Cycle Capital: Will there be a rate cut in September? How will the crypto market perform?

Source: Cycle Capital Research

The most volatile week since 2019

Although the US stock market was basically flat over the week, the market was a real roller coaster.

There was panic selling on Monday, a retaliatory rebound on Tuesday, and a technical sell-off on Wednesday, which caused the market to fall again. On Thursday, the decline in the number of first-time unemployment claims, which had a general influence, triggered the market's impulse to buy the bottom, although this data is not worth being overly excited about because the trend of continuous unemployment claims is obvious. The market continued to rebound on Friday, but the amplitude slowed down.

In the past week, the stock market and the crypto market have been closely linked. In the media, the recession of the United States and the unwinding of the yen carry trade are the two core themes, but I personally think these are two "false propositions". In fact, the real panic was also very short-lived, and there was no usual situation of selling everything including bonds and gold when a crisis breaks out.

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After Monday's sell-off, the US stock market experienced a peak-to-trough fluctuation of about 4.5%, which was the most volatile week since the COVID panic in 2019. Volatility means risk and opportunity. I quickly recorded a video on Monday's intraday to explain why the sell-off except for the yen was excessive panic. For mainstream cryptocurrencies and stocks, this is a golden pit, and for bonds, this is a short-term high. In summary, it is mainly

• Most of the current US economic data is good and the trend is also good. Only a few data support a recession, and these data types have been proven to be unreliable in this round of recovery cycle.

• Corporate profit growth is good, but the margin of excess has not expanded.

• Secondly, it is impossible for Japan to continue to raise interest rates because the huge debt cannot be digested through economic growth

• The short-term panic caused by the unexpected rate hike triggered the unwinding of the previous over-leveraged positions. According to the data, such a stampede was digested on Monday.

• The trends in the fixed income and US dollar foreign exchange markets dominated by large players do not conform to the conditions of panic trading or liquidity scarcity

Therefore, it can be judged that the possibility of an unexpected mistake on Monday is higher.

However, we still need to observe the data changes further. Now we can say that everything is getting better, but it is too early to return to the previous state. After all, from the perspective of capital preference, aggressiveness and defense have not changed so far, and the disappointment with big technology has escalated to the level of "killing narrative" (killing performance, killing valuation, killing narrative, three stages of decline, getting more and more serious). Unless NV's financial report can once again crush all doubts and mobilize industry sentiment, US30 and US500 may be better than US100 in the next few months. But from the trading level, Cyclical has lagged behind defensive recently, and the possibility of a larger rebound in the short term cannot be ruled out.

Goldman Sachs clients bought technology stocks at the bottom last week, with the largest volume in 5 months:

On the other hand, rising bond prices and falling interest rates have provided a buffer for the stock market to fall. In the past month, US10Y has fallen from 4.5% to 3.7%. The change of 80bp has greatly exceeded the decline caused by the change in the expectation of interest rate cuts. Unless we really see a recession, such pricing is obviously an opportunity, just like the market when everyone was enthusiastic about interest rate cuts in the fourth quarter of last year (5% fell to 3.8%). Personally, intuitively, the market in recent years seems to be more animalistic than before, and pricing is no longer so rational.

The recent correction in the stock market started from a record high, with the largest amplitude being 8%. The current level is still 12% higher than the beginning of the year. Moreover, due to the rise in bonds, investors with a higher degree of diversification will not be affected only by the overall decline in stock indexes, so the situation of chain selling is not worth worrying about in the US stock market. On average, over the past few decades, we have experienced about three corrections of more than 5% and one correction of 10% per year.

Stock market declines and corrections, if not accompanied by an economic or corporate earnings recession, are often temporary, followed by a good rally:

However, considering that the pessimistic sentiment of the technology narrative is unlikely to reverse quickly, and the short-term sharp fluctuations have caused great damage to many investment portfolios, this type of medium- and long-term funds still have the need to adjust their positions. The short-term fluctuations may not be completely over, but the market is unlikely to start a larger and deeper decline. The strong rebound in the second half of last week is a positive signal.

