A Glimmer of Hope, At Least for Base Metals

By
Eric Coffin  

It’s all good. Just ask
Janet Yellen or any hawkish Federal Reserve board member.  Indeed, there have been some better readings
on the US economy lately but things are far from outstanding. 

Plenty of equity traders
suddenly expect new highs on the major markets any day now.  The bond market is pricing in 70%+
probability of a December rate hike. 
This time around markets are not jittery because the Fed has assured us
offshore problems won’t touch the US. 
Let’s hope they are more right about that than they were four short
months ago.

As noted in the editorial if
this new narrative holds we’re back to the situation we were in early in the
year in the metals markets.  Hoping the
Fed just gets it over with so traders can stop obsessing over and shorting
because of a potential rate hike.  As
strong as the Dollar has been I remain a skeptic about the 120 USD Index
predictions that are now common.  If that
comes to pass it will obliterate the US manufacturing sector.  The equity rally is already a pretty narrow
one.  More sectors generating negative
earnings growth might be too much to bear.

One thing to look ahead to
is tax loss selling season.  After that
we may actually see inflation start to turn up as lower energy and material
prices are fully reflected in year over year comparisons.  That could make real rates more negative
again which would support metals prices. 

   Eric Coffin

Major markets have continued to
rally. All is forgiven and forgotten after the August Scare.  Best of all, well known economic
prognosticator Janet Yellen assures us that everything is awesome.  What could possibly go wrong?

The rally and the “new” reasons for
the rally are not good news for gold and most other metals—though they would
ultimately help some base metals if the optimists are right this time. 

Sentiment in the gold market turned
extremely negative very quickly and we are in the midst of a test of the
$1180-1190 level. It’s too early to say whether that level will hold but its
clear most traders don’t expect it to. 

An important aspect of the gold market has always been the
“anti-Dollar” trade. Look at the USD chart below and it’s clear why gold’s
bullish followers suddenly vaporized. 
The combination of a hawkish sounding (they really mean it!) Fed talking
about a December rate hike and a very strong October payroll report has the USD
surging.  There are plenty of chartists
around calling 120 targets on the USD Index. 
I remain skeptical about that level of strength for reasons noted later
in this editorial but a breakout is clearly in play.

We’re most of the way through
earnings season. For all the hoopla, this hasn’t been an outstanding one even
outside the energy and materials space. 
Lots of misses on the revenue side and it still looks like earnings will
come in down three or four percent quarter-over-quarter.  Even that result took quite a bit of
accounting magic to pull off.

The current rally is all about
central bank speak. Comforting words from several

central bankers have traders fully
into “risk on” mode once again. 

Note that I consciously chose the
term “words” not “deeds”.  I think the US
Fed is the most serious.  The Fed board
clearly took the message of the market seriously after the September
meeting.  Yellen and Co have decided the
price of waiting until 2016 is a complete loss of credibility.  I agree with that. 

The Fed has telegraphed this minor
rate hike far too much to back down now. 
With the strong payroll report we’d have to see some really awful
economic metrics before the next meeting to forestall a hike. 

The Fed now feels potential market
fallout from a small rate increase is smaller than the potential fallout from
traders losing faith in central bankers. 
That should have been obvious before the September meeting but it apparently
took a shellacking from traders to get across.

Traders aren’t happy there is a
probable rate hike in December. They’re happy about the reasons given to
justify it.  The latest Fed rate decision
removed all the negative language about offshore problems and their potential
to impact the US. 

It’s more than a bit strange all of
that is suddenly not a problem.  While
it’s easy to be cynical about central bankers it’s clear traders still hold
them in higher esteem than they claim to. 
No one questioned the sudden about face.

The damage done to commodities and
gold wasn’t just based on the Fed.  It
was the combination of the Fed all but promising a rate increase in December
and promises of easing from other central banks. 

China’s central bank cut both
interest rates and the bank reserve ratio again. Trade figures released since
then were weak.  The Shanghai exchange is
enjoying an impressive rally of its own, in part because traders assume we’ll
see more and broader stimulus.

The Bank of Japan made no new
promises but just about everyone expects an expansion of their QE program.  Japan’s Q3 GDP reading should be out shortly
after this issue.  Based on a slew of
weak economic readings there is a good chance that reading will be
negative.  That means Japan has probably
entered its umpteenth recession in the last decade or so.  QE doesn’t really seem to be working that
well for the Bank of Japan but traders are convinced it will double down.

The final piece of the puzzle came
from the ECB.  Mario Draghi didn’t
actually DO anything at the last ECB meeting but he promised to do
lots.  Disappointing, though not
terrible, readings from the core countries and continued lack of inflation has
the central bank on edge.  Draghi
promised an extended and expanded QE program and perhaps more if the inflation
picture doesn’t improve by December.

