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‘What’flation, 2Y Treasuries Yielding 67bps

Inflation doves can look no further than near record low yields on 2-year Treasuries to squelch inflation hawks ‘premature’ concerns.  The 2-year yield is reflecting the fact that the recovery will remain lukewarm, with downside risks outweighing the contrary, essentially opening up hunting season on Fed hawks—already in small supply. While hawk hunting may be the primary fundamental driver behind recent yields another technical factor may also be playing a role. Chatter on the trading floor is indicating that, private sector deleveraging coupled with a slower pace of government debt issuance is leaving investors with fewer alternatives, helping push yields down across the curve. 

Over the near-term, negative sentiment derived from a housing market left out to pasture, issues in Europe, the gradual removal of government stimulus—a key crutch to recent growth— and a plethora of other geopolitical risks should keep yields and inflationary fears in check for the foreseeable future, while the risk of deflation and an eventual return to negative GDP growth remain all too real.

Why Homebuilder Stocks Haven’t Plunged

The amount of new homes for sale in the U.S. reached a multi-decade low in May helping boost U.S. homebuilders.  To find a point in time where fewer new homes were on the market you would have to go all the way back to the early 70’s/late 60’s (see chart).  While the sales pace of new home doesn’t bode well for the very short-term outlook for home builders the miniscule amount of new homes on the market means that as buyers return—once labor markets improve—home builder demand will likely spike.  The low level of inventories also implies short-term homebuilder risk could be somewhat limited, giving them more room to wait out the ongoing soft patch.  While I am in no way a housing bull; the outlook for homebuilders could be worse, and the group will likely continue to trade range bound until a clearly employment picture develops.  To monitor this I will be watching weekly jobless claims and housing starts over the months ahead. 

 

Source: Bloomberg

The next shoe to fall will be May’s pending home sales, released on July 1st, which measures contract signings for existing home sales during the month.  I expect the decline in pending home sales will likely be at a smaller magnitude than we saw in today’s new home sales release partially due to no shortage in existing homes and much large monthly sales volumes.  Since the onset of the housing crisis buyers have generally preferred existing homes as they provide better value per dollar compared to their new home counterpart; one could compare it to buying a used car vs. new.   

China’s Real Estate Free Fall May Not Bode Well For Commodities

China’s plummeting real estate transactions could spell trouble for domestic steel and cement industries.  The average number of real estate transaction in China’s 15 largest cities fell 75% on an annual basis according to the most weekly June release according to Goldman Sachs.  On a ytd basis transactions have declined -29%.  The Chinese government has been attempting to cool the overheating sector, in the face of mounting inflation and a more hawkish tone on monetary policy.  According to the China Daily, quoted by Bloomberg, “Apart from one villa development, no residential project obtained a sales license last week and no new residential buildings were put on the market over the weekend.”  One of the primary reasons for the decline is more stringent government policy making it more difficult to receive a second mortgage, coupled with concerns over future policies that have buyers taking a wait and see approach.  The government relied on the domestic economy, including the real estate sector to strengthen growth during the global financial crisis. 

One potentially significant international implication of a slowdown in the Chinese real estate sector is that the country’s construction industry consumes half of the nation’s steel and 36% of its aluminum.  China’s insatiable demand for natural resources has been a major crutch for the commodities industry as demand from the remainder of the world remains tepid at best.  For example in 2009 China consumed 65% of the world’s iron ore exports.  Therefore, any slowdown in Chinese demand for natural resources could have an adverse impact on the commodities sector, and continue to depress shipping companies still at the mercy of China’s whim.  To get a visual on just how significant Chinese demand for natural resources has been please see this piece from Bloomberg’s Interactive Insight team: http://bit.ly/bnCYQz

