Tuesday, June 30, 2009

Outlook for macro-economic and financial markets volatility

The outlook for macro-economic and financial markets volatility is important for any asset allocation decision. A time period of low volatility (such as in the run-up to the financial crisis) sees investors moving into any sort of carry trades, depressing risk premia in turn. A period of high volatility such as ever since the onset of the crisis in 2007, destroys the rationale for carry trades, renders existing positions less desirable (just because of the higher volatility) and acts to increase any king of risk premia (be it the equity risk premia, risk premia for corporate bonds as well as the term premia incorporated into longer dated government bonds).
So where are we headed over the next few years in terms of volatility?
What we do know about macro-economic and financial markets volatility is that:
a) the so-called 'Great Moderation' has depressed the volatility of growth, inflation etc. in a statistically significant manner. However, macro-economic volatility spiked during the financial crisis
b) academic research gives several reasons for the 'Great Moderation', some of which should survive the financial crisis (increasing importance of industries which exhibit only limited cyclicality such as healthcare and education/reduced importance of cyclical industries such as manufacturing; better inventory management with lower inventory on average due to just-in-time production; empirically higher stability of inflation at low levels of inflation) and some of which have probably been only temporary (new financial instruments lead to a more efficient allocation of risk, especially credit risk) while for others it is too early to tell (improved macro-economic policy).
c) financial markets volatility is reduced during periods of increasing leverage in the financial sector and raised during periods of deleveraging. Financial markets volatility is also higher during recessions than during boom periods.

I think a lot of countries will exhibit relatively limited macro-economic volatility in the years ahead with the huge volatility of the past two years proving to be temporary. For one, as written frequently, my outlook remains that inflation will be low for an extended period of time in most of the so-called 'developed' economies. This per se should call for a relatively limited macro-economic volatility. Clearly not as low as in the run-up to 2007 but significantly below what we saw over the last quarters. Furthermore, I think that most of the financial sector deleveraging is behind us which should as well help to reduce volatility.
The key risk is that inflation shoots higher (again we will see that in some countries amid a currency crisis/sovereign default but not in the US or the Eurozone) which will bring with it a sharp rise in macro-economic volatility.

From this perspective, the carry trade is not dead over the medium term. (Higher-rated) corporate credit should profit and combined with a low growth outlook it suggests that developed economies' credit markets should hold a more attractive risk-return profile than equity markets.

Monday, June 29, 2009

Easing inflation fears...

This month's rallye in government bonds has been mainly driven by easing inflation fears. The chart below shows the development of 10y US break-even inflation rates and 10y real yields since the start of the year. Just as the rise in UST yields has mainly been driven by rising break-evens, the latest fall stems to a large degree from the reverse. Break-evens fell by some 40bp from their recent highs whereas 10y reals are only some 10bp lower.
In the Eurozone both, the real yield on the Bundei16 and on the OATei20 have dropped by some 20bp with break-evens down approx. 30bp (real yields and break-evens did not peak at the same time). So, while Eurozone real yields dropped more than in the US, the drop in nominal yields has still come mainly from easing inflation expectations.
First, real yields usually drop due to easing growth expectations/expectations for low short-end central bank real yields (aka accommodative monetary policy) or easing supply worries/rising risk aversion. As the drop in real yields has not been pronounced, changes in any of these factors have probably as well not been very pronounced. In turn, easing supply worries following last week's relatively well-received auctions (where, however, a change in the methodology to calculate indirect bids has played a role as well) should not be seen as the major cause for lower UST yields. Second, break-even inflation rates usually drop due to lower inflation expectations, a lower inflation risk premia (i.e. lower volatility of expected inflation) or as was the case following the Lehman bankruptcy due to a negative liquidity premia associated with inflation linked bonds relative to their nominal counterparts. The latter point is currently not significant given that break-even rates incorporated into inflation linked swaps are falling as well and the most likely cause is a drop in inflation expectations. News on the inflation front has been positive, i.e. no short-term inflation pressures are apparent and also the run-up in commodity prices has taken a breather. This should be seen as positive for the economy (as high commodity prices act like a tax on consumers and corporates in a net-commodity importing country) and therefore dampens the rise in risk aversion.
As I mentioned frequently, I not only see almost no short-term inflation risks given the significant and ongoing rise in spare capacity amid falling demand, I also dont expect inflation to rise to worrying levels (i.e. above 5% or even double-digit rates as some observers fear) over the next few years.
Inflation expectations can fall a bit further in the weeks/months ahead amid a lack of any such pressures building in the short term. Furthermore, I expect that real yields will be able to fall as well, however, this might well take some more time before it becomes more pronounced. Lower real yields - besides being down to easing supply pressures - should go hand in hand with reduced growth expectations and this will probably materialise only slowly as the recovery will likely be more subdued/shorter than consensus is looking for.
In turn, I maintain the long duration call for government bonds and also think that higher-rated corporate bonds remain an attractive investment from a shorter as well as more medium term perspective.

