Cloak and Dagger
“They don’t think, they’re pretty sure he has no brain function.
Ok, Ok, if he wakes up we’ll worry about it then.”
—Burn After Reading
Should we fear bonds?...Again?
Key takeaway: The market is propped up by earnings, an employed workforce, a huge flood of fiscal cash and the promise of AI. Against that backdrop is a Mount Rushmore of risks that can literally crash the party if any of these boulders come down: services inflation, an acceleration in firings and drop in hiring, a reversal in Chinese yields, and further unexpected increases in an already unstable U.S. budget deficit. Last week did not see European markets drop further, but their crisis did have an impact in Japan. The biggest surprise that did not leave an immediate mark on the market was out of the Congressional Budget Office (CBO), but that one has an expiration date as explained below.
Groucho Marx Dept: Tuesday NVIDIA became the largest cap stock in the U.S., beating out Microsoft and Apple. The three combined were over 20% of the market cap of the S&P 500, a record looking back over history of the biggest three stocks in that index. I had said months ago that I was looking for the analogous move in NVIDIA over Microsoft that occurred back at the peak of the 2000 NASDAQ tech bubble when Cisco eclipsed Microsoft to usurp the number 1 spot…temporarily.
Since I made that comment, many have piled into this club, so I really don’t want to belong to it any longer, although I will say we had an interesting test of downside support Friday that I will discuss in the Equity Market section below.
Another analog I would entertain is suggested by the following chart constructed by Daniel Simonyi going back almost 100 years of the 10 largest market cap stocks’ representation of the entire market cap of the U.S. stock market.
I added the current all-time high just above 76% with the red dot (h/t Andy Constan), putting the current market even more top heavy than 1929. I am not saying that we have the conditions in place for a stock market crash nor are we on the precipice of a global depression. However, it is not a stretch to say—unless things are different than at any time in the past century—that this is an ?unstable and untenable situation, and markets are mean reverting mechanisms.
Out of curiosity, here is the 1929 price action in the S&P in black overlaid on top of the current S&P 500 action in red:
Analogs, such as the Cisco/NVDA overlays, are anecdotal. However, this chart, along with the one above it do create a picture, so it is something that I will follow if we do paint-by-numbers over the next few weeks. A crash is not my primary view, however, but limited upside is.
Philosophy 101: Can stocks climb a wall of worry if investors aren’t worried about it?
For now, there are a few items that should be on the worry list for investors but are still dormant. Here is my laundry list:
0. Inflation
The latent inflation scare will remain so until services inflation starts to pick up again. I have headed this section as “0” because there is no immediate danger that I perceive that the consensus is ignoring. For me to get concerned, I will key off the New York Federal Reserve’s Multivariate Core Trend of PCE Inflation indicator shown below since 2019. It has moved back above core PCE since January 2024, but I monitor its probability band (shown below in blue) to completely move above core PCE as it did in 2020 (see yellow highlight on the left) before forecasting rising inflation. The band fell fully below core PCE in 2022 signaling an inflation slowdown. The May data is out in the first week of July:
Again, rising inflation had been the major downforce in risk markets, and has since retreated to the background. The unraveling of the Yen carry trade is also classified in the “0” bucket. Until U.S. inflation accelerates, or the Bank of Japan raises rates again, I am focused on the following problems flying under the radar.
One thing the Fed and the markets are underestimating is the hollowing out of the consumer segment. They are dulled into a sense of complacency due to the focus on the coincident economic series of nonfarm payrolls, which has yet to weaken. However, retail sales is slowing and the University of Michigan Survey of Consumers’ Sentiment Index just hit a one-year low. Below is a chart of the survey’s Real Household Income Expectations over the next one to two years:
he chart above is yet another anecdote that consumers are not feeling as confident about keeping their job as the Fed and equity market investors perceive them to be. The recent rise in continuing unemployment insurance claims and the 4-week average of initial claims is real. I argue that weakening employment trends should not only be recognized soon but should move to the forefront of investor worries. (Chart provided by The Daily Shot).
The chart above may be a driving force behind weaker home demand that homebuilders are already experiencing, even if the equity market indices are not reflecting concern. Here are new privately owned housing permits, hitting levels not seen since June 2020:
The same drop holds true for housing starts, and new home inventory levels are rising, which will dampen construction activity and employment in that sector.
