• Fed policy: let inflation run but control interest rates.

    Very impressive bounce continuation yesterday as the $SPX reached the 50MA resistance level.



    Large investors are supporting the bounce which was visible across all sectors.









    Even defensive sectors attracted money simply because rates pulled back.





    Rates pulled back mostly because reverse repo were increased by $80B. This gave much fuel for Treasuries rehypothecation and hence increased risk taking. This is why we got the almost linear Money Flow increase for most of the day yesterday.



    On the other hand, futures buyers seem to be somewhat more cautious.





    Conclusions:

    I would say that Friday - which is options expiration day - will continue to display strength. Next week could be different, but this is next week.

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    Some extra comments on the mechanical aspect of the market that is mostly reacting to the Fed's policy:

    Even though oil/copper and most commodities continue pushing higher,





    the Fed is still putting a lid on the 10Y rates using increased reverse repo operations.
    We can see below that investors are buying US Treasuries, indicating that they believe into still higher reverse repo.



    Gold is also following the move of lower rates expectation:



    As a consequence, there is a US$ scarcity, which tends to push the US$ higher.



    Note below the correlation between the reverse repo operation and the US$ strength.



    This means that if the Fed has to increase the reverse repo operations to 2T$ by the end of 2021, as a consequence, the US$ will gain strength against everything else. However, since interest rates will be kept low (due to these RR operations) the economic activity will stay strong, expected earnings will continue to increase and as a consequence equities will stay high/move higher.

    But commodities prices will continue to increase. this means a stagflation mode where everybody with money gets poorer since interest rates will not cover the rate of inflation... and suddenly the US economy will not be able to move things around as consumers will lack cash/earnings to buy things.

    In the meantime, the US is exporting inflation around the world. A strong US$ combined to an increase in commodities prices are putting much pressure first on developing countries that have US$ borrowing, but also on bankrupt countries that could fall into civil war or dictatorship (Lebanon, Tunisia, Maroc, Turkey, most African countries, Middle-east countries that do not produced oil, even Argentina.) There starts to also be discontentment seen in Europe as Governments have to subsidize energy consumption in order to partially shield the weakest or their population.

    With the sharp increase in oil prices, there is no surprise that China decided to boost its coal mining operations in order to meet its increasing electricity needs. The consequence will be a general push in CO2 emissions around the world. So certainly faster global warming than what we have been expecting or committed to. Everybody wants to decrease CO2 emissions, but nobody wants to sacrifice anything. So the result will be general pain in terms of inflation and lowered purchasing power... but also more economic migrants into Europe from Africa and into the US from South-America. This is written everywhere and there is really nothing that can be done for each individual, except being prepared for harder times.

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    Are US equities expensive?

    Yes, equities are expensive compared to past prices, but in terms of investment opportunities, still equities seem to be more attractive than anything else - except for reverse repo operations, which bring good free cash to banks. (I expect that the Fed will soon stop publishing this RR operation data though.)

    Lets work on the yield comparison to understand the implications for equities prices!

    First, below is the Figure that I published two days ago. We can see that the equities (S&P500) overbought level was at about $5250.



    In the past two days, the 10Y rates dropped to 1.52% from 1.59%, but the differential between the 10Y Treasuries rates and the 10Y corporate bonds rates also dropped to 1.1% from 1.16%



    Below I only show the consequence of the 10Y rates drop to 1.52% (I leave the rates differential at 1.16%.) We can see that the 'expensive' level automatically increased to $5500.



    When I lower the rates differential from 1.16% down to 1.1%, we can see a dramatic effect on the 'expensive' level that jumps to $6750. This means that as the rates differential drops further, funds have more incentive to move cash into equities from corporate bonds .



    In the Figure below, I show how the level drops down if we use lower earnings expectation down to $ 153.72, which was the level for last quarter.



    We can see with this small exercise how well controlled the equities markets stay simply due to the Fed's control on rates. The negative point of this exercise is that if real inflation was to lower expected earnings while the Fed would lose control of the 10Y rates then we certainly would witness a market crash.

    Maybe in 2022 with extreme reverse repo that will lead to extreme hardship in terms of US$ and inflation of things. The Fed will have to partially replace RR operations by a swift relaunch of QE operations. The US$ will then crash against everything else.