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WALL STREET INSIGHT

Rising bond yields signal reversal of long standing trends

Monday, November 21, 2016 - 05:50

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THE Trump rally faltered last week and US stocks finished below their record peaks, as traders reconsidered the view that the new administration would create a bonanza for all American corporations.

This week could also feature more sector rotation than definitive moves for the broad indexes.

The hyper-speed reversal of longstanding trends in bonds and stock-market sectors hinted that there could be investment downsides to a president prepared to tear up trade agreements and spend freely.

Donald Trump's controversial picks for security roles mark a shift away from the primacy of equality in American justice and foreign policy; his economic policies could also divide markets into winners and losers. Indeed, Ryan Detrick, senior investment strategist at brokerage LPL Financial, said last Monday's session amounted to one of the most bifurcated in stock-market history.

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As many financial, raw materials and healthcare stocks were making new 52-week highs on hopes of deregulation, just as many technology and utilities stocks were making new 52-week lows on fears that the Trump economy would not work as well for them. A pullback from trade agreements could hurt companies such as Facebook and Google, who do much of their business overseas. Utility and telecommunications stocks, meanwhile, are following the lead of Treasury bonds.

On Wall Street, a shock almost as seismic as that of Mr Trump's election to the presidency is the sudden reversal of the Treasury market. Treasury bonds have effectively moved straight upwards for almost a decade, with yields steadily falling. All of a sudden, yields are on fire. The rate on the 10-year Treasury bond had its biggest two-week gain in 15 years.

Bank of America Merrill Lynch called it a "violent rotation"; Treasury bonds saw one of their biggest outflows in the week following the election, and the cash flooded into US stock exchange-traded funds, which saw their biggest ever inflows.

"If Brexit marked [A]5,000 year low in global interest rates, Trump marked the moment investors started to position for bond bear market," said analysts at BofA Merrill Lynch, in a note to clients. The BofA analysts noted that the upsurge in bond yields could get more violent yet, pointing to an occasion in the early 1980s where rates went from 10 per cent to 16 per cent in the space of a few months.

Usually, the chilling effect of rising rates hurts the stock market. This time, however, yields are rising from practically zero, and Wall Street strategists have long predicted that the "Great Rotation" will help the stock market more than the economic effects of the rates will hurt, at least at first.

"Last week's fund flow data may go down in history as the first real indication of the switch from bonds to equities," said analysts at brokerage Jefferies, in a note to clients.

One reason that bond yields are rising is because of Mr Trump's plans to widen the deficit in order to stoke the fires of the economy. Mr Trump ran as an economic populist rather than a fiscal conservative, as past Republicans have invariably been. Think of the economic populist as the parent who doesn't worry about spoiling their child.

Fiscal conservatives say the best form of budgetary discipline is to cut spending while lowering taxes; liberal democrats say spending should be kept steady and taxes raised. Mr Trump would dispense with all discipline, cutting taxes for everyone and increasing spending at the same time.

The Washington Post has quoted congressional Republicans saying they will resist this approach and vote down Mr Trump's infrastructure bill unless the budget is balanced elsewhere. It remains to be seen who wins that fight.

In another unorthodox move for Republicans, who are traditionally free trade, Mr Trump has also promised old-line industries such as coal-mining and steelmaking that he will bring business back from overseas. The only way to do this is to impose tariffs on coal and steel imports. This would help domestic producers of these materials, who were close to extinction before Mr Trump's win. Among the strongest issues on the market since the election were shares of Peabody Energy, which have more than quintupled.

More broadly, many stocks are benefiting from Republican promises to cut the corporate tax rate.

"Mr Trump's protectionist plans look positive for US equities (but not the rest of the world)," said analysts at brokerage Barclays, in a research note. "A 15 per cent corporate tax rate could boost S&P 500 EPS (earnings per share) by up to about 10 per cent, but there could be sizeable offsets."

The other reason for the "violent rotation" out of Treasuries is the calculation that the Fed is set to raise interest rates in the near future. Futures markets show near-certainty that the move is coming in December. There would have to be a stark disappointment in data due this week on factory orders and home sales to change that.

But Ms Krosby, of Prudential Financial, said the Fed's December statement could still move the stock market dramatically, depending on how the central bank characterises the outlook for the Trump era.

There are signs of discomfort with the new president among central bankers. Dallas Federal Reserve President Robert Kaplan has already made the case for the importance of economic ties with Mexico and of a more open immigration policy. For her part, chairwoman Janet Yellen said it is still too early to tell.

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