The Coming Short-Squeeze Will Upend the Market
Speculators have been betting interest rates are going higher ever since President Trump won the election—for the past two years. I’ve been saying this will present a huge opportunity in the Treasury bond market when the shorts get squeezed. However, the opportunity isn’t in Treasuries alone. Speculators have been shorting numerous sectors in the market to push investors into stocks.
What is a short-squeeze and how can it create outsized returns for those betting against the short-seller? Before I define ‘short-squeeze’, I want to share with you the psychology behind the term.
When many investors are convicted about a trend, they take a position in it. For reasons beyond explanation, investors were told by the mainstream media that President Trump’s policies would be inflationary. The proper definition of inflation is an expansion of the money supply, which a President has no control over. As I have shared in previous updates, the banking system multiplies money in our economy which leads to true inflation.
Facts aside, the media and the financial-services industry convinced investors it was time to dump bonds to buy stocks to hedge against inflation. A few people, including me, have demonstrated with evidence that we will not experience true inflation.
Despite the facts, speculators have taken a record short-position in Treasury bonds. When an investor shorts a Treasury bond, they can profit from an increase in Treasury yields. Since speculators are convinced interest rates are headed higher, shorting Treasury bonds makes logical sense, even though their conviction is flawed.
Stock markets tend to make fools out of the largest number of investors possible. Whenever a large number of investors take a one-sided position, markets tend to move in the opposite direction. This happens because because the smart money senses an opportunity to take money from a large group of investors. The smart money enjoys taking money from lots of investors at one time.
The purpose of short-selling is to drive down the price of a security by creating sales of that security. As more shares of a security are sold, prices tend to fall. When the price of a security that is being short-sold falls, the short-seller generates a profit.
When an investor wants to short a security, they borrow the number of shares they want to short from a securities dealer. The act of borrowing is done as a normal trade, so there are costs for the transaction. Once the shares are borrowed from the dealer, they are sold on the open market to complete the short-sale.
Another investor, who is bullish on the same security, will buy the borrowed shares on the open market. To the buying investor, the borrowed shares are the actual security. In the meantime, the securities dealer maintains ownership of the security until the borrowed shares are repaid by the short-seller.
The securities dealer collects all dividends on the security, which is profit to the dealer. The short-seller needs to make the buying-investor whole by paying all dividends to the buying-investor. In the case of a bond, the short-seller must make each monthly dividend payment without receiving any money from the securities dealer. For equities, the short-seller must pay all regular dividends. The ongoing dividend payment is a cost to the short-seller and is one of the reasons short-sellers do not hold their short-position indefinitely.
To close out the short-sale, the short-seller needs to buy the same number of shares of the security they shorted. If the price of the security falls below the price when borrowed, the short-seller profits. If the price of the security rises above the price when borrowed, the short-seller takes a loss. When the short sale is completed, the short-seller will own the security they just shorted.
When there are a large number of speculators shorting a security, the price of the security usually falls due to a large number of shares being sold. At some point, the price of the security falls enough to attract buyers. This is where the short-squeeze begins.
When the price of a security falls far enough to attract buyers, the security will stop falling in price. When investors see the price of a falling security bottom, some will start buying. As the price of the security rises, other investors will start buying as well. When enough buyers push back against the short-sellers, the share price rises and a short-squeeze is triggered.
As the price of a heavily short-sold security rises, the profit of the short-seller is quickly eroded. If the price of the security rises fast enough, then the profit of the short-seller could turn into a loss. Short-sellers will cover their shorts by buying the security to lock in their profits from selling short.
When short-sellers close out their short-position and become buyers, the price of the security can rapidly rise. A short-squeeze is when buyers “squeeze” the profit out of the shorts until they become buyers.
Investors can profit on a short-squeeze by waiting for a heavily shorted-security to stop falling in price. If an investor already owns a security that is being shorted, then the investor needs to weigh the decision to hold or sell. Often, investors sell, only to miss out on the rapid jump in the price of the security when the short-squeeze begins.
In the case of U.S. Treasuries, it makes sense for investors to hold them. Short-sellers began shorting 10-year Treasuries back in November 2017 when the yield was 2.3%. The second wave of short-sellers came in January when 10-year Treasury yields were at 2.6%. Those who shorted at 2.6% are about to become buyers because yields are in the low 2.8% and falling.
The reason the short-sellers who shorted at 2.6% are about to become buyers is because they have been paying the dividend for the past seven months or so, which has been eating into their profits. As yields fall, due to the servicing cost of paying the dividend alone, those short-sellers will be forced into buying Treasuries to close out their short position.
