Written by Jim Welsh
Macro Tides Monthly Report 06 December 2018
Did Chairman Powell’s Speech Change Anything?
Prior to Chairman Powell’s speech to the Economic Club of New York on November 28, market participants thought the FOMC’s dot plot meant that the Federal Reserve was almost obligated to increase the federal funds rate in December and 3 more times in 2019.
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This expectation reflects a lack of understanding by investors of the role the dot plot plays in monetary policy and an assumption that the FOMC would ignore incoming data and simply adhere to the dot plot. This misunderstanding led me to expect the stock market to rally if Powell said the Fed would not be a slave to the dot plot projections as I noted in the November 26 Weekly Technical Review:
“What is far more important is Powell acknowledging that the FOMC will not be a slave to the dot plot projections, but will instead respond if inflation or economic growth changes relative to the Fed’s projections.”
The stock market shot upward after Powell stated,
“There is no preset policy path. We will be paying very close attention to what incoming economic and financial data are telling us.”
The S&P 500 rallied from 2685 just before the text of his speech was released to 2759 on Friday November 30 a gain of 2.4%. Investors believe Powell and the FOMC have changed their tune and may not increase rates 3 times in 2019. Just as investors were incorrect in believing the Fed would blindly raise rates three times in 2019, they may also be wrong in assuming the Fed won’t raise rates 3 times in 2019.
Prior to February 1994 the FOMC never released a statement after a FOMC meeting, even if the FOMC had decided to increase or lower the federal funds rate. The actual minutes of each meeting were originally called “Minutes of Actions” and were released after a delay of five years. Instead, market participants attempted to divine if a policy change had been made by analyzing the amount of Free Reserves in the banking system, or whether the Fed had executed a matched sale to drain liquidity or add liquidity through a purchase of Treasury securities.
After criticism from Congress, the Federal Reserve decided in 2004 to release the Minutes of each FOMC Meeting three weeks after the meeting. The FOMC expected the earlier release of the FOMC meeting minutes would help investors interpret economic developments and better predict the course of interest rates. The FOMC believed if market participants were better informed by what members of the FOMC were thinking there would be less volatility in financial markets. The logic of expanding and improving the level of communication between the FOMC and financial markets evolved and eventually led to the publishing of the dot plot.
The voting members of the FOMC are the seven Board of Governors, the president of the Federal Reserve of New York, and four rotating regional presidents. There are twelve districts and each year four of the 11 district presidents excluding New York serve for one year on the FOMC as a voting member. Nonvoting Reserve Bank presidents attend the meetings of the Committee, participate in the discussions, and contribute to the Committee’s assessment of the economy and policy options.
When listening to speeches or interviews of the members of the FOMC it is important to remember that the voting members determine policy, while the alternate members can only influence policy. The FOMC Hawk / Dove table categorizes each FOMC member based on their voting record and policy speeches and statements. In 2019 the FOMC will become a bit more hawkish with the addition of Evans, Rosengren, and George as voting members. This small shift in the center of gravity within the FOMC could have an impact, especially if the decision to hike or pause at any given meeting is a close call.
Since Chairman Powell will hold a press conference after every meeting in 2019, each meeting has the potential of being a live meeting. Investors have become conditioned to believe the only time the FOMC would decide to increase rates was at a meeting that would be followed by a press conference. This change will elevate the volatility surrounding almost every meeting next year, instead of the four meetings in 2017 and 2018 that were followed by a press conference.
The dot plot reflects each FOMC member’s guesstimate of where the federal funds rate will be over the next three years, based on what that member currently knows. If new data contradicts a member’s expectations for the economy and inflation, they will alter the trajectory of their dot plot. The notion that each member would remain steadfast with their dots irrespective of how the economy performs is contradictory to the process. The flexibility of the process does not mean however that each member of the FOMC may not misread the economy and over estimate or under estimate its trajectory. After all, the majority of FOMC members are two handed economists and hardly immune from getting it wrong. Since the foundation of the Federal Reserve in 1913 the majority of tightening cycles have ended in a recession or worse.
