April 2, 2004
Bonds Are Mauled
Asia was higher overnight. Japan picked up a percent and is back to just shy of its recent highs. Hong Kong and Taiwan both picked up a touch also.
Europe was up a touch this morning (but after the US payrolls number hit, it would leap to up 2 percent), and the US futures were flat. The unemployment report was what everybody had been waiting for all week long, and it hit the wires with a bang. The March unemployment rate came in at 5.7%, up from 5.6% in February, but the part that everybody was focused on was of course the nonfarm payrolls number. As we had been expecting, we finally got a whopper, as the government told us that we gained 308,000 payrolls in March (like I said, there were a lot of reasons to think that we could get a “fluke” today). There were also big upward revisions to the previous two months’ payroll data. The reaction in the market was immediate, and precisely what one would expect. The equity futures surged, bonds collapsed 2 full points, gold fell about 5 bucks, and the dollar soared.
We gapped up huge on the open in the S&Ps and NASDAQ, fluttered around near the highs for a bit and then slowly began easing lower, led by the financials, which were selling off in reaction to the bond market’s blowup. The S&Ps slid back to almost unchanged, while the NASDAQ held up much better and never really filled its opening gap at all. From there, another rally began as the bond market continued to basically flop around on its lows. The S&Ps bounced back up to well shy of their morning’s highs before rolling over to revisit the lows again as the bond market closed on its lows just ahead of the last hour. Meanwhile, during that same period, the NASDAQ made a new high for the day and never really came in much. Finally, both averages turned higher again in the last hour and basically melted up into the close, with the NASDAQ going out at a new high for the day and the very best levels of the session and the S&Ps falling well short of their opening highs but still returning to their afternoon highs for the close. Volume was extra chunky (1.6 bil on the NYSE and 2.2 bil on the NASDAQ). Breadth was barely positive on the NYSE but over 2 to 1 positive on the NASDAQ.
The semis were higher across the board by 2 to 4 percent. The equips were also higher by 3 to 5 percent across the board. The SOX jumped 4 percent to a new high for the recent move off the lows.
Part of the big move in the NASDAQ today was due to a 21 percent jump in SUNW (a $3 bil gain in its market cap) after MSFT agreed to a $2 bil settlement of all litigation between them.
The Internet trash was also higher. The tier 1 junk was up 2 to 3 percent, and the tier 3 trash was also mostly higher by 2 to 3 percent. Within the tier 3 trash, there were, however, a few upside standouts, as NTES jumped 7 percent and SOHU jumped 5 percent.
Financials were lower on the back of the collapse in the bond market. The BKX fell over a percent, and the XBD fell a touch. The derivative king fell a percent, BAC fell over a percent, and GE bounced over a percent. The mortgage lenders were ripped across the board on the back of slaughter in the bond market. Some of our high beta favorites led the way to the downside, as CFC fell 5 percent, LEND 8 percent, NFI 7 percent, and TMA 6 percent. A giant trap in the bond market appears to have been snapped shut today, and these mortgage guys are now all on the wrong side of it. And it’s likely only just beginning too, as today was in my opinion the beginning of something very ugly in the bond market and not the end of it. FRE rose a hair, and FNM fell a hair.
Retailers were mixed, with the RTH ending flat. The homebuilders were smoked by 4 to 5 percent across the board off the big backup in interest rates today. If the current move up in rates is only the beginning of something and not the end, then we can expect the housing stocks to come under further pressure, as rising rates begin to put even more pressure on a housing market that is already looking "toppy" for a whole host of other reasons.
Crude oil rose 12 cents. The XOI and XNG both rose half a percent. The CRB was flat, and the CRX rose a percent and back to just shy of a new high, as all of the commodity reflation trade shares once again surged. Gold opened flat in NY and immediately plummeted about 10 bucks as interest rates rose and the dollar correspondingly strengthened on the back of the strong payrolls number. Gold then stabilized and bounced to retrace about half of its gains, but the bounce didn’t last long, as the metal rolled over again to revisit the lows. The metal then drifted into the close near its worst levels of the session, but a closing spike helped it pick up a couple bucks and only finish down $6.30 to $422.40. Has gold double topped? Potentially.
The COT report also revealed after the close that the net spec long position in gold rose to a new record high of 178,000 contracts, and this is as of Tuesday’s close remember, so it’s likely much bigger than that considering that gold rallied into Thursday. If the dollar index breaks out to a new high for the move next week on the back of rising interest rates, which I think it might, it will be interesting to see what happens to the yellow metal. Everything is certainly set up for a massive spec liquidation.
The HUI gapped down about 5 percent at the open and then spent the remainder of the session rallying back to fill the gap to end down less than a percent. A couple of the gold miners that are still near their highs, like ABX (which has been lagging and is just now getting back to its 2002 high) and GLG, actually traded up a percent, which I view as noise, given that the rest of the sector is so far off of its highs. Still, the way the shares held up in the face of a weak metal today is somewhat encouraging for the gold bulls I suppose in very near term. But let’s remember that I have viewed the reluctance of the shares (which are priced based on where the market believes the sustainable price of gold is going to be in the future) to rally as more of an indication that the market did not believe in the sustainability of this latest push in the metal due to the probability of a coming dollar rally, illiquidity resulting from a huge decline in equities, a reversal of the reflation trade, etc. So far the shares seem to have been right, and we wouldn’t expect them to break down big until the metal played some catch-up, and collapsed through its recent uptrend. The strength in the stock market no doubt also put a bid under the shares today to some degree, as they have been trading more with equities of late than gold.
