On Thursday, Feb. 8, the S&P 500 (SPY) fell 101 points, -3.75% to close at 2,581. The closing index level was 292 points lower than the all-time high set just 9 trading days ago, and marked a correction level decline of 10.2%. The nine-day volatile drop was the fastest plunge to correction territory every recorded for the S&P 500 dating all the way back to WWII.
I have written numerous articles in the past month leading up to the stock market correction warning that the current "fundamental" market dynamics are very unbalanced and signals pointed to a rates up, U.S. dollar down stock market rout in the works. There were ample market signs that blared loudly that the market had reached an unstable pinnacle leading up to the initial broad U.S. stock market (DIA) (QQQ) breakdown on Feb. 2 with a fast and furious follow-on move on Monday, Feb. 5. With the move down in the market today, the market is officially in "correction" territory.
Time to Assess if a 10% Correction is Healthy, or Signs of Pain Remain
Now that the initial shock downward has occurred, I suspect the volume is going to rise in the business media that this mother of all dips is a "historical buying opportunity".
Given how fast this point was reached, I advise restraint unless you are a professional trader. To aid in the evaluation of the market condition, I have done a little forensic review of the issues that led up to the point when the short volatility trade short circuited on Feb. 5; and then how the critical driving forces behind the recent decline, higher Treasury rates and a weaker dollar, responded to the 10% downward move.
And what I have uncovered is very simple. The stock market reaction was systemic in nature, triggered most likely by the Fed allowing Treasuries to run-off its balance sheet on Jan. 31st, but also by a growing market realization of just how Tax Reform is going to fundamentally change the interest rate market going forward. In a nutshell, it is the countervailing force between slowing monetary stimulus and at the same time putting the pedal to the medal on fiscal policy that creates a much riskier financial market structure in the US going forward. And currently, the market is beginning to price in the increased risk.
The best way to illustrate the changing market dynamics is to look at how the volatility of the stock (VIX) and bond (MOVE) markets changed as important milestones were struck in the fiscal and monetary policy arena leading up to the stock market plunge.
Many will look at this chart and say immediately that the Fed did it. During the week of Jan. 31st the Fed allowed $12B US Treasuries to run off its balance sheet, and $4B more is MBS securities. However, this is only a piece of the puzzle. I have also added the points in time the debt ceiling has been a limiting factor in Treasury actions during the last year to give a clearer picture about how new Treasury issuance has changed over the timeline. And, there is also the actual passage of the Tax Reform Bill, which in large part was anticipated by the market leading up to December 2017, but earlier in the year there were questions about its structure and likelihood of passage.
Where the Tax Reform Bill and Fed Balance Sheet Reduction plan collide is in the US Treasury. And what you see in the volatility chart is a Treasury that was limited up to early September 2017 in its ability to access the credit market to issue new public debt (real new dollars raised, not re-financing existing debt). Since the market did not have any new issuance to feed a steady demand for a low level of Treasuries in the world market, market volatility declined after a sizeable spike higher when Trump was elected in 2016. Most of the spike in the MOVE index when Trump was elected was driven by substantial borrowing as Obama left office. But the amount of actual new debt needed by the Treasury in FY 2017 (September year-end) was only $500B, the smallest in many years.
However, once the Treasury was unleashed to cover government operations in September 2017 to fill its coffers which were approaching zero, rates spiked higher. After a couple of months of rapid new issuance in September and October the 10 Year Treasury (IEI) spiked higher from 2.04% to over 2.41%, where it settled at year-end. The MOVE index which spike higher during the time period retreated as the Treasury was shut down when it hit the debt ceiling again in early November. And when Congress was unable to pass a C.R. in December coinciding with the Tax Reform package, the Treasury remained on the side-lines without issuing any new debt through year end, and continues to be hamstrung as this article is written in the first week of February 2018. However, they have a significant amount of new financing needed on a perpetual basis now that Tax Reform has passed:
In other words, after the Treasury market became fully aware of just how much financing the US government was going to need starting in January 2018 after Tax Reform passed, Treasury interest rates began to move much higher. And all of this was taking place without any new debt even hitting the market yet. The only Treasury open market operations taking place were for refunding and refinancing. And then, at the end of January the largest Treasury "customer," the Federal Reserve, shows up with $12B in mature notes and says it no longer wishes to hold the investment. And by the way, it will be back next month with more maturing notes.
