Written by Jim Welsh
Macro Tides Weekly Technical Review 28 January 2019
Focus Will Be on the Fed’s Balance Sheet Plans
The FOMC meets on Tuesday and Wednesday and will release it post meeting statement at 2 p.m. est, which will be followed by a press conference with Chair Powell at 2:30 p.m. est. The post meeting statement probably won’t even mention the Federal Reserve’s balance sheet, but one of the first questions will be about the balance sheet.
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If the financial markets are expecting Powell to provide a definitive answer as to when the Fed will modify its plans, Powell is not likely to give them what they want to hear. Powell is likely to repeat the comments he made on January 4 when he said the Fed would change its normalization process, if it concluded it was contributing to instability. He prefaced this comment by saying the Fed did not believe the normalization of its balance sheet had much to do with the volatility in the stock market in December. The data back up his statement.
The Fed began to allow Treasury bonds and Mortgages to run off its balance sheet in October 2017. The monthly average rose from roughly $8 billion per month in the fourth quarter of 2017 to $12 billion in the first quarter of 2018, $26 billion in Q2, and $33 billion in the third quarter.
While the monthly and quarterly amount of the runoff of the Fed’s balance sheet rose in 2018, the S&P 500 continued to rise until it reached an all time high on September 21, 2018. This data refutes a common misconception about the size of the monthly runoff. The perception is that the Fed is allowing its balance sheet to shrink by $50 billion a month for a total of $600 billion in a year. In fact the amount of runoff and shrinkage in the Fed’s balance sheet during 2018 was about $420 billion or 30% less than what is commonly thought. In 2019 the runoff will be closer to $440 billion which is still 26% lower than $600 billion.
The misunderstanding arose since the Federal Reserve used the $50 billion figure as a maximum ceiling so markets wouldn’t worry that the Fed would unwind its balance sheet too rapidly
Market participants have shown the ability to not hear or misinterpret messaging from the Fed and Powell in particular in recent months. After the FOMC meeting on December 19 Chairman Powel provided the following statement:
” We always emphasize that our policy decisions are not on a preset course and will change if the incoming data materially change the outlook.”
And, given recent developments, the post meeting statement notes that we
“will continue to monitor global economic and financial developments and assess their implications for the economic outlook. This illustrates the nature of data dependence that we always emphasize.”
Rather than hearing and understanding the import of Powell’s statement, financial markets chose instead to flip out after Powell said the unwinding of the balance sheet was on autopilot. Powell made this comment since the Fed had seen nothing to indicate that the shrinkage in the Fed’s balance sheet had caused any ripples in the financial markets.
For instance the spread between the Baa Corporate bond yield and 10-year Treasury yield initially declined from 1.99% on October 2, 2017 to under 1.60% in February 2018, and then traded in a range of 1.80% and 2.0%. It didn’t break out above 2.0% until mid November 2018. The widening was caused by a large decline in oil prices which plunged from $64 a barrel on November 5 to under $50 after President Trump didn’t follow through on Iranian sanctions on November 5. The widening in this spread had little to do with the Fed’s balance sheet operations.
Click on any chart below for large image.
After not hearing or understanding Powell’s comments on December 19, financial markets suddenly had an epiphany on January 4 when Powell essentially repeated his statement from December 19. During a January 4 panel discussion with former Fed Chairs Janet Yellen and Ben Bernanke, Powell said,
“As always, there is no preset path for policy,” [the Fed is] “always prepared to shift the stance of policy and to shift it significantly” [in order to achieve its dual mandate of full employment and stable prices.]
After not hearing or understanding Powell’s comments on December 19, financial markets suddenly Some economists and strategists have said that the decline in Excess Reserves in the banking system is why the stock market sold off in the fourth quarter. It is difficult to agree with this conclusion after reviewing a chart comparing the change in Bank Reserves and the S&P 500.
It wouldn’t surprise me if the market rallied on news that the actual amount of run-off in the Fed’s balance sheet in 2019 will be $440 billion rather than the $600 billion the market believes, even though it changes nothing. Powell is likely to repeat the mantra that there is no preset path for policy which includes interest rates and the balance sheet.
Powell will acknowledge that the FOMC has discussed whether any changes are necessary in the current path of the balance sheet run-off and would make changes if economic conditions warrant. Powell is unlikely to announce a specific target for the Fed’s balance sheet, although he may mention that a range of $3.0 trillion to $2.5 trillion is being considered.
At the expected run-off pace in 2019 and 2020 the Fed won’t reach the upper end of that range until very late in 2020 or early 2021. Will investors care more about what’s happening with global growth and earnings now, or an event that won’t happen for more than two years? A rational assessment would conclude that what’s happening now with earnings and guidance is more important than an event beyond the horizon.
Now that the government shut down has ended (at least temporarily), the focus will be on fourth quarter earnings and more importantly on the guidance provided for coming quarters. The expectation has been that more companies are likely to offer weaker guidance than at any time since late 2015 and e arly 2016. The market has taken support from the knowledge that the Fed is on pause which is why the S&P has rallied so much since January 4. The Fed being on pause however may not provide enough confidence or support if a plurality of companies provide lower guidance. If investors begin to worry about the potential of an earnings recession, the pause in rate hikes may not be enough to keep the S&P 500 from giving back some of the gains since December 26.
