Markets: Fixed Income

On Monday, Greek PM Papandreou announcement that he will call a referendum to accept the latest EMU Summit decisions led to turmoil on all markets. Indeed, it gives the impression that last week Summit’s results are already unravelling. Swelling critics that the main decisions on the EFSF firepower, the bank recapitalization and the concrete implementation of the Greek haircut are missing the crucial details are now supplemented by the decision of Papandreou to give the final say to the Greek people. While the Greek people gave birth to the democracy in ancient times, Europe detests such show of people’s democracy. Europe works on the basis of agreements between political bigheads, in particularly between the German chancellor and the French president, afterwards sometimes with bitterness accepted by the 15 other EMU country leaders. Of course, Papandreou may win his gamble and get the people behind the austerity policy. It is also not yet known what question the people will have to answer. However, recent polls show the majority of the people disagree with the Summit decisions on Greece, even if a majority is still in favour of staying in the EMU. So the question may ask people whether they want to stay in EMU. Whatever, a referendum probably will take only place in January and in between uncertainty will reign. What does this mean for the disbursement of the 6th (November) and 7th tranche of the EMU/IMF loan package? There is a possibility that the catharsis comes earlier. Today, EMU political leaders will talk with Papandreou (ahead of the G20-meeting which starts tomorrow), probably to convince him to reverse the referendum call. We don’t see how Papandreou can back off without resigning. Friday, Papandreou faces a confidence vote in the parliament. If lost, there might be early elections or even (less likely) a new government composed of the PASOK and the conservatives. If Papandreou wins the confidence vote, he still has to get the approval from the president on the referendum. We suppose that is only a formality though.

For markets, the latest episode leaves a bad taste. There was already a lot of scepticism on the EMU “final” plan, as crucial details were missing. The EMU also officialised in all but words the first default of a sovereign. The current upheaval will lead to more rumours and opinions that further defaults are possible. Plans may look splendid on the EMU drawing board, but the acceptance of widespread austerity and structural reforms in a context of increasing unemployment and worship is far from assured. The plans may be voted down in the streets. Whether this will indeed be the case, remains to be seen, but from a market perspective it would be dangerous to believe the sandman will take care of the problems and ring-fence us all.

The market reaction didn’t lie. The core bonds surged higher. The Bund added 268 ticks to 138.15 with an intra-day high at 138.54, nearing already the contract high (139.19). The volumes were very high, if one takes into account that half Europe had a holiday. German yields plunged 13 to 26 bps on the day Also the Dec T-Note future surged higher on Papandreou’s surprise decision. US yields fell a smaller 5.8 to 12.4 bps. All risk markets were hit. Equities tanked and commodities fell, but less substantially. Oil held up quite well and trades around $109/barrel (Brent). Gold couldn’t profit from the panic, but corporate credit spreads widened sharply. Noncore bond yield spread widened and the CDS of the main countries, especially Germany and UK and to a lesser extent the US jumped higher.

On peripheral bond markets, spreads against German bunds suffered a tremendous blow yesterday after Greek PM Papandreou unexpectedly announced a referendum to accept the second Greek bailout deal agreed upon last week. The German/Italian spread added 35 bps to a 442 bps record high and if it wasn’t for the ECB the damage would have been worse. The intraday profile of the Italian 10-year nominal yield shows that as the yield approached the August high (6.39%), new president Draghi was called for duty and stepped up the size of the SMP-programme. Something he will likely need to do more this week. The new stress on the Italian bond market also added pressure to the domestic political tensions. Italian president Napolitano repeated the demand for urgent reforms and indicated that he could consider options for an alternative government. The German/Spanish spread increased 24 bps to 375 bps and also here the ECB had to intervene to prevent further damage. The German/ Belgian spread widened 28 bps to a record high of 263 bps. In Ireland, the government announced that its debt was over 2% less than previously thought due to an accounting error which saved €3.6B. At the end of the week, the Irish government will announce whether it will cut its GDP forecasts.

Today, the eco calendar remains interesting with the final figure of euro zone manufacturing PMI, the German unemployment data and ADP employment report in the US. Even more attention might go out to the FOMC rate decision followed by the press conference. On the supply front, Germany and Portugal (T-Bills) will tap the market.

In the euro zone, the final figure of October manufacturing PMI is forecasted to confirm the first estimate, which surprised on the downside of expectations. According to the first estimate, euro zone manufacturing PMI dropped from 48.5 to 47.3 the lowest level since July 2009. For the final figure, we believe however that a slight upward revision is not excluded on hopes that a solution will be found for the euro zone debt crisis. The German labour market is expected to have remained strong in October. Unemployment is forecasted to have dropped by 10 000 in October, while the unemployment rate is expected to have stayed unchanged at the record low level of 6.9%. In the US, the ADP employment report will be interesting, although it lost much of its correlation with the official BLS reading. In October, the ADP report is forecasted to show an increase in private employment by 100 000, slightly up from 91 000 in September. We believe however that an upward surprise is not excluded as also the claims showed an encouraging development over the month. In addition, in the reference week for the September ADP employment report the claims were 432 000, which provided a drag to the ADP report in September and will probably be encouraging for this month report, when the claims were significantly lower.

Today, the German debt agency taps the 5-year Bobl (€5B 1.25% Oct2016). The issue has €6B outstanding and it is the second to last Bobl auction this year, with a final €5B tap of this Bobl-line scheduled early December. The €6B launch of this line at the end of September was technically undersubscribed with only €5.11B total bids. Recently only German Schatz-auction held up relatively well and despite the risk averse climate, we think that also this auction will be difficult as the German 5- year yield is approaching the all time lows and not at all a sweetener.

