The Big Picture: Feb 22, 2017

We’ll start out today with a quick chart that says much about how these small pre-opening dips keep turning into nice gains on the day.  Note that VIX [see: VIX – Just Another Tool] is ramped higher most every night following the close.

This tends to produce small losses in equity futures (the thin purple line) which are easily propped up in the low-volume after-hours.  The losses are easily converted into gains the following day when VIX is inevitably hammered — even when it’s only to a higher low than the session before.For the past two months, VIX has made a series of lower highs and lower lows — forming a falling channel, the top of which is currently around 12.07.  The biggest drops each occurred when stocks faced overhead resistance or, as was the case on Feb 1 when VIX was hammered by 17% in a matter of minutes, to offset bearish news such as the FOMC rate announcement. Now, on to the big picture.  Aside from VIX, stocks are also being driven by CL and USDJPY.  Where are they going?  And, where will it ultimately drive equities?  Is downside risk a thing of the past?

We talk about oil almost every day, as it has been instrumental in goosing momentum-following algorithms on a daily basis.  As we discussed yesterday, CL’s biggest influence was a little over a year ago.

Oil had broken down below long-term support (the yellow arrow) and stocks — having rebounded sharply the previous October after Bullard’s QE4 bounce was a good possibility — were following it lower.

On Feb 11, 2016, with SPX at critical long-term support dating back to 2011, we reasoned that CL and USDJPY were bottoming out [see: USDJPY Finally Relents.]

USDJPY, along with CL and SPX, should bounce here.  If you’re a bull, they must bounce here.

Although it wouldn’t be obvious until a week or two later, this actually represented a passing of the baton from USDJPY to CL.  The yen carry trade needed a rest [see: The Yen Carry Trade Explained.]

Between 1998 and 2011, the USDJPY fell from 147 to 75.  From time to time, it rallied to help goose stocks.  Perhaps most notably, it broke out past resistance (the red TL) in 2007 to help propel SPX beyond its 2000 highs.

But, it wasn’t until the summer of 2011 that the yen carry trade really proved itself.  In May 2011, in the wake of the Fukushima disaster, SPX had reached the .786 Fib retracement of its drop from 1576 to 666 between Oct 2007 and Mar 2009.  SPX looked toppy to me, so I wrote my first post on May 2 [see: Charts for May 2] which, serendipitously, proved to be a significant top.

Over the following month, I realized SPX was following the same path it had taken during the 2007 top.  This analog [see: Analogs] called for a very significant selloff, potentially below the 2009 lows, which would begin in earnest on July 26 [see: Happy New Year!]

As it was, the correction was limited to 22% — a great short, but not as much as I had expected.  When SPX climbed back above resistance and the analog broke down, I started looking for reasons.  A number of events took place around year-end 2011 which influenced the outcome. But, none was as impactful as the resurrection of the yen carry trade.  It started out with USDJPY simply breaking out of a long, painful meltdown and spiking higher.But, this pattern would repeat itself at several critical points over the following four years.  In addition to busting the analog (purple arrow) that might have sent stocks much lower, it helped SPX break out past its .886 Fib at 1472 (red arrow), break out past its 1.272 Fib extension at 1823 (yellow arrow), and backtest that same 1823 level (white arrow.)The breakouts are shown in the USDJPY chart below with matching colored arrows.  The two labeled with question marks in late 2014 were special cases.  The first simply took USDJPY up past its .382 Fib and enabled it to break out of the falling gray channel from the 1998 high (see the weekly chart above.)  It enabled SPX to continue its breakout past the 1823, a Fib level at which it should have reversed.

The second was a little trickier.  Once an important reversal point is exceeded, a backtest is an effective means of announcing that it now constitutes support.  So, USDJPY leveled off in mid-September, dropping steadily until Oct 15, at which point it began screaming higher — gaining nearly 16% over the next six weeks.

Was it important for SPX to hold 1823?  The USDJPY chart says it was.  Of course, we could always ask Fed President Jim Bullard, who went on TV the following day to suggest that the taper should be paused and QE potentially expanded.  The video [click here] is worth a look.

Aside from the comments regarding QE, Bullard offered a wonderful non-answer answer when asked about inflation and the price of oil.  The discussion leading up to his comment had centered around declining inflation expectations, and what the Fed might do to offset the weakness emanating from Europe.

BB: A lot of people also point to oil prices.  You can’t really influence the direction of oil prices.

Bullard:  (pause) Uh…the inflation goal for the Fed is a headline inflation goal.  It means that we want to hit, on average, over a period of years, the headline inflation rate.  Uh, these are prices that people actually pay.  And, uh, so they’re important prices and people substitute out of goods that are more expensive and into goods that are cheaper. And, uh, that’s part of the way economics works…

In hindsight, I find this exchange particularly fascinating because:

(1) US inflation had recently ticked higher, not lower
(2) low inflation was the rationale for continuing accommodative monetary policies
(3) rising oil prices were a major cause of higher inflation
(4) Japan, with its plunging yen, was particularly hard hit by rising oil prices
(5) someone with a very big margin account did, in fact, influence oil prices

Note that US CPI had recently broken a TL from Sep 2011 (blue, dotted below) and had topped 2% — central bankers’ off-cited, Goldilocks-endorsed inflation bogey.

Rising oil prices, of course, were highly supportive of stocks dating back to SPX’s 2009 bottom.  In fact, oil’s failure to complete an obvious Head & Shoulder Pattern was a major factor in arresting SPX’s decline in October 2011.But, rising oil prices also contributed to inflation, which was rather inconvenient for central bankers around the world who justified ultra-accommodative monetary policy by complaining that inflation was too low.

