Italian yields rose again Wednesday. The take-up of the 5-year tap was not awful, but obviously less than what the market was hoping for. Meanwhile, the Treasury auctioned 30-year bonds at a record low yield of 2.925% and a bid-to-cover ratio over 3.
And that’s where we stand today. The status quo is that US bonds have a bottomless bid and European securities are consistently offered. I suspect that is partly a response to the approach of year-end, and some of that trend will reverse after the end of the year, but I suspect that investors with long-dated liabilities, like pension funds, probably see the US long bond as probably a much better source of duration than long bonds from European sources.
After all, the notion that the Euro might not survive in its current form is finally…uh…gaining currency. While a narrowed Euro should probably be a stronger currency, the uncertainty associated with a splintering bloc – who will be in it, or will the Euro simply evaporate altogether? – deters investors from keeping as many eggs in that basket. The basket is on fire.
For all the wailing about the Euro’s decline below $1.30 Wednesday, to near the lowest levels of the year, Armageddon it is not. The chart below shows the Euro/USD exchange rate over the last five years. Clearly, the Euro does not look strong. But neither is this alien territory, at least not yet.
click to enlargeSource: Bloomberg.
Euro is weak, but it isn’t exactly in no-man’s-land.
I am tempted to call the dollar the least-ugly stepsister, and say that the weakness of the Euro/USD exchange rate is all about weakness of the Euro rather than dollar strength, but Wednesday the dollar was very strong against the constant candle of commodities. While Tuesday commodity indices were strong despite the dollar weakness, Wednesday virtually every commodity fell. Precious Metals fell 5.2%, led by a thrashing of silver; the energy group was also down around 5% and the DJ-UBS Commodity Index as a whole lost a whopping 3.6%.
So were investors right Tuesday when they bid commodities up, or right Wednesday when they cratered them? My personal view is that they were closer to right Tuesday, but again this may be so much year-end noise. Raising liquidity by selling commodity futures-backed investments is easy to do, and the commodity trading business is a capital-intensive one for banks at a time when capital is increasingly scarce.
Unsurprisingly, with commodities down that much and the Treasury auctioning $12bln 5-year TIPS Thursday, breakevens and inflation swaps were weak. Inflation swaps fell 5-15bps. TIPS were unchanged to lower, while nominal markets rallied with the 10y nominal Treasury down to 1.90% and the 10y TIPS still at -0.08%.
Tuesday I showed a fairly violent chart that illustrated how European real yields have risen relative to US and UK real yields. In contrast to the violence of real yield movements, the movements in inflation expectations have been sedate if not stately. This is because an important part of the movement in European real yields is due to the deterioration in the perceived credit quality of the underlying bonds. Inflation swaps tracking inflation in different economies, however, have the same underlying credit (you face your counterparty on a fully collateralized basis) so the relationships are much more stable. For a long time, UK expected inflation (RPI) has been higher than US expected inflation (CPI) which has in turn been higher than Euro expected inflation (see chart).Source: Enduring Investments.
The general configuration of inflation markets has been static for some time.
Now, you would think that, all else being equal, the recent debacle in Europe would imply much lower inflation on the continent. In fact, European inflation expectations have risen and are now trading as close to US inflation expectations as they have since the inflation swap market began, other than the late-2008 to late-2009 period when the US was in crisis. In late 2008 and for parts of 2009, 10-year inflation swaps in the US actually traded as much as 80bps below 10-year inflation swaps in Europe.
But why should the spread tighten when the US is in crisis, and also when Europe is in crisis? The answer is that in both crises, the dollar strengthened versus the Euro. A change in the foreign exchange rate has the effect of importing or exporting inflation from one country to the other. When the dollar is strong, US inflation declines relative to European inflation. When the dollar is weak, the opposite holds true.
However, the currency has nothing to do with the overall level of inflation (call it “global inflation”). Both inflation rates can rise, or both can fall, based on other causes, while the currency determines which one rises or falls more relative to the other. One such cause, and frankly the one that is far and away the mostimportant effect, is the collective action of central banks.
In 2008, central bank intervention was far less coordinated and initially it was quite substantially behind the curve since central banks had been in tightening mode just prior to the crisis; also, we had a not-insignificant fall in money velocity and the dollar, being thus more scarce, strengthened relative to commodities prices (that is to say, commodities prices declined). In the current circumstance, central banks are coordinated and are easing much more aggressively; moreover, bank lending is not plunging like it was in 2008.
I believe that European inflation should rise relative to US inflation temporarily while the greenback strengthens, but that both should rise relative to commodity price inflation. The latter, clearly, is not yet happening, but you can still see in the chart below that commodity prices are falling much less dramatically than they did in 2008, and the crisis now I think is at its root even more severe.Source: Bloomberg.
Commodities prices are falling but much less-dramatically than in 2008.
