The Big Three

I’m probably stating the obvious for many of you, but the moral of the story is always follow the money supply starting with a macro view and all the way down to watching for shifts in what I call “The BIG three” intraday.

First up, the 10s. Ten Year US Treasury notes are perhaps the most widely used and regarded measure of risk appetite in the world. Money isn’t created (usually). As a “first stop” it flows between the S&P 500 index and the 10s in a very reactionary manner initially and from there it is chopped up and allocated to various asset classes with more detail. But if something happens that is bearish, there will be a quick move to park in the 10s and if something is bullish money will flow from the 10s into the 500 initially. It is important to note that we are in a HUGE, organized uptrend in the 10s. Notice how it is mostly uniform and not all messy like the ES? This is a really good first clue that global money is being positioned for flight to quality. Kind of like a bear settling in for a long winter hibernation. I don’t profess to be a macro God, but when I see this I pay attention. Also note that the volume is steadily increasing to the long side. Last year at this time the 10s were trading 5-600K per day. Yesterday we traded more than 1.5M and we are averaging over 1M contracts each day with the net pouring into the long side. Not good for stock indices.

Next is the Euro. Directly correlated with the 500 for quite some time now – especially during price shock conditions. Right now the EU is likely in a move to return to parity or close to it. Without going into a huge explanation of exactly how and why the Euro tracks with the S&P, just know that with the global debt issues being at the fore front right now, everything is tied to the currencies and value against the dollar in particular. Like the 10s, note the uniform down trend with increasing volume to the short side.

Finally, remember to pay VERY close attention to the Euro/Yen cross. Also known as the carry trade. The EUR/JPY cross has succeeded in calling most every major turn in the equity markets WAY ahead of time. Why? Like I said, follow the money. The world money supply is about debt and using borrowing at various efficiencies between world banks to create spread ops as well as to use as a hedge against risk appetite. Basically, the core benefit of the trade is the ability to borrow money for free in Japan at the central bank level. Actually it was really free (as in zero) until relatively recently, but it still may as well be as it is right at a mere 9 basis points. The idea is to borrow money in Japan at 9bps and invest it in US an/or European equities for a nice return and use the ECB tied to the Euro as a backstop as a hedge. Obviously there is a built in “free money” trade, since at the worst case you are borrowing for 9bps points and returning 50bps at the ECB for a difference of 41 basis points in your pocket. What is the catch? If risk appetite shrinks because the equities investments lose more than 50 bps you are upside down on the trade and the cost of borrowing is the minimum loss. This is why the carry trade is the ultimate barometer for global risk appetite. If the biggest and brightest who control the biggest pools of money in the world are pessimistic enough not to grab the free money you probably want to pay attention because obviously it trickles (or pours) down into the equities rather quickly. When the cross goes up it is bullish for equities and when it declines it means risk appetite is shrinking so money will flow out of equities. In turn the Yen declines against the Euro and the money shifts to fixed income, best reflected initially in the 10s almost always. Once again, note the significant down trend and the increase in volume as the selloff deepens.

One last thing about the carry trade: Notice in the following chart plotted against the SPX how the cross leads every major turn in the equities markets. Follow the money. This is all daily stuff obviously but you need to be watching the big three everyday and use them to spot trouble that might run you over at your key levels. Remember: Equities CANNOT win a tug-o-war with fixed income or currencies. The money is just too big and dwarfs them in every way. The S&P against the 10s or the EUR/JPY cross is like Pee Wee Herman against Sly Stallone in an arm wrestling contest…