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posted on 23 October 2017

The ECB, The Dollar, And The Euro

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Macro Tides Technical Review 23 October 2017

The ECB meets this Thursday and their decision could have an impact on currencies and global bond yields. What is interesting is that the Dollar, yields on the 10-year and 30-year Treasury bonds and the 10-year German Bund are hovering just below important resistance levels, while the Euro is holding just above important support.

mario.draghi.scmp


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Economic growth has picked up in the Eurozone and more countries are participating. The ECB is expected to reduce the amount of its monthly purchases from €60 billion a month (about $70 billion) and make no change in its policy rate which is -0.40%. If there is a surprise it would be the ECB extending the end of its QE program from September 2018 to the end of 2018 or a later date. Given Mario Draghi’s enthusiasm for QE and negative interest rates, a decision to extend the QE program shouldn’t really be a surprise. The most important factor isn’t what the ECB does or doesn’t do. It is how the markets react.

ecb.qe

The Euro is just above its support near 1.1670. A close below the horizontal trend line is likely to lead to more selling pressure. The positioning in Euro futures suggests this is the more likely outcome.

Click on any chart below for large image.

welsh.tech.2017.oct.23.fig.02

Despite the recent weakness in the Euro, the long position held by Large Speculators dropped much. If the Euro declines it will put more pressure on those who are long the Euro and I expect selling to pressure to increase as those long the Euro are forced to sell. A decline below 1.150 seems probable, as this long liquidation runs its course. As the nearby chart shows, the current long position is the largest is at least 8 years. A selling wave could be triggered if the Euro doesn’t rally as those long the Euro are expecting going into the ECB’s meeting on Thursday.

A bearish reversal in the Euro is becoming increasingly likely due the wide spread in yields between U.S. Treasury bonds and German Bunds. The spread between yields in the U.S. and Germany across the maturity spectrum (2yr, 5 yr, 10 yr, and 30 yr) indicates that the Euro is overvalued relative to the Dollar based on the higher yields in the U.S.

In recent years, the USD/EUR has followed the direction of the spread quite closely. This suggests that the Euro is likely to decline or yields in Germany or about to rise, or both. Conversely, Large Speculators are holding the largest short position in U.S. Dollar futures since 2011.

The Dollar is hovering just below the neckline of an inverse head and shoulders pattern. A close above 94.28 would trigger a measured move to 97.00. Given the chart patterns in the Euro and the Dollar, a big move is possible, with the Euro falling and the Dollar pushing higher. This has been my expectation since early September. Based on instructions, traders are long the Dollar index from 92.44 and should use a close below 91.40 as a stop.

Treasury Bonds

The 30-year Treasury bond yield rose to 2.91% - 2.94% as forecast four weeks ago (blue horizontal trend line), and then was expected to fall to 2.79%. The low on Friday October 13 was 2.808%, although I noted last week that a lower low was possible. On October 17, the yield dipped to 2.802% before reversing higher. Until a close above 2.94% (blue horizontal trend line) occurs, it is still possible for another dip to 2.75% to develop. The 30-year yield increased from 2.65% to 2.94% so a 61.8% retracement of that move targets 2.76%.

I think the bigger trend in yields is up. A close above 2.94% should lead to a quick run to 3.01% to 3.05% (black down trend line). A move up to 3.17% to 3.20%, the highs last December and in March is likely before year end.

German 10-year Bund

The yield on the German 10-year Bund has edged higher over the last week as the yield on the US 10- year Treasury bond went up. A close above 0.48%, the highs from last January and March, would signal an upside breakout. A move up to 0.62%, the early July high, would quickly follow. A close above 0.64% would open the door to a move up to 0.85% to 0.90%.

A break out in German yields would contribute to higher yields in the U.S. and globally.

Mario Draghi will do his best to temper the improving economic outlook by emphasizing that inflation continues below the ECB’s 2.0% target. Mario will state that the low inflation rate warrants the ECB maintaining an accommodative policy stance. How the market chooses to weight the decline in ECB QE purchases and Mario’s promise to keep policy loose will determine if yields breakout above the cited resistance levels.

