Written by Jim Welsh
Macro Tides Weekly Technical Review 17 May 2021
In the April and May issues of Macro Tides I discussed all the reasons why headline CPI inflation was poised to jump:
“The increase in headline CPI inflation will exceed 3.0% and could approach 3.5% in the next few months and generate attention grabbing headlines.”
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On Wednesday May 12 the Bureau of Labor Statistics reported that the headline Consumer Price Index (CPI) for April soared 4.2% from a year ago. Base Effects played a big role but some of the comparisons were historic. While the increase in the headline CPI was eye opening, the increase in the Core CPI was stunning.
The 1 month increase in the Core CPI was 0.9% and the largest single month rise since 1981. One month does not make a trend but the Core CPI was up 3.0% from last year and the largest Y-O-Y gain since 1995 (yellow).
As discussed in the April Macro Tides gasoline prices are useful in explaining how Base Effects are going to function in the next few months:
“Gasoline prices are correlated with WTI. According to Gas Buddy, the average price for regular gasoline has risen to $2.86 a gallon as of March 29 from $1.74 in March 2020, an increase of 64%. The Bureau of Labor Statistics calculates the Consumer Price Index and gives gasoline a weighting of 3.36% within the CPI. Based on its weighting and the 64% increase in national gas prices, the headline CPI could be lifted by 2.1% just from the increase in gas prices. In July 2020 National gas prices had recovered to $2.20 a gallon, so gasoline’s contribution to the CPI will fall to about 1.0%, if gas prices hold near $2.86 a gallon through June.”
Since the end of March the average price for a gallon of regular gas has increased from $2.86 to $3.03 on May 13, 2021. If gas prices hold at the current level into July, the annual increase will be 37%, and would add 1.15% to the CPI in July.
The 4.2% jump in headline inflation was well above the 3.6% most economists had expected. The overshoot raises an interesting possibility. If the CPI for May comes in a bit lower than 4.2% (i.e. 3.8%) when it is released on June 10, the narrative that the pick-up in inflation is transitory would likely gain traction. The decline from 4.2% to 3.8% would allow Fed Chair Powell and the FOMC more wiggle room to hold to their narrative this bout of inflation will prove transitory.
Had the April CPI met expectations for a 3.6% increase and if May does come in at 3.8%, the psychological impact would be far different, even though the number (3.8%) is the same. In the first case headline inflation would be lower and reassuring, while inflation would still be climbing and worrisome in the second case.
Commodity prices have been on a tear and have strengthened the inflation narrative. Some commodity prices reversed lower last week, and would ease inflation concerns a bit if prices fall more in coming weeks. Lumber has almost become the poster child of soaring commodity prices and for good reason. In early 2020 lumber was trading near $400 and has since more than quadrupled. After reaching $1733 on May 10, lumber fell to $1327 on May 17 down -23.0% in a week.
Steel Rebar has doubled since October 2019 but also reversed lower last week. The Bloomberg Grain Index has rallied from 25.3 in January 2020 to over 43.00 in May. Since last December the cost of a bushel of corn has climbed by 75% rising from $4.20 to $7.35 on May 7, before dropping to $6.33 on May 17.
The price action in these commodities suggests they have either reached a short term high or will so soon. Merely going sideways for a few weeks will take some of the steam out of the commodity leg of the inflation story.
Investors want to believe Jay Powell and the FOMC will be right and the current surge in inflation will give way to lower inflation. The question is how long will it take for the data to definitively confirm the FOMC’s assessment. Ultimately, Powell and Company will be proven correct for reasons I have discussed previously and will review again in the June Macro Tides.
The problem for the Fed in the short term is that core inflation will gradually increase in coming months, even as headline inflation eases, but potentially less than expected. The unwinding of inflation pressures is going to take longer than the market’s level of patience, so there will be a period when it looks like inflation will not be transitory.
Gas prices aren’t the only item that will add less to the CPI in July but the offset may be less than expected if prices for services continue to climb in coming months as gas prices have since March.
