Monday, January 25, 2010

Rates Strategy Update: Still long

I continue to stick with my tactical long stance alongside the strategic bullish view for UST and Bunds (amid an outlook for a prolonged environment of low nominal growth).

Consensus remains heavily in favour of higher yields while positioning is reflecting this bias as net shorts in US bond futures have barely receded in the week up to Jan 19 (this data is always released with a one-week delay). As the chart below shows, the current level of shorts (I use the aggregate net positioning in the 2y, 5y 10y and 30y futures weighted according to their pvbp and is expressed in USD mln per bp), has over the past years always been followed by a (temporary) move lower in yields, irrespective of the medium-term trend.
Net short positioning remains at extreme levels (2y, 5y, 10y and 30y futures)
Source: CFTC, Research Ahead

Furthermore, as I laid down previously (see Rates Strategy: Here Comes the Weatherman dated Jan 12), the weather of the previous month (in the current case December) serves as a good indicator for the direction of bond yields during the next month (i.e. January). Colder (warmer) weather than usual during winter months is on average followed by a move lower (higher) in yields. The reason is most likely that colder-than-usual weather is a negative for the economy in the short-term (it negatively affects construction, retail sales and can also - especially if there are severe winter storms - affect industrial production. The only positive comes from utility output as well as the sale of winter gear). Not only has December been colder than is generally the case in the US as well as in large parts of Europe, January has also seen cold temperatures coupled with heavy snowfalls.
By now this has started to affect economic data releases and the Citigroup surprise indices for the Eurozone and the US have both moved into slight negative territory (i.e. there were more negative economic data surprises in the recent past than positive ones). January is the first month since April last year where both the USD and the EUR surprise index are both in negative territory at the same time.
Eurozone and US economic surprise indices are both in negative territory
Source: Citigroup via Bloomberg

Furthermore, equity markets have taken a hit last week and some multi-months trend lines have been broken to the downside. From a technical perspective what is most interesting is the violation of the upward trend in the CRB commodity index. As the chart below shows, the CRB index has been forming a strong upward trend since early March last year. This trend has been tested several times (in July, September and December) but always held. However, just last Friday, the trend was broken and the index finally closed below the trendline. A move lower in the commodity complex would help to ease inflation fears and should be met with a drop in break-even rates incorporated into inflation protected securities.
CRB index has finally broken its multi-months upward trend
Source: Bloomberg

Finally, the end of the month should see a rather substantial index extension, especially in the Eurozone, as there was the usual heavy supply, redemptions and coupon payments. This should as well temporarily underpin bond markets at the end of this week.
On the downside for bond markets is that near-term stochastic indicators are starting to look overbought. Furthermore, Greece is offering a syndicated deal this week. Should this sale go well, it could ease the risk of a near-term funding crisis and with that help spread products in general at the expense of Bunds.

Still, I think the positives outweigh these negatives at present and I therefore maintain my tactical bullish outlook for UST and Bunds.

Wednesday, January 20, 2010

UK: Nothing New on the Northern Front

Just a quick update amid the latest UK inflation numbers. Last year I wrote several times about the challenges facing the UK (see for example UK: New Data, Same Problem dated Sep 15).
I concluded that "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."

UK inflation has been showing a worrisome trend for quite some time, especially compared to the developments in the Eurozone and the US. The chart below highlights the core inflation developments. One should not forget that UK core inflation was artificially depressed in Dec08/the start of last year due to the temporary cut in VAT. But ever since it has been trending higher throughout compared to a slow grind lower in the US and a more pronounced downward movement in the Eurozone.
Core CPI: UK developments become even more worrisome
Source: Bloomberg

Moreover, 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 headline 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. This was evident again yesterday where actual mom CPI came in at 0.6% vs. expectations of 0.3%:
Source: Bloomberg, Research Ahead

In turn, inflation is clearly misbehaving and much more so than was expected. This adds to the challenges for the UK economy overall (much too high fiscal deficit, significant de facto monetisation of the defict via QE, substantial current account deficit, very substantial exposure to and dependency on the financial sector, still overvalued housing market). But also for the overindebted and undersaving consumer this inflationary development does not help ease the debt burden. What matters for the consumer is not the level of inflation but what happens to wages. Inflation per se does not render serving the debt any easier, only higher income does! And wage income has not grown substantially. In fact, according to the latest data available average earnings were up by only 1.8% yoy in November. This does not help much to ease the debt burden. More importantly, it constitutes a real wage loss which clouds the outlook for consumption growth. The chart below compares headline CPI with the development of yoy average earnings (including and excluding bonuses). As can be seen, average earnings grew by much more than CPI over the past decade, resulting in a real wage gain. However, in 2008, the oil price shock has briefly resulted in a real wage loss. Thereafter, average earnings excl. bonuses were trending lower in line with CPI. Now, however, the spike in inflation results again in a substantial loss of purchasing power.
Average earnings cannot keep up with the spike in inflation
Source: Bloomberg

