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  • S&P 500 index closes at record high on spate of bullish factors
  • 5-year T-note auction to yield near 2.36%
  • Bank of Canada expected to leave rates unchanged 

S&P 500 index closes at record high on spate of bullish factors -- The S&P 500 index on Tuesday closed at a record high, while the Nasdaq 100 index extended this week's rally to easily post a new record high.

The key factors behind this year's sharp rally in the U.S. stock market are (1) the Fed's shift to a neutral policy and the market's expectation for at least one rate hike by mid-2020, (2) expectations that the U.S. and China within the next several weeks will reach a trade agreement and roll back most of their penalty tariffs, and (3) indications that the Chinese economy has regained its balance.

The U.S. stock market has also rallied due to a generally favorable earnings outlook.  The consensus is for Q1 earnings for the S&P 500 stocks to fall by -1.7% y/y (-0.3% ex-energy), according to Refinitiv.  However, that earnings drop is being caused mainly by the fact that earnings spiked higher a year ago in Q1-2018 when the massive 2018 corporate tax cut took effect, making it difficult for earnings to show growth this quarter from last year's high base.  Yet, the absolute level of earnings in the current Q1 is still much higher than it would have been without last year's tax cut.

In addition, the consensus is for earnings growth to improve as 2019 wears on with a consensus for earnings growth of +2.1% in Q2, +2.2% in Q3, and +8.6% in Q4.  On a calendar year basis, earnings growth this year is expected to be weak at +2.9%, but the market is looking for an improvement to +12% next year.

The U.S. stock market has also been helped by the stronger-than-expected Q1 earnings reports seen thus far.  Of the 77 companies in the S&P 500 index that reported through last Friday, 77.9% beat the consensus, which is better than the long-term average of 65% and the 4-quarter average of 76%, according to Refinitiv.  There is also good news in that Q1 revenue is expected to show a solid increase of +5%, which is better than GDP growth and illustrates that large S&P 500 companies are still finding ways to earn revenues and profits even this late in the business cycle.

The single biggest factor behind this year's rally in stocks, however, is the much-improved interest rate situation.  The Fed in January thoroughly caved in on the interest rate front and said that it expects to leave its funds rate target unchanged through the end of this year.  The market is much more dovish and is expecting 38.5 bp of rate cuts through the end of 2020.  Up until January, the Fed was on a mission to raise the funds rate at least to its perceived neutral range of about 2.75-3.00%.  We believe that the Fed would still like to eventually raise its funds rate target by another 50 bp from its current range of 2.25-2.50% to get to that neutral range.  However, the Fed was chastised by the Q4 plunge in the stock market and by fears that the US/Chinese trade war was about to cause the Chinese economy to collapse like a house of cards.  The Fed was essentially forced by the markets to put its rate-hike regime on hold.   The favorable U.S. interest rate situation is currently the most bullish factor for the U.S. stock market.



5-year T-note auction to yield near 2.36% -- The Treasury today will sell $20 billion of 2-year floating-rate notes and $41 billion of 5-year T-notes.  The Treasury will conclude this week's $133 billion T-note package by selling $32 billion of 7-year T-notes on Thursday.  The $41 billion size of today's 5-year T-note auction is unchanged from the size seen in the last four monthly auctions, but is up sharply from the $34 billion size that prevailed during 2016-17.

The 5-year T-note yield is currently trading at 2.36%, which is up by +24 bp from the late-March 1-1/4 year low of 2.12% but down by -74 bp from last November's 10-1/2 year high of 3.10%.  The +24 bp rise in the 5-year T-note yield seen in the past several weeks has been driven mainly by a less dovish view of Fed policy.  The market is now expecting 38.5 bp of Fed rate cuts through the end of 2020 (according to the Dec 2020 federal funds futures contract), which is much less than the peak of 63.5 bp worth of expected Fed rate cuts seen several weeks ago (on March 27).

The 12-auction averages for the 5-year are as follows:  2.42 bid cover ratio, $42 million in non-competitive bids to mostly retail investors, 3.8 bp tail to the median yield, 17.5 bp tail to the low yield, and 59% taken at the high yield.  The 5-year T-note is the third least popular security among foreign investors and central banks behind the 2-year and 3-year T-notes.  Indirect bidders, a proxy for foreign buyers, have taken an average of 59.9% of the last twelve 5-year T-note auctions, which is mildly below the median of 62.1% for all recent Treasury coupon auctions.

Bank of Canada expected to leave rates unchanged -- The Bank of Canada at its policy meeting today is unanimously expected to leave its overnight rate unchanged at 1.75%.  The BOC has left that rate unchanged since last October due to (1) the weaker Canadian economy, (2) US/Canadian trade tensions, (3) concern about the global economic outlook including China, and (4) the Fed's shift to a neutral policy.

The Bank of Canada still has ideas that it wants to raise the overnight rate to its perceived neutral rate of 2.5-3.5%.  However, the BOC has been forced to dial back its hawkish bias, much like the Fed and the European Central Bank.  The BOC today is generally expected to dial back its mildly hawkish bias by another notch towards neutral.  The market believes that the BOC's next move is more likely to be a rate cut than a rate hike.

The Canadian dollar has been trading generally sideways since January.  The Canadian dollar has seen support from this year's sharp rally in crude oil prices but has been held back by the dovish turn in the Bank of Canada's policy bias.




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