President Donald Trump’s plan to cut taxes and regulation while spending billions on roads, bridges and airports will face scrutiny from one of the most unforgiving places: the bond market.
That means borrowing costs for the U.S. government and companies will provide key insights on the future direction of stocks, said Michael Santoli, senior markets commentator at CNBC.
Trump will want to see a rise in Treasury yields as a sign that stronger economic growth is boosting the inflation rate, a key indicator of demand, Santoli wrote in an online commentary.
“And crucially, Trump and stock-market bulls require investors to keep buying up corporate bonds and holding risk spreads drum-tight,” he said. “The idea that higher yields can represent good things for stocks depends heavily on whether the corporate-debt market remains as robust as it's been.”
The strength of the corporate-debt market this year will partly depend on tax reforms enacted by President Trump, Barclays analysts led by New York-based Jeffrey Meli said in a report this month.
“A cut to the tax rate would increase the cash flow available to companies to service debt and, thus, improve credit quality,” the analysts wrote. “Furthermore, we expect companies to decrease leverage because the tax shield benefit of debt would be reduced at lower tax rates, effectively increasing the after-tax cost of debt.”
The S&P 500 rose about 6 percent after Trump was elected, surprising most investors who had priced in a victory by Democrat Hillary Clinton. The rally stalled after 5 weeks and stocks have remained range-bound since the week before Christmas.
“Over the 13 trading sessions in 2017, the S&P managed a gain on only one day when the 10-year yield fell,” Santoli says. “For now it seems the bull case rests on ‘reflation’ – a strong patch of the economic cycle, global manufacturing indicators climbing, commodity prices on the rise, and some U.S. policy stimulus as a kicker to these trends.”
A key indicator to watch is the spread between the interest rates of Treasurys and investment-grade corporate debt, Santoli says. The gap between the rates is an indicator of how investors measure relative value and risk.
“Spreads on the investment-grade corporate bond index are below 1.3 percentage points – levels last seen in May 2015,” he says. “That was the prior equity-valuation peak, and when spreads then started rising, stocks were thwarted for months until the punishing 2015-16 correction kicked in.”
Meanwhile, Bank of America Merrill Lynch analysts say stocks have a good chance of rallying to new records this year, if historical precedence is any guide. The S&P 500 has a history of bouncing back from February declines during the first year of a U.S. presidency.
“The bullish sweet spot of Presidential Cycle Year 1 is March to July, which has an average gain of 7.86 percent (average March to August rally of 11.15 percent for a first-term President),” BofA last week said in a report to clients.
The S&P 500 is set up to rise more than 30 percent to 3,000 from its current level of about 2,270 in the next couple of years, according to the bank.
“Secular bulls start slowly given investor disbelief but build momentum over time as disbelief turns into acceptance,” said a team of analysts led by Stephen Suttmeier. “We believe that 2017 could be the year of acceptance for the secular bull trend that began on the April 2013 upside breakout."
The trading range of stocks shows similarities to a pattern last seen before the 1950 to 1966 bull market, when interest rates rose and the S&P 500 rallied more than fivefold, according to BofA.
“The 1950s was a period of higher stock prices and higher U.S. interest rates,” the bank's analysts said. “The U.S. 10-year yield bottomed near 1.5 percent in late 1945 and the S&P 500 remained firmly within its secular bull market until yields moved to 5 percent-6 percent in the mid-1960s.”
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