(This commentary originally appeared on Real Money Pro at noon ET today. Click here to learn about this dynamic market information service for active traders.)
Washington has been dominating the headlines the last several days, but until this morning, markets seemed to be taking it in stride. In today's column I'll offer a few thoughts on dealing with this kind of uncertainty, plus what it could mean for the Fed, cross-border flows, etc.
Nobody Knows How This Will Play Out
Longtime readers of this column know I'm always counseling humility. Things look very bad for President Trump, but we don't know how this is going to play out. Your natural inclination is probably to make a point forecast, i.e., decide whether you think Trump will be forced from office. I don't think that's a helpful (or profitable) way to think about it.
I'm not even sure it makes sense to treat this in terms of probability; that is to say, invest as though there is X% chance he resigns and (1 - x) chance he survives. Not only do I think you can't make a reasonable estimate about X but you don't know what the market will think. I'm certain the market would react badly initially, but how long would that last? Would it create enough business uncertainty that companies pull back spending? Maybe. But maybe not.
It isn't as though Trump actually got any of his economic agenda implemented. A sudden Trump resignation would probably mean a couple of years of nothing getting done in Washington, but markets seem to do fine with the status quo. We wouldn't get those market-juicing tax cuts everyone wanted, but that now seems like a pipe dream regardless.
I'm not trying to be Pollyanna here. The Trump administration falling apart could give rise to an anti-business political movement, which could be a severe market negative. I'm just saying this is a complex situation, with too many interdependent variables to make any sort of bold prediction.
There Are Some Things We Can Say With More Certainty
Senate Majority Leader Mitch McConnell poured cold water on tax reform yesterday, saying any tax cuts would need to be deficit neutral. That's going to be tough without strong leadership from all three: the House, Senate and the White House. Not only will Trump's ability to push that be damaged by all this, it will also suck all the air out of Congress.
Municipal bonds become an interesting place to be if taxes aren't going to change much. Insurance companies have been sitting on the sidelines for months waiting to see what happens to tax rates. If they come back in, munis could catch a bid.
This Will Probably Take Longer Than You Think
As traders, we are conditioned to move fast. Information gets discounted into market prices very quickly, and if you don't move immediately, you probably missed it. But this can fool us into imagining that other walks of life are similar. For example, I think it is highly likely that Congress will not take any overt action against Trump until the midterm elections, which are more than a year away. Unless Trump becomes so unpopular in red states that he becomes a liability to congressional Republicans, I doubt very seriously the GOP is going to lead any sort of aggressive investigation, much less an impeachment.
Certainly the polls could worsen such that Republicans feel like they have no choice but to turn on Trump. But I don't think that is imminent. Consider this. The Watergate burglars were arrested in June 1972. The "Saturday Night Massacre" (which has been likened to the recent firing of FBI Director James Comey) was in October 1973. Nixon was specifically named in an indictment as a co-conspirator in March 1974. But he didn't actually resign until August 1974. Maybe this plays out that way, maybe it doesn't. But I'd assume it is going to take longer than you think.
What About the Fed?
Could this derail the Fed from hiking in June? I very much doubt it, and for what it is worth, the fed funds futures markets haven't moved much. Pretty much the only way the Fed would move off a June hike would be if the stock market started tanking.
Looking ahead to future rate hikes, the Fed is going to react to real economics and business sentiment. Those things could be impacted by a political scandal, but as I said above, it's unclear what the ramifications will be. If Washington is in turmoil but the real economy is still growing at a mild pace, the Fed is going to keep hiking. I'm still of the view that rates are more likely to be higher than lower, and I'm more bearish on three- to five-year bonds than 10 years and longer.
Could the Dollar Tanking Disrupt International Flows?
If you are invested in corporate bonds, especially investment grade -- e.g., something like the Investment Grade Corporate Bond ETF (LQD) , foreign flows have been a major source of demand in recent months. The trade-weighted dollar index is down 2% in just the last week and has given up all its post-election gains. Could this spook foreign buyers out of the U.S. market?
I don't think volatility itself is a problem for the major foreign buyers, who in corporates are mostly global banks and insurance companies. They are plenty capable of hedging out their currency risk. The issue is more how expensive it is to hedge and at what point is it no longer worth it. The dollar versus euro or yen is one issue, but also LIBOR differentials.
Long story short, it is getting difficult for euro-based investors to justify buying dollar-based corporate bonds. It is slightly better than buying domestically but not by much. If the dollar keeps dropping, we could reach a place where European investors stop participating in the U.S. market. This may have as much to do with European growth as U.S. politics. Europe seems to be turning a corner and if it can sustain somewhat faster growth, both the euro currency and domestic interest rates will rise. That will make the U.S. market relatively less attractive as well.
With corporate bond valuations at nosebleed levels, I'm cautious about what I own. I'm not overly focused on the foreign technical, because if U.S. corporates were to cheapen up, suddenly it would make sense for Europe to buy again. But it tells you there isn't going to be future upside from spreads getting even tighter. If U.S. credit gets more expensive (lower yield), Europe will drop out. Indeed, this might be a reason why credit spreads have been sideways in recent weeks even as stocks have made new highs. I don't mind holding credit as part of a general bond strategy, but I wouldn't hold it passively. Especially not high yield.