Written by Jim Welsh
Macro Tides Technical Review 26 February 2018
Treasury Yields Dictate
After the 10-year Treasury yield bottomed in early September below the target of 2.05% (low was 2.034%), I discussed why inflation was likely to rise in coming months and along with it interest rates.
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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%.
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%. 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.
The initial phase of the correction in the stock market was spurred by the increase in bond yields and then exacerbated by the unwinding of over leveraged positions in volatility ETFs. Once the downward pressure from the unwinding of these positions was spent, the stock market was deeply oversold and poised for a rebound. From its high on January 26, the S&P dropped 340 points to its low on February 9 of 2533. As discussed in the February 12 WTR, a 61.8% retracement of the decline targeted 2743 as a potential high for wave A.
The S&P was then expected to retrace 50% of the initial rally for wave B. Theactual high for wave A was 2754 so wave B was expected to bring the S&P 500 down to near 2650 before wave C resulted in a rally above the high of wave A.
Wave A of (B) topped on February 16 just as the 10-year yield was making a short term low of 2.85%. After the Federal Reserve released the minutes from its January 31 meeting on February 21, bond yields dipped then jumped. The S&P 500 followed, first rising to 2747 and then plunging to 2703.
After a dip the 10-year yield early on February 22, the yield pressed higher on February 22 and the S&P closed on the low of the day at 2698. This completed the a-b-c correction for wave B, with the S&P 500 falling 48 points for wave a (2754 – 2706) and 49 points for wave c (2747 – 2698). The depth of the wave B of (B) pullback was about half of what was expected (56 points versus 110 points).
On February 23, the yield on the 10-year Treasury dropped sharply and wave C of (B) up in the S&P 500 began.
In the February 12 WTR I explained why I didn’t think the yield on the 10-year Treasury bond would breakout above 3.03%.
“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 spike high was 2.943% on February 21 after the FOMC minutes, with a secondary high of 2.929% on February 22, before falling to 2.831% today.
The positioning in the 10-year Treasury futures market suggests the next major move in yields is down, not up as most investors expect. Granted this is a tough call since the deck seems stacked against yields falling. Commercials are considered the smart money and are holding a near record long position. As of February 26, they were long 485,506 contracts. In January and late February of 2017, as the 10-year yield was topping near 2.60% they were long 644, 599 contracts and 594,711 contracts (red line middle panel).
This suggests that they will be buyers on any additional weakness in bond prices and higher yields.
The price pattern for the 10-year Treasury bond indicates that the high last week may have been wave 3 of the rise in yields since the low in early September. If correct, the 10-year yield could mount a more strenuous test of 3.03% in the next two weeks, and could for a brief time trade above 3.03%. If this pattern is correct, wave 4 would allow the 10-year yield to fall below 2.80%, possibly as low as 2.74%.
If Treasury yields continue to fall, the S&P 500 can work its way higher as it finishes wave C of (B). There are a number of price targets where wave C may end. The 78.6% retracement of the 340 point decline in the S&P 500 is 2808. Wave A was 220 points and sometimes wave C will either be 61.8% of wave A or equal to wave A. If wave C is 61.8% of wave, wave C would end at 2834 (220 X .618 = 136 + 2698 = 2834).
If wave C is equal, the S&P would make a new high at 2900 – 2920. Although it is not common, it is possible for wave (B) to exceed the prior low during a large decline or prior high (2873) as in this case.
As noted in the February 12 WTR, the 5 wave decline from the January 26 high (page 2 red chart of S&P) suggests the rally from the February 9 low at 2533 is wave (B) of a larger (A) down to 2533, (B) up, (C) down of an intermediate decline. Once wave (B) is complete wave (C) is likely to bring the S&P 500 down to test the February 9 low. My guess is that wave C of (B) will end after the 10-year yield exceeds the high of 2.943%.
If bond yields rise above their high last week, (10-year 2.943% 30-year 3.221%) and complete the move up from last September, the positioning in the futures suggests a meaningful rally is possible that would bring yields down. At the same time the (A), (B), (C) pattern in the S&P suggests it could be vulnerable to another sharp decline that may challenge the February 9 low or possibly penetrate it.
It is certainly possible that yields just keep rising to 3.30% on the 10-year which is the longer term target before they fall. That would likely crunch the S&P 500. If yields reverse lower after just reaching 3.10%, one would expect the S&P to drop a bit when the 10-year exceeds 3.03%, but then recover if yields subsequently fall. What could cause yields to drop meaningfully and stocks to fall back to the February 9 low?
It would be necessary for something to threaten the economy for yields to fall and stocks to drop hard. My guess is that protectionism could do it. On Friday February 23 Trump indicated his willingness to slap hefty tariffs on steel and aluminum. Although a final decision may not occur until April, the rhetoric could easily heat up before then with our trading partners responding with plans to slap tariffs on American products.
Dollar
As noted in the last two WTR’s.
“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.”
The Dollar dropped to a new closing low on February 15 and a new intra-day low below its low on January 25 on Friday February 16. Friday’s upward reversal was a key reversal day since Friday’s low was below Thursday’s low and high, and was accompanied by a higher close. The Dollar’s RSI on February 15 was 31.8 when it closed at 88.59 and well above its RSI of 21.3 on February 2 when the Dollar closed at 88.67.
The RSI divergence and reversal higher are the first signs that the Dollar has begun its bottoming process. Further confirmation will come if the Dollar is able to close above the 90.57 on February 2. So far the Dollar has not been able to close above 90.57. This opens the possibility that the Dollar will chop sideways in coming weeks before it posts a lower low below the February 16 low of 88.25. Sentiment toward the Dollar is very negative and positioning in the Dollar shows a net short position, which has preceded a rally in the Dollar in recent years.
However, if Trump does push an agenda of protectionism in coming weeks that could easily spark another decline in the Dollar.
Euro
The Euro rallied above its prior high of 1.2536 on January 25 as expected. On February 16 it experienced a key reversal lower as the high and low was above and below Thursday’s range. A decline and close below 1.2100 in coming weeks would likely confirm that an important high has been recorded. Until that occurs, the Euro may chop sideways before one more thrust higher that approaches the down trend line near 1.2770.
The positioning in the Euro futures suggests the next big move in the Euro is down irrespective of any short term squiggles. On February 16 I established a partial position in the Euro inverse ETF EUO which is leveraged 2 to 1. Normally, I use 1 to 1 ETFs, but the volume in the 1 to 1 inverse ETF is too low.
Gold
Gold recorded an intra-day high of 1361.24 on February 16 before reversing lower. A close below $1306 would set Gold up for a decline to $1275 and potentially $1250. Gold stocks continue to underperform Gold which suggests a decline to $20.50 on GDX is possible.
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. Based on the buy signal, a 100% invested position in the top 4 sectors was adopted. The MTI confirmed a new bull market on March 30, 2016. The MTI continues to indicate that a bull market is in force.
Note: Past performance may not be indicative of future results.
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.
