In 1991 Billy and Akaisha Kaderli retired at the age
of 38. Now, into their 4th decade of this
financially independent lifestyle, they invite you
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Last week, we
noted that the market was not expecting retaliation from China.
“Rather than coming
to the table to negotiate, China responded with a reciprocal 34% tariff on
the U.S. plus export controls on rare earth metals needed for technological
production. China is playing “hardball” negotiating tactics with Trump. This
was a smart move from a negotiating standpoint by China, allowing
President Xi to open tariff discussions from a point of strength. However,
without some resolution to the extraordinary tariffs, the market will remain
in turmoil for quite some time.”
That battle persisted this week as Trump raised tariffs on China to 104%, and
China then retaliated with a further tariff increase of 84%. However, as we said
last week, any good
news would cause the market to rally sharply. On Wednesday, President
Trump announced a 90-pause on the full effect of new tariffs. Interestingly, the
same headline sent stocks surging on Monday but was quickly deemed “fake
news” by the White House. I suspect that Monday was a “leak” by
the White House to test the market response, and President Trump kept that
announcement handly to stave off a further decline in the markets. Whatever the
reason, the markets needed the break. Here is Trump’s full statement:
From a technical view, the market completed an expected retracement from the
October 2022 lows. Last week, we laid out the potential correction levels.
The recent
lows are around 5500.(That
level was violated)
Immediately
below that is the 38.2% retracement level at 5134(Is
being challenged)
Lastly, the
50% retracement level at 4816 should hold, barring the onset of a fiscal
event or recession.
Notably, we stated that:
“The market
should be able to find some support at this level and
muster a short-term rally next week. However, there is a downside
risk to 4816, which would be a 50% retracement of the bull market rally. Any
positive announcements over the weekend could spark a relatively robust
reversal rally, given the more than three-standard deviation gap between
where the market closed and the 50-DMA.“
That 38.2% retracement level, using the bull market from October 2022 lows, was
broken early Monday morning as stocks plunged lower amid rising tariff concerns
and a blowup in the bond market. However, the market finally tested the 50%
retracement level on Wednesday morning. Given the deep oversold condition,
President Trump’s announcement to pause tariffs led to the 3rd largest
single-day rally since WWII. For now, the market should be able to hold support
at the previous lows and hopefully find a bit more relief into next week.
As I noted in the previous two weeks, we strongly lean toward the potential of
the markets beginning a more extensive corrective process, much like in 2022. We
will revisit that analysis in this weekend’s newsletter. However, while we are
concerned about a continued correction process as markets realign prices to
forward earnings expectations, there will still be strong intermittent rallies.
As noted last week, nothing
in the market is guaranteed. Therefore, we continue managing risk
accordingly, and as we stated last week and executed on Wednesday, we are now
in “sell
the rally” mode until the markets find equilibrium. When that will
be, we are uncertain, so we continue to watch the technicals, make small moves
within portfolios, and reduce volatility risk as needed.
This week, we will revisit the 2022 scenario and the “basis
trade,” which threatens the financial markets.
Credit
Spreads Sending A Warning
As discussed in “Credit
Spreads,” the one market signal worth your attention is “credit.”
Credit spreads reflect the perceived risk of corporate bonds compared to
government bonds. The spread between risky corporate bonds and safer Treasury
bonds remains narrow when the economy performs well. This is becauseinvestors
are confident in corporate profitability and are willing to
accept lower yields for higher risks. Conversely, during economic uncertainty or
stress, investors demand higher yields for holding corporate debt, causing
spreads to widen. This widening often signals investors are growing concerned
about future corporate defaults, which could indicate broader economic trouble.
The two charts above show that credit spreads are essential for stock market
investors. Watching spreads provide insights into the health of the corporate
sector, which is a major driver of equity performance. When credit spreads
widen, they often precede liquidity events, reduced corporate earnings, economic
contractions, and stock market downturns. Widening credit spreads are commonly
associated with increased risk aversion among investors. Historically,
significant widening of credit spreads has foreshadowed recessions and major
market sell-offs. Here’s why:
Corporate
Financial Health: Credit spreads reflect investor views on
corporate solvency. A rising spread suggests a growing concern over
companies’ ability to service their debt. Particularly if the economy slows
or interest rates rise.
Risk Sentiment
Shift: Credit markets tend to be more sensitive to economic shocks
than equity markets. When credit spreads widen, it typically indicates that
the fixed-income market is pricing in higher risks. This is often a leading
indicator of equity market stress.
Liquidity
Events: As investors become more risk-averse, they shift capital
from corporate bonds to safer assets like Treasuries. The flight to safety
reduces liquidity in the corporate bond market. Less liquidity potentially
leads to tighter credit conditions that affect businesses’ ability to invest
and grow, weighing on stock prices.
The recent market disruption caused by Trump’s trade war has undoubtedly widened
spreads between “risk-free” treasury
yields and corporate bonds. However, while those spreads have widened, they
remain well below the long-term averages. With inflation and economic growth
slowing, this week’s violent turmoil in the Treasury bond market is a signal of
more than just recession concerns. As we noted in our Daily
Market Commentary:
“On Monday,
Treasury bonds had a sharp decline far beyond what the economic or tariff
data suggested would be the case. We
suspect that on Monday, there was forced liquidation through either margin
calls or demand redemption of an institutional fund. The outsized
selling and volume on a single day for bonds is highly unusual. The media
excuses of “tariffs” or “economic concerns” are issues the bond market has
known about for quite some time.”
That type of sharp liquidation has historically been the issue of some liquidity
events in the bond market. In this case, it appears to be the heavily leveraged
arbitrage trade used by hedge funds.
