As the Fed dovishly capitulated on Wednesday, the market aggressively rallied 1.5%, shooting through the key 2800 level. This move convinced markets of a sustained breakthrough, as algorithms chased the trend higher only to see a drastic u-turn on Friday as markets whipsawed back, breaking below 2800.
Such extreme bullishness to extreme bearishness -- what does it mean? Usually when markets go through such violent swings in such a short period of time, it implies an inflection point in markets. These moves are quite reminiscent of 2009, as markets ignored the warning signals being flashed in bond and rate markets, only to later spark a sharp selloff as credit markets snapped, which broke Lehman Brothers.
Bond and rate markets are the most sophisticated of asset classes, not driven by nonsensical one-liner tweets meant to whet the appetite of fickle equity market traders. There can be a disconnect at times, as equities are pushed and pulled by a variety of players with cash on hand, but at the end of the day, they always converge to some sort of fundamental rationale; bond markets supersede equity markets analysis of the broader economic picture.
So, what happened on Friday to cause this u-turn? The bond markets have been showing signs of distress over the past week. Even following Fed Powell's pathetic excuse of a display of intellectual thought, the trigger-happy equity markets got sucked in chasing their tail, but bond markets did not buy this bullishness. Something broke. The yield curve started inverting along the front end of the curve. On Friday, the three-year to 10-year Treasury yield spread traded below zero for the first time in a decade! The last seven times this happened, recession ensued. Quite an ominous signal, so to speak.
In January, the Fed tilted on the dovish side, taking a step back from its aggressive rate hike stance and helping markets to rally. At that time, growth was still decent and with the Fed seen as accommodative, it signalled a goldilocks scenario (good growth, low inflation), which is positive for risk assets in general.
The markets rallied 15% through the first quarter, despite the global macro data showing signs of an aggressive slowdown. That is the power of central bank liquidity injection.
On Wednesday, when the Fed capitulated entirely, something did not seem to add up -- especially as the market had survived the lows reached in December. A classic dovish Fed should, in theory, lower real yields and cause breakevens to widen, implying more economic activity and higher inflationary pressures. But on Friday, we saw a reverse of that, as both real yields and break-evens fell, signalling a massive negative "growth" shock.
The Fed Funds market is now pricing in a 70% chance of a rate cut by 2020! Just three months ago, the market had been pricing in two rate hikes in 2019. Incredible. The bond market is fully bracing for a recession, but the rate market is not far behind. The 1-month US OIS (overnight indexed swap), 2-year-1-year spread declined further into negative territory. Sparing readers the technical significance of this move, needless to say, this is very bearish -- showing stress in the health of the overall economy.
There is just one trade here. This negative growth shock means it is time to sell equities, commodities and all sorts of risky assets. It may appear counter-intuitive to most vanilla equity traders, but this year, the market has been trading off of macro themes, not micro, unfortunately.
The same reason why bearish players got stopped out in December will be the reason bullish players will suffer now. If one stays too focused on their P/E, EV/EBITDA, FCF yield and NAV ratios, they will miss the wood for the trees entirely.
Copper had a false break above 6500 following Wednesday's euphoria, only to trade below $6300/tonne now. Mining stocks are up around 25% from the lows in December and seem at risk of profit taking. The oil price, although fairly valued around $67/bbl Brent, will suffer the same fate as its commodity brethren if risk assets are sold down. Explain that to OPEC, they won't get it. Just like they did not get it back in October last year.
It is human nature to be greedy and investors suffer from FOMO (fear of missing out) as stocks reach new highs. It's always "oh I could have made 5% more," as opposed to "I am going to pocket my 15% and say thank you."
It is important to assess the risk-reward intelligently, taking money off the table when the broader indicators do not make sense. That time is now. Shame the market players currently comprise mostly millennials who have only ever traded the "buy the dip" market.