Don’t Look Down

‍

Setting Up for a Crescendo?

‍

Soundbite: As we mentioned last week, investors are not worried about the downside. Their concerns are missing further upside, and they are scrambling to buy the highs. Normally, dealers are long options because clients are generally selling options to them to generate premium income. When dealers are long options, their position exposure gets longer when stocks rally and shorter when stocks drop. As they hedge by selling into rallies and buying selloffs, it has a dampening effect on price action. Over the past few weeks, however, investors started to buy calls as they worry about missing an extended rally. Now, dealers change to net short from long as clients buy these call options, and dealer behavior changes from selling to buying as stocks rally. Unfortunately, this bullish benefit turns negative during any selloff, and they add to the downside by selling into it. With investor sentiment readings as high as they have been since President Trump’s election, we may be approaching an inflection point.

Investors who thought that they had been able to gauge where tariffs were and then step back into the stock market at new highs are faced with new ones cropping up, making it problematic to determine the economic impact of the final tariff settlement. Hence, we do not know the economic impact on consumption, profitability, or inflation, making current positioning unstable and prone to quick changes. 

During the selloff into the April 7 lows, portfolio gross and net positions were cut drastically. Investors stayed underinvested during the first stage of the rally because the prevailing sentiment was that tariffs would be stagflationary. As prices continued to move higher over the last few weeks, call option skew rose, meaning investors were scrambling to pay up for out-of-money calls.

Short call option positions were closed as investors moved quickly from a consensus of “the world is on fire to “I just can’t get enough.” Additionally, new long call positions were opened as new highs were seen as likely. This flipped dealers’ option inventory from long to short, creating a need for them to hedge by buying the underlying stock or index as prices rise.

This dealer buying extended this rally, and the melt-up has fueled bullish sentiment even further. The American Association of Individual Investors AAII sentiment has returned to its most bullish reading since the week after the election. CNN’s Fear and Greed Index has exploded into Extreme Greed territory as the put/call ratio, the VIX, and high yield spreads have plummeted.

Investors are bullishly one-sided. That creates the potential for selling if prices reverse lower because they will be forced to liquidate to cut losses.

If investors panic over renewed weakness, they will buy puts, which gets the dealer community short puts, creating the conditions for a sharp selloff, echoing the chaos from three months ago. Be mindful of selloffs that accelerate.

‍

Why We Are Attached to Marginally Attached Workers

‍

Soundbite: Companies are faced with either lower revenues if they pass through tariffs, or a reduced bottom line if they do not pass them on to customers. Higher prices will soften demand for tariffed goods, but demand will soften across all goods and services  if workers question their job security. The overall employment data reflects a stable labor market, but we are growing concerned because our favorite leading indicators such as the Employment Trends Index diverged further from rising payrolls, and importantly, the June data holds unwelcome news about marginally attached workers.

On the surface, the June employment report continued the theme of a healthy consumer, with average hourly earnings still growing at a high 3.7% annual rate that is a pillar for solid corporate earnings forecasts. Those classified as working part-time for economic reasons have been slowly rising for three years, but contracted over the last four months, which some could view as a renewed sign of optimism.

The important thing to remember is payroll data is a coincident indicator. Initial and continuing claims are leading indicators, and they have unfortunately begun to rise. Claims are not at alarming levels, but a less well-known data series tracking  marginally attached workers just moved into the red zone.

The Bureau of Labor Statistics defines those individuals unable to find a job but continuing to look for one as “Marginally Attached Workers”. That series can spike right before recessions, and June’s employment report hit a 14-year high. Marginally Attached Workers increased by 362,000, which was close to the January 2008 reading of 385,000 recorded as the recession started. To put the June number in perspective, since that 2008 surge, there have been only three months that have been higher, placing June above the 98th percentile.

A second category of Marginally Attached Workers, called “Discouraged Workers” are those who want a job but have given up looking for work; this category jumped in June to levels not seen since the pandemic.

Companies are not spending their profits on hiring more staff (or increasing capex) due to tariff uncertainty. What has helped buoy the stock market recently is that those companies have decided instead to plow those profits into stock buybacks. If the labor markets weaken, so does consumption, and that will mean companies will have fewer profits to apply toward buybacks at a time when their stocks are overvalued and margins are at peak levels. This would leave equities vulnerable to a potentially strong correction.

