When markets make new lows, it is said after the first bounce to test the first resistance level; it often falls (or rather needs to fall) back down in order to re-test its lows to gauge whether a bottom is put in place. At least that is what the bible of algorithmic and technical trading says. And who am I to argue?
As the landscape of markets change and its players even more so, one must be willing to accept the new norm and its drawbacks. Over the course of two weeks we have seen some significant damage done to the markets, broken key uptrends and 200-day moving averages that in themselves need watching. Once any damage of this extent is done, the market takes its time to find its "true" way back.
Most investors who have seen sharp pullbacks over the last two years are eager to buy the market today given the speed of recovery from past bottoms. But this time, it is not just a growth scare as the U.S. presses China on trade or a technical unwind of leveraged short volatility position. Something has seriously snapped and the Federal Reserve knows it.
The entire financial system has been built on a house of cards, especially since the global financial crisis of 2008. Asset classes, derivatives and all risk instruments are more tightly linked than ever before. The link that ties them together is free money from the Fed via quantitative easing. When that gravy train stops, asset classes come crashing down, as we saw in 2018 prior to the trade wars.
Lo and behold, when Fed Chairman Jerome Powell decided to start with balance sheet expansion in September 2019, markets never looked back and shot up 15% in a straight line. But one of the key metrics that holds all these assets together is a weaker dollar and lower U.S. interest rates. The majority of the world debt is priced in dollars, so the Fed chairman ends up becoming the central banker for the entire world.
To the detriment of central bankers, inflation has just not shot up despite their brave efforts. Every time the market tries to price in reflation, it comes right back in as the U.S. bond market just cannot sustain the path of higher yields. Since the start of this year, U.S. 10-year yields have gone from 1.9% to trading at 0.96% at this writing. They have been screaming deflation outside of what equities have been suggesting for some time.
The coronavirus will be blamed for this economic collapse, but truth be told it was in the offing way before that. The virus just tipped it sooner. As the bears went all in last Friday, the markets experienced an epic squeeze on Monday as global central banks started cutting rates. And we now have retraced back to the first level of resistance, touching the all-important 200-day moving average on the S&P 500 as it hugs onto the 3050-3070 level. Given extremely weak market sentiment on Friday, one can say the easy bounce is done, but now what?
According to a note last week from Nomura's Charlie McElligott, the market has some key strikes whereby speculative positioning plays a very important role. As the S&P 500 viciously fell from 3375 down to 2950, the algorithms (machines) have now reduced their positioning from 100% long down to 15% long; more or less neutral. For them to re-lever on the long side, the S&P 500 will need to break 3125 convincingly to the upside. However, if the market breaks below 2950, these algorithms will get a confirmation that the trend is broken and will lean on the market by initiating market shorts.
The bond market is not happy with the Fed's emergency rate cut of 50 basis points and seems like it is demanding more, with futures now pricing in another cut of 25 basis point at the March Federal Open Market Committee (FOMC) meeting and possibly another in April. That would be a cut of a whopping 100 basis points in the fed funds rate from 1.75%, bringing us awfully close to 2008 levels.
We are in no man's land right now. Everyone wants to buy the market eventually, and rightfully so, but the next move could actually be a lot worse before getting better. At best, one will be paid to wait and find out rather than be caught catching a falling knife. It is best to stay in cash and wait your turn on the sidelines. Keep an eye on the U.S. bond market as 10-year Treasury is making another attempt on moving well below 1%.
Rate cuts are not magic potions that filter into the economy and all becomes well. They certainly are not a cure for a viral flu. They are intended to be more of a boost to confidence.
For now, the coronavirus seems to have stabilized in China due to draconian measures taken. The rest of the world, especially the U.S., is taking a more sanguine view and letting nature play its course as per President Trump's statement Wednesday. The U.S. and Europe would serve themselves well to take the measures China did to nip this in the bud as things can get a lot worse, especially when a majority of the American public cannot even afford basic healthcare and tests. This growth rebound could be delayed as the bond market suggests. Equities would do well to listen to their big brother.