Credit Suisse has failed, and been rescued, over the course of a weekend. While this may have prevented an immediate global banking crisis, danger remains.
Here are five alarm bells that are currently ringing very loudly.
1. Use Of The Fed’s Discount Window Is Through The Roof
The Fed runs an emergency borrowing facility commonly referred to as the “Discount Window” (now formally known as the Primary Credit Facility). It exists primarily to ensure that banks in the US financial system can borrow bank reserves from the Fed in the event of emergencies.
In practical terms, it is the Fed’s lender-of-last-resort facility, and has a reputation of being so. Due to this reputation, a bank tends to only borrow from the facility out of desperation, as being known to have borrowed from the Discount Window casts a large shadow of doubt on its operations.
Since banks run on confidence, they naturally want to avoid situations which would cause their depositors, creditors, and transacting counterparties to question their fidelity. Which means not using the Discount Window unless absolutely necessary.
Note that the largest banks can be an exception to this, especially if they have large trading/dealing operations. During times of crisis, they can sometimes act as intermediaries; by borrowing from the Discount Window to lend at higher rates to smaller banks, pocketing the difference as profit.
As such, the amount of loans borrowed from the Discount Window is an important indicator of demand for emergency funding in the US banking system. The higher its usage, the higher the degree of systemic risk.
As of last Wednesday, the amount that banks have borrowed from the Fed’s discount window hit 152.8 billion, which, as you can see from the chart below, is higher than levels in both 2008 and 2020.
The failure of Silicon Valley Bank, and now Credit Suisse, although Credit Suisse had yet to “officially” fail last Wednesday, is clearly symptomatic of a broader problem – banks are struggling to fund themselves.
2. 0% Rates Are Making A Comeback
The auctions for 4 week and 8 week US Treasury (UST) Bills held at the end of last week saw the low discount rates for both hit 0%. Note that UST Bills are zero coupon instruments, hence the use of “discount rate” as opposed to “yield”; both terms reflect the rate of interest a buyer earns.
Sharp drop offs in low discount rates at these two auctions show that there are bidders willing to pay more than their peers in order to get their hands on both 4 week and 8 week Bills. Moreover, the 0% low rate also means that these bidders are willing to lend to the US government for no interest.
Why would anyone be so desperate to get their hands on UST Bills?
Quite simply, for use as collateral in the repo market, which implies that this key global funding market is currently under severe strain. As repo is one of the most important, and liquid short term funding markets on the planet, a sharp drop in UST Bill rates, which are the best form of collateral, tells us that a good number of participants are rushing to buy as much collateral as they possibly can.
This could be due to them having an immediate need to meet collateral/margin calls, or that they are stocking up on collateral (UST Bills) in anticipation of the repo market seizing up in the near future. Either way, it speaks to a large negative change in the liquidity of the repo market, that is, people with cash are no longer lending it out easily.
That being said, yesterday’s auction for 13 week Bills did not see a drastic change in its low discount rate. While high, median, and low rates for the auction did come down a little, no sharp drops in the manner of the 4 and 8 week Bills occurred.
Keep a close eye on UST auctions, especially for how low discount rates come in at the short end. As long as they continue to stick at, or close to 0% for the 4 and 8 week Bills, demand for collateral remains high, and by extension, funding markets remain stressed.
Should low discount rates in 13 week Bills plummet towards 0%, that would imply increasing demand for collateral, and hence higher levels of stress in funding markets. This in turn would imply a higher probability of further selloffs in global markets, possibly even violent ones.
3. Yield Curves Have Spasmed
Both the UST and Eurodollar yield curves have changed dramatically over the past week, and not in a good way.
Looking at the chart of the UST yield curve above, a few things are immediately apparent. Rates from 1 month to 3 month Bills have risen, but yields after that point have fallen. This naturally means that the curve has grown more inverted, especially between the 3 month Bill and 10 year Note.
Higher rates at the short end reflect higher funding costs than in January, although they have fallen quite a bit from where they were just 2 weeks ago, in response to the banking crisis. This fall points towards stresses in funding markets like repo, as explained previously.
On the long end, lower yields are a result of the market quite clearly pricing in lower levels of growth-driven inflation, which really does not bode well for the economy.
