Tuesday, September 29, 2009

Don't expect the time for an ECB exit to come soon

I frequently highlighted that narrow money aggregates are rising but broad credit aggregates are not as banks are unable/unwilling to lend and borrowers unwilling to borrow. In turn, the velocity of money decelerates and we remain in a state where there are too many goods and not too much money. In turn, remaining price pressures are weakening and core inflation will continue to drop in the months and quarters ahead. Just last week I stated that the combination of falling M3-M2 and even more so M2-M1 coupled with a limited addittional balance sheet lengthening by the ECB vs. a "normal" course of action add further weight to the argument that even medium-term inflation pressures in the Eurozone appear very limited as the money being created by the central bank does not find its way into the broader economy (see Where are the inflationary pressures in the Eurozone's monetary developments).
Since then the ECB has released the data for monetary developments in August. M3 grew by a record low since the launch of the euro of only 2.5% yoy. However, I think that looking at M3 alone does not provide the whole picture. Rather, we should look at M1, M2-M1 and M3-M2 separately.
M1 rises but M2-M1 and M3-M2 continue to fall

Source: ECB, ResearchAhead

As the chart above shows, M1 (the sum of currency in circulation and overnight deposits) continues to rise at a fast pace. However, M2-M1 (deposits with an agreed maturity of up to two years and deposits redeemable at notice of up to three months) is falling further as is M3-M2 (repurchase agreements, money market fund shares/units and debt securities up to two years).

Yesterday, ECB president Trichet stated in the hearing at the Economic and Monetary Affairs Committee of the European Parliament (full speech here) that "The assessment of low inflationary pressures over the medium term is also confirmed by our monetary analysis. In this context, we note in particular that money and credit expansion continues to decelerate. The annual growth rate of the broad monetary aggregate M3 declined to 2.5% in August, the lowest reading since the launch of the euro. As regards lending to the private sector, the annual growth rate of loans virtually stalled in August (at 0.1%)."
Furthermore, with respect to the timing of any exit strategies he said: "The Governing Council of the ECB considers that it would be premature to declare the crisis over. Now is not the time to exit. However, at some point in time exit strategies will have to be implemented. The ECB has an exit strategy and stands ready to put it into action when the appropriate time comes. Our exit strategy is an integral part of our overall monetary policy strategy. This means, in particular, that if we judge that the non-standard measures trigger risks to price stability, we will unwind them."
And finally with respect to potential inflation pressures he goes on: "The second point I would like to emphasise concerns the relationship of liquidity and price stability. Some commentators ask whether our bold programme of liquidity provision could ultimately trigger inflation in the future. Let me explain why this fear is unfounded. To start with, it should be noted that although the liquidity provided by the ECB has increased substantially, this has not led to an increase in monetary aggregates. This would have been the case in normal times when banks use an increase in our liquidity provision to create credit to households and enterprises. However, at present this does not appear to be taking place on any significant scale. As I mentioned earlier, the growth in monetary aggregates – an overall important measure of liquidity expansion in the economy – is at its lowest level for at least a decade. Furthermore, it should be noted that the ECB has all the instruments required to promptly withdraw its liquidity support if necessary, to counter the possible emergence of upside risks to price stability. It helps in this context that most non-standard measures are being phased out naturally, as the operations stop at maturity, unless we decide to extend them."

I completely agree with president Trichet's statements. The rise in narrow money aggregates is not inflationary as it does not lead to a significant growth in broad money and credit aggregates. Once this will take place, the central bank will likely exit their exceptional liquidity support measures and thereby draining excess liquidity. Clearly, the timing of such an exit is key, but I still remain convinced that there is an equal risk between exiting too early and exiting too late. Furthermore, I am convinced that as long as M3-M2 and even more so M2-M1 is not growing on a sustained basis, any exit will be premature! At present, not only are M3-M2 and M2-M1 falling, but the drop is still accelerating! If we look at the annualised 3m percentage changes in the various aggregates, we can't even talk of a stabilisation in the drop of the aggregates. As the table below shows, the 3m annualised change in M2-M1 stayed at its record of -10.5% in August and reached a new record low of -22.4% for M3-M2!

3m annualised growth rates of monetary aggregates (seasonally adjusted)






Aug 08






Sep 08






Okt 08






Nov 08






Dez 08






Jan 09






Feb 09






Mrz 09






Apr 09






Mai 09






Jun 09






Jul 09






Aug 09






Source: ECB, ResearchAhead

Yes, the credit easing operations of the ECB are working in that they have led credit-related yields significantly lower again. This is a necessary condition for the monetary transmission mechanism to work again. However, it is not a sufficient one. As the development of M2-M1 and M3-M2 shows, monetary aggregates continue to shrink significantly. We also need renewed growth in these aggregates before the ECB should contemplate an exit from their exceptional monetary policy measures. I am convinced that we are still far away from the need to do so and do not regard an exit as likely before H2 2010!

