by Jim Welsh
Macro Tides Weekly Technical Review 29July 2019
Markets are expecting the Federal Reserve to lower the federal funds rate by .25% on Wednesday and the FOMC will give markets what is expected. After the announcement the focus will shift to whether the FOMC’s statement or Chair Powell’s comments reaffirm the expectations for 2 more cuts before the end of 2019.
Please share this article – Go to very top of page, right hand side, for social media buttons.
As discussed last week, President of the Boston Fed Eric Rosengren expressed a number of good reasons why a rate cut at the July 31 meeting is not warranted in a CNBC interview on July 19. I think there is 3 or 4 other district Presidents who agree for the most part with Rosengren. This will result in a lengthy discussion by FOMC members, as they discuss the various pros and cons. At the end of the day the FOMC will lower the funds rate by 0.25% in part because markets would be surprised, disappointed, and upset if the FOMC didn’t.
I would be surprised if Rosengren or Esther George, who likely shares his view, will vote against the decision to lower the funds rate. Loretta Mester and Raphael Bostic are the other two presidents who may not support a rate cut but they are not voting members on the FOMC in 2019.
The key question is whether Rosengren, and those who agree with him, strongly suggest that the FOMC should lower expectations for the 2 cuts that market participants are expecting before year end. This may be communicated in the FOMC statement but more likely during Powell’s post meeting press conference. In the June post meeting press conference Powell repeatedly referenced the high level of ‘uncertainty’ in the FOMC’s outlook. Powell referenced the trade negotiations, the global slowdown, and softer U.S. data. This is why the June statement said:
“In light of these uncertainties and muted inflation pressures, the Committee will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion.”
While the level of uncertainty regarding trade has not been notably reduced, the U.S. and China are talking so it hasn’t gotten worse. The pace of the slowing in the global economy appears to have stabilized. Recent data in the U.S. has been good with job growth picking up in June and consumer spending more than offsetting the dip in business investment in second quarter GDP, according to the first estimate. If Powell wants to lower expectations for future cuts he will note that the FOMC’s decision to lower the funds rate at the July meeting addresses some of the concerns FOMC members expressed at the June meeting. Coupled with the better data in the U.S., the FOMC may be more data dependent in assessing any future adjustments to the funds rate.
Powell will do his best to soft peddle any shift away from the expected additional cuts. The FOMC has already decided to stop the shrinking of its balance sheet on September 30. If the FOMC does desire to lower the market’s expectations for additional rate cuts, the financial markets will likely be disappointed with stocks, bonds, and gold selling off, while the Dollar strengthens. To mute this reaction, the FOMC may decide to announce it will end shrinking its balance sooner than September 30.
Stocks
The S&P 500 and the NASDAQ 100 recorded a new high last week. However, the RSI for each index registered a negative divergence as the RSI was lower. A similar negative divergence developed last September when the S&P 500 made a new all time high but its RSI was lower (red line on S&P 500’s RSI). The 5 day (red) and 13 day (green) moving average on the S&P 500 would provide a level of confirmation that a correction had begun when the 5 day MA drops below the 13 MA. That crossover occurred in October and in May, and would develop again if the S&P 500 dropped and held below 3001.
Click on any chart below for large image.
The RSI divergences for the S&P 500 and NASDAQ 100 have additional value since the RSI is below 70, which underscores how much upside momentum has been waning.
The internal strength of the rally in the NASDAQ 100 has been particularly weak as measured by the 21 day moving average of Advances minus Declines. The current level is almost identical to what occurred in September and early October (red lines) which preceded the sharp decline in the fourth quarter.
Bullish sentiment remains elevated as measured by the Call / Put Ratio. Investors expect the FOMC to continue to hold their hand with additional cuts.
If the trade talks simply drag on in coming months, there is a good chance the U.S. and global economy will gradually improve. As noted previously, there is a significant bifurcation between the manufacturing sector and service sector in the US, Europe, Japan, and China. Manufacturing represents just 11% of GDP in the US and about 22% in Germany. The key point is that services have so far proven resistant to the weakness in manufacturing in the U.S., Japan, and Eurozone, and will provide support going forward. Interest rates in the US and globally have fallen significantly, which has eased financial conditions in the Eurozone and U.S.
The budget agreement in the U.S. will offset the slowing in government spending that was expected in the remainder of 2019 and 2020. The debt ceiling was another uncertainty cited by Powell in June. Not only has the uncertainty been removed but its been replaced by more fiscal stimulus.
Given all of this support for the U.S. economy it is unique that the FOMC will be lowering rates as insurance, when most of the ‘insurance’ has already beeen paid for by the decline in Treasury bond rates.
If as I expect the trade talks stall, it then becomes a question of how much patience President Trump has before he decides to enact more tariifs on the remaing $325 billion of Chinese imports. If and when his patience runs out and additional tarifffs are levied, additional rate cuts may not be enough to ofset the slowdown in the global economy and in the U.S. Any increase in selling pressure, no mater what causes the increase, has the potential to upset the stock market. As discussed the technical set up has been weakening and sentiment is quite bullish, which are the ingredients that often lead to qucik and sharp declines.
The price pattern in the S&P 500 and DJIA indicate that there is a probability that the S&P 500 could fall to the lows of last December near 2350. A decline of this magnitude will not materialize just because the S&P 500 has formed a Megaphone, sentiment is too bullish in the short term, or the softening technical landscape. There will have to be a reason to sell since most investors are optimistic and believe the Fereral Reserve will ride to the rescue. The most likely culprit remains an escalation of the Trade War.
