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A Change in the Weather

Posted by Eric Coffin

on Monday, 14 May 2018 14:29

Has Goldilocks left the building?  As 2018 rolls on, markets have become more uncertain about future direction and most have stalled out, or worse.  That doesn’t mean there are no more gains to be had, but it does mean traders, whether they focus on the major indices or small explorers, will have to be selective and nimble.  We have a good set up for the commodity sector right now, better than we’ve had for a few years, but nothing trades in a vacuum.  If the big markets roll over hard, few things will be spared, so we can’t ignore what’s going on in the wide world.

One of the biggest stories in the market recently is the reversal of the US Dollar’s decline.  While the move hasn’t been quite as massive as mainstream financial press is reporting, at least not yet, the chart below does show the USD has broken through some important technical barriers, particularly the 200-day moving average.  That hasn’t happened for a year and a half and, when it has happened in the past, there is usually some follow through that carries the index higher, at least for a while.

ericmay18-1

One reason for the USD move is relative weakness in the Euro, which is the largest component in the USD Index.  Various EU member states have released disappointing economic readings in the past few weeks, coming in below market consensus time after time.  Citi Bank’s Economic Surprise Index, pictured below, gives a good visual representation of this. The chart looks pretty horrible, with the reading is at a multi-year low, meaning just about every recent reading was below consensus.  That’s part of the reason the Euro dropped over 6% in a month, which in turn helped boost the USD.

ericmay18-2

We all know that commodities, which are almost universally prices in US Dollars, tend to trade against the greenback.   Gold is, or is supposed to be, the “poster-boy” for that relationship. You can see from the chart below that gold does appear to be trading against the USD but has still managed to hold it’s 200-day average as a support level.  While gold recently failed, again, to break through the $1360 level to the upside its trading pretty well, given the move in the Dollar lately. 

There are a couple of reasons for this I think.  One is that the general level of uncertainly across markets has increased.  The current economic expansion is the second longest in recent history. You don’t need to be a permabear to acknowledge we must be a lot closer to the end of this cycle than the start. That’s just common sense.  Two of the most commonly cited indicators of late-business cycle activity are rising interest rates and rising commodity prices.  There is a good reason why several of Wall St’s largest investment bankers have recently upgraded their price targets for commodities as a group and for gold specifically.   They sense that the late part of the business cycle is upon us.  $1400+ plus year end price targets for gold are now common.  That is enough to underpin the gold miner and resource sectors if it comes to pass and adds potential for some strong buying from chartists and market timers once gold does exceed the $1360-1370 level. 

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In the meantime, late cycle concerns generated some trading against the S&P itself, with gold used by some traders as a hedge against a large equity market decline.  Those carefree times when the S&P floated higher day after day on a cloud of FOMO (fear of missing out) seem to be over, at least for now.  Wall St just finished one of its best earnings seasons ever and doesn’t have much to show for it.  

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Traders are beginning to wonder if the earnings and economic growth backdrop to the market is as good as it gets. Bond yields have continued to creep higher, with the US 10-year Treasury yield just below 3%.  In a “normal” period that would be no big deal but, after years of near zero rates, traders are hyper sensitive to bond yields.   Everyone knows Wall St is priced to perfection, so it might not take much bad news to generate the next leg down.  

As predicted in the last column, US growth for Q1 came in light at 2.3%, not bad but no surge and not much indication we should expect one.  Likewise, the last two US non-farm payroll reports came in below consensus, as did the growth in hourly earnings.  That too continues to show no sign of surging.  Inflation has edged up, but only slowly and its hard to envisage a real move up in prices unless we see a move up in wages to generate more demand and consumer spending.  The recent rise in the USD also lowers the odds of an inflation spike because it should cap import prices. That last part is good news as it reduces the odds that the US Federal Reserve will get overly aggressive with rate hikes.  If things don’t accelerate I expect the Fed to stick to its plan and hike rates a couple more times this year, but no more.   If we do see modest inflation increases or, if it looks like US growth won’t accelerate, we should see a decline in real (inflation adjusted) yields and possibly the US Dollar as well.   Sentiment is currently so negative on the Euro that the odds of a bounce is increasing.   Most of this is short term stuff.  The medium term is that everyone acknowledges we are heading into the late part of a long economic expansion and, historically, commodities and precious metals perform best during this part of the cycle. 

Good luck and good trading. 

Eric

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