Two months ago, we warned [5]that Deutsche Bank "raised the warning flag", when its strategist Jim Reid, referring to the infamous chart showing the correlation of the Fed's balance sheet and the S&P 500 said:
The risk sell-off we've seen in recent weeks frustrates us a little as the chart we've published most this year has pretty much predicted that tougher times would come around July. We've been paying it a lot of attention for over a year now but decided to wait until the autumn before we raised the warning flags. The chart in question (included in today's pdf) is the one showing the Fed balance sheet and the S&P 500 (as a proxy for risk generally). As you can see, since the Fed balance sheet was used as an aggressive policy tool post-GFC, the graph suggests that the S&P 500 is well correlated with the size of the Fed balance sheet with the former leading the latter by 3 months. Given that the Fed have recently signalled that they will likely be finishing expanding their balance sheet in October, 3 months before that was July. This is important as virtually all of the mega rally in the last 5 years has come in the Fed balance sheet expansion periods. The other periods have been more challenging for markets.
The chart he is referring to, of course, is this one.
And judging by the recent bout of volatility and risk weakness, we are now entering one of the "infamous" other periods.
So as it is finally dawning on even the most die-hard, and naive, pundits that it was all about the Fed for the past 6 years, here is Jim Reid's latest comment on this infamous "pair trade":
With the recent weakness in risk, are we understanding more about how addicted markets have been to the Fed's QE? Or is this just a temporary unrelated blip? The Fed will turn off the QE tap later this month and in our opinion volatility has been increasing as the market adjusts. We've long felt that the Fed pulling back from QE would be an issue for markets and it’s tempting to be bearish here.
That said, it is only stocks that are set for more weakness. As Reid notes, "credit markets have corrected a long way already", as we have shown repeatedly.
In fact, we will show it again, to show just how much further stocks have to plunge because, as always, credit is right and stocks are wrong.
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