Stocks moved lower over the past week as the fears of a seasonal correction mounted. The combination of tightening monetary policy and increasing taxes pressured stocks. Moreover, memories of September and October stock market carnage weighed on the leading US indices. COVID-19’s delta variant continues to pose a threat to economic recovery. Over the past week, the S&P 500 fell 0.74%. The NASDAQ moved 0.82% lower after reaching record territory, while the DJIA posted a 0.62% loss. The VIX was at the 18.15 level, 1.45% above the level on September 8, as the stock market is now in a traditionally volatile period. The bond market moved higher over the past week.
The Fed controls short-term interest rates via the Fed Funds rate. However, market forces determine rates further out along the yield curve. The price action in the ten and thirty-year treasury bonds for almost a year had been a sign that the market was concerned about rising inflation. The Fed manages monetary policy like a captain of an ocean liner. Changes occur slowly so as not to cause any sudden economic turbulence. It will take years for interest rates to return to appropriate levels. The legacy of accommodative policy will impact the US and the global financial system for the coming years. The stock market had shrugged off the prospects for tighter Fed policy and rising taxes as the leading indices are still not far from record highs. The stock market is only one of many examples of asset inflation in the financial system. The trillions in government stimulus is a spending bonanza that rising taxes are not likely to cover. The Fed’s insistence that inflation is “transitory” could be a tactic as increased rates would cause the cost of servicing the ever-growing US deficit to explode higher. Low interest rates and monetary stimulus have become an addiction for the Fed.
The Fed took a prudent approach as it set the stage for tapering its quantitative easing program by the end of 2021. However, tapering the $120 billion in monthly purchases still means the central bank will be purchasing debt securities, and the Fed Funds rate will remain at zero. After Chairman Powell’s Jackson Hole speech, markets reflected the potential for even higher inflationary pressures. The Fed continues to insist inflation is “transitory” while markets are signaling otherwise. Less dovish policy when it comes to tapering QE is still dovish as the central bank will continue to purchase debt securities. The dovish Fed will only lower the altitude of its flight with a slow tapering process.
Chinese stocks fell and underperformed US stocks since the previous report. Chinese shares have been underperforming the US stock market for a long period. The risk discount for Chinese companies continues to be high as President Xi took an aggressive stance towards the US. The latest DIDI IPO that reached a high of $18.01 on June 30 and was trading at the $8.28 level on Wednesday is an example of investors shunning Chinese stocks over the past weeks. DIDI was $0.70 lower than the level on September 8 after the stock bounced and ran out of upside steam at $10.18 on September 7. DIDI had been falling knife, which was been a microcosm of the overall Chinese stock market. DIDI fell to a low of $7.16 on July 26 and made a higher low at $7.18 on August 19 and has attempted to create a bottom since mid-August.
The China Large-Cap ETF product (FXI) settled at the $40.26 level on Wednesday, as it fell 4.12% since September 8. Technical support is at the July 27 $38.24 low, the lowest level since May 2020. The FXI product remains far below the all-time peak at $73.19 back in 2007, while US stocks have made a string of record highs. The high in 2021 came on February 17 at $54.52, the technical resistance level that continues to fade into the distance. China is the demand side of the equation for commodities as it is the world’s second wealthiest and most populous nation.
As I have been writing:
“Chinese stocks carry significant political risk given the government’s heavy hand and role in business and international investments.”
They continue to underperform the stock market as China’s government has become aggressive with the US and the west. There could be some bargains in the Chinese stock market, but the risk remains very high.
December US 30-Year bonds rallied since September 8. The bond market faces opposing forces as inflation increases, and the Fed continues to purchase $120 billion in debt securities each month. While tapering may begin over the coming months, the central bank will continue to buy bonds. The Fed Funds rate remains between 0% and 0.25%, but the central bank only determines short-term rates. Medium and long-term interest rates are a function of the supply and demand for bonds. The quantitative easing program attempts to push bond prices higher, but rising inflationary pressures have had more effect, pushing bonds lower and interest rates higher.
