Tantrums

Regular readers may recall that Macro Man is a bit of a cycling aficionado.   Occasionally, he tries to enroll the Macro Boys to come along with him, particularly Macro Boy the Elder, who has the perfect build for riding and has at some points shown some aptitude for it.  Unfortunately, the lad's heart has yet to be captured by the sport, and so occasionally when your author tries to coax him into a ride the result is a sort of sulky tantrum of the type that 14 year old boys excel at.

As Macro Man confronted another of these moan fests yesterday, his mind wandered to financial markets and the apparent onset of yet another market tantrum.  While the ECB's "no soup for you" routine last week may be fingered as a possible catalyst, in point of fact the market generally tried to shrug off the weak US data well before then.  While the short end isn't pricing  anything like a done deal for a Fed hike by the end of the year, let alone September, even for the latter meeting the odds stubbornly refuse to move towards zero.  Pricing for December, meanwhile, remains near its highest probability since the Brexit vote.

The upshot is that fixed income securities of most stripes have come under the cosh a bit, with Bunds notably trading back to zero yield and US bond futures decisively breaking below the "corridor of uncertainty" highlighted in this space on several occasions recently.

Technically, of course, this bodes for further losses ahead, all the more so because models will be hitting stop losses.   There was a lively debate in the comments section a few days ago about the likelihood of a bond market crash, particularly in Europe;  Macro Man deems it unlikely in the absence of a significant rise in inflation, but this of course does not mean that the market cannot trade lower, because of course it can.  Indeed, for the moment this appears to be the path of least resistance.

The repercussions for other markets are notable and obvious.   Much of the current financial market pricing architecture has been built upon a foundation of very low interest rates, so of course any crumbling of that foundation has potentially significant implications.   In the equity space, "bond replacement" stocks have been amongst the darlings of the year, at least until recently; as the chart of Altria indicates below, these have been taken to the woodshed, most particularly on Friday.  Even after last week's carnage, it's hard to say that it's cheap with a P/E of 22 and little growth; the yield of 3.845 looks a little less tidy if 10y Treasury yields back up another 25 or 50 bps.

On an index level of course, Spooz in particular look like a coiled spring whose potential energy is in the process of being transferred to kinetic (downside energy).  We've seen this film a number of times before, of course, where stocks break down only for the doves to ride to the rescue.   The question is whether we are at that point yet; it seems difficult to believe so in the absence of another few percent.

That being said, we shall have an important litmus test today, when dove ne plus ultra Lael Brainerd gives a speech on the US economy in Chicago.   If the Fed still wants to keep September alive, this is the last chance saloon to give the market a nod and a wink.   Recall that the last few speakers from what might be termed the cabal at the center of the FOMC power structure (Yellen, Fischer, and Dudley) have all striven to keep the notion of near term rate hikes alive.   While Brainerd may not be at the center of the group, her dovish views have been articulated in the FOMC's lack of action thus far in 2016.

As such, if she were to tilt towards the sort of language that we've had recently from the cabal, that's as clear a sign as you could get that the times they are a-changin'...and we should expect more of what we had on Friday.  If, however, she sticks towards her dovish views, it wouldn't necessarily derail the market's tantrum, but it could assuage it.   Certainly the sharp rise in VIX will make it attractive for put holders to cash in if there's a signal that the Fed may capitulate to the market's tantrum yet again.

Because ultimately, that's the conclusion if Friday's ructions are pushed to an extreme.  The tricky bit, of course, is knowing what the Fed would describe as an "extreme"; naturally, there is a multi-dimensional matrix comprising economic momentum and financial conditions as measured by a host of variables (rates, the dollar, spreads, etc) which also must be tempered by balancing actual observations with forward looking forecasts.

The temptation is likely to be there for shorts to take some profits today, particularly if Brainerd is her usual dovish self.  That being said, we know that volatility tends to cluster, and a large move like Friday's is rarely observed as a solitary island in a sea of tranquility; rather, it tends to be accompanied by other moves of comparable magnitude (in either direction.)

In short, Macro Man does not subscribe to the view that this is "the big one", but he does welcome a higher volatility environment as one that provides substantially greater trading opportunities.   Gun to the head, he expects Brainerd to hold her dovish course and provide at least a temporary respite (though that could last only a few hours.)  He may well look to cash in on some shorts to provide a healthy financial and mental platform from which to increase position sizes from more favourable levels.

Either way, it looks set to be a more eventful period as we careen towards the election and the close of the year, for which we can all be grateful.