58 Basis Points To Zero

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Includes: BIL, CLTL, DFVL, DFVS, DLBL, DLBS, DTUL, DTUS, DTYL, DTYS, EDV, EGF, FIBR, FLAT, FTT, GBIL, GOVT, GSY, HYDD, IEF, IEI, ITE, PLW, PST, RISE, SCHO, SCHR, SHV, SHY, SPTL, SPTS, STPP, TAPR, TBF, TBT, TBX, TFLO, TLH, TLT, TMF, TMV, TTT, TUZ, TYBS, TYD, TYNS, TYO, UBT, UDN, USDU, USFR, UST, UUP, VGIT, VGLT, VGSH, VUSTX, ZROZ
by: Ivan Martchev

The way I start writing these columns is not particularly scientific. I look at the major moves in stocks, bonds, currencies, and commodities and see what jumps out. Sometimes there are moves that don't quite fit my outlook, which offer plenty of material for reflection. At other times it’s “the same old, same old,” particularly in a holiday-shortened trading week like Thanksgiving, which historically tends to be very light volume and tends to be rising. In that regard, the stock market did not disappoint us last week.

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

One noteworthy event did happen, however, in the bond market, where the Treasury yield curve registered another multi-year low. The slope of the Treasury yield curve, as measured by the 2-10 spread, is rapidly approaching zero after which barrier we have the rather uncomfortable territory of an “inverted yield curve,” or a situation where the 2-year Treasury note yields more than the 10-year Treasury note.

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

Yield curves do not invert by themselves. Somebody had to invert them and in this case that someone is the Federal Reserve. This is because changes in the fed funds rate directly affect the 2-year note yield which is now rising faster than the 10-year note yield, hence the yield curve shrinkage.

Previously, when the Federal Reserve threw cold water on the Treasury yield curve with its fed funds operations causing it to retract like “a frightened turtle,” we had the market set long-term interest rates, so the rising 2-year note yield (courtesy of Fed open market operations) and the falling 10-year note yield (courtesy of investors’ reaction to the Fed action and the outlook for a slowing economy) met in somewhat natural fashion as Fed policy became more restrictive. Today, because the Fed meddles in the long-term interest rates market with its QE operations and pregnant balance sheet, you would think that they could engineer less yield curve reduction by letting long-term interest rates rise faster. One way to do that is by letting more bonds from its balance sheet mature without getting their principal amounts reinvested, or a run-off rate higher than the present $10 billion monthly rate.

I think we will get a fed funds rate hike at the December FOMC meeting and we will hear more about how that pregnant central bank balance sheet run-off rate will increase. This is why I am a little surprised at the calm in the Treasury market. If the Fed can engineer some yield curve re-steepening by allowing a higher run-off rate, they may want to do that if only to push back on investor psychology. Investors are well aware that an inverted yield curve has preceded every one of the last five recessions, which is why they dread the present shrinkage of the Treasury yield curve slope.

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

There should be no shortage of bonds to run off. At last count, the Fed’s balance sheet decreased to $4.418185 trillion on November 13 from $4.420808 trillion in the previous week. The Fed balance sheet’s all-time high is $4.473860 trillion in February 2015. Before QE operations started, the Fed had a tad over $800 billion on the balance sheet. Right now, the Fed is a little over $55 billion below its all-time balance sheet high, so it will be a long and winding road before that balance sheet shrinks by much.

I don't think the Fed has much time to engineer true balance sheet reduction. The present economic expansion started in June 2009, so that makes it 101 months long as of this week. There are only two other expansions in the history of the United States that lasted longer than 100 months. One ran from 1961 to 1969, the other from 1991 to 2001. Considering that statistical distribution of recessions and expansions, the Fed doesn’t have much time left to engineer significant balance sheet reduction.

The next recession is unlikely to be as bad as the 2008 Great Recession as there is no present problem in the financial system as serious as the mortgage bond leverage that was decimating bank balance sheets back then. In fact, there have been only two other declines as serious as 2008 – in 1929 and 1974. Only the 1929 decline is similar to 2008 because of the financial system leverage that caused it, but since the policy response in 2008 was very different, with no monetary policy tightening and no trade wars as per the infamous Smoot Hawley Tariff Act as in the 1929 case, we avoided another depression.

Since the Fed is unlikely to be as aggressively involved in the markets due to the likelihood that the next recession is likely to be less severe, perhaps they don’t have to balloon their balance sheet as much this time. Still, it boggles the mind to think how a central bank would go about unwinding a $4.4 trillion balance sheet without crashing the Treasury market.

The U.S. Dollar: Down in 2017, Up in 2018?

For all intents and purposes, 2017 was a down year for the U.S. dollar due to the unwinding of the euro disintegration trade after a wave of pro-EU election victories. Since the euro is the biggest U.S. Dollar Index component, it is natural to see the euro rally. What is not natural is to see the dollar decline when the Fed is tightening and the ECB is easing, even though that tightening has been in baby steps.

It is surreal to watch how the U.S. dollar has failed to rally heading into the assumed December fed rate hike. While we did see a rebound off the multi-year lows set in September, the greenback has given up some of that rebound. I think the dollar should rally quite a bit more and take out the multi-year high of 103.21 set January 3, 2017. As of last Friday’s close, the U.S. Dollar Index is 92.76, down 10.1% YTD.

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

The other reason for the decline in the dollar this year has been the complete unwind of the Trump trade in the bond market, where the initial yield curve steepening after the November 2016 Presidential election completely disappeared and then some in 2017. I am all for “making America great again,” but there has to be some semblance of reality between President Trump’s bombastic election promises and his ability to rally his own party in order to put promises into action. There are no signs of improvement in the rocky relationship between the GOP’s leadership and their own President, suggesting more of the same in 2018.

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