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Q1 2017 will likely be the weakest period for economic growth of any rate hike since 1980; stock market earnings expectations are tumbling; uncertainty about the Trumpian pillars of stock market strength are surging, and various 'risk-on' asset classes around the world and breaking bad.

As RBC's macro strategist Mark Orsley previously remarked, something has dramatically, and suddenly changed in the market in recent days, as confirmed by bank's macro model provider. To wit:

There is another interesting force at play in equities that deserves to be flagged. The good folks at QI (our Quant macro model provider) flagged to me that their r² on SPX has been falling precipitously.

 

This means their model which incorporates hundreds of different factors is now unable to explain why S&P's are moving. Previously the main drivers of S&P's were well explained by 1Y forward earnings estimate, inflation, growth, credit spreads, energy prices, and real rates but that is no longer the case.

 

That means S&P's are going through a regime change and typically when the r² falls this way, it is a red flag and caution is warranted.

And RBC's head of cross-asset strategy Charlie McElligott notes, it has become even worse in recent days…

The Quant-Insight Model has collapsed further to 33% – a sign of "real time" macro regime-change, which has marked prior volatility 'gap' periods.

As McElligott previously detailed, The incredibly-stable macro regime of the past year-and-a-half {the feedback loop we’ve pounded into your brains: 1) inflation expectations, 2) credit spreads, 3) equity vol} expressed by both the standard (83d rolling) and long-term (250d rolling) models is now seeing their respective R^2’s drop precipitously.

What does that mean in English?  The macro factor models are losing their ability to ‘explain’ the index moves.  Currently both models’ R^2’s are now at 43% and 57%, respectively, from highs near 90%.  Although the historical data set is not deep, you can see in the charts above (specifically featuring the long-term model) that the prior two instances where the R^2 dropped through the 65% “trigger” in the long-term 250d rolling model, we have seen a concurrent DOUBLING + in VIX through the trough and return through 65% “confidence” period, as the macro regime evolves and ultimately “firms.”

 The equities inflow story continues to be robust (as do jobs and survey / ‘soft’ data), but I believe there is a heightened risk of an equities drawdown occurring alongside:

1) further fiscal policy implementation delays (taxes and infrastructure an ’18 story best-case with ACA, immigration, SCOTUS, wiretapping and Russian messes),

 

2) the current crude sell-off “knock-on” effect” across assets (potential for VaR episode) and

 

3) tightening of financial conditions will likely too see that inflow euphoria abate in coming months, as it is also likely the economic surprise ‘beats’ mean-revert lower as well.

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Yesterday it was the Republican head of the House Intelligence committee, Devin Nunes, who repeated what he first said last week, namely that his panel has still not received any evidence that President Trump was wiretapped during the election campaign. “As I told you last week about the issue with the president talking about tapping Trump Tower, that evidence still remains the same, that we don’t have any evidence that that took place.” Nunes told reporters.

Today, it was the Senate’s turn, when the heads of the Senate Intelligence Committee, Republican senator from North Carolina Richard Burr, and Vice Chairman Mark Warner, a Democrat from Virginia, jointly said they had not seen evidence that the Obama administration “wiretapped” Trump Tower, according to a brief statement issued Thursday.

“Based on the information available to us, we see no indications that Trump Tower was the subject of surveillance by any element of the United States government either before or after Election Day 2016,” Burr said, providing no other details.

Burr is the latest Republican to contradict President Trump’s explosive claims that he was surveilled during the campaign. The bipartisan leadership of the Senate Intelligence Committee said Thursday that no evidence exists for President Trump’s claim that Trump Tower was wiretapped by his predecessor during the 2016 presidential election.

And so with both the House and the Senate denying Trump’s claim, it is up to the Justice Department which has been under pressure from both Democrats and Republicans to disclose whether there is any truth to the president’s claims.  White House press secretary Sean Spicer on Tuesday said Trump is “extremely confident” that the Justice Department will produce evidence to back up his assertion. He said Trump believes the evidence will “vindicate him.”

“I think there’s significant reporting about surveillance techniques that existed throughout the 2016 election,” Spicer said. According to Fox News’ Judge Napolitano, three intelligence sources believe that former President Obama veered ‘outside the chain of command’ and employed British surveillance agents to conduct surveillance on Donald Trump’s team prior to the election, according to a legal analyst. Judge Andrew Napolitano revealed on ‘Fox & Friends’ yesterday that the sources spilled the details to him as the controversial case continues to dominate headlines.

