‘Prepare for a market peak’
Prepare for a market peak. All the models in our toolbox are close to, or about to reach, pinnacles, and what follows next is a short-term episode of systemic liquidity drought. At the moment, news flow is positive, but once that market support peters out, the ensuing impact of the forthcoming negative impact of liquidity tightness will likely have a strong negative bearing on market behavior.
Late last week, expectations of another day or so of declines in yields and equities were quashed by decent non-farm payroll data, which kick-started a new rally in SPX and in the 10yr yield (see chart below).
October payrolls rose 128K, above the consensus, 85K. The net revision was 98K, so overall, these numbers are significantly stronger than expected. Unemployment rose a tenth to 3.6%, as expected. Average hourly earnings rose 0.2%, a tenth below the consensus, 0.3%.
The data was good, although the future of NFP measures is much darker. Forward-looking surveys continue to point to the trend in payroll growth slowing to only 50K or so by the turn of next year. Household employment is hugely overshooting relative to payrolls. This is holding down the unemployment rate, but a substantial correction now looks overdue (see chart below):
The markets have been given an excuse to rally, but there are limits
But for now, that darker NFP data future does not matter – the markets have been given an excuse to rally. And rally they did. Nonetheless, it is important that we understand the limitations of this new market surge.
- The PAM High Frequency model is telling us that an S&P 500 Index top is likely due sometime during the Nov. 5 to 6 time period.
- The HF model also tells us to expect thereafter an equity market downside correction phase up to late second-half of November.
Previously, bond yields generally declined after the Fed’s “hawkish” rate cut, and after affirmation by Fed Chain Jay Powell that this month’s rate cut may be the last until mid-year 2020 (see previous chart, above). Equity markets, on the other hand, have been latching on the China-US trade news flow. Media reports seem to indicate that Stage 1 of the trade discussion is set to be concluded at some future date and at a different venue, after the Asia-Pacific Economic Cooperation (APAC) summit was cancelled.
That had buoyed stock market sentiment and is still providing support. But it may be a thin rationale, and it may be inadequate to sustain market momentum for very long.
That is probably why enthusiasm for the rally has not been shared in equal proportions by yields and equities. Also, the divergence may have its origins on the way various assets variably respond to different liquidity sources. We intend to show how that may have happened.
To do this, we first have to take a look at an active work horse of the PAM stable of liquidity models – the High Frequency SOMA Model.
Equities respond to aggregate liquidity flows, especially so to SOMA transactions
S&P 500 Index (ESc1 as proxy) responds to AGGREGATE systemic liquidity. So happens that the confluence of bank reserves and Treasury cash balances have been, and still are, positive on the aggregate, allowing positive news flow to boost equity prices higher, with more vigor.
The High Frequency SOMA model has been designed to predict short-term SPX moves, and to deliver daily data points by using an interpolation process. Many of the models are derived from weekly data, so it’s reasonable to see the HF model being off-sync sometimes with models derived from weekly data points. But the variance would be within a standard plus or minus 2 days of wiggle, either way. The model has a forecasting horizon of 4 weeks.
The HF model has been the PAM workhorse in several, recent Seeking Alpha articles, and it has enabled us to make some markets calls that are still being confirmed by the markets. The HF model has had a very good run lately.
For now, the HF model remains resolute in calling for continuation of the stock market rally until November 5 to 6. The model also tells us to expect thereafter an equity market downside correction phase up to late second-half of November (see chart below).
Earlier, with other longer term and historical models in supporting roles, it has allowed us to warn readers at Seeking Alpha earlier (on October 21), to prepare for a strong market breakout, but which will be preceded by an initial failure, and by a brief market correction. That happened. We also said the pullback will be followed by a more robust market upthrust which will go through with high degree of momentum (‘Prepare For Breakout’: Assault On SPX’s 3025 All-Time High May Succeed On Second Attempt). And the market did follow-through, upside, convincingly. That momentum is still in evidence today as we write this article (November 1).
This is how the High Frequency model looked at that time (chart below):
Original chart in the October 21 article.
The HF model has been bullish since early October. We documented that bullishness with reports of impending lift-off in risk assets on October 10, 2019 at the PAM, and at Seeking Alpha in general, with an article on October 13 (‘We Have Lift-Off`: Yields Lead The Charge Higher; Load Up On Equities, Exit Gold, Sell The U.S. Dollar).
