Minor Low Mid Week, Then Equities Rally To Sept. 17-18 Top, Yields Bottom, Gold Tops Out

by: Robert P. Balan

After an SPX intermediate trough mid week, we should see a strong rally to a Sept. 17-18 top. That may be followed by a large, sharp decline, until Sept. 23-24.

DXY hasn't responded much to the rise in yields. But it will, probably in a day or two. DXY changes have been lagging changes in yields by about 2-3 days.

Gold closely tracking yields and has completely lost interest on the DXY. If yields fall further over the next few days, Gold should rise. The high-frequency liquidity models provide further details.

If the High Frequency models are correct, and we see at least a 50 pct correction in ESc1 (a return to 2885), then CLc1 also should correct lower again, possibly back to 54.00.

The cryptos continue to build into the gains made earlier in past week. We may be seeing the bottom of a large triangle pattern. Cryptos will probably accelerate higher once gold keels over.

Trading SPX using the systemic liquidity models

Further higher highs in equities are indicated by various liquidity models, but risk assets may be temporarily topping out, or had already temporarily peaked (for now, illustrated by the chart below), so we are looking for confirmation or realization of market weakness over the next few days.

The High-Frequency liquidity model, which drives the very short-term changes in the PAM trading analysis and strategy, suggests what to expect of the S&P e-mini futures (Esc1) over the short term (see chart below and notes below):

Among the major implications of the HF liquidity model are the following:

  1. The decomposition process (light blue line) suggested that a minor top on Sept. 9 will be followed by a brief decline until Sept. 10-12.
  2. From the HF liquidity model's setup, we may just see a 50 pct correction of the rally from Aug. 23 to a top of Sept. 9. That's the correction which bottoms in Sept. 10 to 12.
  3. After an intermediate trough in Sept. 10-12, we should see a strong rally to a top on Sept. 17-18.
  4. That topping out process may be followed by a sharp decline, which could bottom on Sept. 23-24 (see chart above).

It may be helpful, even useful, to see how the liquidity models came to these conclusions at this point. The fact is that in the build-up to this juncture in the models, we already knew most of what should happen this week, as early as two weeks ago. This has been properly documented in an article in the PAM blog on Aug. 23 (here). This article, itself, has been an updated version of a PAM blog article on Sept. 5 (here).

The historic averages models (see chart below) confirm the above set up from the HF liquidity model. Shown is the juxtaposition of several five-year average of liquidity models and of S&P Index and the 10-year yield. The aggregate effect shows a major bottom for the S&P Index by late September and a quick, V-shaped recovery thereafter, which may last for most of Q4 2019.

Those models of historical averages also confirm what we see in the interaction of the SOMA model with repo rates (which fund financial asset transactions), and the positive impact the falling repo rates have on risk assets like the SPX (see chart below).

The most important relationship among the various data is the covariance of the SOMA (Transactions) Model, which leads the inverse of repo rates, and which in turn, leads SPX by several weeks (see chart above). The models show the impact systemic liquidity has on term (money) market rates, which determines the cost of funding asset transactions in the US shadow banking sector, and therefore impacts the degree of leverage financial intermediaries have on their balance sheets.

The cost of funding is crucial, as “. . . for these intermediaries, the margin of adjustment on the balance sheet is done through repos and reverse repos (and other collateralized borrowing and lending) - see “Liquidity and Leverage, Adrian and Shin, 2008, here.

Changes in the leverage of the shadow banking sector have direct, positive impact on the rise of risk asset prices and even on the GDP growth of the US.

Longer-term equity investment implications

Strategically, long-term investors should be gearing up for SPX longs soon, although swing traders can still briefly "beard the lion" with trades looking for a brief retest lower of the recent low in SPX. That opportunity to short SPX however is viable only within the week. This opportunity is highlighted by the tendency of the SPX to make a final dip before rallying toward late H2 of any year, as shown by the five-year average of the SPX, in the chart below.

