Written by Jim Welsh
Macro Tides Weekly Technical Review 10 July 2019
Job Growth Slows, Rate Cut Expectations Soar
Job growth slowed to just 75,000 in May well below estimates of 175,000, and job growth in March and April was shaved by 75,000. Treasury bond yields plunged on June 7 and expectations for the FOMC to lower the federal funds rate at or before the July 31 meeting rose to 70%.
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The slowing in job growth reinforced the expectation that the FOMC may move as soon as the June 19 meeting, after Chair Powell said on June 4 the FOMC would act if necessary to sustain the expansion.
The DJIA leapt by more than 500 points on June 4 in response to Powell’s comment. What should be obvious was undoubtedly a revelation for most investors. “EXTRA EXTRA Read ALL ABOUT IT! The Federal Reserve is monitoring trade developments and will respond if the economy falls apart!!“
The federal funds market is projecting that the FOMC will cut the federal funds rate by more than 0.75% in the next 12 months. The S&P 500 rallied to within 2% of its all time high on June 10 based on potential action by the FOMC and the suspension of tariffs on Mexico slated to go into effect on June 10. The Treasury bond market and the S&P 500 can’t both be right. If the FOMC lowers the funds rate by 0.75% or more by mid 2020, the economy and corporate earnings are going to be weaker than expected and rate cuts alone won’t be enough to save the day. If the economy proves more resilient than forecast, and President Trump doesn’t slap Chinese imports with additional tariffs, the FOMC won’t be lowering rates as much as bond or equity investors are currently expecting.
I think the odds of the FOMC cutting rates at the June meeting are less than 10%, although I acknowledge the quandary the FOMC is in. On one hand consider the economic fundamentals absent the trade issue. The Unemployment Rate remains at a 50 year low after the disappointing jobs report for May, while Unemployment Claims are hovering just above 50 year lows. Wage growth has eased a bit but is still near the highest level in a decade at 3.1% in May. The FOMC has clearly fulfilled its mandate for maximum employment.
The FOMC has a 2.0% inflation target, and depending on which inflation measure is used, the FOMC isn’t far from hitting it. While the traditional Core PCE rate was 1.6% in April, the Dallas Trimmed Mean Inflation Rate (TMIR) was 2.0%. As discussed in the June Macro Tides, the TMIR has been gaining sponsorship within the FOMC:
“In recent weeks, Fed Chair Powell and Vice Chair Clarida have highlighted the TMIR, as have a number of district presidents, including Rosengren (Boston), Bullard (St. Louis), Kaplan (Dallas), and Williams (New York). Although all 12 Federal Reserve Districts are equal, the New York Fed is first among equals which makes William’s support noteworthy. The TMIR is far more stable than the PCE.”
In addition, the Core CPI rose to 2.1% in April. Although inflation isn’t precisely at 2.0%, it isn’t so far away as to justify a rate cut, or say that prices are not stable. The FOMC could look silly if they lowered rates preemptively only for trade talks to resume and prove successful requiring a rate hike before year end. The outlook for rate cuts is so broadly embraced that this whipsaw risk is never mentioned.
GDP growth has slowed to near 2.0% after growing 3.0% in 2018. Based on the current health of the US economy, there would be no discussion of a rate cut at the June meeting if trade wasn’t an issue. The current level of tariffs imposed by the US and China are estimated to lower GDP growth by 0.3% in 2019 which is not significant. The real risk is if tariffs are more than doubled in coming months. This would likely hurt growth by more than 0.6% as the psychological impact causes a bigger pullback by consumers and businesses from the increase in uncertainty and tension.
The FOMC wanted the peak in the federal funds rate for this business cycle to be higher than the current level of 2.4%, so they would have more leverage from lowering rates during the next recession. The FOMC has 10 bullets in its arsenal if they lowered the funds rate in 0.25% increments and fewer if they toss in a cut of 0.50% along the way.
The dilemma is whether the FOMC would be wise to execute an insurance rate cut before they know how the trade negotiations will evolve, or wait until they know if the trade talks have failed.
There are a number of reasons why I think the FOMC will wait. The G20 meeting is on June 28 and by not moving at the June 19 meeting they will know whether talks will be restarted or not. Although equity investors would be disappointed if talks are not resumed, the economic damage wouldn’t necessarily rise since existing tariffs wouldn’t change. By not acting at the June 19 meeting, the FOMC would learn whether the May employment report was a fluke or the beginning of a trend, since they would have the benefit of the June employment report on July 5.
