Bear Minimum

What does the market need to go into full on bear mode?

Your humble scribe, pictured above, is patiently waiting, playing lots of guitar while the scenario unfolds.

Let's see... we have decelerating earnings, weakening breadth, underperformance from banks, small caps and the non confirmation from volume based measures. Investor confidence has again been shattered by a reckless and arbitrary trade war. International markets are in downtrends. And if the bond market with its $16 Tn of negative yielding doesn't scare you enough, just take a peek at the downtrend in high yield versus the 10 Yr Treasury market - not good.

Bears are known to charge at their intended prey but hold back at the last moment. These false charges, while scary, are actually a defense mechanism, designed to avoid actual contact. Bears would rather not engage in full-on conflict if they can avoid it. That's why making noise while hiking in the woods actually is surprisingly effective in avoiding interactions with our ursine friends.

Last week was just such a bluff charge in the markets.

Still, I feel we will need something more to prompt a major decline. Now, I believe it may yet come.

Policy error is brewing in the debate over the appropriate level of interest rates.

Federal Reserve governor Eric Rosengran laid it out plainly yesterday. He is firmly of the view that the U.S. economy is the only thing that matters. That is the root cause of my concern. The reserve currency of the world is being run by ethnocentric bureaucrats with no interest in breaking with conventional thinking.

The mandate of the Federal Reserve is simply to evaluate U.S. data on unemployment and inflation and make appropriate changes to policy based solely upon this data.

How 1950s of them.

It seems to be lost on the U.S. that isolationism is a bad thing. There is not much debate abut the economic damage created by the increasingly 'U.S. first' policies emanating from the Orange-tinted White House.

That doesn't bother me all that much. There could actually be some long term benefit from this trade war. The creative destruction of the world trade system that may be wrought from this messy battle will likely reduce imbalances, ultimately improving economic stability.

Now, I worry more about the instability created by a monetary policy regime that is similarly xenophobic. For the U.S. Federal Reserve to continue to deriving signals from a solely domestic data set is increasingly dangerous in today's financially linked world. They need to address the dichotomy of their narrowly defined, domestic-centric mandate, one that directly is increasingly out of step with reality of the U.S. dollar as the world's de facto reserve currency.

Hence the impending policy error du jour. The slow water torture of a series of 25 basis point Fed rate cuts, priced in to the curve, is directly at odds with the emergency level stimulus being contemplated by the ECB. I know they aren't saying so, for fear of stoking financial panic in the Eurozone, but what else can you call the unprecedented regime of negative administered rates now distorting their risk markets. Germany will be issuing a 30 year zero coupon bond at par this week. Really??

So in the past week we have seen a head-snapping plunge/soar in the U.S. market that has seen more than few traders whip-sawed. Trump's reversal on the timing of tariff implementation is the root cause of the symmetrical volatility swings witnessed last week. But sharp eyed Tuesday at 11 readers knew that the 2020 election strategy is inextricably linked to the derivation of fiscal/trade policy. My final paragraph in last week's missive was eerily prescient.

But the downward trajectory in risk appetite is likely to quickly resume as a result of a collective realization that the Fed is behind the curve. There continues to be rapidly multiplying deflation threats coming from the global economy. Home Depot earning's this morning provide yet more evidence of this. The recent sharp deflation in lumber prices has taken a chunk out of their Q2 numbers.

As the U.S. dollar continues its inexorable climb towards the economic pain threshold of the global economy, pollyanna investors continue to hang on the their bullish dreams. But they are likely to be confronted by a bear at some point in the hike through the economic woods. I don't think it will be bluffing next time.

Risk Model: 2/5 - Risk Off

The only two factors that remain positive in the model come from the market itself. The XIU RSI and 200 DMA signals are are stuck in neutral.The VXV (3 month VIX) AAII Bull/Bear ratio and Copper/Gold are all signaling caution.

It seems the gold market is gathering itself for another run after getting a bit extended. This would be seasonally consistent given the chart below. Any environment in which gold outperforms a rising U.S dollar is inherently unstable. This can only help to reinforce the risk-off signal from the model.