Author: Colin Twiggs

Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters. Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis. Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events. He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
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How the SRF could blow up the Treasury market

Key Points

  • The Fed’s Standing Repo Facility (SRF) is designed to provide backup funding to the repo market during periods of liquidity stress.
  • The $12 trillion repo market is secured by government securities, normally USTs, and has largely replaced unsecured interbank lending.
  • However, hedge funds are taking advantage of the SRF to finance highly leveraged basis trades.

Unsecured interbank lending has largely been replaced by repo financing after the breakdown of trust in the global financial crisis of 2008.

A repo is short for repurchase agreement, where the borrower sells government securities, typically US Treasuries, with an agreement to repurchase them at a slight discount the following day. The repo (discount) rate, formally known as the Secured Overnight Financing Rate (SOFR), has increased in importance as the repo market has grown to almost $12 trillion, overshadowing the widely known Fed Funds Rate (FFR). Both the SOFR and FFR are managed by the Fed through its open market operations.

A sharp spike in the repo rate in 2008 threatened to collapse the entire financial system. The Achilles heel of the banking system, and the reason for the Fed’s existence, is maturity mismatch. Borrowers take advantage of low interest rates in the short-term market and invest in long-term assets, capturing the wide spread. That works well until the yield curve inverts. Short-term rates spike upward as available credit contracts, causing a fire sale of long-term assets as borrowers scramble to raise cash to repay loans. A spike in the repo rate effectively serves as a margin call on long-term assets.

The first instance occurred during the 2008 subprime crisis, when the repo market ceased functioning, leading to a panicked sale of assets. Then, in 2019, repo rates spiked after the Fed’s QT had lowered bank reserves, reducing the supply of bank credit available to fund repos. The spike led to the famous Powell pivot, where the Fed abruptly ended QT and expanded its balance sheet (QE) to inject liquidity into financial markets.

Again in March 2020, repo rates spiked during the COVID pandemic, causing a sell-off of US Treasuries financed through highly leveraged basis trades.

The chart below shows the spread between the repo rate (SOFR) and the fed funds rate (FFR) in 2019 and 2020.

SOFR-FFR

The Fed responded by establishing the Standing Repo Facility (SRF), through which borrowers can obtain repo finance directly from the Fed when there is a shortage in the repo markets. The SRF acts as a market stabilizer, limiting increases in the SOFR and preventing a repeat of earlier repo market collapses. The underlying purpose is to avoid a fire sale of US Treasuries if the repo market ceases to function.

Hedge funds have increasingly tapped the repo market to finance highly-leveraged basis trades, which take advantage of the spread between repo rates and the implied discount on Treasury futures. The SRF has encouraged these trades by limiting the downside risk. Hedge funds pocket the spread when repo rates are low, and rely on the SRF to save them if rates rise.

We suspect that the size of leverage investment in US Treasuries is greater than commonly believed. Over the past decade, offshore investment in US Treasuries has swung from foreign central banks to private sector investment, primarily through offshore financial centers favored by hedge funds.

Basis trades are likely to continue growing as long as the Fed maintains a standing repo facility to stabilize the repo market. The SRF enables hedge funds to enter profitable leveraged trades on US Treasuries with limited downside risk.

As Charlie Munger said, “Show me the incentive and I’ll tell you the outcome.”

Stocks

The S&P 500 remains tentative after last week’s contraction in financial market liquidity.

S&P 500

A contraction in the ADP’s four-week moving average of private sector job creation to -11,250 has not helped.

ADP Private Sector Jobs - NER Pulse

Financial Markets

The secured overnight financing rate (SOFR) remains above the rate paid to banks on reserve balances (IORB), indicating financial market stress.

Secured Overnight Financing Rate (SOFR) & Interest on Reserve Balance (IORB)

Bitcoin is re-testing support at 100K, warning that liquidity remains tight.

Bitcoin (BTC)

Dollar & Gold

The dollar is weakening as prospects for a December rate cut improve.

Dollar Index

Silver rallied to test its previous high at $54 per ounce.

Spot Silver

Gold followed, with a rise to $4,230 per ounce. A breakout above the resistance level at $4,400 would offer a target of $5,000.

Spot Gold

Conclusion

Basis trades funded through repo markets are expanding as the Fed’s standing repo facility (SRF) enables hedge funds to profit with limited downside risk while the Fed acts as a backstop.

