XMas break

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

Rates Strategy: Still long but...

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

Markets appear to be at important cross-roads

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

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

Source: Bloomberg

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

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

Source: Bloomberg

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

CRB index is testing its medium-term upward trend

Source: Bloomberg

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

Diverging behaviour of commodity sub-indices

Source: Bloomberg, Research Ahead

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

ICE WTI crude oil future broke through upward trend on Tuesday

Source: Bloomberg

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

DJ Euro Stoxx 50 has closed below its upward trendline

Source: Bloomberg

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

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

Rating woes

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

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

Source: Moody's

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

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

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

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

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

Source: Citigroup via Bloomberg

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

Seasonal adjustment factors for employment

Source: BLS, Research Ahead

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

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

ECB: Separating rate setting from liquidity provision

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

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

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

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

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

Source: Bloomberg, Research Ahead

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

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

Is the US consumer overleveraged?

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

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

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

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