Written by Jim Welsh
Macro Tides Weekly Technical Review 16 September 2019
Many factors influence the strength or weakness of the Dollar. The level and direction of interest rates play a role, as does the amount of the U.S.’s trade and current account deficits. Trade surpluses have been M.I.A. for a long time, but that hasn’t precluded significant Dollar rallies. The economic outlook for the U.S. economy is also a factor.
Please share this article – Go to very top of page, right hand side, for social media buttons.
However, the Dollar rallied smartly, even though the U.S. economy was in recession in 1981 and 1982, and in 2009 (shaded areas on chart below). While each of these factors influences the direction of the Dollar, I have found that the level and direction of interest rates, trade and current account surpluses or deficits, or the health of the U.S. economy are not consistently accurate in identifying the trend of the Dollar. They work for awhile, and then they don’t.
Click on any chart below for large image.
Over the last 35 years, one factor has consistently exerted more influence over the Dollar’s trend than any other. The global perception of the sitting President and his administration’s perceived support of a strong Dollar or a weak Dollar has been more consistent than any of the other fundamental influences. In a May 2016 interview on CNBC, candidate Trump provided his view of the Dollar:
“I love the concept of a strong Dollar, and in many respects obviously I like a strong Dollar. While there are certain benefits, it sounds better to have a strong Dollar than in actuality it is.”
In the January 2017 Macro Tides I provided this assessment:
“This statement provides a valuable insight as to how Trump might respond if he perceives the Dollar as being too strong and why he might not hesitate to talk the Dollar down, if he thinks it will help improve U.S. trade competitiveness and bring jobs back to the U.S. “
In an interview with the Wall Street Journal published on January 17, 2017, three days before he was sworn in as 2 President, President elect Trump described the Dollar as “too strong.” He also said the U.S. might need to “get the Dollar down” if a change in tax policy pushed it up.
On September 12, 2019 President Trump Tweeted the following criticism of the Federal Reserve, after the ECB decided to lower its policy rate from -0.40% to -0.50%.
President Trump has been pounding Jay Powell for months and whining about the strength of the Dollar and its negative impact on growth. In a Tweet on September 11 President Trump referred to the members of the FOMC as ‘Boneheads’.
Understandably, attention was been focused on the Trade War with China. That may change in November when the trade talk extension with the European Union expires on November 13. The US has told the EU that it won’t negotiate with the EU unless agriculture products are included. On July 23 EU Trade Commissioner Cecilia Malmström said that agriculture “is a red line for us“. The EU has steadfastly rebuffed any attempt to open EU markets for US agriculture products for years. One can reasonably conclude that the EU’s red line is for real and not like the red line President Obama drew in Syria. Malmström did not sound optimistic:
“We don’t have a mandate to enter in agriculture. So yes, there is a stalemate. Can we overcome this? I don’t know.”
What she implied was that a resolution would only occur, if the US dropped its demands to include agriculture in the trade talks.
President Trump wants to help US farmers and getting the EU to open up their markets would be a big win for farmers and the campaign stump. If the EU holds firm as expected, President Trump can choose to impose tariffs on auto imports from the EU and other products. He also may decide to retaliate by talking the Dollar down since the Euro is 57.3% of the Dollar Index. The odds of this occurring will rise after November 13.
Many strategists would likely be skeptical of President Trump’s ability to ‘talk the Dollar down’, since the currency market is the largest and most liquid market on the planet. Each day $5 trillion is traded in the foreign exchange market. By comparison the amount of money traded in the highly liquid U.S. Treasury bond market amounts to just $600 to $650 billion.
The 1934 Gold Reserve Act gives the Treasury Department broad powers to buy or sell Dollars and buy or sell foreign currencies. The Treasury Department maintains a fund of about $95 billion for such operations, which represent a drop in a bucket of the currency market, so the Treasury’s capacity to move the Dollar is tiny.
But there is a much bigger bucket of money that President Trump does has access to – Other People’s Money (OPM).
At the ECB’s monthly news conference on March 6, 2014 Mario Draghi said that the strength in the Euro since July 2012 had shaved 0.4% off annual inflation:
“The strengthening of the Euro exchange rate over the past one-and-a-half years has certainly had a significant impact on our low rate of inflation and, given current levels of inflation, is therefore becoming increasingly relevant in our assessment of price stability.”