The severity of this crisis is not in terms of the pace of economic growth (which I don’t think is likely to contract, in the US at least, as dramatically as it did in 2008) but in terms of the long-term damage being done to financial intermediaries and sovereign credit. No countries fell in 2008, and the banking sector in the US continues to function today. The damage was very large, but it was diffuse. In 2012, we are likely to see some more banks nationalized, and the European financial sector which is already significantly dormant is likely to look very different at year-end from year-beginning. Greece will default and some other countries likely will as well, and there is a reasonable likelihood that the Euro will have a different constituency. But central banks will continue to create liquidity. Oh, will they create liquidity. And so I want to be long commodity indices.
Data Thursday, while still not of prime importance, is likely to continue the recent trend of mildly positive releases. Initial Claims (Consensus: 390k vs 381k), if it achieves the consensus number, will drive the story about an “improving labor market” further along. Empire Manufacturing (Consensus: 3.00 vs 0.61 last) and Philly Fed (Consensus: 5.0 vs 3.6) are expected to be essentially unchanged. Industrial Production/Capacity Utilization (Consensus: +0.1%/77.8%) are to be roughly flat. (Ignore PPI, which is expected to be +0.2% and +0.2% ex-food-and-energy, and wait for CPI to get auseful measure of inflation). I will say that the Citigroup Economic Surprise Index, near a record level last reached in March, suggests that we should begin to brace for some disappointments, but I don’t think these forecasts represent economists getting too far “out over their skis” and I don’t expect big disappointments.
Equities should remain heavy, but one other point I want to make (and keep making) is that these December moves ought to be taken with a grain of salt. The moves will be more dramatic simply because it’s year-end, and sometimes big moves will happen for no other reason than that one big player needed to liquidate a position. We little people can’t know much about those moves, so work hard to avoid overreacting. By now you should already have the position you’re comfortable holding until January, and very little should cause you to change that.
The holiday season means that only a few more of these articles will be published before the end of the year. But there are still some to come, including my year-end piece with updated long-term asset projections and a portfolio allocation exercise. Wouldn’t it be a great holiday gift to your friends to turn them onto this blogger?
Afternoon thoughts from the Trading Room – 3.30pm
Across Asia, regional markets are enjoying modest gains after picking up a fairly positive lead from US markets.
The US is in recovery mode, with recent data suggesting the world’s biggest economy has put the worst behind it. However, trading is relatively subdued into the end of the year, with some caution being exercised due to a potential S&P downgrade. On the data front, there is not a lot happening in the Asian session, with no major economic releases. The Hang Seng, Nikkei and ASX 200 are up between 0.2% and 0.4% each. US and European markets are pointing towards modest gains on the open.
The Australian share market is up 0.4% at 4156, with the defensive sectors leading the mild gains. However, there is some caution after Standard & Poor’s warned that low credit growth would crimp US bank earnings and IMF’s Christine Lagarde stated that the world economic outlook is ’quite gloomy’. The local banks are holding up fairly well, with ANZ leading the pack after putting on 1.3%. The retailers are struggling after JB Hi-Fi issued a profit warning. JBH is down 13% and has dragged the consumer discretionary sector lower. There are some bright spots in the materials sector, with the big miners posting gains.
The consumer discretionary sector has been beaten up today following JBH’s profit warning. This seems to have caught out quite a few investors who would have been pre-empting a recovery in the sector following the recent rate cuts. The profit warning was also followed up by some broker downgrades for JBH and some of its peers. We also saw a profit warning from Caltex, which might start to receive some broker reviews soon as the refiner continues to struggle on various factors.
Again we saw a continuation of the stronger US data, with US weekly jobless claims dropping to 366,000, while both the Philly Fed business conditions and Empire manufacturing showed strong improvement, putting a bid into risk assets. The US has been the shining light in terms of economic growth, although one has to suspect if Europe really deteriorates, then growth in 2012 will almost certainly face headwinds. It was promising to see a successful bond auction overnight in Spain, which encouraged traders to buy not just Spanish bonds, but Italian bonds as well. Comments from IMF chief Christine Lagarde spooked investors after she mentioned ‘there is no economy in the world, whether low-income countries, emerging markets, middle-income countries or super-advanced economies that will be immune to the crisis that we see not only unfolding but escalating.’
Tonight, traders will be looking for positive comments from Mario Draghi who is scheduled to speak in early European trade. US core CPI will also be announced, however given the Federal Reserve is not looking to put the Fed funds rate up anytime soon, don’t expect this to spur too much volatility. On another note, Reuters is reporting, citing EU diplomats that the next EU summit is scheduled to be held on February 7 to 8, so if we do see risk assets deteriorating through January, this will again come into focus as the next ‘key date’ to which the market can get excited about, only to be disappointed once we know the outcome.
Gold remains in focus for traders, as it has desperately held onto the long-term support provided by the uptrend which began in October 2008. The rumour mill has suggested that a number of European banks have been unloading their physical gold reserves recently to raise capital, in an effort to provide insurance against an Armageddon scenario unfolding in the euro banking sector. Traders will be watching to see if this tide of selling pressure is enough to breach the support that exists at the uptrend line, which sits at around $1550.
French Central Bank Attacks British Economy As Eurozone Rescue Plan Starts to Disintegrate