Inside Markets — Off-Ramp into Technical Resistance

Markets are not yet priced for the average recession and getting there implies weaker equities, wider credit spreads, more implied rate cuts and even higher volatility. For equity markets, the historical playbook suggests a peak-to-trough decline of ~25%, which would take the S&P 500 (SPX) to ~4600.

The SPX is bouncing from the upper end of long-term support in the 4500-4800 zone with reflex rallies running into resistance near last Friday’s downside gap at ~5395 or the pattern breakdown at ~5450. Expect the rally to fade in that range ahead of a retest near 4800 with the likelihood of a more lasting bottom following a successful retest. Recall that a successful retest can include a capitulation-based intraday low (below 4800) followed by a steep recovery into the close.

Monday’s back up in 30-year Treasury yields was an 8z move that’s been partially blamed on unwinding the ‘basis trade.’ The Treasury basis trade is a narrow arbitrage that exists between Treasuries and Treasury futures. Pension funds and insurance companies have a natural appetite for long duration US bonds via futures rather than cash. A handful of hedge funds are on the other side buying Treasuries and selling futures to these institutions. These are very narrow margins, so maximum leverage is used with repo rates financing cost. Refinancing costs in the repo market usually rise during periods of financial stress and increased volatility. You may recall that sharply higher repo costs were responsible for the 1998 collapse of LTCM. Thankfully, the Fed and dealer banks seem better prepared for the dynamic today than they were in ’98. This week’s backup in yields has also caused some to question whether the move is based on China selling Treasuries as retaliation for tariffs. This doesn’t seem to be the case with ‘off-the-run’ Treasury (issued in the past) volume and open interest in futures little changed on the week.