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Stocks, bonds diverge over whether Trump will be able to deliver on tax reform, stimulus

Patti Domm

Optimism that the Trump administration will be able to drive through a hefty pro-growth plan or tax package this year is fading by the day.

Treasury Secretary Steve Mnuchin on Monday became the latest official to dial back expectations for a time table that included a tax plan by August. In an interview with the Financial Times, Mnuchin said getting tax reform by August was an "aggressive timeline" and would probably be delayed because of health care.

In the bond market, there was little surprise. Bond yields, which move inversely to prices, have been falling for weeks as traders have become more skeptical that Washington will adopt any pro-growth policy this year. Stocks, meanwhile, have traded side ways recently, and the S&P 500 is still up 10 percent since election day, boosted by hope of fiscal stimulus and tax cuts.

Mnuchin's remarks did not surprise markets, and, in fact, stocks rallied hard based on his comments that Treasury is looking at ways to raise funds to pay for the tax plan without the controversial border-adjustment tax.

"That's exactly why the [stock] market rallied. People hate the border-adjustment tax," said Peter Boockvar, chief market analyst at Lindsey Group. The tax is part of the Congressional tax reform plan and would slap a 20 percent tax on all imports but not tax exports. Opponents claim it could cause inflation and penalize consumers, while proponents say it would encourage more manufacturing in the U.S. and level the playing field for U.S. companies.

The market was not surprised by the push back in the timeline for tax reform, since President Donald Trump last week said health care would come ahead of taxes. Ever since Congress failed to vote on health care in March, the market has become increasingly doubtful a tax plan would get done any time soon.

However, the question is whether markets have adjusted enough to the potential for little or no action from Washington this year.

"At this point, it's either tax reform or bust," said Boockvar, noting the stock market is hanging on the prospect. The administration is also anxious to get it done. "They're dying to have it this year."

Stock traders have been hoping to see the administration separately begin work on fiscal stimulus, since it may be quicker to approval than tax reform.

The fact Mnuchin said there may be other ways to fund tax reform boosted the Dow to a 183-point gain Monday, extending an earlier rally. "It just adds to the hope and intrigue that something will happen, but that's what the market has been betting on ," Boockvar said.

Beisdes a late pop in the stock market, the retail stocks, most negatively impaced by the border adjustment tax, rallied. The XRT, SPDR S&P Retail ETF (NYSE Arca: XRT) was up 0.9 percent.

But the fact that Congress and the administration were unable to pass their first big test and replace Obamacare has added to skepticism.

"I would say anyone whose forecast was predicated on policy has got to be resetting their view. I think the market is strong enough on its own," said Jack Ablin, CIO of BMO Capital Markets. Ablin said he's not worried about the market if the policies take longer than expected because of better global growth.

But the bond market started pricing out expectations for a Trump bump in the economy after yields peaked in December. The move paralleled Fed rate hikes and softer economic data.

Economists have forecast GDP growth for 2017 of just about 2 percent, despite the promise from administration officials that Trump fiscal policies and tax reform could generate higher growth of 3 percent or above. The 10-year yield (U.S.: US10Y) last week broke through a key level of 2.30 percent and is back to where it was trading around the election.

"We have a 2 percent economy. I think what we're learning is those that thought we were going to get a 3 percent economy are increasingly skeptical. …To start out the year, the balance of risks were favorable and positive, and I think the balance of risks have shifted back to negative. If we get upside surprise and there's some signs of fiscal stimulus out of Washington that could certainly change it," said Michelle Meyer, head of U.S. economics at Bank of America Merrill Lynch.

Economists have been paring back expectations for first quarter growth. The latest reduction was due to a negative revision to February retail sales. But stunningly weak consumer price index inflation data also has raised concerns that the Fed may be too optimistic about being able to raise rates twice this year.

"There's one rate hike priced in and about a 10 percent chance of a second one," said Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets. Lyngen said odds have been coming down.

Economists have been pointing to the divergence between strong "soft" data such as consumer sentiment and ISM survey data, and weaker "hard" data like retail sales. For the first time in a while, soft data, like Monday's Empire State Survey and home builders survey, disappointed.

"We've never been on the magical mystery tour of tax reform giving us a 3 percent economy on day one," said Michael Gapen, chief U.S. economist at Barclays. "We're still likely to be a 2 percent economy over the course of the year. On balance, our view hasn't changed."

Gapen added: "The irony is the sentiment will be super strong in Q1 and activity data will be weak, and in Q2, the activity data will rebound and sentiment will weaken. We'll end up with something on the fiscal front. We think it will be more about tax cuts than tax reform."

The weakness in first quarter numbers has raised the profile of even second tier data. Housing starts and permits will be released at 8:30 a.m. ET Tuesday. Industrial production for March is released at 9:15 a.m. ET.

Watch: Tax hopes spur stock rally



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