Stock Market Begins to Fray around the Edges

For the first time since the low in August, upside momentum has peaked and, based on a number of technical indicators, the market looks like it is beginning to roll over. The moving average of the percent of stocks making a new 52 week high peaked on October 13 and posted a lower high even though the S&P made a new closing price high last week. For the first time since August 31, the 52 week new high percent has fallen below its green moving average. After that occurred on August 2, the S&P fell from 2476 to 2425 on August 18. After falling below the moving average on March 3, the S&P fell to 2329 from 2383. In May and June, the S&P moved sideways after dropping below the green moving average.

The same pattern is evident in the Nasdaq percent of stocks making a new 52 week high.

The market is overbought as measured by the percent of stocks above their 200 day average. In February the percent topped at 72%. In April it was 69%, 67% in July, and 68% on October 13, as indicated by the red arrows. The market has been the beneficiary of good news on the economy and tax reform. It is hard to see what news in the short term could provide another leg higher.

While the upside seems limited, it is hard to see what could cause a 5% decline. As noted last week, the S&P has gone 343 days without experiencing a 5% correction, the longest stretch without a 5% correction since 1928. Last week, the S&P set the record since 1928 for the longest stretch without even a 3% pullback.

The largest decline in the S&P in 2017 has been -2.9%, which is the smallest decline in any year since 1914.

These records are being set because there have been no economic reasons to sell and investors have been patiently waiting for the promised tax cut to materialize. This is another reason and maybe the primary reason why selling pressure has been virtually nonexistent in 2017.

That’s not likely to change materially before year end. A spike up in interest rates to the highs in March and a rally in the Dollar to 96.00 to 97.00 could cause a short term pullback. But in order for a deeper than 3% decline in the S&P to develop, tax reform would need to be killed or the economy would have to show more weakness than is probable. Besides, too many investors are waiting for a pullback so they buy. Buying every dip no matter how shallow has been rewarded, so investor’s behavior won’t change until buying a dip is follow by lower prices.

Gold and Gold Stocks

After Gold declined by more than $95 during the past 4 weeks, I thought a rebound to $1310 was possible. Last Monday Gold traded up to $1305.72 cash and then quickly dropped to $1273. The nature of the decline from last Monday’s high opens the possibility that Gold could test $1306 - $1310 before falling below $1260. If Gold does rally to $1310, an equal decline of $97 would bring down to near $1220. This process could take 4 to 6 weeks.

This bearish outlook is guided by the positioning in the gold futures market. It is bearish that the Commercials (red line middle panel) haven’t covered more of their short position during the recent decline. This suggests that should Gold rally up to $1310, the Commercials will be selling into that rally. I continue to expect Gold to trade under $1260 before year end.

The relative strength of Gold stocks continues to mostly trend sideways. Last week the relative strength weakened. If Gold does make another run to $1310, the Gold stock ETF (GDX) could rally back up to $24.00. If Gold does fall below $1260, GDX will at least test the blue trend line near $22.26. My guess is that trend line won’t hold and GDX will fall to the green trend line currently near $21.50. If Gold falls to near $1220, GDX could drop to the black trend line near $20.75.

Tactical U.S. Sector Rotation Model Portfolio: Relative Strength Ranking

The Sector Relative Strength Ranking is based on weekly data and used in conjunction with the Major Trend Indicator (MTI). 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 MTI crossed above its moving average on February 25, 2016 generating a bear market rally buy signal. The MTI confirmed a new bull market on March 30, 2016. The MTI continues to indicate that a bull market is in force.

Although the Major Trend Indicator is positive, the MTI has been posting lower highs since peaking in early March. Since late July, the odds of the S&P continuing the streak of no corrections of either 3% or 5% seemed quite low based on historical patterns and signals from a number of reliable technical indicators.

welsh.tech.2017.oct.23.tactical.table

The Tactical U.S. Sector Rotation Model Portfolio has been 100% in cash since July 24 based on the probability of a 5% correction. In my judgment (so far incorrect), upside potential has been limited relative to the level of risk. Through September 30, the Tactical Sector Rotation program is up 8.52%.

Disclosure

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Russell 2000 Index is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index. The Nasdaq 100 is composed of the 100 largest, most actively traded U.S. companies listed on the Nasdaq stock exchange. All indices, S&P 500, Russell 2000, and Nasdaq 100, are unmanaged and investors cannot invest directly into an index.

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