There are a lot of different ways to assess the week that was both in markets and on Capitol Hill.
But if you’re a trader, there’s pretty much only one conclusion you can come to in terms of the reflation meme: it took a hit this week.
No matter which side of the political fence you fall on, it would be difficult to make the case that whatever small cracks were already forming in the narrative didn’t get larger over the past seven days. The G20 was a debacle, the dollar and yields were predisposed to heading lower coming off the Fed, stocks sold off on Tuesday thanks to some combination of jitters around the health care debate and a technical unwind, and then, on Friday, Trump failed his first major test as President.
Sorry, but that’s just all there is to it. And this assessment is backed up by data showing massive outflows from US equity funds and bank stocks in particular, short-covering in the 10Y, and a USD on the back foot.
Below, find a bit of useful color on all of this from SocGen who notes that “the dark side – protectionism – reappeared at the G20, just when the force – hope of a bold US fiscal plan – is looking weaker.” (Note: this was out prior to the failure of the GOP health care bill).
The dark side – protectionism – reappeared at the G20, just when the force – hope of a bold US fiscal plan – is looking weaker. This has hurt risk sentiment a bit, helping bonds find their feet. We see that as temporary profit taking on crowded trades, rather than a fullblown reversal. Solid global growth and exit fears will keep bonds on the defensive into summer, more so as the political risk in Europe (France) eases.
Reality check for Trump
The failure to break decisive points (2.64% for 10yT and 0.50% for Bund) has been followed by short covering over the past ten days, frustrating our fundamentally bearish bond views. The technical damage is limited; the litmus test is 2.30% for 10yT, still 10bp away, and as long as yields are above that, there is no rush to cover shorts. In the meantime, investors are better off watching Bunds; an unexpected break through 0.40% would likely signal an extension of the rally, towards 0.30% at least.
The bond rally has been US-driven, as Graph 1 indicates. As we discussed in FID, we see the UST rally as a function of 1) mixed US data (e.g. GDPNow from the Atlanta Fed is below 1.0% for 1Q), 2) a dovish interpretation of the March FOMC, 3) renewed concerns about global trade after the G20 statement fails to reiterate a strong push against protectionism, and 4) fading hopes for Trump to deliver on bold economic promises. As we go to press, we do not know whether the “American Health Care Act” has gone through. Approval would partially alleviate concerns that Trump’s hands are tied. That said, the real test for investors will be on fiscal policy. There is little hope left that infrastructure spending can deliver anything soon. The plan will not be ready before the middle of the summer at best, and private-public partnerships tend to be slow on execution. More serious, there are rising concerns that the tax cuts may be later and smaller1 than initially planned, especially if ongoing infighting about health care reform continues to dominate the congressional agenda.
Those concerns are leading investors to reconsider the Trump trades, e.g. construction & engineering stocks are pulling back, the US 2-5y curve is bull flattening and the USD is retreating (Graphs 2 and 3). A clear break of 2-5y USD through 40bp in swap (or 66bp in Treasuries), along with a breach of DXY through 99.23, would be troubling – those metrics are worth tracking closely right now. That said, we do not see the four forces above as powerful enough to support a full unwinding of the post-US election market moves. Global growth is still looking solid, and the increased focus on the ECB’s exit strategy argues against a broad bond rally. We also expect political risk in France to diminish, which should contribute to reviving animal spirits – to the benefit of European stocks. We thus continue to trade bonds on the bearish side, if cautiously so in the near term.