As the September quadruple witching draws to a close, the markets remain wary of the upcoming FOMC meeting on September 22nd. Most seem to underestimate the true power of the derivatives expiry as it dictates the price action of the front month futures, which then affects the large-cap stocks, especially technology as they form more than 20% of the market index. Going into this expiration event, there was significant open interest around 4450 and 4500. What that means is that the market was "pinned" between these levels as market makers were compelled to buy and sell futures to make sure they were flat post the expiration. This tends to keep the market fixed and unable to move freely.
With that over, now what?
There have been many ominous warnings of September seasonality and "correction" into October, especially given lofty valuations and the U.S. economy growth plateauing now. But since when has that really mattered? One of the main drivers of this market has been and will continue to be liquidity. As of this past week the Fed's balance sheet grew to a new all-time high of $8.45 trillion. There has been much talk of the Fed tapering with the market expecting a taper in November by a reduction of $5 billion to $10 billion in MBS and Treasury assets slowly, with them being done by the middle of 2022.
This rate of change in sentiment is what is driving the weak sentiment right now as no one wants to touch anything cyclical or QE related. We can see how badly commodities like copper, gold, silver and iron ore have been beaten down. Let's not paint all of them with the same brush stroke as each has its own drivers which is important to distinguish.
The Fed has time and again said that they will provide monetary accommodation till the economy and employment reaches their objectives. By that they mean full employment to pre-COVID levels. For now, we still saw about 12 million Americans out of a job from the last monthly print, but then now that they have expired, we should hopefully start to see more return back to work. Inflation can cause a setback to those plans.
The Fed's preferred gauge of CPI, which really does not show the entire picture, is still within the Fed's tolerance level. The last print showed a slight downtick from the July highs with a month on month rise of just 0.3% vs. 0.4% expected. They are still quite high on a year over year basis around 5.1%, but at least the direction is showing signs of easing. We all know the real inflation number is a lot higher. One just needs to look at food, energy, and gas prices across the board. Inflation is a lot stickier than central banks imagined, but inflation is not necessarily a bad thing. Deflation is worse. As long as the inflation is contained, stocks and bonds can participate in a healthy way. It is when growth starts to slow and inflation moves higher - that is the most unfavorable set of conditions. And that is exactly the market's nervousness right now.
U.S. 10-year bond yields have been in a narrow range between 1.2% and 1.35%. If this were to break to the upside, we all know that spiking yields will kill all asset classes. That remains to be seen but the Fed will cap the gross bond yields as they cannot let that get away from them. For now, the weakening inflation backdrop has bought them some time. But sooner or later they will need to wean the economy off of the free juice.
The bigger question is, can the market survive without it?
All eyes are on the Fed's Powell and the September 22nd FOMC meeting. The market will be looking for any clues about early tapering as that is the key to all asset classes and the dollar right now. At the end of the day, it is all one big macro trade.
