NEVER-NEVER LAND?

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Something is happening out there, but it is hard to know just what. Exchange traded notes in very risky assets are booming, CLO sales and trading in high risk assets are booming and on Friday someone bought a Da Vinci for $450 mio which many experts have tagged as a possible fake. Risk appears to be thrown entirely out of the window. Assets are rising, risk tolerances are rising and investors of anything have no fear.

However, over the past month we have seen a break in trend between the Dow and high yield. High yield has sloughed off some of its returns whilst the Dow until the last day or so has continued to rally.

So, what is happening? I don’t know but in a normal business cycle it would be easy to say we have reached a top or expect a correction. But wait there is some $8-11 tr of cash (depending on whose statistic you cite) of central bank money sloshing around and that’s just the BOJ, ECB and the Fed.

There is more from the likes of the SNB, the Peoples Bank of China, and of course the Investors who also have cash to invest. The point is, it is hard to call a top when there is so much money to invest. The central banks have put too much cash into the system and risk is well largely forgotten. The better the return, the better the security. That’s wrong, but it can last possibly for a while.

Meanwhile, one needs to be somewhat cautious. Should the market turn, those risky assets will become like glue and difficult to sell. Importantly, with lower numbers of market makers and with hedge funds becoming more the source of liquidity, markets are not in a healthy space should a sell off occur.

As the equity market slipped on Friday, bonds and, in particular, longer bonds rallied. The 2-year hit a fresh peak to record a nine-year high. This caused the yield curve to flatten about 4 bp. This trend looks likely to continue as the market builds in a tightening in December and another early in 2018. With a stable outlook for next year and a crowded issuance agenda for next year, the curve looks set to flatten by possibly another 20 bp.

What a flat yield curve will do to the U.S. economy is anybody’s guess. The U.S economy has a number of competing interests. There is the possible tax cut which will stimulate corporate activity such as share buybacks and increased dividends that will push equity prices higher. Against that you have increasing bond yields as the Fed attempts to slow the economy to prevent the economy overheating.

There is much talk of increasing employment which is interesting given that the U.S. economy is past full employment, and many can get a job easily. However, wages and productivity are not increasing. Increases in the use of technology will decrease employment and as such any investment in capex will require a more skilled workforce and fewer workers.

Mnuchin says the economy and wages will grow as a result of the tax cuts, but they may be overstating the benefits. The economy is growing at around 2% (the last quarter suggests 3%) but there is a disconnect. Employment is already at full employment and structural problems exist.

A tax cut does not fill in the fissures. And the current growth rate is not sustainable as the Fed will be tightening as inflationary pressures build and where will the workers come from? Typically, when the U.S. has been growing in excess of 3%, the unemployment rate has been much higher, enabling growth and enabling employers to find workers to fill job vacancies allowing that growth to continue.

 

Recap:

Equities: The S&P 500 fell 0.3% and the Dow rose 0.43%. The Stoxx 600 rose 0.3%.

Currencies: The pound rose 0.1%.  The yen rose 0.9%. The euro gained 0.2%.

Bonds: the 2-year rose to close at 1.725. The U.S. 10-year closed at 2.345 % a fall of 2bp in yield. The 30-year closed at 2.779 % in 4 bp. The curve flattened. The 2/10 closed at 61.8, the 2/30 at 105.3bp and the 10/30 closed at 43.3 bp. The European 10-year benchmark closes were, gilts closed at 1.293%, bunds at 0.357% and OAT’s 0.54%.

Commodities: Gold rose about 1.2% and WTI rose 2.6%.

 

Aussie Market Today.

U.S. bonds rallied in the long end the current spread between U.S. 10-years Aussie

Ten-years is about 23 bp. If the U.S. curve continues to flatten, the Aussie spread should widen.  However, that does not mean Aussie bonds move up in yield. I expect the long end to continue to rally in line with the U.S. bonds.

What could be a concern for bonds is the looming debt ceiling or an unexpected aggressive tightening policy by the Fed. Both can be discounted. For the time being without a shock, I expect bonds to trade around these levels.

Geopolitical tensions are still a concern although tensions appear to have been cowed for the moment.

Equities are likely to take the lead from the U.S. and weaken slightly.

Demand for solid investment grade credits look likely to continue as the hunt for higher yielding assets continues to gather pace.

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