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posted on 27 September 2016

Banks Of Absurdity

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Macro Tides Technical Review 27 September 2016

As expected the Bank of Japan BOJ on September 21 did not push short term interest further into negative territory, which is a tacit acknowledgment that the BOJ's foray with negative rates unleashed too many negative unintended consequences. Instead, the BOJ announced it would peg the 10-year yield on Japanese government bonds (JGBs) at 0%.


It also said that it was raising its inflation target from 2% to above 2% so that the longer term average of inflation would reach 2%. In the last 12 months, inflation in Japan clocked in at -.5%, despite the BOJ's extraordinary efforts since 2012 to increase it to 2%. This is a bit like a major league player whose batting average has averaged less than .200 in the prior three seasons announcing in spring training that he will bat .300 in the coming season. His statement would not be taken seriously, and neither was the BOJ's announcement.

The BOJ's inflation target change is based on the theory economists call the self-fulfilling nature of inflation predictions. If consumers think prices will rise tomorrow, they are likely to spend and borrow more today, and to demand wage increases to offset the expected rise in the cost of living. BOJ Chairman Kuroda said:

"We are showing an extremely strong commitment."

In November 2012, Kuroda said inflation would rise to 2% in 2 years. Four years later and inflation is below 0%, which implies the only reason inflation is not already 2% is because the BOJ's commitment in 2012 wasn't strong enough. I'd like to bench press 200 lbs. but wishing it so will not help me.

One of the reasons Japanese consumers didn't rush out and bid up the cost of goods in 2013 and 2014 was due to weak income growth. Consumers aren't going to spend and borrow more if their income is growing less than 2% a year, no matter what a central banker says. That may be hard for a central banker to accept, but believing consumers will suddenly take Kuroda seriously after 25 years of deflation without a material increase in wages is delusional.

The pegging of the 10-year yield on JGBs at 0% is taking a page out of the Federal Reserve's playbook back in the 1940's, as the U.S. was funding the cost of waging World War II. Between 1942 and 1951, the Fed capped the yield on 10-year Treasury bonds at 2.5% and 90-day Treasury bills at .375% by buying when yields reached those levels. Since investors knew the Fed would step in, investors bought bonds and bills before they reached the cap limits. As a result, the Fed never had to buy much paper.

Who knows, maybe investors will be excited about buying 10-year JGBs at 0%, since the yield on ten year JGBs traded as low as -.30% in early July. After the BOJ's announcement, some analysts suggested that the increase from -.30% to 0% represented a tightening of monetary policy.

When the BOJ made its announcement on September 21, the 10-year yield was already trading near 0%, so the announcement didn't change the yield much. Any suggestion the BOJ had tightened policy is a reach. Other analysts proclaimed that the new policy would provide pension funds and insurance companies some relief in improving returns, since the yield had risen from -.30% to 0%. Earning 0% on a ten year investment is not going to help pension funds and insurance companies increase their returns to help fund retirements for Japanese retirees. Suggesting that it would be a benefit is ludicrous.

The quality of the analysis of the BOJs changes makes me wonder if some analysts aren't drinking the same water served at BOJ meetings.

As I noted last May, I thought it was noteworthy that the Yen had gone up rather than down as the BOJ wanted. Last week, I thought the key point was how the Yen responded to whatever the BOJ announced. If the Yen fails to exceed the mid August high and then closes below .9580, it will mark the first time the Yen has made a lower high and a lower low in many months, and represent a trend reversal in the Yen.

After the announcement, the Yen rallied to .99850, which is below the August high of 1.00300. On Monday the Yen closed at .9950. If the BOJ has any chance of getting inflation to increase, the Yen must fall in coming months and wages must increases by more than 2% annually.

Japan imports most of its energy in the form of oil, natural gas, and coal, which are priced in dollars. A stronger Yen lowers the cost of imports into Japan and lowers Japan's inflation rate in the process. If the Yen declines, Japan's import costs will increase and lift Japan's inflation rate. A meaningful decline in the Yen would likely spark a good rally in the Nikkei. Since the BOJ announced its negative interest policy in January, the Yen has gained more than 16% against the dollar. If the foreign currency market continues to ignore the BOJ and the yen continues to increase against the dollar, the BOJ will consider intervening in the foreign currency market to weaken the Yen.

Click on any chart below for larger image.

The Fed announced that it would leave rates unchanged, which wasn't surprising since indecision is what the Fed does best. The Fed is certainly better at finding reasons not to act than forecasting economic growth and future inflation. In recent years, the Fed has consistently over estimated economic growth and inflation. This failure has forced the Fed to lower its dot plot and acknowledge that future growth will be closer to 2.0% than the 3% the Fed has forecasted for years.

Coming into 2016, the Fed forecast that growth would be strong enough to justify 4 rate increases. With the end of the year in sight, the question is whether they will even increase rates once. I'm not suggesting the Fed should have increased rates 4 times or should move in December.

As I have discussed at length, the Fed's obsession with forward guidance has morphed into misguidance and has cost the Fed most of whatever credibility it ever had.

The Fed failed to recognize that monetary policy was a big contributor to the bubble, housing bubble, and the Fed's subsequent failure to anticipate the financial crisis. Since the Fed doesn't know what it is going to do, it would be far better to say nothing. That's not going to happen since it would require the Fed to acknowledge that the concept of forward guidance might have made sense in a classroom, but has failed in the real world.

