I see intermarket analysis (the idea that other markets can be predictors of the stock market) mostly as a big waste of time. Often, what correlates today won’t correlate a year from now, or the correlation may even reverse. The best way to analyze and forecast stock price trends is to analyze stock prices themselves. That’s the basis of technical analysis (TA). I spend about half my time on TA in my analytical work for The Wall Street Examiner Pro Trader Market Updates (http://wallstreetexaminer.com/category/professional-edition-3/todays-markets-professional-edition/).
But there is an exception to the rule that intermarket analysis is useless….and it’s the U.S. Treasury market.
If you know what to look for, Treasuries – in particular, the 4-week T-Bill – can tell you something very important about liquidity and which direction the money is flowing. That, in turn, will ultimately tell you where the stock market is headed.
Here’s how it works.
Before You Look at the T-Bill, Get the Bigger Liquidity Picture…
When I’m not working on TA, I spend the other half of my time analyzing macro liquidity trends, not just as they apply to stock prices, but also as they apply to the U.S. Treasury market. Analyzing Treasury yields and Treasury bill interest rates can be helpful in understanding how the forces of supply and demand affect both the Treasury market and stock prices.
The worldwide pool of liquidity that drives the demand for Treasury securities is the same pool of money that drives stock market demand. We’re not looking for a one-to-one correlation that says “If this goes up, that should go up.” It doesn’t work that way. Sometimes bond yields and stock prices move in the same direction. Sometimes they go in opposite directions. That’s why intermarket analysts spend so much time explaining what went wrong or what could go wrong to break the latest correlation.
We do not look first at the bond yields and interest rates. We look at the creation and destruction of liquidity (the fancy word for “money” or “cash”), and then we look at where that liquidity is flowing. Prices and yields are the directional signals.
Liquidity analysis as it applies to the Treasury market helps to establish the context for reading the stock charts. For example, under quantitative easing (QE), stock prices moved up, and bond yields moved down (bond prices higher) with them. That was because the Fed was creating so much money that there was more than enough to drive both markets in a bullish direction.
However, if we know that liquidity will be scarcer, and we see that bond yields are falling, then we know that the bulk of the money available for purchasing securities is flowing first to the bond market. When liquidity is tightening, that’s bearish for stocks.
We don’t have tight liquidity, yet. But we know that we’re headed in that direction as the Fed increases the amount of money it pulls from the system under its program of balance sheet “normalization.”
We also know that if the Treasury follows the recommendation of the TBAC (the committee of bankers that advises the Treasury on its borrowing needs), the Treasury will pound the market with enormous amounts of new supply over a couple of months. The amount of new supply would be multiples of net new issuance the market normally must absorb. That supply will soak up most available cash, especially when the Fed isn’t adding any to the system. Some dealers and big investment firms may also sell stocks to raise the cash needed to absorb the new Treasury supply.
Yields on longer term Treasuries and interest rates on T-bills should rise as that supply hits the market.
Let’s review. We know that when the Fed is adding more liquidity to the system than the Treasury is taking out, then we should read our technical stock price charts with a bullish bias.
When the Fed isn’t supporting the market via QE and the Treasury is removing large amounts of cash from the banking system by selling debt, then holding the proceeds, that will affect our analysis in the opposite direction.
That problem will be made worse when the Fed starts withdrawing large amounts of cash from the system. We would normally expect interest rates and bond yields to rise and stock prices to fall. We would give the benefit of the doubt to the bearish interpretation.
That’s the environment we are heading into over the next year as the Fed pulls money out of the system. This will be the largest tightening of the supply of money available to fuel stock and bond purchases in the Fed’s history.
New Treasury supply was light in September thanks to quarterly estimated tax payments padding the government’s cash account. Supply in October has been as expected based on the TBAC August forecast. The blast of supply that could have come had the debt ceiling impasse lasted a few more weeks did not happen.
Such a huge wave of supply would have kneecapped the markets. Instead, supply has been light, and the rally in stocks hasn’t faced the expected Treasury supply headwind thanks to the early debt ceiling deal.
But at the same time, the stock market hasn’t raced into the stratosphere. It struggled to inch higher last week.
Now, the U.S. Treasury is set to massively exacerbate the situation by issuing more than $500 billion in new supply over the course of November and December. We know that because it’s in the TBAC schedule. The only question is whether the Treasury will follow the TBAC recommendation as it normally does with TBAC recommendations, or whether the next debt ceiling crisis (due on December 8), will derail it.