The curve has also steepened a little between the 2y and 10y tenors since January, although not by much. While this might seem to be cause for some kind of optimism, since if a flattening curve implies trouble, a steepening one should imply the opposite, this isn’t the case, as a lot depends on other circumstances.
In the current environment, the steepening between the 2y and 10y is largely driven by a sharp fall in 2y yields. This is an occurrence that hints at growing trouble in the financial system, which is an accurate reflection of current circumstances given the failure of Silicon Valley Bank and a few others in the US, and Credit Suisse in Europe. Lower yields at the 2y mark means that the market is pricing in lower rates, which reflects expectations of Fed rate cuts, and/or participants rushing to purchase collateral.
Both of these are reasons which do not translate into economic bullishness.
The Eurodollar yield curve has also shifted drastically from the beginning of the year, reflecting the same reality as the UST one, and is now fully inverted over the next 8 months or so.
This shift indicates a large shift in financial market participants hedging against a sharp fall in rates over the next few months, which implies that they expect more funding stress in repo, Fed rate cuts, and a slowing economy.
4. The Fed’s USD Swap Lines
The Fed announced over the weekend that it would be increasing the frequency of its USD swaps with a handful of other central banks, which is a major sign of stress in global USD funding markets (which are closely tied to collateral and repo).
After all, why make more USDs available to international counterparts if they are plentiful and easily available in the global financial system?
There are some issues here, the first of which is that only a few central banks are involved, whereas the USD is needed globally, especially in China (whose central bank wasn’t included). In order to truly avert a global crisis, Dollars must be made available to every financial system on the planet that transacts in USDs, which in current times is the vast majority of them.
In addition, the Fed making more USD swaps available does not mean that everyone who needs them will get them. Only banks with the needed collateral and creditworthiness will be able to access these USDs from their own domestic central banks.
In turn, only the most creditworthy customers will be able to access these Dollars from the banks who are able to get them in the first place. Bear in mind that the Fed’s USD swap lines are only used in times of global USD scarcity. This means that economic and financial conditions are so poor that banks aren’t willing to step up to make Dollar loans to other banks and their customers. Naturally, in such an environment, banks will only make loans to those which are most likely to pay them back.
Consequently, the Fed making more USDs available to central banks will not avert a crisis. It may help to lessen global bank failures and ease the pressure off the largest businesses, but Dollar swap lines are ultimately a tool that tends to only benefit the strongest entities.
For everyone else in dire need of Dollars, it’s sink or swim. The more who sink, the higher the risk of negative cascading effects on the economy.
Note that the Fed also has a permanent Dollar swap facility for their central bank counterparts, the Foreign and International Monetary Authorities Repo Facility (FIMA), set up in 2021. You can learn more about it, and why it isn’t the solution the Fed believes it to be, here.
5. China Cuts Its RRR
In a surprise move, the People’s Bank Of China (PBOC) cut their reserve requirement ratio (RRR) at the end of last week. Most narratives tend to take RRR cuts as a positive for risk assets, believing them to be expansionary and good for growth.
However, such thinking ignores two very important facts. The first being that bank reserves, whose availability to banks increases when the RRR cut, are not lent out. This necessarily means that RRR cuts (or QE for that matter) are not actually expansionary, since bank reserves do not get pushed out to the broader economy. Banks making new, and more, loans is what matters, and their willingness to do so is not affected by having more bank reserves on their balance sheet.
At best, having more bank reserves available to them means that banks will be more able to meet daily transaction requirements, which could help ease pressure on those which are facing large deposit withdrawals. While this would be helpful in preventing possible bank runs, it isn’t expansionary at all.
Secondly, central banks don’t need to increase levels of bank reserves during good times, simply because the economy is growing, banks are lending freely, and the financial system as a whole is confident. In short, liquidity is plentiful and easily available for anyone needing to borrow.
Liquidity only tightens when financial actors become risk averse and reluctant to lend to counterparties. In other words, the system fails, or at least starts to exhibit signs of failure. This is when central banks step in. When they enact steps like rate cuts, RRR cuts, QE, USD swap lines, or whatever other emergency measures they can conjure, it means that the financial system and broader economy is taking a turn for the worse.
Pay Attention To Macro Markets, Not Equities
While most narratives will be focused on how the equity markets are performing, especially UBS stock, macro markets are the truest indicator of systemic risk.