Add to this situation an international funding channel that is running dry and moving in reverse as of November 2017 data (see here) and you have a recipe for a US Treasury short squeeze by the international bond vigilantes.
In addition to all of these circumstances affecting Treasury demand and supply at the present time, the new Tax Reform Bill introduces a "territorial corporate tax system" which is meant to encourage less dependence upon foreign based production and a large current account deficit going forward. Add a visible push by the Trump administration get tougher on trade with the Asia-Pacific region countries like China and Japan who are big lenders to the US Treasury, and you get a scenario in which the Treasury market that is ripe for a spike in volatility.
Now with the 9 day trading pattern in the stock market which has sent the major stock indexes into correction territory, it is evident that the Treasury market volatility is now being transmitted through to the stock market as rates continue to rise well ahead of the Treasury actually pushing $600B in new supply scheduled over the next 5 months.
Treasury Rout Continued through the Stock Market Rout - Safe Haven Bid Limited to Short End of the Curve
In the past when the stock market would begin to pull back, almost on cue the Treasury market would see and influx of bids driving rates lower. However, as the chronology of events during stock market correction plunge illustrates, interest rates have risen, and continue to rise through the volatile trading period.
Also important is the timing of key Fed actions to push additional financing needs upon the Treasury at the end of January, as well as their action to try to push the short end of the curve up to the 1.41% target range of the Fed Funds rate through a tightening move in the Reverse Repo market. The only safe haven flow of funds appears to be in the ultra short end of the yield curve, as the market is struggling to maintain even stay in the 1.30% range in the 1 month T-Bill. The longer term market for 10 Year Treasuries has moved up 22 basis points through the time period, reaching 2.85%. Likewise the 2 year, also was lacking bid pressure throughout, increasing 5 basis points. The 10-2 spread widened to 72 basis points.
Some may interpret the steepening of the yield curve as a risk on signal. I do not see this presently. What I see is very low market demand for long duration US debt.
US Dollar showed tepid support during the 10% down move
The next market that is important to review as stocks fell is the action of the US dollar. In the time period leading up to the stock market correction the dollar was in steep decline. As the correction progressed, the dollar stabilized and even headed slightly higher during the mid-week market attempt to rebound. However, during the market sell-off on Thursday, the dollar held firm. There was little sign of foreign inflows to prop up the U.S. equity market going into the close. The dollar small rise back above 90 appears to have stalled.
Notwithstanding the slight rebound in the US dollar the past couple of trading days that may indicate some inflow of foreign funds into the market as it has declined, I think the foreign channels for funding the Treasury and / or the US equity market is locked down at the present moment.
Bottom Line - Sell any Rallies for the Immediate Future
In my assessment the stock market rout has just begun not about to end. The best analogy I can think of is "that light you see in the tunnel is probably not the other end, but a train coming at you at 100 mph."
However, you should expect a growing chorus in the business media claiming this is a historic buying opportunity. Over the near-term, there will be repeated market attempts to rebound, assuming we are not in the midst of a 1987 style 40% market decline that skipped the testing process. Each of these tests will be monitored closely by market professionals to see if we need to ratchet the correction level down another 10% until a bottom is finally set. During this process the best investment strategy is to sell any rallies (SAFR) and park more and more money in short duration investments, not buy the dip (BTFD), until the coast is clear. Until the Treasury market stabilizes under the duress of the large Treasury financing need being heaped on it by Tax Reform and the Fed, a firm market bottom is unlikely to be set.
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Daniel Moore is the author of the book Theory of Financial Relativity. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.