Con Game

Investor confidence is hard to generate these days. Random and conflicting news items have created multiple short term market swings lately, creating a wall of confusion. The resultant choppy sideways action is getting increasingly frustrating for bulls and bears alike.

What we need is a con artist.

Creating belief is the job of the con artist. Mr Market - the ultimate con artist - often fools people into believing all evidence to the contrary. When markets move, it is on shared confidence, or lack thereof, about the future. The "expectations of others" is the key. If we have conviction on a particular scenario, the market moves in concert with that belief.

The rapid Fed response to last week's repo market squeeze and the Bank of Japan's (BOJ) announcement this morning may help rebuild that confidence. Two seemingly minor tweaks, but important nonetheless.

The Fed has effectively eased by offering unlimited liquidity for overnight funding after stresses in the repo market came to a head last week. The tightening bias that prevailed during last year's balance sheet run-off has now been fully reversed. QT is dead for now.

This morning, the BOJ has messaged its intention to concentrate asset purchases in the front end of the curve, thus steepening the JGB curve. Given the recently implemented consumption tax hike, this is a much needed easing of monetary conditions. Additionally, bank funding is improved, creating an improved lending environment.

These moves, although wonky for all but the most committed econ-freaks, are definitively positive. Removing the liquidity constraints on the banking system is enormously important for global growth prospects. This morning's bank rally is instructive. But the front end of the U.S. yield curve is still too steep for my liking. More easing is likely needed.

These are encouraging moves, but they need follow-through. The playbook for an equity rally is slowly being developed. It is tantalizingly close. The upside risks are starting to outweigh the downside, especially for the value/cyclical market sectors.

My bearish friends will scoff at me for this bout of optimism, but don't get me wrong, I'm not bullish yet. I'm just trying to stay balanced in my arguments.

The 'haven bid' has come out of the market - bitcoin, gold and bonds have rolled over. The recent Citigroup Economic Surprise Index bounce showed how much the bears had gotten over their skis. That's a start, but more evidence is required.

Importantly, the typical October low for seasonality is approaching, reviving contrarian thoughts in me. One last shot of market volatility to the downside should do the trick.

But the biggest thing going for the market is the strong consensus thinking. Positioning is at an extreme. Dollar denominated assets - primarily defensive in nature - have wildly out-performed other global markets. "Fear of recession" thinking has been in ascendancy for over a year. As a dyed-in-the-wool contrarian, I'm holding out hope for one last trade to the upside.

But as we all know, hope is not a strategy. And the crowded trades created by the bearish momentum trade will be hard to break. The Fed has its work cut out for it.

Of course, help from the fiscal/geopolitical side would help too! I look forward to the day when sentiment killing headlines created from Trump's twitter account are silenced either by impeachment or election. Brexit, hard or soft, will soon be history. Alas, those days seem still far away.

The market could do its bit by rallying. Investor confidence would quickly recover, given how dominant the bear case has become.

It could easily con us one more time.

Risk Model: 3/5 - Risk On

Investor sentiment, having contracted last week on a bogus China related headline, is likely to show a recovery this week. The elevated VXV (3 month VIX) remains a bearish indicator this week.

The bounce in the copper/gold ratio generated a positive signal this week, reflecting the demise of the 'haven bid' for gold. But it must be kept in context. Although the ratio is deeply oversold, as we saw in the 2016 slowdown, the turnaround takes time. Back then, it took about five tries - leading to several false signals - to truly reverse (see chart below). We have had only two attempts at a reversal so far. I would rather see this ratio improve on a move upwards in copper than the decline we have seen in gold. A truly durable bottom will take more time.

Copper/Gold Ratio - 2015-19

I hate second guessing the model, but since it was developed for short term trading, I can be forgiven for not relying solely on its output for my macro call.