Chicken Out

Bad news makes headlines; good news makes money.

Unfortunately for bond market participants, the headlines these days are all bad. The failed MOU and renewed war in Iran have rekindled inflationary pressures in commodities. New tariffs announced on Canadian goods have U.S. consumers bracing for more price hikes. The data center buildout has been a tsunami of supply in the credit market. Internationally, there is nowhere to hide. Global bond yields are simultaneously rising on ballooning government budget deficits and weakening currencies.

To top it all off, the bond market is experiencing an existential threat. Debasement isn't a place to hide from a tornado. It's a de facto policy of the U.S. Treasury and the Fed. Both Kevin Warsh and Scott Bessant have been given their marching orders from DJT and his flying-monkey advisors, Navarro and Lutnick. They are desperate to keep rates low, one at the short end, the other at the long end. But despite the massive negative momentum arrayed against them, they persist in their views, lest they draw Trump's ire.

So why are stocks just yawning? Why is implied vol at a two-year low? Why is the average target from strategists still higher? Where is Chicken Little when you need her??

It's the economy, stupid. Or at least the part that is responsible for the biggest annual growth rate in decades - the AI boom. I call it the AI-conomy, and it's 'strong like bull'.

The 'growth' narrative has driven stocks since the decline in short-term rates in early 2025 kicked off this cyclical bull run. Actually, stocks have been running hot since the end of rate hikes became evident to the bulls in late 2024. Starting with 'Magnificent Seven' dominance, markets have morphed into a narrative of AI mania. The rest of the market has now been dragged kicking and screaming into this bull, but make no mistake; everything from financials to copper has been gilded with AI gold.

This bull will end if, and only if, the Fed raises rates enough to cause a recession. In his speech at Jackson Hole, the Fed Chairman took a hawkish tone. But talk is cheap, and try as they may, the FOMC can't talk the bond market into lower yields. Kevin Warsh actually said that the bond market may do what the Fed is unwilling to do - restrict the economy into a lower inflation trajectory. But be careful what you wish for, Kevin; stocks won't like 5% yields. The bull market wall of worry has added another brick.

And Scott Bessant is working at odds with his failed, feeble attempt at yield curve management. His attack on Druckenmiller fell flat with this week's bond yield surge. And banning Bloomberg from the G20 won't help either. Shooting the messenger often backfires - just ask Pierre Poilievre after his attack on the CBC.

So with earnings growth at record levels, investors' preference for stocks over bonds is keeping the markets afloat. Momentum of earnings has seduced the bulls to make one last run for the roses. All the while, the cost of capital on the debt side continues to rise. I remember saying in April, as Trump's war scared the markets, I advised buying the dip, thinking that it was a survivable supply shock. Then Trump cornered himself into a forever war that has elongated the economic and financial stress on the system. At the same time, the AI build exacerbated supply-side pressures in the credit markets, thereby raising the clearing yield of corporate debt. Cue the boiling frog analogy for stocks.

Remember, higher yields mean lower multiples. And as October 1987 taught us, they could happen virtually overnight. Although it was a painful experience, it was actually not the end of the bull market. That came well after the economy finally succumbed to the credit crunch and housing markets came off the boil in late 1989. It demonstrates the difficulty of using a blunt instrument like the Fed Funds rate on a hot economy. But a correction is brewing underneath this market once the Fed starts to act.

So keep some dry powder here for the September Fed meeting. Upcoming data releases on employment and CPI hold the key. If the Fed hikes on strong data, a knee-jerk stock sell-off of limited magnitude and duration is likely, but bonds should strengthen and stocks should recover. If they don't hike in the face of strong data but hold rates steady due to political pressure, a bond sell-off will reflect a higher term premium, reflecting fears of debasement and leading to a sharp decline in stock prices (the 1987 scenario). If data suddenly weakens and they don't hike, it means earnings expectations will reverse lower. All outcomes are initially bad for stocks but have differing longer-term implications.

So you can ignore the 'falling-sky' bond markets only for so long. They are sending a signal here. Sorry to be a Chicken Little, but that's what I see here.

Risk Model; 3/5 - Risk On

A small correction has generated a bias towards buying the dip here from the model. But it could easily reverse if there is follow-through on the downside, as the RSI indicator will fail. The chart below shows a break of the monolithic uptrend evident in the TSX since the May rally started. Both the Cu/Au and AAII Sentiment indicators have remained bearish, and the $VXV is likely to have bottomed out now that the summer doldrum lows are behind us. Ignore this week's Risk Model signal, as the declining CMF (volume confirmation of price) and sharp trend break are flashing sell signals.