Investors kicked off 2018 on a positive note sending U.S. stocks to fresh highs on the first trading day. The optimistic approach on day one was supported by encouraging economic data from China, where the Manufacturing Purchasing Managers’ Index for December beat expectations by coming in at 51.5 versus expectations of 50.6.
Europe was also a bright spot, as factories reported their most robust monthly performance since the creation of the single currency. Eurozone PMI hit 60.6 in December indicating that growth is likely to remain healthy in 2018.
The missing ingredient for global economic expansion throughout 2017 has been inflation, but with consumer demand increasing, unemployment dropping, and commodity prices surging, it’s difficult not to see inflation returning in 2018.
One of the most debated topics last year was the flattening yield curve in the United States. In December the U.S. 10-year/2-year Treasury spread fell to 50 basis points, a level last seen in 2007- signaling that a recession is around the corner. However, when we look at the economic performance in the United States and on a global scale, there isn’t any indication of one occurring soon.
Looking forward, I believe Treasury Bond Yields will be a must watch indicator for how the U.S. stocks and the dollar perform in 2018. If the Phillips curve “the inverse relationship between the level of unemployment and the rate of inflation” finally wakes up after being dead for the last couple of years, the yield curve should start steepening.
The dollar’s performance, which opened the New Year on a downward trajectory, will depend on the magnitude of change in the yield curve. A rise in U.S. 10-Treasury yields toward 3% - 3.5% this year, will likely reverse some of the dollar’s 2017 losses, however a steeper move will have negative consequences on stocks, with the probability of 5%-10% pullback increasingly likely.
Today’s FOMC minutes will provide some assessment on the U.S. inflation outlook. If the central bank reveals concerns over upside inflation expectations due to fiscal policies and an improved labour market, investors are likely to cover some of the dollars short positions. This should be reflected in interest rate expectations for March, which currently indicate a probability of 56.3% rate hike in March, according to CME’s FedWatch.