As many commentators have noted, the brewing sovereign debt crisis isn't anymore about Greece than the financial crisis of 2008 was about Lehman Brothers or AIG. All over the world, government balance sheets have become swollen with debt, and in many places private sector debt has been transfered to public balance sheets, with the result that net debt levels have fallen very little.
Some of the immediate effects of the Greek crisis were a widening of sovereign CDS spreads (Spain hit 170bps, the highest level since Feb 09), a sell-off in risk and a broad dollar rally, and a rise in yields on government debt for other Euro area members, albeit with different degrees for different countries. The Euro was battered, with EURUSD hitting a low of $1.34. I recall in October and November 2009, when stories about dollar doom were in papers everyday, that the magic resistance level for EURUSD was $1.45; later in the year, as it broke that level, it became $1.40.
This has taken many by surprise: in a world where currencies everywhere offer derisory yields, many had imagined that the Euro was the safest of the bunch--I had a German colleague who advised me to buy gold or a "real" currency, like the Euro. To an extent this was justified, as it was expected that the usually hawkish ECB would be the first to raise rates in 2010. But Euro area recovery has been feeble at best, and the Greek crisis has made a rate hike more difficult: differentiation within the Eurozone is finally showing, and while some countries can arguably weather a rise, to others it might be unbearable. The result is that you should expect rates in the Euro area to stay low; with the Fed raising its discount rate last week, the EURUSD equation has thus, in a sense, been turned on its head. Has it run its course? I will be an interested observer on how that cross fares, and like I've said before, I expect USD to be a major beneficiary of risk events in 2010-2011.
Finally, I think it is useful (but of course difficult) to look for relative value opportunities that might arise in the sovereign debt space: for example, the Blackrock co-head of fixed income mentioned last week (see story) that while Greek yields nearly doubled Portugal yields on some parts of the curve, the fundamentals in the two countries were not all that different. One of PIMCO's favorite long-term buys is German bunds, especially versus US treasuries and UK gilts. More on that next time!
Sunday, 21 February 2010
Saturday, 20 February 2010
Greece
John Mauldin (www.johnmauldin.com) mentioned a statistic in his column last week which is quite startling: Greece, a country of 11 million people, had only six people filing taxes for incomes in excess of 1mn Euros. How is it that we notice these absurd statistics only after a crisis erupts? (Another one of my favorites: in January 2008, there were only 12 AAA-rated companies in the world, but 64,000 structured finance instruments with an AAA rating).
I first heard of Greece's precarious sovereign debt position in November 2009, around the same time stories of Dubai World's voluntary restructuring of its debt surfaced. Since then, many developments have occurred and attitudes about the problem have shifted; consider, for example, the following quote by Swedish premier Fredrik Reinfeldt on December 10, 2009:
"What we now are seeing in Greece is of course problematic, but it is basically a domestic problem that has to be addressed by domestic decisions,"
Obviously, this is no longer the prevailing attitude. In fact, as Mohamed El-Erian wrote in a piece in the FT in early February:
"Without external assistance, any Greek policy efforts would entail such contractionary fiscal policy measures as to cause a disaster locally, especially given the initial conditions (including the size and maturity profile of its debt) and the existing policy framework (anchored on adherence to a fixed exchange rate via the euro), such adjustment is difficult and not sufficient."
As of yet, no external bailout has transpired, but the EU has come out and said it will take "determined and coordinated action" to help Greece with its debt problems (as far as I can tell, no one knows what that means exactly). This gave Greece some respite, with its yields and ballooning CDS spreads falling. It's also important for another reason: as the U.S. learned during Mexico's debt crisis in 1994, instilling confidence in a country can massively reduce a bailout package by allowing the government to refinance itself.
According to Fitch, Greece needs to raise around 50bn Euros in 2010, both to cover deficits and roll over maturing debt. So far, Greece has managed to raise 8bn Euros in 5-year bonds via a syndicated issue in late January priced at 6.2%, around 350bps over mid-swaps rate, the rate for credit-worthy borrowers of Euros. The syndicate of banks drummed up massive interest in the bonds, with orders for the issue hitting 25bn Euros. (Despite this massive interest, the bonds quickly sold off on the secondary market, perhaps a sign that many had bought in to the issue for a quick profit, a practice known as "flipping").
