Paper Tiger
“Be with them always in the air, in darkened storm or sunlight glare. Oh, hear us when we lift our prayer for those in peril in the air.”
—The Right Stuff
Will the FOMC be able to withstand the wind and the rain and support high altitude markets? ?
Key takeaway: Monetary policy is the major driver across risk assets, but now the gap between market rates and Fed policy is at a dangerous juncture. There is time to right the ship, but it must be now as the stakes are enormous. Focus on the Fed funds forecast for 2024 when the FOMC releases it with their statement. 1) Outlining the S&P’s divergent paths. 2) High Yield spreads disagree with new all-time highs. 3) Crude hit a major support and bounced despite a weaker demand forecast.
It is at potential major inflections that we must disregard opinions and defer to price. See the list of important levels to follow, and not anticipate, in the Markets section below.
Four Decades Behind the Curve Dept: There has been discussion surrounding the Financial Times and Wall Street Journal articles released last week during the Fed’s blackout period re-introducing a 50-basis point cut bias for the upcoming Federal Open Market Committee (FOMC) meeting. I wrote a detailed breakdown of why I expect 25 basis points in Monday’s Three Pointer.
This independent—or coordinated—Fed leak to the press occurred after the fixed income market had originally rallied on Wednesday’s and Thursday’s CPI and PPI reports, but then reversed that enthusiasm by noon Thursday. Persistent shelter inflation continues to be a warning in the CPI report, and although used car prices were down, that will be short lived, as the Mannheim Used Vehicle Value Index that leads the CPI Used Car Index by two months looks like this:
In Thursday’s PPI, my favored series of Final Demand less Food Energy and Trade Services (removes the depressing effects from lower margins) was also higher:
Therefore, I agreed with the view that there was insufficient disinflation to warrant a 50-basis point cut at the September FOMC meeting. Yet, a decision was made to get something in the paper by Friday morning. This motivates me to air my concern, because the Fed may be fraying at the wrong time.
We have displayed the following chart this year to illustrate how the two-year yield shown with red and blue bars (as a proxy for a longer-term Fed funds equilibrium rate) leads the Fed historically:
The black line is the Fed funds futures price in this monthly chart going back to 1988. I added the highlights to draw the comparison between the October 2007 money market’s reaction and now (note the red arrows). The recent S&P price action is also reminiscent of 2007, as shown later in the Equity Market section. The drop in the two-year note yield relative to Fed funds is excessive, pointing out that the central bank is behind the curve.
How Far Behind the Curve?
In fact, the spread between the yield on the two year note and Fed funds is even wider now than in 2007, as seen by the following chart of the 2-year Treasury note yield minus the funds rate:
This chart is both startling and damning as it hits a 35-year extreme. A Fed that prides itself in transparency should not allow itself to get this out of touch with investors. One could also take this as a market that gives little credibility to a Fed too slow to react to its inflation mandate in 2021, and now is too slow to respond to protect its employment mandate.
Markets love confidence. They love confidence in clear earnings guidance, and they love confidence in competent central bank stewardship. Each of the periods where the 2-year note fell before the FOMC responded were in 1989, 2000, 2007, years that invited outsized asset market volatility. The FOMC has tried to appear unified and strong, with barely any dissent in their recent rate decisions.
Yet we learned in the July minutes that many on the FOMC were ready to cut 25 basis points despite the decision to hold rates steady. As of now, our central bank is little more than a paper tiger (and I can make the same case for almost all central banks). The Fed strives to lend the appearance of depth and vision, but so far offers little more than hollow leadership.
It pains me to criticize because it is so easy to do, and far too common. There are some incredibly capable governors and regional presidents who comprise the FOMC. However, when the market gets this disconnected to its central bank, the Fed should have the clarity to first notice it, and then try to address it. There will be giant costs if that void is not filled.
Perhaps they are coming to the realization that they need to address the problem quickly, and therefore the need to scramble to communicate a 50-basis point cut. But if so, shouldn’t they have done so in a more professional manner? I am concerned about this Fed if markets become untethered, because they could become more of a foe then a friend.
A World Without Lags?
The pervasiveness of the data-dependent process among the major central banks guarantees they fall behind the curve because they reject the need to be proactive. Ian Shepherdson produced the following chart showing a two-year lag between Fed policy actions and U.S. employment demand. ?
The chart below illustrates that when the FOMC raises rates by approximately 200 basis points within a year (the blue series below, and note it is inverted), nonfarm payrolls y/y growth goes negative two years later (the black series scale is on the right-hand side).
The transmission mechanism is very clear. However, there were two exceptions:
If this is a repeat of the 90’s and the flood of fiscal stimulus is propping up labor demand, then we will achieve that elusive soft landing. The gap shown by the green vertical line should get filled as payrolls contract, but I will have been proven wrong if the annual rate of growth only slows and not collapses.
I believe the evidence supports my forecast, but if payrolls don’t go negative, then it opens a pathway to 6000 in the S&P 500. Continued labor weakness leads the way for major reversals in global risk markets.
