Written by Jim Welsh
Macro Tides Weekly Technical Review 17 December 2018
Let’s get to the answer right up frony: The FOMC will increase the federal funds rate at the December 19 meeting for many of the reasons discussed in the December Macro Tides, and change the language of the post FOMC meeting to covey a greater reliance on incoming data.
Please share this article – Go to very top of page, right hand side, for social media buttons.
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 financial markets are going to seize on the wording change, the reality is it really isn’t a big deal. The FOMC has been increasing the federal funds rate quarterly since December 2017, and March, June, and September 2018. And after each of these increases the FOMC weighed incoming data and decided that another increase was warranted. This pattern indicates that the FOMC wouldn’t consider another increase until the March 2019 and would only act if incoming data supported an additional increase.
The change in wording will result in more volatility, as the financial markets attempt to reprice the probability of the next hike in coming months after every important economic report is released. The reality of how the FOMC operates hasn’t changed, but the financial market’s perception has changed and will result in more self inflicted wounds in coming months.
The dot plot for some members of the FOMC is likely to show a modest moderation. A few members will lower their projections for rate increases in 2019 and 2020, i.e., instead of 4 increases through 2020 the dot plot will now show 3. If correct, this will lower the median projection for the federal funds rate reinforcing a more data dependent and more gradual approach.
In early October financial markets were pricing in an increase in the federal funds rate in December and at least 3 more hikes in 2019. Now markets are not even pricing in 1 increase in 2019. This shift was reinforced by the plunge in oil prices and the inversion in the 2yr – 5yr yield curve. These events led investors to believe global growth was slowing faster than thought and the U.S. was also being buffeted.
Investors have failed to account for the unwinding of a large long position in oil futures and short position in natural gas futures, and Trump’s decision to allow Iranian oil to reach the market. In the first half of November natural gas prices rose by 54% and crude fell for a record 13 consecutive days, strong indications that the plunge in crude oil was fueled by the unwinding of losing positions in energy futures.
The 2yr – 5yr yield inversion was the result of a massive short squeeze on a record short position in the 5-year Treasury futures. This positioning analysis suggests that investors are overly pessimistic about economic growth in the U.S. entering 2019.
This raises the question of whether financial markets have swung too far too quickly and whether the market’s more dovish perception will be tested in 2019. Although headline inflation as measured by the CPI will drop sharply in coming months due to the decline in oil and gas prices, the core rate may not fall much and is more likely to go up in the first 6 months of 2019.
The New York Fed’s Underlying Inflation Gauge (UIG blue line) includes 105 economic and market indicators and suggests that inflation pressures will intensify during 2019 and climb to 2.7% in 2020. The labor market is tight with the unemployment rate at a 49 year low, with the unemployment rate falling to 3.67% in November the lowest in this expansion. 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. The Bureau of Labor Statistics Wage Growth Diffusion Index estimates that Average Hourly Earnings will continue to rise as 2019 unfolds and reach an annual rate of 4.0% by the end of 2019.
The U.S. economy is likely to prove more resilient in the first six months of next year than currently expected and core inflation, which does not include energy, is likely to creep higher in the first half of 2019. If this proves true, the prospect of FOMC rate hikes will reemerge as an issue for financial markets probably beginning in the second quarter. This is a risk that is completely off investor’s radar screen as concerns about global growth increase almost daily, which is why it is important to monitor.
Dollar
Not much has changed in the outlook for the Dollar. 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. The Dollar may hold up through the end of the year due to global banks wanting to hold Dollars.
As noted last week, after closing at 96.51 on December 7 and trading down to 96.36 on December 10, the Dollar jumped to 97.24. This increased the odds that the Dollar would push above the November 12 high of 97.69. This was however viewed as part of the process of a high forming in the Dollar. The Dollar rose to 97.71 on December 14, reversed, and traded down to 97.05 on December 17. Confirmation of a top will increase after a close below 96.40 and the rising uptrend line.
Click on any chart below for large image.