Monday, September 28, 2009

Rates Strategy Update: here comes the bull-flattener

In Rates Strategy: decision time drawing closer published 10 days ago I argued that the range-trading behaviour in government bond markets would be drawing to an end and that I expect the break to be on the bond-bullish side with my tactic and strategic outlook remaining bullish. Furthermore, in 30y US bond yield sends encouraging signal dated September 11, I wrote: "Should they overcome this 4.10-4.20% area, then that would be a significant long-term bullish signal for the entire UST market!" On Friday, the US TBond yield has indeed closed below this area at 4.09%! In turn, I see my bond-bullish picture confirmed and reiterate my tactic as well as strategic stance as yields should drop amid a flatter curve.

30y US TBond yield finally broke through 4.10-4.20% support area
Source: Bloomberg

To repeat, I think the US 30y TBond holds the key for the entire US Government bond market as a) it is the least distorted maturity sector and b) given its maturity it incorporates the long-term expectations for growth, inflation and the related risk premia. It is the least distorted part of the US curve as Asian central banks are reported to be most active in the shorter US Treasury notes as well as in TBills, shunning the ultra-long segment. Furthermore, the buying programme of the US Federal Reserve has also not seen large volumes being purchased in the 10-30 year area with USD21bn in the 10-17y area and USD17bn in 17-30y. As of September 23, the Fed has purchased USD USD 289bn out of the planned USD300bn, so the programme is almost finished. Therefore, this should not have affected ultra-long yields significantly. Furthermore, given the long term nature of 30y US Bonds, its trading behaviour should provide insights about long-term prospects for the US economy and its institutions. Amid the high economic uncertainty, ongoing inflation fears, increasing supply pressures and waning credibility of US institutions and the USD as the major reserve currency one should expect that 30y US bonds should fare badly. However, as I have shown in my post on 30y US TBond yields cited above, this is not the case at all. The combination of being the least distorted part of the curve as well as providing information about the long-term expectations and risk premia is the reason why I regard the bullish technical signal being emitted by the US 30y Bonds as so important for the entire government bond universe.

In the Eurozone, 10y Bund futures have followed the 30y US lead and made a new high earlier this morning at 121.91, breaking above the double-top reached on September 2 (121.73) and September 11 (121.74), thereby as well providing a positive technical signal.
Bund future breaks through double-top formed in early September
Source: Tradesignalonline.com, ResearchAhead

In yield terms, I maintain my initial target of a 3% level for both, 10y UST and 10y Bund yields, which I first mentioned at the start of June. I expect these levels to be reached over the next weeks, i.e. on a tactical horizon. On a stratetgic horizon of 3-6m, we might see even lower yields ahead. My longer-term structural view remains for a prolonged period of ultra-low nominal yields in line with a prolonged period of low nominal growth rates amid very low inflation rates and only limited real growth on average.
Finally, this bullish momentum should be accompanied by flatter yield curves, i.e. it will be the long areas of the curve which drive the bond market and not the short-term parts. Usually, yield curves bull-steepen and bear-flatten. This is because short-end yields are more volatile than their longer-term counterparts given that in a normal environment central banks conduct monetary policy via changes in short-term rates and because short-term expectations are more volatile than long-term expectations incorporated into long maturity bonds. However, short-end rates cannot fall much further, leaving only limited performance potential for short-term bonds. Furthermore, central banks have been engaging in non-standard monetary policy action (i.e. QE and credit easing). The Japanese experience has shown that in such an environment of very low short-end yields, it becomes the long-end which is driving the yield curve as the volatility in short-end yields drops once they approach the 0% lower nominal bound. As the chart below suggests, the 1% level in 2y benchmark bonds seems to be where this fundamental shift in the behaviour of the yield curve takes place.
Japan: fundamental shift in the yield curve behaviour around 1% in 2y yields
Source: Bloomberg, Research Ahead

In turn, with 2y UST yields trading slightly below 1% and 2y Schatz yields at 1.20%, we should be looking for the yield-curve to bull-flatten in the weeks ahead. Therefore, I recommend long-term bonds (i.e. 10-30y) not only from a duration point of view but also in curve flattening positions relative to the 2-5y area.
Yield curves are likely bull-flattening from their extremely steep levels
Source: Bloomberg, ResearchAhead

Overall, the fundamental outlook for US and Eurozone government bonds remains supportive amid a prolonged period of low nominal growth with inflation pressures weakening further and the current real growth improvement unlikely to be self-sustaining. Technically, the US 30y TBond is sending a strongly bullish signal and also the Bund future is providing an optimistic picture. With a structural shift in the behaviour of the yield curve, we should look for a bull-flattening of the government bond yield curves in the weeks ahead. Stay long!

