INSIGHTS

On November 03, 2017

The Confusion of a Siren’s Call

We have often said, “Don’t confuse hiccups for heart attacks.”

Perhaps the more relevant version is not to confuse a siren’s call with the sound of the wind.

For some time it has become very apparent that perspectives of once seemingly absolutes have been transformed into artistic license. This became absorbingly apparent in the direct release of the proposed tax plan. The hours following the release showed mathematically proofed statements of devastation and elation. The markets reacted in a more muted and responsible way than did the headlines; a complete switch of what one would have seen some three decades ago in the same situation.

Regarding the tax situation, first and foremost the first iteration never becomes the final iteration. This is especially true in today’s environment in which Washington seems to be suffering from a long case of legislative constipation. I am somewhat surprised there hasn’t been more research and development from pharmaceutical companies applied to this long running situation. One must understand the finality of tax cuts is for all but tax reform is ultimately a zero-sum game. Winners and losers almost balance each other out. The debt markets and equity markets responded appropriately to the release of the tax cut proposal with a 10-year Treasury rate decline of 2 bps (basis points) yield (slight rally in price) and the Barclays Bloomberg Municipal Index had a return of 0.005% for the day. The S&P 500 closed at exactly where it opened the day. The market participants know that ultimately the tax reform deal will go through a blanching process before finally (if at all?) becoming law.

Many market pundits are reminiscent of sailors listening for sirens in Greek Mythology who were called to their death. Sirens were mythical creatures that would call out with desirable music to lure sailors. There are numerous reports this morning about the flattening of the yield curve signaling the potential for a possible sign that a contingent recession may ultimately be on the horizon. There are as many yield curve spread comparisons available to monitor as there are flavors at Baskin Robbins. Today, the spread “du jour” is the 10-year and 2-year Treasury; so let’s put this in a cone and review its merit.

Consider the spread that currently is at 73 bps and that it is at the current cycle’s lowest spread. A warning sign? When the current level was hit in the last 35 years on the way down from the cycle high, you notice some interesting timing issues.

Source: National Bureau of Economic Analysis, Standard and Poor’s, Bloomberg

Monitoring the spreads of the curve is important, however, more importantly is to have a context with this spread as far as time goes and the Fed’s manipulation of the curve via quantitative easing. The latter requires far more artistic license than economists prefer, however, simple truth-false analysis states that if quantitative easing lowered market rates, the unwinding should do the opposite. This could be argued about how impactful a monthly drip takes to empty the lake-sized balance sheet, but the direction is straight forward. With reasonable logic, one could argue a curve steepening slightly if the unwinding continues. If flattening were to continue, the investor should be reasonable about when the typical recession and market peak occurs and not just let analysis without context take place.

Two other side notes to consider is the nomination of Jerome Powell to replace Janet Yellen as Chairman of the Federal Reserve and Friday’s economic numbers. Assuming he makes it through the approval process, Mr. Powell actually tests out as a bit more dovish than Ms. Yellen. However, this past should not be extrapolated to future patterns. One should take note that whenever a transition has taken place, the complexity of the responsibilities and fundamental economic and market operations shapes the future direction of their biases more than the theoretical papers written prior to taking the job. We would expect the transition for full accommodation to more hawkish rate actions to continue on its methodical and predictable pace.

The jobs report released on Friday showed a bit of a letdown in numbers, though the market realizes that the recovery from several natural disasters plays a key role in the volatility of this. The wage numbers came in a bit lower than expected. The more significant number was the ISM non-manufacturing which came in at its highest level since 2005 and has only been this high three times in the last 20 years. Durable goods orders came out in line with expectation at 2.0%, which is well above the 20-year average of 0.2%.

The challenge and benefit of numbers and mathematics was that, in general, they gave us a traditional objective point of analysis. However, over the years, the context and manipulation of these numbers only affirms British Prime Minister’s quote that Mark Twain made famous: “There are three kinds of lies: lies, damn lies and statistics.” Ultimately the measurements will begin to flash red and caution investors to take a more cautious approach, however, the timing of said events look to occur farther down the road. It appears we have transformed into the Greek sailors who are on fairly calm seas but are eager to hear the wind’s normal howl as the sound of sirens. We continue to stay the course and will reveal our outlook for 2018 and changes to them from this year in short order. 

CRN: 2017-1103-6240R