• By raising rates on Excess Reserves, the Fed will kill index investing

    Interesting activity at the end of Friday, which was an options expiration day. The SPY lost ground while IWM gained.



    This is the opposite of the past weeks' patterns where small caps greatly underperformed large caps. The outperformance of small caps at Friday's close could be due to options expirations. It could also be due to lower US rates in the secondary market, which pushed yield-seeking investors back into US Treasuries.



    We can see below that the Money Flow calculated on each component of the S&P500 dropped below zero. This was mainly due to the larger components of the S&P500.



    The Mammoth sector also experienced a sharp drop in Money Flow.



    But the Cumulative Tick staged a spectacular bounce.



    Up to now, the investment theme was that Trump will push for growth. This creates an environment for the Fed to raise rates. Strong rate differentials then attract foreign money into US equities, especially into the large caps, through ETFs.

    We can indeed see that the EV activity on QQQ and SPY is still positive.





    However, the less known story is that there are no investable projects for which banks can lend money at an acceptable margin. Banks prefer to pay 0% interest on saving accounts and park that money at the Fed for 1%. This is a risk free income. Bank or America, for example, has 450 B$ of cash. If it parks half of it at the Fed, that already secures more than 2B$ of annual income. Why do you need to lend money out at a risk if you get a 1% margin at zero risk?

    Since December 2016, rates on excess reserves have doubled from 0.5% to 1%. At 1%, 2.2T$ in reserves costs 22B$. This is a very large amount of money when the government wants to cut spending.



    Since January 2017, 350B$ have found their way back into Excess Reserves. This move will likely accentuate in the coming weeks as rates on Excess Reserves have just been increased.

    Today, this move of liquidity back into Excess Reserves is probably compensated by foreign money buying US assets through index investing.

    Conclusions:

    Index investing is still strong and the Cumulative Tick shows that there is still a positive flow of money across all equities. However, the Fed's policy is forcing money out of the US economy (or out of US assets.) How can this be sustainable?

    Index investing is blind to mundane problems such as earnings, but large US investors are selling the market, especially retail, discretionaries, financials and health related sectors. I think this move will spread to the rest of the market. Once index investors realize their mistake and start selling, finding a bottom will be hard.

    I am 80% short for now, mostly in drugs and biotech, but also in financials.
    My next target will be to short small caps.