Market Recap: Break out the Squeegie

We were thinking the Fed would be forced to act and act they did. The markets were thrown for an option expiration short squeeze when the Fed announced a 50bps cut in the discount rate from 6.25% to 5.75% Friday morning driving the loads of put holders to cover. Selling in stocks (financials) was relentless for most of the week on fears of insolvency at CFC, a lock up in the repo and money markets. The curve steepened to close out the week at 50bps on the flight to quality and subsequent risk premium widening when the Fed eased. As expected carry trade pairs and gold traded in line with the direction of stocks, lower during the first half of the week and rebounding with stocks Thursday and into the weekend.

International Interests: Ride of the Valkyries

As we mentioned last week, the carry trade pairs became subject to other market de-leveraging and margin calls. USDJPY and EURJPY both traded to new lows Thursday night before reversing as stocks recovered. Friday’s Fed ease was more evidence that markets will be difficult to handicap in an environment where central banks are active. The DXY has been a clear beneficiary of the credit unwinding as trillions of $ are literally evaporating from the system. We mentioned months ago that a de-leveraging and credit cycle reversal would be bullish for the greenback and that thesis seems to be playing out. DXY weakened on the Fed ease which is to be expected but the move simply corrected the rally. If the Fed comes in and lowers funds target rate, the DXY could see a new low but Friday’s move shows us how strong the underlying dynamic of the credit reversal really is. The question to be discounted by the market is whether the Fed can inject enough liquidity to offset the rate of capital destruction. We don’t think they have enough bullets. Next week expect the correlation to continue as equity prices look to hold the bounce and follow through to the upside. If they can rally expect weakness in DXY and strength in USDJPY and EURJPY.

Bottom Line: The central banks are active and pumping liquidity to ease the de-leveraging. The BOJ meets this week and with the carnage hitting the Nikkei we would not be surprised to see them ease or worst convey dovish stance. This could re-ignite carry trade appetite and these currency pairs may see a sizable bounce as they remain oversold. Stocks may also bounce on easing credit fears which could utilize the yen for leverage.

Cost of Capital: Gimmie Shelter

Treasury prices continued to benefit from the flight to quality due to de-leveraging but the yield curve is where the market is talking the most. Thursday we saw some capitulation in the front end as T-bill yields collapsed +50bps and the 2YR crossed 4.00% before reversing in the afternoon. 2s/10s blew out to the highest level of the year at 55bps before settling at 50bps Friday. The market is in effect tightening by raising the inflation premium anticipating the Fed priming the pump. This move is totally consistent with our thesis that a steeper curve is bearish for risk premium (multiples) as the relative cost of capital is rising. We have been concerned that the duration would under perform in this scenario and is why we have been recommending the 5YR sector. 5Yrs traded close to our first target of 4.25% and now is starting to get expensive for new money. Anything below 4.25% would cross our fair value estimate near the nominal growth rate of GDP (which we think is falling). With the Fed presumably launching an easing campaign (we don’t think this is the only move) we expect the curve to remain under pressure and thus continue to recommend the front end v long end but would prefer to wait on pullbacks for new cash. Lower that target from 4.75% to 4.50%. We believe growth will be slowing to below 4.00% in the 2nd half and the 5YR sector is attractive on all pullbacks which we expect to get in the coming weeks with the market overbought and subject to a correction.

Bottom Line: The bond market has performed as we expected with the curve steepening 50bps while the 5YR has rallied 75bps. We must back off recommending the 5YR near 4.25% as we view that close to fair value and believe we are due for a pullback.

Beta Maximus: Emotional Rescue

Stock markets have been on an emotional roller coaster ride as the S&P 500 retest4ed the previous March low at 1375 before reversing hard into the close on the Fed discount rate ease. We were looking for a short covering bounce into expiration and though it was a little later in the week we were happy to see the spike giving holders another opportunity to lighten up on exposure. The shorts are providing a “gift”. We are still targeting the 1500 area for a bounce but it could be a quick trip. We encourage investors to not get cute while waiting. Friday’s Fed induced spike may be the best short and while the market could grind up into Labor Day before the big boys come back to work, we would be selling into next week. Even if the market makes a new high, we think it will be a token move generated by the Fed liquidity support. The real economy won’t be able to survive in an environment where bank balance sheets are contracting. Selling rallies has definitely been the appropriate strategy and we so no evidence to change our opinion. Even if stocks don’t fall apart here we think it is unlikely they will out perform 5YR notes. As we have been preaching the stock market is not in charge of its own destiny as de-leveraging and risk premium re-pricing can snowball. This could be a major top in equity prices if our credit cycle reversal thesis is happening. When we get these short covering rallies, they should be sold. “Tape bombs” are impossible to predict and like to hit when the US market is closed causing gaps and panic trading. This is no environment for savings and risk averse.

Bottom Line: Stocks may have put in a low this week as the chart looks like a “V” bottom. They also could have put in a major top in July. We are looking for a bounce but remain defensive. Selling rallies still looks to be the proper strategy until we are convinced the credit event won’t evolve into an economic event.

