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Falling Stocks and Rising Yields Aren't the New Normal

The medium-term outlook will be determined by Trump's policies on trade and the dollar.

Steven Mnuchin roiled Davos.

Photographer: Fabrice Coffrini/AFP/Getty Images

Investors in U.S. equities and bonds headed for the doors on Feb. 2, with the bearish sentiment extending to global markets as the new week began on Monday. The immediate cause of the sell-off was the jobs report for January, which showed that average hourly wages rose at the fastest annual pace since 2009. 

But the rising pay was a false alarm. Workers were employed for fewer hours last month, reducing their weekly take-home pay compared with December, and significantly slowing the pace of increase from a year earlier. These developments, if anything, point to disinflation. They give no green light for the Federal Reserve to boost interest rates at a faster pace than previously believed.

Consequently, the lower equity prices and higher Treasury yields on Feb. 2 and Monday in reaction to the employment report are unlikely to be the final word on where markets are headed. The outlook over the medium-term will more likely be determined by the Trump administration's policy toward global trade and the dollar.

Recall that nervousness about U.S. equities and bond yields began even before the jobs numbers came out (chart below). Market disquiet arose from a statement by U.S. Treasury Secretary Steven Mnuchin on Jan. 24 that he preferred a weak dollar to help U.S. trade -- an unexpected reversal of a two-decade-long Treasury policy of talking up the dollar to maintain investor confidence. After all, why should global investors buy U.S. financial assets when the Treasury secretary tells them they are going to lose by holding the currency?

U.S. Treasury 10-year securities’ yield (solid white line, right scale); Dow Jones Industrial Average (dotted yellow line, left scale)

Bloomberg

Investors now face a fork in the road. If President Donald Trump makes overtures toward reaching new trade treaties rather than pull out of ongoing negotiations, expect equities to resume their recent rally, and for Treasuries to fall again in yield. Similarly, if he repeatedly stresses his preference for a strong dollar that he expressed for the first time at the Global Economic Forum in Davos on Jan. 25, expect the impact on both equities and bonds to be positive.

On the other hand, it would be just as easy to worsen the market turmoil if the president repeats his statements that the U.S. trade deficit warrants higher import tariffs, or expresses preference for a weak dollar to help U.S. exports. Either would invite retaliatory action by other nations on the trade and currency fronts, much as happened in the aftermath of the protectionist Smoot-Hawley Tariff Act that was passed in June 1930. Rather than boost U.S. competitiveness, the Depression-era measure worsened the market downfall.

Here are four steps that Trump and his administration can take to restore market confidence:

First, watch if the administration shifts to trying to open foreign markets and sectors to U.S. products, rather than restrict trade. Trading partners are more likely to accept an increase in U.S. exports than they are a reduction in imports. Such a shift would also have a positive impact on employment, wages and financial assets.

Second, Trump told his Davos audience that he was prepared to negotiate a trade agreement with the 11 remaining member countries in the Trans-Pacific Partnership from which he had pulled the U.S. in January 2017. Naming a senior trade negotiator for TPP talks, and setting dates when negotiations will begin, will boost market sentiment.

Third, six rounds of negotiations to restructure the 24-year old North American Free Trade Agreement have ended with no resolution. Another round later this month is likely to be the last opportunity to resuscitate the accord before U.S. and Mexican politicians get distracted by elections later this year. Announcement of an agreement to continue the treaty that governs movement of more than $1 trillion in goods across the three countries would be a major market-positive.

Fourth, the Federal Reserve has a new chair, Jerome Powell, as of this week. Although the central bank is nominally independent, it has gone through periods of being bullied by the president to serve political ends -- most notably, by President Richard Nixon in the early 1970s when he wanted to boost money supply to help finance the Vietnam war. A statement by Trump that neither he nor Mnuchin would jawbone Powell to influence interest rate policy, or encourage him to weaken the dollar, would boost the currency and be welcomed by investors.

Bond yields and equity valuations are at a critical point. Emphasizing the U.S. role as a key player in global trade, and restoring investor confidence in holding dollars, is key to bringing global investors back to U.S. financial markets.

    To contact the author of this story:
    Komal Sri-Kumar at ksrikumar1@bloomberg.net

    To contact the editor responsible for this story:
    Max Berley at mberley@bloomberg.net

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