G3 Recap 12-07-10

Main Items:

  • The Bush tax cut extension appears ready to pass congress after Obama agreed to a deal with Republicans. Capital gains and dividend tax rates will also be extended for 2 years, along with a 13 month extension of UE benefits, a reinstatement of the estate tax at 35% for estates > 5mm, and a temporary Social Security tax reduction from 6.2% to 4.2%.
  • Bank of Canada kept rates unchanged @ 1% as expected. The statement was fairly dovish, noting the strength of the CAD and ending with “Any further reduction in monetary policy stimulus would need to be carefully considered.”

Overseas:

  • UK IP rose 3.3% YoY in Oct vs 3.9% expected and 3.8% previously
  • RBA left rates unchanged as expected, and the policy statement was fairly neutral.

Commentary:

  • Wow what a big move in treasuries. People pointed to the strong data, the tax cut extension, technicals, and the upcoming auction, but the reality is that positioning was just too long, and all the catalysts are moving in the other direction: data, dealer positioning ahead of year end, MBS convexity hedging, and upcoming auctions. We are just beginning to get to levels that are cheap enough to be fundamentally attractive, but the momentum and catalysts already in place suggest that prices are likely to get cheaper. (after a pullback) We’re still far away, but 3.30 is a good level to start looking at scaling into 10y treasuries.
    Stocks were off as well, likely due to worries over higher yield and deleveraging. But it seems like more of a knee jerk reaction that doesn’t make sense in the context of the broader picture, given that one of the reasons yield prices are higher is that the data is better!
    Gold is a slightly different story. For a while, one of the reasons to buy gold was the low real yields. In fact, a gold model using 10y real yields and the Vix over the past 5 years has had a very R squared. As a result, today’s 15bp move in 10y real yields might have driven some selling. However, the model has not worked very in 2010, with the biggest sell signal occurring right as gold took off in early April.
  • I’ve been looking at Eurostoxx Dividend Futures over the past week. The futures curve is trading at a very substantial discount to consensus expectations: the 2013 future, for example, is pricing a dividend level of 103 vs consensus expectations of 149. (So as a result, several banks have been suggesting buying the futures recently)

    The difference appears to be due to two factors:
    1) The market is discounting a reasonable probability that Eurostoxx financials lose money from their PIGS exposure and thus cut their dividends
    2) Consensus expectations are based on an excessively simple straight 12.5% annual growth rate over 3 years.
    The spot dividend index is at 113. Insurance and Banks represent 27% of the index. Assuming 2% annualized growth, but 0 dividends from financials, the index would be 87.5 in 2013. Thus, at 103, the index is very roughly discounting 40% chance of financial dividends getting wiped out vs a 60% chance that they don’t and there’s no recession. This isn’t a huge edge and is also a trade that is very dependent on uncertain European politics. Pass.
    However, that’s not the end of the analysis:
    1) Given what’s transpired and the duration of support committed thus far, one can be reasonably confident that no PIGS will default by the end of 2011.
    2) 2010 dividends are essentially unchanged from 2009 levels, which themselves were the lowest since 2006.
    3) Furthermore, the 2011 Dividend Future is only trading at a 3pt premium to the 2010 future, a 2.5% increase.
    4) This contrasts with the fact that dividend growth is fairly highly correlated to Eurostoxx price action, with a 1 year lag:

    This suggests that going long the 2011 instead of the 2013 dividend future is good risk/reward, even if equities price action disappoints this year, as European non-financials increase their dividend payouts after a strong 2010.

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2 thoughts on “G3 Recap 12-07-10

  1. I like a spread personally …
    one ‘theory’ for the disconnect is structured product hedging … exotic equity desks receive divvy risk in the (autocallable, reverse convertible) notes they are selling into wealth management products (eg dealer – long the ki puts) and hedge and there is no natural buyers on the other side … you’re getting paid to provide liquidity to the type of people who often are generally short vol of vol, scary when they move like fish

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