The data is consistently surprising on the upside.  A closely watched economic indicator that has historically flashed optimism is causing another dilemma for the Federal Reserve.

The Citicorp Economic Surprise Index, which measures the pace at which data are coming in above or below consensus forecasts, has turned positive for the first time since May.  That means data had been coming in stronger than expected.  In June the index tumbled to a low -78.70 but has since turned and currently stands at 5.80.

Historically, a rising surprise index bodes well for beaten down stocks, but it’s unclear how long equities can follow that pattern this time around.  If the economy has more positive surprises, it will complicate the central bank’s goal of reining in decades high inflation forcing the fed to hike rates even more aggressively.

Interest rates are the largest component of valuation formulas.  Valuations are stretched at best thus suggesting more volatility unless earnings/cashflows can increase at a comparable pace.

Less then one year ago, the two-year Treasury or instrument most sensitive to monetary policy was yielding 0.20%.   Today is over 3.85%.  The rate of increase is unprecedented.

It is largely expected the overnight rate may be around 4.0% by year’s end.  There is a huge difference between discounting cashflows at a 0.00% and 4.0%.  In many regards, the recent declines should be considerably greater than the 26.2% YTD drop in the NASDAQ and 18.2% decline for the S & P 500.

Commenting about yesterday’s market action, trading was choppy perhaps the result of today’s $3.2 trillion option expiration ands rise in Treasury yields.   The markets have fully discounted a 75-bps increase at next week’s FOMC meeting.  The odds of a 100 bps are now over 25%.

Mortgage rates are now over 6% for the first time in almost 14 years.  Last September yields were under 3.0%.  The doubling in rates is partially the result of QT.  Who will buy mortgages given that the Federal Reserve bought the vast majority of mortgages over the past decade?

Speaking of which, the 30-year mortgage historically tracks the 30-year Treasury.  This correlation has collapsed given that 30-year Treasury yields are still below 3.5%

However, the increase in yields has crushed the popular TLT ETF.  [ETF designed to tract the performance of Treasuries with a maturity greater than 20 years].  Year to date, TLT is down 26.0% and 35.4% from its 2020 apex.

Speaking of performance, the widely owned SHY ETF [ETF designed to track the performance of Treasuries maturing in 1-3 years] is down 4.61% year to date and 5.8% from its apex.

What will happen today?  As noted several times it is options expiration day where volatility may become heightened.

Last night the foreign markets were down.  London was up 0.03%, Paris down 1.27%  and Frankfurt down 1.62%.  China was down 2.2%, Japan down 1.11%  and Hang Seng down 0.89%.

Dow and NASDQ futures are down 0.70% and 1.0% on monetary policy fears.  The 10-year is down 4/32 to yield 3.47%.


The views expressed herein are those of Kent Engelke and do not necessarily reflect those of Capitol Securities Management. Any opinions expressed are statements of judgment on this date and are subject to certain risks and uncertainties which could cause actual results to differ materially from those currently anticipated or projected. Any future dividends, interest, yields and event dates listed may be subject to change. An investor cannot invest in an index, and its returns are not indicative of the performance of any specific investment. Past performance is not indicative of future results. This material is being provided for informational purposes only. Any information should not be deemed a recommendation to buy, hold or sell any security. Certain information has been obtained from third-party sources we consider reliable, but we do not guarantee that such information is accurate or complete. This report is not a complete description of the securities, markets, or developments referred to in this material and does not include all available data necessary for making an investment decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. If you would like to unsubscribe from this e-mail distribution, please reply to this e-mail and indicate that you wish to unsubscribe in your response.