I remain worried by the longer term outlook for the UK economy and continue to stick to my negative assesment with respect to GBP-related assets. Look for futher underperformance of Gilts vs. Bunds and also US Treasuries.

Monday, January 18, 2010

Rates Strategy Update: More to go

As an aside, my wife has a multiple fracture of her right wrist and therefore I have to take care of our 3 kids and the households for the next few weeks. I still hope to be able to write on a regular basis but it will be most likely a bit less frequent than usual.

Last week (see Rates Strategy: Here Comes the Weatherman dated Jan 12) I proposed a tactical bond-bullish stance for USTs and Bunds. In the meantime, 10y UST have dropped by 15bp and 10y Bunds by a bit less than 10bp. I still think that this movement has further to go amid all the reasons I provided last week:
a) positioning: the latest data available for Jan 12 suggest that aggregated net short positions in US 2y, 5y, 10y and 30y futures increased even further amid more pronounced net shorts in the 10y future. Overall net shorts are still slightly below the level prevailing at the end of May last year, i.e. just before yields reached their high for the year. However, net shorts in the 10y future have now surpassed their end-of May 2009 level and have reached levels last seen in April 2005.
b) technicals: I wrote last week that technicals were suggesting a temporary bounce might be imminent given that daily stochastics have turned upwards. This move higher in the stochastics can go on a bit further and we have not yet reached overbought levels. Furthermore, the 10y US T-Note contract has broken through its short-term downward trend which started at the end of November. Yields continue to trade within their established ranges (for 10y Bunds: roughly 3.09-3.45% and for 10y UST: 3.18-3.95%). In turn, the overall picture seems neutral (amid the range-trading behaviour of yields) with a bullish tilt (amid the rising stochastics)
c) fundamentals: According to the Citigroup economic surprise indicator for the US, economic data so far this year has rather surprised on the downside on average. The chart below shows the 10y UST yield together with this eco surprise indicator. Usually, the two time series move in a similar direction, albeit the timing and the extent of the moves are not perfect.
US economic surprises vs. 10y UST yields
Source: Bloomberg, Citigroup

d) the weather: I wrote last week about how colder-than-usual weather in the winter can be associated with a move lower in yields (with a delay) as it hinders economic activity. My proposed trading rule suggested that colder weather in a particular month is associated with lower yields in the subsequent month. December was colder than usual and in turn January has a higher-than-usual probability of a move lower in yields. Furthermore, the start of the year was colder-than-usual as well, be it in the US as well as in Europe.
e) supply: there was a tremendous amount of supply hitting the markets since the start of the year, be it in the sovereign sector as well as in the corporate segment. However, especially sovereign supply should be a bit less in the short-term. Furthermore, given the huge supply as well as the high level of coupon payments and redemptions, the end-of-the-month index extension will be a large one. This as well should provide some temporary market support.

So to sum up, the reasons for my positive tactical market outlook have not changed much over the past week and I stick to a bond-market positive assessment. Bund and UST yields are likely to fall further over the next weeks.

Wednesday, January 13, 2010

Greek Fire Part III

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,".

I have been suggesting for quite some time to overweight high-grade corporate bonds of 'strong' countries at the expense of 'weaker' Eurozone sovereign issuers (see for example No easy way out for Eurozone peripherals dated October 30), most notably Greece, Portugal, Spain and Ireland. This view has paid of and by now the Markit iTraxx Western European Sovereign CDS index trades above the Markit iTraxx Europe Index (which is composed of 125 investment grade entities).
European Sovereign CDS's trade above high-grade corporate CDS
Source: Markit via Bloomberg

I see two key reasons for this development:
a) the general shift of private sector risk - most notably emanating from large corporates - onto the government balance sheet (via bail-outs, capital & liquidity assistance as well as traditional fiscal easing steps) which was reflected in the very substantial reduction in corporate bond yields over the past year.
b) the increased awareness of the structural problems facing the periphery of the Eurozone and the associated negative rating actions (most notably in Greece) which led to heightened risks of a potential funding crisis/default and in turn soaring CDS levels.

