As I mentioned in the last macro article, I welcome the market to correct my thesis, and now I stand corrected. Recently, I was forced to close out my bond position at a small loss as the long end of the curve bearishly steeped. I had not properly assessed the risk of the Fed’s adamancy regarding a difference between QE and their repo market driven operations at the short end of the curve. Many would argue that the Fed’s purchase of any debt securities flags a real problem which should mean higher demand for so-called “safe” assets at the long end of the curve. However, from the price action it’s quite clear that the market takes the Fed on its word at this point; so, for now there’s no need for me to fight the market and be short here. Ultimately, I think long yields have lower to go, as I have a hard time believing such a radical spike in repo rates was a simple liquidity technicality. I think we will likely look back on that event as a warning sign that the market was all too quick to forget.
Along with the Fed’s narrative regarding repo market action derailing my short-term fixed income thesis, I am also forced to reevaluate my view on the dollar. The Fed began buying at the short end of the curve as the dollar index was breaking to yearly highs. Following this buying, there has been a dollar sell-off. To me this represents a turning-point for my bullish dollar thesis as the Fed proved that they have an ability to put a lid on it for now. I had based my previous analysis on a global dollar liquidity squeeze that I saw unfolding. This implied a credit-driven squeeze in the Eurodollar market which the Fed should have had a much harder time controlling. Having said all of that, if the Fed keeps having to increase the amount of liquidity provided to the repo market, I could still be proven correct. This will remain in my mind, especially if the dollar index shows signs of a strong rebound. However, in context of my current core positions as a dollar-denominated trader, I do not believe that I face concerning currency risk here short-term. Foreign investors will likely continue to support the dollar with capital flows chasing our strong equity markets and relatively favorable yields. So, while I certainly would not establish an outright levered dollar long here, I do not see dollar depreciation as significantly impacting my returns on current positions.
Finally, equity market price action has been favorable for me. While I was not necessarily correct in linking dollar appreciation to an S&P 500 rally, the rest of my analysis of the remaining strength of the U.S. consumer and the actions of the Fed have led me to the correct side of the trade thus far. Just this week, we finally got the break-out to new all-time highs which I expected on the back of a so far solid earnings season and high probability of an FOMC rate cut decision. I believe it is crucial to have continued equity exposure here as I await what I previously hypothesized would be a short squeeze. As the previous high is retested, I will pyramid into a larger position if that high convincingly holds. However, if the break-out fails on high volume, I will cut losses and reevaluate. Given the general cautiousness I have observed among other equity market participants, if this market really does begin to accelerate to the upside, lots of FOMO money will pour in. Many managers are sitting on piles of cash because of what they consider bearish fundamentals, yet the price action warns them against being short. Widely perceived negative fundamentals considerably over-exaggerated by financial media, coupled with market strength reminds me of so many counter intuitive price action examples highlighting why most people fail to excel in markets. This is exactly why I am positioned long here, as I eventually want to be selling to those who will be chasing this market, instead of paying up with them. However, if we see this market continue to just rise slowly with no true short squeeze materializing, I will really ask myself when valuations start to matter again. In this case as the average p/e ratio moves to or beyond the mid-20s while GDP growth remains merely mediocre to good at best, then I’ll see the favorable risk/reward in the short trade.