The Market: Reset Needed Before Final Blow-Off
The Market: Reset Needed Before Final Blow-Off
Sentiment is a problem here. On watch for Waller to push back.
Discussion
Early in the pre-US market open the curve continues to bull steepen, the USD is down, EUR HY CDX is down, and equities are up. This action is likely in anticipation of a soft PPI print and Chinese stimulus (which apparently has been waiting for a pause in FED hikes to implement). But I am skeptical this bullish follow-through holds with sentiment this elevated.
As discussed two days ago, Mark Hulbert recently pointed out that short-term market timer sentiment is more bullish than it was at the 2000 top with every high levels of recommended equity exposure.
Three things support Hulbert’s read of the sentiment backdrop:
As discussed in the post above, I was on a Twitter space the other day and a former very vocal bear just casually declared that he is now bullish without a lick of supporting evidence beyond “the market doesn’t care about contracting liquidity”
Last night I was on a call with an investment adviser who came into the year defensively positioned on recession risks and is now mocking the risk of recession: “What recession? What yield curve inversion? None of that matters!”
The SentimenTrader Intermediate Term Optimism Index (OPTIX) has blown out to over 85. Very loose analysis: Since 2002, there have been just three times OPTIX has moved above 85 without an immediate pullback of at least a couple %: December 2010, December 2019, and December 2020. Besides the fact the three times happen to occur in the bullish seasonal December period, the one common trait of those periods? The Fed was engaged in quantitative easing.
Not only is the Fed not engaged in QE at the moment, it is actively trying to maintain tight monetary policy in order to ensure inflation falls to 2-3% on a structural basis. Yes, the Fed is actively going for a soft landing, but it does not want financial conditions to loosen in the meantime. They want to hold financial conditions tight at current levels while they sit and wait for the labor market to soften.
Since yesterday’s soft Core CPI print the curve has bull steepened, the USD is down, credit spreads have tightened, and equities are up. That’s a loosening that if sustained risks undoing the very work that is allowing the Fed to go for a soft landing. I do not at all expect a 2022 Jackson Hole redux by the Fed given policy is in a much tighter position than last August, but they will not want this loosening to sustain itself.
Enter: FED Governor Christopher Waller. He is widely known to speak on behalf of Chair Powell, and he is set to speak on the economic outlook at 6:45pm EST tonight.
Look for him to endorse the possibility that July is the last hike while pushing back against the easing of financial conditions with an analysis of how inflation remains stubbornly high and the labor market too tight, while directly acknowledging an easing of financial conditions risks undoing the Fed’s work.
Don’t get me wrong: SPX is highly likely to blow off to 4600/4700, if not ATHs, before all is said and done. But a pullback is needed to shake out late bulls before energy is built for that final push, and pushback from the Fed combined with a questioning of “why” inflation is falling so quickly (aka weak underlying economy) should do it here soon. (The stop-loss on this near-term pullback thesis would be an overtly dovish Waller.)
Exhibits
Bullish Follow-Through
HY CDX closed at the lows yesterday after the equity market close.
EUR HY CDX is down this morning pre-market.
USD continues to move lower.
3y/10y UST curve continues to bull steepen.
Sentiment is a Problem
OPTIX has blown out to 87, above the critical 85 level that has halted all but three rallies since 2002.
2010, 2019, and 2020 all saw SPX continue to power higher despite blown out sentiment. But two key factors in those three scenarios: highly positive December seasonality, and most importantly FED QE, neither of which is in place at present.
All other rallies were halted by elevated sentiment.
Fed to Push Back
The December 2023 Fed Funds futures contract is down 10 bps to 530 in the wake of yesterday’s soft Core CPI print. That’s in line with the prospect of the Fed going on pause after a hike in July, but the risk is to the downside, which would result in an unhelpful easing of financial conditions. Waller tonight will be a key lens into the Fed’s “going for a soft landing” thought process.
