Leon Hinde

US Gross Domestic Product (GDP) for the forth quarter of 2016 came in at 1.9%, reinforcing the stagnation in the US economy.

The December quarter GDP is the fifth out of the past six quarters where GDP has come in under 2%. This may help to explain why US companies are struggling to grow top line revenue.

We’re about two thirds through the reporting season for S&P500 companies, so far earnings appear to be growing at around 6%, which is 50% below the markets bullish expectations for 2017.

Looking ahead, we remain cautious of both the March GDP reading and in particular, the S&P500 March quarter earnings, (reported in April).

An area of concern when we get to the March numbers will be the US financials. The large jump in earnings among leading US trading firms in the December quarter from bond trading, will unlikely be repeatable in the March numbers.

Bond volatility in the March quarter will probably be less than December, therefore, resulting in lower levels of trading income. Furthermore, we’re beginning to see signs that mortgage repricing is starting to negatively impact housing starts. This was evident in the December new home starts data, which showed a 10% fall.

With the USD struggling to move higher as 10-year bond yields move back over 2.50%, some market commentators are calling the USD rally over. We don’t necessarily agree with that assessment but we do recognize that the USD/10-year yield correlation has changed.

The first few days of the Trump administration has been received by the FX market with a mix of relief and fatigue. The lack of follow through on his more aggressive campaign proposals in the area of international trade has been a source of relief.

At the same time, the FX market has traded in a less sensitive pattern to the lack of consistency amongst the views of top administration officials with regard to the USD policy. The net result of the mix of fatigue and relief has been a broad unwinding of bullish USD positions  and higher volatility across the major FX pairs.

Although the USD policy hasn’t been discussed directly, it seems the new administration is willing to talk the USD down. This lingering political risk in the USD has seen a rapid breakdown in the percentage correlation between the USD and 10-year yields. 

On November 1st, the directional correlation between the USD and the US 10-year yield was 93%. This means that the USD was moving higher as US yields moved higher on a 93% correlation. However, as of this Tuesday, this correlation has dropped to just under 50%.

It’s difficult to determine how long this condition might last. Considering  two of the biggest current drivers in the FX market are policy comments from the new administration (which aren’t scheduled) and the steady increase in US equity prices, which seem to be moving further into over-valued territory.

It seems reasonable to expect in the near-term that US equity prices will correct from the recent all-time highs and 10-year yields to find some resistance in the 2.60% area. In this case, the directional impact in the USD would be a bit clearer to map. In general, when the market moves into a “risk-off” phase, the USD will firm against all G-7 pairs except the JPY.

The two key data points in the US today will be the Durable Good orders and Advanced GDP. Both of these data sets have the potential to rattle the market if they print wide of expectations. Between the two, we believe the risk with the GDP number is asymmetrical to the downside. In other words, the “risk-off” trade will be greater on a weaker print than the “risk-on” impact of as better report.