Winds of Change

I expect UST and Bund yields to rise into autumn. I am still of the opinion that the US economic slowdown which became apparent over the past months is a temporary phenomenon (see for example Now it's official: A temporary negative supply shock dated June 10). Furthermore, I continue to remain optimistic about the economic outlook for the Eurozone overall and especially Germany, warranting further rate hikes by the ECB. Clearly, though, the Eurozone sovereign debt crisis has put downward pressure on UST and Bund yields as well as on global risk asset prices. But as a second Greek bail-out is ready to be applied (on the basis that the Greek parliament votes in favour of the Medium Term Plan this afternoon), it seems that a near-term default scenario where Greece can not meet its coupon and redemption payments will be averted.
As I suggested in When should Greece default dated May 25, I don't think that the second bail-out for Greece merely amounts to throwing good money after bad money. While Greece will likely need to restructure its debts in a few years' time, a default now would lead to a devastating outcome for the Eurozone overall given the state of the Eurozone banking system and especially given the risk of contagion to the large sovereign debt markets of Spain and Italy. Even though the way forward will remain bumpy for the peripheral Eurozone sovereigns and some important hurdles remain, I think that the peripheral woes might calm down somewhat during the next few weeks and even months. For one, as mentioned a devastating near-term default scenario has become less likely. Additionally, as reports suggests, a sensible roll-over plan for maturing Greek debts is being negotiated between the banks and the various Eurozone states. This roll-over plan should help Greece to partially refinance maturing bonds and the banks to partially reduce their Greek exposure without taking an accounting loss. Even though it might be deemed a selective default by some rating agencies, this solution should help limit the negative spill-over to the other peripheral debt markets.

10y Spain and Italian bond yields propelled higher by Greek default prospects

Source: Bloomberg

Overall, I expect that markets will slowly start to focus again on the underlying fundamental environment. And here I expect the news to become more favourable in the weeks ahead. I remain a proponent that the US economic slowdown apparent over the past months is largely transitory. Seasonal factors, adverse weather, high food and energy prices as well as supply disruptions following the earthquake in Japan have combined to create a difficult environment for the US economy since early spring. However, all of these headwinds are weakening and some even reversing: I frequently mentioned that the US economy should have become less seasonal than has been the case during previous years (given that the seasonal sectors - for example construction and manufacturing - have seen large job losses over the past 3 years whereas non-seasonal sectors such as health care and education have seen job gains) but seasonal factors have become even larger. In turn, seasonally adjusted data should paint too weak a picture during spring and too strong during July/August and winter. High energy and food prices have corrected over the past weeks with the RICI Agriculture Index being down by approx. 15% since early March and its Energy counterpart by almost 20% since early May. Finally, supply disruptions should ease during the next few months as the situation in Japan normalises.
Overall, therefore, the US economy should increasingly show signs of recovery as summer progresses.

CITI US Economic surprise index has stabilised and should turn up again

Source: Bloomberg

In the Eurozone, I expect the German economy to remain very strong. However, also France should see a pick-up in growth. French exports should react positively given that consumption in its main trading partner - Germany - is picking up whereas the economy in its second most important trading partner - Spain - is showing signs of stabilising. Despite ongoing recession in Greece and Portugal as well as ongoing low growth in Italy, aggregate Eurozone growth should remain well above 2%.
Such an environment - increasing risk appetite, improving growth backdrop and higher ECB repo rates - does not bode well for USTs and Bunds. Furthermore, the technical market situation has also worsened over the past few days. The 10y Treasury future broke and closed below its upward trend which was in place since early April. Today also the Bund future and 10y Bund yields followed. The chart below shows the 10y Bund yield. As can be seen, the downward trend has been tested four times since early April. Today it broke above which would trigger a technical sell signal if confirmed on a closing basis.

10y Bund yields break above their 3-months upward trendline

Source: Bloomberg

Finally, adding to the negative outlook for UST is the end of QE2. Even though the Fed will continue to re-invest maturing bonds, the support for the market is clearly dropping. As an example, at the last 7y UST auction, the Treasury sold USD29bn. Dealers bid for USD 62.3bn and were allocated USD 11.4bn. On June 1 (one day after the auction settled), the dealers sold USD 5.4bn back to the Fed in the Permanent Open Markets Operation and a week later sold another USD 3.2bn. Given that the dealers knew they could sell the bonds back to the Fed just a few days after the auction, they were happy to bid large amounts. Now, however, this game is over and we should expect to see a significant drop in dealer bids at upcoming auctions and in turn intensifying price pressures.

