Thursday, September 28, 2017

Big Tax Cuts are Dollar Negative

FX traders tend to base every currency based on interest rate differentials, and the difference of the near term policy direction of the various central banks.  The generally accepted view is that big tax cuts which provide fiscal stimulus should strengthen the dollar, based on its effect on monetary policy.  It is assumed that you get tighter monetary policy with tax cuts.  But that overlooks recent history.  

One of the main reasons the Fed started QE in 2009 was because it wanted to lower the interest rate burden of the large budget deficits after the recession, because large Treasury supply was going to have to be taken down, and the only way that was going to happen was either by selling at higher yields or by having the Fed by a huge chunk of the supply.  If the market had to digest all that supply at higher yields, you would have had an absurdly steep yield curve, higher rates for corporations and small businesses to borrow at, and higher mortgage rates that would be a negative for the housing market.

With the rising trend in mandatory spending on Social Security and Medicare, the budget deficits are set to rise substantially anyway, without any tax cuts.  You add the proposed budget buster tax cuts to the mix, and you will see $2 trillion budget deficits within a few years.  That is why the market didn't skyrocket yesterday on the Trump tax cut plan.  Rising interest rates with low GDP growth don't mix.  And these tax cuts aren't going to do much for GDP growth, as it's mostly going to those who will pile it back into savings in the form of stocks and bonds, not consumption.  

So what will end up happening is the higher interest rates will more than offset any fiscal stimulus from lower taxes, and when you get the economy slowing down, the budget deficits will skyrocket and you will get huge amounts of Treasury supply coming down the pipe.  The Fed will react like they always do when the economy slows down in the face of rising interest rates due to excess debt:  they will lower them, and then do another QE.  

So these tax cuts will eventually lead to Fed rate cuts and then QE in a couple of years.  Which will lead to dollar weakness, not dollar strength.  Tax cuts are a long term negative for the dollar, due to the higher budget deficits and subsequent larger Treasury supply.  Just look at how the dollar performed in the years after Ronald Reagan's tax cuts in the 1980s and George W. Bush's tax cuts in 2001.  

So if you see any large tax cuts pass, keep this in mind when it comes to the dollar.

Dollar Index (43 year historical chart)



Wednesday, September 27, 2017

A Budget Buster

Based on Trump's tax plan, there is no way the Republicans can stay within their budget guidelines of $1.5 trillion more debt over 10 years.  Politically, most of those deductions have no shot of getting eliminated, with the power of Washington lobbyists behind them.

But the bond market thinks that there will be huge debt fueled tax cuts. For Treasuries, it seems like shoot first, ask questions later at the moment.  This is definitely a budget buster, and will increase Treasury supply enormously over the next 10 years. With the trend of higher mandatory spending for Medicare and Social Security as the baby boomers retire, you could see $2 trillion annual deficits.  Without a QE, that will roughly quadruple the size of the Treasury coupon auctions.  And there is no way that much supply is taken down at these yield levels without a recession.

That is based on the premise that Trump gets everything that he's asking for.  That's probably unlikely, even though the Republicans are desperate to pass anything to save their hides in 2018 elections.  Most likely, the tax cuts get watered down, with no deductions removed, and the corporate tax rate gets cut modestly and you get a little increase in the standard deduction.

But the bond market is hating the uncertainty of a possible whopper of a tax cut passing, and with ECB tapering coming up in late October, a suddenly hawkish Yellen, and VIX hovering around 10, it is fragile times for bond investors.  Once the dust settles, you should get to lower bond price levels which should hold up, but the question is how much lower.  Worst case scenario, if the SPX keeps making new highs till year end, we could revisit 2.60% 10 year yields.  More likely, I think we get up to 2.40-2.50% and find a top there.

In SPX land, the realized volatility is at 3 over the past 10 days, compared to a VIX around 10.  So even at a VIX of 10, vol is actually expensive here!  Just horrible for the ES day trader.

Monday, September 25, 2017

Stalling With VIX Under 10

They could not have ordered up a more boring year than this one for S&P traders.  I am glad that I branched out from being almost exclusively an S&P trader back in the early 10s.  I wouldn't know what to do if I had to trade S&P this year.  Probably just swing trade and wait for the once in 1-2 month dip, scale in and buy, and sell after it hits an all time high.  I don't think there is any other strategy that would have been very profitable this year.  Shorting such a low VIX market is so tough, especially when it grinds higher bit by bit and hardly dips.

