Investors remain cautious for the third day in a row ahead of several key events that may spark volatility including former FBI Director James Comey’s testimony, the UK general election and the ECB meeting, which are all taking place on Thursday.
Risk assets are obviously not ideal at this stage as any of the three major events may trigger a selloff in equity markets, which explains some investors’ behavior who have moved into the defensive. While safe havens such as treasuries, gold, and the Japanese Yen rallied, some traders might be questioning the status of the U.S. dollar which fell to a seven-month low.
Economic data alone is not enough to justify the new post-Presidential election low in the Greenback especially when the Fed remains the only major central bank tightening monetary policy. So, what’s going wrong here?
I think the explanation may be found in U.S. treasury yields. The short end of the yield curve is mainly determined by monetary policy actions, and given that the Fed is still expected to raise interest rates in June, and probably another hike by year end, yields on the two-year treasury notes may remain well supported. However, the falling end of the treasury yield curve which reflects investors’ future growth and inflation expectations has more to say, and I can see clear signals that investors are growing more skeptical towards the reflation trade which drove equities to record highs in 2017.
The ten-year treasury yields fell to 2.13% yesterday, the lowest level since November 10th, and the differential between the two-year and ten-year yields are back to levels prior to Trump’s election. This should be a warning signal, not just for the U.S. dollar but also for equity markets trading at high multiples. The justification for overstretched valuations might not be supported much longer as a failure to pursue the promised tax reforms and stimulus plans will eventually trigger a selloff. At this stage, I still recommend remaining well diversified with a blend of growth and value stocks, but should pessimism grow towards Trump’s administration, then moving into the defensive sector will be a better play.
Comey’s testimony is crucial tomorrow. While it's known that many questions will remain unanswered, the biggest question remains to be whether the former FBI director will accuse the President of abusing his power to derail the FBI’s investigation and whether there’s any indication of potential links between Russia and the Trump election campaign. Should the testimony reveal any unexpected surprises, the same will be reflected in the financial markets.