• Weekly Comments for October 17, 2016

    In past months, the US/Japan 10Y Treasury rate differentials have been useful tools to guess at market reversals. However, we can see below that the two latest upside reversals in the rate differentials have not pushed US equities higher. This is a sign that NIRP money and/or the Yen carry trade have stopped being a source of liquidity.



    We can see below that a strong reversal of the VNQ ETF occurred at the end of September.



    VNQ and XLU have retraced almost 50% of their February-August uptrend. This does not look good for Japanese NIRP refugees.





    Both the Mammoth sector and the Non-S&P500 sector are displaying negative money flow. This is strange, because it looks like Hillary will win the election, which should be equities positive.





    We can see that Hillary's evil biotechs are under heavy pressure, another sign that the election outcome is fairly certain.



    This may be why the US 10Y Yields are higher: the market does not care about the Presidential elections, but is already discounting the Fed's rate increase of December.



    Note that a similar mechanism took place late last year, before the December hike. (As a reminder, the January drop in equities was mostly due to the reversal of excess reserves.)



    We can see below that the drop in Excess Reserves that occurred the week ending October 5 barely compensated for the reversal of the reverse repo operations.





    It seems that last week, the reverse repo operations still put pressure on the markets, but we are only $B40 from the yellow average line, indicating that the liquidity pull might be over soon.



    Conclusions:

    I believe that equities markets should be less negative this week as the reverse repo operations will stop draining money out.

    However, a "less negative" situation does not mean "positive." What we would need for equities to bounce is probably a reversal in the Euro/USD - a sign that fear is easing in Europe - as well as a pull back in US rates. This is what large players seem to be expecting for the coming week.



    Comments 2 Comments
    1. gapcap1's Avatar
      The changing correlation between the US/Japan 10Y Treasuries rates differential and u.s. equities may be signaling a secular regime change. Like any relationship, correlations have life cycles which can vary over time; increasing, decreasing, or even disappearing, depending on the steady or changing market environment. With the fed pushing for a dec rate hike, the policy divergence narrative has been rekindled, and with the subsequent dollar strength, fears of a financial tightening have been bolstered.

      The uptick in inflation expectations and the rally in crude has undoubtedly alarmed the institutional herd long duration, as evidenced by the steepening yield curve. Throw in Japan's shift from qe purchases to 'yield targeting' and one must wonder if the markets are experiencing a secular change, especially one that very possibly could be an end to the bear market in rates.

      As is always the case on sell-offs, the question that looms before us, is one that is impossible to discern with any certainty; is this simply a re-positioning, or have the markets turned ? Risk-parity funds, along with other hedge funds with strategies tied to volatility and VaR, along with funds that are sensitive to a rising dollar (commodities, emerging markets, macro, etc.) have been most adversely affected by the persistent high positive equity/bond correlation and other positive cross asset correlations, along with the spike in volatility and the strong dollar. While their positions have been pared down, they still may have further equity and bond exposure, and if continued dollar strength and a vix finding value above 16 would manifest itself instead of steering clear of that scenario, both the bond and equity markets could feel more pain.
    1. Pascal's Avatar
      Thank you gapcap


      It is indeed difficult to find the right leading indicator in order to assess a market top.
      The Vix is still low compared to past spikes: most spikes above 20 have been good timing to turn equities long. So yes, the Vix has more upside room, but it might as well come back down to 12-13.

      In fact, an orderly portfolio adaptation by the different hedge funds have little chance of creating a spike in volatility. A spike would come from a credit event or an unexpected news (An AAPL or AMZN large miss for example.)

      Attachment 38179

      I am positioned for a slow drift down leading to the December hike. I do not expect a big shake out. The big shake out will come if/when the Fed increases the rates on excess reserves.


      Pascal