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August  20th, 2012

The European Rising Tide Failed to Lift This U.S. Boat
Posted: 19 Aug 2012 09:00 PM PDT
By Rom Badilla, CFA
August 20, 2012
We spend a lot of time on the macroeconomic picture as bond pros since it sets the dinner table for the main meal of investment strategy. Growth and inflation, coupled with monetary policy are one of the main factors in determining the direction of interest rates.
When economic data surprises to the upside, the outlook for growth improves. As economic growth begins to accelerate, resources such as materials, factories, and people are being utilized. As more and more resources become used to a point where they become scarce, the price to use them begins to accelerate. Commodity prices ranging from food to metals start to rise while people’s income and wages start to increase as finding qualified workers becomes difficult. When these costs move high enough where they are passed along by producers to final goods and services – items we use on a day to day basis, they become a problem when individuals can no longer afford them.
So when these price pressures amount to rising inflation, bond yields increase. This occurs because bond buyers want higher yields in order to be compensated for the rising prices of items they can buy in the future. As holders of fixed income securities, the value of their bond investments falls as prevailing market yields are higher.
Conversely, when inflation is flat or declining (via disinflation or deflation), yields decrease which in turn lead to an appreciation in bond prices.
Having said this, we look to see how the economy is performing in order to see the direction of interest rates. The next chart shows the Citigroup Economic Surprise Index which attempts to quantify actual economic data against market expectations via Bloomberg’s survey median. Generally a positive reading means that economic numbers are better than what market participants are expecting. As a result a positive surprise may push up bond yields and equity prices since growth is improving. Conversely, a negative number means disappointment which typically results in stocks tanking and an outperforming bond market via a decline in yields.
This is evident when you overlay the yield of the 10-Year U.S. Treasury with the Economic Surprise Index. It is apparent that there is a strong relationship between the two as shown in the next chart.

Citi Economic Surprise & 10-Year U.S. Treasury
That is, the correlation between the two variables remained fairly strong over time, except in mid-2011 where the relationship began to fall apart when economic data improved relative to expectations but Treasury yields stayed relatively low. The Citigroup Surprise Index bounced higher from a low of -117.2 in early June to a high of 85.7 in early December of that year.
Given the rationale and historical evidence, you would expect to see that interest rates would increase during that time. However, that was far from the case as yields continued to plummet. The yield on the 10-Year fell almost 100 basis points from 2.99% to 2.03%.
So the question is why the divergence? If we look to another indicator, it is fairly easy to determine why Treasury rates did not increase along with the improving economic data starting in mid-2011.
Interestingly at the onset of the divergence, the Euro dollar relative to the U.S. started to tank as the crisis in Europe began to escalate when peripheral bond yields started to surge. In June 2011 when the Surprise Index hit its cycle trough driven by disappointing economic data, the Euro was trading at 1.4635. At that cycle’s peak in early December, the Euro had fallen to 1.3391, for a decline of almost 9 percent.

Divergence in Mid-2011 (Lower Chart – Euro Dollar Currency)
In other words, the bond market started to take its cue from other another source of risk and not the usual suspect in U.S. macroeconomic data. As capital fled the Euro region, demand for safe-haven assets such as U.S. Dollars and U.S. Treasuries surged. As a result, Treasury yields didn’t go up but were suppressed given the dire situation in Europe.
With the ECB’s pledge to save the Euro at all costs, it appears that concerns abroad are taking a backseat and the focus is now back to the U.S. macro picture where recent economic data have come in higher relative to expectations. This explains as to why yields have been increasing lately. However, this uptick may be short-lived.

Post-ECB Pledge Economic Surprise & 10-Year U.S. Treasury
Given that the ECB continues to act alone in supporting the Euro and fiscal imbalances remain without a strong convincing commitment to burden sharing among the developed and the peripheral economies, there is a strong possibility that Treasury yields will begin to take its cue from the Euro again. The question is what is the catalyst for markets to bring the focus back across the Atlantic?
If you look at the calendar when the entire Northern Hemisphere returns back from holiday in September, there are plenty of events on slate that could disappoint. On September 6, another test on Spanish solvency and credit-worthiness is scheduled as the Spanish government will auction more bonds with the hope that their borrowing costs will remain low. In addition, the ECB is scheduled to meet that day. If policy action doesn’t result in some form of Quantitative Easing or “money-printing,” disappointment could deflate risk-seeking market bulls.
In the event that Europe does not flare up again, yields may continue to follow stateside economic data. Keep in mind that the current upward trend in improving economic data may run into another major headwind that is made in the “good ole U.S. of A.” and reeks of political brinkmanship and indecisiveness.
Markets remain short-sighted for the time being with little focus on the impending Fiscal Cliff that follows the November elections. The uncertainty it brings can be prohibitive to consumer spending. Failure to address it could lead to a significant drop in economic activity which in turn may lead to a double dip for the U.S. economy. Interest rates would stay true to its natural path by following U.S. macro data. At that point though, it would be far from ideal since in that scenario, Citigroup’s Surprise Index may begin to disappoint which could push Treasury yields lower.
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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.