‍

ABC’s of the QRA

‍

Soundbite: Every quarter the Treasury announces the size and maturities of securities to be auctioned to finance the federal deficit. Since 2023, the proportion of Treasury Bills sold has been too high, and in May, it represented more than 21% of the total securities scheduled for auction. This is a marked change from the general range of 10-15% that existed before the pandemic. The President wants to abandon coupon securities altogether and focus only on short term issuance (three-to twelve-month bills) until rates fall.

Secretary Scott Bessent was a vocal critic of Janet Yellen’s move to make the quarterly Treasury supply even more bill intensive. However, he may be forced to do something dramatic to appease the President to avoid becoming a target like Fed Chair Powell. While the market may welcome fewer coupons auctioned, Bessent could be risking a debt downgrade if the percentage of bills becomes excessively high. The upcoming July 31 issuance release could inject volatility into the markets and could be the most important release for the rest of the year.

The temptation exists for each quarterly issuance decision to heavily overweight bills (maturities below 12 months) where there is a well-defined, deep demand from money market funds and potential new demand from stablecoins. However, the Treasury Borrowing Advisory Committee (TBAC), comprised of major fixed income participants, has pushed back against front loading the supply schedule. Their reasoning is that if too much of the budget is financed at the short end, it could create more interest rate instability. If rates rise, it will drive up the government’s interest expense, significantly widening the budget deficit.

The last TBAC report was released on April 29 and advocated for no change to the maturity mix to avoid adding to pressure on the 10-year during unstable market conditions. Now that markets have calmed down, we are curious to see if they return to their cautionary stance against excessive bill supply when they publish their next report on July 29.

No one knows the changes that will be released on July 31 in the next QRA. Emerging market government issuance suffers from lower demand for longer term coupons and are forced to issue too many short-term securities that regularly needs to be rolled over. Of course, the U.S. bond market is the deepest in the world and is far from emerging market status. However, pushing too far above 21% for bills pushes our market toward an unstable funding situation. The upcoming releases this month and the market’s reaction to them could create more than a ripple of anxiety.

‍

What to Look for This Week

(All times D.S.T.)

‍

1. Tuesday, July 8 at 11:30 a.m. New York Federal Reserve’s Survey of Consumer Expectations for June. We are keying on the three- and five-year ahead expectation data. Both have been subdued, which has kept many Federal Open Market Committee members comforted that inflation expectations are contained. Since the election, there has been an increase in three-year expectations that exceed 2%. This increases the chances of a headline number that could rise. Earlier on Tuesday, the National Federation of Independent Business releases June’s Small Business Economic Trends Survey at 6:00 a.m. There were major increases in those expecting the economy and sales to improve in May, so those are key subcategories to watch.

2. Wednesday, July 9 at 7:00 a.m. the Mortgage Bankers Association MBA Purchase Index for the first week of July. The series has been strong the last four weeks as mortgage rates have begun to soften slightly. Homebuilder stocks have fallen sharply relative to the S&P 500 since the election but have begun to recover from two-year lows over the past few weeks. We will be watching their reaction on Wednesday morning.

3. Thursday, July 10 at 8:00 a.m. Initial Jobless Claims and Continuing Claims. Initial Claims have contracted for three straight weeks, so if this trend continues, it will bolster bullish views that the resilience of last Thursday’s nonfarm payroll report was valid. However, over the last two weeks, Continuing Jobless Claims hit highs not seen since Q4 2021. This is an important release.

FOMC Voters Speaking: The Fed Minutes are released on Wednesday, July 9 at 2:00 p.m. The meeting left rates unchanged for a fourth meeting, but in their Summary of Economic Projections, they raised their year-end inflation forecast by 0.3% to 3%. We will be looking for more detail in the minutes. St. Louis Fed President Alberto Musalem speaks at 10:00 a.m. on Thursday July 10. He has warned in the past about the potential for inflation expectations to rise, and the inflationary potential of the administration’s immigration policy. Given the recent acrimony coming from the White House, we will see if he softens his tone. Later that day, Fed Governor Christopher Waller speaks at 1:15 p.m. He seems to be in the minority calling for a cut at the July 28-29 meeting. Given that most of the FOMC voters are leaning toward no change for that meeting, plus the latest payroll data, we will see if he changes his view. If not, it bolsters the consensus that he is hoping to be considered for the Chairman’s position next year.

‍