Thursday, June 25, 2009

Consumer comfort bodes ill for risky assets but should depress government bond yields

While not that much news has come out this week and despite risky assets having shot higher again over the past two days, Bunds continue marching higher in a quiet fashion. The bear-trend which started in early March has by now been broken (see chart), confirming the brightening outlook for govies.
Source: Tradesignalonline.com
Furthermore, while USTs have lagged over the past days (also in the wake of yesterday's FOMC-statement), this week's UST auctions have calmed concerns about a buyer's strike, at least for the time being.
Interesting to note as well is that the ABC weekly consumer comfort index is almost back to its lows. The index bottomed in December/January and then recovered up to early May. However, since then it dropped by 10 points again and is just 1 point ahead of the former lows. The reasons for the renewed drop are likely to be found in the combination of ongoing weakness in the housing market, more job losses, tame wage growth and the rise in oil prices. The chart below compares the development of this ABC index with the S&P500. The consumer comfort index peaked in early 2007, well ahead of equities. It bottomed during December08/January09, two months ahead of the bottom in the S&P. From that perspective the drop over the past 5 weeks does not bode well for equities.
Source: Bloomberg
The chart below compares the ABC index with the development of 10y UST. Here, the co-movement appears even closer. Last year, there was one big divergence as bond yields rose starting late March, whereas consumer comfort declined further. Over the past weeks, the same divergence has re-appeared.
Source: Bloomberg
I think that the health of the consumer (and its demand for consumer goods) is vital to get us back on a sustainable growth path, not least because of the high size of consumption relative to GDP. From a historic and a fundamental perspective, the latest drop in consumer comfort bodes ill for consumption which might well drag equities and government bond yields lower again. Stick to a defensive asset allocation and stay long in UST and Bunds.

Wednesday, June 24, 2009

Collapse in Private Pension Funds' Assets a key reason for a secular rise in the savings ratio?

The OECD has released its 'Pensions at a Glance 2009' report. The report itself costs money but some excerpts can be found here. Furthermore, today's FT contains a brief summary here. The report contains some very interesting findings. The chart below shows the pensions fundes' real investment returns for 2008. Across the OECD, on average pension funds lost 17.4% in real value (unweighted by size) and 23% if weighted by size. The losses have been worst in those countreis where the equity share has been highest (unsurprisingly). Irish pension funds held about two thirds of their assets in equities vs. an average of 36% in the 20 OECD countries where data is available. Such losses are enourmous and I think will have several consequences. For one, pension funds are likely to become more risk averse following such losses (unsurprisingly those pension fund systems with the lowest share in equities/highest in bonds performed the least bad: Germany, Czech Republic, Slovakia, Mexico). Furthermore, such huge losses will affect the behaviour of retirees and especially those near retirement in those countries where private funded pensions make up a significant contribution of retirees income. In 5 countries private financial sources make up more than 40% of retiree incomes: Australia, Canada, the Netherlands, the United Kingdom and the United States (closely followed by Denmark and Ireland).
In turn we should expect that especially people near retirement (and parts of the retirees) which have relied on private financial sources for their retirement are forced to save more. This can happen either via spending less or via working more (and retiring later). But clearly, this is an age group where we should expect savings ratio to rise significantly. It is therefore no surprise to see that savings ratios in the countries most affected by the loss in private pensions funds' wealth are increasing dramatically (from an albeit low level). The chart is from News N Economics, see here for post.
Finally, given such a reason for rising savings ratio, this rise in the savings ratio does not promise to be a short-term temporary affair but rather of a more longer term nature! Besides, limiting consumption growth, it also prevents parts of the people near retirement from dropping out of the workforce. Both, factors are rather disinflationary than inflationary.

Tuesday, June 23, 2009

Positive momentum is breaking down across the risky asset universe

In Breakdown in EURUSD and Gold signs of things to come? on June 8 I stated that the break of the upward trendline in EURUSD and Gold "might well signal the start of a much broader correction across risky assets and be followed by a breakdown in the positive momentum in equity markets as well." In the meantime risk appetite has indeed taken a hit and just yesterday, a number of assets have broken through their former upward trends.
a) Equities: the S&P has broken through its former upward trend and also through its 200 day moving average (it broke through the 200 day moving average to the upside at the start of the month). Also the German Dax index has broken through its upward trendline (which it touched several times since early March) and the 200 day moving average. It is currently sitting just on the trendline (at 4727) and the moving average (at 4729).
Source: Tradesignalonline.com

b) Commodities: yesterday Gold broke through a more longer-term upward trendline which was in place since late October. However, more commodities have been sharing into the downward movement. Oil for example is now down some 10% from its recent peak and also broke through its upward trendline yesterday.

Source: Tradesignalonline.com
c) Credit: creditspreads have formed a bottom early this month and started to rewiden approx. a week ago. The 5y iTraxx Europe Index is approx. 25bp wider and the Xover index is a good 100bp wider than at its lows.

