Fixed Income Update 2012-07-11

So where are we and where are we going?

Most of the focus remains on the Euro zone and the continual "kicking of the can down the road". But yesterday also saw some realisation that the situation in the rest of the world is deteriorating as well. China's Trade Data showed that the strength of domestic demand in China is weakening. Given that Europe is moving into a severe recession, the Risk markets only hope was that Chinese and American consumers would have enough demand to not derail the Global economy. Now, it seems, at least the Chinese consumer seems to be holding back a little. The US consumer can't seriously be expected to carry the whole of the Global economy.

Over the past few days the markets have seen volatility in Risk markets whilst the US, UK and German Government bond markets have remained fairly stable.

In Europe the Euro Zone Finance ministers first gave some hope to the peripheral bond markets and the financial credits by announcing that €30bln of the proposed €100bln in aid to recapitalise Spanish banks would be available as soon as the end of this month via the EFSF. The terms of the package was supposed to break the link between a weak banking sector causing a weakening of the Sovereign. We saw 10yr Spanish yields first rise to over 7% Monday before the announcement from the Finance Ministers, only to fall back to 6.75% yesterday before the full details were released.

As always with the way of the Eurozone the details are not so friendly to the risk markets.

It now appears that the details behind the restrictions on the release of the funds to Spain rely on the Spanish government producing a two-year reform blueprint. How can this be a break of the link between Sovereign and Banks? How can the Spanish PM, Mariano Rajoy, claim that this isn't a sovereign bailout when the sovereign is being asked to quicken the pace of reforms to receive the funds. It also means that the Italian PM cannot claim that the Eurozone summit of a week ago was a success for him. Absolutely nothing has happened that he claimed and wanted. So that opens up for Berlusconi to lead an opposition against the Euro.

And just to add to the chaos. The Finns have demanded and been granted collateral for their exposure to the EFSF funds being used potentially for any Spanish banking bailout. As the FT reports, the negotiations and structuring of this collateralisation will almost certainly take longer than the 3 weeks we have to get everything in place before the end of the month.

Another serious restriction is that any Spanish bank requiring a full bailout will need to write off all its Subordinated debt and Preferential Shares. Given that Preferential shares were primarily sold as retail investments, that will surely cause huge protest in Spain as savings are wiped out. The Spanish government are trying to find a way to make the savers whole, which again will limit the break between the Spanish banking sector and the sovereign indebtedness.

And even then there remains a doubt as to whether Spain will need to guarantee any losses incurred by the ESM when, or more likely if, it eventually takes over the lending from the EFSF. Whilst Spain will say it won't guarantee it, the German Finance Minister still says they might have to.

So today, where will we move to?

Spanish and Italian government bonds need to give up yesterday's gains. So Spanish 10yr yields above 7% and Italian 10yr yields above 6.25% by mid morning?

That should mean that European equity markets will have a difficult day. There can be little optimism when the Eurozone Finance Ministers are continuing to push the same policies that are causing such a severe recession.

With a weak US Equity market yesterday, most would have expected a significant rally in Fixed Income markets. But in the end the Bond markets were fairly muted. Why?

Well first of all as I have been pointing out for sometime the Fixed Income markets have been expecting a weakening of the global economy and priced it in somewhat.

Fixed Income Implied Volatilities had been rising over the past weeks even as Equity Risk markets rallied. Fixed Income markets continue to suggest that Risk is mispriced. A VIX in the high 30's makes more sense given the uncertainties. That would suggest a level we have not seen this year in the VIX and would suggest that a fall in the S&P 500 to below the 2011 year end level at least and more likely a fall to close to 1200 or a 10% decline from current levels.

So it remains more a case of Equity markets set to catch up with Fixed Income markets assessment of the Global Economy rather than the other way round.

More importantly for Fixed Income is the decline in inflation expectations.

In the US - Inflation expectations both current and forward are declining. It is starting to justify the flattening of the yield curve.

For yields to decline further in the US the market will have to lower its inflation expectations further.

This will occur if further declines are seen in commodity prices.

At the moment there are two major factors impacting the Commodity markets. The US extreme hot weather has led to a steep rise in Corn and Wheat prices. This will eventually feed through into food prices and as such may cause inflation in those products. So there has been a stalling in the decline of front-end inflation expectations. It is another reason that for the moment the Fixed Income markets are having a limited rally. But Corn and Wheat prices can just as quickly decline as they have risen if the weather changes. Even so, Food prices will not have a lasting effect on US domestic growth, it would have a larger effect on Emerging Market economies where the ability to provide monetary stimulus will be reduced. Will China be able to cut rates if food inflation begins to rise significantly? So food price rises are a larger impact on EM rather than developed markets.

The other pressure on inflation is within the oil price. Middle East tensions continue to run high, especially in US/Iran dialogue. This is keeping Oil higher than it should be given the global growth prospects. Whilst it is preventing inflation expectations falling, it is also preventing the normal level of economic stimulus that a lower oil price would be giving. It will deepen and in particular lengthen the economic slowdown.

On a more technical position, the US Treasury is auctioning 3yr, 10yr and 30yr bonds this week. Last night's auction of 3yr notes was strong with demand at 3.52 times the supply. The only negative in the auction was the 30% sold to indirect bidders. This shows less foreign demand for front-end treasuries than has previously been seen. Tonight sees the auction of $21bln 10yr notes. The market is cautious of rallying ahead of this auction and tomorrow's auction of $13bln 30yr bonds. So it is unlikely until after the auctions that we will see a test of the 10yr US Treasury yield historical lows of 1.45%. But all the signs are that we will indeed see that retest soon.

There is hope for Gold bulls. Gold is outperforming other precious metals significantly. The Platinum/ Gold ratio, is declining again even as platinum supply dynamic is being hampered by mine closures in South Africa. Similarly Silver is at near enough its cheapest level against Gold in the past 3 months. A sign that expectations of further QE is not impacting the precious metals group as much as is talked about. Gold may still suffer from a set-back in a risk sell-off, but this could and should be seen as a buying opportunity. If as expected Spanish retail investors are the first in the EU to suffer losses on what they viewed as bank deposits then there has to be a large deposit flight into hard assets. Gold will then benefit. I would continue to advocate at least a long-term 10% allocation to Gold.

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