Mid-week market update: I noted on the weekend that the S&P 500 was at the end of a upper Bollinger Band ride, and such instances usually resolve in consolidation or pullbacks. In the past, the pullback usually ended at the 20 dma, which is roughly where the market is today. In other cases, market weakness continued until the index reached the lower BB.
Is the pullback over? To answer that question, I turn to the catalyst for market weakness. I woke up Tuesday morning to see a sea of red in equity market indices. The spark was attributable to a decline in the shares of go-go stock Palantir, which reported sales and earnings beats and guided expectations higher. Apparently, it wasn’t enough. The market sold off because of Palantir’s sky high valuation.
I found the explanation vaguely unsatisfying. Here is the real reason.
A Liquidity Scare
Michael Howell of CrossBorder Capital pointed out the spike in the SOFR – Fed Funds spread, indicating a liquidity squeeze in the financial system. Sudden liquidity squeezes can cause dislocation in asset prices and play havoc with risk appetite. Fortunately, the liquidity squeeze was attributed to temporary month-end imbalances and the SOFR-FF spread normalized the next day.
The spike in SOFR highlighted an additional liquidity concern lurking in the financial system. A Risk.net article, Crypto ETFs gatecrash the U.S. Treasury repo market, reported that crypto ETFs borrowed $13 billion from the Treasury repo market in Q2. In other words, crypto leverage is now tapping into the Treasury repo market and the crypto tail is at risk of wagging the market dog. Combined with the recent dramatic decline in Bitcoin and other crypto currencies, this is a sign of possible crypto contagion in the banking system.
Bitcoin and stock prices have shown a fairly high correlation in the past. I have said before, Bitcoin can be thought of as a quick-and-dirty indicator of liquidity. Fortunately for the bulls, Bitcoin rose today after falling below the psychologically important 100K level to recover above 100K.
The last FOMC meeting saw the Fed announce the end of QT as Fed officials expressed concerns about the level of reserves in the banking system. This latest episode is a warning to policy makers the importance of maintaining a smoothly functioning plumbing in the banking system. No doubt, the mini-crisis will pass as the Fed is already paying attention.
In conclusion, temporary bottlenecks in banking system liquidity exacerbated by excess crypto leverage sparked this week’s minor risk-off event. As Bitcoin prices are already stabilizing, the S&P 500 has likely bottomed at its 20 dma. Traders should continue to be positioned for a rally into year-end. I’ll be watching the relative performance of ARK Investment ETF (ARKK) as a sign that liquidity conditions have normalized.
That is such an arcane observation and kind of like finding a needle in haystack. Sad to know that we would be missing great insights from you next year.