True or False? Yesterday’s Market Selloff Was About Trump

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Yesterday’s market selloff was about Trump, true or false? The answer: True and false. Allow me to explain.

To anyone who is not blinded by ideology or unrealistically optimistic risk assets (including equities and high yield bonds) were overvalued. The way I see it is: The markets were waiting for an excuse to reprice, but no one dared be the first one to act. This is the age old tale of the “Emperor’s New Clothes.” Everyone knew the Emperor was naked, but no one dared be the first one to say it for fear of the repercussions of doing so. Trump’s latest controversy was deemed sufficiently serious to embolden some market participants to do what they have wanted to do for some time, de-risk, if only a little.

We saw that, yesterday with the Dow Jones Industrial Average down 372 points and 40 to 50 basis points (depending on specific credits and maturities) of spread widening in better areas of the junk debt market in the neighborhood. These are significant moves, particularly in the corporate credit markets. All the latest Trump debacle has done is permit market participants to express opinions they have held for weeks or months.

One area of the capital markets which has expressed a more cautious view is the UST yield curve. At the time of this writing, the benchmark 2-year to 10-year UST curve was positively sloped by about 95 basis points. This is in from over 135 basis points on 12/22/16.

Benchmark 2-year to 10-year UST curve, year-over-year (Bloomberg):
Market Selloff - Benchmark 2-year to 10-year UST curve, year-over-year (Bloomberg)

As you can see, the UST curve has been flattening for nearly five months. In my opinion, the bond market was telling us two things:

1) The Trump agenda was probably going to be more difficult to implement than optimists believed.

2) The Fed would likely act to offset the inflationary effects of fiscal policy reforms.

That the Fed was tightening in what (according to employment and consumer credit data) appears to be late in an economic cycle, is reason enough to see a flatter yield curve. There is an idea among some market participants that low German bund yields are contributing to the shape of the UST curve, by holding down long-term UST yields via a tether related to currency/interest rate arbitrage. In a recent report, Cantor Fitzgerald made such assertions. Although there is a kind of tether between the 10-year UST note yield and the yield of the 10-year German bund, it is a bungee-like tether, stretching and rebounding, rather than a steel cable-like tie.

Spread between 10-year UST note yield and 10-year German Bund Yield YoY (Bloomberg):

Market Selloff - Benchmark 2-year to 10-year UST curve, year-over-year (Bloomberg)

As you can see, following Election Day 2016, the spread between the 10-year UST note and 10-year German bund widened, as bond market sentiment improved, and gradually narrowed as economic growth hope faded and inflation fear subsided. The curve flattened because the bond market was pricing-in 2.0% to 2.5% GDP, a vigilant Fed and a potential fading of inflation pressures from narrowing year-over-year energy price comps. As such, German bund yields did not and, in my opinion, could not materially impact the shape of the UST yield curve.

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About Thomas Byrne
Thomas Byrne has achieved a 26-year career in financial services, 23 of which have been spent in the fixed income market sector. In his role as Director of Fixed Income for Wealth Strategies & Management LLC., Byrne is responsible for providing strategic analysis and portfolio management to private clients and institutions, in addition to offering strategic advisory services to other financial services organizations. Byrne's areas of expertise include trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt, and convertible bonds. Additionally, Byrne provides analysis, strategy, and commentary within the fixed income market. Prior to joining WS&M, Byrne worked as Director in the Taxable Fixed Income Department of Citigroup, Inc., in addition to predecessor companies in New York, NY.
Twitter: @Bond_Squad
E-mail: Thomas.byrne@wsandm.com

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