According to JPM statistics, from the perspective of the extent of each asset's adjustment relative to its own history, since metals fell more, government bonds rose more, and stocks fell less, the recession expectations reflected by the government bond and commodity markets are actually greater than those of the stock market and corporate bond market

91% of S&P 500 companies have announced Q2 financial reports, of which 55% of companies have exceeded revenue expectations. Although this proportion is lower than the average level of the past four quarters, it is still higher than 50%, indicating that most companies have performed well in terms of revenue.

As can be seen from the chart, there are large differences in the performance of various industries. For example, the Health Care, Industrials and Information Technology industries performed well, with a higher proportion of companies exceeding expectations, while the Energy and Real Estate industries performed relatively poorly.

NVIDIA's valuation has been adjusted:

Its 24-month forward PE is currently 25 times, close to the lowest point in the past five years (about 20 times), and the PE premium endorsement to SPX has dropped from 1.8 times to 1.4 times, which shows that NVIDIA's valuation is gradually becoming reasonable.

The financial reports of large technology companies this quarter are solid. In fact, there is no situation of killing performance. The killing of valuations is mainly caused by increased investment in AI:

Palantir raised its guidance, emphasizing that AI boosts performance, and its stock price soared 37%, sparking some AI narrative discussions on the street.

About the expectation of a September rate cut

JPM research calculated based on the Taylor Rule that the Fed's federal funds rate target should be around 4%, 150 basis points lower than the current interest rate. The Fed has reason to quickly adjust its policy to make it more in line with current economic conditions.

In terms of market pricing, the normal rate cut at the September FOMC meeting will be 25 basis points, but the market expects it to exceed 25 basis points. During Monday's trading session, the price was once priced at 63bp due to panic, and finally closed at 38bp this week. In addition, the current market has digested the Fed's expectation of a 100 basis point rate cut this year, which is four times.

The expectation of exceeding 25bp for the first time and more than 3 times this year needs to be supported by data that continues to deteriorate, especially data on the employment market. Otherwise, this pricing may be excessive. If the data supports it, the market will gradually price in the possibility of a 50bp rate cut in September or even a 125bp rate cut this year.

In terms of trading strategy, in the short term, the US interest rate market will mainly follow the correction mode after rising in the past two weeks, and the buy-sell mode for more than one month is because the interest rate cut cycle is destined to start. The market still needs time to improve the consensus on whether the rising unemployment rate indicates an economic slowdown and potential recession. During this period, there will be repeated emotions.

The speech of Fed officials last week was slightly dovish, but generally noncommittal, which is expected.

Crypto market

After experiencing the sharpest correction since the FTX crisis, the price of Bitcoin rebounded after falling more than 15%. Because the trigger for this correction was not an internal event in the cryptocurrency market, but an external shock from the adjustment of the traditional market. The technical side is also severely oversold, almost the same as last year on August 16, when the price of Bitcoin fell from 20,000 to 20,000, and then experienced two months of shock consolidation.

So it is understandable why the momentum of the crypto rebound is so strong.

The following analysis is quoted from JPM's research on August 7:

Retail investors also played an important role in this adjustment. Bitcoin spot ETFs saw a significant increase in capital flows in August, reaching the highest monthly outflow since the establishment of these ETFs.

In contrast, the risk removal behavior of players in the US futures market is limited. This can be seen from the changes in positions of CME big cake futures contracts. The positive spread of the futures curve shows that futures investors still maintain a certain degree of optimism.

Last week The lowest price reached around US$49,000. This price level is comparable to the cost of Bitcoin production estimated by JPMorgan Chase. If Bitcoin prices remain at or below this level for a long time, it will put pressure on miners, which in turn could exert further downward pressure on Bitcoin prices.

Several factors may keep institutional investors optimistic:

• Morgan Stanley recently allowed its wealth advisors to recommend Bitcoin spot ETFs to clients.

• The pressure of liquidation of cryptocurrency payments from the Mt. Gox and Genesis bankruptcy cases may have passed.

• More than $10 billion in cash payments following FTX's bankruptcy could further stimulate demand in the crypto market by the end of the year.