Overall, bearish technical signals are emitted by a host of risky assets (be it equities, credit or commodities) across the globe. With commodity prices receding as well, the latest inflation fears should calm down, helping break-even inflation rates incorporated into inflation linked bonds to moderate again. A key difference to the surge in risk aversion during Q408/Q109 is that this time gold is falling rather than increasing. I think this is due for one to receding inflation risks while at the same time - a key difference compared to Q408/Q109 - systemic risks in the financial sector promise to remain much more contained.

Monday, June 22, 2009

Asset Allocation: Defensive Stance

As mentioned before, I expect government bond yields to fall during summer whereas risky assets should correct lower. In turn I recommend a defensive asset allocation stance for the next weeks. Inflation fears should subside whereas default worries will increase again.

Government bonds: Long duration
Equities: underweight, especially in cyclicals/consumer durables/financials&commodities
Currencies: overweight USD & JPY. Neutral on CHF. Underweight EUR, GBP and commodity-currencies.
Credit: Neutral to moderately underweight credit overall. Within credit overweight higher-rated non-cyclicals (for example utilities) across the curve vs. lower-rated cyclicals.
Commodities: Underweight, mainly energy and base metals but also Gold.
Cash: Overweight

I do not expect new lows in the major equity indices but think that a 20% correction from the recent highs would be in order. Credit should also re-widen a bit (due to rating downgrades and rising defaults), but this should be more the case for lower-rated credit, i.e. increased differentiation.
I think that commodities have run a bit too far. With world economic growth being negative, end-demand for commodities should be lowered as well. I think that a lot of the run-up in prices has for one been due to speculative demand (especially in oil and gold) but apparently also down to stockpiling in China (especially in Iron Ore, Copper and Coal. See here). To me both look unsustainable and we therefore risk also a significant setback in commodities.
Gold is a bit a different animal as it is said to profit from both, inflationary expectations as well as (a deflationary) deepening financial crisis. However, in an environment where systemic risks should have been moderating a bit whereas nominal growth remains tame, I fail to see a significant upside for gold in the next weeks and would look for another drop in prices.

Rates Strategy: How to position

I maintain the government-bond bullish outlook which I adopted some 10 days ago. Besides recommending a long duration stance, I want to give some more details on what I consider attractive positions.
A) Duration: as mentioned, I expect UST and Bund yields to fall during summer. I think that a medium-sized long position (+3/4 on a scale of 0=neutral to 6=maximum long) is reasonable. I expect help for the bond market from several angles (valuation is relatively favorable, so are technicals while expectations for the economy have become a bit too positive). However, I do not expect the economy to fall off a cliff again as happened after the Lehman collapse. In turn, risky assets - which I expect to drop in value - should as well not collapse. In turn, Bund and UST yields should fall, but not dramatically and not in a straight line. Rather, I think we will trade down towards the 3% area in both, 10y UST and 10y Bunds within a period of 2-3 months.
B) Curve: Usually yield curves are bull-steepening and bear-flattening. This is because longer-dated expectations for inflation and growth are more stable than shorter-dated expectations which in combination with central banks conducting monetary policy via changes in the short-term rate leads to short-term yields being more volatile than longer-dated ones. However, as short-term yields have become very low, central banks' ability to change short-term policy rates has become very limited and instead the need to conduct moentary policy via alternative measures (quant and credit easing) remains high. These alternative measures have more of an impact on longer-dated rates (via quant easing, need/commitment to keep rates low for a prolonged period of time) and on credit-related yields (credit easing). All these factors increase the volatility of longer-dated yields relative to short-dated ones and change the dynamic of the yield curve to bull-flattening and bear-steepening. This is more apparent in the US than the Eurozone (given that Fed funds are almost at 0% and given that the US is engaging in QE). In turn, the US yield curve is prone to bull-flattening, suggesting that long-dated UST are the preferable part of the curve during a rally. In the Eurozone, the yield curve has more scope to bull-steepen which I expect to happen in the 5-30y area. In turn, I expect yields to fall most in the 5y sector and I think steepeners are attractive in the above 5y segment. However, in order to get a long duration position on board and in terms of total return, the 10y and above segment. Though, beyond the 15y segment, to me the curve appears a bit too flat. But that might not change soon as pension funds might be forced to continue getting duration on board.
c) Currencies: I prefer the USD from an absolute return perspective as it should profit from rising risk aversion. Also for the bond markets I see most potential in USTs amid relatively high real yields (given the economic circumstances). Also for Bunds I see a good potential (albeit a bit less as USTs usually have a higher volatility than Bunds and therefore USTs outperform in a bull market). However, here the EUR is likely to weaken and therefore investments should be more on a currency-hedged basis. With respect to Gilts I am a bit more cautious. I have some doubts about the longer-term sustainability of the UK situation (it is a similar mess as the US but just not that important as a reserve currency). Furthermore, even though inflation has been dropping, its trend is not as favorable as in other countries. Therefore, I recommend a less pronounced long exposure in the case of UK Gilts than in the US and the Eurozone.
d) Spreads: Credit spreads are likely to widen and lag the performance in Bunds/USTs. However, I would assume that the likely widening in spreads will not be of such an indiscriminate nature (and clearly not as pronounced by far) as following the Lehman collapse which saw spreads of any credit product blow out sharply. I would rather assume that we see an increased discrimination between industry segments, depending on the overcapacity in a given industry/the outlook for demand etc. So my guess would be that for example utilities hold in better than lets say autos (whereas both widened sharply during autumn) or other durable consumer goods. So a more defensive positioning within credit is warranted with an overweight of higher-rated, less cyclical issuers at the expensive of lower-rated cyclical ones.

