Rising Interest Rates Spoil the Party
I originally wrote this in September 2013. It is just as relevant now in December.
The big news in America is that the rate on the 10-year Treasury bond has risen dramatically from around 1.6% to over 2.9%. This is 130 basis points from a starting point of 160, or an increase of more than 80%!
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Euro Area Credit Markets Remain Calm, But …
Below is an update of the usual suspects, CDS on sovereign debt, euro basis swaps and a few other charts (keep in mind that 4-in-1 charts use different scales, which are identified by colors).
No-one seems to be worried in euro-land at present, in spite of the continued increase in various sovereign debtbergs. There is however a small degree of concern visible in Slovenia, which is going through a political crisis. As Reuters reported last week:
“A dispute over the leadership of Slovenia's ruling party erupted on Wednesday, posing a threat to the euro zone state's four-party coalition government and its efforts to avert an international bailout.
The mayor of Slovenia's capital Ljubljana, Zoran Jankovic, announced he would run for the leadership of the center-left Positive Slovenia (PS), the main ruling party, in a move that prompted dismay among the other coalition parties. Jankovic, who set up the PS in 2011, resigned from its helm in February, enabling his successor, Alenka Bratusek, to form a coalition government with the three other parties and to become prime minister of the tiny Alpine country.
The parties had refused to join a coalition if Jankovic remained PS leader. They cited a state anti-corruption commission report which said in January Jankovic could not explain the origin of a big part of his income in past years. "I decided to be a candidate for the president of Positive Slovenia. This was a difficult decision. I will explain my reasons… at the congress," Jankovic told a news conference, referring to a party gathering planned for October 19. Bratusek has said she will seek re-election as PS leader.
"This is not good for Slovenia. Jankovic has a better chance of winning and if that happens the government will collapse," said Meta Roglic, a political analyst at daily Dnevnik.”
SPX Retakes 50 dma
Yesterday's move in the SPX back above the 50 day moving average bore a very close resemblance to the last occurrence in early July. As the chart below shows, both the price movements prior to the break, MACD and the relative position of the 20 day moving average looked almost exactly similar:
Different Levels of Bullishness Displayed in Positioning/Sentiment Data
What is different are a number of ancillary data. For instance, there is far more enthusiasm about this move in the option pits than there was last time around, but there is less bullishness detectable in sentiment surveys. This may be partly due to the relative strength in technology shares, which never really corrected much. The options of many big cap tech stocks are quite heavily traded.
A Little Goosing of the Money Supply and the World is Alright Again
We have pointed out for several months in these pages that the increase in the euro area's true money supply (+8% year-on-year) would likely produce further improvements in PMI data and other measures of economic activity in the euro zone. See for instance our June 5 article “Euro-Area PMI Data Improve as Money Supply Growth Accelerates”.
This is not rocket science to be sure, but we have noticed that very few economists actually look at these data. In fact, if they look at monetary developments at all, most of them employ money supply measures that are essentially useless, as they include components that are not money. This is why they are continually 'surprised' when economic data are released.
An Update of Selected Charts
We haven't done a chart update of this sort for quite some time, so in order to quickly show the most important recent developments, here is one. Below are charts of CDS on various sovereign debtors and banks, bond yields, euro basis swaps as well as a few other charts of interest. Charts and price scales are color coded (readers should keep the different price scales in mind when assessing 4-in-1 charts). Where necessary we have provided a legend for the color coding below the charts. Prices are as of Tuesday's close.
The Eerie Calm
A brief comment: in the euro area, the eerie calm continues (as we noted previously, the euro area may just be resting a moment to catch its death). Exceptions are Portugal and Slovenia, both of which have seen their 5 year CDS spreads spike recently, although they are already drifting lower again from their recent highs. However, both countries obviously still have problems, even if the markets are not overly worried about them at the moment. Edward Hugh recently remarked in an e-mail exchange that he believes the highest risk in the periphery is now of a political nature, a point which we have frequently stressed as well and which has briefly come to the market's attention when two ministers resigned abruptly from Pedro Passos Coelho's cabinet in Portugal.
As we have pointed out in our most recent missive on Greece, there are a few initial signs that the peripheral countries are seeing a smidgen of light at the end of the tunnel, but progress is very slow and the social strains continue to be severe. Not only that, what progress there has been could be easily wiped out again by an intensification of the problems experienced by the banking systems in these countries, especially Portugal's and Spain's.
Note that there is some movement now in Ireland, where banks after a long period of tolerating 'strategic defaults' by homeowners are beginning to initiate foreclosures at an accelerated pace. Once again, this could prove politically explosive.
Lastly, we continue to believe that the markets are way too sanguine about Italy. Contrary to the remaining 'PIGS' (Portugal, Ireland, Greece and Spain), Italy has seen no improvement in its unit labor costs. Its public debt continues to rise, even while the government resorts to cosmetic and almost comical measures such as slightly reducing the car fleet of its ministers (don't get us wrong, it is certainly a good idea, but it represents not even a drop in the ocean of Italy's public debt). In Italy the political situation is also not exactly stable now that the Cavaliere is under growing pressure to quit.
On to the charts:
Political Risk Threatens to Reignite Crisis in Europe
It couldn't come at a more inopportune moment: the crisis that is increasingly engulfing Mariano Rajoy, and the mounting legal troubles besetting Silvio Berlusconi, the realization that Portugal's crisis remains intractable and Greece careening toward another summer of discontent (even as the tourism industry is recovering slightly), as civil servants and their unions gear up to fight the latest troika-imposed cuts. The moment is so inopportune because Olli Rehn and others have to once again fear for their summer vacation. Euro area crises have an odd habit of flaring up in the middle of the summer.
Rajoy's troubles, as some speculate, may actually be the result of a kind of palace coup: apparently there are factions within the PP that want to be caliph instead of the caliph. No-one ever doubted that Spain's politics were riddled with corruption, so the main question should actually be: 'why is it all coming to light all of a sudden'? After all, if former PP treasurer Louis Barcenas is to be believed, the particular scams he and his buddies were engaged in went on for 20 years running. Former prime minister Jose Maria Aznar has been mentioned as a possible culprit, but he too is on the 'Barcenas list' of receivers. Others suspect that the Most Excellent Countess of Bornos, Esperanza Aguirre y Gil de Biedma, the former president of Madrid, may have a hand in the proceedings, since she isn't implicated and is loudly calling for a clean-up of the party.
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Abe Seeks 'Redemption'
Shinzo Abe, father of the latest attempt to 'reflate' the Japanese economy by devaluing the money issued by the BoJ and by government spending even more money it doesn't have, is said to be by winning the upcoming upper house election.
“Japanese Prime Minister Shinzo Abe is a man with a mission: to erase the bitter stain of defeat and attain personal political redemption with a victory in a national election this month.
With his Liberal Democratic Party-led coalition (LDP) back in power since December and all but assured of a handsome win in a July 21 poll for parliament's upper house, Abe might forgiven for slowing his pace a bit. But allies and critics agree the 58-year-old heir to an elite political family will not rest until the votes are counted and his ruling bloc is in control of the chamber, reversing a humiliating defeat that led to his resignation six years ago.
"I guess history is a turn of Fortune's wheel. The LDP led by Prime Minister Abe suffered a crushing defeat in the last (2007) upper house election, which led us to lose power," Abe's close ally Chief Cabinet Secretary Yoshihide Suga told a news conference last week as the official campaign commenced. "We must resolve the split in parliament through this upper house election. By doing so, Prime Minister Abe can finally get his revenge from the defeat of six years ago."
Upper house lawmakers serve six-year terms and half the seats are contested every three years, so the seats to be filled in the coming election are those that were at stake in 2007.
When he succeeded popular Prime Minister Junichiro Koizumi in September 2006, Abe – then aged 52 – had high support ratings. Ten troubled months later, his popularity eroded by scandals in his cabinet and public outrage over lost pension records, Abe led the LDP to its worst election defeat since it was founded in 1955.
He clung to power for another two months before suddenly quitting in the face of a deadlock in parliament, where the opposition-controlled upper house was blocking a key bill, and ill health due to a flare up of his chronic ulcerative colitis.
Two years and two more LDP prime ministers later, the LDP lost power to the novice Democratic Party of Japan in an historic 2009 lower house poll.
"The setback then has been deeply embedded in my heart," Abe told a news conference after parliament ended its session late last month. "I cannot lose the upper house election."
Hegde fund legend Ray Dalio among other things runs a big fund that is called the 'All Weather Fund'. Its appeal is based on the idea that by holding different investments that will either profit from rising or falling inflation, it will deliver positive returns no matter what happens.
What the fund's managers obviously didn't expect was the scenario that has actually unfolded lately: inflation expectations are collapsing, and bond yields are shooting higher anyway. And so the 'All Weather' portfolio is now suddenly under the weather:
“A $70 billion portfolio managed by hedge fund titan Ray Dalio's Bridgewater Associates and widely held by many pension funds to survive stormy markets is emerging as a big loser in the recent selloff in global markets.
The Bridgewater All Weather Fund is down roughly 6 percent through this month and down 8 percent for the year, said two people familiar with the fund's performance.
The All Weather Fund is one of two big portfolios managed by Bridgewater and uses a so-called "risk parity" strategy that is supposed to make money for investors if bonds or stocks sell off, though not simultaneously. It is a popular investment option for many pension funds and has been marketed by Bridgewater and Wall Street banks as way to hedge market turmoil.
Bridgewater created a portfolio based on two of the four basic economic scenarios: rising growth, falling growth, rising inflation, falling inflation. Different types of assets do well in each of these scenarios and the all-weather portfolio contemplates spreading its risk evenly.
But money managers familiar with the strategy said it does not perform when both stock and bond prices tumble, as global markets have experienced in recent weeks.
The All Weather fund invests heavily in Treasury inflation protected securities, or TIPS, which have lost 4.5 percent in June and over 8.26 percent year-to-date. In fact, the All Weather fund, launched in 1996, was a leader in investing in inflation-protected bonds.
Rick Nelson, chief investment officer for Commonfund, with $25 billion under management for endowments and foundations, said his firm has avoided putting clients into risk parity funds because there are better ways to manage risk.
He said risk parity funds tend to "use a great deal of leverage on the fixed income side" and that can magnify losses. Nelson was not commenting specifically on All Weather because Commonfund has no money with Bridgewater.”
Apparently, the PASOK and DIMAR parties, the junior coalition partners in Greece's government, are pondering whether early elections would be preferable to being seen as complicit in shutting down the State-owned television station, which has proved to be a rather unpopular decision.
According to To Vima, the 'government is in jeopardy' (this follows on the heels of earlier denials by Venizelos):
CDS Spreads Increase Along with Yields
In recent days some CDS spreads on euro area sovereigns and neighboring countries have begun to rise a bit. In recent months all such bounces have proved transitory, but there is always a chance that this changes again – not least as euro area governments recently insist that the faux 'austerity' period is over. Middle Eastern countries and Turkey have experienced a small increase in CDS spreads as well, presumably on account of the recent unrest in Turkey. A small selection of CDS and other data is below.
Yields Begin to Rise
Over the past two weeks, treasury note yields have risen rather vigorously from a higher low. As a side effect of this, mortgage rates are now increasing in spite of Bernanke's truly massive purchases in that sector. Note that the Fed is not only adding $40 billion in mortgage related debt to its balance sheet per month, it is also replacing debt that matures. As a result, the purchases have exploded. In fact, the year-to-date purchases of agency debt amount to $345 billion so far, which is a monthly run rate of $69 billion. Together with its treasury debt purchases, the Fed has therefore bought securities amounting to $113 billion per month this year (of course the replacement purchases do not increase the money supply, unless the old purchases were from banks and the new ones are from non-banks).
In any case, there has been a strong increase in yields, in spite of the fact that market-based 'inflation expectations' continue to decline in both the US and Europe.
Inflation expectations in the US (orange line) and euro-land (measured by comparing nominal yields to yields on 'inflation protected' bonds): apart from a small recent uptick, they continue to fall in both regions, and yet, nominal yields are now heading higher anyway – click to enlarge.
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Spending on Social Security and Debt Service Soars
We recently wrote about Shinzo Abe's desire to beef up Japan's military and alter the pacifist constitution to do so. Apart from the fact that this will divert scarce resources into wasteful lines of production that do little more than increase the probability of war, an important question is: how will he pay for it? Consider the recent trends in government spending in Japan. We have discussed this topic before, but have recently found a chart that illustrates the central fiscal problem nicely.
The growth in Japan's government spending per category since 1960 (source: Japan's MoF). The two largest and fastest growing items are spending on social security and debt service. Defense spending is fairly small slice of the overall spending pie, and now Abe wants push its rate of growth up as well – click to enlarge.
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Bad News Finally Have an Effect
Even though the market moves in the US were fairly large and volatile, the action became a great deal more pronounced when Japan started trading. At first there was such a heavy sell-off in JGBs that the market was (once again) briefly halted. The Nikkei did its usual thing and tried to move higher.
Then the HSBC 'Flash' PMI for China was released (details here – pdf) and showed that manufacturing in China has slipped back into contraction, to a 7 month low of 49.6.
This is what the China PMI chart with the latest flash estimate added looks like (keep in mind that HSBC only measures private sector activity, its PMI data therefore differ from the official data which include the state-owned sector).
That was not what traders in the Japanese stock market wanted to hear apparently. The Nikkei, which is always more volatile than the US market, produced a huge 1,125 point intraday swing, a move of roughly 8% on the day.
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JGBs Weaken Again
Overnight the JGB market once again weakened slightly, to 141.875 points. To be sure, this wasn't a very big move, but the fact is that JGBs continue to consolidate below the lateral support line provided by the interim highs made in the 2010-1012 period. Moreover, an uptrend line that has been in force for several years has been violated.
There is an even more important lateral support zone visible on the weekly chart at the 140 to 141 level. Since this support zone is not very far away from current prices, it is certainly conceivable that it might break fairly soon. If so, we believe the selling will probably intensify. As we remarked to a friend in a recent e-mail exchange:
“For more than two decades anyone trying to short the JGB market got burned. It has become an entrenched truism that the JGB market cannot decline because only Japanese domestic investors hold the bonds. Kyle Bass believes Japanese government bonds will eventually plunge because of Japan's high public debt, but it seems actually more likely that it could do so because Kuroda loses control of the effects of his policies. Japan's public debt is huge, but the government also holds valuable assets one must deduct from the gross figure (the result is still a very large number, both in absolute and relative terms, but it is only about half of the reported gross figure). The problem is a different one: banks, insurers, pension funds, all hold JGBs because they think it is impossible for inflation to flare up. Once just one of the bigger investors gets scared and concludes that this may no longer be true, there will be a snowball effect.”
JGB Rallies Back to Former Support – And Turns Down
We may just have seen what is known as a 'good-bye kiss' among technical traders in the JGB market. The JGB contract rallied back to its former lateral support at the 143 level overnight and then turned back down from there. Below is a chart illustrating the action. We hasten to add that it is still too early to call this a definitive breakdown, but it is something we are watching closely. We continue to believe that the whole world should keep its eyes glued to this market – it is the most likely source of trouble for the current 'happy consensus':
JGB, one hour chart: a classic 'good-bye kiss'? – click to enlarge.
On the long term monthly continuous chart of the nearby JGB futures contract we can see that an uptrend line that has been in force for several years has now been slightly violated. It is only a small warning sign thus far, but this market could well do the unexpected and eventually make a very big move (a non-linear hyper-volatility event is what we are thinking of here).
The JGB's price history since the bursting of Japan's bubble in 1989: the uptrend from 2006-2013 has now been violated ever so slightly – click to enlarge.
Deceptive Calm Continues
Italy finally has a new prime minister, Enrico Letta, who is expected to be supported both the center-left (its leader Bersani has recently resigned, as he was unable to get the bloc to vote for his choices for the job of president) and Berlusconi's center-right coalition. Apparently this has given fresh impetus to the buying of peripheral bonds in the euro area. Consequently, credit default swaps and other measures of systemic stress remain subdued. However, there are still technical divergences that must be considered worrisome and inflation expectations in Europe continue to plunge (this is often a precursor to credit stress). Moreover, safe haven debt continues to enjoy a good bid. We ask again, if everything is truly fine, then why is this so? Something obviously does not compute here.