Yesterday, we were looking at what has moved the gold market, why there are few long-term correlations and how a dominant but temporary heuristic focuses the price on one set of issues, ignoring others.
Today, we're going to look at whether the stock market rally can continue in the face of rising bond yields and a rising dollar.
Here is roughly what happened on the markets in the aftermath of the Trump victory:
- The stock market went up (after a spectacular turnaround on election night)
- The bond market sold off strongly
- The dollar is up
- Gold is down
- Emerging markets are down
Markets seem to price in higher growth, which is good for equities and the dollar. The bond market sold off on the expectation of higher growth, which increases inflation expectations. What might also play a role is a worsening outlook for public finances. Inflationary expectations are certainly going up.
Indeed this can, as SA contributor Bill Ehrman argued, be the first inning of a global reflation. If that is the case, there is every reason for optimism.
However, a combination of higher spending and tax cuts isn't promising for public finances, reinforcing the bond sell-off.
An interesting question at this point is when the rising bond yields and rising dollar are going to trump (Trump!) the stock rally, as dividend yields are plunging with respect to bond yields.
Here is SA contributor John Mason:
The current economic recovery contains a booming stock market, an increase in consumer wealth and economic growth led by consumer spending. However, the business capital spending did not take place and the growth rate of the US economy has remained very modest for the almost seven and one-half years it has been recovering. Sole reliance on the monetary policy of central banks, including historically massive injections of reserves into the banking system, not only in the United States, but in Europe and in England, has not been able to achieve more rapid economic growth. Monetary policy does not seem to be able to impact real variables. Economic growth seems to be, more or less, determined by the supply side of the economy.
He quotes Gillian Tett form the Financial Times, pointing to the Trump election as ground zero for the shift from monetary to fiscal policy. Long overdue, according to Tett, and Mason agrees.
We agree as well, albeit for different reasons. Where Mason points to Friedman and the long-run neutrality of money, we've pointed to a liquidity trap. SA contributor Lars Christensen argues that the Fed isn't likely to remove the punch bowl entirely before the party even starts (emphasis ours):
In yesterday's post, I wrote about why I believe it is the combination of Donald Trump's fiscal stimulus plans (infrastructure investments and tax cuts) combined with the Federal Reserve's willingness not to (fully) offset this, which has pushed inflation expectations in the bond markets up very significantly since Tuesday. If the Fed's inflation target was fully credible, fiscal stimulus would be fully offset by the expectations of a tightening of monetary policy to "neutralize" the impact on aggregate demand from fiscal stimulus. This, of course, is known as the so-called Sumner Critique.
We tend to agree. However, there are a number of caveats:
- The rising bond yields (and rising dollar) are perhaps enough already to prevent the party from going.
- Inflationary expectations could get out of hand, forcing the Fed to act.
- The expected growth from the fiscal boost might disappoint, or not even materialize at all.
The Heisenberg weighs in with the "uncertainty thing":
Still a Trump presidency reduces the chances of aggressive Fed hikes (it's the whole uncertainty thing) which should, on its face, be positive for risk. But who knows? Central banks looked set to scale back their role as guardians of multiple asset bubbles, but Trump's election has thrown that into question.
It's of course somewhat curious that, as David Deuchar notices, the markets are rejoicing the Keynesian part of Trump while the party he (nominally) represents wanted nothing to do with that.
Not to speak of the fact that the stock market rally, which Trump has called a bubble, might very well depend on further generous accommodation by the Fed, which Trump has criticized exactly for being too accommodative already.
The combination of higher bond yields, a stronger dollar, a possible tightening of monetary policy and possible weakness abroad (see below) could also conspire to prevent the expected growth revival from materializing. Others, like SA contributor Bill Conerly, don't expect big tax cuts to emerge:
Trump promised to cut top tax rates and eliminate the Alternative Minimum Tax, plus some other changes. Changing tax law will require approval of both houses of Congress, and Senate Democrats won't go along with this. Some Republicans will object over increased deficits. Trump's tax plan will increase the deficit by one trillion dollars over ten years under very optimistic estimates of stimulative effects of the lower tax rates (according to Tax Foundation analysis). Reality would probably be worse. To get his tax plan passed, Trump will have to wheel and deal with Democrats, perhaps regarding health care. My expectations of tax changes are very low.
He weighs the different policy proposals and their likelihood of materializing, and arrives at the conclusion that growth is likely to slow.
What's also important to realize is the possibility that the economy is bumping up capacity constraints, especially in the labor market. Wages are already creeping up and unemployment is at levels which used to be associated with full employment in the past.
While Trump might have signaled a reflation in the US, the rest of the world is a different ball game.
For instance, there are those emerging markets. Rising US bond yields and a stronger dollar are really pretty bad news for many of these with enormous outstanding corporate dollar debt, exceeding $25 trillion, rising from 57% of GDP in 2008 to 104% of GDP last year.
In the past, we have seen several emerging market debt crisis when US interest rates and the dollar were rising in conjunction; it gives a double whammy to that outstanding corporate debt, much of it dollar denominated.
And then there are these Italian bonds misbehaving:
We'll leave this for another day as it deserves a more extensive treatment, but needless to say it's not good.
What can derail the stock rally? A summary
- Further rising bond yields
- Further dollar strength
- Fed tightening
- Emerging market turbulence
- Growth disappointing
- Italy, Portugal
While we marvel at the stock rally heralding reflation and Keynesian pump, we're not at all sure rising bond yields and the dollar will not stop the rally in its tracks any time soon.
Of course, markets are aggregates, and perhaps not even the most useful ones. Even if they go down, there is still money to be made if you're positioned in the right sector, and there have been massive sector rotations going on since the Trump victory.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.