Unsustainable

It can't continue like this.  Yields trending higher and stocks trying to rally.  It is puzzling to see the eagerness with which stock investors are looking for a bear market rally, going from pessimism to optimism in a matter of days.  Its that recency bias kicking in.  The 13 years of mental conditioning.  And all it took was a hint of a Fed step down (hinting at a 50 bp hike in December) via WSJ's Nick Timiraos before the Fed quiet period started.  The Fed showed their true colors again.  They got nervous that the bond market would go haywire while they were in their quiet period, afraid that the long end of the yield curve would get unhinged, like the UK gilts market a few weeks ago.  The Fed, along with Yellen, came to the rescue (not a true rescue, but a sneak peek), trying to calm the bond market to prevent any further liquidations.  

For a moment there, I thought the Fed were united in brainwashing the market to believe that they would pull a reverse Draghi and do whatever it takes to crash the economy to bring down inflation.  Apparently, it was all an act, as I suspected.  Powell has long lasting dovish credentials, and its not going to fade away after 2 months of talking tough on inflation.  

It doesn't make me bullish on stocks, I suspect stocks will change its focus in the coming months to falling corporate earnings away from rate hikes and bond yields.  I eventually expect a massive bull steepening in the Treasury market as the market starts pricing in the turn, and gets more aggressive with second half 2023/first half 2024 rate cuts.  A bull steepening based on a weakening economy is what happened from late 2000 to mid 2003, late 2007 to mid 2009, and from late 2018 to mid 2020.  It was a very bearish time period for stocks in 2 of those 3 instances.  The last one, the economy just didn't get weak enough to hurt corporate earnings, very different than the current situation.  

The stock market will be competing for capital with a liquidity starved Treasury market that cannot function under the current lopsided supply/demand situation.  The last few weeks are a glimpse of what the Treasury market will be with no QE.  Actually, its negative QE, or QT. There aren't enough natural buyers of long end Treasuries at these levels when the Fed is so determined to take short rates higher.  The supply demand doesn't match when you have trillion dollar deficits needing funding + nearly $100B/month in Treasury/MBS balance sheet runoff.  Especially when the biggest recipient of dollars from the US (China) goes on a Treasury buyer's strike, as buying US bonds doesn't align with their political interests.  Also, it doesn't help that the US is ratcheting up the pressure on China by banning certain chip exports, and froze Russia's overseas dollar assets.  China would rather own commodities or US real estate, than Treasuries, and I don't blame them.  

So if you no longer have China buying Treasuries, then the US has to make up for it with mostly domestic demand, which requires higher yields to bring in buyers.  And if the long end yield gets too high, that puts an even bigger squeeze on housing, which got priced based on much lower mortgage rates, pre 2022.  

Its just unsustainable.  The Fed is pushing the bond market closer to the systemic edge, with its hawkish talk and 75 bps raises, as well as the silent killer, QT that is running in the background, slowly taking liquidity out of the system.  Its causing a supply demand mismatch, something this liquidity addicted market can't handle in the long run.  What is unsustainable in the long run eventually stops.  But the market is very short term focused, because hedge funds are short term focused, and because retail money is even shorter term focused (dopamine addicts who are pouring huge sums into 0DTE options).  So you don't have too many looking out beyond the next few days or weeks.  That's why you see so many who are long term bearish, but are short term bullish looking for a bear market rally.  By the way, when most of the fast money tell you that they are short term bullish and long term bearish, it means they are positioned long and looking to get out quickly, which is NOT a bullish scenario. 

The irony of this market is that the more that investors hold on to Fed pivot hopes and not sell, keeping stocks afloat, the longer it will take for the Fed to pivot as they see no need to rush to the rescue to save the market.  These rate hikes work with a lag in the real economy, so the economic data hasn't gotten weak enough for the Fed to pivot without blowback.  If they pivot at the upcoming Fed meeting, there will be a lot of observers who will criticize the Fed for being so soft on inflation with unemployment so low.  So barring a big slowdown in employment or a big drop in inflation, the only out for a Fed pivot is a very weak stock/credit market.  And the stock market dip buyers are not throwing in the towel to provide a pretext for the Fed to offer the market a get out of jail free card.  

Yes, the inflation and jobs numbers will slow down in the coming months, but the stress is more in the financial economy than the real economy.  The real economy eventually gets infected by the weakness in the financial economy, but it will take a few more months.

Not only are there a lot of bottom pickers in stocks, I am also seeing some bottom pickers in the bond market.  This is not a great sign for those looking for a real durable bottom where they can aggressively play for a trend change.  A recent JP Morgan Treasury client survey showed the biggest net long responses since 2020.  And the COT data for Euro FX showed speculators as being quite long, something that is unusual considering how weak the euro has been versus the dollar.  All this tells me that the most likely scenario over the next 3 months is further dollar strength, stock market weakness, and a bond market that will probably be range bound at best.  Over the next 2-3 weeks, the fast money and underinvested hedge funds can chase this market a little bit higher, but that just sets up another huge bull trap, like mid August to end of September.  

A quick word on earnings.  Once again, this earnings season proves that being short in the middle of earnings season is a bad trade.  Even with weak MSFT, GOOGL, and TXN earnings where each of them dropped after their reports, the SPX brushed it off like it was nothing and actually managed to squeeze all the way up to 3880 yesterday.  Proving once again that the SPX doesn't trade based on its individual components, even the big dogs.  It trades based on short term investor flows and the macro picture.  

I am short, but small size, and only looking to play for a shorter term swing.  If they try to push it towards 3900 this week, I will be adding to shorts.