Friday, September 25, 2009

Strengthening headwinds for commodities

I frequently highlighted the connection between the BDI and commodities as well as between commodities and government bond yields (see for example: Commodities and related markets to fall first? dated August 26). Following a sideways trading pattern between mid August and mid September, the BDI has fallen by another 12% over the past 10 days. I still think that a great part of the surge in the BDI during H1 this year and the subsequent rally in commodity prices was down to stockpiling, most notably by China. When this stockpiling faded, the BDI collapsed and in turn commodity indexes moved into a sideways trading behaviour. The latest fall in the BDI suggests that further downward pressure in commodity markets is upcoming - in line with my fundamental view.
Latest fall in BDI as a precursor for the fate of the commodity prices?
Source: Bloomberg, Research Ahead

On an individual commodity price level there area also some interesting developments. For example, oil prices have broken through an upward trend following the release of US inventories earlier this week which have increased significantly. Technically, it is too early to tell whether oil prices are at the start of a new downward trend or whether the sideways trading pattern of the past months continues. However, fundamentally I continue to look for lower prices as the rise in inventories seems to confirm my view that indeed end-demand remains subdued while spare capacity remains relatively high.
Oil prices have broken through their upward trend
Source: Bloomberg

Moreover, also copper shows signs of exhaustion following the doubling in prices up to end August and has since retreated by 10%. This is fairly important as industrial metals are the sub-component of the commodity index which have shown the largest performance since the start of the year. The chart below shows the various sub-components indexed at 100 at the start of the year. Agriculture and Livestock have both not contributed much to the general commodity price performance this year and a break-down in energy and industrial metals prices could bring a significant correction in the overall commodity indexes.
Industrial metals and energy products have been a key driver of overall commodity performance

Source: Bloomberg, Research Ahead

As suggested several times, commodities and government bond yields show a high co-movement at present and a significantly different picture than the development of equity markets. This should not be that surprising given that lower commodity prices would go hand in hand with low headline inflation and therefore low nominal growth. Nominal growth, however, is the key driver for the longer term development of nominal government bond yields.
Ongoing co-movement of commodities and government bond yields
Source: Bloomberg, Research Ahead

Overall, fundamental headwinds for commodity prices remain substantial and the technical situation for energy products as well as industrial metals is weakening. I stick to my view from late August where I stated that timing wise we should see commodity markets to start falling which will spill over into commodity economies' equity markets and be followed by developed equity markets moving lower as well.
On the other side, the fundamental environment for government bonds remains supportive and I continue to expect a break lower in government bond yields over the next days/weeks.

Thursday, September 24, 2009

Where are the inflationary pressures in the Eurozone's monetary development?

Much has been written about the inflationary pressures the lengthening of the central bank's balance sheets would create. I have stated on various occasions (see for instance Is inflation just around the corner? Part II) that I do not see that this will ultimately be followed by inflation rates moving higher significantly on a sustainable basis (barring the ups and downs in headline inflation rates due to the high volatility of commodity prices, most notably oil). On a cyclical view the spare capacity is just too high to suggest that corporates have any meaningful level of pricing power (in the same way employees have only very limited capability to demand higher wages at present). But on a more medium term view, also the lengthening of the central banks' balance sheet does not need to be followed up by higher inflation rates. I previously stated that narrow money aggregates are rising but broad credit aggregates are not as banks are unable/unwilling to lend and borrowers unwilling to borrow. In turn, the velocity of money decelerates and essentially we remain in a state where there are too many goods and not too much money.

With respect to the ECB's balance sheet, my former colleague Christoph Rieger provided me with the following chart:
Source: ECB, Federal Reserve, BoE
It shows the development of the size of the balance sheet together with a trend for the ECB since mid 2007, i.e. long before the height of the financial crisis. Christoph suggests that the additional lengthening of the ECB's balance sheet following the bankruptcy of Lehman Brothers compared to a theoretical "normal" course of action - while still significant - is not as substantial as is generally believed with a key reason behind the growth of the ECB's balance sheet over the past years was the growth in currency in circulation as the chart below shows.
Currency in circulation has been growing strongly ever since 2002

Source: ECB

Furthermore, if we look at the development of the monetary aggregates M1 to M3 there are also some interesting features worth highlighting. As a reminder: M1 is the sum of currency in circulation and overnight deposits; M2 is the sum of M1, deposits with an agreed maturity of up to two years and deposits redeemable at notice of up to three months; and M3 is the sum of M2, repurchase agreements, money market fund shares/units and debt securities up to two years.

The first chart below shows the development of the annual rate of growth of M1 vs. the ECB repo rate (inverted). As one would expect, there is a strong co-movement between the two data series. In an environment where the ECB cuts rates, the growth rate of M1 increases - an accommodative monetary policy environment - and vice versa.
Lower repo rate = higher M1 growth rate
Source: ECB

The next chart shows the annual growth rate of M1 together with the annual growth rate in M3. Here the link is not as close but generally, when the growth rate in M1 increases, M3 growth tends to accelerate as well. However since late 2005 there is a big discrepancy. When the ECB started to rise rates in late 2005, M1 growth started to fall until it reached bottom in the summer of 2008 (just when the ECB hiked for the last time) and has been moving sharply higher since to 12.2% in July. On the other side, growth in M3 peaked in late 2007 and has been on a downward moving path ever since and reached a level of 3% in July this year.
Significant discrepancy between growth in M1 and M3

Source: ECB

Now, M1 is a part of M2 and M2 is a part of M3. Therefore, if M1 is increasing (because currency in circulation and onvernight deposits have been growing), then this boosts directly the level of M2 and M3. However, as the chart below shows, the remaining parts of M2 and of M3 have not been growing at all, rather they are shrinking!
Only M1 is growing, the exclusive parts of M2 and M3 are shrinking
Source: ECB

The exclusive part of M3 (i.e. the one which is included in M3 but not in M1 and in M2) fell by 7% yoy in July, just shy of the record -7.1% reached in March 1994. Even more dramatic is the fall in M2. M2-M1 has never fallen since the data is available (that is since 1981). After having continued to grow, in July this year for the first time ever annual growth in M2-M1 turned negative with a rate of -2.6%!
The combination of falling M3-M2 and even more so M2-M1 coupled with a limited addittional balance sheet lengthening by the ECB vs. a "normal" course of action add further weight to the argument that even medium-term inflation pressures in the Eurozone appear very limited as the money being created by the central bank does not find its way into the broader economy.

