161009 technicalsWe bounced a little Friday off of that meh payrolls.  We weren’t able to decisively break the four month lows in say, EDZ8 (chart on right).  It’s unclear if this was a deadcat bounce, or the start of a move back up in the range.  In looking at potential catalysts in next week’s calendar, the two things I am looking at are the Fed minutes on Wednesday (potentially bearish) and Retail Sales (who knows?[1])  We also have a BOE meeting Thursday, but I don’t know that will affect the US markets much.

And this gets us to thinking about the many countervailing larger-picture forces at work:

BULLISH FORCES

  • Nothing has changed in the global growth picture. No one thinks there are upside risks to growth, and a large number of people still think there are downside risks.
  • Nothing has changed in the global inflation picture. See the OECD inflation bullet on page 1.  Unless free trade gets abolished by a new horny President, it’s unlikely global downside pressures on inflation will abate.
  • The ECB and BOJ are still engaged in QE. Visibility on a near-term recovery in those areas is non-existent, so QE may go on for a while.
  • ECB taper rumors have been shot down numerous times, via the minutes and Draghi himself. It’s just precautionary… like me planning what I’m going to say to Jessica Alba on a date.  Doesn’t mean it’s ever going to happen.
  • An Article 50 deadline has been established. The UK economy has been okay following the Brexit vote.  But Brexit hasn’t actually happened yet.  Additional fears may arise as the March deadline approaches.  While a “Brexit vote”-type short squeeze may not be likely (see “cry wolf” example from last week), the sterling flash crash reminds us it is not impossible.
  • There will continue to be rumors of banking stresses. Some German companies, Qatar and even the German government (gasp) have been rumored to be interested in supporting Deutsche.  As mentioned before, Deutsche is not going under.  However, there are tons of tiny crap banks all over Europe that could easily go belly-up.  It just takes one or two to cause nervousness.
  • The Cubs look good. So does Cleveland.  The world as we know it may be coming to an end.

BEARISH FORCES

  • The markets have been underestimating Fed hikes in recent months. Part of this may be structural, as some traders may be looking at value vs other countries’ securities, rather than Fed probabilities.  However, as hikes look more likely (move closer to the front of the curve), the underpricing should dissipate.
  • Oil prices are higher. Watch for higher inflation prints, and possibly higher investment.  For parts of the past few years, the long end has rallied in sympathy with the drop in oil.  We may see the reverse.
  • Tapering by ECB. The ECB may be starting to think about exit plans for QE.  In particular, it’s interesting the discussion is around tapering before the end date.  One would think that if there was an end date, there is no need to taper.  But this may just be semantics, because what the markets care about is the total amount bought.  Tapering would smooth out purchases better and may be less disruptive to the markets.
  • MORE IMPORTANTLY… The Fed may already be considering exit plans for portfolio reinvestment.  Mester did mention balance sheet shrinkage last week.  As I’ve said for a number of weeks, as we get closer to “neutral” (which is just a few hikes away), the FOMC will want to look at other ways to normalize policy.
  • Rates are depressed by historical norms. Gundlach has called for the end of the 35 year bull market.  I don’t particularly agree his calls, but he is supposed to be a smart guy.
  • Rates are low based on Fed expectations. There is a lot of weakness priced in.  EDZ6-Z7 is only 20bps.  Consider that this is less than one hike.  The hurdle for two hikes next year is not very high – pretty much the status quo 2+% GDP would do it.  Playing for the belly of the probability distribution makes sense.

Technically, we are at key levels.  We could see a decisive break to the downside, or we can see a bounce back to the recent highs.  I think the prudent thing to do is to take some profit on some of our bearish trades and look for a large bounce to put on bearish trades again, or a large selloff to put some bullish trades on at good risk-reward levels.  Trying to guess direction from here may not be much better than a coinflip.  So I think “unbalanced” directional positions should be kept small.  I prefer counterpunching in this environment.

[1] While I think we are “due” after two poor prints, this can be all over the place.