DXY reached our next downside target this morning as it continued to weaken relative to the euro and, intermittently, against the yen. Whether or not DXY holds these levels is critical to bonds, oil and gas and, by extension, equities.  We’ve been bearish on DXY ever since a long-term TL broke down last April (over 8% ago.)

But, the path has been incredibly erratic, and the effects have been all over the map.  As evidenced by USDJPY and VIX, the algos are struggling with the implications of a breakdown.I’ll pick up where I left off yesterday, with a discussion of two past patterns with potentially important bearing on the path forward: an analog.

continued for members…

First, a couple of charts regarding this morning’s action…VIX is looking somewhat indecisive.  It dipped below the latest paper tiger TL to help boost futures prior to the open.

But, it then rallied up through the TL as the inflation and FB and bank news hit.  If stocks stall, or simply don’t  advance fast enough, we’ll watch to see whether it dives below the TL or continues climbing.  ES dumped all its gains on the morning news, but only enough to backtest the rising red channel midline.  This midline needs to break down in order for any of our downside equity targets to have a chance. USDJPY has broken below the important SMA200.  Our next downside target is 110.14-110.55, followed by 109.48.  And, EURUSD continues to breakout with a new high on its way to our upside targets of 1.2404 and 1.2597.  Be aware that if DXY bounces decisively before reaching 91.011, EURUSD could run out of steam at the .786 channel line at 1.2225. The latest RB chart – clinging to a TL of support from Dec 13… And, CL has run into a potentially important channel line at 64.22.

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OK, back to the big picture we were looking at yesterday.

First, without RB and CL putting in strong YoY increases, CPI has little chance of reaching 2%.  When RB and CL tank, CPI does too.  The only time CPI has been able to stay relatively close to 2% was when RB and CL were oscillating in a gradual uptrend.

The correlation is pretty clear; but, it’s important to remember that CPI is a rate of change.  So, if oil and gas prices remain level, they’re not contributing to a positive rate of change.  In fact, if oil and gas prices don’t increase, CPI typically falls.But, the impact has evolved over the years.  The chart below compares annual rates of CPI calculated each month with WTI prices.  Note how the two diverged quite markedly in 2015.  I chalk this up to:

(a) other components of CPI such as rent and healthcare;
(b) the gaming of CPI data (happens frequently, lately)
(c) the effort to keep stocks rising

I believe this last reason is where the rubber meets the road.
Note that CPI rose back above 2% in early 2011.  CL was in the middle of a big uptrend, and it finally started pushing CPI to levels that were not in keeping with the Fed’s “we need more inflation” meme.  If the Fed were no longer able to claim that inflation was too low, it would be tough to justify easy money – low interest rates and QE.

But, low interest rates and QE were critical to stocks’ recovery.  So, oil prices had to stop rising.  And, in 2014, when CPI was making higher lows and higher highs, it was time to crash oil.

As we’ve discussed, there was another important aspect to this decision.  The yen had spiked higher during the GFC (USDJPY had plunged.) The final straw was the Fukushima disaster, which led to all of Japan’s nuclear plants being shuttered.  The yen carry trade was resurrected and the USDJPY started soaring.

This meant the yen was dropping sharply in value — a problem when you have to import oil priced in dollars for virtually all of your energy needs.  For a while, oil prices ratcheted higher with USDJPY.

But, there came a point when inflation was becoming an inconvenient problem for Bank of Japan — whose QQE dwarfed the Fed’s on a relative basis.  As with US CPI, it came in handy that oil happened to plunge in value exactly at the same time that USDJPY needed to break out.The CBs knew it would work because it had been used before – albeit in more urgent circumstances.  Oil rallied sharply as the GFC began to bite in 2008.  But, headline inflation became a problem.  How could they justify all that easy money with inflation at 4%?Plus, the economy really was contracting.  It probably didn’t take that much effort for TPTB to crash oil prices.  CL peaked in July 2008, when CPI also peaked (5.6%.)   CL crashed 77% by Jan 2009 — at which point CPI had dropped to 0.03%.  Imagine the mess CBs would have faced with a contracting economy in the midst of 5-6% inflation!

