Markets retraced their June highs during much of August, confounding many observers. Let's follow what happened and look at why stocks were able to recover most of the losses made in July -- and then plummet.
August is typically known to be an irrational month, given quiet summer volumes and a market that is most disinterested in holding positions especially after a hectic start of the year. It seemed the trigger this time, however, was the Fed July Federal Open Market Committee meeting, in which the Fed really did not say anything different -- but then the moves are about positioning as much as they are about real fundamentals. And, as the market rose, the narrative kept changing about what was driving it higher, compelling the algorithms and "fear of missing out" traders to chase ever higher. The rally became self-fulfilling.
Back in July, Wall Street was bearish, which actually helped the market climb that wall of worry in August. It seemed the August Jackson Hole economic conference proved to be the reality check the market needed. After the Fed Chair Jerome Powell's Jackson Hole commentary last Friday, the market finally reversed from 4200 and has fallen back 8% giving back most of the gains made in August. During Jackson Hole the Fed said exactly what it had been saying all along, that inflation is quite far from the 2% target, the tight labor market continues, and that it will keep tightening as the data come in, to make sure to keep inflation in check.
It is not about whether the Fed is raising rates by half percentage point or three-quarters of a percentage point, the fact is that the Fed is still tightening, which proves to be a headwind for asset classes in general. In September, the Fed will also be doubling the pace of its balance sheet reduction to reach its target of slashing it by $500 billion this year. Liquidity has been one of the most powerful driving forces for markets in general, so as the balance sheet reduces, that takes excess money out of the system, taking markets lower.
The Fed has changed the landscape of investment forever, since the Great Financial crisis. The only rational reason investors have to buy the market here is based on the premise that surely the Fed will pivot their policy and start quantitative easing again to support markets. One can be forgiven for thinking that as that has always been the case. But this time, it really is different as the Fed is unable to print its way out of its own mess as in inflation is just too high. It has no choice but to apply the brakes to reign in that inflation as otherwise the entire system is at risk of imploding.
The derivative set up of the broader market is as important as the Fed's course of action. September is known for the infamous "triple witching" expiration, whereby stocks, indexes and futures expire. There is a significant amount of open interest focused between 4000 and 4300, which has been causing much of the futures trading. In addition, the bond market has been signaling distress for months now and never partook in the equity markets rally in August. The curve has been inverted in the front, but also further out with the U.S. 10-year yields making new highs around 3.25%, which does not bode well for long duration assets.
It seems the U.S. is on its way to becoming like Japan, where it will eventually become the only buyer of its own debt as the rest of the world sells their holdings. One can argue that at 3.25% there is some yield attraction here, but then again, the Fed will only have to print more money later down the road and issue debt to service the existing debt pile. We are on the path to Japanification, Europe is already there with its central bank unable to raise rates by even a mere quarter of a percentage point. Central banks have been kicking the can down the road each time there has been a "plumbing" problem. How long can this mad experiment keep going on is anyone's guess. But, it really is different this time.
