The end of austerity?

At first glance, the Eurozone debt crisis still seems to be the pre-dominant driver of financial market dynamics: Bund yields are reaching new record lows almost on a daily basis while spreads of peripheral bonds trade at wide levels. However, while fears concerning a Spanish debt explosion were the key driver behind market dynamics up to mid April, amid rising expectations of more monetary easing and most importantly an end to austerity, the focus has no shifted towards a general Eurozone recession with different implications for the markets.

The chart below shows the level of 10y Bund yields together with the 10y Spain-Bund and 10y Italy-Bund spreads. As can be seen 10y Bund yields started to fall around mid March, just as Italian and Spanish spreads to Bunds started to widen again, following the ECB-LTRO induced easing of tensions at the start of the year. Between mid March and mid April peripheral bond spreads to Bunds widened sharply. This was the period where fears about the crisis in Spain intensified (recession, imploding housing bubble, uncertainty about the recapitalisation needs of the banking sector etc.) and also fears regarding a potential rating downgrade of France (not least due to a potential change in the presidency) intensified. However, from mid April onwards peripheral spreads stopped widening and moved into a range-trading environment while Bund yields continued to fall.

10y Bund yields and 10y BTP/BONO spread to Bunds

Source: Bloomberg

A very important implication is that prices for peripheral bonds are falling again (lower Bund yields + stable spreads = lower peripheral bond yields) which is a very welcome development. But why are yields now suddenly falling across the Eurozone government bond universe? I think the reason is twofold: a) rising speculation concerning a potential ECB rate cut and b) waning political support for austerity/rising political support for growth enhancing measures.
Given a deposit rate of 0,25% and the high amount of excess liquidity, EONIA has settled in the low 30bp area and should be expected to remain there as long as neither the deposit rate nor the amount of excess liquidity changes. However, in mid-March EONIA Forwards (I used the 9x12M. EONIA Forward in the chart below) have started to price in a tightening of monetary conditions some months down the road and moved significantly higher (assuming a lower level of excess liquidity or a higher deposit rate). This potentially was also a key driver behind the peripheral bond spread widening which started at the same time. Amid the wave of very weak economic data out of the Eurozone which are increasingly painting a recessionary picture, around mid-April EONIA forwards started to discount a lower level of EONIA than warranted by the current monetary stance (so starting to price a depo rate cut/higher level of excess liquidity). Hence, expectations of an easier monetary policy stance are supporting asset prices in general.

9x12m OIS have started to price further monetary accommodation

Source: Bloomberg

Also supporting peripheral bond prices is the waning support for further austerity measures. The negative feedback loop (weak growth = higher deficit = more austerity = weaker growth) threatens to lead more economies into an environment of everlasting recession and with that rising debt-GDP ratio (as GDP shrinks), rising risk of social unrest and waning support for the Euro. However, the political consensus for further austerity measures seems to be a thing of the past. With a potential victory of Mr. Hollande in France who wants to renegotiate the fiscal compact and the call for early elections in the Netherlands two important allies of Germany are change sides. Rather the focus is now shifting towards growth enhancing measures via infrastructure investment and more structural reforms. Sure enough, even if these would be enacted, it would take time to support growth. But more important is that the period of further austerity measures in an environment of weak growth seems to be coming to an end. 

In sum, markets have shifted from pricing a worsening debt crisis lead by developments in Spain towards pricing in a recession in the Eurozone which, however, leads to further monetary accommodation but no more fiscal tightening. This in turn, would increase the probability of a more growth friendly environment further down the road and hence reduces the risk of a Eurozone break-up/debt-deflation spiral.
As long as the austerians do not gain the upper hand again and the prospects for more monetary easing stays alive, the stabilisation in peripheral bond markets can continue. As long as economic data continues to disappoint, Bund yields can fall further.

Trend Change in 10y Bund yields

The easing of financial market stress is continuing. In fact, the ECB has managed to break the former downward spiral where higher peripheral government bond yields lead to a worsening in fiscal solvability, more austerity programmes and weaker growth. Additionally, lower government bond prices weaken bank balance sheets which increases the need to deleverage and also reduces growth. Lower growth, however, further weakens fiscal solvability and leads to higher yields for peripheral government bonds.
The ECBs action, however, have managed to improve the position of banks and of sovereigns alike. Lower yields for peripheral sovereigns improves fiscal solvability and lower the need for additional austerity measures. Furthermore, higher prices for peripheral bonds improves banks' balance sheets and reduces the need to deleverage. Hence, there is now a weak form of an upward spiral in place.
Overall, these actions have helped to stabilise the macro-economic environment in the Eurozone. Furthermore, sentiment indicators can rise from formerly depressed levels and expectations for Eurozone growth should start to improve as well.
As a result, financial markets can now enter the second phase of the easing in financial tensions. Whereas the first was driven mostly by the surge in liquidity where all asset prices can rise, the second phase should be driven largely by the improvement in the macro-economic environment. This means that so-called risky assets (i.e. peripheral bonds, credit bonds, equities) should continue to perform and dips should continue to be bought. However, the so-called safe-haven assets (i.e. Bunds, but also precious metals, JPY, USD, CHF) should increasingly come under pressure and upticks should be sold. For one, investors will start to actively switch out of these assets into risky assets to profit from an improvement in the macro outlook. Additionally, as the outlook improves, expectations for another ECB rate cut will vanish. Furthermore, I expect inflation expectations to start rising. The ECB will face huge difficulties to drain the excess liquidity (to the tune of EUR 900bn) it has created via the two 3y LTROs. Most likely, if it were to actively drain this liquidity (via a rise in the reserve ratio or reverse auctions/issuance of bills) it could do so only with the help of significantly higher short term rates which, however, will be very difficult to achieve amid the persistent weakness in parts of the peripheral countries' banking sectors. Most likely, the level of excess liquidity will remain very high for the foreseeable future and hence this liquidity will continue to slosh around the financial system and drive up asset prices in turn. As a result, inflationary pressures should rise and be reflected mostly in rising break-even inflation rates at the longer end of the curve. Hence, the yield curve should bear-steepen, driven by higher yields for long-term Bunds.  Fundamentally, therefore, longer-term Bund yields should rise markedly in the months ahead. The underperformance of Bunds vs. peripheral and corporate bonds should continue.

Trend change in 10y Bund yields

 Source: Bloomberg

Technically, the picture for Bunds now shows first bearish signs as well. As the chart above shows, 10y Bund yields are still within their 1.74-2.02% range they have been trading at for the past few months. However, earlier this week, they have finally broken through the downward trend which was in place for almost one year. I take this as a first sign that investors have started to shift out of Bunds into other (more risky) asset classes. Furthermore, this assessment is confirmed by a simultaneous flattening of the peripheral curves. While the first phase of the liquidity glut was marked by steepening peripheral curves (as some money from the 3y LTROs found its way into shorter-dated peripheral bonds), the second phase should be marked by ongoing spread compression mainly at the long end as investors increase risk taking.
Overall, I think that markets have entered a second phase of the easing in financial tensions which will see ongoing performance in risky assets but safe-haven assets will come under increasing pressure. 10y Bund yields are likely to rise back towards 2.50% in the months ahead.

US Data Warning: Heightened Risks for Negative Surprises

Amid a multi-month string of positive data surprises – which was mirrored by an improved sentiment towards US assets - and especially following the change in seasonal adjustment factors for data referring to January 2012 onwards – as published by the US Department of Commerce on Wednesday – the near-term risks for negative data surprises have increased substantially. I expect US economic data referring to January and especially to February to disappoint on average! However, it does not alter the medium term trajectory of the US economy nor change my positive view on Eurozone assets (see also 2009 all over again? dated January 23). Rather it should see speculation about QE3 in the US intensifying.

I have stated on several occasions that I think the seasonality of the US economy should have decreased but the actual seasonal factors used to adjust the raw-data have increased (see for example: Growing probability of positive US data surprises dated May 31 2011). Since the onset of the last recession in late 2007 the US economy has lost several million in manufacturing and in construction (approx. 2mln each). On the other side, employment in sectors such as healthcare (+1,5mln) has increased. While the former are highly seasonal, the latter is not. As a result, the seasonality of the US economy should have decreased. However, the seasonal factors which have been used in 2010 and 2011 assumed that the seasonality of the US economy has rather increased! The reason for this is that the seasonal factors are calculated via statistically analysing historical data. The sharp slump in GDP following the bust of Lehman Brothers took place in autumn and winter. Given that this period is the seasonally weak period of the year anyhow (with January being the weakest month), the statistical techniques resulted in larger statistical factors. This can be seen in the chart below which shows the seasonal factors used to adjust the raw data of the ISM manufacturing index.

Seasonal Factors used for the US manufacturing ISM index: higher seasonality in 2011?

Source: ISM, ResearchAhead

The factors for 2007 are shown in blue, those for 2011 in grey and the difference between the two in red. As can be seen, in 2011 the period from November to March (i.e. those months where the financial crisis in 2008/2009 led to a stand-still of global trade) was assumed to be significantly weaker than in 2007 (the seasonal factors are lower). On the other side, the seasonal factors for April-August assumed that the economy would be showing more momentum in 2011 than in 2007. Hence, the seasonal factors assumed in 2011 (and 2010) that the US economy’s seasonality increased significantly. As a result, the published seasonally adjusted data painted too positive a picture for data relating to the November-March period and too negative a picture for the April-August period. I think it is no coincidence that the US stock market topped out in spring 2010 and 2011, i.e. just as the period of artificially positive data came to an end. Furthermore during both years it bottomed in summer, i.e. just as the period of artificially weak data was about to end.  

However, yesterday, the US Department of Commerce published the seasonal factors to be used for the calculation of the manufacturing and non-manufacturing ISM indexes in 2012. It stated that: “In response to concerns that the unusually large declines in autumn 2008 associated with the recent recession that may not have been adequately handled with default settings, this year the Department of Commerce used lower thresholds (critical values) for detecting outliers. “

Seasonal Factors used for the US manufacturing ISM index: lower seasonality in 2012
 
Source: ISM, ResearchAhead

As a result, the seasonal factors which are to be used for this year’s ISM releases have been changed materially as the chart above shows which compares the factors for 2011 and 2012. Especially the seasonal factors relating to January-March have been increased significantly (and those for May-October lowered significantly). In turn, the seasonal factors have moved closer again to where they were before the financial crisis.
The result though is significant. For today’s release of the January ISM index, the difference between the 2011 seasonal factors and the 2012 numbers amounts to approx. 0,6 points in the headline number (i.e. the 2012 number should be 0,6 points lower, all else equal) and a full 2 points for the February release! The difference is the largest for the New Orders component where the seasonal factor rose from 0,944 in 2011 to 0,999 in 2012 which depresses this sub-component by approx. 3 points! For the non-manufacturing index, the January 2012 numbers should be 1 point lower than in 2011 purely due to the change in the seasonal factors.
Given that US economic data has surprised positively in the second half of 2011 (see chart below for the Citigroup US economic surprises index), sentiment towards US risky assets and economic forecasts have improved also. However, coupled with the changes in the seasonal factors, this should lead to a significant downside risk in economic data over the next weeks, starting with data relating to January and intensifying for data relating to February!

US Citigroup Economic Surprise Index: multi-months positive surprises should by now be reflected in improved forecasts

 Source: Bloomberg

2009 all over again?

I am convinced that the global economy - ever since the financial crisis started in 2007 and put in motion a deleveraging wave - is going through a multi-year cycle which looks in general like this: Weak growth --> low inflation -->  Liquidity glut (emanating from the central banks in the deleveraging economies) --> higher prices for financial assets --> macro-economic stabilisation --> higher commodity prices --> higher inflation -->tighter monetary policy --> lower prices for financial assets --> lower growth --> low inflation.
2010 was the year where financial asset prices imploded and growth/inflation weakened but I think that we are now again in an environment where the liquidity glut intensifies (mainly due to the ECB's 3y LTRO) which leads to a longer-lasting rebound in prices for equities, (risky) bonds as well as commodities.

The financial crisis (especially following the Lehman bankruptcy in 2008) pressured prices for financial and real assets sharply lower and led to a severe global recession. Inflation fell significantly and in turn global central banks coul,d orchestrate a massive easing wave and liquidity injections. This led a rebound in prices for equities, (risky) bonds and commodities which - coupled with significant fiscal easing steps - helped also the economy to recover. But mainly due to higher commodity prices, this also led to higher inflation rates which was mirrored by a wave of central bank tightening in 2010 and 2011 (mainly in emerging market economies but also in the Eurozone). This in turn weakened growth and - also via a tighter liquidity environment in the Eurozone - intensified the Eurozone sovereign and banking crises. However, as growth weakened substantially and prices for equities, (risky) bonds and commodities fell markedly, inflation started to fall back again, allowing a growing number of central banks to start easing monetary policy. Furthermore, as in late 2008/2009, the central banks at the epicentre of the financial crisis (this time the ECB) injected an unprecedented amount of liquidity into the system.
I have mentioned previously that the ECB's 3y LTROs are leading to a liquidity glut in the Eurozone (see: The Eurozone liquidity glut dated  Jan 17) which should put downward pressure on the external value of the Euro and peripheral/credit bond spreads while it strengthens banks' balance sheets. As a sidenote, the ongoing high level of usage of the ECB's deposit facility usage is not a sign of the stress in the banking sector. If the ECB's support measures create excess liquidity then one way or the other it has to find its way back to the ECB (The liquidity does not go away). More important is whether this liquidity is being hoarded by the banks (a sign of stress) or is floating around the system (and drives asset prices higher as this happens). Last year, banks used the ECB's liquidity operations to hoard cash. However, as Draghi has mentioned at the last press conference, now the banks which make heavy usage of the 3y LTRO are not the ones which deposit liquidity at the deposit facility. Hence, the liquidity has started to float around the system and we are in the midst of a liquidity glut environment!
As a result, I am of the opinion that 2012 could well see a (partial) re-run of 2009, the year where financial markets recovered substantially from very depressed levels and growth turned the corner. I expect financial markets to continue pricing out the systemic risk of a Eurozone collapse/wave of sovereign and bank defaults given that the 3y unlimited liquidity provision keeps the banks liquid and increases the incentives to set up carry trades which in turn also keeps the sovereigns liquid. As this happens, the financial sector should outperform (i.e. bank shares should outperform vs. the rest of the market as should bank bonds). In a second phase, the economic prospects should improve (as sentiment data recovers) which should then take cyclicals higher.


In this environment, especially, the valuation of the Eurozone banking sector appears still at too low levels. The chart below shows the price-book ratio of the Stoxx600 Bank index as well as the index itself. The price-book ratio fell to around 0,5 in early 2009 before recovering to approx. 1,2 in late 2009 and trading around 1 until early 2011. Last year it fell again towards 0,5 and is currently around 0,6. In order to justify these levels, the market assumes that banks either have to take significant losses (which lowers the book-equity) or have to raise new equity at values significantly below book-equity. The first appears unlikely in the short term, given that prices for peripheral bonds (where banks hold a significant exposure) have risen substantially over the past weeks. With the liquidity glut significantly reducing the probability of a default wave, it is difficult to see the banks suffering from such big losses which would lower their book equity. Furthermore, the banks had to present how they plan to fulfil the capital requirements as defined by the latest EBA stress tests until last week and further large rounds of external financing - which dilutes existing shareholders - should be limited. Finally, the ECB essentially injects a two-digit billion Euro amount into bank equity over the next three years without diluting existing shareholders. Following the collapse of Lehman Brothers, markets for bank bonds were shut and banks issued bonds with state guarantees. These bonds had a 3-year maturity (and are expiring this year) and carried an average coupon of 3.5%. Adding to that a fee for the state guarantee, the cost of this funding should have amounted to approx. 4%. If we take this 4% as an average funding cost, then a Eur 500bn take-up at the LTRO for 1% would result in a reduction in financing costs (and hence an improvement in the P&L) of EUR45bn over the next 3 years. In turn, I think that the recovery in prices for financial shares (as well as bank bonds) has further to run.

Eurozone banks still appear undervalued

Source: Bloomberg