The Fed Continues to Tighten by Reducing Its Balance Sheet

Last week, there was chatter from both hawks and doves regarding Federal Reserve monetary policy, with the doves more vocal. It appears that the common call is for the Federal Reserve to cut the federal funds rate back to 1.75% to 2.00% this year from its current 2.25% to 2.50%. My call remains that the Fed will leave the funds rate unchanged through 2019 and potentially until the end of 2020 after the presidential election.

Wall Street has forgotten about the fact that the Fed is continuing to unwind its balance sheet. Federal Reserve Chairman Jerome Powell says that unwinding the balance sheet is not tightening monetary policy, but I say he's lying, as unwinding is quantitative tightening because it reverses quantitative easing, which ballooned the Fed's balance sheet to $4.5 trillion.

Each week, the Federal Reserve takes a snapshot of its balance sheet on Wednesday. On March 27, the balance sheet was at $3.956 trillion, down $6 billion from $3.962 on March 20. This amounts to tightening by the Fed, as $6 billion was pulled out of the banking system. At the end of September 2017, the balance sheet was $4.5 trillion, so the total unwinding has been $544 billion.

The Federal Reserve balance sheet strategy: The Federal Reserve will stop the unwinding at the end of September 2019. The Fed has set an unwinding schedule of $50 billion in April and then $35 billion for each of the next five months through September. This is an additional $225 billion in Fed tightening, which would take the balance sheet down to $3.731 trillion.

This reduction will not meet Chairman Powell's stated goal of a $3.5 trillion balance sheet. Did he lie again, or did he simply not mention that further unwinding needs to happen to achieve this goal? The additional $231 billion in unwinding will likely be scheduled after the 2020 election.

The daily chart for the yield on the 10-Year U.S. Treasury Note

The daily chart for the yield on the 10-Year U.S. Treasury Note shows that this yield has been under a "death cross" since Jan. 11 that favors lower yields. The 50-day simple moving average fell below the 200-day simple moving average to show that lower yields would follow. On that day, this yield was 2.70%, and it declined to a 2019 low yield of 2.34% on March 28.

The 10-Year Treasury yield has been below its semiannual pivot at 2.605% since March 20, when the FOMC announced a more dovish view on monetary policy. The yield closed last week at 2.414%, with my pivot for this week at 2.466%. I show monthly and quarterly value levels at 2.576% and 2.759%. Yields are a clear sign that economic weakness in Europe is helping a "flight to safety" into U.S. Treasuries.

The weekly chart for the yield on the 10-Year U.S. Treasury Note

The weekly chart for the yield on the 10-Year U.S. Treasury Note shows the decline in yields that began from a high of 3.26% set during the week Oct. 12 as the stock market peaked. This week sets the lowest yield from this high at 2.340%, holding its 200-week simple moving average, or "reversion to the mean," at 2.356%. The chart favors lower yields moving forward, with the note below its five-week modified moving average at 2.593%. The 12 x 3 x 3 weekly slow stochastic reading declined to 21.87 this week, down from 25.55 on March 22.

Daily chart for the SPDR S&P 500 ETF (SPY)

The SPDR S&P 500 ETF (SPY), also known as the Spiders ETF, is 20.8% above its Dec. 26 low of $233.76 and 3.9% below its all-time intraday high of $293.94 set on Sept. 21. This bull market rally follows a bear market decline from its all-time intraday high of $293.94 set on Sept. 21 to the Dec. 26 low. The fund saw a "key reversal" day on Dec. 26, as the close of $246.18 that day was above the Dec. 24 high of $240.83.

The close of $249.92 on Dec. 31 was an important input to my proprietary analytics, and two key levels remain in play. The semiannual value level is $266.14, with the annual risky level at $285.86. The close on March 29 at $282.48 was also input into my analytics, resulting in a monthly value level at $272.17, a weekly risky level at $287.14 and a quarterly risky level above the all-time high at $297.56.

Weekly chart for the SDDR S&P 500 ETF

The weekly chart for Spiders is positive buy overbought, with the ETF above its five-week modified moving average at $276.6 and above its 200-week simple moving average, or "reversion to the mean," at $238.78 after this average held at $234.71 during the week of Dec. 28. The 12 x 3 x 3 weekly slow stochastic reading rose to 89.80 last week, up from 88.80 on March 22 and moving further above the overbought threshold of 80.00. SPY will likely begin April becoming an "inflating parabolic bubble" with a reading above 90.00.

How to use my value levels and risky levels: Value levels and risky levels are based upon the last nine weekly, monthly, quarterly, semiannual and annual closes. The first set of levels was based upon the closes on Dec. 31. The original quarterly, semiannual and annual levels remain in play. The weekly level changes each week; the monthly level changes at the end of each month.

My theory is that nine years of volatility between closes are enough to assume that all possible bullish or bearish events for the stock are factored in. To capture share price volatility, investors should buy shares on weakness to a value level and reduce holdings on strength to a risky level. A pivot is a value level or risky level that was violated within its time horizon. Pivots act as magnets that have a high probability of being tested again before their time horizon expires.

How to use 12 x 3 x 3 weekly slow stochastic readings: My choice of using 12 x 3 x 3 weekly slow stochastic readings was based upon backtesting many methods of reading share-price momentum, with the objective of finding the combination that resulted in the fewest false signals. I did this following the stock market crash of 1987, so I have been happy with the results for more than 30 years.

The stochastic reading covers the last 12 weeks of highs, lows and closes for the stock. There is a raw calculation of the differences between the highest high and lowest low versus the closes. These levels are modified to a fast reading and a slow reading, and I found that the slow reading worked the best.

The stochastic reading scales between 00.00 and 100.00, with readings above 80.00 considered overbought and readings below 20.00 considered oversold. Recently, I noted that stocks tend to peak and decline 10% to 20% and more shortly after a reading rises above 90.00, so I call that an "inflating parabolic bubble," as a bubble always pops. I also refer to a reading below 10.00 as "too cheap to ignore."

Disclosure: The author has no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours.