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.
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.
According to Bloomberg:
SNB Vice Chairman Thomas Jordan said earlier today that the central bank has “countered” pressure on the franc during the financial crisis. “During the financial crisis, there has been much pressure on the Swiss franc which appreciated,” Jordan said in Wettingen, Switzerland. “The SNB has countered that pressure so that until now we haven’t seen an excessive appreciation of the Swiss franc.”
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.
The prevailing trend across trading floors this morning is a rare lack of conviction. One contact said, “It is silent here, everyone is just sitting staring at their screens, no one has any convictions”. This loss in confidence could lead to oversized reactions—volatility—to breaking news; especially further negative developments in Europe. The VIX Index, which measures the implied volatility of the S&P500, is approaching its recent high experienced in the wake of May 6th’s ‘flash crash’. Additionally, investors continue to remove risk from the table preferring the safety of US Treasuries (with 10Y yields now yielding less than 3.4%). The AUDJPY exchange rate is at its lowest levels since early 2010, this currency carry trade acts as a real-time gauge on investors risk appetite (see chart).
Rising producer prices eventually translate into higher consumer prices as businesses are forced to pass on a portion if not all of the price increments to their customers. So what you might be asking, this morning’s PPI indicated that producer prices fell -0.1% on a monthly basis. While this is true the PPI is broken out into three sub-components crude, intermediate, and finished goods—the headline PPI only tracks finished goods. As higher producer prices eventually pass-through to consumer prices; higher crude material costs ultimately impact intermediate good prices, while rising intermediate good prices in time increase the headline PPI. As of April crude material rose roughly 30% y/y, while intermediate good prices climbed 9%, the highest reading since 2008 (See chart). Core raw material prices rose 49.7% y/y–its largest yearly gain on record. While this isn’t an immediate recipe for higher consumer prices; it is definitely indicative that pressure is building in the pipeline.
In terms of monetary policy, short-term inflation expectations as measured by the US TIPS breakeven curve have diminished significantly on waning commodity prices and a stronger dollar stemming from the ongoing crisis in Europe and concerns over Chinese tightening. This will likely keep the Fed on hold through-out the remainder of the year as unemployment remains high and growth below what would be anticipated following a major recession. Looking further ahead, inflation pressure is gaining some momentum and should become more of a factor in monetary policy decisions as the year progresses.
Defying most investors’ expectations, LIBOR’s climb has continued unabated, despite the reopening of the Fed’s Reciprocal Currency Swap lines. According to the ECB’s records on May 11th seven bidders tapped USD9.2bn of the swaps at a rate of 1.22%, or nearly 100bps above the OIS funding rate. Ray Stone of Stone & McCarthy Research Associates, may have the best explanation I have been able to find as to why LIBOR has been unaffected by the Fed’s announcement. In short Ray says that the liquidity provided by the central banks will be available at ‘fixed rates’ that is set ‘roundly 100bps over the OIS funds rate, or equivalent, setting up a penalty rate similar to the Fed’s discount rate. Ray believes this penalty rate will act as a ceiling on LIBOR, which according to my calculations would presently put a 1.22% cap on 3M LIBOR, compared to a current rate of 0.460%. Therefore, the mechanisms significant penalty over traditional interbank funding (LIBOR) ‘accounts for lack of impact on underlying money market conditions’.
3M LIBOR vs 3M Treasury
Credit card delinquencies declined in April for the fourth straight month, indicating that consumers are gaining traction. Diminishing delinquency and default rates could eventually lead lenders to reduce strict lending standards; following significant tightening subsequent to the subprime crisis. On this note, more lenient lending standards could have wider implications for the U.S. economy, which consists mostly of consumption. Since the onset of the recovery, consumption growth has lagged previous recoveries with deleveraging and a lack of credit acting as a strong headwind. As confidence builds, more lenient standards could eventually bolster consumption by providing consumers increased purchasing power.
While the downward trend in delinquencies is a move in the right direction,
significant changes to lending policies will not occur overnight–delinquencies remain well above their historical averages. To monitor changes to lending standards I recommend you review the Fed’s quarterly Senior Loan Officer Survey, which tracks credit standards, demand for credit, and borrowing costs for personal, business, and real estate related loans.
Credit Card Delinquencies:
As of this morning, not only have US equities (as measured by the MSCI)outpaced their global counterparts, but on a year-to-date basis it’s the only index still showing gains, albeit somewhat modest. Interestingly, as of this week the spread between the MSCI US and MSCI World index reached its highest spread of the year, mostly due to losses in Latin America and emerging Europe.
MSCI Indices:
