Markets will be watching to see if interest rates continue to climb Wednesday, as the tax bill makes its way through Congress.

The stock market’s tax party took a breather Tuesday, just as Treasury yields snapped higher.

While not many traders were tying the two moves, the markets will be watching those yields again Wednesday, with concern that the volatile year-end streak higher is a sign of what could be ahead for 2018. The Dow slipped 37 points to 24,754, while the S&P 500 lost 8 points to 2,681.

The 10-year Treasury yield touched 2.47 percent Tuesday. While it was at that same level in October, the move had an unexpected ferocity, gaining more than 11 basis points in two days in one of the biggest such moves this year. The 2-year note yield was also as high as 1.87 percent, before trading at 1.85 percent.

“It kind of started [Monday] out of nowhere,” said Peter Boockvar, chief market analyst at Lindsey Group. “I’ve been noticing upticks in inflation expectations.” He also said investors may be considering that the tax package, expected to be approved by both the Senate and House by Wednesday, could result in more economic growth but also a bigger deficit, two things that could drive yields higher.

Boockvar said the stock market could have been moving lower on a ‘sell the news’ reaction to the congressional votes on taxes. The House passed a bill, but because of a procedural glitch, the body will have to vote again Wednesday.

Bond strategists said Treasury yields were also responding to rising yields in Europe on Tuesday, after Germany expanded the amount of debt it will issue next year. That drove bund yields higher, and Treasury yields also rose, breaking some key technical levels in the process. Yields move inversely to price.

Treasury strategists say they expect to see volatile trading as investors make year end moves end in a very illiquid trading environment. But Boockvar said the market may be anticipating less easing by the world’s central bankers in the new year.

“That will be the thing to keep in mind all through 2018. Trump and tax reform dominated 2017. Central banks and their removal of accommodation will dominate 2018,” he said. Boockvar said the Fed in January begins to pare back another $10 billion of its bond purchases, bringing the total decline in purchases to $20 billion a month. He added that the European Central Bank is also cutting its $70 billion in monthly bond purchases in half.

“There’s $55 billion less liquidity from December to January,” he said. “I think it matters. There’s going to be $1 trillion less liquidity in 2018.” The Fed’s reduced purchases of what are mostly Treasurys is expected as the U.S. is expected to increase debt issuance.

Michael Schumacher, head of rate strategy at Wells Fargo, said trading could continue to be volatile into the year end, but he does not expect a sharp move higher in yields next year. His target for 10-year in 2018 is 2.95 percent.

“You’ve got two big changes on Jan. 1 and it’s a cumulative thing,” he said of the reduced central bank asset purchases. “I don’t think it’s a light switch kind of thing. This is the first year in a while the Fed has delivered on the dots. So it’s got the market nervous about the Fed coming through again next year. “

The Fed forecasts three interest rate hikes for 2018, and it presents its forecast on a chart with anonymous ‘dots’ on a timeline to represent each individual official’s view.

“The Fed’s got three hikes for next year. The market’s got two. I think people have too comfortable a view about Jerome Powell’s stance on monetary policy. There’s a lot we don’t know about him yet. The idea that he’s a clone of Janet Yellen is too simplistic,” he said. Powell takes over from Yellen in February.

Bob Sinche, global strategist at Amherst Pierpont, points out that the Treasury market has made curious moves at this time of year in the past, like 2016 when the 10-year note contract reached its low of the year on Dec. 21.

Note contract reached its 2016 low on December 21, followed by an irregular rally over the following 9 months, so important moves in late December are not unprecedented.

“A break lower in price, if sustained through the week, would be interesting as the key PCE deflator report is out Friday. So while this could be a false break, significant fiscal stimulus, 3 plus percent real GDP growth, a market that appears to be underestimating Fed hikes next year and the increasing net supply as the Fed ramps up balance sheet reductions certainly appears to be a recipe for higher yields,” he wrote. The PCE deflator is the Fed’s preferred measure of inflation.

The markets have been concerned about a “flattening” in the Treasury curve, where long end yields were moving closer to the short end, which was rising in anticipation of Fed rate hikes. Investors keep an eye on that trend since a flat curve can signal economic trouble ahead, and if it inverts, it would be taken as a recession warning. But that trend relaxed Tuesday as yields on the long end moved higher.

Brian Levitt, senior investment strategist at OppenheimerFunds, said he does not see a problem with the curve flattening for now, but it could be if the Federal Reserve tightens policy too much. That is his big worry for stocks, which he expects will have a positive 2018, but with a more normal 10 to 12 percent correction, after barely a sell off in 2017.

“All cycles are going to end with too tight a policy in one of the major economies of the world,” he said.

Levitt said he doesn’t believe the tax bill has been the big driver of stocks, which he says have been benefiting from synchronized global growth.

“I worried maybe the tax law becomes a little bit of a sugar rush to the economy, but not enough investment in productive assets to make it sustainable,” he said. He said he expects businesses to make some investment but much of their savings will go to dividends and buybacks.

“If you bring forward a little of the growth, the Fed could become more aggressive and paradoxically it could shorten the cycle,” he said.

Existing home sales data is expected at 10 a.m. ET Wednesday, after Tuesday’s new home sales rose more than expected. Earnings are also expected from General Mills, Blackberry, Winnebago, Bed Bath and Beyond and Herman Miller.

Source: cnbc economy
Quick move higher in interest rates could be warning for 2018