Trump Vs. Fed

by: Douglas Adams


Markets adjusted quickly to the Trump victory, posting impressive end-of-year gains in sectors of the economy most likely to benefit from fiscal stimulus derived from enhanced government spending.

With the labor market close to full employment, interest rates on the rise and inflation creeping into the greater economy, the Federal Reserve is pulling back on monetary stimulus.

The Trump administration and the Fed could be on a collision course in the medium term. In the interim, the Fed has the luxury to wait and see.

Markets adjusted quickly to the surprise victory of Donald J. Trump in November's presidential election, with the S&P 500 gaining almost 5% from the election through the end of the year. The risk premium, or the amount of compensation demanded by investors to assume perceived market risk, broke positive with the Trump victory as the yield on the 10-year Treasury note soared from 1.828% on the eve of the election to a year-high of 2.603% by the 15th of December before falling back to a yield of 2.445% to end the year. The bond market in pure binary fashion saw the incoming Trump administration as clearly inflationary with talk of fiscal spending on infrastructure, tax cuts for both households and businesses and pushing back regulation of the finance and health sectors of the economy.

Of course, market enthusiasm for the so-called Trump trade could easily derail as his erratic executive order banning US entry from seven Muslim majority nations and his open and very undiplomatic feuds with Mexico, Australia and now Iran appear to be aptly demonstrating. Such gyrations from standard diplomatic procedures and "gut" approaches to problem-solving are fairly standard features of the decision-making processes in many developing countries. The implied uncertainty carves out discounts on equity valuations and attaches added risk premia to fixed instruments in an effort to price in volatility - political, economic or otherwise. The suggestion here is that some implied sort of uncertainty measure could become a component of stock valuations and fixed instruments here in the US, particularly to sectors to which investors have flocked in hopes the administration will deliver on the holy trinity of tax cuts, deregulation and defense spending - with perhaps some infrastructural spending tossed into the mix. Such implied uncertainty measures would make dollar-based assets less attractive as both a store of value and a safe harbor vehicle from uncertainty - reflective of the sharp swings in the dollar index against other world currencies.

The dollar index (DXY) was at 97.97 on the eve of the election and hit a 14-year high on the 28th of December with a post of 103.22. It is now less than 2 points shy of traveling full circle since the election at 99.65 at Friday's market close (3 February), its lowest market close since the 11th of November. Of course, comments by the president criticizing Japan and China for making currency devaluations a primary policy tool, while his trade advisor took Germany to task over its trade advantage derived from a grossly undervalued euro were far from helpful, causing further dollar volatility in world currency markets. Comments about quickly changing the terms of NAFTA sent the dollar to its lowest levels since December against the peso. The fluctuation in the dollar, including its downward path YTD has breathed new life into gold, exercising its safe harbor status in times of market uncertainty.

The yield on the 10-year Treasury has taken a rather different path from that of the dollar. From an all-time low of 1.361% on the 8th of July, the benchmark yield rose to 1.857% on the 8th of November when the election results were known. By the 16th of December the 10-year yield had soared to 2.603% for a gain of just over 40% in little over a five-week period. By the end of the year, the note's rise had mitigated somewhat with a 2.445% post that closed the year. In the New Year, the yield on the 10-year note ebbed and flowed, falling to a low of 2.323% on the 17th of January before moving up to 2.470% at Friday's market close (3 February).

Turning to the so-called Trump trades, PowerShares Regional Banks (NASDAQ:KBWR) captures a basket of small and regional bank stocks across the country. These are domestically based companies that derive most if not all of their revenue from local markets. Since their exposure to international markets and revenue streams is minimal to non-existent, they incur little forex risk. They don't usually have the luxury of routing earned revenue through foreign tax havens which means the savings from a tax cut would drop pretty directly to their bottom line. Rising interest rates means borrowing at the low end and lending at the high end of the curve increases profit margins as the yield curve steepens. Improving market conditions and investor sentiment allowed KBWR to turn in a stellar run from the 8th of November through the end of the year, returning almost 26% over the period. This year, the pace has slacked off dramatically with a 0.45% loss to date as investors wait for policy particulars. Some of those particulars came with Friday's executive order to begin the process of rolling back Dodd-Frank (2010).

