Thursday February 23

Stock indices rose slightly today as Steve Mnuchin’s comments on tax reform didn’t have too much of an immediate effect. The S&P 500 rose fractionally to 2,363 and the Dow Jones rose 0.2% to 20,810. Economic data today showed that jobless claims came in at 244k which was right in line with estimates and still on the very low end of historic norms. Data from the EIA showed that crude oil inventories rose just 600 thousand barrels last week compared to the prior week’s increase of 9.5 million barrels. In Europe French bond yields fell for the second consecutive day as investors scale back their expectations for a Marine Le Pen victory. Mnuchin’s comments likely didn’t have a huge impact on stock prices because investors have already priced in the impact of tax reform. In the US the two year Treasury yield fell 4bp to 1.19%. The ten year Treasury yield fell 3bp to 2.38%. 2yr vs 10yr finished at 1.18%. The dollar was weaker for the second consecutive day as investors weigh the probability that the Fed won’t raise interest rates in March. USD fell 0.2% against EUR to $1.0584. USD fell 0.5% against JPY to Y112.70. USD fell 0.8% against GBP to $1.2551. On the bullish EIA data oil prices rose. WTI rose 1.4% to $54.36 and Brent gained 1.1% to $56.45.

Steve Mnuchin gave initial guidance on tax reform and his economic growth hopes during his time as Treasury secretary. He mentioned that he thought slow economic growth following the financial crisis could be attributed to political policies that restrict growth such as high tax rates and heavy regulations. By lowering taxes and reducing regulation Mnuchin expects to bring economic growth back to 3% or higher. That compares with the Fed’s long-run annual growth rate of just 1.8% which is in line with the expectation of the Congressional Budget Office. Some researchers believe that slow growth is a secular trend that can’t be avoided as a result of slow productivity growth and slow labor force growth. As a result of these demographic challenges output in developed countries has averaged just 2% annually over the last 10 years. Mnuchin and other officials in Trump’s administration hope that by reducing taxes and regulation that could combat some of those problems however it remains to be seen. The administration will present its first budget blueprint next month and analysts will be looking closely to see how the administration plans to deliver stimulus and growth without increasing the deficit too much. Mnuchin also said that his team in the Treasury was in the process of examining the border-adjusted tax and is aware of the complaints from certain industries and is also skeptical of its effect on the dollar. He also suggested that he looks forward to collaborating with China and working on certain trade issues.

Now that inflation is on the rise again investors are paying more close attention to real yields in the United States. Real yields show how much interest investors earn in a country net of inflation so they are a big driver in movements in the dollar of late. Since Trump’s election real yields have slid from 0.74% in December to 0.4% currently which is what is pushing the dollar lower. Falling real yields could be attributed to investors tempering their expectations for economic expansion under Trump from their peak. A declining yield differential between the short term eurozone government bonds and US Treasuries suggests that a decline in that spread can be attributed to the depreciation in the euro. That suggests that as euro government bonds are becoming less attractive to hold net of inflation compared to US bonds that the euro has been falling relative to USD. But in order for the dollar to appreciate further real yields in the US will have to increase.

German bund yields have been dropping partly due to political risk across the region and partly due to other factors such as ECB bond buying. The two year bund yield keeps on pushing deeper into negative territory and has benefited as the ECB removed its restriction on buying debt that yields less than -40bp. Yesterday the yield on German 2 year bonds hit a record low of -0.92%. That could be due to haven buying as investors express concern about potential outcomes in France as yields between the two have diverged. All throughout last year the two traded in lockstep however towards the end of last year they each shot in opposite directions. Fixed income and equity investors seem to be taking opposing views on this as equity prices in both countries are doing quite well. Based on derivatives markets analysts can tell that traders expect April to be a volatile month in the rates market which coincides with the elections in France. There are some dislocations becoming apparent in other areas of the market as well. For example options pricing also reflects that there is high demand to hedge against a drop in EUR against USD over the next few months, however the demand for the euro to fall against other currencies such as CAD isn’t there. Demand for short term German bonds could also be due to investors betting that peripheral spreads will rise.

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Thursday February 23

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