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Is Low-Yield, Low-Volatility Environment Setting Us Up for a Fall?


Low volatility with high stock prices makes sense -- but falling yields are making heads spin.

Nearly every 15 minutes on financial news TV this morning, mention has been made of both the low-volatility environment that has set in and the "surprisingly" low level of US Treasury interest rates. Why all the confusion? Don't we already know that the powers-that-be have every intention of keeping rates as low as possible for as long as possible? Take a look at one or two of my MV pieces from late last year where I go over why the Fed and other governmental string-pullers may be in a position where they MUST keep rates subdued at all costs. 
What's the Real Deal With the Lack of Volatility?

On the other point about low volatility, take a look at the chart below, which shows the Volatility S&P 500 (INDEXCBOE:VIX), represented by $VIX.X on the top of the chart, and the S&P 500 (INDEXSP:.INX), represented by $INX at the bottom of the chart. Notice the green boxes on the VIX graph? Those were long periods of low volatility that didn't coincide with market tops (keep in mind that the chart below uses monthly candles). 

To really stretch the bounds of credibility, you could say that a low VIX eventually led to a market top -- but there's no way this analyst/portfolio manager would be shorting stocks solely based on that piece of evidence. The only truth that can be drawn from this chart is that a low VIX has always eventually gone higher -- especially off of current levels. But "eventually" can mean either five-plus years (as was the case in the late 1990s) or three-plus years (as was the case leading up to the financial crisis of 2008). Most readers here wouldn't be willing to put on their bear suit with reckless abandon given those time frames -- or given the magnitude to which the equities markets continued to rally before the top was made. No, more confirming evidence would be needed before sizable bearish bets should be made.

Click to enlarge

What About Yields?

The yield on the CBOE Interest Rate 10-Year Treasury Note (INDEXCBOE:TNX) has been tumbling of late, which should be of no surprise to readers of my bimonthly features. The question I (and everyone else in my position) is facing is: How low can they go?

Well, based on the chart below, if the 2.464% yield level (which happens to be the 38.2% Fibonacci retrace of the November 2012-December /2014 rise in rates) on the TNX is broken on a closing basis, the next target lower wouldn't come into play until 2.291%. Given the fact that wave "2" on the chart (which bottomed in November of 2012) was a deep retrace of wave "1" on the chart, the current wave "4" should be a relatively shallow decline based on Elliott Wave Theory. I typically define "shallow" as being no more than a 38.2% retrace of the previous move. So, in theory, this decline (if typical) in rates should stop right around current levels. If, as many on the tube have speculated today, the decline in rates is tied to something more sinister brewing (perhaps geopolitically), then a break of the 2.464% level could easily occur. No real EWT rules would be broken unless wave "4" closed below 2.056% -- so anything CAN happen from here -- even if the "normal" action would be for yields to hold current support. 

We all know what to expect here, right? Not exactly. If support here falters and rates go sliding lower (meaning a deeper wave "4" is occurring), does that mean trouble for stocks? Thus far, it hasn't -- so why would we confidently expect that to change? On the other hand, if rates turn and start to go higher (for wave "5"), it's very likely that they'll only be doing so in conjunction with continued strength in risk assets in general and equity prices in particular.    

Click to enlarge

Any Tells From Currency Land?

I like to look across all asset classes to see if I can find any consensus in terms of the evidence being presented so that I can properly craft my macro thesis. Nowadays, that's a nice idea in concept, but much more difficult in reality. 

In scanning the charts diligently this morning, I came across a fairly bearish short-term setup in the chart of the euro/Japanese yen currency cross (EURJPY). Based on the wave count shown on the chart below, the EURJPY appears to be in a wave "iv" correction to the downside, with the most optimistic target being 135.27. If you draw the Fibonacci lines using different pivots (intraday extremes instead of closing levels), the target is even lower than that. 

The EURJPY has long been a go-to tell in the currency markets in terms of the global appetite for risk. Right now, the EURJPY is clearly sending a bearish message in the short term -- directly conflicting with that of the equity markets. If any synergy does exist, it would be between the EURJPY and the US bond markets, both of which are sending short-term bearish signals for risk assets. The question is: When will those signals turn into a bearish reality for equities?

Click to enlarge

Summing It All Up

So, we are getting continued strength in equities with only minor imperfections appearing on occasion (like the rolling bouts of selling that have occurred first in biotechs and then in the high P/E tech and social media complexes).  However, that strength seems to be flying in the face of tumbling Treasury yields and a short-term bearish outlook for the euro / Yen cross.  Some would add to the bearish chorus the low volatility condition that exists in the US markets, but I think we've shown that to be faulty logic based on recent history.  Overall, with my upside target range for the current wave higher in equities being 1910 - 1936 on the S&P e-Mini futures (right where we touched yesterday and today - not shown in today's report), we collectively may be wise to be on the lookout for some playing along on the downside on the part of stocks - finally falling into lock-step with the other asset classes' more bearish messages.

Twitter: @seachangereport

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