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posted on 13 February 2018

Yields Broke Out, Stocks Tumbled, Now What?

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Macro Tides Technical Review 12 February 2018

In recent months I’ve discussed why inflation was likely to rise and along with it interest rates. The expectation was that the yield on the 10-year Treasury would breakout above the 2.63% high from last March and test the December 2013 high at 3.03%, while the 30-year yield was expected to breakout above 2.95% and rise to 3.15% - 3.20%.

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The 10-year yield broke out on January 19 when it closed at 2.639% (first close above the top black trend line). The 30-year followed on January 30 when it closed at 2.98% (first close above blue trend line lower chart). The S&P 500 closed at 2810 on January 19, topped on January 26 at 2873, and was 2822 on January 30.

Click on any chart below for large image.

In the January 22 WTR I discussed how a falling Dollar and spiking interest rates caused the S&P 500 to top out in August 1987 and subsequently crash as the Dollar fell further and yields soared after the German central bank raised rates on October 6 less than 2 weeks prior to the October 19 Crash.

“What most investors may not remember is the Dollar was quite weak in 1986 and 1987 and Treasury bond yields rose sharply before the Crash on October 19, 1987. From early 1986 until October 1987, the Dollar lost more than 18% of its value. The yield on the 20-year Treasury bond rose from 7.3% in January 1987 to 8.8% in late August an increase of 20.4%. The S&P topped on August 24, 1987. In the first week of October 1987, the 20-year Treasury yield topped 10.0%, up 37% from where it was at the beginning of 1987.

"Since peaking in January 2017, the Dollar has fallen by 13.0% and is likely to fall further in coming weeks. At the end of 2017, the yield on the 10-year Treasury bond was 2.40%. To mirror the increase of 20.4% in 1987, which led to a top in the stock market in 1987, the yield on the 10-year Treasury bond would need to climb to 2.88%. The yield would have to reach 3.29% to match the percentage increase in 1987 just before the stock market crashed."

The 10-year Treasury yield touched 2.884% on February 8 and 2.882% today. The key question is whether the 10-year yield rises above 3.03% in coming weeks, and begins to move toward 3.33% which is the long term target. (The yield on the 10-year Treasury bottomed in July 2016 at 1.33% rose to 2.63% (+1.30%) in the first quarter of 2017, before dipping to 2.03% in September. An equal move up of 1.30% targets 3.33%) A breakout above 3.03% on the 10-year Treasury would likely pressure stocks since valuations are extended.

There are a number of reasons why I don’t think yields are going to breakout in coming weeks. Bond yields have already moved a lot since the end of 2017 with the 10-year rising from 2.40% to 2.88%. Bond prices are oversold and sentiment is uniformly negative after such a big sell off. The trigger for the acceleration higher was the 2.9% increase in average hourly wages embedded in the January employment report announced on February 2.

State mandated increases in the minimum wage began on January 1 and were included in the January calculation for Average Hourly Earnings (AHE). But the average workweek was down 0.2% in January and hours worked were down 0.5% due to bad weather. Average Hourly Earnings for Production and Nonsupervisory workers, which represent 82% of the workforce, rose just 2.4% from January 2016. Conclusion - the 2.9% increase in AHE was likely overstated in the January employment report and could dip when the February employment report is announced on March 9. Bonuses are not included in AHE but will show up in Personal income growth.

As forecast in the February Macro Tides, oil prices have fallen from $66.66 a barrel to under $60.00 and could be headed to $55.00. In the midst of all the extreme volatility in the stock market, this has been overlooked by the bond market.

The decline in oil prices is already causing inflation expectations to dip as measured by the 10-year Breakeven Rate. Should oil fall further, some of the inflation concerns could ease, which may enable bond yields to decline in coming weeks. It is common for a market to breakout and then retest the breakout level before resuming the primary trend.

If this pattern is repeated, the yield on the 10-year Treasury could fall below 2.70% as part of a retest of the 2.63% level which represents the breakout.

The positioning in the Treasury futures market is also supportive of a rally in bond prices and lower yields. Large Speculators (Green line middle panel) are holding a substantial short position in anticipation that the 10-year yield is going higher. The last time they held such a large short position was in March 2017 just before bond yields fell. Conversely, Commercials (red line middle panel) are almost as long as they were last March. If inflation eases a bit in the next two months, bonds can rally and force those short bond futures to cover. This would bring bond yields down.

The Consumer Price Index for January will be reported on Wednesday and is projected to rise 0.3%. The Producer Price Index will be announced on Thursday and is estimated to have climbed 0.4%. If bond yields climb on these reports and the Treasury ETF (TLT) falls below $117.50 (chart below), a good short-term trade may develop. If yields fall and retest their breakout levels, TLT may rally to $121.00 - $122.00. A close below $115.25 should be used as a stop. The primary trend in bond yields is up, so this is a counter-trend trade which means the risk is higher. If the February employment report does show a moderation in average hourly wage growth, bond prices could jump higher on that news. The key to short term trading against the primary trend is selling into strength went it appears since counter trend moves often end on a news inspired pop.

