If one ever had a desire to venture on roller coaster rides, there is no need to go as far as to visit Six Flags, just watch the U.S. equity market. A week ago, Fed Chair Powell's speech -- suggesting that the Fed is closer to the neutral rate -- gave the market a lot to cheer for as they finally got the cue that perhaps the Fed was done raising rates.
The dollar fell and the S&P 500 rallied 3%. Then, President Trump and President Xi Jinping so called a "trade truce," announced over the weekend, added another 2% to the rally -- even though there was absolutely no detail other than "it was an incredibly positive meeting." It left even the White House advisors scrambling for information.
The squeeze was seen in almost all asset classes except credit and bond markets. There was something more ominous happening in those markets on Monday when the world cheered that a bottom was in place.
The front end of the U.S. Treasury yield curve inverted. The 3-year vs. the 5-year traded below 0 for the first time since 2007. More sensitive, and perhaps the leading indicator of recessions, the 2-year vs. the 5-year went flat and slightly negative yesterday. Even the 1-year vs. the 2-year forward U.S. OIS curve has worsened and inverted.
What does all this mean? In layman's terms, it means the market is suggesting that Fed is embarking on a policy error ("over-tightening") and might (or be forced to) cut rates much earlier. Historically speaking, when the front of the curve inverts like this, we have pretty much ended up in a recession in the next few months. Great examples of this phenomenon occurred in 2000 and 2006. This is worrying, no doubt.
While equities rejoiced in their glory, the more "sophisticated" markets hinted at something more sinister. While we have 90 days before any details of the Trade War settlement emerge, that was not enough to support a market that is already fragile. We enter 2019 with slower year-over-year earnings growth progression as tax cuts fade, slowing emerging market growth, tighter liquidity, lower leverage, and uncertainty over Chinese demand.
All major indices crashed below their key technical support levels. The long end of the U.S. bond market saw its 10-year yield fall to 2.90%. Bonds rallied as the curve flattened aggressively. The iShares 20+ Year Treasury Bond ETF (TLT) (an ETF that tracks U.S. bonds with maturity of 20-years plus) has rallied 6% since November. On Tuesday, as the curve inverted, there was aggressive bond buying vs. equity selling. It hinted of a big program sell order into the day -- an unwind of sorts? Bank stocks were hammered, tracking the yield curve lower. Goldman Sachs (GS) is down 33% from 52-week highs. The FANG stocks got crushed and moved back into bear market territory.
We need to monitor the 2-year vs. the 10-year U.S. bond spread, trading around 11 bps currently. If that were to fall into negative territory, it is lights out for equities and risk assets. We will hear from the Fed at their FOMC meeting on December 18. A December rate hike is almost a certainty, but any shift to a complete pause will be seen as support for markets and top for the dollar. Going back historically, markets tend to collapse after the first Fed cut, as typically means they are too late to the party. Usually when markets exhibit such extreme volatility on either side, it hints of inflection points. No doubt higher volatility is here to stay. Volatility Index (VIX) cheap?
For those hoping for a Santa rally, the S&P 500 needs to hold onto its 2700 level and manage to regain and close around 2800 for a positive weekly confirmation. If President Trump just stayed quiet and did not go back onto his so-called victory declarations, perhaps we would have ground higher.
This week is still filled with a lot of fireworks, as OPEC announces the result of their proposed cut, while key partners are still not in agreement as to the size of the cut or timing.
For now, back to technicals, momentum and algorithms dictating this market. Investing right now is like running through a minefield with absolutely zero training and wire traps everywhere. Perhaps it's best to close 2018 as one for the memory banks, and sit this one out.