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July 31th, 2012

 

* No-Growth Trap on Tap for Europe
* No QE for You
* Europe: Urgent or Not?
* Bonds Rally as Opportunity Rises from Friday’s Decline
* US Manufacturing Activity is Hampered by Declining Orders and Rising Inventories
* China’s Growth Has Past Its Trough
* Housing Recovery Strengthens

No-Growth Trap on Tap for Europe

Posted: 31 Jul 2012 03:00 AM PDT

By Rom Badilla, CFA

July 31, 2012

The European economy is “Stuck in a No-Growth Trap” and is expected to contract for the remainder of this year with dim prospects for 2013 according to Morgan Stanley.

In the latest European Economics report by Morgan Stanley’s, the research team led by Elga Bartsche reduced their forecasts for real GDP growth to -0.5% for 2012 and to 0.0% for 2013. This places their expectations for next year’s euro area growth below the median of consensus surveys which currently stands at +0.5%.

The factors that shape Morgan Stanley’s outlook for slower growth are additional austerity measures, elevated funding costs, and policy-uncertainty shock.

Similarly, many euro area governments, notably those in the periphery, have announced additional austerity measures for 2012 over the last few weeks. For the euro area as a whole these come to almost 0.5%-points. Most of these measures have been, or will be, introduced in the course of this year, thus weighing on growth in the second half, creating a negative ramp into 2013. For next year, we presume – contrary to most official forecasters who assume unchanged policies for the out-year forecasts – that governments will comply with the requirements of the Stability and Growth Pact and their commitments under the Excessive Deficit Procedure. The challenge in quantifying the impact of the additional austerity measures lies not just in the wide variation in estimates of the fiscal multiplier in the academic literature but also in the size of the austerity programs, which could create nonlinear effects, especially in those countries already in a deep recession.

 

The research report pointed out that Europe is in the middle of a credit squeeze as people are deleveraging.

…We continue to think that a good chunk of the contraction in bank lending is demand driven and hence endogenously caused by the poor economic performance and the need to repair balance sheets.

Available data would suggest that at the aggregate level euro area deleveraging is happening in an orderly fashion and at a relatively modest pace. Bank lending surveys show a continued, albeit modest, further tightening of credit conditions, while new loan contracts continue to be signed at a roughly steady pace and at similar, if not lower rates, at least in the aggregate.

Furthermore, Morgan Stanley stated that a lack of transparency and failure to provide a roadmap centered on economic policy by the region’s leaders are weighing on the European economy.

Clearly, the degree of uncertainty about the future course of economic policy is sharply increasing. Both in Europe and in the US, the strategies to address the sovereign debt crisis and reduce budget deficits are subject to an intense political debate. The political standoffs around this debate have increased uncertainty meaningfully.

 

Corporate investment seems the most vulnerable demand component, followed by consumer durables. Historically, a rise in the uncertainty about costs and revenues by one standard deviation (s.d.) has reduced German corporate investment by 6.5%. The renewed surge in uncertainty – from an already elevated level – will thus likely weigh on spending decisions by corporates and consumers.

Uncertainty also dampens economic sentiment. Our empirical work shows that a 50 point rise in a policy uncertainty gauge dents euro area economic sentiment by 1.6 points for the European uncertainty gauge and by 0.7 points for the US uncertainty gauge. As you would expect, the impact of uncertainty over the US outlook has a bigger impact on industrial sentiment, while the impact of uncertainty about European policies is more marked on consumer confidence. As one would expect, there is also a regional feedback loop between sentiment and uncertainty.

As a result, the research team expects the European Central Bank with declining inflation pressures as a tailwind, to embark on accommodative monetary policy where they would cut interest rates by an additional 50 basis points in the latter half of 2012.

They added that asset purchases via Quantitative Easing will “likely be a close call” and may be considered after all conventional and complimentary non-standard measures such as SMP and LTRO, have been utilized. They view that the key to enacting QE will be evident broad-based deflation risks and once governments have committed to an integrated governance structure. Due to this, the bar for QE is currently high.

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No QE for You

Posted: 30 Jul 2012 09:00 PM PDT

By Rom Badilla, CFA

July 31, 2012

The Federal Open Market Committee is set to meet tomorrow with results announced on Wednesday to determine the outlook for the U.S. economy which in turn sets the direction of monetary policy. After last week’s tape bomb by European Central Bank President, Mario Draghi where the Euro will be defended at all costs coupled with Ben Bernanke’s testimony in mid-July that they are “prepared to act”, the stakes are high for the Fed to follow suit.

There is talk around both the media and the investment circle that the Federal Reserve will announce another round of Quantitative Easing where they expand their balance sheet. While recent economic data has been lackluster and the conditions across the pond in Europe are severely strained, it might be premature to talk about Quantitative Easing due to current levels of inflation expectations.

When we look at inflation expectations which is the yield differential between 10-Year U.S. Treasuries and 10-Year U.S. Treasury Inflation Protected Securities aka TIPS, and overlay it with prior balance sheet expansions, we can see the conditions necessary for another round of QE.

 

As you can see from the chart above, inflation expectations (red line) have dipped below the two percent threshold (green shaded area) prior to the initial announcement of QE and subsequent period of Treasury purchases (shaded in grey).

Prior to Round 1 which was announced on November 25, 2008, the yield differential fell below zero briefly and was at 0.20% or just 20 basis points the day before the announcement. While Round 1 was completed by the end of March 2010, the U.S. central bank went to the well once more.

The Fed initiated Round 2 on November 3, 2010 but Bernanke provided the markets strong hints of their intentions in his Jackson Hole speech <https://beta.hub.com/#/B64ENCeyJTdGFuZGFyZEZpbHRlciI6eyJwdWJsaWNhdGlvbnR5cGUiOnsidmFsdWVzIjpbImJhbmsiXX0sInRpbWVmcmFtZSI6eyJ2YWx1ZXMiOlsiNyJdfSwibmF2aWdhdGlvbiI6eyJ2YWx1ZXMiOlsiUHJvZHVjdDpGaXhlZCBJbmNvbWUiLCJQcm9kdWN0OkVjb25vbWljcyIsIkNvdW50cnk6VW5pdGVkIFN> on August 27. The Fed kicked off Round 2 on the grounds of promoting a stronger pace of economic growth and “to ensure that inflation, over time, is at levels consistent with its mandate.” As was the case before in Round 1, the yield differential fell to a low of 1.51% just days prior to the announcement.

Given the Federal Reserve’s dual mandate of price stability and full employment, we can understand the logic of the process. This analysis shows that the Federal Reserve needs to see evidence of the former before it can act to address the latter mandate. Prior to the Fed setting inflation targets earlier this year, price stability has historically fallen somewhere in the 2-3% range.

In the case of the first two rounds and in light of signs of contracting economic activity, the country was facing significant deflationary pressures where inflation expectations were falling significantly below that range. At that point, Bernanke and Company had the green light to act. The Federal Reserve added fixed income assets to its balance sheet and flooded the system with liquidity in order to reflate the economy.

Currently, inflation expectations are above the same threshold. The yield differential between the two market indicators is at 2.08% with a recent low of 2.00% set on July 25, 2012. Granted, the spread has been declining from the 2.30-2.40% range set in March and April 2012. However, the fact remains that it is still elevated by my eyes and beyond the Fed’s liking for another round of QE. That is, asset purchases are highly unlikely for the August FOMC meeting (I could see changes in guidance where low rates will be in place until 2015). Looking farther out though, QE might be in store if current conditions continue to deteriorate.

While the millions that are currently unemployed will agree, economic conditions are far from perfect. Employment growth has yet to gain much momentum in this recovery as the unemployment rate remains sticky at 8.2%. Nonfarm Payrolls figures have not picked up as hoped and Initial Jobless Claims <http://www.bondsquawk.com/2012/07/26/jobless-claims-drop-could-be-short-lived/> continue to hover in the 350,000 to 400,000 range which is closer to levels associated with job destruction than creation.

Furthermore, the fiscal cliff and the European Debt crisis is another hurdle of economic uncertainty that can weigh on consumers and businesses which could pressure downward pressure on the economy.

Given these escalating headwinds coupled with the latest ISM Business Survey <http://www.bondsquawk.com/2012/07/02/u-s-manufacturing-activity-contracts-risk-of-recession-looms/> , it’s easy to see that the Fed may act in another round. However, action in the form of QE is not in the offing for the August 1 announcement which could disappoint the market, in particular buyers of risk assets.

 

If you have any questions or feedback on anything regarding the economy, markets, and bonds, feel free to Contact Us <http://www.bondsquawk.com/about/> . We would be delighted to respond.

Disclaimer
The above content is provided for educational and informational purposes only, does not constitute a recommendation to enter in any securities transactions or to engage in any of the investment strategies presented in such content, and does not represent the opinions of Bondsquawk or its employees.

 

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Europe: Urgent or Not?

Posted: 30 Jul 2012 03:00 PM PDT

Marc Chandler – Marc to Market <http://www.marctomarket.com/2012/07/europe-urgent-or-not.html>

July 30, 2012

The ECB’s Draghi expressed an appreciation for the urgency facing the euro area, but he seems more isolated than he did last week when Merkel and Hollande reiterated their willingness to do what was necessary.

Even though the euro fell more than a 1.5 cents from its pre-weekend high just below $1.24, Spanish bond yields have continued to retreat. The 10-year benchmark is now about 100 bp below the level seen early last week and the 2-year yield is off about 200 bp.

The market is pricing in a resumption of the ECB sovereign bond purchases (SMP). Yet in the past purchases by the ECB did not seem to have much lasting impact as yields and spreads continued to widen after some short-term and mostly limited reaction. The decline in Spanish yields will be tested Thursday just before the ECB meeting when Spain will raise 2.4-3.7 bln euros of 2, 4, and 10 year bonds.

The decline in Spanish sovereign yields has a positive impact on Spanish banks, as they are large holders of sovereign bonds. Spanish bank share are up over 3% today, while the overall market is up less than 2%. Over the past three sessions, the Spanish equity market has rallied 13.5%.

Ironically, Draghi seems to have a greater sense of urgency than Spanish officials. Spain continues to deny that it needs a larger aid package, such as a 300 bln euro package speculated about last week. Spanish officials also have indicated that are not prepared to formally request the EFSF to buy Spanish bonds.

Recall that Draghi’s plan called for ECB buying bonds in the secondary market and the EFSF buying bonds in the primary market. It is true that German officials do not seem particularly keen about it, but Spain itself is the biggest immediate obstacle. It needs to make the formal request.

One would think that the recent news would light the proverbial fire under Spanish officials. Unemployment appears to have ticked up to a new high 24.63% and the economy contracted by 0.4% in Q2 after a 0.3% contraction in Q1 and no end to the contraction in sight.

Yet if there is a single number that captures the lack of urgency on the past of Spain it is the average cost of its debt issuance this year: 3.27% vs 3.90% last year. Ironically, this supports Germany’s Schaeuble’s argument that a few auctions with higher yields is not an emergency for Spain.

Although officials may say that the rating agencies are wrong or irrelevant and we agree that they use only publicly available information for the sovereign ratings, we suspect that Moody’s decision to put Germany, the Netherlands and Luxembourg on credit watch (but not Finland which has insisted on collateral for its participation) is indeed noteworthy. Merkel’s coalition partners (CSU and FDP) opposition to additional support for the periphery can only be emboldened by Moody’s decision. Merkel’s own support appears to have waned, according to the latest YouGov poll.

Draghi may have tried to deliver a fait accompli to European officials by promising to deliver a game changer, but we think the market will be disappointed. We anticipate that pressure will return. Can Spanish 2-year yields really decline another 200 bp or the can the 10-year decline another 100 bp ? The return of pressure will underscore the urgency and push European officials to address the more difficult decisions in September.

 

If you have any questions or feedback on anything regarding the economy, markets, and bonds, feel free to Contact Us <http://www.bondsquawk.com/about/> . We would be delighted to respond.

Disclaimer
The above content is provided for educational and informational purposes only, does not constitute a recommendation to enter in any securities transactions or to engage in any of the investment strategies presented in such content, and does not represent the opinions of Bondsquawk or its employees.

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Bonds Rally as Opportunity Rises from Friday’s Decline

Posted: 30 Jul 2012 02:00 PM PDT

By Bondsquawk

July 30,2012

There was a large inflow in both US-Treasuries as well as in corporate bonds following a huge sell off on Friday. Friday saw an increase in yields of 11 basis points after GDP growth posted a pleasant surprise <http://www.bondsquawk.com/2012/07/27/u-s-treasuries-tank-after-growth-surprises-higher/> . As a result of the rebounce, the 10-Yr Treasuries yields were lower by 5 basis points and ended at 1.50%. The 30-Yr and the 5-Yr also by 5 and 4 basis points and are now at 2.57% and 0.61% respectively. The 2-Yr is trading at 0.22% as yields decreased by 1 basis point.

Sovereign Bonds of European Governments had a good day as well with yields on the German 10-Yr and Spain 10-Yr decreasing by 2 basis points and 15 basis points to 1.376% and 6.584% respectively . UK 10-Yr and and Italy 10-Yr, however, was flat and ended the day at 1.54% and 5.958% respectively.

The Corporate Bond market rallied as well with yields falling on most of the bonds issued. Bonds of Wells Fargo and JP Morgan were the biggest gainers with yields declining by 11 and 10 basis points respectively. Yields on Citigroup bonds were 5 basis points lower while Barclays and Morgan Stanley bond yields decreased by 4 basis points.
Industrial Bonds were not far behind with most of the bonds rallying. Cisco Systems and Kraft were the biggest movers as the yields on their bonds decreased by 11 and 10 basis points respectively. Yields on Verizon were lower by 9 basis points whereas Comcast Corporation, Target and Intel bond yields were down by 7 basis points.

Information Provided by Trade Monster’s Bond Trading Center <https://www.trademonster.com/Products/Bonds.jsp?PC=iTB>

<http://www.bondsquawk.com/wp-content/uploads/2012/07/Capture50.png>

If you have any questions or feedback on anything regarding the economy, markets, and bonds, feel free to Contact Us <http://www.bondsquawk.com/about/> . We would be delighted to respond.

Disclaimer
The above content is provided for educational and informational purposes only, does not constitute a recommendation to enter in any securities transactions or to engage in any of the investment strategies presented in such content, and does not represent the opinions of Bondsquawk or its employees.

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US Manufacturing Activity is Hampered by Declining Orders and Rising Inventories

Posted: 30 Jul 2012 09:00 AM PDT

Walter Kurtz – Sober Look <http://soberlook.com/2012/07/us-manufacturing-activity-is-hampered.html>

July 30, 2012

Markit flash (preliminary survey results) PMI suggests a material slowdown in US manufacturing. The US manufacturing advantages of relatively low labor costs (discussed here <http://soberlook.com/2012/03/when-it-comes-to-manufacturing-next.html> ) and inexpensive energy have failed to prevent the slowdown <http://soberlook.com/2012/07/us-manufacturing-stalls.html> .

<http://3.bp.blogspot.com/-eQ0JBC5zmZA/UBNbArwRlXI/AAAAAAAAJH8/UN95pxyzSew/s1600/US+Manufacturing+PMI.GIF>
Source: Markit

It seems that at least some of the decline is due to falling exports, as Europe undergoes a recession and China has slowed.

Chris Williamson (Markit): – “The U.S. manufacturing sector is clearly struggling under the pressure from falling exports, which showed the first back-to-back monthly decline for almost three years in July. Growth of production is slowing closer to stagnation as a result, and rising levels of unsold stock may mean companies seek to scale back production in coming months unless demand picks up again.

This trend of declining orders and rising inventories is now clearly visible in the data. Last year a decline in orders corresponded to a correction in inventories as companies quickly adjusted to lower demand. This time around however inventories have climbed even as orders fell. That’s a worrying sign because firms will need to work through the inventories before production picks up again.

<http://4.bp.blogspot.com/-t7_C32Mk-gY/UBNczL_07bI/AAAAAAAAJIE/-ZTDkXoPsH4/s1600/New+orders+vs+Inventories.GIF>

 

If you have any questions or feedback on anything regarding the economy, markets, and bonds, feel free to Contact Us <http://www.bondsquawk.com/about/> . We would be delighted to respond.

Disclaimer
The above content is provided for educational and informational purposes only, does not constitute a recommendation to enter in any securities transactions or to engage in any of the investment strategies presented in such content, and does not represent the opinions of Bondsquawk or its employees.
Source: Markit/JPMorgan

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China’s Growth Has Past Its Trough

Posted: 30 Jul 2012 07:00 AM PDT

By Bondsquawk

July 30,2012

According to Citi Research, China’s economy bottomed in Q2 and is likely to rebound moving forward.

The key drivers of growth recovery are that de-stocking is near its end, the hard landing risk of the property sector is contained, and investment, consumption and exports had shown signs of improvement in June. In our view, given more policy supports in the near term, 3Q GDP growth will likely be flattish.

In addition, credit and fiscal policy support is likely to help boost the economy.

First, the planned Rmb360bn infrastructure investment will be fully implemented. Second, the government may draw down Rmb150bn from its macro stabilization fund to elevate the spending capacity, including interest subsidies to designated strategic new industries. Third, in the medium term, experts agree that it’s more fundamental to cut valuate added tax rate. And if it happens, it will be much more significant on the VAT conversion in the service sector.

The article also stated that proper rebalancing by China in the near term future could have a very strong impact on its growth.

Instead of 10-15 years, China’s rebalancing is expected to be largely completed by the end of the 12th five-year plan or early 13th five-year plan. If so, China’s potential growth rate may return to 9% p.a. Urbanization is likely the major driver of growth. From 1978 to 2010, the net increase of permanent urban residents (those with urban hukou) was only 280mn, In the future, another 900mn people will move into cities assuming 70% urbanization rate. This will lead to fundamental changes in household savings and consumption behavior, and require huge increase in public goods and services. Financial reforms could be another area of key policy focus in the new government.

 

If you have any questions or feedback on anything regarding the economy, markets, and bonds, feel free to Contact Us <http://www.bondsquawk.com/about/> . We would be delighted to respond.

Disclaimer
The above content is provided for educational and informational purposes only, does not constitute a recommendation to enter in any securities transactions or to engage in any of the investment strategies presented in such content, and does not represent the opinions of Bondsquawk or its employees.

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Housing Recovery Strengthens

Posted: 30 Jul 2012 05:00 AM PDT

By Bondsquawk

July 30, 2012

According to Morgan Stanley’s research, shadow inventory (houses waiting to be sold or in foreclosure stage) declined and thus casting positive light on the situation of the distressed housing market as well as the housing market in general.

The shadow inventory has fallen to 5.65 million units now from a peak of 8.79 million in January of 2010. The percent of homes with mortgages that have been delinquent for over a year has begun to dip, and is now about 53%, after reaching about 56% in late 2011.

<http://www.bondsquawk.com/wp-content/uploads/2012/07/Capture30.png>

Morgan Stanley stated that the rate of decline in the shadow inventory varied significantly with different areas in the United States.

Shadow inventory in the West is declining at the fastest pace, down 52% since its peak in February 2010. The South and Midwest regions have experienced similar declines, both down 33% from their peaks. The Northeast, in contrast, is only down 17% even though it is worth noting that the level of shadow inventory in the Northeast was relatively smaller to begin with.

<http://www.bondsquawk.com/wp-content/uploads/2012/07/Capture311.png>

The comparatively steep decreases in shadow inventory out West can be attributed to the higher percentage of distressed transactions in the region (Exhibit 3). Distressed transactions currently constitute 40.3% of home sales in a given month in the West, and peaked at 72% of transactions in January of 2009. In contrast, the Northeast region has never seen distressed sales make up more than 23.6% of monthly transactions, and they currently sit at 16.8%.

<http://www.bondsquawk.com/wp-content/uploads/2012/07/Capture215.png>

There were notable differences in the housing market with respect to judicial and non-judicial states as well.

A driving factor behind the different regions’ rates of improvement is the relative concentration of judicial and non-judicial states. “Judicial state” in this context refers to states that require foreclosures to be processed through the states’ court systems. This requirement is time consuming and consequently expensive.

<http://www.bondsquawk.com/wp-content/uploads/2012/07/Capture46.png>

<http://www.bondsquawk.com/wp-content/uploads/2012/07/Capture54.png>

The research also mentioned that short sales have increased and is a great sign for distressed property recovery values.

Short sales have been growing steadily more popular since the beginning of 2011. They now constitute 47% of distressed transactions in judicial states and 38% in non-judicial states. These figures are up from 35% and 27% in January 2011, respectively.

<http://www.bondsquawk.com/wp-content/uploads/2012/07/Capture64.png>

The research concluded saying that these factors could result in benefits and provide stability to Residential Mortgage Backed Securities (RMBS) as well.

These factors provide at least a partial explanation for some of the recent exuberance in the non-agency RMBS market. We think there is a good case for moderating loss severity expectations relative to the levels being applied even a few months ago. Some of this may already be happening.

 

If you have any questions or feedback on anything regarding the economy, markets, and bonds, feel free to Contact Us <http://www.bondsquawk.com/about/> . We would be delighted to respond.

Disclaimer
The above content is provided for educational and informational purposes only, does not constitute a recommendation to enter in any securities transactions or to engage in any of the investment strategies presented in such content, and does not represent the opinions of Bondsquawk or its employees.

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