G3 Recap 11-24-10

Main Items:

  • S&P cut Irish debt rating from AA- to A, while remaining on watch negative.
  • US Initial Jobless Claims declined to 407k vs 435k expected and 439k previously. This is the lowest print since July 2008. The unadjusted level of claims rose by 52k, but initial jobless claims typically increase between the Veterans Day and Thanksgiving holidays, and the rise in the unadjusted numbers was much less than seasonal factors would predict.
  • U Michigan Confidence improved to 71.6 in the final readings for the month vs 69.5 expected.
  • US Personal income improved 0.5% MoM vs 0.4% expected, although Spending improved 0.4% MoM vs 0.5% expected.
  • Core PCE slowed to 0.9% YoY in Oct vs 1.0% expected and 1.2% previously.
  • DGO ex air, ex defense declined -4.5% MoM in Oct vs +1.0% expected. However, the previous print was revised from -0.6% to +1.9%.
  • The US is sending an aircraft carrier group to South Korea. The Kospi index was roughly unchanged on the day, after opening down 2%.
  • WSJ reports that the BAB program is likely to be extended.

Overseas:

  • German IFO survey for the Business Climate improved to 109.3 vs 107.5 expected and 107.6 previously.
  • UK 3Q GDP improved 0.8% QoQ as expected. Better than expected trade balance offset weaker consumption and investment.

Commentary:

  • The drop in front Eurodollar contracts suggests that bumpy times are ahead. The steepening at the very front end is notable, since we know that the Fed isn’t going to even consider hiking in the next 6 months. As a result, we can infer that the market is expecting Libor peak sometime in 2Q.

    The sharp steepening further out the curve was probably driven by the jobless claims print. It’s pretty significant, as it is the first ‘real’ print below 430k in over 2 years. We should wait to see if it’s a one off, but consecutive prints below 400k will allow the unemployment rate will trend lower:

    However, even if UE trends downward at the same pace as the last recovery, (-1% in UE over 2 years) it will still take 7 years for UE to hit 6%, which was the upper end of the FOMC’s NAIRU estimate.
    After today’s sell off, Fed Fund futures are now pricing in the first hike in February 2012, which is very likely too aggressive. CFTC positions reports show that speculator positioning (in white) in Eurodollar futures (rolling 4th ct in orange) is now at the lowest level since last June, and at levels consistent with subsequent rallies.

  • Looking at the PIGS CDS chart, we note that there is a demarcation line somewhere close to the 300bps area. Basically, once a countries’ CDS crosses it, it basically just keeps going:

    My theory, as I discussed yesterday, is that
    1) countries running current account deficits need a positive capital account in order to prevent declines in domestic asset prices.
    2) With CDS levels below 300bps, foreign banks could justify increasing their holdings of said countries’ sovereign debt at a pace that keeps sovereign bond prices stable.
    3) Once CDS spreads cross 300bps, this sponsorship falls
    4) When combined with the fact that these countries need increasing sponsorship to offset their negative current accounts, sovereign bond prices continue to cheapen until
    5) At ~1000bps or so, distressed players start buying based on their estimates of recovery value.
    This analysis suggests that there is a ‘no man’s land’ area between 300-1000 bps on sovereign CDS, where sovereign debt does not have sufficient sponsorship to have a stable price. We see that this is a level that Spain is flirting with right now.
    As a result, we need to watch ratings alerts on Spain very closely. Even something like Fitch changing the outlook to negative could be sufficient to push CDS spreads wider. From there, it can trigger a self-reinforcing cycle that can overwhelm the fact that fundamentally speaking, Spain is much better off than any of the other PIGS.

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4 thoughts on “G3 Recap 11-24-10

  1. Happy Thanksgiving !
    Great piece of analysis on the CDS + Euroland.
    Agree that Spain is the big gorilla out there and we (ie us Europeans) can’t afford to
    have that go down the toilet.
    If that would to happen, I think a 2 tier Euro land will be a dead cert : a North Euro
    and a Med Euro , with 2 different values ,interest rates, bond markets etc..
    Sad but inevitable.
    Then ‘Brussels’ as we know it and its Euroland political authority will cease to exist as well.
    That could be a good unintended consequence from the euro crisis.

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