Keep a close eye on developments in US rates, especially at the front end of the curve, with the understanding that volatility in short term rates is not a good development, even if rates on 1 month and 3 month UST Bills move sharply higher. A healthy rates market is one where movements are relatively small and incremental; large moves demonstrate high levels of uncertainty.
If you can, also pay attention to how Eurodollar futures are performing, as they give meaningful insight into how participants in the global financial system are hedging interest rate risk.
In addition, don’t forget to monitor the USD’s performance in the weeks and months ahead. A stronger Dollar would demonstrate rising scarcity of the world’s reserve currency, which directly translates into banks cutting back on USD lending. Nothing positive happens in the global economy when USDs grow scarce, which is the primary reason for the Fed moving to make its USD swap lines available on a daily basis over the weekend.
Should equities rally while interest rates and the USD continue to trade in a manner indicative of systemic weakness; that is, lower rates, both at the short and long end, and a steady or stronger Dollar, be very wary of narratives proclaiming that the crisis is over.
Finally, it is entirely possible for global markets to calm down substantially in the immediate future, with large rallies in equities and Dollar selling possible. This, however, does not necessarily mean that systemic pressures have been fully alleviated. Crises in global funding markets, like repo, tend to resolve themselves in their own time, more often than not after a massive deleveraging and selloff in markets.
In short, regardless of how positive stocks and the accompanying narratives may or may not be, now is not the time to be complacent.
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Trouble in the banking system has very quickly metastasized from the failures of regional banks, Silicon Valley Bank and Signature Bank, to hit a globally systemic important one, Credit Suisse.
Systemic risk is obviously a major concern now, which is best observed and indicated in two macro markets, the USD and US rates.
Pay very close attention to what they are doing!
- While each bank has its own individual issues that contributed to their problems, the common underlying factor determining their fate is the same – the global repo market (as explained in our article on SVB)
- Systemic risk is obviously a major concern now, which is best observed and indicated in two macro markets, the USD and US rates
- The main indicator to watch for is an alignment in these two markets, where both move together in a direction which signals deteriorating conditions in the global financial markets. This specifically means a stronger USD, and lower US rates
- The more important macro markets, like oil and base metals, that line up in the same direction, the more danger of a global crisis and selloff
- Currently, US rates have begun to move sharply lower, but the USD has yet to breakout of key levels
Charts for this week’s report can be found in the slides embedded at the beginning of the article.
The recent failure of Silicon Valley Bank (SVB) has driven markets into a frenzy of trying to understand why it happened, and what broader systemic implications it may have.
The US government has stepped in to backstop depositors in an attempt to prevent further bank runs, but mainstream narratives continue to miss a broader point – bank runs are symptoms of a much more troublesome problem.
One large enough to potentially trouble the entire global financial system.
The Repo Lurking Behind The Narrative
Popular narratives that have been used to explain SVB’s blowup run along similar lines:
- Banks took in cheap deposits when rates were low and couldn’t lend all of it out, which led them to invest in other fixed income securities, like US Treasuries (USTs) and Mortgage Backed Securities (MBS) instead. With the Fed and other major global central banks’ recent campaign of aggressive rate hikes, this narrative concludes that falling prices from rising rates caused, and will cause, banks to take major losses.
- Or, with a subtle difference, banks took in cheap deposits and invested them in longer term fixed income securities. This mismatch of borrowing and lending durations caused them to be unable to fulfill depositors’ rush to withdraw their money.
The issue with the first narrative is that it is quite misleading. Banks do not “lend out deposits” in quite so direct a manner as is implied by the narrative. Bank loans are made by simple ledger entry, with a bank creating an asset on its balance sheet (the loan), offset with a liability (the amount of the loan in the loanee’s account).
As such, bank loans are not a simple matter of taking $1000 of deposits from one depositor and lending that same $1000 out to a loanee.
Briefly, when a depositor receives money in their bank account, for example as a salary payment, bank reserves are transferred from the employer’s bank account to the depositor’s. Bank reserves are what banks use to settle interbank transfers initiated by its customers, and are shuttled between banks via the Fed’s Fedwire system on a net basis at the end of each day.
What this means is that a bank needs to have adequate bank reserves to cover any net outward transfers at the end of each business day. Of course, if more people are transferring funds into the bank than out of it on that day, it does not need to worry about bank reserves (at least for that particular day).
