XMas break

There will be no posting over the next days.
I will be active again towards the middle of January.
Merry XMas and a happy New Year!

Rates Strategy: Still long but...

10y UST and Bund futures remain guided by their medium-term upward trends. However, momentum has weakened and especially 10y UST futures have corrected considerably over the past two weeks. Bund futures have held up better which should be seen in light of the Greek woes. Overall, I maintain my tactic long stance for the time being but see increasing risks of a trend break.
Risks to the positive tactical stance are increasing. First, positioning in US futures has moved from a short base to neutral over the past weeks even though markets have corrected weaker. Additionally, so far equities and commodities have remained within their upside trends following a test towards the end of last week. I still think that commodities should be headed lower - which would help government bonds - but clearly from a technical perspective the upward trend running at currently 268.5 in the CRB index needs to be broken on a closing basis for the near-term outlook to turn negative.
Most importantly and as I have written last week (see Watch out for a rebound in seasonally adjusted economic data during winter), the winter months are likely to see a more positive fundamental backdrop even if only largely due to seasonal adjustments which overplay the usual economic downturn. This temporarily better economic backdrop in combination with reduced short positions risk becoming a significant headwind for government bonds over the next weeks. To be sure, I remain of the opinion that growth will remain subdued over the medium term amid a lack of a self-sustaining economic dynamic as well as lower trend growth. Furthermore, I still do not see rising inflation pressures to be on the horizon over the forseeable future (i.e. 1-2 years) in the US or the Eurozone. This should help government bonds to remain at historically low levels over the longer term.
For the time being and given that the upward trend in the Bund future remains intact (currently running at around 121.63), I stick with a bond-bullish tactical outlook but see rising risks of a temporary but potentially significant setback on the horizon.

Markets appear to be at important cross-roads

Besides the clearly negative performance of assets related to Dubai or Greece, the past weeks have essentially seen range-trading in important markets. However, this range-trading seems to mask some interesting breaks or tests of the medium-term trends, highlighting that the risk of a fundamental change in market sentiment has grown larger again.
First, it was widely reported over the past weeks that the trade-weighted USD has broken through its downward trend (see chart below) late October. However, despite this trend-break, the USD continued to make new lows.

Trade-weighted USD broke through medium-term downward trend in October

Source: Bloomberg

One reason why the USD continued to weaken is that this technical signal (the trend break) was not confirmed by the major crosses and the USD remained in its downward trend vs. for example the EUR and the JPY. However, at the end of last week EUR-USD has broken through its upward trendline (see chart below). This to me is the first confirmation that a trend reversal in the fate of the USD is indeed in store.

First confirmation of a USD trend-reversal: EUR-USD has broken through its upward trend

Source: Bloomberg

In the commodities space, the bullish trends have so far remained intact. However, the index as well as some important sub-components are just trading at the trend line. First, the CRB index has almost exactly closed at its medium-term upward trendline (in place since early March) yesterday. The trend was running at 267.55 vs. a close in the index of 267.75. With a slope in the trend of 0.34, the CRB index needs to move slightly higher today in order to remain above this trend.

CRB index is testing its medium-term upward trend

Source: Bloomberg

Within the commodities space, the sub-indices for Livestock and Agriculture remain in a longer term sideways trading pattern whereas industrial metals continue to trade higher. Precious metals technically also remain in a longer-term upward trend despite the latest correction. However, the energy sub-index has closed below this year's upward trend just yesterday.

Diverging behaviour of commodity sub-indices

Source: Bloomberg, Research Ahead

Looking into the energy sub-component, we find that while the roll-adjusted ICE Brent crude future has closed just slightly above its medium-term upward trend yesterday (exactly as the overall commodity index), the ICE WTI crude oil future has broken below this trend on Tuesday and the Nymex WTI crude oil future yesterday.

ICE WTI crude oil future broke through upward trend on Tuesday

Source: Bloomberg

In the equity space, the S&P index is trading just above its upward trendline and also other major equity indices so far remain above the trends. However, the DJ Euro Stoxx 50 index has also broken below its upward trend on a closing basis yesterday.

DJ Euro Stoxx 50 has closed below its upward trendline

Source: Bloomberg

As stated several times previously, in the rates space, 10y Bund and 10y US Treasury futures remain guided by their upward trends.

Overall, markets appear to be at interesting cross-roads and especially the commodity complex looks weak. I think that especially energy commodities trade too high amid a lack of end-demand which should result in lower prices. Therefore, I also look for a break lower in the overall commodity index. Moreover, I still remain convinced that the subdued growth environment will act as a significant headwind for risky assets in general which should become more apparent again once the wave of central bank liquidity ebbs.

Rating woes

Over the past 24 hours there have been several news with respect to sovereign ratings. S&P put Greece's A- rating on creditwatch negative and revised the outlook for Portugal to negative from stable. S&P stated that Greece's rating may be affirmed if the government's strategy is aggressive enough to secure a significant and sustained decline in the public debt burden, otherwise the rating could be cut a step to BBB+. This step has been a bit of a surprise given that S&P's rating for Greece is already two steps below the Moody's rating for Greece of A1 (Fitch cut Greece to A- in October). However, from my perspective it is well warranted by the structural challenges facing the economy on the one side and the lack of precedents in the recent Greek history to deal with any of those even during good times (most notably the fiscal deficit). One should not forget that the Greek economy has been used to relatively high levels of nominal growth and a comparatively low level of nominal yields, rendering debt service (not only for the governnment) a minor problem. However, the period of substantial nominal growth is likely to be past for at least several years whereas especially real interest rates are likely to be substantially higher than over the last decade. In turn, the servicing of the outstanding debt will become a larger problem in the future and clearly there is no easy way out of this.
I have frequently mentioned that I see Ireland, Portugal and Spain having similar problems to Greece. In turn, I expect more negative rating actions on any of these sovereigns over the upcoming year. So far, I have not seen any steps which convince me that the challenges (low competitivity, high indebtdedness, higher real interest rates/rising debt service burden in real terms) have been fully understood and the will is there to remedy the situation on the sovereign as well as the corporate side. Therefore, despite the wide levels of spreads I maintain my underweight view in all of these sovereigns. I also reiterate that I remain less worried with respect to Italy and expect the 10y spread between Italian and Spanish government bonds to narrow to single-digit levels over the course of next year from the current 20bp area.

Unrelated to that, Moody's published its latest AAA Sovereign Monitor which mostly focused on the four largest AAA-rated countries - France, Germany, the US and the UK - out of the eight AAAs. FT Alphaville has the following chart (found here). The expected development especially of the UK and the US look worrisome.

Source: Moody's

With respect to the UK, Moody's cites that the "the UK government exhibits a high degree of debt reversibility" which is "supported by the trend over recent months towards an apparent consensus among the public that fiscal retrenchment (including cuts in expenditure) is both inevitable and desirable." However, Moody's also warns: "While assumed capacity for fiscal adjustment currently supports the maintenance of the Aaa rating of the UK government, this assumption will have to be validated by actions in the not-too-distant future to continue to provide support for the rating." In turn, if following the election the government does not take action to reduce the structural budget deficit, then we should expect Moody's to become much more outspoken with respect to the UK's AAA rating.

