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Are the Markets Getting Ahead of Themselves?

It has been a full week after the US elections and the markets are still in a state of euphoria. The US Dow Jones Industrial average closed the week 20.27 points higher or about 0.11% posting an all time high of 18934.05 before closing on Friday at 18867.93. Meanwhile the S&P500 index ended with 0.81% gains on the week. The rally in the equity markets was heightened as global bond yields surged across the board in what is being dubbed as a Trump Reflation trade.

Campaign promises of spending nearly $1 trillion on infrastructure spending has stoked market expectations and pushed the longer term yields higher as a result. The yield on the US 10-year treasury rose to 2.357% after briefly posting a new high of 2.366 this week.

Besides the “Trump Factor” there were other narratives in play as well. Last week, the US economic data showed that the economy was surging ahead at full steam, indicating that the GDP growth in the fourth quarter is likely to be robust. Inflation was seen rising at a pace of 1.6% on a year over year basis in October. It is still below the Fed’s 2% inflation target rate but given the current market expectations, it is quite likely that inflation could very well strengthen in the coming months.

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US Consumer Price Index: 1.6% (October 2016 y/y)

The US consumer was upbeat in October as latest retail sales figures showed a 0.8% increase on a month over month basis, pushing the annual retail sales to 4.3% from a year ago.

On Thursday, Fed Chair Janet Yellen testified to the Joint Economic Committee in Washington. She gave an upbeat assessment of the US economy noting that the labour market was close to its mandate while also underlining the fact that inflation expectations had strengthened. In short, Yellen’s comments were seen by the market as an acknowledgement on the economy indicating that the Fed is likely to raise the short term interest rates in December.

By Friday’s close, the CME Futures Fed funds tool assigned over 90% probability for a 25 basis points rate hike, making it an almost done deal. The fact that the equity markets continued to push higher after Thursday’s comments from the Fed chair added to the conviction.

The US dollar index posted strong gains this week recapturing the psychological barrier of 100. The US dollar index futures for December delivery closed at 101.28 this was just after the dollar index surged to a 52-week high of 101.54.

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US Dollar Index Futures for December 2016 Delivery

Rate hike expectations and promises of stimulus spending has so far been the main driver for pushing the US dollar and the equity markets higher. However, nothing is set in stone just as yet. While the Fed is very likely to hike rates this December, the longer term questions on fiscal spending and the impact it will have on inflation is still open to interpretation.

While the President-Elect Donald Trump takes office in January 2017, the markets are pinning hopes on nothing short of the $1 trillion in fiscal spending. There are a lot of variables that will eventually impact the market expectation such as whether the spending will be a one-time event or if the spending will come in tranches. No matter what the outcome will be, the current rally in the markets and the rise in bond yields should serve as a caution for investors as the markets are clearly getting ahead of itself with the rally supported by speculation than facts.

With less than three weeks to go for the Fed decision, safe haven assets have been pounded while the gains in the bond yields and the US dollar have sprung up sharply. This strong rally with nothing but speculation to support the view is likely to see a sharp correction in the near term as the