Stocks
The strength of the rally since the low on December 26 has included a breath and volume thrust in which the ratio of advancing to declining stocks and up and down volume exceeded 9 to 1 on December 26 and January 4. This strength has forced me to alter the expectation of a retest despite the historical data going back decades that indicated that a retest was the most likely outcome after the deeply oversold condition was achieved on December 24.
This change has been discussed in the last two WTR’s (here and here):
“The bigger picture has been for the S&P 500 to decline from 2940 in Wave A, experience a large retracement rally of the Wave A decline for Wave B, and subsequently in 6 months or so fall sharply in Wave C to a level below the low of Wave A.”
The challenge and goal has been to identify the high for wave a of Wave B since it will provide guidance as to how much of a correction can be expected to complete wave b of Wave B. Once wave b of Wave B is complete, wave c of wave B would expected to reach 2800.
The S&P 500 rallied from 2347 on December 26 to 2675 on January 18. The blue trend line connects the trading low in February 2016 and November 2016 and comes in at 2644 the 50% retracement of the decline from 2940 to 2347. If wave a of Wave B did top at 2675, the S&P 500 would have gained 328 points from its low. A 38.2% retracement would bring the S&P 500 down to 2550 while a 50% retracement would target 2511.
It is interesting that these prices levels bracket the February 2018 low at 2532. Further confirmation that wave a of Wave B ended at 2675 would occur if the S&P 500 dropped below 2613. If the S&P 500 is able to punch above 2675 it is likely to be motivated by a news event and could reach 2713 to 2750.
If the S&P 500 does jump to 2735 I would be inclined to add to the short position in order to lower the cost basis on the short trade, since wave b of B has the potential bring the S&P down to under 2600 and possibly below 2520. For those who are more conservative use a stop above 2676.
Dollar
The expectation remains that the Dollar Index can fall to near 94.00 in coming months.
Treasury Yields
In the January 14 WTR the expectation was that the next move in 10-Treasury yield would reach 2.78% – 2.83% soon. The 10-Treasury yield rose to 2.799% on January 18, before falling to 2.701% on January 24. The yield could touch the underside of the red trend line connecting the lows in July 2016 and September 2016 at 2.85%.
In the January 14 WTR the expectation was that the 30-year Treasury yield could rise to 3.10% to 3.13%. The 30-year popped to 3.109% on January 18, and looks like a test of the red trend line from the 2016 low near 3.13% is possible.
With the government shutdown over the positioning data in Treasury futures, Dollar, Gold, S&P 500, VIX, and Oil should become available soon, hopefully on Friday February 1.
Gold
The expectation has been for Gold to trade above $1300 and potentially tag the trend line near $1340. As discussed this rally is in the context of a large triangle pattern that began in July 2016 when Gold traded up to $1375. The current rally from the low in August at $1160 would be wave d of the triangle and be followed by a decline representing wave e. It will helpful if the positioning data is available for Gold on February 1 since it will provide a sense of how bullish Large Speculators have become and more clarity on whether Gold will be able to breakout above $1360.
Based on extreme positioning in Gold last spring I recommended buying GLD in May and June which proved premature. The average purchase price for GLD was $120.84. In the January 14 WTR I recommended selling 75% of the position at $123.25. GLD traded up to $123.29 on January 28. Sell the remaining 25% if Gold trades above $1330 or GLD trades above $124.60 using $122.00 as a stop.
Gold Stocks
In the January 14 WTR I suggested a conservative approach toward the Gold stocks since they had been underperforming Gold:
“At the risk of sacrificing some upside potential if Gold does rally to $1310 – $1315 or higher, a stop at $20.50 for GDX will be used. Sell GDX if it trades above $21.50.”
GDX traded under $20.50 on January 18 but managed to hold the blue trend line. The rally in the past two days in GDX appears to be wave 5 from the low on November 13 which may complete a larger a-b-c rally from the low in mid August. If correct, it would open the door for a meaningful correction in the Gold stocks, especially if Gold does pullback in wave e of its triangle. If you were smart enough to hang on to GDX, selling a portion above $21.55 may be a good idea.
Tactical U.S. Sector Rotation Model Portfolio: Relative Strength Ranking
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 on November 7. 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 16.5% position established on November 7 when SH was trading at $28.35 was closed on December 20 when SH was trading at $31.81.
The U.S Sector Rotation Portfolio established a 16.5% short position in an inverse S&P 500 ETF (SH) at $31.80, when the S&P 500 opened above 2470 on January 2. This position was increased to 33% when the S&P 500 traded above 2520 on January 4 when SH was trading at $31.16, and increased to 50% when the S&P 500 traded above 2575 and SH was $30.46. The average price for the SH position is $31.14.
If the S&P 500 does jump to 2735 I would be inclined to add to the short position in order to lower the cost basis on the short trade, since wave b of B has the potential bring the S&P down to under 2600 and possibly below 2520. The odds of a retest are low but not 0%.
The MTI fell below the blue horizontal trend line on November 21 so the probability of a bear market increased until the MTI climbs above the green horizontal trend line as it did in March 2016. If the S&P 500 does correct to 2550 or lower and technical indicators become strongly bullish (i.e. Call/Put Ratio, 10 and 21 day average of TRIN) a long position would be warranted in anticipation of a rally to 2800.
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.
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