soon. The 'retesting' is shown right now, as we see the value of the security hovering just under that red line, called the 'neckline'. When this retesting is complete, which will happen soon, the Euro is expected to fall in value yet again, likely into the rest of January and February.

MyFxBook

The second image shows the value of the Yen (currency pair USD/JPY). Notice another neckline shown by that red line, but this time it is an INVERSE head-and-shoulders pattern. It's that head-and-shoulders pattern, but turned upside down. Similarly, instead of being 'bearish', this pattern is 'bullish', anticipating the value of the security will rise soon. Thus, the Yen is expected to decrease in value again in the near future.

Teletrader.com

It's no coincidence that these two things are happening at the same time. When the Euro and Yen both fall in value, as is projected to happen per this technical analysis, it's typically due to the U.S. Dollar strengthening. The third image (the Spot Dollar Index, symbol DXY) shows what may well be a very messy inverse head-and-shoulders pattern in the short term, using the same time intervals as the first two images, but again it's very messy. The messy quality of this pattern throws into question a strengthening dollar.

But this question exists only briefly.

In my fourth and final image, I show you what will be a news story for the next several years. We are currently going through, if not just exiting, the retesting phase of an inverse head-and-shoulders pattern in the Spot Dollar Index, but this time it's a 20-month-long pattern instead of just a couple of days, like the first three images.

Teletrader.com

It will be a consistent news story, because it could very well usher in the next recession. A stronger dollar for the long term is favored strongly by this technical analysis in the fourth image. While it increases purchasing power of the U.S. consumer, it will increasingly trim profits of multinational companies, especially those who make the majority of their revenue from other countries. Converting those currencies into a stronger US Dollar will take more of that country's currency to make 1 USD. Over time, that hurts companies' earnings, and by extent their stock prices.
The stronger dollar will force the Federal Reserve to hike overnight lending interest rates faster than they want to, something that will squeeze the bond bull market (which is already looking shaky post-election). For companies that have been living off of easy monetary policy put into place by the Fed since the Recession, this is a big threat. If it comes to fruition is another question and another story for another day, but the threats are very real.

To summarize:
1) Short-term weakening is expected for the Euro.
2) Short-term weakening is expected for the Yen.
3) Simultaneously, strengthening is expected for the U.S. Dollar.
4) Long-term, the U.S. Dollar is expected to strengthen, and may very well be the catalyst for the end of this already very-long economic expansion.

Andrew

Dow Jones Industrials Looking Distressed

I'm entering the fifth week of being contaminated by some kind of illness. This time, it's a nasty cold that developed last Thursday, and gave me a fever every day this past weekend, into Monday morning. That was accompanied by an incredibly sore throat, cough, and inordinate amounts of post-nasal drop. Not exactly the most fun way to spend a weekend, but thankfully it looks like things are turning a corner.
A handful of technical indicators on the Dow Jones Industrial Average are flashing warning signs that the market might be slightly distressed.

StockCharts.com

Attached above is a picture of the Dow Jones Industrials over the last six months, with the Average Directional Index (ADX) posted below. The +DI (Positive Directional Index) and -DI (Negative Directional Index) are superimposed on the ADX. In a nutshell, an ADX value over 20 generally indicates the presence of a trend in the market. Using the ADX alone, one can't determine the direction of the trend without looking at the values of the stock or index. The Directional Indexes help out by separating the ADX into positive and negative components. When the ADX exceeds 20 and the +DI is greater than the -DI, the trend of the security is generally positive/upward. Likewise, when the ADX exceeds 20 and the -DI value is greater than the +DI value, the trend of the security is generally negative/downward. This is by no means foolproof, but can be a guide to identifying trends and momentum, to some degree.
The ADX has been stuck in a pretty tight range since middle September, eyeballing it says it's hovering between roughly a 22-27 value window. Although the index has stagnated, it remains above 20, and therefore it is plausible that a trend still exists in the market. How can there be a trend if the Dow is stuck in a sideways pattern, you ask? Well, that's the gist of it. The trend is for the sideways pattern to continue, it would appear, as has been the case since last month. When taking into account the Directional indexes, we get a different story. Since mid/late August, the -DI line has consistently been above the +DI line, save for a brief come-together in late September. This was not a red flag back in August and early/mid September, because the ADX was below that key 20 threshold. However, it's been about a full month that the ADX has been above the 20 mark, and the -DI line has exceeded the +DI line. This has bearish implications for the Dow, and while there's nothing from this particular index screaming "correction" in the very near future, this indicator is raising the possibility that a correction cannot be ruled out down the road. A sideways trend with -DI exceeding +DI isn't something I'm fond of.

