DOVES OR HAWKS?

Following the comments by the Fed that inflation was likely to rise to their target level and that the economy was growing, markets took a momentary pause before some selling followed by some buying of equities.

Bonds, however, were resolute and continued with the selling. Of note on the day the ISM manufacturing index slipped 0.2 points in January and productivity dipped 0.1% in the fourth quarter. Manufacturers reported an increase in export orders. However, that can rapidly change if Trump’s dogma of America First upsets those countries purchasing American goods.

The soft productivity should be a concern for both Trump and markets and especially the bond market. Weak productivity means the 3% growth rates needed to get somewhat close to not blowing the deficit may be unreachable.

For the bond market, the potential of a $1.5tr blowout in the deficit and the need to issue more bonds is an unhealthy prospect. The productivity number is hugely important and should be monitored. Weak productivity, slowing population growth and rising rates will make reaching a sustainable 3% growth rate difficult.

Profit taking was believed to be the catalyst for the steepening of the yield curve today. The curve flattened a lot yesterday with 5/30 yr bonds at 41 bp, a level not seen since August 2007. That level is now 43 bp and is set to challenge the low once the market has finished taking profit.

For the moment, markets are behaving. The doves are winning but how long before the hawks have their day? Bonds have a number of reasons to not be so cheerful and equity valuations are somewhat stretched on the premise of low inflation and growth rate in excess of 3%.  With tax cut in place and the possibility of a budget deficit blowout the U.S. market is poised perilously. Rates will rise and at some point that will impact equity pricing.

Equity can look and remain bid now but for how much longer? The budget hawks are silent and the debt ceiling will be breached shortly. Taxation receipts are likely to be lower than expected and that may well be the catalyst the hawks require.

The Eurozone was affected by the Fed commentary. Bond rates in Europe have steadily risen in response. German 10 years hit a 2 year high at 0.738%, borrowing costs rose by 2-3 bp and demand for peripheral bonds is waning. The European economy, however, is a good story and probably justifies higher bond rates.

The manufacturing industry raced into 2018, with output the fastest in over 20 years. The highest the PMI has been was 60.6 and that price was a preliminary price taken in December 1997. The PMI was 59.6 and factories increased prices the fastest since 2011.

Recap: 

Equities: The S&P 500 rose 0.07%. The Dow fell 0.11%.

Currencies: The pound rose 0.3%, the euro rose 0.3% while the Bloomberg Dollar Spot Index was down 0.3%.

Bonds: The ten-year hit 2.77%. The 2-year closed at 2.157%.the ten-year bund closed at 0.66% and the UK gilt closed at 1.53% and the OAT closed at 0.976%. The U.S. curve closed 2/10 at 61bp, 2/30 at 84.5 bp and the 10/30, closed at 23.1 bp. The U.S. 5-year closed at 2.56.

Commodities: Gold fell 0.4% and WTI 1.1 %.  And in another concession to the chemical industry, Trump is considering eliminating the Chemical Safety Board. This will allow frackers to not consider any issues caused by fires or chemical spills in environmentally sensitive areas such as nearby communities and waterways. The agency’s brief is vast with agency reviewing the Deepwater Horizon blowout and the recent gas explosion at a Houston chemical plant.

Aussie Market Today.

Today could be an ugly day for bonds as the trend from offshore is weak and the movements in the U.S. bond market sharp. Credit looks likely to be a little wider on the day as equity is a little weaker and borrowing costs are rising slightly.

The equity market should drift weaker over the course of the day.