I still think the metal’s fate is tied to how all this reflation speculation in commodities and stocks ends (and obviously I am including silver in here too). A stronger dollar and rising interest rates are obviously not positive for the reflation trade, and if the dollar and interest rates continue to move higher, it should eventually begin to weigh on commodities and stocks. But, it still boils down to the fact that if stocks in general don’t fall apart, there’s little chance that either the gold shares or the metal will decline substantially. However, I don’t think today’s rally in stocks is indicative of their ability to ignore rising interest rates forever. Thus, it’s still difficult to get excited about the gold shares given that stocks in general continue to look like an accident waiting to happen.
The US dollar index one and a half percent and back to just shy of its high for the year. The yen fell nearly a percent is threatening to turn lower once again and put in a potential failed breakout on the charts. If the Nikkei finally begins to decline, foreign outflows will only put even more downward pressure on the yen, as foreign buying has been driving the rally in Japanese stocks lately.
The euro plunged nearly 2 percent and back to just shy of its lows. A breach of those lows would likely lead to a large move to the downside, and drag the rest of the G7 currencies down with it, including potentially the yen now that it has begun to falter as well.
Treasuries were buried, as the 10yr fell over 2 full points price and the yield rose 27 basis points to 4.14%, which makes this the biggest move since the LTCM crisis in late 1998. Fed funds are discounting a 100 percent chance of a rate hike in August at this point, but I seriously doubt this lunatic Fed is ever going to actually raise rates. That doesn’t mean, however, that the market won’t do it for them after having been artificially held down by BOJ buying over the past 6 months or so, and that’s exactly what I think finally started today. With today’s move being only day one of the collapse in the bond market, and a long-term trend line not too far away up at 4.29% on the 10yr, things could get even uglier early next week A quick glance at the chart of the 10yr’s yield reveals an enormous head and shoulders bottom spanning over a year, and with today’s move we are now breaking towards the neckline after completing the right shoulder.
With commercial banks engaged in what Steven Roach has called “the mother of all carry trades,” today’s massive break in the bonds is causing a lot of financial pain right now. Add to that the nature of mortgage related hedging, and you have the beginnings of a potential crash in the bond market. Can stocks and the housing industry handle a big rise in interest rates (which from these low levels doesn’t take much of a move in order to dramatically increase borrowing costs on a percentage basis)? I don’t think so. There’s simply too much leverage throughout the financial system to withstand a big rise in interest rates, and since the economy is based on our two favorite asset bubbles (stocks and housing), we may be potentially witnessing the early stages of the perfect storm. If this storm sounds familiar, that’s because this is a lot like what happened during the 1987 crash, except the economy wasn’t as vulnerable then as it is now and most of the damage was limited to the financial markets. It’s a little different from 1987 in that the BOJ has held back the natural forces putting upward pressure on interest rates as a result of the dollar’s decline for the past 6 months, such that the dollar may actually rally as rates rise, unlike in 1987 when the dollar continued to collapse and helped propel rates up due to foreign liquidation of treasuries.
Well, my hunch was right that the Bush administration would move heaven and earth (plus some help from the end of the California grocery strike, seasonal factors, etc) to get us a whopper of a payrolls number as the bond market and dollar’s response to it all, but as is typically the case, nothing ever works out quite like you think, as stocks never did come in today off of their initial celebration like I thought they would. Still, that doesn’t mean that today’s equity rally was not a giant head fake. For today, stocks focused on the good news in the payrolls data (that maybe the economy was actually taking off finally). But if interest rates continue to rise, which I think they will, that focus will quickly shift back to what has gotten the economy to this point in the first place: low interest rates (a.k.a.: massive leverage), which fed the housing bubble and partially reinflated the equity bubble.
A couple of things besides the collapse in the bond market jumped out at me today and make me question the sustainability of this rampjob that has been running nearly nonstop since last Thursday. First, the equity put/call once again came in at a low .53 today, which continues to suggest that this rally is on borrowed time due to the massive amount of call buying that has occurred during it. Additionally, the financials not only did not participate in today’s ramp but instead actually declined, and since financials are 21 percent of the S&P500, I find it highly unlikely that the S&Ps can rally much further from here without them.
A lot of times, we’ll see the initial reaction to an unemployment number reversed out the following Monday and a complete reversal begin, as we did last month where you’ll recall that we rallied that Friday on the data only to plunge the following week. So while it’s a little disturbing to see the NASDAQ recover the 2000 level and the S&Ps gain more ground, I’m not willing to toss in the towel just yet. This sort of a sharp rally is still consistent with the sort of wild (but failing) rally that you get at major speculative tops before a potential collapse. And with interest rates now moving up sharply, which are going to negatively impact liquidity, a sharp reversal and a return to the lows is still a high probability sometime early next week. Remember, we’ve had all asset classes melt up together over the last year: stocks, bonds, real estate, and commodities. Meanwhile the only thing that has gone down was the dollar. This was called “the reflation trade.” We’re now looking for that trade to blow up, and all asset classes to decline together as the dollar likely rallies, giving us what I like to call a “deflationary panic.”
Disclaimer: Lance Lewis periodically publishes columns expressing his personal views regarding particular securities, securities market conditions, and personal and institutional investing in general, as well as related subjects.
Mr. Lewis is the president of Lewis Capital, which manages a hedge fund in Dallas, Texas. This fund regularly buys, sells, or holds securities that are the subject of his columns, or options with respect to those securities, and regularly holds positions in such securities or options as of the date those columns are published. The views and opinions expressed in Mr. Lewis' columns are not intended to constitute a description of the securities bought, sold, or held by the fund. The views and opinions expressed in Mr. Lewis' columns are also not an indication of any intention to buy, sell, or hold any security on behalf of the fund, and investment decisions made on behalf of the fund may change at any time and for any reason. Mr. Lewis' columns are not intended to constitute investment advice or a recommendation to buy, sell, or hold any security.
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