Meanwhile, Trump stood by the assertion in an interview this week, telling Fox News that his administration would be submitting evidence of a wiretap or other surveillance by his predecessor to lawmakers “very soon.”

So while we wait for the DOJ to either drop the whole affair or provide the missing link, meanwhile both Burr’s and Nunes’s committees continue to investigate Russian interference in the U.S. election, including any links between Trump campaign officials and Moscow.

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After claims by both democrats and republicans that Trump’s “skinny” budget proposal is dead on arrival, Trump’s nemesis, John McCain chimed in and said that in its current form the Trump budget simply won’t pass the Senate.  “It is clear that this budget proposed today cannot pass the Senate,” the Armed Services Committee chairman said in a statement. The Arizona senator added that as lawmakers work on funding the government, they must come up with a deal “that provides sufficient funds to rebuild the military.” Trump’s budget included $603 billion for total defense spending, which includes money outside of the Pentagon, plus an extra $65 billion in overseas contingency funding that is not subject to budget caps.

However, while for most other members of Congress the funds being allocated to the military are grotesquely too much, for McCain they are not enough, and the senator argued that the baseline budget for repealing the 2018 fiscal year needs to be at least $640 billion and that lawmakers should start working on defense funding for the rest of the current fiscal year, which expires at the end of September.
“Failure to do so will only lead to more political dysfunction that has inflicted such harm on our men and women in uniform over the past six years,” he said. 

The House passed a defense appropriations bill last week to fund the department through the end of the 2017 fiscal year. Any push by Republican defense hawks to increase military spending would likely hit roadblocks in the Senate, where Democrats are demanding equal increases in defense and non-defense spending. Lawmakers have until April 28 to pass legislation funding the government and avoiding a shutdown.

Yet while McCain had his own reasons to declare the Trump Budget DOA, most on Wall Street also agrees, which is why it made virtually no impact on markets – and especially defense stocks – when it was unveiled overnight. Instead, as analysts noted, the priorities outlined weren’t a surprise to anyone who paid attention during the campaign, and those proposals will likely have trouble making it through Congress unscathed, analysts said. Here are some sellside opinions:

CAPITAL ALPHA (Byron Callan)

• “Fat chance” for the “skinny budget” as the fiscal year (Oct. 1) will likely open under a continuing resolution, with Congress wrestling over defense, non-defense discretionary spending, borrowing and taxes
• Sees 10% odds of budget passing Congress
• Proposal sets up “yet another” period of uncertainty for defense spending, while cuts to infrastructure spending appear at odds with administration rhetoric

COWEN (Chris Krueger)

• Document offers even less detail than expected, with no mention of tax reform or health care repeal/replace; that means it’s back to watching the healthcare “saga” and potential April 28 government shutdown
• Budget process will begin once those are resolved

EVERCORE (Terry Haines)

• Trump’s budget is “a nonstarter,” as Congress is likely over the next six months to approve budget/appropriations that continue pattern of spending for the past 4 years (stable, with small increases for both defense, domestic spending)
• Investors should understand any president’s budget submission is “inherently a political document”; Congress isn’t bound to follow it

COMPASS POINT (Isaac Boltansky)

• At this point, the document is more messaging than actual policy, but the message is important nonetheless, Boltansky says in email to Bloomberg
• Budget signals Trump’s campaign promises – especially the America First framework – will continue governing his policy positions

HEIGHT SECURITIES (Peter Cohn)

• Trump’s ~50-page, $1.15t budget is less than half the size of initial documents submitted by prior incoming administrations
• Budget adds ~$54b to defense-related accounts within regular spending caps, plus another $77b for Overseas Contingency Operations (OCO)
• Domestic program cuts exacerbated by need to pay for increases for Dept. of Homeland Security, including $2.6b for Mexico border wall, $1.5b for detention/transportation/removal of undocumented immigrants (may help private prison cos. CXW, GEO)
• Proposal accompanied by supplemental request for $33b of defense funds
  • $13.5b for procurement, including Apache (BA), Blackhawk (LMT) helicopters, F-35 (LMT), F/A-18 (BA) fighter jets, DDG-51 destroyer (GD, HII)
  • $2.1b for R&D efforts, including missile, air defense (RTN)
• Supplemental funds likely “a tough sell” with Democrats given non-emergency designation

Source: Bloomberg

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Having surged after The Fed hiked rates ‘dovishly’, EURUSD is surging- bouncing off 1.07 the figure – after ECB Council member Nowotny told Handelsblatt that a “rate increase may be on the way.”