My instinct tells me that it will have a much harder time raising the rest of money (it will need some new financing as early as April), due to a host of issues:
- According to the numbers I have seen (see aforementioned John Maludin column for details) and based on historical precedent, Greece’s 3-year plan to reduce its deficit from 13% to 3% of GDP is not credible and/or impossible;
- There are major issues with data collection and book-cooking in Greece, although Greek authorities seem genuinely intent on changing this;
- Over 50% of Greece's GDP is government spending, 30% of its economy is underground, and it has powerful trade unions and major problems with tax collection. These are not issues the market can gloss over, and are not problems which Greece can solve in the short-term.
Thus, to many the question is shifting from if to rather how (and by whom) Greece will be bailed out.
In the next post I consider the implications of a Greek default for markets, and how the Euro is faring during this crisis.
I first heard of Greece's precarious sovereign debt position in November 2009, around the same time stories of Dubai World's voluntary restructuring of its debt surfaced. Since then, many developments have occurred and attitudes about the problem have shifted; consider, for example, the following quote by Swedish premier Fredrik Reinfeldt on December 10, 2009:
"What we now are seeing in Greece is of course problematic, but it is basically a domestic problem that has to be addressed by domestic decisions,"
Obviously, this is no longer the prevailing attitude. In fact, as Mohamed El-Erian wrote in a piece in the FT in early February:
"Without external assistance, any Greek policy efforts would entail such contractionary fiscal policy measures as to cause a disaster locally, especially given the initial conditions (including the size and maturity profile of its debt) and the existing policy framework (anchored on adherence to a fixed exchange rate via the euro), such adjustment is difficult and not sufficient."
As of yet, no external bailout has transpired, but the EU has come out and said it will take "determined and coordinated action" to help Greece with its debt problems (as far as I can tell, no one knows what that means exactly). This gave Greece some respite, with its yields and ballooning CDS spreads falling. It's also important for another reason: as the U.S. learned during Mexico's debt crisis in 1994, instilling confidence in a country can massively reduce a bailout package by allowing the government to refinance itself.
According to Fitch, Greece needs to raise around 50bn Euros in 2010, both to cover deficits and roll over maturing debt. So far, Greece has managed to raise 8bn Euros in 5-year bonds via a syndicated issue in late January priced at 6.2%, around 350bps over mid-swaps rate, the rate for credit-worthy borrowers of Euros. The syndicate of banks drummed up massive interest in the bonds, with orders for the issue hitting 25bn Euros. (Despite this massive interest, the bonds quickly sold off on the secondary market, perhaps a sign that many had bought in to the issue for a quick profit, a practice known as "flipping").
My instinct tells me that it will have a much harder time raising the rest of money (it will need some new financing as early as April), due to a host of issues:
- According to the numbers I have seen (see aforementioned John Maludin column for details) and based on historical precedent, Greece’s 3-year plan to reduce its deficit from 13% to 3% of GDP is not credible and/or impossible;
- There are major issues with data collection and book-cooking in Greece, although Greek authorities seem genuinely intent on changing this;
- Over 50% of Greece's GDP is government spending, 30% of its economy is underground, and it has powerful trade unions and major problems with tax collection. These are not issues the market can gloss over, and are not problems which Greece can solve in the short-term.
Thus, to many the question is shifting from if to rather how (and by whom) Greece will be bailed out.
In the next post I consider the implications of a Greek default for markets, and how the Euro is faring during this crisis.
Thursday, 18 February 2010
The State of the Real Economy
The U.S. reported very good growth numbers for Q4/09, and manufacturing data and ISM indices indicate that Q1 growth should come in strongly too--the one recent blemish is February's non-farm payrolls number. This is important, because it highlights the fact that employment is still not recovering. With no growth in real wages, weak consumption growth and deleveraging households, it is not clear where private demand might arise (or is arising). As PIMCO notes, the growth numbers could very well be driven by inventory rebuilding and fiscal stimulus.