As I wrote in the April 2014 Macro Tides:
“All the ECB may need is for Draghi to state the 3 desire for a lower Euro and willingness of the ECB to sell Euros if necessary. Currency traders would be happy to accommodate the ECB’s wishes, since they could sell the Euro short knowing they were doing so with the blessing of the ECB, and with almost zero chance the ECB would intervene. The ECB wouldn’t have to sell a single Euro to achieve their goal.”
The Euro peaked in early May 2014 just below 1.40 and by March of 2015 traded below 1.05, a drop of 25% in less than 1 year, and the ECB never had to intervene. The decline was fueled by OPM as currency traders were happy to profit from a decline in the Euro.
If President Trump and Treasury Secretary Mnuchin consistently indicate a desire for the Dollar to fall, currency traders would jump on the band wagon and sell the Dollar and buy foreign currencies. Positioning in the Dollar would be supportive of a decline, since the currency market is long the Dollar and short the majority of currencies against the Dollar.
Once the Euro and other currencies begin to rally, short covering would provide a further lift to the Euro as those short bought back their short positions to cover. This would push the Dollar down and traders could then sell the Dollar short and purchase foreign currencies with the blessing of the Treasury knowing the Treasury would not intervene until the Dollar was down by at least 10% or more. The Dollar would fall using OPM (Other People’s Money).
As discussed in prior WTR’s, the Dollar could rally in the short term and the attack on the Saudi Arabia oil fields provided a flight to safety that lifted the Dollar on September 16:
“From its low in late June the Dollar rallied by 3.1 points. An equal move up from the low on August 6 at 97.20 suggests the Dollar could reach 100.10 – 100.30, or at least test the rising trend line at 99.65.”
The Dollar could also receive a boost if the Federal Reserve doesn’t provide the assurance of additional rate cuts markets are pricing in before the end of 2019. This upside potential would be greatly reduced if not eliminated, if the Dollar closes below 97.80 and the rising trend line from the late June low.
The long term chart of the Dollar suggests the Dollar could be on the cusp of a significant decline. After bottoming in February 2018 at 88.25, the Dollar has moved higher in a choppy manner, especially when compared to the 5 wave impulsive decline from the high in January 2017 at 103.82. This suggests the rebound since February 2018 has been a retracement of the 15.57 point decline from 103.82 to 88.25. It should be noted that the 15% drop from the January 2017 high occurred, while the FOMC raised the funds rate by 0.75% and another 0.25% in March 2018. It may be logical to expect interest rates to drive the direction of a currency but markets love to defy logic.
Based on the Dollar’s price pattern since January 2017, the decline to the low in February 2018 would be labeled wave A, the rebound wave B, which implies that the Dollar could be vulnerable to an equal decline of 15.51 points for wave C from the high of wave B in the next 12 to 15 months. The Dollar appears to be setting up for an extended decline and President Trump may provide the impetus for the kickoff of the move lower in the not too distant future.
Emerging Markets
A decline in the Dollar of this magnitude would provide a tailwind for emerging stocks and bonds priced in their local currency. However, the attack on Saudi Arabia’s oil assets and jump in oil prices has the potential to upset an already fragile global economy. This is why the response coordinated by Saudi Arabia, its Middle East partners, and the US could push oil prices even higher. Given the success of the attack one must consider that another attack could follow soon, which would be met by a far larger negative reaction in financial markets.
Emerging Market economies would be vulnerable should the global economy slow sharply, and a rising risk of a recession in Europe and Japan materialize. Even if the Dollar falls, there could be a window of time that Emerging Market equities get hit hard. The impact on Emerging Market bonds is less certain, since Treasury yields would be expected to drop in response to a decline in global equity markets. With this setup as the backdrop, let’s look at what opportunity Emerging Market bonds offer.
The Emerging Market Local Currency ETF (EMLC) yields 6.5%, which is significantly more than yields available from developed countries. The additional yield could provide support and help Emerging Market bonds resist any weakness in Treasury bonds and sovereign bonds in Europe and Japan, if sovereign yields rise in coming months. If oil prices soar or the Trade War talks collapse, sovereign yields would likely fall and provide a tailwind for Emerging Market bonds. The trend of the Dollar will play a decisive role in whether Emerging Market bonds rise
When the Dollar fell from its high in January 2017 to the low in February 2018, EMLC rallied from $35.00 to over $39.50, a capital gain of 12.8% on top of the 6.0% yield provided. As discussed in the March 2018 Macro Tides I expected the Dollar to rally and hurt Emerging Markets:
“If the Euro declines in coming months the Dollar Index will rally since the Euro comprises 57.6% of the Dollar. Once the top in the Euro is confirmed, the Dollar chart suggests a rally to near 95.00 is possible in coming months. This would represent an increase of almost 8.0% from its low at 88.25. A Dollar rally of this magnitude could prove a headwind for U.S. stocks, some commodities, and Emerging Markets.”
The Dollar did rally to 95.00 in June 2018 as expected, which instigated a sharp selloff in EMLC. The decline in EM bonds and increase in yields was attended by a rise in Treasury yields last fall.
Even as the Dollar has grinded higher since last November, EMLC has shown decent relative strength. The declines in May and August were spurred by concerns about slowing in the global economy and in response to the inversion in the US yield curve. This suggests EMLC could be vulnerable to another dip, if concerns about the global economy reemerge. This downside risk could be reduced if the analysis for a decline in the Dollar materializes as it would support emerging market bond prices
Ironically, if Treasury bond yields rise, because investors are less worried about growth in the US and globally, Emerging Market bonds may find support from the better economic outlook compared to May and August.
The expectation is that EMLC has the potential to trade up to the horizontal trend line near $35.00. A close above $35.20 would open the door for a move up to $38.50 – $39.50. It is important the EMLC hold above the May low of $32.51. I would recommend a 50% position and look to add to it if EMLC falls.
FOMC
At the July 31 FOMC meeting 2 Fed governors dissented (Rosengren – George). During the annual Jackson Hole meeting two other FOMC members (Mester and Harker) said they weren’t in favor of lowering the funds rate at the July meeting but went along with the consensus. The data since the July meeting does not show any acceleration of weakness and one could argue most data points have come in better than expected. Since the July meeting the Citi Surprise Index has climbed from below -60 to +18, which indicates how consistently data has been reported above estimates.
In addition, core inflation as measured by producer (2.3%) and consumer prices (+2.4%) last week were above the Fed’s inflation target of 2.0%. While these metrics are not the Fed’s preferred inflation metric (Core PCE), they do suggests that Core PCE inflation is more likely to rise from the current level of 1.6% toward 2.0%.
With the economy holding above 2.0%, unemployment at a 50 year low and wage growth of 3.2%, inflation firming, and the yield curve flattening, there is no justification for the FOMC to lower the funds rate. The reduction at the July meeting was intended as insurance to address the uncertainty caused by the Trade War.
Prior to the strike on the Saudi Arabian oil production, I thought Mester or Harker might join Rosengran and George in dissenting about a second ‘insurance’ cut. At a minimum, I thought Roengren, George, Mester, and Harker would want language that downgraded the potential of another automatic cut before year end, unless the data truly supported it. My expectation was that the FOMC might throw the markets a bone and cut the funds rate by 0.25%, but the messaging to the markets about future cuts might be hard to swallow.
The attack on the Saudi Arabian oil production adds a level of uncertainty that didn’t exist on September 13. I’m not sure this will fundamentally change the outlook for the four FOMC members who didn’t favor the first insurance cut, but it does make a cut on Wednesday a lock. No one knows how long and how much of Saudi oil production will be impacted. It does appear that the Trade War has been dialed down at least temporally, which was the justification for the first insurance cut. Chair Powell will continue to emphasize that the FOMC will do what is necessary to sustain the expansion. My guess is the language about the certainty for future cuts will disappointment the stock market.
Saudi Arabia Oil Production
I found this interview on CNBC to be informative. Both gentlemen are knowledgeable, with one serving in the Obama administration and the other under Bush. Based on the sophistication of the attack and the equipment that was targeted, some of the oil output from Saudi Arabia may not come back for up to 6 months (3 minute mark).
<p><a rel=’nofollow’ rel=’nofollow’ href=”https://www.cnbc.com/video/2019/09/16/sophisticated-actor-targeted-saudi-oil-facility-says-expert.html?__source=cnbcembedplayer”>’Sophisticated actor’ targeted Saudi oil facility, says expert</a> from <a rel=’nofollow’ rel=’nofollow’ href=”//www.cnbc.com/?__source=cnbcembedplayer”>CNBC</a>.</p>
Stocks
The major market averages gapped lower in response to the attack on Saudi Arabia’s oil production and double digit gain in crude oil prices. The market rebounded as investors jumped in to buy the value sectors that rallied last week after many months of underperformance. At the close the S&P 500 was off only -0.31% and the Russell 2000 was up +0.41%, with 1593 stocks rising versus the 1345 that fell.
Most investors were heartened and impressed with the market’s resilience. My take is the resiliency is more like complacency, since the Trading Index finished at 0.83 today and the 10-day average is quite low (black line). Even the 40-day average (red line) has dropped a lot which suggests that buying power is less. Quite a difference from the high level it reached in August when investors were really concerned.
Sentiment has also reversed sharply from the high levels of fear reached in August. The CBOE 10-day Equity Call / Put ratio fell to a low level last week, which indicates that too much call buying has replaced the Put buying spree in August. Encouraged by the market’s resilience traders are not likely to buy puts so the ratio will remain low.
Most investors expect the impact from the strike on oil production to be small, since they given many reasons all day why it is not a big deal i.e.:
- The US is the world’s largest oil producer, is not as dependent on oil imports as it was 40 years ago, and can increase production.
- President Trump will release oil from the Strategic Petroleum Reserve which will keep a lid on oil prices.
- Saudi Arabia will get 40% of the lost production back online by tomorrow and the rest soon after.
- The FOMC will lower rates and will be more willing to cut rates even more in coming months.
Based on the 21-day average of Advances minus Declines the market was overbought last week. It would have been constructive had the market declined in the face of negative news as it would have alleviated some of the overbought condition. This suggests the market is still susceptible to a further decline. Confirmation of the next correction will be provided if and when the S&P 500’s 5 day average (green line) falls below the 13 day average ((blue line). (Down arrows on the S&P 500)
I expected the market to hold up until the FOMC meeting as noted last week:
“My guess is that the S&P 500 can hold up until the FOMC meeting on September 18, and could press near the prior high of 3028 if it closes above 2989 in coming days.”
The high last week was 3022. This Friday September 20 is a quadruple witching with the expiration of futures and option contracts, and often provides support into the Wednesday of expiration week. The huge rally in Treasury and corporate bond prices this year has likely allowed bonds to become over weighted relative to their benchmarks in institutional portfolios. The end of the quarter could also provide some support for the stock market, if institutions rebalance their portfolios by selling bonds to buy stocks. These factors suggest the S&P 500 may hold up and could make a new high before the end of September.
The DJ Transports and Russell 2000 may provide insight as to when this rally is ending, since both have tended to move down prior to declines in the S&P 500 since January 2018. Both averages jumped last week as investors rotated out of momentum stocks and into stocks that have performed poorly in 2019. On September 6 the 50 stocks that had performed the best in 2019 were down – 1.45%, while the worst performing rose a whopping +3.37%, according to Bespoke. Both averages are now nearing important resistance levels so they are approaching a make or break level.
The Transports are attempting to push above the black down trend line connecting the highs since last September. The more important resistance level is the horizontal red trend line near 11,050. If the Transports are able to close above the red trend and stay above it, it would suggest the market can continue to rise.
The Russell 2000 sports a similar pattern and needs to close above the red horizontal trend line at 1600. It would be a good sign for the overall market if the Russell 2000 is able to close above 1600 and stay above that level. At the high in early May the Russell 2000 was able to close above the red trend line for 2 days before reversing lower.
The RSI’s for the Transports and Russell 2000 are hovering just below 70, so both are over bought and ripe for a pullback in the short term. I remain skeptical of the market’s capacity to mount a sustained rally much above the previous high in the S&P 500, but will allow the charts to be the guide.
Treasury Bonds
As noted the last two weeks, the trend toward lower yields was intact and wouldn’t indicate the potential for an intermediate low in yields, until the 10-year Treasury yield closed above 1.63%:
“After dropping to a new low of 1.429% on September 3, the 10-year Treasury yield jumped to 1.635% before closing at 1.622% on September 9. This reinforces the importance of 1.63%.”
The 10-year closed above 1.63% on September 7 and promptly soared to 1.903% on September 13. The RSI on the yield rose to 70 indicating that it was overdone, just in case the obvious wasn’t obvious. I also discussed the channel the 10-year has traded in for months:
“For months the 10-year Treasury yield traded within a channel until it crashed below the lower channel line in early August after President Trump increased tariffs. That lower channel trend line is currently at 1.68%. A rise into the channel would further solidify the technical evidence that Treasury yields had made an important low.”
On the surface it appears that the 10-year Treasury yield has recorded an important low. However, looking under the surface one can make the case that the low yield was wave 3 down from the high of 3.248% last November, as the labels on the chart illustrate. The rebound since the low of 1.429% would be wave 4, and implies that another drop below 1.429% is possible to complete 5 waves down from last November.
The same pattern is evident in the 30 minute chart of TLT. As long as TLT does not drop below the low of $136.54 on September 13, the pattern suggests TLT could rally to a higher high. If TLT does fall below $136.54 it will complete 5 waves down from the high and confirm that the intermediate trend in Treasury yields is up.
What could possibly cause Treasury yields to fall to a lower low? A trade deal with China in October is a low probability event, and a trade dislocation with the EU is possible in November. If this comes to pass a decline to 2730 – 2760 or lower on the S&P 500 is possible. If the oil disruption proves more lasting than markets now expect and oil prices climb above $70 a barrel on WTI oil, the S&P 500 could fall to 2730 – 2760 or lower. If trade and oil are a problem, the S&P 500 could fall to 2350, which is what the Megaphone pattern in the S&P 500 has suggested. These aren’t interesting times, they are crazy times. So ruling out anything may be a big mistake.
Gold
Despite the $71 drop in Gold from $1556 to $1485 the positioning in Gold didn’t improve much, as it is still a stretched long. This suggests there is more downside to come in Gold. After falling from $1556 to $1485, Gold bounced up to $1521 on September 12. An equal decline from the rebound high of $1521 targets $1450 as an initial target. A drop to $1450 or so could represent an A-B-C decline, and support only a modest rally, unless the positioning improves significantly in coming weeks.
As discussed in last week’s WTR:
“A 38.2% retracement of the $290 rally ($1556 – $1266) would bring Gold down to $1445, while a 50% retracement would target $1411. Gold traded in a range between $1410 and $1430 from June 25 until the end of July, so there is a fair amount of support in this price range.”
However, if Gold traces out 5 waves down from the $1556 high, it would suggest a deeper and more protracted correction that could carry well below $1450.
Gold Stocks
As noted last week, the Gold stocks were set up for a bounce after experiencing a 4 day drubbing:
“After a drop of -10.75% in just 4 trading days, GDX is probably close to a short term low. A bounce that carries GDX up to near $29.00 is certainly possible. The high of any bounce will offer the opportunity to measure a potential downside target that may provide a more precise target.”
After falling to $27.45 on September 10, GDX popped to an intra-day high of $28.70 on September 12 before closing at $27.27. From its high of $30.96 GDX fell $3.51 before rebounding to $28.70. An equal decline would target a decline to $25.19. This price target is just bit below the target discussed last week based on retracements of the huge rally in GDX:
“The Gold stocks have enjoyed a monster rally that carried GDX from a low of $20.14 to $30.96. A 50% retracement would bring GDX down to $25.55.”
Tactical U.S. Sector Rotation Model Portfolio: Relative Strength Ranking
The MTI generated a Bear Market Rally (BMR) buy signal on January 16, 2019 (green arrow) and climbed above the green horizontal trend line on February 26 confirming the uptrend. The progressive weakening in the technical structure of the market since late April led me to reduce exposure.
When the S&P 500 was trading at 2877 at 7am on May 16 I lowered the exposure in the Tactical U.S. Sector Rotation Model Portfolio from 100% to 50%. I lowered exposure to 25% in the Tactical U.S. Sector Rotation program on June 11 after the S&P 500 gapped up to 2903 at the open. I lowered exposure to 5% from 25% at the close on Wednesday when the S&P 500 was 2913. I sold the 5% position in Technology ETF (XLK) shortly after the opening on July 1.
I established a 25% short position in the S&P 500 through the purchase of the 1 to 1 inverse ETF SH on July 23, when the S&P 500 traded above 2995 (SH $26.09). The short position was increased to 40% on August 8 when the S&P 500 was trading at 2930 (SH $26.69). The short position was reduced to 20% on August 28 when the S&P 500 was trading at 2882 and SH was sold at $27.09.
I will likely increase the short position in SH if the S&P 500 rallies into the FOMC meeting on September 18. If the S&P 500 does trade below 2760, I will likely cover the short position in anticipation of another sharp rally since the market will be over sold.
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.
.
