Friday December 30

Stocks fell today finishing 2016 with three days of declines. The S&P 500 fell 0.5% to 2,238 and the Dow Jones lost 0.3% to 19,762. Over the course of the week the S&P and the Dow were 1.1% and 0.9% lower respectively. Nevertheless in 2016 the S&P 500 rose 9.5% and the Dow Jones rose 13% which were the best annual gains since 2014. These gains are impressive given that equities started off the year on very shaky footing touching a two year low on February 11. In order for this rally to continue throughout next year investors will be looking at actual fiscal policies enacted as well as improvements in corporate earnings growth. Today Treasury yields continued to fall. The two year Treasury yield fell 1bp to 1.21%. The ten year yield fell 3bp to 2.45%. Accordingly 2yr vs 10yr bull flattened to 1.24%. Over the course of this week the 2yr and 10yr were flat and 9bp lower respectively. In FX markets the dollar was mixed. USD fell 0.2% against EUR to $1.0519. USD rose 0.4% against JPY to Y116.97. USD fell 0.5% against GBP to $1.2325. Commodity prices were similarly mixed however little changed on the day. WTI finished at $53.84 and Brent finished at $56.75.

China continues to open up its domestic markets in order to attract foreign investors. Foreign banks and investors have long faced troubles making investments and setting up business in China. The rules state that in order for a foreign entity to make an investment in China’s finance industry it must have a maximum 49% stake in a joint venture with a Chinese company. However that restriction may be taken away as regulators try to encourage more companies to do business in China. The National Development and Reform Commission said that the goal is to level the playing field between foreign and domestic companies. This will ease restrictions on manufacturing, transportation, food, and energy sectors as well. Other areas that will be opened up to foreign capital are accounting, architecture, audit, and rating agencies. Telecommunications, internet and education are sectors that will be pushed for next. In doing so, the NDRC will reduce the number of restricted sectors from 93 to 62. This could help China’s capital outflow problem. Foreign investors bringing in money could reduce net outflows.

European money markets are an attractive place to borrow money at year’s end. Overnight borrowing rates in the European repo market over the last few weeks has turned sharply negative, indicating that borrowers are effectively paid more to borrow money there. Repo rates on French and German general collateral have fallen from around -0.5% in August to now -1% and -2% respectively. That suggests a sharp imbalance between supply and demand for money market funds. There is relatively little demand for investors to borrow money currently, and money market funds are in need of places to invest and as a result they are willing to give up yield. Typically money market funds lend cash to banks in exchange for sovereign bonds since that is safer than leaving cash in deposits. Banks are willing to exchange their inventories of bonds for cash so they may go out and buy more bonds. However at the end of the year banks cut down their inventories of bonds before reporting their balance sheets to investors and regulators. This time around especially due to the harsh regulatory environment the trimming in inventories on behalf of banks has been especially sharp. As a result banks are not borrowing as much cash from money market funds, and therefore money market funds desparately need places to put their funds. Money market funds are limited by regulators on how much cash they can hold, and therefore that explains why they are willing to give up so much yield to attract borrowers.

Year to date a Barclays index of Treasuries returned -0.8% due to fiscal outlook changes as a result of the election. On the other hand TIPS returned 4.3% this year as those same events increased demand for inflation protection. Junk bonds returned 17% as oil prices rebounded from the start of the year and the economy is expected to improve under Trump. Investment grade credit returned 5.8%. Munis were for the most part flat returning 0.2% as a sector. Obviously those return metrics can vary greatly depending on duration.

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Friday December 30

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