What to expect in this week’s Market Slice:
- The recent crisis in the U.K. bond market sparked by new announcement of tax cuts
- Do fundamental factors support strengthening in the dollar, or has it shifted global currency markets
- Updates on S&P 500 indexes, NASDAQ composites, and 3 month and 1 year U.S. Dollar Index charts
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When Markets Wobbles Central Banks Cave
On Monday, we wrote to Concierge subscribers concerning the previous week’s fallout from the Bank of England’s reversal of Quantitative Tightening in the face of a bond market squeeze.
The recent crisis in the U.K. bond market, sparked by new PM Truss’ announcement of tax cuts with continued spending increases – the opposite of what is needed in an inflationary environment, if reducing inflation is the goal – triggered a massive selloff in Gilts, which are British bonds.
This in turn caused margin calls, as the value of assets on the books of major pension funds (among other institutional investors) fell. This in turn threatened a major liquidity crisis, forcing the Bank of England to step in with a promise to buy the bonds no one else wanted, thus staving off a total collapse of the financial system.
If the Fed does adopt even a moderately dovish tone at the Monday meeting, it is likely the markets will respond positively. Bond yields could fall, and stocks could rise. And if there is any suggestion of a policy reversal – the long-anticipated Fed pivot – we could see a ripping rally.
As we suggested, Monday did see a big rally in the markets. What’s curious, though, is that Fed Chair Powell did not appear…in fact, no significant announcements were made. Despite this “emergency meeting” being a nothingburger, the markets took off – as of market close on Tuesday, all the major indexes are up close to 5% on the week. Here’s the S&P chart:
And this is the NASDAQ:
This does not mean, however, that the Fed governors did not discuss events in the global bond market, the BOE policy reversal, and policy direction. And while the market seems convinced that the Fed is now on the cusp of a policy reversal of its own, our conclusion is different.
The wild swing from oversold to overbought reflected by the RSI and Stochastics readings indicates two things, neither of which are indications of a reversal of the current bear market.
- Investors with huge reserves of cash on the sidelines are desperate for returns, and ready to jump back into equities at the first sign of a market turn; and,
- The increasing volatility in equities is a harbinger of a major downside break at some point in the near future.
We will return to our favorite chart for this year’s bear market, comparing where we are now with what happened in 2008.
While normal seasonality indicates October as an “up” month – and that’s certainly how the month has opened — the pattern which has unfolded throughout the year still holds. In case you are buying the idea that “this time is different,” we will remind readers again of what a bear market rally looks like.
Here’s what Market Ear says with this post from Monday: “Guess we need something/ somebody big to blow up in order for this analogy to continue.” This is consistent with our thesis that the next Black Swan event – which could be anything from our long list of potential dangers posted in May – will be the trigger that sets off the Bear Market Bomb of 2022:
- Runaway inflation
- Interest rate hikes
- Debt defaults
- Crashing bond values
- Global supply chain bottlenecks
- War in Ukraine
- Tension with China
- Chinese real estate bubble
- U.S. stock market bubble
- Decades-long bond market bubble
- And more…
Right now, the Fed appears to be committed to holding the line…fighting inflation is “Job #1,” and there is no reason to anticipate a near-term pivot, no matter what Mr. Market thinks. When the rubber meets the road, however – that is, when a major economic or geopolitical event upsets the status quo apple cart – the Fed is almost certain to follow in the footsteps of their English cousins. Here’s how we put it back in August:
What seems most likely is that sometime this fall, the Fed will realize – too late, as always – they are choking out the patient, and stop tightening. The problem is that inflation will still be well above their 2% target, and once the punchbowl is restored, we are likely to see another stock market frenzy… until the final collapse hits in 2023.
Is This the Top of the Dollar Bull?
The events described above also sparked a fall in the US Dollar this week, as measured against a basket of foreign currencies by the U.S. Dollar Index ($DXY). Here are the 3-month and 1-year charts:
As you can see, this week’s turn indicates a possible peak in a very long upward trend. The question is: is this a top in the dollar, or just a correction in a continuing bull market run?
Here’s another chart, showing support and resistance in the current DXY trend:
What this chart indicates is that there is a lot of potential downside to this move, without constituting a break in the trend. Even if the DXY drops to 105, a case can be made the uptrend is intact. What traders need to answer is whether fundamental factors support continued strength in the dollar, or has the current relationship of forces in global currency markets shifted in some decisive way.
We wrote about how the strong dollar is distorting financial markets two weeks ago, and did an in-depth analysis in July. Readers might want to revisit those articles to get a handle on the complex Dollar dynamics. For now, we are simply watching. It’s too soon to call a top, but at the same time, the factors that have been driving the dollar relentlessly upward are looking increasingly suspect.
Graham Summers, in his Gains, Pains, and Capital daily email, linked the recent decline in the dollar and Treasury yields with the question of the Fed pivot. We’ll give him the final word:
With both Treasuries yields AND the $USD falling yesterday, rate and liquidity pressures are much lower than they were last week.
The $USD reversal in particular is a welcome relief as it allowed the British Pound and other currency that were under pressure to rally hard… But this again erases any need for the Fed to pivot.
Bottomline: the Fed will no doubt pivot at some point… but it’s not doing so now. And the market’s action has made the likelihood of a pivot MUCH lower.