Not all "risk assets" are created equal

We all talk about the old RO-RO - the so called "risk-on/risk off" behavior of markets. It hasn't always been this way. "Risk assets" became particularly correlated after the financial crisis (see 2009 discussion). Many newer market participants simply accept this as a given. One constantly hears comments such as "it's been a risk-off week".  It's as though there are just two markets in the world: one consisting of the euro, the S&P500, oil, etc. and the other of treasuries and the US dollar.

Recently, however, correlations among risk assets have been on a decline. Certainly they are still elevated, as macro-focused asset managers reallocate exposures far more efficiently than they did 10 years ago. But market participants are beginning to differentiate among risk assets.

The Australian dollar is a good example. Generally viewed as one of the "risk assets" due to the nation's exposure to natural resources and therefore global growth, AUD has correlated well with other such assets. When we discussed the fact the AUD remains vulnerable due to Australia's economic slowdown (see discussion), many FX traders remained skeptical. The view was that the "risk-on" trade will lift AUD irrespective of Aussie growth. That's not what happened however, as we've seen AUD decouple strongly from risk assets such as equities.

Similarly, the Japanese yen recently lost its status as a "risk-off" trade due to Japan's fundamentals (see discussion). So before jumping on the next RO-RO bandwagon, consider the fact that these days not all risk-on (as well as "risk-off") assets are "created equal".

SoberLook.com

From our sponsor:

What drove the sharp reduction in US trade deficit

Some folks in the media are making a big deal out of the US trade deficit decline in December.

The SF Chronicle: - Number of the day: 20.7 percent
That's how much the U.S. trade deficit shrank in December from the previous month, the U.S. Commerce Department said Friday. The gap between imports and exports was the smallest since January 2010 and much less than the $46 billion expected by 73 economists in a Bloomberg poll. The deficit was cut by record exports of refined petroleum products to countries such as Brazil, combined with lower imports of crude oil.

Yes, that's an impressive showing indeed. But let's take a look at the chart, because such numbers should not be viewed in isolation. The decline in deficit follows a sharp increase a month earlier.

The deficit increase in November was driven by hurricane Sandy, and was exacerbated by the Northeast US refineries' shutdowns. Fuel output in November dropped materially. The lower imports in December are therefore distorted by the reversal of the "Sandy effect". Trade deficit excluding fuel in fact declined less sharply than the overall number in December.

This is clearly a welcome result, but the real trend will not be fully visible until the January numbers are out.

SoberLook.com

From our sponsor:

Inflationary pressure building in Brazil

Brazilian central bank's highly accommodate policy in the past year and the recent weakness in the Brazilian real has helped boost growth.

But with economic growth stabilizing, the nation is beginning to face inflationary pressures (as predicted). Ultra dovish central bank policies, whether in Brazil or elsewhere, usually come at a price.

Reuters: - Brazil's inflation accelerated to the fastest rate in nearly eight years in January, raising bets of an interest rate hike this year that could complicate the government's drive to reignite a near-stagnant economy.

The Brazilian currency, the real , also jumped on the news, hitting a 9-month high against the dollar after central bank president Alexandre Tombini said he was worried about inflation.

Brazil's inflationary pressures are becoming broad-based instead of simply focused on a particular sector of the economy.

GS: - What is of particular concern is that the acceleration of inflation in Brazil was broad-based, i.e., it was not driven by narrow-based shocks to just a few items. In fact, the Brazil IGI shows that items with a combined weight of about 60% in the CPI have annualized seasonally adjusted inflation now running above the 6.5% inflation target upper limit.

In response, the central bank is expected to begin raising rates aggressively - with futures already pointing to 100bp increase in the near future, - dampening the nascent economic recovery.

SoberLook.com

From our sponsor:

Sharp reversal in EUR sentiment

It's quite amazing how the world has changed in just a few months. Back in July traders were still piling into the short-euro trade. Nobody wanted to hear that it was becoming a "crowded trade" (as discussed here) - after all the euro "can only go down".  Since then these euro bears have endured pain, as the sentiment reversed sharply. The Goldman EUR/USD sentiment index, which is based on the CFTC statistics of speculative positions of futures traders, is moving deep into the bullish territory.

GS: - Net EUR long spec positioning continued to rise; at 80.4 percent our Sentiment Index (SI) is now at its highest level since May 2011

The fundamentals continue to support this position, with the ECB uninterested in pushing the euro lower (see post). But the technicals will need to be watched closely for signs of overcrowding.

Source: GS

SoberLook.com

From our sponsor:

Gasoline prices on the rise; may pose risk to consumer sentiment

As the winter storm pounded the Northeastern United States today, gasoline futures hit another high. The March delivery contract broke $3.06, indicating that retail prices for fuel will be going up.

