It has been an interesting couple of weeks in the markets with a significant rotation among asset classes starting around the Fed meeting on September 20th. As we touch on below, the Fed basically reaffirmed that they want to raise interest rates in December, countering those who thought they might wait given the tame inflation data. The broad equity market in the US has taken the news in stride, helped in part by the fact that tax cuts are back on the table (more below). This week the S&P 500 advanced +0.5% while the NASDAQ added +0.8%.
Interestingly, we have seen a massive rotation into small-cap stocks. This asset class had been seriously underperforming this year, but has recently gone on a tear. As you can see below, the YTD return on small-caps has gone from basically 0% a few weeks ago to +10% in short order. The Russell 2000 was up +2.8% this week alone.
The Fed news has also helped turn the tide for the dollar. The U.S. currency has been under pressure all year, but this week it gained +1.1% against the euro (chart below) and +0.8% versus the British pound. Partly as a result of this international stocks have lagged their domestic peers. For example, the EAFE was down -0.1% this week.
Along the same lines, emerging market equities have taken a hit. The index was off –1.3% this week and has given up -2.5% since the highs seen a couple weeks ago. Emerging market currencies have similarly sold off hand over fist. Both areas of the market remain well in the black YTD though.
Bond yields have ticked up noticeably, especially after Trump’s tax proposal was floated on Wednesday. The yield on the 10-year Treasury increased from 2.26% to 2.32% this week. At the beginning of the month yields hit a low of 2.03%. The yield on the 2-year is at its highest level since 2009 (see below) and the recent rally is pricing in a high likelihood of a fed hike in a couple months.
For the week, intermediate-term government bonds gave up -0.4% while long-term government bonds dipped -1.2%. Credit held up much better. High-yield and bank loans both added +0.3% for the week. However, not all corporate bonds have done well. After Toys “R” US declared bankruptcy last week its short-term debt fell in price dramatically. As you can see below, the price on the October 2018 issue fell in value by 80%.
Yellen Will Go Out Swinging
Let’s go back to the reversal in the dollar and the rise in yields. The immediate trigger was the Fed meeting last week. There were two key takeaways:
1. First, the balance sheet tapering plan will be implemented in October. No surprise here as they have been advertising it for months. Essentially the Fed will no longer reinvest the proceeds from maturing securities up to an initial limit, and that limit will increase every quarter going forward. As you can see below, the Fed’s holdings of bonds should shrink from roughly $4.5 trillion today to $2.5 trillion by the end of 2020.
2. Second, it is very clear that the Fed is betting that the slowdown in the inflation rate is temporary. They indicated that they still plan to hike rates in December and hike three more times next year. This point took some by surprise. There was a growing belief that the softening inflation numbers might tempt the Fed to slow the pace of rate hikes in 2018. They are having none of it, though.
Chairwomen Yellen then followed up this week with a speech that emphasized the following:
– Gradually raising of interest rates is the most appropriate policy.
– “It would be imprudent to keep monetary policy on hold until inflation is back to 2%”
– She is willing to consider other scenarios other than rising inflation, but only hesitantly.
– She is also concerned about financial stability risks of keeping rates too low for too long.
All of this made the market adjust rapidly. As you can see below, the odds of a Fed hike in December shot higher and are now approaching 90%.
This helped spur the rally in the dollar and increase in Treasury yields.
One thing that hasn’t moved materially is the market’s expectations of Fed policy in 2018 and beyond. The chart below shows the Fed’s own expectation for rates (the dots) and the market’s expectation (blue line). The dots are still far above the market, indicating that investors still haven’t bought into the inflation/hawkish Fed narrative for 2018 and beyond.
This implies that if growth and inflation come through in 2018 as the Fed hopes/expects, there is more upside for the dollar and bond yields.
This Isn’t Going to be Easy
Finally, we saw the opening bid in President Trump’s efforts to tinker with tax policy on Wednesday. Nothing surprising really. Key points include:
– Cutting the corporate tax rate from 35% to 20%. If this passes it would put corporate taxes in the U.S. between those of South Korea and the U.K.
– One-off levy on accumulated offshore earnings.
– Moving to a territorial system where only domestic earnings are taxed rather than global income.
– Introduce a top tax rate of 25% for partnership and many small businesses.
– For individuals, collapse the existing seven tax brackets into three (12%, 25%, 35%), double the standard deduction, and eliminate the personal exemption.
– Eliminate the personal deductions for state and local taxes.
– Repeal the estate tax.
– Eliminate the AMT tax.
It is of course up to Congress to put flesh on the bone of this opening gambit. How this evolves in anyone’s guess, but one thing is clear, the Republicans are aiming to pass any bill with a simple 51 vote majority in the Senate. For this to happen any budget bill passed by the House and Senate must build the tax cuts into the 10-year forecast. The other wrinkle is that any bill passed through reconciliation must meet two standards:
1) It cannot exceed the tax cuts allotted for in the agreed-upon budget during the 10-year budget window, and
2) It cannot add to the budgeted deficit after the end of the 10-year budget window (the so-called “Byrd Rule”).
Last week the Senate agreed on a draft budget that bakes in $1.5 trillion of tax cuts over the next decade. So, the battle is on to fit the proposed tax changes noted above into the $1.5 trillion target. Then there is the question of what happens after 10-years. Do the tax changes go away, or can lawmakers finesse dynamic scoring?
But what do the proposals cost? No one is quite sure, but Tony Nitti from Forbes made the following estimate:
A million here and a million there and pretty soon you are talking about real money. At first blush the overall cost of the plan is $5.3 trillion. Eliminating all itemized deductions (except for mortgage interest and charitable deductions) increases revenue by roughly $1.5 trillion. Binning the corporate interest deduction would raise $1.1 trillion. This means we still have a plan that has a net cost of $2.7 trillion ($5.3 – $1.5 – $1.1). That still leaves a $1.2 trillion hole.
Nothing about this process is going to be easy.
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