The first day of Q3 saw Wall Street closing decisively higher. Might this be an early sign of a shift in sentiment for the new quarter? With the US on Independence Day public holiday, we look into what needs to happen for this rebound to be more than a flash in the pan and develop into a recovery of substance.
- US Treasury yields may have topped out, this can help to support Wall Street
- However, the continuing trend of USD strength remains a barrier to recovery for indices
- The technical outlook remains negative for now and a lot needs to be done for recoveries to be sustainable
Fundamental correlations are mixed
We will begin with a quick look at bond markets. Fears of recession appear to be taking over from fears of inflation in recent weeks. However, as inflation expectations have been tracking lower recently, the added worry about recession seems to be pulling market participants back into Treasury bonds, pulling yields lower.
There has been a notable decline in not only inflation expectations, but also the yield of the US 10-year Treasury.
The net effect has been slightly negative on “real” bond yields (yields minus inflation). For now, there is still not only a positive real yield (interest rates are still positive even after inflation) but there is also a trend higher since March.
We will be watching to see if this trend is broken and potentially starts to reverse. This is important, as a trend can be broken without a reversal taking hold. A decisive reversal in the real yield (potentially bond yields falling faster than inflation) would be seen as supportive for Wall Street markets as there is a negative correlation between real yields and indices.
As we can see in the chart of the S&P 500 futures versus real bond yields, there is an average correlation of -0.26 over the past year. This would be even greater, had there not been a positive alignment for six weeks as war broke out in Ukraine. As such, when real yields go down, this is positive for indices.
However, ideally, there would also be a reversal of USD strength that would help Wall Street too. There is a strong negative correlation between the USD and S&P 500 futures. The correlation averages c. -0.38 over the past 12 months. A strong USD has played a key role in the decline of Wall Street.
However, this now becomes a problem for a recovery in indices indices. We see the USD remains in a strong positive trend, and we continue to believe that the Fed’s aggressive policy of interest rate tightening will drive further USD strength. Whilst this would not guarantee that indices cannot recover (the relationship is not a perfect correlation) this does not bode well for recovery.
What are the technicals saying?
Looking at the markets themselves, we always believe that price action is a strong indication of outlook. New positive trends managing to develop, with higher lows and higher highs would be a good indication of recovery. As yet, this has not been seen. However, there are a few chinks of light that give us hope. We will now look into what is needed to make this hope sustainable.
The S&P 500 futures (SP500ft) rebounded off 3741 last week to form a low above the 3641 June low. The next step has to be a break above 3950 to form a new higher high., thus forming a first decisive recovery move since March. The RSI moving above 55 on the daily chart would add confirmation of a more encouraging outlook too. However, to be truly sustainable in the recovery outlook there would need to be a break above the moving averages and the barrier of the three-month downtrend.
The negative outlook on the NASDAQ 100 futures (NAS100ft) is more defined, but also it is closer to a technical recovery. Holding on to Thursday’s low at 11,350 is a must, whilst a break above resistance at 12,260 is necessary for a higher high formation. This would also have broken the three-month downtrend, whilst the bulls would be looking for a move on the RSI above 55 to point towards strengthening momentum in the move. The more important technical barrier is the resistance between 12,600/12,950, but that is a hurdle that would need to be tackled much further down the track.
Finally, on Dow futures (DJ30ft) there has been a consistent run of lower highs throughout 2022, but a downtrend is harder to define. Despite this, there has been a pick-up from 30,400 above the key 29,635 low. The bulls will now be keen to defend this as a potential higher low and then push for a move above 31,865. If this can be seen then a 10-week downtrend can be broken and the bulls can begin to think of a sustainable recovery. A move on the RSI into the high-50s would act as a positive confirmation.
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