Written by Jim Welsh
Macrotides Technical Review 08 January 2018
One of the main drivers for financial markets in 2018 is whether bond yields rise as much as I think is possible. At the end of 2016, the majority of bond strategists forecast that the 10-year Treasury yield would rise to 3.0% in 2017 and were positioned for that outcome.
In the December 19, 2016 WTR I noted how bearish most traders were and expected bond yields to fall rather than rise. “The Treasury ETF (TLT) has been grinding lower over the last 13 trading days, and spiked down to 116.80 after the Fed meeting. With less than 10% of trader’s bullish Treasury bonds, and negative sentiment reinforced by the Fed’s forecast of 3 rate hikes in 2017, a decline in yields is coming. A short covering rally could provide The Treasury ETF (TLT) a nice lift and get legs, if the economy slows as I expect in the first quarter, and investors realize that inflation and fiscal stimulus may not kick in as quickly as expected. The yield on the 30-year Treasury bond could drop to 2.75% – 2.85% and the 10-year yield may fall to 2.10% – 2.20%. If this comes to pass, TLT has the potential to rally up 127.00 – 129.00.”
In the next 5 trading days TLT traded below $118.00 (first black arrow).
Click on any chart below for large image.
In mid March 2017 TLT tested it December low as Treasury yields rose and retested their December 2016 highs of 2.62% for the 10-year Treasury bond and 3.20% on the 30-year. In the March 13, 2017 WTR I thought TLT had completed its decline from its July 2016 high and was poised for a rally:
“The Treasury bond ETF (TLT) has dropped below its mid December low of 116.80. 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. (second black arrow). This suggests that once a bottom is in, TLT will likely rally to at least wave 4 of lesser degree (122-123). A 38.2% retracement would lead to a rally to 126.00 or so, while a 50% retracement would bring TLT back up to 129.00.”
As noted by the blue arrows on the chart, TLT rallied above $128.00 in June and again in September. In the June 26 WTR I noted
“that TLT traded as high as $128.57 that day, so it is near the 50% retracement level of $129.00. It is certainly time to sell at least half of the TLT position.”
In the August 7 WTR I thought Treasury yields were near a low and recommended establishing a partial short position in an inverse Treasury bond ETF:
“If the 10-year yield drops below 2.20 and the 30-year yield drops below 2.806%, it would offer an opportunity to establish a partial short position through one of the inverse ETFs”.
On August 11 Treasury yields did fall below those thresholds. In the August 28 WTR I provided this assessment:
“Three weeks ago, I recommended a partial short position through one of the inverse Treasury bond ETFs if the 10-year yield dropped below 2.20%, and the 30-year yield fell below 2.806%. The trading pattern in the 10-year and 30-year Treasury bonds suggests that the yield on the 10- year can drop below 2.103% (2.05%) and the 30-year could fall below 2.682% (2.64%) before yields reverse higher. Adding to the partial short position through one of the inverse Treasury bond ETFs is recommended if yields do make lower lows.”
On September 7, Treasury yields fell below the noted trigger points of 2.103% and 2.682%. The entry points are noted by the red arrows on the chart of 10- year Treasury bonds and 30-year Bonds.
The 1 to 1 inverse Treasury bond ETF I’m using is TBF. On August 11 it closed at $22.15 and $21.62 on September 7 when the 30-year Treasury bond fell below the trigger points recommended for partial positions. The entry points on TBF are noted by the green arrows. The average price is $21.885. TBF closed at $22.09 on Friday January 5. Although not likely, if TBF drops below 21.70, I would add to my TBF position.
Since September 7, the yield on the 5-year Treasury bond has climbed from 1.618% to 2.295% today, an increase of .677%. During the same period, the 10-year Treasury yield has gone up by 0.455% (2.489% – 2.034%) and the 30-year has risen by just 0.176% (2.827% – 2.651%). The obvious question is ‘What’s it going take for 10-year and 30-year yields to rise to their highs of March 2017 of 2.62% and 3.20%?’ Even though the Fed did raise the federal funds rate three times in 2017, as they had forecast, most investors are skeptical about the Fed’s projection of three more hikes in 2018 since they don’t expect inflation to stir. Like the boy who cried wolf too often, economists have been forecasting an increase in wage growth for years which has yet to materialize.
