Don’t Short a Dull Tape –Fed Funds Edition

One of the classic adages that guides my thinking is “don’t short a dull tape.”  The construction is anachronistic – there hasn’t been a ticker tape in decades – but the logic is not.  Periods of low volume imply lower liquidity, and lower liquidity implies that intraday moves can get extended.  We’re seeing this in action this week, and it could easily persist on Friday’s half-day/month-end.

There is a solid rationale for the recent enthusiasm that is taking advantage of the pre-holiday relative lull.  As we noted last week, the market’s mindset flipped almost instantly on Friday morning after comments by New York Fed President Williams that he favored a 25-basis point cut in the Fed Funds target rate at the upcoming December 10^th meeting.  We saw an immediate near doubling in the market’s expectations for a cut, and those odds have continued to improve in the ensuing days.  Both the CME FedWatch and ForecastEx currently show a roughly 82% likelihood for a cut as I type this.  This is up from roughly 30% just last week. 

ForecastEx “Yes” Price for “Lower 25bps” in December

Source: ForecastEx

CME FedWatch Probabilities for Today, Yesterday, 1-Week, and 1-Month Ago

Source: CME

Stocks love the prospect of interest rate cuts.  They are catnip to liquidity-loving traders.  Heck, there is a reason for the more powerful adage “don’t fight the Fed.”  Liquidity is the lifeblood of financial markets, and if the Fed is planning to make liquidity either more plentiful or cheaper, there is little reason to stand in the way of that activity.  The following chart shows the relationship between Fed Funds and ES (S&P 500 Mini) futures since the last FOMC meeting – which, not coincidentally, was the last closing high for the S&P 500 (SPX) index:

1-Month, December Fed Funds Futures (ZQ, red/green 30-minute candles), S&P 500 December Mini Futures (ES, blue line)

Source: Interactive Brokers

When we look at the chart above, the influence of Fed Funds on SPX becomes apparent.  Yet as last Thursday’s huge reversal was occurring, we noted the short-term relationship between NQ (Nasdaq 100 Mini) futures and bitcoin, and blamed a slide in bitcoin for turning enthusiasm for Nvidia (NVDA) earnings into a substantial decline.  Various factors can influence stocks at any given time, and the recent precarious nature of the cryptocurrency markets amidst a sustained decline in those assets was enough to flip the mood among a wide group of active traders.  A big part of bitcoin’s recent uptrend was powered by the popularity of bitcoin ETFs in the wake of a new crypto-friendly administration.  But that also meant that there was a convergence between those who traded and invested in cryptocurrencies and stocks.  As I put it recently,

The bottom line is, bitcoin is for normies now.  As a result, the normies are going to view it as another speculative holding in their portfolio … it’s going to be treated like a volatile mainstream investment.

But after that brief flirtation with using bitcoin as a “lead” for stocks, we’re back to the more meaningful relationship between rates and stocks.  We can certainly question whether 25 basis points is really worth adding trillions of dollars of market capitalization to the entire stock market, but that would be nitpicky.  This is less about the effect of short-term rates on the bottom lines of index constituents than the willingness of investors to expand multiples (paying higher prices for a given level of earnings) when rates decline.

Back to the original premise of “don’t short a dull tape” – when volumes and trader attention decline, so does liquidity.  Spreads widen and posted sizes shrink, meaning that less volume is required to get prices moving.  Given the path of interest rate probabilities and its tight relationship with major indices, it is quite possible for sizeable rallies to take hold on skimpy volume.  The recent average daily volume on the consolidated US tape is around 19 million shares.  Monday’s sharp advance occurred on roughly that level of volume.  We normally want to see major moves be bolstered by higher-than-average volume, which was the case last Friday.  Volumes were nearly 11% lighter yesterday, and the pace is even slower today.  Yesterday we noted that Friday’s half-day coincides with month-end, meaning that an institution that wants to do a bit of window dressing might find it especially easy under those conditions.  We may be getting overbought and overextended on a short-term basis, but it is difficult to stand in the way of a concerted advance when volumes are light.

Happy Thanksgiving to those who celebrate.  Happy Thursday to everyone else.