We know the rest of the story: USDJPY rallied sharply, propping up stocks, while inflation fell to a reasonable level and remained largely under control — frequently dropping low enough to justify continued easy money ad infinitum.

Oil and USDJPY are typically highly negatively correlated.  But, between Oct 2011 and July 2014, they marched largely in lockstep.

Remember, a higher USDJPY means a weaker yen and more expensive energy. The USDJPY needed to break out in order to keep the yen carry trade alive.  But, that would have created a problem.

Inflation was already pushing 4%.  If the yen weakened even more, inflation would have been much higher — unless oil prices came down.

Obviously, high oil prices were a problem — particularly when measured in yen.DXY obviously broke out, too.  The rise was dramatic.  Having broken out of a sharply dropping channel, DXY traced out a sharply rising channel (purple) within a moderately rising channel (white.)The reasons most commonly touted at the time were that the economy was strengthening and that the Fed would start to normalize rates.  But, as the chart below shows, the rate hikes enacted since Dec 2015 have each precipitated drops in DXY, not increases.  Long rates have been largely unaffected, dropping substantially after most of the discount rate hikes and usually rising only in the absence of one.

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continued: Jan 16, 2018

A quick look at this morning’s futures action…

After a strong runup overnight, ES is heading for the intersection of the rising white channel bottom and rising red channel midline.  If it drops through there at 2777, then the SMA10 comes into play at 2747.  This would also constitute a backtest of the larger rising red channel top.

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Look at it from the standpoint of a central banker, and you might see a mounting problem.  The 10-year has topped its 2015 highs and is back to its 2016 highs.  Focusing on the 10-yr……we can see that it has broken above a very long-term TL from 2007 as well as a secondary TL from 2014.  The 2013 highs aren’t far away, and would mean 3%+ rates again.  The CBO, in its budget and deficit projections, assumes the 10-yr will rise to 3% in 2018 and 3.5% by 2020.  This is a significant increase from current rates.With the deficit expected to increase over the coming years……this will result in interest payments consuming an ever larger share of expenditures, creating a feedback loop that, in turn, pushes deficits and debt even higher.

If I were a central banker, this is what would keep me awake at night.

My point in presenting this info isn’t to alarm but to educate and enable investors to profit.  If we assume that central bankers are concerned about runaway debt/deficits and that higher interest rates are the enemy, what should we expect from markets that are managed by these same central bankers?

First, I think we can expect CBs to put the brakes on 10-yr rates going much higher.  They no doubt have a ceiling in mind. My best guess is that they’re worried about the recent breakout.  2.7% would complete an IH&S Pattern, and 2.856% would likely represent red-alert territory from a chart standpoint. So, how to keep rates from rising much further?Clearly, they would need to put a cap on inflation.  Official CPI was 2.1% in December, while PCE is closing in on 2%.  So, it’s probably time to put the brakes on.  The question is how, and how to take advantage of it.

Since CPI has rarely leveled off without CL/RB either leveling off or dropping, I think it’s safe to say that they will at this point.  Between the two of them, I continue to believe RB will be most susceptible.  It’s impact on CPI is both direct and immediate.

This is where an analog makes sense.  Note the period between late 2016 and May 2017 when CPI was near or above 2%.   YoY gas price increases went from barely positive in November to a +13% in December, when CPI crept over 2%.  From there, they increase at rates of +24%, +32%, +18% and +15%.  In May, the rate of increase dropped to 5% and CPI dropped back below 2% to 1.9%.Focus for a moment on the thin purple line on the above chart: DXY.  When RB was sliding between May and Nov 2016, DXY was on the upswing, making a series of higher lows and higher highs.  It’s slightly easier to see in the chart below.After the US election — when SPX broke back below horizontal support (and the IH&S’  red neckline) — DXY broke above its horizontal support in order to help stocks recover and, ultimately, make new highs.

