Dollar and equity indices not correlated, but USD and Bond yields are

Outlook:

Today is a big data day in the US, including the next estimate of GDP, dur ables, and per - sonal consumption, but the week has all but ended for a majority of traders. Bloomberg has a 3.3% forecast for GDP on robust consumer spending. We also get a revised GDPNow forecast from the Atlanta Fed today, after 2.6% last time (Dec 16).

We will have plenty of things to worry about as the week comes to an end and next week while so many take a holiday. Here are three: Trump ramping up a trade war with China that leads to China dumping Treasuries, the confusing outlook for US equities, and a (likely) botched Italian bank bailout.

First, less than 24 hours after Trump announced he is forming a National Trade Council and appointing a trade hawk to head it, China said it may "adjust" investment in US Treasuries, according to Reuters. The speakers were from the State Administration of Foreign Exchange (SAFE). Reducing US holdings would be a "tactical move" and a "counter-cyclical" step to control capital outflow, which has been too big and too fast this year. And the government can meanwhile keep the yuan basically stable, according to PBOC chief economist Ma Jun, "as optimism about the U.S. dollar may be overdone." For what it's worth, Bloomberg reports Gold man estimates capital outflow from China at $69.2 billion in November alone and others estimate about $1 trillion this year.

Well, that didn't take long. Just as China responded swiftly to the Taiwan phone call and the drone theft, it's on the ball when it comes to Trump. The FT story says Peter Navarro, the new Trade Council chief, is the author of books such as Death by China and Crouching Tiger: What China's Militarism Means for the World. Trump claims to have read one of his books (when his ghost writer says he never reads books, ever). The new NTC will seek "Buy America, Hire America."

The FT calls it a collision course with China and says, "Without realising it, US voters appear to have opened the gates to a new cold war." The FT has it wrong. The voters knew perfectly well that Trump was itching to pick a fight with China and they elected him in large part because of it. More educated minds are worried. A Cato Institute economist said among other undesirable consequences, a trade war would cause capital flight. No kidding.

Realistically, China is in a bind. Bloomberg says economists call it the "impossible trinity," meaning "No country can simultaneously sustain a pegged exchange rate, a sovereign monetary policy and free capital flows. At some point, policy makers must make a trade-off." Blomberg advises banking reform and tackling the giant debt first, but guess which approach is easier. It may be going backwards, but China is good at that—devaluation and harsh capital controls. SocGen places the probability of a freefloatintg (devalued) Rmb at 50% next year. As for the debt overhang, a crisis is probably unavoidable. The BIS in Sept estimated the credit-to-GDP ratio of major countries (thank you, Rinehart and Rogoff). A number over 10 means the risk if a debt crisis is very high in the coming three years. China has a score of 30.1.

We don't need to guess what happens to the Chinese equity indices when markets finally acknowledge all these things—a debt crisis and a currency crisis. Then, in a reprise of last January, the rest of the world's equity markets get very unhappy, very fast.

Secondly, a Chinese crisis leads to the next issue, the currency effect. It's an interesting fact that the dollar and equity indices are not correlated—as many, many studies show--while the dollar and bond yields are. Many analysts are sure there is an inverse correlation (such as Zacks) but no one has found such a thing over any sustained period of time. Sometimes, when the dollar goes up, the S&P goes down on the assumption that foreign earnings will be suppressed. This is true, in part, but it is also true that some inputs denominated in now weaker foreign currencies will go down, favoring earnings. Inputs from Mexico, for example. In the year 2016, both the dollar and S&P went up. To be fair, we get a better correlation of the USD/JPY and S&P, at least sometimes, and those times are when crisis is upon us, such as 2007-2010.

In March last year, FXStreet had a dandy article on not buying into the correlation myth. "The 21-day (1-month) correlation coefficient, which mathematically measures the extent to which two data series move together, is currently -0.54; this means that over the last month, US stocks have tended to fall when the dollar rises. That said, the 1-month correlation was actually positive at the start of March (indicating that the dollar and S&P 500 were moving in the same direction). More to the point, the 1- month correlation has "flipped" from positive to negative five times already this year, showing no consistent relationship between the USD and US equities. The 6-month rolling correlation has also flipped from mostly negative in 2012 to positive in the middle of 2013, then back to negative until midway through last year, and it's now showing a positive relationship once again."

So what are we make of the chart below (from the Daily Shot)? It shows an equal amount of money flowing out of bonds and into equities. Not to stretch the point, but when demand for bonds falls, as it must be doing now--$3 trillion is not chump change—and assuming supply of bonds remain the same, basic economic logic dictates prices must go down to attract buyers, meaning yields must go up.