As short-sellers become buyers, yields will rapidly fall towards 2.3% where the early group of short-sellers sold short. As the early short-sellers profit rapidly disappears, they too will cover their short-positions and become buyers. Should that happen, yields will be on a fast track to their all-time lows, aided by the record number of short-sellers buying U.S. Treasuries.
Why did I hold onto Treasuries despite all the short-selling? Because I understand how true inflation is created and I understand that our financial system can’t create inflation. Also, there is risk in selling, by missing out on the forthcoming short squeeze. Most investors who sold their Treasuries will wish they held onto them when yields plummet back towards their all-time lows.
The reason I follow the weekly Commitment of Traders reports is that it explains how the Commercial Hedgers, or smart-money, and how the Speculators, or dumb-money, are positioned. In the case of U.S. Treasuries, the smart-money has been buying while the speculators have been selling. I’d rather follow smart-money than dumb-money!
One of the reasons I have written extensively about the money supply is because an expanding money supply can keep asset prices, including stocks, elevated. In the case of the speculators, an expanding money supply provides more money to buy stocks, short volatility, and short bonds.
This Bull market has been built by buying stocks, shorting volatility and shorting Treasury bonds. The market is a three-legged stool being propped up by a record amount of debt that has been used to perpetuate those trades. As the Treasury short-squeeze builds, it will fracture one of the three legs which will put the entire stock market in danger of tumbling down.
As long as there is sufficient growth in the money supply, which is currently decelerating, the stool can be propped up. However, stocks cannot go up indefinitely, volatility cannot go to zero, and bond prices cannot go to zero. This Bull market has an end date, and when it comes, it will unwind in a spectacular fashion.
Q&A with Steve – Your Questions Answered
- Thoughts from the Weekend
The stock market is a three-legged stool held up by three trades: long stocks, short volatility, and short bonds. The short bond trade is on the cusp of reversing which will squeeze investors and speculators who are short U.S. Treasuries into buying U.S. Treasuries. With cash levels near historical lows and the money supply decelerating, it is likely the speculators will get the money to buy Treasuries when the short-squeeze begins by selling some of their other holdings. If they sell stocks or exit their short volatility positions, the stock market will likely begin unwinding in a rapid fashion.
There is a huge amount of debt that is propping up these trades in the form of margin debt. Nobody knows how levered the long stock, short volatility and short bond positions are. But what I do know is that two out of three of those positions needs to be rising to keep the market elevated.
Due to the Federal Reserve lowering interest rates, speculators and investors have taken a margin loan to buy stocks, short volatility, and short bonds. A margin loan allows an investor to borrow 50% of the value of their account. After taking a margin loan, investors can take a second loan against their equity holdings, but for the moment we’ll assume most investors aren’t dumb enough to take a second loan against their margined brokerage account.
As long as stocks are rising, volatility is falling and bonds are falling, the ability to borrow more money increases. It’s just like taking an equity line of credit against your house. As long as your property is rising in value, the bank will increase the line of credit. The same principle applies when borrowing against your brokerage account.
As the biggest short-squeeze in the history of the U.S. Treasury market gets set to unwind, those holding these positions will need to get money to further add to their short positions. Unfortunately for these speculators, volatility is not falling as much as it was before. As the Fed unwinds its balance sheet and raises interest rates, volatility rises. With interest rates starting to fall and volatility unable to go much lower, stocks need to rise.
Despite weakening economic data, stocks rose last week. Volatility fell but not much. Treasury bonds increased in value and are starting to attract traders who see a major breakout in Treasuries. At the end of the day, stocks cannot go to infinity, volatility cannot go to zero and interest rates cannot go to infinity. It’s just a matter of time before this trade blows up, which will send stocks spiraling down as speculators and investors try to escape a falling market.
What few people seem to understand is the same leverage and debt that was sitting under the housing market going into the Great Financial Crisis, is now sitting underneath the stock market. The risk from the housing market didn’t go away, it was just transferred to the equity markets. To avoid a crisis, U.S. equities need to indefinitely rise, even though they won’t.
In a recent interview, Dr. Harald Malmgrem shared some valuable insight on some of the hot topics today. Since his interview was for a subscription service, I can’t share it with you, but I will share some of his views about what is to come.
He believes China will win the trade wars and that the current administration lacks the ability and the experience to properly negotiate a winning agreement for both sides. He also believes gold is falling because investors are forced to sell gold in an attempt to hold prop up their existing trades He said people sell gold because it’s the only investment you can sell as markets weaken.
