Monday April 24

Stocks rose today after investors liked the result of the French election and the Trump tax comments. The S&P 500 rose 1.1% to 2,347 and the Dow Jones rose 1.1% to 20,766. The KBW Bank index rose 2.5% while utilities rose 0.4%. The VIX dropped more than 25% to 10.89. Emmanuel Macron and Marine Le Pen will be advancing to the second round of voting for the French election as Francois Fillon and Jean Luc Mélenchon were eliminated yesterday. That avoids the dreaded showdown that some analysts feared could happen between Marine Le Pen and Mélenchon. Peripheral yields tightened and French stocks rallied. The CAC 40 rose 4.1% and financials within that rose 7.8%. The polling showed that voters are leaning 62% in favor of Macron and 38% for Le Pen. Implied volatility between the euro and dollar were back to pre-election norms. The spread between 10 year French and German bunds tightened to 44bp as French yields rallied 11bp and German rates sold off 8bp. In the US interest rates were higher. The two year Treasury yield rose 4bp to 1.23%. The ten year Treasury yield rose 2bp to 2.27%. Accordingly 2yr vs 10yr bear flattened to 1.04%. USD fell 1.3% against EUR to $1.0870. USD rose 0.6% against JPY to Y109.72. USD rose 0.2% against GBP to $1.2790. Gold and oil prices both fell. WTI lose 0.8% to $49.21. Brent fell 0.8% to $51.56.

President Trump today announced that tax reform was on the top of the agenda today as he ordered staff to work on a tax plan to drop the corporate tax rate to 15%. While this would be cheered by markets it still faces a long way to go before a piece of legislation passes. Trump is prioritizing cutting taxes over deficit issues since at a meeting last week he said that a loss of revenue is less important to him than cutting taxes. He ordered for a plan to be released by Wednesday. That plan would push yields higher due to the effects it would have on the deficit most likely. Tomorrow Steve Mnuchin, Gary Cohn, Mitch McConnell, Paul Ryan, and other officials are going to meet to discuss the proposal ahead of the announcement on Wednesday. According to some researchers a plan such as this could cost the government $2tn over the course of the next ten years. If Republicans choose to take this legislation through the reconciliation route they wouldn’t need votes from Democrats to pass however the reforms couldn’t extend past 10 years. However in order to pass cuts that don’t expire they would need some votes from Democrats. Mnuchin has said that the proposal would pay for itself with economic growth however that is hard to quantify in the immediate term. The United States has lost competitiveness with other countries as they have lowered their tax rates and the US has held steady at 35%.

Markets breathed a sigh of relief today after Emmanuel Macron advanced to the second round of voting in the French election over the weekend. Investors are confident that Macron will prevail over Marine Le Pen in the elections next month. Macron does not come from one of the traditional political parties in France and he will need cooperation from other political Assemblies for him to be effective in passing his policies. Macron’s policies include labor market reforms, increased integration both economic and fiscal with the EU as well as fiscal consolidation. Investors will turn their attention away from Mélanchon and Le Pen and instead towards how Macron will be able to implement his suggested reforms. One possible outcome could be a political environment in which there is gridlock between the president and prime minister when nothing really gets done. That environment would be seen as a negative for economic and business conditions in the country. As Macron pulled away in the elections over the weekend risk assets in France and the EU rallied. Banks in particular in France benefited disproportionately with BNP, SocGen and Credit Ag rising 7.4%, 10.1% and 10.3% respectively. Banks are the most exposed to business and economic cycles compared to some other types of businesses so that explains why they benefitted to such an extend. The spreads between German and French bunds tightened to reflect less political risk in the country.

One senior economist takes the contrarian view that as the Fed unwinds its balance sheet that could have an easing effect on the economy. The argument suggests that as the Fed holds less Treasuries then investors and other market participants will have access to more high quality collateral. If collateral is reused and lent out through repo markets then that could have a lubricating effect across financial markets. Manmohan Singh argues that as the amount of good collateral available to markets increases and excess deposits held at the Fed decrease then financial markets will be able to function in a smoother manner. The rate at which collateral is reused is similar to the money creation process with how banks use fractional reserves. Excess reserves aren’t a good thing because it is money in the banking system that isn’t being put to use where it could be used to make a loan. Excess deposits are taking up a lot of space on bank balance sheets presently as excess reserves held at the Fed are over $2tn. That gets in the way of monetary policy transmission. As that amount decreases along with the asset side of the Fed balance sheet Singh homes that more money will be able to be put to work in the financial sector which would have an easing effect.

Monday April 24

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