In all the excitement following Powell’s speech investors may need to remember what the FOMC’s long term and intermediate goals are. The Federal Reserve wants to get the federal funds rate as high as possible, without damaging the economy. The primary reason is that the Fed wants to have as much leverage on the economy through the federal funds rate when the next slowdown or recession develops. Prior to the 2008 financial crisis the manipulation of the federal funds rate was the Federal Reserve’s primary policy tool. The higher the federal funds rate is going into the next recession the less likely the FOMC will have to revert to launching another round of Quantitative Easing.
The FOMC’s intermediate goal is to lift the federal funds rate up to a level so monetary policy is neither accommodative nor restrictive, and where growth and inflation are both at their natural rate on a stable basis. More clarity will be provided when the FOMC publishes the next dot plot after the December 19 meeting. The dot plot provided by the members of the FOMC at the FOMC’s September meeting indicated that the doves on the FOMC thought it was 2.75% while the hawks thought it was 3.0%.
The important point is that even the doves support two more increases in the federal funds rate based on data members had at the September 26 meeting. Since the September meeting financial markets have experienced more volatility with the S&P 500 falling by almost 10% and the Dollar strengthened. The minutes from the November 8 meeting indicate FOMC members took note of the volatility but importantly still judged monetary policy as accommodative.
“Participants observed that financial conditions tightened over the intermeeting period, as equity prices declined, longer-term yields and borrowing costs for most sectors increased, and the foreign exchange value of the dollar rose. Despite these developments, a number of participants judged that financial conditions remained accommodative relative to historical norms.”
The minutes never identify any FOMC individual member but do provide insight as to the number of FOMC members agreeing with an assessment. The word ‘participants’ suggests that half of the members were on the same page, while the phrase ‘a number’ likely implies 3 or 4 members. One of the keys in deciphering FOMC minutes is finding points of broad agreement since that reveals the bias of the FOMC. In the November minutes there were a couple of points of clarity.
“Almost all participants reaffirmed the view that further gradual increases in the target range for the federal funds rate would likely be consistent with sustaining the Committee’s objectives of maximum employment and price stability. Consistent with their judgment that a gradual approach to policy normalization remained appropriate, almost all participants expressed the view that another increase in the target range for the federal funds rate was likely to be warranted fairly soon if incoming information on the labor market and inflation was in line with or stronger than their current expectations.”
This suggests that a December rate hike is pretty much a done deal. Although there was widespread support for a hike in December and for additional gradual increases, some members were reluctant to go on autopilot. This implies that a rate hike in March will need to be supported by economic data:
“A few participants, while viewing further gradual increases in the target range of the federal funds rate as likely to be appropriate, expressed uncertainty about the timing of such increases.”
This suggests that the bias of the majority of FOMC is to continue to raise rates unless incoming data is weak enough to persuade them otherwise.
Since 1960 the federal funds rate has been above the rate of inflation most of the time. The exceptions have proven problematic, although in different ways. In the mid 1970’s Arthur Burns was the Chairman of the Federal Reserve, and oversaw an extended period when the effective federal funds rate was below the rate of inflation, which was followed by soaring inflation. G. William Miller held the post for a brief ineffective period. Paul Volcker became Fed Chairman in August 1979 and on Saturday October 6, 1979 Volcker announced the results of an extraordinary unscheduled FOMC meeting held earlier that day. Pointing to the recent economic releases, Volcker said,
‘Business data has been good and better than expected. Inflation data has been bad and perhaps worse than expected.’
Volcker announced that the discount rate was being increased a full percentage point to a record 12%. This became known as the ‘Saturday Night Massacre’ since it precipitated sharp declines in the bond and stock markets. For the following two decades the effective federal funds rate was on average 2.0% above inflation.
That changed after Alan Greenspan allowed the effective federal funds rate to remain under inflation for almost three years starting in 2002. The FOMC then hiked the federal funds rate a quarter point at 17 consecutive meetings to 5.25% in 2006, 2.55% above the rate of inflation. After being well below the rate of inflation for a decade in the wake of the financial crisis, the effective federal funds rate is only now approaching the rate of inflation, after 8 quarter point increases since December 2015. And that’s the rub.
The U.S. economy is in the tenth year and second longest recovery since World War II. The unemployment rate is 3.7% a 49 year low and inflation is hovering at the Fed’s target of 2.0%.
The Federal Reserve has achieved it mandate of maximum employment and stable prices, but the current rate of GDP growth is well above the Fed’s estimate of the economy’s long run potential growth rate of 1.8%. Under the current circumstances it is inappropriate for the real federal funds rate to be 0%. This is why the majority of FOMC members support additional increases in the federal funds rate. The only questions are how many and when. The minutes of the November meeting reinforced this outlook.
“Participants emphasized that the Committee’s approach to setting the stance of policy should be importantly guided by incoming data and their implications for the economic outlook. They noted that their expectations for the path of the federal funds rate were based on their current assessment of the economic outlook. Monetary policy was not on a preset course; if incoming information prompted meaningful reassessments of the economic outlook and attendant risks, either to the upside or the downside, their policy outlook would change.”
The November minutes revealed what issues FOMC members were watching that might lead some members to vote to slow the pace of quarterly quarter point increases:
“A few participants indicated that uncertainty had increased recently, pointing to the high levels of uncertainty regarding the effects of fiscal and trade policies on economic activity and inflation. Some participants viewed economic and financial developments abroad, including the possibility of further appreciation of the U.S. dollar, as posing downside risks for domestic economic growth and inflation. A couple of participants expressed the concern that measures of inflation expectations would remain low, particularly if economic growth slowed more than expected. Several participants were concerned that the high level of debt in the nonfinancial business sector, and especially the high level of leveraged loans, made the economy more vulnerable to a sharp pullback in credit availability, which could exacerbate the effects of a negative shock on economic activity. The potential for an escalation in tariffs or trade tensions was also cited as a factor that could slow economic growth more than expected.”
The most pressing and timely concern of a number of FOMC members was the uncertainty surrounding trade and tariffs with China. The agreement by President Trump and President Yi on December 2 to postpone the imposition of additional tariffs until March 2 relieves the economic risk and inflationary potential in the short term, but does not eliminate them. At the margin it is likely to provide a modest brief boost to the U.S. and global economy. It should also weaken the Dollar since it has strengthened whenever trade tensions escalated. A decline in the Dollar alleviates another concern some participants harbored about Dollar strength.
In the next month or two President Trump will likely emphasize that progress is being made and won’t be bashful in Tweeting this view. The President may not incorporate pom-poms but he will be a cheerleader. The real nitty gritty of whether the 90 day window will generate substantive progress and resolution won’t come into view until the last few days of February. The devil is always in the details and the details of intellectual property rights, forced technology transfers, and industrial espionage require China to alter their way of doing business. I’m skeptical China will meet the U.S. halfway on these issues.
Consumers visit a gas station regularly which is one reason why inflation expectations are clearly influenced by the rise and fall of oil and gasoline prices. After oil prices fell from $55.00 a barrel in February 2017 to $42.00 in June 2017 and gas prices dropped by more than 20%, the 5-year Forward Expectation Rate dipped from 2.23% to 1.78%.
The 5-year Forward Expectation Rate subsequently rose to 2.35% in February 2018 after oil and gas prices recovered to a higher high. No surprise then that the recent plunge in oil and gas prices has been followed by another decline in the 5-year Forward Expectation Rate from 2.29% in early October to 2.09% on November 27. It may be noteworthy that the 6 5-year Forward Expectation Rate fell by only 0.20% compared to the drop of 0.45% in the spring of 2017, even as oil prices fell by a larger percentage. It implies that Expectations are more firmly entrenched and may hold up better than some FOMC members thought.
