Written by Jim Welsh
Macro Tides Weekly Technical Review 23 Spetember 2019
FOMC Cuts as Uncertainty Trumps Solid Domestic Data
During the July 31 post FOMC meeting press conference Chair Jay Powell said, “An ounce of prevention is worth a pound of cure.” This provides all the analysis that is necessary to understand why the FOMC lowered the funds rate at their September 18 meeting.
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As noted last week:
“Since the July meeting the Citi Surprise Index has climbed from below -60 to +18, and core inflation as measured by core producer (2.3%) and consumer prices (+2.4%) are above the Fed’s inflation target of 2.0%. While these metrics are not the Fed’s preferred inflation metric (Core PCE), they do suggests that Core PCE inflation is more likely to rise from the current level of 1.6% toward 2.0%. With the economy holding above 2.0%, unemployment at a 50 year low and wage growth of 3.2%, inflation firming, and the yield curve flattening, there is no justification for the FOMC to lower the funds rate.”
As expected the two district Presidents dissented and voted against lowering the funds rate (Rosengren and George).
However, a third President (Bullard) dissented since he thought the FOMC should have lowered the funds rate by 0.50% rather than 0.25%. On September 23 Bullard explained his reasoning in a speech noting that uncertainty surrounding trade could result in a sharper downturn than expected, as well concerns about the yield curve, and low inflation and inflation expectations:
“It is possible that a sharper-than-expected slowdown could materialize in the quarters ahead.”
Bullard then discussed the downside risks, which include the effects of magnified global trade policy uncertainty; slowing growth in the global economy; contraction in global and U.S. manufacturing; slowing U.S. business investment; and an inverted yield curve:
“Although the 10-year yield is currently above the two-year yield, it is only because markets are anticipating future policy moves by the FOMC.”
If one had any doubts, this comment provides a clue as to how Bullard will vote at the meeting in late October:
“The bottom line is that U.S. monetary policy is considerably more accommodative today than it was as of late last year.”
Even though policy is “considerably more accommodative today than it was as of late last year“, Bullard is still more worried about inflation and inflation expectations:
“A sharper-than-expected slowdown may make it more difficult for the Federal Open Market Committee (FOMC) to achieve its 2% inflation target. This is occurring despite more than two years of upside surprise on the real growth rate of the U.S. economy. Insurance rate cuts may help re-center inflation and inflation expectations at the 2% target sooner than otherwise.”
As discussed in the August Macro Tides, when it comes to inflation expectations Bullard has an academic fetish. James Bullard explained their role in a 2016 essay:
“Central bankers believe that inflation expectations play an important role is the level of inflation. Modern economic theory says that inflation expectations are an important determinant of actual inflation. How does expected inflation affect actual inflation? Firms and households take into account the expected rate of inflation when making economic decisions, such as wage contract negotiations or firms’ pricing decisions. All of these decisions, in turn, feed into the actual rate of increase in prices. Given that central banks are concerned with price stability, policymakers pay attention to inflation expectations in addition to actual inflation. The concern is that if inflation expectations remain too low for too long, Central Bankers will find it more difficult in getting real inflation up to 2.0%. What a shame! Some economists are so serious about this ‘problem’ that they have urged the Fed to adopt price-level targeting in which the Fed would pledge to achieve future inflation that is 1.0% above the Fed’s 2.0% target. As if the Fed had that much power by simply pledging to raise inflation above the target they have failed to reach in 20 of the past 25 years! What hubris!”
It is actually beyond hubris since the San Francisco Fed has done research showing that the Fed’s preferred inflation gauge is flawed, as explained in the August Macro Tides:
“As noted the Fed’s preferred inflation measure is the Personal Consumption Expenditure Index (PCE), but there may be a problem in the components within the PCE. In 2017 economists at the Federal Reserve Bank of San Francisco published an analysis of the PCE in a paper entitled What’s Down with Inflation? They divided the components of the PCE into two categories: procyclical and acyclical. They found that the categories exhibiting a procyclical relationship make up 42% of the PCE and include housing, recreational services, food services, and some nondurable goods. The acyclical categories, which make up the remaining 58%, include health-care services, financial services, clothing, transportation, and other smaller categories. They found that the cyclically sensitive components of core inflation had accelerated to 2.33% annually by May 2017 from 0.41% in mid-2010.
