It was a quiet data week, but we had a very interesting news week, that had some interesting implications for the curve.
- It seemed for most of the year that everyone was expecting oil to go back down. That has not materialized. Higher oil prices are generally inflationary (even for core inflation). Depending on whether the Fed is seen as being vigilant or patient, the front or back of the curve could lead a selloff. It is unclear how much escalation we could see in the Middle East and how long this could last. You would think that oil could keep going higher as tensions increase. However, we have to remember that Iran is a nuclear power so it’s possible the markets could eventually get spooked into a crisis rally.
- Junk bond selloff. One of the reasons the longer end EDs have kept flattening is that swap spreads have gotten compressed. It is especially crazy in the EU, where some “junk” bonds were trading at yields lower than US Treasuries. So having a small correction in junk bonds should return some of the risk premia back on the curve. I think a correction is healthy. However, with the ECB and BOJ still adding to QE, the bar for a *real* correction in term/risk premia is very high. We started seeing some dip-buying in high yield at the end of Friday. We also saw FFJ8 sell off noticeably on the FF curve, so people are not thinking that a junk bond selloff is a concern to growth.
- Trump Asia trip. I think Trump has done a reasonable job on his Asia trip. He avoided a lot of potential verbal landmines and he has opened the door to more trade and business with the Asian countries. This all adds to potential growth later on.
- The election results have been decidedly Democratic. This was not difficult to predict, with Trump at a 37% approval rating. This does two things: (1) it lights a gigantic bonfire under Congress to get some positive legislation passed for next year (i.e middle class tax cuts), and (2) barring some tremendous growth in the economy in 2018, this makes a legislative logjam in 2019 more likely (since the Democrats could control one house of Congress). Where have I heard the “upside risks to growth but downside risks in 2019” story before? But I’m going to have to amend this a little…
- Tax reform. I found it amusing that the House proposal and the Senate proposal reflect the urgency with which the members of each house need to get elected. The entire House is up for election next year (2 year terms), while only ⅓ of the Senate is up for election (6 year terms). One example would be the House wanting corporate tax cuts to start next year (they need stimulus ASAP), while the Senate wants to delay this for a year. The House also has more of the tax cuts going to the low and middle class (more voters). The House allows for a partial deduction for state and local taxes, while the Senate version does not. House Republicans can kiss their seats goodbye in higher tax states like NY, CA and NJ if some SALT concessions are not made to those states. The differences are not so large however, that a deal can’t be worked out. As a result, some sort of tax cut for next year seems high probability. This will add to a potential selloff in the long end. However, in case some of the corporate tax cut gets deferred, we should think more about the early meetings of 2019.
So how to weigh the above in terms of curve positioning?