China and Russia Sign Major Gas Deal, Bypass Dollar

Thu, May 22, 2014 - 8:27am

China and Russia just signed a huge natural gas deal that has been in the works for nearly a decade. The 30-year agreement will provide China with over $400 billion dollars’ worth of natural gas. This deal comes at an interesting time considering the situation in Ukraine. As events unfold, the European Union has been trying to find alternative sources of gas in anticipation of the Ukraine crisis causing supply disruptions. Nearly a third of Europe's natural gas comes from Russia, with about half of that traveling through Ukraine.

By signing this agreement and expanding their gas market, Russia is protecting its interests and reducing economic risk. According to Capital Economics, gas exports in Russia account for roughly 10% of total exports and 6% of government revenues. The prospect of energy related sanctions, which the EU has been reluctant to impose so far due to their heavy reliance, has been a concern for Russia.

What is not being outwardly discussed is that this trade agreement is the latest to bypass the US dollar. China and Russia have agreed to pay each other in their domestic currencies, furthering initiatives by the BRICS — Brazil, Russia, India, China, and South Africa — to diminish the international role of the dollar.

To be clear, in the grand scale of international trade this agreement is very small. But it is symbolic of the continued foreign desire to reduce dependence on the dollar.

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Over the last six months or so I've presented a number of indicators that can be used to identify the possibility of economic problems ahead. Let's go over another one today.

Every Thursday the Labor Department publishes a report on initial jobless claims for the prior week. This report is frequently glossed over, but the trend in jobless claims can be a helpful predictor of economic momentum. The chart below shows weekly initial claims going back across seven different recessions. You can probably spot the pattern yourself, but notice that prior to each recession (gray shaded bar) weekly jobless claims tend to begin rising a year or so in advance. I've marked these areas with black arrows.

Jobless claims can also give us an idea of when recessions are coming to an end, as the sharp spike we see during the recession reaches its apex and begins to fall. These areas are marked by the green circles. No indicator is ever perfect, and there is no promise that any indicator that has proven reliable in the past will continue to be so in the future. However, we've looked at a number of data points and none of them are screaming "recession imminent." Last week jobless claims came in at the lowest level in 7 years.

[Read: Is a Major Correction and Bear Market Around the Corner?]

There is a unique dynamic at play regarding interest rates and the stock market. Over the last few decades, and up until a few weeks ago, bond yields typically had an inverse relationship with stocks. That is, as bond yields rise, stocks fall, and as interest rates fall, stocks rally. This makes sense because bonds provide natural competition to stocks. Rising yields entice investors to ditch the risk of equities in search of safer yields. And when yields fall and bonds pay less, investors shift money to stocks.

But lately that relationship has reversed. Over the past few weeks the stock market has risen and fallen in sync with bond yields. Today is no different. The yield on the 10-year is up and so is the broader stock market. During yesterday's action bond yields fell and the major averages followed suit. Same story last week.

In my opinion the reversal of this long-standing relationship has to do with mass psychology. There is a widespread view that an improving economy comes with rising interest rates. Investors are looking at the recent declines in rates, evident in the chart of the 10-year Treasury yield below, as an indication that the economy is struggling. They're then inferring that this economic slowdown will lead to weaker profits and lower share prices, especially in cyclical companies.

[Read More: Is the Bond Market Sending Bearish Omens?]

It's true that lower interest rates and a flattening of the yield curve usually accompany a deteriorating economy. But there are other potential explanations for why rates are moving lower. One possibility that stands out is that the steep rise in interest rates that occurred in the middle of last year was a vast overreaction, and took rates too far above their natural upward glide path.

Beginning last May when Bernanke first discussed tapering, interest rates on the 10-year skyrocketed from 1.65% to 3% over the course of four months. This can be seen in the section of the chart below highlighted by the green box. Here we're looking at the same chart of the 10-year Treasury yield as above, just over a longer time frame. That spike in yields was not because the economy all of sudden started firing on all cylinders, it was a reaction to news that the largest buyer of Treasuries would soon be scaling back. As is always the case, everyone wanted to be the first out the door, and the massive selling in Treasuries caused rates to rise dramatically.

I think it’s quite possible that the overreaction in the bond market during that time frame took yields above their natural trajectory. I've inserted two blue lines in the chart below to approximate the channel that interest rates were following prior to the big taper news. If interest rates had continued to rise at that modest pace, you can see that rates would be in range of where they just recently fell back to.

I forgot to bring my crystal ball to work today so the above is just speculation, but it makes more sense in my mind than the notion that we're falling into another recession. If another recession were on our doorstep, we would have noticed some indication from the numerous leading indicators we've reviewed in past months. In my opinion the new dynamic at play here is the market as a whole misinterpreting the direction of rates as implying an upcoming recession, instead of a basic reversion to the mean.

The above content was an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.

About the Author

Chief Investment Strategist
matt [at] modelinvesting [dot] com ()