The bad part about this market for the trader is that the crowd is very reluctant to go to emotional extremes, either on the downside or the upside.  It is almost as if the crowd has finally realized the stupidity of dumping in a panic on a correction, or chasing prices higher, that they are mostly sitting still, holding their stocks or their cash and just waiting.  Many are waiting for a correction to buy, but what is the point if you are going to let the market go up 10-15% while waiting, and then buying a 5% correction?  You end up paying 5-10% more that way.

The best approach is either:
1) You think the market is too expensive, and wait for a bear market to buy, or
2) You think the market will become more expensive, a bigger bubble, and buy now and hope it goes higher.

The worst approach is just waiting and waiting, until the market goes so high and the volatility starts picking up, and then buying the 5% dip during the topping phase, and panicking out once it becomes a bear market.  Sure, we could have a 5% dip and then keep rising and rising like we did several times in 2012, 2013, and 2014.  But VIX was higher then, and the market much more skittish than it is now.  This is such a complacent market that the tolerance for bad news headlines is very high, and it would take multiple stabs at this beast before the crowd sells in full force.

I am obviously in the 1) camp, thinking the market is too expensive and waiting for a bear market to buy.  That is why I am not buying here even though I see SPX likely to grind higher into the beginning of 2018.

There was a leak of the Republican tax cut plan released this past weekend.  It calls for a top individual tax rate going from 39.6% to 35%, corporate rate from 35% to 20%, and pass through (small business) rate from 39.6% to 25%.  This looks like a fantasy for the Republicans, but if they are all on board, then it will pass Congress because they only need a simple majority using reconciliation.  It would be a big weight on Treasury bulls if the full cuts go through, as the budget deficit will balloon to huge numbers, probably up to $1.5-2 trillion.  That would cause a definite steepening in the yield curve as the large supply would weigh heavily from 10 years to 30 years.  The short end would be anchored by the Fed funds rate, so less bearish for that end.  Anyway, it will probably take several weeks before the plan becomes a reality, so not an immediate negative for bonds, but a big potential negative catalyst for sure.

Thursday, September 21, 2017

Fed Dot Plots

Looking at the Fed dot plots for September, I find it interesting how the long run projection is still at 2.75%, albeit down from 3.00% in June.  What happened in 3 months that would cause a long run projection of interest rates to go down 25 bps?  Nothing happened, other than the Fed throwing the bond market a bone, to try to keep the bond vigilantes at bay, while they announced balance sheet tapering. 

Everyone with any money on the line knows that the Fed dot plots are a running joke.  They have consistently inflated future interest rate projections, only to bring them down in drip drip fashion.  Is that the Fed's way of increasing optimism about future economic growth?  I don't know if the Fed is being dishonest, or if they're just incompetent.  Probably the latter. 

If you look closely at that dot plot, there is one guy who keeps the projection at the current Fed funds rate level, at 1.00-1.25% till end of 2020, but somehow manages to put the longer run projection at 2.25% or higher.  I know this is Neel Kashkari, the super dove.  He's a bit controversial, and an attention seeker, but he's got the best forecast of them all, which isn't saying much.  Although his longer run projection seems way too high, unless he's thinking something like 2040 as longer run. 

The eurodollar market is pricing in 3 rate hikes over the next 3 years.  That would put the Fed funds rate at a 1.75-2.00% range by September 2020.  I feel like that is a bit ambitious considering that when pricing in future interest rates.  If you consider that there is a decent chance that the economy could enter a recession within the next 3 years and the Fed could cut rates, then there should be a lot less than 3 rate hikes priced in over 3 years.  Remember, you must come up with a probability weighted average of all possible interest rate scenarios, not just the mostly like one. 

The median Fed dot plot is between 2.75-3.00% by end of 2020.  Do they realize that when GDP growth went from 2.9% in 2015 to 1.5% in 2016, they stopped rate hikes dead in its tracks, and were scared stiff.  The economy doesn't even need to go to recession for them to stop rate hikes.  It just needs to slow down to under 2%.  Considering the heavy debt load, low productivity, and low population growth among the developed economies, it is more likely that growth will slow down from here over the next few years, not pick up. 

