A Change in the Wind

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Markets are reacting to Friday’s abandonment of the GOP health care plan, and so far the narrative is one of uncertainty regarding the high expectations that have been set over recent months.

The new health care bill was seen as the first real test for Trump and fellow republicans, and it’s probably fair to say that they are not delighted with the outcome.

While many are suggesting that the health care defeat, if you can call it that, portends negatively for upcoming policy changes, it’s quite possible that the reverse is true.

Read A Look at the Yield Curve and Why the Fed Is Raising Rates

The failure of the Obamacare repeal means that the new administration’s focus will now turn 100% towards tax policy. Of course, there is an additional wrinkle now, since savings from an Obamacare repeal would have gone to offset reduced tax receipts, but it’s always been tax policy driving this market’s gains. And that should soon take center stage.

The fate of this market will ultimately depend on fundamentals, but as that story continues to develop we’re seeing a number of key technical developments come into play.

First, let’s take a look at what’s going on with the yield curve. Back on March 13, I explained that an increase in the federal funds rate (a Fed rate hike) often has the reverse effect upon rates at the long end of the yield curve.

Since the Fed’s most recent rate hike, we’ve actually seen that exact dynamic play out. The Fed hiked rates (notice the left side of the chart below ticked up) but longer term interest rates declined (their prior “shadow” shown in black).

fed fund rates

This means that the yield curve has flattened, a development typically viewed as negative for the economy because it implies suppressed inflation expectations—a result of less robust economic growth.

This flattening does not yet elicit major concern, as there is still a substantial positive slope to the curve, but it does warrant further monitoring. You can bet that the Fed is watching this closely, as they’re well aware of the implications of tightening to the point where the yield curve is flat, or worse, inverted.

Notice in this rather amazing chart below that prior to each of the last seven recessions, the Federal Reserve had increased the federal funds rate (blue line) to the point where it exceeded the rate on the 10-year Treasury–thereby causing the yield curve to invert.

fed fund rates

I would never be so bold as to utter those infamous words, “this time is different,” but it does seem to me that Yellen is more conscious of this danger–and therefore apt to move slower–than her predecessors.

Either way, we’ll keep watching this situation closely moving forward.

Wrapping things up, I’d like to take a look at one more chart … this time the CRB commodity index.

As with the broader stock market, we’re at another critical threshold in this key indicator. Notice below that after declining for most of 2017, the CRB index is now bouncing off its rising support line.

CRB 24 mar 2017

Considering that much of this current rally has been based off the concept of reflation, it’s a bit disheartening to see the commodity index falling back to previous levels. In addition to the possibility of breaking below the rising trendline, we see the possible development of a head-and-shoulders pattern.

The left shoulder and head have been formed, along with a distinct neckline. If we do see a right shoulder form and the pattern complete, it will coincide with a break below the trendline that has been in place for nearly a year. This would be a negative development indeed and would cast doubt on whether we are truly seeing a reflation of the global economy.

As always, only time will tell, so be patient and watchful.

The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe.

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About Matthew Kerkhoff