SVB getting a huge influx of deposits just means that it received a lot of bank reserves, which are not actually lent out – as explained a few paragraphs above. Consequently, the influx of bank reserves into SVB due to the tech boom did not create a situation where SVB could not lend them all out, as they aren’t lent out in the first place. (If you want to get a better understanding of these concepts, you can learn more about bank reserves here and how money is really created here)
Instead, SVB’s ability to create more loans would be determined by how stringent their loan officers were in screening new clients, as well as demand for loans by the bank’s customer base; not by how much deposits SVB received.
However, the influx of deposits did still mean that SVB was faced with a choice of how to invest them in order to get a decent return. They did so by purchasing safe fixed income assets, which brings us to the next point – banks do not need to take losses on their fixed income investments if they are classified as held-to-maturity securities.
That is, if a bank’s intention is to hold USTs as an income generating investment, and not simply to buy and sell them for a quick profit or market making purposes, they do not have to mark their investments to current market prices.
This runs contrary to the simple relationship that current mainstream narratives seem to imply, that losses from SVB’s fixed income investments were the main factor in toppling the bank. Moreover, it also completely misses out on a very important point. That is, US Treasuries can be used as collateral to raise capital quickly in the repo market, as USTs are the best source of collateral used in repo.
Which begs the question, why didn’t SVB tap the repo market?
Two broad scenarios are plausible here. The first being that SVB chose not to do so. In SVB’s 1Q23 mid quarter update, dated 8 March, SVB stated that it sold $21 billion in fixed rate available-for-sale securities (page 9 of the PDF linked above), which are securities that are not held-to-maturity, and also not purchased for trading purposes.
This was done with the intent to rebuild its portfolio with shorter duration fixed rate USTs.
In other words, SVB ostensibly didn’t sell their portfolio to raise capital to fund customer withdrawals, but to attempt to benefit from what the bank thought was going to be a sustainably higher interest rate environment. If this were entirely true, SVB’s management had their plan completely backfire, as the proceeds raised from the sale of their securities obviously wasn’t enough to cover withdrawals.
The second plausible reason for SVB not tapping the repo market is that it simply could not do so. That, even with its large holding of USTs, the bank failed to raise money in the repo market; to the extent that it had to sell its securities to raise capital.
Note that most financial institutions prefer to pledge USTs as collateral to borrow in the repo market first, as repo borrowing can be easily rolled over most of the time. Outright selling tends to be a last resort, which implies that it wasn’t just depositors who lost confidence in SVB, the repo market did too. This could have meant that SVB faced repo borrowing costs (haircuts) that were so high as to completely discourage them from transacting, and/or counterparties in the repo market simply refused to do business with them.
Moving on to the second narrative, which pinpoints the mismatch in SVB’s assets and liabilities as the main cause in the bank’s failure; in other words, borrowing in short term markets to fund longer term investments. This isn’t inaccurate per se, and actually highlights one of the biggest problems that all banks face, which is their business models naturally push them to mismatch the duration of their assets and liabilities.
Consider that all banks operate on the same basis of taking in deposits and lending on a longer term to businesses, consumers, and governments (by buying government bonds).
Deposits are “short term” because they can be withdrawn by depositors at any time, while loan payment periods can stretch out over decades. There isn’t a bank on earth that takes in deposits and only makes overnight loans, simply because it would struggle to make any kind of decent profit.
However, not all banks fail. As a matter of fact, on a percentage basis, much more banks survive (or get bought up/merged) than fail. The evidence for this lies in the fact that the modern banking and credit creation systems have existed for a few centuries.
Consequently, the model of borrowing short term to fund longer term assets, while dangerous in its own right, not to mention awfully short convexity, is only part of the SVB problem.
As discussed above, SVB clearly could not access any kind of short term funding market in the run up to its failure. But, this does not mean that the sole cause of the problem lies in their mismatch of assets and liabilities. The other part, is, once again, the loss of the bank’s ability to fund itself in short term borrowing markets.
Financial history is littered with spectacular failures of firms, both financial and otherwise, who blew themselves up when they could no longer access short term borrowing to meet the funding needs of their long term investments.
Repo, The Root Of Systemic Problems
At this point, it is quite clear that the repo market is the unseen, and untalked about, common factor lying in the shadows of both narratives. Which brings us to a curious observation, that SVB’s failure has occurred during a seasonal period of time where liquidity in the repo market tends to be low.
