Two Main Forces are Driving the Markets

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There are powerful moves underway in the capital markets. Some are new, and others have accelerated in recent weeks. The moves have stretched technical readings, but key drivers not only remain intact but may strengthen over the next week.

We argue that there are two main forces driving the shifting portfolio allocations. The first emanates from the US and the second from Europe.

There is growing confidence that the Federal Reserve will hike rates next month, and more next year. Nevertheless, the market does not have two Fed hikes priced in for next year, suggest there is scope for additional adjustment. Two hikes next year will likely be the base case for many forecasts. The dramatic rise in long-term Treasury yields is the direct consequence anticipation of fiscal stimulus when the economy is already growing toward trend. Both US presidential candidates' programs call for fiscal stimulus. Trump's was larger and included significant tax cuts as well.

While many of the comparisons between Trump and Reagan are superficial and faddish, one kernel of truth may be found in the policy mix. An expanding fiscal policy and a monetary policy that was becoming less accommodative characterized Reagan's first term and coincided with the first dollar rally post-Bretton Woods. Of course, Trump has not assumed office yet, and he will have to negotiate with a more austere Republican leadership in Congress.  A deft negotiator may secure Democrat support for spending increases and Republican support for tax cuts.  

However, the economy that Trump will inherit is significantly different from what Reagan received. Presently, the US economy is growing near-trend, and unemployment has slipped below 5%. Many investors suspect that may prove to be inflationary.  Four months ago the yield was just above 1.30%. It finished last month a little above 1.80% and closed last week near 2.35%. Ironically, despite the continued expansion of the US economy and rising price pressures, the 10-year bond yield is still below last year's high seen in July near 2.50%.

Long-term interest rates remain lower than what used to be associated with the current economic conditions and price pressures. The US 10-year yield peaked near 16% in Q3 1981. One does not have to assume that secular downtrend in interest rates is over. There have been other significant counter-trend moves. However, the trend could be over as deflationary forces have been arrested and global growth appear to be stabilizing.

This week's data is unlikely to alter views but may strengthen the appreciation of the solid economic performance since struggling in Q4 15 through Q2 16.  Growth in Q3 is expected to be tweaked up to 3.0% in this week's revision. The US economic data continues to be mostly reported stronger than expected. The NY Fed estimates that US economy is tracking 2.5% growth here in Q4, while as of the middle of last week, the Atlanta's Fed model was more optimistic; tracking 3.6%.

At the same time, investors will be reminded of the proximity of the Fed's objectives. The core PCE deflator is expected to have remained steady in October at 1.7%. The Fed's target is 2%.  At the end of the week, the US reports the November jobs data. It is expected to show solid, even if not spectacular job growth of 175k-185k. The unemployment rate is expected to be unchanged at 4.9%, and hourly earnings are forecast to be steady at the 2.8% year-over-year, the highest rate in seven years reached in October. The bond market and the dollar, given the recent tight link, may be particularly sensitive to downside surprise in the unemployment rate or an upside surprise in earnings.