The procyclical categories have behaved as they did from 2002 to 2007. However, core inflation in the acyclical categories slowed from 2.26% in mid 2010 to 1.04% in May 2017. (Chart shown later below is updated though May 2019.) The key driver holding down acyclical inflation has been persistent changes to the health-care sector that began after the end of the recession.
Cuts to Medicare payment growth rates have restrained health-care services inflation. Health care makes up a large share of the PCE, so price changes within this sector have a sizable effect on overall PCE inflation. The economists at the San Francisco Fed concluded that low health-care services inflation is currently subtracting about 0.3% from core PCE inflation. Core PCE inflation, which has been running about 1.6% would be close to 2%, if acyclical inflation were behaving as it did prior to the financial crisis.”
I agree with Bullard’s view that the Trade War is likely to drag on for far longer than expected and continue to dent global growth, business investment, and ultimately slow growth in the U.S. These are legitimate and understandable reasons for lowering rates before domestic data softens, compared to academic gibberish about inflations expectations. One has to wonder whether the FOMC is receiving information about the real status of trade talks, which is leading a plurality of FOMC members to expect talks to falter and hurt the economy. In this context former New York Federal Reserve President Bill Dudley’s August 27 Bloomberg opinion piece makes sense:
““Central bank officials face a choice: enable the Trump administration to continue down a disastrous path of trade war escalation, or send a clear signal that if the administration does so, the president, not the Fed, will bear the risks – including the risk of losing the next election. After all, Trump’s reelection arguably presents a threat to the U.S. and global economy, to the Fed’s independence and its ability to achieve its employment and inflation objectives. If the goal of monetary policy is to achieve the best long-term economic outcome, then Fed officials should consider how their decisions will affect the political outcome in 2020.”
In other words the FOMC shouldn’t cut rates now since it emboldens Trump, and lower rates will soften the economic fallout if the trade talks collapse. Better to do nothing now and let the economy take the hit, so it is clear that President Trump’s Trade War is responsible.
Stocks
As noted in the September 9 WTR, the S&P 500 was likely to hold up until the FOMC meeting and potentially the end of the quarter for one reason:
“The problem in the short term is that it is difficult to identify a reason why institutional investors would sell and raise cash.”
The economy is OK, most investors expect there will be a trade deal when they meet in October, and institutional investors want to show their clients they are fully invested. As noted last week stocks may also benefit from portfolio rebalancing on September 30:
“The huge rally in Treasury and corporate bond prices this year has likely allowed bonds to become over weighted relative to their benchmarks in institutional portfolios. The end of the quarter could also provide some support for the stock market, if institutions rebalance their portfolios by selling bonds to buy stocks. These factors suggest the S&P 500 may hold up and could make a new high before the end of September.”
A form of rebalancing has already begun as institutional investors rotate out of momentum and growth stocks and into the stocks that have lagged so far in 2019, as noted in the September 9 WTR:
“The rally on September 9 was a huge rotation out of the sectors that have performed well so far in 2019 (technology, REIT’s, utilities, staples) into the sectors that have performed the worst (financials, energy, industrials). The question is whether these down and out sectors can truly provide leadership over an extended period of time or was today’s big bounce a flash in the pan. If the prior leaders continue to correct, it could be an upward slog for the S&P 500 since Technology, Real Estate, Utilities, and Consumer Staples represent 35.11% of the S&P 500. The weighting of Financials, Energy, and Industrials is 27.50%. So far in 2019 Health Care (14.2%) has been neutral, while Consumer Discretionary (10.19%) has done well so it could be a swing factor. Unless Technology and the interest sensitive sectors can move up during a rally led by the prior laggards, it is hard to see the S&P 500 pushing much above the prior high.”
On September 9 the S&P 500 closed at 2978 and 10 trading sessions later it has made it up to 2991. Since September 11, the Advance / Decline Line is virtually unchanged as the internal rotation in market breadth has flat lined.
Click on any chart below for large image.
Last week I thought the DJ Transports and Russell 2000 might provide insight as to whether this rally could have legs, since both have tended to move down prior to declines in the S&P 500 since January 2018:
“Both averages are now nearing important resistance levels so they are approaching a make or break level. The Transports are attempting to push above the black down trend line connecting the highs since last September. The more important resistance level is the horizontal red trend line near 11,050. If the Transports are able to close above the red trend and stay above it, it would suggest the market can continue to rise.”
After testing the black trend line the Transports reversed lower, which suggests the odds of a breakout have receded, even if the S&P 500 is able to record a new high. The Transports appear poised to test the late August low near 9700.
As discussed last week, the Russell 2000 sported a similar pattern to the Transports and needed to close above the red horizontal trend line at 1600:
“It would be a good sign for the overall market if the Russell 2000 is able to close above 1600 and stay above that level.”
After trading up to 1590 the Russell 2000 has backed up, so the odds of a positive breakout have diminished, even if the S&P 500 does post a new high before the end of the quarter.
Investors are optimistic about the prospects for a trade deal. I don’t share that view and do not expect a trade deal to develop anytime soon. The Chinese have the incentive of stalling in hopes President Trump will accept less than a comprehensive agreement, just to improve his reelection prospects. That may be a miscalculation as Trump is not like the normal politician who is highly susceptible to manipulation just to get reelected. Trump is more likely to pursue a deal that addresses the theft of intellectual property and reduces the trade deficit with China.
If no deal is achieved, and the economy weakens too much, even if it is not in a recession, Trump may decide not to run to avoid a loss. Trump remembers how many in the Republican Party supported the ‘Anyone But Trump’ movement and holds no allegiance or loyalty to the party. If this assessment is on target, the stock market is set up for another disappointment in October as the trade talks don’t yield a deal.
The S&P 500 could test the red trend line connecting the January 2018 high, September 2018 high, and July 2019 high near 3045. A breakout above the red trend line is not expected.
Dollar
In the short term the Dollar still has the potential to exceed its September 3 high of 99.37, as discussed previously:
“The Dollar hit its high of 99.37 on September 3 and has pulled back. However, until the Dollar Index drops below 98.00 it still has the potential to move to another modest new high. From its low in late June the Dollar rallied by 3.1 points. An equal move up from the low on August 6 at 97.20 suggests the Dollar could reach 100.10 – 100.30, or at least test the rising trend line at 99.65.”
Once a high is confirmed, the Dollar is expected to fall since positioning is negative. Asset managers are holding a larger long position than in January 2017 as the Dollar Index topped at 103.82. The Dollar Index fell from 103.82 in January 2017 to 88.25 in February 2018. The large long position was unwound which contributed to the decline.
The long term chart of the Dollar suggests the Dollar could be on the cusp of a significant decline. After bottoming in February 2018 at 88.25, the Dollar has moved higher in a choppy manner, especially when compared to the 5 wave impulsive decline from the high in January 2017 at 103.82. This suggests the rebound since February 2018 has been a retracement of the 15.57 point decline from 103.82 to 88.25. It should be noted that the 15% drop from the January 2017 high occurred, while the FOMC raised the funds rate by 0.75% and another 0.25% in March 2018. It may be logical to expect interest rates to drive the direction of a currency but markets love to defy logic.
Based on the Dollar’s price pattern since January 2017, the decline to the low in February 2018 would be labeled wave A, the rebound wave B, which implies that the Dollar could be vulnerable to an equal decline of 15.51 points for wave C from the high of wave B in the next 12 to 15 months. The Dollar appears to be setting up for an extended decline and President Trump may provide the impetus for the kickoff of the move lower in the not too distant future.
The Trade Weighted Dollar Index (TWD) has a very different composition as the nearby table illustrates. The Euro’s weighting shrinks from 57.6% to just 17.1%, with China getting a 21.9% weighting versus nothing in the Dollar Index.
The TDW recorded a new all time high on September 3.
The TWD’s weekly RSI posted a lower high compared to prior price highs, which is a technical negative momentum indication that a correction is likely. Last week WTR I recommended buying the Emerging Market Local Currency Bond ETF (EMLC) in anticipation of a Dollar decline in coming months. On September 17 EMLC opened at $33.10. A rally to above $35.00 is possible and EMLC yields 6.5%.
India
On Friday September 20 the Indian government cut the corporate tax rate for Indian companies to boost economic growth. Going forward local firms will pay a 22% corporate tax, down from 30%. India is also offering companies that may be contemplating moving supply chains out of China an incentive to open up shop in India. Companies that begin manufacturing within the next four years will be subject to a tax rate of only 15%. This is a fundamental change that should help improve economic growth in India in coming years and attract foreign investment that could lift the Rupee India’s currency.
I purchased the India ETF (INDA) for my managed accounts on Friday at $33.23. INDA has the potential of testing the green trend line that connects the August 2018 and June 2019 high above $36.00. If the Dollar depreciates as expected in coming months, INDA has the potential to break out above those highs and retest the January 2018 high above $38.00.
Treasury Bonds
As reviewed last week:
“On the surface it appears that the 10-year Treasury yield has recorded an important low. However, looking under the surface one can make the case that the low yield was wave 3 down from the high of 3.248% last November, as the labels on the chart illustrate. The rebound since the low of 1.429% would be wave 4, and implies that another drop below 1.429% is possible to complete 5 waves down from last November.”
The same pattern is evident in the 30 minute chart of TLT. As long as TLT does not drop below the low of $136.54 on September 13, the pattern suggests TLT could rally to a higher high. TLT has bounced from $136.54 to $143.15 on September 23. If TLT is going to rally to a new high above $148.90, it should not fall below $137.95 which is the 78.6% retracement of the $6.61 rebound from $136.54.
If TLT declines to under $139.00 in three waves, (i.e. a down, up, down pattern), it might offer the opportunity to buy TLT in anticipation for a rally above $148.90, using $136.54 as a stop. If TLT does fall below $136.54 it will complete 5 waves down from the high and confirm that the intermediate trend in Treasury yields is up.
Gold
The positioning in Gold became more negative after Gold bounced back above $1500. The 61.8% and 78.6% retracement of the $71 drop in Gold from $1556 to $1485 allows for a bounce to $1529 (61.8) and $1540 (78.6%). The positioning in Gold suggests Gold can drop to $1445 and possibly as low as $1410.
As discussed in last week’s WTR:
“A 38.2% retracement of the $290 rally ($1556 – $1266) would bring Gold down to $1445, while a 50% retracement would target $1411. Gold traded in a range between $1410 and $1430 from June 25 until the end of July, so there is a fair amount of support in this price range.”
However, if Gold traces out 5 waves down from the $1556 high, it would suggest a deeper and more protracted correction that could carry well below $1450. This rebound is another opportunity to reduce exposure to Gold. Traders can short Gold (or an inverse ETF) if it trades up to $1531 (cash) using $1548 as a stop.
Gold Stocks
The rally since the low at $27.45 is likely corrective and could reach $29.61, which is the 61.8% retracement of the $3.51 drop from $30.96. This is another opportunity to reduce exposure to Gold stocks since a drop to $26.04 or lower is likely in coming weeks.
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 (SH $26.09). The short position was increased to 40% on August 8 when the S&P 500 was trading at 2930 (SH $26.69). The short position was reduced to 20% on August 28 when the S&P 500 was trading at 2882 and SH was sold at $27.09.
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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