Written by Jim Welsh
Macro Tides Weekly Technical Review 20 August 2018
Going against the consensus poses a difficult investment challenge, which is why incorporating Contrary Opinion is such a valuable investment tool. Most investors follow price trends which works fine until the trend changes. Ironically, trend changes are accompanied by extreme sentiment and positioning especially for trends that are easy to understand or have been in place for a period of time.
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With the U.S. economy posting a 4.1% pace of growth for Q2, it is easy to expect the Federal Reserve to continue increasing short term rates that ‘should’ push Treasury bond yields higher. Higher short term and long term interest rates ‘should’ enable the Dollar to continue to rise since higher rates are why the Dollar has rallied by almost 10% since February. Higher rates and a stronger Dollar ‘should’ cause Gold to fall more, even though it has declined by more than 14% since mid April.
The logic behind each of these conclusions is solid and investors have established extreme positions in the futures markets to profit from what ‘should’ happen. Large Speculators have the largest short position in 10-year Treasury futures since 1992 according to Rick Santelli on CNBC. Hedge funds have their largest long position in the Dollar and short positions in other currencies since January 2017. Large Speculators have established their largest short position in Gold since 2001 when Gold was trading around $250 an ounce.
Treasury Yields
In recent weeks economic reports have indicated that GDP grew 4.1% in the second quarter and that core CPI inflation was the highest since 2008. This is exactly the kind of news that ‘should’ drive yields higher. As I have discussed for weeks, the large short position in Treasury futures was likely to bring Treasury yields down. In total 1.438 million Treasury contracts have been sold short in Treasury bond contracts in the 5-year, 10-year, and Ultra Long bond futures. The first estimate of second quarter GDP was announced on July 27. Since then the 10-year Treasury yield has fallen from 2.96% to 2.823% on August 20. With the bond market not trading as Large Speculators expected some are being pressured to cover some of their short positions, which is pushing Treasury yields lower. As previously noted, the 10-year Treasury yield could test the March low of 2.715% and possibly the 2017 high of 2.63% in coming months, especially if the economy loses some steam in the second half of 2018 as I expect.
Click on any chart below for large image.
Since July 27 the yield on the 30-year Treasury bond has declined from 3.10% to 2.98% on August 20. The 30-year Treasury may fall below the July 6 low of 2.925%. If it does, it would complete the potential Head and Shoulders top that has been forming since the February high at 3.221% and allow for a decline to 2.66%. (Head 3.24% – Neckline at 2.95% = .29% subtracted from the Neckline at 2.95%)
Dollar
President Trump’s plan for making America great again depended on making American multi-national corporations more competitive. To achieve this goal, corporate taxes would be lowered, the burden of government regulation would be lessened, and the Dollar would be talked down if necessary. As you may remember, President Trump made his views on the Dollar clear in an interview with the Wall Street Journal days before he took office, as I discussed in the January 2017 and February 2017 Macro Tides:
“In the January issue of Macro Tides, I discussed Trump’s view of the Dollar and suggested that Trump might not hesitate to talk the Dollar down sometime in 2017. The only surprise is that he didn’t even wait until he was in office to do it. In an interview with the Wall Street Journal published on January 17, he 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 pushes it up. “Having a strong Dollar has certain advantages, but it has a lot of disadvantages.”
After that interview the Dollar fell for 13 months until it bottomed at 88.25 in February 2018 after peaking at 103.82 in January 2017. Whatever gains President Trump hopes to achieve with tariffs and trade negotiations are being eroded by the strength in the Dollar. Corporate taxes and regulations have been reduced, but the Dollar is making U.S. multi-national corporations less competitive. The Dollar has rallied 10% since the February low and it’s just a question of when not if President Trump will attempt to talk the Dollar down. Criticism of the Federal Reserve and Chairman Powell is an indirect way of taking some steam out of the Dollar. President Trump is not known for subtlety so a more direct assault on the Dollar is likely.
