Ten Year Yield Falls To 2.33%

Monday was the first day of the second quarter which usually means new money is flowing into the stock market. However, there was a minor sell off led by financials. Besides it being the first day of the month and quarter, another reason why I thought stocks may have rallied Monday is because Senator Rand Paul and President Trump went golfing over the weekend. They made progress in their negotiations to get a new healthcare bill passed. This is a great step in the right direction because Rand Paul was the leading critic of RyanCare.

There was never a need to get a healthcare plan done right away. The bulls are hoping the next attempt at healthcare reform will, from the start, take suggestions from all sides in an open manner. This will increase the likelihood of it passing. Healthcare reform makes tax reform easier to pass because it will likely save the government money. I’m expecting something to come of this meeting by the summer. This plan will have a better chance of passing than the first try. In Silicon Valley, there is a saying ‘fail fast, fail often.’ The great thing about the failure of RyanCare was the GOP fell fast, which means there’s enough time to draft and pass a new plan.

In the past few days, I have been making the point that the stock market is a sideshow compared to the action in the bond market. Since the beginning of March, the S&P 500 is down about 2% which isn’t much of a move. The ten-year bond yield is down almost 30 basis points since March 13th as it was down an additional 5.5 basis points on Monday. It has moved from the high end of its range to the low end of its range. It would be a technically important move for the ten-year yield to fall below the bottom end of the range. Even though I forecasted this decline in yields, that was a much easier prediction than the situation we are in now. As you can see in the chart below, there has been a lot of short covering in the ten-year treasury in the past few weeks. This means there’s less fuel for this short squeeze rally.

The chart below shows the hedge fund net shorts in the ten-year note futures in a slightly different manner. As you can see, the amount of shorts fell 30.8% to the lowest level since November 2016. For the low end of the range in the ten year to be broken through, the hedge funds would have to switch to being net long on a weekly basis.

Of course, the direction of the treasury market isn’t solely determined by the positioning of hedge funds. Any bad economic, earnings, or fiscal policy news will send investors into treasuries as they move into ‘risk off’ mode. Some have suggested that President Trump’s election did more for inflation expectations than three rounds of QE, but the latest increase in PCE has been caused by the base effect of rallying oil prices. With no fiscal policy boost coming soon and the base effect of rising oil prices wearing off, the increase in yields has waned.

The latest FactSet aggregate S&P 500 earnings expectations were released over the weekend. As you can see in the chart below, Q1 earnings expectations fell and the S&P 500 rallied for the sixteenth time in the past twenty quarters. That stat sounds bad, but it doesn’t provide context on the size of the declines and what the earnings expectations started with. Going from expecting 3% growth to a 1% decline is much different from going from expecting 12% growth to expecting 8% growth. The stock market can rally on earnings growth even if it disappoints. In the past three months, earnings expectations fell from expecting 12.5% growth to 9.1% growth. 9.1% growth is still a rapid acceleration from 2016 which saw 0.5% growth. The 3.5% decline in earnings expectations is also lower than the ten-year average decline of 5.9%.

The total expected S&P 500 earnings per share fell from $29.56 to $29.49. The expected earnings for 2017 increased from $131.06 to $131.13. The trend of stagnant earnings expectations continues. This is very bullish news because the current expectations are high. 2017 earnings are expected to grow 9.8%. Financials’ earnings growth expectations were stable at 11.9% while energy earnings growth expectations fell from last week’s 306.5% to 301.1%. I expect the declining expectations we saw in energy in Q1 to occur for financials in Q2 as loan growth decelerates.

Consumer discretionary earnings are expected to grow 5.6% in 2017. That’s another sector which I expect to have a weak year. On Monday, Retail Metrics released their updated expectations for retailers in Q1. It expects traditional retail earnings to fall 6.8% and revenue to grow 1.6% which would both be the weakest reporting periods since Q4 2013. Online stores are taking share. This change is represented by how Bebe is closing all its stores, but keeping the online one. At some point the cuts in physical retail locations will go overboard and times will be good again. I expect that to happen after the next recession. As of now, the outlook is for more bankruptcies as this quarter had the most retail bankruptcies since 2009.

Conclusion

I consider Rand Paul’s meeting with the President a step in the right direction for the chances of fiscal policy passing Congress. The process will still come after the Fed’s rate hikes. The declining ten-year bond yield makes rate hikes questionable. As you can see in the chart below, the ten-year breakeven inflation rate has stagnated since the beginning of the year, after rallying at the end of 2016. Inflation is still below what it was in 2011 when the Fed was much more dovish. I think the next few inflation reports are going to come in below expectations which will send stocks lower because it will look like the Fed is off-base. Weak retail sales and restaurant sales add to the argument against rate hikes. Rising rates would increase consumer default rates since they have more debt than ever before.

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