Saudi Arabia and Russia are likely to agree on production cuts at the OPEC Summit meeting on December 6 which should help stabilize crude oil prices and then enable a rally to ensue. If oil prices rebound, the 5-year Forward Expectation Rate could be expected to rise as well. Saudi Arabia depends on oil revenue to fund 80% of its government budget while Russia derives 50% of government revenues from its oil production. Failure to cut production would likely be followed by a decline to $45.00 a barrel or lower.
The FOMC projections for GDP growth in 2019 show that the FOMC expects growth to slow to 2.5% and the reasons for the slowing were discussed at the November meeting:
“Several participants observed that the stimulative effects of fiscal policy would likely diminish over time, while the lagged effects of reductions in monetary policy accommodation would show through Federal Open Market Committee more fully, with both factors contributing to their expectation that economic growth would slow to a pace closer to trend.”
The stimulus from fiscal policy will fade during the course of 2019 and the cumulative drag from prior interest rate hikes will slow growth as is already apparent in housing. Despite slowing to 2.5%, GDP growth will remain comfortably above the long run growth potential of 1.8% in 2019.
At the November meeting FOMC members did not sound concerned that growth could slow unexpectedly and noted a number of reasons why they were confident that GDP growth would average 2.5% in 2019:
“Participants pointed to several factors supporting above-trend growth, including strong employment gains, expansionary federal tax and spending policies, and continued high levels of consumer and business confidence.
With regard to upside risks, participants noted that greater-than-expected effects of fiscal stimulus and high consumer confidence could lead to stronger-than-expected economic outcomes. Some participants raised the concern that tightening resource utilization in conjunction with an increase in the ability of firms to pass through increases in tariffs or in other input costs to consumer prices could generate undesirable upward pressure on inflation.
Reports from business contacts and surveys in a number of Districts were consistent with some firming in inflationary pressure. Contacts in many Districts indicated that input costs had risen and that increased tariffs were raising costs, especially for industries relying heavily on steel and aluminum. In a few Districts, transportation costs had reportedly increased. Some contacts indicated that while input costs were higher, it appeared that the pass through of these higher costs to consumer prices was limited.”
The inflation concern expressed by FOMC members is corroborated by the New York Fed’s Underlying Inflation Gauge (UIG) which includes 105 economic and market indicators. The UIG (blue line) suggests that core inflation pressures will intensify throughout 2019 and reach 2.7% in 2020. The Bureau of Economic Analysis (BEA) is also projecting an increase in the Federal Reserve’s preferred inflation measure the Core Personal Consumption Expenditures Index (PCE). The BEA’s forecast is that the Core PCE will rise to 2.3% at the end of 2019 and to 2.5% in December 2020. Should this increase materialize it would be noteworthy since the FOMC has forecast that Core PCE will end 2019 and 2020 at 2.1%. The difference may not seem like much, but it would virtually guarantee that the FOMC would decide to increase the federal funds rate to at least 3.0%. It would also force financial markets to confront the possibility that the FOMC might raise the federal funds rate beyond the perceived neutral rate of 2.75% – 3.0% in 2019.
After Powell’s speech on November 28 the financial markets have completely dismissed this possibility and have assumed the terminal rate for the federal funds rate in this cycle will be 2.75%.
The risk that the FOMC may be pressed to go beyond 2.75% in 2019 was buttressed by the FOMC’s assessment of the labor market:
“Participants agreed that labor market conditions had strengthened further over the intermeeting period. Payrolls had increased strongly in October, and measures of labor market tightness such as rates of job openings and quits continued to be elevated. The unemployment rate remained at a historically low level in October, and the labor force participation rate moved up. Participants observed that, at the national level, measures of nominal wage growth appeared to be picking up. Many participants noted that the recent pace of aggregate wage gains was broadly consistent with trends in productivity growth and inflation. ”
The labor market is so tight it now takes a record 31 days for companies to fill an open position compared to 26 days in 2006. In this environment companies are often forced to offer a higher wage to lure workers from other companies, and higher pay to retain existing employees from leaving. This ‘bidding’ for workers will over time benefit an increasing number of workers and result in a rise in Average Hourly Earnings. The Bureau of Labor Statistics Wage Growth Diffusion Index estimates that Average Hourly Earnings will be increasing at an annual rate of 4.0% by the end of 2020.