Treasury Yields
Bond yields are expected to trend higher in 2019 so a good short trade opportunity is coming, but it is going to take a little time to set up. The RSI on the 10-year Treasury bond fell to 18.1 on December 7 which is the lowest level since February 2016 when it reached 18.4 (red arrows). A similar but less extreme low was formed in April 2017 when the RSI fell to 26.1. The extreme low RSI on December 7 suggests that Treasury bond yields are likely to fall further in coming weeks.
A persistent uptrend in bond yields is not likely to begin until there is a negative RSI divergence with the 10-year yield recording a lower low while the RSI is above 25 or higher. This is what developed after the extreme low in February 2016 and April 2017 as noted by the green trend lines on the RSI. As Treasury yields complete forming a bottom, the 10-year Treasury yield is likely to test and probably fall below the red trend line connecting the secular low in July 2016 and secondary low in September 2017. The trend line is currently at 2.80%. If the S&P 500 plunges below 2400 in January 2019, the 10-year yield could drop below 2.74% before reversing higher.
The 30-year Treasury yield is likely to test and probably fall below the red trend line connecting the secular low in July 2016 and subsequent lows in December 2017 and August 2018. The trend line is currently at 3.09%. If the S&P 500 plunges below 2400 in January 2019, the 10-year yield could drop below 3.00% before reversing higher.
Stocks
The more often an area of resistance or support is tested the more likely the supply forming resistance or the demand providing support will give way. The S&P 500 had tested 2600 on a number of occasions and each time that support held and the S&P 500 rebounded. I thought the S&P 500 would break below 2600 if it were tested again as noted in last week’s WTR:
“The S&P 500 traded under 2600 on December 10 which suggests the support at 2600 has been eroded with each successive test. The next time 2600 is tested a clean break below is likely to follow with a subsequent test of the February low of 2532.”
The S&P 500 closed at 2599.95 on Friday December 14 and fell to 2530.54 on December 17. Who knew 0.05 could make such a difference?
In the December 11 American Association of Individual Investors survey (AAII) the percent of bulls fell to 20.9% and the percent of bears rose to 48.9%. The spread between the percent of bulls minus the bears dropped to -28.0% the lowest since February 12, 2016 when it reached -29.5% (red arrows). The S&P 500’s low was 1810 on February 11, 2016 so the extreme level of net bears in the AAII survey proved coincident with a trading low. I’ve lost count of the number of times I’ve heard or read strategists citing the AAII survey as proof investor sentiment has become too negative.
The extreme in the AAII survey is not supported by other sentiment measures. The weekly Investors Intelligence survey (II) on December 11 had a plurality of +25.0 more bulls than bears. In February 2016 the percent of bears exceeded bulls by -14.5% (blue arrows), so the II survey isn’t close to its February 2016 level.
The Call/Put Ratio wasn’t even below 1.0 on December 14 as it has been at prior trading lows (green arrows). This suggests too many investors are more worried about missing a bottom than more losses
On December 7 the 10-day average (black line) of the Trading Index (TRIN) climbed above 1.30 when the S&P 500 closed at 2633. It was one of the reasons why I thought the S&P 500 could rally to 2697 and possibly as high as 2740. The S&P 500 was able to rally for two days and only managed on December 12 to reach 2685 intra-day. Despite the weakness on December 17, the 10-day TRIN average closed at 1.18 while the 21-day average is 1.17 (red line).
The 21 day percent of net Advance minus Declines closed at -17.4% and below the green horizontal line at -15.0%. As discussed in prior letters, the S&P 500 is likely to bounce and then retest the initial price low when the A/D percent becomes so oversold. This pattern occurred at the low in August-September 2015, January-February 2016, and February-March 2018. The recent attempt to establish a trading low on December 7 failed, and the December 17 reading is the lowest since October 29. This suggests the trading low of 2531 on December 17 will likely be exceeded in coming weeks. Sometime in 2019, the S&P 500 may test its long term uptrend line at 2300 (black line).
In the November 5 WTR I made the following recommendation:
“A 25% short position in an inverse S&P 500 ETF (SH) can be established if the S&P 500 trades up to 2790 and increased to 50% if the S&P 500 trades up to 2805.”
