The failing of The Netherlands’ Budget talks looks likely to lead to a collapse of the Dutch coalition government. It has led to Moody’s stating that there is a threat to the Dutch Aaa rating. Whilst there is a threat if a new Dutch government went on a wild spending spree, it is not the policy of any of the likely winners of the elections. But it does yet again leave the markets with some uncertainty.
Yet again the firewall put in place in the Euro zone, effectively becomes smaller as the Aaa rating of the EFSF is placed more and more at risk.
The bond market reaction yesterday was predictable with the yield on 10yr Dutch Government bonds rising 10bp, but that was to just 2.429% at the close and that has been reversed completely today.
The 10yr yield differential to Germany did blow out to 78bp, which is not far off the Euro timeframe’s largest differential of 86.5bp recorded back in February 2009. But that is likely to narrow over time as the Dutch Political parties announce their manifesto spending plans.
More and more at risk is the French Aaa rating at Moody’s. S&P already downgraded to AA+ on Jan 13th. The horse trading that will now go on by both the surviving presidential candidates will lead Moody’s to make statements regarding its position. And whether or not the actual spending occurs is beside the point. Moody’s is more than likely to react to the threat as opposed to the fact. I expect the Aaa rating to be cut immediately after the election.
Yesterday’s very weak Euro zone PMI surveys is being used by the markets to downgrade GDP for Q2, what that does do is worsen the fiscal position of all the Euro zone countries. More sovereign rating downgrades will come quickly now. Spain looks the most vulnerable. S&P has had a negative outlook on the single A rating since Jan 13th and Moody’s has had a negative outlook on its A3 rating since February 13th. Downgrades from both agencies are inevitable given the significant worsening of the Spanish fiscal position and the rise in bond yields Spain has suffered since then . The only question is the size. The current level of Spanish credit spreads would be commensurate with a junk BB rating. I doubt if the agencies will be that brave.
But the risk of these downgrades means that the markets are looking for some safety and the “flight to quality” premium keeps on increasing.
How much can be seen from the relationship with the Inflation markets. Whilst not a perfect correlation it does give some measure of the risk premium at the current moment.
In the Euro-zone 10yr German Bunds on a longer-term basis look to have a premium of around 100bp in them and even short-term the recent moves suggest a 30bp premium.
In the US the relationship would suggest a fair value for 10yr yields at 2.30%, so there is a similar premium to German Bunds.
It is at the widest it has been for some time and shows the level of nervousness. It is not misplaced as austerity is losing political support in Europe and that means that the Euro zone may lose its main supporter, Germany.
Is that why inflation markets remain elevate in the core European markets? They are pricing in a risk that planned austerity measures are not implemented. If so, German Bunds and US Treasuries will see even more “flight to safety” and lower yields.
Commodities are not expecting a sudden turnaround in growth and point to lower inflation not higher. Looking at price movements over the past year, in US$ terms Copper remains lower by approximately 13%, Corn, Wheat and Cotton have similar declines, whilst Fuel Oil is higher by around 3%. So inflation is not being led by a rise in commodities. Given the weak labour picture in both the US and Europe, Manufacturers are unlikely to face a need to raise wages either to find employees. So from a very simplistic view, inflation currently cannot be a concern.
And falls in Inflation in Australia below expectation have led to market anticipation that the RBA will cut rates 25bp next week. CPI for the first quarter was 1.6% below the 2.2% market expectation and the 3.1% for the last quarter. The market expects rate cuts of around 100bp over the next year but the risk with the fall in commodities is that rates will fall more than currently priced in. So whilst the yield differential in 10yr Australian bonds to the US has narrowed to below 175bp, from the 210bp seen mid February, it does have the prospect for further declines. So even here I favour Australian 10yr Government bonds over US although the lack of liquidity and depth to the market means that the positioning has to remain relatively small in a portfolio. A yield differential of 100bp to the US is possible.
Canadian Government bonds have underperformed the US since the BoC put out a hawkish statement but there is a similarity with Australia. Canada’s 5yr bond now yields 79bp more than the US. I would think that this does look an attractive pick-up as inflation fears are probably overstated as they were in Australia. I would buy Canadian 5yrs here but as rate hike expectations fade the currency will weaken versus the US so I would also hedge the currency exposure.
In credit the weakening Euro zone sovereign position has led to wider financial credit spreads. The iTraxx Series 16 5yr Financial Senior spreads widened to 272bp yesterday. It is still not a crisis situation and as I have talked about before the shape of the credit curve is more important than the absolute level. Here the financial credits are not as yet seeing flattening and that probably limits the flight out of the Euro as of yet. I would however expect that the situation will deteriorate and that will occur when the sovereign ratings are indeed cut.
But with Financial CDS hitting the 270bp target I had set for me covering the short position held in Euro Gold the position was covered over the past 2 days. Unfortunately the target of €1225 wasn’t achieved, but even so the decline in Euro Gold over the past two months has been significant anyhow. Now the prospects are for even further widening of Financial Credit spreads and that should lead to a resumption of the relationship that Euro Gold has had in the financial crisis. There could be some stability around current levels, but the prospects here are more favourable for gold than they had been previously.