Thursday, January 29, 2015

The FOMC and the Markets – Something Has Changed

by Pater Tenebrarum

Still “Patient”, but too Upbeat for the Stock Market

As a look at the WSJ’s FOMC statement tracker reveals, the Fed currently sounds quite upbeat about the US economy. Given that organs of the State are usually the last to recognize a trend (in this case the trend of a subdued, but better than elsewhere US economic performance), this should be taken as a warning sign that the trend may be close to reversing.

There was only one word for liquidity junkies in the statement: the term “patient”, in the context of the widely anticipated, but continually postponed, rate hike. While the Fed ponders rate hikes, US macro data have begun to weaken rather noticeably of late. Not to an extent yet that would be worrisome, but they offer a strange contrast to the upbeat FOMC statement. Also, the Fed keeps stressing that it sees the recent collapse in inflation expectations as “transitory” (it may well turn out to be), again removing a reason for waiting much longer with a rate hike. Meanwhile, central banks from Canada to Singapore are cutting their administered interest rates, or are adopting a dovish stance (New Zealand, Australia), or are engaging in outright money printing (ECB, BoJ). Bond yields keep plummeting all over the show, including those on treasuries, which benefit from still offering a sizable spread pick-up in today’s world of ZIRP, NIRP and negative yields on government bonds.


As a result of having communicated the impending interest rate hike so persistently, the Fed is practically forced to follow through, as it would otherwise endanger its vaunted “credibility”. This is not what stock market participants want to hear in light of the less benign macro-environment and the not overly convincing revelations of the current earnings season.

Who could have known? The strong dollar actually eats into the profits of US multinationals. Interestingly, even some unemployment related data may well be at a turning point, in spite of unemployment being known as a lagging indicator of the economy. The main reason why it is worth pointing this out is that the US stock market exhibits a well-established negative correlation with initial claims data.

Here is a recent chart of initial and continuing claims; both appear set to head higher, which would actually not be too surprising considering that the bulk of US jobs growth since the 2008/9 crisis was produced by the shale oil producing states. It is a good bet that their jobs situation will once again be determined by the oil price, and the oil price keeps hitting new lows.


Unemployment claims data – bottoming out?  – click to enlarge.

As a little aside to the oil market: as of last week’s CoT report, speculators were still net long nearly 287,000 WTI crude oil contracts. Although surveys show that bearish sentiment on crude oil has become quite pronounced, the speculative positioning in this market belies that view. It looks to us like some of the sellers – the net long position has declined from an all time high of approx. 490,000 contracts to today’s level – have been replaced by bottom fishers. It should be noted that although a lot of longs have given up relative to the all time high in net long positioning, the current level is what used to be a record high a mere three years ago. So historically, the current positioning is still revealing a foaming-at-the-mouth bullish attitude, which is more than passing strange. As a result, it should perhaps not be too surprising that the oil market has yet to find even a short term low (admittedly, its inability to put together a bounce lasting longer than a day or two does surprise us a bit).

A Rare Event

Yesterday the stock market began to slide as soon as the FOMC statement hit the wires. This is worth noting, because it hasn’t happened in an eternity that the market falls both the day before and on the day of the statement’s release. We don’t even remember when something like this happened the last time. In terms of the echo bubble it is definitely a first.


Mirabile dictu…the market falls around the FOMC meeting – click to enlarge.

Stock market bulls have reason to be concerned. For instance, margin debt is still close to a record high, but its actual peak occurred several months ago, usually a warning sign, especially when it happens after a very large increase in said debt. Also, as the updated Rydex data below show, traders continue to be “all in” and bears have practically given up completely, with Rydex bear assets all but disappearing. In other words, almost no-one is looking down – and yet, the market appears vulnerable both from a technical and fundamental perspective (however, we must add to this that the evidence is not clear cut – many sector charts continue to look good, and the fundamental picture is at most displaying a few small cracks so far).


Rydex money market fund assets, bear assets and the bull/bear ratio. These data represent a microcosm of market sentiment, and it presumably just doesn’t get any more lopsided than this. We only had to adapt our annotations slightly – for instance, bear assets are currently plumbing new all time lows, but some traders have hopped on the fence, as evidenced by a small rise in money market fund assets.


Market participants were able to look beyond the end of QE 3-4 as other central banks started to go on a printing spree, creating carry trade flows into dollar-denominated assets (e.g. foreign inflows into US stocks have gone bananas, which is by the way also a warning sign). However, now that the Fed is announcing that it is optimistic on the economy, market participants may be having second thoughts – after all, the ZIRP policy was a major driver of debt-funded stock buybacks and a vast bout of re-leveraging in numerous financial markets. At the same time, it should be clear that loose monetary policy has distorted prices, which in turn has undoubtedly caused a lot of capital misallocation in the economy (some of the more adventurous shale oil investments are testament to that). If loose monetary policy is indeed about to be reversed, a great many things could in fact go into reverse as well, possibly faster than generally expected.

The stock market has largely been driven by an expansion of multiples in recent years – overall, actual earnings growth wasn’t all that great, even with stock buybacks flattering per share earnings. The median stock in the US market has never been as highly valued as it is today. It is difficult to rationalize buying at such extreme valuations, and if monetary pumping no longer lends support to the market, it may not be a good time to throw caution to the wind. It’s not as if there were no warning signs in evidence after all – essentially almost all of last year was a big warning sign, with trend uniformity crumbling and high yield debt diverging from stocks. We believe 2015 is likely going to be a quite volatile year.

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