Saturday, September 13, 2014

A return to normalcy? & Scottish referendum

Over the past few weeks traditional inter market relationships have dominated the financial markets and even stocks, in desperate need of a rest, are grudgingly starting to succumb to the pressure of a surging US Dollar.

As a student of inter market relationships I get excited when markets validate these relationships in such a strong way.  Markets have been confusing for much of 2014 as these relationships have been skewed but as these historical inter relationships once again "kick in" it allows us to draw more definite and convicted opinions regarding market direction.

We'll start by looking at stocks as represented on the daily chart of the S&P 500 SPDRs ETF (SPY):

(click on chart for larger image)

There are a number of points to take away from the chart.  First, we had some selling pressure on Tuesday and Friday but secondly, I have pointed out on this "candlestick" chart (blue arrows) where there are tails or wicks on each daily candlestick. This denotes consistent "nibbling" (buying) by market participants going into the close of business every day.  The bulls aren't giving up!  The "buy the dip" mentality is very strong!  Thirdly, we are still butting up against all time highs in the S&P.  Nevertheless, momentum is waning as can be seen in the MACD momentum indicator (second panel on top) and KST indicator (bottom panel) where the indicator is ready to cross over it's red signal line.

Although there has been some deterioration in market breadth it is hardly anything to be concerned with at this point.  We're seeing some short term weakness that might suggest further consolidation or even some type of correction but there is nothing frightening going on.  The chart below is a daily chart of the S&P 500 with measures of advancing and declining stocks in the index.  There is some deteriorating breadth as reflected in the first two lower panels but the advance/decline and more importantly advance/decline volume lines are in strong up trends:

(click on chart for larger image)

As stated in my opening comments, all markets have been moving in lockstep to traditional inter market relationships as the US Dollar has surged leaving in its path the litter of falling commodity prices. 

 As a primer for some of my readers, the cost of commodities drop when there is a strengthening dollar because you don't need as many dollars to buy the same commodity as before.  And since the US Dollar is still universally and formally recognized as the world's reserve currency, this impacts prices globally. 

 Here's a daily chart of the popularly traded proxy for the US Dollar, the Powershares DB US Dollar ETF (UUP):

(click on chart for larger image)

The dollar has absolutely exploded and has gapped higher twice in the past two weeks.  The chart has characteristics of a "blow off" top and I identified a possible "island reversal" pattern which is bearish on Twitter on Monday.  However, it's pretty clear from the chart that the dollar is just consolidating before another attempt higher.

With the European Central Bank (ECB) committed to expanding its balance sheet by another trillion euros and the Bank of Japan (BoJ) on an enormous campaign to devalue their currency in order to win a two decade war with deflation, it is no wonder that, with formal QE (quantitative easing) ending in the US and the inevitability of higher short term interest rates, global money flows are being directed to the dollar.  The following chart is a ratio chart of the three day exponential moving average of the US dollar compared to the other major foreign currencies:  

(click on chart for larger image)

When might the Dollar rally stop?  I'll have some answers in my analysis below.

The Dollar continues to rally because short term rates are moving higher as can be seen in the Two Year Treasury Note yield below:

(click on chart for larger image)

This price action and attendant increase in yields as the market prices in the inevitable move by the Federal Reserve to raise short term rates has been flattening the yield curve as the gap between the Two Year yield and Ten Year yield is compressing (see chart below).  In "normal" economic times this compression is healthy for the economy and stocks.  But is it now?  I'll have some answers in my commentary below:

(click on chart for larger image)

The impact across the entire US Treasury yield curve is becoming more apparent as the long end ( ten plus year duration US debt) is selling off.  The chart below is a daily chart of the iShares Barclays 20+ Year Treasury Bond ETF (TLT) which many traders use as a proxy for the long end of the Treasury yield curve:  

(click on chart for larger image)

I identified an "island reversal" pattern (black circle) on Twitter two weeks ago and right now TLT ended the week resting on Fibonacci support.  The momentum indicators suggest more downside.  Another indication that the selling in Treasuries is not over was the price action in the Dow Jones Utility Average ($UTIL) on Friday.  Utilities are interest sensitive stocks that often move inversely to the direction of short term interest rates.  As seen in the chart below, the utilities had an inordinate move lower to the rest of the market on Friday which isn't a good harbinger for bonds in the short to intermediate term:

(click on chart for larger image)

And so, true to inter market relationships that have persisted in different magnitudes for the better part of sixty plus years and specially since the Asian Currency Crisis of 1997, Gold is taking a drubbing as seen in the chart below.  Even the gold miners (bottom chart) are signaling more downside as they are often a predictor of the yellow metal's price direction:

(click on chart for larger image)

Oil is also taking a beating as West Texas Intermediate Crude and Brent Crude take a nose dive.  See below:

(click on chart for larger image)

Even "stodgy" basic materials as measured by the Dow Jones World Basic Materials index have broken through a major uptrend line on the weekly chart below:

(click on chart for larger image)

And industrial metals have also been impacted by the Dollar's meteoric rise.  Below is a weekly chart of the Dow Jones UBS Industrial Metals Index ($DJAIN).  The index had a big "down" week:

(click on chart for larger image)


There are many moving parts to this commentary so let me start this analysis by identifying the traditional inter market relationships that have persisted for decades.  Some of these relationships have persisted in different magnitudes since the end of World War II.

Generally speaking, the US Dollar moves inversely to all commodities and gold.

Generally speaking, prior to 1997, a strong currency was reflective of the economic strength of the country which issued the currency and the impact on stocks was generally a positive one.

Generally speaking, between 1997 and 2008, an inverse correlation between stocks and the Dollar persisted due to the effects of "risk aversion".

Since 2008, there has been a very strong inverse correlation of the US Dollar and Treasuries to stocks and commodities because of pronounced "risk aversion".

Now that the parameters have been set, it's been my thesis (and that of others) that a return to "normalcy" after the momentous and near catastrophic events of 2008 would be signaled by the return to pre 1997 inter market relationships.  

The inverse correlation of the US Dollar to commodities will always stay the same but what of the Dollar to stocks and Treasuries?

Well, we're starting to see the breakdown of the positive relationship of the Dollar and Treasuries.  In the past, because of the two significant market downturns we experienced (2000 and 2008), Treasuries especially and then the Dollar benefited from global flight to the "safe haven" of Uncle Sam's debt.  It can also be said that gold benefited from this "flight to safety" but I see gold's rally in the first decade of this century as more of a reaction to the Greenspan Fed's efforts to inflate away the crash with low interest rates with the anticipation of inflationary pressures which never materialized.

This breakdown of the positive correlation between treasuries and the Dollar is a healthy development if it persists.  It signifies a lessening among global market participants of fear and the constant need to be hyper vigilant regarding "risk aversion".  

Since 2008, the inverse correlation between the US Dollar and equities has been just about absolute.  A move in the US Dollar such as we had in the past two weeks would have been met as late as mid 2012 with significant selling of stocks.  But we are seeing a resilient stock market (so far) in the face of a strong dollar and incrementally rising interest rates.  This too, is a healthy development.

If we continue to see a rising equity market in the face of a strengthening dollar and rising interest rates we will be able to say that the distortions created by central bank interventions of the past five years are working themselves out and we are returning to "normalcy".

As far as the Dollar rally goes, it's been a function of a greatly depreciated Euro, Yen and to a lesser extent the British Pound.  With Mario Draghi's (President of the European Central Bank) announcement about a week ago that the ECB intends to expand it's balance sheet by a trillion Euros, the Euro which is about 57% of the Dollar index, has nosedived.  The Japanese Yen (about 13% of the index), continues to tumble as the Bank of Japan continues with their historic quantitative easing which actually proportionally dwarfs our and the European's QE.  The British pound (about 12% of the index) has weakened considerably because of all the "noise" over the Scottish referendum on independence.  The Canadian Dollar (about 9% of the index) has weakened because it is a commodity based currency and commodities are currently sliding because of Dollar strength.

Make no mistake, the Dollar's strength still speaks to global deflationary pressures, especially in the Eurozone.  But even here, there may be light at the end of the tunnel.  I had the opportunity last week to interact on the internet with Marc Chandler, chief currency strategist with Brown Brothers, Harriman in New York, over my concerns that the European Central Bank (ECB) was not doing enough to stimulate Europe out of deflation.  Marc is a gracious guy and his comments are always informative and "spot on".  Excluding the comments about ABS (Asset Backed Securities) which I would not expect most of my readers to understand, I highlighted the comments that most struck me in his response:

 "I think euro zone inflation is near bottom. I think that there has been further convergence in borrowing rates between core (Germany) and periphery (Spain and Italy). I think ABS/covered bond purchases will expand the ECB balance sheet and need to be understood in the context of TLTROs and negative deposit rates. The divergence between its monetary policy and US will push euro lower still and that will also help boost inflation and on the margins stimulate growth. Does it address all that ails the euro area, no. Will it make thing better or worse? I say better, but difficult to quantify, especially as details of ABS not known. Hope this helps spur yours and others thinking."

So, the question becomes, will there be any break to the Dollar's rise?  I think the answer can be found in the Euro.  With Draghi's intent on driving the European currency lower to spur exports and growth here's where I see possible bounces in the Euro:

(click on chart for larger image)

There is some support in the 128-127 area but I see the possibility of the Euro testing 120.  

With the Scottish referendum on Thursday, 9/18 we may see a Dollar correction as I am expecting a "no" vote to prevail concerning Scottish independence.  The Pound took a beating after a YouGov poll last weekend indicated that the "yes" vote may dominate on Thursday.  However, I expect saner minds to prevail among the voting populace as all the major banks have indicated that if Scotland votes for independence they will be moving their offices to London and becoming British banks.  Additionally, Shetland and the Orkney Islands have indicated they would probably stay with the UK.  This development would take away any economic clout Scotland would have as all that oil in the North Sea would stay under the British crown.  Thirdly, an independent Scotland would not have an easy time being admitted to the European Union for a variety of political and financial reasons and they desperately need admittance to remain economically viable in a world of growing global economic blocs.

A rally in the British Pound would spill over to the Euro which would be the catalyst for a Dollar correction.

Finally, there may be some longer term concerns regarding the market but I've said enough already in this commentary so I'll save those concerns for future "musings".  I'll leave my readers with one more chart that I find fascinating and I'm developing a thesis around:

(click on chart for larger image)

The Shanghai Composite has been surging recently and I overlaid the US Dollar price action (thick black line) over it.  I find it fascinating that the dollar has been positively correlated to the Shanghai since May and has been moving in lockstep with Chinese stocks since July.  What's my take away?  

So far, I'm thinking that the positive correlation can be attributed to the world's two largest economies recovering in lockstep and the mutually beneficial aspects to both economies of stronger Chinese growth as they transition to a consumer based economy.   Add to this the irrefutable fact that the US economy continues to grow slowly but with a more solid foundation under it with every passing day.  The Chinese Renminbi has also been weakening against the Dollar since the early part of the year which could also be impacting the relationship.

Admittedly, my thesis is incomplete and ignores certain relationships that would hurt Chinese exports.  But I'm watching the chart and will be thinking through my thesis in the coming weeks.  Stay tuned!  

Have a great week!

The statements, opinions and projections made in this writing are for informational purposes and are my own.  They do not represent the views of my broker/dealer.  Additionally, this writing does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by me in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction

The information contained in this writing should not be construed as financial or investment advice on any subject matter. This writing is not published for the purpose of utilizing the information for short term trading or long term investing in stocks, bonds, ETFs, mutual funds,currencies, indexes, index or stock options, LEAPS, and stock or commodity futures. I expressly disclaim all liability in respect to actions taken based on any or all of the information on this writing.  Seek the personal, face to face guidance of a registered investment advisor before entering any trade or investment.  Anyone who trades or invests based on the information in this commentary does so at his/her own risk.  

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