How Does The SPX/NQ Bubble Pop? – Revisited

I put together a post two months ago which walked through my thoughts about how we could see a top in equity markets. You can see it here from March 13th, 2024:

How Does the SPX/NQ Bubble Pop?

I would say many of the concepts I thought about two months ago still largely hold true today. While stocks did fall nicely from the high in April on back of what I thought was the beginning of this path, SPX and NQ made new highs this month after Powell’s more dovish May press conference performance suggested that he still thinks financial conditions are tight and monetary policy is sufficiently restrictive to bring inflation back down to 2%. Interestingly, IWM still hasn’t taken out the highs for the year set back in early March, as small caps remain most exposed to a higher for longer interesting rate environment.

Here are my updated thoughts on this path:

• In my view, we are going to need to see the elimination of the market’s expectations of an aggressive easing cycle this year in order to pop the equity bubble. I think the June Fed meeting could help push us down that path in a more aggressive way.

• We will need to see yields move higher as the Fed abandons the idea of real rate normalization cuts because financial conditions have eased too aggressively over the last six months, which has led to a bottoming of inflation, forcing a recognition by the Fed that achieving the last mile toward 2% inflation will be more difficult.

• Various Fed members have already expressed some concerns that easing financial conditions (which are now as loose as they’ve been since the start of the easing cycle according to the GS and Chicago Fed Financial Conditions indicators) is self-defeating toward achieving the 2% inflation target and that the economy to start the year doesn’t need more accommodation. I have referred to these voting members as the “Killer Bs”: Bowman, Barkin and Bostic, all of whom are nowhere near embracing a rate cutting regime starting at this point. Even many of the more centrist Fed members have been pushing towards a more hawkish outlook.

• Not only will the Fed have to show they are willing to stay higher for longer but they are going to have to increase the odds that their next move could actually be a hike or a cut. A return of interest rate volatility is key towards bringing inflation back to target.

• In my view, Powell is not going to start cutting rates with any dissenting votes. He is going to want unanimous approval for a cut otherwise the cut will look political and he will look like Arthur Burns 2.0. Given this bias, and the difficulty at this point to move these three voters, we should be pricing in an increased likelihood of no rate cuts this year.

• At the upcoming June Fed meeting, I anticipate that the median dot in the SEP will fall to only one interest rate cut this year and there will be several members who are now looking for no cuts. I also expect the Fed to remove a cut or two from the 2025 outlook and I believe the trend of higher neutral rate expectations will continue.

• If the Fed removes more cuts at the June meeting, interest rate volatility would move higher, which is a precursor for overall equity volatility moving higher. There has been a tremendous chase for upside calls already as most investor groups (retail, CTAs, vol control funds, etc) are operating very close to max long positioning again.

• As equity volatility starts to move higher, we would start to get the systematic flow selling that could exacerbate a move to the downside, especially now that we are on the other side of May option expiry, a 5 week cycle where vanna/charm flows are diluted earlier in the window. As the start of a down move gets going, this would push dealers back into a negative gamma regime where selling begets more selling.

While anything is possible, and we need to trade the Fed we have not the Fed we want, this is the framework I would use to see if it’s all going to start to unravel. At this point, I expect the Fed meeting in June to be hawkish, delaying the start of cutting cycle further out in time and increasing the odds that their next move could actually be an interest rate hike. While next week’s PCE is expected to come in around 0.25-0.3% mom and is well known at this point, I think the May economic data we see in the first week of June on the labor market and on PMIs will help demonstrate an economy that does not need accommodation any time soon, solidifying the hawkish path for the June meeting. I would also look for any hints in the economic assessment of the Beige Book next week to see if the Fed is setting up for more hawkishness by acknowledging the overall strength in the economy coming in better than they expected to start the year.

However, if the Fed, led by Powell, continues to say that data to start the year hasn’t really impacted their decision making and that they could still start the cutting cycle this year if the labor market starts to slow, we are going to keep bubbling up even further until inflation expectations truly become unanchored and the Fed then really gets uncomfortable as inflation will increasingly be back and become an even larger election issue this year.

My asset allocation biases remain long gold/bitcoin, short small cap equities and short USTs.

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