Did Ben Bernanke just drop a bunker buster bomb on the markets?
Let’s begin with the latest Fed announcement. The Fed's Open Markets Operations desk will immediately start buying $40 billion in Mortgage-Backed Securities (MBS) per month, or about $10 billion each week. At the same time, the Fed will continue Operation Twist by purchasing $45 billion in "longer-term" Treasuries, sterilized by $45 billion or so in 1-3 year bonds. Unfortunately, at the end of the year it runs out of short-term paper to sell.
Every month in 2013, the Fed will increase its balance sheet by $85 billion consisting of $40 billion in MBS and $45 billion in 10-30 year Treasuries, up to the natural monthly supply of longer-dated US Treasuries. It appears the Fed may monetize roughly half of the US budget deficit in 2013.
From July 2011 through June 2012, foreign holders of Treasury Bonds and notes have been purchasing $30.6 billion of longer-dated Treasuries per month
. To date in 2012, the average US Treasuries issuance per month has averaged $82.83 billion per month
. This leaves an average of $7.2 billion of net issuance available to banks, pensions, and private individuals. Could that be a problem?
The bond market thinks it spells trouble. On the day of Bernanke’s speech, US Treasury yields spiked to 3.108% from the low of 2.663% just two weeks ago, causing a technical breakout above the previous high of 2.982%. This portends rising yields through the rest of the year -- reaching or possibly exceeding the 3.612% yield shown at the weekly mid-cycle line.
What’s more, starting in 2013, new rules in the Dodd-Frank Act
, designed to prevent another meltdown, may force traders to post US Treasury bonds or other top-rated holdings to guarantee more of their bets. The change takes effect as the $10.8 trillion market for Treasuries is already stretched thin by banks rebuilding balance sheets and investors seeking safety, leaving fewer bonds available to backstop the $648 trillion derivatives market
Is it possible that the very law designed to reduce risk in the markets may cause unintended consequences, especially after the Fed announcement?
At first blush, equities investors are saying, “What could be better?” The S&P 500 Index
(^GSPC) not only broke out above its 2012 high, but has broken above its 2008 high as well. What’s not to like?
A glance at the daily chart shows that the S&P 500 Index has broken above its daily trading (cyclical) channel. Traders know that a break above or below the trading bands often results in a swift and high (or deep) reversal. The rise out of the October 2011 low is one such example, where the index rose to the mid-cycle line in less than a month. The same magnitude reversal from the top of the channel at 1446.95 today may take the index below the bottom of its trading channel very quickly, since declines tend to retrace rallies in far less time.
The next observation is the Orthodox Broadening Top pattern first described by Robert D. Edwards and John Magee in their book entitled, Technical Analysis of Stock Trends
(pages 144-147 in the 2008 edition). They portray this formation as a very bearish topping pattern.
Thomas N. Bulkowski, in his book entitled Encyclopedia of Chart Patterns
, further defines the parameters for Broadening Tops by noting that once the downside breakout is made (at 1395.00 in the S&P 500 Index), the failure rate of these formations drops to 4%. The average decline is 23%, with 64% meeting or exceeding that target.
But wait... there’s more! Also shown in the daily chart is an Ascending Broadening Wedge (Encyclopedia of Chart Patterns
, page 72). The Broadening Wedge is less bearish than the Orthodox Broadening Top, but has only a 6% failure rate after crossing its lower trendline just above 1300. But keep reading -- there’s still more!
The weekly chart of the S&P 500 also shows a spike above the top of the Trading Channel at 1462.50. In addition, it reveals an even larger Broadening Wedge Formation engulfing the broadening formations in the daily chart. Its triggering trendline is above the potential target lows projected by both of the prior formations, so it is possible that this may also drive the market lower. If the trendline (near 1100.00) is triggered, there may still be a 61% probability of a final crash landing at or below 900.00.
Finally, the equities market reveals a convergence of cycle patterns indicating a major top is at hand. The Liquidity Cycle, which we have referred to in the past, is nearing an end that is divisible by both the number 13 (a Fibonacci sequential integer) and pi (3.1416), which is the ratio of a circle's circumference to its diameter).
In summary, the Bernanke announcement may have been badly framed and poorly timed. The attempt to reflate the markets at all-time highs in both equities and Treasuries may start a series of reactions that is negative for each of these. In addition, the Dodd-Frank Act has many financial institutions who are involved in the derivatives market boxed into a tight corner. The search for quality collateral may accelerate into the realm of unintended consequences, causing a sell-off in the markets that the very act had intended to prevent.
See more from Anthony M. Cherniawski at The Practical Investor, and more from Janice Dorn, M.D., Ph.D. at Trading With Art and Science.
No positions in stocks mentioned.