Intensifying The Fed's Balance Sheet Drama

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by: Ivan Martchev

Another week, another all-time high for the stock market and another uptick in the interest rate markets, due to the long-awaited start of the unwinding of the huge $4.5 trillion balance sheet of the U.S. Federal Reserve. This maneuver is also pushing the U.S. dollar higher, fueling what looks like the beginning stages of a major intermediate rate move to the upside that is likely to fuel fresh multi-year highs.

United States Ten Year Government Bond versus Two Year Note Yield Chart

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

What is most intriguing about these interest rate moves is that while the 10-year Treasury yield has moved higher, the 2-year Treasury note yield has moved higher even faster. This has resulted in the slope of the Treasury yield curve generating an overall declining trend, now reaching multi-year lows of near 82 basis points (0.82%), even with 10-year Treasury yields rising from 2.03% in September to 2.36% now.

Treasury Yield Curve Chart

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

Flattening yield curves are a part of life and they happen towards the end of economic expansions. This is completely normal. In most cases, the yield curve flattens because of Federal Reserve monetary policy as they push short-term interest rates higher (and unwind the balance sheet). We have had an inverted yield curve in every one of the last five recessions and I suspect this time will be no different.

The yield curve remains suppressed even as we seem to be getting details on the Trump administration tax plan, which seems to be politically timed with the midterm election cycle in 2018. If the Republican majority passes sensible tax reform by the end of 2017 (ambitious) or early 2018 (more likely), the supposed economic boost should help them win those midterm elections. I think there may be an infrastructure program in 2018 right after the tax plan, which makes for great election slogans.

It will be interesting to see how the yield curve situation develops if both a tax overhaul and infrastructure plan are passed. If we get a flattening or inverted yield curve, that would mean the bond market would not have "bought into" the election promises of the Trump administration. There was some yield curve steepening after the 2016 election, but it completely unwound as the chaos of the White House political agenda hit the front pages and made formerly boring news programs must-watch reality TV. Since there has been no change in that dynamic, there is no reason to suspect that it will get better in 2018.

I am on record saying that the 10-year Treasury is likely to hit 1% or lower before Mr. Trump's first term runs out in January 2021 simply because of the statistical distribution of economic cycles in the past 240 years. Since there has never been an economic expansion longer than 10 years, and the present expansion is 8 years and 4 months long, the odds are that we will see a recession before Mr. Trump's first term ends.

United States Ten Year Government Bond Chart

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

But first, we have to worry about this balance sheet unwinding, as it sure started with a bang last month.

I think that as larger amounts of Fed balance sheet bonds are allowed to run off, the call that the Fed may overshoot will get louder, even though this is not getting in the way of the stock market at the moment. My guess is that a whiff of panic becomes notable on a move of the 10-year Treasury yield above 2.63%.

Fed Impact On The Dollar

Waiting on the dollar to find a bid in 2017 was like waiting for Godot, until September, when Godot decided to show up for a visit. The dollar had marginally undercut "support" near 92 and just as the markets like to test any bull or bear, it turned around on a dime and has not looked back since.

The catalyst, in my opinion, is the commenced Fed balance sheet unwinding.

United States Dollar Index Chart

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

How high can the dollar go? Significantly higher, particularly if the 10-year Treasury yield can rise above 2.63% and stay there for a while. I did not anticipate the move lower in the dollar from a high of 103.88 in January to a low of 90.99 in September. The move lower came for two reasons, the first of which is a wave of pro-EU election victories in the Netherlands, France, and Germany. The second of course is the White House chaos that has brought few of Mr. Trump's election promises into action, so far.

Since I don't see any more political developments in Europe in 2018 that would help push the euro higher and as a consequence the dollar lower, we have one obstacle to the dollar rallying removed. And since the Republican majority in Congress has maximum motivation to get the legislative ball rolling for the 2018 elections, I suspect more will get done on the infrastructure and tax fronts than what we've seen so far.

Given that most hurdles to the dollar rally have been removed, I think the only way for the greenback is up in 2018.

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

Disclaimer: Please click here for important disclosures located in the "About" section of the Navellier & Associates profile that accompany this article.

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