The market can rally all the way to the January historical highs, and beyond, ONLY if the Financial Sector convinces investors that the best is yet to come rather than "you have seen the best and from here it's all downhill"
The delusion of good earnings is just that: an illusion, smoke in mirrors, and also it's history. The market looks forward, not back. The market's gluttonous craving is summed up in: "what have you done for e lately and will do for me" instead of living in glories of the past."
Higher interest rates does not necessarily mean lower markets but the transitory phase - like we have now - can be volatile with wild gyrations, but if the market can overcome that and adjust to the new paradigm of higher interest rates & lower but steady growth with a stable & not too unpredictable political environment, then new highs can be achieved by end of 2018. If not, then the bear will take this market to the cleaners, all the way down to SPX 1900. or lower.
April 21, 2018
Who ever thought the yield curve would be a hot topic? Bond nerds (like me) find the configuration of interest rates across the maturity spectrum a matter of endless fascination, but we usually try to keep it among ourselves rather than put off regular folks.
Dan Clifton, Strategas Research Partners’ keen Washington analyst, reports that the yield curve has been as big a topic of conversation among his firm’s clients as the Mueller investigation or China tariffs. The buzz, if you can believe it, is about the shrinkage of the spread between shorter-term yields—such as the two-year Treasury note, which reflects expectations about the Federal Reserve’s overnight rate—and more distant yields, such as the 10-year Treasury, the de facto benchmark for longer-term borrowings.
The narrowing between short- and long-term yields has historically been like a drop in the barometer, indicating stormy economic times ahead. Last week, the spread between two- and 10-year notes shriveled to 43 basis points, the lowest since 2007, when the financial crisis and Great Recession were about to hit. This aroused disquiet among investors, as Clifton writes in a note. (A basis point is a hundredth of a percentage point.) By week’s end, the curve steepened as the 10-year note hit a cycle-high yield of 2.95%, for a 50-basis-point spread over the two-year note.
That’s still a relatively small extra increment of return for an additional eight years’ commitment of your money. It’s only worth it if an investor thinks yields won’t rise significantly. In turn, that implies the economy isn’t strong enough to push interest rates appreciably higher. “My take from discussing the issue with clients is that the headwinds from a possible trade war are colliding with the tailwinds from $300 billion” of additional stimulus from spending on top of the recently enacted tax cuts, Clifton writes.
This sentiment is playing out in the financial markets, with the Standard & Poor’s 500 index giving up all its post-tax-cut gains as the yield curve narrowed in the wake of the announcement of tariffs on imported steel, he notes. More substantively, clients are worried about the clash between the Fed’s path of interest-rate increases and the sharp rise in the fiscal deficit. The International Monetary Fund called out the U.S. as being an outlier among major nations in boosting its debt relative to its gross domestic product.
This week will provide a direct reflection of that, with Uncle Sam auctioning $274 billion of fresh Treasury securities, observe BMO Capital Markets rates strategists Ian Lyngen and Aaron Kohli. Heavy Treasury issuance, concentrated on shorter maturities, along with Fed policy on track for further rate increases, will tend to keep pressure on the short end of the market, which tends to flatten the yield curve.
However, this only takes into consideration traditional relationships between financial indicators and the economy, according to Lena Komileva, who heads G+ Economics in London. What’s different this time (and that dangerous phrase is used advisedly) is that the dollar is softening while the yield curve is flattening. The latter is an indication of tighter money, while the former indicates the opposite.
What’s truly different this time is that longer yields are low, even negative, given the economic cycle, “denoting deeply easy financial conditions,” she writes in a client note. That reflects not only the Fed’s quantitative-easing program but also “the multiplication effects of concerted money printing by all other major central banks after the financial crisis, and cubed by the surplus savings of the aging populations of China, Japan, and Germany looking for long-term pension yield.”
“A combination of depressed U.S. yields, a flat [yield] curve, and a falling dollar, even as the Fed was hiking rates, is a reflection of too much dollar liquidity in global markets,” Komileva writes. “A surplus of investment funds looking for returns in low-yield global markets” results in a cap on longer-term yields and a flat yield curve.
Rather than too-tight liquidity, she concludes, “ultraeasy financial conditions, coupled with unprecedented fiscal easing in the U.S. at this late stage of the economic cycle, have the potential to overextend investor demand for risk and debt creation too far relative to weak productivity in real economies.” All of which raises the potential for “financial pain and recessionary volatility for the future.”
