On Tuesday, the day before Yellen's historic rate hike, the S&P closed at 2,043. Today, the day after a Fed announcement which everyone cheered overnight as simply fantastic, perfect, "dovishly goldilocks", and countless other superlatives because it sent the market surging, the S&P closed at.... 2,042. In the process all the euphoric gains from the widely telegraphed Yellen announcement and press conference have been completely wiped out, not just for stocks...
... but also for the most "sensitive" asset class in recent weeks, junk bonds which suffered a bruising wipeout today.
... and then there is the one asset class that has so far slipped through the cracks, but which will be very closely scrutinized in the coming weeks now that rates are rising: leveraged loans.
All of which begs the question: did algos finally figure out precisely what we said first thing this morning, namely that the market completely ignored what was a hawkish hike..
Yesterday, in a carbon-copy response to what happened in December 2013 when the Fed announced the Tapering of QE, stocks first sold off then, as if to validate the Fed's decision as being accurate, saw a dramatic buying surge which pushed them to close just off the highs. With bonds and gold selling off while the dollar rebounded, the Fed could not have asked for - or engineered - a better reaction, while markets, as Bloomberg's Richard Breslow points out, 'chose to hear the parts of the statement and press conference that they wanted to."
That was the easy part. The hard part now is how to ween the market away from the old narrative, the one which has pushed the S&P to record highs over the past 7 years on bad economic news, and to renormalize the market's own "reaction function" to that of the Fed. The problem is that from day one there is a major discrepancy between the two: as previously observed, the Fed did not deliver the desired dovish hike, and kept its 2016 year-end fed funds rate unchanged at 1.4% suggesting 4 rate hikes in the coming year, and which as Breslow notes means "being less dovish than the meeting previews suggested is now a sign of bullishness on the economy." This sets the Fed on a collision course with the market because "with the market pricing fewer hikes than the Fed suggests, someone is going to end up being wrong. If we do get four hikes next year, markets (read equities) will need to deal with a hawkish surprise. If the Fed is forced to backtrack, there goes the full-speed ahead theme."
What this explicitly means is two things: bad economic news is no longer good for the market - after all the dominant paradigm now is one of strong dollar=strong economy=strong S&P (ignoring that the stronger the dollar, the worse the earnings recession sets up to be, the sharper the full economic recession), and that as Breslow concludes, the "Fed needs to focus on the real economy and get out of the QE mindset. I suspect that will be easier said than done."
... and that as a result, what Yellen has done, now that the kneejerk reaction is over, is policy error, pure and simple? To be sure, the pancaking of the 2s30s screams "error" and an imminent global deflationary wave:
Or maybe it has nothing to do with the Fed, and everything to do with tomorrow's quad witching. We warned about just this in last week's "Beware The "Massive Stop Loss." Recall:
[The Fed's rate hike] falls at a peculiar time—less than 48 hours before the largest option expiry in many years. There are $1.1 trillion of S&P 500 options expiring on Friday morning. $670Bn of these are puts, of which $215Bn are struck relatively close below the market level, between 1900 and 2050. Clients are net long these puts and will likely hold onto them through the event and until expiry. At the time of the Fed announcement, these put options will essentially look like a massive stop loss order under the market.
And what is the number one rule about broken markets? All stops get taken out.The irony will be if, regardless of what the Fed does, the subsequent move is driven not by the market's read through of monetary policy but by the "pin" in this massive $1.1 trillion option expiry, the biggest in many years, one which if recent market action is an indicator, suggests the stop loss strike level will be taken out in the process setting the "psychological" stage for market participants who will look at the drop in the market, and equate it with a vote of no confidence in what the Fed is doing, potentially forcing the Fed to backtrack in less than 2 days!
This is how we concluded:
"The irony will be if, regardless of what the Fed does, the subsequent move is driven not by the market's read through of monetary policy but by the "pin" in this massive $1.1 trillion option expiry, the biggest in many years, one which if recent market action is an indicator, suggests the stop loss strike level will be taken out in the process setting the "psychological" stage for market participants who will look at the drop in the market, and equate it with a vote of no confidence in what the Fed is doing, potentially forcing the Fed to backtrack in less than 2 days! "
If so, tomorrow's already illiquid expiration may be an event for the ages, one which may culminate with a Kervielesque-rate cut just days after the historic first ratae hike, only this time the Fed can't do a 75 bps rate cut in response to one panicked futures trader, so 25 will have to suffice.
Or perhaps it is neither the Fed, nor tomorrow's market technicals, and the reason is an old and familiar one. Dennis Gartman.
This is what the "world-renowned commodity king" said in his overnight letter:
What then do we make of this? How then are we to invest? What then are we supposed to do? ... All we know is that the trend remains upward and it was for that reason that although we were cautious and recommended openly that it was wise, ahead of the Fed’s to become neutral of equities (a position obviously we wish we had not taken, with the benefit of hindsight), we did not and would not recommend being short of the equity market. As we have said for years, and shall say as long as we are able to write TGL on a daily basis, in a bull market there are only three positions that one can have: Aggressively long of equities; modestly long of equities, or neutral of them. As of earlier this week, ahead of the Fed meeting, we advocated neutrality. Now we have to suggest the middle course once again. We’ve really no choice.
There we sit this morning, knowing yet again that these things do not end well, but knowing too that it is better to be modestly long than otherwise.
The rest is history.
So tune in tomorrow when, if the JPM "Gandalf" is right again, things are about to get very exciting.