Add to that Trump's inclination to choose a dovish Fed chairman because he's a low interest rate guy.  Therefore, you have a bond market that is mispriced.  And a Fed dot plot that is even more wrong.  Now I could be wrong and the global economy could have a huge boom and the S&P could become a giant bubble, but that's not likely given the data.  There is always some uncertainty in predicting the economy and the financial markets, which is why there are mispricings in market.  This game is about probabilities, and it is the difference in how market participants weigh the likelihood of various scenarios which provide the long term opportunities. 

The S&P didn't disappoint yesterday.  Once again, it found a way to bounce back after the hawkish Fed statement.  And do it in a non-volatile manner.  It has proven its boring nature AGAIN.  Just untradeable.

Wednesday, September 20, 2017

Fantasy Land at the Fed

There is lot of projections that the Fed spews out, the most egregious and error-prone, being the dot plots for interest rates.  These Fed officials must have used a time warp, going back to the 1990s when the neutral Fed funds rate was at 6%.  They still fantasize about a neutral Fed funds rate above 3%.  Conveniently ignoring the 2% GDP growth rate and the heavy debt burden this global economy is running on.

It is funny that they can't even fathom the thought of consecutive 25 bp hikes at Fed meetings, especially since one of them would not have those "informative" press conferences, but they have the audacity to state that the Fed should reach a Fed Funds rate of 3.5% in a couple of years!

Then when it comes time to actually follow through on their projections, they chicken out with any excuse they could find, such as China in September 2015, the strong dollar and falling oil in March 2016.  Only after the S&P just keeps grinding higher, and the dollar grinds lower do they finally back up their fantasy land projections (at least for a few meetings), and put in rate hikes.

Ok, enough of the ranting, now time for how to play this upcoming Fed meeting.  I expect the S&P to be a snoozer, as it is about as boring as a market can be.  But for the bond market, it is a bit more interesting.  You have seen bond yields bounce back up strongly after bottoming a couple of weeks ago on hurricane and nuclear war fears.  Now that investors have regained their senses, they realized that they pushed rates too low, and we are getting the payback over the last several days.  At 2.23% 10 year yields, as I write, it is still in the middle of the 2.00% to 2.40% range that we seem to be stuck in at the moment.  With my expectations of the stock market to continue to be strong, I don't see how rates can break below 2.00%.  At the same time, there is just too much investor demand at higher rates for the 10 year to get much above 2.4% without seeing dip buyers charge in.

I do expect the Fed to talk tough, now that the S&P is at an all time high, and with rates well within their comfort zone.  Balance sheet runoff will be slow, and probably they won't be able to keep it going for as long as they say, because as soon as the market has a correction, they will stop dead in their tracks.  Guaranteed.  Think we could get more weakness in bonds over the coming weeks, and probably more of a grind higher in equities.

Monday, September 18, 2017

VIX is the Guide

In recent S&P 500 history, you have not had a market top out when the VIX was under 12.  In July 2007, the VIX was ~15 when the market topped out.  Also in May 2011, the VIX was ~15 when the market topped out.  2015 was a bit of an unusual case because the market topped out when the VIX was at 12, but you did have the market flatten out and chop for almost 6 months without any major breakouts, and it was quite a bit more volatile than it is now.

Right now, we have a VIX around 10, with realized VIX in the mid single digits.  Plus, we've made new highs since last week, and now easily above the 2500 SPX psychological barrier.  These are the types of markets which grind higher as investors watch in disbelief that there is hardly even a 5% correction.  Since we had the washout in late August, and nervousness till last week, this move higher has at least 2 more weeks to go, and probably well more than that.

It is a slow motion bubble, so it looks innocuous, with the low volatility, but it is building up a lot of potential imbalances when the top is reached.  When will that top happen?  That is one of the hardest things to predict, the top of an equity bull market.  It is clear that there are still not enough signs.  So while I will not participate in any upward moves from here, I definitely will not get in the way and short it until we start seeing more volatility.  The VIX has to sustain above 12 even after several days of rallying in order for me to be interested in the short side.

Saturday, September 16, 2017

Traders: What Not to Do

It is a fact that most traders end up losing over the long term.  In order to be part of the minority of traders who win long term, you must trade differently than the majority.  That is just simple logic.  Then the first step is to identify what the majority of traders do.  The second step is to avoid doing those things.  By reading books about traders (Market Wizards series is a good starting point), seeing what traders say on Twitter, Stock Twits, stock message boards, etc. you start to get a sense of what the majority do.

