Go Short Again At 2800 (Thanks to This Horrifying Story)

You can follow my analysis of the government’s real time tax data on at the beginning of every month in The Wall Street Examiner Pro Trader Federal Revenues Report.  This report is chock full of charts that clearly illustrate the current trends before the economic news hits the headlines.

The real reason to track tax data isn’t to tell us what the economy is doing. It’s for supporting data for the TBAC’s Treasury supply forecasts upon which we rely so heavily. While Wall Street is busy focusing only on demand for investment paper, it forgets the other half of the Law of Supply and Demand.  We don’t. I cover both the demand and supply side.

The biggest supplier of investment paper to the markets is of course the US Government. So we pay close attention to how much supply it is scheduled to bring to market every month, and relate that to the prices of financial assets-stocks and bonds.

Bloomberg reports: “Trouble is brewing.”

All investments compete with US Government paper for their share of the pool of money available for investment. Investors and dealers must choose between asset classes all the time. Liquidity and investment preferences are constantly shifting. But one thing is constant in the current environment. The Fed is removing money from the system at an increasing pace. The liquidity pool isn’t growing any more, and soon it will start shrinking outright.

So while investors may choose stocks over other asset classes at any given time, such as recent weeks, the more Treasuries that come to market, the more money they will suck out of a stagnant pool. And as the Fed increases its draining operations, and the Fed’s two big cohorts-the ECB and BoJ-cut back on their QE programs, that pool of money will even start to shrink.

The current supply data is horrifying and it won’t get better any time for the foreseeable future. I’ll just give you a thumbnail here. I cover the bad news in depth in my monthly reports on Treasury supply and demand.

Frightening “Supply” Data Points to Our Next Short Entry

The Treasury ramped up its pounding of the markets over the past month, and there’s no respite on the horizon. At the same time, the Fed is pulling money out of the system, with an increase in the rate of withdrawal scheduled for July.

It doesn’t bode well for either the bond market or stocks, despite the rally in stocks over the past few weeks.

Treasury bill rates and bond yields have been surging because of the tightening monetary conditions, even though the Fed did not raise the Fed Funds target in May. It will need to do so at next week’s FOMC meeting to ratify changes that have already happened in the market, and will continue to happen.

The Fed is, as always, behind the curve. The boys and girls don’t like to rock the boat and spook the markets so they’ll just tag along with the market as it tightens and pushes rates higher.

But it doesn’t matter what the Fed says about rates. What matters is that it will continue to pull money out of the market. The supply of the money that fuels investment demand will diminish. The supply of paper that absorbs the money will grow. That will continue to cause interest rates and bond yields to rise as far as the eye can see.

As the market tightens, every asset class will get its turn in the barrel. Liquidity is no longer adequate to support bull moves in both stocks and bonds concurrently. Rising money rates are an indication of those tightening conditions.

While stocks have gotten a bid lately, it has been at the expense of liquidation of Treasury bills and bonds. No doubt stocks will get their turn in the barrel as well.  The only issue is the timing, and that’s a matter for technical analysis.

Treasury supply will surge in the third quarter and the Fed will increase its withdrawals from the system. And unlike under QE, when the Fed was literally buying or indirectly funding all new Treasury supply, it’s no longer buying. In fact, by allowing its holdings to mature, the Fed is actually adding to supply at the same time it extinguishes the money that is the fuel for investment demand. That makes the seasonal increase in Treasury supply that is headed our way, a much bigger problem.

The problem will be exacerbated in July when the Fed increases its withdrawals of money from the banking system from $30 billion to $40 billion per month.  That’s when I suspect we’ll start to see more selling in stocks, not just bonds.

Meanwhile, the Treasury issued $89 billion of net new supply in May. That was $39 billion more than last year’s May issuance of $50 billion!

June could be just as bad or worse. The Treasury has scheduled $44 billion in net new issuance for the mid-month coupon auctions. That compares with just $28 billion for the same auctions last year. And the Treasury paid down $37 billion in T-bills on that date last year, vastly easing the burden of the coupon issuance. That won’t happen this year. The TBAC says that the paydown will be just $2 billion.  That would mean $35 billion of new issuance just at mid month.  And that will be with the help of quarterly estimated taxes coming in to reduce cash needs for the month.

Treasury Supply

I have been warning about investment rotation in an environment of tightening liquidity. To buy new bonds, holders of existing bonds are selling them in the secondary market. To absorb the increases in Treasury supply, dealers and institutions who normally purchase the new supply need to liquidate existing holdings, whether Treasuries, other bonds, or stocks.

