Markets are in risk-off mode: Some of the 'bloom is off the rose' for AI, strategist says

Key Concepts

• Risk-off mode: A market sentiment characterized by investors selling riskier assets (like equities and cryptocurrencies) and moving towards safer assets (like bonds).
• Fed dovishness: A stance by the Federal Reserve indicating a willingness to lower interest rates or implement other accommodative monetary policies.
• Crypto markets: Markets for cryptocurrencies like Bitcoin.
• Carry trade: An investment strategy where an investor borrows in a currency with a low interest rate and invests in a currency with a high interest rate, profiting from the interest rate differential.
• FOMC meeting: Federal Open Market Committee meeting, where the Federal Reserve discusses and decides on monetary policy, including interest rates.
• AI trade: Investment strategies focused on companies involved in Artificial Intelligence development and application.
• Bottom-line efficiencies: Improvements in a company's profitability and financial performance.
• Hyperscalers: Large cloud computing providers like Amazon Web Services, Microsoft Azure, and Google Cloud.
• Seasonality: Predictable patterns in market behavior that occur at certain times of the year.
• Santa Claus rally: A tendency for the stock market to rise in the last week of December and the first two trading days of January.

Market Sentiment and Crosscurrents

The market is currently experiencing a "risk-off mode" post-Thanksgiving. Equities are caught between potential "Fed dovishness" (indications of a possible rate cut) and risk aversion signals from the crypto markets. This morning, the market is giving back Friday's gains, which occurred on very light volume. The speaker notes that while there were questions about the current decline, there were few on Friday about the "mysteriously" low-volume rally. This rally is attributed to factors like the end of the month, window dressing, and a half-day trading session.

Bitcoin and Risk Sentiment

The significant sell-off in Bitcoin is highlighted as a more notable event. The speaker observes that algorithms are trading off of Bitcoin as a proxy for risk aversion or risk sentiment. The current decline in Bitcoin is linked to a sharp rise in Japanese bond yields and a corresponding increase in the price of the Yen. This makes the "carry trade" more difficult, as many investors use the Yen to finance other investments. However, the speaker cautions against reading too much into this immediate reaction, given that much of the recent market movement was built on a light-volume rally across various assets.

Fed Rate Expectations and Market Pricing

The outlook for interest rates is a key driver. The speaker believes that the market has been pricing in potential rate cuts. The rally observed in the days leading up to the current pullback began as Fed funds rate expectations improved, with the probability of a cut rising from around 30% to over 80% in a short period. This significant shift in expectations is seen as a healthy reason for a rally.

Supporting Evidence: The last high in the S&P 500 coincided with the last FOMC meeting, after which Chair Powell tempered expectations of a consistent pattern of rate cuts. This suggests the market is now repricing based on this more cautious outlook.

Potential Impact of Kevin Hasset's Stance

The potential appointment of Kevin Hasset as the next Fed leader is also a point of discussion. The speaker intends to monitor 10-year and longer-term bond yields. If Hasset aligns with the President's inclination for "lower rates forever," it could raise concerns about a rekindling of inflation and inflation expectations, as the market may perceive an inability to achieve both low rates and stable inflation.

AI Trade and Diminishing Returns

The enthusiasm for the "AI trade" is currently experiencing a reassessment. While there are ongoing headlines about AI investments (e.g., Nvidia buying $2 billion worth of Synopsys, OpenAI partnering with Accenture), there's a growing focus on whether AI is delivering "bottom-line efficiencies" to end-users, not just to chip producers and hyperscalers.

Analogy: The current situation is compared to the late 1990s/early 2000s, where companies saw a stock bump simply for announcing a website. The market is becoming more discriminating, demanding tangible results from AI investments.

Perspective: While some of the initial excitement ("bloom is off the rose") has faded, the underlying mentality supporting the AI trade remains, as AI is considered a dominant market force.

Key Catalysts for Year-End

Looking ahead to the end of the year, the main catalysts to watch are:

• The Fed Meeting: The Federal Reserve's upcoming meeting will be crucial for monetary policy signals.
• Economic Data: A "data dump" of incoming economic information will provide a clearer picture of the economy.
• Low Volume Period: The period of low trading volume as the year concludes can amplify market movements.
• Seasonality: Expectations of seasonal rallies, such as the "Santa Claus rally," are already being factored into market sentiment.

Conclusion

The market is navigating a complex environment with conflicting signals. While there's anticipation of potential Fed rate cuts, this is being weighed against risk aversion, particularly evident in the crypto market. The AI trade is maturing, with a greater emphasis on tangible results. Key upcoming events, including the Fed meeting and economic data releases, along with seasonal patterns, will likely shape market direction into the year-end.