Watch relative yield curves for bank performance clues

Since our last update the markets turned down below suggested support zones to watch on strong volume and breadth and now have a clear downward bias that confirms that our suspicion about the rally since mid-March being only a bear market rally is likely correct.  Adding fuel to concerns TLT’s broke down below the critical 89.6 level to trigger a bear market signal in long bonds.  Investors should continue with a defensive posture and have a downward bias towards global equities now, although 2-way trading continues to work. 

Part of the negative fallout from higher bond rates has come in the form of US bank group consistent underperformance.   Higher interest rates and flattening yield curves couldn’t come at a worse time for banks, and RKH, the banking ETF and other bank indexes have made new lows below the March lows, leading the market lower.  Chart 1 shows the 10 year rate minus the 3 month rate yield curve flattening since late April in particular.  Since banks make money by loaning short and lending long, this is a negative for their earnings potential and helps explain the breakdown in bank stocks as rates rise.

 
Chart 1:  US short rates have fallen versus long rates, flattening the yield curve for banks, recently.  Courtesy Bloomberg

 
Chart 2:  Japanese long rates have risen more than short rates, steepening the yield curve for banks.  Crtsy Bloomberg

However during the same period since late April, while US yield curves have flattened to the detriment of US banks, Japanese yield curves have steepened, to the benefit of Japanese banks.  In fact a little bit of inflation is exactly what the Japanese economy needs right now.  As Japanese yield curves have steepened, Japanese banks can profit more from borrowing short-term to lend long-term.  Thus Japanese banks have substantially outperformed US banks, something that is likely to continue, and which traders could exploit via the MTU/RKH pair.  Investors could look to buy MTU and short an equal dollar amount of RKH, the US bank ETF, as a way to exploit this development.  Trailing stops under the 50 day ma and up-trendline could be used to follow up new highs as they potentially develop.

 
Chart 3:  Japanese banks rising swiftly versus US bank ETF’s and likely to continue to do so.  Courtesy Bloomberg

We’ve also suggested watching USO for a high volume close under the 50 day ma, as a signal that oil is finally correcting – this signal has not been given yet and oil appears to march onward and upward until this signal is given.  Our buy signal in JJG over 65.55, suggested in our last update, developed and JJG now sits just over 74, with a substantial profit.  Now move trailing stops up to break even to make a 0 dollar risk trade.  We’ll look to raise stops again after a consolidation and new highs, and we continue to believe the grains have substantial upside potential.  The dollar remains in the rectangle we last spoke of and we would be hesitant to bet too heavily in either direction in the major currencies against the dollar until this rectangle is broken.  Investors long FXA were stopped out at around break even as our stop suggestion of our last report was hit.

We’ve been commenting on the dollar versus the Chinese currency as one of our favorite forex trades for more than two years.  The ETF in the Chinese currency is the CNY.  Although it is our least favorite vehicle to exploit this trend, for many it is the only option.  Note therefore that as of Wednesday the CNY ETF has broken above its Head & Shoulders bottoming pattern and could be bought or added to on the long-side with stops under the May lows now.  While this is unlikely to be a home-run because the upside is limited by a likely slow but steady move, we think double-digit annual gains with relatively low risk could be achieved here and this could be a hideout.  We still much prefer NDF’s or other vehicles which apply some leverage to the strong trend, but for those unable to access these, buying CNY the ETF (as opposed to shorting the CNY forex NDF’s which is the same directional trade and is therefore confusing to many) with stops under the May lows seems like a potentially good trade to us that should be relatively uncorrelated with other instruments.

 
Chart 4:  CNY ETF has just broken out of head & shoulder pattern and should move higher.  Courtesy Bloomberg

Our long/short strategy is now long AGU (raise to break even), MON (also use break even trailing stop now), we bought and were stopped out of MPWR since our last update, and NE just broke out to trigger a valid trade on the upside, while we are short LVS (use stops over this week’s highs to lock in profits) as well.  Since our last update we got close calls on the long side in BAP, POT, MOS, BRY, SCL, CF, AE DNR, and PXP, and short side close calls in CTX, FED, DDS, and WTM.  As the chart at the bottom of the page illustrates, bottom relative strength new lows are shooting for dominance over top relative strength new highs here, in what we would describe as a two-way downward biased market.

For those not familiar with our long/short strategies, we suggest you
review my book “The Hedge Fund Edge,” my course "The Science of Trading," my video seminar, where I discuss many new techniques, and my latest educational product, the interactive training module. Basically, we have rigorous criteria for potential long stocks that we call “upfuel," as well as rigorous criteria for potential short
 stocks that we call "down-fuel." Each day we review the list of new highs on our "Top RS and EPS New High List" published
on www.midasresourcegroup.com for breakouts of four-week or longer flags, or of valid cup-and handles of more than four weeks. Buy trades are taken only on valid breakouts of stocks that also meet our up-fuel criteria. Shorts are similarly taken only in stocks meeting our
down-fuel criteria that have valid breakdowns of four-plus-week flags
 or cup and handles on the downside. In the U.S. market, continue to only buy or short stocks in leading or lagging industries according to our group and sub-group new high and low lists. We continue to buy new long signals and sell short new short signals until our portfolio is
100% long and 100% short (less aggressive investors stop at 50% long
 and 50% short).

The chart below shows that Top RS new highs (available on www.midasresourcegroup.com) are now below bottom RS/EPS new lows but neither have had an edge over the other by 40 or more consistently for more than five trading days in a row to signal a clear strong biased trend in either direction yet.  That means allocate cautiously and have both longs and shorts in this environment!