JOLTS Construction Jobs Openings
Speaking of employment, I included a chart of construction employment last week that displayed a strong growth uptrend that could give the FOMC an argument against recent jobs softness. I wanted to follow up on that to show that construction has exhibited deteriorating labor demand: the construction job openings data from the Bureau of Labor Statistics (the same agency that collects the payroll data) going back to 2000 is displayed here:
Construction job offerings are approaching pandemic lows.
Also from the JOLTS database, the 2024 Quits rate looks similar to 2007 (see yellow highlights) and is another example of a lagged dynamic where we can expect lower wage data into year end.
Fed Governor Waller is outspoken in his confidence about consumer resilience, but falling wages over the next 6 months will only mean that savings continue to contract and add even more pressure on a stretched consumer.
Japan FX Update: Will Dollar Yen Elicit a BoJ Rate Cut this Week?
Score one for the yen-carry-trade-is-over crowd. USDJPY made new lows during Asian hours last week but did not weigh negatively on the U.S. equity market. There was no repeat of the early August chaos, although we saw yield spreads widen as we discuss in the Fixed Income section.
Here is an updated chart on USDJPY, breaking the August 5 lows and making a new low for the year:
The currency pair has support between 135-137 if the double bottom does not hold at 140.50.
The Yen gained strength as BoJ member Junko Nakagawa said monetary policy could look through Yen strength, triggering stops. Even though he said the BoJ’s hiking campaign will not be impeded by USDJPY weakness, I believe they will stand pat this week at a 0.25% discount rate.
They raised rates once in September 2001 from zero to 0.25% and stopped their hiking campaign. They raised rates from zero to 0.25% in September 2006 and waited until March 2007 before raising one last time to 0.50%. It would be a major departure if they raised a few hours after the Fed cut rates this week. I do expect hikes out of the BoJ at their next meeting on October 31. ??
If they do surprise and hike, that could be the trigger for major equity weakness.
Bitcoin: Watch into FOMC
Bitcoin thrives under easy financial conditions. Oddly, futures have been in a downward trend after March’s all-time high as gold powered to new all-time highs last week on hopes for an aggressive Fed cut. Bitcoin’s down channel is pictured below in a daily chart.
In this down channel, each time Bitcoin has fallen from a lower high (green circles) below the black support line, it has made a lower low (rectangles). This week, BTC futures failed to make a new low and closed the week at the $60,000 pivot. With gold at all-time highs, I am watching this Bitcoin divergence to see if it can break the pattern post-FOMC or it returns to the bearish pattern and makes another new low.
Markets:
Equity Market: SPX’s divergent paths / RSP has cleanest risk return profile
Weekly Trend: Neutral
Gap sandwich
The S&P 500 SPY ETF filled the September 6 gap and rebounded sharply all week as shown by the chart below. SPY then approached major resistance at the remaining down gap after gapping up on Friday morning.
As I wrote last week “SPX guidelines: Trend reverses back to positive on a daily close above 5560.” That 5560 cash level is now major support vs. the 5626 Friday S&P 500 close. Immediate support is at 5595 which fills the gap from Thursday’s close. A daily close below there early in the week before the FOMC meeting is negative, confirmed by a close below 5575 and of course 5560.?
No major selling above 5560. Any negative reaction to the FOMC statement, the Summary of Economic Projections (SEP), or the press conference opens the door for a subsequent break of 5545 intermediate support. Longer-term players start to sell below 5495 with 5425/40 as the first major support, below which brings in big selling.
Blowoff scenario to 6000
This is what must happen:? Either a quick rejection at 5650 highs, or short covering pushes a climax to 5715, that sets up a drop to 5500 in 3 waves then a rally to 5750 that pulls back once again to 5650. That pattern then begins a run to 6000. We know our parameters and will track.
All for All
The equal-weighted S&P 500 Index ETF RSP is within a half percentage point of an all-time high, and closed Friday at its second highest level ever. The 176 price level fulfilled three separate price targets, so if there is a breakout above that resistance, then 176 will become critical support. Above 176, refer to the path to 6000 for the S&P 500 cap-weighted index described above. The following is a weekly chart from the March 2020 lows in the RSP.
Whether a breakout occurs above 176 or not, I will become a seller on daily closes below 168, 166.5 and 161.80 respectively in RSP, confirmed by a weekly close below those levels.
SMH
Semiconductors have been lagging but moved above a daily resistance level this week after hitting an oversold condition (see rectangles below). The price action resembles Bitcoin this past week, typical of Bitcoin’s tendency to track the Nasdaq.
The defensive rotation is evident when you compare the strength in the equal-weighted RSP to the lagging nature of semiconductors. Semis will continue to lag If we are about to make slight new highs in the S&P and then reverse lower. For the S&P to fulfil its bullish potential to 6000, SMH will need to make new highs also.
In the bigger picture, all is well above the April / August double bottom at 200. The first warning is a break below 230.
Last and least
Pulling out the 07 analog again since it targets 5715 in SPX and the timing could be as early as this week.
