Home Morning Commentary

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The US markets enjoyed a long weekend as US equities markets were closed in observance of President’s Day. Regular trading will begin today, and the outlook for the markets as a whole seems unchanged. The equity index futures are poised to open lower, with the Emini S&P 500 futures trading down about -0.68% at the time of this publication. In concert with this, VIX futures are currently set to open higher, with the front month contract currently trading up nearly +2% over Friday’s close.

Both the index and VIX futures contracts suggest that the markets are little changed since Friday. While we are not opening higher, this is not surprising given the gains made between Wednesday and Friday of last week for equities. These gains nearly erased the losses experienced from the close of Friday, February 2nd. And given that the all time high was reached in the week before February 2nd, it would be surprising to see the markets rebound quickly to the previous all-time high and continue beyond.

Rather, it seems more likely that the indexes will continue to consolidate in this area as investors continue to survey the economy for indications of future growth, as well as eye the FOMC for indications of any changes in their outlook on inflation and growth that could signal a shift in the chances of four rate hikes this year. With these things in mind, we can expect mostly choppy trading this week with ranges more narrow than what we saw last week.

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The stock indices rallied for the 5th day in a row.  As we said yesterday, suddenly higher interest rates are bullish; however, that was also rather sarcastic.  You picked that up, right?  

Last week the market was crushed by a series of financial dominos falling that was started by the volatility indices (VIX & XIV) blowing up.  At the time, many were furious that “the tail was wagging the dog” when such a massive effect rippled through the whole market.

Additionally, almost every pundit on television was making like Chicken Little: “the sky is falling!”  Of course, a 5-day rally sure changes things; those same analysts are telling anyone who will listen that it’s all over and to buy with both hands.

Not everyone believes that.  Charlie McElligott, MD at Nomura Cross-Asset Strategy, certainly disagrees.  He wrote the following to his clients: Regarding yesterday’s selloff in USTs, comments from our Rates team were extremely telling from the positioning perspective, in that there was very little “stress.”  My outstanding colleague Darren Shames noted that the shorts were in no rush to cover, communicating high conviction that yields still have more room to move higher.  Real Money simply wasn’t there, feeling like there is still more move to shake out / better entry-points, potentially eying that ~3.20% level in the 30Y that has held since 2014.  Darren too mentions that convexity hedgers were present to a certain extent, but by no means forcing the flows—even at the worst levels of the day.  When viewing that alongside his observation that dealer gamma hedging flows too were negligible, it indicates that the “sellers are lower” supply still has yet to be seen (although notable that ~7k futs traded overnight as yesterday’s 120-08 low in TYH8 was breached—looks like a “stop loss”).

As previously stated, it’s the move in “real rates” that risk traders need to keep an eye on.  My yesterday afternoon piece focused on this, because despite the move in nominal yields, the “gap” move in inflation expectations (thus the widening in breakevens) actually kept “real rates” stable on the day.  This in turn provided relief from the recent equities-theme of the negative impact of “tighter financial conditions.”

However, I REALLY think that it was the USD breakdown which provided the most relief for US equities.

I think you’re gonna have another chance to buy stuff lower, before another rally off the back of a “tradeable bottom”…and more importantly, that higher volatility / “chop” is “here to stay.”

If there will be another (and tradeable) bottom, then it better get to falling soon.  If it doesn’t, then traders will believe, if they don’t believe this already, that the low is in.  If true, then the market will be going higher from here on a near daily basis…with LESS volatility and less volume.  In other words, back to normal.

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Is inflation making a comeback?  We received a specialized government report today that measures inflation; consumer price inflation (CPI) to be exact.  The market was on edge wondering if the early CPI report showed a jump in inflation, which the market does not want to see.  Higher inflation leads to more than expected Fed interest rates that lead a slowdown in the economy (normally) and that leads to a drop in the stock market.

In addition to the CPI data, Retail Sales data were reported as much worse than expected. What’s more, prior data were revised sharply lower, which will lead to a decrease in the GDP data. This is all bad for the stock market.

What was the result? The S&P500 made an initial move lower – sharply lower – then reversed course.  In fact, the S&P500 reversed straight up nearly EIGHTY POINTS… yes ~ 80.00 points despite the terrible news.

