With the Federal Reserve finally cutting rates for the first time, the attention turns to how many additional cuts to expect, how deep the future cuts will be and what that means for us as investors. Indeed, tracking CPI, PPI and the other various economic reports we see every month matters. Traders instantly react to the data (sometimes wildly so), especially when the actual numbers are distinctly different than estimates.
However, the market in aggregate is a forward-looking mechanism, thus, prices will move in anticipation of an event or trend, sometimes way before said event or trend even starts to happen. The performance of the Utilities Select Sector SPDR (XLU) 2024 is the epitome of that. It is the best sector year-to-date.
XLU is a veritable "bond proxy." Thus, historically, XLU has been correlated with the direction of treasury bonds (which move in the opposite direction of bond yields). That's happened again this year, of course, and XLU has been a true leading indicator from a trading perspective.
Here's a chart with XLU and the TLT 20+ Year Treasury Bond ETF, which we're using since it's the most widely traded treasury bond ETF. From 2022 through 2023, XLU and TLT moved in the same direction more often than not. Both made key lows in October'23 and short-term trading tops in January'24.
.. In February, though, TLT continued to decline, while XLU exploded higher.
.. and it has continued to advance at a rapid pace.
TLT eventually followed its lead, but it didn't start moving higher until late April. What has caused XLU's strong relative strength? One explanation is that the AI surge has put a lot more demand on utility companies. That's clearly been a factor.
But even as some of the most popular AI companies have come under pressure in recent months, XLU has continued to surge. Another reason is simply that investors are aggressively seeking yield producing instruments, with the understanding that bond yields were destined to fall. XLU's 2024 advance shows that it has correctly anticipated lower yields, and now, FOMC-induced rate cuts.
The concern, of course, is that if inflation comes back, the expected cuts may not last as long or be as steep as the market is pricing in now. We're not predicting this, but if the biggest traders sense a shift is, indeed, about to happen, we'd most likely see it reflected in XLU reversing lower. Extended From a short-term perspective, XLU has gotten quite extended.
This chart shows XLU along with the Bollinger Bands indicator. The bands are two standard deviations above and below a security's 20-day moving average (the middle-dotted line). The red arrows depict the times when XLU has traded noticeably above its upper band over the last year-and-a-half.
The periods directly following spikes understandably have been weaker: sometimes we've seen digestion phases result and other times, bigger selloffs have taken place. This being the case, it wouldn't be surprising to see XLU's pace slow over the near-term again now. Much bigger picture, XLU recently has broken out to new all-time highs by finally overtaking its former September '22 high point.
That's bullish, but each breakout to new highs since 2012 eventually has been undercut. The past reversals haven't happened immediately, as sometimes XLU extended for months after breaking out. But each time, it did fall back under the most recent breakout zone.
In other words, buying long-term breakouts in XLU has NOT paid off over the last decade. Buying the ensuing sell-off after XLU finds a bottom has been the better play The bottom line is that trading XLU has been tricky, but tracking the ETF for clues about the bond market and the economy has been helpful. And that's why we need to continue to watch it closely.
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