2012 Non-Predictions - Rates

Friday, January 13, 2012

First, TMM must apologise for the lack of posts in recent days, a function of a lack of enthusiasm to start the new year coupled with significant head-scratching with respect to their 2012 Non-Predictions. As readers know, TMM don't do predictions, but they *do* try to make "Non-Predictions" however, this year they have found them particularly difficult to make given that the investment backdrop hinges almost entirely upon the European situation.

While intellectualising about what could happen, how it might play out, which politician will do what, which country might leave (if any) and the potential for a global depression is an exercise that all traders and investors must carry out, TMM believe that forming views and positions *only* as a function of such an analysis is misguided. The reason for this is that this catastrophic outcome is still a tail risk. It is a very large tail risk, and undoubtedly, would result in significant damage to asset prices and the social fabric within Europe. Having thought particularly hard about how policymakers might come to implement an exit of one or more countries from the Eurozone, TMM have come to the conclusion that it is just not possible to do without political, social & economic consequences that are both domestically and internationally unpalatable. There is no conceivable firewall to a country leaving the Euro that does not include troops at the border, capital controls across Europe and the closing of world financial markets. One nightmare TMM once had went along the lines of the following course of events:

Day 1: Financial markets sell off sharply, the NeuDrachma plummets 20% on world markets.

Day 2: Financial markets sell off sharply, the NeuDrachma plummets 25% on world markets.

Day 3: Rioting and food shortages in Greece. TV pictures across the world of Spanish, Italian, Portuguese and Irish citizens queuing outside banks and driving to the borders.

Day 4: Bank runs in foreign countries of EMU bank branches.

Day 5: Stock markets crash 15% in the absence of a policy response.

Day 6: Military coup in Greece.

Day 7: Italy and Spain announce they are closing their borders.

Day 8: After the weekend, stock markets fall another 20% as borders close and riots erupt across Europe.

Day 9: EM stock, bond & currency markets collapse as the Eastern European & Asian central banks confirm rumours that they have exhausted their FX reserves.

Day 10: Germany announces that it will not roll over ECB Target 2 balances with the Bundesbank.

Day 11: After yesterday's 40% fall in the Euro, World financial leaders meet and agree to shut markets for a week.

Day 12: Rioting erupts across the world as banks are shut and food shortages arise.

Day 13: Israel launches a pre-emptive strike on Iran.

Day 14: EU dissolves.

Policymakers are well aware of the consequences - TMM believe eventually the ECB will blink to prevent a country exit should the possibility of such an outcome materialise - but if one does occur, then the last thing TMM will be doing is attempting to trade Macro. They will be in those queues at banks and supermarkets. This reminds TMM of the 1983 film War Games... the only option is not to play. And like Mutually Assured Destruction, TMM strongly believe that markets will simply learn to live with the large tail risk, and the risk premia priced into various assets probably reflect this to some extent. That said, the usual trades like Schatz calls (which would likely be Deutschemark denominated), and EUR/DKK forwards/puts are certainly worth sticking in their books as tail hedges...

But TMM want to put the above behind them and move into 2012 on the assumption that the Euro continues to exist, and below present the first of their 2012 Non-Predictions... Rates:

1) 10yr Gilt yields will NOT finish 2012 below 3%.

As regular readers will know, TMM were wrong-footed by the Bank of England last year with respect to their (lack of) response to inflation surprises but more importantly to the lack of pass through to wages. However, TMM reckon the BoE have been very lucky in that the Eurozone shock has depressed activity and prevented rates markets from testing the BoE's credibility. Tesco's Christmas earnings shock notwithstanding, TMM remain of the view that the UK still has an inflation problem, and certainly relative to many parts of the developed world, it is the least likely to experience deflation (that particular baton is being passed from Japan to Europe).

