FYI | Jan 27 2017
By Kathleen Brooks, Research Director, City Index
The Trump trade is back on as the key US stock indices post record highs as politics and earnings growth boosts the mood in the markets. Donald Trump’s flurry of executive orders this week have given financial markets clarity about the economic direction of the Trump Presidency, and this clarity is being rewarded with stock market gains.
Looking to the inevitable sell-off…
Of course, markets don’t go up in a straight line, and even the perma-bulls out there will be expecting a pullback at some stage, the question is when will this happen? While we don’t have a crystal ball in the City Index offices, the market does give us some clues. Firstly, the lead stock market indicators, such as the Russell 2000 and the Dow Jones transportation Index. These indices reached record highs in mid-December, and led the way for the Dow to break its milestone figure on Wednesday. But if they start to roll over, then we would expect the major indices to follow suit.
Can volatility tell us where stocks will go next?
The other area to watch is volatility. As we have mentioned before, the current post-election rally in stocks has been accompanied by a decline in volatility. The Vix index fell to 10.70 on Wednesday, its lowest level since 2014, when it hit 10.28. If we breach this level, then some may get nervous that a stock market sell off could be in sight. However, the record low for the Vix was 8.89 in 1993, so even if we fall below 10.0, there is precedent for the Vix to go lower, and potentially for stocks to eek out further gains.
Another area to watch is Treasury yields. The 10-year yield rose 8 basis points on Wednesday, which is a large daily move for this market. Experts (if you trust them) have been calling 2.65% a line in the sand for the 10-year yield, and if it breaches this level then it may herald the start of a multi-year bear market for US bonds. If we breach this level then it is worth watching what stocks do, as rising borrowing costs could trigger a sell off in stocks, albeit with a bit of a lag.
Dollar proves Trump trade could be fading
The “twist” to the Trump trade, as mentioned in the title, is the dollar. Post the election, the dollar, bond yields and stocks all rose together. In normal cycles, bond yields rise, which pushes up the dollar, both of which weigh on stocks. However, in recent days stocks and bond yields have risen yet the dollar has slumped; it is the worst performer in the G10 so far this year. The decline in the dollar can be attributed in part to concerns voiced by President Trump and his choice of Treasury Secretary, Steven Mnuchin, who both raised concerns about a strong dollar and the negative impact on the US economy. Thus, US politicians talking down the greenback is a key risk for FX traders in the coming weeks.
The euro could be one to watch in the coming days after German 10-year bond yields reached their highest level for a year. Treasuries tend to lead global bond markets, so watch out for further upside in European bond yields. Inflation in Germany is at a 3-year high, yet bond yields are very low, this could be the perfect mix for a sharp spike higher in European yields, which could boost the euro.
Trump’s Wall fails to knock peso
The Mexican peso rose more than 2.5% against the dollar on Wednesday, seemingly triggered by Trump’s comments about Mexico, including his issuing an executive order to build the wall on the Mexico/ US border, something he promised on his campaign trail. However, the more Trump talked about the wall on Wednesday, the more the Mexican peso seemed to rally. Talk about sell the rumour, buy the fact. Perhaps Trump’s new mantra should be buy the peso, as this would help to make American goods attractive to one of its closest trading partners.
Watch out for our UK GDP preview coming out later. Overall, we are on high alert for signs that this stock market rally is coming to an end. Right now we don’t see any signs that suggest an end to the rally is in sight in the short term.
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