The other half of the bank equation embraces large and behemoth US banks and holding companies. Financial Select Sector SPDR ETF (NYSEARCA:XLF) had the second-best performance from the election through the end of the year returning almost 18% for the period. While rising interest rates and tax cuts are indeed important to the bottom line of these banks, so is the deregulation bent of the administration that could bring back some highly profitable revenue centers back into play. The loosening of the Volcker Rule regarding proprietary trading and other Dodd-Frank-inspired limitations on profit centers of large banks could be significantly altered in the short and immediate term. The announcement yesterday (3 February) by Gary Cohn, former Goldman Sachs (NYSE:GS) president and now director of the White House national economic council, rolled out the administration's new policy that looks to end the controversial ruling by the Department of Labor that would require financial advice for the $16 trillion US retirement savings industry to be in the best interests of the client, a ruling that is currently set to go live come April. Of course, the administration's authority via executive orders is limited and big changes to Dodd-Frank would require Congressional approval - including overcoming the 60-vote floor threshold in the Senate. Yet the headline-grabbing attention that comes with the executive order is a big driver of investor sentiment - not to mention setting the enforcement agenda for regulators. Not unexpectedly, financial shares, particularly the shares of insurance companies, whose annuity products would make for a difficult sale under the fiduciary ruling, soared with the announcement. Year-to-date XLF has barely maintained a positive market performance as investors await further policy announcements on the sector by the administration.

The iShares U.S. Basic Materials (NYSEARCA:IYM) captures the infrastructural component of the Trump trade. From the 8th of November through the end of the year the issue returned 10.46%. The caveat here is the source of funds to pay for the $1 trillion of infrastructural spending, which is one of the main reasons why interest rates rose so dramatically and quickly between the election and the end of the year. Fiscal conservatives and deficit hawks in Congress are increasingly nervous as the administration attempts to squeeze growth from policy ideas without much thought as to how these programs will be funded. Completing a wall project on the US-Mexican border, augmented defense spending, infrastructural spending combined with tax cuts and precious little to date on offsetting spending cuts implies a significant increase in the supply of Treasury notes. How this debate is resolved will go a long way toward offering a clue as to how well infrastructural issues will fare in the next few years. To date, IYM is up 4.59% through Friday's market close (3 February).

The iShares U.S. Aerospace & Defense (NYSEARCA:ITA) has been the weakest member of the Trump trades. From the 8th of November through the end of the year, ITA was up just under 8%. Ronald Reagan had few worries around increasing the federal deficit in order to achieve his policy ends and the Trump administration appears to be following a similar path - with certain caveats. Mr. Trump's recent and very public criticisms of Lockheed's (NYSE:LMT) F-35 project and Boeing's (NYSE:BA) new presidential jet saw investors corral their enthusiasm for the sector until more policy direction became available. To date, ITA is up 1.31%.

