The equity markets “Christmas” rally has been fuelled by the expectation of a deal to avert the US fiscal cliff and the imminent release of the next tranche of financial loans to Greece. Both of which to me seem little to cheer about.
There should be a deal between the Republicans and the Democrats to avoid the automatic introduction of spending cuts and the removal of tax breaks. A failure would be a gross dereliction of duty of their position as politicians. But, whatever deal happens there will be spending cuts and tax rises in the US for 2013 and beyond. The problem is that the recent political discussions centre on a compromise deal which if anything show that the US will continue to attempt to kick the can further down the road. It may indeed trigger another credit rating downgrade. Businesses will therefore continue to have little certainty as to future tax rates or fiscal policy. The economic damage is already done.
Yesterday the December round of Federal Reserve Bank business surveys started with the Empire State Business Climate survey. It was weak across all categories and significantly weaker than the market had been expecting. Economists often try and disregard this survey as not being highly correlated with the national Purchasing Manager’s surveys and as such the market shrugged this disappointment off yesterday. But look for the major Phili Fed survey to similarly disappoint this week and then economists will start to downgrade their Industrial Production forecasts.
One important thing for the Fed in these surveys remains the inflation components. And the Empire State survey shows that deflationary pressures remain evident. The Current Prices Received component fell to its lowest level in 2 years. If this is matched by a decline in the Phili Fed survey then it will justify the Fed’s extension of QE into 2013.
US Inflation is not and in the current economic environment will not be a concern for the Federal Reserve. In fact the reverse continues to be a bigger concern with deflation remaining a large risk.
So the recent increase in US inflation expectations will again likely dissipate. So whilst the rise in the 5yr 5yr forward Inflation Swap Rate has dragged US 10yr Treasury yields higher by steepening the yield curve, the prospects are that the inflation expectations will begin to decline again and move back in line with the 10yr US Treasury yield and not the other way around.
One of the consequences of the Fed’s announcement of a dual and targeted policy was not what the FOMC would have wanted. The Fed has used QE in the past to successfully reduce interest rate implied volatilities. But now the Fed’s stated target of 6.5% Unemployment before it starts to remove monetary stimulus has made the monthly employment reports more of a focus. So after a few days of Implied Interest Rate Volatility declining, the markets are starting to increase implied volatilities. That makes Risk assets vulnerable and shows complacency in those markets.
There is less complacency in Europe, even if Equity markets are being led higher by the US.
German Bunds continue to find demand from both domestic and international fund managers and the 10yr yield differential to the US is now at 39bp. Over the last 2 years the average yield differential has been 16bp. Once the Risk market has digested the consequences of any new US Budget deal I would expect this yield differential to move back to around 20bp to 25bp. And if there is no US budget deal than the differential should be below 10bp.
A further sign that European investors are not so complacent is that whilst the European Financial Credits have seen increases in their share prices and substantial reductions in their credit spreads, Gold, a safe haven investment in Europe, has not fallen a similar amount. It looks very similar to the price action of 2011, and in the first half of 2012 saw the two asset classes revert to their close correlation. It was only after the announcement of the ECB’s OMT programme that the correlation was broken. However it seems that retail investors seem less convinced of the ECB’s plans for financial stabilty or the ECB’s actual ability to provide it. Whilst it seems likely that Gold priced in Euros should fall in price, towards €1250-€1275/toz, a rise in European financial credit spreads is more of a certainty. It also points to a decline in the value of the Euro.
There remains little fundamentally changed in either the US or European economic situations- and little to see any change occurring in 2013.
So I remain with my targets for US and European bond yields.
3 month US 10yr target of 1.35% and 10yr Bund yield of 1.10%
The question of course is timing. Liquidity is significantly reduced at the moment. However I can still envisage a year-end yield target of 10yr US yields of 1.50% and 10yr Bund yields of 1.25%