liquidity cycle

[dtrader98]

Zoom in of local region on prior chart overlay. Up to mid 90s.

Also, notice both periods started (and volatility peaked) near the bottom of their respective economic recession troughs.

<img src="http://elitetrader.com/vb/attachment.php?s=&postid=1549049" border="0" alt=""><br /></font></p></font></p>

 

[dtrader98]

Some ISEE investor sentiment updates for fellow insomniacs.

<img src="http://elitetrader.com/vb/attachment.php?s=&postid=1550284" border="0" alt=""><br /></font></p></font></p>

Always good to see how the crowd thinks at the extremes.

This is from an earlier thread I posted...

Interesting quote I pulled off the internet.

"In a market like this, every story is a positive one. Any news is good news. It's pretty much taken for granted now that the market is going to go up." - Wall Street Journal, 8/26/87, the day after the 1987 market peak


This is VERY different from today's environment. Headlines today would read more like, "In a market like this, every negative story is spun as a positive one. No one can believe that the market is going up."

The fact that joe investor sentiment is so different is what is causing shorts to pile on like there's no tomorrow. A few wise observers have noted that the market will try to screw the most participants most of the time. In this case the majority are bearish right now.

In order to think of the sentiment differences between 87 and 95 (as seen in VIX/S&P chart), here are some headlines from those periods --


Oct 09, 1987 -- Stocks Plunge, Partly in Reaction To Sell Signals From Forecasters

Wall Street Journal, 10/8/87


Jul 13,1995 "Soaring stock market puzzles industry analysts"
St Louis Post

Aug 6,1995 "Stock market looks for next fed rate cut"

Dec 20.1995 - "Market in stratosphere,
Stock prices soar to unprecedented heights." Dallas Morning News

Which period most resembles today's environment?

 

[dtrader98]

For those of you following the liquidity cycle thread, I'm always looking for ways to see where we are on that curve. Originally, I've suggested that we might be about 1/4 - 1/2 way below the pk. With regards to more objective tools on how close we are to a recession trough, I found the following blog's approach pretty interesting.

They calculate the probability of a recession based upon a model Jonathan Wright from the Fed board reserve created. It's based upon the 3mo and 10yr treasury spread. And it currently stands at a 40% likelihood, if I entered data properly.

What's most interesting about the graph they created below is that it shows how the probability has been approaching the >50% threshold over the last several tightening cycles. Although the graph is slightly outdated, we would currently show a data pt. at (5.25, -0.13), which is getting very close to the linear threshold line. Upshot is we are getting closer to >=50% likelihood but not there yet, meaning no reason for concern as of yet. While, our emotions may tell us a recession is on the way, it's nice to have a reliable objective indicator to override those emotions. This is a great tool IMO.


If the graph disappears, you can find it here.

http://photos1.blogger.com/blogger/8076/693/1600/tightening-cycle-0603-to-0506.3.jpg
<img src="http://photos1.blogger.com/blogger/8076/693/1600/tightening-cycle-0603-to-0506.3.jpg" border="0" alt=""><br /></font></p></font></p>
From http://politicalcalculations.blogspot.com/2006/04/reckoning-odds-of-recession.html


The site contains a calculator to determine the probability of recession.
It also also has a pretty interesting visual, going back to the 60s. It helps to strengthen the argument laid out by this approach IMO.

 

[dtrader98]

Ok, so everyone is wondering if the fed will step in and cut rates next week.
Some probabilities are:
Fed res bank Cleveland: 85.6% No Cut
Fed Funds Contracts: ~100% No Cut

<img src="http://www.elitetrader.com/vb/attachment.php?postid=1555574" border="0" alt=""><br /></font></p></font></p></font></p>


My take, going back to a graph I posted some while back, is that the Fed will not cut until the market pulls back and at least touches the dotted white trend line. And we just aren't there yet. My premise is that the markets (at least major indices) aren't really reflecting any major disasters as of yet.
More likely, they'll use soothing verbiage and open mouth operations to prop up the market.
Now, if the market continues to pullback
(which is certainly likely by December), the trend line kiss is a possibility, and that makes the increased probability of a cut by December all the more likely
(forward contracts are pricing this in).
That being said, as 2000 has showed us, a rate cut does not always stop a raging waterfall.

Considering the current backdrop, I definitely don't see a surprise hike in the cards. Verdict: No change next week.

 

[dtrader98]

I think I found a more accurate 1st order approach to calculating the probability for a rate cut
using FF contract for august.

5.25% * (7/31) + [5.0%p + 5.25%(1 - p)] * (24/31) = 5.22%

Where 5.22% = 100 - 94.78 (current contract)

p = probability of 1/4 pt. cut to 5%
=> p(1/4 pt cut) = 16%
The contracts have been fluctuating near this value.

Notice any likelihood of a rate cut has been dropping quickly since mar meeting.