Basis trades increase the vulnerability of US Treasury markets as hedge funds are highly leveraged short-term holders of USTs. In the past, unwinding basis trades have caused a sharp rise in Treasury yields when repo rates spike. The SRF may prevent a repeat of past spikes but provides an incentive for hedge funds to take on greater risk, expanding the size of their basis trades and increasing Treasury market vulnerability.

Financial markets remain unsettled, with Bitcoin testing long-term support at 100K. Gold and silver rallied, and breakout to new highs would offer targets of $5,000 and $62 per ounce, respectively.

Acknowledgments

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Gold bear trap & the AI illusion

Key Points

  • Gold recovered above $4,100 per ounce, signaling another test of $4,400.
  • Silver similarly recovered above $50 per ounce.
  • Bitcoin at 106K indicates improving liquidity.
  • The S&P 500 also completed a bear trap, indicating another rally.
  • A recent Stanford study suggests that the adoption of generative AI has had a minimal impact on employment levels.

Gold recovered above $4,100 per ounce, completing a bear trap with a target of $4,400.

Spot Gold

Silver similarly recovered above $50 per ounce, offering a target of $54.

Spot Silver

Bitcoin, our real-time indicator of financial market liquidity, rallied to 106K. Respect of long-term support at 100K offers a target of 116K, indicating the liquidity squeeze is fading.

Bitcoin (BTC)

The S&P 500 completed a similar bear trap at 6750, suggesting a rally to test 7000. Follow-through above 6900 would confirm.

S&P 500

41 AI-related stocks dominate the market capitalization of the S&P 500. Investors have gone all-in on AI and its ability to generate future earnings.

S&P 500 AI-Related Stocks

Jonathan Levin argues in Bloomberg that, excluding the AI-related Tesla and Amazon, consumer-facing sectors of the S&P 500 are in recession.

S&P 500 Consumer Staples & Discretionary

A recent Stanford study on ChatGPT adoption indicates significant increases in productivity in fields with high adoption rates. However, it notes that the improved productivity has, so far, led to increased wage rates rather than reduced employment levels.

Treasury Markets

10-year Treasury yields are consolidating around 4.10%, with resumed BLS inflation readings likely to provide further direction.

10-Year Treasury Yield

Trump-appointee Fed Governor Stephen Miran on Monday repeated his call for a half-percentage-point cut at the FOMC December 9-10 meeting. (Reuters)

Consumer perceptions of long-term inflation remain elevated, with the University of Michigan survey indicating that perceptions of 5-year inflation have averaged 3.7% over the past three months.

University of Michigan: 5-Year Inflation Expectations

Dollar & Gold

The dollar has weakened following high private sector layoffs in October, with financial market pricing indicating a 63% chance of a 25-basis-point rate cut in December. (Reuters)

Dollar Index

JP Morgan estimates that the labor market added 52K jobs in September but lost 35K in October, increasing the likelihood of another rate cut in December.

JP Morgan Estimated Labor Market Growth

Conclusion

We expect further rate cuts to weaken the dollar and boost prices of gold and silver.

S&P 500 performance depends on projected AI productivity gains, driving a massive increase in earnings for AI-related corporations. However, there is currently limited evidence to support this conclusion.

Acknowledgments

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Record Lows and Highs spell trouble in the USA

Bull/Bear Market Indicator
Stock Market Pricing Indicator

The gauge on the left indicates whether the market is in a bull or bear phase, and the one on the right reflects the current stock market valuation levels. Stock market pricing indicates whether stocks are cheap or expensive relative to earnings, but it is a poor indicator of market timing. We do not recommend selling stocks because the market valuation is high. Still, we advise investors to exercise caution when adding new positions.

Bull/Bear Market

The Bull/Bear indicator remains at 40%, warning of a bear market ahead. Updates to three market indicators (highlighted in orange below) are delayed because of the US government shutdown.

Bull-Bear Market Indicator

Another indicator, the University of Michigan index of current economic conditions, plunged to 52.3, the lowest reading since the series began in 1960. The low reading would typically signal a recession, but has not yet been confirmed by either tighter financial conditions or a fall in the S&P 500.

University of Michigan Current Economic Conditions

The Chicago Fed National Financial Conditions Index turned up to -0.515 but continues to signal loose monetary conditions, which support high stock prices.

Chicago Fed National Financial Conditions Index

The S&P 500 has not experienced a significant correction since April, and the 30-week Smoothed Momentum indicator continues to oscillate above zero.

S&P 500 30-Week Twiggs Momentum Smoothed

Stock Pricing

Stock pricing eased slightly, to 98.32 percent from a new high of 98.66 percent last week, and an April low of 95.04 percent. The extreme reading warns that stocks are at risk of a significant drawdown.

