MorningWord 6/28/16: Eyes Wide Shut

by Dan June 28, 2016 9:46 am • Commentary

Prior to the Brexit vote last week in the UK, a Leave decision was not a major input for my cautious view in U.S. stocks (MorningWord 6/23/16: Cause I Don’t Want to Be… Anarchy). In hindsight, it was a massive short term trading opportunity, and clearly under priced as far as risk considering how tight the polls were. But the aftermath only reinforces my prior theses.  The U.S. Dollar (DXY) is down a few percent year over year, I believe it will remain range-bound, and well above its 2014 breakout:

DXY 1yr chart from Bloomberg
DXY 1yr chart from Bloomberg

That’s despite the fact that Treasury Yields will remain suppressed given the Fed’s inability to meaningfully raise interest rates off of the zero interest rate bound. The 10 year UST yield just bounced off of an all time low:

From Bloomberg
From Bloomberg

The relative strength of the USD will remain a headwind to U.S. corporate earnings, while the long term downtrend in UST yields confirms the fragility of the global economy. The relative dollar strength may be offsetting the benefits of low rates for corporate profits.

In other words, the longer the dollar remains bid, and rates remain low, the greater the potential of recession.  Brexit gave U.S. companies a massive mulligan for Q2, but the probability of recession will rise and fall with second half corporate guidance.

Fed Fund Futures are now pricing the higher probability of a rate CUT than an Increase at the Fed’s remaining 2016 meetings!

from Bloomberg

Back on May 20th, Jawboning by Fed-Heads pushed the probability of a June hike to 32%, and a 40% probability of two hikes by year end:


And it’s gone. This sort of shift in such a short period of time is insane. And insanity is what we’ve seen in overseas equity and currency markets. For the most part we’ve avoided any real damage on large cap U.S. stocks.

In my nearly 20 year career in this business have never seen so much global financial uncertainty met with such complacency. I’m not arguing that the SPX should be massively lower than it is now, merely pointing out how much of a safe haven trade it has become. But the risk to that is if this global economic/market uncertainty turns any sort of financial market contagion or global recession, then investors closing their eyes and buying every dip in the SPX becomes the most crowded trade in the world. One reason the VIX (the SPX Volatility Index) surged 50% on Friday was because investors were so off-sides in S&P 500 stocks into the Brexit vote.

If the Fed is forced to get (more) unconventional, it’s not good for the SPX. While the SPX has shown tremendous relative strength to most major global equity markets over the last year, remember that a large component is that others have already gone negative on interest rates. Trillions of dollars of sovereign debt now a have negative yield (Europe & Japan). And although no one knows the what’s a correlation or a causation, we do know that their equity markets act the worst, both down 25% from their 52 week highs.

Despite the perceived relative strength in the SPX, its inability to make a new high since its all time highs in May 2015 suggests the path of least resistance is no longer higher. Lower rates here in the U.S. could spell new 52 week lows for the SPX in the back half of the year. Yesterday’s close at key technical support puts a target on 2000, and what lies beneath is an air-pocket to 1900. Watch that level closely:

From Bloomberg
From Bloomberg

No matter how you look at the SPX, it’s a crowded trade. And whether it’s a less than constructive technical set-up, a confused FOMC, or something from overseas, it’s already hinted at its vulnerabilities for those with their eyes wide open.