The Difference Between the ECB and the Fed

The European Central Bank (ECB) announced that it would be reducing its asset purchases from €60 billion down to €30 billion starting in January 2018. This, of course, means that the ECB will be buying less of the debt supply which in turn means that the bund rate should be increasing. That, however, is not what is happening; the yield on the bund has gone from 0.50% to 0.30% since the ECB announcement.

At the same time, the ECB increased its GDP growth outlook for 2018 from 1.8% to 2.3%, and the manufacturing PMI for the eurozone printed at a record high of 62.0. The implication is that economic conditions are improving in Europe, yet the ECB’s policy rates remain at ultra-low levels. This seems like an incongruous divergence, but it makes sense when viewed in the context of the ECB’s one-and-only mandate of maintaining inflation rates below 2%. Despite GDP growth in 2017, inflation has decelerated from 2.0% in February, to 1.5% today, so the ECB has no need to raise rates.

The Federal Reserve, on-the-other-hand, has a dual mandate to maximize employment and maintain price stability (keep inflation in check). Because of gains in U.S. employment, the Fed has been raising interest rates while the ECB has not. This has pushed European buyers to join Japanese investors in a search for yield which is found in the 10-year and 30-year Treasury bonds. The difference between the 10-year Bund and US Treasury is -2.05 (chart below).

The resulting demand for long-dated U.S. Treasuries has kept their rates low even while the 2-year rate climbs steadily in response to increasing Fed funds rates. As a consequence, the 10-y minus 2-y rate curve keeps flattening, but has yet to invert. Until the U.S. Treasury rate curve inverts, we see no threat to the equity bull market, but we continue to expect some sort of correction in the near-term.

Equities

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The AAII investor bullish sentiment jumped 8.1% to 45%, while the bear and neutral sentiments dropped 6.1% and 2.0% to 28.1% and 26.9% respectively. This puts sentiment closer to levels that correlate with local market tops (chart below).

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The NAAIM index 50 MA continues to roll-over while the SPX charges higher. This negative correlation is similar to what preceded the 2015 double-dip correction. The fact that the market has refused to correct a healthy 3–5%, could mean that in the near future (first week of 2018?) the correlation will revert to the mean with a more substantial 10–15% correction in the S&P 500, like it did in 2015 (chart below).

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The VIX volatility index has reversed course putting the pattern in jeopardy. Although the pattern is not completely invalidated at this point, it does reduce the probability of a near-term correction. This fits with our present view that a correction may not appear until the new year (chart below).

The put-to-call ratio continues to turn upward. If this continues, there is an 80% chance of a correction (chart below).

Technical
The long-term technical averages continue to demonstrate a late-stage bull market and no warning signs are evident. The 8-month moving average falling below the 12-month moving average, would be a long-term bear signal. The ADX trend still has room to move up before it bumps up against the down-sloping major trend (blue dashed line on chart below).

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Fundamentals
The 10-year minus 2-year rate differential continues to drop, but is still in positive territory. Its slope points to another 12-to-18-months before the probability of a recession becomes significant (chart below).

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Oil

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Gold

Last week we wrote, ”Having reached support, gold is likely to bounce slightly to the $1265 resistance before continuing its slide” and gold remains on track to do just that.

Long term, gold continues to fit the head-and-shoulders pattern and is set to break below the upper trend line (chart below).

The USD/JPY FOREX ratio continues its bounce off of the 38% Fibonacci retrace. The uptrend continues at this point (chart below).

Gold has reversed last week’s divergence from the inflation expectation (TIP), but the negative correlation has yet to turn around. Either gold continues to rise along with TIP, or TIP drops along with gold. The last time this negative correlation occurred was August 2016 which led to weakness in gold at that time (chart below).

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Forty years of private equity trading, and still learning.