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Yesterday was the inverse of the day before.  Strong gains evaporated following a public dust up between the President and Democratic Congressional leaders concerning funding for the Wall. The market then rebounded following comments from key Senate leaders’ desires to avoid a government shutdown and then again reversed gains and closed almost unchanged.

To remind all, Monday the markets reversed a 2% slide to end nominally higher.

At this juncture there is little more that I can write about the impact of technology based trading other than it is completely dominating market activity as such comprises about 80% of equity volume.   The question at hand is the extent of the long lasting damage that it will inflict.  As noted several times, often times change will not occur until a crisis unfolds.

In my view, the regulatory entities have tacitly supported such trading given its emphasis upon speed and cost of execution and through regulatory fiat the obliteration of the capital markets that supplied necessary capital to fund business expansion.

Changing topic, considerable attention has been focused upon the inversion of the yield curve, an inversion between the three and five year Treasury.  As noted the other day, I am not aware of such a benchmark, instead focusing on the traditional part of the yield curve such as the slope between the 2 and 10 year Treasury or the overnight rate and the 10-year Treasury.

Currently the 10-year is yielding about 70 bps more than the overnight rate; a spread that I think is too small given current economic conditions.  Historically the yield on the 10-year Treasury should be close to that of nominal GDP which is real GDP growth plus inflation.  Nominal GDP is around 4.8% which then suggests the 10 year is about 200 bps (2%) lower than it should be.

A major reason for this distortion is monetary policy, a policy that is today changing.

Many have commented the bond market is all telling, suggesting weaker growth is expected in the immediacy.  I disagree for simple aspect that the Fed balance sheet has never expanded in such a manner as it did eight years ago to combat the ramifications of the Great Recession.

As noted many times the Fed has changed policy to QT  (Quantitative tightening) from QE.  Starting next month the Fed sales will double sales of its portfolio, sales taking place as government demand for borrowing is surging.

What impact will this selling have upon the price/yield of the 10-year?  As noted above the 10 year is already priced about 200 bps below where it should be.  I will continue to argue growth will remain robust, a view maintained by the Federal Reserve.

Will yields now surpass on the upside by the same magnitude as it has on the downside?  If this were to unfold, I believe volatility will further increase.  Wow!  At least there would be a rational explanation…higher interest rates that will impact the value of current and future corporate cashflows.

Last night the foreign markets were up.  London was up 1.12%, Paris up 1.62% and Frankfurt up 0.94%.  China was up 0.31%,  Japan up 2.15% and Hang Sang up 1.61%.

The Dow should open moderately higher on trade optimism.  Oil is up on a larger than expected inventory draw.  There is also some political clarity in both the UK and the US.    The 10-year is off 3/32 to yield 2.90%.


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Ken Engelke

Chief Economic Strategist Managing Director

The views expressed herein are those of Kent Engelke and do not necessarily reflect those of Capitol Securities Management. Any opinions expressed are statements of judgment on this date and are subject to certain risks and uncertainties which could cause actual results to differ materially from those currently anticipated or projected. Any future dividends, interest, yields and event dates listed may be subject to change. An investor cannot invest in an index, and its returns are not indicative of the performance of any specific investment. Past performance is not indicative of future results. This material is being provided for informational purposes only. Any information should not be deemed a recommendation to buy, hold or sell any security. Certain information has been obtained from third-party sources we consider reliable, but we do not guarantee that such information is accurate or complete. This report is not a complete description of the securities, markets, or developments referred to in this material and does not include all available data necessary for making an investment decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. If you would like to unsubscribe from this e-mail distribution, please reply to this e-mail and indicate that you wish to unsubscribe in your response.