Looking at the US, Moody's states: "... it is clearly necessary to bring the defict down to a sustainable level to avoid an unsustainable upward trajectory in debt ratios in the future. Administration officials have said that the next budget, which will be presented in February 2010, will include measures to reduce the deficit to a lower level in order to prevent debt from reaching the levels implied by the current projections. A credible fiscal consolidation strategy would reduce the risk of higher interest rates and therefore a major deterioration in debt affordability that could come from a decline in confidence in financial markets." Therefore, it is likely that Moody's will step up its language should the next budget not show a will to reduce the longer-term deficit.
Overall, a negative rating action on the UK and even more so on the US is a much larger challenge for any of the rating agencies than downgrading say Greece. In turn, it needs a long preparation by the rating agencies and I would not bet on negative rating actions to take place soon. Rather the language will become tougher several times before we a negative outlook can be rewarded. I personally think that the US will not see a negative rating action but that the UK will suffer from at least a negative outlook (if following the elections no significant actions are taken that could be the case already before the end of 2010). My views with respect to the UK remain unaltered and I look for a prolonged period of economic underperformance which will be mirrored in the development of financial assets. Furthermore, I also continue to see the highest risk of an inflationary outcome amongst the major economies for the UK.

Watch out for a rebound in seasonally adjusted economic data for winter

I have been of the opinion that autumn would see a weaker growth picture due to technical factors (see for example Autumn growth weakness is finally becoming evident dated Oct 2). A key reason has been that seasonal adjustment factors are likely to overstate the extent of the true seasonality at the current juncture. Given the massive amount of job losses and the huge decrease in industrial production during the recession (and especially following the collapse of Lehman), the usual economic slowing into summer should have been less pronounced than is generally the case. With that, seasonally adjusted data are likely to overstate the dynamic of the economy going into summer. However, it directly follows that the usual seasonal strengthening into autumn should be less pronounced than is usually the case and therefore seasonally adjusted data for autumn are likely to understate the true dynamic of the economy. Indeed, while economic data during the summer months surprised positively on average, economic data was in line to slightly negative on average during the period of September-November. The chart below shows the Citigroup economic surprise indicator which confirms this picture. However, with winter having started this story is turning around again.

Citigroup US economic surprise indicator: autumn slowdown seems to be over

Source: Citigroup via Bloomberg

I think that the change in the seasonal adjustment factors could already be seen with Friday's employment report. First, this was a positive employment report. Most notably the pace in the hiring of temporary workers has increased and the development of temporary workers is usually a good leading indicator for the hiring/firing of permanent employees. Furthermore, the index of aggregate weekly hours moved from 98.5 to 91.1, the largest uptick since March 2007, i.e. before the start of the recession. However, it seems that seasonal adjustments played only a relatively small role for the November report. According to the establishment survey, the seasonal adjustments assumed a "normal" job creation for November of 91k vs. 820k for October. The chart below shows the seasonal adjustments of the past 12 months (in dark blue) as well as the average of the seasonal adjustments of the 9 years prior (in light blue). As can be seen the seasonal adjustments assume a significant slowing of the job market during summer as well as winter (December and especially January).

Seasonal adjustment factors for employment

Source: BLS, Research Ahead

Furthermore, it can be seen that the current seasonal adjustment factors are not much different from the usual seasonal adjustments. This makes sense from a statistical point of view and clearly during periods where economic volatility is not much pronounced. However, in the wake of the financial crisis, we do still not have a 'normal' economic environment. Just to repeat, I think that given the magnitude of the previous job losses, the seasonal adjustment factors overplay the current importance of seasonal economic weakness and strength. Given the large seasonal adjustment to the October jobs data (which was even larger than usual), the weakness in the job market during October was likely overplayed and with seasonals being amongst the lowest for November, the latest jobs data might show a truer picture about the underlying dynamic.
Looking ahead, we are about to enter the period of the most pronounced seasonality. In turn, what we witnessed during summer and autumn might be even more pronounced during the upcoming months. Just one example is retail hiring and firing. Usually retail hiring is strong during October and November in the run up to Christmas (see chart below, courtesy of CalculatedRisk). However, especially last year but also this year has seen less hiring than usual. If less people are hired for the pre-Christmas period, less people will be fired again going into January.

Given the large likelihood that the usual seasonal economic weakness is likely to be less pronounced than seasonal adjustment factors assume, seasonally adjusted economic data for December and January is likely to show a healthier momentum than the data for autumn.

ECB: Separating rate setting from liquidity provision

The ECB's decision to use the average minimum bid rate instead of the fixed 1% rate for its next and last unlimited 12m tender came as a surprise. Short rate futures initially fell on the news just to recover all the losses and more as Trichet stated that this would not signal anything with respect to the outlook for rates. And indeed if one looks at the ECB staff projections for GDP growth (2010 0.1%-1.5% and 2011 0.2%-2.2%) and inflation (2010 0.9%-1.7% and 2011 0.8%-2%), then there seems to be no need to change rates over the life of the upcoming 12m tender.
To me, yesterday's decision signals that a) the ECB acknowledges the uncertainty with respect to the macro-economic outlook and is happy to have this uncertainty also reflected in the LTRO, b) the ECB wants back to an increased separation between setting the price for liquidity (aka traditional monetary policy which is dependent on the macro-economic outlook) on the one hand and of ensuring a properly working transmission mechanism of monetary policy via the provision of liquidity on the other. With this they confirm that the systemic financial crisis has been abating but that at the same time the macro-economic crisis - aka muted nominal growth - might be past its most acute phase but clearly is far from over. Indeed the liquidity provision measures have done a lot to improve the working of the transmission mechanism of monetary policy compared to one year ago. Credit spreads have tightened drastically and markets have been digesting a huge amount of credit-related supply. In turn, it is warranted to reduce the amount of excess liquidity over the upcoming year.
However, it should not be forgotten that low yields per se are only a necessary but not a sufficient condition for the transmission mechanism to work properly. Liquidity has been ample hence the lower yields and increased appetite for risk. But capitalisation across the banking sector and/or the corporate sector and/or households in a large number of countries remains poor and therefore the provision of credit via the traditional banking channel is still very restrictive.
Moreover, the ECB's economic projections imply that nominal growth should be in between 1%-3.2% for 2010 and 1%-4.2% in 2011 with the central values at 2.1% and 2.6%, respectively. Historically, these are very low levels of nominal growth and should go hand in hand with a prolonged period of low nominal yields. I have used the chart below on numerous occasions. It shows the 10y UST yields (more precisely, the 10y constant maturity treasury yield) vs. US nominal GDP growth and vs. smoothed nominal GDP growth. Not surprisingly, the longer-term trends are the same for nominal yields and nominal GDP growth.

US nominal GDP growth and nominal yields are moving in tandem over longer term

Source: St. Louis Federal Reserve, Bloomberg, Research Ahead

In the Eurozone, the situation is the same even though we have less history available to prove the point. The chart below shows the development of nominal Eurozone GDP growth vs. 10y Bund yields since the start of 1999. There has been a close co-movement for the past 10 years with the exception of this year where nominal growth fell much more than nominal bond yields. This is down to the negative growth rate being a temporary one while the bond yield has a long maturity and should therefore not be only dependent on short-term growth but is largely influenced by the medium-term outlook.
In between January 1999 and Dec 2008, nominal GDP growth averaged 4.2% (based on 2.1% average real growth and an average GDP deflator of 2.1%) while 10y Bund yields averaged 4.3%. That the two averages are very similar should not be seen as a coincidence as nominal bond yields need to be closely linked to nominal GDP growth over the medium term.