Friday, June 19, 2009

Random Thoughts

Random Thoughts is a regular column with the aim of providing some interesting bits and pieces but does not give a holistic picture/view/outlook.

a) US CPI (from macroblog): "The chart below (hat tip to Brent Meyer at the Cleveland Fed) shows another interesting feature of yesterday's CPI release. Notice the clear downward shift in the distribution of CPI component price changes. Over half of the prices within the CPI market basket posted declines at or below 1 percent last month, up from an average of 29 percent in 2008, with a whopping one-third of the price index posting declines in May."
To me this highlights that an incresingly large area of goods and services is affected from disinflationary forces and the low headline number is not only down due to energy.

b) Guarantees, loan facilities and costs: the sums involved in the bailout measures are huge and also the costs involved are huge. However, guarantees, loan facilities/credit and costs are NOT THE SAME THING. If my local tv station or newspaper states: "Germany has spent EUR430bn to bail out the banks", then that is just not true. In fact they have provided capital injections (which is a real cost), much more money via credit injections (which is a cash-outflow for the state but no cost and we will only see in the future how much that really costs in the end) and finally a lot of guarantees (which is no cash-outflow and we will see how much it costs in the end). You can forgive the public and journalists for not knowing what they say but increasingly in the professional sphere the same mistakes are made as well. For example for this chart (Bailout Costs vs Big Historical Events) provided by the Big Picture - an otherwise very insightful blog - it seems that the aim was more to show a dramatic picture than to compare apples with apples: The post states: "This early Bailout Nation graphic shows the the total costs to the taxpayer of all the monies spent, lent, consumed, borrowed, printed, guaranteed, assumed or otherwise committed."
Again: you do not need to be an accountant to know that a guarantee is not the same as a cash-outflow via a loan facility and a cash-outflow is not the same as a cost. Furthermore, just because a loan facility has been established it does not mean that it has been drawn upon (otherwise the Fed's balance sheet would be much larger than it currently is). We just do not yet know how much the enacted (and potentially future) bail-out measures will cost. I personally see that buying the crappy Bear-Stearns assets can amount in a 100% loss but I fail to see how extending the swap lines with other large central banks such as the ECB can be stated as a cost...
Bloomberg provides an internet-based tool to view various programs and how much money has been drawn in each (but I do not know how up-to-date it is). For example out of the committed USD540bn for the money-market investor funding facility exactly USD0 has been drawn.

c) Brad Setser is pretty sure that China did not sell USTs in April and May: "China shifted from bills to short-dated notes in April rather than actually reducing its overall Treasury portfolio. It just so happens that China buys all its short-term bills in ways that show up in the US TIC data, but only a fraction of its longer-term notes in ways that show up in the US TIC data. A shift from bills to notes then could register in the US data as a fall in China’s total Treasury holdings and a rise in the UK’s holdings."

Wednesday, June 17, 2009

Government bond yields are falling again

As suggested what might happen (see for example Have we seen the highs in UST and Bund yields?), government bond yields have started to fall with 10y Bunds some 25bp below recent highs and 10y UST some 30bp. I regard this as a significant development. For one, in both cases this constitutes the largest fall since mid March when yields fell approx. 50bp for 10y UST and roughly 30bp in 10y Bunds in the wake of the FOMC announcement to start purchasing longer-term US Treasuries on March 18. This time, however, there is much less of such artificial help for government bonds (albeit there is talk the FOMC could become more explicit at its next meeting about keeping the funds rate low for some time). Again, I think the technical picture looks good (as the chart shows, the 50% fibonacci retracement has held in the case of 10y Bunds at 3.774%) and the market has turned bullish from oversold conditions.
Positioning as well remains tilted in favour of shorts according to CFTC in the case of US bond futures. Fundamentally, the longer term outlook remains challenging for the global economy and by now it seems that economic data releases are not tilted in favour of positive surprises anymore with some releases coming in below expectations and some above. Additionally, the rating downgrade cycle in the credit space is continuing unabated while defaults continue to rise. Therefore, the stage has been set for risk appetite to wane again. Finally, supply turns market supportive at least in the Eurozone with gross supply of government bonds becoming significantly lower from next week onwards. Overall, technicals, positioning, the medium-term fundamental outlook as well as shorter-term risk appetite are finally working in favour of govies again. Therefore, the outlook for the safe-haven of government bonds in the form of US Treasuries, Bunds as well as the USD has been brightening and setbacks should be used to add to longs. On the other side, risky assets are breaking through their recent upward trends highlighting an increasing probability of a deeper and longer-lasting bear-move.