Tuesday, September 22, 2009

Rates Strategy: A look at the relative value of 10y Bunds

I have received several questions with respect to the movement in 10y UST-Bund spreads as well as of inflation expectations. In this post I try to shed some light on this. As a warning: this is a bit of a technical post and might only be suited to rates nerds (such as me).

Essentially since the middle of July US break-evens have traded in a range whereas Eurozone break-evens incorporated into benchmark bonds have moved continously higher. On the other side, US as well as Eurozone real yields have fallen.
US: 10y break-evens in the middle of the range, 10y real yields close to recent lows
Source: Bloomberg

Eurozone: 10y break-evens close to wides, reals close to lows
Source: Bloomberg

However, why Eurozone break-evens should outperform vs. their US counterparts seems a bit of a mistery given the appreciation of the trade-weighted euro of some 2.5% over the past two months vs. a depreciation of approx. 3% of the trade-weighted USD. Furthermore, why have real yields in the US and the Eurozone both fallen given that during this period growth expectations as well as equity markets have improved considerably?
In early July I suggested that 10y Bunds were expensive vs. 10y US Treasuries (see Rates Strategy: Digging below the surface). A key reason was that the liquidity premia incorporated into nominal Bunds was high relative to the premia incorporated into 10y US Treasuries. The chart below tries to show this. It shows the spread between 10y inflation swaps and 10y break-even inflation rates incorporated into US Treasury and Bund inflation linked bonds. Before the financial crisis this spread has been trading around the 40bp level in the US. However, during the height of the financial crisis this spread moved sharply higher as nominal US Treasury bonds were the safe haven and inflation linked bonds lost in relative value, depressing the implied break-even inflation rate by even more than the inflation outlook warranted. In turn, the spreads to inflation swaps shown below reached record historical levels early this year. Effectively, this meant that inflation priced into inflation swaps was far higher than the same inflation priced into similar maturity inflation linked bonds.
Difference between inflation priced into government bonds and inflation swaps as a liquidity premia
Source: Research Ahead

However, starting in March just as equities hit bottom, these spreads started to normalize again with a significant countermovement in May, before a renewed tightening trend set in. Since mid July, this spread tightened slightly, by approx. 5bp in the US. But in the Eurozone the spread tightened by a massive 25bp!
The tightening of this spread happens via an outperformance of inflation priced into government bonds relative to inflation priced into inflation swaps. As Eurozone inflation swaps did not move during this time period, break-even inflation rates priced into Eurozone linkers had to rise. Furthermore, with nominal bonds not moving much, real yields fell. Given this, I would assume that Eurozone inflation expectations did not move over the past two months and the rise in break-evens was due to a relatie cheapening of nominal bonds (amid a lower liquidity premia).
Source: Bloomberg

Additionally, this cheapening of nominal Bunds vs. linkers was also accompanied by an outperformance of 10y US Treasuries vs. Bunds as well as by a relative steepening of the Bund curve vs. the US curve as shown in the chart below.
5-10y Bund curve outsteepened UST curve
Source: Bloomberg, Research Ahead

My conclusion from all this is that Eurozone real yields and break-even inflation rates priced into inflation linked bonds are now more closely reflecting again inflation expectations as the (negative) liquidity premia has been reduced. Furthermore, I think that 10y Bunds look fair value again relative to their US counterparts from this perspective. This suggests that the relative underperformance of nominal Bunds on their own curve (i.e. the steepening seen in the 5-10y area of the curve) should soon stop and flattening positions have become more attractive again in the 5-10y area.

