Stocks had a weak santa rally and the S&P 500 ended the yearly nearly unchanged. The S&P remains confined to the 2000-2100 range and the next major event is going to be when stocks break away from that range, up or down. Let’s have a look at the chart (click image to enlarge it):
The bad news is that a pattern of lower highs and lower lows is starting to appear, and that’s bearish. The good news is that the slower Earl2 (orange line) has finally turned up, suggesting that the recent correction is nearing an end. But the faster Earl (blue line) is just turning down, pointing to short term weakness first. The MoM indicator is rather neutral. Meanwhile we are in a lunar green period, normally favoring rising stock prices, but the LT wave for January indicates an unusually weak green period. So, this is a very mixed bag and not a straightforward setup to buy.
Whenever we have so many noses pointing in different directions it is usually the shorter term indications that pan out first. In this case that would mean stocks stay weak until the Earl bottoms out again and gets in a position to go up together with the Earl2. And it could take a few weeks to get there.
Besides stocks I would also keep an eye on bonds in the first months of 2016, and this is our chart of the week (click image to enlarge it):
As this Bloomberg article points out, the world’s main economies have to refinance $7 trillion worth of bonds in 2016. With interest rates projected to go up from their historically low levels, investor’s appetite for those bonds may not be what it used to be. And that could get interesting, especially in the countries where bond redemptions will go up compared to 2015 (US, UK and China).
As you can see in the chart, US long term bonds (TLT) have been stuck within a huge triangle from which a breakout can be expected soon. If TLT drops below 119, then a slide towards 105 becomes likely and that would be a 10% loss for bond investors. From a foreign investor’s perspective it would take a 10% climb in the US dollar to offset that loss. Of course, if the US dollar keeps climbing it would also make US stocks more attractive for foreign investors, provided they don’t enter a bear market. That’s why I am watching bonds for the potential ripple effects it will have on US$ and on stocks. If bonds decline while the dollar goes up then US stocks could become the winner because of foreign inflows.
Putting the QE toothpaste back in the tube
Posted by Danny on November 19, 2018
Last year I wrote an article on what to look for when the Fed unwinds its QE program: Quantitative squeezing – what you need to know.
Since the start of QT (quantitative tightening) the stock market is more or less flat and long term bonds are down about 10% yoy.
Let’s have a look at how the unwind is progressing and detect possible implications for investors.
The Fed’s balance sheet remains the main chart to watch (https://fred.stlouisfed.org/series/WALCL):
From $4.46T a year ago the balance sheet is down to $4.14T, or an unwind of $320 billion. At this rate it would take about 10 years to get to a balance sheet that is back in line with the levels prior to 2009. As I pointed out last year, that’s not going to happen. Trying to put all the QE toothpaste back into the tube would create an economic crisis that is worse than the one they claim to have “solved” with their QE program.
I pointed to excess reserves held by commercial banks as the prime candidate to pay for the unwind. Here is the current situation (https://fred.stlouisfed.org/series/EXCSRESNS#):
From $2.2T excess reserves a year ago the banks are down to $1.75T. That’s a reduction of $450 billion. It does look like those excess reserves are indeed picking up the QT tab. But the interesting thing to note is that a $320 billion QE unwind came with a $450 billion reduction in excess reserves. A reduction at this rate could continue for another 3 years, bringing the Fed balance sheet to around $3T, but that would still be three times higher than it was before the crisis. Essentially, the excess reserves of banks are back down to late 2011 levels already, with the Fed’s balance sheet still $1.3T above its late 2011 levels. This is a strong indication that only a partial unwind of QE will be possible.
I also keep an eye on commercial banks’ holdings of government paper (https://fred.stlouisfed.org/series/USGSEC#0):
There is only a small rise from $2.49T a year ago to $2.56T now, an increase of $70 billion. This means banks are not showing much appetite for the debt paper that the Fed is unwinding, which is what I expected.
How about foreign buyers? Official foreign holdings of US treasuries were around $6.3T a year ago and are down to $6.2T now. Largest holders China and Japan have reduced their holdings and Russia has sold almost all its US treasuries. Predictably, those foreign buyers are also refusing to become QT bagholders: http://ticdata.treasury.gov/Publish/mfh.txt.
This weak demand by major participants is why longer term treasury bond prices are down 10% over the year:
How about cash on the sidelines held by stock investors? The data are now here: http://www.finra.org/investors/margin-statistics
Stock investors have about $340 billion in cash and $650 billion in margin debt. Not much change. With those numbers we can’t expect stock owners to play much of a role in a $3T QE unwind. If anything they may panic alongside bond holders at some point, because margin interest rates go up together with rising Fed funds rates.
The question becomes: how much more QT can be done before it causes global bond market stress and starts choking the economy? We may be reaching that point already. If Europe and Japan start their own QT it could become even more interesting.
My guess is that QT in the US will be stopped (paused) as soon as excess reserves at commercial banks approach zero. It may be stopped even before that point. Stock and bond markets could show a very positive response to any such announcement. That’s going to be a wild card for investors in the year(s) to come. At some point it will be concluded that it is more desirable to freeze central bank’s balance sheets at their elevated post-2010 levels. Europe, Japan and China may never start their own QT (or only do a small symbolic reduction) because their economy remains too weak to take it.
A possible side-effect of doing too much QT would be an unexpectedly strong US dollar because it makes dollars more scarce.
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Posted in Market Commentary | Tagged: bonds, Fed, margin debt, quantitative squeezing, US dollar | Leave a Comment »