Also in the Eurozone nominal yields and nominal growth are co-moving over the medium term

Source: Bloomberg, Research Ahead

The relationship of nominal growth and nominal yields in combination with the ECB's economic projections, supports my expectation that nominal yields should remain low for a pro-tracted period of time. Additionally, it should not be forgotten that if nominal growth should indeed be around 2.5% for a multi-year period, then 10y nominal Bund yields of 3-4% are not really accommodative. Furthermore, we should not forget that even with an unchanged level of the ECB repo rate of 1%, as core inflation continues to fall, the realised real interest rates for most market participants will be rising nevertheless during 2010.

To conclude, the ECB has started on its exit path with respect to the emergency measures enacted to support the financial system. It thereby tries to better separate rate setting from the provision of liquidity. It has made no decision with respect to its exit strategy from the record-low repo rate environment. This will be dependent on the outlook for inflation and growth and at present it does not look like 2011 will be the year of the first rate hike.

Is the US consumer overleveraged?

Readers of this blog will be aware that my view is one where the US consumer is over-indebted on a structural basis, the savings ratio will rise and consumption growth will be muted for a prolonged period of time. Consumption growth is being determined by the growth in disposable income and changes in the savings ratio. The outlook for disposable income growth remains poor (see for example Small business job creation, personal income & consumption: weak dated October 7). Furthermore, amid the rising unemployment rate and the previous drop in house prices, the creditworthiness of a large sum of households has deteriorated significantly and the propensity to incur new debt has been reduced while banks on the other side remain unable and unwilling to lend. In turn, the savings ratio is likely to trend higher.
However, J. Wilmot, chief global strategist at Credit Suisse, suggests in FTs Alphaville blog that the idea of the US consumer being overleveraged and that it may take a decade to unwind the damage "is the most overbought idea coming out of the current crisis".
His argument is the following:
"Everyone is by now familiar with the first chart below, but few know the second one, which we find much more informative. Essentially it shows that, although leverage ratios increased in the Greenspan era for all income groups, it is really only the bottom 20% of the income distribution who have clearly borrowed more than they can afford to service. And it is these higher income groups who account for 90% of US consumption. So the debt issue is arguably as much or more a major social and political problem as an economic disaster."

He goes on: "The debt story is really about the cyclical vulnerability of consumer spending, not a structural obstacle to future spending that matters even when income grows. The distinction is critical. Full recovery of consumer spending can occur with house price stabilisation and a return of income growth. It has little to do with getting the savings rate or debt-income ratio to certain levels."

I disagree with this view.
a) That the weakness in consumption is more pronounced than during the average recession is highlighted by the chart below (taken from Will consumption growth return to its pre-recession level? by Mark Thoma). To quote: "This graph compares the movements in aggregate real consumption during and after the onset of the current and three most recent recessions. The graphs show the first month of a recession as defined by the NBER — normalized to 1.0 to facilitate cross-recession comparisons — and the subsequent 22 months after the recession begins (for a total of 23 months, the length of time since the current recession began)"
He goes on:" First, in every other recession consumption returned to close to its pre-recession value no longer than 9 months after the recession started. Second, the drop in consumption has been larger and more sustained than in previous recessions. The drop in the 90-91 recession was nearly as large, but nowhere near as sustained as the present case."
This comparison with other recessions highlights that there is more to the weakness in consumption than just "cyclical vulnerability".

b) "it is really only the bottom 20% of the income distribution who have borrowed more than they can afford to service": According to this data, 1 in 8 American (12%) currently uses food stamps. The increasing usage of food stamps to me suggests that those people will not have a lot of money left to help drive consumption growth. But it is not only in the bottom 20% as Wilmott suggests that high indebtedness is prevalent. The chart he uses also shows that for all income groups except the top decile, indebtedness grew significantly over the past years and stands at roughly 170% (up from less than 100% just 20 years ago). Now also 170% sounds high to me and the rise of in the indebtedness over the past decades shows just by how much the rise in consumption was debt-fuelled. If that growth in debt can not be sustained, so cant be the growth in consumption. Wilmot states that it is only the bottom 20% who have lived beyond their means, however, his chart suggests that only the top 10% have lived within their means!
Additionally, as Richard Green argues here: "The counter-argument is that average household net worth relative to GDP remains quite normal by historical standards. But here is where the skewed distribution of wealth is a problem. I am reasonably sure that when the next Survey of Consumer Finances is released for 2010, median household net worth will be down. Corelogic says that one in four households with mortgages has negative home equity--this would be about 18 percent of owner households (about 30 percent of owners have no mortgage). If we combine this with the fact that 1/3 of the country rents, this means that the median households has little or no home equity. The median household is not loaded with financial assets, either. According to the 2007 Survey of Consumer Finances, only half of families have a retirement account, and only 21 percent owned stocks. Put this all together, the median household is not in great shape financially, and the median household consumes a higher share of its income than higher income households."
I do not see anything in Wilmot's argument which would make me change my view of a prologed period of limited consumption growth in the US.

Rates Strategy Update: Still in a long-term bull market!

The combination of the Greek and Dubai woes has helped bond markets to perform strongly over the past days. What is more, despite the flight to safety amid rising risk aversion, yield curves failed to steepen over the past days in both, the US as well as the Eurozone. The 2-5y segments flattened whereas 5-10y was range-bound and only 10-30y segments were able to steepen. This should highlight that in an environment where 2y yields are close to or even below 1%, a bull-flattening of the yield curve is difficult to achieve given that the room for yield performance becomes very limited at the short-end. Looking ahead I maintain my bullish tactical outlook with a flattening bias - in line with my bullish strategic view - but admit that especially German Bund yields look expensive on a relative value basis.
First, the technical picture has improved further vs. last week. The adjusted Bund future contract was able to trade to a new high on Friday. The previous high in the roll-adjusted contract was reached on March 9 at 123.57 according to Bloomberg (in unadjusted terms the March 2009 Bund future reached its high on January 15 at 126.53). This is a very positive medium-term signal as it suggests that the bull-trend which started in July 2008 remains intact and the sell-off in spring this year was merely a temporary counter-movement and not the start of a bear market!

Bund future remains in longer-term bull trend

Source: Tradesignalonline, Research Ahead

Also the 2y Schatz future and the 5y Bobl future made new roll-adjusted highs. However, in the case of the Schatz future, Friday's 108.75 level constitutes also a new high in unadjusted terms (vs. 108.625 for the March09 contract reached on March 5 and 108.735 for the Sep09 contract reached on Sep 8). In the US, the 2y future as well reached a new record high in unadjusted as well as in adjusted terms. The 5y future a new high in adjusted terms whereas the 10y future remains below its adjusted high reached on Dec 18 last year.
Overall, bond futures continue to emit bullish signal with the only caveat that they start to look overbought. On the other side, 10y yield charts remain a bit less bullish as both 10y UST and 10y Bund yields continue to trade above the record lows reached early in the year and also above the early October lows. In the case of the 10y Bund yield, the current level of 3.15% compares to an early October low of 3.093%. In turn this would leave the picture neutral. Still, if we look at the underlying bonds (the early October lows were reached with the old Bund benchmark the Jul09 vs. the current benchmark Jan20), then the picture becomes bullish as well. The Bund Jul19 traded down to a yield of 3.054% on Friday, i.e. clearly below its early October lows. Furthermore, shorter-dated yields provide also a more bond-bullish technical picture, especially in the US as 2y UST yields have traded down to 0.67%, i.e. almost back to the all-time lows reached last December at 0.649%.

