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Expect no letter on Friday, October 7, 2022.
Markets printed lower, this morning, ahead of the US cash-open. This bonds, commodities, and equities down phenomenon we’ve unpacked in detail many times before.
At its core, supply chokepoints and a hot labor market are keeping inflation high and sticky. To lessen this inflation, policymakers are seeking to tighten monetary policy.
That means raising interest rates and quantitative tightening (QT).
As we discussed on September 20, the transmission mechanisms of these drivers vary with QT having a very weak transmission “to economic activity but very strong to financial markets.” On the other end are rates that have a stronger transmission to economic activity.
And so, on “the incremental effects on liquidity” these drivers pose, markets are trading more in sync; on the way up, through fiscal stimuli, interest rate decreases, and QE (i.e., buying of US Treasuries and mortgage securities), investors sought more yield elsewhere.
Risk assets like stocks, crypto, and beyond thus enjoyed a boost.
In a way, the opposite is happening now, and selling across risk -on and -off assets is persistent.
Liquidity measures (which we began unpacking months ago, and were covered in Bloomberg by Kevin Muir of TheMacroTourist.com, recently, too) show a near-lockstep decline in the S&P 500 (INDEX: SPX). Please check out Kevin Muir’s Substack, too!
Net liquidity (NL) we calculate by taking the size of the Fed’s balance sheet (BS) and subtracting both the amounts in the reverse repo operation (RRP) and Treasury General Account (TGA).
Muir said that “the liquidity created from QE and fiscal stimulus was so great that commercial banks no longer wanted deposits from large institutional clients because there were not enough safe assets available to purchase.”
This prompted the expansion of RRP (beyond primary dealers to include the mutual funds and non-traditional accounts), a liquidity-draining operation (cash in the system removed through an increase in the number of bonds), through which the Fed would deliver “high-quality collateral with the promise to buy it back in a certain number of days at a higher price,” Muir explained.
Other NL drivers include the TGA which, prior to Covid, was fairly well-balanced by taxes (i.e., money coming in) and the issue of fixed-income securities (i.e., money coming out).
Post-Covid, the TGA increased a lot and this has “the same effect as QT … [as] bonds are issued and cash [is] withdrawn from the financial system, but the money is not distributed into the economy,” Muir elaborated.
Combining the moves of the RRP and TGA, with the BS, provides us a measure of NL (shown below) that well explains stock price movements, as we’ve put forth in letters before.
And, despite the far-spreading risk-on and -off context (i.e., stocks, crypto, and bonds down), it is believed that the large amounts in liquidity-draining operations (RRP and TGA), the impacts of QT, from hereon, may be lessened; per Muir, “[i]f the Fed had securities on its balance sheet that matched the maturity profile demanded by the institutions engaging in reverse repos, it could sell an amount equal to the total reverse repo balance to these institutions, reducing the need for reverse repos and elicit no change in the financial or real economy.”
“On top of that, the actual amount of monthly QT [$95 billion per month] is not that large,” Muir added. That’s because, over the span of five months, into the end of 2021 and the beginning of 2022, the TGA was up $816 billion. This equates to ~$163.2 or so billion per month of QT.
At the end of the day, though, the programs outlined above do less to provide market support. One can argue that the market has priced the programs and some economic slowing. It is not likely the market has priced the impacts of a sharply slowing economy and business.
That said, some data – less corporate profits falling out of bed – suggests “the stock market tends to do better when EPS growth rates are negative than when they are hugely positive.”
The key to explaining this is to remember markets are a forward-looking mechanism.
“By the time earnings growth rates are extremely high–as they were late last year and early this–they have long since been reflected in stock prices.”
“During such periods, the market has instead shifted its focus to earnings several quarters hence—to factors such as the Fed having to put the brakes on an overheating economy.”
The reverse will happen when the year-over-year growth rate in trailing fourth-quarter EPS is negative; “investors will have shifted their focus to earnings’ likely imminent rebound.”
Pending is a final resolution “tied to the incremental effects on liquidity,” (e.g., QT manifesting itself as “$4.5 billion less in demand for assets per day,” and buyback blackout).
This is all the while options repositioning may actually make the case for increased fragility, as traders’ falling demand for put protection opens the door to less supportive hedging flows and more impact from macro-type flows (talked about above) if we will.
The last-mentioned SpotGamma explained well:
“As traders realize that options protection is doing little to protect them, there may be a flip; the sale of volatility, which appears to be a good trade (now), could leave markets vulnerable to an event into which traders are no longer well-hedged. Should something bad happen and traders reach for protection, that could result in limit-down type of movement.”
If unsure of what direction to participate, consider pricing some Box Spreads that offer some competitive and guaranteed interest rates, similar to those earned with Treasury bills.
As of 6:40 AM ET, Wednesday’s regular session (9:30 AM – 4:00 PM ET), in the S&P 500, is likely to open in the lower part of a negatively skewed overnight inventory, inside of prior-range and -value, suggesting a limited potential for immediate directional opportunity.
In the best case, the S&P 500 trades higher.
Any activity above the $3,771.25 HVNode puts into play the $3,826.25 HVNode. Initiative trade beyond the last-mentioned could reach as high as the $3,862.25 HVNode and $3,893.00 VPOC, or higher.
In the worst case, the S&P 500 trades lower.
Any activity below the $3,771.25 HVNode puts into play the $3,722.50 LVNode. Initiative trade beyond the LVNode could reach as low as the $3,671.00 VPOC and $3,610.75 HVNode, or lower.
Click here to load today’s key levels into the web-based TradingView charting platform. Note that all levels are derived using the 65-minute timeframe. New links are produced, daily.
Volume Areas: A structurally sound market will build on areas of high volume (HVNodes). Should the market trend for long periods of time, it will lack sound structure, identified as low volume areas (LVNodes). LVNodes denote directional conviction and ought to offer support on any test.
If participants were to auction and find acceptance into areas of prior low volume (LVNodes), then future discovery ought to be volatile and quick as participants look to HVNodes for favorable entry or exit.
POCs: POCs are valuable as they denote areas where two-sided trade was most prevalent in a prior day session. Participants will respond to future tests of value as they offer favorable entry and exit.
After years of self-education, strategy development, mentorship, and trial-and-error, Renato Leonard Capelj began trading full-time and founded Physik Invest to detail his methods, research, and performance in the markets.
Capelj also develops insights around impactful options market dynamics at SpotGamma and is a Benzinga reporter.
Some of his works include conversations with ARK Invest’s Catherine Wood, investors Kevin O’Leary and John Chambers, FTX’s Sam Bankman-Fried, ex-Bridgewater Associate Andy Constan, Kai Volatility’s Cem Karsan, The Ambrus Group’s Kris Sidial, among many others.
In no way should the materials herein be construed as advice. Derivatives carry a substantial risk of loss. All content is for informational purposes only.