Within the sovereign realm we can build several clusters.
On the one side, we have the relatively solid sovereigns of Germany, France, the Netherlands and Finland. CDS levels are relatively close (the lowest currently is Germany with 27bp and the highest France with 33bp) and have been rather stable even though with a slight upward trend over the past months. This upward trend most likely reflects the risk that some of the weaker countries will in one form or another have to be bailed out.
The 'solid' core: Germany, France, the Netherlands and Finland
Source: Bloomberg

The second chart shows the other Eurozone sovereigns where CDS levels are available. Dispersion is much larger as is the volatility of the CDS levels. However, there are some interesting observations to be made. Ireland, Belgium, Austria and Italy have been outperforming while Spain, Portugal and Greece have been underperforming within this group. By now, both Spain (112bp) and Portugal (103bp) trade above Italian CDS (99bp).
The rest: volatile with high dispersion
Source: Bloomberg

Looking ahead, the general shift of private sector risk into the government sphere does not promise to be reversed soon and in turn I expect high-grade corporate bonds to continue their outperformance vs. sovereigns in general. However, the more interesting question at present is what happens within the Eurozone sovereign realm. Can Greece (or any other peripheral) find a solution to get out of their current mess or will the situation aggravate further, leading to an even higher risk of a funding crisis/default? Will a solution involve the transfer of Greek sovereign risk (and with that peripheral risk in general) towards the safer core issuers? Clearly, this would provide downward pressure on non-core CDS and related bond-yield spreads as well as upward pressure on core CDS levels.
By now even the European Commission has acknowledged that the Greek statistics are unreliable and not worth their paper. But that should not come as a surprise. Since having become a Eurozone member, Greece has frequently tended to substantially revise past deficit and debt data. Furthermore, if the statements in this article (Culture of Corruption Drags Greece Down) are correct, then not even 5,000 people in all of Greece report a gross annual income of more than €100,000 on their tax returns (the country has slightly more than 11mln inhabitants). Besides the unreliability of the data, the high level of corruption (it ranks 71th place in the corruption perception index of Transparency International, see here) will render a Greek-only political solution without outside help even more difficult. At least politicians seem to start acknowledging that their is a fire burning in Greece but that does not mean that they have the ability to extinguish it.
Personally, I am of the opinion that Greece should not have been allowed to join the Euro early last decade but not because the government fudged the data, rather because them joining rendered the Euro even less of an optimal currency area (it wasn't one from the beginning). But then again the Euro is more a political project than an economic one. In turn, this leads me to believe that ultimately Greece will not be left on its own and measures will be implemented to avert a default. However, when this will happen, what form the support (probably an IMF/EU combined effort) will take and what the restricions for Greece will be is hard to forecast. In light of the difficulty of the situation and the uncertainty relating to a potential solution, I do not see a favorable risk-reward for investments relating to Greek bonds for the time being and still favour to shy away from GGBs. For investors who expect to see a solution soon, I rather think that Irish government bonds would offer a more favorable risk-reward. For one, the Irish government seems to be willing to take the necessary steps while at the same time if there would be a Greek solution it might well help the periphery in general.

To sum up, I maintain my view of overweighting high-grade corporate bonds from 'strong' countries vs. sovereign bonds from 'weak' countries (most notably Spain, Portugal and Greece). However, I would be moving back to a neutral allocation for Ireland given the high spread levels, the apparent willingness to cope with the structural problems as well as the non-negligible probability that steps will be taken towards a stronger fiscal support mechanism within the Eurozone in the not too distant future.

Tuesday, January 12, 2010

Rates Strategy: Here Comes The Weatherman

I concluded my last tactical bond market outlook (see Rates Strategy Update: Still long but... dated December 14) with: "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."
In the meantime 10y Bund and UST yields rose by approx. 20 and 30bp, respectively before coming back a bit over the past days.
In turn, I believe that the temporary setback I was talking about is behind us and expect yields to retreat again from here onwards and propose a tactical bond-bullish stance.

First, consensus for this year seems to be that there is only one way to go for bond yields during 2010, up. By now, however, this seems to be reflected in positioning. The chart below shows the risk-weighted net positioning by non-commercial accounts in the US 2y, 5y, 10y and 30y futures (I used the pvbp to aggregate the various futures contract and in turn, the positoning should reflect mln USD per basispoint in yield change). While in early December, positioning was neutral (following a long period of a short base), within a matter of only one month, net positions have moved back to a very significant short base. This has come about by a reduction in net longs in 2y and 5y futures and an increase in the shorts in 10y futures. Over the past 3 years only one week at the end of May had a more pronounced short position which was just before the 10y yields hit their intra-year high at the beginning of June.
Positioning in US bond futures are strongly tilted in favour of shorts
Source: CFTC, Research Ahead

Also from a longer term perspective, the current positioning can be considered significant. The chart below shows the history since mid 2002 to cover the last rate hiking cycle/multi-year bond bear market between early 2003 and early 2007. When net shorts were of the magnitude they apparently are today, 10y UST yields tended to top out soon and fall back significantly even if only on a temporary basis. In turn, at present positioning gives a strong signal against the bond-bearish consensus!
The current level of short positions was historically soon followed by a drop in yields
Source: CFTC, Research Ahead

Technically, bond markets look a bit more vulnerable given that the previous bullish trends which guided trading since early June have been broken. However, markets look oversold and stochastics have been turning higher from a low level which is usually also seen as a (temporary) buying signal. The chart below highlights this situation for the Bund future.
Bund future: bullish trend was broken but upturn in stochastic gives a temporary buy signal

From a cross-market perspective, bunds and USTs were trading at expensive levels in early December vs. equities and commodities. However, in the meantime, the rise in yields has taken bonds back to fair-value. For 10y Bund yields, the error-term of the regression is approx. 0bp after having been above 20bp (i.e. larger than 1.5 standard deviation) in December (see chart below).
10y Bund yields vs. EStoxx and the CRB-index: back at fair-value
Source: Research Ahead

Fundamentally, I think that inflation worries, especially in the US where break-evens have increased significantly over the past weeks to almost 2.50% in 10y TIIs, are overdone given the amount of spare capacity and given that the broad-based credit aggregates are shrinking. Furthermore, the recovery hopes might get another temporary dampener in the weeks ahead. The reason here might well be that the cold weather and the associated heavy snow falls in large parts of the Northern Hemisphere act as a strong headwind for economic activity. The impact of the weather on short-term economic developments is frequently underestimated. There are various ways the weather affects the economy (for example people tend to go out less when the weather is poor and in turn consumption suffers; also when there are snow storms it affects the production by corporates etc.). The weather is a key reason for the seasonal variation in the economy. However, seasonal adjustments only take care of the average seasonal weather. Unfortunately, the weather is rarely average! In order to highlight the importance of the weather on short-term economic and market developments I constructed a small trading rule. In short, this model goes short bonds (here expressed via a payer position in 10y USD swap rates) whenever the weather is milder than is usually the case, i.e. warmer in winter and colder in summer. It enters a swap receiver position whenever the weather is more pronounced than is usually the case, i.e. colder in the winter and warmer in the summer.
[I use the monthly data for population weighted heating degree days and cooling degree days for the US (they intend to measure the average energy needs for heating/cooling purposes and an overall number as well as the deviation from the "norm" is published). If the HDD days during winter are larger than the norm, then the winter is colder than is usually the case and accordingly a receiving position is initiated (and vice versa). Given that the weather for a specific month is only known at the end of that month, the position is opened at the start of the next month. This means that a colder-than-usual December triggers a long/receiving position for January. Given that most economic data is also released with a delay, this should fit the market impact.]
The chart below shows the development of the 10y USD swap rate together with the cumulative p&l of this simple trading rule. Over the past 11 years this trading rule shows a cumulative profit of more than 1000bp. This highlights that the weather indeed has a significant impact on short-term macro-economic and market developments.
Profitable trading rule suggests that the weather has indeed a significant impact on short-term market behaviour
Source: Research Ahead
In the US (but also in Europe), November was much warmer than is usually the case. However, December has been much colder. In turn, this rule would have suggested a short bond/swap payer position for December but is now proposing a long bond/swap receiver position for January).

Overall, I think that we should see yields falling back again in the weeks ahead especially due to a pronounced bond-bearish consensus/short positioning but also because the stronger-than-usual winter in the Northern Hemisphere might temporarily act as a headwind for the Western economies. In turn, I continue to propose tactic long positions in both 10y Bunds and 10y UST.