G3 Recap 1-24-11

Main Items:

  • New Push at Fed to Set an Official Inflation Goal – WSJ. This is part of the Fed’s exit strategy. With an official inflation target, it can maintain the Fed Funds target at 25bps while anchoring inflation expectations and calming the hawks. This will enable the Fed to keep rates unchanged despite 3%+ growth. However, this has been one of Bernanke’s objectives for a while, so there is also a possibility that it is unrelated to Bernanke’s future plans.
  • An accounting change at the Fed will allow the Fed to denote losses by the regional reserve banks as a liability to the Treasury rather than a hit to its capital. It would then direct future profits from Fed operations toward that liability. – CNBC. This doesn’t make the Fed capable of going bankrupt, but should help head of worries that the Fed will lose its independence as a result of capital losses.
  • Ireland’s government is set to be the first to fall as a result of the Eurozone crisis after the Green party pulled out of the ruling coalition on Sunday – FT.
  • Hedge funds and currency traders have reversed their bets against the Euro amid hopes that European leaders will resolve the region’s debt crisis – FT.
  • Earnings: (misses in bold)
  • Philips: 1.63 vs 1.828. Sales 7.4bn vs 7.45bn
  • ICICI Bank: 12.48 vs 11.781
  • Halliburton: 0.68 vs 0.633
  • McDonald’s: 1.15 vs 1.155. Revenue 6.21bn vs 6.20bn.
  • Texas Instruments: 64c vs 63c. Revenue 3.53bn vs 3.51bn. Sees 1Q EPS 54c-62c vs 57c est.
  • CSX: 1.14 vs 1.09.
  • Amex: adj 94c vs 96.5c. Revenues 7.32bn vs 7.28bn.
  • VMware: 46c vs 44.3c

Overseas Data:

  • Eurozone PMI composite improved to 56.3 in Jan vs 55.6 expected and 55.5 previously. The Services print was better than expected, while manufacturing was in line. The manufacturing input prices subcomponent rose by 5.7 points to 79.8, the highest level in the series’ history
  • Trichet made some hawkish remarks in a WSJ interview – WSJ “All central banks, in periods like this where you have inflationary threats that are coming from commodities, have to…be very careful that there are no second-round effects” on domestic prices. “In the U.S., the Fed considers that core inflation is a good predictor for future headline inflation," he said. But in the euro zone, "core inflation is not necessarily a good predictor.”

Commentary:

  • There has been a lot of discussion about how the BoE is behind the curve, and UK inflation is starting to impact expectations. This view appears broadly justified, as model driven outputs suggest that ‘fair value’ for 2yr Gilts should be in the neighborhood of 2% by now. However, our job is not to be a central banker. Therefore, despite this view, we have to be aware of where the MPC is leaning vs market expectations.
    Currently, the rolling 8th short sterling contract is pricing in roughly 7 hikes. This is one of the wider spreads in history:

    Over the past 20 years, the BoE has never hiked interest rates more than 175bps in a 2 year span: (although this is admittedly because interest rates started out at such a high level)

    Therefore, we must assess whether this level of tightening is likely. BOE staff forecasts have consistently forecast low intermediate term inflation despite the high headline inflation prints. The majority of the MPC appears to believe these forecasts as well as the assumption that the high headline prints are due to one-off items. As opinions tend to follow Newton’s first law, the MPC is likely to keep policy rates unchanged unless either the BOE staff forecasts shift materially upward, (unlikely for now, also because of Newton’s first law) or if the high headline prints increase inflation expectations further.
    Recent inflation breakeven readings have not yet reached levels (~3.5%) that have sparked MPC hawkishness in the past:

    This suggests that a small position at the front end of the UK money market curve offers attractive risk reward. The position should not be large to the big tail risk of a commodities driven price spike.

  • I put out a bullish EURUSD opinion on 1/10. Since then, it has rallied almost 7 figures in 2 weeks. Now however, the model that I used to initiate the position is also suggesting that that the cross is back to ‘fair.’ With short term indicators very overbought and headlines like Bloomberg’s “Hedge Funds Bet on Euro After ‘Massive’ Reversal,” it’s probably time to take some chips off the table.
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5 thoughts on “G3 Recap 1-24-11

  1. short sterling always overreacts in part due to the disproportionate amount of flows (curve and mortgage related flows) compared to the liquidity afforded. certainly given how cautious places like canada, norwary, new zealand, sweden have been in relation to hiking cycles with far better banking sector health, one would imagine that MPC would be very cautious indeed.

    the UK fundamentally has a stagflation-lite situation that should be really hurting discretionary income particularly outside of london. combined with a feeble housing market of late and fiscal tightening that doesn’t even begin to start taking effect until march, i tend to agree that too much may be priced into reds. rather than level terminal level, its the timing and path of rates that seems perhaps wrong. gilts sub 4% are not cheap either so maybe trade is for less curvature in the money market … ie buys reds vs whites/greens segments or reds versus gilts if global yields to rise further.

    nice shout on the eur/usd … lots of folks gotten stopped out of wrong side of that … momentum players may take it a bit further, but my gut feeling is that in a few weeks time that will also reverse itself.

  2. http://www.statistics.gov.uk/cci/nugget.asp?id=206

    hmm … let me see who else has on balance sheet debt to gbp of 160% … uhh greece! high inflation low growth does not a pretty picture make … also, about 25% of total gilt issuance is linkers so cost of services debt also going up … ergo MPC ain’t hiking aggressively any time soon and gilts are and should not be considered safe haven versus europe.

  3. Hey Bert – Thanks for those comments. You’re probably right about Gilts… I’m still trying to figure out how to model out the fiscal premium for gilts – not sure if the CDS market accurately reflects that.
    I didn’t know that 25% of issuance was linkers. That’s going to be expensive! At least they can put off paying until maturity, but that doesn’t help narrow the fiscal premium either.
    You can put on 3m1y GBP receivers for only 50% of the cost of rolldown right now. Pretty compelling, even after today’s move in the front end.

  4. In commodity space, oil + copper prices starting to feel ‘heavy’ and the premium Brent over WTI getting lot of air time in the market.

    Both commods quite a bit away from their ealy Jan ’11 hi’s now.

    Commodity players starting to price in a soft landing in China perhaps ?

    OPEC opening the taps on pressure from OECD / G20 saying $100 oil kills any hope of economic growth picking up?

  5. Hey PKK – there definitely feels like people are starting to get nervous about the impact of PBoC tightening. Anecdotally, there seems to be more articles about it recently. I don’t think they can tighten much more without creating a bigger slowdown than they want. We will see…

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