StockCharts.com

We now turn to another indicator, using the same 6-month timeframe as the ADX analysis. This time, we're looking at the Moving Average Convergence/Divergence Oscillator, or the MACD. This is a momentum oscillator, and will work in tandem with our ADX analysis above. The MACD, while a wonderful indicator, is also a rather complicated indicator to learn, given the number of crossover signals and such that can be learned. For this analysis, we will be focusing solely on the positivity or negativity of the MACD line itself (black line). In a nutshell, when the MACD value is positive, the momentum for a gain in the security is increasing. Taking this point further, a strongly positive MACD value can predict a strong upward breakout, whereas a weakly positive MACD value may anticipate weak gains or even stagnation. Similarly, when the MACD value is negative, the momentum for a loss in the security is increasing. A strongly negative MACD value may anticipate a large drop in the security's value, whereas a weakly negative MACD value may predict small losses or stagnation.
Something right off the bat that worries me is that the MACD has been negative since early September. This implies that there is more momentum for the index to lose value than to gain value. However, as we saw with the ADX, we are stuck in a rather small window, and in order for the MACD or ADX to succeed in anticipating this downward momentum, we need something to break out of the small window. Perhaps a series of worse-than-expected earnings, as we're in the thick of earnings season, or some other shock to the system. Those kinds of things can't really be anticipated, but when a breakout does occur, the MACD agrees that a downward movement is more likely than an upward movement.

Of course, we can't discuss stress in the market and not bring up everyone's favorite fear gauge.

StockCharts.com

The CBOE's Volatility Index, or VIX, is Wall Street's 'fear gauge', measuring volatility in the markets. When investors get jittery and uncertainty over the future increases, the VIX goes up. When markets are calm and the economy's looking good, the VIX goes down. As of the day this post was written (Tuesday), the VIX closed at 13.46, about where it's been since this past spring. That's something that I find a bit concerning.
As we described above, when volatility is low and investors are calm, the VIX is down. When you take into account that the 52-week range of the VIX currently stands at a high of 32.09 and a low of 11.02, you don't need a financial analyst to tell you that investors are pretty complacent with economic conditions right now. In some aspects, this is good; stock markets generally stay up during calm periods, enabling a prolonged, slow appreciation of capital if this calm period were to extend into the longer term. In other aspects, this is not good; investors are a little too complacent right now. The Federal Reserve is well on its way to boosting interest rates, either in its November or December meetings (likely the latter), and while experts are pricing this likelihood in, I don't believe the stock markets are doing the same. To some degree, this is warranted, as the FOMC has lost some credibility in the last few meetings after building up the case for a rate hike and then keeping rates steady. Despite this, I believe a correction will occur at some point if/when the markets realize that interest rates could very well rise in December. It shouldn't be a big correction, but at least a few days in the red ought to accurately price in a rate hike.

Another thing to discuss concerning the VIX is the Relative Strength Indicator, or RSI, placed above the VIX price chart. The RSI is an indicator of whether a security is overbought or underbought. Values above that dashed line at 70 indicate a security is overbought and a pullback in value can be expected soon. Similarly, values below the dashed line at 30 indicate the security is underbought, and a rise in value can be expected in the near future. The 'neutral' line is at 50, so anything between 50 and 70 generally is accurately priced but perhaps a bit too pricey, while anything between 30 and 50 is generally accurately priced but perhaps a bit too cheap for its real value. The VIX stands at about 46 at Tuesday's close, below the neutral line of 50 but not below the 'underbought' line of 30. In other words, volatility is about where it should be based on recent history, but might be just a bit too low. The RSI isn't perfect of course, but it's one of the more accurate technical indicators. Using the RSI, the VIX should be watched for a slight short-term boost.

