Combustion Cometh: Central Banks Are Hopelessly Trapped

Authored by Sven Henrich via NorthmanTrader.com,

This is all going to end badly, even some ardent bulls will freely admit this, the question is the how, when and the where. Frankly it’s a tragedy that’s unfolding and discerning eyes can see it. Since the December lows markets have taken the scripted route higher salivating at the prospect of dovish central bankers once again levitating asset prices higher. A Pavlovian response learned over the past 10 years. Record buybacks keep flushing through markets and cheap money days are here again as yields have dropped markedly since their peak last fall.

But investors may sooner or later learn the hard way that this sudden capitulation by central bankers is not a positive sign, but rather a sign of desperation.

Fact is central banks are hopelessly trapped:

The capitulation is as complete as it is global and 10 years after the financial crisis there is not a single central bank that has an exit plan. As today’s Fed minutes again highlighted: No rate hikes in 2019 while the tech sector is making a new all time human history high this week. What an absurdity. A slowing economy ignored by markets as cheap money once again dominates everything.

So great is the fear of falling markets and a slowing economy that the grand central bank experiment has ended in utter failure. But at least the Fed tried for a little bit before capitulating. The enormity of the central bank failure is perhaps best encapsulated by the state of the ECB under Mario Draghi:

Yet in their desperation central banks may have set a combustion process in motion that they can’t stop, one that may bring about even more ghastly consequences than the market troubles they sought to avert in the first place.

A blow-off topping scenario driven by several factors: All in dovish central banks, a renewed desperate hunt for yield, FOMO chasing, a China deal, continuous record buybacks, trillion deficits ($1.1T for 2019 now) and an administration pre-occupied with managing market levels with the expressed goal to levitate markets to ever higher prices for the 2020 US election.

The latter point not lost on Wall Street, here from Morgan Stanley’s chief global strategist of investment management: Trump’s dangerous obsession with the markets

“Mr. Trump’s willingness to bend policy to please the markets is now clear — and it’s risky. In recent years the stock markets have grown larger than the economyand they are now big enough to take the economy down with them when they deflate.“

And that is the underlying motivation of it all, prevent any lasting damage to equity markets to minimize the impact on the economy. Central bankers know this hence they always intervene when things get hairy:

And this is how you end up with the loosest financial conditions in 25 years, 3.8% unemployment and a Fed too scared to raise rates with the lowest Fed funds rate on record during and while on the verge of the longest economic expansion cycle in history. Well done.

The steepness and relentless nature of this rally has left many people confounded even though it is not inconsistent with the concept of a bear market rally and I’ve written extensively about this.

But because so many people and funds are left behind the case can be made that a psychological capitulation could add further fuel to the fire.

Fund flows have been negative, hedge funds are underperforming and exposure to this rally is generally weak:

The underlying message: What happens if all these folks feel the need for speed, can no longer take the pain of being left out and want to get on board? One could easily imagine the ultimate freak chase, throw all caution to the wind and chase. Markets have undergone periods like this before, think 1999/2000. Just relentless buying, caution be damned until it all falls apart and crashes.

So what’s so bad about all that if it happens? The answer is both technical and fundamental. While central banks and a China deal may successfully delay a global recession stocks have already disconnected from the underlying growth picture. As I outlined in Icarus Warning many stocks are already historically stretched to the upside. Yes the extremes can become more extreme, but it is the historical references that suggest further squeezes to new highs would be unsustainable setting up markets for something sinister.

How sinister? Very and let me use technicals to outline the scenario.

Let’s start with a chart I’ve been talking about since January 2018 and have discussed again recently in my YouTube videos:

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The technical pivot zone is based on the 2.618 fib level derived from the 2007 highs and the 2009 lows. On $ES futures that level is 3102.

Note the 2 major trend lines, the upper trend line following the 2007 highs into the January 2018 and September 2018 highs, and the lower trend line from the 2009 lows, the one that was broken in December 2018 and has been hugged by markets for the last several weeks. The resulting wedge has an apex, precisely at the 2.618 fib.

But it gets more fun. Check this long standing trend line from 1987:

Originating from the 1987 crash it formed following the 2000 crash and then ended up being resistance in 2014/2015 and again twice in 2018.

How’s this relevant? Check what happens when you combine all 3 trend lines on one chart:

I kid you not. Freak coincidence? I can’t say, I also can’t say if the apex will be met, but were it to get hit it would be a point of unprecedented historical confluence resistance.

The 2.618 fib and 3 historic trend lines converging at the same point in time. When?

October 2019:

From October 1987 to October 2019 and all points meeting there for quadruple confluence suggesting a massive technical reaction to take place there at a point where key individual stocks would be massively overbought and disconnected from the underlying economy.

What would happen then? Here’s a technically based possibility, chart courtesy from my wife Mella:

A classic megaphone structure that suggests a 30% drop from the pattern top. What’s the implication? You already know:

“In recent years the stock markets have grown larger than the economyand they are now big enough to take the economy down with them when they deflate.“

I don’t want to use the “C” word, but in context of a global slowing economy, massive debt run-ups, an administration desperate to manage markets higher, a panicked FOMO chase and trapped central bankers left with historic little ammunition to deal with an upcoming recession this script not only points to a “C” event but also toward a path of a multi-year bear market.

What’s this scenario suggest? 5%-7% upside risk and 25%-30% downside risk.

In closing let me be absolutely clear: None of this is set in stone. It’s a speculative scenario that may never happen, but one that is based on specific technical points of confluence and structures and a scenario that has some solid foundation in context of the current environment outlined. But it’s a scenario that should scare bulls and bears alike, stubborn bulls and bears alike that is.

I’m on the record that I’m not a fan of this portion of the rally. The construct is poor, both technically and fundamentally (driven by central banks, jawboning and buybacks) and as it keeps levitating vertically higher it becomes ever more subject to sudden reversal risk. But I’ve also said it can keep squeezing until something breaks and nothing has broken yet. And perhaps the initial break will be sizable and invalidate this scenario, or it may be shallow and build sufficient energy for this scenario to unfold.

None of us can know how it all ends. But what we can do is be extremely mindful of the overall environment, the driving factors and technicals and recognize that global markets, central banks, politics, the economy, the business cycle and technicals are all converging here in 2019 for a toxic combination that may result in combustion. Stay sharp.

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