This tends to happen close to the end of each quarter, and coincides with some of the largest and most disruptive financial crises in recent history.
In 2008, Wall Street was grossly over-leveraged and overexposed to the US housing market, with Bear and Lehman falling victims to their inability to fund margin calls during quarter end repo liquidity tightness. Bear collapsed in March ‘08 (late 1Q), and Lehman in September of the same year (late 3Q).
The same thing happened on a much larger scale in late Feb/early March of 2020, when global shutdowns due to the initial outbreak of COVID, coinciding with the nearing end of the 1st quarter, wreaked havoc on financial markets all over the world.
The point here isn’t to simply blame seasonal drops in repo liquidity for bank/financial system failures. It is simply to state that the probability of such failures are markedly higher when confidence in banks takes a battering during periods of lower liquidity in repo.
Which brings us to the potentially trillion dollar question. Is SVB’s failure a harbinger of things to come from a global, systemic perspective?
Due to the narratives mentioned above, which place the blame squarely on banks holding large amounts of Treasuries (and other fixed income instruments), many people are currently inclined to believe that banks all over the world are in trouble, since the value of their fixed income holdings have plummeted.
However, as also explained above, the real danger does not lie in the holdings’ themselves, but the inability of banks to fund their capital needs.
Here is a simple breakdown of what goes on:
1) Deposits are essentially unsecured loans that customers make to banks. This in effect makes depositors junior creditors. They are junior because in the capital structure, secured loans have seniority when it comes to being paid back first in the event of liquidation. Of course, with government intervention, as witnessed over the weekend, political necessities can upend the capital structure.
2) Banks don’t lend deposits out, instead, the cash is used to meet daily transfer requirements arising from the transactions of its customers, and also for a bank’s own business needs.
3) Should there be a large demand for customer withdrawals, i.e. a bank run, a bank needs to fund these withdrawals by borrowing cash. They can do so either via short term borrowing markets, like repo and the Fed Funds market, or in emergencies, from the Fed’s discount window (or other emergency Fed/government lending facility).
As such, holding unrealized losses on fixed income investments does not actually hinder a bank’s ability to meet withdrawals. If it did, many more banks, and not just in the US, would be facing bank runs at this point, given how much rates have risen over the last year, and how quickly.
Instead, as already mentioned multiple times above, but bears repeating again just because of how important it is – what matters is a bank’s continued access to short term borrowing markets. When this access is revoked, the bank will fail barring an intervention from the central bank and/or government.
This is not to say that huge losses on banks’ fixed income investments aren’t important. They are. Firstly, when a struggling bank is forced to sell its fixed income investments at a loss, it leaves them with less capital than they initially borrowed to pay back their creditors, which obviously is a recipe for disaster.
But what is of more importance here is the psychology of it. At the end of the day, our modern banking system and economy runs on confidence. When confidence evaporates, access to credit quickly dries up.
As such, SVB’s failure, embedded together with the growing momentum of the “large fixed income losses” narrative, is a very dangerous combination that could lead to further bank runs. Adding fuel to this fire is tighter liquidity conditions in the repo market, which now has to contend with not only its seasonal quarter end issues, but also the fear and uncertainty of other bank failures.
Systemic Risk Watch: Look Beyond Equities!
The temptation at this point will be to look at US equity markets for direction, as well as indications of future selloffs in global markets. After all, bank stocks have a giant crosshair drawn on them at this point, especially in smaller segments of the banking sector, and it intuitively makes sense to look at further selloffs here as indications of a broader crisis to come.
However, from a systemic perspective, lower repo liquidity means a general, across the board withdrawal of short term funding for all other financial markets. After all, when lenders pull back on providing credit, they tend to do so en masse, and indiscriminately.
Naturally, this leads to margin calls and sell offs, which have the potential to spark a vicious and nasty cycle of liquidations across the globe.
Consequently, focus needs to be on the largest macro markets instead, namely the USD and UST rates, as they will give a clearer and more reliable indication of the probability of a global risk off scenario. The reason for this is that repo and other short term funding markets are both global and highly interconnected in nature, not to mention much larger than US equity markets.
Therefore, while US equities can be driven by wild swings in bank stocks as equity investors and traders panic, the USD and UST markets take much more to move them in a meaningful way.