Monday, September 21, 2009

Spain and Estonia: More evidence of a vicious circle

In Germany exports its disease dated September 3, I argued that during the next decade the peripheral countries in the Eurozone are likely to suffer Germany's economic fate. While Germany earlier this decade was caught in a vicious circle (low inflation=high real yields=low growth=low inflation), the bust of the previous housing and consumption boom in countries such as Spain and Ireland is threatening to hold back economic growth for a protracted period of time. Inflation in Spain and Ireland for the first time since the existence of the Eurozone has dropped significantly below German inflation and therefore real yields in Spain and Ireland have risen above Germany's. This in turn, will hold back Spanish growth relative to Germany. However, it is not only the inflation/real yield linkage which renders low growth self-reinforcing in the currency union.
Additionally, low growth constitutes a strain on public coffers and in turn, the budgetary situation deteriorates. Even though the 3% deficit limit according to the Maastricht Treaty has in practice not been adhered to strictly, it still serves as a soft limit. In turn, the underperforming economies are forced to conduct a tighter/less easy fiscal policy than the outperforming economies, again strenghtening the economic vicious circle. This article in El Pais dated 11 September states that the Spanish prime minister Zapatero is planning to plug the rising budget deficit with new taxes, possibly an increase in VAT, and other consumption tax to help close the gap of the country’s fast expanding budget deficit. There are no details available yet but it is thought a VAT increase could raise approx. 1.5% of GDP. This alone would constitute a significant fiscal tightening, adding to the economic difficulties of Spain.
However, this vicious circle is not only apparent within the Eurozone, it is also happening in EU member countries who would like to join the Euro. This article in the Telegraph from today entitled Debt deflation laboratory of the Baltics suggests that the Baltics and especially Estonia are exhibiting the same dynamics (but on an even larger scale). To quote: "Estonia's euro peg is anything but free-market. It makes Tallinn dance, awkwardly, to Frankfurt's distant tune. It stoked the boom by enticing people to borrow cheap at eurozone rates: it is now prolonging the bust....Most governments would try to cushion the blow. Estonia is instead pushing through yet another austerity package to keep the budget deficit below the EMU ceiling of 3pc of GDP. Such is the totemic appeal of euro entry in 2011."
While the article makes the case for a devaluation vs. the Euro, this would be difficult to achieve and might not help the situation. it could threaten the euro entry and additionally it would hurt the private sector as foreign debt totals 116% of GDP. But given the low indebtedness of the state (the article states that national debt stands at 5% of GDP), a temporarily large budget deficit could indeed be part of the solution.
Still, what the case of Germany over the past decade and currently Spain and Estonia are showing is that in a currency union (or a de-facto currency union such as with Estonia) without a fiscal union, economic weakness carries self-perpetuating traits via low inflation/high real yields and via the pressures for fiscal tightening amid rising budget deficits. This is not new but what it means is that it will take a very long time to cure the economic imbalances and with that puts more pressure on the government to conduct structural reforms to improve the economic situation. A return to sustainable above-trend growth rates for any of the affected countries should not be expected over the next several years!

Friday, September 18, 2009

Rates Strategy Update: Decision time draws closer

Since I wrote Rates Strategy: Indecision on Monday 7 September, government bond markets have not done much. The 10y Bund future has been trading around the 121 level with a slight downward bias and the 10y TNote future around the 117 level with a slight upward bias. Technically, nothing changed: So far the 10y UST yield has failed to trade below the 3.304% July yield low on a closing basis while 10y Bund yields still remain in their upward trend which started in January and is currently running at 3.24%. On the other side, 10y Treasury and Bund futures prices remain guided by an upward trend. The combination of a rising 10y Bund yield trend and a rising Bund future price trend, suggests that decision time from this technical perspective is inevitably drawing closer.
From a correlation perspective, 10y yields remain guided by the development of commodities. While gold has been continuing to move higher, the broad commodity indexes remain in their sideways trading behaviour. This suggests that inflationary pressures remain low and explains the ongoing divergence between commodities and government bond yields on the one side (sideways to lower) and equity markets on the other (higher amid the ongoing improvement in the outlook for real growth):
Source: Bloomberg, Research Ahead

I continue to think that while from a cross-market perspective, commodities hold the key for the development of government bond yields, within the government bond universe, 30y UST yields should guide trading. As I wrote in Rates Strategy: 30y US Bond yields send encouraging signal, the US long bond is fighting with a vital 4.10-4.20% area, an area which served as a support several times during the current decade. Theoretically, the long maturity of this bond should render it the most affected by rising risk premia as well as a potential fading of the inflation fighting crediblity of the US Fed and a USD which is seen as a one-way street to eternal weakness. However, so far none of these fears seem to be mirrored by the price action in the 30y. Furthermore, the 30y area remains the least distorted by the buying behaviour of Asian central banks which seem to concentrate on the shorter end of the UST curve. However, also the Fed's own Treasury purchase programme seems to concentrate on other areas. The chart below shows the maturity distribution of the Fed's buying activity up to September 9:
Source: Atlanta Federal Reserve

To quote the Atlanta Fed: "The Fed has purchased a total of $281.3 billion of Treasury securities through September 9. Of the $276.8 billion in non-TIPS securities, the Fed has focused on the four-to-seven-year and seven-to-10-year sectors the most, purchasing approximately $65 billion and $71 billion, respectively. The two-to-three-year and three-to-four-year sectors have also received a fair amount of attention, especially following two large purchases in each sector in late August. The Fed purchased $6.1 billion in the two-to-three-year sector on August 24, $2.3 billion on August 26 in the 17-30 year sector, and $5.6 billion on September 1 in the three-to-four-year sector."
So, up to Sep 9, the Fed has only purchased USD17.3bn in the 17-30y sector. Furthermore, there were only USD 18.7bn left in the overall buying programme. These numbers suggest also that the Fed's UST purchase programme should not be the key reason for the encouraging showing of the 30y US T-Bond and supports my notion that it should be the least distorted instrument across the entire US Treasury curve.