There are two triggers that would spur the FOMC to lower rates: Additional weak data that confirms the economy is slowing more rapidly than expected or, President Trump levies tariffs on the $300 billion of Chinese imports not currently subject to tariffs. Another round of tariffs and retaliation by China would likely lead the FOMC to execute an insurance rate cut before economic data confirmed the anticipated weakness.
Stocks
The S&P 500 was expected to rally from the low on June 3:
“Although the S&P 500 is likely to trade down to 2650, it is likely that it will bounce first. The table is set for the S&P 500 to rebound to near 2800 within the next week or so, unless the market is blind-sided by another tariff on somebody else Tweet.”
The rally was far more exuberant than expected and given a big boost after Chair Powell said the FOMC would take action to sustain the recovery, which in July will become the longest in US history. Had I published a WTR last Wednesday or Thursday I would have noted that the 61.8% retracement of the 225 point decline from the high of 2954 would have target a rebound to 2868. The 78.6% recovery allowed for the S&P 500 to rally to 2905. This level is quite interesting since the high on June 10 was 2904.77.
I would have also drawn attention to the similarities between the form of the decline during October and May and how similar they are. From its high on October 3 the S&P 500 dropped to its support at 2700 (blue horizontal line), and then had a fast snap back rally to 2816 before breaking support and plunging to 2604 on October 29. The S&P 500 then rallied sharply for 7 days into November 7 at 2815, almost touching the mid month rally high of 2816.
During May the S&P 500 dropped to support at 2800, snapped back to 2892, before breaking below support at 2800 and falling to 2729 on June 3. Based on the pattern in October and May, a rally to 2892 would duplicate the rally to 2815 on November 7.
Click on any chart below for a large image.
If the S&P 500 is going to continue to follow the pattern, it should fall to 2750 or so by the end of next week June 21, before launching one more last gasp rally back to 2880. If the pattern holds, the S&P 500 would fall below 2730 and at least to 2650 or lower in short order. The ‘story’ causing this pattern would be the FOMC not cutting rates at the June 19 meeting (drop to 2750), rebound to 2880 on hopes that Trump and Xi will restart talks, and then a drop to 2650 or lower when no talks are scheduled.
There is however another pattern that would allow the S&P 500 to run up to 2955 or higher, before the market would unravel in a big way. In the short term the S&P 500 would first drop to 2780 to 2820, before moving up to a new high above 2954. The fundamental ‘story’ could be a stronger Retail Sales report on this Friday , dimming hopes for a rate cut at the June 19 meeting, leading the S&P 500 to drop to 2780 – 2820 when the Fed doesn’t lower rates. The S&P 500 would then rally hoping that Trump and Xi restart talks and lo and behold they announce that talks will resume in a few weeks. On that news the S&P 500 could be expected to rally above the old high at 2954 and possibly as high as 3010 – 3030.
A large Megaphone is a broadening top formation that contains higher highs and lower lows and looks like the graphic below in a text book. The pattern in the S&P 500 since January 2018 would be a replica, other than the labeling on the Classic ‘megaphone’ example.
The high in January 2018 would be labeled wave (3) from the March 2009 low. (See chart above.) The decline to the low in February 2018 is wave (A), the rally to the September 2018 high is (B), the plunge into December 2018 is (C), and the May 1 high may be all of (D). The alternate is that the S&P 500 would, after a quick dip, rally to a higher high above 2954. The key point however is that the S&P 500 would then be expected to drop below the December low of 2347 to complete the Megaphone pattern and Wave 4 from the March 2009 low. If this pattern is correct, the downside risk from the close of 2887 on June 10 is -18.6% or more, and the upside opportunity to 3020 is +4.6%. The ratio of risk to reward is 4 to 1 to the downside.
In order to negate the Megaphone pattern the S&P 500 would have to close above the red trend line connecting the January 2018 high and September 2018 high which is currently near 3010. A brief excursion above the line is OK as long as the S&P 500 reverses lower and closes below the red trend line within a short time.
What could possibly cause the S&P 500 to fall back to the low of December?
My expectation prior to May 3 was that a trade deal would occur and Treasury bond yields would rise by 1.0% and the FOMC would be considering raising the federal funds rate before the end of 2019. With investors now expecting 3 cuts by the FOMC by the end of 2019, a trade deal and higher rates could shock the stock market.
The alternative, which seems a bit more likely at this point, is that trade talks are not resumed and President Trump levies more tariffs on the remaining $300 billion in Chinese imports leading to a full blown trade war. Although the FOMC would cut rates, lower rates may not provide the right kind of monetary cushion needed during a trade war.