This view was reinforced by the December 2017 employment report which indicated that average hourly earnings were up 2.5% from December 2016, which was unchanged from November. On the surface it certainly did appear that wage growth remained stuck at 2.5% in December. As is said the devil is in the details. Average hourly earnings rose from $25.91 in November 2016 to $25.98 in December 2016, and the Labor Department reported that wage growth in December 2016 was 0.3%. The Labor Department reported that wage growth in December 2017 was up 0.3% from November, which certainly looks no different than wage growth in December 2016. But in December 2017 average hourly earnings rose from $26.54 in November to $26.63 an increase of 0.339% compared to an increase of 0.27% in December 2016. Since the Labor Department does not use two digits to report monthly changes, it rounded up the December 2016 figure to 0.3% and rounded down the December 2017 increase to 0.3%. Clearly, the two 0.3% increases are not the same. Had average hourly earnings risen $0.10 in December 2017, rather than $0.09, the monthly increase would have been 0.377% and the Labor Department would have reported the increase as 0.4%. That increase would have received far more attention, maybe even a headline, than the reported 0.3% increase.
This under the surface analysis suggests that upward pressure on wage growth continued in December which sets up January as a potential game changer. According to Strategas Research, 85 large companies have announced bonuses and wage increases for their employees since the tax cut was passed. As discussed in the January 2018 Macro Tides:
“As I have discussed previously, the spread between the U6 and U3 unemployment rates has narrowed to the level that has resulted in a pick-up in wage growth. This spread will narrow further in 2018 and cause wage growth to rise from the recent level of 2.5% as 2018 unfolds. Wage growth will also be lifted by the 18 states that will increase the minimum wage in 2018 which will help 4.5 million workers, according to the Economic Policy Institute. Increases in the minimum wage often results in a trickle up effect as workers earning just over the minimum wage also receive an increase based on their experience and value, so the impact will affect more than 4.5 million workers. The decline in the corporate tax rate will increase profit margins and some number of companies large and small will increase wages more than they have in recent years. Wage growth is going to pick up in 2018.”
Once it becomes apparent that wage growth is indeed accelerating, yields on 10-year and 30-year Treasury bonds are likely to rise as investors’ price in higher inflation and 3 rate hikes by the Fed. In Ernest Hemmingway’s novel ‘The Sun Also Rises’ a character is asked how he went bankrupt. He replied, “At first gradually, then all at once.” That quote may describe how the bond market could trade in the first half of 2018. At some point before June, I expect the 10-year Treasury yield to breakout above the highs in December 2016 and March 2017 at 2.62%, and subsequently run up to near the December 2013 high of 3.03%. If the 10-year yield does rise above 2.62%, the odds would favor the 30- year Treasury bond yield rising to near 3.20%, which was the high in March 2017 and December 2016. If this occurs, TBF has the potential to reach $24.25 and provide a return of more than 10% from the average entry price.
Gold and Gold Stocks
As I noted in the December 18 Weekly Technical Review:
“The positioning in the futures suggests Gold is likely rally to at least $1305 and could make a run at the September high of $1357 in the first quarter of 2018.”
As noted in the December 29 update:
“Short term the RSI on Gold is near 70 and modestly overbought, so a modest pullback would not be a surprise.”
Last week Gold (cash) traded up to $1325.56 before pulling back. As long as Gold holds above $1300 and doesn’t close below $1305, Gold is likely to rally above last week’s high before a more pronounced decline takes hold. A decline to $1265 – $1275 would be possible before another push higher commences.
After showing modest improvement, the relative strength of gold stocks as measured by the Gold GDX Ratio has softened. It is still below the black rising trend line so the breakout below the line is still valid. It did however close above its blue moving average today. In addition, GDX’s RSI pushed above 70 last week, so on a short term basis GDX was overbought. The price pattern of GDX suggests it is still possible for another push above last week’s high at $23.84 before a deeper correction unfolds. If GDX does rally above $23.84 I will likely sell 37% of my position since I am overweight Gold stocks. I will use a close below $22.50 as a stop.
On December 18, I established at 25% position in the Junior Gold stock ETF GDXJ at $32.035. The analysis of GDXJ is the same as GDX with one important exception. Last week the RSI on GDXJ rose above 70 as GDXJ was pushing up against a trend line connecting the February and September highs. If GDXJ exceeds its high last week of $35.17, I will sell half of my position. Given the volatility of GDXJ, I may sell 25% if GDXJ trades above $34.70. I will use a close below $33.01 as a stop.