This is very similar to the BOJ's faith that telling consumers inflation is going to rise will prompt Japanese consumers to rush out and spend more and borrow more to beat coming price increases. We now know how many central bankers can fit on the head of a pin - too many. History may well show that this era of central bankers will be best known as pin heads.

The Market

In last week's WTR I thought the stock market was likely to have a knee-jerk rally on an announcement that the Fed was not raising rates, but I doubted the rally would hold, and didn't expect the S&P to get above 2180 on any rally. The market did experience the expected knee-jerk rally after the Fed announced it wasn't raising rates. The high for the rally was 2179.99. This morning the S&P traded down to 2141, touching the red trend line connecting the low in February with the low at 2119 on September 14, and has bounced. Supposedly, the market is relieved that the first Presidential debate was won by Clinton.

A poll last week found that only 33% of Trump and Clinton supporters would be happy if their candidate won. This sounds like a variation of the old Miller Lite beer commercial - less filling and no taste. I suspect this rally is temporary and the S&P will fall below this morning's low soon. I'm wrong if the S&P closes above 2180.

The technical underpinnings of the market continue to weaken. Last week, the Russell 2000 posted a new closing high, as did the Nasdaq 100. These sectors have been the best performing, but the new high in each index was not confirmed by its RSI. The Russell's RSI was 68.3 on September 7, but only 62.0 on September 22.

The Nasdaq 100's RSI was 74.8 on August 15, but had dropped to 64.0 on September 22 as it closed at a new high. The RSI divergence on the Russell 2000 and Nasdaq 100 suggests that these leading sectors are starting to tire and becoming more vulnerable to a correction. Once these two sectors begin to correct, the S&P is likely to drop below the red trend line on the S&P and its support at 2120 (third chart above).

The rally after the Fed's announcement was broad based, but the 21 day average of the advances minus declines became modestly overbought as the S&P reached 2180, and the Russell 2000 and Nasdaq were making new closing highs on September 22. I continue to believe that a solid trading low will not be established until the 21 day average of the advances minus declines becomes oversold by falling below the green horizontal line at -400. If the NYSE closes below the rising blue trend line, the NYSE and S&P will be susceptible to an additional decline of -2% to -4% before the market becomes oversold.

Sentiment - Improving But Not There Yet

As I noted in the August 15 WTR, which was the day the S&P peaked at 2193.81, 'Sentiment Suggests the Upside Is Limited.' The choppy trading activity since then has eroded some of the bullishness that was widespread in mid August. The percent of net bulls minus bears in the weekly Investors Intelligence survey has fallen from 36.5% on August 26 to 20.3% last week.

The daily Call/Put ratio has pulled back from 1.246 on August 15 to 1.04 as of Monday September 26. A ratio of 1.246 means investors had purchased 124.6 calls for each 1.0 put purchased during the preceding 10 trading days. If the C/P ratio drops below 1.0 (green horizontal line), the market will likely rally as it did in mid May and just after the Brexit vote.

Ironically, today's rally will postpone the C/P from getting below 1.0. If the S&P does break below 2120, the C/P ratio will quickly fall below 1.0. This is one reason why a close below 2120 is not likely to result in a large decline. My guess is that the S&P will likely hold 2050 - 2070, and then experience another rally.

While a decline in the C/P ratio will spark a rally, a significant multi-week trading rally is not likely until the Option Premium ratio spikes above the green horizontal line, as occurred in August and September of 2015 and earlier this year. As of Monday, it was nowhere near providing a trading low signal.

Tactical S&P Sector Rotation Portfolio Model: Relative Strength Ranking

The Sector Relative Strength Ranking is based on weekly data and used in conjunction with the Major Trend Indicator. As long as the MTI indicates a bull market is in force, the Tactical Sector Rotation program is 100% invested, with 25% in the top four sectors. When a bear market signal is generated, the Tactical Sector Rotation program is either 100% in cash or 100% short the S&P 500.

The Major Trend Indicator generated a bear market signal on January 6, when the S&P closed below 1993, and was confirmed on January 14. The Tactical Sector Rotation program went 100% short when the S&P closed at 1990.26 on January 6. The short position was reduced to 50% on February 8 when the S&P closed at 1853, further lowered to 25% early on February 24 as the S&P traded under 1895, and closed on February 25 when the S&P was 1942. The S&P's average 'cover' price on the short trade was 1885.75. The short trade earned 5.2%. Past performance is no guarantee of future results. The MTI crossed above its moving average on February 25, generating a bear market rally buy signal. The MTI confirmed a new bull market on March 30.

In the July 25 WTR, I explained why I thought Energy stocks were likely to fall since I thought oil prices where set up for a decline. A decline in XLE to below $65 still seems probable. Small cap stocks have continued to perform well since their breakout on July 7, and now occupy three of the top four spots, and four of the top five. As discussed earlier, the Russell 2000 made a new high last week, but its RSI was well short of its prior high. This negative divergence suggests the momentum in small cap stocks is weakening, setting up the potential for a correction. A decline to 1200 on the Russell 2000 seems likely and would represent a correction of more than 3% from current levels.

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