The increased anxiety over their personal financial outlook is quashing demand among prospective homebuyers. Home buying traffic has sagged, and given the potential for buyers’ anxiety to increase, any further drop in housing could become a significant market, and economic, signal.
One chart I am using to track the degree of investor fear regarding housing is the homebuilder ETF XHB. The chart goes back almost 5 years, and hit upside targets in March, as indicated by the cluster of resistance lines.
Most stops are going to be set below the April and June lows around 100, but my indicator triggers a sell below 101.50. Any rebound above the upper band and flip to a blue bar would be a welcome turn.
2. Silicon Valley Bank, Japanese Style, or Sichuan?
News out of Japan’s Norinchukin Bank that they are taking a $10 billion hit in their foreign sovereign bond portfolio reminds us of two overhangs for risk assets. First, that dollar funding rates in Japan remain a problem, and second, that any uptick in rates that mimic France’s could have global ripple effects. Norinchukin announced they will rotate out of their $63 billion foreign sovereign bond over the next nine months due to an upturn in short-term funding costs. However, funding costs did not change recently, but what did were credit-related losses in their European sovereign holdings stemming from the EU Parliament vote. A $10 billion write off is not a welcome event, but considering this is a financial institution with $840 billion in total assets, it is hardly a reason for a SIVB-type bank run.
In the unlikely case of the Bank of Japan being forced to raise rates quickly, then losses in JGB holdings at Japanese banks could occur, but the Bank of Japan tends to move glacially.
What could develop into a Silicon Valley Bank rerun is more likely to unfold in China. The Chinese fixed income market is rallying strongly as investors price in more rate cuts, which creates the potential for massive losses on any dramatic yield reversal.
Here is a chart of two-year government yields over the last three years:
The People’s Bank of China has become vocal as rates continue to fall across the curve. There used to be a race between stocks and housing—when one asset class was hot, capital would rush into it. Since housing is underwater, and stocks moribund, bonds have been the beneficiary, but things are getting out of hand. Trading volume is exploding: trading volume in 10-year bonds increased fivefold in the first quarter. According to Bloomberg, the yield premium to accept interest rate risk is at a record low, with only a move up of 40 basis points to create a drop in price greater than a full year of interest payments. This is similar to what caused the bank runs here when U.S. banks bought low duration Treasuries, and a small rise in yields translated into significant price drops.
The problem is, institutions will keep going into fixed income securities until something breaks, because housing keeps weakening:
I am watching Chinese equity indices. After enjoying a strong rally since the beginning of the year, they have pulled back to a level that could start a rally. (It reminds me a bit of what is going on with Bitcoin, as both are driven by global financial liquidity.) If Chinese 10-year bonds start moving toward 2%, and 2-year yields as seen above go to 1.5%, it sets up the potential for very volatile events to arise.
3. The 0DTE Version of the Yen Carry Trade
There has been an ongoing concern about the dispersion trade, where call options are purchased on a basket of individual stocks containing mega cap tech and other AI beneficiaries from power grid themes, along with some other sectors. Index options are sold against them to help cut the options premium decay from the long outright call options on the individual stocks. This trading strategy, called the dispersion trade, profits from the lack of correlation between stocks and the indices, pictured below:
The low levels are a function of the first chart I included in this report; when market breadth is extremely narrow, individual stock correlation to the index is very low, making these option pairings quite attractive.
The previous lows in the above chart are 1998, 2000, and 2018. In retrospect, those were poor risk/return environments for equities. When stocks sell off quickly, correlation jumps toward one, as everything falls together with the indices. The dispersion trade is based on a foundation of low, stable volatility in the VIX, which goes hand-in-hand with the low correlation of the basket of stocks to the indices.
With massive selling going on in index options, and low correlation based on the popularity of the AI theme, what can go wrong?
Here is where the CBO comes in.
The Congressional Budget Office just increased the size of the 2024 budget forecast to -1.9 billion. The deficit is now expected to end the year $400 billion higher than what was assumed at the time of their last forecast in February.