Tuesday, June 16, 2009

And yet again - inflation

I clearly subscribe to the view that inflation is everywhere a monetary phenomenon. Too much money chasing too few goods leads to higher prices. Obviously central banks have created some more money (but again as described in an earlier post – Is inflation just around the corner? - it is central bank money and not broad-based credit which is increasing). But on the other side, the drop in demand for goods is just truly astonishing. And it is this drop in demand which is deflationary. Today’s release of the US capacity ratio shows just how weak demand is at the moment. Not only did the capacity utilization rate fall further, it continued to come in below expectations (even if only slightly) and at 68.3% showed another record low (see chart). This per se shows how strong the demand-destruction has been.

The second chart highlights how closely the change in capacity utilization is mirrored in changes in inflation (i.e. when capacity utilization falls, inflation falls as well even though a bit later). Even during the inflationary 70s, this cyclical relationship held.

Second, it also underlines that the money being created by the central bank does not (yet) find its way into the consumers’ pockets (rather US banks’ excess reserves have grown) and the stimulus injected by the government does not get spent (as households restore their savings ratio).

In the end, if the additional central bank money is not being used to finance additional goods-purchasing transactions, then there is not too much money and if demand-destruction continues to be faster than supply destruction (via existing capacity being closed or becoming outdated), then there will be too many goods. In turn, we have too little money chasing too many goods resulting in downward pressure on prices remains. So far, I am not overly worried about upward price pressures in the US and the Eurozone (the UK is a different animal though).

Some administrative issues

Some administrative things:
a) anyone who would like to have specific themes discussed in the blog can send me a mail (or use the comment function). I have received several propositions so far and will start working on them.
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c) any suggestions on formatting etc. to make it easier to read are also more than welcome.


Monday, June 15, 2009

End of recovery in risk appetite?

A week ago in Breakdown in EURUSD and Gold signs of things to come? I wrote that "...the break of the upward trendlines (in EURUSD and Gold) might well signal the start of a much broader correction across risky assets and be followed by a breakdown in the positive momentum in equity markets as well. Risk appetite might well take a setback again in the days and potentially weeks ahead." By now also equities and commodities such as oil have started to correct while government bond yields are falling again. I do think that this correction has further to run in the weeks ahead.
Yes, things are less bad in the economy than they have been in Q408 and Q109. But it should become evident soon that less bad does not mean good. My personal base case is that growth in the quarters ahead will oscillate around 0%, i.e. we will have some quarters with positive growth interrupted by the odd quarter with negative growth. This would clearly not constitute a self-sustaining recovery. Households everywhere remain under severe stress from falling asset values (household net worth in the US decreased by another 2.5% in Q109 or USD1.3trn) and rising unemployment. Furthermore, the default cycle in the corporate sector is nowhere near its end as excess capacity across a host of industries will continue to rise. Rising excess capacity amid slowing demand means that supply needs to be cut as well which in turn implies further rises in unemployment.
With growth far from becoming self-sustainable and a scenario for oscillating growth below trend, financial markets should as well not show a sustained ongoing recovery across risky assets. I rather think that valuations in risky assets following the recent strong recovery seems to have gotten ahead of itself. Therefore, I think that we are only at the start of a more significant correction in risky asset markets including commodities. On the other side, government bonds and the USD should perform further in the weeks ahead.