Assuming the Treasury sticks to the TBAC’s recommended schedule of issuance for November and December, the bull party should come to an end soon. $500 billion in new supply is four to five times the usual amount of new issuance over any two months. It should be enough to crush both the stock and bond markets. Prices would fall materially.
However, the debt ceiling will loom when the current deal expires on December 8. That’s a wild card. This time, I won’t attempt to make any predictions. The politics are so volatile that there’s simply no way that I know of to predict the outcome. The past hasn’t been prologue. We have entered a brave, new world.
We’ll see what happens as the December 8 deadline draws close. In the meantime, we’ll keep an eye on Treasury supply to see whether the government follows the TBAC schedule to raise $500 billion over the last two months of the year. If they start to fulfill that forecast, it should be a bull killer.
The T-Bill Shows You the Effect of Fed Tightening on a Real Market
This is where it might be useful to watch interest rates, especially the interest rate on the 4-week T-bill. I’ll explain.
The 4-week bill continues to trade mostly below the overnight Fed funds rate. This isn’t normal. The 4-week bill rate should be a bit higher than the overnight Fed funds rate. But the Fed’s attempt to manage rates by paying interest to the banks isn’t normal either. I’ll expand on the “fake” Fed funds rate later, but for now, just know that no one questions it, and now the illusion has become the reality.
Here’s where T-bill rates come in. T-bills are actively traded in a real market. Their rates reflect not only the Fed illusion, but also the degree of market liquidity tightness. When they’re below the Fed funds rate, it means that the money market is still loose.
If T-bill rates rise and start to exceed the fake Fed funds rate, it will mean that liquidity is becoming increasingly scarce. Stocks may still be the most favored target of that liquidity, but rising T-bill rates would mean that there’s less liquidity to go around. That ultimately will choke off the stock market, too.
So we should keep an eye on the 4-week bill rate for any sign that the Fed’s tightening is starting to be felt in a real way in a real market. It may or may not show up in T-bill rates before it shows up in the stock market. The patterns of stock prices themselves are the best barometer of market conditions. But T-bill rates are at least as important. So we’ll keep an eye on them each month, looking for signs of market tightening, which could lead or confirm the early signs of declining stock prices.
A Tighter Market Means a Red LAMPP – And That Means Sell
The Short-Term LAMPP remains on red while the Long-Term LAMPP is just a hair away from turning red. The party is almost over.
The Short-Term LAMPP has looked wrong and has been, at least, a few weeks premature. It is not an exact timing indicator. It’s an indicator of market context. Liquidity may still be plentiful in some respects, but it is tightening and, therefore, bearish. However, in the late stages of a bull market, mindless trend-following momentum takes over. The trend is your friend until it isn’t. Latecomers pile onto the buy side while dealers and other investors hold or sell minimally.
Too many traders are now fighting the Fed. It won’t end well for them.
The talk of European Central Bank (ECB) and Bank of Japan (BOJ) QE tapering is building. The ECB is expected to begin cutting back on its securities purchases soon. That will reduce the cash flowing to the U.S. At the same time, the Fed will be gradually increasing the amount of cash it pulls from the U.S. banking system each month.
These two forces will slowly but surely reduce the amount of money available to buy stocks (liquidity). That will cause the stock market to gradually roll over within the next six to twelve months as the Fed increases its cash withdrawals from the system to $50 billion per month.
In the short run, the Treasury could have a dramatic negative effect if it sticks to the TBAC recommendation to issue more than $500 billion in new debt to rebuild its cash contingency fund over the course of November and December.
Due to the next debt ceiling deadline looming on December 8, we don’t know if the Treasury will stick to the plan. All we can do is follow the money. I’ll do that for you here every week, so be sure to check in for that. And be sure to check in to follow the status of the Long-Term LAMPP. It should turn red within the next couple of weeks. That will signal the imminent end of the bull market.
Under the circumstances and despite the fact that the market is bucking the Short-Term LAMPP signal, continue to sell small amounts of stocks each month with the goal of raising a substantial cash cushion over the next six months. I’m talking about 60-70% cash. Your target percentage will depend upon your personal financial needs and goals. Just keep in mind that the more stocks you hold from here on, the greater your risk of incurring substantial losses in the coming bear market.
And when you have cash, you’ll be able to buy great stocks at lower prices when the opportunity presents itself. If you hold through the bear market, you’ll only be waiting to break even, perhaps for years. And some of your stocks may never recover.