Written by Jim Welsh
Macro Tides Weekly Technical Review 24 September 2018
The Federal Reserve will increase the federal funds rate by 0.25% on Wednesday by lifting the range to 2.0% to 2.25%. In recent weeks the federal funds rate has averaged 1.92% and will likely rise to 2.17% after the hike. None of this will come as a surprise to the markets. The focus will be on the FOMC post meeting statement and whether the FOMC decides to remove the word ‘accommodative’.
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In the August 1 statement the FOMC stated:
“The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation.”
I don’t think the FOMC will remove the word accommodative at this meeting as I discussed in the September Macro Tides Monthly Report:
“In the next six months the Fed will attempt to identify the neutral level for the federal funds rate. The neutral interest rate is the rate at which monetary policy is neither accommodative nor restrictive, and where growth and inflation are both at their natural rate on a stable basis. Once the majority of FOMC members believe the neutral rate has been reached, the Fed will remove the word accommodative from the post FOMC meeting statement. My guess is the FOMC is more likely to determine that the neutral rate has been reached after two more rate increases, rather than at the September meeting. The federal funds rate will rise to 2.16% after the Federal Reserve increases it 0.25% at their September 26 meeting. The headline CPI was 2.9% in July and the core CPI was 2.3%. The real federal funds rate will still be negative, which means monetary policy will remain accommodative after the September hike. Historically, the federal funds rate has had a real return of 2.0%.”
Whenever the FOMC removes the word accommodative from its post meeting statement, some in the financial markets may think that it implies that the Fed is nearing the end of its rate hiking program. This misplaced conclusion could spur additional risk taking and stretch valuations further in the corporate bond market and stocks. The Federal Reserve has a duel mandate which the FOMC references in its post meeting statement after every meeting:
“Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.”
Recent comments by Fed Chairman Powell and FOMC member Lael Brainerd suggest that more attention is being directed at the non mandated impact of excesses in the financial markets. In his August 24 Jackson Hole speech Powell made an important statement that received little attention. Powell cautioned against placing too much weight on inflation as a key signal of overheating, noting that “destabilizing excesses appeared mainly in financial markets rather than in inflation” in the run-up to the previous two recessions.
In the 1950’s, 1960’s, 1970’s, and 1980’s, the Federal Reserve increased rates after the core CPI rose markedly. This is why the yield curve inverted and liquidity became scarce, leading to a recession as noted by the shaded areas. Prior to the 2001 recession and the 2008 financial crisis the increase in the core CPI was quite tame. However, the dot.com bubble grossly inflated equity values prior to the 2001 recession and the bubble in housing set the stage for the 2008 financial crisis.
Click on any chart below for large image.
The effective ‘real’ federal funds rate is calculated by subtracting the Consumer Price Index from the federal funds rate. When the real funds rate is below 0% it indicates an extremely accommodative monetary policy since the cost of money is less than 0% – or as Dire Straits put it “Money for Nothing.” In the run-up to the housing bubble the real funds rate was below 0% from October 2002 to November 2005. This was the Federal Reserve’s contribution to the housing bubble and subsequent crisis.
Even though the federal funds rate was just 0.12% in 2009, the real funds rate rose to 2.0% because the CPI was below -2.0%. After oil prices collapsed in 2015, the CPI was below 0% for a brief time which is why the real funds rate went above 0%. As noted, even after the Fed increases the federal funds rate on September 26, the real funds rate will still be below 0% and policy will remain accommodative.
In the section entitled Corporate Debt, This Cycle’s Excess in the September Macro Tides I noted:
“In every extended economic cycle excesses build up that are usually recognized in hindsight as the excesses are unwound, create instability, and negatively impact the economy.”
I described a number of excesses that have built up in the corporate bond market, including the record amount of low quality investment grade corporate bonds, the record amount of covenant lite loans, and the record level of corporate debt to GDP. Lael Brainerd is a member of the FOMC and in a September 12 speech she noted that financial excesses were already apparent in the corporate bond market, leveraged loan market, and stated that the valuation of the equity market was ‘elevated’. Brainerd also echoed Powell’s comments in saying that overheating sometimes shows up in markets before more conventional inflation measures:
“The past few times unemployment fell to levels as low as those projected over the next year, signs of overheating showed up in financial-sector imbalances rather than in accelerating inflation. The Federal Reserve’s assessment suggests that financial vulnerabilities are building, which might be expected after a long period of economic expansion and very low interest rates.”
In particular, she said corporate debt is rising and is susceptible to downgrades if conditions should change. She also noted that leveraged lending is rising as underwriting standards ease and said stock market valuations are “elevated.”
The FOMC statement will not make any reference to financial market excesses, but Powell might in the Question and Answer session with the media. More importantly, these concerns underscore why the Fed will continue on its gradual rate hiking path, even if economic growth slows before year end as I expect or inflation moderates.
In coming months, it is possible that Fed members may amplify their concerns about excesses in financial markets. This may lead market participants to worry that the Fed might become more aggressive and less gradual. This could lead to a correction in the corporate bond market that causes the spread between high yield and investment grade bonds to widen, less issuance of leveraged loans as demand slumps, and a decline in the stock market.
By reducing some of the perceived excesses in financial markets through jawboning and the threat of more rate hikes, the Fed may alleviate a potential problem without having to increase rates that would ultimately do harm to the economy. Although financial excesses are not part of the Fed’s mandate, the comments by Powell and Brainerd are noteworthy since they indicate that some FOMC members are broadening their analysis and making an effort to learn from the lessons provided by the dot.com and housing bubbles.
Dollar
Since peaking in mid August the Dollar was expected to decline to 93.20 to 93.75. At its low last week, the Dollar had fallen to 93.81. One of the reasons a correction was expected was that positioning had become wildly bullish with too many hedge funds and trend followers going long the Dollar, or short other currencies in anticipation of additional Dollar strength. +Normally, traders pare back a position when it goes against them and initially as the Dollar corrected that’s what happened. But last week, traders added to their long position in the Dollar, according to CFTC data as of September 18. This indicates that bullishness toward the Dollar is entrenched and leaves the Dollar vulnerable for more weakness.
As previously noted, one never knows when President Trump will send out a Tweet reiterating his desire for a lower Dollar. The 50% retracement of the rally from 88.25 to 96.98 is 92.61. A decline below 92.50 could begin to put some heat on those long and potentially enable a larger decline to develop.
Euro
A 50% long position was established in the Euro ETF FXE when it declined below $110.55 on August 9. The instructions were to sell half of the position at $112.85 and the other half at $113.95. FXE traded up to $113.14 on September 24 before reversing and closing at $112.49. Rather than raising the stop on the remaining half to $111.50 as suggested last week, simply sell the remaining half at the open on September 25. Today’s reversal makes it likely FXE will fall to $111.50 soon so booking the additional profit although small makes sense.
Treasury Yields
Over the past two weeks I thought the 10-year Treasury yield may be forming a triangle (a, b, c, d, and e) since the low of 2.759% on May 29. A triangle would allow the yield to climb to 3.03% or so to finish wave e, and then the 10-year Treasury yield might test the March low of 2.715% and possibly the 2017 high of 2.63% in coming months.
I also said I wanted to wait until the short term trading pattern cleared up. That proved to be a good decision as the 10-year yield jumped above 3.03% and climbed to 3.096% on September 19. With this surge the RSI on the 10-year Treasury yield became overbought, which means 10-year Treasury bond prices have become oversold. This suggests that yields could come down a bit in the short term as bond prices bounce to alleviate the oversold condition.
The short position in Treasury bond futures remains extreme with a degree of unanimity that yields must go higher that is historic. The potential for a significant decline in Treasury yields to develop only needs a fundamental reason to trigger a robust round of short covering by those who are short. Until a sign that economic growth is about to slow, patience is warranted.
The FOMC’s dot plot is likely to reaffirm that the Fed will increase the fed funds rate in December and three additional times in 2019, when it is released on September 26. The bond market has factored only two increases for 2019 so this may cause some additional selling.
The RSI for the Treasury bond ETF (TLT) dropped to 27.3 on September 19 indicating that bonds are oversold and due a bounce. Prior to the trading rally off the low in February and May, TLT’s RSI recorded a positive divergence even as TLT posted a lower price low (green line on RSI). Something similar may develop soon, especially if TLT can bounce a little more on Tuesday – Wednesday, and then sell off after the FOMC meeting. TLT recorded an intra-day low of $114.88 on June 26, 2015 which may be tested in coming days. Establish a 50% position in TLT if it trades down to $115.08. This is likely more of a scalp trade unless questions arise about economic growth.
Emerging Markets
The RSI for the Emerging Markets ETF (EEM) fell below 35 on September 10 so it was modestly oversold. The recent bounce has alleviated this and EEM continues to make lower lows and lower highs which is the definition of a downtrend. The Dollar may fall a bit more in the short term which would push its RSI below 35, and enable it to rally soon. Any strength in the Dollar is likely to push EEM lower and potentially bring EEM below $38.50.
Gold – Patience Required
Not really much to add since last week’s comments so I’m going to repeat some of those those now. Positioning and sentiment suggest that Gold is in the process of forming a major low. The only question is “What will it take to finish the bottom?” From the high in January, Gold appears to have traced out a 3 wave decline into the low in mid August. The bounce since the low at $1161 does not look impulsive since it was an up, down, up pattern. The initial rally carried from $1161 to $1214 or $43. I thought Gold had the potential to rally up to $1231.
Needless to say the trading action has been less than inspiring as Gold hasn’t been able to rally above $1214 even as the Dollar corrected. This reinforces the view that the move up from the mid August low of $1161 is likely wave 4 from the high in January. This suggests Gold could retest the $1161 low, or fall to $1123 which is the December 2016 low before the bottoming process is complete.
Looking out over the next 6 to 12 months and longer, Gold is likely forming a major bottom even as this process extends in time. Longer term, Gold is likely to trade above $1300 before the end of 2018 and above $1400 sometime in 2019.
I recommended buying the Gold ETF GLD in three steps and the average purchase price for the entire GLD position is $120.84. If Gold rallies above $1230, GLD could trade above $116.50. Sell 33% of the position, if GLD trades above $116.50. GLD could subsequently fall below $111.00 in wave 5 and possibly as low at $107.00 which is why selling a portion at $116.50 makes sense. It may be easier to add to this position if wave 5 does develop.
Gold Stocks
The Gold stock ETF GDX rallied from $12.40 in January 2016 to $31.79 in August 2016. A 78.6% retracement of this rally could bring GDX down to $16.55. The relative strength of the Gold stocks has improved, but this extreme downside target can’t be dismissed.
The average cost for the recommended position in GDX is $21.62. Last week I recommended selling 33% of the position if GDX traded above $19.00. GDX traded above $19.00 on September 20 and September 24. There is a potential inverted head and shoulders pattern forming in GDX but it needs to hold above $18.00 to keep that hope alive. If Gold does test $1161 or falls to $1123, I will recommend adding to the GDX position.
Stocks
The fragmentation discussed last week has continued. Although the S&P 500 exceeded it August 29 high, the Russell 2000, Nasdaq Composite, Nasdaq 100, and NYSE Composite remain below their prior highs. The longer these divergences persist, the more meaningful they become.
The percent of stocks above their 200 day average nudged up to 53 last week, which is below the 56% on August 29 and 68% in January. (NYSE Comp chart above)
As the following charts below illustrate, the market continues to lose internal strength as measured by a number of momentum indicators. This suggests the market is now vulnerable to a sharp sell off if any reason to sell materializes. The expectation remains that the S&P 500 is vulnerable to a pullback of 3% to 5%. A close below 2790 would open the door for a decline to 2720 – 2750 which encompasses the low in the second half of June and the 200-day average at 2752.
If the S&P 500 is going to fall to the lower targets, it could be a sharp decline given the positioning in VIX futures. As previously discussed, a large short position in VIX futures has developed that is comparable to the position that existed prior to the hard and quick decline in early February.
The percentage of stocks making a new 52 week high has continued to fall after making a lower peak on August 29 than in mid June, despite the new high in the S&P 500.
The number of net advancing stocks in the prior 21 days was far lower last week than in late August
For the first time in many months, the NYSE Advance / Decline line posted a lower high as the S&P 500 made a new price high. This indicates that market breadth is narrowing.
The percent of Nasdaq stocks posting a new 52 week high has been trending lower after making a lower high on August 29 than in June and was far lower than in January.
For the first time in many months, the Nasdaq Advance / Decline line has not made a new high.
The Call/Put ratio indicates that investors were more bullish last week than in June, even though a number of major market averages failed to confirm the new highs in the S&P 500 and momentum and measures of the market’s internal strength were weaker.
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 climbed above 3.0 as the S&P 500 posted its all-time high on August 29. 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.
Not being invested in the weakest sectors at the bottom is just as important as being invested in the top four sectors.
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.