What most traders do:

1. Bet too big.  In equities, it is betting it all on one stock.  In futures and options, its using too much leverage by buying or selling as much as you can.  Even if you have good pattern recognition skills and accurate analysis of the long term macro situation, there is still a lot of uncertainty in this game.  Good traders still lose a fair number of times.  It is just part of the game, you can't be perfect in this business.  If you bet too big, you can have a string of winners and then that one big loser will eliminate all your gains plus more.  Or even blow you up and take you out of the game.

In my early career, I had a habit of trading only one or two stocks at a time, and using full 2 to 1 margin.  It led to some exciting times, lots of wins and losses, and I was lucky to have survived.  I had a very effective strategy and it worked about 90% of the time, but the 10% of the time that it didn't, I lost huge on the trade and it would eliminate all the progress I made building up my account.  This happened a number of times and I still didn't fully understand why I couldn't really breakthrough to the next level. 

It wasn't because I didn't have an understanding of the market or good pattern recognition skills.  I was just constantly betting too big. And although that led to rapid growth in account size during the good times, I would inevitability trade a stock that would act like an outlier and end up losing anywhere from 50% to 90%.  Remember, if you lose 90% of your money, you need to make 900% to get back to even.  900%!

Try this math exercise:  you bet 50% of your account on a 1 to 1 payout, with 60% chance of winning, 40% chance of losing.  See where that account value goes over the long term.  The effect is the opposite of compounding. 

2.  Try to make money everyday.  I am lucky that I didn't have to work for too long before I was able to just trade for a living.  I never developed that worker's mentality.  Although in the short amount of time I did work, I quickly developed a dislike for having to wake up early in the morning to do something that I didn't want to do, just for money and my "career".  So when I started trading for a living, I tried to make as much money as I could, so I could amass enough money to not have to find a job ever again.  Unfortunately, that led me to trade too big, and go all in too often, because of my greed and overzealous desire to build up my account as fast as possible. 

But I never really chased prices, and would often let halfway decent opportunities go by because I didn't feel like I needed to make money every day.  If a good opportunity was there, I would plunge in. And usually there was.  But if not, I didn't do any trades.  I watched TV, read a book, and tried not to stare at the trading monitors.  I didn't make money that day, but I didn't care.  I never treated trading like work, so I never expected to get paid based on the hours I put in.  I was willing to wait for the next good trade.

On the topic of daily trading, one of the dumbest things that a good trader can do is to quit for the day because he made his daily profit goal.  Unless that trader has some psychological problems dealing with winners, he should try to make as much as possible when the going is good because most of the time, they aren't.  Especially these days.  As Stanley Druckenmiller says, "it takes courage to be a pig". 

More importantly though, a trader shouldn't force trades and trade bigger to try to make a "comeback" for the day and turn a losing day into a winning one, to make yourself feel better.  I have made this mistake countless times and at the end of the day, when I stare at a huge loss on my trading screen, I think to myself, "What the hell am I doing?"  Its the same feeling a gambler would get at the casino when he keeps hitting the ATM to try to comeback and recover his losses, only to end up with a huge loser when the night is over.  Trading is a long term game, not a daily one. 

3. Think short term.  It is hard to come up with good trades, especially long term trades.  If you turn a good long term trade into a good short term trade, that is a big mistake.  Yes, it is a higher level mistake.  For those who have traded for a while, and made some money at it, it is a common mistake.  I have made it numerous times throughout my career.  If only I had just stuck with the trade for another few days, another few weeks, another few months.  Then I would have had a home run.  Those who have bought dips in the SPX know what I am talking about.  Same goes for those who bought dips in Treasuries this year. 

That is why it is so important to thoroughly analyze what the current long term opportunities are in the market and then when the market gives you a chance to get in at a good price, you need to ride it for as much as you can.  You can only do this if you have a lot of conviction on your trade, and your short term view aligns with your long term view of the market. 

