Summer Breeze

A warm summer breeze has blown through our battered risk markets lately. And like those gentle zephyrs, it has been a welcome relief. But like many of these winds, the market breezy rally seems like temporary relief from the heat of a bear market. And often, such relief is fleeting.

A dovish Fed pivot - one based on lower inflation expectations is now priced into markets - especially in long bonds. The negative effects of the sharply rising short-term borrowing costs and the recessionary implications of the tightening financial conditions created these expectations. But are they accurate forecasts or just a reversal of the extreme positioning adopted in this initial phase of the Fed's tightening of credit?

Although I have been a believer in the bounce, it has gone too far too fast. The chart (below) of the percent of stocks above their 50-day moving average is instructive. After reaching a dramatically oversold position, it has bounced and bounced hard. That looks a bit overdone to me, but since I have been looking for just such a bounce I'll take it.

S&P 500 - Stocks Above 50 DMA

Yeah, the market has gotten ahead of itself, but that doesn't necessarily mean we will see new lows. If the economy can decelerate to a soft landing, and the Fed can truly pivot away from its tightening, we could have already seen the lows for equities. Sound too optimistic? Oh, does it ever! The Mike Wilson view, ( not the ULF one, the Morgan Stanley one), is a fair depiction of the bearish view. The Fed, in his view, will be forced to continue to tighten due to the persistence of inflation and push the economy into recession. And the bond market seems to agree.

Meanwhile, in Bondland, the inverted curve has made its once-a-cycle appearance. After a huge 100 basis point rally in the 10 Yr Treasury bond, real yields have returned to zero. With Fed expectations of further hikes, that has driven a 30 basis point inversion between 2's and 10's. That is a recession prediction if I've ever seen one. It isn't necessarily right though. Bonds are getting a disproportionate share of fund inflows due to the pervasively pessimistic investor sentiment. Apple's $5Bn debt offering yesterday had a $23Bn book. The threat of QT - the run-off of the Fed's balance sheet - doesn't seem to worry markets very much.

Credit spreads are, so far, well-behaved. Spreads in the High Yield markets (chart below), although well off their lows, are not signaling a recessionary environment as they did in prior downturns. The attractiveness of bond yields, suddenly higher due to the Fed's hawkish tilt, is drawing cash off the equity market sidelines. Maybe the 60/40 portfolio is still valid? Of course, the credit bears will argue that we are yet to see the effects of a economic down-turn on corporate income statements. That may be true, but isn't that what drove investor expectations to the positioning extremes we just witnessed?

High Yield Spreads

So with the next Fed meeting over 6 weeks away and only Jackson Hole as a reference point, the path of least resistance is still upward. Especially as energy is giving us a breather from the headline inflation shock. That is my biggest worry, however. The strong seasonality of energy demand is about to kick in hard. With the heating season in view, low distillate stocks, and the threat of a complete cessation of Russian gas exports to Germany, I don't think the demand destruction argument from a recession is enough to hold oil down for much longer. Should the OPEC+ meeting not assuage the fears of a supply crunch, there could be a reignition of energy prices, and therefore a reversal of the sudden complacency that has entered investors' fickle psyches hoping for a Fed pivot. Saudi Prince MBS seems to care more about placating Phil Mickelson than Joe Biden right now.

The tailwinds of a positive equity market breeze, one that was long overdue, are fading on renewal of the litany of concerns that we are facing. With the impending arrival of the negative seasonality typical of September-October, I'm gonna enjoy the last few weeks of summer, drink in hand, from the risk market sidelines. It is time to take a trade here.

Risk Model: 4/5 - Risk On

True to form, the lagging risk model has kicked in a bit late to the party. It is instructive that the one missing element of the bullish indicators is Copper/Gold. If we were truly out of the woods on a recession, I would have expected to have done better. The equity rally has been centered on Growth over Value and interest-sensitive sectors that have bounced hard. Commodities have generally lagged, demonstrating the persistence of the deceleration in global economic activity. These internal dynamics are not supportive of durable low in equity markets based on a growing economy. Bond-like equities and speculative assets are what got us into trouble in the first place. I don't expect them to lead us out the bottom, so hence the caution I espoused above.

The $VXV did break the pattern that I have been depicting, but a throwback rally in this indicator is already underway. I would like to see it below the April low of 23 as well. Good luck with that, given that seasonal volatility tends to rise into the beginning of Q4.

CBOE 3-Month Volatility Index

Gold is acting well and has positive seasonality through to the typical October equity lows. September gold rallies are always a good bet. Real rates have collapsed and the U.S. Dollar has broken off its steep uptrend. The sector looks unloved and the selling pressure has ebbed recently. XGD.to anyone?