Now it's official: A temporary negative supply shock

In the last blog post I suggested that US economic data should turn around soon given that at least part of the apparent weakness during spring should be down to seasonality issues. These seasonal adjustments render the data weaker than the underlying trend during spring but should render the adjusted data stronger than the underlying trend during the June-August period. Clearly, though, the strong weakness in economic data relating to April and May has not only been down to seasonality issues. Also the previous rise in food and energy prices has eaten into consumers' pockets while adverse weather seems to have had a meaningful impact as well. However, the importance of one additional factor was revealed by this week's release of the Beige Book (which covers the mid April to end May period) as well as by yesterday's trade data for April: supply disruptions in the wake of the Japanese triple catastrophe (earthquake, tsunami and nuclear crisis). Given that the effects of these supply disruptions should be temporary and slowly start to revert, my view that economic data covering the June-August will likely surprise on the positive side again remains unchanged.

To quote from the Beige Book: "Auto sales were mixed but fairly robust in most of the country, though some slowing was noted in the Northeastern regions. Widespread supply disruptions--primarily related to the disaster in Japan--were reported to have substantially reduced the flow of new automobiles into dealers' inventories, which in turn held down sales in some Districts. Widespread shortages of used cars were also reported to be driving up prices....Supply disruptions related to the earthquake in Japan led to reduced production of automobiles and auto parts in several Districts. The Cleveland District noted a sharp drop in auto production, the Atlanta and St. Louis Districts also saw production fall, and auto deliveries were reported as having declined in the Richmond District. The Atlanta District said lost production in its region would be made up later in the year. Contacts in the Chicago District said that contingency plans to deal with supply disruptions were helpful in mitigating the effects. High-tech firms in the Boston and Dallas Districts reported that shortages of parts, due to disruptions in Japan, had adverse effects on business."
Essentially, the Beige Book suggests that there was a significant negative supply shock occuring, especially in the auto industry but also ini IT manufacturing. The implications are significant, for one, cars manufactured in Japan can not be shipped (as they are not produced), furthermore, cars manufactured in the US cannot be produced as important parts are missing. But also the production of complementary parts should be affected significantly given that less production in cars means less demand for these parts. Furthermore, whereas a negative demand shock should result in lower production and lower prices, a negative supply shock should result in lower production but higher prices. This is exactly what we have been seeing over the past months. The chart below shows the Mannheim Used Vehicle Value Index. This index reached a new high in May.

Used Vehicle Prices reaching a record high

Source: Mannheim Consulting

But also price indications for new cars suggest the same: lower volumes but higher prices. Usually prices for new cars are not changed frequently (normally this is done when new models are being released). Instead of changing official prices, discounts are being adjusted and a higher discount is the same as a price reduction whereas a lower discount equals a price rise. The chart below shows the development of the industry wide discount percentage for the last 13 months. As can be seen, discounts have been reduced (from 12.9% in March, i.e. ahead of the supply disruptions to 11.4% in May).

Industry average discount percentSource: edmunds Auto Observer

Additionally, according to the April US trade data released yesterday, US imports of automotive vehicles, parts and engines dropped by 13% from March! This seems to be entirley due to reduced imports from Japan. Overall Japanese imports dropped by 25% (passenger cars - dropped by 70%, auto parts by 21% and technology imports by 14%).

In turn, the weakness in auto production and auto sales should not be down to a worrisome drop off in demand but rather to a temporary negative supply shock. Given that these supply disruptions should also be felt in complimentary parts used in the auto manufacturing process as well as in the technology sector, it can explain a substantial part of the weakness in the US manufacturing sector over the past two months. However, once the supply disruptions ease, the situation in the US manufacturing sector should improve again. As this article published yesterday suggests, the situation in the Japanese semiconductor industry has been improving significantly: "Following the devasting earthquake, tsunami and electrical power crisis that severly impaired both the Japan and world semiconductor industry, many supply chain players now report that production has reached pre-earthquake levels with minimal risk to future shipments. In addition, the Japanese government has excluded semiconductor fabs and many chemical plants from the 15% power cuts planned for this summer." However, reports from some auto parts manufacturers suggest that in this sector it might take a bit longer before production has been fully restored.
Overall, though, the negative supply shock should slowly ease over the next few months. Coupled with a turn in the seasonal factors used to adjust economic data, the US economic reports covering the June-August period should increasingly paint a friendlier picture again.