How do you develop conviction that is usually accurate and helpful rather than irrational confidence?  Through studying, experience, and gut feel.  Some of it can be taught and developed, but the gut feel is usually more innate.  This conviction is something that I am constantly trying to improve, both in accuracy and breadth.  Some markets and time periods are just easier than others.  Right now, we are in a bit of a difficult time period, low volatility and very few good medium term opportunities.  However, that should pave the way for some monster long term opportunities.  There is a good long term opportunity developing, but it will only come to fruition once the price action and higher volatility confirms the topping phase of this US equity bull market.  So I am trying to preserve capital for what I view as interesting trading opportunities in 2018.

Wednesday, September 13, 2017

S&P Strength and Bond Weakness

The two big things that have happened over the past 2 days is the rise in the S&P 500, but more importantly, the disproportionately big drop in bonds relative to the SPX strength.  In a short term risk on move, you usually get about a 0.04% rise in 10 year yields for a 1% rise in the SPX.  We have gone up 0.12% on the 10 year since Friday, while SPX has gone up 1.2%.  In normal circumstances, the 10 year should have gone up only about 0.05%.

Obviously it does speak to the overshoot short squeeze higher that happened in the bond market last week while the stock market was only slightly down.  But it also re-emphasizes what I believe to be the new en vogue hedging strategy for the hedge fund manager.  They are now going long bonds as a hedge for their long stock positions.  In the past, they would have just used VIX or shorted SPX for a more direct hedge.  It probably means that you will not likely see much more upside in bonds this year until you start seeing stock weakness.  At these levels, I find it hard to believe that both stocks and bonds will just keep going higher without a break in that positive correlation.

I do expect the SPX to stall out here as we are right at that psychological 2500 level, which should provide short term resistance.  Also the weakness in bonds should be a bit of a headwind for stocks to go even higher.  Due to the near term SPX resistance, I don't think bonds will sell off much more, but I don't see much of a bounce either.  So while near term downside in bonds is limited, the near term upside is also limited.  It looks like last week took out most of the weak hands in both bonds and gold.

SPX should flat line around these levels right under 2500, and then expecting a dip next week. That should help bonds have a bounce, which probably won't last long, just as I don't expect any dips in stocks to last long.  Low conviction here, so I won't be putting on big positions.  October should provide better levels to make longer term trades. 

Monday, September 11, 2017

Irma and N. Korea Hype

You know how the media like to blow up headlines to draw eyeballs to their articles.  It is slightly, just slightly more refined form of click bait. 

The algos didn't bite and refused to selloff the market on Friday ahead of the fear mongering.  As I said last Friday, the algos are getting much smarter.  There is definitely AI and machine learning going on, because they have gotten more sophisticated from even a few years ago.  If you had the same headlines and weekend risk 5 years ago, the S&P would have likely dipped at least 3% ahead of the event, led by emotional hedge fund managers, and then rebounded like a screaming banshee as those same hedge fund managers bought back what they sold ahead of the "scary" events. 

Nowadays, the hedge fund managers don't even do much manual trading, their performance reviews have shifted their funds to more quant based, AI and machine learning strategies.  This makes the market much less emotional and more price action based, which shows you the muted market reaction to the North Korean nuclear test last week, and less derisking ahead of the fears of a North Korean missile launch and Hurricane Irma this past weekend.  All in all, it makes the market tougher to trade, as there always has to be someone on the other side of your trade.  And AI computer based trading programs are much tougher opponents than trigger happy hedge fund managers.

We are getting a repeal of the risk off moves in Treasuries and gold this morning, along with a gap up in the S&P.  It is notable that the Treasuries and gold are selling off much more than expected for a 0.5% gap up.  It tells you that traders have resorted to hedging not by shorting S&P, but by buying Treasuries and gold.  They have finally caught up to the risk parity hedging strategy.  It could make for a nasty move if Treasuries can ever go down and stay down while stocks are flat.  But that's a story for another day.  Expecting a dull market this week in S&P land.  The bond market should be a bit more interesting, but it too is probably going to have a low volatility trade after today's selloff.

Friday, September 8, 2017

Short Squeeze in Bonds and Gold

Yesterday, you had heavy volume as bonds and gold both squeezed higher, after the ECB decided to postpone the taper.  This was what most expected, but you still had a significant minority that thought Draghi might provide more details of their future tapering plans.  He didn't give the bears an inch, and provided the usual dovish spiel, while throwing the euro bears a bone by saying that he is keeping an eye on the euro and its strength.  Draghi definitely likes to bring out the "whatever it takes" line on various topics, this time, it was on getting to 2% inflation.  He sure talks like a determined dove, but he can't solve the scarcity of German government bond supply problem when it comes to following the capital key guidelines for QE.

