Yesterday the Fed stood up and declared itself to be not a particular friend of the stock market right now. It usually declares itself one way or the other, at least implicitly. In this case, the market knew the hike was coming, but was clearly looking for a spoonful of sugar to help the medicine go down. Instead, we received an accelerated sense of when balance sheet tightening would begin and a Dot Plot showing 4 rate hikes through 2018, slightly ahead of market expectations.
How should we be thinking about the US rates markets? The initial reaction to the Feds announcement was to continue the curve flattening of the last couple of months as US data and specifically inflation data disappoint. Remember, we have been long US duration and we had been expecting a decline in headline inflation data based on the y/y roll-off the early 2016 crude oil price spike.
The announcement of balance sheet reduction is effectively the opposite of a new QE program. We know that the consensus in every instance of new QE implementation has been to expect a decline in rates as a major central bank starts with a new buy program. Sentiment data and speculative positioning have both been quite clear on that point. So, my starting position would be that “most market participants” would see the unwinding of the Fed’s balance sheet as bearish for bonds.
At the same time, it should be deflationary, which would be bullish for bonds. Large speculator capital in the form of large net long positions in the futures market reflects this, anticipating lower rates over the next 6 months.
Based on this backdrop, we would expect a range bound rates environment in the US and will stick with our current positioning in the long-end of the US yield curve.
Given that on margin the Fed is more hawkish and the ECB and BOJ more dovish, we would continue to support our thesis to favor equity markets outside the US. Additionally economic data, equity valuations, and earnings growth are supportive of foreign equity market outperformance.
Sir John Templeton wrote that “bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” I wrote after the election that we were just then entering the “optimism” phase of the bull market. Since that time, economic data in the US has plummeted, Trump’s growth agenda has been sidetracked, and the White House has been embroiled in investigations. Does this feel like optimism to you?
All that being said, as of yesterday we were at all-time highs for the major US equity indices. How is this possible you may ask? The simple answer as illustrated by the chart below is Central Bank liquidity.
June is historically a tough month for equity markets, so a small corrective period would make sense. However, I believe that a powerful risk rally should emerge in the second half of 2017 into 2018 as liquidity fueled Animal Spirts take us into the final phases of Templeton’s Bull Market thesis.
Stay tuned and stay Tactical!!
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