"Fed put option" is facing the test! Bank of America warns: don't copy the bottom at this time

Source: Wall Street

The future of US stocks is uncertain and investors are losing confidence in bargain buying. This time, the Fed may not help either.

The BofA derivatives team observed a week ago that "US stock investors have lost confidence in bargain buying" and warned that the outlook seemed far from clear after "major setbacks in recent weeks".

The bank pointed out that the US stock market has recently become more vulnerable, with two selling of more than three standard deviations in just seven trading days, the 24th time since 1928 that S & P has experienced two or more swings of three standard deviations in 10 trading days.

A week later, the BofA derivatives team issued a more pessimistic warning--It is becoming increasingly difficult for the market to rebound from the recent downturn, with S & P not hitting an all-time high for 27 trading days, the longest since September 2020.

They point out that the momentum is weakening this autumn. "the longer the horizontal consolidation of the market continues, it is possible that investor confidence in bargain buying will continue to weaken."

Us stocks are bearish.

Due to the lack of active buyers-such as the recent refusal of retail investors to enter the market, and the fact that share buybacks are in a lock-up period because of the upcoming earnings season, "The market is likely to have its first shock since the collapse of the epidemic, and it is unknown whether the Fed will rescue the market after the next sell-off."Bank of America warned.

Minutes released by the Fed on Wednesday show that if the November meeting decides to start scaling back bond purchases (taper), it could start in mid-November or mid-December.

Of course, there is a view that "taper is not austerity" and that "curtailing asset purchases has less impact on the economy than raising interest rates, so the threat is not as good as the previous rate-raising cycle."

In response, BofA analysts retorted that investors "should focus not only on how cuts and rate increases will change basic economic conditions, but also on their impact on investor sentiment in the current environment." For example, the S & P indexIt was strong in three rate hikes in 2017, but lacklustre when it was raised in 2018, and this retrenchment cycle is likely to be as painful for the stock market as the previous one. "

In elaborating on this point, Bank of America starts with the obvious fact that "Unprecedented monetary policy contributed to historic returns and valuations in the stock market after the outbreak.”

Now, as taper approaches and market momentum weakens this autumn, "it may take a while of bad news for the market to get the Fed on its side or return to more attractive valuations."

Although it is certain that once the taper begins, the Fed will "make a fuss" on the timing of interest rate hikes in order to support the stock market, which is a common way for the Fed to reverse the decline in the stock market.

In 2015, for example, against a backdrop of renewed weakness in the stock market, Ms Yellen, then chairman of the Federal Reserve, delayed the widely expected rate hike before and after the September FOMC meeting, and then postponed the next rate hike for a full year.

But BofA warned that "the Fed's delay in raising interest rates does not rule out a period of greater volatility" because:

1. We have not seen the actual reaction of the market to taper.

2. "Fed put options" may need to be tested.

3. Inflation rising too fast could limit the Fed's ability to save the stock market as easily as it did in the last contraction cycle.

"Fed put option" faces the test

Markets tend to view stock market panic as a sign of the Fed's rescue. However, Bank of America believes thatA major shift in the Fed's attitude is often based on the fact that the US bond market "disagrees" with the Fed's plan to raise interest rates.

By far, for example, the biggest panic in the US bond market was in 2013, when the US debt volatility index (MOVE index) rose sharply and the Fed withdrew from QE in 2014 but did not raise interest rates for the first time in December 2015, during which the US five-year break-even inflation rate (5Y Breakeven Inflation Rate) fell sharply and Eurodollar futures implied interest rates (Eurodollar futures implied rates) remained relatively low.

What's more obvious is 2019.With Powell raising interest rates for the fourth time this year at the end of 2018, the five-year break-even inflation rate of the United States and the implied interest rate of Eurodollar futures (Eurodollar futures implied rates) fell sharply, which was inconsistent with the trend of future interest rate increases, corresponding to a U-turn in Fed policy, which cut interest rates for three consecutive times in July, September and October 2019.

Today, on the contrary, implied interest rates and break-even inflation in Eurodollar futures are rising, which is much higher than in past tightening cycles, which is in line with the future uninterrupted cycle of raising interest rates. the recent volatility in interest rates on US Treasuries has remained stable during the rise in long-term yields.(unlike the sell-off in US debt in the first quarter of 2021),Raised the threshold for the Fed to rescue risky assets.

Therefore, BofA believes that the US bond market does not "oppose" the Fed's statement to reduce QE, which may be a double whammy for US stocks.

Bank of America strategist Riddhi Prasad warned

The Fed may be reluctant to deviate from the retrenchment plan and rescue the market as easily as it did in the last cycle, further increasing the risk of US stocks. "

In other words: another crisis is coming.

Risk reminder and exemption clause

There are risks in the market, so investment should be cautious. This article does not constitute personal investment advice, nor does it take into account the special investment objectives, financial situation or needs of individual users. Users should consider whether any comments, opinions or conclusions in this article are in line with their specific circumstances. If you invest accordingly, you will bear your own responsibility.