As inconvenient as higher inflation was for the FOMC, it alarmed the BoJ.  By early 2014, when USDJPY reached the top of the falling gray channel and its .382 retracement, the yen had lost 40% of its value.  Oil was ratcheting higher in dollar terms, but was climbing rapidly in yen: up 192% from its 2009 lows.

The effect was exacerbated by the closure of Japan’s nuclear power plants in the wake of the Fukushima disaster.  Either the yen needed to stop depreciating, or oil prices needed to fall.  Central bankers knew what would happen if the trillions of dollars tied to the yen carry trade unraveled.  Oil had to fall.

The only way to offset the damage to stocks was for USDJPY to do something equally beneficial, such as break out of the falling channel it had been in since 1998.  And, that’s exactly what happened.  On Jul 29, CL broke down through the small, purple TL — the same day USDJPY broke out above the falling red TL.

On Aug 18, CL broke down through the white neckline/TL and began a 73% nosedive.  The following day, USDJPY broke out through the red TL and began a 20% spike higher.

The impact was almost immediate.  Oil’s breakdown, on the back of the FOMC officially ending QE, sent SPX 87 points lower — a modest 4.3% decline.  It might have gone ahead and backtested 1823 at that point.  But, USDJPY backtested its red TL and spiked higher.  Only after USDJPY took its early October breather was SPX’s backtest permitted to occur.

Bullard’s QE comments put an exclamation point on SPX’s backtest, and the BoJ’s surprise Halloween QQE expansion two weeks later sent USDJPY and SPX soaring to new highs.  The only problems:  USDJPY’s .618 Fib at 120.11 and SPX’s Fib 1.618 extension at 2138.

Since SPX didn’t so much as pause as it sped through the 1.272 at 1823, the 1.618 attracted a lot of attention.  It had been our next upside target after 1823 for several years.  And, USDJPY’s .618 at 120.11 was not only a key Fib level, but was a level at which Japan’s inflation seemed destined to be stuck at over 2%.

USDJPY reached 120.11 on Dec 4, 2014, and spent the next 14 months flitting back and forth, above the below that price.  When USDJPY fell back below it in Aug 2015, as forecast by another analog based on the yen [see: Our Analog Plays Out,] it marked the beginning of a very volatile six months.  It was a glorious time for short sellers.

Looking back, it’s clear that the BoJ was simply trying to buy time until oil reached an acceptable/defensible bottom.  But, as we discussed above, oil’s losses accelerated after the Aug 2014 breakdown, plunging from around 100 to only 44 in mid-January 2015.  It got a nice 35% bounce by May, where it sat, rangebound between 57-62 for two months — just long enough for SPX to reach 2134, before continuing its plunge.

I suspect this next leg down was a bit more than many expected.  But, as usual, there was a method to the madness.  SPX’s Aug 2015 plunge only reached 1867 — no man’s land from a harmonic standpoint.

When CL’s long-term channel broke down, SPX had permission to dip all the way to 1823 again.  If there’s one thing stronger than a backtest of a critical Fib level, it’s two backtests.  Or, maybe it’s the other way around.  Oil’s losses were accelerating, and TPTB realized they had to provide a floor or SPX would drop back through critical support  at 1823.

I’m not sure it really matters.  It was Feb 11, and SPX had dipped to 1810, and the bull market would be over if something wasn’t done to get it back above 1823.  As we surmised at the time [see: USDJPY Finally Relents], this marked a bottom for USDJPY and oil.

Oil doubled over the next 4 months, while USDJPY got a nice bounce before continuing lower — not really needed as, by that time, SPX was back within 14 points of its all-time highs.

Of course, the rally was almost undone by both Brexit and the US election.  But, massive spikes in USDJPY (both times) and a nonsensical rally in CL (the election) saw to it that the dips were quickly reversed.  The election reversal was the game changer, as USDJPY, CL and VIX all conspired to rescue stocks from the overnight selloff.  The reaction was so strong as to launch SPX to new all-time highs.

As we discussed above, there’s a cost associated with a cheaper yen and higher oil prices — especially for Japan.  The fact that USDJPY broke out of its falling red channel on Oct 4 led me to believe the yen carry trade would take over the ramping responsibilities while CL backed off its highs.

It especially made sense, given that oil had doubled since its Oct 11, 2016 lows.  The YoY comparison in fuel costs, even after the BLS massaged away much of the actual impact, would drive CPI to unacceptable levels.  Sure enough, the January CPI released on Feb 15 showed a 0.6% MoM increase and a 2.5% YoY increase.  February’s release should be even worse.

Was this what Janet Yellen was talking about when she suggested the economy would benefit from running a little hot for some time last October?  Or, should we believe her comments from last month when she said it would be unwise to allow the economy to run hot?

Either way, CPI is now well over 2% — the holy grail, the magical target that central bankers held dear all these years as the key to economic prosperity and the signal to take their very heavy feet off the gas.

The US dollar is 2% below its 14-year highs.  10-year treasuries have broached 2.5%.  And, stocks are partying like it’s 1999.  The talking heads call it the Trump Rally.  The fear that so many felt on election night was elected magically transformed into enthusiasm over the tax cuts and fiscal expansion that would soon be rolled out.

The clock is ticking for details on Trump’s “phenomenal” tax plan and his strategy for talking conservative Republicans into increasing the deficit.  Meanwhile, stocks keep ticking higher.  And, those of us who watch markets all day know that the real determinants of higher equity prices have been USDJPY, CL and VIX and the algos they drive.

I took the opportunity last week to capture a full day of movements in the three and how they are transformed into gains in ES and SPX.  As soon as the video is done processing, I’ll post it here — along with the rest of the current forecast.

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