John Williams Changes the Tune

(Today’s theme music is a selection of John Williams’ – the composer, not the central banker – themes.  Take your pick as to whether Indiana Jones, Darth Vader, or the shark from Jaws is the best soundtrack for today.)

This morning had the potential to be another nasty one.  A brief attempt at an overnight bounce faded, and many of us woke up to another combination of lower stock futures and bitcoin.  Then, in a speech in Chile, New York Fed President John Williams improved the odds for a rate cut in December.  Stocks spent much of the first part of the session meandering around the unchanged line but then began a concerted move higher after European markets closed.  As we saw yesterday, correlations can influence short-term market movements, but fundamentals still matter more.

Here is the phrase that has calmed markets:

I view monetary policy as being modestly restrictive…Therefore, I still see room for a further adjustment in the near term to the target range for the federal funds rate to move the stance of policy closer to the range of neutral

It sounds relatively benign, but it had a profound effect on the likelihood of a rate cut at the next FOMC meeting.  CME futures are now indicating a roughly 65% probability for a cut on December 10^th, nearly double yesterday’s 35% chance.  ForecastEx traders broadly agree, with a 63% “yes” for a 25-basis point cut at that meeting. 

Some of you might be wondering why a set of comments from a single regional Fed President would be sufficient to not only reverse markets’ course, let alone send them zooming.  The turnaround, if not the zoom, can be explained by the New York Fed’s outsized role at the Federal Open Markets Committee.  While 11 of the 12 regional Reserve Bank Presidents serve on the committee on a rotating basis, the New York Fed President has a permanent seat because of its role in implementing the FOMC’s policies via the capital markets.  Various Fed watchers refer to a “leadership troika”, consisting of the Fed Chair, Vice Chair, and NY Fed President.  Under that perception, it is clear why the views of a member of that group would seem to outweigh those of other FOMC members.

As for the “zoom”, well, that’s up to traders and their habits.  We have noted not only traders’ oft-rewarded propensity to buy dips, but to chase rallies.  The former strategy is based upon perceptions that stocks, bonds, or any other tradeable instruments can become underpriced on a short- or long-term basis.  That assessment can be based on valuations or fleeting oversold conditions.  We can certainly debate whether traders have become overly dependent upon this strategy or whether it is being overused indiscriminately – there is a plausible case to be made for both – but dip buying is indeed rooted in an assessment of fundamentals.

Rally chasing, however, is rooted in the concept of momentum.  When a trend presents itself, it becomes quite simple to follow it.  It can also be seductive to follow that trend to the point where it becomes overextended.  When one does that, it means that prices can more easily become disjointed from valuations.  We have explained that:

… fundamentals don’t really matter when momentum rules.  Price action, not the underlying justification for those prices, is all that’s important.

Frankly, I believe that rally chasing caused some of the trouble yesterday and is potentially setting us up for it once again today.  We were off to a solid start yesterday, thanks to a well-received earnings report from Nvidia (NVDA), but then traders extended that rally in the first hour of the day.  I will assert that the trading rally went beyond the solid fundamental report, making stocks more susceptible to a drop when the mood changed.  It is far too early to know if something similar will transpire again today, but we seem to have moved from a situation where a sober assessment of interest rate probabilities that calmed unsteady nerves into a Friday “buy and chase” rally using expiring options as a catalyst.

2-Days, 2-Minute Candles, ES December Futures

Source: Interactive Brokers

One reason for my skepticism about the sustainability of today’s move comes from the nature of yesterday’s.  We experienced what technical analysts call a “bearish outside reversal” in the S&P 500 (SPX).  That occurs when a stock or index has a higher high than the prior days but finishes below the prior day’s low.  That indicates a major change in short-term sentiment.  For reference, a “bullish outside reversal” occurred at the April lows in the post-tariff selloff.  I can’t assert that a similar change in mindset occurred yesterday on a long-term basis – there were many other important factors that led to the April recovery – but I do believe that at least in the near term, traders need to be more prepared to sell rallies than buy dips.

SPX 3-Months, Daily Candles

Source: Interactive Brokers

Finally, I’d like to share a clip from an impromptu media appearance that I made yesterday.  A network producer asked for a reason behind yesterday’s abrupt reversal, and she seemed to like what I had to say so much that she invited me to discuss it on air about an hour later.  I think it resonated.