Clock (Still) Ticking, But Now Faster

By: Michael Ashton | Wed, Apr 20, 2011
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The clock is clearly ticking on Greece and Portugal's default or severe restructuring, and the clock seems to be speeding up. Today Greek 10-year yields rose to 14.75% and 2-year yields soared past 22%. If you think Greece is not going to default and force significant haircuts on its bondholders (including the ECB), you have a great opportunity to buy a 22% note that will pay off at par! Portuguese 10-years are at 9.28%; 2-years at 10.5% (see Chart below for the 2yr). The Irish 2y and 10y are both over 10% as well.

Chart 1
Portuguese, Greek, 2y or 10y. It doesn't matter, they all look this bad. This happens to be the Portuguese 2-year note yield.

This is starting to be an all-the-king's horses situation. With all the powers that can be brought to bear on the problems, all of the ECB secondary market support, all of the rescue packages and promised rescue packages - and even after Spain and Portugal both successfully sold bonds over night - these markets are in free-fall.

One reason for it is that investors are newly skeptical that the European Financial Stability Facility, and its successor European Stability Mechanism, are going to work because of one little design flaw: the fact that member countries must cough up the dough. Well, make that two design flaws: member countries are by and large democratic, and the 'little people' seem to object to coughing up the dough. We saw the recent German election results, and the Finns this week gave a lot of votes to a "Euro-skeptic" protest party (although a Finnish friend of mine thinks it is unlikely that party will end up as part of the ruling coalition). Today, the ruling party in Slovakia declared that it won't support the creation of the ESM, which means that two minority parties will need to form a coalition if Slovakia is going to participate. The words of the ruling party's chairman resound:

"We are here to defend interests of Slovak citizens, not the interests of foreign banks, which have for a long time made profits on high interest on loans to irresponsible countries."

Investors are gradually coming to realize that the cacophony in Europe right now isn't merely distracting, but destructive to the notion of a unified Eurozone. And that is causing them to separate the (German) wheat from the (periphery) chaff when it comes to periphery markets. This may ironically be good for the Euro if only the periphery are jettisoned, but the behavior of the Euro bond markets look much like a film of the mid-1990s "convergence trade" being run in reverse.

Having a bailout mechanism that requires consensus of the members appears to be simply not workable. By contrast, the U.S. bailouts do not require state approval, nor Federal approval. The Fed just prints the money and voila! And so far, it has worked.

It has worked, that is, except for the fact that the dollar's downtrend periodically threatens to become disorderly. Today the greenback reversed the rest of Monday's rally and went to new lows on the year. It is challenging 2009's low now. Partly as a consequence, commodities rallied again today, with NYMEX Crude Oil setting its second-highest close of the year (above $111). Softs, Precious Metals, and Industrial Metals all rallied.

The dollar's problems and the imminent shuttering of the debt markets to Portugal and Greece didn't impact the equity markets. Stocks soared overnight and then traded sideways on light-to-medium volume throughout the day. Supposedly this was due to Intel's generous outlook in their earnings release yesterday. I've never understood why Intel's earnings, or those of almost any other single company with the possible exception of a megaconglomerate like GE, matter to the other 5000 stocks, but this was the excuse. Stocks are back up near the 2011 highs again! I suspect that we'll need some actual good news, rather than scattered positive quarterly earnings reports, to propel stocks much higher but to be honest I'm not sure why they're levitating now.

Bonds sold off slightly, with 10y nominal Treasuries at 3.40% and the 10y TIPS at 0.78%. Tomorrow the Treasury auctions $14bln new 5y TIPS at 11:30ET ahead of the early close and Good Friday holiday.¹ The new TIPS will have a coupon of 0-1/8%, the lowest ever auctioned, and if they still issued paper bonds I'd buy some just to frame for that reason. They'll be auctioned at a premium at that coupon, because the real yield will be negative. It doesn't light my fire unless and probably only unless your alternative is the nominal Treasury note. The market needs inflation-linked paper because of all of the money flowing into inflation-linked bond strategies, but I think there's a chance this one is sloppy and needs to be cleaned up next week.

The economic data today didn't do much to push the inflation outlook higher. Existing Home Sales were somewhat above expectations (although, as with Housing Starts, the current level isn't impressive), but the inventory of existing homes rose slightly to 3.549mm units. That implies CPI Shelter over the next 12 months should be expected to be roughly +1.1%, all else being equal (see Chart).

Existing Home Sales
Housing Inventory like this augurs something like 1.1% Shelter inflation in the year ahead.

All else, of course, is not equal and this is a very simple regression. CPI Shelter could well be higher and could possibly be lower. But if CPI for Shelter is only +1.1% over the next 12 months, it will be difficult for overall inflation to really blast off. Still, if core CPI ex-Shelter continues to rise, it will still feel bad.

Tomorrow, we have another Initial Claims figure (Consensus: 390k from 412k), with the consensus hoping...praying...that the jump last week was an aberration. If we get another number around 400k-410k, bonds might get a bid into the long weekend. Also tomorrow is the Philly Fed index (Consensus: 36.4 vs 43.4), which should remain fairly strong, and some home price data. As noted, it is also a short trading session (in the bond market). I will write a comment after tomorrow's session (or on Friday), but then I am out of the country for a week and will not be writing commentary from the beach. The next installment of this serial, after tomorrow, will be on or around May 2nd. Happy Easter.


¹ SIFMA, the self-regulatory body that 'recommends' early closes and holidays for the bond market, made a decision in 2009 to de-emphasize early closes and holidays. Oddly, although Good Friday isn't always a holiday (unlike Christmas) in the market, they've decided this year that it should be even though they're trying to make bond traders work harder. I don't understand why, but I'm grateful.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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