The Dollar was expected to exceed its July 19 high of 95.65 before a high was recorded. After the tariffs were increased on Turkey the Dollar spiked higher reaching 96.98 on August 15, before dipping to 95.88 on August 20. Positioning and sentiment indicate the long Dollar trade is crowded. A close below 95.50 would be the first indication that a top may be in place, while a close below 94.90 would be more emphatic. Despite the new high in the Dollar its RSI was below the level it reached in late May, which is another sign that a top appears to be forming. A pullback to 93.20 to 93.75 is likely in coming weeks.
Euro
The Euro was expected to fall below the June 21 low of 1.15089 which was why the Dollar was forecast to exceed its 95.65 high. The Euro has fallen sharply since August 9 reaching 1.1305 on August 15 and now looks like it has completed 5 waves down from the high in February. A rally to 1.172 to 1.180 is expected in coming months. The instructions were to establish a 50% long position in FXE if it declined below $110.55. After closing at $110.54 on August 9, FXE gapped lower on August 10 as the Euro fell sharply. A rally that retraces 50% of the decline would lift FXE to at least $113.00 with a chance for a move up to $114.60 if President Trump tweets about the Dollar.
Gold
The positioning in Gold continues to get more positive. Large Specs are now net short which is rare (green line middle panel). The last time was in 2001! Managed Money has the largest short position ever (blue line bottom panel). Smart money Commercials have their smallest short position since December 2015 (red line middle panel).
Last week the percent of Gold bulls was less than 10% for 3 consecutive days and hit 6% on one day. The extreme bearish sentiment confirms the message from positioning.
The final piece is price momentum which has been terrible until Friday August 17. Gold needs to show more price strength so it can begin the bottoming process. This may take a few weeks as it did in November and December 2015 as can be seen on the chart above. Gold rallied from a low of $1123 in December 2016 to a high of $1365 in January 2018. A 78.6% retracement of the $242 rally would target support at $1174. Although Gold spiked down to $1160.75 in the overnight session on August 16, the lowest close has been $1173.90. It is important that Gold holds above $1170. If price action instead is lousy on balance, there is the potential that Gold could drop to $1123 which was the December 2016 low. Sentiment and positioning suggest that this is a low probability, but there are other factors in play.
Last week some of the selling in Gold was probably done by the Turkish central bank, especially after the Lira lost -14.0% on Friday August 10. I referenced this in last week’s WTR:
“Some of the selling pressure in Gold today August 13 came from Turkey’s central bank. By selling Gold, it will have money to buy the Lira with purchases funded from its Gold sales.”
The President of Turkey won’t allow the central bank to increase rates, so selling Gold, which is priced in dollars and converting the proceeds into purchases of the Lira makes sense. Gold was hammered last week on Monday and Wednesday. After spiking to a low of 7.1 to 1 versus the Dollar on Monday August 13, the Lira rallied sharply on Monday and Wednesday. That’s not likely a coincidence.
The fundamental driver for a continued decline in Gold is more selling by the Turkish central bank. Most banks usually increase rates to stem the flow of money out of the country and the downward pressure on its currency. If higher rates fail to provide enough support, a central bank will use its currency reserves to purchase the domestic currency. That’s a problem for Turkey since by most measures it doesn’t really have enough to support its financing needs.
One of the most common methods used to gauge the adequacy of a country’s reserves is to compare them with its upcoming debt payments with 100% considered the minimum. In January Turkey’s ratio of reserves to upcoming debt payments was just 90% and by mid-year had fallen to 74%.
Turkey needs to refinance around $200 billion a year on average which will be difficult and another reason why selling Gold was a better choice than using precious reserves to support the Lira.