Undoubtedly, in the face of the Eurozone crisis reducing the pool of available AAA assets (and ensuring the media is focused on economic woes, providing businesses with a convenient argument to resist wage demands), the front-loaded UK fiscal consolidation and continued Gilt purchases by the BoE have kept yields low. Indeed, over the past six months in particular - beginning when Italy came under market pressure - Gilt yields have fallen dramatically as foreign investors (in particular the Japanese) have switched out of core European bonds and into Gilts. Now, TMM completely appreciate that the reasons behind this all make a lot of sense. Having an independent currency and active central bank on the canvas of weak aggregate demand and large balance sheet adjustment is a significant advantage. Inflation risk is much easier for investors to understand than credit risk, especially when the latter is governed by the often arbitrary whims of politicians in a multitude of jurisdictions. That argument has clearly been won, and when compared to TMM's macro-based model of Gilt yields, appears responsible for something like 130bps in negative risk premium (see below chart). While any sort of rigorous estimate of this risk premium is inherently difficult to do, a back of the envelope comparison with French OAT spreads to EONIA (~125bps), a country with not massively different aggregate fiscal metrics to the UK, but which should reflect this risk premium would appear to be of similar magnitude.

TMM digress. In spite of all the above, we reckon that markets price significant risk premium in Gilts (and non-Eurozone DM bonds in general), and that the risk reward sits with expecting some decrease in this as Europe gets on with its structural reforms and drift towards fiscal union. Should this occur, TMM believe that markets will begin to test to the Bank of England at some point, and selling Gilts at 2% yield is just too juicy for us to resist.

2) 3yr CNY Shibor swaps will NOT close 2012 lower on the year.

TMM were heartened to see the China bull mafia come to grips with some of the issues China faces last year. While TMM doesn’t think China is universally a fraud, it has structural issues of which the largest is the implicit tax on savings and subsidy to capital expenditures via consistently negative real rates. 2011 was a watershed for China because it became abundantly clear to investors and some more outspoken policy officials that China had a serious over-investment problem that could not be justified by being a developing countries. Empty cities, ridiculous skyscrapers in the middle of nowhere, freshly built highways with no traffic – there was no shortage of stuff to point out indicating over-investment and it has been extensively here and elsewhere. This subsidy has led to really silly credit growth and inflation, as covered elsewhere and generally an asset bubble or two (see below chart of real rates, A Shares and Hong Kong property).

As China’s capital account has become more porous China’s inappropriate monetary policy has moved from strictly local stuff (stocks) to offshore stuff that Chinese people like to hoard as inflation hedges (silver - see below chart of Chinese net silver flows) or which are intermediate goods hoarded in supply channels like copper.

None of this is particularly new, however, but what *is* new are financial outflows from China, anecdotally related to wealthy Chinese people taking money offshore to invest in stuff with a real yield now that property measures are restricting them from hoarding apartments. TMM are reminded of Winston Churchill’s line about Americans…"Americans can always be counted on to do the right thing...after they have exhausted all other possibilities". And think it may equally well apply to Chinese central bankers. If China wants to reform incrementally without crashing the bus for every property developer and steel mill then rates need to go up, but at a manageable pace. The solution to avoid widespread bankruptcies is to reduce the Reserve Ratio Requirement to free up lending, but similarly charge higher rates to ensure the weak get winnowed out and investment is disciplined. To keep CPI down, better deposit rates should pressure property and a steady rise in CNY with higher rates should reverse financial outflows and keep food price pressures at bay.

All of this requires higher long term SHIBOR expectations and to avoid a hard landing likely requires some credit & fiscal easing which we are already seeing. As such TMM, reckon SHIBOR and the Yuan move higher, while credit incrementally loosens and is supported by demand-stimulus from the fiscal coffers.

3) 5y5y forward UST will NOT finish the year below 4%.

TMM reckon that the past two years provide ample evidence to the resilience of the US economy which, in the face of a multitude of shocks - from the Arab Spring-driven oil shock to the Eurozone crisis - has manifestly refused to fall into recession. Indeed, the rebound in consumer confidence, credit aggregates and the consistent upside economic surprises have convinced TMM that the US has exit velocity. TMM's models reckon ISM is likely to move back towards 55 over the coming months, and this will likely solicit upgrades to GDP forecasts over the coming year which, according to TMM's analysis (see chart below) are largely a lagged-function of the current ISM print.

