Have yields stopped listening to economic releases? ......

I came across this very interesting graph this morning. In normal times and circumstances (whatever that may mean), bond yields are heavily influenced by how weak or strong the economies prospects are perceived to be. In the graph, the white line is the Citi economic surprise index, which is an index that shows the deviation of actual economic releases in comparison to the expectations. Clearly, the index has had a very strong move up in the latter half of the year, as US economic releases have generally been stronger than expectations. In the past, the yield (the 10 year - orange in the graph) would have moved up in tandem, as a better than perceived economy would have led to a movement from the fixed income market (lower prices higher yield) into the equity market.
But times are far from normal. Markets are absolutely terrified of PIIGS defaults. Thus despite stronger news emanating from the US, the awful news out of Europe has seen the Treasuries retain an unprecedented demand for the "perceived" safe haven status.

Surely though in unveiling Operation Twist, whereby the Fed is aggressively buying long dated bonds (to keep the yields low) and selling shorter dated bonds, that has been the determinant in keeping lower yields? I'm not so sure. If for some reason, somehow, the market became convinced that Europe was turning the corner, and that there was light at the end of the tunnel, wouldn't the yields be expected to rocket higher, Fed or no Fed?

Yields are at all time lows- yields are pricing in the risk that the market may not exist in a recognisable form in the not too distant future, with fears of defaults and a collapse of the financial system.

Greece

One of our avid readers (hi Mum!) pointed out how we have failed to comment on the main story currently hitting all the headlines …. that of Greece. That is correct- probably the main reason is due to the fact that the news flowing out of Greece, is so fast, that I would have undoubtedly got to the end of my blogging, by which point I would have had to write a whole new posting due to an updated newsflash! Often, the latest revelation is a full 180° from the previous newsflash, and that is no doubt significantly contributing to the increasing volatility we have been privy to, with investors being whipsawed from one side to the other! Risk on, risk off, threat of contagion, restructurings, haircuts ….. isn’t life exciting! The other reason for not writing about Greece, is that I would undoubtedly have to disclose that my main ECONOMICS tutor was Greek, and what does that say about my knowledge of economics/finance?!!! Truth is, he was also my Football Manager ……. And he was a darn sight better at football than at Economics!!!

What is clear, is that Greece has run out of money, again, and needs some form of bailout/restructuring. So far, Europe, the ECB, IMF and everyone else has responded to the problem by throwing more money at Greece, allowing them to "buy time". Nobody has used the downright rude and ugly term of "insolvent", with "liquidity" being the preferred terminology. Lenders have been willing to lend more money, because the problem is one of liquidity. They have been willing to lend more money to banks and Governments. And Greece for their part, have not once admitted the need for default or restructuring, and so the banking sectors have not been forced to write down any more debt and/or need to raise more capital. A win win for everyone.

This would have bought some more time. Time is a fantastic healer. However, the issue was not one of liquidity, rather one of insolvency-debt problems are unlikely to be solved by taking on more debt. As a minimum, investors will require a credible plan for the economy to return to solvency to become willing to fund the banks and public debt of the troubled economy in question. This does not seem to be the case though, with the general Greek population revolting (in the other sense of the word), then one has to wonder where that credible solvency plan is going to come from. What is clear though, is that of those included around the negotiating table, nobody but nobody is "allowing" Greece to simply default. A solution will seemingly be found to prevent Greece from "legally" defaulting- even if it means some quick changes to EU law, account rules or ECB operation guidelines.

Whats the big deal with a Greek default? Why are they working so hard to prevent it? The Eurozone debt crises, is not especially extraordinary- it is merely another credit cycle, whereby debt extends beyong the capacity of consumers and economies. Debt then contracts as uncollectable debt gets written down, and bad debt is purged from the system. Throwing more money at Greece is merely extending and prolonging the problem?

Although a default is a default, and from a value point of view it doesn’t make any difference whether it is the debt of Greece, Portugal, Azerbaijan or the US that is written down, from an economic point of view, it certainly makes a difference. If Greece are thrown another lifeline, both Ireland and Portugal will operate under the assumption that in the future, they will also get another bailout should they need it. Markets know that, and hence speculation will continue on the "Who's next path", and cause investors to demand additional premiums, causing yields to rise. Eventually, the larger economies will be targeted too. How do I know you wont default either Spain? And that will cause even more serious problems, as who is left to bailout the larger and more important economies?

---------------------------------------------------------------------------------------------------------------------------------LEGAL DISCLAIMER: The views mentioned above are purely that of the author, and does not necessarily reflect the official view of Goldrock Capital or employees. Unless of course the aforementioned view was a phenomenally good call, with exquisite market timing, in which case Goldrock Capital reserves the right to all credit!!!!!More Serious disclaimer:The financial advice offered on this site is of a general nature and may not be suitable for some people. No individual financial needs or goals have been taken into account in the advice offered on this site, you should always seek independent advice about specific financial decisions. Neither Goldrock Capital nor its employees makes or gives any representation, warranty or guarantee that the information it provides in this website is complete, accurate, current or reliable (including that it has been or will be audited or verified). Goldrock Capital and its employees shall not be liable for any loss or damage whatsoever (including human or computer error, negligent or otherwise, by one or more of the authorities, or incidental or consequential loss or damage) arising out of or in connection with any use or reliance on the information or advice on this site. The user must accept sole responsibility associated with the use of the material on this site, irrespective of the purpose for which such use or results are applied. The information on this website is no substitute for financial advice.

US to default?

With the world and their Mother watching the European sovereign debt drama unfold with abated breath, the not insignificant risk posed by a U.S. sovereign debt crisis increases by the day. The risk of a US default continues to rise which can be seen in the sharply increased cost to insure U.S. sovereign debt. Risk of a U.S. default can be seen in the credit default swap (CDS) market. 1 year U.S. CDS has risen from 23 to 37 or by 60% in the last six trading days (see chart).



























The orange line is the US CDS premia, yellow is Japan and pink is the UK.


In the more liquid 5 year U.S. CDS, the cost to insure has risen by some 50% in the last week. Whereas there is normally minimal trade in the US CDS market, the norm is a handful of trades (sometimes as low as one), last week saw investors placing 135 trades in U.S. CDS’s. Just to compare, there were 360 CDS trades on Spain's sovereign debt, 191 on Greece, 142 on Portugal and 136 on Italy. A US default would not be “catastrophic” it would likely lead to a very sharp fall in the U.S. dollar, (especially versus the hard currency, collateral and monetary asset that is gold), sharp fall in U.S. bonds and sharply higher interest rates. This has the potential to create another systemic crisis involving sovereign nations and banks globally and could lead to a deep recession. Indeed, it would not be unfathomable to suggest that the S&P “warning” of US debt was a mere warning precisely because it was the US in question. Anyone else would have resulted in a downgrade of 3 notches at least!-----------------------------------------------------------------------------------------------------------------
LEGAL DISCLAIMER: The views mentioned above are purely that of the author, and does not necessarily reflect the official view of Goldrock Capital or employees. Unless of course the aforementioned view was a phenomenally good call, with exquisite market timing, in which case Goldrock Capital reserves the right to all credit!!!!!