Airfares popped 10% in April from March but are still down by 15% from February 2020. Airfares are likely to rise more as demand picks up significantly during the summer months as everyone goes somewhere. The airlines aren’t the only sector that is going to hike prices as demand increases. Most consumers will be less cost conscious than they were before the Pandemic changed their life. Staying overnight in a hotel or motel is going to cost more and so is eating out as restaurants raises prices to make up for lost revenue and higher food and labor costs. As consumers return to the shopping mall they will be paying more for just about everything since shipping costs have climbed sharply and inventory levels are low.
Vehicle inventories are 50% lower than normal and the supply of cars and trucks isn’t going to magically meet demand anytime soon. The computer chip shortage has hurt vehicle production and may last until sometime in the fourth quarter, which means new and used car prices are going to remain elevated for at least another 6 months. They won’t increase much more, but they aren’t going to drop much either. If lumber prices drop 50% from their recent peak to $850, they will still be up 100% from before the Pandemic. The demand for major appliances is going to fade in coming months but the price of a new washer, dryer, refrigerator, or dish washer isn’t going to decline much.
Headline CPI will gradually recede as prices stabilize for new and used vehicles, major appliances, and car rentals, but not drop significantly until new car supply appears and the Base Effect works in reverse in 2022. It is possible that headline inflation could be rising by less than 2.0% by mid next year. On the other hand, core inflation is set to persistently rise as service inflation ticks up and Owner’s Equivalent Rent reverts to its mean average of 2.8%.
Treasury Yields
Last week inflation as measured by the CPI and Producer Price Index (PPI) showed much more inflation than expected. Given the news it wouldn’t have been surprising if Treasury yields had moved above their March 30 highs. The fact that yields fell well short of the prior highs increases the potential discussed last week:
“It’s possible that Treasury yields have completed an a-b-c pattern from the 1.765% high to (to 1.471%) to complete Wave 4. Although Treasury yields could rise in a B-wave and then fall below the low on Friday (May 7), the odds are not high.”
The 10-year Treasury yield topped last week at 1.700%. The increase from 1.471% to 1.70% may be part or all of wave B. A decline in commodity prices would be supportive of keeping Treasury yields consolidating for a longer period. If the CPI for May is less than 4.2% when it is reported on June 10, Treasury yields could drop enough to test the May 7 low of 1.471% before the end of June.
The wake-up call could arrive when the June employment report is released on July 2 as it is likely to show a large increase in jobs. A strong jobs report will restart the debate about when the FOMC will discuss tapering their monthly purchases.
If Treasury yields are in the middle of a larger Wave 4 and yields test their May 7 lows, it will provide a great short. In the second half of this year the 10-year is expected surpass 2.0% and could reach 2.25%, before the FOMC intercedes with talk about Yield Curve Control (YCC) .
The decline in the 30-year Treasury yield from 2.505% on March 30 to 2.161% on May 7 could be wave a of an a-b-c pattern for Wave 4 from the peak in March 2020. The increase from 2.161% to the high last week of 2.417% would be wave b and be followed by a wave c drop to near or slightly below 2.161%. Once wave c of Wave 4 is complete, Wave 5 would begin. Before year end the 30-year Treasury yield is expected to climb to 2.85% and could jump to 3.15%.
If Treasury yields test the May 7 lows before the end of June, it may be setting up an opportunity to short Treasury bonds in anticipation of a big increase in yields in the second half of this year.
If Treasury bonds are tracing out an a-b-c pattern, TLT could be expected to rally above $142.00 during wave c of Wave 4. Longer term TLT has the potential to decline to $125.00 and potentially as low as $110.00.
Dollar
A decline in commodity prices helps keep any change to monetary policy at bay, which would also be a negative for the Dollar. In addition, the rate of vaccinations have ramped up in the EU and estimates for growth are being raised which should give the Euro a lift in the near term.
As noted previously the long term pattern in the Dollar suggests it should fall below the January 4 low of 89.21 before an important low is established. It’s possible the Dollar index could briefly dip below the February low of 88.25 as explained previously:
“The January 2017 high was 103.82 and was 102.99 at the March 2020 top. If the decline from the March 2020 high equals the January 2017 – February 2018 drop, the Dollar could bottom 0.83 below the February low of 88.25. This is why it’s possible for the Dollar to not only drop below the January 2020 low of 89.21 but also under the February 2018 low of 88.25, although it is not required.”
Gold
As noted last week:
“As long as Gold holds above $1797.00, a rally above $1900 is expected, with a test of $1950 possible.”
The low last week was $1809.80 on May 13 and Gold rallied to $1868.00 on May 17.
Silver
As discussed last week:
“As long as Silver holds above $25.80, Silver could test $30.00 in the summer as inflation concerns intensify.”
Silver dropped to $27.22 on May 13 and hit $28.24 on May 17, and just below the January 23 high of $28.26. A close above the September 1, 2020 high of $28.88 should be followed by a test of the February 1 high of $29.79. A close above $30.00 could lead to a rally to $33.00 – $36.00.
After buying the initial 50% in the Gold ETF IAU at $17.23 on February 23 and the second 50% position at $16.09, the cost basis is $16.66. Traders were instructed to sell half of the position at $17.60. IAU opened at $17.62 on May 17, for a gain of 5.75%. Raise the stop to $17.31. Traders took a 50% position in the Silver ETF (SLV) when SLV dropped to $23.25 on March 23, and were instructed to sell half of the position at $25.80. SLV traded up to $25.87 on May 10 for a gain of 11.0%. Raise the stop to $24.92.
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. Two weeks ago traders were advised to add 33% to the GDX position on a pullback to $32.75. GDX fell below $32.75 on March 23, so the cost basis became $31.94. The stop of $34.70 was hit on April 29 as end of month selling caused GDX to weaken more than expected. The trade gained 8.6%.
A rally to $37.50 was expected and GDX reached $38.22 on May 10. Traders were instructed to sell half at $38.25 (if you still own GDX). On May 17 GDX opened at $38.27 and up 19.8% from the average purchase price. Use $36.43 as a stop.
Stocks
As noted in the May 3 WTR:
“The shallowness of the recent pullback suggests that the S&P 500 will complete 5 waves up from the March 4 low by rallying above 4219 before a more significant top forms.”
The S&P 500 traded above 4220 on May 7 and reached 4238. After some early strength on May 10, the S&P 500 reversed and closed at 4188 as selling in the Mega Cap stocks pulled it down.
In the May 10 WTR, more weakness was expected if the S&P 500 closed below 4118:
“A Close below 4118 would likely lead to additional selling and a drop to the blue trend line near 4030.”
On May 11 the S&P 500 fell to 4111 before closing at 4152, only to plunge to 4057 on May 12.
The Daily Indicator measures market breadth by comparing the 5 day and 21 day moving averages of net advances minus declines, hew highs minus new lows, and up volume less down volume. When it has dropped to -40.00 for the NYSE (See arrows) the S&P 500 has posted at least a short term trading low. On May 12 the Daily Indicator fell to -60.9 underscoring just how oversold the market had become. The rally on last Thursday and Friday worked off the oversold condition as the Daily Indicator was +6.6 on Friday. Today’s pullback was a modest retracement of the sharp gains recorded at the end of last week.
The NYSE Advance – Decline reached a new high before the recent correction which suggests the S&P 500 is likely to rally to another new high before the end of June. The stock market would get some support from the bond market if Treasury yields don’t exceed their March 30 highs, and even more support if yields fall.
As long as the Nasdaq 100 doesn’t close below 316.00 (last week’s low), the Nasdaq 100 could also rally to a new high. However, the continued weakness in the Nasdaq Advance – Decline line suggests that a larger decline is coming. If Treasury yields rise as expected in the second of half of this year, the Mega Cap growth caps would likely come under selling pressure.
If it looks like a tax increase will become a reality, Mega Cap stocks could experience additional selling pressure. The Mega Cap stocks comprise almost 50% of the Nasdaq 100 (QQQ) and continue to lag behind the S&P 500 as measured by the QQQ’s relative strength. This is not a good sign longer term, but doesn’t preclude a rally that posts a modest new high.
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, 2020 as the S&P 500 closed at 2800. A new bull market was confirmed on June 4, 2020 when the WTI rose above the green horizontal line.
The S&P 500 was expected to push to a new high above 4220 and it did. We will have to wait for the NYSE Advance – Decline to show more weakness and for the S&P 500 to fall below last week’s low of 4057, before getting more cautious. Until then the trend is higher until Treasury yields reverse higher and the Dollar bottoms
The primary 10 sectors for the S&P 500 with the Russell 2000 and Midcap included.
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