The trend in the bond market and technical break on the downside was a sign that the Fed was losing control of the market on longer-term interest rates. The FOMC said they are prepared to adjust monetary policy with market conditions, and there was finally some scent of tapering or tightening at the latest FOMC meetings. The bond market has rejected the central bank’s actions since August 2020 by declining despite debt security purchases. The latest inflation and employment data remain a warning sign for the Fed. The FOMC appeared to signal the start of a shift in the central bank’s policy path. The recent data confirmed that the Fed would need to pivot monetary policy soon. However, the latest report was muted as some raw material prices corrected.
Meanwhile, higher rates will increase the government’s cost of funding the deficit. Moreover, rising rates could ignite selling in stocks and create another crisis for the central bank, which is between a rock and a harder place. The government stimulus under the Biden administration will continue to flow. Even if the Fed moves towards a more hawkish stand on monetary policy, fiscal initiatives remain unprecedently dovish.
Meanwhile, consumers are not exempt from rising food and energy prices, so the core CPI measure is a bit of a fantasy. Higher prices continue to take a significant bite out of consumer’s paychecks. Time will tell how quickly and decisively the Fed is willing to act. Last year the central bank changed its inflation target from 2% to an average of 2% in August. This year, the central bank indicated they are likely to begin tapering QE soon but are not prepared to consider short-term rate hikes.
Even the most aggressive tax hikes in history will not pay for the trillion in stimulus and other initiatives over the past year and those coming before Congress in the immediate future. The US Treasury Secretary is working with other G-7 nations to establish a 15% minimum corporate tax structure. The initiative could be more about moving the US towards globalism than taxes.
On Wednesday, September 15, the December long bond futures contract was at the 163-28 level as it moved 0.79% higher over the past week. The December 30-Year Treasury bonds futures made a low at 161-01 on August 11 and 12. Technical support is at that level, the double bottom low. Technical resistance is at 165-12, the August 4 high on the December futures contract. Upward pressure on rates further out on the yield curve over the past year has been an inflationary signal for markets.
With Chairman Jerome Powell at the head of the central bank and former Chair Janet Yellen, the Treasury Secretary, the doves have their hands firmly on the wheel of the US financial system. Secretary Yellen expressed her support for another term for Chairman Powell when his term expires in 2022. However, the progressive wing of the administration’s political party may pressure the White House to replace the current Fed Chair, a Republican appointee.
The Fed was encouraging inflation, but up until recently, it ignored the evidence in raw material markets and other asset markets that could lead to a far larger dose of the economic condition than it is bargaining for over the coming months. Once a ball begins rolling, it could pick up momentum and becomes more challenging to stop. Energy, agricultural, metal, and mineral prices had been trending higher over the past months. Bull markets rarely move in a straight line. Commodities can be highly volatile; they rise higher than most believe possible, and corrections can take prices far lower than logical levels. However, the trends since the 2020 lows remain very bullish despite the recent corrections over the past weeks. The most recent commodity to take the bullish torch has been natural gas which continued to rally to higher highs over the past week.
Many commodities moved substantially higher over the past months. April and May were bullish months in the commodities sector, with more than a handful of raw materials rising to new multi-year highs and some reaching record levels. While many commodity prices have stabilized and moved lower since reaching highs, they remain far above the levels at the 2020 lows. The bullish price action has been like a relay race; while some commodities pull back, others have rallied to new highs. In July, coffee had the bullish baton. In August, it handed off to the sugar market, which probed above the 20 cents per pound level for the first time since 2017. Natural gas futures rose to the highest price in August and September in over a decade last week as the price reached the $5.65 per MMBtu level. Natural gas now has the bullish commodity baton. The last time natural gas traded at $5.65 was in February 2014.
The tidal wave of liquidity and tsunami of stimulus comes with a price tag that will not be satisfied with a gradual shift towards tightening monetary policy. The stock market’s rise over the past year could be a mirage as it may reflect a decline in money’s purchasing power instead of bullish fundamentals for many companies.
Meanwhile, even the most aggressive bull markets rarely move in a straight line. Periodic severe selloffs are the norm, not the exception. Bull market corrections can be sudden and brutal, as witnessed in more than a few markets. The overall trend in raw materials and other asset prices, including stocks and cryptocurrencies, remains higher, a clear sign of inflationary pressures. However, we are now at a time of the year when the stock market has a habit of correcting. September and October can be challenging months for the stock market.