10y Bund yields break below 3.20-3.40% range but remains above early October lows

Source: Bloomberg, Research Ahead

While the technical picture suggests the bullish movement can run further, valuations look a bit stretched following the significant yield drop of the past two weeks. Judging from the correlation of bonds vs. equities and commodities, especially 10y Bunds appear expensive to the tune of some 20bp (i.e. approx. 2 standard deviations). I see a key reason for this expensiveness in the development of intra-Eurozone government bond spreads. Just as the Greek spreads vs. Bunds have blown out again and took other Eurozone periphery spreads to wider levels, Bunds on the other side moved into expensive territory. This was further accentuated by the Dubai woes at the end of last week. While I do not have a strong view with respect to the developments in the Middle East, I think that intra-Eurozone spreads will not re-tighten back to their levels prevailing at the start of November but rather face more widening pressure over the medium-term and in turn Bunds should remain expensive for some time.
Overall, therefore I maintain my tactical bullish outlook and look for flatter yield curves. However, in light of the expensiveness of 10y Bunds, I would not add to positions anymore at present levels.

Money for nothing

Central bank money is available in huge quantities for almost 0%. However, while this has helped to propel risk asset prices higher/credit spreads lower, it has only masked but it clearly did not solve the deeper problem of undercapitalisation. The latest events in Greece as well as in Dubai should are testimony to this assessment.
While I do not have any special insight into the Dubai situation, to me it has some similarities to the Greek developments. In Greece, we have an undercapitalised banking sector in a structurally weak and uncompetitive economy. The undercapitalisation of the banking sector was only masked by the ECB's liquidity provision measures but just as you cannot extinguish a Greek fire with the help of water alone you can not heal an undercapitalised banking sector with the sole help of liquidity. Furthermore, the Greek problems are not confined to Greece as a host of Eurozone countries face a very similar structural situation while the undercapitalisation of the banking sectors in a large number of countries across the globe are being masked by a massive amount of central bank liquidity.
In the case of Dubai we have had a debt-fuelled housing bubble which left housing markets overvalued and the corporate sector massively overindebted. Again, this sounds rather familiar and is not an issue solely confined to Dubai. A debt-fuelled housing bubble was also a global phenomenon and has left corporates and/or households over-indebted in a host of countries. While the non-financial corporate sector seems to be in an unsustainably large financial deficit for example in Spain, France and Italy, household finances seem unsustainable especially in the US and the UK. Again, a massive dose of central bank provided liquidity for banks will not solve the problem of over-indebtedness of corporates and households. It is the same as with the banking sector, corporates and households need to recapitalise. For corporates this can either be done via increasing equity (hurting share prices) or paying down debt (from internal cash-flows/selling of assets) which in an economy growing only at limited speed largely means cost-cutting. Households on their side can only 'recapitalise' via higher incomes (from wages, capital or the government) and/or lower spending which would result in a higher savings ratio. However, this process is made even more difficult by the increasing unemployment rates.
In turn, we live in an environment where money/liquidity is available for nothing but capital is scarce. Given the challenges to recapitalise in a world of low nominal GDP growth, we should brace ourselves for more defaults within the banking, the corporate as well as the household sector over the next few years.

Greek Fire - Part II

This is a follow-up to the original post Greek Fire dated November 17.
The underperformance of Greek assets has continued over the past days. In the bond market, 10y GGB-Bund spreads have widened sharply to currently around 174bp from 132bp just two weeks ago and a low of 108bp in early August. As the chart below shows, this spread widening has been mirrored by wider CDS spreads for Greece. Interestingly, the absolute level of the Greek CDS seems to top and bottom ahead of the GGB-Bund spread. In early March it peaked 9 days ahead of the top in the 10y GGB-Bund spread and in early August it bottomed 7 days ahead of the low in the cash-bond spread. What is more, the relative performance of equities seems to lag the developments in the bond markets (I used the difference in the percentage-performance since the lows in the equity indices on March 9). Greek equities have only really started to underperform since late October, i.e. more than two months after the outperformance of Greek GGBs came to a halt and started to revert.

Greek assets remain under pressure

Source: Bloomberg, Research Ahead

This highlights once again that equity investors ignore the developments in bond markets at their own peril. Furthermore, given that the underlying problems responsible for the latest underperformance are also present in a host of other countries, bond and equity investors should take note. First, Greece is suffering from a structural weak economic position (significant imbalances, low relative competitiveness etc.) coupled with limited room for an ongoing environment of stimulative fiscal as well as monetary policies. Fiscal policy is seriously constrained by the high level of indebtedness and the exorbitantly high budget deficits. In turn, fiscal policy needs to be tightened significantly just to stabilise the deficit near 10%. This, however, will further harm the economy. Moreover, monetary policy is far from exerting the same level of accommodation as in other countries. The level of longer-term interest rates is higher with 10y Greek government bonds yielding 170bp more than their German counterparts (vs. a pre-crisis level of roughly 35bp) whereas the inflation differential has decreased (currently 1.2% difference in headline inflation rates vs. an average of 1.55% over the past 10 years). In turn, the monetary environment for Greece is significantly less accommodative than it is for Germany. Moreover, Greek banks seem to rely relatively more on the ECBs liquidity providing measures. As this FT article suggests - citing a BNP Paribas research piece - 7% of excess reserves provided by the ECB have gone into Greece which only represents 0.9% of EMU GDP. Furthermore, Greek banks seem to have used this liquidity to buy local government paper helping sovereign spreads come down.
However, similar problems (significant structural imbalances, high deficits which will need to be reduced via fiscal tightening, lower level of monetary policy accommodation than for the Eurozone average, high reliance on ECB liquidity providing measures) are apparent in a host of Eurozone countries. I continue to see the largest problems - besides Greece - for Ireland, Portugal and Spain. I still remain a little less worried with respect to Italy (largely because the deficit still appears relatively low which means that there is no need to actively tighten fiscal policy as of yet).
Given the structural economic imbalances coupled with the need to tighten fiscal policy, monetary policy would be more important for those countries to deliver ongoing policy support. But again, the level of interest rates in these countries is significantly higher (especially in Ireland) than in the core of the Eurozone. Coupled with lower inflation rates than for the Eurozone average (-1.5% for Portugal, -0.7% for Spain,-6.5% for Ireland vs. -0.1% for the Eurozone) this means that real yields are much higher. Furthermore, this high level of real interest rates is especially apparent at the long end of the curve given the high level of credit spreads on top of the already steep undlerying yield curve (as measured via Bunds or swap rates). This renders it much more attractive for the banks located in these countries to use the short-end of the yield curve to refinance than locking in rates at the longer end. As a result, I assume that the dependency on the ECBs liquidity provision measures tends to be higher in those countries on average (this is not to say that for example also some weak German Landesbanks do not rely extensively on ECB liquidity). In turn, as the ECB starts to withdraw this liquidity, it will be especially the banking sectors in those weak countries which will suffer significantly, leading to further underperformance of respective bond and equity markets.

Given that the ECB should start to embark on its exit path - even if only at a gradual pace - it becomes even more important to shy away of investments in the structuraly weak Eurozone countries such as Greece, Ireland, Portugal and Spain, be it in sovereign or corporate bonds as well as in equity markets.

Rates Strategy Update: looking for flatter curves amid lower long-end yields

Last week's hot topic in the government bond area was the record-low short-end yields in the US with some T-bills trading at negative yields and also 2y UST yields back at the record lows of last December. The combination of lower policy rates for longer coupled with window-dressing by banks before year-end as well as a reduced issuance of T-bills is driving short-end rates lower. In turn, we have high demand by banks and by money-market mutual funds in an environment of shrinking supply. The outstanding amount of commercial paper is still only slightly more than half of what it was before the financial crisis started in mid-2007. Furthermore, in September, the US Treasury said that it was going to reduce the balance of its supplementary financing program, which was about $200 billion in September, to $15 billion. The SFP started in September 2008 and through this program, the Treasury sold T-bills to provide cash for use in Federal Reserve initiatives.
While I expect T-bill yields to remain low for an extended period amid limited growth and low inflaiton, the current levels will not prove sustainable into 2010 as the window-dressing goes into reverse.
However, while I regard the short-end of the US curve as too expensive, I still maintain my overall bond market bullish view as I look for lower long-end yields. On average, fundamental data has been surprising rather on the negative side as of late. Furthermore, while a week ago the technical picture appeared neutral, some bullish signals have been emitted in the meantime. First, the Bund future - while still trading below its early October high at 123.04 - has moved above the interim high reached on November 2 at 122.44. However, as cash bond yields remain stuck in their 3.20-3.40% range with 10y currently at 3.28% (and also the previous benchmark at 3.23%), the bullish signal is a weak one. In the US, the situation is similar. 10y futures have traded above their early October high of 119-29 on an intra-day basis, reaching 129-31+ on Friday before falling back. But in yield terms, the 3.30% level could once again not be broken and continues to serve as an important support area. Therefore, technically 10y bond futures look rather bullish, but yields remain in a neutral zone and the overall picture is neutral-to-bullish.
Positioning remains market supportive as short positions in US bond futures according to CFTC data increased even though they remain far from extreme. More importantly, the curve exposure rose ever higher amid larger longs in the 2y/5y segment and more pronounced shorts in the 10y/30y area. The current curve exposure (I used a pvbp-weighted measure, for further details refer to Beware of the Steepener dated November 16) is close to the all-time record and was only surpassed in between end September and end October last year (see chart below).

Curve exposure increased even further: warning signal for steepeners

Source: CFTC, Research Ahead

The combination of expensive short-end valuations coupled with an extreme curve positioning raises a serious warning flag for steepeners. I have already last week suggested that flatteners hold a more attractive risk-reward than steepening positions. And despite the position drive into the short end, the US curve failed to steepen over the past days and has remained range-bound. In the Eurozone, however, 2-10s on the Bund curve flattend by roughly 20bp since mid-November with all curve segments (i.e. 2-5s, 5-10s, 10-30s) showing a flattening tendency. So far, I do not think that this flattening movement is about to end and continue to expect flatteners to perform in the weeks ahead, in the Eurozone as well as in the US. This should largely be driven by long-end yields falling whereas short-end yields should remain range-bound (Eurozone) or even increase moderately (US).

The view that there is a disconnect between large firms with a direct access to financial markets on the one side and medium-sized/smaller firms as well as households which mostly rely on banks for external capital on the other is gaining more followers. I have frequently written about this subject (see for example Small is beautiful dated Nov 3). The fundamental environment for small businessess, especially in the US, has changed dramatically. They rely heavily on bank credit and are more dependent on the domestic economy than the larger firms. Furthermore, in past recessions they did not lay off a significant amount of people whereas they were responsible for a high share of job growth during growth periods. Now, however, the combination of a heavy reliance on bank capital as well as on the domestic economy means that their access to external capital has become very difficult. Banks either cant lend (as they are poorly capitalised) or wont lend (amid the higher credit risk for domestically focused operations). For me, this is one of the top challenges facing various economies. First, smaller businesses are usually more innovative and flexible than their larger counterparts and therefore a more difficult environment for small businesses should be putting downward pressure on trend growth. Additionally, as the small business sector gets smaller, the large businesses get relatively larger, leading to an increased concentration in many industries, hurting competition and increasing rent-seeking behaviour by those large corporates.
This week, Nouriel Roubini has been making a similar point in 'A Tale of Two American Economies'. To quote: "The story of the U.S. is, indeed, one of two economies. There is a smaller one that is slowly recovering and a larger one that is still in a deep and persistent downturn...Prime borrowers with good credit scores and investment-grade firms are not experiencing a credit crunch at this point, as the former have access to mortgages and consumer credit while the latter have access to bond and equity markets. But non-prime borrowers – about one-third of U.S. households – do not have much access to mortgages and credit cards. They live from paycheque to paycheque – often a shrinking paycheque, owing to the decline in hourly wages and hours worked. And the credit crunch for non-investment-grade firms and smaller firms, which rely mostly on access to bank loans rather than capital markets, is still severe. Or consider bankruptcies and defaults by households and firms. Larger firms – even those with large debt problems – can refinance their excessive liabilities in or out of court, but an unprecedented number of small businesses are going bankrupt...Consider also what is happening to private consumption and retail sales. Recent monthly figures suggest a rise in retail sales. But, because the official statistics capture mostly sales by larger retailers and exclude the fall by hundreds of thousands of smaller stores and businesses that have failed, consumption looks better than it really is."
A lot of small businesses also rely on small banks for loan financing, however, these small and regional banks themselves remain in a more challenging environment than the larger banks as the growing number of failing banks suggests. Furthermore, also the large banks do not lend to small businesses. To quote this article 'Small business loans: $10billion evaporates':"The 22 banks that got the most help from the Treasury's bailout programs cut their small business loan balances by a collective $10.5 billion over the past six months, according to a government report released Monday. Three of the 22 banks make no small business loans at all. Of the remaining 19 banks, 15 have reduced their small business loan balance since April, when the Treasury department began requiring the biggest banks receiving Troubled Asset Relief Program (TARP) funding to report monthly on their small business lending. Over the six months that the reporting requirement has been in effect, the banks have cut their collective small business lending by 4%. Their cumulative balance stood at $258.7 billion as of Sept. 30, according to a Treasury Department report. The bank with the biggest lending drop was Wells Fargo, which cut its loan balances by $3 billion. However, Wells Fargo also remains by far the biggest small business lender, with $73.8 billion lent out to small companies. No other bank comes close to that tally. Some banks are unapologetic about their cutbacks. Small business defaults are soaring, and banks are under pressure to shore up their balance sheets and reduce their exposure to risky loans. Two key small business lenders, CIT Group and Advanta, filed for bankruptcy this month."

Lending freefall

Source: Treasury Department via CNNMoney.com

To me this is further confirmation that indeed there is a disconnect between the state of large (quoted) firms which are gaining market share on the one side and smaller firms/households which continue to face a recessionary environment. Growth is not yet self-sustaining and any economic dynamic remains dependent on the support provided by fiscal and monetary authorities. I still do not see how trend growth over the next decade can match the levels of the past decade.

Greek fire

Greek fire: An incendiary weapon used by the Byzantine Empire. The key to its effectiveness was its ability to continue burning under any circumstances, even on the surface of water, making it a "wet, dark, sticky fire,".

Yesterday, the Bank of Greece published the following announcement: "The Bank of Greece has recommended to a number of Greek banks that they show restraint with regard to their participation in the twelve month Eurosystem liquidity providing operation in December, in order to facilitate their exit from the extraordinary and temporary measures of the Eurosystem when these measures are withdrawn." Besides confirming my cautious view with respect to the Eurozone periphery, it serves as a timely reminder that you can not extinguish every fire (in this case an undercapitalised banking system in a structurally challenged economy) purely with the help of water (or as the Greek banks have tried with the help of ECB-provided liquidity). Given the extent to which banks are relying on the central bank liquidity provision measures and because the inevitable adjustments in the economy and in the banking sector via recapitalisation as well as via changes to the business models have not taken place yet, it is no wonder that central banks worry about the feasibility of their exit strategies.

The announcement caused a stir in the Greek equity and bond markets where the ASE lost 3% yesterday (vs. a gain of 1.5% for the ESTOXX) and where 10y Greek government bonds underperformed a bit more than 20bp since last Thursday vs. German Bunds. Yields on 10y Greek bonds have now moved back again above the level offered by 10y Irish government bonds. Furthermore, the uptick in Greek-Bund spreads has also been mirrored by a small uptick in spreads over Bunds for Eurozone issuers (see chart below).

Greek bonds reclaim the top spot for Eurozone government bond spreads over Bunds

Source: Bloomberg, Research Ahead

I have frequently written about the challenges facing the Eurozone peripherals and my view of a multi-year underperformance in economic terms vs. countries such as Germany and France (see for example No easy way out for Eurozone peripherals dated Oct 30) where I also reiterated my underweight stance for Greece, Ireland, Portugal and Spain vs. an overweight in Italy, Austria and Belgium to generate yield pick-up and a neutral allocation for Germany and France.
The announcement by the Bank of Greece confirms my fundamental assessment as well as my market view. The strucutral challenges facing the Eurozone peripherals will dent their economic performance for years to come.
However, it also highlights a deeper problematic with respect to the rising dependency on easy money and the resulting threats posed by the potential ECB exit. The liquidity provided by the ECB has helped banks to survive the freezing up in the credit markets following the Lehman bust. However, it has also delayed a necessary recapitalisation and inevitable adjustments to their business models. This is not purely a Greek problem but applies in general to a lot of Eurozone banks. Clearly, the ECB wants to prepare the grounds for a tightening in liquidity conditions. However, a too early/too quick removal of the added liquidity will put especially the weaker institutions into the danger of a renewed liquidity shortage. It can be assumed that especially those institutions with a weak balance sheet rely most on the ECB's liquidity provision. However, it will be exactly those institutions that will face the most challenging environment if they have to rely again on a market that differentiates/discriminates between counterparties and other banks/investors will either not be willing to lend or only at rather punitive rates.
In turn, one should not expect that the ECB will be able to exit their unconventional measures at a fast pace. This can only take place in a gradual process. On the downside though, if they cant take away the liquidity as quickly as inflation pressures would demand, they will also revert to rate hikes again before they have progressed significantly on the liquidity absorbing front. Still, given my view on the outlook for growth and inflation, I do not expect that this will take place anytime soon.

Rates Strategy: Beware of the steepener

In outright terms, 10y Bund and 10y UST futures have both gained half a point since the start of last week. While this performance confirms my view from last week to stick with tactical longs (alongside the strategic long duration view), price developments have remained muted and 10y yields remain stuck in their tight ranges. Relative to equities and commodities, 10y Bund yields have moved back to fair level after having traded almost 25bp expensive at the start of the month (corresponding to 2 standard deviations) as the chart below shows.

10y Bund yields are back to fair levels vs. equities and commodities

Source: Bloomberg, Research Ahead

Furthermore, positioning as measured with the help of non-speculative net positions in the US bond futures remain tilted on the short side, but not extremely so. Therefore, technicals, cross-market factors as well as positioning does not send strong signals for either direction. However, I stick with my tactical bullish view because a) I do not see a sell-signal from any of these factors and b) I maintain the view that fundamental developments are likely not as positive as the consensus would like to have them. I have frequently laid down my view that the major economies lack a self-sustainable dynamic and the summer months have profited from massive fiscal stimulus and the technical help of seasonal adjustments. However, with respect to the latter, autumn should see a partial payback as the usual seasonal acceleration should be less-pronounced, resulting in - on average - weaker than expected seasonally adjusted data. Looking at the Citigroup economic surprise indicators for the US, the Eurozone and the UK seems to confirm that picture as economic surprises have been in a declining trend as of late.

Economic data tends to surprise on the downside as of late

Source: Citigroup, Research Ahead

While in outright terms, not much happened, the yield curve seems to have become a hot topic with a steepening view becoming consensus. Key reasons for an ongoing yield curve steepening can be found in the expectations that short-term rates will be kept low for a prolonged period whereas medium-term inflation pressures would be growing while the shockingly high fiscal deficits raise the riskiness of government bonds, put pressure on the sovereign ratings and increase the probability of a flight out of this asset class. In turn, risk premia for longer dated bonds are expected to rise. Here, Japan stands in the spotlight where amid the sovereign debt approaching 200% coupled with a low savings ratio, credit-default swap rates have doubled to 75bp over the past two months (just to fall back to 65bp on Friday).
However, I am not convinced on fundamental grounds and in terms of positioning think that it has become a crowded trade. First, I frequently argued that the monetary policy transmission mechanism is not yet working properly. While narrow money aggregates have been rising sharply given the lengthening of the central banks' balance sheets, broad credit aggregates are not as banks remain unwilling to lend and especially households unwilling to borrow. Furthermore, spare capacity remains at very high levels. In turn, it will take a long time before we will move in state where there will be too much money chasing too few goods which would result in inflation. Finally, I remain convinced that much of the additional liquidity which central banks have created over the past two years can and will be absorbed relatively easily if the fundamental situation warrants it. With respect to the ever-increasing supply of government bonds, I also see that the deficit numbers are nowhere near sustainable. However, we should not forget that also demand is increasing amid a rising savings ratio and because banks - which do not lend - use the steep yield curve to recapitalise themselves over time as they finance at close to zero rates and invest into higher-yielding longer maturity bonds. The ongoing rise in the level of excess reserves in the US banking system is an indication that this is indeed taking place.
Still, I remain seriously worried with respect to the medium term prospects of the UK. The reasons are the extent of the structural imbalances, the size of the budget deficit as well as my belief that while the investor community can not do without the USD, they can avoid the GBP. The BoE has effectively monetized a third of public spending via its quantitative easing program. Besides the deficit itself, also this sort of financing is clearly not sustainable and only delays the inevitable adjustments. Interestingly, this Asia Times article Which big country will default first? holds a similar view.
Therefore, fundamentally I agree with the steepening view in the UK (and to a lesser extent in Japan) but not in the US and the Eurozone. Moreover, judging from market positioning, non-commercial accounts seem to be heavily involved in steepeners. The chart below shows the risk-weighted net curve positions by non-commercial accounts in US futures. I have added the risk-weighted net positions for the 2y and 5y futures and also the net positions for the 10y and 30y futures. Then, I deducted the net-outright positions and used the difference between the two groups as an indicator of the curve exposure. Currently, in risk-weighted terms the net-positions in the 2y and 5y futures are USD +11.5mln per basispoint and USD -18.8mln per basispoint in 10y and 30y futures. Therefore, in outright terms, the market is short USD 7.4mln per basispoint. Furthermore, we can also say the market has a net steepening position of USD 11.4mln per basispoint (this steepener together with the outright short equals the net position in 10y and 30y futures). The chart below shows the development of the so calculated curve position. As can be seen, steepeners seem to be widely held again and not that far away from the record exposure in late 2008. Given that it seems to be such a crowded trade, I think this warrants caution and I would refrain from steepening exposure in the US and also the Eurozone. Rather, I see a better risk-reward in curve flatteners.