Here’s how Econoday reported the surprisingly inflationary CPI news: Tangible increases in many basics lead a stronger-than-expected 0.5 percent jump in consumer prices for January. The core, which excludes food and energy, confirms the strength, up 0.3 percent which hits Econoday’s high estimate. Despite the strength, neither year-on-year rate were able to advance, at 2.1 percent overall and 1.8 percent for the core.

Transportation leads the month, up a very sharp 1.8 percent with parking, vehicle leasing, body work, insurance and vehicle fees all up in what looks like beginning-of-the-year price increases. Prices of new vehicles actually fell 0.1 percent though used cars were up 0.4 percent.

Medical care, which had been flat, rose 0.4 percent despite a 0.2 percent dip in the closely watched prescription drug component. Hospital services jumped 1.3 percent with health insurance up 0.6 percent. Apparel, which had been sinking sharply, popped back in January with a 1.7 percent jump led by a 3.4 percent surge in women’s apparel.

Gasoline prices were up in the 5.7 percent in January which fed a 3.0 percent rise for energy. Food prices remain subdued, up 0.2 percent. Housing, which is the largest component in this report, rose only 0.2 percent though the owners’ equivalent rent sub-component rose 0.3 percent for a second straight month.

Consumer prices are showing what could, in retrospect, be seen as emerging life, early acceleration tied perhaps to the emergence of underlying wage pressures. Today’s report is certain to lend itself to anti-inflationary prudence especially among the hawks on the FOMC.

The stock market not only ignored all of this news, it rallied like mad – panic buying, if you will. How did the other major markets react to the news? Gold exploded higher as a hedge of inflation. Future rate hike odds at the CME soared. The 10-yr Note yield went UP, making it even higher than where it was that helped cause the 10% correction.

I guess higher interest rates suddenly became bullish?  OK, let’s go with that then.

 

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First of all, we’d like to wish all of you a happy Valentine’s Day. We hope that you share it with that special someone in your life.

Moving forwards, the US equity indexes managed to clock in a third rally in a row as they continue to recover from the mess created by Monday’s plummet. The S&P 500 closed up 6.94 points to settle at 2662.94 for the session, a gain of +0.26%. While this percentage gain is more reminiscent of the kind of positive gains we say nearly every day in 2017, it is worth noting that the market originally gapped lower on Tuesday’s open, but managed to reverse those losses to finish positive for the day. In fact, it had opened on Tuesday nearly 40 points lower than where it closed the same day.

With the bullish reversal of the gap lower from Tuesday’s open, the VIX was forced to retreat somewhat from its current exaggerated levels. We say that it is exaggerated because by all observations the markets are nowhere near the volatility levels implied by the VIX, and there are no perceived future risks being factored into it that would suggest that such a level is appropriate. The VIX closed down -2.50% for the session overall at 24.97, but like the S&P it had gapped open, but instead of lower it had gapped higher, opening at 27.14 for the session.

It is worth noting the VIX futures have a vast spread between today’s February contract expiration and the March contract. Feb futures closed on Tuesday at 25.225, but March settled at 19.825. This is over a 20% spread between the two, and the spread generally widens as you go further out into later expirations. Thus, the VIX is demonstration what is known as backwardation, suggesting that there is some massive change in risk from Wednesday to Thursday, even though anything that would be this significant for today would certainly carry over to Thursday. Perhaps this is evidence of the manipulation alleged by an unnamed whistleblower who alerted the SEC this week.

Let’s keep an eye on the markets as it appears that several major themes are developing, particularly with regards to allegations of market manipulation. Last Monday’s decline may turn out to be the next incarnation of 2010’s “Flash Crash” in hindsight. Only time will tell.

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After last week’s dramatic declines in the US and global equity indexes, the markets have been able to achieve upward momentum two sessions in a row. As we stated yesterday, it is unlikely that federal regulators will stand by and watch the markets if they were to continue to decline. At the very least, after so many years of QE globally, it would be unusual for them to abandon a policy that they used to clearly strong effect over the last 8 plus years. That is to say, when given the option of stepping in or stepping aside, political pressure would most likely lead them to step in and repeat the process of propping up the markets. However, so far as we know, they have mostly stepped aside at this time and plan to continue to do so. Thus, the lesson for the US markets at least is simple: it’s time for it to stand on its own feet.