For now, this is a curiosity, nothing more. It only becomes relevant on a sharp selloff this week.
Fixed Income: Rounded divergence from High Yield spreads
Weekly Trend: Bullish / Overbought
Noisy Chart with a Clear Message
The weekly chart below shows a tendency for 10-year yields to hug between the moving average in black and the Bollinger band in purple, forming a corridor (see red and blue highlights):
As can be seen, these corridors contain the movement in yields within a tight trend, and the trend will remain down (bullish fixed income) until a weekly close above the corridor’s top end at 3.80%. Keep that level in mind during the FOMC releases and the press conference. This downtrend has two lower targets at 3.52% and 3.45%, respectively. Additionally, the trendline channel’s lower support was just hit this week at the dotted line, so reversals higher are possible as early as Monday.
Break the trendline and the lower targets bracketing 3.50% increase in likelihood.
High Yield Red Flag
ICE Bank of America High Yield Option-Adjusted Spreads widened recently, diverging from the strong equity rally. The chart displayed below is a daily chart from late 2020. Normally, high yield bond spreads are at their lows as stocks move into record territory. Tight spreads reflect supportive business conditions, so this pattern puts me on alert.
The rounded bottom formation that has unfolded this year is analogous to the late 2021/early 2022 pattern when the major stock indices made strong reversals from all-time highs that resulted in a 10-month selloff.
Crude Oil: China pulls crude forecasts down
Weekly Trend: Bearish
The International Energy Agency (IEA) cut its 2024 world oil demand forecast for yearend by an astonishing 7.8%—that is a dramatic shift in a crude forecast that is only 3? months away. China is the key factor to the IEA’s lower global oil demand growth due to its slowing economy and their strong adoption of electrical vehicles. While the 2025 demand forecast was unchanged, the IEA did note that “Current balances suggest the world oil market will be oversupplied in 2025 if OPEC+ proceeds with its proposed unwinding of cuts.” The IEA expects non-OPEC+ oil supply to rise into year-end and in 2025 too.
This demand forecast is yet another reason that has pushed hedge funds to a net short Brent futures position for the first time on record. That type of positioning should get your attention if you are a contrarian. ?
The updated monthly chart below shows WTI crude futures did hit the lower Bollinger band for only the seventh time in 18 years last week:
There have only been two times when the lower band did not create a multi-month bounce (see blue circled areas in 2014 and 2020). Last week’s lows are critical into the end of the year considering that oil seasonals are negative in October into November.
As mentioned in earlier commentaries, I had $71.25 as support that was broken. That now becomes important resistance. A daily, and especially weekly close back above $71.25 is a bullish trading signal.
.
Best,
Peter Corey
Pave Pro Team
Pave Investment Advisors, LLC. ("Pave"), a subsidiary of Pave Finance, Inc., is an SEC registered investment adviser. Such registration does not imply any level of expertise by the registrant. Pave provides services on a discretionary and non-discretionary basis.
The enclosed material is for educational purposes only, any client subscribing to Pave’s advisory services will need to accept the Term of Service and execute, by accepting, the Investment Advisory Agreement in the Pave application. Investing is speculative and involves risk, including the possible loss of principal.
The information contained herein is provided for discussion purposes only, is only a summary of key information, is not complete, and does not contain certain material information about Pave or any of Pave’s affiliates and is subject to change without notice.
The distribution of the information contained herein in certain jurisdictions may be restricted, and Pave may not be available in all jurisdictions.
Unless otherwise indicated, the information contained herein is believed to be accurate as of the date it was produced. No representation or warranty is made as to its continued accuracy after such date.
This material is not intended to be, nor should it be construed or used as an offer to sell, or a solicitation of any offer to buy, any securities or investment advice. No offer or solicitation may be made prior to the delivery of an Investment Management Agreement, which will contain additional information about Pave, including disclosures relating to risk factors and conflicts of interest. Clients will also receive ADV Part 2A, 2B and Part III (Form CRS). You should review all the material provided about the advisor. In the event of any discrepancies between the information contained herein and the Investment Management Agreement, the Investment Management Agreement will control. You should make an independent investigation of the investment described herein, including consulting your tax, legal, accounting or other advisors about the matters discussed herein.
Pave’s investment methodology may not be suitable for all investors.
There can be no assurance that any investment objectives will be achieved. Investment losses may occur, and investors could lose some or all of their investment. No guarantee or representation is made that Pave’s investment methodology will be successful. Nothing herein is intended to imply that Pave’s investment methodology may be considered "conservative", "safe", "risk free" or "risk averse”. Economic, market and other conditions could also cause Pave to alter the investment methodology. Certain information contained in this material may constitute "forward-looking statements," which can be identified by the use of forward-looking terminology such as "may", "will", "should", "expect", "anticipate", "target", "project", "estimate", "intend", "continue" or "believe" or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events or results or the actual performance of Pave’s methodology may differ materially from those reflected or contemplated in such forward-looking statements. Pave believes that the information contained in this material to be reliable but does not warrant its accuracy or completeness.