Will Current Economic Data Speak in Favor of a Second Term for Obama?
Posted: 19 Aug 2012 09:00 PM PDT
By TJ Kim
August 20, 2012
According to Credit Suisse’s Economic Research Analysts, Neal Soss and Jill Brown, certain economic variables such as increases in Gross Domestic Product, Real Disposable Income, Inflation and etc… have been fairly predictive measures in determining the likelihood of a second term for the past presidencies. In their article, “Are You Better Off Than You Were Four Years Ago?”, the two analysts gathered economic data from past years and compared the progress in the economy of past administrations with the current Obama Administration. While it is difficult to quantify a president’s overall performance in the economy, international relations and defense, the article provides a rough estimate of where Obama’s odds of winning a second term stands.
Economic Growth and Real Disposable Personal Income
These two variables have played a significant role in determining a candidate’s chance to earn a second term. In these two areas, Obama has performed poorly in comparison to his previous presidents.
Credit Suisse: “The data suggest that economic growth plays a role in a candidate’s ability to win a second term. Real GDP grew slower under George HW Bush than all the other nine presidents, followed by his son, followed by Ford (when comparing compound annual growth rates).”
“Real disposable personal income was even more definitive, growing at the slowest pace under the three presidents who were unseated (George HW Bush, followed by Ford, followed by Carter).”
“With one more quarter left to be reported before the election, under Obama’s first term as president, real GDP is running slower than any of his predecessors, expecting only George HW Bush, and real disposable personal income is the slowest of any of his predecessors”

Real GDP Growth

Real Disposable Personal Income Growth
Unemployment Rate
Although the Unemployment Rate has not improved, lingering above 8% for almost four years throughout his first term, Mr. Brown and Mr. Soss find that this factor shouldn’t prevent Obama from being re-elected.
Credit Suisse: “Unemployment also rose over Ford’s and George HW Bush’s presidencies by more than any of the others, and ticked up some under Carter’s. Despite the current weakness in the labor market, Obama’s record in this regard is better than two-thirds of his predecessors’ presidencies.”

The Unemployment Rate Growth
Inflation
Accelerating inflation can work against the incumbent. Luckily for Obama, inflation has been relatively tame during his tenure.
Credit Suisse: “Inflation surged during both Carter’s and Ford’s first (and, as things turned out, only) terms. The misery index, a measure of economic well-being (the sum of the unemployment rate and the inflation rate) also rose sharply under Ford and Carter.”
Unfortunately, the misery index has increased under Obama’s watch which shouldn’t impede his goals since Credit Suisse pointed out though that the misery index has increased in 6 out of the past 9 presidencies.

Change in Inflation
Consumer Sentiment
Credit Suisse: “Ford who had poor economic performance had positive sentiment numbers over the course of his tenure, while Carter and George HW Bush, both saw declines in confidence. The only other president to see a decline in consumer sentiment was Nixon, which evidently didn’t interfere with his landslide reelection. To date, Obama has seen an eleven point advance in sentiment.”
One of the reasons against Obama’s re-election is the recession he inherited coupled with the lackluster growth in the recovery. Having said this, Credit Suisse pointed out that all the presidents with the exception had to deal with a recession during their first term. Interestingly, the length of the recession didn’t play a role. As an example, Ronald Reagan experienced one of the longest recessions in his first term but was able to secure a second bid.
While the economic data has been mixed in providing clarity for Obama in winning a second term, perhaps the final arbiter lies elsewhere. Credit Suisse stated that the University of Iowa runs a financial futures market that has predicted prior elections. Right now, the futures market is expecting for Obama to win a second term.

Iowa Electronic Futures Market

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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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