An important offset to higher wages comes from increases in productivity. If wages grow by 3.0% and productivity rises by 2.0%, the net inflationary impact is just 1.0%. This is why the FOMC monitors changes in productivity since the economy can grow faster without generating upward pressure on inflation if productivity is growing. Business investment is the leading indicator for changes in productivity. After growing strongly in late 2017 and the first half of 2018, business investment has slowed which I have primarily attributed to uncertainty regarding tariffs and trade.
The FOMC discussed the slowdown in business investment at the November meeting:
“Participants observed that growth in business fixed investment slowed in the third quarter following several quarters of rapid growth. Some participants pointed to anecdotal evidence regarding higher tariffs and uncertainty about trade policy, slowing global demand, rising input costs, or higher interest rates as possible factors contributing to the slowdown.”
The slowdown in business investment hurts economic growth in the short term but also delays when a meaningful pick-up in productivity will take hold. The postponement of more tariffs on China only delays when clarity can help corporations confidently increase business investment.
The FOMC is likely to make one significant change to its post meeting statement on December 19. The FOMC has included the following sentence since at least early 2017:
“The Committee expects that further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term.”
To reinforce that the FOMC is data dependent and approaching the neutral federal funds rate, the FOMC will remove the phrase ‘further gradual increases’ from the December 19 statement. Although the discussion at the November meeting didn’t specifically mention December it’s a good bet they will:
“Participants also commented on how the Committee’s communications in its post meeting statement might need to be revised at coming meetings, particularly the language referring to the Committee’s expectations for “further gradual increases” in the target range for the federal funds rate. Many participants indicated that it might be appropriate at some upcoming meetings to begin to transition to statement language that placed greater emphasis on the evaluation of incoming data in assessing the economic and policy outlook; such a change would help to convey the Committee’s flexible approach in responding to changing economic circumstances.”
If correct, it will give market participants another opportunity on December 19 to read too much into the change and conclude it must mean the federal funds rate is near the peak for this business cycle. Maybe, but maybe not.
Yield Curve Inversion Hysteria
In the September Macro Tides I discussed Yield Curve Inversion Angst which has now morphed into hysteria. On December 4 the yield on the 2- year Treasury note rose above the yield on the 5-year Treasury bond which ignited a wave of terror in the financial markets and a plunge of 799 points in the DJIA. The oft quoted spread between the 2-year Treasury note and the 10-year Treasury bond narrowed to 11 basis points (0.11%) the lowest since 2007.
According to the TV talking heads the bond market is surely telling anyone smart enough to listen that there’s something very wrong with the economy, otherwise this wouldn’t happening! One of the most widely accepted axioms on Wall Street is that markets are a discounting mechanism. The implication is that markets possess a form of collective wisdom and those who listen to the message of the market are smart investors.
Reality: At every major top and bottom markets are always wrong. Not sometimes wrong, always wrong.
There are three reasons why bond yields have been falling in recent weeks. Investors thought the FOMC would become more dovish in the wake of the selloff in the stock market during October and that inflation would fall in coming months after oil’s 30% plunge. Fed Fund futures are now pricing only 1 rate increase in 2019 (0.295%) down from 2 hikes in early November (0.550%).
It must be noted that the Fed Fund futures market has for years done an especially poor job of forecasting when the Federal Reserve would raise rates. So much for the market telling investors anything of real value!