• Both parties in the U.S. election are likely to support regulations that favor cryptocurrencies.

Funds and Positions

Although equity allocations have declined significantly in recent weeks due to falling stock prices and a sharp increase in bond allocations, the current equity allocation ratio (46.5%) is still significantly higher than the post-2015 average. According to J.P. Morgan's calculations, for equity allocations to return to the post-2015 average, stock prices would need to fall a further 8% from current levels.

The current cash allocation ratio of investors is extremely low, which indicates that investors' funds are more concentrated in stocks and bonds. Low cash allocation may increase the market's vulnerability when facing pressure, because when the market falls, investors may need to sell assets to obtain cash, which may exacerbate market volatility. There has been a significant increase in bond allocations recently, as investors turn to bonds as a safe haven during stock market corrections:

There has been a significant increase in bond allocations recently, as investors turn to bonds as a safe haven during stock market corrections:

In the recent market volatility, the reaction of retail investors has been relatively mild, and there has been no large-scale withdrawal of funds:

Retail investor sentiment surveys remain positive:

The change in Nikkei futures positioning suggests that speculative investors have significantly unwound their long positions:

The speculative net short position in the yen (blue line in the figure below) was basically zero as of last Tuesday:

How big is the "yen carry trade"?

The yen carry trade has three main parts:

1. The first part is that foreign investors buy Japanese stocks. To be on the safe side, they will short sell derivatives of an equal amount of yen. Recently, due to the decline of Japanese stocks and the rise of the yen, these investors have lost money on both sides and have to close their entire portfolio. According to the statistics of the Japanese government on the amount of foreign investment in Japanese stocks, it is estimated that the scale of this transaction is about 600 billion US dollars.

2. The second part is that foreign investors borrow yen to buy assets abroad, such as stocks and bonds. According to the statistics of the Bank for International Settlements on the total amount of yen credit to non-bank borrowers outside Japan, this operation was about 420 billion US dollars at the end of the first quarter of 2014. However, the relevant data is updated only once a quarter, and the data for the second quarter is not available yet.

3. The third part is domestic investors, that is, Japanese investors use yen to buy foreign stocks and bonds. For example, Japan's pension funds will use yen to buy foreign stocks and bonds in order to pay for future payments. This transaction was about 3.5 trillion US dollars before adjustment, of which about 60% were foreign stocks.

If we add these three parts together, the total size of the yen carry trade is estimated to be about $4 trillion. If Japan's inflation situation in the future forces the Bank of Japan to raise interest rates, then this trade will gradually decrease. So this is why short-term positions have been completely unwound but long-term positions may still be affected.

In summary, different types of investors are adjusting their investment strategies according to market changes:

1. Trend following or speculative investors (such as CTA): Recently, they have had to sell a large number of long stocks and short yen positions they held before.

2. Yen carry trade: If the yen appreciates, this operation will lose money. Although the yen trade has changed from oversold to overbought, overall, this $4 trillion trade has not been unwound on a large scale.

3. Risk parity funds: Due to the recent market volatility, they are also reducing their investments, but less than CTAs. But the rise in bond prices has helped them control their losses.

4. Ordinary retail investors: Compared with previous stock market declines, their withdrawals this time are not much

China-themed funds have inflows of US$3.1 billion Passive funds have continued to buy since the end of May:

Despite the market turmoil, equity inflows remained positive for the 16th consecutive week this week and even increased from the previous week. The inflow of bond funds slowed down

The allocation of subjective investors fell from a high level to slightly below the average level (36th percentile). Systematic strategies’ allocations also fell from a high level to just below average (38th percentile), both of which were the first to fall to such low levels since the big correction last summer:

This Monday, the VIX index fluctuated more than 40 points in one day, setting a record. However, considering that the market fluctuated less than 3% on Monday, historically, when the VIX jumped 20 points in one day, the stock market spot volatility could reach 5%~10%. Therefore, the Goldman Sachs trading desk commented that this was a "vol market shock, not a stock market shock". There are problems with the liquidity of the VIX market, and the panic in the derivatives market has been amplified. The market may remain turbulent before the VIX expires on August 21: