ETFs React To Double Whammy Of Big News

November 02, 2017

What could have been a day of fireworks for the markets ended up being a yawner. Stock and bond markets barely budged as two huge pieces of news hit the wires Thursday, a counterintuitive, but typical, reaction in a year that has seen record-low volatility in financial markets.

As of this writing, the SPDR S&P 500 ETF Trust (SPY) and the iShares Core U.S. Aggregate Bond ETF (AGG) were last trading close to unchanged on the session.

New Fed Chair & Tax Plan

The first piece of big news to come out today was the nomination of Federal Reserve governor Jerome Powell to be the next chairman of the Federal Reserve. If approved by the Senate, as is widely anticipated, Powell will replace Janet Yellen as the head of the U.S. central bank when her term ends in February.

This marks the first time since 1979 that a Fed Chair wasn't reappointed, according to Reuters.

The second big news of the day was the unveiling of the Republican tax plan. Called the "Tax Cuts and Jobs Act," the bill slashes taxes for corporations from 35% to 20%, consolidates the number of individual tax brackets from seven to four, reduces the cap on mortgage interest deductions, and more.

House leaders have an ambitious goal of passing the tax bill by Thanksgiving, while President Trump wants to sign it into law by Christmas.

No Surprises

The appointment of a new Fed chair and changes to the tax code could have significant ramifications for the economy, and by extension, financial markets. But stocks and bonds aren't reacting because much of the news is already priced in, according to Brian Jacobsen, chief portfolio strategist at Wells Fargo Funds Management.

"The lack of market reaction is a case study in how markets are forward looking. Surprises matter. There was very little that was surprising in what was unveiled today," he said.

Jacobsen believes Powell's ascension to Fed chair represents continuity with the existing monetary policy framework, which is why markets haven't reacted dramatically.

"Yields moved slightly lower on the news, but it wasn’t anything shocking," he noted.

Potential Instability

However, "what could represent a discontinuity for monetary policy is if Yellen steps down and President Trump then needs to fill the Board with four people," Jacobsen explained.

In that case, "the stability and predictability of monetary policy could shift to a bit more instability until those seats are filled. I’m inclined to think the market could price in a faster path of normalization, which could be a head wind to risk assets and a tail wind to the dollar," he added.

The $644 million PowerShares DB U.S. Dollar Index Bullish Fund (UUP), which tracks the greenback, was trading close to unchanged today, but has steadily rallied since bottoming out in September.

Opportunities In Munis

As for the tax plan, the most significant part for stocks―the reduction in the corporate rate―was already widely expected, as evidenced by the lack of market reaction, says Jacobsen. But aside from that, the tax plan has a lot of nuance that must be examined, he adds.

"The municipal bond market will be the place to look for a reaction, as there are provisions galore that could affect that market. Eliminating the AMT, changing private activity bond income treatment, eliminating stadium bonds, and taxing income on advanced refunding bonds could create some really interesting relative opportunities in that market," Jacobsen explained.

The $9 billion iShares National Muni Bond ETF (MUB), the largest ETF in the space, was last trading up fractionally.

Homebuilder ETFs Drop

Unlike most areas of the markets that weren't seeing much action after the news, one industry that did react convincingly to the Republican tax plan was homebuilders.

The $2.2 billion iShares U.S. Home Construction ETF (ITB) and the $1.1 billion SPDR S&P Homebuilders ETF (XHB)  fell more than 1.5% each amid concerns that demand for new homes could drop with the reduction in the cap on mortgage interest deductions.

Under the Republican tax plan, mortgage interest can only be deducted on home loans up to $500,000, down from $1 million. However, current homeowners will still be able to deduct interest payments up to $1 million.

Real estate groups have come out against the changes, claiming the new rules will hurt homeowners and homeownership levels.

In contrast to homebuilders, ETFs tied to real estate investment trusts (REITs) were trading up on the day. The $34 billion Vanguard REIT ETF (VNQ) gained 0.8% on the session.

REITs develop, own and operate real estate, generating income for investors through rents and price appreciation.

Contact Sumit Roy at [email protected]

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