Secondly, bond investors have interpreted Powell’s speech as reflecting a more dovish outlook than previously thought which sparked buying of Treasury bonds across the maturity spectrum. After Powell’s November 28 speech the 2-year Treasury note yield fell from 2.839% on November 27 to 2.803% on December 4, while the 5-year Treasury yield fell from 2.89% on November 27 to 2.821% on December 3. On December 4 the 5-year Treasury yield plunged to an intra-day low of 2.782% and below the 2-year Treasury note yield of 2.803% causing an inversion.
The curve inversion developed because the 5-year Treasury yield dropped by 0.108% as the 2-year yield only dipped by 0.036% from November 27 and December 4. The reason the 5-year Treasury yield dropped so much was due to positioning in the futures market. This may be the primary reason why Treasury yields in the 5-year, 10-year, and 30-year Treasury have fallen so much especially after Powell’s 10 speech on November 28.
With the economy growing nicely through September and the outlook fairly certain the FOMC would continue to raise rates well into 2019, Large Speculators and Hedge Funds established an enormous short position in 5-year Treasury futures. By early October the aggregate position was more than –850,000 contracts which would profit only if the 5-year Treasury yield continued to rise. As the 5-year yield fell during October, this huge short position generated losses that could only be stopped by buying 5-year Treasury futures. This buying caused the yield to fall further and turned into a full scale short squeeze after Powell’s speech.
The data in the CFTC CBOT 5-year Treasury chart is through November 27 the day before Powell’s speech, so it doesn’t reflect the full impact of the plunge in yields that generated even larger losses for those short. The next data report will be released by the CFTC on December 10. There was also a large short position in 10-year Treasury futures which explains why the 10-year Treasury yield fell from 3.075% on November 28 to 2.986% on December 3, before plunging another 0.11% to an intra-day low of 2.885% on December 4.
The intense short squeeze in Treasury futures that crumbled yields in recent weeks tells us nothing about the economy. It only shows that too many traders bet on Treasury bond yields rising and were caught on the wrong side of a bad trade. I didn’t hear a single TV talking head on December 4 even mention positioning as a possible cause for the plunge in Treasury yields and the curve inversion between 2-year and 5-year Treasury yields. Instead there was only babbling that the drop in yields was telling them that the risk of a recession was now higher.
The best yield curve is not the 10-year minus 2-year, but the 10-year minus the 90-day Treasury bill rate. Recessions don’t develop until months after an inversion. As of December 4 it was a positive 0.48% and not close to inverting.
U.S. Economy
The most reliable indicators suggest that a recession is not likely in the first half of 2019. While the yield curve is important it really doesn’t provide much insight as to what is happening with liquidity. The economy is far more at risk once liquidity begins to deteriorate since it means companies and consumers are losing access to money. Bank lending standards are a great barometer of whether liquidity is improving or drying up, since banks are the source of liquidity. A lowering of lending standards indicates that banks are confident in economic growth and willing to lend more.
The Federal Reserve conducts a quarterly survey of large banks to determine if they are easing or raising lending standards for large and small companies. The Fed also asks if banks are increasing or lowering the spread between their cost of funds and loan rates. The October Senior Loan Survey indicates that the amount of liquidity flowing out of the banking system for lending is plentiful, even though the 2-year minus the 10-year Treasury yield curve has narrowed significantly.
The Conference Board’s Leading Economic Indicator (LEI) has provided a warning of recession with a median lead time of 11 months compared to 19 months after an inversion of 10-year minus 2-year Treasury yields. In October the LEI posted a new high so it hasn’t even turned lower yet, so the odds of a recession is at least 7 months away based on the shortest lead time since 1969. (Charts compliments of Doug Short and Advisor Perspectives)
However, the LEI for October only increased fractionally to 112.1 from 112.0 in September, so it may be close to rolling over. The Six Month moving average of the 6 month rate of change has turned down. In the past 50 years and seven business cycles it has become negative less than 7 months prior to a recession.
