On Friday Feb 10, behavioral-change in the stock market rocked the Richter.
Stocks themselves seem rather to be rocking the Casbah, Clash-style (obligatory Grammy Awards Week musical reference, and showing my age I reached back to 1982). Plus it’s that time again: Options expire today through Friday.
Naturally, Janet Yellen picked this week to tell the market – I say “tell” loosely since her utterances are so inscrutable that we’re left to construe and guess – a rate-hike is coming.
I find it troubling that the regulator of the world’s most important banking system appears to be ignorant of how markets work. Why hint at momentous monetary matters two days before volatility bets lapse? Then again, maybe it’s purposeful.
And far easier than ruminating on Chair Yellen’s comments for signals is checking the Fed’s balance sheet. Want to know if the Fed will raise rates? Look for big moves in either Reverse Repurchases or Excess Bank Reserves.
Let me interrupt here: Investor-relations folks and investors, I return to the Fed theme because it remains the linchpin of the market. We’ll make it an intriguing visit!
On the Fed’s balance sheet, sure enough – big changes. Excess Reserves have risen from about $1.8 trillion in January to $2.2 trillion last week (huge numbers, yes. For the 20 years before the financial crisis, excess reserves averaged about $10 billion).
That’s a $400 billion push, almost as big as the $500 billion the Fed heaved at the market last January and February when it was collapsing under the weight of the mighty buck following the Fed’s first rate-hike in ten years.
You can hardly remember, right? Back then, the top price-setter (followed by Fast Trading) was Asset Allocation – selling by indexes and ETFs jammed up at the exits.
It stopped because the buck didn’t. The dollar fell. When the dollar weakens, stocks generally rise because they are denominated, like oil, in dollars. Smaller dollar, bigger price.
And vice versa. The dollar strengthened ahead of the 1987 stock market crash. Ditto the Internet Bubble. In May 2010, the dollar rose right ahead of the famed Flash Crash. Last January’s swoon? The dollar surged in November and December with the rate-hike.
From Mar 2009 until Aug 2014 the dollar was weak as the Fed trampled it, and stocks, commodities, bonds, housing and so on all rose. Then abruptly in latter 2014 the Fed stopped beefing up dollar-supplies. Stocks statistically flatlined till Nov 9 last year. The Dow was 18,000 in Dec 2014 and 17,888 Nov 4, 2016.
Since the Fed is no longer creating new dollars rapidly by buying debt, it instead moves money into or out of the counted supply. Excess reserves increase the counted supply of money, which decreases dollar-value. And yup, from early January to last week, the dollar dropped 4% (using the DXY, the dollar-futures contract from The ICE).
Why does that signal a rate-hike? Because increasing interest rates is akin to reducing the supply of money. The Fed hopes the yin of bigger reserves will mesh with the yang of higher rates and stop the buck in the middle.
But the buck is back up 2% already. We come to the Richter move I mentioned to start. We track the four big reasons people buy and sell stocks. From Nov 9 to Feb 9 as stocks soared, the leading price-setter was Active Investment. Rational people are bullish on American economic prospects.
But the Number Two price-setter is Risk Management – portfolio leverage with derivatives. And it’s nearly as big as Active Investment. Investors are buying the present and betting on the future, which means both present and future back current stock-prices.
The problem arises if the future isn’t what it used to be, to paraphrase Yogi Berra. And one axiom of Market Structure is that behavioral volatility precedes price volatility. Much like clouds gather before a storm.
On Feb 10 clouds formed. Risk Management marketwide jumped almost 18%. It’s unusual to see a double-digit move in any behavior, and this is among the biggest one-day moves we’ve ever seen for Risk Management. Is money questioning the future?
It came right ahead of the Grammys. And more importantly, before Options Week and Janet Yellen. Were we monitoring the Ring of Fire for seismic events, we’d be predicting a temblor.
Of course, in the same way that seismic activity doesn’t mean The Big One is coming, it might be nothing. But stocks are near a statistical top in our 10-point Behavioral Sentiment Index again and the buck is rising toward a March rate-increase. Sooner or later, the present and the future will clash.
Life will go on. And we’ll be measuring the data.