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

Small is beautiful

It is generally thought that in most developed markets it is the small and mid-sized businesses that provide the backbone of a prosperous economy. They are usually more flexible and more innovative than their larger counterparts. Additionally, they do not have significant market power and as a result, competition is fierce. On the other side, large businesses profit more from economies of scale and scope. However, as an industry gets increasingly dominated by a smaller number of larger firms, market power increases and with that the risk of a reduction in competitivity for example via on average higher prices or less investment in R&D. Large firms tend to engage increasingly into rent-seeking behaviour. Overall, an economy dominated by a relatively small group of big businesses will deviate increasingly from the ideal of perfect atomistic competition, resulting in lower trend growth amid an increasingly sclerotic economy and a society where economic and political power is concentrated in the hands of a few. The only beneficiaries of such a process will be the owners of these increasingly large companies.
Unfortunately, there are strong signs that the US has been taking a step in this direction (this is not to say that they are close, just that they are moving closer). I have already previously written about the state of small businesses in the US (Small business job creation, personal income & consumption: weak dated Oct 7). Small firms (defined as having less than 50 employees) were responsible for approx. a third of all jobs created in the period of Q392-Q42000 and Q303-Q307 and only accounted for 9% of the job losses in between Q101-Q203. However, in between Q407-Q408 they accounted for 45% of all job losses! The reason for this shift in job creation can be found in the dependency on the domestic economy and the restrictive financing environment. Small firms tend to be more domestically focused than large companies. If the data here are anything to go by, then small businesses - this time defined as those with less than 500 employees - were responsible for half of nonfarm private GDP but only roughly for a quarter of exports. Given the subdued outlook for the domestic economy, their creditworthiness has deteriorated substantially. Furthermore, while large businesses can access the capital markets directly and were able to profit from the bond issuance boom of this year, small firms are depending on the banking sector to get access to credit. Important sources for the smallest US businesses have been home equity loans and credit card loans. But home equity values have been declining sharply while the lines for credit cards have been cut back significantly and lending standards tightened as banks remain unwilling and unable to lend.
In turn, this combination of a poor outlook for the domestic economy (amid an overindebted and undersaving consumer in an economy overly dependent on consumption) and a lack of financing creates an extremely challenging environment for small businesses and job creation does not promise to stage a rebound soon.
A result is that the trend growth rate of the US economy (or any economy with a similar dynamic) should decline - in line with my multi-year view - as in aggregate small businesses lose market share in favour of large businesses. Large businesses in turn should fare relatively better than their smaller counterparts, be it in terms of market share as well as in terms of profitability. I think that the banking sector provides a case in point given that the largest banks have been showing significant profits again for the past quarter whereas below the surface, the bankruptcy of smaller and medium-sized banks is continuing. The chart below shows the number of bank failures per week as reported by the FDIC. Last week marked a new record in the current crisis with 9 bank failures (that is excluding CIT), bringing the total to 115 this year.Finally, if this is indeed the case then the numbers being reported by the quoted company sector do paint too rosy a picture with respect to the state of the (US) economy.

Rates Strategy: Upgrading the tactical view back to bullish

On Thursday in Last day of Fed Treasury purchases: Do as the Fed does?, I argued once again that nominal growth will be at historically low levels for several years to come given subdued real growth in a stop-and-go economy and amid the lack of inflation pressures. In turn, nominal bond yields should trade at historically low levels as well and I suggested to stick to the strategic long duration positions I started to propose back in June. From a tactical perspective I last downgraded the outlook to neutral from bullish on Oct 12 (see Rates Strategy: Back to neutral). I think that by now, the combination of weaker risky assets, a government bond friendlier macro-view as the V-shaped recovery hopes take a hit and a more supportive positioning environment by non-commercial investors should open the doors for further price gains.

While growth in the US has rebounded sharply from -0.7% in Q2 to +3.5% in Q3, the outlook for Q4 does not look as bright. First in Q3 the impetus on growth by the fiscal stimulus was very significant. However, this does not promise to be repeated in Q4. Remember that for the fiscal stimulus to continue to exert a significant positive impact on growth, it needs to get larger. However, the additional fiscal stimulus in Q4 vs. Q3 does not promise to have that significant an impact on growth. Additionally and as written previously, the summer months were likely to have profited from seasonal adjustments (as argued in more detail here). Given the previous job and output losses, the typical seasonal weakness going into summer was less pronounced resulting in stronger than expected seasonally adjusted data. However, now that summer has ended, the typical seasonal strength should also be less than usual. In short, the people who would normally have been let go for the summer period will not be hired for the autumn rebound as these jobs have been lost irrespective of the seasonal pattern, i.e. on a more medium-term to permanent basis. Therefore, parts of what we perceived to have been good news at the start of the summer was only a technical aberration which is being corrected now as the summer ended. As a result, Q4 growth is likely to surprise negatively vs. consensus and put a dampener on the hopes for a V-shaped recovery.
The latest drop in equity and commodity prices as well helps to ease the upward pressures on bond yields which was apparent during October. Whether especially the weakness in equity markets will be sustained or proves to be just another shallow and temporary setback on the way to new highs remains open. I remain cautious given my fundamental macro-economic view.
Finally, non-commercial investors in US bond futures - which moved to neutral by early October - have scaled back into short-duration exposure over the past three weeks.

In turn, I think that fundamentals as well as positioning open the door for further price gains in government bonds over the next weeks and I move back to a tactical bullish outlook for government bonds.