What This Rare Bond Signal Could Mean for Stocks

Plus, two things to note about SPY open interest this week

Senior Vice President of Research
Jul 15, 2019 at 8:16 AM
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"Though there are only two samples to work with, history has taught us that big short-term directional moves have occurred shortly after a first touch of a new millennium level, as is evidenced by the 17% advance just five months after the first touch of 1,000, or the 9% pullback only one month after the first close above 2,000."
-- Monday Morning Outlook, July 8, 2019

"The yield on short-term Treasurys has been higher than on long-term notes for more than 30 consecutive trading sessions, a sign that investors are concerned about the durability of the decadelong economic expansion … Investors watch the dispersion between yields on short- and longer-term Treasurys, known as the yield curve, because shorter-term yields tend to exceed longer-term ones before recessions ... Two different financial models used by the Federal Reserve Banks of New York and Cleveland each show that the probability of a recession in the next 12 months has risen to about 1 in 3, odds last reached in 2007."
-- The Wall Street Journal, July 9, 2019

On the heels of Fed Chair Jerome Powell's testimony to Congress last week, during which market participants perceived the central banker was hinting at a rate cut at the end of the month, the S&P 500 Index (SPX - 3,013.77) rallied to the 3,000 level -- the first touch of this millennium level. So, what's next? As I stated last week, there is very limited history after prior conquests of millennium levels, although the two prior occurrences led to double-digit or near double-digit percentage moves in five months or less.

As the SPX trades around a potentially pivotal psychological level, the fixation on interest rates and the inverted yield curve continues -- evidenced by the WSJ excerpt above -- as the three-month Treasury bill yield remains above the yield on the 10-year Treasury note. According to our data, as of the end of June, the inversion had persisted for six consecutive weeks -- something not seen since 2006. This has given investors plenty of time to ponder the future implications of the inversion as it relates not only to the economy, but to the stock market. 

And it should give investors something to ponder, especially as the SPX trades at the round 3,000 area. Per the table below, in the past three instances when an inversion in the three-month/10-year yields prevailed for six consecutive weeks, the SPX moved by double-digit percentages in just a six-month span. In two of the five instances since 1979, the SPX moved lower. Bulls will point out that following two of the last three inversions that lasted six consecutive weeks, the SPX managed to rally by double-digit percentages in the following six-month period.

MMO 1 - yield inversion

Many are interpreting the interest-rate environment as foreshadowing a slowdown in economic growth. Therefore, a slowing economy in the months ahead is likely factored into stocks, making the market less vulnerable if slowing materializes. But any hints that the economy is not slowing as expected would likely boost stocks, as earnings would likely exceed estimates or analysts would guide future earnings higher.

At the same time, even though recession risk has increased, very few talking heads see a recession looming, suggesting the market is much more vulnerable to recessionary conditions relative to slowing economic growth.

I have been making this point for a long time, but the Fed remains the wildcard amid the numerous headlines -- whether on trade wars, slowing economic growth overseas, etc. -- that threaten the current expansion. Even though equities are responding well to dovish Fed comments, there are many doubts that rate cuts will stimulate the economy with trade uncertainty lingering. This might be a valid point, but nonetheless, investors have been quite clear that they want a Fed that is dovish amid trade uncertainty with China and political uncertainty in Europe.

The interest rate environment and trade uncertainty have combined to suppress optimism, with strategists expecting little from stocks in the second half, and investors clamoring for bonds over stocks, as discussed last week. In fact, last week, Morgan Stanley downgraded its allocation to global equities to "underweight."

Meanwhile, the SPX and Nasdaq Composite (IXIC - 8,244.14) achieved record highs last week. Moreover, the Dow Jones Industrial Average (DJI - 27,332.03) touched the 27,000 level for the first time in history. Admittedly, not all stocks have participated, and this is evident when looking at an index of small-cap companies -- the Russell 2000 Index (RUT - 1,569.99), which is roughly 10% below its 2018 high. The unimpressive breadth is one of the main concerns lingering among technicians, but plays into a growing list of worries that has resulted in money managers raising cash -- cash that represents future buying power.

Do not be surprised if round numbers like SPX 3,000 and Dow Jones 27,000 act as barriers in the short term. For what it's worth, SPX 3,008 is around 20% above the 2018 close, and could act in concert with SPX 3,000 as resistance. There was evidence of this resistance on Wednesday and Thursday, as the SPX effectively went sideways after a quick push up to 3,000, when Jerome Powell's prepared remarks to Congress were released before his actual appearance.

The top pane in the chart below is a daily SPX year-to-date (YTD) percentage return. While it popped through the round 10% YTD return in February, note that there were two "retests" of this area in March and June.

As an important side note to the round-number discussion above, the Cboe Market Volatility Index (VIX - 12.39) is trading around 12.71, which is 50% below the 2018 close of 25.42. This general area has marked a VIX floor so far in 2019 and could be viewed as a short-term risk for bulls (see second graph below).

MMO 2 - SPX YTD daily

MMO 3 - VIX YTD daily

It is expiration week, so, as usual, I will look at the July open interest configuration on the SPDR S&P 500 ETF Trust (SPY - 300.65), which is one-tenth the value of the SPX. A couple of things stand out:

  1. There is not a huge amount of put open interest just below that could act as magnets and magnify declines related to delta hedging. In other words, the big put open interest strikes are far below the SPY's current level, and delta-hedge sell-off risk would not come into play unless the SPY broke below the 290 strike, and this would be mitigated by the call open interest sitting here. 
  2. The peak call open interest in the immediate vicinity is at the 300 strike, which corresponds to SPX 3,000. Most the calls were bought to open, so sellers of the calls would like to see the SPY close below $300 at expiration to pocket the premium. But delta-hedge buying is a possibility if the SPY gets through the 300 strike, although the incremental buying related to this open interest would not be as heavy as selling that tends to occur when big put strikes are breached to the downside.

In the absence of a market-moving tweet or event, I expect expiration week to be rather uneventful, with SPX resistance in the 3,000-3,010 area and support in the 2,955-2,965 area. The 2,955 area is the site of both the SPX's close after the last Federal Open Market Committee (FOMC) meeting and the May 1 high before a 7% pullback. SPX 2,965 is the site of last week's low.



Todd Salamone is Schaeffer's Senior V.P. of Research.

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