To put the unemployment issue in perspective, I quote David Rosenberg of Gluskin Sheff, an eternal pessimist throughout this crisis (bold emphasis mine):
"While... it could well be argued that we are entering some sort of healing phase in the jobs market... the reality is that the level of employment today, at 129.5 million, is the exact same level it was in 1999. And, during this 11-year span of Japanese-like labour market stagnation, the working-age population has risen 29million. Contemplate that for a moment; fully 29 million people competing for the same number of jobs that existed more than a decade ago. That sounds like pretty deflationary stuff from our standpoint."
The last comment about deflation is, I think, also really important, because the strong economic data is not having much of an effect on bond yields, with these staying low across the term structure. QE has obviously contributed to this, but maybe part of the story is that yields are so low because the market in fact does not believe in the strength of the recovery, and expects a benign inflation outlook and policy-makers to keep rates low. As Bloomberg writes:
"Treasuries indicate traders are paring bets inflation will accelerate. The difference between yields on 10-year notes and comparable TIPS, a gauge of trader expectations for consumer prices, touched 2.22 percentage points, the lowest level since Dec. 14. The so-called breakeven rate reached the intraday high for this year of 2.49 percentage points on Jan. 11."
Going forward, it is crucial to keep re-evaluating this combination of low rates/benign inflationary expectations yet seemingly robust growth.
To put the unemployment issue in perspective, I quote David Rosenberg of Gluskin Sheff, an eternal pessimist throughout this crisis (bold emphasis mine):
"While... it could well be argued that we are entering some sort of healing phase in the jobs market... the reality is that the level of employment today, at 129.5 million, is the exact same level it was in 1999. And, during this 11-year span of Japanese-like labour market stagnation, the working-age population has risen 29million. Contemplate that for a moment; fully 29 million people competing for the same number of jobs that existed more than a decade ago. That sounds like pretty deflationary stuff from our standpoint."
The last comment about deflation is, I think, also really important, because the strong economic data is not having much of an effect on bond yields, with these staying low across the term structure. QE has obviously contributed to this, but maybe part of the story is that yields are so low because the market in fact does not believe in the strength of the recovery, and expects a benign inflation outlook and policy-makers to keep rates low. As Bloomberg writes:
"Treasuries indicate traders are paring bets inflation will accelerate. The difference between yields on 10-year notes and comparable TIPS, a gauge of trader expectations for consumer prices, touched 2.22 percentage points, the lowest level since Dec. 14. The so-called breakeven rate reached the intraday high for this year of 2.49 percentage points on Jan. 11."
Going forward, it is crucial to keep re-evaluating this combination of low rates/benign inflationary expectations yet seemingly robust growth.
Interview Prep
I'm preparing for an interview next week and would thus like to be sharp when talking about markets. I'm going to write up an entry everyday containing interesting information I've learned and any reflections/thoughts I might have--I find that this format helps me remember what I read and learn.
Sunday, 7 February 2010
EURYEN and EURUSD cross vs. S&P500
The Euro-Yen cross is a popular proxy for risk, because of the Yen's status as a funding currency of choice in the carry trade--that is, you can finance positions by borrowing in Yen and investing in higher-yielding instruments. Above is a graph of EURYEN vs. S&P500 over the past two years; the Yen has strengthened versus the euro recently on the back of Europe's sovereign debt problems, and with it the S&P500 is falling. If the Yen carry trade is unwinding, we should expect weaker equity markets going forward.
It is interesting to note that EURUSD (below) vs. SPX is registering a similar effect--despite its ugliness, USD should be a major beneficiary of any risk events in 2010.
Finally, what of USDYEN (at 89.19 now)? Japan is still suffering from a significant output gap, challenging demographic trends, and self-feeding deflationary expectations. The Bank of Japan seems set to maintain its base borrowing rate at near-zero levels; if so, then the driver of the USDYEN cross should be US rates. If the Fed does not raise rates in 2010, then USDYEN has likely seen its bottom. If it does, then USDYEN at its current level could be a good buy.
Wednesday, 23 December 2009
The crash of 1907
I just finished reading a book (The Panic of 1907, Bruner and Carr) about the US market crash of 1907--the year saw a 50% drop in the NYSE from its 1906 peak and a widespread loss of confidence that resulted in multiple runs on banks and trusts. A recession followed, and the enduring legacy of the period was the creation of the Federal Reserve Bank. I offer here some observations and notes I made while reading the book.
