Identifying trends is one of the most important jobs of a market technician. Regardless of our time horizon, we have to understand the general direction the market is taking.
It sounds simple, but it’s the foundation of any market thesis.
Once we have the underlying trend nailed down, we can focus on the areas of the market we want to exploit and pinpoint the best tools and strategies to do so.
When I think of the most critical trends to date, my mind immediately goes to interest rates. Rising rates and inflation have been the key drivers for two years now.
Despite some corrective action in recent months, the bond market has been reminding us that we’re still in a rising-rate environment.
Let’s take a look.
First, we have an overlay chart of the US 10-year breakeven inflation rate and the US 10-year yield:
As you would imagine, yields and inflation rates tend to follow one another over time. Rising rates and inflation go hand in hand.
But these charts will often highlight valuable divergences.
Most recently, the 10-year breakevens made a lower high after peaking in April as the US benchmark rate continued to catch higher.
This turned out to be a poignant heads-up as both corrected lower into the summer.
Over the past few weeks, US yields and inflation rates have been rising together again. It appears the recent correction was nothing more than a countertrend move.
With the primary uptrends assuring us they are still intact, we want to lean on the areas of the market that benefit most when rates are on the rise.
That’s right, cyclicals!
We’re already starting to see money flow back into cyclical value sectors of the stock market, such as energy, materials, and industrials. These stocks are starting to impress again after digesting previous gains.
But, as inflation persists, we can’t leave commodities out of the conversation.
Here’s an overlay chart of our equal-weight commodity index and the 10-year breakeven inflation rate:
Our commodity index and the breakeven inflation rate look almost identical. That’s because commodities are inflationary assets.
When inflation is on the rise, commodities are usually doing well.
Even with the slightest rise in breakevens recently, commodities across the board have dug in and caught higher.
Natural gas hit fresh 14-year highs, cotton trading halted limit up, and grain markets resolved higher from critical support levels.
This is the type of market behavior we would expect in a rising rate environment. And it confirms our structural market outlook and our commodity supercycle thesis.
To witness both rates and inflationary assets catch higher while energy and material sectors assume leadership just adds to our conviction.
Now, all we need to do is prepare accordingly and position ourselves for a fresh leg to the upside. Stay tuned.
Countdown to FOMC
Following the release of the minutes from last month's Federal Open Market Committee meeting, the market is pricing in a 75-basis-point hike in September.
Here are the target rate probabilities based on fed funds futures:
