Written by Jim Welsh
Macro Tides Technical Review 20 March 2017
The Fed and Treasury Yields
As expected the Federal Reserve raised the Federal funds rate at the FOMC meeting on March 15, and Janet Yellen used the press conference to explain why the Fed had acted:
“The simple message is the economy’s doing well. We have confidence in the robustness of the economy and its resilience to shocks.”
The Fed’s confidence in the robustness of the economy is so strong that it left its GDP forecast for 2017 unchanged from its assessment in December of 2.1%. In addition, the Fed has forecast that growth in 2018 will be 2.1% and will slow to 1.9% in 2019.
I don’t want to get carried away about GDP forecasts by the Fed since their forecasts in recent years of GDP growth and inflation have been grossly inaccurate. Nonetheless, it is interesting that the Fed projects no acceleration of GDP growth, while equity and the Treasury markets have certainly priced in growth well in excess of 3% in 2018 and 2019.
As Janet Yellen noted:
“If we were to see a major shift in fiscal or private spending, that could very well affect the outlook. I’m not seeing it at this point.”
In the December Macro Tides I wrote:
” Members of the Federal Reserve have said that monetary policy can only do so much and that fiscal stimulus would improve growth. Trump has promised to deliver it, but at this point, the size, timing, and focus of the coming fiscal stimulus plan is unknown, until Congress actually passes legislation. Only then can the Fed assess and estimate the impact the stimulus plan will have on the economy and when that impact will kick in. Until the FOMC has this information, they will be in no rush to further increase rates.”
Yellen’s comment confirms my assessment and suggests the Fed will wait until it sees the details of any stimulus plan that passes Congress. This may lead the Fed to not raise rates at the June meeting, unless it appears legislation will pass before the August Congressional recess.
As of March 15, the Atlanta Fed’s GDP Now forecast for first quarter GDP is 0.9%. This forecast likely understates actual growth since it subtracts the impact of imports from GDP. Even if Q1 growth is closer to 1.7%, it would still be a slowing from the 1.9% growth in Q4. With Congress mired in reforming the ACA and tax cuts still on the horizon, I have thought the gap between current growth and expectations for faster growth could create a trading opportunity in the Treasury bond market and lead to a decline in yields. Despite rising expectations for a rate hike, a good employment report, and finally the Fed raising rates, Treasury bond yields have so far failed to break out above the yields highs in mid December. Often, it’s how a market responds to news, rather than the news itself, that is most revealing. In this case, market participants were positioned to profit from an increase in bond yields as the positioning in the Treasury futures market have been indicating.
Last summer, Large Specs (Green line middle panel chart below) were very long and Commercials (Red line) were very short. As is often the case, the smart money Commercials were right and the trend following Large Specs were wrong as bond prices suffered one of their largest declines in the past 30 years.
Now, the Commercials have a large long position, while the trend following Large Specs are short. Since the shorts will have to buy to cover their short positions at some point, bond prices may not fall much. This is what seems to be happening since bond yields have fallen since the Fed raised rates on March 15. If upcoming economic numbers show a bit of softness, those short may be forced to cover quickly, which would lead to a nice rally in Treasury bonds and cause yields to drop.
The 10-year Treasury yield has declined from 2.615% in the days leading up to the Fed meeting to 2.473% today and the yield on the 30-year Treasury bond has declined from 3.201% to 3.090%.
Click on any chart for large image.
As you can see, Commercials (red line middle panel below) have increased their long position in the 30- year Treasury bond futures, even as prices have yet to move higher. This is bullish.
The Treasury bond ETF (TLT) marginally dropped below its mid December low of 116.80 with its recent low of 116.49. Despite the new price low, TLT’s RSI was much higher as was the Major Trend Indicator, which has also turned up. (Chart below.) Now that TLT has made a new price low, it is possible to count the pattern from the price high last July as a 5 wave decline. This suggests that TLT will likely rally to at least wave 4 of lesser degree (123). From its high of 143.62 last July, TLT declined 27.13 points. A 38.2% retracement would lead to a rally to 126.85, while a 50% retracement would bring TLT back up to 130.00.
The 10-year Treasury yield could drop to 2.3% or lower, especially if short covering comes into play.
Stocks
The NYSE Composite broke out in early February, and then tested the breakout trend line on March 8 and March 14. The subsequent rally has so far failed to make a new high, which is a modest negative. The percent of stocks above their 200 hundred day average rose above 70% during February after the NYSE broke out. On one hand this was a sign of good participation. On the other hand, and despite all the headlines, the percent of stocks above their 200 day average in February was comfortably below where it was last summer. The percent has since dropped from 72% to 59%, before rebounding to 65% on March 17.
The recent weakness has clearly broken the uptrend in the percent of stocks above their 200 day average, which suggests the internal strength of the market has begun to weaken.
When the NYSE posted a new high on March 1, the 21 day average of net advances minus declines did not exceed +400, which was the first time that occurred since early December. More importantly, the bounce last week fell well short of the red horizontal line (+400), which is further evidence that the market is becoming more vulnerable to an increase in selling pressure.
The Option Premium Ratio (OPR) shows that investors are buying too many calls, which is why the Ratio has fallen below the red horizontal line. Over the past year, the NYSE has either stalled or declined after the OPR has dropped below the red horizontal line as noted by the blue arrows.
The S&P has left a number of gaps as it marched higher during February and the high on March 1. Traditional charting indicates that the gaps will be filled sooner or later. The S&P has filled the gap at 2371.54, which was created when the market celebrated the most presidential speech President Trump has given on March 1. There are two other gaps that I expect to be filled in coming weeks. – 2351.90 from February 15, and 2311.08 from February 9.
