Written by Jim Welsh
Macro Tides Weekly Technical Review 27 August 2018
The Dollar Falls, Gold Rallies, and Treasury Yields Hold Steady
As noted last week, 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. 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.
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Federal Reserve Chairman Jerome Powell’s speech at the annual central bank confab at Jackson Hole Wyoming on Friday did nothing to dispel the notion that the Fed won’t continue to increase rates in 2018 and 2019. 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. Going against the consensus poses a difficult investment challenge, which is why incorporating Contrary Opinion is such a valuable investment tool.
Dollar
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. As I have noted for a number of weeks, the positioning and sentiment indicate the long Dollar trade is crowded.
Click on any chart below for large image.
Last week I thought a close below 95.50 would be the first indication that a top might be in place. On August 21 the Dollar closed at 95.26, which was why I did a Special Report recommending Emerging Markets on August 21. A close below 94.90 would be a more definitive sign that a top in the Dollar was in place and that occurred on August 27. A pullback to 93.20 to 93.75 is likely in coming weeks. Given the positioning and sentiment this target may prove conservative.
Emerging Markets
On August 21 I recommended the Emerging Markets ETF (EEM) in anticipation that the Dollar was likely to decline after its 9.9% rally since February, and the expectation that Treasury yields would not rise above their May high. The Emerging Markets are far cheaper than US equities so the EEM’s valuation is more attractive. A recent Fund Manager Survey (FMS) by Bank of America Merrill Lynch found the highest allocation to U.S. equities since January 2015 and US equities the number 1 allocation for the first time in five years.
The high level of allocation is in response to data showing the U.S. economy has been performing better than Europe, Japan, Great Britain, and other developed economies and the fact that the US market has been performing better. If the US slows in coming months as seems likely, it may lead Fund Managers to rotate out of the US into EM. Technically, EEM’s RSI was oversold on August 15 but posted a higher low than in late June, even though EEM’s price fell below the June low (red line).
The last time a positive RSI divergence occurred was in November and December 2016 (green line on RSI). This was followed by a substantial rally after the Dollar peaked in January 2017. A rally to $44.50 or so seems likely. A rise above $45.00 would exceed the late July high and would break above the down trending upper blue trend line and black horizontal trend line. A rotation into EEM will only happen after EEM starts to perform better and starts to register on computer screens. A close above $45.00 is the first hurdle. On August 21 EEM closed at $42.93 after trading between $42.80 and $43.11 in the hours after I sent out the Special Update.
Euro
The Euro was expected to fall below the June 21 low of 1.15089 and in the process finish a 5 wave decline down from its February high. On August 15 the Euro fell to 1.13 and has since rebounded. A 38.2% retracement of the decline from 1.255 to 1.130 targets an initial high near 1.179, which happens to be the Euro’s high on July 9. The instructions were to establish a 50% long position in the Euro ETF FXE if it declined below $110.55. This entry price was not as attractive as expected since the Dollar spiked higher after the tariffs on Turkey were applied and the Euro fell further below the May 29 low than seemed likely.
Since the rally in the Euro is probably a counter trend move and the purchase price was not optimal, selling into strength makes sense. Sell half of the position at $112.85 and the other half at $113.45. Use a stop of $110.32 on the position. If this is a counter trend rally, the Euro is likely to move higher in an up, down, up pattern. Maybe we’ll get lucky and sell half of the position near the high of the first up move.
Treasury Yields
In his speech at Jackson Hole last Friday Fed Chairman Powell summarized why the Fed should continue with its gradual approach of increasing the federal funds rate:
“I see the current path of gradually raising interest rates as the approach to taking seriously both of these risks… While inflation has recently moved up near 2 percent, we have seen no clear signs of acceleration above 2 percent, and there does not seem to be an elevated risk of overheating.”
Unless the data materially deviates from what the Fed expects in coming months the Fed plans to increase rates at its meeting in September and December. How anyone could interpret his comments as being dovish is beyond me. He seems like the ultimate pragmatist to me and is clearly not beholding to economic orthodoxy as Yellen.
It is remarkable that the short position in Treasury futures continues to grow despite the fact that Treasury bond yields have refused to rise, despite strong economic news, higher inflation, and a resolute Federal Reserve. In the week ending August 21, Large and Small speculators were short a record 852,899 10-year Treasury futures contracts. Clearly, those short have a high conviction level that Treasury yields must go up sooner or later, and a high pain threshold to take the heat when bearish news fails to have an impact.
As I listen to CNBC I frequently hear strategists proclaim that the bond market is telling them that the Fed may not raise rates in December (maybe I need a hearing aid so I can listen to the bond market too). The inference being that Treasury yields wouldn’t be this low if the Fed was going to raise rates in December, which is good for the bond market and the stock market.
These strategists never mention or refer to the record short position in Treasury futures and that this may be why yields seemingly defy logic by falling. There is a good chance that the economic data for August when it is released during September will provide more evidence that the economy is slowing. If correct, the squeeze on the record short position could bring yields down further and come close to inverting the yield curve, after the Fed raises rates at its September 26 FOMC meeting. On August 27 the spread between 2-year and 10-year Treasury bonds narrowed to 20 basis points or 0.20%.