Stock Market Value Indicator

We use z-scores to measure each indicator’s current position relative to its history, with the result expressed in standard deviations from the mean. We then calculate an average of the five readings and convert that to a percentile. The higher that stock market pricing is relative to its historical mean, the greater the risk of a sharp drawdown.

The S&P 500 reached a new high of 3.28 times sales, compared to a long-term average of 1.80 times.

S&P 500 Price-to-Sales

Conclusion

A record-low current economic conditions index and a record-high price-to-sales ratio for the S&P 500 both warn of instability ahead. Stock prices are supported by loose monetary conditions, but cannot hide the underlying economic fragility.

The bull-bear indicator at 40% warns of a bear market ahead, while extreme pricing increases the long-term risk of a significant drawdown.

Acknowledgments

Notes

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ASX Stock Pricing Falls

Bull-Bear Market Indicator
Stock Market Pricing Indicator

The gauge on the left indicates whether the market is in a bull or bear phase, while the indicator on the right reflects the current stock market valuation. Stock market pricing indicates whether stocks are cheap or expensive relative to earnings, but it is a poor indicator of market timing. We do not recommend selling stocks because the market valuation is high. Still, we advise investors to exercise caution when adding new positions.

Bull/Bear Market

The ASX Bull-Bear Market indicator remains at 56%, down from 66% four weeks ago. Four indicators from Australia and China indicate a risk-on stance, with a 60% weighting, while the US Bull/Bear indicator, with a 40% weighting, is 60% risk-off.

ASX Bull-Bear Market Indicator

The OECD composite leading indicator for China strengthened to 99.59 from 99.52 in September—values below 99.0 signal risk-off.

OECD Composite Leading Indicator

September Australian building approvals rebounded to 16.8K, with the 3-month moving average holding above the 20-year average—values below the long-term moving average signal risk-off.

Australian Building Approvals

Stock Pricing

ASX stock pricing declined to 86.44 percent from 88.70 percent last week, compared to a high of 92.23 percent in August and a low of 67.85 percent in April.

ASX Stock Market Value Indicator

We use z-scores to measure each indicator’s current position relative to its history, with the result expressed in standard deviations from the mean. We then calculate an average of the five readings and convert that to a percentile. The higher that stock market pricing is relative to its historical mean, the greater the risk of a sharp drawdown.

Conclusion

The ASX bull-bear indicator reflects a mild bear market, while the extreme valuation increases the long-term risk of a significant drawdown.

Acknowledgments

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AI might just be a scapegoat for recent layoffs

It’s not easy to use AI to replace jobs.

Many layoffs cite AI as the cause, but the real cause may be that business is declining. It’s known as “AI-washing.”

The artificial intelligence landscape is teeming with players, and they’re not all legitimate. Some are practicing something called “AI washing,” which Securities and Exchange Commission chair Gary Gensler explained in a video includes “false claims to investors by those purporting to use those new technologies.” (CNBC, May 2024)

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RBA trapped by rising unemployment and inflation

Key Points

  • The RBA maintained the cash rate at 3.6%.
  • The strong housing market creates a wealth effect that encourages spending.
  • However, unemployment is rising, and the RBA can’t do much because of the upturn in inflation.

The RBA held rates steady at 3.6%, citing the recent upturn in inflation. Although some inflationary pressures are viewed as temporary, the policy statement says the housing market is strengthening and the labor market is “a little tight.”

We believe the labor market is deteriorating despite the “pick-up in private demand” mentioned in the RBA policy statement. ANZ-Indeed job ads declined by 2.2% in October, bringing the annual change to -7.4%.

Australia: Job Ads

The decline emphasizes the surprise increase in the unemployment rate to 4.5% in September. The graph below compares job ads on an inverted scale (blue – LHS) against the unemployment rate (red – RHS).

Australia: Job Ads & Unemployment

Growth in monthly hours worked is also slowing, and we expect the uptrend in unemployment to continue.

Australia: Aggregate Hours Worked

Housing

Building approvals for private dwellings indicate resilience in the housing market, with the 3-month moving average (15.5K) above its 20-year moving average.

Australia: Building Approvals

Housing prices continue to reflect a market shortage due to high immigration.

Australia’s home value growth hits the fastest pace in over two years as national dwelling values surged 1.1% in October, marking the strongest monthly gain since June 2023 and pushing the annual growth rate to 6.1%. (Cotality)

Conclusion

Australia faces a similar K-shaped economy to the US.