I am asserting that equity volatility reverses higher based on what the Quarterly Refunding Announcement will contain on July 31. Last August’s increase in coupon issuance caused an equity selloff that doubled the VIX as the S&P sold off over 10% from August into October:
I anticipate that the increased deficit will not be financed through a big increase in Treasury Bill auctions for year end, because the Treasury is already stretching too far in its short term issuance. Therefore, I expect the Quarterly Refunding Announcement (QRA) to increase the amount of coupon securities scheduled for auction, and it should depress the equity market as 10-year rates rise. Note that the VIX chart above had similar low levels to last year before the QRA. Also note that 10-year yields sit at a similar 4.20% level as July/August 2023. Yields rose toward 5% over the next three months.
Could yields rise to those levels again without inflation rising? Core CPI peaked at 5.5% in 2022 and fell in a straight line to 3.5% into October 2023, and that did not stop 10-year yields from rising 80 basis points under the weight of increased supply.
Finally, do not forget that the top decile of the country has heavy stock exposure, and thanks to that positive wealth effect, that cohort has been supporting the overall consumption data. If the wealth effect gets impaled, then the consumption drop that I am expecting gets accelerated, as would the employment downturn.
Markets:
Equity Market: Are we there yet?
Weekly Trend: Bullish
The weekly charts are still showing a positive trend, but the same negative divergence persists.
The daily chart is bullish above the 5375-5400 gap created after CPI, but the advance/decline line and the momentum indicators are still bearish, and the CNN Fear and Greed Index remains in the Fear category. The RSP/SPY chart ticked up slightly Thursday and Friday after making new lows Monday and Tuesday, so breadth continues to be perilously narrow.
I still look for a reversal lower with the same caveat as last week “I cannot rule out an extension as high as 5510-15, so, until the S&P 500 closes the week below the CPI gap, one cannot press the short side too hard.” The high last week was 5506.
The only thing that did change—potentially—is NVDA’s price action.
NVDA daily
I have marked the NVDA chart (log of daily prices over the past year) to show that it could follow the same topping pattern as before: a large selloff followed by a bounce to challenge the highs, and then a selloff.
NVDA hourly
The intraday price action broke out at 85 (850 pre-split) in late April above the cloud (see arrow at the bottom far left in the chart below) and has yet to go below 125 support (see the retest of support at the arrow on the right). There is a nuanced difference in the structure of this week’s selloff--it formed 5 waves down, typical of at least a bigger correction once a bounce occurs, and potentially the beginning of a major down leg.
The oscillator at the bottom portion of this chart suggests a rally this week. If we continue lower, that would be the first sign of trouble.
Fixed Income: Prepare yourself for QRA headlines in July
Weekly Trend: Bullish
As mentioned above, based on this week’s Congressional Budget Office updated deficit forecast, the Quarterly Refunding Announcement on July 31 inevitably will have an increase in coupon issuance, and that is never good news for stocks or bonds.? Perhaps one month is an eternity in 0DTE years, but it will be discounted in the coming weeks. Prepare yourself for the headlines because they are coming.
10-year yield weekly
This model has been targeting higher yields since October 2020 with three brief, and limited, hiatuses spent below the lower bands: June/July 2021 for 8 weeks, March/April of 2023 for 4 weeks, and December into January of 2024 for 5 weeks. As seen in the daily chart to follow, the key yield level is what we had discussed last week, 4.20%.
10-year yield daily
In the daily chart below, 10-year yields never traded below 4.20% support last week. A weekly close below there would be of note.
Crude Oil: Breakout, but not really
Weekly Trend: Neutral
Crude did cross above the $80 resistance threshold in WTI futures as seen below:
Futures prices broke above, but not exactly broke away from that $80 region. The front contract settled between the 50 percent and .618 retrace of the April highs to the June lows hit two weeks ago. I added two contracting trend lines to show the entirety of the 2024 price action has been contained by the September – December 2023 selloff range from $9 5to $67. In fact, OVX, crude’s equivalent of the VIX, dropped below 24 this week for the first time since the September 2023 top. Those low oil volatility levels have not been seen since before the pandemic.
Additionally, one-year futures spreads are stretched, last seen within a week of that $95 top. This does not mean we are striking a major top, but a pullback from here would not be unusual. Be on the lookout, as it could represent a good opportunity to add to long term positions for a move to revisit than $95 neighborhood in WTI futures.
Best,
Peter Corey
Pave Pro Team
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