Companies in Turkey have $198 billion in dollar denominated debt. Since December 31, 2017 the Lira has lost 58%, with a loss of 31% occurring just since July 9. The cost to service the dollar denominated debt for Turkish companies that derive all their revenue in Lira has exploded by 58% since the end of last year and 31% in less than 6 weeks. This will prove too much of a burden for a significant number of Turkish companies and there is going to be a wave of defaults in coming months. The only question is how soon and how many companies default. The Turkish economy will be hit hard by the Dollar denominated debt burden and higher domestic interest rates would only make it worse. This is another reason why Turkey’s president prefers supporting the Lira with purchases funded by Gold sales, rather than increasing interest rates.
While most of the fallout will be contained within Turkey, banks in Italy have a large loan exposure to Turkey. There is also political risk in Italy since the leading coalition is comprised of an extreme liberal party and an extreme conservative party. The liberals want to spend more and the conservatives want to cut taxes. Any resemblance to the Democrats and Republicans in the U.S. is simply obvious. If the coalition government pursues their agenda it will be in conflict with the European Commission’s rules.
The yield on the Italian 10-year bond has climbed from 2.5% on July 18 to 3.16% on August 15, which is just above highs of 3.10% on May 29 and 3.13% on June 8. If the Italian 10- year yield breaks out above 3.20% decisively, attention will shift away from Turkey and toward Italy. Whether this develops in the next few weeks or materializes three months from now is completely dependent on the Italian bond market.
An increase in the Italian bond yield above 3.2% will likely cause weakness in European equities which could easily spill over into the US stock market. Should the Turkish Lira close decisively above 7.1 to the Dollar, weakness in emerging market equities would likely ensue. Lastly, if the Dollar rallies above last week’s high of 96.98 (cash), it may lead to weakness in Gold and commodities in general.
Stocks
After testing 2800 on Wednesday August 15, the S&P 500 rallied sharply after it was reported on August 16 that China was sending a trade delegation to Washington for talks. The likelihood of meaningful progress or concessions by China on the points that matter most to the U.S. is low. In the short run this reality doesn’t matter. The S&P 500 is less than 1% from its peak in January. Low volume and selling pressure allows the impact of stock buybacks to exert a greater influence. A new high seems a foregone conclusion despite numerous technical indicators that show the market’s internal strength has weakened since the S&P 500 reached 2790 in June.
As I have discussed for weeks, a little more than half (52% on August 17) of NYSE stocks have been above their 200 day average compared to 68% in January, even as the S&P 500 is less than .6% below its January peak. The lack of broad participation has also been evident in the percent of stocks that have made a new 52 week high in the past 21 trading days. On August 17 just 0.84% of NYSE stocks made a new 52 week high compared to 2.61% in mid June and 6.92% in January.
The Nasdaq Advance / Decline Line peaked on July 9. This divergence suggests the Technology sector could come under more selling pressure, especially if the trend line from the April and June low is broken.
The Semi-Conductor sector has been a primary driver of the strength in the Technology sector. The Semi-conductor ETF (SMH) has closed below the black trend line connecting the low in May and June, although it is still above the June low at 100.90 (green trend line).
Rotation has been extreme this year as the S&P 500 remained locked in the range it established between its high of 2873 on January 26 and low on February 9. Since Treasury yields peaked in mid May, defensive sectors have rallied. Utilities and Real Estate have benefited from the fall in long term rates, as have Consumer Staples. Health Care is considered a traditional defensive sector. I think the economy is going to slow from 4% to near 3% before year end and the strength in these sectors supports that view. These sectors are now overbought as measured by their RSI, so additional upside seems limited, unless I’m wrong and the discussions with China prove more productive than expected.
A close below 2790 would be the first indication that a short term top was in place, while a close below 2690 would indicate that an intermediate top has formed. The number of VIX contracts that have been sold short is almost back to the record established in January. These short VIX positions are betting on lower volatility in coming weeks. If the S&P 500 closes below 2690, there may be a big increase in volatility which could cause the VIX to soar above 30 and elicit more selling broadly.
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 which is still in effect.
The MTI remains well below its high from January. A close below 2690 would suggest a meaningful top had been completed. 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.
