Email of the day on lengthy bond market top formations
We may not be done with the bull market in bonds, or at least a very extended period of ranging if this article has merit. It is publicly available so ok to post. Would appreciate your comments
David Fuller and Eoin Treacy's Comment of the Day
Category - Fixed Income
Italexit is not a solution for Italy's problems
Thanks to a subscriber for this article by Lorenzo Codogno and Giampaolo Galli which may be of interest. Here is a section from the conclusion:
The euro is irrevocable. It was designed as Hotel California: “you can check out any time you like, but you can never leave!” However, we know that it would be wrong to take it for granted. Italexit could still happen as the unwilling and messy result of an unbearable deterioration in public finances and economic performance, combined with misguided political will and financial market turmoil. It would be a huge mistake. Much better, and less costly, would be to address the underlying problems, allowing Italy to survive and thrive within the euro by enhancing potential growth and economic resilience.
It would be wrong to conclude that Italexit, or exit from the monetary union by any other Member State, is going to be an easy process that can be evaluated with a straight cost-benefit analysis and smoothly managed in an orderly way. While Roger Bootle, one of the advocates of the return to national currencies, came to somewhat different conclusions, he acknowledged that the exit merely being the reverse of the construction process does not make it easy: “it would be the equivalent of unscrambling an omelette”.
In the case of Italexit, redenomination and default would become very likely and would cause a number of side effects and negative spillovers into the economy. Exit without redenomination would lead the debt-to-GDP ratio to reach 190%, assuming 30% devaluation, making default even more likely. Hence, Italexit would not address the issues its proponents claim it would address, while producing significant financial instability. Just mentioning it as a viable solution as part of a political platform would imply risks of making it a self-fulfilling prophecy. The economic, social, and political consequences would be enormous and last for a number of years.
Deviations From Covered Interest Rate Parity
I found this report by Wenxin Du, Alexander Tepper and Adrien Verdelhan for the National Bureau of Economic Research to be fascinating and commend it to subscribers. Here is a section:
In this paper, we examine the persistent and systematic failures of the CIP condition in the post crisis period. After formally establishing CIP arbitrage opportunities based on repo rates and KfW bonds, we argue that these arbitrage opportunities can be rationalized by the interaction between costly financial intermediation and international imbalances in funding supply and investment demand across currencies. Consistent with this two-factor hypothesis, we report four empirical characteristics of the CIP deviations. First, CIP deviations increase at the quarter ends post crisis, especially for contracts that appear in banks’ balance sheets. Second, proxies for the banks’ balance sheet costs account for two-thirds of the CIP deviations. Third, CIP deviations co-move with other near-risk-free fixed income spreads. Fourth, CIP deviations are highly correlated with nominal interest rates in the cross section and time series.
Looking beyond our paper, we expect a large literature to investigate further the CIP deviations. The deviations occur in one of the largest and most liquid markets in the world after the crisis in the absence of financial distress, suggesting that other arbitrage opportunities exist elsewhere. While trading in exchange rate derivatives is a zero-sum game, the CIP deviations may have large welfare implications because of the implied deadweight cost borne by firms seeking to hedge their cash flows. Furthermore, the existence of CIP deviation introduces wedges between the interest rates in the cash and swap markets, which affects the external transmission of monetary policy. The welfare cost of the CIP deviation is behind the scope of this paper; it would necessitate a general equilibrium model. Yet, even without such model, the CIP condition is a clean laboratory to test the impact of financial frictions in a very general framework. In this spirit, we present the first international evidence on the causal impact of recent banking regulation on asset prices. We expect more research in this direction in the future.
Markets on the cusp ...?
Thanks to a subscriber for this report by James W. Paulsen for Wells Fargo may be of interest to subscribers. Here is a section
Trends matter, for among other reasons, because they impact the impressions, expectations and actions of policy officials, investors, consumers and businesses. For this reason, we think investors should be aware of just how many financial market trends are on the cusp this year threatening to breach significant milestones.
Undoubtedly, not all of the trends we highlighted will actually break new ground this year and perhaps none will reach levels that draw much investor focus. However, in 2017, the following list of financial market trends are worth monitoring because they are “on the cusp”…
1. Evidence of inflation is broadening and inflation expectations embedded in the 10-year Treasury TIP bond is only about 0.5% below the highest level in at least 20 years.
2. Three major themes are on the cusp in the U.S. stock market. First, is the recent breach of a two-year old trading range in the S&P 500 Index to a new recovery high possibly suggesting a third leg in this bull market? Second, the relative total return performance of conservative investments is nearing its lowest level of the entire recovery. And finally, the relative performance of small cap stocks is within 10% of rising to a new all-time record high relative to large cap stocks.
3. Bond investors face several important trends on the cusp including the potential end of a 30-year bond bull, a flatter Treasury yield curve and investment grade yield spreads about to reach new narrows for the recovery.
4. The U.S. dollar is in a two-year old trading range which, with a break, will settle whether this is just a pause in an ongoing dollar bull market or the start of a fresh dollar bear market.
5. In the commodity markets, crude oil is on the cusp of breaking out of a two-year old trading range above $60 and industrial commodity prices are within 10% of rising to a new six-year high.
So far, this year has been dominated by political news and what it means for future economic and regulatory policies. Perhaps, however, in a year with so much on the cusp, investor mindsets will eventually become more impacted by financial market trends breaking outside old recovery trading ranges?
