The Precise Take – Strength in equities leading into critical Treasury auction week

Treasury Analysis:  Today is the first of three major auctions this week for Treasury securities—today is the 3 Year, tomorrow the 10 Year and Thursday the 30 Year.  The 30 Year T-Bond future backed off its major resistance are Friday on the equities advance, nearly reaching the 50% retracement support at 118 7/32 from the August interim low.  As equities are now testing highs, key will be to watch the 30 Year’s reaction this week to the various auctions with 117 4/32 to 118 7/32 containing the Fibonacci box from August lows and VWAP anchored from the June 11 09 low of the year.  If we do get reversals this week in equities (down) and Treasuries (up), it will most likely be from this support area by early tomorrow (though possibly after the 10 Year auction at 1:00 pm tomorrow).  We expect Treasury auctions to be the biggest news items of the week and they should be watched closely.

Gold:  Gold futures broke through 1000 overnight (high of 1009.40 basis Dec 09), but we would like to see confirmation with gold priced in Australian and Canadian Dollars break through swing high resistance from late June to mid-July 09.  Until that happens, we consider the rally based on Dollar weakness, and not yet sufficiently broad based to signal a strong move up.

POMO:  Today is the only day on which the Federal Reserve Bank of New York will conduct permanent open market operations for Treasury securities this week (though it will likely announce another Agency POMO), and the Treasury program is expected to end with next week’s two POMO days (Sep 16 & 17).  The program was prolonged to end in October 09, but will likely reach the $300 B cap in next week’s auctions.  In the unlikely event that the program dollar cap is increased, expect violent moves in both Treasuries and equities.  Both have benefited from the program—Treasuries because POMO supports demand and equities because the proceeds appear to have been channeled into the stock market.  However, the markets may call Bernanke’s bluff and any prediction on an eventual reactionary move is extremely speculative.  Though the day trading POMO pattern of paint-the-tape closes had subsided, it was resurrected with last Thursday’s strong close (it was a POMO day for Agency securities).  The Treasury POMO program could end with a bang rather than a whimper into next week, with every last leveraged dollar from the proceeds squeezed into equities, so just a word of caution to the shorts.

Trading Today:  While we are not surprised to see the ES up again at the highest market profile value area (primarily because of gold strength and the correlation we noted last week), the rally was not on what we would consider a clean NFP reversal.  Rather the move began a bit high (10 points off the lows) to consider the NFP pattern to have held.   Back to market profile, if the ES continues to accept value above 1019-1020, there is a good chance we will see new highs.  If current highs are to be respected, the ES should reject this area by early tomorrow.  We are willing to go long in an early retracement into the daily gap/pivot area of 1019.00 to 1021.75, but become intraday bearish below.  Despite this, we will likely avoid…

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After posting our three scenarios yesterday, we have been alerted that the panic into gold may have been caused by the belief that the CFTC will curtail or eliminate the ability of funds to use commodities as a speculative asset class.  The official CME/NYMEX reason cited by a Reuters story is:

NEW YORK, Sept 2 (Reuters) – The CME Group will not list additional futures contract months for the New York Harbor No. 2 Heating Oil Futures contract beyond the August 2012 contract due to proposed sulfur-content specification changes.

“The proposed legislation, currently pending in New Jersey and New York State, intends to reduce the sulfur level in heating oil,” CME Group, which owns the New York Mercantile Exchange, said on its website.

“The existing New York Harbor No. 2 Heating Oil Futures and corresponding Option contracts, listed below, will continue to be listed for trading through August 2012.”

We have not been able to confirm the rumors that the CFTC will lock out speculators, though they have certainly made overtures to that effect before, and the belief in the rumor would be justified.

Once again, we repost our three scenarios and revise the conclusion slightly:

1)  Recent correlations hold and gold is simply forecasting another inflation-led [stock] rally that will begin in the next few days (meaning yesterday’s correction is not the bearish bellwether everyone thinks it is), or

2) Recent correlations hold and the move today in gold is a bull trap that will be reversed in the next few days, or

3) Recent correlations have broken and gold is decoupling from other markets, including equities.  Because correlation-changing paradigm shifts are rare, this is the least likely scenario; however, should it end up being the case, the significance is tremendous.  A break above 1,000 on a declining stock market would be definitive evidence for this scenario.

As to 3, because the move in gold may be a result of large investment funds looking for the most liquid commodity play that is the least likely to be subject to overt government interference, a breakdown in the correlation between equities and gold is no longer remote, and it would be possible for gold to advance, equities to decline, and the US Dollar and bonds to rally.

To confirm that gold is advancing on its own merits and not the result solely of US Dollar weakness, we want to see eventual confirmation of an up move in gold priced in other currencies.  Below shows gold priced in the Canadian Dollar (CAD), Australian Dollar (AUD), Japanese Yen (JPY), and the Euro (EUR).  When gold began its last advance in November 2008, it was confirmed by higher lows in the commodity currencies of the CAD and AUD, as well as the EUR (even though there were lower lows in the JPY and USD gold).  Eventually, there were higher lows in the JPY and USD gold at the beginning of December 2008.  Accordingly, for the gold bull case, early confirmation would be to see current lows in AUD, CAD and EUR gold respected on the first pullback, especially in the former two as they are commodity currencies.

* Thanks to the members of the Value in Time group for their comments and postings on this issue.