Mid-week market update: The stock market has been exhibiting a series of positive breadth and momentum divergences as the S&P 500 weakened, but the recent main driver of risk appetite has been the fixed income and currency markets.
Do divergences matter anymore?
The divergences matter less inasmuch as the stocks in the S&P 500 are all moving together, indicating that equities are being driven by either extreme emotion and external macro forces. In this case, the external drivers are mainly the bond and currency markets.
You’ve got three days
The market was thrown into turmoil yesterday when BoE Governor Andrew Bailey told pension fund managers to finish rebalancing their positions by Friday when the Banks ends its emergency support program for the country’s fragile bond market, “And my message to the funds involved and all the firms involved managing those funds: You’ve got three days left now. You’ve got to get this done.” The market was instantly thrown into turmoil, though the FT reported that the Bank walked back the sudden stop in BoE support, but left participants confused. The yield on the 10-year gilt surged to levels last seen during the GFC.
The MOVE Index, which measures the volatility of the Treasury market, has also surged to GFC levels, though the anxiety can largely be attributable to the Fed’s tightening trajectory.
Even then, I am seeing a number of cross-asset signals that may be conducive to a better risk appetite.
I have heard from some readers expressing concern about the breach of support by TLT, the long bond Treasury ETF, other ETFs representing the shorter end of the Treasury yield curve held support during the latest bond market downdraft, which may be a constructive sign for risk appetite.
The S&P 500 has been inversely correlated to oil prices and the USD. Oil prices have been flat even as stock prices fell, and the USD Index is exhibiting a slight positive divergence against the S&P 500, which is another positive sign for risk appetite.
Poised for a bear market rally
I interpret these conditions as the stock market is washed out and poised for a rally. The NYSE McClellan Summation Index (NYSI) has fallen below -1000. Stock prices have historically rebounded when NYSI reached these levels. Even during the bear markets of 2002 and 2008, the market rebounded before weakening again.
The VIX Index is nearing or reaching the minimum level of 34, which has signaled near-term bottoms in the past year.
As well, the term structure of the VIX is inverted, indicating widespread fear.
Analysis from SentimenTrader shows that the Fear & Greed Index exhibited a positive divergence. The last time this happened was the Christmas Eve Panic of 2018, and the market rallied hard afterwards.
You can tell a lot about market psychology by the way it responds to news. PPI came in hot this morning, and stock prices have been roughly flat on the day instead of tanking as they did after the NFP report, indicating that risk appetite is becoming numb to bad news. Much will depend on the CPI report tomorrow morning.
The Cleveland Fed’s inflation nowcast
is calling for a monthly headline CPI of 0.3% and core CPI of 0.5%, compared to consensus expectations of a headline of 0.2% and a core of 0.5%.
Ahead of the CPI report, SPY option open interest is skewed very bearish, which may mean that we need a very hot CPI print for stock prices to tank. If the report comes in at or below expectations, it could spark a strong risk-on bounce tomorrow.
Disclosure: Long SPXL