Monday, December 20, 2010

Weekly Observatory: A return to steepening in the US curve (and positive spreads vs. German rates)

As expected, the European Council took minimal decisions on Friday by approving a treaty amendment whereby the EFSF will be approved by January 2013 by simplified procedure and operative by June 2013. In a further step to calm down the financial markets, the ECB announced that it will increase its subscribed capital by €5 billion in three years to €10.76 billion. In our view this decision gives the central bank more margin to buy bonds and reduce tensions. Additionally, the more open attitude from Germany to new proposals open the way to reach a solution to reduce risk premium.
Fed stand by QE2
While the Fed announced in its open market committee to continue as planned with large-scale asset purchases and similar to November’s statement, FOMC noted that reluctant hiring and insufficient economic recovery has kept unemployment high.
Macro data supportive… but confirms the decoupling in Europe
The Euro zone composite PMI declined slightly in December, with manufacturing up and services down, suggesting that the industrial sector recovery is not yet having the expected pull effect on the service sector (outside France and Germany) showing clear evidence of decoupling between core and peripheral countries. The index for Q4 confirms that growth should be similar to that of Q3 (0.4% q/q) or even accelerate. In the US, CPI surprised on the downside in November. More importantly core housing prices showed important increases which suggest that the turning point in its trend is consolidating and thus, its offsetting effect of the disinflationary pressures from core goods is still the most likely scenario. Meanwhile, activity related data continues to point to stronger growth.


A return to steepening in the US curve (and positive spreads vs. German rates)
The most significant feature of OECD curves is a reflection of a continued rally in long-term US rates. After easily breaking above 3.30%, the 10Y Treasury reached levels above 3.50% (a rise of around 75bps so far this month). In addition to the factors behind this movement that have already been looked at (the impact of an improved cyclical outlook, less deflationary risk and even certain aspects of the valuation of Govt debt) it is also important to highlight the implications of other issues affecting the relative value of these rates: i) one of the main results of this is the marked steepening which has also occurred: although the short end of the curve has also risen slightly (some revival of a hawkish outlook from the Fed, but not immediately), it has not done so enough to prevent the 2/10Y spread widening by around 50bps this month. This reversal of the flattening movement seen since April partially confirms our idea that it is still difficult to anticipate consolidated flattening in OECD curves in general, and the US curve in particular, until the Fed is on the verge of a drastic change of direction in terms of rates (which has not happened yet). ii) moreover, the spread with German rates has also widened significantly (almost 40bps), which is a reflection of the greater difficultly they have in following US rates in the midst of a phase of a particularly noticeable risk premium in the Eurozone. In fact, in the last part of the movement the German rate has only just managed to break above 3%).
Based on this analysis, a continuation of both trends will be dependent on the movement in 10Y rates, and in our opinion although it may not happen in the short term, they may find it difficult to rise further.
Is there any risk in corporate earnings forecasts for 2011?
On one hand equity, and European stocks in particular, remain marked by sovereign risk, and are becoming so cheap (P/E 11e EuroStoxx 50 9.7x) that as soon as any good news concerning sovereign bonds is released the rises could be significant in the coming months, and the pressure on margins that we will now look at could become a secondary issue.
The underlying picture is not bad at all, since although some companies might have difficulties in passing on cost increases to consumers, it should be possible to do so. At least, it ought to be partially possible, as in the case of commodities, since emerging markets are still growing at a good rate, and we continue to believe that companies with exposure to these regions will come out on top.
Sovereign newsflow does not imply any further punishment
The various news items relating to sovereign bonds have had a limited impact on credit markets this week. The iTraxx Main has narrowed 2bps in the last seven days to 105bps, and the iTraxx SovX closed at 187bps, representing a -1bps change for the same period. Meanwhile cash indices moved very little, due to the limited liquidity on the secondary market. In terms of financial indices, the iTraxx Subordinated narrowed 30bps after reaching a historical high last Friday, to 306bps. The far-reaching downgrades of German subordinate debt announced by Moody’s yesterday due to the introduction of the new banking legislation in the country from January 2011 (which increases the possibility that holders of LT2 or lower debt could incur losses in a distressed scenario) is an additional negative factor which will put pressure on subordinated financial debt’s performance in the short term.


QE2 is working
The Fed expected QE2 to work by making long-term interest rates lower than they would otherwise, mainly by raising asset prices via substitution effects (portfolio balance effect). Both would have expansionary effects and eliminate the risk of deflation. The underlying problem in which the Fed sought to influence was insufficient aggregate demand and a rally in risk assets that would lead to improved confidence – and thus, a boost to aggregate demand – driven by wealth effects. The recent spike in bond yields does not mean that the Fed’s QE2 is failing: i) real rates are still remarkably low (just above 1%) and below the average level of 1H10; and ii) the recent jump reflects improved prospects for growth. Not only is the Fed surely pleased with what the rising trend reflects; additionally, the tightening of overall financial conditions has not been as large as the Fed’s intended portfolio rebalancing effect. The actual effects from QE2 are evident: i) risk spreads have narrowed; ii) stocks have risen; and iii) the USD has depreciated. Therefore, signs that the Fed’s policy is succeeding are so far clear.
Stronger role of domestic demand
The high levels of the household’s and financial institutions’ indebtedness in the developed markets (DM) at the start of the crisis, favoured a deleverage process in this two sectors in the following years. Meanwhile, emerging countries had to change their growth models toward one based on domestic demand rather than external demand, in order to offset the huge decrease in domestic demand in DM. Recent economic data such as retail sales or personal expenditure, suggest that household spending has increased in main economic areas. More importantly, there are some factors that could push private consumption ahead. In this regard, the new US’s fiscal stimulus that includes the extension of the employment benefits and the tax cut, among other measures, may increase GDP and disposable income growth. This could boost private consumption and allow to accelerate deleverage. Meanwhile in Germany, positive employment could increase wage gains, while in China, higher consumption growth should be supported by faster wage growth and by supportive government policy, including social safety net improvement, extension of subsidy programs and enhanced access to consumer finance. Overall the recent consumer data combined with ongoing industrial recovery point out to a stronger role of the domestic economy in the coming year.
EU governance: Uncertainty persists, but there are positive signs
Yesterday’s proposal to amend treaties goes in line with low expectations. Some elements allow us to be slightly more positive and signs of German flexibility open the door to new solutions, but basic uncertainties remain. The main news is that the EFSF will be made permanent in January 2013 and become operative as from June 2013. Other points of the meeting: I) The private participation is likely to be done on a “case by case” basis. II) The use of the permanent EFSF does not necessarily require private participation. III) There was no reference to collective action clauses or other kind of specific mechanisms, but these are likely to be decided during the coming three months. IV) The very recent proposals of issuing Eurobonds (together with further integration), increasing the current EFSF or make it more flexible (to buy bonds) where not addressed in the meeting. However, when asked about it both Van Rompuy and Barroso were very clear that leaders will do whatever is necessary to preserve the stability of the euro, which we interpret as an eventual increase of funds or its flexibilization. This amendment, together with the yesterday´s increase of capital for the ECB and a more open attitude from Germany to new solutions, will help to counter further tensions. However for those who expected strong measures, nothing has been provide. Stress is not likely to fall

Calendar: Indicators

Eurozone: Flash Consumer Confidence(December, December 20th)
Forecast: -8.9 points Consensus: - 9.0 points Previous: -9.4 points
Comment: We think that consumers’ sentiment is likely to improve further in December, supported by good economic data released recently. Overall, data for Q4 as a whole suggest that private consumption should remain resilient in the current quarter, after growing at 0.3% q/q over the last four quarters. Nevertheless, we also see large differences across member states, with private consumption declines in those that are facing severe fiscal adjustment. Market Impact: There are some downside risks to our forecast due to renewed financial strains from the sovereign debt crisis that could end up affecting consumers’ mood adversely. As markets are pricing these events, we think that a positive surprise could have a stronger impact on markets.
Germany: GfK Consumer Confidence (January, December 21st)
Forecast: 5.7 points Consensus: 5.7.points Previous: 5.5 points
Comment: This indicator will be the first sign from private consumption performance at the beginning of next year. Like other soft data, the GfK index suggests that German households’ consumption could have been supporting the economic recovery in Q4. As the labor market improved in recent months and both financial and sovereign crisis are not affecting the German economy severely to, we see that the GfK is likely to increase further in January, suggesting that the incipient private demand recovery could be sustainable over next year. Market Impact: A sharper decline could reflect that economic agents read. European decisions to resolve the current crisis as inadequate.
US: Personal Income and Spending (November, December 23 rd)
Forecast: 0.3%m/m, 0.4%m/m Consensus: 0.3%m/m, 0.5%m/m Previous: 0.5%m/m, 0.4%m/m
Comment: U.S. retail sales in November increased by 0.8% and reached a level of 7.7% above its November 2009 level. Total sales in the last three months jumped 7.8% from the same period a year ago. Retail sales excluding autos also increased by 1.2%, above expectations of a 0.6% increase. Furthermore, the ICSC/UBS Retail Chain Store Sales Index rose 1.1% in November following a three consecutive month fall. Therefore, we expect personal income and spending to continue increasing in November. Market impact: If the real PCE continues to increase at the same pace as in the last three months, it would imply a very strong PCE contribution to economic growth in 4Q10.
US: Durable Goods Orders (November, December 23 rd)
Forecast: -0.3% m/m Consensus: -0.5% m/m Previous: -3.3%m/m
Comment: Durable goods orders and new orders excluding transportation declined 3.3% and 2.7% in October, respectively and disappointed the market. Excluding defense, new orders were 2.1% lower than the previous month. Transportation equipment also dropped in two of the last three months. The current trends continue to point to a slowdown in the new orders for durable goods and therefore we expect durable goods orders to continue declining in November but at a slower pace. Market impact: A betterthan- expected new orders might indicate a better-than-expected economic activity in the coming months and welcome by the markets.
Taiwan: Exports Orders in November (December 20 th)
Forecast: 13.8% y/y Consensus: 13.1% y/y Previous: 12.3% y/y
Comment: Taiwan export orders, a 1-3 month leading indicator of actual exports, are expected to remain broadly unchanged on a sequential monthly basis, but should rise on a year-on-year basis due to base effects. The figures are significant not only for Taiwan, given its export dependence, but for the rest of the region as an indicator of export demand in the coming months. Market Impact: A stronger-than-expected outturn may reinforce positive sentiment toward Asia’s growth prospects, and could accelerate currency appreciation pressures.
Brazil: Current Account (November, December 21 st)
Forecast: USD - 5.000 millions Consensus: -USD 4.600 millions Previous: USD - 3.700 millions
Comment: Brazil’s current account deficit is expected to widen in November in comparison to the previous month following a narrowing of the trade surplus and the continuity of the significant deficits in the Services and Income Balance. The current account deficit accumulated in the last 12-months should come up around 2.5% of the GDP. Market Impact: Impacts will be limited, although strong positive (negative) surprises could help to somewhat ease (fuel) current account concerns. Markets will also look at FDI levels which surprised to the upside in the last few months.

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