Although the ISM manufacturing Index is going to fall in coming months, as it did when oil prices fell in 2015 after oil prices fell, it remains at a high level. With Consumer Confidence at an 18 year high (previous chart), wage growth accelerating, and the decline in gas prices putting more spending money in consumer’s pockets, retail sales are likely to be good this holiday season. Tax refunds are likely to be larger than expected next April. This will help spending rebound after consumers pay off credit card balances in the first quarter. The large decline in oil prices and the inverted yield curve may cause economists to become overly negative about the economy’s prospects in 2019 which opens the possibility that the economy prove stronger and more resilient than expected.
The wild card remains the trade and tariff negotiations with China which certainly have the potential to disrupt the U.S. and global economy more than the uncertainty already has.
Global Economy
As discussed in the August Macro Tides the primary reason why synchronized global growth transitioned from growth to synchronized global slowing in 2018 was the change in the growth rate in the G4 central banks’ balance sheet as 2018 progressed. That downward pressure will continue well into 2019.
The shrinkage in global liquidity has had a pronounced impact on global assets which have performed poorly in 2018. This is one year where portfolio diversification has done a better job of producing investment losses than lowering risk as the table below illustrates. In 2018 a record percent of global assets have posted negative total returns going all the way back to 1901 according to Deutsche Bank.
The negative change in the G4 total central banks’ balance sheet has caused the Global monetary base to shrink for the first time since 2006. Since 1980 this has only occurred five other times – 1982, 1990, 1998, 2001, and 2006. In each case it preceded a global slowdown so this bears watching. The U.S. was already in a recession in 1982, and the recessions in 1990 and 2001 last only 8 months and both were shallow.
The stock market got crushed in 2001 – 2002 because valuations had become outrageous in 2000. Although there was a stiff correction in the fall of 1998 due to non economic issues, the U.S. economy remained healthy. The main message is to view any decline in the U.S. Leading Economic Indicators as a serious warning. It also reinforces a degree of vulnerability in the global economy if a full scale trade war develops between the U.S. and China.
Stocks
I thought the S&P 500 had the potential to rally above 2815 from its low of 2631 on November 23 based on its pattern and technical indicators. This rally would be wave C of an A-B-C countertrend rally from the S&P 500’s low of 2603 on October 29. The fact that the S&P 500 failed to exceed the high of wave A’s high of 2815 is a sign of weakness. There is a good chance the S&P 500 will trade below 2603 before the end of December. At some point in 2019 the S&P 500 has the potential to trade down to 2300 which is where the long term red trend line connecting the March 2009 low and February 2016 low resides.
Treasury Yields
After the current short squeeze in Treasury bonds runs its course, Treasury yields are expected to trend higher in 2019. Inflation may be higher than currently expected and the U.S. economy may prove more resilient. From the low of 1.32% in July 2016, the 10-year Treasury yield increased to 2.62% in March 2017, an increase of 1.30%. From the September 2017 low of 2.037%, an equal rise of 1.30% suggests the potential for the 10-year Treasury yield to climb to 3.33%. The yield on the 30-year Treasury yield can rise to 3.52%.
Dollar
A senior legal adviser to the European court of justice (ECJ) told the court on December 4 that Britain could revoke Article 50 independently, without needing the permission of every other EU member state. If Britain’s Parliament does not vote in favor of the deal negotiated by Prime Minister May next week, the odds that Britain may not exit the European Union would rise. This could give the Euro a big lift, which would weaken the Dollar since the Euro comprises 57.6% of the Dollar Index.
Large Speculators continue to hold very big short positions in the Euro, Yen, Australian dollar and the majority of other foreign currencies. These short positions represent a de facto long position in the Dollar since they will profit if the Dollar rises against these currencies. Sentiment is also wildly bullish the Dollar. This suggests the Dollar is a crowded long trade and ripe for at least a decent correction in the first quarter of 2019.
Gold
Gold’s relative strength to the Dollar has been improving and should the Dollar decline to 94.00 in coming months, Gold would seem poised for a solid rally. Gold is expected to rally above $1300 in the first quarter and could approach $1350. Sentiment toward Gold is negative which suggests a rally would surprise most investors.
This chart needs no additional comment.
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