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- Interim Update 22nd June 2016
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Negative bond yields
and negative interest rates are very different things
You have probably read that more
than ten trillion dollars of governments bonds now have negative yields.
In case it isn't already understood, this doesn't mean that the bonds in
question have negative interest rates. It means that the bonds have what's
called a negative yield to maturity (YTM).
If a bond had a negative
interest rate then the holder of the bond would have to make regular
interest payments to the issuer of the bond. This is obviously not
happening and could never happen in the real world. The fact is that the
holders of the bonds with negative yields are still receiving interest
payments; it's just that if these bonds were purchased at their current
prices and held to maturity then the net result for the bond-buyer of the
interest payments and the full repayment of the principle would be a
nominal loss.
To further explain, if a bond with a par value of
$100 is purchased at a 20% premium (that is, at $120) then the yield to
maturity will be negative (the bond will be said to have a negative yield)
if the cumulative value of the interest payments over the remaining life
of the bond is not high enough to offset the initial $20 price premium.
It is therefore possible for any bond to have a negative yield -- it
just depends on how much is paid for the bond. Furthermore, a bond with a
coupon (interest) rate of close to zero would have to trade at only a
small premium to its par value to push its YTM into negative territory.
There is therefore a difference between a negative bond yield and a
negative interest rate, although the two are often conflated. For example,
a negative interest rate is applied to money deposited by commercial banks
at the ECB, which means that the commercial banks regularly have a tiny
portion of their ECB deposits removed, whereas the holders of all
negative-yielding government bonds are receiving payments of interest.
Nobody would choose to accept a negative interest rate, but commercial
banks in the euro-zone don't have any choice in the matter and it's
possible that depositors at commercial banks will -- if the Keynesian
death spiral continues -- eventually have no choice in the matter. As is
plainly evident, however, the alternatives have become so risky that many
large investors are now CHOOSING to pay such a high price for
relatively-safe bonds that the bonds have negative yields.
Has the Brexit reaction
already happened?
It became clear a couple of
weeks ago that Britain would probably vote to stay in the EU. This is
based on how people were betting. When the opinion polls say one thing and
the betting odds clearly say the opposite, the betting odds will usually
be right. There is still some uncertainty, meaning that there is still a
chance that the "leave" side could win. However, the chance is now small.
With the financial markets having apparently gone a long way towards
factoring-in a "stay" result it is probably the case that the post-vote
reactions we've warned about (relief rallies in stock markets, price
declines in 'safe-haven' assets such as gold and T-Bonds) have, to a large
extent, already happened. There remains sufficient uncertainty that there
will still be a noticeable market reaction to news that the "stay" side
has prevailed; it's just that the reaction won't last more than two days
and could be over within a few hours of the news. Traders/investors will
then go back to discounting other information and expectations.
Of
course, with the financial markets having gone a long way towards
factoring-in a "stay" result, a "leave" result would now come as a shock
and prompt a much larger market reaction. In this case, gold and T-Bond
prices would likely spike well above their 2016 highs while the S&P500
Index would drop well below important short-term support at 2040. However,
even if the vote result is a surprising victory for the "leave" side, the
market reaction will probably still be over within a few days.
The Stock Market
The S&P500 Index (SPX) has
essentially been marking time for more than two months. Over the past few
days it has rebounded in response to the ramping down of "Brexit" worries,
but the rebound hasn't changed anything.
As previously advised, it
needs to close below 2040 to signal the start of a meaningful decline. If
this were to happen in the days following a British decision to remain in
the EU it would be particularly significant as the breakdown could not
then be blamed on a disruptive news event.
The Dow Transportation Average (TRAN) is possibly leading the SPX to
the downside, but it, too, needs to break below support to signal the
start of a meaningful decline.
As illustrated below, TRAN made a
double top during March-April and made what could turn out to be a double
bottom during May-June. A solid close below 7500 would eliminate the
double bottom possibility.
Note that our short-term bearish outlook for the stock market has
nothing to do with "Brexit", although in the unlikely event of a "leave"
result the ensuing stock-market swoon could prompt us to take some profits
on bearish speculations.
Gold and the Dollar
Gold
The
US$ gold price broke below support at $1280 on Tuesday 21st June. This was
a bearish signal because it established a failed upside breakout, but, as
has happened on multiple occasions over the past few months, the
superficially bearish price action in the bullion market was not confirmed
by the gold-mining sector. As discussed below, the gold-mining indices and
ETFs did nothing over the first three days of this week to reduce the
chances of moves to new 2016 highs in the near future.
