Wall Street under stress on the concern of China’s ‘Lehman moment’ and quad witching despite easing of inflation

calendar 14/09/2021 - 19:25 UTC

Dow Future tumbled almost -400 points Tuesday ahead of Friday’s quad witching (simultaneous quarterly expiration of stocks and indices in futures & options), which involves heavy trading volume (rollover and arbitrage opportunities). Wall Street was already under stress last week for multiple reasons like Goldilocks progress of U.S. employment and elevated inflation, which may prompt the Fed to announce the inevitable QE tapering by Dec’21 and liftoff (gradual rate hikes) by Dec’22. As Fed has already acknowledged substantial further progress on the inflation front for QE tapering condition, the factor is now not inflation, but the progress of employment.

Apart from taper tantrum and liftoff concern, the risk trade was also affected by China’s Lehman moment (possible debt default by Evergrande by 15th Sep, the Lehman day), ongoing Chinese regulatory crackdown, especially on techs, deleveraging effort, and trade/cold war suspense with the U.S. (as per respective domestic political compulsions).

Also, lingering suspense over Biden’s $4.7T fiscal stimulus and tax hikes plan is affecting the stimulus savvy Wall Street sentiment. Biden’s Democrat colleagues led by Manchin & Co (moderate Democrats) have serious objections over the huge fiscal stimulus, which will inevitably cause hotter & persistent inflation, negative for the U.S. economy, low earners (vote bank), and Biden’s 2022 mid-term election prospect. Biden’s popularity is sinking amid the allegation of inflation, economy, COVID vaccinations as well as Afghanistan mismanagement (economy, COVID, and foreign policy). The market is also concerned that U.S. may even technically default on its debt service obligation in an unprecedented event if the U.S. debt limit is not increased by Congress on time amid the yearly ritual of debt limit political drama.

On Monday, Dow Future recovered in hope of cooler inflation and short covering, thanks to NY Fed PPT (plunge protection team). On Tuesday, all focus was on U.S. CPI (inflation) whether Fed’s transitory narrative holds. The BLS data shows that U.S. headline CPI eased to +5.3% in August from a 13-year high +5.4% recorded in June and July, right on the market expectations (y/y).

The cooling of August inflation (y/y) was helped by a slowdown in the cost of used cars & trucks and transportation services including airlines fares. Inflation was boosted by food items, new vehicles, energy and medical care services, while shelter and apparel inflation was steady.

The August sequential (m/m) CPI rate also eased to +0.3% from +0.5% in July, lower than market forecasts of +0.4%. The sequential CPI was dragged by lower prices of airline tickets, used cars & trucks, and motor vehicle insurance, while boosted by higher cost of gasoline, household furnishings & operations, foods, and shelter.

The U.S. core CPI also eased to +4.0% in August from a July print of +4.3%, the smallest increase since May and below market expectations of +4.2%. On a sequential basis, the core CPI increased +0.1% in August against +0.3% in July, the smallest increase since February and lower than the market expectations of +0.3%. The August core CPI was boosted by new vehicles (cars & trucks), household items, shelter, recreation and medical care services, while dragged by used vehicles, airline fares and MV (motor vehicle) insurances.

Overall in 2021 (till August), the U.S. core CPI is increasing around +0.43% sequentially (m/m) on an average; i.e. almost +5.17% annualized rate. The 2020 average sequential core CPI rate was +0.11%; i.e. +1.36% annualized.

The 2019 average sequential core CPI rate was around +0.17%; i.e. +2.01% annualized. The 2018 average sequential core CPI rate was around +0.16%; i.e. +1.91% annualized. The 2017 average sequential core CPI rate was around +0.13%; i.e. +1.54% annualized. Overall, during 2017-19 (three years), the average core CPI was around +1.82%, below Fed’s hypothetical target of +2.0%. Now Fed has to ensure the average core CPI during 2020-22 (three years) at around +2.20% so that overall core CPI would be around +2.0% over 6-years (2017-22).

Fed goes by core PCE price index, not core CPI; but both inflation indices are now converging. If the core PCE price index reaches around 118.00 in August, the sequential increase would be around +0.20% and the yearly increase +3.5%.

On Tuesday, as a result of cooler than expected core CPI data, USD slips, and Gold, Dow surged (as a knee-jerk reaction) on the assumption that it may delay QE tapering. But soon the risk trade reversed as Fed/Powell has already acknowledged ‘substantial further progress on inflation front for QE tapering condition. The issue now is not inflation, but the progress of employment.

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What’s next?

Overall, Fed may go for the QE tapering announcement by Dec’21. The QE tapering may start from Jan’22 at around $12B on an average ($6B each for UST and MBS) to complete the same by Oct’22 (total $120B). Fed may complete the $40B MBS QE tapering by June-July’22 and then increase the UST tapering pace to $12B/M to finish the same by Oct’22. And then after complete QE tapering (reinvestment will go on during QE tapering process and also after that), Fed will go for liftoff (gradual rate hikes) from Dec’22 with a moderate increase of +0.25% in Dec’22 and Dec’23, followed by two hikes in 2024 and four hikes in 2025 to hike cumulatively by +2.0% to +2.25%.

And Fed may go for QT (quantitative tightening) also from 2025 (after the 2024 U.S. election) and hike once more in 2026 to +2.50% to prepare itself for the next cycle of the financial crisis- usually every 10-12 years after a major GFC. The combination of elevated inflation, higher borrowing costs, and subdued tax revenues (amid subdued employment/wage gain) may cause another wave of GFC after 2025-26, even if there is no COVID-like pandemic in another 100-year. The transition to green energy is impacting the oil capex, resulting in lower oil production, but the demand may remain elevated during the transition phase. This may cause oil even above $100, resulting in uncontrolled inflation. Thus policymakers need to balance the green aspiration and reality of the world so that oil stays below $80 in the medium to long term.

The Fed has to control rising inflation and inflation expectations by effectively using its available tools; i.e. tightening; otherwise, it will soon find itself well behind the curve and lose control over U.S. bond yields. If U.S. bond yield goes above 2%, then the ratio of U.S. borrowing costs in terms of tax revenue will be around 20-30% from the present level of 10%, which will trigger another GFC.

Technically, Dow Jones (DJ-30) now needs to sustain above 34500-400 zone for any rebound; otherwise, expect more correction. Similarly the ‘do or die’ levels for SPX-500 (S&P-500) are now around 4430-15, while for NQ-100 (Nasdaq-100), it’s 15300-250.


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