The S&P 500 touched an all-time high intraday yesterday at 3042 but closed just shy of the closing all-time high in July of 3039. It has been an incredible rally of around 5% in October, unwinding all of September's losses and repo market jitters. The Fed has cut rates twice by 25 basis points and is expected to cut one more time when it meets on Wednesday. This is almost a forgone conclusion as probability of a 25-bps cut is around 90% now. The bigger issue here is how the Fed will guide the market going forward and what the market expects.
When the Fed first cut rates in July, talking heads justified it as a "mid-cycle adjustment." Since then they have gone guns blazing, cutting rates twice, buying $60 billion/month of U.S. Treasury bills and pumping about $100 billion per day in overnight open market operations. That is hardly a mid-cycle adjustment.
It appears more to be a panic-move insurance cut from a Fed that is afraid to repeat the mistakes of 2007 and the fourth quarter of 2018. They are hoping to do whatever it takes to sustain the expansion, but are not addressing what is causing the turbulence. Both times in July and September as the Fed cut rates, the market rallied into the event in excitement and optimism, only to sell off after. Could we see similar price action this week as well?
The market is rallying on hopium, a clever word coined by the media lately given the surge higher in the S&P 500. Earnings have disappointed but numbers were probably lowered so much in anticipation, everyone is more scared to miss the rally than actually trade on the fundamentals alone. With U.S./China trade talks reaching a good point, where a Phase 1 deal is to be signed in Chile in November potentially, Brexit delayed till the end of January 2020 and the U.S. market back at highs, the Fed may have reason to alter the language somewhat, rather than go on full easing mode with no end. If not, and if things really go pear-shaped, it will lose whatever credibility it has left. Besides, the Fed cannot possibly know how two rate cuts have impacted the economy in a month's time. It would be prudent to let it come through to gauge whether any more is needed. After all, this is not 2007. They do not have 500 bps of interest rate cuts to play with.
There are three possible scenarios. Powell could cut rates one more time and then lean slightly hawkish on the market, saying they are there to support it but feel the adjustment was transitory given robust U.S. economy and overall risks. This would disappoint markets, no doubt. The dollar will rally and investors intoxicated on hopium will be forced to sell the rally. Surely, given all the cash on the sidelines and uninvested and earnings not as bad can all be factors to support the market on the low end of the range. At least that is the justification I get from investors buying the market today.
The second scenario could be to cut rates by 25 bps but then keep the language open to "sustaining the expansion." This outcome would be mega bullish, as it would be a green light, for right or wrong reason, and will certainly take the market way past old highs. It would avert the short-term problem, but the fall later might be much bigger and messier.
The third and least likely scenario is if the Fed does not cut rates at all and in fact reiterates that it was a mid-cycle adjustment. This would be a huge disappointment and take the market back to more normal levels. It is a very small tail risk, but one that should not be counted out by the market. The Fed will then have passed the baton to Trump to sign the Phase 1 deal with China to get the market to close higher. Trump cannot afford any market hiccups from now until next year, so going aggressive on China is not in his interests -- and China knows that. Any deal will be a fake deal, but one cheered by the market nonetheless.
Over the summer, there was a lot of talk about the inverted U.S. yield curve and how it inevitably precedes a recession. Strangely enough, there has been no press mention of this indicator over the past month at all. Since the Treasury bill buying, the curve has re-steepened as the 10-year yield has rallied from 1.5% to 1.86% as long-term bonds got sold, whereas the Fed buying of the front month has kept yields low. An important distinction to make on yield curve inversions is that a recession does not occur when the curve inverts. In fact, the economy falls into a recession just after the curve re-steepens as the Fed cuts. Deja vu 2007 anyone?
At the risk of sounding like the Prophet of Doom, I would be remiss if I didn't point out exactly what happened back in 2007 in July, September and October. The market ignored subprime mortgage market and signals in credit, instead rallying to new highs on the back of Fed rate cuts. Then the market finally topped out in October 2007, and the rest is history. Today, the discrepancies in the repo market, with banks demanding liquidity every day close to $80 billion a night for the past month, is more than worrying. Auto sub-prime mortgage default rates are rising aggressively. Given the earnings calls and high cost eating into profit margins, especially with the slowdown in U.S. Shale drilling, there is no doubt that we will start to see a pick-up in unemployment as layoffs start hitting nonfarm payrolls soon. Those traders using record unemployment as a justification for a "solid" market will find the carpet pulled from underneath them.
Trends always take time to appear in actual economic numbers. We all know that data reported today is hardly relevant. It is about reading between the lines on the small indicators, observing bigger picture trends and putting them altogether that paints a much more accurate picture as to what the next month's numbers will say.
That is what one should trade on. Not what has happened but what will happen. If it were not for the Fed's aggressive intervention, the market would almost certainly be lower with the same earnings numbers witnessed. The Fed liquidity is supporting the market for right or wrong reasons. But calling it "fundamental" labels one a fool.
It is all about liquidity. It has always been about liquidity. Fundamentals? Shmundamentals.