Written by Jim Welsh
Macro Tides Weekly Technical Review 29 May 2018
As I discussed last week, a number of markets appeared to have reached an inflection points independently of each other:
“The drivers behind the potential changes in trend are more likely to be the result of extreme sentiment and positioning. The timing of the changes in trend in the Dollar, Treasury yields, Gold, Gold stocks, and possibly the S&P 500 are near completion based on the individual price patterns in each market.”
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Treasury Yields
In the May 14 WTR I discussed the price pattern in Treasury yields and why Treasury yields might top soon:
“If Treasury yields rise above the April 25 high, the Treasury bond ETF TLT is likely to drop below the low of wave 3 ($116.51) and complete a 5 wave decline from the price high in September 2017. It took 3 months from the time TLT made its wave 3 low in December 2016 and the wave 5 low in March 2017. An equal amount of time from the wave 3 low on February 21 would target May 14 – May 21 as a guess of when Treasury yields will exceed their recent high and TLT records a low for wave 5. Establish a 50% position in TLT if it trades under $116.51 in the next few weeks.”
On May 17, the 30-year Treasury yield rose to 3.247% and TLT dropped to $116.09 triggering the buy signal. Based on the price pattern, my expectation was that TLT had the potential to rally to near $121.00 in the next 1 to 3 months. Today, TLT traded up to $122.52 just 7 trading days after the buy signal. As I have been noting for a number of weeks:
“The positioning in Treasury futures in all maturities shows a record short position being held by Large Speculators. This suggests Treasury yields are more likely to fall in coming months than continue to rise.”
Click on any chart below for large image.
The yield on the 30-year Treasury bond has plunged from 3.247% on May 17 to 2.954% today May 29. The news coming out of Italy and the rise in Italian bond yields certainly provided the impetus for yields to decline. But the real octane came from the large short position in Treasury bond futures. One contract has a value of $100,000 and requires a margin of $4,300. Each one point move in Treasury bond prices represents $1,000. Since May 17, 30-year Treasury bond prices have soared from 140.16 to 146.21, or more than $6,000 for each futures contract. For any firm short Treasury bonds, this is a devastating loss in a short period of time.
In order to maintain a short position which is losing so badly, a firm would likely receive a margin call and be required to bring in more money within one or two hours. If the firm fails to bring in more capital to maintain the position, the trading firm would simply liquidate the position. In the case of a short position, the liquidation would actually be a purchase of bond futures to close out the short position.
The intensity of buying in Treasury futures today suggests a measure of panic buying was responsible for the huge one-day decline in interest rates. The five – year Treasury yield fell 18.5 basis points, while the 10-year yield dropped by 16.3 basis points, and the 30-year plunged by 12.2 basis points. This is an example of the power of positioning when a trade goes against the position.
I recommended buying TLT at $116.50 in anticipation of a rally to $121.00. I would recommend selling half of the TLT position tomorrow since it closed at $122.24 and has more than achieved the price target. I established a 15% notional position in TLT on May 17 by buying a 5% cash position in the 3 to 1 Treasury bond ETF TMF at $17.07, when TLT was trading at $116.40. I sold the position this morning when TMF (Too Much Fun) was trading at $19.03.
There are two reasons why holding on to half of the position in TLT makes sense for now. The Italian situation is not going away immediately and could become more problematic in the short term. This could cause yields to fall more in the U.S. and potentially enough to change the longer term outlook if the 10- year yield drops below 2.60%. From the low of 1.336% in July 2016, the 10-year Treasury yield rose to 2.621% in December 2016 and 2.615% in March 2017. Should the 10-year yield fall below 2.60% it would potentially negate the break out in January 2018 above 2.62%.
When the 10-year yield topped at 3.115% on May 17, it may have completed an A-B-C move up in yields from the July 2016 low of 1.336% (Chart below (red A, B, C). This pattern suggests that the secular bull market in bonds is NOT over and eventually the 10-year yield will fall below 1.336% at some point in coming years.
Fundamentally, the only way this happens is if deflation overwhelms the cyclical inflation that has been building during the current recovery. This would be accompanied by a recession and a new round of Quantitative Easing by the Federal Reserve. I have no doubt the Fed will expand its balance sheet to $10 trillion or more if the economy is threatened with recession. As I noted in my August 2007 commentary:
“The one bubble the Federal Reserve cannot allow to burst is the credit bubble.“
Debt levels are higher now than in 2007 in the U.S., Emerging Markets, and globally.