Lastly, we apply the ADX we discussed earlier to the VIX. I'll save you the trouble of re-explaining the ADX and +/-DI, as it's all explained at the beginning of this post, so we'll just analyze the chart. The +DI line has exceeded the -DI line ever since the first few days of September, up until the last couple of days before this writing. Over the last few days, we've seen the -DI and +DI switching back and forth, seemingly fighting over which is more dominant. In a situation like this, I would call it neutral. But it doesn't really matter too much because the ADX itself (black line) is below that key 20 threshold, indicating there isn't really a trend present for the -DI and +DI lines to anticipate momentum. The momentum recently has been negative, and while that momentum and the trend are currently neutral, it could very well return and place continued upward pressure on the VIX.

Lastly, adding on to this theme of losing momentum and being stuck in a sideways pattern, let's check out just how low volatility has been, using numbers.

TradingViews

Shown above is the Dow Jones Industrials over the last year, with two price change windows on the right side of the chart. The larger window is where I measured the range in index values from highest close/open to lowest close/open. Since mid-August, a period of about 2 months, the Dow has varied by 626 points, or 3.36%. That's not much of a move at all, when looking at other 2-month periods over the last year. Applying the same method to the last month and a half, we get the Dow varying by 320 points, or 1.74%. These two price changes, particularly the window over the last month and a half, show this pattern we've been stuck in. The Dow Jones has been moving sideways on this chart, hence the 'sideways pattern' references. While there is downward pressure on stocks as we described above, until we get out of this pattern there's really nothing that can be done. Thus, we're waiting for an event that triggers either an upward breakout, such as a slew of much better-than-expected earnings from big companies, or a downward breakout, such as a series of poor earnings and a decrease in economic conditions. Time will tell just when this breakout happens, but until then, it's a waiting game. Which direction will it go? What will be the trigger for the breakout? Those two questions are at the forefront of my mind for the medium term.

Andrew

Yellen's 'High-Pressure Economy' May Pressure Stocks

Janet Yellen laid out her take on current monetary policy in Boston on Friday at a luncheon, describing how a "high-pressure" economy may be necessary in order to boost growth. The speech comes at a time when the Federal Reserve is divided on whether to raise benchmark interest rates this year, or keep them steady at their historically-low levels. (More information on her speech can be found in this link from Reuters).

I have a few concerns about letting inflation run temporarily hot.

FRED - Federal Reserve Bank of St. Louis

Shown above is the civilian unemployment from January 1948 to the most recent data point, September 2016. Shaded gray areas indicate economic recessions. There are two main take aways from this graph:

1. When looking at past economic expansions, a common signal that the expansion is coming to an end is when we start to see the slope of the unemployment rate line go to zero. This was seen prior to the recessions of 1970, somewhat in 1973-1975, again in ~1979 and ~1981, and notably just before the early 1990s recession, the early 2000s recession, and a bit before the Great Recession back in 2008. While one could nitpick and say the slope never did get to zero, merely eyeballing it shows that before recessions, the unemployment curve generally becomes flat, if not close to flat, as the economy reaches full employment.
Taking a look at our current position on the curve, we're right around (if not at) that point where the unemployment line's slope hits zero-ish. The table below illustrates this quite well:

The attached table shows civilian unemployment data from FRED, compared year-over-year for September of each year during the current economic expansion. We began the economic expansion in September 2009 with a change of -0.3% from then until September 2010. The YoY change in the unemployment rate from September 2015 to September 2016 was the smallest change throughout the entire economic expansion when looking at September YoY changes. I haven't run the data for all the months' YoY change, but going through a few more data points, it appears this could very well be the smallest YoY change throughout the entire expansion, including all months' YoY changes.
What does that tell us? Right now, the only thing we can plausibly assert is that the labor market is near full employment, based on how the slope of the unemployment line is getting closer and closer to zero. I don't believe this shows that a recession is barreling our way, primarily because the Fed is keeping monetary policy extremely accommodative and investor sentiment remains more-or-less high, though we saw an unexpected drop on the Consumer Sentiment Index on Friday. However, given the Consumer Sentiment Index is a lagging indicator, and by most other measures the domestic economy is still chugging along, I don't believe a recession is pending in the short-term.