Considering Fed res bank Cleveland has 14.4% Chance of a 1/4 pt. Cut, It would mean a MAJOR upset to both prognosticators for a rate cut here.
Just don't see it possible considering the market pricing as well as reasons in last post. Although, nothing is impossible (disclaimer )

<img src="http://elitetrader.com/vb/attachment.php?s=&postid=1556935" border="0" alt=""><br /></font></p></font></p>

 

[thriftybob]

The current problem isn't that the rate is too high or too low, its that those who were/are expected to lend no longer have anywhere near as high an expectation that they are going to be repaid, plus interest.

Sub-prime smelled bad from the get-go

Hate to say it but Alt-A is the "Liar Loans"

I forget which mortage co president said it recently, but defaults on PRIME mortages have doubled since last yr.

Home prices are declining. Look at all the homes for sale now with "price reduced" on them. They still haven't sold, and prices will need to go lower to attract buyers.

Ok, given the above, would you want to put up YOUR money to lend to all these people? At what rate would you be willing to? Obviously, it should be defined as inflation + risk + profit, and those 3 combined need to be higher than 8% to have anything in the profit column.

That's why nobody wants to buy the CDO's. They had been ASSUMING risk was near zero and that inflation was 2 or 3%. It just wasn't true.

 

[dtrader98]

One more graphic depiction of sentiment extremes. Volatility is at an extreme high on s&p 500. I wish I had more data length to compare for summation index. For the period shown in the diagram, it's a pretty darn reliable indicator. Summation index is a commonly used breadth indicator. In this case derived from advancers and decliners on NYSE.

<img src="http://elitetrader.com/vb/attachment.php?s=&postid=1563106" border="0" alt=""><br /></font></p></font></p></font></p>

If anyone has a longer period data or knows a source to get it (gratis), pm me and I'll update it.

 

[dtrader98]

Top 25 1 day drops. Calculated from open to close data.

Lot of clustering in year 7.
Although, we already had a contributer in 2007, they tend to cluster (87).

<img src="http://elitetrader.com/vb/attachment.php?s=&postid=1571996" border="0" alt=""><br /></font></p></font></p>

 

[dtrader98]

Someone had asked me whether the trendline in my earlier post had been touched before the discount rate cut today. Looking back on it, it indeed did.
Which tells me that while TA may be subjective, I don't think it is a coincidence that they waited until the trendline was kissed to take drastic measures. I think there are decision makers watching these TA constructs (if you want to call them that) very closely.

Although, the actual funds rate target wasn't reduced, I think this pretty much signals the extreme worry that is on their minds and corroborates my original thesis that the FED cuts rates AFTER a major pullback, NOT before, as pundits have been predicting all the way back to the beginning of the year.

Also, I am more inclined to vote slightly more on the side of a fed funds target rate cut by the end of the year, although today's action was the symbolic equivalent in principle.
We'll have to keep watching the market's response to get a better idea.


<img src="http://elitetrader.com/vb/attachment.php?s=&postid=1572327" border="0" alt=""><br /></font></p></font></p>

Quote from dtrader98:

Ok, so everyone is wondering if the fed will step in and cut rates next week.
Some probabilities are:
Fed res bank Cleveland: 85.6% No Cut
Fed Funds Contracts: ~100% No Cut

<img src="http://www.elitetrader.com/vb/attachment.php?postid=1555574" border="0" alt=""><br /></font></p></font></p></font></p>


My take, going back to a graph I posted some while back, is that the Fed will not cut until the market pulls back and at least touches the dotted white trend line. And we just aren't there yet. My premise is that the markets (at least major indices) aren't really reflecting any major disasters as of yet.
More likely, they'll use soothing verbiage and open mouth operations to prop up the market.
Now, if the market continues to pullback
(which is certainly likely by December), the trend line kiss is a possibility, and that makes the increased probability of a cut by December all the more likely
(forward contracts are pricing this in).
That being said, as 2000 has showed us, a rate cut does not always stop a raging waterfall.

Considering the current backdrop, I definitely don't see a surprise hike in the cards. Verdict: No change next week.

 

[dtrader98]

Last chart today is a graph of fed funds rate target changes vs. discount rate changes going back to 1990.


<img src="http://elitetrader.com/vb/attachment.php?s=&postid=1572389" border="0" alt=""><br /></font></p></font></p></font></p>

Generally, the discount rate and fed funds target rate have tracked each other for most of the 2000s.
However, there were cases, such as in the 90s recession, whereby the discount rate cut was much steeper than the fed funds target rate cut, although the fed funds rate moved in the same direction. In no case was a discount rate cut followed by a fed funds target rate increase. However, there were cases where a discount rate cut was made with no corresponding fed funds target rate change. Likewise, there were cases where a fed funds target rate cut was made with no change in the discount rate.

From the looks of the past data, I would expect the fed funds target rate to track today's directional change and likewise, expect that a new cycle of cuts downward has begun.

However, keep in mind my earlier comment that a rate cut does not always stop a raging waterfall, and the fed has been known to step in too late in the past.