As the market enters October, there is both good and bad news. The sell-off that started in September is continuing. The good news is that we should be close to the bottom.

 

Blame the waterfall decline in the price of the 10-year U.S. Treasury bonds, the continuing gains in the U.S. dollar, and the seasonal pattern in the equity market. Throw in the absolute mess in Washington and the market's free fall can be understood.

 

None of this should be new to readers because this is exactly what I predicted would happen back in August. I expected markets to correct into the second week of October and here we are with one week to go. The argument over government spending levels and the potential shutdown has forced investors to focus on not only the amount of our national debt but also the rising cost of servicing it.

 

The fiscal deficit this year is more than $1.5 trillion. Overall, the U.S. government debt is roughly $33 trillion with a debt-to-GDP ratio of 120 percent. Estimates are that we are now paying 8 percent of Gross Domestic Product (GDP) to holders of Treasury bonds worldwide just to service this debt. That number could easily rise to 9-10 percent, or more.

 

I suggest that you take a peek at my Thursday column. It will explain the background and risk to the markets caused by the dysfunction in Washington. Bottom line: we can expect Moody's credit agency to cut its rating of our government debt unless the country and its politicians can get their act together.

 

The Fed's policy of keeping short-term interest rates higher for longer doesn't help. But the bond market is now also bidding up the yields on the longer-end of the bond curve as well. The 30-year bond is almost 5 percent. This is shaking investors' confidence in the soft-landing scenario popular among many economists.

 

As such, all eyes are on the employment numbers. These are the keys some believe to what is happening to the economy. Stronger job numbers and wages mean more tightening from the Fed. Weaker data is okay, but if it is too weak, that would set off fears of a deeper recession. That leaves investors in an impossible situation where they are looking for a Goldilocks scenario where jobs are neither too hot nor too cold. Good luck with that.

 

This Friday's non-farm payroll numbers were almost double the 171,000 job gains expected. The U.S. economy added 336,000 jobs, which sent yields even higher, and stocks lower on the news. And yet, yields, the dollar and stocks all reversed during the day. That should tell readers that we are in the bottoming process.

 

Yield-wise, the benchmark 10-year, U.S. Treasury bond hit 4.83 percent, which was its highest level since 2007. And we all know what happened in 2008 (the financial crisis). Not that I am expecting something similar, but a lot of the investment community is freaking out at where interest rate yields can go from here.

 

I think we may be close to a short-term top in yields, at least in the short-term. That is one reason I am expecting a bottom in the equity markets. And where yields go, so does the U.S. dollar. The two asset classes have moved together over the last month. Friday's jobs number pushed the greenback up .65 percent on the news but it quickly gave all its gains back. The dollars’ gains have trashed just about everything from commodities, foreign markets, U.S. equities, and precious metals. That could be changing.

 

Underlying the rise in yields has been the avalanche of U.S. Treasury auctions that began in earnest this quarter. I'm guessing that yields have risen in anticipation of that event. Could we therefore see a "sell on the news" event where bond traders cover their shorts and buy back bonds at some point soon? Stanger things have happened.

 

Last week I targeted the 4,200 area on the S&P 500 Index, which is the 200-day Moving Average as a level we could look for in the bottoming process. I also said that looking for a perfect number like that is not usually the end of the story, since markets overshoot on the upside and the downside. We could easily slip below that number before all is said and done.

 

Keep an eye on the dollar and yields because they are the big dog wagging the tail of the equity markets. When they roll over, as they may be next week, stocks will have reached a bottom.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.