The S&P 500 traded up to 2815 on November 8 triggering both positions. In the November 19 WTR I recommended covering half of the position if the S&P 500 traded under 2650 which it did on November 20. In the November 26 WTR I recommended to:
“Use the 25% that was covered when the S&P 500 traded below 2650 to add to the short position if the S&P 500 rallies above 2730.”
The S&P 500 rallied above 2730 on November 28 after Powell’s speech. On December 10 I recommended covering the 25% short position established on November 28 at 2730 at the opening of December 11. Prior to the open on December 11, President Trump tweeted that Treasury Secretary Mnuchin had spoken to his Chinese counterpart. The S&P 500 futures went from being down 10 points to up 27 points before the market open. The S&P 500 opened at 2664.44 on December 11. On December 10 I also recommended to use the 25% covered at the opening on December 11 to short the S&P 500 if it traded up to 2695. The S&P 500 only made it up to 2685 so this trade was not triggered.
The net of the closed 25% S&P 500 trades: 1) November 8 short 2790, November 20 covered at 2650 = 140 points 2) November 28 short 2730, December 11 covered at 2664 = 64 points. The total 204 points of profit represents a gain of 7.5%.
Lower the stop on the 25% short position established on November 8 at 2805 to 2725 from 2820. Cover this position if the S&P 500 trades below 2485.
Gold
Gold has been showing better relative strength to the Dollar. When the Dollar traded up to 97.69 in mid November, Gold traded under $1200. On Friday, as the Dollar traded at 97.71, Gold only traded down to $1233. If the Dollar pulls back as expected Gold has the potential to trade up to $1265 or a bit higher in the short term. Gold is expected to rally above $1300 in the first quarter and could approach $1350. Sentiment toward Gold is remains negative which suggests a rally would surprise most investors.
Gold Stocks
Last week I noted that it would be positive if the relative strength of the Gold stocks was able to drop below the Gold GDX Ratio black trend line and fall below its low in late October. Last week the relative strength of GDX was able to accomplish this which is a short term positive. On December 17, GDX traded above the high on October 23 at $20.51 and closed at $20.61. This near strength suggests GDX can trade up to $21.35 and test the red horizontal trend line at $21.40. This may mark a short term high. Longer term a test of the green trend line near $23.20 is likely in the first quarter.
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.
Past performance may not be indicative of future results.
The MTI has weakened significantly since early October. The U.S Sector Rotation Portfolio was moved 33% into cash/money market at 2738.30 on November 6, 66% into cash/money market when the S&P 500 opened at 2774.13 on November 7, and moved 100% into cash/money market fund as the S&P 500 moved above 2800. The average exit price was 2770.81.
The U.S Sector Rotation Portfolio established a 33% short position in an inverse S&P 500 ETF (SH) at $28.35, when the S&P 500 traded above 2800. Half of the position was covered when the S&P 500 traded under 2650 and SH was trading at $29.97. When the S&P 500 exceeded 2730 on November 28, the 25% that was sold when the S&P 500 traded under 2650 was bought with SH trading at $29.03. This position was closed at the open on December 11 when SH opened at $29.60.
The U.S Sector Rotation Portfolio is holding at 16.5% short position in an inverse S&P 500 ETF (SH) at $28.35, which was established on November 7.
The MTI fell below the blue horizontal trend line on November 21 so the probability of a bear market has increased. The MTI signal is one reason why I favor looking for the opportunity to go short rather than trying to play a counter trend bounce from the long side.
One of the reasons I thought the S&P 500 was vulnerable to more weakness in recent weeks was the herding mentality that led investors to crowd into Utilities and Consumer Staples. Investors thought they could hide out in these sectors since they are defensive in nature and would not get hurt. One of the signs that a trading low might be developing would come once Utilities and Consumer Staples were sold. This would indicate that investors were actually beginning to become concerned about additional weakness in the overall market. On December 17, the Utility average lost 3.2% wiping out more than 2 weeks of gains in one session.
Although Consumer Staples only lost 2.2% on December 17 compared to the S&P 500’s fall of 2.1%, they have lost -5.95% since December 3. The fact that these ‘safe’ sectors are now getting swept up in the selling suggests that an initial trading low is coming soo
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.