Is inflation just around the corner? Part II

The second group of higher inflation advocates focuses on the increase in base money via the lengthening of central banks' balance sheets as well as the huge fiscal deficits. Given that M*V=Y*P always holds (The amount of money times the velocity of money is equal to the amount of output times the price level) and M has been increased by an almost unprecedented amount, P needs to increase drastically as well. Furthermore, as fiscal deficits are ballooning and government's indebtedness will reach levels which cannot be repaid, inflation is the only solution to reduce the debt-to-gdp ratio.
First, is the lengthening of the central banks' balance sheet really such a big problem? I doubt it. For one, I regard more the broad credit aggregates as being important for creating inflation than the narrow central bank money aggregate (that is to say I would not use M0 in the above formula but rather M3, M4 etc.). In fact, the US Fed has increased its balance sheet from around 850bn in mid-2007 to around USD900bn in early September and then in the wake of the Lehman bankruptcy to around USD2200bn by the end of 2008. Since then, the size has been fluctuating around USD2100bn. However, this size pales in comparison to the broad credit aggregates in the US economy which are estimated to be around USD50trn. The lengthening of the Federal Reserve's balance sheet came about by buying assets to stabilise credit markets (with the buying of US Treasuries being only a small part). However, this buying was not enough to a) help restore private credit markets to work properly again and b) lower yields on credit instruments (bar shorter-term securities) to levels below those prevailing at the onset of the financial crisis in 2007. In turn, for most economic agents (bare the government), monetary conditions remain tight (even though the credit crunch has eased over the past months) in terms of yield levels and availability of credit. The deleveraging by corporates and private households has only just started (see the higher households savings ratio) and the broad credit aggregates are unlikely to grow significantly over the next quarters. In turn, the velocity of money ("V" in the above equation) will remain depressed and the inflationary impulse provided by the lengthening in the Fed's balance sheet will not hit the real economy/will not be enough to offset the deflationary forces of the private sector deleveraging. Finally, I think that most of the enacted credit easing can be reversed relatively easily. A lot of the credit easing has been conducted via shorter-dated paper. In turn, even once the economy has moved back on a self-sustainable growth path, the Fed does not need to actively sell most of its holdings. Rather they can stop their buying programs and let existing paper mature.
I am more concerned with the size of the fiscal deficit and the ballooning debt-to-gdp ratios as history has shown that it is very difficult to reverse a structural budget deficit. However, I still fail to see how this can have significant inflationary consequences on its own as long as the state does not default/the currency does not depreciate sharply and/or as long as the central bank can conduct monetary policy independently (and I am convinced this is still the case in the Eurozone and the US).
Here, the USD's reserve currency status will prevent both: a funding crisis and a sharp devaluation. I think that the talk about a sharp USD devaluation is much overdone. For one, I do not see any alternative to the USD for the next years and additionally, the US remains the most important export market for most of the producing world. The situation in the UK remains very different though as no-one really needs to hold GBP.

So overall, I do not believe that inflation is just around the corner due to higher oil prices. Furthermore, I am not worried as well that inflation will skyrocket once the economy recovers given the huge level of excess capacity, the ongoing debt-deflationary process and the ability of central banks to reduce the balance sheet again if need be.

Is inflation just around the corner? Part I

There are several groups of inflation advocates. One group - similar to last year - focuses on rising commodity prices (especially oil), while another is concerned about the lengthening of central banks balance sheets and the huge fiscal deficits. In the first case, inflation is just around the corner while in the latter, inflation will be ballooning (with several proponents calling for double-digit inflation rates) once growth recovers. I still fail to see noticeable inflation pressures unless we see a currency crisis/sovereign default a la Iceland.
The rising oil prices will have some impact on headline inflation rates. However, even more so than was the case one year ago, this constitutes much more so a change in relative prices and a negative terms of trade shock for an oil-importing country. Higher oil prices mean that corporates and households need to pay more for their energy consumption. It does nothing to help increase nominal wages (with the exception of some countries where there is still wage indexation) or employment (rather to the contrary). Excess capacity in the form of unused production capacity and unemployment is much more prevalent than 12 months ago which will render it very difficult to pass on energy price rises. It therefore should reduce profit margins even more than last year. Additionally, higher headline inflation due to rising energy prices will not render houses any cheaper or lead to a real reduction in indebtedness. Inflation only helps to prop up house prices/reduce household indebtedness if it is mirrored by rising rents (which reduces the house-price-to-rent ratio and unless house prices rise, increases the expected return on purchasing a house as an investment) or rising wages (which helps to pay back debt).
In turn, I do not expect that higher commodity prices (in commodity-importing countries) will lead to higher inflation rates bar a temporary blip. Rather to the contrary, they dampen any economic recovery and put more downward pressure on core inflation rates. Furthermore, I expect the run-up in oil prices to be partially reversed again during the next weeks and months (more on that in another post).

Thursday, June 11, 2009

Have we seen the highs in UST and Bund yields?

In the post "Recovery or just getting less bad" dated May 27, I stated that "while government bonds should face more headwinds in the short term, I expect that over the next 1-2 weeks government boned yields should stop rising, slowly followed by yields trending towards the 3% again for 10y Bunds and UST during summer." In addition, this Monday June 8 I stated that "I maintain the view that the yield highs are close and we should top out in the days ahead" (see: Breakdown in EURUSD and Gold signs of things to come?). So as two weeks have past since the former and four days since the latter post, have we now seen the yield highs for Bunds and UST?
First there are fundamental reasons for lower yields from current levels: Yes, the economic situation is getting less bad compared to Q408/Q109 but any positive growth momentum will remain dependent on macro-economic stimulus for a prolonged period of time. The most likely scenario is that following a move back into positive territory during H209, growth will oscillate around 0% for several more quarters. Furthermore, despite all the talk about inflation being around the corner, I remain unconvinced. The deflationary impetus of the private sector deleveraging is far from having run its course (see for example the previous post: consumer deleveraging spiral still getting worse). I am not yet concerned about the balance sheet lengthening of for example the US Fed as velocity of money is falling. Furthermore, most of the expansionary monetary policy measures can be reverted relatively easily (I am more concerned about the size of the budget deficit as history shows that it is much more difficult to reduce the cyclically adjusted fiscal deficit).
So overall, I expect nominal GDP (which shows a good long-term relationship with nominal yields, see chart) to remain subdued for a prolonged period of time. In turn, longer-dated UST yields should remain relatively low as well. 10y UST yields of close to 4% do not fit with the outlook for nominal GDP growth of below 4% for the next several quarters.