After this respite, wage inflation pressures are likely to continue to build as more firms increase their minimum wage to hold onto good employees, as I discussed in the February Macro Tides:

“The pace of wage growth will also be boosted by the wage increases announced by large employers like WalMart (1.5 million workers) which will pressure other employers even outside of retail to raise pay to keep workers from defecting to WalMart and competitors increasing pay."

Last week CVS announced it was raising its minimum wage to $11.00 for its 240,000 employees. I expect to see more of these headlines in coming months. Although February Average Hourly Earnings may dip when reported on March 9, the trend is up.

There is a good chance that the yield on the 10-year Treasury bond will breakout above 3.03% before Labor Day as the Fed increases rates in March, June, and potentially September. As the stock market swooned last week, the probabilities of a Fed rate increase in March fell from 92% to 77%, and to 69% in September and just 44% in December. If economic and inflation data are stronger than expected, especially if inflation dips before resuming its uptrend, the bond and equity markets could overreact with another round of selling into the summer, and the Fed may not ride to the rescue. In an interview on February 8, and after the S&P 500 had dropped about 10% in 9 trading days, New York Fed President William Dudley said:

“So far, I’d say this is small potatoes."

Stocks

Last week I thought the S&P 500 would rally as soon as Tuesday, after it broke below last Monday’s intra-day low of 2638:

“Given the downside momentum of the past two days, it would be surprising if the S&P didn’t fall below this trend line. The green trend line connects the low in November 2016 days before the election and the low in August and is near 2615. The S&P’s RSI is down to 27.8, the lowest since November 4, 2016. The market is oversold and near two trend lines that ‘should’ provide enough support to inspire a sharp rally which could begin as soon as Tuesday February 6. Ideally, it will commence after the S&P has dropped below today’s low at 2638."

After gapping down to 2593 on Tuesday, the S&P rallied to 2727 on Wednesday morning, a gain of 134 S&P points in just over 8 hours before rolling over. The S&P 500 then plunged 194 points to 2533 on Friday morning before mounting a strong rally into the close.

The pattern of the decline from the January 26 high is instructive in terms of what is likely to unfold in coming days. It is fairly clear that the S&P 500 declined in a 5 wave pattern. This suggests that this correction is not over and after a rally is likely to be followed by another decline that will at least test Fridays’ low of 2533 or make a new low.

The rally from Friday’s low has been impressive but the 5 wave decline from the January 26 high suggests it is an oversold bounce within the context of an intermediate decline. The rally from Friday’s low is wave A which should be followed by a wave B decline. Wave A has traveled 140 points (2673 minus 2533). A 50% retracement of this rally would imply a pullback of 70 points. Even if the rally pushes a bit higher, a decline to between 2620 and 2600 is possible for Wave B. This type of selloff could certainly occur if the CPI or PPI cause bond yields to rise.

Once wave B is complete, a wave C rally should ensue and carry the S&P 500 above the high for wave A and possibly move up as much as wave A. If wave B does bottom near 2600, an equal rally of 140 points would bring the S&P 500 up to near 2740.

The S&P 500 fell from 2873 to 2533 or 340 points. A 61.8% retracement would target 2743 as a potential high, which is just above last Wednesday’s high of 2727. Once waves B and C are finished, the rebound from Friday’s low would be complete. The S&P 500 would then be vulnerable to another 5 wave decline that carries it down to 2533 or below.

If the rebound does end near the 61.8% target of 2743, an equal 5 wave decline of 340 points would suggest the S&P 500 would finish the correction near 2300.

As I noted last week, in the wake of similar declines i.e. the flash crash in May 2010, the downgrade of U.S. debt in August 2011, the China devaluation in August 2015, and even the Crash in October 1987, the S&P made a low, bounced and then dropped to a new low or at least tested the initial low. This is the process that is likely to play in coming weeks. The attached piece entitled “How Has The Market Behaved After Prior Sharp Declines?" reviews prior sharp declines including the Crash in 1987.

The bull market is still intact as long as Treasury yields do not rise above 3.03% on the 10-year Treasury bond and 3.20% for the 30-year. The other potential risk is how the trade negotiations proceed with Canada and Mexico regarding NAFTA, and whether trade discussions with China degenerate and increase the risk of a trade war. The economy is in good shape, and the Federal Reserve is not likely to over react by increasing interest rates more than a couple of times between now and June.

Gold and Gold Stocks

Gold and Gold stocks were swept up in the selling tsunami with Gold falling below $1324 but holding important support at $1306. Gold has the potential to bounce up to $1340 but is not likely to close above $1352 (black horizontal line resistance) in coming weeks even if bond yields fall. Should Gold close below $1306 a quick drop to $1250 could follow, which is my expectation.

Gold stocks acted very poorly last week but part of their weakness was likely due to the overall decline in stocks. The RSI for the Gold stock ETF (GDX) fell to 30 on Friday so an oversold bounce to $23.50 is possible. Unless Gold stocks’ relative strength to Gold improves significantly and Gold closes above $1352, a better buying opportunity is likely at lower prices.

Dollar & Euro

I expect the Euro to exceed 1.2536 before a top is in place, and the Dollar to fall below its low of 88.44 before it bottoms.

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. Past performance may not be indicative of future results. The decline exceeded the 7% threshold expected as the unwinding of leveraged positions in the VIX and 3 to 1 and 2 to index ETFs caused selling pressure to explode as discussed last week.

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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