Thursday, February 25, 2010

Here Comes the Weatherman II

The discussion of the likely impact of the adverse weather has intensified following some unexpectedly weak economic numbers such as US housing starts, consumer confidence or the German Ifo index. The ifo institute stated that the drop in the business climate has been on the back of worsening sentiment in the retail sales sector as well as a weather-related weakening in construction activity. At the start of the year when I suggested a tactical long position in government bonds (see: Rates Strategy: Here comes the weatherman dated) I referred to the unusually cold winter as one factor which would be likely to drag yields lower. Unfortunately, my proposition to move to a tactical short last week seems a bit ill-time now. Still for the time being I maintain this view.

The loss of economic momentum in several sectors during winter is a regular phenomenon and statistical techniques are employed to adjust economic data for this loss in momentum (and also for the gain in momentum that follows during spring). However, if the loss in economic momentum is more pronounced than usual due to a stronger-than-usual winter, then the seasonally adjusted economic data should turn out weaker than expected. This is confirmed by a study on the impact of the mild winter 2001-02 on the US economy (Lessons from the unusual impacts of an abnormal winter in the USA. Changnon & Changnon. Meteorological Applications 12, 187-191 2005. The abstract can be found here). More specifically, the study found that the mild winter reduced costs of heating, led to reductions in transportation problems, lower road/highway maintenance costs, increased construction activity, reduced insurance losses, greater retails sales and increased home buying.

On the other side, if we have a cold winter and especially if there are severe snowstorms such as happened in the US and continental Europe since the start of the year, then one should expect retails sales to be weaker than usual (people will stay at home more often), higher insurance losses, less home buying, weaker construction activity, more frequent transportation problems (which also means that people will get to work later, hurting output). On a brighter note, utility output should have profited. The impact of these effects should not be underestimated. I already presented at the start of the year a small model which enters a receiver or payer position in the 10y USD swap rate depending on whether a certain month was colder or warmer than usual. The model enters a receiver position if a winter month is colder-than-usual or a summer month warmer-than-usual (and a payer position if it is the opposite). The position is entered at the start of the following month and held for one month. I used the population weighted heating degree days and cooling degree days vs. the norm for that particular month to determine the positioning (the actual HDD/CDD as well as the normal HDD/CDD can be found here on the website of the CFTC. Additionally, the website provides a description of the methodology used to calculate the degree days). Over the past 11 years this would have resulted in a profit of 1130bp (excluding transaction costs) with gains in both bearish as well as bullish market environments.

Profitable trading rule suggests that the weather has indeed a significant impact on short-term market behaviour
Source: Research Ahead

This profitable simple model should highlight that indeed the weather has an impact on the economy and therefore financial markets which should not be underestimated. Winter in the US and continental Europe has been colder-than-usual with more snowstorms since early December. Also January has been colder (albeit not that much) as have the first weeks in February. In turn, near-term economic data is likely to continue painting a weak growh environment. However, most of this weather related economic loss should not be a permament one. It is much more likely that once the weather improves, there will not only be the usual seasonal strength of spring but rather also some catch-up in the form of improved retails sales etc. Again, this is confirming my neutral strategic outlook for government bond markets (with a horizon of approx. 3 month). However, my bearish tactical call seems to be a bit premature.

Thursday, February 18, 2010

Rates Strategy Update: Rising risks of a rise in yields

I have been recommending strategic longs since early June last year in UST and Bunds. The view was based on my outlook for an extended period of historically low bond yields given my outlook for a multi-year environment of low nominal growth amid limited real growth and muted inflation. This still holds and I see no convincing reasons yet to change that view. Broad based credit aggregates are shrinking which will keep inflationary pressures in check. Furthermore, the private sector deleveraging has only just started and promises to run for several years, limiting consumption growth. Finally, the current fiscal deficits are clearly unsustainable be it in the US or in Europe and we will see an increasing number of countries tightening fiscal policy sharply over the next years. Again, this will act as a significant headwind for growth.
However, over the next few months, we are likely to witness a stronger-than-usual seasonal upswing, led by the US. Winter has been strong in the US and most of continental Europe since early December. Cold weather and heavy snowfall have acted to depress economic activity by more than is usually the case during the December-February period. Every year from March onwards, the US and the European economies see a strong seasonal uptick in economic activity as the weather gets more friendly again. This year, given the strong winter, this uptick promises to be even more pronounced than is usually the case. Furthermore, the fiscal easing programmes as well as the accommodative monetary policy are still providing support. This combination promises to temporarily lead to stronger growth going into spring.
As a special factor in the US, we also have the end of the MBS-buying programme by the Fed in March and growing talk about an early implementation of exit strategies (see for example the latest FOMC minutes released yesterday). This might lead to an environment where the ongoing huge Treasury supply will only be digested at higher yields. In turn, I see a large probability that the 10y UST yield will break out of its trading range of 3.15%-3.95% which has been in place since the end of May and move above 4%.
In the Eurozone, the Greek woes (and with that the dismal situation in the periphery in general) will continue to weigh on growth over the medium term. I am convinced that we will see a substantial fiscal tightening in several peripheral countries and the combination of weak private sector demand and weak public sector demand will weigh significantly on overall Eurozone growth. This should also keep the ECB from raising rates in the foreseeable future and leave Bund yields at historically low levels. However, given the EU's signal to provide funds to Greece should it really be necessary, should keep default fears in check. In such an environment, Bund yields will not be able to withstand the upward pressure provided by rising US Treasury yields for much longer. In turn, I expect 10y Bund yields to trade higher within the established range of 3.09%-3.45% with a likely break into the wider 3.09%-3.75% band by June.
In turn, I downgrade my former strategic bullish stance to neutral and on a tactical basis advise to close longs and to adopt a mildly bearish stance for Bunds and a bearish stance for US Treasuries. Finally, I stick to my negative assessment of the UK Gilt market. 10y Gilt yields have already broken out of their former trading range (the UKT 4.75% Mar20 is currently at 4.16% vs. a high in June 2009 of 4.08%) and can rally further.

Friday, February 12, 2010

Tough Lough

Just a quick comment regarding the EU's rescue plan for Greece.
I stated previously that I don't believe Greece can handle the situation on its own (amid the scale of the problems on the one side and the difficulty to implement change in an an environment of substantial corruption, limited data quality and a high share of the black market economy on the other). Once you accept that Greece cannot go it alone and that there is no political will to let Greece default (as this would be just the start of a real speculative attack on other Eurozone members, similar to the Asian crisis), some sort of bail-out directly follows. I personally have been surprised by the timing of the rescue announcement (I rather thought this would come towards spring, i.e. after the sale of the new 10y GGB and around the time when there are big redemptions on maturing GGBs in April/May).

Be it as is, I do think that the promise for a rescue plan is going in the right direction:
a) There was (and still is) the risk that a bail-out would be done similarly to the bank bail-outs in 2008/2009, i.e. almost unconditional injection of money with no change in behaviour by those being bailed out. This would not do much to solve the problems at hand, would clearly aggravate the moral hazard issue and promote fiscal irresponsibility across the Eurozone. However, at present the impression is much more one of giving no money (yet) - just the explicit promise to lend once it becomes necessary - while at the same time demanding a more significant change in behaviour towards a sustainable fiscal path.
b) It does not constitute a bilateral deal (say between Germany/France and Greece) but involves the European Commission and also the expertise of the IMF. This is vital as the EC and IMF have more means to advise on and monitor the austerity measures, improve the statistics and state management tools as well as sanction non-compliance if necessary.

As a result, I think that the rescue plan should be seen in a positive light and does send rather strong signals to other Eurozone members to do more to bring their house in order.

However, one should not forget that to re-balance the Greek economy (as well as Spain, Ireland Portugal) will take several years. The challenges at hand are immense. Competitiveness needs to be restored, the current account deficit reduced, private sector indebtdedness needs to drop and house prices have further to fall amongst others. During this period, private sector demand will be weak. Furthermore and as a significant change to especially the past two years where fiscal deficits shot higher, demand by the state sector will be weak as well. In turn, domestic demand will be restrained for several years. The export sectors are not large and competitive enough to take up all the slack. As a result, real and nominal growth rates across the periphery promise to be exceptionally weak for a number of years. In such an environment, the corporate sectors in these countries will face an extremely challenging environment and one should prepare for a multi-year period of high corporate default rates across the periphery (and almost no capacity for a bail-out by the respective sovereigns).

Monday, February 8, 2010

Rates Strategy Update: Short-term overbought but no sell signal yet

As my wife is still handicapped given the fracture of her right wrist, I am a full-time house husband at present and therefor I am unable to update the blog as frequently as I would like. So here is just a quick update on the rates markets.

Bunds and UST have continued with their upward trend amid easing inflation fears (on the back of the drop in the CRB index) and a general increase in risk aversion. Interestingly as the chart below shows, US data on average has surprised positively as of late (and I personally also think that the January employment report has rather been a strong one, if judged by the household survey). But that has not been enough to stem the fears of a Greek contagion as well as further monetary tightening measures in China.
US data has surprised positively as of late
Source: Citigroup via Bloomberg

Looking ahead, I think that the air is getting a bit thinner for Bunds and USTs given that technically, bond markets start to look overbought. However, so far technicals remain rather positive, especially in the Eurozone, and positioning is still tilted in favour of shorts. In turn, there is no sell signal yet and I stick with my tactical bullish view for the time being, alongside the bullish strategic market outlook.

Technically, the Bund future has managed to finally break above the 123.50-124 resistance zone where it failed in March 2009, November/December 2010 and in January this year. This highlights that in price terms the bullish medium-term trend remains fully intact! In yield terms, this has not yet been confirmed, however, and 10y Bund yields have not traded to new lows. On Friday, they hit 3.104%, just slightly above the 3.09% reached in early October last year. As long as this support zone is not broken, the diverging price (bullish) and yield trends (sideways) suggest that from a medium-term perspective bullish positions remain warranted (amid rising adjusted future prices) but the absolute performance is subdued amid only a limited yield drop. However, on a more positive note, 30y yields have overcome their early October lows (3.835% vs. 3.82% at present) and trade now at the lowest since mid March last year! Furthermore, also 10y swap rates have traded below their early October lows and have also reached levels last seen in March 2009. This might well be a precursor for a similar break lower in 10y Bund yields.
On the downside, though, following the steady price gains since the start of the year, Bunds are starting to look overbought.
The medium-term technical situation in the US is much more neutral. 10y US Treasury futures so far remain significantly below their highs reached in late November while 10y UST yields remain firmly anchored within the established trading range of 3.95% reached in June and 3.19% reached in early October. Friday's close at 3.57% is exactly in the middle of this range.
Positioning, though, remains heavily tilted in favour of shorts and despite the steady price gains of the past weeks, the close to record-shorts reached in early January have been reduced only by approx. one quarter until the start of February.

Fundamentally, the environment is much more challenging in the Eurozone than in the US where the fiscally induced recovery seems to take hold. The economic woes in the periphery of the Eurozone are spreading and while spreads of Greek government bonds to Bunds have stabilised, peripheral spreads in general have continued to widen given increased fears with respect to Portugal and Spain. I have written on numerous occasions about the subdued outlook for the Eurozoone periphery (see for example No Easy Way out for Eurozone Peripherals). It will take several years to rebalance these economies (restore competitiveness, increase savings ratio, reduce private sector indebtedness etc.). What is more, the ability of the state to support this rebalancing with the help of an easy fiscal stance is fading. Rather, there need to be significant steps of fiscal tightening in conjunction with structural reforms. However, for the domestic economy this will render the situation even more difficult in the short term (but should shorten the overal adjustment period). In turn, the corporate sectors within Greece/Spain/Portugal/Ireland should face a particularly tough environment for several years. Demand by the private sector as well as the government will weaken at the same time (so far only demand by the private sector has weakened), hurting cash-flows. Finally, the ability of the state to continue bailing out the domestic corporates is severly tarnished as well. As a result, the contagion emanating from Greece should not only hit other peripheral sovereigns but much more the peripheral corporate sectors!
I therefore remain of the opinion that for investors being in need of yield pick-up, the corporate sectors of the 'strong' Eurozone countries (i.e. Germany, France, Benelux) offer a more favorable risk-reward than the 'weak' sovereigns and especially than the corporates located in the 'weak' sovereigns.
While it is difficult to forecast the exact timing of the healing process for the periphery, we can be pretty sure that this problem will remain with us for several years and hold back Eurozone growth and inflation during this process. In turn, it will render it a significant monetary tightening by the ECB much less necessary.

