Friday’s non-farm payroll report, which showed 184,000 jobs added to private payrolls, blew away the consensus estimate of 120,000 and was the third best month of the year. The stock market responded with a modest gap higher only to roll over hard in afternoon trading that saw the S&P 500
(INDEXSP:.INX) close down 13 handles (0.94%) and the Dow Jones Industrial Average
(INDEXDJX:.DJI) down 139 points (1.05%). The S&P 500 e-mini contract that I have been watching due to the positioning of large speculators closed at 1405.50 right on top of 1400 that is acting as a critical pivot level due to positioning of large speculators.
The bond market reacted with similar oddity as the initial 1 point gap lower below my 148-00 pivot on the US bond futures contract saw no follow through and immediately reversed back higher to close at 148-13. The 148-00 level we have been watching alongside 150-00 provided support on Wednesday, preceding a 1 point rally before the payroll data was announced, so the gap-through on Friday morning was significant. This means that the reversal back above 148-00 was even more important. Thus, after closing the week on top of this level, investors should expect the market to challenge 150-00.
The financial media must have been so confused because headlines and articles attempting to explain this atypical price action were hard to find. I can find no mention of this relationship on the front page of Bloomberg.com
and you had to dig deep in this weekend’s Wall Street Journal
only to find a scant mention only under the "
Markets" section on B5:
NEW YORK—US stocks closed broadly lower, with blue chips falling into negative territory for the week in the last half-hour of trading, as a bigger-than-expected increase in October payrolls was offset by sharp declines in materials and energy shares.
In other words, we have no idea what just happened.
I have been pounding the table with the idea that flow -- and not discount -- is driving market price action; if Friday’s counterintuitive reaction to relatively robust economic data was not evidence to prove this point, I don’t know what is.
Bernanke must be very proud because he has successfully removed math and fundamental analysis from the equation. For most analysts and portfolio managers, this has created a very toxic, volatile, and unpredictable investment environment. However, for investors willing to embrace this flow dynamic and the volatility that comes with it, there can be tremendous opportunity where patience and liquidity is rewarded.
Last week in Saying Goodbye to the Bernanke Put
, I concluded:
It's flow, not discount, that is driving price action, therefore investors need to be careful about getting trapped into drawing any fundamental conclusions from market prices. Furthermore, the main risk in this market is not fundamental. The main risk is a violent unwinding of speculative positions that are predicated on the Fed’s ability to reflate assets via QE.
The previous two unwinds occurred in 2010 and 2011 after the Fed walked away. If we get something akin to either of those moves in the coming months it will be as if the Fed is still active in the market. So during the next QE unwind it will seem as if the Fed is no longer able to affect asset prices. If there has been one constant in the Bernanke Put, it has been a reduction in volatility, however, if he loses control, that put will be worthless. That will no doubt see a spike in implied volatility premiums which will correspond to a significant widening of risk premiums, threatening all leveraged positions and wreaking havoc across financial markets.
I believe Friday’s downward price action in equities and commodities (gold) was a sign that a QE asset reflation unwind is imminent. How this plays out is not clear. Money is very scared going into year-end, and scared money hits bids and asks questions later. The election on Tuesday is potentially the most important with regards to financial markets in a generation because Romney has pledged to fire Bernanke. This is the first time I can recall when fiscal and
monetary policy were both on the ballot. This is unprecedented in recent memory and investors should expect a potentially severe market response to the outcome of this election.
Perhaps the biggest story of the week was the heavy put buying in the bond futures pits at the CBOT
reported by Bloomberg. On Monday, RJ Obrien’s John Brady reported large TYZ2 (December 2012 10YR futures) put/call combo buying by a Geneva-based macro hedge fund. On Wednesday, this put buying continued with CBOT clerk Dan Grant noting, "[B]ig payday on a Romney win." Thursday it was again reported that January 2013 TY puts were a favorite trade and investors were waving them in with both hands. Grant continues, "[E]veryone thinks if Romney wins, Bernanke is out and all the QE nonsense will end," i.e., bond prices will fall and yields will rise.
I agree, and we all want higher more normalized yields, but here is the problem. The banking system is loaded with very volatile, negatively convex, low coupon, and long duration securities that are short volatility. What has been a benefit to the borrower in negative interest rates is a cost to the lender (bond investor) in the form of negative coupons. Only a modest rise in interest rates could see these negative coupons rapidly discounted. If and when you get the pro-growth trade where yields rise, the banking system will see the present value of its bloated securities holdings decline, potentially exposing them to large losses.
The market is going to move first, so when banks finally do see demand for money increase, they won’t be able to fund the loans because their bond portfolios will be underwater. Banks won’t want to take losses on their securities so all that supposed liquidity will be locked up. What currently looks to be an overly capitalized liquid banking system would suddenly become very illiquid. This exposes the fundamental flaw behind Fed policy designed to force interest rates lower and increase borrowing.
There is a consensus belief that Romney is good for stocks and Obama is good for bonds. This notion is predicated on the discount that would result from Romney’s pro-growth agenda and Obama’s pro-government agenda. I don’t think it really matters who wins. What matters is how the QE asset reflation trade gets reconciled.
If Romney is good for growth but he crashes the bond market, will equities rally in a rising rate environment? If Obama is good for bigger government but crashes the stock market, will bonds continue to rally as the deficit and debt outstanding continue to balloon? These are valid questions, and simply believing each candidate will support one asset at the expense of the other is short sighted in my view. It’s not that simple.
Since Charting a Course
, I have attempted to map out a scenario for how I thought markets would trade vs. important pivots in both equities and bonds as investors faced multiple ensuing catalysts including this Tuesday’s election. Thus far, the markets are trading according to plan. For stocks, it was about surviving 1400 on the S&P. For bonds, it was about the US futures contract being on top of the 150-00 pivot that has confined the market since the May payroll report in early June.
I think the odds of an Obama victory are high based on the projected Electoral College math. I also think -- regardless of who wins -- there is a big head fake coming and that the initial market reaction may need to be faded. You will have a lot of pressure on the 1400 level if Obama wins and the large short base in the Treasury market could ignite a short squeeze. I am inclined to let both moves settle before reassessing.
The speculators will be pressing both of the aforementioned levels. With the monthly options expiration looming, you would usually expect a premium burn counter trend move at some point. However, the situation is very fluid and these critical pivots must be respected.
With all the uncertainty, there is one thing that is for certain: Bernanke is prone to blowing up his own trades, and the more control he thinks he has over the market’s pricing mechanism, the more susceptible it is to a disruption. As I have said before, most investors are focusing on the known risks, but I am focused on the unknown risks. The unknown risk is the catalyst for how and when this QE trade unwinds. It’s quite possible it will be something the consensus thinks is bullish for the QE trade, such as an Obama victory.
Bernanke has this market so wound up that no one knows how to trade it. Good news is bad news, bad news is good news, fundamentals are irrelevant, and the only thing that matters is which way the wind blows. Trying to navigate this environment takes liquidity and an unbiased flexibility. There are no rules so if you think you have it figured out, chances are you are going to lose. Don’t get caught up in absolutes like Romney is bullish for equities and Obama is bullish for bonds. The market gets the only vote in that election, and it has not yet been cast.