Trading often is an exercise in reading the market's tea leaves to try to get a sense of direction. Sometimes the most important tea leaves are technical and involve watching moving averages and chart patterns. Other times, it's all about fundamentals, like revenue and earnings. Then there are times, such as right now, when getting a read on the markets is all about broader metrics, such as rising interest rates and the action in emerging market bonds.
But what, precisely, are the market indicators traders should be looking at now, and what will they tell us about future market turns?
To answer this question, we have to roll back the calendar to late May and June, when equities began their initial decline on the prospect of Fed "tapering." It was at this point in the market that my friend and astute colleague, Tom Essaye of The 7:00's Report, explained to me that there were two very important things to watch for as we adjust to the reality of higher interest rates.
The first thing to watch for is the pace of rising interest rates. Here I'm referring not just to the absolute level of rates, e.g., the yield on the 10-year Treasury note, but the reaction in the trading pits to big surges in bond yields. As long as interest rates make an orderly move higher, stocks can adjust and the rally can continue. However, the shock of an abrupt rise in the cost of capital spooks markets and causes equities to sell off.
This spike in yields and the concomitant sell-off in equities certainly took place in May and June, as evidenced by the charts here of the 10-Year Treasury note and S&P 500 index.
These charts tell the same tale in August, as a sharp rise in the yield of the 10-year Treasury note to multi-year highs has been accompanied by a drop in the S&P 500 that's taken the benchmark index below its 50-day moving average for the first time since the June sell-off.
The second market indicator to watch here is a bit more complex, and it is emerging market debt. Emerging market debt has become the canary in the global equity coal mine.
The two metrics I choose to keep tabs on this trend are the PowerShares Emerging Markets Sovereign Debt ETF (PCY) and the iShares JPMorgan USD Emerging Bond Fund (EMB). Both of these funds serve as a barometer for the price and yield performance of emerging market debt.
The charts below show that as interest rates rose in June, emerging market debt got slaughtered. And their direction in August is a troubling indicator for stocks going forward.
So why do emerging market bonds matter, and why are they an indicator of pending weakness or strength in U.S. equities?
In a nutshell, ever since the Fed instituted "ZIRP," or its zero interest-rate policy, and since it accompanied ZIRP with multiple rounds of quantitative easing (QE), traders, hedge fund managers and other big market players have sought higher yields in a variety of emerging market currencies and bonds.
Now that the Fed will almost certainly begin tapering QE as soon as next month, these same investors are essentially reversing the trade. Basically, there is no need to take the risk of buying emerging markets when interest rates here at home are moving higher.
As these traders sell their emerging market bonds and convert those investments back into U.S. dollars, it is causing foreign currencies to drop. As these currencies drop in value, and as emerging market bonds sell off, traders still caught up in the original long emerging market bond trade have been forced to cover losing positions.
When these positions are leveraged (and they usually are with hedge funds), the race is on -- and that means liquidating whatever holdings necessary to cover those losing positions. The result, of course, is a decline in the major domestic averages such as the S&P 500.
The bottom line here is that the unwinding out of emerging market debt is having a negative effect on U.S. stocks, as the so-called smart money runs for cover from emerging market debt losses. So, by watching closely the action in two bellwether emerging market debt funds -- PCY and EMB --we can get a good sense of where the U.S. equity market is heading.
Along with the pace of interest rates, the action in the emerging market debt market gives us two powerful tools by which to take this market's temperature. So, before you go headlong and buy the current market dip, make sure you check yields on the 10-year Treasury note, as well as the action in PCY and EMB.