Are We Edging Closer to Historic Sell-Offs?

Last week I wrote about the unsustainably low levels of volatility in the S&P500.  Right on cue, the market complied with a series of active trading days, driving the VIX volatility level up from an ultra-low level 11.8% to 17.19%.  Today the market action was even closer to the sort of hyper-volatility I am expecting over time as the S&P500 dropped by 2.30%, its largest down day since December 2022.  The VIX volatility level is now over 18%, and suddenly the market has really come to life. 

I have been warning my readers for some time that the stock markets are setting up for historic sell-offs. I believe we are close to the start of these down moves, but there is a chance we may still see a blow-off top in stocks first.  I haven’t decided yet. This final top, in turn, would be followed by a fierce, multi-year reversal that should reach shockingly low levels. In an ideal scenario, the Fed would cut rates in September, triggering a final mad panic from retail investors to buy stocks, and then the down trade would start once everyone is invested.  Alternatively, the move that has recently started could develop into something much, much bigger.  The move in the Nasdaq, by the way, will be even larger and more violent.

I have been clear that I am expecting some seismic shifts in multiple markets over the coming months and years.  My forecasts are based on a variety of proprietary inputs, including macroeconomic analysis, statistical research, cyclical studies, and technical analysis.  Although it is possible that dramatic government intervention can smooth part of this extremely bumpy path, I don’t think it is at all likely that intervention will be able to prevent the final outcome.  Of course, wild and crazy government intervention can delay these moves for a while, but not indefinitely.

The US has absolutely blundered its fiscal management the past few years, squandering the opportunity to take advantage of our economy’s strong growth.  Instead of managing our deficit spending wisely by keeping the expansion of our deficit under control and preserving our financial fire power, we continued to borrow and spend as if we were in a recession. Now, with the US economy slowing rapidly, our fiscal situation is already stretched to terrifying levels. We have $35 trillion of debt, a sharply slowing economy, and a Fed balance sheet that is bloated and overextended.  Worse still, that debt level is growing by $1 trillion every 100 days.  I hope it never happens, but I am concerned that we are fast approaching the tipping point beyond which emergency fiscal relief to prop up an ailing economy during a severe economic slowdown will be prohibitively expensive.  At that point, investors will no longer be willing to buy our government’s paper without extracting egregiously high interest rates to compensate them for the growing credit risk.  This leads to a dangerous snowball effect that almost always leads to some sort of default.

In the short term, the Fed will of course try to boost economic growth by cutting rates.  The rate cuts, however, will likely have limited effect  as consumers are already over-leveraged and corporate profits are declining.  The huge handouts from the government during Covid are largely spent and the percentage of consumers who are late on their credit card payments just hit a 12-year high.  Commercial real estate is reeling from high vacancy rates and even higher refinancing costs. Residential real estate is also softening quickly, with high levels of unsold new homes and a resale market that is stagnating due to the high mortgage rates.  Price drops are common, and incentives to new buyers are offered more and more frequently.  The used car market had a near crash last month, with prices dropping by more than 10%.  The overall jobs market is softening quickly, and we will likely start hearing about expanding levels of layoffs.

It is almost a certainty that the Fed will lower rates in September, if not sooner.  As I have written, Powell is going to pretend that inflation is no longer a problem and focus on the weakening job market, justifying the move by rambling about the Fed’s dual mandate to support maximum job growth while maintaining low inflation.   He will brag about the great progress the Fed has made in combating inflation  and explain that the softening in the labor market requires immediate attention.  If only this were true.  The Fed knows that the economy is slowing far faster than the rate of inflation, so there is a real risk that cutting rates in September could lead to another crushing rise in inflation.  The Fed is in a box, as is the government.

It is true that the Fed has the dual mandate to promote non-inflationary growth, but the Fed isn’t even close to achieving its arbitrary 2% inflation target.  There is a fairly high probability that the Fed fully expects inflation to stabilize around the 3% level, but they have no intention of admitting this.  In fact, the Fed is perfectly willing to accept this in exchange for continued economic growth. They just won’t come out and say that they have shifted the goal posts.  Individual consumers will hate it, but the Fed doesn’t really cater to the individual.  

With this ugly scenario as the backdrop to the situation in the US, we have the added risk that Japan’s Government Pension, its corporate pensions, and its major banks all get the nod from the Ministry of Finance and the Bank of Japan to start bringing their money home. In total, they have a few trillion dollars invested in the US, with US treasuries being their largest holding and the S&P500 their second largest.  It is one thing to liquidate a few billion dollars slowly, giving the market some time to digest the move.  It is quite a different matter, however, if the Japanese abruptly start a wholesale liquidation of hundreds of billions of dollars of their US investments. At that point we would then be well on the way to a currency crisis, with dollar yen plunging to levels that seemed impossible just months earlier.  We would also likely have .some serious issues in the bond market, as sudden dumping of bonds could lead to emergency buying by the Fed even though their balance sheet is so bloated.  That, however, is another story.       

It was just three and a half years ago that dollar yen was trading at 102 yen per dollar, and we can easily reach this level over the next several years.  Finally, my forecast for yen strength is playing out.  The dollar has dropped about nine and a half yen from its recent highs, and it is likely on its way to much, much lower levels. There will be obvious levels along the way that will provide solid support for technical bounces, and these bounces will be sharp and violent, but depending on how things play out, my multi-year target could potentially be new all-time lows in the dollar.  Twelve years ago, dollar yen traded at 76 yen per dollar, and it is not impossible that dollar yen will eventually break below that level. The yen would strengthen dramatically against all major currencies, with especially fierce moves against the commodity-based currencies – the Canadian dollar, the Australian dollar, and the New Zealand dollar.  

Interest rates are coming down in Canada, Europe, the US, Australia, and New Zealand.  Rates are only going to nudge higher in one place – Japan.  Additionally, Japan is going to start tapering their bond buying program, probably by as much as 50% over the next eighteen to twenty-four months.  That is actually a very significant shift.  

As interest rate differentials compress, the absolutely massive, short yen positions in the market will be forced to progressively cover.  This unwinding, by itself, could easily push the yen to test the 140-yen per dollar level, and perhaps even break it.  Below 140, the market won’t find significant support until we reach 127.  It will take a while to break through these levels, and it will require some major sentiment shifts.  These shifts would eventually trigger a reversal of the current short yen exposures into long yen exposures by the speculators.  If we simultaneously get some wholesale unloading of dollar assets by Japanese investors, then we should expect the dollar to retest the 102 level, at a minimum.  

If we are getting the overall risk-off scenario in the other markets that I am expecting, then we should expect these currency shifts to lead to a multi-year trend that will provide some of the best trading markets we have ever had.  The yen and Swiss franc would likely become the safe haven currencies once again, and their upside potential against other currencies would be huge. There will simultaneously be an abundance of wonderful trading opportunities in nearly all the major markets:  commodities, currencies, stocks, and fixed income.  Yes, even crypto will be affected.   

These moves will be so significant that they could easily have huge political repercussions for a decade or more.  Honestly, I hope I am wrong, but we would be facing the ugliest possible market condition – severe stagflation.  I will write more about this next week, when I also dig into some interesting ideas about the New Zealand dollar, a currency near and dear to my heart.

In the meanwhile, I wish you all the best of luck with your trading.  Strap on your seatbelts.  We will have some wild rides.

Andy Krieger