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2012-10-09_image003

Distortions are all over the markets again- shows so many in the market really lack the conviction of their statements

And the risk markets are always hoping for Central Banks to intervene and to bail them out. This continues to look like a pyramid scheme. The latest optimism comes today from a Chinese press report suggesting that the Chinese will cut the Reserve Requirement Ratio in the coming weeks, ahead of most analysts expectations. It still seems unlikely that the PBoC will act ahead of the party congress on 8th November. Instead the PBoC is injecting huge quantities of cash into the banking system by Reverse Repos, an old method of short-term monetary stimulus. However this method is showing less and less signs of being effective. Both the short-term rate fixings and Interest Rate Swaps were hardly affected by today's actions.
The near 2% rise in the Shanghai Comp and the near 1% rise in the Hang Seng led to a stronger opening in the European equity markets and initially a rise in the S&P500 futures. But Central Bank intervention is becoming to have  less and less an impact on the markets.
The bigger news overnight, which shouldn't have come as a surprise to many, was the lowering of 2012 and 2013 Global Growth forecasts from the IMF. Even the US saw the IMF lower its growth forecast to 1.3% this year and 1.5% for 2013. That's as close to a recession as the US can come. These forecasts, the IMF says, are at risk if the US administration does not reach a deal to stop automatic tax rises next year.

Similarly Europe risks a severe recession with the IMF highlighting that the economic weakness coming from a forced reduction in public expenditure is now spreading into the core economies. The IMF's forecast of 0.2% growth in the Eurozone for 2013 is dependent on the Euro members fulfilling the promises that it has made over the past months. This of course is a real concern.  The IMF's concern is that the link between Bank recapitalisation and sovereign indebtedness has still not been broken as the ESM is being restricted from making direct recapitalisation of Banks by the German. Finnish and Dutch governments. It continues to show an unwillingness to take the necessary  steps as they are politically impossible in those countries that will provide the funding.
The market is expecting Spain to request a bailout around the EU leaders summit on October 18th and 19th. The Spanish Prime Minister is betting on the fact that the Eurozone will not request any further austerity measures than it has already announced earlier this month. However those plans have lost credibility as the calculations used estimate just a 0.5% decline in Spain's 2013 GDP. The IMF estimates Spain's GDP will contract 1.3% next year, and even the Spanish Central Bank head has said that the government's numbers are overly optimistic. So it seems unlikely that Germany, Finland and the Netherlands will not want to impose further austerity measures on Spain.
With civil unrest growing in Spain, there is a call for a referendum on the current austerity plans, the government would certainly fall if it was seen accepting further forced austerity as conditionality of an ESM deal.
The ECB has also made it clear to Greece that it cannot reschedule its debt held by the Central Bank. Draghi made that clear at his recent press conference and ECB Board member Asmussen reiterated that yesterday. The Greek's see an official  debt restructuring as essential for their current budgetary plans and for debt sustainability. So with the ECB standing firm it will require the other members of the Troika, either the EU or the IMF, to provide additional aid. It seems highly unlikely that the IMF would agree to a restructuring of its debt, so the EU is the Greek's only option. That would mean lengthy parliamentary debates in the German and Finnish parliaments and all the uncertainty that would bring.  Looks like the October 18th and 19th meetings could be the start of a lengthy and again messy discussion process. Market's at the moment price in a positive result from that meeting. Greek bond prices have risen significantly over the past weeks with 10yr prices up by 3 points in the past 2 weeks to the highest levels since the debt restructuring . Yet again the politicians seem to have little incentive to take the necessary and decisive action at this meeting unless the market's sentiment turns more negative.

And so to the markets.
Friday's US employment report led to US Treasury yields rising by 5bp to 8bp in the 5yr to 30yr maturities. However the market has now discounted the decline in the Unemployment Rate as a short term anomaly and expects the rate to return above 8% next month. Growing concerns in Europe yesterday say German Bunds rally and dragged US Treasury futures to rally, with the long bond future higher by as much as 1-23 which would have led to 30yr yields falling back below 2.90%. However the markets are reluctant to see such a strong performance in a holiday session and with the US auctioning 3yr, 10yr and 30yr bonds this week we have seen markets give up some of those bond price gains.
The US Treasury market is under pressure as an unintended consequence of the Fed's new QE. The Fed's purchases of $40bln in MBS securities each month has led to a rush by investment banks to buy mortgages off of the banking sector to bundle into MBS. This bundling is leading to an initial hedging requirement and leading to Investment Banks borrowing in the long end Swap markets. This has a consequence of seeing selling in the US Treasury markets. Long end Swap spreads have narrowed , 30yr Treasury yields are now 20bp above Swap from 25bp at the end of September, showing that it is paying in Swaps that has driven rates higher over the past weeks not outright selling of US Treasuries. When this supply of MBS is bought by the NY Fed over the coming weeks and months, the rise in Swap rates will be reversed as the hedge is removed. So the recent back-up in US Treasury yields will be short lived.
One consequence that the FOMC will be happy about is the reduction in Interest Rate Swap Implied Volatilities.
Investors which have seen declines in MBS yields and that are expecting the Fed's purchases to reduce the liquidity in the MBS market have been looking to manufacture products with similar dynamics. As such they have been entering receiving (i.e receiving a coupon) 10yr Swaps and selling a 1yr option to allow the payer ( borrower)  of the swap to cancel the swap if interest rates were to fall. This  has led to a decline in implied swap volatilities whilst there has been little decline in historical volatility.
Whilst the decline has been sizeable, the outright implied volatility levels remain at historically elevated levels.

Declines in implied volatilities have previously seen the risk markets rally. That was a major consequence of QE2 which saw the equity market rally. However this time round the decline in interest rate volatility came after the risk markets had already rallied as those markets priced in more monetary stimulus.  Therefore if we see a further decline in implied interest rate volatilities the rally in risk markets, corporate credit spreads in particular is not a given this time round.

And the shape of the US Interest Rate curve may well limit the decline in implied volatilities caused by those investors reinvesting MBS proceeds. As I stated earlier the sale of new MBS issuance to the Fed should see a reversal in the rise in interest rates over the next few weeks, especially in the 10yr to 30yr area of the curve. That should see the yield curve flatten and reverse the steepening bias we have had since the last FOMC meeting. That should reverse the decline in IR Implied Volatilities. Then risk markets will again have little to support the current pricing levels.

There is some justification to the higher government bond yields- that is the rise in inflation expectations. However the rise in inflation expectations  isn't coming from a rise in commodity prices and even though the US Employment statistics did show an increase in wages, the US economy still has significant slack to take up before wage rises will be seen as truly inflationary. So as we see from below, using Copper as a proxy for commodities in general, 5yr US Inflation breakevens should tend down to 2% as the markets stabilise. But the price of Copper looks to be toppy here and a pull back towards end of August levels should see inflation expectations fall well below that 2% level. That would be very supportive for US Treasury 10yr yields.

And similarly a decline in commodity prices, especially Oil, would be very supportive for UK Gilt prices. 10yr Gilts have less of a safe haven premium built into their yields than either the US or Bunds and as such perhaps offer better value than either of those markets. 10yr Gilts currently yield 25bp more than 10yr German Bunds, which is close to the top of the recent range. As such 10yr Gilts look attractive as an alternative to 10yr Bunds currently.

The next few weeks look likely to be pretty subdued. That is investors are showing little conviction in taking the markets one way or the other. That change in conviction will almost certainly come from further signs that politicians are taking this lull in market turmoil as a sign that they can be complacent. So I would expect range bound trading for the next week.
10yr US Treasury- 1.75%-1.60%, 30yr US Treasury 2.97%-2.77%. 10yr Bund 1.50%- 1.40%
Ahead of the auctions in 10yr and 30yr US Treasuries we should see some yield concession built in. So German Bunds and Gilts should outperform US Treasuries into Thursday before Friday seeing the 10yr and 30yr US Treasury yields moving towards the bottom of the recent trading range.

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