The week of March 13th through March 17th saw the S&P 500 (NYSEARCA:SPY) stay relatively unchanged with the index closing the week at 2,371, down slightly from 2,372 the week before. Also during the week, the Federal Reserve raised rates by 25 bps to a Federal Funds rate range of 75 bps to 100 bps. Despite the Fed rate hike, Ten-Year Treasury rates fell to 2.50% from a rate of 2.58% on the 10th. Finally, the Dollar Index also fell to 100.31 from 101.38 over the week.
If any of the moves in the market post-Fed sounds surprising, it should. It was to me as well, given a Fed raising rates and a BOJ the next day pledging to keep an aggressive accommodative policy. The previous week saw the ECB continues to keep rates low and continues with QE measures. The fallout?
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Over the past several months we have seen interest rates rising globally from the lows seen in July of 2016. US Treasuries, Japanese Government Bonds, and German Bunds have all moved higher in yield since that time. However, there seem to be some clear divergences now occurring throughout the global yield curve as central banks seem all heading in different directions.
One can see in the charts above how the US Yield Curve has been relatively stagnant over the past several weeks, while the JGB and Bunds continue to steepen. In fact, in the chart below of the 10-2s the trends of the global yield curves are much easier to see. The trend in the JGBs and Bunds have been clearly steeper for several months, while the US Yield has remained fairly flat.
In fact, these directional shifts in each country's yield's curve have led to changes in the spreads of the 10-10s.
It has also become clear that the US ten-year Bonds and the German ten-year Bunds now have a spread that is contracting. Of course, the contraction would be bullish for the euro and bearish for the dollar. Meanwhile, the ten-year JGBs vs. the ten-year USTs still presently appears to be widening after some mild contraction. However, it is important to note it has not reached a new short-term high. If the spread should continue to widen, it should lead to continued US dollar strength vs. the Japanese yen. However, this needs to be watched carefully at this point. Finally, after months of stagnation, it appears the spread between German Bunds and JGBs is now widening again. The widening spread would be bullish on euro vs. the Japanese yen.
In the chart below we can see that the dollar has been weakening vs. the euro. The weakness is likely a sign that the market is now anticipating a less hawkish Fed and less dovish ECB.
The analysis of the yield curve spread and the movements in the currency market post-Fed indicates the Bond and Currency markets were likely pricing in more than three Fed rate hikes in 2017. Now that we are post-Fed meeting, the market is apparently in the process of repricing both yield spreads and currency rates. Expectations seem to be shifting towards a Fed that is likely to raise only two more times in 2017 and the possibility of an ECB that will continue to reduce the size of its QE program. This would be an explanation as to why we are seeing spreads between Bunds and USTs contracting and dollar weakening vs. the euro.
Over the past week the yen did strengthen vs. the dollar, but since July the trend has been clearly a weaker yen. One can see in the 10-10's chart, the trend appears to be a widening overall, but more recently the pace of the expansion has slowed materially. Given the BOJ's stance on monetary policy and the Fed's position on Monetary policy, one should expect that the US 10's and the JGB 10's spread should continue to expand and the yen should continue to weaken.
When exploring the spread between the German Bunds and JGBs the euro should continue to strengthen vs. the yen.
Of course these continued shift post-FOMC will have implication in the equity market in the coming weeks should these recent trends continue. A US yield curve that is stagnant will have a direct impact on Financials (NYSEARCA:XLF). The recent run in Financials since the election is likely to stagnate as well. Since banks borrow short and lend long, a yield curve that remains stagnant means banks' profit will remain stable. Although, good from a standpoint of stability, it will not allow for banks and financials to move higher from current levels.
We can see that Financials have clearly been the strongest sector since the Presidental Election; while, Biotech, Industrials and Tech are essentially in a dead heat. However, since the beginning of 2017, the XLF has been fairly stagnant like the US yield curve.
In fact, since the beginning of the year, we can see that the XLF has underperformed much of the market - up only 5% versus the SPY up over 6%. One should expect to see continued XLF underperformance. Additionally, a weakening dollar would be beneficial to Materials (NYSEARCA:XLB) and Commodities. This could lead to moves higher in the XLB and Energy (NYSEARCA:XLE), should we begin to see a dollar that stabilizes at current levels or even retreats. Finally, we can focus on the sectors that could likely benefit should interest rates remain stable which would include the real estate (NYSEARCA:XLRE), utilities (NYSEARCA:XLU) and staples (NYSEARCA:XLP). These are more interest rate sensitive in nature due to the business structures or because the sectors tend to have higher yielding equities. Finally, a weakening yen vs. the euro and dollar would be bullish on Japanese Equities hedge for currency risk (NYSEARCA:HEWJ). Also weaker US dollar would be bullish on emerging market equities (NYSEARCA:EEM) as well.
This past week we saw that top four performing sectors by average were the XLRE, Consumer Discretions (NYSEARCA:XLY), XLU and XLB. Meanwhile, the worst performing sectors by average were the Biotech (NASDAQ:IBB), XLF and Healthcare (NYSEARCA:XLV). Finally, Energy, IBB and XLU were the most volatile.
Risk metric such as the VIX and the S&P 500 Bollinger Band Spreads contracted; this indicates that volatility this week seemed to continue to subside. Meanwhile, the SKEW Index was at 154, the index measures the tail risk in the market and the probability of outlier returns.
It is easy to see we are currently at the highest levels since Brexit.
This week we saw a little bit of deterioration in the "leaders" of the market, which we identified last week as Biotech, Tech and Healthcare. We will need to continue to monitor this closely over the week to see if other signals develop.
There are many pieces in motion at this point as central bank policy is clearly on the move around the globe. Currently, a stagnate US Yield Curve is allowing German/US Spread to contract and US/Japanese Spreads to appear relatively static. Both of these situations are allowing for the dollar to weaken versus both major currencies currently. A static US yield curve will lead to a financial sector that is likely to continue to underperform the broader markets. Additionally, this could benefit Utilities and Staples as investors could begin looking for higher yielding equities as Bond yield stabilizes. A weakening US dollar would be bullish for Energy, Commodities, Materials and Emerging Market equities.
For now, despite the mild pullback in biotech, tech and healthcare, the market still appears to be a very much risk on mentality. The contraction in the spreads of the S&P 500 Bollinger Bands and VIX suggests an equity market that is likely finding a period of low volatile in the short term.
Although not apparent at first the central bank policies over the past two weeks have clearly gotten the market moving again. The Yield Curve and Currency markets currently appear to be in a resetting period. As this reset continues to play out, we will continue to get a better sense of the winners and losers.
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