Finally, my longer term fundamental outlook has not changed over the past months. I remain convinced that the next several years will on average see subdued growth around a lower trend. However, quarter-over-quarter growth rates should see a heightened volatility with some quarters fairly positive and some showing negative growth rates. This heightened volatility stems from the combination of a lack in a self-sustaining dynamic coupled with an increased reliance on fiscal policy. However, fiscal policy does tend to change in a rather abrupt manner and hence growth will strengthen and weaken signficantly in turn. Inflation on the other side, should not become a major issue, especially in the Eurozone. The lack of credit creation coupled with significant overcapacity suggests that we have still too many goods and not too much money. As a result, nominal growth promises to be low for a prolonged period of time which will keep nominal bond yields at low levels as well.

Monday, February 1, 2010

Greek Fire Part IV

I have written on several occasions (see for example Germany exports its disease Sep 3, No Easy way out for Eurozone Peripherals Oct 30) about the problems facing especially Greece, Spain, Portugal and Ireland and suggested to shy away from respective government bonds (although last time I upgraded the market view with respect to Irish government bonds). I also stated that I dont believe that Greece can enact the necessary heavy dosage of fiscal tightening and structural reforms on its own. On the one side, the extent of the mess is enormous given the size of the fical deficit/debt, the magnitude of the economic imbalances and the low competitiveness. On the other side, the public acceptance for restraint as well as the political power to enact any meaningful change is clearly limited in a country plagued by faulty statstics, a very high level of corruption, a super-sized black economy as well as a generally low inclination to pay taxes.
In turn, Greece needs outside help in the form of carrots (i.e. money) and sticks (to enact structural reforms) and I am convinced that in one way or the other, they will get it even if it wont be called a bail-out (in order to satisfy the Maastricht/Lisbon treaties). While it is difficult to make predictions about what form the support will take and what the timing of any such move will be, the latest press reports have given some clues about the sticks: As this Reuters article states, the European Commission will suggest to Greece to cut nominal wages in the public sector and set a ceiling for high pensions amongst others.
This would amount to little else than what the IMF would demand as well. More importantly, if the EU/Eurozone or a sub-group of EU countries were to lend money to the Greek and do get real structural change in return, it would not necessarily need to be a bad thing for either side. Furthermore, if the conditions for getting any bail-out money are hard enough, then it should not worsen the moral-hazard problematic as the Spanish/Portuguese/Irish/Italian etc. would have strong incentives to take care of their domestic problems on their own before they are faced with a buyer's strike and need to revert to a bail-out as well. Interestingly, Portugal and Spain which always have been in denial over their structural as well as fiscal problems, seem to at least start acknowledging the need for more significant budget cuts.
Overall, I am still convinced that the Eurozone faces a multi-year period of low nominal GDP growth (amid little real growth and only limited inflation). As the pressure to enact significant fiscal tightening measures is growing and as a potential Greek bail-out seems to have strings attached, the probability of such a low-growth outcome remains high.

With respect to market pricing, peripheral spreads have ballooned drastically since the start of the year and my suggestion to underweight Greece, Portugal and Spain has been proven correct. Also the relative assessment of Italy has proven right as Spain is finally trading with a pick-up relative to Italy in the 10y area. But where to go from here? As spreads have been widening, the carry available has been improving. Furthermore, given that Bund yields remain at historically low levels, carry remains an important driver of total returns.
Intra-Eurozone spreads: unprecedented volatility vs. significant carry
Source: Bloomberg

Earlier this year, I suggested to upgrade Ireland back to neutral while remaining underweight on Spain, Portugal and Greece. Structurally, not much changed and the fundamental risk associated with these countries has not diminised materially (but in my view it has also not risen). On the other side, especially the level of Greek spreads is discounting a significant amount of problems down the road. In turn, the risk-reward for investments into peripheral government bonds has improved. I maintain my negative fundamental/structural assessment of these countries but given the current spread levels, I temporarily upgrade the market view back to neutral on a tactical basis.