The action of the financial markets since the surprise presidential election victory by Donald Trump in November of last year makes for a fascinating study in investor psychology and behavior. The stage was set dramatically by a near market meltdown on the night of November 8th and then a subsequent recovery and strong finish of the cash market on November 9th. This U-turn in market sentiment marked the beginning of a growing belief that the Trump agenda of individual and corporate tax reform, infrastructure spending, fiscal stimulus, and other pro-growth policies would lead to a general reflation of the economy. This reflation sentiment has been manifested in a swing away from positioning for deflation and an economy dominated by monetary policy, in favor of active fiscal policy and preparing for a return to inflation.
The Trump reflation trade has been reflected across asset classes with a rise in equity markets, interest rates, the US dollar, and energy prices. In general, market participants seem to have collectively embraced the fundamental narrative that the Trump agenda will be positive for the economy and the financial markets. Interestingly, the trade has included both professional and retail investors. To wit, two weeks ago bullish sentiment among investment advisors was at the highest level in 30 years1, and CTAs, Risk Parity, Equity Long/Short, and Macro Hedge Funds all showed an increase in beta, which implies higher allocations to equities. (See Figure 3 and Exhibit 16 below.) Over the past weeks these positions have been trimmed, but professional investors remain meaningfully net long the market. Furthermore, while oil prices retreated briefly in March due to growing global inventories, they’ve rebounded as investors remain long energy on belief that the reflation trade is alive and well.
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With respect to interest rates, the 10-year Treasury was priced at 2.62% on March 13th just two days before the Fed meeting on March 15th, which seemed to fully discount a Fed rate hike of 25 bps. Indeed, the Fed raised rates by 25 bps, but a funny thing happened; the 10-year Treasury yield closed 2.50% on March 15th and closed on March 22nd at 2.40%, at or below where it traded prior to the December Fed rate cut. The 10-year Treasury yield continues to trade around the 2.40% level, indicating at the very least some disbelief in the reflation trade.
Consistent with the reaction of the bond market to the Fed rate hike the US dollar moved up in anticipation of the Fed raising rates. However, about a week before the Fed met the USD started to move lower and then accelerated its decline after the Fed announced its 25 bps hike. Accordingly, it appears that the currency markets were a bit ahead of the bond market in expressing their doubt in the strength of the reflation trade.
Interestingly, even a week before the USD began its slide, oil prices turned lower, notwithstanding the OPEC decision to cut production in an effort to reduce global inventories and prop up prices. US shale producers quickly offset the OPEC production cut leaving global inventories relatively unchanged. However, one might argue that oil prices would have remained stable in light of the “reflation” narrative.
Indeed, it appears now that bond, equity, currency, and commodity market participants embraced an oversimplified fundamental narrative of the Trump agenda and its impact on financial markets. This narrative pushed short interest in Treasuries higher, as well as USD long interest and risk assets across the board. The GOP’s inability to coalesce around a universal party theme of repealing Obamacare puts in doubt their ability to effect meaningful tax reform, which is arguably the linchpin of the Trump rally. Moreover, the promise of a $1 trillion infrastructure spend igniting domestic growth and inflation expectations is entirely dependent on the ability of Congress to successfully negotiate policy and navigate legacy economic and budgetary limitations. This task would be massively difficult for even the most cooperative of legislators. The markets appear to recognize the challenge at hand and may continue to reprice accordingly.
[1] Investor Intelligence, March 2017.