Note that its initial rise above horizontal support corresponded exactly with SPX’s breakout from the falling purple channel, and its backtest of the support corresponded exactly with SPX’s rise through the purple 1.272 at 2223.02 (Dec 7.)

DXY and USDJPY continued rallying into the end of the year (i.e. finishing on the usual high note), as did RB/CL.  This marked a high for DXY, top ticked when the FOMC hiked rates.  It also marked a high for RB/CL, as CPI was now up to 2.5% on its way to 2.7%.  RB had rallied 36% between Nov 14 and Jan 3.

If the Fed had had their way, I believe they would rather have let CL/RB decline past their Feb 2017 lows.  But, by then, SPX had reached its purple 1.618 and needed the help to get through that resistance.   CL/RB helped stocks get past those obstacles, but it resulted in 2.7% CPI, the highest since Feb 2012.

Note that DXY made its March highs at about the same time that Feb’s 2.7% CPI number came out.  Though there was a rate hike that month, DXY fell through horizontal support and has continued falling ever since.  There were no serious repercussions for stocks, as RB/CL were rallying strongly at the time (in the midst of a 31% rally.)

So, finally, what might be the Fed’s takeaway?  If they’re interested in keeping rates under control:

(1) they need to keep CPI under control.
(2) to keep CPI under control, they need to moderate CL/RB’s increases…
(3) …but, not so low that CPI falls much below 2%, as this will undermine the USD.
(4) both CL/RB and DXY need to rally if stocks reach serious overhead resistance
(5) if not, one or the other can prop up stocks
(6) if neither one can rally, VIX can usually do the job at least in the short run.
(7) they should continue talking up rate hikes to try to prevent DXY’s collapse
(8) but, bond investors aren’t so easily fooled, and DXY is collapsing anyway.

Take all this into account, and we face one of two possibilities.

If USDJPY breaks down below 109.42ish (the white channel bottom and yellow midline) then stocks are going down.  Period.  This will probably result in CL/RB ratcheting higher and VIX collapsing to try and compensate.  In late 2015, USDJPY’s breakdown below the red TL from the 2012 lows resulted in a 300-pt drop.  In June 2016, its decline below the yellow midline resulted in a 120-pt decline. If USDJPY catches strong support here (stronger USD, weaker JPY), CL/RB can ratchet lower in order to moderate inflation and help keep interest rates under control.  If it were me, I’d run EURUSD up to 1.26 to accommodate DXY reaching strong support at 88.682 or so, which in turn would allow USDJPY to remain above 109.50ish and keep the rising white channel intact.

This would likely result in SPX backtesting 2700, but that’s not a big deal — only 3.7% off today’s highs.  It might quiet the guffaws from analysts like me who find stocks’ rise ridiculous.

As for CL/RB, they could begin the process of ratcheting higher as in late 2011 through mid-2014, where CPI would periodically reach 2% or so, but never so much that it results in much higher interest rates.   In 2011, this meant bounces between 2.44 and 3.44.  In 2013, it was between 2.49 and 3.12.  These were pretty large and very tradeable swings.

The key principle, I believe, will be to alternate the rises in USDJPY and CL/RB so that one  is always rallying while the other is resetting.  VIX plunges can fill in the gaps, especially when the algos are tacking from one to the other.

Here’s a reminder of what that looked like back then. If I haven’t put you to sleep yet, good. Thanks for bearing with me while I try to hash out a fairly complex situation. Bottom line, I think there will be some very juicy opportunities in CL, RB and USDJPY.  I happen to like the second scenario the best and anticipate those moves described above in currencies, along with the first oscillation down in RB and CL.

I’ll work tomorrow on some price targets.  But, for now, let’s say DXY to 88.423-88.682, EURUSD to 1.2404-1.2597, CL to 60 and, if broken, to 57, RB to 1.75.  As discussed over the past week or two, I’m still looking for VIX to reach 13.93.