Tuesday January 17

U.S. stocks fell today after markets digested more comments from Trump and the financial sector was a drag on performance. The S&P 500 fell 0.3% to 2,267 and the Dow Jones fell 0.3% to 19,826. The KBW Bank index today fell 3.4% while utilities rallied 1.2%. This comes as markets seem to be reversing some of the Trump trades that propelled equities at 2016 year’s end. On the backdrop of uncertainty rates rallied. The 2 year Treasury fell 5bp to 1.15%. The 10 year Treasury yield fell 8bp to 2.32%. Accordingly 2yr vs 10yr bull flattened to 1.18%. USD fell 1% against EUR to $1.0707. USD fell 2.9% against GBP to $1.2397. USD fell 1.6% against JPY to Y112.67. Oil prices were mixed with WTI rising 0.3% to $52.53. Brent fell 0.7% to $55.49. Gold prices benefited from the uncertainty, rising 1.7% to $1,216.70.

Real rates in the U.S. suggest that the economic growth and prosperity that some markets are currently pricing in may not be coming. Over the last few weeks real interest rates, which is equivalent to 10 year Treasury yields less market based inflation expectations have fallen. That could be a sign that investors are tapering back their growth projections. The 10 year real yield has fallen from 0.74% in mid December to just 0.38% now. This pullback also corresponds with a weakening US dollar since that time. Real interest rates are positively correlated with U.S. economic growth. Real rates are still higher than they were before the election, when they were just 0.15%. If Donald Trump’s large fiscal stimulus, lower taxes, and deregulation come into fruition real rates would likely shoot back up again. At the same time even as the real rate has fallen the 10 year breakeven rate, the market’s estimate for what inflation will average over that time span has widened from 1.87% in December to 2% currently. In this way the market is pricing in higher inflation without the economic growth which seems counterintuitive.

Theresa May spoke today and outlined her plans and expectations for Brexit negotiations before the U.K. actually invokes article 50. This amounted to the most detailed statement that she has made about her expectations. She came across as slightly conciliatory however still stuck to the hardline views of control over immigration. She emphasized the importance of a “clean Brexit” and said that in negotiations officials would push for the “freest possible trade” with the EU. The pound rallied 2.5% to $1.2340 and rose 1.4% during the speech. The increase in clarity and reduction of uncertainty surrounding this process is a welcome development for the pound. The UK hopes to negotiate its own trade deals to further globalize the nation. This month the Supreme Court will rule on whether or not invoking Article 50 will require the approval of British parliament. May has previously said that they would invoke Article 50 regardless of the court’s ruling. The British pound had previously fallen below $1.20 over the weekend after reports circulated outlining the key points in May’s speech, however given the response today May’s comments must have resolved some of those concerns.

A risky trading practice that is common in China is coming to light now that yields are starting to sell off there. “Dai chi” or DC resembles a US repo transaction in some ways, however the market is not regulated and has unique risks. In a DC transaction, one trader may sell bonds or other debt instruments off to another investor, with the agreement to buy them back at a higher price after a period of days, weeks, or months. In this situation the buyer earns the higher price plus an added fee, and the seller hopes that the bond’s price has appreciated higher than the repurchase price by the time he buys it back. Traders use this practice in order to move certain assets off their books during reporting periods or audits, and it also is a way for them to use leverage. DC is an effective strategy in a bull market, however it becomes riskier if yields are rising like they are now in China. Additionally agreements are often informal and not legally enforceable. As a result it could happen that one trader may back out of his end of the trade which could potentially send ripples through the market. Such was the case when Sealand Securities said it would not buy back $2.4bn in DC agreements, however it eventually settled with counterparties after regulatory intervention. Some analysts estimate that around 19% of China’s bond market could be involved in these risky repo trades.

Trump’s comments sent the dollar tumbling today. In an interview he said that he prefers a relatively weaker dollar, which is a contrast from prior administrations who refrained directly from commenting on the strength of the currency. Additionally he discussed a tax proposal that has been referred to as a border tax that has been proposed by republicans and many investors saw as an impending reality. The border tax would tax imports and make exports tax exempt, which many analysts predicted would strengthen the dollar. However Trump denounced that plan saying it was too complicated. As a result the WSJ dollar index fell 1% today. These comments also introduce some more uncertainty into the picture. Other analysts believe that these comments long term won’t do much to keep the dollar lower, since in reality higher interest rates and a growing US economy will return upward pressure.

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Tuesday January 17

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