G3 Recap 12-20-10

Main Items:

  • The ECB announced a Stg10 bln lifeline to help shore up Ireland’s banks system just hours after a sharp credit rating downgrade threatened to undermine confidence in the crisis hit country further – FT.
  • Chicago Fed national Activity Index dropped to -0.46 in Nov vs 0 expected and -0.28 previously.

Overseas:

  • EU Consumer Confidence fell to -11 in Dec vs -9 expected and -9.4 previously
  • 64% of Germans consider the wage rise demands from unions as being justified, according to a survey made by Faktenkontor of 1000 citizens. Due to ongoing economic recovery, one in three Germans expects wages to increase between 2.5 and 5% in 2011, while 40% expect that wages will rise less than 2.5%.
  • SNB’s Hildebrand commented yesterday: “If problems in Euro zone persist I see EURCHF down to 0.50”.

Commentary:

  • A number of brokerage houses have sharply upgraded their YE2011 yield forecasts. Much of this makes sense based on the upgraded growth expectations after the spate of strong 4Q economic releases. The recent jump in yields has drawn several comparisons with yield behavior over the last recovery. If we go down that road, however, we should remember that treasury yields defied widespread expectations for sharp rises in 2004, causing Greenspan to dub it a ‘conundrum.’ Explanations for the conundrum varied – surveys suggested that market participants thought that the largest drivers were foreign central bank and pension fund demand, while Fed staffers ran univariate regressions on the error terms of different models to conclude that the largest driver was the decline in treasury implied volatility.
    Regardless of which effect it was (I have my own opinion but that is for another day!) all of these effects remain in full force. Foreign central bank net purchases of Treasuries are not expected to turn negative anytime soon, and there have been wide spread reports that pension funds have been changing their asset allocation toward fixed income over the past 2 years. Finally, the mess that is the US housing market has sharply reduced the ability of much of the US MBS universe to refinance, which has in turn driven MBS prices to historical highs while sharply reducing convexity demand.
    The Bloomberg consensus forecast for 10y yields in 12 months is 3.3%. Considering the factors above, as well as the pretty ugly (and contrarian) track record of forecasters, we should not be surprised at another bond yield ‘conundrum’ in 2011.

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