With a new week comes hope that we have turned the page on all those tricky problems that were previously plaguing the markets. Stocks may be down a touch this morning, but hey--Bitcoin's higher! The government shutdown was averted! It's also the start of new quarter now, with September--a notoriously tough month for stocks--thankfully behind us.
Plus, the sense is that stocks are now so "oversold" that perhaps a nice bounce into year-end can materialize. Even longtime bear Mike Wilson at Morgan Stanley seems to be hinting that the post-Fed-meeting selloff was overdone, and that if a weaker economy soon or later causes the Fed to abandon its "higher for longer" interest rates, that would take some pressure off of the market.
Before letting these narratives take hold, however, it's important to realize just how significantly the landscape has changed since stocks peaked in late July. The biggest "shock" to the markets was the Treasury's August 2 announcement of its second-half bond issuance plans. For the first time since Covid, it had to boost the size of its quarterly bond sales, because the U.S. budget deficit has been wider than expected this year. That was on top of the $1 trillion in issuance already expected this quarter.
The Treasury is "making bigger adjustments than people expected," and "they've got a lot of catch-up bond issuance to do," explained Bridgewater co-CIO Greg Jensen. Basically, Treasury had issued a lot of very short term bills earlier this year to fund the deficit, which were easily absorbed by the market as they supplanted what the Fed had previously offered in its repo facility (which had become increasingly controversial as it swelled to over $2.5 trillion in size).
"As T-bill rates rose [to] slightly higher than the repo facility, money just shifted right out of that repo facility into T-bills, which meant you could fund the budget deficit without absorbing any capital that was in use in the world," Jensen observed. "That increased the amount of money available for...risky financial assets," and explains why the market and the U.S. economy were surprisingly resilient in the first half of this year, he said.
But now, that process has run its course. The August announcement from the Treasury showed they are gradually shifting back towards increased bond issuance, as they can't over-rely on costly short-term bills to fund the deficit. The "hidden stimulus" from that earlier funding swap is gone now, in other words. And to fund the deficit, the money for all of these Treasuries has to come from somewhere. The risk, says Jensen, is a "liquidity hole" that sucks capital out of financial assets and the real economy over the next 9 to 12 months.
Similar concerns also underpin why Barry Knapp of Ironsides Macro has turned bearish on the markets. He thought the Fed's recent meeting was a very big deal, because the central bank is showing no sensitivity to these concerns or to signs of a looming slowdown in the economy. "A policy rate above 5% for 15 months will cause large losses in small banks, real estate, highly levered and small businesses," Knapp warned.
Sure enough, the rising bankruptcy rate at small businesses was just highlighted in The Wall Street Journal. And we've detailed the concerns about private equity, which are already impacting the funded levels of pension plans, a major investor into that asset class.
"Our base case of a rally by year-end to [S&P] 4800 is slipping away due to a Fed that professes to be proceeding cautiously, but in fact...is behaving recklessly," wrote Knapp. "Notable in the post-Fed reaction," he added, "was a widening of credit spreads that heretofore had been well-behaved." His probability of a recession "increased by approximately 25%" following the meeting. On top of that, last week's poor housing data "put an end to the narrative that housing was stabilizing," he cautioned.
Or as Michael Hartnett at Bank of America wrote over the weekend, global central banks "likely ain't finished breaking stuff. Stay bearish/defensive, and sell the last hike." And mark your calendars for November 1, the next Treasury supply announcement. These releases, says Jensen, are now the thing that "other than the employment report, [are probably] the biggest market-moving day."
See you at 1 p.m!
Kelly
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