A very long time ago we wrote a book for CNBC and wanted to compare dividend yields to bond equivalent yield. We couldn't find the data. It was just not something investors were considering at the time. In fact, if you Google "bond equivalent yield" today, you still can't get a number. The WSJ will show S&P earnings vs. the 10-year yield, but S&P earnings are not S&P dividends. And bond funds are no help, either. They don't bother to show the bond equivalent yield. To be fair, calculating the equivalent yield is complicated. What we were able to find easily is that S&P earnings are now at 2.17% and the average Dow dividend is 2.71% (from a range of 0.87-4.37%).

The purpose of the exercise is to find a level where flows into equities fall off because bond returns, however you massage them and whatever the name, are better. Ah, but then you have to factor in the Trump effect of expectations of higher equity earnings and thus, maybe, an expected rise in dividends. This has to offset the rise in yields that will come with inflation, assuming we get that, too. We say the assumption chain is too stretched. And even if we could name a point at which flows into equities start decelerating or fall off, we can't deduce a dollar effect. A China cr isis that includes China dumping Treasuries may be offset or more than offset by safe-haven flight to dollars. Or maybe a global stock market meltdown together with China dumping Treasuries kills the dollar.

Third, the looming bailout of Monte dei Paschi and per haps other banks r aises the question of bank bailouts in general. The Five Star political party calls for nationalizing all the troubled banks and a consumer lobbying group says the €20 billion will cost each Italian citizen €833. Depending on how the bailout is handled, the loss of confidence in the banking system may be hard to recover, with people putting their money under their mattresses. Even though Monte dei Paschi has been drowning for years, a bailout is still a shock.

Handled well, however, a bailout doesn't have to be disastrous to commerce or confidence. It also doesn't have to cost the taxpayers a dime. In the US during the financial crisis, the FDIC swooped in take over hundreds of small banks--and the customers barely knew anything had happened. The too-big -to-fail banks got all the headlines, but the bailout was far wider and deeper than anyone really appreciated at the time.

And mostly excellent management meant the recovery was faster and more thorough than if it had been botched in any significant way. We heard from a usually liberal person the other day that TARP was a bad idea and should never have been allowed. Let the banks fail, he says. We appreciate comments like this from the Von Mises crowd—all government interference is inherently bad—but TARP saved the banking sector, the auto sector and heaven only knows how much of the insurance sector. Two years ago in Dec 2014, TARP sold the last of its equity stakes (in Ally, which used to be GMAC). You'd think that a financially literate person would understand why letting the banks fail is a very bad idea, with ripple and pinball effects leading to a Great Depression worse than the 1930's version.

As of November 2016, 97.7% of the amounts disbursed has been repaid. Cost to the taxpayer— negligible. The chart below is from the Treasury. ProPublica.com adds in Freddie and Fannie, and comes up with a profit. "Altogether, accounting for both the TARP and the Fannie and Freddie bailout, $622B has gone out the door—invested, loaned, or paid out—while $390B has been returned. The Treasury has been earning a return on most of the money invested or loaned. So far, it has earned $303B. When those revenues are taken into account, the government has realized a $71.2B profit as of Dec. 12, 2016."

Despite numerous problems and revisions to the TARP rules, we have to admit that not only did TARP work to keep the financial sector functioning, it did so at little or no cost to the taxpayer or maybe a profit. Why would anyone today still complain about a now-completed bailout, especially since the aftermath included new capital adequacy requirements and the end, possibly, of too-big-to-fail? Well.

Minneapolis Fed chief Kashkari, who ran TARP for the first two years, says the too-big-to-fail measures are not enough. New regs since 2008 reduce the chances of another government bailout to only 67% from 84% before the crisis.

Kashkari's ideas are not getting any traction at all in the environment where leaders like Trump seek less regulation, not more. But he has an intriguing explanation: the current political anger arises from the government helping large banks to survive while individuals lost their homes and jobs. He told the WSJ a month ago, "The bailouts violated a core belief that has been handed down from generation to generation in our society that if you take a risk you bear the rewards and consequences of that risk. We had to tear that up during the crisis because the biggest banks were going to fail and bring down the U.S. economy. And when you violate the core beliefs of society it does lead to anger and a feeling that this wasn't fair."

As we have written many times before, the symbol of that anger is that not a single bigshot banker went to jail. The prosecutors whine that they can't prove intent to defraud, just stupidity and greed. Golly, just imagine—if a few elite bankers had gone to jail, maybe we wouldn't have Trump. Italy, pay attention.