US curve steepening exposure is significant

Source: CFTC, Research Ahead

Forget Japan's "bridges to nowhere", here comes China's "city for no one"

I am not an expert on China, but I found this video below really fascinating (via Prieur du Plessis' Investment Postcards):
China’s economy is continuing to grow despite the global recession, helped by a massive government stimulus package of $585 billion. But doubts remain whether such strong growth can be sustained by public spending alone. Al Jazeera’s Melissa Chan reports from Inner Mongolia, where a whole town built with government money is standing empty.

Random Thoughts November 13

Some comments on US small businesses and on inflation expectations.

a) I have written previously about the difficulties for small businesses (see for example Small is beautiful dated November 3) amid the lack of external financing and how this would likely be a key reason for a lower flexibility/innovation power in the economy and with that reduce trend growth. Macroblog in its latest post (Small businesses, small banks, big problems?) makes the connection between losses on commercial real estate and the financing environment for small firms in the US (also referring to a speech by Atlanta Fed president Lockhart earlier this week):
"What are the connections between CRE and small business? An obvious direct link running from small businesses to CRE is that small businesses are an important source of demand for many types of commercial space. A link from CRE to small businesses is that CRE problems in banks could potentially affect credit availability for small businesses....The dependence of small businesses on banks is particularly problematic if the banks facing the most severe CRE problems also are a significant source of loans to small businesses. It turns out that much of the CRE exposure is concentrated among the set of 6,880 or so smaller banking institutions (banks with total assets under $10 billion). Based on the June 2009 Bank Call Report data, these banks represented 20 percent of total commercial bank assets in the United States but hold almost half of the CRE loans.
It seems reasonable to assume that the banks with high exposure to CRE (say, those with CRE exposure as measured by a CRE loan book that is more than three times their tier one capital) are likely to take a conservative approach toward additional loan growth. The bad news is that the banks with the highest CRE exposure also account for about 40 percent of all commercial loans under $1 million–the types of loans most likely used by small businesses."
This suggests that the difficult financing environment for small firms will likely persist for a prolonged time. In turn, one should not expect that small businesses overall will have the means to significantly increase investment as well as hiring. Remember, in the recession at the start of this decade, US small businesses were responsible for only 9% of all job losses but for a third of job growth in between 2003 and 2007. In between the end of 2007 and 2008, however, small businesses accounted for 45% of all job losses!
I am convinced that the macro-economic challenge this issue poses remains underestimated by the public as well as by the investment community given that layoffs by small businesses usually do not get media coverage and given that small businesses are not quoted on the stock exchange.

b) A quick comment on inflation expectations: Much has been written about the rising inflation expectations, especially in the US. Yes, the break-even inflation rate implied by US TIIs has risen significantly and reached a new high for the year (see chart below).

10y US break-evens have reached a new high for the year

Source: Bloomberg, Research Ahead

Still, I am not overly worried about this development. First, as the chart also shows, 10y EUR break-evens have not moved out of this year's trading range. Therefore, it is mostly a US phenomenon than a global one and should also be seen in context with the weaker USD which lost 10% over the past six months.

Trade-weighted USD and break-evens have been closely correlated during the financial crisis

Source: Bloomberg, Research Ahead

Furthermore, I have frequently suggested that inflation-linked swaps give a better picture of inflation expectations amid the substantial and very volatile liquidity premia incorporated into nominal US Treasuries. The chart below shows the development of the 10y break-even rate implied in TIIs and 10y inflation swap rates. Additionally, it shows also the difference between these two time series which I consider as a proxy for the liquidity premia inherent in nominal US Treasuries. As can be seen, this liquidity premia has dropped as of late (amid TII break-evens rising more than inflation swap rates) and has moved back to pre-crisis levels.

Liquidity premia inherent in US Treasuries back towards pre-crisis levels

Source: Bloomberg, Research Ahead

While 10y TII implied break-even inflation rates have increased by 45bp since early October, 10y inflation swap rates have risen by 33bp. More importantly, at currently 2.63% they remain well within the established 2.30-2.80% range of the past six months. In turn, I do not yet regard this as a very significant market development.

There is more to celebrate for Germany

Yesterday, Germany celebrated the anniversary of the fall of the Berlin wall. But also in economic terms, there are several developments to celebrate. I wrote previously about the medium-term trends which seem supportive for the German economy following a decade-long underperformance (see A German history lesson dated Oct 27). Clearly though in a country where "da gibt es nichts zu meckern" (there is nothing to moan about) is the most positive statement you can reasonably expect, providing a non-negative view is not really welcomed.
Nevertheless, I see myself confirmed by the latest data and developments which lend further weight to my view.

Just yesterday the German cabinet backed additional tax cuts which will take effect in 2010 to the tune of EUR 6bn (these cuts still need the approval of the Upper House). The cuts focus on more supportive child benefits, changes in the inheritance tax as well as on changes to the corporate tax code and come on top of a previously agreed income tax cut worth approx. EUR 10bn amid an improved deductibility of health and insurance payments. In combination, these measures therefore provide an additional fiscal stimulus to the magnitute of a bit less than 1% of GDP. Clearly this is not huge but a) they come on top of the significant stimulus measures which started to take effect earlier this year and b) they come against the announced fiscal tightening in a host of other Eurozone countries and c) highlight that there still remains fiscal flexibility in Germany. Moreover, they take place in an environment where the economy has outperformed expectations over the past months and moved back into positive growth territory in Q2 this year. Remember that Q2 growth came in at 0.3% qoq not annualised vs. expectations for -0.2%. Eurozone GDP, however, continued to fall with a qoq rate of -0.1%. Data for German Q3 growth will be released this Friday and expectations are for a rise of 0.8%, i.e. above 3% annualised! Furthermore, given the stronger-than-expected growth in German exports in September as released yesterday, Bloomberg reported that Germany's export-driven recovery would be undermining ECB president Trichet's efforts to slow the currency's record rise (and the calls by Spain, France and Portugal to weaken the euro). Germany's exporters - while being more competitive - are competing relatively more via quality than via price and should therefore be less sensitive to changes in the exchange rate than their co-Euro counterparts. In turn, the rise in the trade-weighted euro of 3% over the past 3 months (doesn't seem that large to me) does not constitue a significant headwind for the German economy.
Additionally, with respect to the monetary environment, besides facing the lowest nominal yields of any Eurozone member states, the disapperance in the inflation gap (i.e. German inflation is not below Eurozone inflation anymore) means that real yields in Germany have come down more than elsewhere.

