Although the Federal Reserve maintains the Federal Funds interest rate is the primary monetary tool, Quantitive Tightening , also called  QT began last Wednesday June 1. They intend to reduce liquidity from the monetary system by reducing the Federal Reserve's holdings by not replacing maturing securities at the rate of $47.5 billion each month for three months, and then increase the runoff pace to $95 billion per month. While the markets have apparently discounted announced rate increases the consequences of reduced liquidity will soon become apparent.

S&P 500 Index (SPX) 4108.54 declined 49.70 points or -1.20% last week as the bounce from the late day reversal on May 20 continued, although Tuesday's abnormally high volume of 3.7 bn shares and a slight pullback created some doubt. While back on track Thursday with a 75.59 point gain it slipped again Friday making a narrow inside range day on low volume.

Unless derailed by an unexpected macro event the bounce will likely continue up to test the 50-day Moving Average at 4249.27.

From the perspective of the SPX options market, implied volatility declined slightly. For the week, IVX declined .58 points or -2.55% to end at 22.17% compared to 22.755 on May 27.

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Consequences of Reduced Liquidity

Comparing the yield on iShares iBoxx $ High Yield Corporate Bond ETF (HYG) to iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) provides one way to measure declining liquidity. With less liquidity high yield rates will likely increase faster than investment grade rates. On May 27, the spread ended the week at 1.80% down from 1.93% on May 24 helping the SPX gain +6.58% for the week. Most recently for the week ending June 3, the spread widened slightly to end at 1.85% as the SPX declined 1.20%.

For an alternative and perhaps an easier method, use the prices of the two ETFs to compute a ratio by dividing HYG by LQD. While both rise and fall, during periods of abundant liquidity HYG rises faster and the ratio increases. For example, on April 21 the ratio reached .7071 before reversing as the SPX also reversed that day declining 1.48% followed by another decline of 2.77% the next day.

While the ratio and SPX often move in the same direction, they also diverge. On March 29, SPX made a pivot at 4637.30 and turned lower, however the HYG/LQD ratio increased from .6815 and increased to .7071 on April 21 as SPX declined. On a daily basis, the ratio may not be very useful; however, its trend should begin to reflect reduced liquidity as QT continues.

Market Breadth as measured by our preferred gauge, the NYSE ratio adjusted Summation Index that considers the number of issues traded, and reported by McClellan Financial Publications gained 265.00 points to end at -308.16 closing above its 50-day Moving Average at -441.30 with the next stop up at the 200-day Moving Average at -213.58. Continued breadth improvement supports the view that the SPX will continue higher and test resistance up at the 50-day Moving Average now 4249.27.