I think the S&P is in Wave (5) of the bull market that began in March 2009, after wave (4) ended in February 2016. (Follow chart below) Wave 1 of (5) began in February 2016 and ended in April 2016. (Follow chart below) The Brexit decline was wave 2 and the beginning of wave 3, which has developed into an extended wave that will have its own 5 waves.
If this pattern analysis is correct (Follow chart below), wave 1 (in red) of 3 from the Brexit low ended on August 15. Wave 2 of 3 lasted from August 15 to November 4 and the S&P declined 5.0% during the decline (2193.81 – 2083.79). Wave 3 of 3 ended on December 13, which is when the peak momentum of the rally was recorded. Wave 4 of 3 finished on December 30.
While it’s possible that wave 5 of 3 ended on March 1 at 2400.98, I think the odds favor one more push above 2400 to finish wave 3. If the S&P does rally one more time above 2401, there will be more pronounced momentum divergences, which would suggest it was appropriate to become more defensive, since wave 4 would quickly follow. Aggressive traders could consider going short on a rally above 2401 as a decline of 4% to 6% is likely.
The alternative is that the S&P will continue to grind lower during the next 4 to 6 weeks as it eventually closes the gap at 2311.08.
The wave 2 decline between the high in April and the low after the Brexit vote lasted 9 weeks and shaved 5.7% off the S&P. Since the S&P’s high of 2401 on March 1, the S&P has fallen less than 2% in less than 2 weeks. This suggests wave 4 will consume more time and result in more weakness in the S&P before it is finished.
Gold and Gold Stocks
From its low on December 15 at $1127.20, gold rallied to a high on February 27 of $1264.90, a gain of $137.70. Gold then dropped $70.40 to a low of $1194.5 on March 10. A 61.8% retracement of the $70.40 decline would target $1238, while a 78.6% rebound would bring gold up to $1249.80. Today gold reached $1235.50, so it is getting close to the targets. My guess is that the rebound in gold will top out between $1238 and $1249 and then be followed by another decline of $70.40. A 61.8% retracement of the $137.70 rally from $1127.20 to $1264.90 would bring gold down to $1179.80, while a 78.6% retracement would have gold make a low near $1156.65. My guess is that gold may bottom in coming weeks between $1170 and $1180 which is close to the low of $1182.60 on January 27.
When gold traded down to near $1200 on March 10, 13, and 14, Commercials (red line in middle panel below) reduced their short position in gold. In other words, they were buying on weakness, which is an intermediate positive. If gold follows the pattern I’ve outlined, the coming bottom near $1180 has the potential of being followed by a significant rally. As discussed in prior WTR’s, I think gold will rally above the $1385 high in August last year and may reach $1450 -$1480 before year end.
Since the high last August in the gold stock ETF (GDX), gold stocks have enjoyed a good rally each time GDX’s RSI fell to 30 or below (blue arrows). The lone exception was after the election, when the Dollar soared and gold stocks went sideways before making an intermediate low in December. I recommended GDX in December and recommended selling half of the position as GDX rallied above $23.00 and the remaining half at $25.17 – $25.25.
GDX then lost $4.57 from its high before bottoming at $21.14. When its RSI dipped under 30 on March 3, I recommended GDX in anticipation of a rally of roughly 10%. It’s time to sell GDX. If gold follows the pattern described above, GDX has the potential to decline to $19.43, where a gap was created on December 23 (chart previous page).
Last week, GDX spiked to $23.45 (the 50% retracement of the $4.57 decline is $23.42), which might be challenged or slightly exceed in the next few days. My guess is that GDX has the potential of experiencing another decline of $4.57, so the risk reward in the short term does not appear attractive. If $23.45 marks the high on this rebound, an equal decline would bring GDX under $19.00. The 61.8% retracement of the $4.57 decline would allow GDX to rally up to $23.96 sometime this week. A subsequent equal decline of $4.57 would bring GDX down to $19.39, which would close the gap at $19.43. If gold does exceed Augusts’ high, GDX has the potential to rally to at least $31.00.
Tactical S&P Sector Rotation Portfolio Model: Relative Strength Ranking
In the February 27 WTR, I noted that the Real Estate ETF (IYR) had reached $80.57, the 61.8% retracement level discussed in the February Macro Tides. I thought IYR had the potential to decline to below $69.00 in coming months. Since the February 27 WTR, IYR declined more than 5.3% before rebounding. The current bounce could reach the red resistance line near $79.00 which is also near the 61.8% retracement at $79.15.
In the March 6 WTR I noted that the Utility ETF XLU had recovered 78.6% of its decline from the peak in July. The RSI was over 70 which indicated that it was over bought and bumping up against a resistance line. (Chart next page) Since March 6, the Utility ETF XLU has experienced a modest pullback and looks like it may want to challenge its trend line resistance again. Last week, XLU tested its resistance line again and made a new closing recovery high, but its RSI diverged badly suggesting there is more weakness coming.
I think Treasury bond yields are going to come down which would normally be supportive of utilities. But if something “big” is coming, that will result in a flight to safety for Treasury bonds and increased selling pressure for equities.
If Treasury bond yields fall as I expect, the yield curve will narrow, which is likely to put pressure on Financials. This could be one catalyst for a correction in the overall market as investors lose patience at Congressional progress and an economy that shows no signs of accelerating.
Jim Welsh
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 smallcap 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.
