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Trading  | November 2, 2017

If you consider the tactical situation facing the Federal Open Market Committee, two pictures really tell the tale.  First is GDP, FedFunds, 2 year Treasury Notes and 10 year T-bonds, as shown in the chart from FRED.


But more important that the mere rates, especially those scarce market rates, are the spreads behind them.  Credit spreads remain extremely tight, an indication of the deliberate shortage of duration in the financial markets.  Note that market interest rate spreads such as 2s to10s are already signalling bearish trend regarding the economy. Powell and his colleagues on the FOMC will need to decide whether the private markets will be allowed to function again.  This means that as in 1987 after Black Monday, the Fed let’s the markets sort out its own problems without government assistance.

If a Trump-appointed Fed does allow the markets to function freely, and ends the exraordinary open market operations known under the NewSpeak as “QE,” this is bad for global equities.  As with residential housing, the persistent shortage of assets is likely to support prices for stocks that are 1) big and 2) free of specific negative factors.  But the real question that impacts FOMC policy is how markets will react in a scenario where both bonds and stocks correct at the same time. That is, volatlity surges and returns fall as credit spreads widen.


Now looking at the second chart from our friends at Merrill, this is not a market that is screaming bear trade.  Indeed, absent distreactions like tax cuts or terrorism or China, my guess is that the bias in the bond market remains bullish — until changes in central bank purchases actually begin to affect credit spreads.  But again, in a world where the Fed has driven high-yield credit spreads down to an average of 3.5% and the Street has repurchased $3 trillion in equity funded with debt, just how does the FOMC think we push FedFunds up much above current levels? 

How do you think, Governor Powell, equity markets will react if Chair Yellen inverts the yield curve on her way out the door?


A revolutionary initiative is helping average Americans find quick and lasting stock market success.

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