In addition, the USD is a reliable indicator of global crises due to it being the world’s reserve currency, and its close connection to the global repo market, where banks, corporations, and governments regularly post collateral to borrow USDs to meet their needs. In other words, problems in the repo market, when they get big enough, will show up in the global USD market, and hence USD FX rates.
While US equities might present decent trading opportunities in the short term, both on the long and short side, depending on how you might want to position yourself amidst current uncertainty, don’t lose sight of the bigger macro picture.
This is especially important as overall macro conditions have deteriorated from where they were a year ago (except for the US labor market), and global recession is now a real concern, as indicated by deeply inverted UST and Eurodollar curves.
In other words, any economic mishaps that occur now have the potential to cause more harm than if conditions were more benign. It is also worth noting that economic mishaps, such as bank runs, tend to occur much more often during periods where economies are sliding towards recession, simply because financial conditions are no longer as forgiving as they were during expansionary parts of the cycle.
As such, look past any large rallies in equity markets driven by hope and speculation of what the Fed, and/or the US government, is, or may be doing. Focus on the USD and US rates, and if you can, Eurodollar futures.
These are the markets that really matter when it comes to systemic risk, and which really tell you what to expect in the future.
Especially keep an eye out for change in trends, breakouts of key levels, and most of all, an alignment between markets. When multiple markets start to move in tandem, and in a direction which screams danger, the likelihood of a global selloff, if not a full blown systemic crisis, is at its highest.
At time of writing, government bond yields have fallen sharply, which mainstream narratives will portray as a flight-to-safety trade. While the desire for safer assets will be a part of why rates have fallen so quickly in just 2 days, lower rates also demonstrate a collateral crunch. Simply put, participants in repo and other short term borrowing markets are dashing to get as much collateral as possible to ensure that they have enough to meet potential margin calls should volatility and uncertainty persist.
Lastly, bear in mind that a sharp and broad global selloff in risk assets may not come immediately, and indications of one may not show up for a few more months. This is not a time to be complacent, as the rest of 2023 now looks increasingly dicey for markets, which are growing increasingly vulnerable to a large global selloff.
Remember that Bear Stearns failed in mid March 2008, but the Fed intervened and everyone thought that was the end of any further mishaps… until Lehman took down everything else just 6 months later.
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Recession or no recession?
This is the crucial question that traders are grappling with at the moment. Naturally, how you answer the question will determine how you position your portfolio for the months ahead.
But what if you simply want to wait for the markets and/or data to give a clearer heading? Waiting and not trading is certainly one way to go, but so is taking non-directional positions.
- Markets are not fully aligned towards a weaker global economic environment (do note that they were fully aligned and indicating a global recession as recently as October 2022)
- Weaker USD in short term, but the medium term trend is still biased towards strength
- Same in US equities, medium term weakness, but short term strength
- Commodities also aren’t aligned. Oil and Aluminum remain range bound, while Copper and Iron Ore have rallied strongly since Oct ‘22
- When the Fed starts to cut rates in response to a slowing economy, expect lower short term and long term rates, but also lower prices in risky credits as investors pay more for safety and liquidity
- Hedge market risks:
- Not a good time to take directional risk in markets. Short term trends are not aligned with medium term trends in key markets, which makes the future direction of global markets unclear
- Given the current uncertain macro environment, what characteristics should we look to add to portfolios?
- Preferably, positions which are relatively:
- Low risk
- And also offer some sort of yield
- Long 1 month or 3 month US Treasury Bills
- Fed controls the short end of the curve, and long term rates are not pricing in levels of growth driven inflation commensurate with the Fed’s hikes; hence massive curve inversion
- Buying bills in this uncertain environment gives:
- Higher yields than buying at the long end
- Flexibility to roll them over every 30 or 90 days, without having your capital locked up for longer should market conditions shift rapidly
- Buying longer term Treasuries at this point for the sake of yield will:
- Lock up your capital should their short term trend reverse and prices fall, saddling you with a capital loss
- Give you a lower yield
- Represent a directional bet, even if their prices continue to rise (giving you a capital gain along with yield)
- US 1 month Bills are currently trading with a yield of 4.56%, and 3 month Bills at 4.67%. US 10y Notes are trading with a yield of 3.55%
- These trades are non-directional, but more aggressive in terms of cost and the risk profile of the asset classes involved
- Long SPX, hedge with ATM 1y put
- Gives upside exposure if equities continue to rally, guards against downside crash if downtrend resumes
- SPX (S&P 500) is currently trading at 4136
- Straddle (buy calls and puts) on risk assets, which will profit should markets begin to trend strongly in one direction. ATM straddles on:
- SPX, NASDAQ, Russell 2000
- NASDAQ Composite is trading at 12006, and the Russell 2000 at 1985
- USD, via the most liquid currency pairs – EURUSD, GBPUSD, AUDUSD, USDCAD, etc.
