As I stated last week, we remain on the precipice of what could be some major changes across all the financial markets.
That includes interest rates (the credit market), the dollar, gold, the stock market and so on.
Last Thursday, in view of a strengthening labor market, the FOMC reiterated its firm stance, whereby neither rain, nor sleet, nor hail, will deter it from its goal of "normalizing" interest rates and reducing its balance sheet. Rising interest rate mean falling bond prices, of course.
As justification, the Fed claimed "the labor market has continued to strengthen" with economic activity rising at a "strong" rate. This reinforces investor expectations for a rate hike at the December meeting. The debate has now shifted toward 2019 where expectations range from two to four further hikes. You can’t get much more aggressive than that!
So the firming tone (and future trajectory) of U.S. interest rates can be inferred by the long-term chart of the High-Yield Corporate Bond ETF (HYG) …
When viewing this chart, it’s important to understand that the price moves inversely to interest rates. So the bearish look to this chart is definitely correlating with rising interest rates.
Consider also that price often moves ahead of events as well. The bearish rounding top here indicates the market really is starting to adjust to those future interest rates. That’s why HYG’s rounding top looks close to breaking down beneath the long-term support at the 84 level. I suspect we’ll smash through that (and then 83) as the forces of (much) higher interest rates are unleashed on bond prices.
So this chart is something we want to keep an eye on as it will affect so much else in the markets. Including the dollar, of course.
Because the U.S. Dollar Index (USDI) is decidedly looking very bullish right now. Last week it reversed higher with a bullish key reversal and appears poised to resume its upward trajectory.
The inverted head and shoulders pattern reinforces the bullishness of this thesis. It’s not a conventional head and shoulders because the right shoulder is higher than the left, giving a rising (and bullish) neckline. A normal head and shoulders is already bullish — but one inclined like this is VERY bullish.
That means we could see some very rapid — even explosive — rises in USD once the rising neckline is breached.
We could still see some back and forth for a few more weeks, but ultimately the dollar is headed a lot higher. It’s just a matter of time.
Now let’s look at a 20 year chart of the USDI to see where it might go …
First, look at the double bottom formed back in 2008 and 2011. The neckline was tested earlier this year after first breaking through late in 2014. From the way it bounced off so strongly, we could be on the cusp of another major run to the upside … perhaps even to the highs going all the way back to 2001 - 2003 at the 120 level.
But that’s for the longer term.
More immediately, the inverted head and shoulders shows up on this chart too and we can consider a near-term target at 104 (the 2017 high). That’s a substantial run from the 96.73 level we see now.
In my mind, when you combine rising interest rates and both the weekly and long term chart patterns I’ve shown you, it’s ultimately a question of not if but when the dollar is going higher.
In response to that fundamental background and favorable price action, I favor going short EURUSD and long USDCHF.
Let’s look at the monthly EURUSD (Euro against the dollar) first.
In contrast to the hawkish U.S. Fed, things don’t sound nearly so aggressive at the European Central Bank. ECB Chairman Draghi took a more dovish tone when speaking before Irish parliament last week. He claimed the ECB could push out forward guidance if growth disappoints. That’s likely to be bearish for the Euro.
This is consistent with the long term descending wedge pattern that began forming back in 2008. (Off the left edge of the chart the Euro had been in an uptrend until it began carving out that bearish descending wedge.)
The price is now resting on or near that long-term neckline … but with the implications of a major dollar run, EURUSD is likely to return to its intermediate and long-term lows. We could see a secular bear market in EURUSD going forward.
After all, there’s even a bearish head and shoulders forming — the exact opposite of what we see in the USDI.
So even if there’s some sideways price action for awhile, I think it’s a matter of not if but when EURUSD craters. Any rallies here should be shorted. Alternatively, you could wait for new lows to be made beneath last month’s low before going short.
Now another pair that seems destined to move strongly is USDCHF (the dollar against the Swiss franc).
Right now we’re trading slight above parity here at the 1.03 area and there’s a fair amount of resistance going back a few years.
But given the ascending triangle that’s formed, I think there’s tremendous upside for a major move. While USDCHF still has to break the neckline, the recent bullish key reversals should give the price a lot of momentum to rise here. Near term I want to see the price break the most recent resistance before tackling the long-term neckline. But I think it’s going to happen … sooner or later.
So what’s going on with the pound lately?
Well … on Nov 21, we’ll finally know the outcome of the Brexit negotiations. In the meantime, I expect a lot of volatility in GBP-related pairs.
There’s one pair I’m feeling decidedly bearish on already, though. After 18 months of heading higher, it appears GBPNZD (the British pound against the New Zealand dollar) is vulnerable to a break lower from current levels.
After a false breakout from the ascending triangle, GBPNZD has now broken below the trendline of that triangle last week. It appears to be headed lower to the 1.80 level again. In my opinion, the best way to play this is to short any rally back above that trendline.
As you might know, I was very bullish on this pair until recently. But the false breakout (which fooled me at the time) has now convinced me that GBPNZD’s very profitable bull run is over and it’s a good time to be a bear on this pair.
What’s all this doing to the stock market?
We’re seeing a clear sector rotation out of technology, and into consumer staples. I put together this 3-way chart of the Dow Jones Industrials (dominated by a number of consumer staples companies), the S&P 500 (broad sector), and NASDAQ 100 (tech stocks) to show you the evidence.
You can see the DJIA has broken its neckline and come back to re-test it. But the S&P bounced off its own neckline. And the NASDAQ100 never even came close to hitting its neckline.
So the DJIA is clearly the strongest of the three indexes right now.
There’s historical precedent for this. After all, sector rotation indicates a long-term bull market is getting "long-in-the-tooth", and could roll over soon. Consumer staples are typically one of the last sectors to rally in a bull market whereas tech stocks are one of the first.
We’re in the fourth quarter of this bull market — early contraction — so be very careful if you’re in stocks.
In light of the rotation, I suggest constructing a more defensive stock portfolio. That means buying consumer staples like CLX, HSY, PG, MKC, LW and ECL, while dumping (or even shorting) the biggest tech stocks. That translates to the FAANG stocks (FB, AMZN, AAPL, NFLX, GOOG plus other perennial tech favorite NVDA.
You could also short the NASDAQ itself. After all the head and shoulders with the double-top head is very bearish.
As with GBPNZD, shorting any rallies would be the most sensible way to play this. I expect a drop to the recent low soon … and then perhaps much, much lower than that.
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