March 2013 gasoline contract

Already prices at the pump are the highest for this time of year.

CNBC: - Nationally, retail gasoline prices have soared 11 cents in a week and nearly 30 cents in a month to $3.57 a gallon on Friday, according to AAA. Pump prices are the highest on record for early February, and are rising the fastest along the coasts.

The state-wide average price of gasoline in New York is $3.92 a gallon and California gas prices on average have now surpassed the $4-a-gallon mark.

Increased demand from abroad, stronger crude prices, and some refinery shutdowns are all contributing to higher prices.

MarketWatch: - Consumers haven’t even seen the worst, with a perfect storm of factors driving higher prices.

Many of the issues lifting fuel prices higher are common, but they “seem to have combined at the right time,” said Matt Tormollen, president and chief executive officer at FuelQuest, a Houston-based fuel management software provider.

Typically at this time of year, refineries begin their switch to the more environmentally-friendly summer-blend gasoline and perform maintenance, which “temporarily restricts supply and drives up prices,” he said.

Some refineries have also announced unexpected shutdowns or closings, leading to even tighter refining capacity, said Jeff Lenard, a spokesman at the National Association of Convenience Stores (NACS), a trade group for an industry that sells 80% of the nation’s gasoline.

Late last month, Hess Corp. HES +1.23% said it would close its Port Reading, N.J., refinery by the end of February, completing its exit from the refining business. See Jan. 28 story on the rally in Hess shares.

And of course the Fed's recent activities are not helping the situation either (discussed here). Ultimately this trend of rising fuel prices, combined with the possibility of higher taxes in the future, constitutes the biggest risk to US consumer sentiment and spending.

SoberLook.com

From our sponsor:

Corporate commercial paper outstanding is at record high

Consistent with the growth in corporate bonds (discussed here), corporate commercial paper outstanding hit a new record recently - exceeding the pre-crisis highs on a seasonally adjusted basis. These of course are the largest and the highest rated corporations who use the CP market to manage cash flows. The mid-sized and smaller firms do not have access to this market. Also it's important to note that corporate CP constitutes just over a quarter of bank CP, which still dominates the market.

Non-financial commercial paper outstanding (SA, source: FRB)

Who is buying this paper? Interestingly enough the purchasers (other than the usual suspects such as money market funds) often tend to be other corporations who have massive amounts of cash on their balance sheets. They buy CP (as well as other short-term instruments) as a substitute for bank deposits to boost yields.

WSJ: - Commercial paper accounted for 11.06% of corporate cash assets at the end of January, an increase of 1.19 percentage points from a month earlier, representing the biggest jump among all assets categories, according to data from Clearwater Analytics...

.

SoberLook.com

From our sponsor:

Ireland takes major steps toward recovery

Back in April we discussed Ireland's attempt to restructure the so-called promissory note (see discussion and diagram). It seems that last night they finally succeeded.

NYTimes: - The Irish government reached a deal on Thursday to restructure debt tied to local struggling banks, as the country tries to shrug off the financial burden that it inherited during the recent debt crisis.

The hard-fought agreement, which followed 18 months of negotiations with the European Central Bank, will have Ireland swap 28 billion euros of so-called high-interest promissory notes — a form of i.o.u.’s — that were used to bail out Anglo Irish Bank in 2009 for long-term government debt.

Although crucial details of the agreement were not immediately disclosed, it appeared to mark another important milestone in Ireland’s slow emergence from a banking and real estate crisis that has cut living standards, caused unemployment to soar and left cities scarred by half-finished building projects.

During the crisis the Irish government made the holders of Anglo Irish Bank senior unsecured debt whole instead of forcing them to take a haircut. The nation was pressured by the EU to do so because so many European banks had held Anglo Irish Bank bonds, and the EU was concerned about contagion. That was a mistake because it cost the Irish taxpayer 20% of the GDP. Ireland therefore pressured the EU and the ECB to allow them to swap the promissory note (PN) for long-term government debt  (34yr average maturity) - effectively as a payment for taking it "for the team"  in 2009. The outcome is quite positive for the nation as it improves Ireland's fiscal situation going forward.

Barclays Capital: - First, from a political perspective, the Irish government had strongly committed to ease the terms of the PNs, in part as a compensation for the costly bail-out of senior unsecured bondholders of Anglo Irish bank, which resulted in costs of c.20% of GDP for the Irish tax payer. Quoting the Irish prime minister, “this government is undoing the disastrous banking policies that brought this State to the brink of national bankruptcy”.

