Washington turmoil finally sparks sharp market reaction
Unemployment claims continue to support strong labor market view
U.S. leading indicators expected to remain strong
10-year TIPS auction to yield near 0.42%
Washington turmoil finally sparks sharp market reaction — The markets on Wednesday finally reacted sharply to the events in Washington as the White House turmoil deepened. The market fears that the Republican growth agenda will become even more difficult to pass if Congress gets bogged down with a presidential investigation. President Trump may be able ride out the current turmoil if nothing new emerges, but the Washington political uncertainty could nevertheless put a dent in business and consumer confidence and thereby undercut the U.S. economy.
It remains an open question how much of the post-election rally in the stock market depends on the Republican’s growth agenda and a corporate tax cut in particular. The more important factor behind the post-election stock market rally in our view has been the sharp expected improvement in SPX earnings growth to +11% in 2017 after negligible growth in the past two years. However, the stock market has been priced to perfection with valuations at very high levels. That has left the stock market vulnerable to a technical correction on any negative news, which emerged with the Comey letter and the talk of possible obstruction of justice.
The S&P 500 index on Wednesday fell to a 1-month low and closed sharply lower by -1.82%. Meanwhile, the VIX index soared to a 5-week high of 15.59% and was just mildly below the 6-1/4 month high of 16.28% posted on April 17 before the first round of the French presidential election. The dollar index extended its sharp 1-week sell-off to post a new 6-1/4 month low and closed the day down -0.54%.
On the interest rate front, the 10-year T-note yield fell to 1-month low and closed sharply lower by -10.1 bp at 2.224%. The TYVIX moved sharply higher to a 3-week high of 5.00% and closed the day up +0.64 points.
Market expectations for Fed policy turned more dovish on Wednesday’s political turmoil and the sharp sell-off in the stock market. The odds for a rate hike at the next FOMC meeting on June 13-14 fell to about 70% on Wednesday from 80% on Tuesday and 90% last week, based on federal funds futures. The Dec 2017 federal funds futures contract on Wednesday fell by -6 bp to 1.165%, reflecting expectations for an overall rate hike of only +29 bp by year-end, substantially less than the Fed-dot projection for an overall +50 bp rate hike by year-end.
Unemployment claims continue to support strong labor market view — The unemployment claims data continues to support the view of a strong U.S. labor market. The initial unemployment claims series is currently only +9,000 above the 44-year low of 227,000 posted in February. Meanwhile, the continuing claims series last week fell to a new 28-1/2 year low of 1.918 million. The multi-decade lows seen in the unemployment claims series illustrate how tightly businesses are holding on to their employees.
The consensus is for today’s initial claims report to show a small +4,000 rise to 240,000, more than reversing last week’s -2,000 decline to 236,000. The consensus is for continuing claims to show a +32,000 increase to 1.950 million, reversing about half of last week’s sharp -61,000 drop to 1.918 million.
U.S. leading indicators expected to remain strong — The market consensus is for today’s April leading indicators report to show a solid gain of +0.4%, matching March’s +0.4% gain. The expected report of +0.4% would support the view that the U.S. economy in Q2 is recovering from the weak Q1 GDP pace of +0.7%. The LEI gave no real heads-up for the weak Q1 GDP report since the LEI was very strong over the past four months (Dec +0.6%, Jan +0.6%, Feb +0.5%, Mar +0.4%). On a year-on-year basis, the LEI in March rose to a 1-1/2 year high of +3.5% y/y, which bodes well for Q2 GDP. The Atlanta Fed’s GDPNow is forecasting that Q2 GDP will improve sharply to +4.1% from the Q1 pace of +0.7%.
10-year TIPS auction to yield near 0.42% — The Treasury today will sell $11 billion of 10-year TIPS. This will be the second and final reopening of the 3/8% 10-year TIPS of Jan 2027 that the Treasury first sold in January. Today’s 10-year TIPS was trading at 0.42% in when-issued trading late Wednesday afternoon.
The 12-auction averages for the 10-year TIPS are as follows: 2.35 bid cover ratio, $23 million in non-competitive bids, 7.2 bp tail to the median yield, 15.5 bp tail to the low yield, and 52% taken at the high yield. The 10-year TIPS is the most popular security among foreign investors and central banks. Indirect bidders, a proxy for foreign buyers, have taken an average of 67.5% of the last twelve 10-year TIPS auctions, which is well above the average of 59.8% for all recent Treasury coupon auctions.
Demand for today’s 10-year TIPS faces uncertain cross-currents. Today’s 10-year TIPS should see the usual strong demand from foreign investors and central banks and should benefit from Wednesday’s bullish T-note environment. However, demand for last week’s Treasury refunding operation was lackluster. In addition, there may be reduced demand for inflation-protected securities due to the sharp drop in inflation expectations seen in the past week due after last Friday’s soft CPI figures and with this week’s Washington turmoil. The 10-year breakeven inflation rate on Wednesday fell to a new 6-month intraday low of 1.802%. Wednesday’s 10-year breakeven rate close of 1.81% was down by -28 bp from January’s post-election peak of 2.09% and was only +8 bp higher than the pre-election level of 1.73%.