Once the December low was exceeded and the Megaphone pattern completed, the FOMC would cut rates aggressively, President Trump and President Xi would agree to resume talks, and probably complete a trade deal. This resolution would provide the perfect back drop for a huge rally to well above 3000 on the S&P 500.
In the May 13 WTR I recommended becoming more defensive if the S&P 500 rallied as expected:
“If you didn’t become more defensive last week I would recommend selling into a rally if the S&P 500 does manage to rally above 2870 in the next few days.”
The S&P 500 moved above 2870 on May 16. In the 5 Tactical Sector Rotation program I lowered exposure from 100% to 50% when the S&P 500 was trading at 2877. I will lower exposure to 25% on June 11 as long as the S&P 500 is above 2850 at the opening.
Treasury Bonds
In the May 13 WTR I discussed the chart of the Treasury bond ETF (TLT) and noted it projected a move above $130.00. In the May 28 WTR I explained why TLT could rally to $133.00:
“If TLT retraces 61.8% of the 27.13 decline from its high in July 2016 to the March 2017 low, TLT could extend the current rally up to 133.25.”
On June 3 TLT traded as high as $132.58 and closed at $132.44. TLT’s RSI reached 84 on June 3, which indicated TLT was quite over bought. In the June 3 WTR I decided it was time to sell since TLT had basically reached the price targets previously discussed:
“Although TLT has the potential to rally a bit more, a pullback is equally likely before a higher high is achieved. I recommend selling TLT tomorrow June 4 at the open.”
TLT opened at $131.39 on June 4. Like the stocks market, Treasury yields could become volatile if Retail Sales for May are stronger than expected when it is announced on June 14 dimming hopes for a rate cut on June 19. Volatility could pick up more if the FOMC doesn’t lower the funds rate at the June 19 meeting. However, positioning in the 10-year Treasury futures is supportive of another push lower in yields since Large Speculators have amassed a large short position.
Dollar
From its recent high of 98.37 on May 23, the Dollar index declined in what looks like a 5 wave pattern. This suggests that the odds are now high that the Dollar has indeed peaked and is likely to drop to near the low on January 10 at 95.03. After a 5 wave move either up or down, a counter trend move typically follows. This suggests the Dollar could bounce to 97.37, which is wave 4 of lesser degree, before resuming its decline.
The recent decline also violated the higher uptrend line that intersects 4 touch points but held the lower trend line that has 3 touch points. After the 5 wave decline these trend lines merely provide support for a bounce in the Dollar. The odds are good that the next time down the Dollar will close comfortably below both trend lines as it makes its way toward 95.03.
Gold
The expectation has been that Gold would drop below $1250 before a significant rally developed based on the Gold’s chart pattern since July 2016. This outlook was turned upside down when the Dollar jumped after the tariffs on Mexico were announced on June 3. However, Gold would have to rally above $1367 (Wave (b) of the triangle) to invalidate the triangle and the expectation that Gold will fall below $1250 in coming months.
As long as Gold remains below $1367, Wave (d) of the triangle since July 2016 has merely thrown a curve by pushing above $1347 and reaching $1348 last week.
If Gold does negate the triangle, then Wave (e) of the triangle bottomed at $1266 rather than below $1250 as expected. Should Gold push above $1367 the expected rally to $1450 or higher has already begun. If Gold drops below $1320 establish a 50% position in GLD or IAU using $1301 as a stop. This is not the ideal entry point as a decline below $1250 would have been. But the opportunity of a rally above $1400 and higher has been developing for almost 3 years and it would be a bummer not to have a position on, if Gold runs due to more tariffs on China.
Gold Stocks
There is gap on the Gold stock ETF (GDX) at $21.74. The RSI for GDX reached 73.4 on June 6 and would be expected to drop below 50 and maybe get close to 40 before GDX tries to rally again. Establish a 33% position at $21.80 since GDX is likely to close the gap.
Tactical U.S. Sector Rotation Model Portfolio: Relative Strength Ranking
The MTI generated a Bear Market Rally (BMR) buy signal on January 16, 2019 (green arrow) and climbed above the green horizontal trend line on February 26 confirming the uptrend. The progressive weakening in the technical structure of the market since late April led me to reduce exposure. When the S&P 500 was trading at 2877 at 7am on May 16 I lowered the exposure in the Tactical U.S. Sector Rotation Model Portfolio from 100% to 50%. I will lower exposure to 25% on June 11 as long as the S&P 500 is trading above 2850.
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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