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Putting the Fiscal Cart Before the Monetary Horse?


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Did anyone get the license plate number of that truck that ran over my bullish 10-year Treasury call, backed up, and ran over it again? I think the truck had a gold-plated grill and seemed to be heading toward Washington, D.C. at high speed! Risk is definitely on and bond yields are definitely up. Following the electoral win by President-Elect Donald Trump, equities and the U.S. Dollar (USD) have surged.

 

The yield on the 10-year Treasury note has increased 26 basis points from its close on Election Day. More impressive is that it has increased nearly 40 basis points since early Wednesday morning when markets panicked over the possibility of a Trump victory. Meanwhile, the USD has been on a tear as measured by Bloomberg’s Dollar Index (DXY). On Election night, when it became highly probable that Donald Trump was going to win, the Index dropped from 98.15 to 95.89 (around the time S&P 500 futures were down 5%). It then surged to 99.07, an increase of 2.2%. That is a huge move.

What has made this move even more perplexing is most market observers, myself included, expected Treasury yields to plunge, along with equities, if Trump had a surprising win, and expected the opposite with a Hillary Clinton victory. What I find maddening is that I predicted the election result correct two weeks ago, but got the market move completely wrong! Given the market reaction to President-Elect Trump’s surprising win, at least I can take solace in the fact that I was not alone.

So what happened? It seems that sometime early Wednesday morning, the utter market panic of a Trump victory turned to euphoria.

It is my observation that market participants decided that the $500 billion stimulus package Trump talked about on the campaign trail, along with his promise of a large tax cut, was literally happening at that moment! Suddenly, stocks and the USD went bid and long-dated Treasury notes went “offer without.” Was this response rational? If you think that President-Elect Trump is going to get a massive stimulus package signed into law along with a significant tax cut while we have sub 5% unemployment, then it is very rational. I say this because if this scenario occurs, the Federal Reserve (Fed) will most likely have to start withdrawing monetary stimulus much faster in 2017 than previously thought in order to avoid higher than desired inflation. Therefore, investors have begun to sell the long end of the curve, essentially telling the Fed that they need to get moving.

Trump’s amazing political feat has garnered him tremendous political capital, in my opinion. The fact that he won this election without the support of many powerful politicians in his own party gives him political power that few presidents enjoy coming into office. Trump proved that Republican voters sided with him despite the objections of the party’s leadership. His popularity, coupled with Republican control of both chambers of Congress means, in my opinion, he can get a lot of what he wants pretty quickly. If he wants a large stimulus package accompanied by tax cuts as his first legislative initiative, I think he can get it done. Moreover, I think Trump, much like the Fed, views the strong employment growth but disappointing GDP growth as a conundrum. One of the logical solutions is to implement a large stimulus package of infrastructure spending combined with tax cuts.

However, there’s another issue lurking. If the Fed begins to reduce their extraordinary monetary stimulus in the form of more policy rate hikes in 2017, this creates a problem for China (as well as many emerging market economies). Nobody wants to create or exacerbate a problem for China. The Chinese Yuan has continued to slide versus the USD, now down 1.8% since the end of September 2016. The Chinese are selling treasuries and the People’s Bank of China is draining liquidity to defend the Yuan and stop capital flight out of the country. The Chinese are tightening monetary policy at a time when they can ill afford to. Currently, China is in the process of trying to deflate a tremendous real estate bubble that their banking authorities created through very easy financing. Tightening policy too quickly makes the likelihood of this bubble popping sooner rather than later all the more likely. China is in a box and unfortunately, we are in there with them. A bad outcome for China can be a huge threat to the global economy, similar to what we experienced earlier this year when China wobbled.

The Fed is independent, and they will do what they believe they have to do to keep the risks between growth and inflation balanced. Possible tension between the Fed and the Executive Branch could develop quickly once Trump takes office, potentially derailing the new administration’s legislative agenda. I believe when you combine this possibility with the continued, active Quantitative Easing policies of the world’s major central banks, it will work to halt this sharp sell-off in medium- and long-term rates.

Member SIPC & FINRA. Advisory services offered through SWBC Investment Company, a Registered Investment Advisor.

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