Historically, from circa Sept. 24 (last week of September), SPX should start making a move for a new high by year end. And the historical outlook for strongly rising 10-year yield in any year's H2 period provides reversal of the dismal view on risk assets still being foisted by market bears.

We have put together in one chart all the sources of financial systemic liquidity flows (see chart below). The historical averages of the models and risk assets are telling us that this time will not be different - we will have rising risk assets and falling safe havens going into Q4 this year. The so-called "Santa Rally" will not be denied this year.

The 10-year yield, DXY and gold trilogy

The montage of 10-year yield, gold and DXY chart offer some insights into the lagged reaction of DXY to changes in yields and to the close negative covariance between gold and the yields (see chart below). This consistent behavior has practical use in timing trades in DXY and in explaining the occasional divergent behavior between the inverse of gold and the US dollar (DXY).

So far, DXY has not responded to the recent rise in yields and to the fall in gold prices. But the relationship will reassert in a day or so. DXY changes have been lagging changes in yields by about three days, and the usual coincidental, positive covariant relationship is due very soon.

If we do get a pullback higher in DXY, PAM will sell it again. The DXY is topping out in the liquidity models and could be downward bound until first week of October (see chart below).

Meanwhile, gold is closely tracking yields and has completely lost interest on the US dollar. DXY and yields are inverted in the chart above. If yields fall further over the next few days as we expect, then we should see gold still retesting highs, as equities correct lower, per the liquidity models (see chart below).

But gold prices are in a topping out process (as yields bounce off the bottom of the recent range, see chart below). The liquidity models warn of a large decline in gold prices going into late Q4 this year, which is consistent with the outlook of sharply rising bond yields into year end.

WTI and crude oil trading relationship

We also highlight the continuing close positive covariance between ESc1 and the WTI CLc1 (see chart below).

Therefore, if the HF liquidity model is correct, and we see at least a 50 pct correction in ESc1 (a return to 2885) then CLc1 should also correct lower again, possibly back to 54.00. Look at these price dips as an opportunity to build long positions.

Crude oil has the best momentum coefficient of all the risk assets, so we make it a point not to short this instrument. Moreover, the lagged effect of previously very good oil fundamentals will be impacting the oil price very soon (on a delayed basis), and that should set up oil prices for a strong rally until late in the year (see chart below).

Natural gas: outlook for the rest of 2019

Meanwhile, given the strong residual momentum in natural gas, NGc1 should retest, even exceed, the previous 2.48 top. But this current rally has been humongous and has been very sharp.

Therefore it's natural to look for opportunities to short any pullback, which could be large, as shown by an Elliott Wave Principle depiction of a forthcoming correction stage (see chart below). PAM waiting for NGc1 to provide a nice pullback, so we can get in cheaper.

Given that our natural gas model shows a very strong, straight-line feature of the price rise until year-end (see chart below), PAM just wanted to get into long trades. But we have been working on the models, and have created modules derived from lagged changes in production impacting current NG prices, and so we may have found a way to short NG as well (see chart below).

Unfortunately, we have not had the time to interpolate the weekly prices of the data, so it just says in this new model that a top in NG should be seen in the week of Sept. 2 to 9 (which is basically this week). Then NG should fall until October 14 to 21 in a sizable price correction. A subsequent rally does not provide any opportunity to short until the end of November - first week of December, when we should see a major top (see chart above).

Cryptos set for a sharp uptake

The cryptos continue to build into the gains made earlier in previous weeks. We believe we are seeing the bottom of a large triangle pattern forming (see chart below). This pattern suggests a subsequent sharp breakout which could be very brief.

The liquidity models are still supportive of one final rally in cryptos before a large correction. That projected sharp rally should happen very soon (a matter of few days). Cryptos will probably accelerate higher once gold keels over. That should signify asset rotation at work (see chart below).

Disclosure: I am/we are long OIL, EURO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.