Rising housing values and a buoyant stock market create a wealth effect, encouraging spending by wealthier consumers.

However, the increase in demand has not translated into strong job growth. Unemployment is rising, and growth in monthly hours worked has slowed, but the RBA can’t do much while inflation is increasing.

Acknowledgments

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A sense of urgency | Joseph Calhoun

There is no sure fire way to know if you should be buying an asset that has already risen a lot. I do think that your sense of urgency is a pretty good contrary indicator. If you feel like you absolutely, positively need to buy some asset today, you might want to just hold off a bit and see if prices come back down. And I don’t mean you have to wait until it crashes because it may not, but we all know that prices that have been rising rapidly won’t continue to do so indefinitely.

~ Joseph Y Calhoun III, Alhambra Partners

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US Stock Pricing at New High

Bull/Bear Market Indicator
Stock Market Pricing Indicator

The gauge on the left indicates bull or bear market status, and the one on the right reflects stock market valuation levels. Stock market pricing indicates whether stocks are cheap or expensive relative to earnings, but it is a poor indicator of market timing. We do not recommend selling stocks because the market valuation is high. Still, we would advise investors to be circumspect about adding new positions without carefully investigating the underlying value.

Bull/Bear Market

The Bull/Bear indicator remains at 40%, warning of a bear market ahead. Updates to three market indicators (highlighted in orange below) are delayed because of the US government shutdown.

Bull-Bear Market Indicator

The Philadelphia Fed Coincident Economic Activity Index deserves mention in the absence of updates for some of our regular indicators. A decline below 2.5% typically only occurs several months ahead of a recession.

Coincident Economic Activity Index
The Chicago Fed National Financial Conditions Index continues to signal loose monetary conditions, supporting high stock prices.

Chicago Fed National Financial Conditions Index

However, a decline in bank reserves below $3.0 trillion warns that repo markets are tightening.

Commercial Bank Reserves

And Bitcoin continues to test support at 110K, warning of tighter liquidity.

Bitcoin (BTC)

Stock Pricing

Stock pricing increased to a new high of 98.66 percent, compared to an April low of 95.04 percent. The extreme reading warns that stocks are at risk of a significant drawdown.

Stock Market Value Indicator

We use z-scores to measure each indicator’s current position relative to its history, with the result expressed in standard deviations from the mean. We then calculate an average for the five readings and convert that to a percentile. The higher that stock market pricing is relative to its historical mean, the greater the risk of a sharp drawdown.

Robert Shiller’s CAPE index climbed above 40 for the first time ever outside of the Dotcom bubble. CAPE compares the S&P 500 index to a ten-year average of inflation-adjusted earnings.

S&P 500 CAPE

Conclusion

The bull-bear indicator at 40% warns of a bear market ahead, while extreme pricing increases the long-term risk of a significant drawdown.

Acknowledgments

Notes

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ASX Leading Indicators

Bull-Bear Market Indicator
Stock Market Pricing Indicator

The gauge on the left indicates bull or bear market status, while the indicator on the right reflects stock market valuation. Stock market pricing indicates whether stocks are cheap or expensive relative to earnings, but it is a poor indicator of market timing. We do not recommend selling stocks because the market valuation is high. Still, we advise investors to be circumspect about adding new positions without carefully investigating the underlying value.

Bull/Bear Market

The ASX Bull-Bear Market indicator remains at 56%, down from 66% three weeks ago. Four indicators from Australia and China indicate risk-on, with a 60% weighting, while the US Bull/Bear indicator has a 40% weighting.

ASX Bull-Bear Market Indicator

China’s NBS Manufacturing PMI fell sharply from 49.8 in September to 49.0 in October. A PMI below 49.0 signals risk-off.

NBS China Manufacturing PMI

September Australian building approvals will be released on Monday, where the 3-month moving average was close to a risk-off signal in August.

Australian Building Approvals

Stock Pricing

ASX stock pricing declined to 88.70 percent, compared to a high of 92.23 percent in August and a low of 67.85 percent in April.

ASX Stock Market Value Indicator

We use z-scores to measure each indicator’s current position relative to its history, with the result expressed in standard deviations from the mean. We then calculate an average for the five readings and convert that to a percentile. The higher that stock market pricing is relative to its historical mean, the greater the risk of a sharp drawdown.

Conclusion

The ASX bull-bear indicator reflects a mild bear market, while extreme valuation increases the long-term risk of a significant drawdown.

Acknowledgments

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