He believes central bankers have exhausted their policy tools, which means the next crisis will be much longer and deeper because central bankers are out of ammunition to soften the blow. He thinks the crisis is going to come from foreign dollar-denominated debt, which is currently at $11.5 trillion. As the dollar rises in value, the cost to service this debt also rises, which will lead to an Emerging Markets crisis.
He also mentioned the speed of the next market downturn will be much faster than anyone expects due to a large number of computer algorithmic trading programs which are trading commodities, stocks, bonds, and options all within milliseconds. When these programs decide to sell, there are no buyers left to absorb the large positions these programs hold. Should that happen, the market will become illiquid and prices will plummet.
Goldman Sachs published a report over the weekend showing global air freight and sea freight volumes are rapidly decelerating, with air freight showing a slight contraction on a year-over-year basis. If there is a global economic recovery, then freight volumes should be rising. This is a red flag.
In addition to the Fed unwinding more of its balance sheet this week, the U.S. Treasury is set to auction off another large amount of debt this week. Both are a drain against market liquidity. I must say I have been impressed the U.S. stock market has held up to the Fed’s monetary tightening and the U.S. Treasury’s borrowing, but for how much longer is the question. With the Fed expected to raise the Federal Funds rate next month, based on my research, the economy should hit a wall. We’ll know soon enough.
- What happened to the stock market on Monday?
Global equities were all up today after Fed Chairman Jerome Powell dedicated five paragraphs of his Jackson Hole speech to why Alan Greenspan made the right decision to keep the Federal Funds rate low between 1995-1999. We all know how that story ended, but the stock market saw this as a dovish statement that Powell is going to keep interest rates low to allow the stock market to continue rising.
Stock market Bulls are failing to account for the decelerating money supply and the Fed’s balance sheet unwinding program which has the economic effect of the Federal Funds rate increasing by 0.25% for approximately every $60 billion the Fed unwinds. Based on Powell’s speech, we can infer the Fed will raise the Federal Funds rate at the end of September and likely in December. Based on my models, our economy should grind to a halt after the next rate hike due to the continued balance sheet unwind.
Even though the news made a big deal out of the preliminary trade agreement with Mexico, you can thank Powell for the stock market going higher.
The U.S. Treasury auctioned off over $120 billion in debt today, with a great deal of interest on the 2-year Treasury auction. Foreign investors took a little less than half of the auction, which shows continued demand for our debt. A rising U.S. dollar may not be good for all the foreign dollar-denominated debts, but it is good for foreigners who own U.S. Treasuries.
Treasury yields rose a bit today as short-sellers try to hold on to their positions. On the first of next month Treasuries pay their monthly dividend, so short-sellers will need to pay another dividend check to hold their short position.
With yields barely budging today as the S&P 500 set a new all-time high, it makes me believe we’ll see the short-sellers start vacating positions this week.
Agricultural commodities got a boost from the preliminary trade deal with Mexico as President Trump remains focused on exporting soft commodities.
Physical gold was up a little and the gold miners tried to rally, but the gold miners are facing heavy resistance from the short-sellers. The reason short-sellers are targeting gold is due to the recent strength in the dollar.
If the dollar is rising because foreign currencies are strengthening, then gold should fall. If the dollar is rising because foreign currencies are weakening, then it is bullish for gold. Another indication the short-sellers are on the wrong side of the trade.
- What happened to the stock market on Tuesday?
The excitement of the bilateral US-Mexico trade deal appears to have worn off, or perhaps it’s the realization the bill must be signed before it goes to Congress for approval. With the midterm elections coming, it’s unlikely the bill will have time to go before Congress prior to the elections and depending on how the elections go, this bill may not get very far.
The short-sellers were back aggressively shorting bonds, gold and agricultural commodities in an effort to prevent a major short squeeze from developing. The short-bond trade is in jeopardy of blowing up as yields rose but ran into stiff technical resistance, or where the buyers are at.
Due to the aggressively gold shorting today, the gold miners took a strong move down, which I have been expecting. Should the shorts continue to press their position, they can get the price down one more level before I think the bottom is in.
After yesterdays upward move in the agricultural commodity space, the short-sellers were back once again trying to push prices down. One way we know it is short-sellers who are pushing prices down is because the dollar has been falling. Commodities often, but not always, trade inversely from the dollar. If the dollar is falling, which it has recently, then commodities should be rising. They haven’t, which is an indication short-sellers are trying to push prices down.