In light of all this, I maintain by bullish tactical outlook for government bonds in line with my strategic view amid a subdued medium-term growth outlook and in line with my expectations of ongoing disinflation in the core CPI rates given a lack of inflation pressures on a short as well as medium term horizon.. I think that 30y US T-Bonds are key and think that the 4.10-4.20% support area should be broken to the downside soon, brightening the outlook for the government bond universe in turn.

Tuesday, September 15, 2009

UK: New data, same problem

I remain convinced that most developed markets' economies exhibit much less inflation pressures than is generally believed. Core inflation rates will fall further and nominal growth rates will remain muted for a prolonged period of time. However, I am seriously worried about the developments in the UK. I previously argued that I see the most pronounced risk of an inflationary outcome for the UK (see for example: Revisiting the UK: Not much good news dated August 18) and highlighted the disappointing development of UK inflation relative to the US and the Eurozone. Today, the August CPI data were published. Unfortunately, they did nothing to change my downbeat assessment as inflation once again overshot consensus and core inflation failed to moderate.
True, yoy inflation fell further, to 1.6% from 1.8% in July. However, this was once again above consensus expectations (which were looking for a 1.4% reading). Furthermore, compared to the US and the Eurozone, the UK's inflation moderation during the current year remains much more muted (last US and Eurozone numbers are for July):
Source: Bloomberg, Research Ahead

Moreover, as mentioned above, inflation has continued to overshoot expectations. As the chart below shows, this is unfortunately the rule rather than the exception. The chart adds the difference between actual inflation (mom value) minus the forecasted value (Bloomberg consensus). While during 2007, US inflation tended to overshoot vs. expectations, since mid 2008 this has been the reverse. In the Eurozone (I have used German inflation as it is been released relatively early), inflation tended to be more or less in line with expectations. In the UK, however, since early 2008, the consensus has consistently underestimated inflation (be it on the way up during early 2008 as well as on the way down over the past months). This was evident again today where actual mom CPI came in at 0.4% vs. expectations of 0.3%:
Source: Bloomberg, Research Ahead

Finally, core CPI in the US and the Eurozone has been falling (albeit slowly) on a trend basis since late 2008. However, UK core CPI has been increasing over the course of this year! This trend has been confirmed today with yoy core CPI remaining unchanged at 1.8% vs. expectations for a fall to 1.6%.
Source: Bloomberg, Research Ahead

Therefore, I can only repeat my conclusion reached in mid-August:
"I remain seriously worried about an inflationary outcome in the UK (in contrast to the US and the Eurozone) and suggest to underweight the UK from an asset allocation perspective. UK Gilts risk underperforming significantly vs. the US and Eurozone counterparts over the medium term and yields are likely to rise over the next quarters."

Monday, September 14, 2009

Market Update: Beware of the inflationistas

I highlighted several times the discrepancy between commodities and bond yields on the one side (sideways to lower) and equities on the other (up). As written in Commodities and related markets to fall first? I expect more downside in commodity prices in general amid a lack of end-demand which will subsequently spill-over into equities whereas government bonds should remain well supported. However, given that gold has traded higher recently and amid a falling USD, several market commentators have suggested that inflation pressures are resurfacing. This would clearly have vast implications from an asset-allocation perspective and run completely against my proposed stance.
However, I disagree with this inflationary view. I have frequently made the fundamental case for ongoing disinflation (amid a very high level of unused capacity and low credit creation). Furthermore, I also think that it would provide an inconsistent picture about what is currently happening in global markets. If inflation fears were indeed rising, then why are commodities in general not rising and why are government bond yields falling (with US yields at the short and long end outperforming their international counterparts)? Rather, I think, markets are not sending any signal about rising inflation fears:
First, last week I suggested that the price action in Gold might well be down to Barrick Gold buying back their gold hedges (which increases demand for gold now but also increases future net-supply). This would explain the surge in gold prices but would not send any inflationary signals.
Second, if inflation fears would be rising, it would be the ultra-long bonds which should send the least bullish/most bearish signal from the government bond market. On Friday, I suggested that 30y UST yields were sending an encouraging signal for the entire US Treasury market as they trade in a downward trend and try to overcome a strong support area in between 4.10-4.20%. Furthermore, and in contrast to its 10y counterpart, it has already traded through its former July yield-low and sends a bullish technical signal. So again, no inflation signal from this part of the market.
Third, the fall in the trade-weighted USD might well be down to USD Libor rates for the first time falling below their Japanese counterparts and rendering the USD the new funding currency of choice for carry trades, or at least reducing its appeal as an investment target. Both, make it more difficult to finance the current account deficit. However, as the experience of the Swiss and the Japanese economies have shown, a carry trade currency does not need to be mirrored by rising inflation rates. Therefore, the weakening USD - rather than signalling rising inflation expectations which would go hand-in-hand with rising yields - might well be down to USD rates dropping more than elesewhere amid low inflation pressures.
USDJPY: pressured downwards by falling USD yield advantage
Source: Bloomberg, Research Ahead

Fourth, within the commodities space it is so far mostly gold (and silver) which move higher, whereas the broader commodity complex continues to trade in a sideways to lower fashion. Frequently, gold shows a different behaviour than most of the other commodities. The chart below compares gold with the CRB index and shows that expecially during the past 12 months, there has been a significant discrepancy.
Gold and the CRB-index: not much co-movement
Source: Bloomberg, Research Ahead

On the other side, oil is much closer correlated with the CRB-Index (yes, energy has a larger weight in the index than gold but it is also true for other commodity indeces):
Source: Bloomberg, Research Ahead
Energy (as well as several base metals and agricultural commodities) are continuing to trade in a sideways to lower fashion and are not sending any inflationary signal which would confirm the rise in gold prices.