The European Central Bank (ECB) could be heading away from loose monetary policy in a different manner than the U.S. Federal Reserve, Ewald Nowotny, the Austrian ECB council member, told Handelsblatt in an exclusive interview.

 

The American model was to finish bond purchases first, but this model might not transfer well to Europe, said Mr. Nowotny, who also serves as the Austrian National Bank governor. All interest rates also wouldn’t have to be increased simultaneously nor to the same extent, he added. 

 

“The ECB could also raise the deposit rate earlier than the prime rate,” Mr. Nowotny said.

And EURUSD’s early weakness is erased…

Bund Futures are under pressure on the news (as the TSY-Bund spread narrows).

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The initial reaction to the Fed was big. But, as Bloomberg's Mark Cudmore notes, there’s much more to come still as the message was about as dovish as could have been envisioned, given it was accompanying a rate rise. Cudmore had argued that long-end yields would fall after the Fed hike, and while an 11 basis-point drop in 10-year Treasury yields on Wednesday might seem significant, he notes it’s not in the context of what happened at the meeting.

Apart from lower commodity prices, solid but not exceptional economic growth, and a lack of runaway inflation, much of my anticipation of a dovish market reaction was based on the fact that the market was very much positioned the other way.

 

But Yellen didn’t just disappoint the extremely hawkish hopes — she genuinely wasn’t hawkish at all. Of course, she couldn’t be outright negative on the economy and inflation given the Fed was tightening policy — but she went as far as she could in that direction.

 

Notably, near-term risks to the economic outlook still “appear roughly balanced,” rather than skewed to the upside as some had anticipated. The Fed emphasized it’s targeting a “sustained” return to 2 percent inflation, rather than just reaching that target.

 

Yellen also reiterated that the benchmark rate will persist for some time below levels that are expected to prevail in the longer run, with “gradual” hikes still the plan.

 

Not only did the median dot plot not rise above 3 hikes in 2017, but the average barely rose. Only five dots showed more than three hikes this year — the exact same as there were in December. Four hikes weren’t even a near miss — it wasn’t even on the radar of the majority.

 

 

And there was no discussion of the central bank balance sheet either. That was only a tail risk but it’s yet another point lacking for the hawks.

 

Everything about this meeting that could surprise dovishly, managed to do so.

 

U.S. yields and the dollar have much further to fall as a result.

 

And given the extreme positioning, we suspect Cudmore may be right…

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On the heels of yesterday's McCain meltdown exclaiming that Rand Paul "is now working for Vladimir Putin," the Kentucky Senator released a short statement…

"Currently, the United States has troops in dozens of countries and is actively fighting in Iraq, Syria, Libya, and Yemen (with the occasional drone strike in Pakistan). In addition, the United States is pledged to defend 28 countries in NATO. It is unwise to expand the monetary and military obligations of the United States given the burden of our $20 trillion debt."

And then appeared on MSNBC's 'Morning Joe' to explain…

he did not pull any punches (via RealClearPolitics)…

GEIST: So, Senator, a little context around that. The vote was around putting Montenegro into NATO. What's your reaction to Senator McCain's characterization of your objection?

 

PAUL: You know, I think he makes a really, really strong case for term limits. I think maybe he's past his prime; I think maybe he's gotten a little bit unhinged.

 

I do think that when we talk about NATO, there can be a rational discussion about the pros and cons of expanding it. We currently have troops, combat troops, in about six nations. We have troops actively just stationed in probably a couple dozen others. We have a $20 trillion debt. And one of my favorite articles of the last couple years is one that talked about the angry McCains, and if they — if we put active troops and got involved in combat where McCain wants us to be, they put a little angry McCain on the globe, on the map. And it's virtually everywhere. So his foreign policy is something that would greatly endanger the United States, greatly overextend us. And there has to be the thought whether or not it's in our national interest to pledge to get involved with a war if Montenegro has an altercation with anyone.

