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Bonds, Not Stocks, Are the Real Midterm Winners

Robert Burgess
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Bonds, Not Stocks, Are the Real Midterm Winners

(Bloomberg Opinion) -- There's an old Wall Street cliche that says political gridlock is good for financial markets. The thinking is that a divided Congress can't do anything stupid that disrupts the economy. And while the big gains in stocks Wednesday would seem to support that old saw, the action in bonds might be more telling.

Longer-term U.S. Treasuries jumped even though a government auction of 30-year bonds drew sub-par demand and weighed on the rally. At the same time, the difference between short- and long-term Treasury yields shrank as much as 5 basis points, the most since February, to 25 basis points. This is concerning, because a flattening of the so-called yield curve has historically been associated with a slowing economy. The way bond traders seem to be viewing election results is that there will be less fiscal stimulus going forward under a divided Congress. That means less government borrowing. The Treasury market has been under a lot of pressure the past 14 months, with yields rising from an average of 1.73 percent in September 2017 to a recent 3.08 percent as the Treasury raised funds to pay for the corporate tax cut, increasing the amount of marketable government debt outstanding by about $1.3 trillion to $15.4 trillion. The rally in longer-term bonds Wednesday is a sign that bond traders see some relief from the deluge of new debt — or at least a slowdown. Then again, the Democrats aren't exactly known for their fiscal conservatism, and may decide their best chance in the 2020 election is to work with the Senate and Trump administration on some key issues that could juice the economy.

"Longer term yields are falling as there will be no movement on making the recent tax cuts permanent," Bleakley Financial Group chief investment officer Peter Boockvar wrote in a note to clients Tuesday. "We'll hear all about infrastructure (legislation) but I'd fade that, too. Firstly, rising deficits don't help the case and good luck finding the skilled workers to actually get on the job."

THE DOLLAR BACKS UP BONDSThe action in the foreign-exchange market seems to corroborate what bond traders are thinking. The Bloomberg Dollar Spot Index fell on Wednesday, and at one point was at its lowest level in more than two weeks against a basket of developed-market currencies. While the poor bond auction damped some of the dollar's appeal, the bigger notion among currency traders is that gridlock may slow the pace of government borrowing and in turn temper the rise in bond yields relative to the rest of the world, which has helped boost the Bloomberg Dollar Spot Index by more than 8 percent between mid-April and the end of October. Since that time, it has dropped 1.13 percent as it became clear that the Democrats would regain control of the House. A split Congress is moderately bearish for the dollar as “the first-order effects of U.S. growth deceleration and increasingly limited monetary policy support cause a reevaluation of long (dollar) exposure,” Bank of America Merrill Lynch strategists including David Woo wrote in a research note. They added that "acrimony” in Washington could lead to traders demanding a higher risk premium to own the dollar, as gridlock may limit policy action to the bare minimum of keeping the government funded and raising debt ceiling.

STOCKS LIKE A WEAKER DOLLARThe dollar's decline may help explain some of the gains in stocks on Wednesday, as the S&P 500 Index surged 2.12 percent. October's slide in equities corresponded with the biggest gain in the Bloomberg Dollar Spot Index since November 2016, making U.S. exports less competitive. Jodie Gunzberg, managing director and head of U.S. equities at S&P Dow Jones Indices, wrote in a blog post in May that the S&P 500 rises 3.7 times more from a falling dollar than a rising one. So, all else being equal, a weaker greenback is a positive for equities. Stocks aren't in the clear yet. The Federal Reserve is still raising interest rates, President Donald Trump’s trade war with China and others isn't likely to let up anytime soon, and there's a sense that the economy is more likely to slow in coming quarters, according to Bloomberg News. Ed Clissold, the chief U.S. strategist at Ned Davis Research, cut his recommendation for U.S. stocks to neutral from bullish. While Wednesday’s stock gain is in line with the market’s historic pattern after midterm elections, investors should be careful not to chase the rally, reports Bloomberg News's Lu Wang.

RUSSIA LOSES IN THE MIDTERMSOne clear loser from the midterm elections is Russia, at least judging by its bond market. Russia sold just over half of the bonds it offered in two debt auctions on Wednesday, as traders assessed what Democratic gains in Washington mean for America’s willingness to impose further sanctions. Although a weaker dollar in the wake of the U.S. midterm elections is good news for emerging markets, investors are unwilling to commit to Russia until they have more clarity about proposals being discussed as punishment for alleged election meddling and poison attacks, according to Bloomberg News's Aine Quinn. Many believe the Democrats are more likely to push for harsher penalties. "Until there is a clear position on the likelihood of new sanctions targeting the financial sector, the risk versus reward is not compelling enough" to invest in Russia, Mike Workman, a fund manager at DG19 Management Ltd in Moscow, told Bloomberg News. The yield on Russian government bonds due in 2023 has jumped to 8.43 percent from this year's low of 6.52 percent in March. At 66.1582 per dollar, the ruble has weakened from 55.6409 in late February despite oil prices, a main Russian export, being higher over the period.

OIL STRUGGLES TO FIND A BOTTOMOPEC is getting a bit too uncomfortable with the drop in oil prices. With West Texas Intermediate crude down about 19 percent since early October, the cartel is signaling it will consider a return to cutting output next year. Amid a summer of rising prices and unprecedented political pressure from Trump, Saudi Arabia, Russia and other producers had opened the taps, according to Bloomberg News's Grant Smith and Javier Blas. Now, with the U.S. midterm elections over and crude futures wilting in the face of another historic shale-oil surge, the cartel will discuss a change of course when officials meet in Abu Dhabi on Sunday. Perhaps in a sign of the times, as well as the diminishing influence of OPEC and the rising influence of U.S. producers, oil prices fell on Wednesday to $61.75 a barrel, their lowest since March. U.S. crude inventories rose by 5.78 million barrels last week, the seventh straight weekly increase, according to the Energy Information Administration. “Basically, too much supply, too fast,” Rob Thummel, a managing director at Tortoise Capital Advisors, which manages $16 billion in energy-related assets, told Bloomberg News. If OPEC does decide on product cuts, it will need to secure the support of rival-turned-partner Russia, which has less need for high oil prices. There’s also the risk of antagonizing Trump, who repeatedly accused the group on Twitter of inflating prices.

TEA LEAVESBack to reality. That's what market participants will probably be thinking Thursday as the Fed wraps up its latest meeting on monetary policy. While no change in interest rates is expected, the official statement released by the Federal Open Market Committee is likely to make clear that policy makers are strongly leaning toward raising interest rates in December for the eighth time since December 2016 despite the turbulence in financial markets in October. That could put a damper on the recent strong rebound in equities, while hurting bonds and giving a boost to the dollar. "Officials may adjust language from the previous statement describing business fixed investment as having 'grown strongly' in light of evidence to the contrary in the latest GDP results," Bloomberg Economists said in a report. "However, they will retain a generally favorable tone toward the outlook for the economy and inflation."

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To contact the author of this story: Robert Burgess at bburgess@bloomberg.net

To contact the editor responsible for this story: Beth Williams at bewilliams@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Robert Burgess is an editor for Bloomberg Opinion. He is the former global executive editor in charge of financial markets for Bloomberg News. As managing editor, he led the company’s news coverage of credit markets during the global financial crisis.

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