Did Yellen Just Promise a Late-July Rally for Stocks?

Fed Chair Janet Yellen proved policymakers are steering this market when her dovish testimony to Congress sparked big gains

Senior Vice President of Research
Jul 17, 2017 at 8:38 AM
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"...the most relevant headlines to investors have been the outcomes of Federal Open Market Committee (FOMC) meetings, which occur every six weeks... If the pattern in this rate-tightening cycle continues, I would expect the SPX's 2,438-2,440 area to act as resistance, or a 'hesitation' area, until the next policy decision on July 26. While 2,438 marked the Fed day close, the 2,440 level was the site of the Tuesday high close just ahead of last Wednesday's policy decision. Note that these levels are situated not far below another potential resistance point -- the 2,450 half-century mark. For SPY followers, based on closing data on the same dates, the levels to watch are 244.24 to 244.55..."
    -- Monday Morning Outlook, June 19, 2017

"Traders now see a 55% chance of another rate increase before the end of the year, according to CME Group data tracking fed funds futures contracts, up from 41% in mid-June. The probabilities now match the one remaining increase penciled into the Fed's most recent projections."
    -- Bloomberg.com, July 12, 2017

"...ultimately, we believe the extremely strong performance by equities and bonds in H1 is very unlikely to be repeated in H2... [it's] now politically unacceptable for the Fed and any other central bank to stoke a bubble on Wall St... monetary policy will have to tighten to raise volatility, reduce Wall St inflation, and reduce inequality. There are two ways to cure inequality: you can make the poor richer, or you can make the rich poorer. The Fed will reduce its balance sheet in the hope of making Wall St poorer."
    -- Bank of America (BAC) Chief Investment Strategist Michael Hartnett, July 12, 2017

If you are not convinced that the Federal Reserve and its actions on monetary policy are most relevant to investors in the current environment, consider the price action in the SPDR S&P 500 ETF Trust (SPY - 245.56) since the mid-June Federal Open Market Committee (FOMC) meeting, as well as last week's comments (excerpted above) from B of A's chief investment strategist.

As I had predicted in previous commentaries, based on historical patterns during the current rate-tightening cycle, the SPY level around the time of the mid-June FOMC meeting has acted as resistance in the last month. But consider also the excerpt above from Bloomberg, which notes that expectations for another rate hike by year-end had increased from 41% in mid-June to 55% just prior to Fed Chair Janet Yellen's congressional testimony on monetary policy last week. The growing probability and anticipation of another rate hike ahead of last Wednesday's remarks from Yellen likely caused stocks to grind lower, even as investors fixated on other news.

But after Yellen suggested that interest rate hikes will continue to be gradual, and added there will not be too many more before a "neutral" level is achieved, Wall Street took notice. Traders bid stocks higher as the odds of a rake hike by year end receded to the levels of mid-June.  Not surprisingly, and in a flash, the SPY was also back to its levels of mid-June, right around the time of the FOMC meeting.

spy hourly chart 0714

Remember, last week's dovish testimony followed a hawkish tone perceived by investors when the June meeting minutes were released earlier this month, as some Fed officials fretted about easing financial conditions (weak dollar, rising stocks, falling bond yields) and subdued market volatility leading to the possibility of a buildup of risks to financial stability. The takeaway from the minutes was that the Fed could tighten regardless of weaker economic data, which pushed the odds of a rate hike higher and equities lower.  

The past month has been a grind for both bulls and bears, with noise-generating headlines including the provocations of North Korea, the ongoing debate over healthcare reform, and a U.S. president under the microscope amid rising accusations of collusion with Russia during the 2016 elections.  

At the end of the day, though, it's all about the Fed. And the grind may soon be over, as the next FOMC meeting is scheduled for July 26. There is little chance that the Fed raises rates at this meeting, and a "status quo" policy stance could provide a launching point for stocks, if the recent pattern continues. In fact, if the late-week breakout is sustained over the next few weeks, this month's "no-hike rally" may have arrived earlier than usual, driven by Yellen's dovish testimony.

Before we get to July 26, the expiration of standard July options occurs on Friday. And the earnings schedule begins to heat up, with a wide range of companies in different sectors reporting -- including finance, healthcare, technology, transportation, and industrial companies.

Moreover, on Wednesday morning, standard options on CBOE Volatility Index (VIX - 9.51) futures expire. Roughly 45% of the 8 million-plus VIX calls in open interest will expire, leaving some without portfolio protection or hedges on the enormous short VIX futures position that I've been commenting on for several weeks.

Some readers asked me about the behavior of the VIX last week. My response was that despite two intraday moves above 11.25, which is half the November pre-election closing high, there were two closes below this level, indicating that volatility could stay suppressed. Admittedly, minor advances have occurred when the VIX is below 10, but you will likely have to see the VIX close above its 2017 highs in the 15-16 area before a serious run at 25-30 occurs.

vix hourly price chart 0717

With July expiration just days away, the options market could give us clues as to what to expect in the week ahead. In the July series, call open interest begins to exceed put open interest at the SPY 244 and 245 strikes, which coincide with the closing levels when the Fed met in mid-June. Moreover, the 245 strike approximates 2,450 on the S&P 500 Index (SPX - 2,459.27), and half-century numbers historically mark hesitation or key pivot areas on the SPX. It is this area that I would expect to continue to act as a sticking point.  

Check out the huge call open interest at the SPY 247 strike. If resistance is taken out this week, this strike could act as a "magnet," as much of the open interest originated from buy-to-open volume. Sellers of the call options would have to buy S&P futures to hedge if the SPY begins to approach this strike at any time between now and Friday expiration -- and following the end-of-week rally we just saw, a move up to this strike price now looks well within reason.

Again, there are not any huge put open interest strikes that would induce more selling if the market drifts lower this week. In other words, a sharp sell-off induced in part by delta-hedge selling is unlikely. The 243 strike is a level to watch -- it's the site of not only the 20-day moving average, but also where the largest numbers of calls and puts would expire worthless at expiration.

spy open interest by strike 0714

"... the recently maligned large-cap technology group likely to experience a drift higher in coming weeks. A move to the round 140 strike is one scenario, as this is the site of heavy call and put open interest, as well as a trendline that connects the June highs."
    -- Monday Morning Outlook, July 10, 2017

As I discussed last week, the tech-heavy PowerShares QQQ Trust (QQQ - 142.12) was poised to rebound, but did more than "drift" higher, as it staged a "V" rally from put support and its 80-day moving average. It comes into the week trading above the 141 area -- which is the first strike where call open interest exceeds put open interest, and is also the site of the late-June high. The round 140 strike represents the point at which the maximum number of calls and puts would expire worthless at expiration, so that is a level to keep on your radar as we move through expiration week.

qqq july open interest by strike 0714

The recent action in the CBOE Nasdaq Volatility Index (VXN - 13.80) favors the bulls. After peaking last month just above the 20 level -- double this year's closing low -- the VXN has declined below both its 2016 close of 16.68 and the 15.15 level, which is 50% above the 2017 closing low.

The technical backdrop, whether looking at volatility measures or multiple broader equity indexes, favors the bulls. The Fed is still the wild card, but dovish actions and commentary amid weak economic data, or a more hawkish tone amid strong economic data, would be supportive of stocks.  If there is a different combination (such as hawkishness amid weak economic data), then stocks become more vulnerable to a setback as volatility pops due to short covering in the volatility futures market.

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