WISHFUL THINKING?

The White House has the budget to be released on Monday as having growth at a much higher pace than any of the analysts have predicted. The mercurial Mnuchin must know something that others don’t to reach the conclusions. And why are these conclusions important? Because bond markets and equity markets will behave and trade on the budget depending on how much they believe various targets can be met.

For starters, the budget has a lower inflation rate and borrowing costs than Treasury projected last year. Those assumptions are combined with strong growth. The budget forecasts show smaller deficits. Later on the economy is forecast to grow at 3% over the decade with growth at 3.2% in 2019.

This year the U.S. economy grew at 2.5%, slightly higher than earlier predictions of 2.5%. The only problem is that productivity is running at 0.7%, the lowest since 2010. Treasury has growth at 2.5% falling to 2.1% in 2019. The budget has 10-year bonds at 2.60% whereas the market now has bonds at 2.80% with the expectation to go higher if we have three rate hikes.

All up the budget seems somewhat illusory. The markets will give the benefit of the doubt for a period. And then, as I expect, will sell when it becomes apparent that the growth numbers are not being met and the deficit is blowing out. The numbers are rubbery at best given the economy has grown at 2% over the past decade.  So any boost to 3% won’t simply come as a tax rate cut but has to come from productivity, increases in population growth, increasing rather than slowing expansion in the labour force and new innovations or a war. The Government is betting that people will spend on goods, thus requiring more investment in infrastructure to service that need. That may be wishful thinking.

Bond rates are set to surge again especially if the deficit widens. As such, the GDP numbers become important because any slowing will see bonds rise in yields and equity sell. The free cash is leaving the system, and this is the massive error in the budget forecasts. The new normal is not the norm. Bond investors will fret over increased issuance, increasing deficits regardless of where inflation is, but under this scenario inflation rises.

Last week, the tail wagged the dog and a number of defensive strategies proved to be just as vulnerable as aggressive strategies.  Some ultra-defensive or low volatility strategies resuled in a 7.8% loss. At some point, the equity market will review their holdings and start to adjust to a more lukewarm market.

And if all this is not enough, political intrigue still has a part to play. Kim Jong Un has played the U.S. like a card at the Winter Olympics and has left the U.S looking rather impotent and naive in the political stakes. Trump still has to contend with the ongoing Russian investigation. And if that was not enough, the White House has its own Barnaby Joyce moment with a dalliance between a close aide to the President and the recently ousted Rob Porter.

Hicks is being distracted by the attention and now has Trump railing against her.  At the same time Trump is also blasting Kelly publicly. There is turmoil in the White House and these distractions should be a concern. It certainly cannot help the GOP as the GOP is trying to put on a face that suggests good governance.

In a week just past where changes in volatility caused a massive surge of selling, investors will be looking for a quieter week. That may still happen. However, the stakes are rising. And investors may just start to now start paying attention and realise that the days of the free lunch are nearing an end.

With rates rising and a steepening yield curve it is only a matter of time before equity markets start to adjust. When that adjustment occurs the markets will then rebalance.

Recap. 

Equities: The S&P 500 rose 1.5%. The Dow regained 1.4%. The Stoxx 600 fell 1.4%.

Currencies: The pound fell 0.7%, the Bloomberg Dollar Spot Index fell 0.1%.

Bonds: The ten-year hit 2.85%.The 2-year closed at 2.07%.the ten-year bund closed at 0.69% and the UK gilt closed at 1.586% and the OAT closed at 0.99%. The U.S. curve closed 2/10 at 77.4bp, 2/30 at 108.3 bp and the 10/30, closed at 30.7 bp. The U.S. 5-year closed at 2.54.

Commodities: Gold fell 0.3% and WTI fell 3.2 %.

Bitcoin is trading around $8,220 and steady. There is a story out that an Italian exchange lost some $100mio or so worth of nano coin. There appear to issues relating to security with cryptocurrencies.

Aussie Market Today.

Equities will have a chance to recover some of the lost ground today. However, stalling commodity prices could hold any advancement back slightly. The equity market also has to start weighing up issues relating to drought. Any stalling in economic growth could have an impact on valuations and send prices tumbling.

Bonds should be sold a little today. The equity advance should see bonds selling and given the AUD 10-year is now 1 bp through the U.S 10-year this could become a selling point. I expect that bonds could sell a few points today.

The currency at this stage appears to be taking the selling pressure for the moment and this selling pressure is likely to continue.