Or, as over the past month, they cash out T-bills. Every investment class has been getting its turn to get bashed in this game of whack-a- mole. Stocks will get their turn again soon.

Bill rates and bond yields forged higher in May. Rates at the auctions averaged 0.38% higher than last month in spite of the fact that the Fed did not raise the Fed Funds rate. The upward movement of rates showed just that the financial markets are still tightening as the Fed drains money from the system.

The market is tightening on its own. When the Fed does raise the Fed Funds target, it is merely ratifying what has already occurred. It skipped that pretense last month, making it absolutely clear that rates are rising on their own. The Fed will need to ratify the latest move in rates by moving the Fed Funds target at least ¼ point higher in the next FOMC statement to be released June 13.

Here’s a graphical look at the impact of the combination of Treasury supply rising while the Fed pulls money out of the system.

4wk

Meanwhile, stocks are rallying. I have warned that we should not be chasing this rally. I believe that it’s only temporary and a part of a normal topping process as stocks transition from bull to bear markets. These transitions always take months and always involve at least one test of the initial high.

Your Detailed Short Game Plan for the Coming Top

We may be in the era of deregulation where no fraud is illegal, the consumer be damned, and anything goes, but Rule Number One-Don’t fight the Fed-hasn’t been repealed. It just takes time for its impact to be felt across the investment spectrum. It’s been felt in the bond markets since last September when the Fed announced its monetary bloodletting program called “normalization.” Bond prices have been crushed.  Stocks got hit in February and will get their turn again soon.

The fact that the stock market is attempting to test the highs here doesn’t bother me at all. We have been to the mountaintop and we’re lookin’ over to the other side. This isn’t new.  In 2007 we had a top in May-July and another one in October. In 2000, we had a top in March and another in August-October.  This year we had a top at the end of January and we’re trying again now. Do we hear history rhyming here?

I think so. This market even reminds me of 1973. It had a blowoff in January and repeated rallies all year before sinking to minor new lows later in the year, before it sank like a rock in 1974.

Yes, this is frustrating if you’re trying to trade it from the short side, but I don’t have a problem with it in the big picture. I’m still pretty sure that the Law of Supply and Demand is still in effect, and that Rule Number One-Don’t fight the Fed-hasn’t been repealed either.

So what should we do?  If you are not already largely out of stocks, use this rally to lighten up.

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If you’re of a mind to hedge or trade from the short side, keep in mind that tops take time. This could take several tries before the really big move down starts. Look to put on short positions on the SPY, or buy puts, at key resistance levels. We broke out of one of them earlier this week at SPX 2742. That was a sign to cover shorts. The next key resistance level is 2800. That might be the place to put them back on.

And remember, puts can go to zero, so keep your positions small in relation to the total size of your portfolio. That way, when the 10 bagger comes, you won’t simply be getting back to breakeven.

Friday might be an important inflection point. I’m writing this in the morning, so I don’t know yet if the condition for a turn has been met. As I write, the market is right on the cusp. By the time you see this, you will know.

This is a modified cycle chart using moving standard error, linear regression channel projections that I use in my trading platform. It illustrates the particulars of this setup. There are two levels to watch. One is at 2780, where trend resistance was projected and has now been established. If the SPX clears that, then the trend will still be up, and we’ll have to wait for a test of the 2800 area for the next possible short entry.

spx

On the other hand, the short term time cycle is entering a down phase, and this breakout has been accompanied by a negative divergence in momentum. In other words, the move is slowing down as it rises. That can be an early warning of pending trend change. If the market closes below the sharpest short term uptrend line at 2765 on Friday, that would be a signal to establish shorts again for at least a test of the breakout line at 2742, and perhaps, finally, the big decline that we’re looking for.

You can follow my technical work weekly in the Wall Street Examiner Pro Trader.

As always, if you’re interested in making profits on the downside of the market, in addition to our ideas here, you can check out Shah Gilani’s put play recommendations in Zenith Trading Circle.

Sincerely,


Lee Adler

One Response to “Go Short Again At 2800 (Thanks to This Horrifying Story)”

  1. Is the US Treasury actually redeeming bonds the federal reserve holds as they do with other bond holders, or does the federal reserve simply let the bond expire and remove it from its balance sheet. I cannot find evidence of either accounting method. The same goes for the GSE securities.

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