Gold's
closing price on Wednesday 22nd June was roughly the same as its intra-day
high on 11th February. This means that the gold price has made no upward
progress in almost 4.5 months. However, it's fair to say that aside from
the short-lived breakdown in late-May there has been a slight upward bias
in the price action over the past 4.5 months. The upward bias is indicated
by the channel drawn on the following daily chart. During the May
correction it wasn't until this channel was breached that the gold-mining
stocks started to take the declining gold price seriously.
Gold's price action over the remainder of this week will obviously be
dominated by Britain's EU referendum. A vote in favour of "Brexit" would
probably cause the gold price to surge well above last week's high of
$1320, whereas a vote in favour of remaining in the EU would probably have
a smaller effect because the financial markets have already gone part of
the way towards discounting this outcome.
By the way, it's very
unlikely that a Brexit-related surge in the gold price over the next few
days would result in SUSTAINED price gains. This means that if it happens
it should be viewed as a short-term SELLING opportunity, not as a reason
to anticipate a multi-month or even a multi-week extension of this year's
rally.
Gold Stocks
As mentioned above, for
not the first time over the past few months the gold-mining sector hasn't
confirmed weakness in the bullion price. The lack of confirmation is
illustrated by the following chart, which shows that over the first three
days of this week the HUI continued to consolidate within striking
distance of its year-to-date high. Furthermore, the overall pattern since
the 2nd May high now looks far more like a routine short-term correction
than an intermediate-term top.
The chart pattern of the Junior Gold Miners ETF (GDXJ) is a little
different, in that GDXJ broke above its 2nd May high earlier this month
and has since done nothing more on the downside than test its upside
breakout.
The upshot is that the gold-mining sector took gold's break below
$1280 in stride.
Channel support for the gold price is presently at
$1257-$1260. It seems that this is the support that will have to be
breached to bring about significant weakness in the gold-mining indices
and ETFs. Looking at it from a different angle, if the gold price is able
to hold this support (on a closing basis) in the wake of a "stay" result
in Britain's EU referendum then the gold-mining indices will have a shot
at making new highs for the year next week.
Of course, if the Brits
choose to leave the EU then a breach of gold-price support will not be a
near-term issue.
The Currency Market
The
British Pound is naturally the focus of attention and the major currency
exhibiting the greatest volatility at the moment.
The Pound
reversed upward during the final two days of last week as the financial
markets began to discount the increasing likelihood that Britain would
vote to remain in the EU. After testing important support at 1.40 only 5
trading days ago it is now testing important resistance at 1.47. It
actually closed slightly above the aforementioned resistance on Wednesday
22nd June, but for the breakout to be genuine it will have to be confirmed
by the weekly close.
Due to the position-squaring that occurs prior to the end of each
trading week, the weekly close will always be more important than the
daily close in any market. This week, however, the weekly close will be
more important than usual due to Britain's critical referendum.
The
referendum takes place on Thursday in the UK, but the outcome won't be
known until Friday morning. The outcome will almost certainly be known by
the start of North American trading on Friday, which means that the US
futures markets and stock market will have an entire trading day to react
to the news prior to week's end.
Friday should therefore be a very
interesting day in the financial markets, with the greatest interest (to
us) being the closing prices. We will be especially interested to see if
the immediate -- and largely predictable -- reactions to the referendum
result are sustained.
With one exception we are not attempting to
trade around the Brexit vote. The exception is the British Pound
speculation* that we first outlined several weeks ago. The plan for this
speculation was to average into a long position in the Pound on weakness
during the lead-up to the 23rd June "Brexit" vote and to then either exit
(take profits on a rebound) following a win by the "stay" side or double
the position following the sharp -- and totally unwarranted, since leaving
the EU would definitely be an economic plus for the UK -- sell-off that
would be provoked by a "leave" result.
The plan is mostly
unchanged. In particular, if the result is "stay" then we will exit our
Pound position on Friday. Also, we will exit on Thursday if the Pound
rallies to around 1.50. If the result of the vote is "leave" then we will
wait a few days for the 'dust to settle' before adding to our existing
position or establishing a new position.
*This
is a trade that we have discussed at TSI and are doing in our own account
but is not part of the TSI List.
Updates on Stock Selections
Notes: 1) To review the complete list of current TSI stock selections, logon at
http://www.speculative-investor.com/new/market_logon.asp
and then click on "Stock Selections" in the menu. When at the Stock
Selections page, click on a stock's symbol to bring-up an archive of
our comments on the stock in question. 2) The Small Stock Watch List is
located at http://www.speculative-investor.com/new/smallstockwatch.html
Chart Sources
Charts appearing in today's commentary
are courtesy of:
http://stockcharts.com/index.html