When it comes to the prospects for rising taxes, corporations are likely to pass along hikes to consumers, adding to inflationary pressures. Global tax agreements are a move towards supranational governing. The US has enough problems breaching the divide between political policies on issues and initiatives. Cross-border agreements would raise far more cultural, political, and economic issues. What seems ideal to politicians is often unachievable in the practical world. The latest proposal to tax cryptocurrencies to pay for a part of the infrastructure rebuilding package is another shot in the dark that will come nowhere near covering the costs of the stimulative initiative.
A capital gains tax hike could eventually cause selling in the stock market as investors cash in on significant profits and need to sell more shares to pay the government more at tax time. Moreover, higher corporate taxes trickle down to the consumer, so all Americans from rich to poor will be paying more to the government either directly or indirectly. Higher inheritance taxes could increase selling. Over the past years, retirement accounts have provided the stock market with consistent and natural buying, making the path of least resistance for stocks higher. Rising taxes could interfere with the phenomenon and balance buying and selling or even create periods where selling overwhelms buying, adding to stock market volatility and creating more significant downdrafts. US government remains divided even though Democrats have majorities in the House of Representatives and the Senate. However, the majorities are razor-thin, and the midterm elections are coming closer each day. An agreement on infrastructure rebuilding will create more stimulus and stoke inflationary flames.
Open interest in the E-Mini S&P 500 futures contracts moved 7.93% higher since September 7. Open interest in the long bond futures moved 2.19% higher over the period. Over the long term, fighting the Fed has been a losing battle, but the last year remains an exception. The VIX at 18.15 on September 15 was 1.45% higher since September 8. Taxes and regulations will increase, which is not bullish for the stock market. I expect price variance in the stock and bond market to accelerate. The coming weeks are critical as they are historically the time of the year for speedbumps in the stock market. I have been buying VIX-related products as they fall and selling them on rallies, trading for small profits while adjusting risk-reward expectations according to market conditions. Commodities and bonds have been significant barometers of inflationary pressures over the past year. In 2021, the bond market told us that the Fed policies have significant inflationary side effects. A correction in stocks causes the bonds to bounce higher, as we witnessed in mid-July and recently.
Meanwhile, China is a substantial holder of US debt. As the tensions between Washington and Beijing remain elevated, any Chinese selling could push rates much higher further out along the yield curve. Financing the US debt through the bond market could cause the Treasury to issue bonds with longer maturities to pay for the trillions in stimulus packages, but they better hurry. Even though yields have increased, they remain historically low. Higher yields over the coming months and years could close a window of opportunity for fifty or one-hundred-year US debt securities to fund the deficit, which makes sense at today’s rates.
The administration is looking to raise tax rates and take advantage of the growing wealth. Markets remain more than bubblicious. We are either in a bubble, or fiat currencies are losing value at an accelerating pace. Higher interest rates and rising taxes are not a bullish cocktail for the stock market. However, TINA or there is no alternative to stocks for capital growth, and tax-advantaged retirement accounts continue to push money into the stock market. As of September 8, the stock market trend remains bullish. The trend in bonds was also bullish as they remain above the 161-01 level, which is short-term support.
As I wrote over the past weeks, hedging stock portfolios at or near all-time highs could be the optimal approach given the uncertain future of markets. Markets reflect the economic and political landscapes, creating high odds for lots of volatility over the coming months. I believe a very volatile period is on the horizon, and we will see lots of two-way price action in markets across all asset classes sooner rather than later.
Be cautious in the stock and bond market, as they could become highly volatile over the coming weeks. We could see increased price ranges.
Substantial sell offs, and corrections tend to arrive when the market least expects them. Markets remain cautious, and liquidity has been low over the past week. The most bullish factor for stocks is TINA, and the deterioration of fiat money’s purchasing power. On the bearish side, the prospects for tighter monetary policy and higher taxes could trigger selling in the stock market that is sitting within reaching distance of all-time highs.