It’s a bit hard to write about markets right now given the election outcome, but I’d like to say a few things in light of the market action and the endless string of “Trump Trades” reports that are being sent around.
· No one knows what Trump wants to do. And even if that is known, no one knows what he’ll be able to do. Trump is facing not a simple Republican majority in Congress but rather a minority of ‘core’ Republicans, the Freedom caucus, and Democrats. Thus, a massive federal fiscal deficit is almost certainly going to require the buy-in of a large number of Democrats.
· Barriers to trade are a different story, since Trump does not need Congressional authority to throw up roadblocks. As a result, the moves in currency crosses vs the USD are arguably likely to be more persistent for those with a large trading relationship. Note that the roadblocks (including a currency manipulator designation) do not even need to take effect to justify these moves. The very threat is likely to restrain US companies from building factories outside the country, and dissuade foreign companies from exporting here. This suggests that the US non-petroleum trade deficit is likely to stabilize, at the very least.
· Having said that, the paradigm for US rates has abruptly changed. Treasuries are no longer seen as simply as cash like instruments, or risk off hedges. Now there is a clear downside risk via a worsening fiscal deficit, and the market is moving to price that risk premium.
· Having said that, remember that there is a limit to how high that risk premium can go. Japan has shown that the sovereign Debt/GDP ratio is much, much higher than here.
· I’ve been doing some more modeling for US rates and now believe that the fair value for nominal 30y Treasuries to be close to 2.5%.
· The selloff in fixed income is likely to accentuate inflows into equities. Most surveys suggest that investors are underweight risk assets, but there hasn’t been an impetus to reverse that given that fixed income has been performing all year. There are a few similarities to 2013 there.
· The market tone for US equities is unambiguously bullish. If a massive uncertainty shock like this AND a massive jump in treasury yields can’t send the market lower, it’s hard to imagine what will in the near term.
· Volatility spikes like what we’ve seen the past 24 hours will persist. Successful investing thus requires a combination of correct position sizing, fortitude, or ignorance.
· In my last update back in August, I said that shorting duration and being long equities is likely to work over the intermediate term. The former call has worked better than the latter, but I think those views still apply, though obviously the case for short rates is less strong now given the move.
· I also like USDCAD upside over the longer term. Regardless of what happens politically, Canada needs both lower interest rates and a weaker currency vis-à-vis its largest trade partner. Plus it is positive carry, and negatively correlated to risk assets. It’s not necessarily a fantastic trade based on an ex-ante Sharpe basis, but should work well as part of a pro-risk portfolio.
· For the EURUSD, barring a hiccup in Europe, new lows are likely to be limited. Beneath all the noise, Europe has been closing its output gap at a faster pace for about a year and a half now. IMO, that is one reason why the ECB is even hinting about tapering, which arguably is a much more hawkish shift than the Fed resuming its gradual hiking path. Real yield differentials in the belly of the curve has increased 60bps (!) in favor of the EUR since a year ago. The current market tone is focused on protectionism and the dollar positive effects from that, but a substantial move lower here would make a long position attractive, IMO.
As always, thoughts & responses are welcome.