2. Despite claims that the labor market is not yet at full employment, recent recessions indicate it could be. Referring back to the FRED unemployment rate chart, note how the minimum unemployment rate, or at least the point when the slope of the curve begins to flatten to zero, has been creeping up ever since April 2000, when it hit an expansion-low of 3.8%. The expansion-low prior to the Great Recession was 4.4%, hit multiple times from Fall 2006 to Summer 2007. Our expansion-low in our current economic expansion is 4.7%, from May 2016. The gradual uptick in apparent minima with respect to the unemployment rate could be a signal that our labor market is at full employment, in addition to the signal from the flattening slope of the curve.

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My other main concern resides in the fact that the stock market is already near record highs, and broke record highs this past summer. Allowing inflation to run hot could create a bubble, if one hasn't already been formed.

Big Charts - Marketwatch

The chart above reflects the DJIA's history through early 1988 or so, on a weekly scale. Note how we are currently just below record highs reached earlier in the summer. Record stock prices generally come about around the peak of a bull market, and it's been my belief for some time that we are either at the peak or just past the peak of this current expansion's bull market. But that's not my primary point of discussion relating to the stock market.

Extraordinarily-accomodative monetary policy in the U.S. for the last many years, and expectations of continued accommodative policy, has led to prolonged risk-on sentiment, as reflected in the record highs for all three major equity indices this past summer, and the near-record-high valuations at present date. Many financial analysts promote the idea that this accommodative policy has led to the 'Central Bankers' Bubble', named after central banks' continued enforcement of such monetary policy that some believe has blown a bubble in more than just one specific asset. To be sure, this is by no means a prevailing opinion, as far as I can tell, and the theory that we are mid-bubble does not stand for all financial analysts. However, I do personally believe that this is the case, at least to some degree, and this is where my concerns over a 'high-pressure economy' come to light again.

In a general sense, inflation is bearish for the stock market. When inflation begins to ramp up, typically the Federal Reserve will act to tighten monetary policy by hiking interest rates, thus placing a more risk-off sentiment across financial markets as investors leave stocks and seek safer investments, like bonds. However, if the Federal Reserve were to maintain low interest rates while allowing inflation to rise, the 'lower-for-longer' concept (the idea that interest rates will stay lower for a longer period of time) that has boosted stock prices over the last few years would persist. Inflation would begin to eat away at the stock market, and at that point the Fed would begin tightening monetary policy, but until then it would be a continuation of low interest rates and more-or-less tepid inflation, until the 'high-pressure economy' kicks in and inflation rises.
Why the worry? With inflation expectations so low, we could be talking about a number of years in a low interest rate, low inflation environment, which would almost certainly blow an equities bubble, if one hasn't already begun forming. Consequentially, if/when inflation reaches a point that the Fed deems as conducive to hiking interest rates, the pullback in stock markets would be far sharper than it would be if the Fed were to hike rates today.

In my eyes, the Fed has dug itself into a hole by maintaining interest rates for so low. To be fair, this was a good choice when you see how steadily the unemployment rate fell. However, good cases could have been made for a rate hike in the last few FOMC meetings, particularly after some FOMC members began taking far more hawkish viewpoints. Then, when they didn't hike, the Fed began losing credibility, but that topic is for another write-up. By allowing a low-inflation, low-interest rate environment to persist, possibly for a prolonged time period (longer than Ms. Yellen believes, as the FOMC is notorious in recent history for being too aggressive in their inflationary expectations), equities would almost certainly enter into a bubble, and if other assets also enter into bubbles as ultra-accommodative monetary policy continues, the pullback if/when tightening occurs could be nasty.

Lucky for us, all of this is hypothetical, and assuming the FOMC goes along with Yellen's ideals. While she posed the high-pressure economy as a 'question that needs more research', it's quite frank that she is looking for every excuse to not hike interest rates, and it's entirely plausible that the chairwoman is able to convince the FOMC to follow suit.

Andrew