- EURUSD is trading at 1.0795, GBPUSD at 1.2066, AUDUSD at 0.6930, and USDCAD at 1.3406
- SPX, NASDAQ, Russell 2000
- More importantly, these trades allow:
- Exposure to both sides of the market during this uncertain time
- Flexibility to reduce exposure to one side should markets begin to trend strongly in one direction
Charts for this week’s report can be found in the slides at the beginning of the article.
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Talk of global recession is gaining momentum as we begin 2023. Here are three signs which will indicate that a broad market selloff is imminent.
Before we begin, it is important to note that a broad market selloff occurs when all markets are aligned on a cyclical basis. This means that the general idea behind looking out for indications of a coming selloff rests on understanding where important markets are trading in their own cyclical patterns, as well as how they normally trade just before inflection points.
1. The Dollar Strengthens, Or Remains Strong
As you can see from the chart, the Dollar (DTWEXBGS) was the first market to turn, way back in mid-2021, signaling that USD funding conditions were beginning to tighten across the globe. This is the precursor to all global recessions.
As we begin 2023, the USD has sold off, but remains much stronger globally than it was compared to its weakest levels in 2021. In other words, the Dollar is still signaling that a global economic contraction is on the horizon.
2. Eurodollar Futures Turn Higher
Eurodollar futures are one of the main ways participants in the global financial system hedge against changes in short term US Dollar interest rates.
From the chart below, you can see that they have spent the last few months selling off, as the Fed has been hiking rates. Conversely, should Eurodollar futures prices turn up, it means that the market is beginning to price in lower short term USD interest rates (remember that interest rates run inverse to prices in fixed income instruments).
Put another way, Eurodollar futures getting bid implies that the market is expecting the Fed to start cutting rates.
Lower short term USD interest rates, projected by the Eurodollar market, would bring it into alignment with global Dollar strength. This is due to the fact that lower rates, especially during times of market turmoil and economic crisis, do not actually indicate an abundance of liquidity. On the contrary, low rates in crisis periods indicate hoarding. For more information on this, refer to our articles on the Interest Rate Fallacy.
Bear in mind that the Eurodollar yield curve is currently inverted, just like the yield curve for US Treasuries. Both markets are massive and global, and both are indicating that liquidity conditions around the world are getting very tight.
3. Equities & Commodities Moving Lower
Equities have already turned lower in the current cycle, which is unusual, as they normally are the last, if not one of the last markets to turn, just before the global economy tips over into contraction and possible crisis.
However, should the world economy continue to move towards recession, it is quite likely that equities will rally, possibly quite strongly. This behavior is normal and is simply due to the fact that many equity market folks hold strongly to the paradigm that lower rates are good for stock prices, and higher rates aren’t.
The factors that determine stock prices (and in every other market) are myriad and complex; reductive statements claiming simple causal relationships between one factor and how it affects prices tend to be more folksy than accurate.
Should Eurodollar futures start to move higher (implying lower rates), equities start to rally, and the Dollar strengthens, it would be advisable to not bet too much on a sustained trend higher in stock indices. In fact, should such a scenario materialize, it might be wise to look into ways of getting short equities.
Other markets you can use as indicators of an impending slide towards a broad market selloff include the price of oil and copper. Both are sensitive to global growth conditions, although micro factors are important to consider in commodities markets.
Oil for example, is currently affected by Russia’s war in Ukraine, which naturally acts to keep its price elevated. With this in mind, should oil begin to trend firmly lower, it would indicate that global economic conditions are rapidly deteriorating, to the extent that even war-related supply disruptions cannot keep prices high.
If you would like to know how to prepare and profit from trading a crisis, you can learn to do so in our course on How To Make Money Trading A Crisis. The course will teach you about the market cycles mentioned above, how this relates to financial markets, and most importantly, which markets to trade and why.
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