Where is the Dollar weakest?
France's Neighbors Sound Alarm Over Election 'Catastrophe' Risk
This article by Esteban Duarte and Patrick Donahue for Bloomberg contains a useful calendar of political events for 2017 and may be of interest to subscribers. Here is a section:
Polls suggest that National Front leader Marine Le Pen will make it to France’s run-off vote on May 7, giving her a shot at claiming the presidency on anti-euro, EU-skeptic ticket. She shared a stage last weekend with Frauke Petry of Alternative for Germany and Geert Wilders, whose anti-Islam platform has helped propel his Freedom Party to within reach of winning the March 15 Dutch election.
Europe’s anti-establishment forces are drawing inspiration from Donald Trump’s surprise elevation to the U.S. presidency and unexpected victory of Brexit supporters in last year’s referendum. Another common strand is an anti-immigration stance that has flourished during the worst refugee crisis since World War II, with more than one million people fleeing war and oppression in Syria, Afghanistan and elsewhere having sought asylum in Germany alone.
Gabriel, who is poised to become German foreign minister in a cabinet reshuffle allied to the Sept. 24 election, pointed to France’s two-round ballot as the key moment that will shape Europe’s destiny. While no recent poll has shown Le Pen coming close to winning the second round, Brexit and Trump’s victory have made political analysts and investors reluctant to rule anything out.
“If Europe’s enemies, after Brexit last year, manage once again in France or in the Netherlands to be successful, then the threat to us is the collapse of the greatest civilization project of the 20th century, the European Union,” Gabriel said in a speech to lower-house lawmakers in Berlin on Thursday.
Italexit Risk Low, Debt Re-Profiling Better Option: Mediobanca
This note by By Francesca Cinelli summarises a report issued by Mediobanca earlier this week discussing the economic implications of Italy exiting the Euro. I’ve read the original report but we are precluded from posting it on the site.
Time costs money for Italy, due to collective action clauses (CACs) and thus, purely on financial grounds, it reduces Italexit risk and makes any voluntary debt re-profiling a better option to eventually sustain its borrowings, Mediobanca says in note.
Highlights no growth undermines debt sustainability; Sentix Index, which estimates the one-year probability of Italy leaving the monetary union based on the assessment of investors, signals stress
Says redenomination in any Eurozone country is a function of the freedom allowed on bonds issued under domestic law and the constraints of the recently introduced EU discipline on
CACs
Quantifies cost of re-denomination, says four variables suggest EU280b loss, partly offset by EU191b gain from the Lex Monetae on bonds under domestic lawCompares CACs and non CACs pairs of Italian govies displaying similar features in order to test Mediobanca’s “time costs money” finding; that means as time goes by the
financial incentive for redenomination declinesData suggest 30bps yield premium on 3.5yr non CACs bonds actually drops to 10bps on 12yrs
Says “Quanto” spread captures the “convertibility risk” implied in the premium between USD- and EUR-denominated CDSsData suggest that at end 2016 for the first time Italy’s “Quanto” exceeded Spain’s, confirming Italy crucial role for eurozone future given a 90% correlation the brokerage notes between Italexit probability and a euro break-up probability
Fed Debate Over $4.5 Trillion Balance Sheet Looms in 2017
This article by Christopher Condon for Bloomberg may be of interest to subscribers. Here is a section:
The dollar is a particular source of worry for U.S. policy makers, having appreciated 23 percent since mid-2014. The Fed expects to keep tightening while central banks in Japan and Europe hold steady or consider more accommodation. That could further strengthen the greenback and introduce a headwind for U.S. growth.
“Slowing down the economy a little bit at the long end of the market has some benefits if you think primarily that exchange rates are driven by short-term interest rates,” Rosengren said. “You might want some of the removal of accommodation to come at the long end, which would be done by the balance sheet.”
The Boston Fed released research on Jan. 19 that backs up this view of exchange rates and the yield curve. Former Fed economist Roberto Perli was more skeptical, pointing to global demand for longer-term U.S. Treasuries.
“If long U.S. rates were to increase significantly as a result of balance sheet shrinking, there would still be large inflows into U.S. assets, which would support the dollar,” said Perli, a partner at Washington consulting firm Cornerstone Macro LLC.
The Tech Bubble Year 5+
This very well-illustrated presentation by Anand Sanwal from CBInsights for the benefit of attendees at the CanTech Conference in Toronto may be of interest to subscribers.
Bond Guru Who Called Last Bear Market 40 Years Ago Says Go Long
This article by Andrea Wong for Bloomberg may be of interest to subscribers. Here is a section:
Money velocity isn’t a bullet-proof economic indicator. Financial innovation, and the rise of shadow banking, have made it hard to measure exactly how much money is floating around in the financial system. And some would say that "money" itself is going through an identity crisis these days.
Hunt isn’t the only one seeing the record-low pace as an ominous sign. The fact that money velocity declined rapidly during years of near-zero interest rates may signal aggressive monetary easing actually led to deflation instead of inflation, economists at the St. Louis Fed wrote back in 2014.
"In this regard, the unconventional monetary policy has reinforced the recession by stimulating the private sector’s money demand through pursuing an excessively low interest rate policy," economists Yi Wen and Maria A. Arias wrote.
"I know I’m the minority here,” Hunt said. “I’m just trying to see the world as I think it should be seen.”