Traders have gone all in on the
“it’s all good” narrative suddenly emanating from the Fed.  Combined with good earnings from a few of the
companies that account for most of the rally (think Amazon and Alphabet) has
the S&P back to the top of its range and only a couple of percent off its
record high.

The combination of strong dollar
and faith in central banking has hit commodities again.  Expectation that virtually every central
bank outside the US will increase stimulus added to the assumption that US
growth may be quickening again has lit a fire under the USD.  How far will this trend go?

The charts above show the S&P
and Value Line indices we’ve been tracking. 
Like the last couple of times we looked at these to indexes together a
considerable divergence remains.  It
looks better than it did a month ago but relatively weak XVG shows the rally is
still a narrow one.  This could still
resolve in the favor of the S&P if the rally broadens.  It may do that if we see new S&P highs
but the narrowness of the rally means it’s still prone to failure. 

The US will report retail sales for
October a few days after this issue goes out. 
A good gain in retail sales, say 0.4% or better, could be the final
boost needed for new highs.  Conversely,
a weak reading would call the growth rate for Q4 into question again.

Another red flag for equities is
the stubborn refusal of bond traders to get fully on board.  The very long term chart below displays the
Dow Jones average against Aaa bond yields. 
There have only been a handful of times (about one per decade) when both
equities and bonds sold off significantly together.  The most recent occurrence was last
month.  Because bonds (at least
government and highly rated corporates) are considered safe havens you tend to
see yields drop as traders shift money into their perceived safety when the
stock market is falling.  The reason why
this doesn’t happen occasionally isn’t well understood but the assumption is
that bond traders are seeing increasing risk in corporate debt.

Bond traders have a good track
record for seeing risks early.  That is
borne out by the fact the DJIA dropped 10% or more within six months in every
instance when the DJIA and bond indices saw large simultaneous selloffs.

This time could be different.  There’s very little “normal” about the cycle
we’re in.  That said, it’s important to
remember how central share buybacks and leveraged takeover transactions have
been during the post 2009 rally.  They
have provided a substantial percentage of the buying volume across the major
markets.

Almost all that buying is debt
funded.  The bond market’s willingness to
let companies leverage their balance sheets provides much of the fuel for this
bull market.  Equity traders can’t shrug
off bond traders and expect to see the rally continue unless a new source of
buying appears.

Near term prices for most metals
will be tied to the USD.  With central
bank divergence expected traders have gotten very bullish on the USD and I have
seen several analysts targeting the 115-120 level.  Perhaps, but there are reasons to think
things won’t go that far.

Short term the USD is very
overbought, which should lead to some easing. 
Medium term, the high targets assume not only a Fed rate increase but
significant easing by other central 
banks, the ECB in particular (the Euro makes up more than 50% of the dollar
index weighting). 

Draghi has certainly made promises,
but so far they are only that.  Interest
rates are already zero (or less) across the continent.  Draghi is hoping to bring down the Euro to help
reverse deflationary forces. His dovish call and the Fed’s newfound backbone
has already moved the Euro from $1.15 to $1.07 in a couple of weeks. 

A 115 to 120 level for the USD
index implies a Euro well below parity, as low as 90 cents.  That’s possible but not likely unless the EU
economy really falls apart.  Germany has put
up some weak manufacturing numbers (like everywhere else) but there have been
more positive than negative surprises in EU data.  Draghi and more hawkish ECB board members
could well decide the Fed has done their work for them and stand pat.

At a more general level, a USD
index above 110 means huge pain for the US manufacturing sector and more
emerging market dislocations.  We could
see a repeat of the issues that generated the August Scare.  The latest trade report from China was quite
weak and the biggest negative surprise was exports.  The world biggest exporter reporting lower
sales for the fourth month in a row says something.  The Fed needs to be proactive but I could see
currency traders reversing the USD bullish move well below the levels targeted.

With a rate increase on the table
we’ll just have to see how things play out. 
I’m skeptical we see levels for the USD being targeted and wouldn’t
underestimate the dangers to the market from renewed weakness in manufacturing
and refusal (so far) of the bond market to play along.  Equity traders are overwhelmingly bullish
again which should add a cautious note by itself.

Gold is already back near its July
lows.  It won’t take much to push it
lower.  Unless we see move higher of at
least $40-50 (to start) assume lower lows are in play.  We’re back to the pre-July scenario of
hoping the Fed just gets it over with. We may need that rate increase to put a
bottom in on bullion.  In the meantime we
are seeing more supply response from base metals, copper and zinc
particularly.  That could breathe a bit
of life into those sectors.

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