Dollar
In the December 18 WTR I thought that unless the Dollar rose above the neckline of the inverse head and shoulders at 94.25, the downtrend would be intact. The downtrend did continue and carried the Dollar from 93.69 on December 18 to a low of 91.75 on January 2. At that point the Dollar’s RSI was below 30 indicating the Dollar was oversold and overdue for a bounce. The Dollar has rallied to a high on January 8 of 92.33 which is not much below the low on November 27 of 92.496, so over head resistance isn’t too far away. The price pattern looks as if the Dollar could drop again below 91.75 which would likely register an RSI positive divergence and set up a better rally. The positive divergence in early September, when the Dollar dropped to 91.01, preceded the rally to over 95.00 in early November.
There is a chance the Dollar will test the September low of 91.01 in the first quarter before a potentially major rally commences. There remains a very large short position in the Dollar and a multi-year high long position in the Euro. Sentiment toward the Dollar is very bearish. Ironically, the Euro may top when it becomes apparent the ECB is going to soften its link between its QE program and 2.0% inflation target. After all, 4 rate increases by the Fed since December 2016 didn’t prevent the Dollar from losing 10% of its value in 2017.
Euro
The Euro topped on May 5, 2014 at 1.3993 and dropped .3652 until bottoming on January 2, 2017 at 1.0341. A 50% retracement of that large decline would carry the Euro back up to 1.2167, so the area between 1.200 and 1.220 is a zone that could coincide with an important top. As discussed in the December 18 WTR, positioning in the futures market is probably the best measure of sentiment since it shows how money is positioned. When positioning becomes extreme, with Large Speculators holding a large long or short position the odds are high that the trend is about to change. Large Speculators are trend followers so by definition as a group they hold their largest long position as an uptrend is nearing a high and the largest short position after a large decline that is close to a bottom. The unwinding of large long positions held by Large Speculators contributes to a decline as they sell, and pushes prices higher as they buy to cover a large short position.
In March 2014 when the Euro was trading just below 1.40 and nearing a very important top, Large Specs held 39,634 contracts long. Conversely, when the Euro was bottoming in March 2015 just above 1.05, Large Specs were holding -220, 963 contracts short in anticipation of lower prices. By August 2015 the Euro had rallied to just below 1.14. As the Euro was bottoming below 1.040 in December 2016, Large Specs were holding -114, 556 contracts short. Rather than falling more, the Euro had zoomed to 1.20 by August 2017. Currently, Large Speculators are long 127, 868 contracts which is their largest long position maybe ever (green line middle panel chart below).
The green line in the middle panel illustrates the positioning of the Large Specs and how they were way too short at the important lows in March 2015 and December 2016. And now they are holding their largest long position ever. As you can see by the red line in the middle panel, the Commercials were long at the lows in 2015 and 2016, after which the Euro rallied smartly. The Commercials now hold their largest short position ever. The positioning in the futures market suggests a sizable decline in the Euro is coming, and will probably start in the first half of 2018.
Since the Euro comprises 57.6% of the Dollar index, a sizable decline in the Euro will contribute to a meaningful rally in the Dollar. In 2017, the Dollar fell sharply and equity markets around the globe did well, especially emerging markets. A big rally in the Dollar could certainly upset the apple cart and lead to a unexpected correction in global equity markets. And if inflation ticks up and results in higher bond yields in the U.S. and globally, 2018 could prove a very interesting year.
Technically the pieces are not yet in place to confirm a bottom in the Dollar or a top in the Euro. At a minimum, the Euro will need to violate the uptrend that has been in place since the low in early November. A close below the low on December 12 at 1.1717 will signify the first breakdown in the chart shown below.
Stocks
Stocks have come out of the gate with strength, with the Advance / Decline making new highs accompanied by a healthy expansion in the number of stocks making new 52 highs on both the NYSE and Nasdaq.
Just about every measure of bullish sentiment is at or near multi-year highs and in some cases multidecade highs. Bullish sentiment usually peaks before prices top out, so the widespread bullishness is a warning of an approaching high in the market. However, until the majority of technical indicators begin to show marked deterioration, it is too early to turn bearish. The first dip in the market will be bought. The odds of a 3% to 5% pullback will increase after mid February.
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.
The rally since mid November has been strong and has pushed the MTI to a level that suggests a meaningful correction in the S&P (greater than 7%) is likely months away.
Technology continues to lead the pack as it has for months. Financials and Basic Materials have also maintained their position in the top four sectors. In mid December Industrials nudged ahead of the Russell 2000. Energy has improved significantly since early December as oil prices were finally able to climb above $60.00 a barrel. Next week I will review oil since the positioning in the futures market and the price pattern suggests that WTI oil is nearing an intermediate high.
Click on table for large image.
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