Commodities: No Respect

With all the action in money markets and the Fed ease we will continue to focus on gold prices as we believe they are regaining the inverse correlation to the dollar. Gold saw a volatile week as Thursday’s risk aversion and de-leveraging trade took $25 off prices only to rebound Friday $15 on the Fed ease. Gold likely will continue to chop around and reflect the risk appetite which is under re-pricing. We will stay out of the way as gold is losing its luster with us.

Bottom Line: Gold could see some buyers looking to hedge against central bank liquidity infusions but we view the long term prospects as marginal and will instead watch the metal for signs that liquidity is finding its way past the banking system.

The Ex Ante Factor: Material World

The TTC chart of the week for the July 14th update we asked: Are commodities topping as the dollar is bottoming? Dominick has pointed out two potentially simultaneous ending diagonals in the CRB (see RSI diverged) and the Dollar Index, which if correct would be consistent with each other and a signal the credit cycle is reversing. And concluded: This could be the writing on the wall as the liquidity/credit cycle that has been supporting asset prices for the past 5 years may be ending.

We certainly are witnessing a credit event unfold before our eyes, but this weekend we want to expand on these charts and take them a step further:
The CRB/DXY chart came through for us as an important indication that we could be experiencing a contraction of credit if those ending diagonals broke. With RSI now sitting on support, the question now becomes whether the diagonals broke or need another move to complete. This may determine whether this financial event in the form of a credit market seizure manifests itself into an economic event such as a recession. We think the answer could lie in the performance of materials which have been leading the market lower over the past couple of weeks. This is not a coincidence, so why not expand the scope of this CRB/DXY chart pattern to provide direction of the materials sector which should tell us whether the broader market will bottom here or resume the decline.

The most obvious conclusion from this chart is that commodities are priced in dollars therefore a fall in their prices implies the dollar is worth more. With all the finagling by central banks we can’t be sure the performance of financials can be a true representation of healthy economic activity. A band-aid on their balance sheet tells nothing about whether risk capital being re-deployed. We think the CRB chart and subsequent performance of the materials sector will provide a better indication of the real economy and we will focus on the “confirmation” line on the CRB as a make or break/line in the sand for the overall market.

The materials sector can be thought of as a high beta play on the credit boom as they were one of the end market beneficiaries of increased leverage and thus capital deployment through the real estate and infrastructure economies. They also enjoy the benefits of the excess credit in the form of a depreciating dollar which in turn raises the value of their underlying assets. As de-leveraging occurs and loans are called, cash is drained, activity stops and thus demand for these material fades. The materials sector is on the front line and literally at the margin of capital investment giving us a real time indicator of this level of economic activity. The financials are the facilitator of this capital and the fluidity of the whole economy rests on the ability for them to expand balance sheets. Conversely, when de-leveraging occurs and assets are sold at a discount, money evaporates, the amount of future lending is reduced and the expansion of capital reverses, reducing the demand for these materials.

This week’s trouble at thrift giant CFC was a perfect example. They have been essentially locked out of the repo and commercial paper market and there was a semi run on the bank deposits, their other source of short term funds. The discount window was their only option to replace those funds, but it does them no good to replace borrowed money at 5.00% with 6.25% to make loans at 6.375% (where they quoted 30YR fixed Friday). The Fed had to lower the discount rate to provide them and others some breathing room or we may have experienced a lock down in credit. Had CFC been forced to raise cash by liquidation at discounts, it could have started a chain reaction with ripples throughout the whole overnight lending market. No collateral would be accepted. No loans could be made. No capital investment. Money would cease flowing to markets and producers such as AA (-30% from the highs)

So, what is the current situation? Did the Fed dodge a bullet on Friday? Banks can sit behind their net interest margin as long as their assets perform, but the materials require new investment. We believe these stocks will be first to know if risk capital is being deployed again or if the banking system is contracting further.

Since the market high on 7/19, the materials have been one of the worst performing sectors in the S&P at -14% compared to the financials at -7%, after the late week’s recovery. Both sectors looked to put in important lows at previous support but we think materials are leading and will want to see them specifically follow through higher for evidence last week’s bounce was more than a selling opportunity. Holding support on the CRB may be a key indication that sufficient liquidity is being provided via central banks to unlock the banking system and return demand for materials. A break of the “confirmation” trend line would suggest further economic contraction causing us to be very defensive in all asset classes with the exception of dollars (or short term treasuries) which look poised to appreciate on further liquidation of collateral.

What is the discount?

Stock and risk spreads continued to widen v quality assets this week with the implied risk premium in holding equities v 10YR notes is the widest since the March lows. The total return offered by the S&P 500 is also just off the cheapest level of the year at 782bps. These widening of risk spreads suggests there could be some value buyers stepping in this week and these are some relatively attractive levels.

Bottom Line: Stocks got cheap fast and if we can see some stabilization in the credit markets we could see a relief rally back to the 1500 area. We think it’s also plausible that an aggressive easing from the Fed or other foreign central banks (BOJ meets this week) could vault us to a new high. We are sellers on that rally and will remain defensive as we are not convinced the Fed can engineer a soft landing when balance sheets are de-leveraging. The odds of a 2008 recession are growing with this credit contraction adding insult to injury in an already decelerating economy.