Inflation is beginning to stir across a wide swath of economic activity both here and abroad as deflationary pricing has flipped in the US, parts of the eurozone, the UK and even Japan. The rebound of energy prices from historic lows continues to put upward pressure on prices as has falling unemployment which reduces slack in the labor market. With falling unemployment comes upward pressure on wages as the national hourly compensation rate among private sector workers hit its highest YOY growth level of 2.93% in December here in the US for all private nonfarm payrolls. In January, wage growth fell back to about 2.48% - despite adding 227,000 jobs during the month. The January jobs report headline number was well above consensus estimates. Still, involuntary part-time workers at 5.8 million are about a million more than economists expect at full-employment. Further, the national average of hours worked in January came to 34.4 hours which is little changed from that of January 2016 at 34.6 hours, signaling that full employment is still further down the road. Headline inflation hit 1.8% in the eurozone in January YOY - the highest post in the past four years. However, core inflation, which strips out the volatile food and energy sectors, remains subdued at 0.9%. The European Central Bank's policy statement concluding its recent governor's meeting deflected calls, particularly from German members on the council, to end the bank's current asset purchase program that is scheduled to continue through the end of 2017. While German price inflation has been the main driving force of inflation in the currency bloc, prices in both France and Spain were particularly strong at 1.6% and 3%, respectively through February. Even in Japan where deflating prices have been a constant drag on economic growth over the past two decades, inflation measures crept upward from 0.45% to 0.61% YOY, as the yen weakened in world currency markets in the latter part of the year. The dollar is up almost 8% against the yen through the end of January since the US election. With the divergent paths of the Bank and Japan, which continues to buy Japanese assets, and the Federal Reserve, which projects at least three 0.25 basis point upticks in the Federal Funds rates over the course of the year, the yen is expected to weaken even further as the year progresses. Japanese inflation is expected to inch higher over the period, but will remain well below the BOJ's 2% target for the foreseeable future.

Here in the US, the reflation of the economy has been most pronounced since the surprise election of Donald Trump this past November. Headline inflation broke through the 2% threshold in December for the largest YOY post since June 2014. Rising housing costs and rebounding energy prices are largely behind the rebound in inflation as the twin effects migrate through the general economy. Inflation trending upward on the heels of both rising energy and home prices over the medium term. Long contracts on oil futures outnumber short bets by 370,939 through the 24th of January, the largest net bullish position in 10 years of data, according to the Commodity Futures Trading Commission, signaling that investors think energy prices will continue to rise, dragging prices in the greater economy along for the ride. Market-based inflation measures, as did their 10-year Treasury brethren, rose dramatically through the end of the year. The yield on a 10-year Tip on the 8th of November implied an inflation rate of 1.607% over a 10-year period. By the end of the year the 10-year Tip yield was signaling an inflation rate of 1.945%-a 20% increase. Year-to-date the implied inflation rate over a ten year period had cleared 2%, settling at 2.04% at Friday's market close (3 February).

All of this amounts to a different set of calculations for the Federal Reserve from that of any of its central bank peers in Japan, the eurozone, Britain or even China. While the Fed's Open Market Committee contemplates its pending schedule of hikes in the Federal Funds rate, the European Central Bank (ECB) continues to purchase a basket of €80 billion of sovereign and corporate bonds. While the program will cut back to a pace of €60 billion in April, the original program was extended to the end of the 2017 from its original stop month of March. Monetary policy in Japan is also uber-loose as the BOJ continues its ¥80 billion asset purchasing program. There is now a big push in Japan to use more fiscal stimulus. As in the US, Japan is largely at its natural rate of full employment so tax cuts and government spending could push Japanese consumers to spend more thus creating more demand in the greater economy. There is resistance to triggering a fiscal response largely out of concern that government spending and tax cuts would contribute to Japan's huge public debt-already one of the largest in the world.

The Fed's preferred inflation gauge, the core personal consumption expenditures (PCE) deflator, was unchanged from the 3rd quarter and remains shy of the Fed's 2% inflation target, a level of inflation the country has not met since September 2011. In December, the Fed penciled in three increases in the Federal Funds rate for 2017, a schedule that could readily change if a fiscal stimulus program is put into place. On the opposite end of the spectrum, if the administration's economic policies end up thwarting growth the Fed's interest rate schedule could slow or even reverse course. A brief and indirect mention of the seeming conflict came via the FOMC statement at the conclusion of their January meeting in regard to an improvement of both business and household sentiment. Of course, any major change in fiscal policy will likely have a long lead time as spending authorizations would be subjected to the often protracted legislative dance through Congress before the first shovel breaks ground. Accordingly, any impact on the economy from the fiscal side would likely be years in the making and gradual in overall effect, affording the FOMC the luxury, at least at this juncture, to simply to wait-and-see. As of Friday's market close (3 February) the Federal Funds futures for a March FOMC rate increase carried a probability of just 12%. Accordingly, the highly rate-sensitive yield on the two-year Treasury note was down 2 basis points at 1.18% and down 3 basis points for the week. By June's scheduled FOMC meeting, the probability leaps to 64%.

