Analysis, Perspective, Trading Strategy
At the Edge of Chaos: The Fed is in a Cage Match with the Bond Market and there is no Escape
Editor Joe
Duarte in the Money Options
The Federal Reserve is clenched in a cage match with the bond market
from which there is no escape for them or for the markets. Point in fact
were the technical sell signals in the major indices and the increasing
weakness in the market’s breadth as I detail below.
Indeed, the strange relationship between rising bond yields and rising
stock prices may have finally been broken returning the markets to the traditional
entanglement where rising bond yields are a negative for stocks. Still, despite
the short term pull back in yields, the long-term trend for bond yields remains
up and the stock market, although weakened, is still not completely in sell
territory, although that could change in a hurry.
So, what’s the bottom line? The Fed is either going to have to step up
its bond buying to lower rates, or they will be forced to raise interest
rates in order to slow the stealth inflationary pressures that are apparent
in the real world, as in grocery and gasoline prices. Certainly, given the
drop in yields over the last two trading days last week, the central banks
might have already fired their initial salvo.
Unfortunately, unless something dramatic happens, such as an overnight
and massive recession materializing, it’s a no-win situation for the Fed
and for the markets; for increasing bond purchases will require an increase
in QE and will be seen as fanning inflation. Meanwhile raising rates after
promising that they won’t do so until 2023 makes the Fed an unreliable partner
to the markets potentially causing a major debacle in stocks.
More Messy Markets Likely Ahead
Last week while describing the relationship between bond yields and stocks
I noted: “what happens in the next few days and weeks may well define what
happens over the next few months in this important and newly redefined intermarket
relationship. Stay tuned.”
Furthermore, I wrote: “the rising trend in yields may be nearing a period
of consolidation. We may even see a dip below the now important support levels
– that were once resistance. But it remains to be seen whether this simultaneous
uptrend in bond yields and stocks can be deterred without intervention from
the Federal Reserve.”
I also sounded a note of caution about the stock market, noting: “this
is a highly unnatural market relationship which means that although we are
trading it on the long side, we should not trust it. What I’m saying is that
even as the market may make new highs from here as bond money moves into
stocks, the odds of a correction in stocks are likely to rise as this strange
phenomenon continues. It’s more of a matter of when than if.”
In fact, what happened on Wednesday, Thursday and Friday of last week suggests
that the stock and bond markets came to the same conclusion. This was especially
noticeable in the relationship between the U.S. Ten Year Note yield (TNX)
and the homebuilder stocks. Here is a summary:
- Fed chief Powell in his testimony to Congress continued to voice
his doubts about the economic recovery and inflation on Wednesday
- As Powell spoke the U.S. Ten Year note yield (TNX) retraced the
intraday yield highs it had made above the 1.40% early in the day
closing below this key chart point
- Along with Powell’s testimony home sales made
new highs on Wednesday but new mortgage applications crashed
simultaneously suggesting housing activity may have topped
- This was confirmed when pending
home sales were down on Thursday
- And after a huge rally in stocks on 2/24 rising bond yields finally
exploded above 1.5% and brought down stocks
- Finally, by week’s end, bond yields retreated suggesting that
the Fed might have intervened but few stocks were able to recover
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Indeed, what that sequence of events told us is that the 1.4-15% area on TNX
is the line in the sand for stock traders. Moreover, it suggests that bond
yields may have now reached the point at which the housing market is starting
to feel the negative effects as 30-year mortgage rates were in the 3% range
and are likely to climb in the next few weeks barring something dramatic
from the Fed.
Meanwhile Fed Chairman Powell continued to signal that the Fed’s easy money
QE policy is not likely to change until 2023. So, the real question is what
will happen if and when the inflation in real life begins to accelerate beyond
the point in which the Fed can’t cite its own inflation measures, which do
not account for many real-life prices such as those for buying (not renting)
a home and food prices as the reason for continuing QE.

And in case anyone doubts it, the spell has been broken as rising bond
yields are now doing what they were designed to do, cause stock traders to
sell as they consider moving money back into bonds. The problem is that bond
yields may still have a way to go to the upside before it’s a good idea to
buy into the bond market.

