Written by Jim Welsh
Macro Tides Weekly Technical Review 22 March 2021
The FOMC followed the script as outlined in last week’s WTR and Treasury yields rose as expected:
“Chair Powell is going to reiterate the FOMC’s commitment to keep rates down so unemployment can fall and tolerance of any pick-up in inflation toward its target of 2.0%. Chair Powell will state the Fed’s expectation that the coming rise in inflation is likely to be temporary, so the FOMC will not react by hiking rates if the Core PCE is above 2.0% for a period of time.
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“Some market participants are eager to hear if Chair Powell hints about the FOMC implementing Yield Curve Control (YCC), which would be expected to minimize any increase in Treasury yields. I doubt Chair Powell will provide even a hint that the FOMC is considering YCC anytime soon. If correct, the Treasury market may be disappointed and sell off.”
The 10-year Treasury yield rose from 1.621% on March 16 to an intra-day high of 1.754% on March 18, while the 30-year Treasury yield traded up to 2.505% from 2.391% on March 16.
The FOMC communicated its resolve through its quarterly projections for GDP, Unemployment, and PCE inflation. The FOMC increased its GDP estimate from 4.2% to 6.5% for 2021, lowered its Unemployment rate projection down to 4.5% from 5.0%, and projected that PCE inflation would reach 2.4% and Core PCE would tick up to 2.2%. Even with strong GDP growth, falling unemployment, and the FOMC’s favorite inflation gauges rising above 2.0%, the FOMC indicated no rate hikes should be expected before 2023.
The commitment to keeping the federal funds rate just above 0% was despite the increase in the number of FOMC members favoring an increase in the funds rate in 2022 from 1 to 4. This represents a significant change in monetary philosophy by the Federal Reserve.
After Paul Volker became Chairman of the Federal Reserve in 1979 and during the decades that followed, the Federal Reserve relied on the Phillips Curve as its primary guide. The Phillips curve is named after economist A.W. Phillips, who examined U.K. unemployment and wages from 1861-1957. Phillips found an inverse relationship between the level of unemployment and the rate of change in wages. As slack in the labor market fell as measured by the unemployment rate wages began to grow faster, company’s increased prices and inflation rose.
In the U.S. the relationship between the unemployment rate and the lagged increase in the Personal Consumption Expenditures (PCE) index was fairly tight in the 1950’s, 1960’s, 1970’s, and 1980’s. However beginning in the 1990’s and since, the PCE didn’t rise much, even though the unemployment rate fell to historically low levels.
The expansion after the financial crisis was the longest in U.S. history and by 2019 the unemployment rate was the lowest in 50 years. Based on the Phillips curve the PCE should have gone up but it remained muted. The breakdown in the relationship between the unemployment rate and the PCE brought about the demise of the Phillips Curve, and the Fed’s willingness to allow it to guide monetary policy.
The FOMC will no longer increase rates based on projections of low inflation but instead will wait until inflation materializes, even though there is a risk the Fed could fall behind the inflation curve.
The economic projections provided by the members of the FOMC reinforce their expectations that the coming increase in inflation will give way to lower inflation in 2022 and 2023. There are political and social pressures on the FOMC pushing the members of the FOMC in this direction.
Income inequality is a real problem and the only the Fed can help is by allowing the economy to run hot in hopes that wage growth for the lowest paid workers rise faster. This was occurring in 2019 when the bottom quintile of workers saw their wages grow faster than any other group. If you have any doubt about the political pressure on the Fed just listen to the questions about income inequality Powell is asked anytime he appears before Congressional committees.
In coming weeks, members of the FOMC will act as disciples for the new gospel of allowing the economy to grow, inflation to exceed 2.0%, and the FOMC refraining from hiking rates. In the short term this ‘forward guidance’ may restore some calm to the Treasury market and allow yields to come down. However, inflation is likely to run hotter than the Fed expects and the Treasury bond market will test the Fed’s commitment by pushing yields higher until the Fed is forced to launch Operation Twist. The members of the FOMC may believe in the New Gospel 4 but there are many traders (sinners) in the bond market that lack the faith to keep them from selling when headline CPI inflation holds above 3.0% for a few months.
Stocks
As noted last week the Nasdaq 100 could provide timely information if stocks were going to succumb to another selling wave:
“The Nasdaq 100 ETF (QQQ) has pivoted around the 310 – 312 level. After closing below this level it quickly dropped to 297 on March 5. If the Treasury market is upset by what Chair Powell doesn’t say about YCC, the Mega Cap stocks could experience another quick decline.”
The Nasdaq 100 ETF QQQ, which is dominated by Mega Cap stocks, did decline after Powell failed to mention Yield Curve Control. The QQQ’s dropped to 309.66 on March 19 but didn’t close below 310.00. Since February 24 the QQQ’s have tested 324.00 on four occasions, so a close above 324.45 could lead to a quick move up to the high of 338.19.
Conversely, should the QQQ’s close below 310 a drop to 300.00 is likely. At this point I don’t think the QQQ’s will fall below the March 5 low of 297.00. The expectation is that the QQQ’s will test or exceed 338.19 during the next market rally.
There are signs that the Mega Cap stocks may be in the process of making a longer term top. Historically, the stock market will top after the Advance – Decline line has recorded a high, even as the S&P 500 subsequently posts a higher price high. The Nasdaq A/D line topped in early February so it needs to monitored in coming months.
The percent of Nasdaq stocks making a new 52 week high has contracted noticeably, which is another sign of deterioration. A break of the March 5 low would be a big negative in light of the weakness in the Nasdaq A-D line and net highs – lows.
The QQQ’s rallied +1.9% on March 22 as Treasury yields dipped. The S&P 500 was only up 0.70%, while the Russell 2000 was down -0.91%. The reason for the disparate action was profit taking in the cyclical stocks which have been outperforming the Mega Cap stocks for weeks.
The trigger was the decline in Treasury yields but also some concern about the lockdowns in Europe as COVID cases rise, and the increase in the British variant in more than 30 states in the U.S. This has raised concerns that the pace of reopening the U.S. economy may slow, especially if cases and hospitalization jump in the next few weeks.
More than 1 million people have boarded a plane in each of the last 10 days, and the Spring Break partying in Florida and other states could lead to a real acceleration in cases two to four weeks from now.
If Cyclical stocks and Mega Cap stocks pullback again the S&P 500 could drop to 3700 – 3800.
As noted last week end of quarter rebalancing could still play a role in knocking the stock market down:
“The spread between the average stock as measured by RSP up +12.4% compared to the performance of government and corporate bonds is wide. It is estimated that between $50 billion and as much as $110 billion of stocks may be sold and a comparable amount of bonds purchased by the end of March by defined benefit pension plans to rebalance their portfolios.”
If the S&P 500 does correct in the next two weeks, it is expected to rally above 4000 fueled by the next round of stimulus checks, stable Treasury yields, and good economic news.
Treasury Yields
In the March 1 WTR I noted that the weekly RSI for the Treasury bond ETF (TLT) had fallen below 30 for only the fourth time in the past decade:
“Since 2012 the Weekly RSI for TLT has dropped to 30 on four occasions (green arrows). In June 2013 after the Taper Tantrum, December 2016 after President Trump won the election and bond holders were worried about his promised tax cut. TLT’s RSI fell below 30 in October 2018 after the bond market was distressed about rate increases by the Federal Reserve. The fourth time is last week.”
The deeply oversold level TLT had reached suggested that a trading low was approaching. In the March 8 WTR I discussed why TLT was likely to drop below the February 25 low of $136.61:
“The longer term Treasury ETF (TLT) is expected to fall below the February 25 low of $136.61 7 in its wave 5. From June of 2019 until mid January 2020 TLT traded above and below $135.00 so this should provide significant support.”
On March 18 TLT traded down to $133.19 before closing at $133.92. TLT’s RSI recorded a significant positive divergence suggesting that TLT has bottomed and Treasury yields have topped. The last time the Weekly RSI was below 30 was in October 2018 and a similar positive divergence developed.
The economy and fiscal policy is in a different place than in October 2018 but the positive divergence in TLT suggests that Treasury yields are more likely to fall in the next two months than rise further. TLT has the potential to rise to $142.00 – $143.25.
Foreign buying could play a role in bringing Treasury yields down for a spell. Japanese and European institutions can now buy Treasury bonds, hedge their currency risk and earn a much higher return.
In Germany the 10- year German Bund yields -0.307% and the Japanese JGB will get an investor +0.10%. After hedging the Yen a Japanese institution can earn 1.25%, while European institutions can receive 0.75%, more than 100 basis points above what a German Bund provides.
Dollar
Longer term the Fed’s Dovish policy change is not a plus for the Dollar and if Treasury yields do fall in coming weeks the Dollar has the potential to correct. In the short term the Dollar has the opportunty to rally above its recent high of 92.50 in large due to weakness in the Euro. Europe is experiencing another wave of COVID infections and a number of countries have reimposed lockdowns.
The pace of vaccinations in Europe is much slower than in the U.S. with only 1/3 as many people per 100 vaccinated.
This has lowered expectations for GDP growth in Europe so that GDP won’t recover what was lost in 2020 until the first half of 2022.
If the Dollar rallies a bit in the short term and then experiences a deeper correction, Gold, Silver, and Gold stocks stand to benefit.
Gold
Gold is likely to hold above the recent low even if the Dollar does rally modestly above 92.50. Any additional weakness is likely to be short lived and Gold is expected to rally to $1950 and possibly above $2070 this summer. The only caveat is if the Dollar manages to rally above 94.00 in the next few months.
This is not expected.
Gold has been correcting since it topped at $2070 last August so the correction has already lasted 7 months which has dampened bullish sentiment. After buying the initial 50% in IAU at $17.23 on February 23 and the second 50% position at $16.09, the cost basis is $16.66.
Silver
Silver has been holding up better than Gold since both peaked last August. It would be classic for Silver to show more weakness now, which could be another sign of bullish sentiment in the metals being washed out. When the strongest sector finally caves after months of correcting, it often occurs at the end of the corrective period. Silver is expected drop below $24.90 and could test $24.50. Silver is expected to rally above $30.00 by mid-year.
Traders can take a 50% position in the Silver ETF (SLV) if SLV drops to $23.25.
Gold Stocks
Traders were recommended to take a 33% long position if GDX closed below $32.00, and on February 26 GDX closed at $31.13. The improvement in GDX’s relative strength to Gold and close over the green trend line suggests buying GDX on the next pullback. Traders can add 33% to the GDX position on a pullback to $32.75.
Tactical U.S. Sector Rotation Model Portfolio: Relative Strength Ranking
The MTI generated a Bear Market Rally (BMR) buy signal when it crossed above the red moving average on April 16 when the S&P 500 closed at 2800. A new bull market was confirmed on June 4 when the WTI rose above the green horizontal line.
Although the MTI has confirmed the probability of a bull market, it doesn’t preclude a correction. The S&P 500 still has the potential to revisit 3700 – 3800, if Treasury yields post new highs and Mega Cap stocks correct again. Once this correction is complete, the S&P 500 is expected to rally, after the next round of stimulus checks are received, to 4000 and potentially higher in the first half of 2021.
The primary 10 sectors for the S&P 500 with the Russell 2000 and Midcap included.
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