With a ZIRP policy from the Fed, traditional links between growth expectations and real rates in recent years have broken down to some extent, with longer dated forwards now exhibiting a high degree of co-movement with near-term GDP expectations. The usual theories of "New Normal", Fed activism and Financial Repression can certainly explain a structural lowering of real rates post-crisis (t least in the near term) and, like in Non-Prediction #1 above, there has been an additional premium priced in reflecting "Europe" risk. It now seems that rather than pricing long-run growth expectations, longer-dated forwards are more strongly a function of short term growth prospects (see below chart).

While TMM are certainly sympathetic to all of the above, the evidence in the US is that while the recovery has been slow to get going (as a result of multiple shocks), it seems to be picking up steam. The recent noise about Fed QE3 in MBS should only serve to raise both long-term real rates and inflation break-evens as easier policy spurs future growth. Simply put, at 3%, USTs arguably price a Japanese-scenario to a significant degree: back of the envelope, 5y5y JGBs are 1.6%, while the years of the "Bond Conundrum" (2004-2007, arguably a conservative upside estimate) had the 5y5y UST at an average of about 4.75% (i.e. - something like long run expectations of about 2% inflation plus 2.75% real growth), implying a 52% probability of being in the Japanese state. In TMM's view, the pendulum has swung too far toward the deflationistas in this respect and reckon paying this part of the bond market in the context of very large CTA & Real Money longs is not a bad punt.

4) The RBA will NOT cut more than 25bps and the Cash Rate will also NOT finish 2012 below its current level of 4.25%.

TMM recognise that this is a very punchy Non-Prediction given both market pricing of just shy of about 100bps of cuts over the year, and also for (probably) trying to be too clever for our own good in expecting the RBA to hike rates later this year should it cut them to 4% earlier on. But we thought, "what the heck", it wouldn't be the first time we've been wrong on a punchy call. TMM digress... 2011 saw a very large rally in the front-end of Australia as expectations of multiple RBA rate hikes reversed with the risk aversion of the summer into a cutting cycle. As far as TMM can tell, much of this move was driven by tail-risk hedgers looking to protect themselves against a global recession and deepening of the Eurocrisis. The trouble is, that the Aussie front end now prices the bulk of such an event, and without multiple RBA cuts, there is a lot of risk premia to be taken out.

TMM believe that the stickiness of the curve is related to the very bad experience many punters had here in August, when 10 sigma moves were seen alongside a complete evaporation of liquidity in the bill future market. Scars take a long time to heal, and TMM share those scars. But looking at the fundamentals, inflation is not showing any signs of collapsing (see below chart) and the turn in the policy cycle in China, coupled with an accelerating US argue that pricing in global recession is just wrong.

And TMM's forward-looking Taylor-type rule (see chart below) reckons that - even assuming global growth does not rebound from current levels implied by PMIs (something TMM believe is an overly pessimistic position) - that even though near term the base effect-driven slowdown in inflation might argue for a modest easing to 4%, that by the end of the year, policy will need be tightened once more. Of course, this will not do wonders for domestic demand and is something TMM will look at once more when they come onto their Equity Non-Predictions. But in the meantime, they are dipping their toes back into shorts in the Aussie front-end.

TMM will now get back to their homework and try and come up with some more Non-Predictions. In the meantime, we wish our readers a good weekend.

Posted by cpmppi at 1:38 PM  

8 comments:

Just wanted to say thanks, made my day. Exit velocity, I hope so, the bear suit is beginning to wear out.

Corey said...
4:06 PM  

I should think policy could be termed "Abby Normal." Still, that ended well, at least for the monster and the good doctor. Thus, 5y5y seems like a no brainer.

It may also suggest that it's time to don the Helen Keller glasses and go long select USD equity.

Secret--Sauce said...
4:10 PM  

Great writeup. I liked #2.

re: 1 and 3
IMO, model fair value estimates need to take into account the substantial impact of QE. Otherwise, the assumption is that QE does not have an impact. Yes, yields may be too low relative to expectations. But the market may not care.
In my experience with models, a structural break between market and model values usually suggests that something is missing from the model.

