NOAA announced its 2010 Hurricane forecast today catching markets off-guard with an expectation of 8 to 14 Hurricanes during this year’s season–much higher than average. The forecast caused natural gas futures to close higher after falling earlier in the day due to inventory data. While the implication of this forecast can’t be ignored, NOAA has a surprisingly checkered past in predicting Hurricane seasons. Historical data shows that NOAA’s forecast has been accurate in just 2 of the past 9 years. According to NOAA’s website, “The seasonal activity is expected to fall within these ranges in 7 out of 10 seasons.” This is clearly not the case (see chart):
Source: NOAA
Not since June 2008 has the housing sector been completely devoid of some form of tax incentive to help bolster sales, until now that is and it shows. MBA purchase applications have taken a precipitous drop over the past two weeks falling to levels not seen since the end of 1997. The government’s approach of bolstering current sales by borrowing from the future sales appears to have worked, and now it’s time to pay the piper. Headwinds for the sector remain strong generated by stiff credit conditions, high unemployment, increasing foreclosures, large inventories of vacant homes, and a lack of tax credits; while tailwinds are slowing to a breeze. A robust recovery in housing during 2010 is extremely unlikely.
MBA Purchase Applications
Rumors have been spreading across trading floors that the Fed may lower the penalty for using its dollar liquidity swap line to reduce stress in the interbank market. As I mentioned in a previous note, a 100bp ‘penalty’ over the overnight indexed swap (OIS) rate for the Fed’s dollar liquidity swap line is preventing the tool from impacting interbank borrowing risks as LIBOR continues to climb. The OIS rate currently stands at 0.22%, which means anyone utilizing the Fed’s swap program would be paying 1.22%, well above the current 3M USD LIBOR rate of 0.54%, leading to the programs ineffectiveness. In fact, the ECB’s most recent offering for the program on May 19th lacked even a single taker. If market speculation pans out and the Fed reduces the penalty spread to 50bps from 100bps, then the borrowing cost would fall to 0.72%–below the Fed’s discount rate of 0.75%–, but still remain well above current LIBOR levels meaning the impact could be minimal.
OIS (White) vs. 3M LIBOR (Orange)
Source: Bloomberg
After stabilizing from 5/20 to 5/24 AUDJPY’s decline has returned with a vengeance falling to 72.88 from 74.63 a day prior. The currency pairs stability over the last few days led some to believe the market could be approaching a bottom. Other notable risk indicators moving this morning include the TED spread, now up to 38.6bps (from 18.6 at the beginning of the month), and US breakeven rates. 1Y breakeven rates fell below zero this morning, with rates on the long end of the curve beginning to see more significant declines. Investors in Europe continue to flock to the safety of Germany with German 10Y yields reaching a record low 2.56%. Other than a quick peaceful resolution to the geopolitical risks building in the Korean peninsula, there doesn’t appear to be any near-term positive catalysts in the pipeline to shift investors sentiment.
http://www.bloomberg.com/insight/euro-breach.html
Here is an interactive graphic from Bloomberg highlighting the divergence of the Euro-Zone from their own financial criteria since the currency was introduced.
One year inflation expectations, as tracked by the breakeven rate for U.S. Treasury Inflated Protected Securities (TIPS), have fallen to almost 0%, while the more often quoted two year rate plummeted to 0.7% (see chart). While longer-term inflation expectations have diminished, albeit at a much smaller magnitude, the spread between 2Y and 5Y rates has widened to 90bps from just 20bps a month ago. Diminishing short-term inflation expectations are a product of traders’ flight to quality leading to among other things falling commodity prices. While short-term breakeven rates will likely remain under pressure as long as developments in Europe control the market; a mounting economic recovery in the U.S. should make it very difficult for short-term breakevens to remain this low indefinitely.
Source: Bloomberg
Global markets may be converging on a new ‘volatile’ norm as investors revalue risk, as governments begin the painful process of deleveraging to more sustainable debt levels. Thus far fears of sovereign defaults have remained contained to the usual suspects—fundamentally weak nations—leading investors to flock to the safe-havens of the U.S., Japan, and Germany. Risk aversion has pushed 10Y German Bund yields down to a multi-decade low of 2.632%; while 10Y U.S. Treasuries are yielding 3.113% from nearly 4% in April. Yet, safe-haven debt levels are in most cases worse than their weak counterparts, especially in the case of Japan, meaning deleveraging is a unilateral prescription. I won’t beat a dead horse on who could be the next Greece, but I do want to emphasize that deleveraging is a painful process, which can adversely impact growth. Eventually, in the U.S. tough austerity measures coupled with substantial tax increments will be necessary, transforming the fuel of the nascent economic recovery, fiscal stimulus, into fiscal drag. Japan’s likely the most at risk of the safe-havens with a vast amount of its debt financed domestically, by what is now a shrinking and ageing population; meaning external financing will ultimately be necessary. This could cause investors to reassess Japan’s stability. The good news is while tough measures in the US are necessary— creating significant economic headwinds— it should allow the nation to avoid the fate of Greece. Meanwhile, I recommend monitoring investor sentiment toward Japan as the canary in the coal mine for the U.S.
Political risk, typically a relative constant in trading, has investors running for the doors this morning as concerns grow around Germany’s real intentions behind its short-selling ban, along with what regulations might come next. Uncertainty is being compounded by the financial overhaul debate taking place currently in DC. One comment that especially caught traders’ attentions yesterday came from Michael Novogratz, president of Fortress Investment Group, who said on CNBC, “The market is de-risking itself.” He also said, “When you want to get short there are a lot of weapons you can sell.” Glenn Dubin of Highbridge Capital added, “The sovereign debt crisis hit a wall and all bets are off,” telling CNBC. “We’re seeing massive de-risking.”
Risk indicators seem to confirm Novogratz’s and Dubin’s views showing no signs of easing this morning. LIBOR has continued to climb reaching levels not seen since last summer. At the same time AUDJPY, a popular carry trade and risk proxy, has plummeted. Until confidence returns to the market investors will continue curbing risk, and as of right now no clear short-term catalyst can be seen in the pipeline.