Overall, I would warn of any inflationary explanation of the recent rise in gold prices and the fall in the USD as it is inconsistent with current market behaviour. Rather, I think that gold is rising due to a special factor (the buying back of former gold-hedges) and the USD is falling amid reduced yield pick-up (given a DROP in US yields on an absolute basis and relative to their international counterparts). Overall, the fundamental picture calls for ongoing disinflation amid exceptionally high unused capacity and limited credit creation and market developments do not stand in this way. I still maintain my view that inflation pressures are very low and commodities should suffer further in the weeks and months ahead, ultimatley being followed by equity markets trading significantly lower again whereas government bonds remain supported.

Friday, September 11, 2009

30y US Bond yield sends encouraging signal for government bonds

Yesterday's 30y TBond auction according to Reuters had the 2nd highest bid-to-cover since 30Y were brought back in 2006. Even more than this surprisingly positive demand, I think that the trading behaviour of 30y UST yields merits a closer look. Given talks that Asian central banks which continue to buy Treasuries do so largely at the short end, it should be the least distorted part of the curve. Furthermore, given its long-term nature, its trading behaviour should provide insights about long-term prospects for the US economy and its institutions. Amid the high economic uncertainty, ongoing inflation fears, increasing supply pressures and waning credibility of US institutions and the USD as the major reserve currency once should expect that 30y US bonds should fare badly. However, as I will show below, I cannot find ANY evidence that this is indeed the case. Rather to the contrary, 30y US Treasury yields are at an important support level and if breaking through that would be a very significant medium-term bullish sign for US government bonds. On the other side, it would need a move above 4.70% to send a bearish sign for government bonds.

In order to come to such a conclusion we need a bit of background and history: Usually, yield curves bull-steepen and bear-flatten. This is because short-end yields are more volatile than their longer-term counterparts (as during normal times central banks conduct monetary policy via changes in the level of short-end yields and because long-run expectations are more stable than short-term expectations). However, over the longer-term this relationship is anything but stable. As the first chart below shows, the relationship between the steepness of the US yield curve (I use 3y and 10y constant-maturity Treasury yields due to data availability) and the level of short-end yields has shown significant changes over time.
During the inflationary period between thee late 60s up to the start of the 80s, the yield level shifted higher across the curve/the yield curve steepened structurally (i.e. for every given level of short-end yields, the yield curve was steeper than it would have been otherwise).
The Great Inflation: yield level shifts higher across the curve, breaking the cyclical relationship
Source: St.Louis Federal Reserve, Research Ahead

The reason for this has to be seen in the fundamental economic environment. As the next chart shows, during the same time period the so-called Phillips cure exhibited significant structural shifts towards higher unemployment and rising inflation. Theory as well as empirical research suggests that these structural shifts in the Phillips curve are down to rising longer-term inflation expectations.
Worsening inflation-unemployment trade-off amid rising long-run inflation expectations
Source: Bloomberg, Research Ahead

During the disinflationary 80s and 90s, both trends reversed. The inflation-unemployment trade-off improved as the US Fed moved to an implicit inflation targeting regime which brought long-run inflation expectations lower.
The disinflationary 80s and 90s improved the inflation-unemployment trade-off
Source: Bloomberg, Research Ahead

Once again the strucutral shifts in the Phillips curve were mirrored by the behaviour of the bond markets. Yields moved towards structurally lower levels/curves towards structurally flatter levels over the past 25 years.
The past 25 years: Structurally lower bond yields
Source: St.Louis Federal Reserve, Research Ahead

Now, if we bring 30y yields into the picture, the story is the same (but available history is not as long). If we look at the steepness of the 3-30y curve vs. the level of 3y yields we see exactly the same behaviour over the past 25 years: a movement towards structurally lower yields/flatter curves.
30y yields behave in the same way
Source: St.Louis Federal Reserve, Research Ahead

Given that it is long-run inflation expectations which are a key driver for long-term yields, therefore, 30y yields do not currently send any danger signals. Rather, their relationship with 3y UST (and again it is the short-term part of the curve where Asian central banks are most active these days), is extremely stable, baring a brief exception late 08/early 09 during the worst part of the financial crisis. If inflation would indeed be such a problem down the road why then is it not showing in the asset least distorted and most at risk of such a development? To me it is a) because and as I have stated on numerous occasions inflation fears are overdone and b) because the underlying economic developments do not send such a signal as is evidenced by the stable behaviour of the Phillips curve over the past 2 years.
Finally, the technical situation of the 30y US yields is extremely interesting as the below chart shows.
30y US yields remain in long-run downward trend but are at an important support
Source: Bloomberg