The market did take off, and the various risk assets performed as the models suggested they would. Bond yields and equity indices rose, and oil tagged long higher. Gold and the US Dollar (DXY) counter-intuitively fell sharply together – fitting developments for previously safe haven destinations.
This is how the High Frequency model looked at that time (chart below):
Original chart in the October 13 article
It was clear to us at even at that time (in early October) that the limited, initial repo operations undertaken by the NY Federal Reserve were going to have a beneficial impact on risk assets, especially so for equities. Of course, not long after that (on October 11), Fed announced a new QE program to the tune of $60 bln a month starting October 15, which provided an even thicker icing on the liquidity cake.
That was crucial for equities which respond to AGGREGATE systemic liquidity, but with deep affinity for SOMA transactions which later morph into Bank Reserves and Treasury Cash Balances (TCB). That is, in fact, the genesis of the PAM High Frequency model – it is a forecast of a vector autoregressive process applied to SOMA transactions.
Here is how the High Frequency SOMA Model fits with the 5-year averages of the other standard, liquidity models (see chart below). Historical averages and other historical, yearly SPX profiles also show the predilection for a market pullback at this time of the year.
Bond yields respond mostly to seasonality of Treasury Cash Balances and Bank Reserves
It is slightly different for bonds yields.
For bond yields, it is changes in the seasonality of the Treasury Cash Balances (TCB) and Bank Reserves (BR) that impact yields the most (see chart below). The chart illustrates how the 10yr yield (blue line) matches with the 5-year average of the TCB (dashed black line). As a refresher, TCB and Bank Reserves are both liabilities in the Fed’s balance sheet, but have opposing signs, like yin and yang. When TCB levels rise, the level of bank reserves recedes.
We have discussed the impact of TCB on yields, and the relationship between TCB and bank reserves in more detail in these two previous Seeking Alpha articles (here) and (here).
As we have illustrated in past articles, liquidity infusions from the Fed and Treasury take a while to percolate through the financial system. But once done, the market reaction is decisive, and the lagged, positive effect lasts for some time, for as long as the inflows are continuing. Rising bond yields manifest the effect of liquidity inflows first, equities follow after a short lag (usually after two to three days), then the rest of the risk-asset universe falls in line thereafter.
At this point, ESc1 is making new highs. However, the 10yr yield is a completely different story, still sagging although still responding to a surging Treasury Cash Balance, $435 billion as of Oct. 31, the highest since October 2016, according to data released Friday (see chart above, pink line).
The rising Treasury Cash Balances, which have been rising longer than usual seasonal patterns, have been front ran by bond yields, which may follow the lead of equities higher still (see chart above). But as the chart below shows, yields may also fail to sustain upwards momentum, probably within two trading days, and then fall over the next two to three weeks (illustrated by the 2016 Treasury Balances Models, green line). Once the Treasury Cash Balances fall, yields will fall as well.
Explaining the ongoing divergence between the moves in equities and yields in graphics
For us, the chart below graphically explains the divergent moves between equities and bond yields – those assets were (and still are) responding to different frequencies of liquidity flows from the Federal Reserve and the US Treasury.
The chart above shows how yields mostly respond to the impact from SOMA transactions and from the seasonality of the TCB. As we have shown before, there is a very high degree of seasonality in SOMA transactions and in the changes in the TCB – that is why it has been a lot easier (for PAM) to predict the moves in yields since we started doing these exercises from last year. Changes in yields have very high fidelity to the changes in TCB data. The TCB data is what’s being front-run by the investment banks.
The global central banks’ continuing gift to the financial markets
For the longer-term market forecasts, we again roll out the charts showing how liquidity from global central bank players gets to prime the financial markets. This is how the balance sheets of the G5 central banks (Federal Reserve, European Central Bank, Bank of Japan, People’s Bank of China, and Swiss National Bank) are impacting US equities (SPX as proxy) and bond yields (10yr yield as proxy). See two charts below.
For us, systemic liquidity from the largesse of the global central is the ultimate high the financial markets can have. The charts above and below illustrate the power of the global central banks’ money in pushing risk asset prices – with an even longer lead than that provided by the Fed’s money alone.
If this is true, H1 2020 will deliver fantastic equity returns (chart above), but meager returns for bonds (chart below).
The best feature of all: both G5 central bank liquidity profiles also show nesting of liquidity inflows in late November, followed by sharp rallies in equities and yields until early next year. We could not ask for better supporting data than that.
(This article is an expanded version of the PAM Market Report which was published on November 1, 2019, here)
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Disclosure: I am/we are long TMF, EURO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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