4:42 PM  

Bunker mentality, citi-style:

http://www.retronaut.co/2011/06/maunsell-forts/

Anonymous said...
4:55 PM  

Apologies in advance for long-windedness. Some fairly bold non-predictions here in rates land. I found 3) and 4) interesting, and can certainly see the logic behind 2), although I am not 100% sure I agree.

To amplify a little, I have three main areas of disagreement. Firstly, the data-driven models are always going to be dependent on trends in macro data, and so are perhaps least accurate at turns. Secondly, I think that sometimes TMM's outlook is coloured more than they realize by where they sit, at the very epicenter of Mervinflation. Thirdly, I know from experience one can often be right, but early.

Non-prediction 2) is probably the strongest, and TMM are probably correct that the UK is the LEAST likely to experience deflation. However, some of the logic depends on the assumption that UK housing bubble has finished deflating (watch London after the bank layoffs) and that there is little chance of a steep global slowdown in 2012. I'd watch both of those, as they have the potential to make shorting gilts the new Widowmaker.

Non-prediction 3) suggests that TIPS will outperform vanilla Treasuries as 5y5y inflation expectations increase. The immediate future in the US, however, shows a very firm dollar, and the resulting moderation in commodity prices will be filtering through the price chain even as hourly earnings remain mired. In addition, I believe that the US employment miracle is a mirage and that the 225k mall Santas and elves will be signing on soon, while the weight of foreclosures continues to drag down housing values and banks. Being in NY I tend to see US data through less rosy spectacles.

The first half of 2012 probably will offer very slow US growth but with a modestly deflationary first derivative, so then the critical issue will be the timing of the QE3 ± any European restructuring events. In my view this could drag on and be later than most expect. Bernanke isn't going to do QE3 until crude and gasoline prices are much lower than they are today. Therefore, TMM may be correct, but it may actually be 2013 before we see the fully expressed expectation of reflation in 5y5y.

Non-prediction 4) is really a measure of two things: Australia's continued growth and AUD strength in terms of trade with China, and an assumption that the Aussie housing bubble will not implode violently - with the implicit expectation that the blessed land will escape without a banking crisis. I think RBA may find itself under more pressure than many expect, and I think selling AUD will be a favorite trade for many in 2012.

In the end, this year may well be a "game of two halves": a deflationary first half, followed by more CB intervention and then a reflationary second half. If TMM are right, then the introduction of the substitutes at half-time will make the second half a feast of financial fun. LB warns that this year might be a grinding defensive struggle that goes into extra time.

The antics of the European players are likely to be critical, of course, with Mangler and the rest of the German defenders clearly determined to keep the scores low. There are a few individuals on loan from Athens who might see the red card. Why not send off the Greek midfielders as an example to the Italian strikers? Clearly such actions will be restricted to one country at a time, but it could happen, Argentina 2001 style.

Leftback said...
8:10 PM  

Great non predictions. I tend to agree with Leftback on shorting Gilts, I been bearish on those for well over a year just to been proven wrong time after time again. Even a broke ass clock is right twice day, but not me.

Tradebot said...
1:02 PM  

Interesting post as always.
I will be the contrarian here with regards to non-prediction #1. Even if yields rise a bit, it will be a small correction and I certainly don't see the 10yr above 3%.
I agree with your statement that the UK is the least likely to experience deflation, however that does not necessarily mean we will see rates increasing. At the end of the day what will lift interest rates is nominal GDP growth. With fiscal tightening, the Eurozone spillover effect, weak ex-London housing market, weak financial sector (more layoffs), I just don't see the massive GDP growth that will lead to IR increases. Continued stagflation and ZIRP is more likely IMHO. If anything, the last couple of years should serve as strong evidence that the powers that be are quite content with persistent above-target inflation (or mervynflation).

theta said...
9:58 PM  

good thinking, good analysis, thanks.

eveningstar said...
10:43 PM  

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