It's number 3 again!

23 April, 2018

Number 3 has been of crucial significance in 2018. Trump has been predicting that his policies would bring an increase in annual growth to over than 3% a year. The Federal Reserve is expected to raise interest rates 3 times in 2018. However, investors and traders are most concerned about U.S. 10-year Treasury Yields breaking 3%. At the time of writing U.S. 10-year yields are less than 3 basis points to breaching the 3%, a level it hasn’t topped since 2014, so what happens when this level is breached?

Looking back on February, when interest rates started rising along with concerns over trade tensions, U.S. equities fell sharply with all major U.S. indices entering a correction territory. Higher interest rates mean higher borrowing cost for corporates, and another sharp spike would eat away a significant element of their profitability, by increasing interest expense. Investors will also readjust their required cost of capital as risk-free rates rise, which could make equities less attractive. Many consumers will find their disposable income fall, as they have to pay more for their mortgages. So, unless the growth in the economy, wages, and companies’ profitability offsets the rise in interest rates, there may be bad times ahead, especially for equities.

Dollar bulls were the most excited by the rallying yields as they found it to be an excellent opportunity to take long positions. The DXY stood at two weeks high early Monday trading above 90.40. Bulls are probably awaiting confirmation from the bond markets before considering their next move, where a break above 3% could encourage more investors to join the long trade.

Oil prices are another thing to keep an eye on. President Trump last week accused OPEC of keeping oil prices artificially high. His intervention came after reports on Wednesday showed that Saudi Arabia would be happy to see crude rise to $80 or even $100 a barrel, a sign that OPEC and friends will not alter the supply cut deal anytime soon. Although Trump’s tweet may have encouraged profit taking, it will not have a long-lasting effect. What OPEC should be worried about is how higher oil prices will impact inflation and thus, interest rates. Although inflation is what many economies are lacking at the moment, a steep rise in prices would add further pressure on global economy which is already showing signs of weakness. That’s what could put a ceiling on oil prices.

Today’s release of Flash Manufacturing and Service PMIs from France and Germany could remind some that Europe has lost momentum in 2018. ECB’s President, Mario Draghi warned on Friday that Eurozone growth cycle may have peaked, so any signs of further slowdown will likely delay any plans for tightening. That’s why I do not expect any policy change when the ECB meets on Thursday, not even a sign of the end of quantitative easing, which is likely to add some pressure on the Euro.

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