Back at last ...... but is the world a different place?
There's been an awful lot going on whilst we've been away for so long but have things really changed ? Well, maybe ..... the spike in average hourly earnings last month certainly suggested that meaningful inflation might finally be on the way and caused a long overdue correction (i.e. > 10%) in stocks. The Fed's preferred measure of inflation however still languishes at little more than 1.5%, so what are we to believe ? Friday's US employment data will be even more crucial than normal.
The spectre of inflation at last meant that 10yr US Treasury yields were scared into a sharp upmove that tested the "crucial" 3.00% level , but have backed off to 2.80% (every level is "crucial" to someone it seems, and it pays to be wary of false signals).
What about volatility, which recently has seemed to be barely alive under the weight of massive central bank actions (QE) to add liquidity and to soothe any market jitters ? If the recent history of stock market prices before the correction is anything to go by, they did a lot more than just soothe jitters but nevertheless the early Feb conflagration saw the VIX measure of volatility spike to above 37 after spending most of the previous year wallowing around 10. After a post-spike pullback, the VIX is above 20 again this morning as the world digests President Trump's imposition of tariffs on imported steel and aluminium, and judges the likelihood of a hung parliament in Italy (after big gains for the populist parties) to be more newsworthy than confirmation of a working, Merkel-led coalition in Germany.
It might just be us, but things do FEEL a bit different ..... or at least, some the well-flagged threats to both stocks and bonds look like they're finally beginning to come into play.
You can call President Trump's tax package "Tax Reform" if you like, but essentially it's a "Tax Cut", and by far the largest beneficiaries are corporations and the very wealthy (whatever the administration may say). That's a minefield politically but not one that seems to bother the powers that be. From a trading point of view, the tax deal was plainly stock market-friendly as companies with cash reserves boosted by the cut in corporation tax and the deal on repatriation of overseas earnings embark on share buyback schemes or increase dividends to shareholders. Predictably, the notion that the extra cash would be used for essential investment looks some way down the list of priorities of most companies.
One of the defining features of markets in recent times has been the SIMULTANEOUS strength of both stock and bond markets, but of course tax cuts mean less revenue for the Treasury and are bad news for public finances to the tune of over $1 trn -- so in this instance what's seemingly good for share prices is bad for bond prices, and hence the spike higher in yields. The administration contend that the increase in growth will make up for the immediate loss of tax receipts, but that's a long-term assertion and one that's very far from being universally accepted. Increased issuance of government I.O.U.'s is inescapable.
Interestingly, the Treasury seems keen to weight the larger proportion of their borrowing towards the short end of maturities, which helps explain why the spread of 10yr US Treasury yields over the 2yr equivalents, after widening out to 79 basis points, has narrowed again to 61 bp. Even more of a factor is the perception of what the Fed might do with headline rates, which of course more directly affect the shorter maturities than the longer ones. New Fed Chairman Jay Powell, in his first testimony to Congress last week, stuck to the Fed's forecast of 3 rate hikes likely this year (with the first of them very likely this month). But his acknowledgement of the strengthening economy also opened the door to the possibility of a fourth rise (at least in the mind of Fed watchers).
Mr Powell has been on the Fed board since 2012, but unlike his predecessors who were fully-fledged economists, he has a background in private equity. Some investors have taken this to mean that he would be more tolerant of bouts of volatility than Janet Yellen say, and therefore would be less concerned about any short-term adverse market reactions to a fourth rate hike should it be necessary.
For years, investors have been comforted by the notion of the "Fed Put" (as in "Put Option") -- the theory being that the Fed would ride to the rescue of investors in the event of major market upsets. The suggestion is that such a comfort would not necessarily apply under Mr Powell. Frankly, that could be reading an awful lot into very little evidence. If it's true that Mr Powell might be more prepared to accept a bit of turbulence than those that have gone before, it's probably due to where the US now is in the economic cycle rather than a desire to force investors to look out for themselves.
And talking of where we are in the cycle, this seems an extraordinary time to be adding large amounts of fiscal stimulus (tax cuts, infrastructure spending) to the system. They are measures that one might expect to be implemented in a push to emerge from recession. To put them in place when the economic growth is strong and unemployment is running BELOW what was previously considered the minimum realistic sustainable level obviously greatly increases the danger of the economy overheating. Cue : Inflation, higher rates and yields and falling bond prices with knock-on effects for stocks.
So, in the sense that everything hinges on the stubbornly low inflation data bursting into life, you could argue that actually not much has changed. Or on the other hand, you could take the view even after recent corrections in both bonds and stocks, markets are more vulnerable than ever. It's too early to tell but maybe Mr Powell and his compadres at the Fed will show both the will to keep markets calm and skill in any attempt to do so. The trouble is, there's not much they can do about the politicians .....
P.S. On those Steel and Aluminium tariffs, by the way ...... As former Treasury Secretary Larry Summers has pointed out, there are a lot more steel and aluminium USERS in the US than PRODUCERS. How will inevitably higher prices help the economy as a whole ?? And if the whole thing results in a broader trade war with current trading partners across the globe, is the "America First" policy really likely to be judged a success in the final reckoning ?? The support for bonds as a result of these measures and the damage they may cause to growth suggests that the market thinks not. Mr Trump's provocative assertion on Friday that "Trade wars are good, and easy to win" may prove to be his most crass tweet yet -- which really would be saying something.