The real key, when faced with aggressive short-selling, is to either bail then re-enter before the short-sellers turn into buyers or just to ride it out. Neither bonds, gold or agricultural commodities can be shorted to zero, and once you know that, you also know all these short-sellers will eventually become buyers. As they turn into buyers, prices will rapidly rise.
The short-sellers are also shorting volatility, which rose today. These sellers are aggressively shorting multiple sectors, which they cannot do indefinitely. The deceleration in the growth rate of the money supply and the Fed’s monetary tightening will eventually force the short sellers into buyers.
Today’s five-year Treasury auction saw indirect or foreign buyers take 66.2% of the near $37 billion offer. Consider this: foreign investors are buying US Treasuries and banks are buying US Treasuries. This is how you know the short-sellers are going to end up being wrong. Everyone predicted yields had to rise, but they are looking every wrong. As long as the dollar stays elevated or rises, foreign investors will continue to buy Treasuries.
- What happened to the stock market on Wednesday?
It was a relatively quiet opening for the stock market today until Morgan Stanley set a price target for Amazon +28% higher than it trades today. There were no details on how this number came to be, but one can only assume MS has clients that want to sell. Regardless of the true intention, this drove Amazon shares higher along with the broad indices.
Morgan Stanley’s move could be a snug at Hedge-Fund managers who are back shorting tech stocks as the Nasdaq-100 continues to move higher. By promoting Amazon, MS effectively moved the entire index with one upgrade.
Pending home sales fell for the seventh straight month, which indicates the Fed’s tighter monetary policy is working. Slower homes sales mean fewer home loans, which is going to slow down the monetary growth engine as new money is created when a new loan is originated. Slower home sales is not an indication of a booming economy.
The US and Canada are meeting today with a Friday deadline to have a trade agreement in place. On the subject of trade and tariffs, next week President Trump is expected to make a decision if he will add an additional +$200 billion in tariffs on China’s imports.
The S&P 500 has been rising on the back of two sectors, whereas the prior peak in January had seven sectors making new all-time highs. Stocks over their 200-day moving average is at 68%, compared to January when 83% were over their 200-DMA. New highs on weaker breadth is not a sign of strength.
The Fed is scheduled to unload $14 billion from its balance sheet this week. I just found out today that the Fed has been selling 1- to 5-year maturity bonds from its portfolio, rather than longer-term bonds. This explains why long-term bond yields haven’t fallen as quickly as I expected from the Fed’s balance sheet unwind. Why the Fed is biasing towards shorter-term debt is unknown, unless they are trying to avoid inverting the yield curve.
Today’s 7-year Treasury auction came with a surprise – domestic demand. Foreign buyers took 59.5% of the offering and direct buyers took 19%, which is the highest percentage since August 2014 and above their 13.4% average. Yields promptly fell.
It’s extremely impressive to see a near $2,000 per share stock that finds buyers. The day belonged to Amazon, courtesy of a timely price upgrade by Morgan Stanley. It is hard to believe that Amazon is 28% undervalued. From a chart perspective, the price has gone parabolic, which isn’t necessarily a good thing for recent buyers when they look to sell.
Despite the equity market making new highs, the bond market completely ignored the news. Ten-year Treasuries were flat on the day, with 30-year bond yields down. Bonds usually are a better predictor of where the economy is going, and they are signaling a potential recession. Otherwise, Treasury yields should be at a new cycle high, but they aren’t even close.
Remember, stocks must go up indefinitely. The stock market is the economy.
Agricultural commodities look to have found a bottom. Sellers appear to be exhausted as they can’t seem to push prices any lower.
Physical gold traded down slightly, and the gold miners were up slightly. Sellers have been fairly aggressive here, suggesting gold has one last move down to approximately $1,135/oz.
The U.S. dollar has been falling, but in the bigger picture, it is forming a 1+ year head and shoulders reversal pattern. If this pattern is correct, then based on classical charting principles, the dollar should at some point retest its all-time highs at $103. I’m looking at $93 on /DXY as a potential entry point for a small position. This would be the right shoulder and the breakout to the upside is somewhere around $96.
- What happened to the stock market on Thursday?
The stock market is largely being led by two stocks, Apple, which is spending its own cash to buy its shares back, and Amazon, who got a mysterious upgrade from Morgan Stanley yesterday without any details as to why they believe Amazon stock is 28% undervalued. As far as I am concerned, Morgan Stanley has Amazon stock they want to sell, so they generated a buy recommendation to get people in.
What I find more interesting is the artificial-intelligence computer trading programs that read such press releases, trade on such press releases. Perhaps Morgan Stanley knows this and is tricking the computer programs into buying. Regardless of what Morgan Stanley is up to when a market is being led by fewer and fewer stocks, it tells you the peak is not far away.
Considering tomorrow the Federal Reserve will drop $20 billion of bonds from its portfolio, volatility should rise, bond yields should fall, and stocks should fall tomorrow. All at a time when market liquidity is thin. While it’s not evident based on the S&P 500 and Nasdaq-100, the Fed’s liquidity drain is having an effect. Remember, risk happens fast.
I’m surprised short-sellers continue pushing agricultural commodities. In an interview I saw the other day, farmers said the same crops grown anywhere else in the world are selling for 15-20%+ higher. The 25% tariff China put on our crops has been mostly offset by speculators shorting agricultural commodities. Just goes to show, when the short-sellers are squeezed out and become buyers, agricultural commodity prices should shoot straight up.
The Fed is now officially behind their own inflation curve as Core Personal Consumption Expenditures, the Fed’s preferred gauge for inflation, just hit their target of +2.0%. The Core PCE is a lagging indicator, which suggests the Fed will need to raise the Federal Funds rate in September and again in December.
Wage growth was up +0.3% MoM in July, but spending increased +0.4% MoM in July, indicating consumers are continuing to deficit spend. As long as consumers can access cheap credit this can persist, but with interest rates rising and the money supply decelerating, this trend cannot go on forever. When consumers are forced to cut spending, economic growth will rapidly decelerate.
For all the stock market Bulls, inflation-adjusted pre-tax corporate profits are still below their 2014 Q3 peak, while the stock market is much higher. Unless profits are going to magically rise to catch up, stock prices remain significantly overvalued.
The stock market was rising on the backs of Amazon and Apple until news broke that President Trump is supporting further tariffs on Chinese goods. On September 5th, President Trump is believed to enact $200 billion in additional tariffs on China, which will affect 50% of all imported Chinese goods. Keep in mind this is not new news, but apparently, it was new to the stock market which promptly sold off on the report.
Federal employees will not be getting any form of raise next year, despite a booming economy. This is an early sign the tax cuts aren’t working as the government is borrowing to pay for the already massive deficits that will increase to over $1 trillion next year.
We will also find out tomorrow if Canada is going to join the US-Mexico bilateral trade agreement. Canada has three days to agree to terms, while Mexico had thirty. Should Canada choose not to, President Trump is expected to enact further tariffs on the Canadian auto industry.
Treasury yields fell on the Chinese tariff news, which continues to put pressure on the massive speculative short position on Treasuries. Yields are expected to fall tomorrow as the Fed unwinds $20 billion from its balance sheet.
Physical gold and the gold miners were down today, but I believe they are both near a bottom. There is a similar chart pattern on the gold miners going back to November 2016 where gold mining stock prices tumbled, consolidated, then tumbled one last time. There are buyers at the current price, but not enough. The further prices fall, the more buyers are likely to show up.
The Money Supply resumed its deceleration this week by posting a 3.92% year-over-year growth rate. Recessions and depressions can be found when the growth rate of the money supply falls below 3.70%, which is not far off. A decelerating money supply means economic growth should slow, stock prices should fall, and bond yields should fall.
- What happened to the stock market on Friday?
There was no deal with Canada today, but both parties agreed to come back to the table on Wednesday. The Fed unwound $20 billion as expected and the market, once again, digested it. At this point, the Fed has to be thinking that the excessive amount of Quantitative Easing was unnecessary because the market is not showing any signs of stress during Quantitative Tightening.
Stock investors will go into the weekend happy the market didn’t sell off. Treasury short-sellers were aggressively selling today as foreign investors were buying Treasuries in overnight trading. Treasuries are on the cusp of a major move higher as the short-sellers continue to believe bond yields are headed higher.
Shortly before markets closed, bond buyers came in to put a halt to the selling on strong volume; a good sign. I am surprised the short-sellers were so aggressive today with dividend payments due next week. The shorts must be confident because they are about to be upside down on today’s trade.
The long-bond tagged its 50-day moving average and held, which is another positive sign. Rallies tend to begin when price moves over a security’s 50-DMA and then reconfirms as it is rising. The long-bond has now made two 50-DMA confirmations.
Physical gold was flat on the day, but the gold miners were down and are on the bottom side of a technical level, which suggests one more move down is in the cards.
Agricultural commodities found buyers in overnight trading as foreign investors are seeing an opportunity in the least expensive asset class in the market. Perhaps there still are a few people who believe in buying low and selling high, whereas the current market has people buying high, hoping the market will go higher. Volume has been rising over the past few days which is another sign buyers are coming back.