There are two competing views of the yield curve. The traditional one holds that the Fed has pushed up short-term interest rates enough, and the bond market sees they’re near a peak; so money is tight. Conversely, the policies of other central banks and excess savings abroad have depressed long-term yields; in which case, money is easy.
Regardless of the reason, borrowers with loans tied to short-term rates—whether small businesses or homeowners—feel the effects of rising yields on the short end. At the same time, oil prices are rising—which President Donald Trump blasted Friday in a tweet—along with other commodity prices as the dollar declines.
No wonder the yield curve’s flattening is getting the attention of regular folks.
Speaking of the president’s tweets, “There he goes again,” as the Gipper would say.
“Russia and China are playing the Currency Devaluation game as the U.S. keeps raising interest rates. Not acceptable!” Trump tweeted on Monday.
Yet again, his assertions about China’s supposed manipulation of its currency, the renminbi or yuan, are contrary both to the market and the findings of his own Treasury Department. As for the ruble, its recent drop has been the result of actions in Washington, not Moscow.
But could the target of Trump’s ire also be the U.S. monetary authorities?
Since publication of our cover story “Trump Is Wrong on China” (Nov. 14, 2015), we have explained that China hasn’t been driving the yuan lower, but rather has been supporting it by spending billions of its cache of foreign-exchange reserves. Indeed, since the yuan’s addition to the IMF’s Special Drawing Right basket of currencies, or SDR, in October 2016, the Chinese currency has been steadily appreciating. Joining the SDR was mainly symbolic but nonetheless important to Beijing, which has made its currency’s stability politically significant.
Since the beginning of 2017, the yuan has appreciated nearly 11% against the dollar. Trump had vowed during the 2016 presidential campaign to label China a currency manipulator on “day one” of his administration, which was Jan. 20, 2017. That didn’t happen. And a week ago Friday, the Treasury contradicted the president’s tweet by refraining once again from naming China as a currency manipulator in its semiannual report on international exchange rates.
The ruble, however, has tumbled 7% in reaction to sanctions placed on some Russian oligarchs by the U.S. administration, which makes Trump’s contention that Moscow manipulates currency all the more incomprehensible. (Russia isn’t among the 12 trading partners covered by the Treasury report.)
While Trump’s tweet attracted attention for his contradiction of his own Treasury and the market regarding China’s currency, his ambiguous comment about U.S. interest rates drew little notice. Were the Fed’s interest-rate hikes “not acceptable”?
Earlier this month, Peter Navarro, the national trade director, said he was “puzzled” that the Fed had “announced three rate hikes before the end of the year.” The central bank, however, has raised its federal-funds target rate once, to a range of 1.5%-1.75%, at last month’s meeting of the Federal Open Market Committee. The FOMC’s dot-plot graph of year-end projections by the panel’s members implies two additional quarter-percentage-point increases, which the fed-funds futures market corroborates.
So was Trump’s tweet also directed at the U.S. central bank? That would be odd, given that the administration this week announced two more Fed nominees, which means five of the six members of the Board of Governors will have been named by Trump once they’re confirmed by the Senate. One vacancy remains after this week’s nomination of Richard Clarida as vice chairman and Michelle Bowman of Kansas as a governor.
Looking at what will be the de facto Trump Fed, JPMorgan’s chief U.S. economist Michael Feroli writes that the central bank led by Fed Chairman Jerome Powell, Clarida, and Williams is likely to maintain the current policy course of continuing to raise rates as long as growth remains above the economy’s trend. And it is “very likely” to do so if the three-month average increase in nonfarm payrolls remains above 200,000.
The central bank should continue to pursue its dual mandate of maximum employment with stable inflation “irrespective of any political pressure,” the veteran Fed watcher writes. Feroli notes that past presidents have tried to “cajole” Fed policy makers. But “theories that recent Fed nominees have stuck a deal with the president have about as much evidence behind them as faked moon-shot theories,” he concludes.
As interest rates continue to rise, at least partly reflecting the widening budget deficits under the administration’s fiscal policies, it nevertheless would be surprising if Trump was reticent about monetary matters, as his tweets about exchange rates indicate.
Email: randall.forsyth@barrons.com
https://www.barrons....sion-1524269431