Yesterday’s action was clearly bullish. When looking at the volume of buy orders versus sell orders for stocks on the NYSE, it was clear that cumulative buying volume exceeded selling by by a clear margin. This was the case throughout most of the day. However, it would be somewhat misleading to suggest that this is the end of the story. Instead, it seems more plausible that the markets are simply settling into range bound trading. The SPY etf, for example, appears to be settling into a range very accurately represented by the range between yesterday’s high of 267.01 and Friday’s close of 261.50. Other indexes are likely to mimic action on the SPY as the markets attempt to stabilize.

At this juncture, it does appear that the markets have finished the extreme price volatility levels demonstrated last week. However, options volatility levels continue to be high and the VIX index is currently at levels substantially higher than the amount of volatility demonstrated by the markets over the past week. This is likely due to the large number of short volatility trades that have to be unwound after last Monday’s debacle. Let’s keep an eye on the VIX and SPX options implied volatility levels to see if and when trading is returning back to more normal levels of volatility, with the hope that we do not go back to the extremely low volatility we saw in 2017.

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Whenever we talk about increased volatility, you can bet that the market is falling.  For some reason, when the market is rallying, volume and volatility decrease.  Currently, the exact opposite is happening: volume and volatility are spiking.  So with the markets down, people are wondering if the central bankers across the world will somehow stop the decline by instituting another QE of some kind.  

According to the assortment of statements below, the answer is no.

When asked about the markets and what it would mean for the overall economy if it became bearish, outgoing Fed Chair Yellen said “The financial system is much better capitalized. The banking system is more resilient,” the former US central banker added, listing her accomplishments. “I think our overall judgment is that, if there were to be a decline in asset valuations, it would not damage unduly the core of our financial system.”

“I think it’s basically a market event, and these things can be healthy. I don’t think it will have economic implications. 2018 will be a strong year in America. We’re at or near full employment. I continue to expect three rate hikes this year.” – Robert Kaplan, Dallas Fed president.

“This is the most predicted selloff of all time because the markets have been up so much and they have had so many days in a row without meaningful down days. Something that has gone up 40% like the S&P tech sector would at some point have a selloff.” – James Bullard, Philly Fed president.

“An equity rout like the one that occurred in recent days has virtually no consequence for the economic outlook.” – Bill Dudley, NY Fed president.

Apparently this theme is shared overseas. “the recent drop in equities is a normalization, a reasonable wake-up signal to show that stock markets can’t just keep rising all the time. Behind [the drop] there is an expectation in markets that central banks will increasingly raise interest rates, and there are certain good reasons for that. The U.S. is expanding. However, one has to say that the task of central banks isn’t to satisfy markets but to ensure overall economic stability. So if necessary, interest rates will have to rise and markets will adapt to that.” – Ewald Nowotny, Austrian Central Bank and ECB member.

This is interesting.  They’re saying that they will not be coming to the rescue. We’ll have to revisit the issue in the future if the markets keep falling. I believe that they will change their statements then.

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You have probably heard more than once that the retail trader often makes the worst decisions possible, like wading into the markets at peaks, and then selling out at the lows.  Well, the first part of that has happened, and the latter part may be happening now (but it’s too early to tell).

The markets peaked just a few weeks ago.  Guess when retail investors ploughed huge money into the markets?  OK, this is an easy question – it was at the peak.  It was literally the day that made the high.  The markets saw a record $33.2bn inflow to equity funds, a record $12.2bn inflow into active funds, and $1.5bn into gold.  The average retail investor loved the market rally and just had to get in.  What could go wrong; after all, equites always go up – right?  Sure…and then stocks crashed.

Last weekend JPM said the following: If these equity ETF flows start reversing, not only would the equity market retrench, but the resultant rise in bond-equity correlation would likely induce de-risking by risk parity funds and balanced mutual funds, magnifying the eventual equity market sell-off.

You know what happened next: record equity outflows, a great deal surely coming from ETFs.

Citi recently said the following: “in the week of 2/7/2018, bond funds had an inflow of US$4.0bn and equity funds lost US$30.6bn to outflows. This was the largest outflow on record from equity funds, which just had their record high inflow of US$33.2bn only two weeks ago. The largest outflow had come from US funds which saw US$32.9bn of outflow. “

Some things never change.

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As we have mentioned recently, the severe market volatility started last Friday.  It increased dramatically Monday, thereby making trading on Tuesday extremely difficult. Wednesday’s trade was still “whippy,” as it is called by many active traders, but far less so than the prior few days.

Have you ever thought of how the market may change when volatility radically increases?  Do to the surprise factor, where traders realize that markets can actually go lower, trades are not held as long.  Traders will consistently take quick profits, which makes the sharp swings in the market look like a school of mackerel changing directions while feeding.  

And what may help this process?  Look at how much the volume size in the order book decreased.  In the ES futures, the volume size at each price can drop from a “normal” size of 1,000 or more, to as low as a single digit.  This lack of “size” in the order book means that the change in direction can be extreme, surprising, and therefore “whippy” because there are so few trades to slow it down in the queue.  Think of the school of fish changing directions!

The crash of the short volatility index, XIV, has been discussed a great deal in the financial media; but what caused the increased vol that crushed the short-vol trade?  Many people believe that the rally in the long Treasury market yield is the answer.  What’s more, many people were warning of market upheaval if the 10-year traded above 2.63%.

When the yield traded north of 2.80% last Friday, the steady rise in interest rates just could be ignored any longer.

Expect another round of wild volatility when the 10-YR trades above 3.00%.

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Tuesday represented a massive rebound for the equities markets. In fact, in sheer points, we saw the largest bounce back from Monday’s lows in history for a number of indexes and their related futures contracts. This is NOT to say that these were the biggest percentage rebounds in history, but they were still very large. On top of this, the VIX’s rise was the biggest ever in comparison to the percentage declines experienced by the S&P, actually going up over 2X what the average for such a percentage drop.

But the VIX is still relatively high, mostly due to the fact that most of the markets were caught off-guard by the action on Monday, and firms such as Credit Suisse experiencing record losses for their VIX etn XIV, with this etn now scheduled to be closed out by the end of February due to the magnitude of losses. XIV is an inverse VIX etn, meaning that it holds short positions in VIX futures products. Thus, with the enormous jump in the VIX on Monday, futures prices skyrocketed and caused XIV to collapse under the weight of its leveraged positions.

The massive volatility we saw on Monday was not replicated on Tuesday, but volatility was still high overall. Day traders in futures and equities had two of the most opportune situations for making potential profits as the markets had big swings up and down all day, with Monday being biased lower and Tuesday the opposite. Tuesday also presented a great opportunity for value investors to pick up shares of their desired stocks at substantial discounts over prices from only a week ago.

But things are not in the clear yet. The debacle caused by the spike in volatility in the VIX has clearly forced many traders to offset their risks elsewhere, or liquidate positions they held in order to cover losses. This has caused clear swelling of implied volatility levels for nearly all stocks in the near term, and we still have the aftermath visible in VIX products as large shorts continue to unwind positions the are massively upside down. Expect it to take another week for things to get back to more normal activity, but in the meantime, take advantage of whatever good opportunities you can find.

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Let us go out on a limb and say that yesterday, Monday February 5, should from now on be known as the “Big Red Day”. Now there was a movie called the “Big Red One” about an army unit in World War II fighting during the allied campaign in Europe during and after D-Day, but that is not the idea here. Rather, we clearly mean that the financial markets as a whole, nearly across the board, were down yesterday. From oil to Bitcoin to the S&P to the Euro, nearly everything was in the red. Notable exceptions were gold and silver, the US dollar, and most impressively the VIX.

As you may recall, we’ve lamented the lack of volatility that has been present in the markets recently. This has been evidenced by the VIX make a persistent series of new all time lows, in concert with the equity indexes making new all time highs. But the VIX short bet was destined to hit a dead end at some point, particularly given that it was unlikely that the markets could go over a year without any significant selloff. Well on Monday, they not only sold off, but the Dow declined more points than it ever had in history. It did not, however, decline the greatest percentage in history, but either way is was a very big decline, it was very sudden, and it clearly caught short volatility traders off guard. Many VIX etfs, such as VXX, made tremendous gains during the day session, and then continued to rally much more AFTER the market closed during the after hours session.

To be clear, most things were down and slid lower after the close of the regular session and also in foreign indexes after the US close as well. At this juncture, we can be assured that bargain hunters will come into the markets in mass as some point given that fundamentals in the global marketplace. This does not mean that Tuesday will be a buying day, but what is does mean is that traders will be more on the alert as the markets are finally shifting around and acting, well, normal. Keep an eye on the VIX for clues to when sentiment is beginning to shift to a more bullish perspective. The VIX closed up +115.60% to settle at 37.32 for Monday’s session.

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