[Below are the factors I discussed over the weekend, that will affect the shape of the curve going forward in the new trading regime.]

 

One of the things I always say is that you have to be careful of historicals because the regimes you are comparing may be different.  In a new regime, there will be new assumptions/constraints on what is likely/unlikely to happen to the curve.  I thought it would be good to just go over some assumptions so we can get a preliminary idea of what the curve should look like.

  • The Fed is going to be gradual. Yellen reiterated this in her speech.  This can change based on the data, but 2017 may have a hard time getting above 2 hikes.
  • Yellen does not think the neutral rate has materially changed. The Fed does not think we need a lot of hikes right now.  Yellen said, “because monetary policy is only moderately accommodative, the risk of falling behind the curve in the near future appears limited, and gradual increases in the federal funds rate will likely be sufficient to get to a neutral policy stance over the next few years.”  It sounds like she thinks something along the lines of 2 hikes a year for a “few” years and we will be at neutral.  The level of the neutral rate is also critical for equity valuations.  Of course, her opinion can change based on the data and new stimulus policies we see.
  • Yellen will “probably” not be around in 15 months. So we don’t know if the next Chair is going to be more like Brainard or George, who are at extremes in the dot plot (not counting Bullard).  While the Chair is only one vote, their vote seems to count for something closer to half of the votes.  A more hawkish chair could affect the path of rates starting in 2018.  But as Hilsenrath and I have said, it seems unlikely Trump would want a hawk as the Chair.  How is Trump getting to 4% GDP if his Chair is simultaneously tapping on the brakes?  4% is hard enough already.
  • We don’t know what Trump’s policies are. Nor do we know how long it will take to reach the intended targets.  I’ve mentioned game theory a bunch of times in the past, but this is one of those times where we will probably be one of the last ones to know what is going on (there will be other market participants in the “inner circle”), so some caution is warranted because of the information asymmetry.  We know what he has talked about, but we are not sure what is going to get passed.  We currently have debt ceiling “laws,” after all.  Could policies that would cause a massive deficit get passed when some Republicans in the past have argued for a balanced budget amendment?  This is not clear.  Republicans have gotten on board with Reagan and Bush during their spending sprees, so this time may be no different.
  • Trump policies could take some time before they are enacted. I suppose something like tax reductions and corporate repatriation, could have earlier effects.  Infrastructure spending could take some time to kick in.  It’s hard to ascertain the timing impact of his trade, energy, regulatory and health care policies.  The effects may not be seen until the second half of 2017 (or later).[1]
  • Article 50 timing has been thrown off from the legal challenge two weeks ago. Previously, I suggested fading the Q1 hike partly because of March 2017 Article 50 deadline.  It’s not clear now that Article 50 could be triggered by March 2017.  In fact, there was a story last week that a UK Supreme Court judge warned that Brexit could be delayed for two years![2]  I’m no legal expert and there’s going to be a lot of maneuvering on both sides.  We’ll find out more at next month’s Supreme Court hearing, but for now, we need to probabilistically widen the timeline dispersion of Article 50.
  • Foreigners are still buying. One of the more interesting things to watch is what happens to the BOJ’s targeting of 0% on 10 year JGBs.  Assuming they keep buying, how high can US ten year yields get, given the international linkages between rates?  Right now the rate spread is at 231 bps.  Can the US ten year really get to say, 3.0% when JGBs are at zero?  It seems either the BOJ or FX would have to give.  As for the ECB, last week the spread between 10yr Treasuries and Bunds reached a 27year high, at 208bps.  The ECB also got a little economic boost with their currency (EURUSD) dropping, but as Constâncio, ECB vice-president, said Monday, Eurozone core inflation was “not recovering” and rising protectionism could damp any spillover from acceleration in the US economy.  Last week, Nowotny (ECB) said that a Trump win was “not a good day for the world economy.”  And throw in some defection risk (UK, Italy, France) and prospects for stable EU growth are not looking great.  This means an increased chance of a longer term stimulus from the ECB.  Again, it will be interesting to see if the US-EU spread continues to widen with the weight of ECB buying.
  • Where is the neutral rate under Trump? There has been a lot of discussion regarding the neutral rate this past year.  The thinking was that the neutral rate had structurally decreased.  A lower neutral rate keeps the longer end rates theoretically lower.  It is not clear what effect Trump’s policies would have on the neutral rate.  A higher neutral rate would mean higher longer term rates and lower equity prices, all other things being equal.

What does this mean for the curve?  And how can we capitalize?  See the Trade Thoughts section.

 

[1] SocGen: “Over the next 12 months little will happen on the fiscal side in the US as any stimulus is slated for 2018/19”

[2]  http://news.sky.com/story/brexit-could-be-delayed-for-two-years-supreme-court-judge-warns-10658698