Flashcards

“Haven’t any of these drivers read the rule book?” --Speed, Speed Racer

When the market tips its hand, be wary.

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I am headed to Pave’s NY headquarters, so will make this brief, but my brevity should not belie its potential importance.

First, the market did something interesting last week, twice. No, not rip back from a dip, nothing new there. It sold off hard on two separate pieces of news. Tuesday’s announcement that PacWest bank was being taken over caused its price to drop 25% in less than an hour, reminding investors of Janet Yellen’s warning that there will be more banking mergers. KRE, the regional bank index ETF, fell by 3% in 15 minutes. Instead of going into freefall as it did after the Silicon Valley Bank fiasco, KRE closed the week up 4.4% from those lows.

On Thursday, the Nasdaq fell almost two percent in half an hour on a leak a day before the Bank of Japan (BoJ) meeting where they moved their yield cap on their 10-year government bond from 50 basis points to 1%. Global equity markets recovered, and the US indices closed the week strongly, with the S&P 500 closing at a new move high, and its highest level since April 2022.

The move from the BoJ carries importance, as do two fast selloffs in the U.S. equity markets in a week.

The forward S&P yield is now only 90 basis points above the 10-year Treasury note, matching the lows at the top of the 2007 equity market, as the U.S. was entering a recession. The move by the BoJ should create a yield curve steepening, and we must not forget that our yield curve inversions forecast recessions, but recessions only occur once the curve returns to a more positive slope. If we see a yield curve steepening in Treasuries, this should translate into higher yields in the 10-year notes, or what bond players label as a “bear steepening.”

We cannot rule out the historical pattern playing out here, making 10-year yields even more attractive compared to stocks at a time when the Federal Reserve and its Chairman made it clear that while rate hikes may be drying up, there is no rate cut in sight.

This last point is critical because financial markets always operate on the margin. The fact that the Fed may not be hiking again creates a bullish consensus due to the end of the hiking cycle. However, as highlighted last week, the NFIB survey of small businesses revealed that the actual interest rate paid on short-term loans has gone from a pandemic low of 4.1% to 9.2% currently, and there is no “on the margin” benefit to that. The level itself matters because it matters for profitability, and if the Fed is going to keep rates at current levels into 2024 at a minimum, this polling question from the NFIB is going to be one of the central data releases to watch for the rest of the year.

All of this relates back to my point today, which is do not ignore the equity market air-pockets this week. The fact that there was a strong recovery following both selloffs will add to investor complacency. Seasonally, this is the time for peak complacency as seen by the following chart.

Flashpoint

We have often written of volatility funds who are positioned to be major sellers on large down days, and they may have contributed to the downside volatility that we glimpsed on Tuesday and Thursday. There is a confluence of institutional factors that make me place great weight on the anecdotal and fleeting bearishness last week.

Again, unless and until there is a breakdown, there is no reason to anticipate a market selloff. However, if there is a move below 4540 in the S&P futures, and 15,500 in Nasdaq futures, there should be inherent instability in the equity markets. The character of the selloff will tell us quite a bit about whether it will become a great setup for further bullishness from lower levels, or to look for bounces to sell into.

We are at a juncture where it is foolish to ignore negative price action.

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Peter Corey

PavePro Team

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