Preface: Explaining our market timing models
The latest signals of each model are as follows:
- Ultimate market timing model: Sell equities (Last changed from “buy” on 26-Mar-2023)
- Trend Model signal: Neutral (Last changed from “bullish” on 17-Mar-2023)
- Trading model: Bearish (Last changed from “neutral” on 02-Jun-2023)
Update schedule: I generally update model readings on my site on weekends. I am also on Twitter at @humblestudent and on Mastodon at @email@example.com. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
A liquidity catastrophe?
Even before the resolution of the debt ceiling impasse, analysts had been warning about the consequences of a post-deal hangover.
It was said that the U.S. Treasury market would see a flood of new issuance which would draw liquidity from the financial system. Such a loss of liquidity would create significant headwinds for the prices of risk assets. Since the conclusion of the debt ceiling deal, the warnings have become a cacophony. Estimates vary, but consensus market expectations call for the issuance of about $1 trillion in Treasury paper over the next three months.
I have warned before about the liquidity impact of new Treasury issuance and I am certainly cognizant of the risks. However, there is a narrow path for a benign resolution of the reset of the U.S. Treasury’s cash balances without significantly affecting the price of risk assets.
A financial plumbing primer
The Open Market Trading Desk (the Desk) at the Federal Reserve Bank of New York (New York Fed) is responsible for conducting open market operations under the authorization and direction of the Federal Open Market Committee (FOMC).
A reverse repurchase agreement conducted by the Desk, also called a “reverse repo” or “RRP,” is a transaction in which the Desk sells a security to an eligible counterparty with an agreement to repurchase that same security at a specified price at a specific time in the future. The difference between the sale price and the repurchase price, together with the length of time between the sale and purchase, implies a rate of interest paid by the Federal Reserve on the transaction.
The Federal Reserve’s Overnight Reverse Repo (ON RRP) facility provides a floor to implement its interest rate target (i.e., the federal funds rate) in abundant reserve environments. (For an explanation of repo markets, see the 2020 article, The Repo Market Is Changing (and What Is a Repo, Anyway?)
The idea is that the ON RRP facility gives participants in the short-term funding market the risk-free overnight option of lending to the Fed at the guaranteed ON RRP rate. Thus, other lending rates — like the fed funds rate — will be above the ON RRP rate.1 Figure 1 illustrates how the short-term funding network functions in the U.S.
In the original design, ON RRP was a backstop, as market participants should lend to banks or others (via federal funds, repo, wholesale deposits, commercial papers, etc.) before lending to the Fed.2. This was the case during the early stage of the pandemic: The daily usage of ON RRP averaged $8.7 billion from March 2020 to March 2021.
However, ON RRP usage steadily increased after March 2021 and reached an unprecedented $1.6 trillion in September 2021. This hints at an excess supply of nonbank savings that is not intermediated by banks or absorbed by Treasuries, which has ultimately flowed into the ON RRP facility. The Fed becoming the borrower-of-last-resort has prompted concerns about how the U.S. banking system is functioning during the pandemic. Concerns include, for example, bank capital regulation being too tight or the Fed’s actions creating asset dislocation.
At about the same time, TGA balances (blue line) fell dramatically, though that’s not the only reason for the surge in RRP levels (red line). The Richmond Fed offered the factors as reasons why RRP rose so dramatically:
- The escalated supply of funds due to the saving glut in the shadow banking sector.
- The reduction in the supply of Treasury bills (due to TGA drawdown) that used to absorb non-bank savings.
- The dislocation and uptake of banks’ balance sheet capacity due to quantitative easing.
- The reduction in banks’ ability to expand balance sheets due to capital regulation.
- The reduction in the profit margin of banks’ intermediation due to the interest rate policy.
June swoon still in play
Turning to the technical conditions of the stock market, conditions are setting up for a pause and pullback and a June swoon scenario is still in play.
From a technical perspective, the S&P 500 is testing overhead resistance while the NYSE McClellan Oscillator reached an overbought condition and pulled back.
Sentiment readings are turning giddy. The weekly AAII bull-bear spread has reached levels similar to readings achieved just before the market top in late 2021. While sentiment can’t be described as euphoric, current conditions call for a measure of caution.
Similarly, the CBOE put/call ratio has fallen to levels consistent with complacent conditions based on recent readings. Longer term, however, they have only normalized to pre-pandemic levels. I interpret these conditions as the market needs a pullback and consolidation, but they don’t forecast a crash.
Last week’s market stall saw a surge in the small-cap Russell 2000. Sentiment has become so frothy that the Russell 2000 ETF (IWM) call volumes spiked to an off-the-charts level.
Putting it all together, current technical and sentiment conditions indicate that near term risk and reward is tilted to the downside. The magnitude of the pullback may be a function of how much of the funds from the RRP facility flows into TGA without affecting overall financial system liquidity. The coming week will see a crucial U.S. CPI report and interest rate decisions from the ECB, the Fed, and the BoJ, which could be sources of volatility.
My inner investor remains neutrally positioned. My inner trader is short the S&P 500. The usual disclaimers apply to my trading positions:
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
Disclaimer: Long SPXU