 

There's also another argument, is that when you ask the people of Montenegro, only about 40 percent or slightly less are actually in favor of this. They are close to Russia, they're close to being sort of, like Ukraine, in the transition from Europe to Asia. Perhaps it would be good to be like Switzerland and be more neutral and trade with both.

 

So, there's a lot of considerations but to call someone somehow an enemy of the state or a traitor might be considered by most reasonable people to be a little over the top.

 

GEIST: But Senator, you just called John McCain unhinged. You said he was past his prime. Why do you think so many other senators have voted in favor of this measure if it's so crazy?

 

PAUL: I think that there is a bipartisan consensus that's incorrect that we should have the whole world be in NATO. For example, if we had Ukraine and Georgia in NATO — and this is something McCain and the other neocons have advocated for — we would be at war now because Russia has invaded both of them.

 

And so I think having former satellites or former parts of the Soviet Union is NATO is very provocative. And you have to decide in advance whether you're ready go to war. If you guys are ready to send a million troops into Ukraine and fight World War III, you're going to do it without my support because I think that's a really foolish notion.

 

GEIST: Do you think, Senator, places like Albania and Croatia then should have been allowed into NATO in 2009?

 

PAUL: I think it's a real debate how big NATO should be and whether or not it's more provocative than good. And there's also the debate that the president brought up throughout the campaign, and that is we seem to be paying for all of it. Whenever there's a war fought, our soldiers fight it and our dollars pay for it. And so the 45 soldiers that Montenegro has I think are hardly an asset to our national security. And, really, our decisions need to be about our national security. And so I just don't think it enhances our national security to have Montenegro part of NATO.

Paul makes a good point, and as Mike Krieger noted yesterday, the McCain outburst should alarm all Americans. McCain is accusing a fellow Senator of disloyalty and allegiance to a foreign power simply because he disagrees with him. It’s remarkably similar to what we saw Adam Schiff do a few months ago in an embarrassing interview with Tucker Carlson. It seems yelling “Russia” is simply the new strategy for clueless politicians when they can’t win an argument.

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Earlier today, German police reported that a militant Greek group called Conspiracy of Fire Cells claimed responsibility for the attempt to kill Germany’s finance minister Wolfgang Schauble with a package full of explosives that was mailed to the German Finance Minister. The parcel was mailed to Schaeuble from a post office branch in Athens but as discussed previously, was intercepted by the German finance ministry’s mail department. Luckily, nobody was hurt.

Unfortunately, today someone was hurt when a letter bomb exploded at the French headquarters of the IMF. And, according to a report by the AFP, “militant”, or otherwise, Greeks may have been responsible for this terrorist activity too, because as the French news agency notes, “fragments of Greek stamps found at Paris IMF letter bomb site: probe source.”

As Reuters, adds, a female employee of the IMF suffered injuries to her face and arms on Thursday when a letter bomb mailed from Greece and addressed to the world lender’s European representative blew up as she opened it, officials said. The letter, which had arrived by mail, exploded as it was opened by a secretary at the institution’s office in an upscale part of Paris.

The secretary, whose hearing was also affected, was receiving treatment but her injuries were not life-threatening, Paris police chief Michel Cadot told reporters. The blast caused little damage to the office.

A militant Greek group, Conspiracy of Fire Cells, claimed responsibility for a parcel bomb mailed to German Finance Minister Wolfgang Schaeuble on Wednesday, but there was no immediate claim for the Paris attack.

 

However, a Greek return address was on the envelope which exploded in Paris, Greece’s public order minister said in Athens. “French authorities just informed us that it was mailed from Greece,” Nikos Toskas told Ant1 Television.

 

The explosion was caused by a device that was fairly home-made, “like a big fire cracker,” police chief Cadot said. Asked if the head of the IMF’s European office had received threats, Cadot said: “There had been some phone calls in recent days but they don’t seem necessarily to be linked to this matter.”

 

The IMF has been involved in talks between Greece and its international creditors on disbursing new loans to Athens under a bailout program.

Alas, we have no more information as of this moment, so anyone asking if Greek terrorist passports were also found, or why the package wasn’t mailed by Russian hackers, will have to wait.

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