Second, the extension of the PNs maturity and reduction in interest rates will improve the chances of Ireland hitting its future fiscal targets, including reaching a deficit of below 3% of GDP by 2015. The reduction in interest payments would either reduce Ireland’s deficit (eg, in 2013 the interest cost on the PNs would have amounted to EUR1.9bn, about 1.2% of GDP) or liberate fiscal resources to reduce taxes or increase public expenditures. Perhaps, more importantly, the maturity extension of the PNs will reduce Ireland’s funding needs in the coming years and will also facilitate the exit from official funding and the return to the markets with a regular issuance schedule, possibly in H2 2013. The PNs had costly interest payments starting in 2013 of well over 1% of GDP and would have continued in the coming years at a steep pace.

Furthermore, Ireland successfully concluded its 9th troika review, showing that the nation is on path to exit the EU bailout program by the end of the year. The markets have responded accordingly, as Irish sovereign debt yields hit another post-euro-crisis lows. Clearly the banking sector is still in the deleveraging mode (see post), as economic conditions remain fragile. But the nation has been able to overcome some major hurdles recently.

Ireland sovereign 8yr yield

SoberLook.com

From our sponsor:

The ECB staying out of currency wars - for now

Once again some analysts in Europe question the potency of the so-called currency wars launched by Japan and the US. The euro-yen currency cross has had an unprecedented rally, changing the export landscape where Japan and Europe (particularly Germany) compete.

Yen per one euro (EUR/JPY)

The impact of this adjustment in currencies is quite visible in the shares of exporters. The chart below compares share prices of Volkswagen and Toyota - as an example. It demonstrates once again how effective currency wars can be (see discussion). Weak yen is making Japan's products cheaper and/or margins higher.

Toyota (blue) vs. Volkswagen (red)

This trend is likely to negatively impact the Eurozone's economy, which, for the first time since the start of the euro crisis, is starting to show signs of recovery (see post). The question now is whether the ECB is going to "retaliate" in the currency war by attempting to weaken the euro.

Bloomberg: - Since the European Central Bank president talked up the economic outlook last month and signaled that the worst of the debt crisis is over, the euro has surged to a 14-month high against the dollar. Banks have fueled the euro’s rally by paying back more emergency loans than forecast, shrinking the ECB’s balance sheet just as the Federal Reserve and the Bank of Japan expand theirs.

That’s threatening to stymie Europe’s recovery before it has begun, highlighting the tightrope Draghi is walking as he seeks to boost confidence without encouraging euphoria. With looser monetary policy in the U.S. and Japan weakening the dollar and the yen, the ECB may soon come under pressure to enter the so-called “currency war” and rein in the euro, economists said.

“The euro-zone economy needs a rising euro like it needs a hole in the head,” said Nick Kounis, head of macro research at ABN Amro in Amsterdam. “If verbal intervention does not stem the euro’s upward trend, the central bank may eventually once again consider rate cuts.”

So far however the ECB has stayed away from direct asset purchases.

Bloomberg: - “A significant shift is underway in global central banking,” said Paul Mortimer-Lee, global head of market economics at BNP Paribas SA in London. “There is a worldwide currency war and the ECB seems to be a central bank that is not targeting the real economy as much as the Fed, the Bank of Japan and the Bank of England,” he said. The ECB “risks being the loser.”

It is expected that Draghi will retain a highly dovish stance (as he announced today) with respect to the ECB's policy but will not explicitly target a lower euro.

Barclays: - ... Draghi may adopt a more dovish tone to convince market participants that monetary conditions will remain loose, but we view any specific ‘talking down’ of the EUR as unlikely. Based on the check-list of indicators from the ECB’s January press conference (CDS prices, stock market indices, realised volatility, capital inflows, Target 2 imbalances, confidence indices, current account balances), market developments are likely to be viewed as broadly positive by the ECB more than offsetting any negative impact from EUR strength. 

What makes Draghi's situation particularly difficult is the fact that the Eurozone banks have been repaying some MRO and LTRO loans. That is resulting in declines in the EMU's monetary base (as bank excess reserves drop). At the same time the monetary base has been on the rise in Japan, the US, and the UK. This differential in base money growth (h/t Evil Speculator) continues to pressure the euro higher (although we are seeing a bit of a reversal today). And European politicians as well as some bureaucrats are beginning to argue that something should be done. For now, however, it is expected that the Eurozone will have to tolerate the relative euro strength, as the ECB stays out of the currency wars.

Source: ECB

Econoday (today's ECB announcement): - Perhaps more significantly, Drahi's opening remarks made no mention of the exchange rate despite some speculation that the central bank might have become concerned by the euro's recent appreciation. However, in response to questioning, he commented that current levels of both the nominal and real effective exchange rates are close to their long-run averages. This may not be what the ECB would prefer given the weakness of Eurozone domestic demand, but it also suggests that for now at least, the level of the single currency is not a major factor in setting monetary policy. In turn, this may be seen by speculators as a green flag to take the euro still higher.

SoberLook.com

From our sponsor: