Rate Cuts are Coming

Interest rates are now the main focus after the much feared nonfarm payrolls came and went without much damage to stocks.  Friday's reaction to a bad NFP number wasn’t as dramatic as many expected.  The bad jobs number now all but guarantees a dovish Powell at the upcoming FOMC meeting.  The CPI this week is all but meaningless.  In a weakening economy, the Fed prioritizes jobs over inflation.  

Investors are conditioned to believe that lower Fed funds rates is bullish for stocks.  Its likely they will be buying in anticipation of a rate cut and a dovish Powell on September 17.  I do expect Powell to come out dovish, but that’s going to be expected.  Unlike going into Jackson Hole, when the majority were bracing for hawk Powell, but got dove Powell, the expectations will be much higher.  Unless Powell goes big with 50 bps, its probably a sell the news reaction.  Given how reluctant Powell was to turn dovish until last month, I doubt he does the 50 bps.  Especially since he's going to be replaced, there is no need to pander to Trump now.  

Rate cuts are not what they used to be.  In fiscal dominance, lower short term rates means less interest expense for the government, which is less fiscal stimulus.  Lower Fed funds rates means less interest income from T-bills and money market funds.  Most of that interest income is going to the wealthy, who have a high propensity to invest in financial assets.  Less interest income = less inflows into stocks and bonds.  

A weaker job market means less consumption, which feeds into lower corporate profits.  It also means less inflows into 401k's and equity funds.  Passive inflows into index funds and target date funds has been one of the biggest factors in this bull market.  Its clear that the jobs market is slowing, a combination of less immigration, aging demographics, and tariffs.  

Counterbalancing the negatives of a weaker labor market, bond yields went down significantly across the curve, which is a short term positive for the stock market.  When bonds outperform stocks, like last week, target date funds and pensions have to rebalance by selling bonds, buying stocks.  It is this strength in Treasuries which makes me want to be more patient in putting on index shorts.  

Not much in the COT data for index futures, but the COT for VIX futures shows a continued expansion of speculative shorts in VIX.  This sets up a possible VIX explosion higher when these shorts are unwound.  After a 5 month rally, the market is a powder keg.  Any spark that gets investors nervous could cause an explosion. 

VIX COT Positions

I noticed last week an unusually large number of fast money trader warning about September weakness as if it was a near certainty. That’s not common.  Seasonality usually doesn't work when most traders and investors are focused on it.  I think it was these seasonality bears that caused the sharp drop on September 2.  A weak jobs number may be setting a bear trap this week.    September weakness mostly comes in the first couple of days, and then in the  2nd half of the month coinciding with the post triple witching opex period.  This week could be a short window of strength leading up to the FOMC meeting. 

While the SPX was barely up last week, the path from Friday close to Friday close was quite volatile.  Despite the Friday drop, VIX went down and SPX fixed strike vols also dropped.  SPX fixed strike vols going lower even though SPX went down is short term bullish.  However, looking at the important components of the market, signs of weakness remain.  NVDA, which is the most important stock in the world, is lagging badly.  The momentum stocks and retail favorites also mostly underperformed last week.  In the past, retail investors were a non-factor and could be ignored.  But they have become an important segment of the market.  Their increasing participation has caused the market to be stronger than it would otherwise be.  Signs of weakness among heavily owned stocks among retail is an important tell.  Something to keep in mind as we get closer to FOMC and the big triple witching opex on September 19.  September opex is a big vol dampener on both upside and downside, as there is huge open interest.  So definitely would not recommend chasing any big moves from now until September 17.  

Covered all short positions last week, as I was wary of being short ahead of NFP.  On the sidelines for now, waiting for higher prices to re-short.  The plan is to wait until after CPI is released on Thursday to see how the markets react, and assess the situation then for a possible short.  Not everything goes according to plan, so will adjust if conditions change.