There is a second pattern that is just as viable as the A-B-C, but ends with an entirely different outcome. If the secular bull market in Treasury bonds ended in July 2016, a new secular bear market began which will lead to much higher interest rates in coming years. If this is the case, the move up from 1.336% to the March 2017 high would be labeled as wave 1 (Chart below – red 1). The decline to 2.034% in September 2017 would represent wave 2 (red 2). The increase in the 10-year yield from 2.034% to 3.115% is wave 1 of wave 3 (red 1 of 3), and the current decline would be wave 2 within wave 3 (red 2 of 3).
This is why going long TLT made sense since positioning and both patterns suggested that Treasury yields would likely decline from the high at 3.115%. If this is the correct pattern, it is unlikely that the 10- year yield will fall below 2.62% in coming weeks. But a decline below 2.62% would not eliminate the potential of much higher yields. A 50% retracement of the increase from 2.03% to 3.115% would target 2.57%. In the short term yields can fall further as the huge short position is worked off.
Dollar
In recent months I expected the Dollar to rally in large part because the positioning in the Euro was so extreme. Large Speculators (hedge funds, trend follower) were holding the largest long position ever in Euro futures. These traders expected that the Euro would move higher. In late April the Euro began to fall which started to pressure those long the Euro. As losses on their long Euro contracts mounted, selling pressure rose. Last week the news out of Italy provided a good fundamental reason why the Euro was likely to decline further which only caused more selling. In February Large Speculators were long more than 140,000 contracts. As of May 22 that position had shrunk to 109,744 contracts. In December 2016 as the Euro was bottoming below 1.04, Large Speculators were short -87,513 contracts. This suggests there is fuel for a further decline in the Euro as more long positions are liquidated.
Since the Euro represents 57.6% of the Dollar index, the manic selling pressure in the Euro is why the rally in the Dollar has been so unrelenting and illustrates the power of positioning. The liquidation of Euro longs was one of the reasons I thought the Dollar had the potential to rally to 94.50 to 95.00 from a low of 88.25 in February. Last week I noted that a recent survey of trader sentiment showed that more than 90% were bullish, which is about where sentiment was as the Dollar was topping in early November 2017. This was one reason why I thought the Dollar was ready for a pullback 1% to 1.5%, which would be wave 4 and followed by wave 5 to a new high and presumably a move up to 95.00. The unwinding of the large long position in the Euro allowed the Dollar index to reach 95.02 on May 29.
In the April 2 WTR I suggested establishing a partial position (up to 50%) in the Dollar ETF (UUP). On April 3 UUP opened at $23.64. On April 23 the Dollar broke out and I recommended adding to the position. On April 24 UUP opened at $23.86. In the May 7 Macro Tides I recommended selling 1/3 of the position if UUP traded above $24.50. On May 8 UUP traded up to $24.52. In the May 14 I recommended selling the remaining 2/3 of the position if UUP traded above $24.52 which it did on May 25.
Gold
In the May 14 WTR, I recommended:
“Buying a 50% position in Gold or the Gold ETF GLD, if Gold trades under $1301. Increase it to 100% if Gold trades under $1285.”
On May 15 Gold traded under $1301 and the Gold ETF GLD opened at $122.82. I established a 25% notional position (using 8.33% of cash) in the 3 to 1 Gold ETF UGLD at $10.43. Although Gold has traded under $1285 during night trading sessions, it has not traded under $1285 while GLD was trading. Increase the position to 100% if Gold trades under $1285. Gold has the potential to trade to $1270 – $1280 before reversing. A close above $1297 would be a positive sign that a bottom was in place.
Gold traded up to $1307 last week and has probably been held in check by the strength in the Dollar. The initial target is for Gold to rally to $1315 – $1325 which is the first area of resistance. If Gold is able to overcome this resistance, the next target would be $1360 – $1370. As noted in the Gold Special Update on May 9:
“If the analysis shown below is correct, a decline below $1301 should lead to a wave 3 rally that carries Gold above $1400 by the end of July.”