In addition, the inverse relationship between stocks and bond yields is
very much alive regarding the housing stocks as we can see in the chart relating
TNX to homebuilder DR Horton (DHI, upper linear graph). Notice DHI’s long
consolidation as TNX rose. Also notice that as TNX pulled back inside the
upper Bollinger Band DHI shares began to nudge higher.
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Applied Industrial Technologies: A Cyclical Diamond in the Rough
for a Post COVID World
he market’s leadership has changed of late in response to rising bond yields.
And not withstanding last week’s bond market volatility, the premise that
shares of smaller stocks in the industrial complex may still benefit from
an economic recovery remains viable until proven otherwise. As a result,
it makes sense to examine engineering materials and solutions company Applied
Industrial Technologies (AIT); a $3.4 billion market cap company which is
quietly gaining a nice foothold in a market that is betting on an economic
recovery.
As is the case with many small to midsize industrial companies, AIT is
not a household name. However, its business is becoming increasingly crucial
as the Post COVID dynamic evolves.
First, it’s important to understand how ATI fits into the so called “recovery.”
And to do so we must look at its product mix, which ranges from fluid control
systems and robotic systems repair and installation to seemingly mundane
things like hoses. Sure, not the sexiest of things; unless you’re trying
to manufacture vaccines or repair the frozen motor or valves in your recently
frozen wind turbines or oil and natural gas derricks.
In fact, as the company stated in its most recent earnings call, it’s noting
an increase in demand for its services in key industrial areas such as chemicals,
aggregates, paper, lumber and energy. All of these are signs that the industrial
and manufacturing sector is starting to awaken, at least in the U.S.
Moreover, although the company’s sales have not turned positive year over
year yet since the start of the pandemic, its free cash flow, net income,
and market share are all positive year over year. Even better is the fact
that the company is starting to see increasing demand for its businesses
in the 5G, vaccine production, and robotics business.

The price chart certainly tells a compelling story as the stock recently
broke out of an extended base on big volume, which confirms the positive
Accumulation Distribution (ADI) and On Balance Volume (OBV). Furthermore,
there is very little price resistance above the breakout point as illustrated
by the Volume by Price (VBP) indicator.
Indeed, from this vantage point, it looks as if AIT is joining the ranks
of industrial and engineering companies whose futures are improving as the
world looks to emerge from the COVID nightmare. Finally, in the current market
it makes sense to see how the shares fare in response to the evolving volatility.
However, as long as AIT remains above its 50-day moving average it is worth
considering.
I own AIT as of this writing. For more stocks like AIT consider a FREE
trial to Joe Duarte in the Money Options.com. Click here .
Market Breadth Nears Sell Signal and Major Indexes Deliver Short
Term Breakdown
The New York Stock Exchange Advance Decline line (NYAD) almost delivered
a new high on 2/24/21 but failed in the attempt just one day before the dam
burst on bond yields. This is clearly a sign of weakness for the uptrend.
Therefore, caution is warranted.

What that means is that we now have to pay special
attention to key NYAD chart points in order to see what comes next. Specifically,
consider that as long as NYAD continues to make new highs, remains above
its 50- and 200-day moving averages and its corresponding RSI reading remains
above 50, the trend is up. This combined set of observations has been extremely
reliable since 2016.
That said, the way things ended last week leaves us in limbo as RSI closed
right at 50 and NYAD crashed through its 20 day but not its 50-day moving
average. The most recent two similar situations resolved to the upside but
patience is a virtue here.

For their part, the S & P 500 (SPX) and the Nasdaq 100
(NDX) rolled over midweek, in response to the volatility in the bond market.
Moreover, NDX broke below its 50-day moving average and is near the 30 area
on RSI, which would make it oversold. SPX, remained above its 50-day moving
average but is also trading below 50 on RSI.

The bottom line, though, is that if this pullback
is similar to recent pullbacks, because of the aggressive selling in the
indices, much of the selling may be nearing its conclusion. If this is
true, then the RSI 50 area for NYAD will provide support and the uptrend
will resume. A failure of the NYAD would confirm the sell signal in NDX
and likely lead to further selling for the entire market.
Next Move in Stocks is Anyone’s Guess
The volatility in bond yields seems to be creating confusion in the stock
market, which means that trading may be difficult in the next few weeks as
things sort out. That said, in a market ruled by artificial intelligence
algos and still fueled by QE from global central banks the current confusion
may be over as quickly as it started.
In other words, the best way to manage this market is to stick with sound
trading rules and watch each individual position as it relates to the general
trend in the market.
For more on how to deal with the current market checkout my latest Your
Daily Five video here .
For more details on bonds, currencies, and stocks check out my recent interview
with Wall Street Reporter.com here .
Joe Duarte is a former money manager, an active trader and a widely recognized
independent stock market analyst since 1987. He is author of eight investment
books, including the best sellingTrading
Options for Dummies, rated a TOP
Options Book for 2018 by Benzinga.com - now in its third edition, The
Everything Investing in your 20s and 30s and six other trading books.
Meanwhile, the U.S. Ten Year note yield (TNX) is trading in a The
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