Both the S&P 500 and DJIA have the potential of making another new high before reversing lower. There are enough technical and sentiment warning signs to suggest that a pullback to 2800 is coming and possibly 2730 (Key Support), even if the Megaphone pattern is ultimately invalidated.
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 lowered exposure to 25% in the Tactical U.S. Sector Rotation program on June 11 after the S&P 500 gapped up to 2903 at the open. I lowered exposure to 5% from 25% at the close on Wednesday when the S&P 500 was 2913. I sold the 5% position in Technology ETF (XLK) shortly after the opening on July 1. I established a 25% short position in the S&P 500 through the purchase of the 1 to 1 inverse ETF SH on July 23, when the S&P 500 traded above 2995. This position will be increased to 50% if the S&P 500 trades above 3028.
Treasury Bonds
Positioning by Large Speculators in 10-year Treasury bond futures is not as extreme as it was in early 2017 or last fall when a record net short position suggested that bond yields were primed for a decline. The net short position is still large enough to fuel a further rally in bond prices and lower yields in coming weeks.
When the 10-year Treasury yield bottomed at 2.03% in September 2017, Commercials were net short. (Red line middle panel) When the Large Speculators had a record short position last November, the Commercials had their largest long position ever (Green line middle panel). This positioning was why I expected Treasury yields to fall. Commercials are still long +311,782 contracts, while Large Specs are short -380,169 contracts. It is likely they will be forced to cover most of the short position before the 10-year Treasury bond yield bottoms.
This suggests that the 10-year Treasury yield will drop below 1.943% in coming weeks.
If this assessment if correct, the Treasury ETF (TLT) will rally above $134.29 to complete wave 5 and potentially finish the rally from the November low of $111.90. However, if I’m right and the FOMC dampens expectations for additional rate cuts, the bond market could suffer a quick decline that would bring TLT below $128.00. After peaking at $134.29, TLT declined in a 3 wave pattern $4.61 to a low of $129.68. If TLT experiences an equal decline from the recent high of $132.49, TLT would fall to $127.88. I would recommend buying TLT if it falls below $128.40 using a stop of $126.60.
Dollar
The ECB meeting on July 25 was expected to give the Dollar a boost as Mario Draghi pledged to further ease monetary policy. The Dollar has rallied and could rally more if the FOMC signals that additional rate cuts won’t be as automatic as investors expect. The Dollar could rally to 98.80 the lower trend line and although unlikely as high as 99.50 which is the higher trend line. Sooner or later President is likely to talk the Dollar down, especially if the trade talks falter and he levies more tariffs on China.
Gold
The positioning in Gold has changed dramatically since last October when Commercials were net long +25,866 contracts and Large Speculators were short -38,175. As of July 23, the ‘Smart Money’ Commercials were short -287,839 contracts, while the trend-following Large Speculators were long +251,250 contracts. When Gold topped in January 2018, Large Speculators were long +214,634 contracts and the Commercials were short -234,552 contracts.
The positioning is more extreme now than in January 2018. Gold subsequently fell from $1350 in January 2018 to a low below $1170 last fall.
I do not expect that deep of correction in the next few months. A period of consolidation including a test of the recent breakout level of $1360 to $1380 seems realistic. After a pullback Gold is expected to retrace 50% or 61.8% of the decline from the September 2011 high of $1920 to the low in December 2015 at $1045.
A 50% retracement would lift Gold to $1480, while a 61.8% recovery would target a rally to $1588. My guess the $1588 target is more likely, especially if the Trade War escalates and the Federal Reserve is forced to slash rates and potentially entertain another round of Quantitative Easing.
Gold Stocks
The relative strength of the Gold stocks while still strong has begun to weaken modestly. After Gold and GDX peaked in the summer of 2016, GDX rebounded to $28.70 and $28.56 before subsequently plunging to under $19.00 in December 2016. I thought the area near those two highs would likely provide resistance and likely cap the current rally. Last week GDX traded up to $28.41 and could exceed that high briefly before a deeper correction takes hold. If Gold does drop toward $1383 or lower, GDX could easily trade below $26.00 before another buying opportunity develops.
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 lowered exposure to 25% in the Tactical U.S. Sector Rotation program on June 11 after the S&P 500 gapped up to 2903 at the open.
I lowered exposure to 5% from 25% at the close on Wednesday when the S&P 500 was 2913. I sold the 5% position in Technology ETF (XLK) shortly after the opening on July 1.
I established a 25% short position in the S&P 500 through the purchase of the 1 to 1 inverse ETF SH on July 23, when the S&P 500 traded above 2995. This position will be increased to 50% if the S&P 500 trades above 3028.
The Megaphone pattern allowed for the S&P 500 to trade up 3000 and modestly above that big round number. The S&P 500 traded up to 3028 on July 26. Although it may take a bit more time for the stock market to complete its topping process, the next big move is likely to be down not up. As noted there 10 are enough technical and sentiment warning signs to suggest that a pullback to 2800 is coming and possibly 2730 (Key Support), even if the Megaphone pattern is ultimately invalidated.
Volatility is likely to increase after the FOMC’s rate decision at 11am on July 31. The July employment report before the open on Friday could also cause some volatility, if the number of jobs is much above 180,000 or below 80,000. Wage growth and the unemployment rate will also be in focus.
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.
.