While increasing the Federal Funds rate is the Fed's headline approach toward tightening monetary policy, its $4 trillion balance sheet provides a more passive approach that carries the equivalent impact on the yield of the 10-year Treasury note as two 25-basis point increases over the course of 2017. In 2011 under the Operation Twist program, the Fed swapped out much of its short-term for long-term holdings which had the effect of increasing the duration of its Treasury positions without increasing the value of its overall holdings. The program applied downward pressure on long-term borrowing costs. Due to Operation Twist, the value of maturing bonds was relatively small in recent years. Now, maturing Treasury debt now is estimated at just under $200 billion in 2017 and double that in 2018, compared to about $4 billion in 2015, according to Bank of America/Merrill Lynch estimates. As bonds matured and the proceeds from those bonds were reinvested through regularly scheduled Treasury auctions, the duration of the Fed's Treasury holdings has fallen to an average of about six years according to Deutsche Bank (NYSE:DB) research. The downward pressure on long-term interest rates is expected to diminish as a result which will passively remove monetary accommodation from the greater economy. Over the course of 2017, this passive removal of monetary accommodation could add about 15-basis points to the 10-year Treasury note, which is about the equivalence of two 25-basis point increases in the Federal Funds rate. The Fed's balance sheet through the week ending the 2nd of February holds $2.463 trillion in Treasury notes and $1.745 trillion in mortgage-backed securities (MBS). Given the path of the 10-year Treasury note since its July low of 1.361% to yesterday's market close of 2.47%, the tightening of monetary policy has already been considerable.

The Fed has not announced its intention of downsizing the portfolio of yet and is not expected to do so much before the end of next year. The decision to invoke these passive measures will not be taken lightly as the impact on current levels of monetary accommodation is significant. While the sheer size of Treasury securities on the Fed's balance sheet is more than three times that of December 2007, the official beginning of the Great Recession of 2007, the portfolio never held mortgage-backed securities until January of 2009 after the Fed announced the agency purchase program in November of 2008. The Fed's MBS holdings, similar to its outsized holdings of Treasury notes, applies considerable downward pressure on the yield of the 30-year mortgage benchmark. Ending just the reinvestment of maturing MBS would have an immediate impact on the housing market, already struggling with the 30-year mortgage rate jumping from the pre-election level of 3.54% to 4.32% through the last week in the year. In the New Year, the 30-year rate has pulled back to 4.19% through the week ending 2 February.

The Trump administration's fiscal stimulus program and the Fed's downsizing of its portfolio could potentially collide over the medium term with all the potential of unnerving financial markets as the taper tantrum of 2013 aptly demonstrated. In essence, the Fed is removing monetary accommodation from the greater economy, reducing the safety net for investors against downside risk. It took another year after the taper tantrum before the Fed was able to end its asset purchase program at its December FOMC meeting in 2014. The impact of rising interest rates in the US strengthened the dollar in world currency markets and caused global capital flows to increase dramatically into dollar-based assets. Currency values in the emerging markets space fell against the dollar while local interest rates and borrowing costs rose sharply applying downward pressure on economic growth. The Fed does have the luxury of time on its side as there is little evidence that the size of the Fed's portfolio is distorting market functionality. The real market distortion comes when the portfolio begins to unwind which, as Janet Yellen stated in her Stanford speech, is all the more reason for the Fed to move slowly.

Disclosure: I am/we are long KBWR, ITA, IYM, XLF.

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.

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