Tuesday March 7

Stocks drifted lower today to start the week with two consecutive days of losses. The S&P 500 fell 0.3% to 2,368 and the Dow Jones lost 0.1% to 20,924. The KBW Bank index lost 0.3% and utilities fell 0.1%. The market for Fed funds futures continues to reflect a 84.1% chance that the Fed will raise the fed funds rate to 0.75% to 1.0% next week. Healthcare shares in the U.S. lost ground after Republicans unveiled their plans to roll back Obamacare coupled with a Trump tweet about lowering drug prices. Interest rates continued to creep up in the U.S. The two year Treasury yield rose 2bp to 1.33% and the ten year Treasury yield rose 3bp to 2.52%. Accordingly 2yr vs 10yr bear steepened 1bp to 1.19%. The dollar also rose modestly on the day against peers. USD rose 0.1% against EUR to $1.0569. USD rose 0.1% against JPY to Y113.99. USD rose 0.3% against GBP to $1.2202. Commodity prices slid back with gold and oil prices both dropping. WTI fell 0.2% to $53.10. Brent fell 0.2% to $55.89.

The ECB is facing internal divisions the same way the Fed is going through when deciding whether or not to raise rates. The eurozone economy is picking up and inflation is on the rise across the region based on PMI and CPI indicators that have been coming in. However the ECB is tentative to act ahead of important elections coming up in the Netherlands, France, and Germany. Officials in Germany are taking a more conservative and hawkish stance while others want to remain accomodative while elections are going on. According to IHS Markit inflation is now at 2% in the eurozone which is slightly above the ECB’s target. The central bank is set to meet on Wednesday and Thursday and investors will be closely parsing any information that comes out of that meeting regarding the future of QE and the future of rates. The challenge is that there is a high degree of variation between the most healthy eurozone economies and the least healthy eurozone economies. While the economic environment countries such as Germany might warrant higher interest rates the unstable economies such as Greece might still benefit from accomodation. Accordingly Mario Draghi is being pulled in different directions by officials all over the eurozone. The ECB”s credibility is a little lower than that of the Fed and how the ECB is able to communicate its policies to the market will be key to how economies actually respond. With so many constituents within the ECB however sometimes different members of the ECB send conflicting signals which undermines the policies. Regardless the ECB is expected to leave policy unchanged for now, and any clues or hints to future plans will be the most important thing as well as comments on euro skepticism.

Global central banks have been increasing their foreign reserves which could be to raise their buffer against future outflows. Of the 30 largest emerging market economies 20 have increased foreign reserves and reserves hit records in Israel, Vietnam, and the Czech Republic. Even China last month reported increases in reserves by $6.9bn which snapped eight consecutive months of declines. Switzerland as well has been increasing foreign reserves. Countries typically try to increase their reserves in anticipation of stress when they may need to meet redemptions or defend their currencies. In this way foreign reserves act like insurance for sovereign governments as governments need foreign currency to pay back bondholders. For investors therefore rising reserves are a good thing since it reduces the odds of a hard currency shortage. As interest rates rise in the U.S. foreign central bankers may need to use these reserves to meet capital outflows as investors pull money out to earn higher rates. Capital inflows of $192bn last year marked a 60% increase from 2015 and also contributed to the increase in foreign reserves. The trend is not broad across all emerging markets however. Governments in the Middle East in particular have decreased their foreign reserves to finance spending given the drop in oil prices.

Supply factors are influencing the short end of the Treasury market right now as there is a standoff in Congress that is holding up new debt issuance. As a result the spread between the one-month Treasury bill is close to a one year low and has been highly volatile over the last year. At the same time the cash balance at the U.S. Treasury has dropped off significantly from around $380bn last month to $189bn this in February. Therefore technicals are driving the short end of the Treasury market rather than macroeconomic factors. To look at the relative value of T-bills relative to the market investors use overnight index swaps (OIS). Those instruments allow investors to place positions based on the Fed funds rate, and it allows investors to bet on the fed funds rate will average during a given period. As the spread between T-bills and OIS declines it shows that T-bills are getting more expensive.

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Tuesday March 7

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