The great thing about low inflation is that central bankers can continue accommodative monetary policy without too much criticism.  Stocks love easy money. The crummy thing about low inflation is that it makes it that much tougher to prop up the US dollar.  For some reason, investors just don’t believe the FOMC will keep hiking rates while prices are falling.  Investors are funny that way.

A lower USD, of course, means a lower USDJPY.  Stocks don’t like a falling USDJPY — which has, again, dropped through its SMA200.For its part, DXY has spent over a week bumping along an important channel line, and is testing it again today.  With USDJPY struggling, the onus has been on VIX, CL and RB to help prop up stocks.

VIX did it’s best yesterday, with a dramatic turnaround at its SMA200 as expected.  But, the charts suggest it could be pushing 14 by next Wednesday.

RB is trying to rally, but the last two inventory reports argue for lower prices, not higher.  And CL…well, it’s the key, isn’t it?  As we discussed earlier this week, it’s one sure way to get PPI/CPI up to where it needs to be.  That’s important, because the Fed’s inflation problem is morphing into a credibility problem.

If inflation were measured accurately and not gamed the way it has been for years, there would be no credibility problem at all.  Between healthcare, gas and housing, true inflation is closer to either 6% or 10% (Shadowstats.com.)  Of course, if the Fed ever acknowledged this, higher interest rates and cost of living increases would increase the deficit and debt to untenable levels.So, instead, we live in a world where average Americans are increasingly unable to make ends meet, where their income can’t keep up with the bills despite what the official data says.  The savings rate is dropping just as fast as consumer credit is rising.At what point will oil’s rally and the dollar’s drop run out of steam?  If the past is any indication, we have two specific patterns with which to concern ourselves.

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It’s one thing when the Fed hits the pause button.  It’s quite another when China, holder of $3.1 trillion in foreign-exchange reserves, hints that they might be a little overinvested.  Bloomberg reports that China is reconsidering its commitment to funding the US debt addiction.

And, that has stock and bond futures searching for a new equilibrium.  For starters, USDJPY plunged to our next downside target overnight.ES came within 9 points of our downside target for it.  And, EURUSD’s slide was halted at a backtest as we discussed yesterday.  DXY is clinging stubbornly to the channel bottom reached last week.  But, it remains to be seen whether or not it’ll hold.

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The BoJ tapered its bond purchases just a bit yesterday, sending the USDJPY marginally lower on the news.  The fact that it would taper at all was a bit surprising, but it appears the falling white channel will remain intact long enough for our next downside target to be tagged.The big question: will the trend continue or are they just buying a little time for EURUSD to backtest?

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I can’t begin to count the number of times I’ve written about the manipulation of VIX futures over the past several years.  With 80% of daily equity volume tied to algorithmic inputs, it’s one of several powerful methods by which equity markets are propped up.

My comments have drawn a fair amount of scorn over the years, particularly from those who reject the idea that central bankers are involved in propping up equity prices.  That scorn waned over the past year, however, as it became increasingly obvious that VIX was under more pressure than market forces alone would generate.

A favorite graph of mine depicts the large channel that has guided VIX gradually higher since Mar 2009 — the depths of the Great Financial Crisis.  VIX tagged it roughly once a year (the yellow arrows) until December 2016.  Since then, VIX has tagged or dropped below it about 75% of the time.The reasons are perfectly clear.  Having plunged 12.5% and 14.5% in two severe corrections in 2015 and early 2016, SPX had attempted a breakout in July 2016.  The breakout failed, however, and SPX fell back below support (the neckline of a IH&S Pattern) as the US election approached.

When Trump was announced the winner, equity futures plummeted 4.5%. Central banks panicked, and took decisive action.  USDJPY, which had oringally plunged on the news, suddenly spiked higher — on its way to a 20% gain over the next month.  VIX, which had spiked on the news, suddenly began to sell off — even while equity futures were plummeting.  This was the equivalent of cancelling ones homeowner’s insurance as a tornado comes into view.

By the time the market opened the following morning, futures were back in the green.  SPX actually booked a gain.  It was a gutsy move, but it worked.  It worked so well, in fact, that it continues to this day.  Moves above VIX’s channel bottom continue to be a rarity and have been largely responsible for the last 32% of gains in SPX.

Who, in their right mind, was ballsy enough to short VIX in the midst of a 4.5% flash crash?  Who changed the course/cost of volatility protection, resulting in new all-time lows?  Who continues to hammer VIX every time stocks threaten to dip more than the allowed amount?  Once the musing of tin-foil-hatted conspiracy theorists, we now have confirmation from incoming Fed Chair Jerome Powell.

Excerpted from the transcripts of the FOMC meeting, Oct 23-24, 2012.

MR. POWELL.

I have concerns about more purchases. As others have pointed out, the dealer community is now assuming close to a $4 trillion balance sheet and purchases through the first quarter of 2014. I admit that is a much stronger reaction than I anticipated, and I am uncomfortable with it for a couple of reasons.

First, the question, why stop at $4 trillion? The market in most cases will cheer us for doing more. It will never be enough for the market. Our models will always tell us that we are helping the economy, and I will probably always feel that those benefits are overestimated. And we will be able to tell ourselves that market function is not impaired and that inflation expectations are under control. What is to stop us, other than much faster economic growth, which it is probably not in our power to produce?

Second, I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so. Meanwhile, we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy.

My third concern—and others have touched on it as well—is the problems of exiting from a near $4 trillion balance sheet. We’ve got a set of principles from June 2011 and have done some work since then, but it just seems to me that we seem to be way too confident that exit can be managed smoothly. Markets can be much more dynamic than we appear to think.

Take selling—we are talking about selling all of these mortgage-backed securities. Right now, we are buying the market, effectively, and private capital will begin to leave that activity and find something else to do. So when it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response.

So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month.

Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position. When you turn and say to the market, “I’ve got $1.2 trillion of these things,” it’s not just $20 billion a month— it’s the sight of the whole thing coming. And I think there is a pretty good chance that you could have quite a dynamic response in the market. And I would just say I want to understand that a lot better in the intermeeting period and leave it at that. Thank you very much, Mr. Chairman.

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The term “overhead resistance” refers to a price level that should be difficult to rise above.  When I wrote my first post back on May 2, 2011, it was to note that trend lines and Fibonacci patterns indicated an approaching top that might be difficult for SPX to overcome.  As it turned out, May 2 was the top, and we saw a substantial correction of 21.6% that was touched off by a beautiful shorting opportunity that fulfilled an analog forecasting the drop to the very day and dollar [see: Analogs.]

We’ve had many additional shorting opportunities over the years where overhead resistance proved potent enough to provide substantial shorting opportunities.  In April 2012 we were rewarded with an 11% short after a Butterfly Pattern completed [see: All the Pretty Butterflies.]  A few months later, in September, we nailed up a 9% correction courtesy of another important Fib level [see: The World According to Ben.]Another fun one was in May 2015, when SPX came within 4 points of our long held upside target at the 1.618 Fib extension at 2138 [see: The Last Big Butterfly.] This one was worth a healthy 12.5%.It was followed by a 14.5% correction in November when the rebound completed a Bat Pattern [see: Beware the Bat.]There have been countless other levels of overhead resistance that: (1) provided meaningful opportunities for traders to short; and/or, (2) warned of substantial declines for buy-and-hold types.

At times, however, important overhead resistance has simply melted away.  The 1.272 extension at SPX 1823 was an important Fibonacci level that should have smacked stocks for a minimum of 13.5% in late December 2013.

Instead, SPX virtually ignored it until after the fact — when it was backtested an astounding seven times over the next two years.  It was irrelevant as resistance, but incredibly important as support.

Once SPX broke through the 1.618 extension at 2138, it’s been off to the races.  The next important Fib level is the 2.24 extension, which is 2703 for SPX and 2728 for ES.  As we’ve been discussed the past few days, we’re there.It required a bit of gymnastics (and, loads of help from the algos) but SPX gapped up through its 2.24 on Wednesday and ES tagged its just yesterday.  Both moves required a resurrection of broken down channels.  And, both have left us wondering whether or not there’s any integrity at all left in the “markets.”Overhead resistance is still relevant.  But, it has increasingly become a test of the extent of the manipulation being exerted.  There is little that can’t be accomplished with well-timed ramp jobs in USDJPY or oil or a severe smackdown in VIX — particularly against a backdrop of record setting stock buybacks and central bank accommodation that continues a full ten years after the crisis.  When we see SPX gap through important resistance like this, we have to wonder whether market integrity has reached its own overhead resistance — whether it has failed its moment of truth.

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I wanted to title today’s post “Snow Job” in honor of yesterday’s FOMC minutes.  But, it felt a little snarky, even for me.  If you haven’t read the minutes, here’s a quick synopsis:

We don’t understand why inflation’s not at 2% yet, but we’re going to continue to raise rates anyway. We will continue to raise rates until we decide not to. The economy might get a bump from the tax legislation. But, odds are the corporate tax savings will go toward M&A and more stock buybacks [bigger bubbles!]

Stocks might have been buoyed by the comments, but the real story was the latest collapse in VIX (-19.4% since Tuesday night) — a collapse which has come in handy as DXY’s FOMC minutes rally lasted all of 30 seconds. It’s now continuing its slump toward our next downside target.

As we’ve discussed, the big question is whether it can catch support here at a key channel line and Fib level. The answer lies with the S&P 500 futures.While SPX reached and shot through its 2.24 extension (of the drop from 1576 to 666 between 2007 and 2009), ES is till 7 points away (2728.79.) If TPTB pull out all the algo igniting stops today like they did yesterday, we’ll see it leapfrog through 2728 and usher in another few months of melt-up.

If, on the other hand, ES reverses off the overhead resistance, it’ll be because USDJPY, CL and RB stop ramping and VIX is allowed to bounce up to where it belongs at 16.12.  Which will it be?

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An increase in short-term interest rates is traditionally viewed as bullish for the dollar. Yet, take a look at FOMC rate hikes over the past year.  Each was followed by a strong decline in the dollar index (DXY.)  When the FOMC declined to raise rates, on the other hand, DXY usually rallied — at least temporarily.

The FOMC made no secret of their plans to raise the discount rate.  So, naturally, we can surmise that front-running played an important role in the price action.  But, does it explain the continuing slump that, so far, has nailed each of our downside targets without fail?

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There’s a disconnect between the reported and the true inflation rate.  We’ve touched on this many times over the past year.  And, I think this is key.  The FOMC is well aware of the actual issues — rent, health care and fuel/gas prices.  Gold investors/speculators are aware, too — as witnessed by its recent surge.

So, despite the fact that CPI and PCE perennially report inflation to be under control, it’s not.  The FOMC gnashes its teeth over the failure for PCE to reach 2%…but, maybe to justify continued dovish monetary policy.

The real objective can be seen in the relationship between DXY and SPX.And, as we discussed last week, the problem lies in the chart below.  With TNX about to break out, we can expect continued weakness in DXY.  Needless to say, this will present difficulties for the yen carry trade crowd and, ultimately, equities.As SPX approaches its next key Fib level, and a backtest of the recently broken white channel, I suspect the dollar’s slide isn’t over — with our targets at 88.423-88.682 the next major support when it breaks below September’s lows.The 2.24 extension has been hanging out there ever since SPX broke through the 1.618 in the wake of the US election — when the full court press involving USDJPY, CL and VIX manufactured (for the first time ever) 12 consecutive months of positive gains.If it pushes through the 2.24, the next Fib resistance isn’t until the 2.618 at 3047.34 — only 12.6% higher than current levels.  If it can’t, then the first real support is the bottom of the gray channel, currently around 2588.

And, if that fails, then the SMA100 is currently around 2560 and the SMA200 is around 2485.  Neither of them currently lines up with any significant chart patterns, so it’s difficult to feel very confident about those downside cases in the near term.  But, the MAs are on the rise, so we’ll reevaluate in a few weeks.I’d feel much more confident if DXY would continue dropping, taking the USDJPY with it, and CL and RB would stop rallying to support the equity regime.

GLTA.

ES’ latest rising channel broke down rather decisively on Friday.  ES closed well below its SMA10 and almost tagged its SMA20 — a feat it hasn’t accomplished since Nov 20.This morning, the futures have pushed back above the SMA10, hinting at a full recovery.  Yet, as we’ve discussed, there are several factors that might prove problematic for the bulls.

First and foremost, it’s a New Year.  With a 20% gain in the bag for 2017, might we see stocks at least pause to catch their breath?  If nothing else, it might alleviate some of the incredulity surrounding 2017’s record-breaking ascent.

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The spread between the 10-yr and 2-yr has now narrowed to 50 bps — the same level it was when stocks peaked in October 2007.  Many take this as a harbinger of financial disaster. Is it?

Flat or inverted yield curves typically signal a recession.  And, it’s hard to argue the point.  Investors would have to be pretty pessimistic if they’d rather tie up their money for 10 years at a rate lower than shorter-term instruments offer.

The yield curve inverted just before the recessions of 1981, 1991 and 2000.  And, it inverted about two years before the 2007-2009 GFC.  But, as the chart below shows, inversions and market peaks haven’t always lined up that well.

In 1998, a brief inversion occurred about two months prior to the 22% correction.  In 2000, we saw the same two month lead time but this time the inversion lasted 11 months and stocks plunged by over 50%.The curve inverted again beginning in late 2005 and bounced around for quite a while before going positive in May 2007.  Five months later, as the curve was rapidly steepening, the S&P 500 peaked and began a 57% crash.

The other significant selloffs since then — Apr-Jun 2010, May-Oct 2011, and May 2015-Feb 2016 — have occurred with positive curves that were either in the midst of flattening or about to flatten sharply.

The current levels are, indeed, equal to those at about the same time as the market peaking in Oct 2007.  But, in 2007 the curve was rapidly steepening.  Today, it is (not quite as) rapidly flattening.  I’ve highlighted a similar move in 2005 (from 1.34 to .57) for comparison purposes.

Note that in 2005 the rate of change was even greater that it has been this past year.  But, it still took another 8 months to invert and another 22 months for stocks to peak.

While admittedly a very simplistic exercise, I believe the above shows that while the potential is there for a recession, this is just an early warning at this time.  If the yield curve bottoms out here and rapidly steepens, we’ll have a lot more to worry about.

Stay tuned.

As we expected [see: Dollar Duldrums] the US dollar has continued to slide.  Today’s price action threatens to take out the November 27 low and reach our 91.483 target.

Today, we’ll update some key currency pairs and see if we can make sense of the bond market.

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