An Oxymoronic 'Dovish' Rate Hike

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by: Ivan Martchev

I heard a lot about last week's rate hike being "dovish," which sounds like a contradiction. A rate hike is an attempt to tighten monetary policy, while "dovish" (in Fed-speak) means looser and less restrictive. Perhaps market participants heard what they wanted to hear and not necessarily what the Fed actually said, but the number and magnitude of rate hikes in 2017 will give us clues as to how dovish the Fed is.

United States Two Year Treasury Note Versus Ten Year Government Bond Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The action in 2-year note yields (blue line, above) tells that this rate hike was anything but dovish and that more are coming. Two-year Treasury note yields kept making multi-year highs last week as they are the most sensitive to Fed policy and short-term economic conditions. Surging 2-year note yields mean more rate hikes and an expectation of a stronger economy. Sharply falling 2-year note yields - the last time we saw that was in 2008 - mean a sharply weakening economy and an expectation of loosening Fed policy.

The action in 10-year Treasuries (black line, above) is quite different. Yields actually declined after the Fed began hiking rates in December 2015. While the 2- and 10-year yields are on different scales in the chart above, you can see that after the Presidential election there was a surge in 10-year yields faster than the surge in 2-year yields, causing "a steepening yield curve" as the difference in yield between the 2- and 10-year yields is called. Last August, the 2-10 spread was 76 basis points, but the gap surged to 134 basis points in December. Now, the yield curve is flattening again with the 2-10 spread at 118 basis points.

This yield curve analysis may seem esoteric, but it says a lot about the state of the economy and the banking sector. Banks love a steep yield curve environment as they can borrow short (tied to short-term rates) and lend long (tied to long-term rates). A steep yield curve means the banking business is more profitable. This is why some bank stocks surged after the election.

Goldman Sachs Group - Monthly OHLC Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

This brings me to my personal Goldman Sachs (NYSE:GS) indicator. I am always wary of a market where GS stock is weak (as it was in early 2016). I usually look at the stock market more positively when GS stock is acting well (like it is right now). If the best-run Wall Street firm is acting well, that tells me a lot about the stock market and the economy. Without necessarily singling out Goldman Sachs as an indicator, I think one could also use J.P. Morgan Chase (NYSE:JPM) as a similar indicator, even though it is organized much differently as a money-center bank. It would not be an overstatement to say that I think JPM is the best-run bank in the U.S., having largely avoided the balance sheet problems many banks suffered in 2008. (Please note: Ivan Martchev does not currently hold positions in GS or JPM. Navellier & Associates, Inc. does not currently hold a position in GS for any client portfolios. Navellier & Associates, Inc. does currently hold a position in JPM for some client portfolios. Please see important disclosures at the end of this letter.)

J. P. Morgan Chase and Company - Monthly OHLC Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

While the action in the banking sector and the overall market is constructive, we are at the beginning of a Fed tightening cycle. Fed tightening cycles tend to invert the yield curve, a.k.a. the 2-10 spread, and an inverted yield curve has preceded every one of the past five recessions. Such monetary policy operations have created a notion that the Fed actually causes every recession in the U.S. economy. The Fed certainly made the Great Depression worse by tightening monetary policy at the wrong time. The other big factor that made the Great Depression worse was the Smoot-Hawley Act Tariff act implemented in 1930 that hints at uncomfortable parallels with the present political debate on a Border Adjustment Tax (BAT).

Beginning of a Fed Tightening Cycle Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Even though the yield curve did steepen somewhat from a short-term perspective after the Presidential election, it has been flattening quite a bit in the past three years as the economic expansion has aged.

This coming June, the present economic expansion will be eight years old, which would make it the third longest in the 240-year history of the U.S. The two longer economic expansions were 8 years and 10 months (in the 1960s), while the longest one ran exactly 10 years, from March 1991 to March 2001.

Since the present administration has been in the White House only two months, one would have to say that it is too soon to say if any new policy initiatives will extend the present economic cycle in order to beat the 10-year record. It is my opinion that if there is sensible tax reform that repatriates the corporate cash from abroad combined with a federal infrastructure program, the present economic expansion may be given a boost. If there is a trade war with Mexico, China, or both, however, the present expansion may be cut short. It is too early to say which way the administration will go. The present policy agenda is still too erratic for one to be able to make a firm judgement call as to the likely economic effects.

What's Behind the Sharp Dollar Pullback?

Despite last week's Fed rate hike, the dollar pulled back sharply to near the 100 level on the U.S. Dollar Index. That would seem like a counterintuitive move, but I think the outcome may be due to political reasons.

United States Dollar Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Specifically, the March 15, 2017 parliamentary elections in the Netherlands did not go the way of the Trump-Brexit political nationalism. Simply put, the populist leader Geert Wilders did not do as well as some had feared. As a result, a more sensible pro-EU political party will get to form a government there.

Mr. Wilders' Populist Party won just 13% of the vote (20 seats) while the Liberals, led by Prime Minister Mark Rutte won 21% of the vote (33 seats). There was also a notable gain for the pro-EU GreenLeft party with 9% of the vote. That election result caused a surge in the EURUSD cross rate. With a 57.6% weight in the U.S. Dollar Index, the euro strengthened and the dollar declined, despite a higher fed funds rate.

I think we will see more defensive trading in the EURUSD cross rate as the first round of the French Presidential election draws near at the end of April. No candidate is likely to win 50% of the vote, based on present polls, so the second round on May 7th will decide the next President of France. There are French parliamentary elections a month later, which could check the nationalist inclinations of a Le Pen victory.

German Two Year Schatz Yield Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

There will also be German federal elections on September 24, 2017. This gives us plenty of time for the euro to weaken and the U.S. dollar to rally. Yields on the 2-year bundesschatzanweisungen (German federal treasury notes), more conveniently referred to as "the Schatz 2-year yield" (to avoid tongue injuries), are still deeply in negative territory, having been as low as -0.96% on February 24. They closed at -0.78% last Friday with "the Schatz" selling off marginally to get a smaller negative yield as cooler heads prevailed after the results of the Netherlands parliamentary election came in.

Think of the negative Schatz yields as an insurance premium against the domino effect expected after a feared dissolution of the EU and eurozone, which would likely result in sovereign defaults and bank failures. With the German federal government being the least likely eurozone nation to default in such an unfortunate scenario, it gets to charge investors 0.78% a year for two years to hold their money for them!

How about that?

Disclosure: *Navellier may hold securities in one or more investment strategies offered to its clients.

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