Germany vs. France Not Just Being Played on the Pitch

The spread between France’s and Germany’s 10y Government bonds remain near levels not seen since the collapse of Lehman as France takes on tough fiscal tightening.  Since the onset of the European debt crisis France and German yields have benefitted from worried investors moving funds away from economically weak Eurozone peripheries to the regions ‘stable’ AAA rated credits.  However, after being blindsided by Europe’s debt crisis investors are developing a new sense of risk, which doesn’t bode well for France’s lackluster history of correcting past deficits, especially while its current budget deficit approaching 8% of GDP.    This has given Germany an edge in investors’ flight to quality. France has already undertaken remedial measures to rein in the deficit, including raising the retirement age to 62 from 60, prompting  protests from the country’s socialist party and labor unions.  France will likely struggle with its ability to rapidly implement the necessary austerity policies, with any significant slippage, or success, revealing itself in the country’s spread to equivalent German government bonds.

Source: Bloomberg

Spain Begins to Echo Greece

The spreads for Europe’s economically weak peripheries over equivalent German bonds—the European benchmark—continue to approach their pre-bailout highs.  The 10Y spread in Spain again reached record levels amidst rumors that IMF, EU and the U.S. Treasury may be creating a EUR250bn credit line for the country (so far the EU and the Treasury department have denied the report).  This coming Friday the head of the IMF, Dominique Strauss-Khan, is scheduled to meet with Spanish Prime Minister to discuss, “structural reform measures the government is undertaking, the labour reform to be approved tomorrow by the cabinet, and other measures to tackle the deficit, as well as measures by other countries and other economic zones.”  Spanish officials have indicated that these meetings were scheduled prior to reports of a Spanish bailout.  But, in the minds of some investors this visit is too coincidental, echoing a similar visit by the IMF to Greece just prior to that country’s own demise. 

Amidst this strife, Spain is expected to auction 10Y and 30Y government bonds tomorrow totaling an estimated EUR3.5bn.  This auction will be watched closely by investors, and any signs of weakness could spell trouble for Spain, Europe and any global risk correlated assets.  Here is a complete list from Barclays of expected European bond auctions for the remainder of the week:

Date            Country     Bond                                       Amount (EURbn)

17-Jun-10     Spain        10y SPGB (total range €2-3.5bn)    2.00

17-Jun-10     Spain        30y SPGB (total range €2-3.5bn)    1.50

17-Jun-10     France      2yr BTAN (range €6.5-8bn)              2.00

17-Jun-10     France      3yr BTAN (range €6.5-8bn)              2.00

17-Jun-10     France      New 5yr BTAN (range €6.5-8bn)     4.00

17-Jun-10     UK            2014 Gilt tap                                     4.00

17-Jun-10     France     OATi Auction (range €1.3-1.8bn)      0.50

17-Jun-10     France     OATei Auction (range €1.3-1.8bn)    0.40

17-Jun-10     France     OATi Auction (range €1.3-1.8bn)      0.70

The Decline in the BDI Doesn’t Mean Much…

The Baltic Dry Index (BDI) has fallen 28% from its recent high on May 26th, indicating to some weakness in the global economy.  The BDI tracks the prices of bulk carriers which are the life-blood of global trade carrying everything from iron ore to grain.  While the 28% decline may seem ominous, the BDI is being influenced by two outside factors that have very little to do with global economic health.  The first factor is that during shipping’s boom period, prior to the recession, a record amount of new ships were ordered that are only now being delivered creating a supply glut in the sector, while demand remains tepid at best.  Secondly, China’s unprecedented stimulus package, stoking the country’s demand for raw materials through new lending and infrastructure projects, gave the country enormous sway over the index as they were receiving the vast majority of dry bulk goods.  Further tightening in China without substantial offsetting demand increments from the remainder of the world—which are returning, but at a gradual pace—along with an armada of vessels coming online over the next several month will likely place continued pressure on the BDI, but not necessarily indicate a slowdown in the global economy. 

