Bank of America’s bull-bear index is close to extreme bullish levels. What does that mean?

Bank of America’s bull-bear index is close to extreme bullish levels, and a pullback seems to be just around the corner. Will the fed’s inability to halt its repurchase operations accelerate the process? What impact will it have on the market?

Bank of America’s (34.74, -0.29, -0.83%) global research said in its latest report released Friday that its bull-bear index is currently at 6.5, its highest reading since March 2018. Near the extreme bullish territory of 8-10, the index hit 8.6 on January 30, 2018, and the dow immediately posted a correction of more than 10% the following month.

So when exactly will such a market turn come?

I believe two time nodes

Bank of America said bullish sentiment and dovish sentiment could peak after the fed’s January 30 decision.

Michael Hartnett, chief investment strategist at bank of America, remains optimistic that the s&p 500 could rise to the 3,333 level at least until March 3.

In the New Year, market expectations for liquidity have been upbeat, helped by $1.1tn of QE by the us federal reserve, the European central bank and the bank of Japan over the past four months, and 80 rate cuts by central Banks around the world over the past 12 months. Fears of a recession, defaults and inflation by 2020 have eased.

But Hartnett isn’t optimistic about the market beyond march, when he expects the fed to start draining its liquidity from its repurchase program, which contracted last week for the first time in four months.

Since September, the relationship between global liquidity and the s&p 500 has been rising in tandem, and Hartnett worries that once the fed withdraws liquidity, the initial big push could turn into a headwind that could cause U.S. stocks to fall.

A fatal risk — a trapped fed

There is now a broad consensus among investors that the fed’s liquidity injection has largely supported the stock market rally. But if you look at it the other way, you could also say that the fed is a big, uncertain risk for the stock market to rise — what if the fed stops buying? Are markets used to relying on the fed really not collapsing? (the pain from the fed’s rate hike seems to be still fresh.)

It is worth noting that the scale of the fed’s current repo operations is not justified. Curvature Securities analyst Scott, durkheim (Scott Skyrm) pointed out that the fed’s last Friday overnight and long-term repo total more than the end of last year. By the end of the year, the fed had pumped $255.95 billion into the market, up from $258.9 billion on Friday. Liquidity is supposed to be scarcest at the end of the year, after which the fed’s liquidity should be reduced.

There are two irrationality here:

When the fed first started “operation repo” in late September, the explanation was that quarterly corporate tax payments drained liquidity from the market and needed to be replenished. But corporate taxes are due quarterly and can be easily predicted weeks in advance. Why is this time so different? And, if that is the reason, after October 15th the “repo” operation should no longer be needed, but the scale of the fed’s “water letting” has increased.

As the end of the year approaches, repurchase operations are again being interpreted as making up for the year-end liquidity shortfall. But why bother in 2019 when the fed has been ignoring the usual liquidity shortages that occur at the end of every year for nearly a decade?

In the absence of a reasonable explanation, the fed’s continued use of water has raised doubts among market analysts that it may have been caught in a “liquidity trap”.

Believe the liquidity trap

A liquidity trap is a situation described in Keynesian economics in which central Banks flood the private banking system with cash but fail to lower interest rates and thus fail to stimulate economic growth. By now, the most popular explanation for a liquidity trap is that when people anticipate an adverse event such as deflation, a shortfall in aggregate demand or war, they start hoarding cash, eating up much of the liquidity unleashed by central Banks.

Skyrm points out that the fed’s current problem is not only that they are caught in an “economic liquidity trap”, in which monetary policy becomes ineffective in stimulating growth, but also in a “market liquidity trap”.

“The fed’s problems in the repo market are similar to those observed with quantitative easing and the overall balance sheet over the past decade: the market has become highly dependent on the fed’s liquidity.”

The short answer is that markets have become addicted to the fed’s QE and could suffer if it stops — the fed raised rates in 2018, scaled back and tried to normalise its monetary policy, and the market fell about 20%.

In such circumstances, even if the fed knew that the best solution might be to stop the repo operation, they would not dare to do so because of the risk of a crisis if they stopped, and the more cautious they were, the greater the risk. Federal reserve vice chairman larry clarida said last week that some repurchase operations may need to continue through at least April, but that the fed should gradually withdraw from active repurchase operations.

At a time when the fed is inflating a market bubble through buybacks, the longer it continues to do so, the less likely it is to escape without causing market turmoil. Next, it’s up to Powell to see how long he can hang on.

Ford Austin

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