Overall, it slowly emerges that Germany faces a much more accommodative environment than other Eurozone members. This is just the opposite of what happened at the start of this decade and highlights the improved structural position of the German economy. In this environment, I reiterate that I see a more favorable risk-reward for German corporate bonds than for peripheral government bonds.

Rates Strategy: Sticking to longs

Last week I upgraded my tactical bond market outlook back to bullish. Since then the 10y Bund future has dropped by roughly one point and the US TNote future has lost some 6/32nd. Therefore, the move back to bullish seems ill-timed. However, I maintain my view.
Technically, 10y Bund yields look trapped in a range of roughly 3.20-3.40%, a range where they spent most of the past months with only short-lived deviations on both sides. 10y US Treasury yields are still trading within a slowly falling donwnward trend channel (see chart). Arguably, Bunds look a bit more bearish than USTs but still do not give a clear sell signal from the technical side.

10y US Treasury yields remain in downward trend channel

Source: Bloomberg

Positioning-wise, not much seems to have changed if judged by the CFTC data for US bond futures. Non-commercial accounts remain positioned on the short side with significant shorts at the long-end of the curve. However, given partially offsetting longs in 2y and 5y futures, overall net shorts are considerable but still only roughly half of what they were at the end of May, i.e. just before yields hit their highs.
Cross-market wise I frequently use the chart below to compare 10y govie yields with the development of equities and commodities. The combination of equity and commodity performance should give a good indication about the changing outlook for real growth as well as inflation and therefore for nominal growth. Given that it is nominal growth which should be the key driver for nominal bond yields, government bonds should exhibit a close correlation to the combined equities and commodities performance.

Government bond yields vs. equities and commodities

Source: Bloomberg, Research Ahead

To quantify the cross-market impact, I regressed 10y Bund yields on the ESTOXX and the CRB index. With this regression I can calculate an implied value for 10y Bund yields. The chart below compares this implied value with the actual 10y Bund yield and also plots the difference (labelled Error Term) in basis points. Furthermore, it gives the 1.5 standard deviation bands for the error term (corresponding to roughly 20bp). Unfortunately what I missed at the start of last week is that government bond yields were looking expensive based on this simple model. In fact, the error term was at 24bp corresponding to 1.9 standard deviations. This means that 10y Bund yields were trading 24bp below the level implied by equities and commodities. In the meantime, however, this expensiveness has corrected significantly and moved down to 5bp at present. In turn, current 10y Bund yields were expensive at the start of last week (highlighting that my change in the tactical outlook was indeed ill-timed) but have since moved back to a level which is not deviating to a statistically significant extent from the implied cross-market level.

10y Bunds have moved back from overly expensive level

Source: Research Ahead

Fundamentally, I stick to my shorter-term view. That is, I think that seasonally adjusted data risks coming out rather on the weak side as the typical seasonal strength going into autumn should be rather less pronounced than usual. Friday's employment report confirmed this assessment. While the not-seasonally adjusted payrolls according to the establishment survey increased by 641k, the seasonally adjusted payrolls decreased by 190k, meaning that usually employment in October increases on average by 831k. However, according to the household survey, unadjusted employment increased by only 9k, resulting in a seasonally adjusted decrease of 590k. These numbers are weak. And remember that the establisment survey excludes self-employed as well as the job-losses by business deaths and instead uses a statistical method to account for net business births/deaths which added 86k in jobs during October. Given this method and given my belief that amid the lack of credit availability for small firms, the recession for small firms is far from over, the establishment survey should paint too rosy a picture of the employment situation.
Therefore, in light of all this, I maintain my tactical bullish outlook.

Random Thoughts November 5

a) Fitch downgrades Ireland: Yesterday Fitch downgraded the sovereign credit rating of Ireland by 2 notches to AA-. The downgrade reflect "the severity of the decline in nominal GDP and the exceptional rise in government liabilities" However, the agency also notes the vigour of the government's fiscal consolidation response to date and the expectation of further aggressive budget tightening which helped stabilise the outlook for Ireland's creditworthiness. Fitch expects a cumulative fall in the nominal GDP of 14% in between 2007 and 2010! The downgrade and the rationale fit perfectly with my view on the Eurozone peripherals laid down in detail on October 30 in No easy way out for Eurozone peripherals. It also shows that while for example France and Germany are contemplating further fiscal easing measures, Eurozone peripherals' ability to even maintain the current level of fiscal accommodation is severely constrained. Rather the need to tighten fiscal policy is growing sharply which will result in a prolonged recessionary environment, a higher output gap and with that lower inflation pressures and therefore higher realised real yields than in the core of the Eurozone. Again, it will take several years to rebalance the economies and restore competitiveness, not only for Ireland but also for countries such as Spain and Greece. I continue to suggest an underweight stance in these countries for any fixed income investments.
b) US employment report: Expectations for tomorrow's US October employment report are for a loss in nonfarm payrolls of 175k. What is more, the growth in average hourly earnings is forecasted to fall further to 2.2% from 2.5%. It is this combination of falling employment and falling wage growth (amid the rising unemployment rate) which will hold back consumption growth if fiscal support is not increased further. Wage income growth (i.e. essentially hours worked times hourly earnings) grew at a yearly rate of 4.9% at the end of 2007 but has since collapsed to -5.6% yoy according to the Q3 GDP report. Personal income (where wages constitute a bit more than half) itself has dropped by -2.8% yoy with the fall in the sum of wage income accounting for the largest part of this drop. With personal income continuing to fall, it will be difficult to see a significant growth in personal consumption, not even taking into account a likely rise in the savings ratio. As the chart below shows, personal consumption growth and personal income growth are closely related with both having grown by approx. 5.5% yoy in between the start of the 90s and the end of 2007. While employment growth is usually being seen as a lagging indicator, I think that as long as the sum of wages earned (i.e. hourly earnings times worked hours) continues to drop, the underlying dynamic in the US economy will almost excclusively be dependent on the accommodation provided by monetary and even more so fiscal policy. And as long as personal income continues to fall, we need ever increasing fiscal support just to maintain the level of consumption! Therefore, what I will be focusing on in tomorrow's employment report will be the development of nominal hourly earnings and the so-called index of aggregate weekly hours. This is not the same as the data on average weekly hours (which indicates how much an employee has worked on average) as it measures the total of hours worked in the private economy (i.e. it is dependent on the average workweek as well as on the number of people in employment).

The drop in personal income growth bodes ill for consumption growth

Source: Bloomberg