Stocks fell last week for the fourth week in a row and there was the whiff of panic mid-week. Despite that losing streak the S&P 500 is only 6% from its all time high but the pain for the leveraged investing crowd (the misnamed “hedge” funds) appeared to hit a crescendo last week – at least for now. Wednesday last week we got close to the Wall Street definition of official correction of down 10% and with bond yields falling like politicians’ approval ratings there was a moment when it looked like we might finally be on the verge of creating some bargains in stocks. Alas, James Bullard of the St. Louis Fed decided that surging bonds, falling inflation expectations and falling stocks was just a bit too much and took the opportunity to opine on Bloomberg that maybe the Fed should hold off on ending QE3; stock buyers got the hint and the Dow surged 500 points from the lows. He was careful to say that he still thought the US economy was hunky dory and that rate hikes should still come next year but if you had any doubts about what indicators the Fed is watching, you got your answer. The Yellen put, if ever doubted, has been affirmed.

The bond market riot last week, in which the 10 year Treasury note yield dropped nearly 40 basis points in a matter of hours and then recovered over the next two days, was I think a warning about the dangers of receding liquidity and not, as many seemed to assume, a statement about the fundamentals of the US economy. The surge in bond prices coincided with two weaker US economic reports but the move was, in my opinion, too large to be justified by the data. Certainly, there were, prior to Wednesday’s bear massacre, a large number of shorts in the long end of the US Treasury curve, but to believe that all of them simultaneously decided to cover their shorts on two weaker than expected reports (retail sales were down 0.3% but after a surge last month and the Empire State manufacturing survey was less than expected but still positive) is a bit too simple to satisfy.

A more likely explanation is that the Fed’s attempt to wean the market off the morphine of QE is coming a cropper. Moves like we saw Wednesday in the bond market are more often associated with stress in the system due to a lack of liquidity. It had all the hallmarks of a leveraged trade coming undone with a bank or broker closing positions without regard to price. In other words, it appears more likely to have been a margin call than an economic one. Of course, I don’t know that to be true and maybe the “interest rates have nowhere to go but up” crowd finally capitulated but it sure does seem odd that they all came to the same conclusion at exactly the same time.

Other evidence of reduced liquidity emerged in the WSJ a few days later when they reported that corporate and junk bond sellers were having problems finding buyers. Banks and brokers are not stepping into the void and using their balance sheets to absorb inventory as they have in the past. Part of the reason is regulatory, as Dodd-Frank limits their ability to warehouse bonds, and part is probably just a reduced appetite for risk which can also be seen in the rise of Treasuries on their balance sheets. One last clue that the Treasury market surge was a function of liquidity, was the coincident fall in stocks which at one point Wednesday saw the Dow down nearly 500 points. When there are liquidity issues in the market, funds sell what they can rather than what they want and US stocks are about as liquid as they come.

Which of course, begs the question of what exactly was causing the pain for the leveraged crowd? I really don’t know but European bonds immediately come to mind. The bonds of the European periphery have been selling off for the last month and finding a buyer for a Greek or Italian bond right now, especially considering the state of the European banking system, is probably not merely a matter of picking up the phone. If you’ve got a margin call because your European bonds are tanking and you can’t find a buyer, it would be considerably less painful to close another position – say short US Treasury bonds or long oil or long US stocks – than to take an even bigger haircut on your allegedly safe European government bonds. Certainly it isn’t hard to imagine a large leveraged fund long European bonds and US stocks versus a short in US Treasuries. That trade has worked – or at least it did for the last two years – like a charm for so long that you might begin to think you’ve found a perpetual motion machine or at least a golden goose.

It must be causing some heartburn at the Fed to realize that the markets, on which they’ve hung their hat as stimulus, can’t seem to deal with the withdrawal of liquidity that ending QE implies. If one believes that higher asset prices are stimulative – the wealth effect – then falling asset prices are a major problem. Bullard cited falling inflation expectations in his Bloomberg appearance and the Fed is certainly fearful of anything that has a whiff of deflation to it, but it is not just the TIPS market that has the Fed’s attention. If the selloff in risk assets goes too far it risks creating the very recession the Fed is trying to avoid. If you have an economy growing at roughly 2% and the junk bond market seizes up, the reduction in credit to the marginal borrower may be enough to push the economy over into contraction. If spending has really been raised by higher stock prices, then a reversal must surely produce the opposite and considering the psychological impact of losses versus gains, probably by more than it was raised.

I don’t know how all this will play out over the coming weeks and months. Maybe it is just a matter of the market adjusting to the new liquidity conditions and a short delay of the end of QE will allow that to happen in a benign manner. Or maybe not. Certainly we don’t have sufficient evidence at this point to say the US is headed for recession but then we never do right before it happens. But bond markets have been signaling economic weakness all year and the divergence between stocks and bonds was untenable; one of them was obviously wrong and for now the market is saying that bonds are winning the argument. That would not seem to bode well for a stock market that even after this correction is far from cheap. So, to answer the question that is the title of this post, not likely.

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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or   786-249-3773. You can also book an appointment using our contact form.