Although my expectation for a rally above $1400 is unchanged, the odds of it occurring before the end of July have diminished. Instead, a rally that lifts gold to near $1360 which is followed by another pullback that holds above $1282.This trading pattern would potentially be wave 1 and wave 2 of wave C. Wave 3 of C may kick in before Labor Day and top sometime in the fourth quarter with Gold above $1400.
The positioning on Gold futures continues to get more constructive but not as rapidly as expected. Large Speculators have cut their long position from 224, 417 contracts in late November to 90,957 as of May 22 (green line middle panel). Commercials have reduced their short position from -246,541 to -115,575 (red line middle panel). Prior to Gold’s rally from $1205 in July 2017 to $1357 in early September, Large Speculators were long only 60,260 contracts and Commercials were short only -73,916.
Since a similar rally of $140 is possible based on the chart pattern, I have expected the positioning to become as positive as it was last July. One position has become quite bullish. Managed Money (blue line bottom panel) is only long 16,531 contracts which is the smallest long position since December 2015 just as Gold was bottoming near $1050.
Gold Stocks
Last week I noted that it was possible that the move up from the low of $22.03 on May 18 was an a-b-c rally for wave 4. If correct, GDX had the potential to trade under $22.03. On May 23 GDX traded down to $23.01 so it it’s possible that the pattern is complete and the low is in place.
The only fly in the ointment is that GDX’s RSI has not closed below 35 which would be more supportive of a bigger rally. GDX’s RSI is still above 40 which leaves open the door for another shoe to drop which might include a drop below $21.75. Conversely, GDX may only rally up to $24.00 – $24.25 in the next few weeks before another correction takes hold.
The relative strength of GDX to Gold weakened modestly on Friday and again today (Chart above). This is another reason why GDX may have another sinking spell before a stronger rally can take hold. If GDX’s relative strength doesn’t improve significantly and GDX trades up to $24.00 – $24.25, it may be a sign that selling into that strength will prove a good idea. We won’t know if and until it gets there.
I established a 33% notional position in GDX by buying the 3 to 1 Gold stock ETF NUGT at $24.68 with 11% of cash.
Stocks
Although the S&P 500 has a number of different options, especially in the short term, I still expect the S&P to work its way below the February 9 low of 2532 in coming months. Today’s low of 2677 tagged the black ‘break out’ down trend line from January’s peak. The relative strength of the Nasdaq 100 and the Russell 2000 suggests that both averages may make a new all-time high in coming weeks which would not be confirmed by the S&P 500 or the DJIA.
In October 2007, the S&P 500 and DJIA made new alltime highs which were not confirmed by the majority of the major averages. The strength in the Russell 2000 and Nasdaq 100 has the feel of money jamming into these sectors based on the strength in the Dollar and buying big cap tech growth stocks since they are cheap. The Russell 2000 is supposedly insulated from Dollar strength since they derive only 20% of their revenues from international sales. That may be true, but about 30% of small companies in the Russell 2000 don’t make money and as a group carry much more debt than either mid cap companies or large cap stocks. Higher rates may outweigh the lack of exposure to the Dollar and small caps won’t fare well when economic growth slows.
The big cap tech stocks are over owned and over loved and may still face legislative hurdles in coming months and a backlash from users who become more concerned about privacy. Are you listening Alexa?
As noted last week:
“The rally from the May 3 low AND the April 2 can be considered finished as an a-b-c (noted in black chart above), which would be enhanced if the S&P 500 trades under 2683.”
The S&P 500 did trade under 2683 on May 29 which increases the odds that a rally above 2760 is not likely in coming weeks. My guess is the S&P 500 will dip to near 2660 – 2670 before mounting a stronger bounce that may allow the Russell 2000 and Nasdaq to make a new high. If this pattern develops it could set up a good shorting opportunity before the flush lower.
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. Although the MTI has rebounded since the May 3 low, it is only back to where it was in November 2016. The MTI recorded another lower peak on May 25 and turned lower with the weakness on May 29. This high is just above the green horizontal line and is similar to the high posted in November 2015 which was followed by a bout of weakness in January 2016. Based on the S&P 500’s price pattern and waning momentum, down side risk in the market is rising.
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.