The FOMC will meet for its penultimate meeting of the year. Chairman Bernanke will hold a press conference after the meeting. The FOMC tweaked during the August meeting its forward-looking language. It now anticipates rates would remain low at least through mid-2013 Bernanke added during his October 18 speech that the FOMC continues to explore ways to further increase transparency about its forecasts and policy plans. At the September meeting, the FOMC decided a $400B operation twist which aims to lengthen the duration of its asset portfolio by actively selling shorter dated Treasuries and buying for similar amount longer-dated Treasuries. To help the mortgage market, it will now reinvest principal payments of maturing agency and agency MBS paper in agency MBS paper (before it reinvested in Treasury paper).

The Fed got a lot of criticism for the non-conventional policy measures taken since the crisis erupted, including the QE, zero rates and now operation twist. The criticism came from academic circles, but, potentially much more dangerous, also from political circles especially from the Republicans and more in particular the Tea Party. Given that the operation twist has only started in earnest and the widespread critique on the Fed and his chairman, we expected that the Fed would stand put at least until the beginning of 2012. Somewhat stronger eco data and still high inflation were also considered as arguments justifying a wait-and-see approach. However, it seems that the debate on the Fed is raging and more policy action in the near term is not excluded. Two interesting debates are taking place. Recently, chairman Bernanke said that forward guidance about the future path of policy rates, already used before the crisis took on greater importance as policy rates neared zero. The Fed, he added “continues to explore ways to further increase transparency about its forecasts and policy plans.”

Chicago Fed Evans, a representative of the so-called dovish wing inside the FOMC, has argued for tying policy to specific measures of unemployment and inflation. He favours to keep policy rates low until unemployment drops to 7% and as long as inflation stays below 3%, which compares to the Fed’s (informal) target of 2% inflation. Governor Yellen said the FOMC should give “careful consideration” to Governor Evans proposal. Minneapolis Fed Governor Kocherlakota, a hawk who dissented against recent Fed decisions, was surprisingly in favour of Evans way of thinking. By clarifying the Fed’s goals the number of dissenters at the FOMC meetings would be smaller, he said. By past easing, he added, the Fed suggested it will tolerate higher inflation in order to help the job market in the short term. This might lead to increasing inflation expectations and thus weigh on longer-term outlook of the labour market.

An “Evans-like” message from the Fed would avoid such negative implications. So, markets will closely look whether the FOMC becomes more precise and transparent in its forward looking guidance.

Washington-based governor Tarullo, normally not outspoken on monetary policy affairs was straight-forward in the speech he gave. He summarized his findings in three points: Firstly, the acute problems are largely the result of a shortfall of aggregate demand following the financial crisis and recession. As such they can be addressed through measures designed to increase total investment and consumer spending. Secondly, because the recession arose from the financial crisis, which itself followed a build-up of asset bubbles and debt in areas as housing, the policies likely to be the most effective at increasing aggregate demand may be somewhat different from those associated with a more normal recession and, even so, are not likely to work as quickly. Thirdly, if labour market conditions remain this unfavourable for long, the problems described as acute could transform in a chronic problem (erosion of skills resulting in loss of productive capacity). To tackle these problems, Governor Tarullo proposes to concentrate on the housing market. Why? Because “housing continues to hang like an albatross around the necks of homeowners and the economy as a whole”. He favours that if the eco situation doesn’t improve rapidly the Fed launches another Large Scale Asset Purchases programme, especially MBS paper. That would lower the effective yield on the MBS, putting downward pressure on mortgage rates. The aggregate demand effect should not only be felt in new home purchases, but also in added purchasing power of existing homeowners who are able to refinance. It won’t solve completely the problem of a shortfall of aggregate demand, but that should be no justification to do nothing. Help from the fiscal authority would be welcome, but the absence of such help may not justify inaction by the Fed, he concluded, he concluded. Vice-chairwoman Yellen also said that a third round of large-scale securities purchases might become warranted if necessary to boost the economy. So, while the FOMC meeting most likely won’t bring new initiatives, the momentum for the Fed to act is gathering speed though and new measures might be coming forth rather fast, if the recent slow re-acceleration of the recovery doesn’t pick up speed. Therefore, it will be very important to listen to Bernanke for hints the Fed is preparing such a new QE programme directed to the housing market.

Regarding bond markets today, the focus will be on the drama that is enfolding in Greece, on the G-20 meeting that starts officially tomorrow and of course on the FOMC meeting. It is difficult to propose a precise short term tactic for the day, as event risk is the driver. Risk aversion is back in town again, after a two-day break last week (EMU Summit). We didn’t expect much new from the FOMC and ECB meetings, but the renewed turmoil raises the odds for some surprise. Governments and Central Banks have the tendency to feel obliged to do something when markets are looking as if they may at any moment fall from the cliff. That might sometimes help, but the effects of such often hastily and bad crafted “solutions” are rapidly fading (law of decreasing returns). Nevertheless, in a daily perspective and following huge risk aversion moves in the past two days, there is maybe some scope for a more neutral posturing by the markets and some profit taking on past moves. Asian equities trade mixed, the Bund opened lower and US equity futures are up, all signals that indeed the market is a bit cautious ahead of these events. Technically, overbought conditions and the contract high (139.19) suggest that more progress is difficult in a ST perspective. Partial profit taking looks sensible as highs are approached. There is little value in German bonds in a long term perspective at current levels, unless Armageddon or Japanese-style deflation occurs.

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