1. Market crises, as the authors note, are a result of the confluence of several "perfect storm" factors--for example, a complex system with inadequate safety buffers is exacerbated by behavioral aberrations due to buoyant growth (today's "irrational exuberance") and (unwitting) adverse leadership. It is useful to think of financial crises in these terms rather than look for a simple "silver bullet" explanation.
2. Here is an example on the effect of adverse leadership in the 1907 episode. Teddy Roosevelt, who was then president under an anti-big business platform, had passed legislation to limit the amount railroads could charge passengers. The legislation brought into question the profitability of railroad companies, and their stock prices were battered in an already depressed market. Moreover, at a time when markets were already volatile, the legislation engendered only more uncertainty. Looking at some of the discussions policymakers are having today, there is real danger that we are still falling into the same traps. As Milton Friedman was wont to say, we should not judge policy proposals by their intentions, but by their effects.
3. Before the Fed, the national banking system did not have an efficient mechanism for increasing the supply of money, and rates would remain stubbornly high because counries had to hoard gold to prevent potentially crippling money supply outflows. Thus, in times when liquidity dried up, one option was for the Treasury to redeem bonds earlier than their maturity and/or make lump-sum interest payments, but this was done on an ad hoc basis. In response to the 1907 crisis, clearing houses instead issued temporary, emergency loans to member banks in the form of "clearing house certificates"--this was called an "artificial" increase in the money supply, because the certificates did not add to the supply of money directly, but instead freed up cash on bank balance sheets. Obviously, these certificates were only good insofar as they were deemed acceptable by counterparties--somehow, with the backing of J.P. Morgan (person, not bank), this was achieved.
For today's Fed critics and skeptics, I think it is a useful but challenging execrise to think about what our monetary system would look like without a central bank. Would we revert (at least partially) to a gold standard? Would private groups perform central banking functions, as happened in 1907? How would this affect the business cycle we know today?
Finally, a cartoon contemporary to the period, which is titled "The Cental Bank-why should Uncle Sam establish one, when Uncle [Morgan] is already on it?"
1. Market crises, as the authors note, are a result of the confluence of several "perfect storm" factors--for example, a complex system with inadequate safety buffers is exacerbated by behavioral aberrations due to buoyant growth (today's "irrational exuberance") and (unwitting) adverse leadership. It is useful to think of financial crises in these terms rather than look for a simple "silver bullet" explanation.
2. Here is an example on the effect of adverse leadership in the 1907 episode. Teddy Roosevelt, who was then president under an anti-big business platform, had passed legislation to limit the amount railroads could charge passengers. The legislation brought into question the profitability of railroad companies, and their stock prices were battered in an already depressed market. Moreover, at a time when markets were already volatile, the legislation engendered only more uncertainty. Looking at some of the discussions policymakers are having today, there is real danger that we are still falling into the same traps. As Milton Friedman was wont to say, we should not judge policy proposals by their intentions, but by their effects.
3. Before the Fed, the national banking system did not have an efficient mechanism for increasing the supply of money, and rates would remain stubbornly high because counries had to hoard gold to prevent potentially crippling money supply outflows. Thus, in times when liquidity dried up, one option was for the Treasury to redeem bonds earlier than their maturity and/or make lump-sum interest payments, but this was done on an ad hoc basis. In response to the 1907 crisis, clearing houses instead issued temporary, emergency loans to member banks in the form of "clearing house certificates"--this was called an "artificial" increase in the money supply, because the certificates did not add to the supply of money directly, but instead freed up cash on bank balance sheets. Obviously, these certificates were only good insofar as they were deemed acceptable by counterparties--somehow, with the backing of J.P. Morgan (person, not bank), this was achieved.
For today's Fed critics and skeptics, I think it is a useful but challenging execrise to think about what our monetary system would look like without a central bank. Would we revert (at least partially) to a gold standard? Would private groups perform central banking functions, as happened in 1907? How would this affect the business cycle we know today?
Finally, a cartoon contemporary to the period, which is titled "The Cental Bank-why should Uncle Sam establish one, when Uncle [Morgan] is already on it?"
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