From a more shorter term perspective and as mentioned earlier, positioning by speculative accounts in US bond futures is heavily tilted in favour of shorts. Additionally, consensus has shifted to a bear-market base scenario for government bond yields. Furthermore, technicals are now oversold. In combination, this suggests that a lot of the negative news for government bonds is now factored into positioning and price.
Finally, I think that we have touched a major correction level in 10y Bunds this week, the 50% Fibonacci retracement of the Jul08-Mar09 upward move. This Fibonacci level is on the adjusted future chart at 117.44. The bund future traded down to 117.47 on Monday and to 117.52 today.
Overall, therefore, I see a larger than 50% probability that we have seen the highs in 10y UST and Bund yields this week and that we are now in a topping process for yields/bottoming for prices with no new significant yield highs. My basecase of yields falling during summer remains intact.

Tuesday, June 9, 2009

Consumer deleveraging spiral still getting worse

A lot has been written about the difficult state the US consumer finds itself in: overindebted and undersaving for quite some time. And besides the falling house prices, also the deteriorating labour market is making things worse, much worse. A lot has been written about the employment data and lately the focus has turned on the development of aggregate weekly hours as a potential signal to call a bottom in the economy. To quote Jeffrey Frankel, a member of the NBER Business Cycle Dating Committee (http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/2009/06/08/the-labor-market-has-not-yet-signaled-a-turning-point/): "Total hours worked is equal to the total number of workers employed multiplied by the average length of the workweek for the average worker. The length of the workweek tends to respond at turning points faster than does the number of jobs. When demand is slowing, firms tend to cut back on overtime, and then switch to part-time workers or in some cases cut workers back to partial workweeks, before they lay them off."
Unsurprisingly the amount of aggregate weekly hours worked in the US economy has fallen significantly during the current recession (one indicator of the "unused capacity") and the outlook suggests that this will remain the case for at least another few months.
There are several points to make:
a) over the medium term aggregate weekly hours in the US economy and the S&P500 index exhibit a strong co-movement (I have used the natural logarithm of the S&P500 given it is exhibiting stronger growth over the longer term):
b) the Fed does not seem to start hiking rates while aggregate weekly hours are still falling:
c) What I find most interesting is the development of the index of aggregate weekly hours multiplied by the average weekly nominal hourly earnings. This can be interpreted as an index of aggregate weekly nominal earnings (of total private nonfarm payrolls). The chart also highlights the NBER-dated recessions:

The drop in this nominal earnings index is unprecedented since the data is available (January 1964). This is further underpinned if we look at the yoy %-change of this index:
Never over the past 45 years have nominal aggregate weekly earnings been dropping for such a long time and to such an extent. The chart below compares this change with the development of US CPI (again yoy change). This time, however, nominal earnings are lagged by 18 months. The strong co-movement between the two time series suggests that CPI only tends to rise (fall) subsequent to a rise (fall) in aggregate nominal weekly earnings with the lead time of the earnings time series being roughly 18 months. Even during the strongly inflationary 70s, inflation rates fell subsequent a significant drop in aggregate nominal earnings.

In short, the medium term outlook for the US economy remains subdued and a self-sustained recovery is very far off. Furthermore the talk about sharply rising inflation rates seems premature as well (this is not to deny that current monetary and fiscal policy will have significant inflationary pressures over the longer term if not reversed). The yoy growth rate of aggregate nominal earnings is 10% below the rate at the start of 2008 and negative. This is one element of the deflationary deleveraging spiral which is still getting worse ...

Monday, June 8, 2009

Breakdown in EURUSD and Gold signs of things to come?

Market developments following the release of the US (un)employment report have been very interesting. Even though as is frequently the case, the payroll numbers could be interpreted in a positive (below expectations drop in payrolls) and a negative way (fantasyland adjustments on the back of the birth-death model, lower average weekly hours), the markets chose to move significantly against recent trends. Especially the sell-off in EUR-USD and Gold seems noteworthy. The rising risk appetite (as well as rising inflation worries) have propelled Gold and EUR-USD higher over the past months in line with rising equity markets. While technicals for all three assets have been highlighting overbought conditions, short USD (vs EUR) and long Gold seem to have been the much more crowded trades than long equities. In turn, the break of the upward trendlines might well signal the start of a much broader correction across risky assets and be followed by a breakdown in the positive momentum in equity markets as well. Risk appetite might well take a setback again in the days and potentially weeks ahead.
Bond yields have continued their march higher. However, I maintain the view that the yield highs are close and we should top out in the days ahead.

