A few weeks back I examined the likely reasons that I was wrong about the current rally.
The most important of them was the increase in speculative borrowing by shadow bank financial institutions, who include broker dealers and other financial intermediaries.
This indicator clearly correlates with, and leads, stock price movements.
I have shown this indicator to you a few times over the past month or so, to illustrate what I think is largely driving this rally-an increase in leverage, in essence, a return to hyper bullish market sentiment, typical of a top.
Right now, the indicator is showing a continuation of bullish sentiment, which may be a signal to cautiously buy calls.
So today, I thought I’d take a deeper dive into this one indicator I underestimated, and show you exactly how it’s influencing the markets…
An Important Chart Reveals Exactly How to Monitor the Indicator
This indicator comes from a new line item created by the Fed in its weekly H8 statement of the consolidated balance sheet of all US commercial banks and foreign banks with US branches.
The Fed ran the data back to 2015. It was designed to encompass an old indicator of repo lending and other loans for financing securities and lump it in with other types of loans to nonbank financial institutions. But make no mistake, the bulk of this number is still about financing stock and bond inventories.
Here’s a look at the chart:
The picture above tells us all we need to know. You can see the correlation between the S&P 500 (red line) and loans to nonbank financial institutions (blue line).
I will continue to monitor this indicator closely for any sign that the speculative bloom is coming off the market rose.
[Trending]: See this now (before word on this new discovery hits the mainstream press)
Meanwhile, broad market liquidity continues to tighten. When traders are determined to buy and hold stocks, and use leverage to do it in the face of tightening liquidity, history tells us that such periods end badly. We mustn’t lose sight of that.
And I can assure you that the broad based liquidity picture is not improving, and won’t for the foreseeable future. That fact is showing up day in and day out in the relentless rise of money rates in the Treasury market.
Here’s a great visual of this rise in money rates:
This chart shows the interest rate on the 3 month US Treasury bill. It has risen relentlessly month after month, regardless of whether the Fed increases the Fed Funds target in a given month. That’s because market interest rates are driven by the tightening market conditions. That tightening comes from the constant increase in Treasury supply, against the backdrop of the Fed draining funds from the system.
As for the relentless increase in Treasury supply, the Treasury Borrowing Advisory Committee (TBAC), whose mid quarter estimates of future supply are usually spot on for the current quarter, just issued its revised forecast for the third quarter. This includes a month, July, that’s already done.
The new forecast calls for net new issuance of $329 billion in this quarter. That’s 10%, or $10 billion per month, more than the average $100 billion per month that I had previously estimated. It’s also $56 billion more than the TBAC had estimated for Q3 back in June. Their new estimate was 20% higher than the original estimate.
$90 billion of that new debt will hit the market this month. Helped by quarterly tax collections, the Treasury won’t need to issue as much in September. The next two months are as “easy” as it gets for the market. But with the Fed also pulling $40 billion a month from the market, “easy” it won’t be. This is as tight as monetary conditions have been in 36 years, when Paul Volcker was engineering his draconian tightening. And they will get tighter from here, much tighter.
The real problem starts in the fourth quarter, when the TBAC tells us that the Treasury will need to inundate the market with a mind blowing $440 billion in new debt. October will be in the same range of new issuance as August and September. But in October the Fed will also increase the amount of money it erases from the banking system to $50 billion per month, from the current $40 billion.
The real problem will come in November and December when supply explodes. The Fed will concurrently pull a total of $100 billion out of the banking system over those two months. In December, a fearsome total of $219 billion in new supply is forecast in the face of those massive Fed draining operations.
The pressure will build relentlessly from now until the end of the year and beyond.
Option One Is Out. Option Two and Three Indicate We Can Cautiously Buy Calls
Meanwhile, assuming you took my advice and largely, and prudently, got out of stocks, what should we do now? Two weeks ago, I laid out 3 scenarios. The first had the market topping out around the then current level. We’ve slightly exceeded that, and we’re waiting to see if this sticks by holding above 2850 on the S&P. That leaves Scenarios 2 and 3.
Second scenario: The market makes a minor new high but runs out of gas finally in the 2900-3000 range when it again hits trend resistance…
Third scenario: Although it’s least likely, the market could see a strong breakout through the January high (2873), supported by surging 10-12 month cycle momentum and a resurgence in 4 year cycle indicators. A 4 year cycle high would then ideally be due in May of next year, and could be even later. This is the case that long term bulls are banking on and I’m betting against.
If the price and momentum do break out, then the way to play it would to be to buy calls on the SPY…
Since we are finally getting paid to hold cash, our interest income is rising rapidly. That income allows us a low risk hedge against the market going higher, while protecting our principal. We can be comfortable in cash, holding it with no risk of loss, and can use the income we’re now getting to buy SPY calls to participate in the rally if it extends.
If the market holds above 2850 today, I would buy at or slightly in the money SPY calls with a month or so to go until expiration. That’s a cheap way to play with minimal risk.
Then when the market finally breaks support, now at 2800, we can reverse the strategy and buy puts to participate in the downside we expect.
Stay tuned right here for ongoing updates on the market and the tactics we’ll use to take advantage of moves in either direction, while keeping our principal safe and secure.
P.S. How everything changed in a $1 trillion industry on June 25th at 1:22 PM