The great divide

The air of calm that pervaded the start of the week lasted barely for a few hours.   By yesterday, it has morphed into a full scale rout in European bonds that saw spreads to Germany widen out once again.   Banks are taking any opportunity to sell and the decline in liquidity as year-end approaches will only serves to make matter worse and prices more volatile.  

The distance between the ‘haves’ and ‘have-nots’ is growing ever greater. German yields are down nearly 0.25% so far this week and in Switzerland, investors are paying the government to have their money, yesterday’s 3-mth t-bill sale coming in at a yield of -0.30%.   Even at the very short end of the German curve, some t-bills are seeing negative yields, but not yet on a consistent basis. For currencies, the bond sell-off led to more risk aversion.

The dollar index is at a 5wk high, the Aussie is naturally getting hit and the euro was also one of the weaker performers through yesterday, currently pushing below the 1.35 level.   It’s also worth keeping an eye on Greece, where political developments are Greece, where the new PM faces a vote of confidence to secure his mandate to implement reforms and talks begin with bondholders this week on their further voluntary contribution.

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The contagion from the EBA’s regime. Bullied by global investors into implementing stricter capital adequacy requirements, the European Banking Authority has (predictably) contributed to the contagion that is afflicting Europe’s bond markets. Unable and unwilling to raise fresh capital to meet the new targets, the vast majority of Europe’s banks are employing other tactics such as retaining earnings or freezing dividends.   To compound the problem, money managers are being sucked into the same vortex – other than Bunds and Gilts they are being slaughtered on exposure to most of the other European sovereigns, they are aware that the banks are big sellers, they are aware that liquidity has evaporated, they are aware that massive downgrades are on the way (unless Europe somehow puts a freeze on it) and as a result they are also panicking. There is no other way to explain the incredible price action we were witnessing Tuesday. Little wonder that solace is being found in other currencies and bonds such as the USD/USTs, GBP/Gilts and JPY/JGBs.   This loud sucking sound of balance sheet deleveraging by major banks was always inevitable, but it could have been contained somewhat were it not for the draconian capital demands foisted on banks by the EBA. It was obvious that these banks were always likely to choose asset shrinkage as the preferred path to meeting these new targets, effectively reinforcing what was already a damaging credit crunch. Angela Merkel may dream of political and economic union, but right now that nirvana has no hope of emerging while credit provision is cratering and the finances of Germany’s partners are imploding.


Hope springs eternal for UK inflation.  The fall in inflation in October was a touch more than anticipated, but with headline prices still at 5.0% this is nothing to get too excited about. The factors pulling inflation lower in October (air fares, food prices) are notoriously volatile, especially air fares, so there is a risk that these unwind and keep inflation steady or nudge it higher in November. Thereafter, headline inflation is set to fall dramatically in December and more so in January. The main reason for this is the dropping out of the increase in VAT from the YoY calculation, which should see CPI nearer to 4.0% in January.   Of course, with the Bank having undertaken more quantitative easing last month in response to the sluggish state of the economy, the inflation figures make for uncomfortable reading and the Bank of England remains convinced that inflation will fall substantially next year. In his letter to the Chancellor, the Governor bases this on the amount of spare capacity in the economy together with the “substantial” risks around the global economic recovery. Sterling is entangled in something of a push-pull fight. The developments in the eurozone have elevated it to a position of one of the stronger performers in Europe in recent weeks, but high inflation and more QE are counteracting these safe-haven winds and could well continue to do so in the dying weeks of 2011.


Aussie and global growth.   High-beta currencies such as the Aussie and the Kiwi have been buffeted at the start of the new week by fresh concerns over the deteriorating global growth picture. On Monday, the OECD leading indicators suggested that growth in the G7 and the BRICs is likely to slow markedly in coming months. In the case of the Aussie, it also has pressing local concerns. The RBA lowered the cash rate earlier this month and looks set to repeat the medicine, quite possibly at next month’s meeting, in response to weak growth and moderating inflation. Property prices down under are declining in most of the major capital cities. In addition, commodity prices are falling e.g. the price of iron ore has plummeted almost 20% this year.   After last month’s dramatic recovery which saw the Aussie rebound 14% to above 1.07, the current month has been a real struggle. Last week witnessed some significant buying around 1.01 from local corporates and hedge funds. Now at 1.0150, it will be interesting to observe whether this level attracts some further buying support. With Europe still mired in a debilitating sovereign debt and banking crisis, one which is infecting the rest of the world, it is little wonder that the Aussie is losing traction.

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