Towards the end of May, the market was obsessed with the 61.8% Fibonacci retracement level struck at 2960 at the time, and the key 200-day moving average of 3050. The first week of June saw an aggressive move higher in U.S. bond yields, taking the 10-year from 0.6% all the way to 0.92%. This created a domino effect, as the market misread the narrative that there was a cyclical recovery, a return to inflation. What was missed was that the central bank was actually reducing their purchase schedule of Treasuries in May onwards.
Now that the U.S. Treasury needs to sell X amount of Treasuries to finance all its spending -- there is just so much supply of U.S. paper and less demand for it -- the Fed is the buyer of last resort. When they are not, we know what happens: bond prices fall and yields spike.
This is not because there is, or is going to be, an economic recovery. When you take that aggressive move, and a market desperate to fit a narrative, that caused one of the most violent shifts higher in all the laggard stocks with weak balance sheets and tons of debt, the Value stocks. The market has been aggressively short value/cyclical sectors like Energy, Banks, Industrials, Retails vs. being long the darling Technology, Utilities, Healthcare and bonds. The massive unwind in just five days was astonishing as those baskets got destroyed in the blink of an eye.
Asset classes can no longer be looked at in isolation. This is something that has been the case since 2000 and the urbanization of China. We are more correlated and linked than one can imagine. Even with commodities, which are so dominated by their physical market inventory balances, the spot price falls victim to the broader bond/equity/FX markets.
As the aggressive rotation took place, low and behold, so too did oil prices rally about $8/bbl in one week, about ~25%! The spreads did not move, and we were building inventories and demand was still much below pre-covid levels, but of course, no one wanted to listen to logic or exhaust their mental capacity. Instead, even smart fund managers who have years of experience and qualifications were giving up everything they had learned and started chasing this so-called recovery and "cheap' stocks. They were fitting the narrative to what they wanted or hoped to make.
Fear and greed muddle logic and conviction.
At the end of the day, commodity markets are dictated by pure fundamentals, whether we like to believe it or not. The prices can get exaggerated for a time, as there is so much money chasing macro, but physical markets always take precedence eventually. As funds and investors started chasing all the "crap" in Energy and Financials -- up 30%+ in a week -- screaming that they had missed out and this is the start of the recovery, what they failed to realize was that this was just an unwind because of the yield curve moving the way it did.
The Fed knew that, as they cannot afford to live in a world where U.S. bond yields trade above 1% and the 30-year trade close to 2%. It simply will not work with their plan -- and yield curve control, for right or wrong, will be activated. The Fed now knows this and so during their FOMC meeting announced that they would be buying $120 billion in U.S. Treasuries going forward ($80 billion in Treasuries and $40 billion in MBS). This would make sure that the U.S. Treasury supply would be soaked up by them and yields would be capped. In essence, they indirectly announced yield curve control -- without saying it, as it would be a taboo and everyone would call them Japan.
In addition, the Fed painted a very gloomy picture of the outlook and the uncertainty that remained. This was at odds with what the equity market was perceiving, given the aggressive narrative of a V-shaped recovery and bounce over the last few weeks. A strong disconnect.
Of course, it is the Fed's job to paint a cautious picture to justify their actions and to do more if needed. More importantly, Powell said that the 21 million people without a job would be without one for a lot longer, and they were concerned that the May labour market report was a one-off. It was too soon to tell that the labour market was recovering.
It is true, as economies are opening, we are expected to see a bounce from 0, but that is more of a stabilization than an actual V-shaped recovery. Some companies hired workers back as they were incentivized to turn their loans to grants. It was all quite technical.
Businesses are laying off more workers across the U.S. and Europe, and these jobs are not coming back for at least a year. The equity market and cyclical stocks were pretending that Q4 2020 would be back to January levels of the global economy. The reality is we have seen a paradigm shift and some jobs are never coming back, as those companies are not coming back.
There is no doubt that this market has been supported for the past 12 years with Fed liquidity. They have been stuck between a rock and hard place for such a long time, they know not what else to do. When people say the stock market is not the economy, in fact, it kind of is.
At the start of this year, we traded at 160% of GDP, and net capital gains for the U.S. are 200% of annual personal consumption, which is about 65% of GDP. Effectively, the stock market is linked to consumer spending and their wellbeing. This is one of the main reasons why the Fed is so eager to support "asset prices".
Offering these vulnerable people, as the Fed called them, a stimulus cheque of $600/week is really not incentivizing them to get back to work. These jobs will never come back if the Fed is writing them a cheque to sit at home and day trade -- which many are doing as seen by Robinhood accounts making 400% on bankrupt stocks in one day just because it popped up on their screen and they did not want to miss out. Every stock in the last 10 weeks had been up, it was a no brainer to just buy.
The market may be made irrational by liquidity, but the fundamentals of capital structure arbitrage still hold, the equity of a bankrupt company is 0 and one plays it via debt. As we saw in Hertz (HTZ) and Chesapeake (CHK) , stocks rallied and then fell immediately afterwards. Perhaps the CARES act will end July 31. Otherwise, we might be dealing with another dotcom collapse like in 2000. These consumers are not spending, they are gambling.
We are back to the key 200-day moving average in the S&P 500 at 3030, and holding it after the aggressive 7% selloff from 3250 all the way down. Whether we will hold or whether it was just a false break over the last week as all sectors rallied -- not only Technology -- that remains to be seen. Perhaps Q2 2020 earnings will be the reality check that will make investors question paying 25x PE for 2021 when a recovery is nothing more than a stabilization at a much lower level.