Thursday, June 4, 2009

Outlook for Government Bond Yields

I wrote last week (Recovery or just getting less bad?) that Bund and UST yields should stop rising within a period of approx. 1-2 weeks and then slowly start trending lower again towards the 3% area during the upcoming months. I still think this is very likely even though the recovery hopes will not go away soon (but are likely to receive further nourishment in the near term).
The reasons for the end of the current bond-bear market are several:
a) As shown previously, a lot of the former liquidity premia has been priced out of UST (and Bunds) and in turn I do not regard govies as expensive anymore.
b) According to the CFTC, risk-weighted net positions at the long end of the UST curve via 10y and 30y futures have now reached an all-time record (see chart), i.e they are even more pronounced than in early 2004 just ahead of the last hiking cycle (first hike was in June 2004).c) inflation rates priced into inflation-linked swaps (again, I think swaps give a better indication of inflation expectations than break-evens priced into TIIs due to various premia) are back at levels last seen at the beginning of 2007, i.e. just ahead of the housing market crash and the deleveraging cycle. Even with the latest rise in oil prices, it is hard to see how inflation linked products can generate a positive carry over the next few months and quarters.
d) the talk about a potential downgrade of the US seems very premature. Additonally, while the bond supply will remain huge given the fiscal deficit, demand is there as well as the share taken by indirect bidders at the last few auctions has shown.
e) the technical situation appears oversold (but no buy-signal given so far).

So overall, I think that the pessimism with regards to the outlook for government bond yields (especially USTs and Bunds) is overdone and I would look for a friendlier picture to emerge over the next few months (probably led by a drop in break-evens in the first stage).

Wednesday, June 3, 2009

Is the rise in US Treasury yields a problem? Part II

The last post concluded that for highly rated/government near instruments yields are rising whereas for lower rated instruments yields are still falling.
This post tries to analyse where the rise in UST yields comes from. The first chart shows 10y nominal yields, 10y real and 10y break-even yields as incorporated in inflation-linked Treasuries (TIIs). This years' rise in nominal yields was mostly down to a rise in break-even inflation rates from around 0%. Furthermore, real yields kept falling earlier this year (in line with falling equity markets) and fell significantly after the FOMC announcement to buy UST bonds. Only since then have real yields backed up somewhat, in line with rising risky assets/risk appetite and the increasing talk about green shoots as well as about the sustainability of the huge fiscal deficit. Still, real yields remain low by historical standards - in line with an easy monetary policy. Furthermore this historically low level of real yields does not yet seem to be a cause for concern in terms of holding back the real economy. Additionally, it does not yet hint at a significant rise in the real risk premia (on the back of the unsustainably large deficit/supply).
The second chart shows what I consider as one proxy of the liquidity premia incoroporated in US Treasuries. Following the collapse of Lehman Brothers, a huge liquidity premia was priced into US Treasuries, however only into nominal Treasuries and not any other assets, including TIIs. In turn, not only did swap spreads of US Treasuries balloon (as swaps underperformed vs. UST), but also TIIs underperformed heavily vs. USTs and by more than what the inflation outlook would have indicated, leading to a sharp collapse in break-even inflation rates. However, this led to a significant difference in what TIIs priced as break-even inflation and in what Inflation Linked Swaps priced for the same economic variable (see second chart).
After having reached a level of 150bp at the start of the year, the spread between TII break-evens and inflation-linked swaps has narrowed by almost 100bp. This means that TII break-evens rose 100bp more than inflation priced into inflation-linked swaps. In turn, I think that the associated 100bp rise in 10y UST (out of the total rise of 160bp since the start of the year), is purely down to the pricing out of the former liquidity premia. Pricing out this premia (and more so the underlying flows out of UST into risky assets) should be seen as a positive sign for the economy given that it suggests that the credit crunch is easing. The remaining 60bp of the rise in 10y UST yields can be split down into a "proper" rise of inflation expectations of around 90bp (as measured via the change in inflation-linked swaps) and a fall in real yields of around 30bp.
Therefore, at a maximum I would only consider 60bp of the rise in 10y UST as a cause for concern for the economy.

Tuesday, June 2, 2009

Is the rise in US Treasury yields a problem? Part I

The massive rise in UST yields (and the resulting curve steepening) has been another reason for the bears to rise their voices against a potential economic recovery as rising yields would kill any such development. However, while the 160bp rise in 10y UST yields since the start of the year cannot be neglected, we should look deeper for clues whether this will prove harmful for a recovery or not. Yes, mortgage rates have started to rise as of late adding to the existing downward pressures in the housing market. However, most credit-related yields have continued to fall due to the ongoing compression in credit spreads alongside the recovery in risk appetite and risky asset markets. Just as the record low yields around the turn have only been signalling an environment of easy money for the government and not for most corporates and households, the rise in UST yields is (not yet) hurting most corporates given that their funding costs are still falling.
Overall, the higher the rating and the more explicit the government involvement (i.e. US Treasuries, Mortgage rates etc.), the more pronounced the rise in yields.