• Edward Ballsdon

Short Term Extremes

The Relative Strength Index can give two very useful signals:

  1. How strong a price trend is

  2. If momentum is changing, warning of a change of trend.

A post on the 29th May highlighted the use of the RSI, in that case noting that bullish sentiment for the FAAANG growth stocks might be fading (a confirmation is still required). This was because there was a potential "Divergence" signal forming whereby new price highs were occurring with lower price momentum. Despite the S&P registering a staggering 6.0% price gain since that date, the FAAANG index has gained a "mere" ~2.0% (at one point it was down 1.7% despite S&P only trading higher).

The recent strength of Equity and Credit Markets, and the weakness of the US Dollar have been remarkable to not just this commentator, but to a host of market participants. The degree of re-leveraging has been truly astounding.

The table below shows the DAILY RSI readings for a set of Bond, FX, Equity, Credit, Commodity, EM and Volatility indices, highlighting only the "overbought" (>70) and "oversold" (<30) readings.

Just to be clear, an over/under bought RSI reading indicates a very strong bull or bear trend. It shows that the price is moving far away from the moving average of the asset's price. It is only if the RSI drops from being overbought (or rises from being oversold) that there is a sign that trend momentum is weakening.

There are a few standouts:

1. There are a large number of overbought and oversold prices in equity, credit and FX markets. The readings close to 80 and 20 show momentum reaching extreme levels (i.e. exceedingly strong trends). The large number of readings also shows the strength of cross asset correlations that currently exist, which is in keeping with the 4Q18-1Q19 sell off and rebound, demonstrating that its almost "all the same trade, but with differing betas". Below for example shows the correlation between the S&P 500 vs AUDJPY (left) and vs Oil (right), the latter which has returned to 86% after the negative price shock.

2. The rally of some EM equity indices have taken them to very high RSIs, notably Turkey and Brazil, as is the case for some EM currencies (ZAR and BRL).

3. Neither Bond, Precious Metal or Commodity prices have the respective oversold or overbought conditions that might have been expected given the strong risk asset rebounds (except Aussie 10yr and Copper).

The bifurcation between the strength of the bull trend in risk assets against that of commodity/bonds can be explained by a large re-leveraging market in a climate of anchored interest rates whilst commodities recover from a state of excess oversupply.

The one caveat is that unlike the risk asset price recoveries of 2009 and 2019, when real yields declined markedly, longer dated real yields have recently shown signs of rising (i.e. the curve is bear steepening as opposed to bull steepening).

Corporate bonds with now tight spreads no longer have a large credit cushion to protect their prices against rising government bond yields, whilst stocks with low dividend yields will look less attractive if the risk free rate rises. Likewise, rising real yields will necessitate revaluations of future cash flows for highly indebted households and corporates.

To that end its worth noticing that the US 10 year Treasury is at a key make or break yield level on the medium term weekly chart. Whilst the recent decline lower in yields to 50bp was impressive, it occurred with a slower momentum compared to the 2019 decline. The RSI has thus formed a "Divergence" signal, similar to the ones in 2011/12, 2013 and 2018 that foretold trend reversals that ensued.

There is clearly a risk that any further rise in yields would inevitably lead to a break of the RSI downtrend in place since 2018, which would result in a 10yr yield target of 1.50%.

Indeed, this comes to the heart of the problem. In a climate of already vast government bond supply (see this morning's post), IF Central Banks allow investors to think that yields will rise, their consequential reductions of government bond holdings in portfolios will lead to higher long end Real Yields. This would not be compatible with a re-leveraging environment.

Given the incompatibility of the Central Banks' required re-leveraging policy and higher yields, the market should expect Central Banks to intervene if there is any decent rise in real yields so as to to protect the risk asset price recovery. The clearest policy is further acquisitions of Government Bonds.

Likewise, Central Banks are likely to continue to intervene on any risk asset decline that looks to be more than a simple correction, just as they did in 2018 and this year. To that end, the current high levels in Daily RSIs, some extreme in nature, need to be monitored closely for any sign that the existing strong momentum changes.

The recent set up of rising long end yields and rising risk asset prices cannot co-exist in the medium term. The recent back up in yields makes bonds attractive on a long term basis given the US's debt dynamics, underlying dis-inflationary trends and the Fed's long standing policy to drive real yields lower. The issue that makes this very tricky is that the Fed has almost completely taken its foot off the pedal, buying an ever smaller amount of Bonds as debt supply continues to be very high indeed. That should make everyone very nervous, both Bulls and Bears.