Risk Makes a Comeback

Investors are feeling more at ease with the uncertainty facing global market.  The AUD/JPY exchange rate—a popular FX carry trade and risk metric—has moved off of its recent lows of less than 74 to a level of 79.4.  At the same time, 3M LIBOR halted its climb, and has remained fairly steady around 0.54%, albeit still more than double early March levels.  Investors growing appetite for risk partially stems from a successful Spanish three year government bond auction last week, which received a surprisingly strong bid to cover of 2.1, while still yielding an elevated 3.3%–compared to less than 2% for bonds of a similar duration in March.  Spain is scheduled to reopen EUR3.5bn of 10Y and 30Y bonds on June 17th.  With a relatively quiet week on the data front—barring the auctions in Spain and a European summit on Thursday—traders will likely continue adding on risk, pushing European spreads down; US Treasury yields up, all boding well for growth correlated assets, including equities.   

Source: Bloomberg

Building Material Sales Add Volatility to Retail Sales

Unusual volatility in the sale of building materials has exaggerated retail sales over the past three months.  While this doesn’t change the prevailing trend, sales in both April and March would have appeared far less optimistic than reported.   Building material sales climbed 8.0% in both March and April-a pace not seen since March 2004-plummting -9.3% in May.  In April the surge in building material sales, despite broad-based weakness in most other retail components permitted retail sales index excluding automobiles andgasoline to rise 0.6%. However, as you can see from the attached chart, if you excluded building materials from the index retail sales ex-autos and gas in Aprilwould have fell -0.2%, compared to the reported 0.6% rise.  Using the same parameterssales in May, sales would have risen an anemic 0.1% (still better than the -0.5% decline reported in today’s release).   Reducing the recent volatility caused by building material sales, the trend still points toward a lackluster summer selling season without significant, albeit unlikely, improvements to household balance sheets.

Source: Bloomberg

France Shows Signs of Weakness…

France is no European angel in terms of its fundamental, yet like Germany the credit has received  ‘safe-haven’ status from investors; that is until recently.  French 10Y government bonds have traded mostly lockstep with equivalent German debt since the onset of the European debt crisis, but since the beginning of June the spread between the two have begun to widen.  Historically, France and Germany have had easy access to global financial markets, allowing them to readily issue large sums of Euro denominated bonds, separating the pair from smaller Eurozone peripheries including Greece.  However, investors are growing increasingly concerned over France’ ability to to rein in spending and control a surging deficit.

One of the best quotes I have seen on the topic comes from Nicolas Lenoir, chief market strategist at ICAP Futures LLC, who says, “Being French I can promise you first hand that if there is any form of austerity required as part of the $1 trillion package it will not fly one bit,” Lenoir said in a recent correspondence “We had riots with a daily car-burn rate above 1,200 for over a week because a teenager electrocuted himself trying to escape from the cops, so just try and imagine if railway workers can no longer retire at 50 or 55 after being driven to exhaustion watching a computer do their job 35 hours a week.”  In short, investors’ recent concerns–demonstrated by rising spreads to Germany–are likely not unfounded given France’s past on implementing such measures.  Looking ahead, France will likely continue to come under the microscope of investors, and without clear continued indications the country is headed in the right direction what historically has been easy access to foreign money may feel a bit more painful.

Source: Bloomberg

Chinese Government Officials May Have Leaked Key Economic Data

“Dear all: One Chinese official apparently leaks May macro data According to Reuters, a senior Chinese government official leaked some key macro data during an internal investor conference. If confirmed, it will be one of the largest leakages in China in two years. Official numbers are yet to be released. Relevant numbers are for CPI, PPI, Industrial production, FAI, Exports, new loans, and M2. The most surprising number is the 52% export growth, though people are deeply (in our view, not so necessarily) concerned about the 3.1% CPI inflation which for the first time this year surpassed the targeted annual target at 3%.”  -Ting Lu (陆挺), Ph.D., CFA (Bank of America – Merrill Lynch)