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. Last week the 10-year yield fell to 2.808% slightly undercutting the July 6 low of 2.811% and testing the trend line connecting the April low of 2.717% and May low of 2.759% before ticking higher.
On August 24 the 30-year fell to 2.963% just above the green trend line that is also the neckline of a potential Head and Shoulders formation. 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%)
Since January the Treasury ETF TLT has been trading in range bound by $116.85 (lower black horizontal line) and $122.50 (upper black horizontal line). If the 30-year Treasury yield falls below the neckline of the Head and Shoulders pattern, TLT could rally to $127.30 – $128.15. If the range (122.50 minus 116.85 = 5.65) for TLT is added to $122.50 the target is $128.15. Establish a 50% long position if TLT falls to $120.30 using a stop of $118.75.
Gold
The positioning in Gold is truly extreme with Managed Accounts holding their largest short position in history and Large Speculators short for the first time since 2001. Hedge funds have their largest short position in years. Note how large their long position was in July 2016 when Gold was trading above $1375.
A recent article in Bloomberg highlights just how negative sentiment has become. From a contrary Opinion perspective this is about as good as it can get. The table is set and the only thing left is for Gold to rally enough to begin squeezing those short and igniting a short covering rally.
The recent trading action is encouraging but a more convincing signal will be given when Gold is able to close above $1236 and GLD closes above $117.40. Those were the intra-day price lows in December 2017. I suspect it will take more than one try for this obvious resistance to be overcome. In the meantime Gold needs to hold above $1173 to lower the potential of a drop to the December 2016 low of $1123. Longer term, Gold is likely to trade above $1300 before the end of 2018 and above $1400 sometime in 2019 based on the positioning.
I recommended buying the Gold ETF GLD in three steps and the average purchase price for the entire GLD position is $120.84. I will recommend adding to this position when the risk of a decline to $1123 is eliminated.
Gold Stocks
When Gold broke below the December 2017 low of $1236 the Gold stocks were simply crushed after mid July, as can be seen in the comparison between Gold and the Gold Miners ETF GDX. I didn’t see this extreme weakness coming. The RSI for GDX fell to 14.2 on August 16. Normally when something gets this oversold there is a retest of the initial low, since it takes intense selling pressure to push the RSI so low. The reasons for such selling pressure simply don’t evaporate over night. This suggests it will likely take some time to repair the damage and allow the Gold stocks the opportunity to show stronger relative strength to Gold.
A 50% position was recommended if GDX traded under $21.80 and a 100% position if GDX fell below $21.56. On July 17 GDX opened at $21.73 and opened at $21.50 on July 19, so the average cost is $21.62. I cancelled the stop of $21.16 in the July 23 WTR. The rational was based on how constructive the positioning in Gold futures had already become at that point and the pattern in the Dollar which suggested it was topping. The tariffs on Turkey were not anticipated and triggered more Dollar strength and weakness in Gold as the Turkish central bank sold Gold to support the Lira.
I will recommend adding to GDX after the risk of a decline in Gold to $1123 is gone and the Gold stocks show an improvement in their relative strength. The positioning in Gold suggests a strong rally is coming and the Gold stocks will catch fire. One of the variables may be a correction in the stock market that leads to a rotation into Gold stocks.
Stocks
As expected the S&P 500 rallied to a new high. “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.” As you recall, 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. I thought the likelihood of meaningful progress or concessions by China on the points that matter most to the U.S. was low, which proved accurate. After less than one day of discussions on August 23, the Chinese delegation left Washington the next day with no time table for future talks. In the short run I didn’t think it would matter and it didn’t. Prior to the open on August 27, the administration announced that it had reached a trade deal with Mexico. After opening up 150 points the DJIA pushed higher as President Trump and the outgoing President of Mexico patted each other on the back.
With the exception of the DJIA the majority of cap weighted market averages made a new all time high today. The NYSE composite is the broadest average, and although it isn’t close to a new high, it did breakout above resistance that had contained it since February 27. The percent of stocks above their 200 day average was 55% on Friday and undoubtedly rose today. The market has every reason to follow through in the coming days and seasonality prior to the Labor Day weekend is also a plus. If the NYSE Composite reverses and closes below 13,000, it would be a short term negative.
One indicator to watch is the Volatility Index (VIX) which actually rose 1.4% today. In January as the S&P was running to new all time highs every day, the VIX began to rise which is unusual.
In January the VIX closed above the black horizontal line at 12.30 on January 29 just after the S&P 500 peaked. Today the VIX closed at 12.16 after trading as high as 12.48. The S&P 500 is making a new high but the VIX did not confirm the new high by falling to a lower low than on August 9. If the VIX continues to rise as the market rises further, it would be wise to be attentive for a reversal.
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. It would be positive if the VIX drops back to near the August 9 low.
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.
Although the MTI remains well below its high from January, it rose to 2.93 today. Readings above 3.0 in a bull market suggest the risk of a meaningful correction greater than 7% are low.
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.
