Politics Not Economics is Driving the Markets

The US dollar has been correcting lower since mid-December.  Interest rates have begun moving in the dollar’s
favor, and the equity market is again knocking on record highs.  The US
economic data, coupled with Fed comments, keep the Fed on track to hike rates.
Even with the
weaker than expected wage growth in January, investors saw a greater chance of
a June hike. 
 Yellen has warned of a “nasty surprise”
if the Fed waits too long, and even the dovish Chicago Fed President Evans
seems endorsed two, and possibly three hikes this year.
This year is
different than 2015 and 2016 when the Fed
hiked rates in December both years. 
 The Fed is more confident of the
underlying resilience of the economy and more sure that price pressures will
continue.   In December, the FOMC statement said that “…inflation
is expected to rise…”  Last week the FOMC statement said that
“…inflation will rise…”
The five-year
breakeven (conventional yield minus the yield on the five-year inflation
protected security) closed above 2% for the second consecutive week.
  A year ago it was a little more than
1%.  The 10-year breakeven has closed above 2% for four consecutive weeks.
 It is approaching 2.10%, the highest since September 2014.
The US economic calendar turns lighter next week. However, after a disappointing first
estimate for Q4 16 GDP, the typically more conservative NY Fed GDP tracker is
pointing to 2.9% growth in the current quarter.  The Atlanta Fed sees the
economy tracking 2.3%.
unpredictable nature of the new US Administration, and its seeming willingness
to antagonize allies and rivals alike, and making arbitrary judgments, appears
to have increased the uncertainty. 
Although Administration officials
articulate pro-growth sentiment, there is a concern that other policies will
undermine the investment climate.  
Still, as the
Trump Administration begin turning its attention to its economic agenda,
investors’ confidence may be bolstered.  
Already a group of large exporters,
including GE, Boeing and Oracle are forming a lobby to support the border tax.  The executive order to
review Dodd-Frank signed before the weekend, send the S&P 500 financial
index up 2%, with several of the large bank shares rallying the most in three
However, the
focus seems to be on parts of the legislation, like the Volcker Rule that curbs
proprietary trading by banks, which were seen a
conflict of interests and encouraging risk taking that is ultimately
backstopped by taxpayers’ money. 
the fiduciary rule, which forces financial
advisers to put client interest first in managing retirement savings,
has also incurred the wrath of the President.  These are not the kind of
things will help Trump’s supporters or broaden his base.
The vice-chair
of the House Financial Services Committee sent a pointed letter to Federal Reserve
demanding that it ceases and desist from
continuing to participate in multilateral financial regulation negotiations,
including the Financial Stability Board.
  The letter is not from the chair of
the committee or President Trump.
 Nevertheless, it is important, and the Federal Reserve will respond,
perhaps in the days ahead.  Yellen will deliver her semi-annual testimony
to Congress in the middle of the month, and this will likely be a key topic.
 Like other positions Trump is staking
out, the claim that US participation in global regulatory efforts is
undermining US growth has been made for several years by top US bankers,
including JP Morgan’s Jamie Dimon.
Given the
recent ECB and BOE meetings and preliminary estimates for Q4 16 GDP,  data
from December are unlikely to move markets. 
 Investors seem to focused on three
things:  Brexit, European elections, and the sharp rise in European
interest rates and expanding premiums over Germany.  UK Prime Minister May
is widely anticipated to formally trigger Article 50 next month and begin the
two-year negotiation process.  Meanwhile, the next month’s Dutch elections
are not drawing the same attention as the French election even though the
populist-nationalist forces seem stronger.  

In France, Fillon, who had been the leading candidate to
meet Le Pen in the second round has been
undermined by a scandal in which he hired family members as advisers
with lucrative salaries. 
Macron, the former Socialist who broke
away to form his own centrist party, is on
the ascendancy.   As it stands now, it appears that the
populist-nationalist shift in the UK and the US is seeing support for the EU rising in Europe.  It is forcing liberal
(in the European sense) global elites to offer a better defense of their vision
and forging a bulwark against the spread of populism-nationalism.  

It is
still the early days, but there does appear to be a reasonably good chance that
a coalition government in the Netherlands excludes the Freedom Party, even if
it gets a plurality of the vote.
Pen is likely to lose in the second round of the French elections. In
Germany, the CDU and SPD are most likely to for another coalition government,
with Merkel as Chancellor.  The AfD are barely drawing one in nine voters.
peripheral yields stem from at least a couple factors, including stronger world
growth, higher inflation in Europe, and political concerns. 
 Peripheral yields are often like high-beta Bunds.
 In a falling interest rate environment, the spreads tend to narrow, and in a rising rate environment, they
typically widen.  There does appear to be some preliminary evidence of a
readjustment of portfolio flows within Europe which favor Germany. 
What has been
lost in some of the recent criticism of Germany and the euro by the new US
Administration is that while the euro may be too weak for Germany, it may be
too stronger for large parts of South Europe and France. 
 Also, the
competitive strength of Germany is not appreciated.  German exporters can
be competitive with a stronger euro, but many other countries would not.
 And in a weak euro environment, German companies can take market share or
boost margins.  German retail sales fell a little more than 1% December
from the year earlier.  
The best way to
address the large German surplus is not through a zero-sum foreign exchange
adjustment but through stronger domestic
demand in Germany through investment and stronger wage growth.
  Although the German government is
correct in noting that these are private sector decisions, it is somewhat
disingenuous in that government policy can create the proper incentives
structure to increase the likelihood of the desired outcome.  
The highlight
from Japan will be its December current account balance. 
 There is a large seasonal component.  The December
balance is typically worse than the November balance.  In fact, this has
been the case for eight of the past 10
years.  The pattern is expected to hold.  The December surplus is
expected to fall from JPY1.415 trillion to JPY1.183 trillion.  However,
the details may be more interesting.  The trade surplus typically grows in
December and is expected to do so again.  The Bloomberg median expects a
JPY751 bln BOP trade surplus after a JPY313 bln in November.  What will
likely hold back the large balance is investment income, which often tapers in
Elsewhere, we
note that both the Reserve Bank of Australia and the Reserve Bank of New
Zealand hold policy meetings in the week.
  Neither central bank is expected to
change rates,  The recent strength of their respective currencies may draw
some attention. The improvement in terms
of trade can be eaten away by continued currency appreciation. However, with buoyant housing markets, the central banks will be
reluctant to ease policy, especially when global growth prospects have

Canada reports
December trade figures and January employment data.
 In November, Canada reported its first
monthly trade surplus in a little more than two years.  Higher energy
prices may have helped offset a pullback in other exports after a 4.3% increase
in November.  The risk is for some payback in the employment report as
well.  Recent job growth has been strong.  In the last five months,
Canada created roughly 200k jobs.  This
would be as if the US created two mln, which is a little more than twice the
reported pace.  There is some risk that Canada’s jobs growth is overstated
and may correct lower.  


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