The “Basis
Trade” – A
Near LTCM Moment
For a simple explanation of the basis trade, I asked Grok:
“The “basis
trade” in the Treasury bond market is a strategy commonly used by hedge
funds to profit from small price discrepancies between Treasury bonds (the
cash market) and Treasury futures contracts. Here’s how it works: hedge
funds buy Treasury bonds while simultaneously shorting Treasury futures (or
vice versa), betting that the price gap, or “basis,” between the two will
converge. This trade relies heavily on leverage—often 20 to 56 times the
initial investment—borrowed through the repurchase (repo) market, where
Treasuries are used as collateral. The goal is to capture small, consistent
profits from this arbitrage, amplified by the leverage while assuming the
relationship between cash bonds and futures remains stable.”
While the Fed suggests that the hedge fund basis trades leverage is above 50x,
the Treasury Borrowing Advisory Committee wrote in January that “20x
appears to be a good approximation of leverage typically used in these trades.”
If you don’t
understand that math, it simply means that a 5% loss at 20x leverage is a 100%
loss on the trade.
Furthermore, just for context, when Long Term Capital Management (LTCM) blew up
over an unexpected move in interest rates, it cost the Fed $100 billion to keep
financial markets afloat. As shown below, the current magnitude of today’s hedge
fund giants running these “basis
trades” are multiples of LTCM.
As of this past week, the market liquidity event appears to be the “basis
trade” unraveling. This turbulence is driven by hedge funds being forced to
unwind their basis trade positions as Treasury prices drop (and
yields rise.) That change in the value of the collateral backing those
leveraged bets decreases, triggering margin calls from lenders. To meet those
margin calls, hedge funds must sell their Treasury holdings, which exacerbates
the downward pressure on bond prices, increasing yields, which triggers more
liquidations.
This “liquidation
event” in the bond market is very reminiscent of the “Repo
Crisis” in 2019 and the “Dash
For Cash” during the COVID-19 pandemic. It also reminds us of the “Silicon
Valley Bank Crisis” in 2023. In all three events, the Federal
Reserve stepped in to provide liquidity to the Treasury market. As Deutsche Bank
noted on Wednesday:
“As far as
the marketcircuit-breakers go,
if recent disruption in the US Treasury market continues we
see no other option for the Fed but to step in with emergency purchases of
US Treasuries to stabilize the bond market (“emergency QE”). This
would be very similar to the Bank of England intervention following the gilt
crisis of 2022. While we suspect the Fed could be successful in stabilizing
the market in the short-term, we would argue there is only
one thing that can stabilize some of the more medium-term financial market
shifts that have been unleashed: a reversal in the policies of the Trump
administration itself.”
I have updated the chart for this week’s market close. The massive rally on
Wednesday completed the 50% retracement from the low, which allowed us to reduce
portfolio risk in portfolios. Most likely, the correction process that started
with the break of the 200-DMA is likely not yet complete. We will discuss those
actions in the “How
We Are Trading It”section below.
The market tells us that the risk of a more significant correction or
consolidation process is increasing, particularly as economic growth slows and
valuations are repriced for reduced earnings growth expectations. As we noted in
that article two weeks ago:
“While such
does not preclude a significant counter-trend rally in the short term, the
longer-term risks seem to be growing.”
So far, the current corrective cycle, including the massive reflexive rally this
week, remains very reminiscent of the 2022 correction. If we enter another
corrective period like 2022, given some of the same technical similarities,
there is a decent “playbook” to
follow despite substantial differences. In 2022, the Fed was hiking rates,
inflation was surging, and economists were convinced a recession was on the
horizon. As noted above, earnings estimates were revised lower, causing the
markets to reprice valuations. Today, the Fed is cutting rates, and inflation is
declining; however, due to Trump’s trade policies, the risk of recession is
rising, and earnings estimates likely remain overly optimistic. We
must realize that the analysis can change as time passes.
However, let’s review the 2022 correction process. In March 2022, the market
triggered the weekly “sell
signal” as it declined. Notably, the market rallied sharply after the “sell
signal” was initially triggered. Much to the same degree as we saw on
Wednesday. Such a rally is unsurprising, as when markets trigger “sell
signals,” they are often profoundly oversold in the short term. However,
that rally was an opportunity to “reduce
risk,” as the failure of that rally brought sellers back into the market.
The “decline,
rally, decline” process repeated until the market bottomed in October. One
of the defining things we will be looking to identify where the current market
will bottom is the positive divergence of momentum and relative strength. Even
though markets continued to struggle in the summer or 2022, the positive
divergences suggested that market lows were near.
In that article two weeks ago, we stated:
“With the
market approaching decently oversold levels, I expect a rally to start as
soon as this week or next.”
That rally occurred, and we are starting to track the initial “sell
signal” process as of 2022. Such suggests we could see a further rally over
the next week.
We used the rally this week to reduce portfolio risk and raise cash levels, and
we will continue that process on a further rally. While
no two corrections are the same, it is essential to understand that corrections
do not occur in a straight line. With the weekly sell signal in place,
investors should expect that we will likely see further declines, which will
likely be punctuated by short-term rallies that allow investors to rebalance
portfolio allocations and reduce risk as needed.
With that understanding, this is what we did this past week.
The views expressed by Lance Roberts are not
necessarily those of RetireEarlyLifestyle.com
Billy and Akaisha Kaderli are
recognized retirement experts and internationally published authors on
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information they share on their award winning website RetireEarlyLifestyle.com,
they have been helping people achieve their own retirement dreams since
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Adventurer’s Guide to Early Retirement and Your
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Early Lifestyle appeals to a different
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