You basically had a perfect storm in the form of ECB can kicking, and of course North Korea and Hurricane Irma over the weekend.  That was just too much for bond and gold shorts to deal with and they finally capitulated and bought in a panic. We got remnants of that buying wave this morning, but with the current price action, it seems like most of the weak hands have been taken out. All this while the S&P trades in a sleepy range from 2350 to 2370 this week. 

I expect their to be a little relief buying in stocks on Monday, after the weekend event risk is behind us, but it should be a small pop because the market just hasn't gone down much ahead of these uncertainties.  It is clear that the US stock market has gotten smarter, as the market is very reluctant to provide a good buying opportunity even in the face of bad news.  If we had similar news flow 5 years ago, the market would have pullbacked a lot more, and then subsequently rebounded a lot more.  Now, its short and small pullbacks on bad news, and short and small rebounds after the V bottoms.  After seeing the volatility on Tuesday, I was expecting much more this week.  But it's been a dud for S&P traders. Just a dreadful S&P trading market.

Thursday, September 7, 2017

Debt Ceiling Deal and Dovish Draghi

We should be much higher considering we got the debt ceiling extension without any headaches and then a dovish Draghi at today's ECB meeting. So we had a good news wave that peaked out at SPX 2470 this morning.  That is the high optimism price point in this market.  Last week's low of SPX 2430 on North Korean missile launch is the low optimism price point.   Keep that in mind when trading this chop over the next couple of weeks. 

There is a lot of caution that I hear from financial TV, but the put/call ratios and the low VIX tell me that real money is not doing much here.  The low VIX is a tell that the pullback should be shallow, as the VIX is a very good predictor of near term potential losses in the market.  You would think with North Korea and a massive hurricane heading towards the US, the market would be a bit more nervous.  But this market has been so resilient for so long that the algos are all programmed to buy dips and support the market on down days.  That is why you got the V bottom on Tuesday, saving the market from an ugly close. 

Remember that last week, after North Korea fired a missile past Japan, there was a sense of optimism that the market was able to shrug off that event and head towards 2480.  The crowd got back to being bullish.  Now they feel like they are offsides. They don't turn on a dime.  I expect them to take a few days to sell off some positions to get to a more risk off stance.  One supporting factor, a big one, is the strength in bonds in the face of a flat stock market. The lower interest rates will help to keep the stock market from completely falling apart here. 

If we do selloff again towards 2430, I would expect there to be a lot of fear mongering on CNBC.  It should be a point where one should put on longs for the eventual ride higher.  This bull still has a while to go, and you need to keep that in mind when trading during these choppy times.

Tuesday, September 5, 2017

Nuclear War Threat

We got the North Korean nuclear bomb test and it was good for a 6 point gap down on the SPX.  Is anyone really surprised when the stock market shrugs off geopolitics?  This happens over and over again and investors still act like the market is acting irrational.  North Korean bomb tests are nothing new, and neither are their missile launches.  The only variable that's changed is Trump and general public mistrust of his judgement and temperament. 

The reaction in the non-Asian equity markets clearly shows that North Korea is a non factor.  The overnight trader overreacted again as we are now trading higher than the overnight range in the regular trading hours.  Oh and look at the bond market.  It is screaming higher, even when equities are basically flat.  All North Korea has done is provided corporations lower interest rates to sell bonds at.  So you have a net positive from a liquidity perspective. 

It's going to take something other than geopolitics to take this market down.  You will need to have a weaker bond market or a weaker economy to bring down this bubble.  Right now, economy is just strong enough to maintain low single digit earnings growth while keeping the Fed easy.  Real GDP growth at 2% is Goldilocks, post 2008 style.

If there is a dip down this month, anywhere close to 2420, I would buy that dip and ride it to SPX 2500+.  There is still some juice left in this bull market, as the Republicans will be desperate to get some kind of tax cut package through Congress to put some points up on the board.  After the debt ceiling, that catalyst becomes the main focus of the market, so expect a better tone to the market and higher prices once we get to late September.  In the meantime, hope for a little drop to get in long for the ride higher.