30y US yields have reached a low of 4.173% in June 2003 and traded 3 times to 4.192% in June 2005. In July this year they reached a temporary low of 4.194%, however, and in contrast to their 10y counterparts they have last week tradeed below this July-low and moved to 4.121%. Currently they trade at 4.20%. Should they overcome this 4.10-4.20% area, then that would be a significant long-term bullish signal for the entire UST market! On the other side, the multi-decade downward trend is running at roughly 4.70% at present. I think that as long as this downward trend has not been broken, the odds for an ongoing constructive bond-market environment remain favorable.

Thursday, September 10, 2009

Gold and the USD: A warning flag for government bonds?

If the run-up in gold prices and the fall in the USD is driven by or is fuelling inflation fears, thenthe situation for government bonds will become more challenging, as not only are equities continuing to rise amid improving real growth expectations but rising gold prices and the weak USD (and associated with that rising oil prices) threaten to reverse - at least temporarily - a key reason for the bond performance of the last weeks: waning inflation fears.

Trade-weighted USD vs. Gold: Close relationship
Source: Bloomberg

As the chart above shows, gold and the USD (I used the trade-weighted index) have been moving in a close relationship over the past year, barring the armageddon-like environment at the start of the year which drove investors into the safe haven of the USD and gold at the same time. However, the usual relationship is the opposite: a weak USD is going hand-in-hand with rising gold prices. A weak USD can be judged to be inflationary for the US which would help gold but additionally, a weak USD can be a sign of waning confidence in the US economy and its institutions.
Now if we compare the performance of the USD and gold with the development of 10y UST yields, at first sight there exists no meaningful relationship. The first chart shows the last 5 years of 10y UST yields and the USD (inverted).
10y UST and USD: no meaningful relationship over the longer term
Source: Bloomberg

The next chart compares 10y UST and gold over a shorter time frame (the period of the financial crisis) and again I can detect no meaningful relationship.
10y UST and gold: no meaningful relationship during the financial crisis
Source: Bloomberg

However, it gets much more interesting if we use break-even inflation rates instead of nominal yields. Given that 10y TIIs have been suffering ever since the financial crisis started from very high liquidity premia, the incorporated break-even inflation rates have been distorted and I think that 10y inflation swap rates provide a more accurate picture about the development of inflation expectations. The first chart below, therefore, shows 10y inflation swaps vs. the trade-weighted USD. It shows a relatively close co-movement during that time period, however, again at the start of this year clearly an opposite directionality.
10y inflation swap rate vs. USD
Source: Bloomberg

If we compare the swap rate with gold, then the co-movement - while far from perfect - appears closer.
10y US inflation swap rate vs. gold: a relatively close co-movement during the financial crisis
Source: Bloomberg

What I take from these developments is that a) inflation expectations are indeed as is frequently stateed a key driver for gold prices but b) while gold seems to be a good hedge against a systemic financial crisis it is not a good hedge against a deflationary development. For government bonds, though, if the recent performance in gold and the USD is driven by or is causing renewed inflation fears, then this would bode very ill for the near-term outlook. As I have written on several occasions, the reason for the apparent discrepancy between equities (up) and government bond yields (down) over the past weeks can be found in easing inflation pressures as evidenced by a falling commodity price index.
Discrepancy between equities and government bond yields explained by commodity prices
Source: Bloomberg

As I stated previously, I still fail to see how inflation pressures will intensify in the US and Europe (baring the UK) amid huge overcapacity and limited credit creation but admit that the latest price action in gold and USD are raising a warning flag for government bonds as it might suggests that markets' inflation fears are on the rise again which would take away a key support for govies if it carries through into the broader commodity complex.

But was the surge in gold prices really been driven by inflation fears? The usual suspect behind anything that moves these days, the Chinese, have naturally been cited. However, the behaviour of nominal USTs does not fit this picture as the 10y US T-Note futures is trading unchanged from its Friday close. If indeed the Chinese were behind this move (as they lose faith in the USD), then nominal US Treasuries should have suffered more this week, especially given the heavy supply. It rather seems to be that a large gold producer (Barrick Gold) is unloading its gold hedges (i.e. buying back the gold it sold forward). This article refers to research by UBS which states that between July and September 7, Barrick has reduced its fixed price contracts from 5.4moz to 3moz and apparently has reduced outstanding contracts further over the past days to a level closer to 2moz. If this is indeed the prime reason behind gold's recent bull run, then it would rather constitute a temporary increase in demand for paper gold (via the closing of outstanding contracts) offset by a future increase in supply (via the selling of then unhedged physical gold). In turn, I would not regard this explanation as having an inflationary spin.

Overall, the jury is still out on whether inflationary fears are likely to rise once again in the short term which would see government bond yields moving higher. So far, I stick with my assesment from Monday (Rates Strategy: Indecision): government bonds are still undecided about the next move and I still do not yet see enough reasons to change by bullish tactical stance.