Greece-ing the wheels of recovery

Greece returned to the international bond markets last week with its first issuance since 2014, which at the time was its only issuance since the European Sovereign Crisis when the vast bulk of its debt was ‘restructured’. This return to the market is another small step in the long road back to financial health. Around half of the issuance was bought in exchange for existing debt but some new investors subscribed to the deal, some at least likely to be from outside Greece.

In a small way this should help the Greek banking system by injecting funds from outside Greece into the country, and allowing the amount borrowed under the Emergency Liquidity Assistance (ELA) programme to continue to reduce – something that is probably necessary before the 2015 capital controls are removed. Since 2015, many changes have occurred in Greece and it may surprise some that the outlook is looking much more favourable. Economic growth has turned positive, helped by firm Eurozone economic performance. Unemployment levels, although very high, have been falling since 2014. The fiscal position also looks better, with Greece recording a primary surplus in 2016.

The outstanding level of total government debt is still enormously high and is almost universally agreed as being unstainable in the long term. That said, in view of these more recent positive developments, Greece has been upgraded by rating agencies Standard & Poor’s and Moody’s over the last 12 months. Still rated at a worrisome B- at best, but at least going in the right direction. For this reason Greece offered a credit premium of near 5% over German debt in its recent issuance. This compares with the 1.3% spread that Portugal offers, the next ‘worst’ of the major countries that are active in the debt markets.

The credit trends are not isolated in Greece. Two of the other former ‘PIIGS’ countries, Ireland and Spain, have also seen upgrades in their credit ratings in recent years, and while Portugal’s rating has remained stable, Fitch has upgraded its outlook to Positive. Only Italy has seen a downgrade recently – but even there the outlook looks, for the short term, reasonably sanguine. The revival in economic growth and the long-awaited action regarding the banking system should mean stability for the foreseeable future. The good news can continue.

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UK employment is not the full story

The dilemma for the Bank of England (BoE) intensifies in light of this morning’s May employment figures. UK unemployment has fallen further to 4.5%, versus the BoE forecast at 4.7%. To find a similarly low level you have to go back to the mid-70s, as shown in Chart 1. Moreover, the current level of unemployment is below where the BoE sees the natural level (the level of unemployment below which inflation should rise), all at a time when monetary policy is at emergency levels and inflation is well above the target.

Chart 1: UK unemployment

Source: Bloomberg as at 11 July 2017

And unlike in the US where the participation rate has been coming down, in the UK it has been increasing. Over the last three months the economy has created an impressive 175,000 jobs, taking the overall employment figure to 32m people, 324,000 higher than last year. The employment rate is 74.9%, the highest since comparable records began in 1971.

But employment is not the full story.

Real disposable income for UK consumers continues to be challenged by elevated headline inflation and low earnings. Leaving aside employment, the macroeconomic data has been surprising to the downside (Chart 2). The weak Q1 GDP at 0.2% will likely be followed by only a marginally better Q2 at 0.3%, and below what the BoE was expecting in its inflation report.

Chart 2: UK Economic Surprise Index
Source: Bloomberg as at 11 July 2017

On balance, the BoE has gained back some optionality. The market is now listening to its rhetoric and reacting to the macroeconomic data. In a speech on 20 June, MPC member Haldane complained about market complacency – but the market is no longer pricing the first rate hike in 2020 (a full hike is now priced for May 2018) so expectations appear to be much more reasonable.

I do believe that a removal of some of the emergency measures adopted in August 2016 is becoming more likely. But in the near term I don’t expect this to be a rate hike as the conditions set by the central bank are unlikely to be met. The economy remains weak and I am not hopeful that investment and exports will be strong enough to compensate for the weakness in consumption, while the chances of a smooth negotiation of Brexit are very slim. Instead, the BoE will leave the door open to a rate hike, but focus its efforts on the unwind of macro prudential measures, such as the countercyclical buffer and Term Funding Scheme.

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Monetary policy: Soft or hard approach – not just a political dilemma

As the anniversary approaches of the Brexit referendum it is not just political life that has been buffeted by the referendum’s fallout. Yesterday, Bank of England MPC member Andy Haldane said he would most likely be voting for higher rates later this year. This was a day after his boss, Mark Carney, indicated that rates shouldn’t go up. This is the central banker’s equivalent of the different approaches to Brexit voiced by Philip Hammond and Theresa May.

Wind back to the policy response after last year’s referendum. BoE action was fast and furious as rates were cut by 25bps and a further round of gilt and corporate quantitative easing was announced. For some this response was an outcome of the pessimistic expectations for the economy from the ‘Project Fear’ playbook and was ahead of events. However, the solid growth of the last year is starting to lose energy. Weak-currency-induced inflation and continued high debt levels are playing havoc to consumers’ real spending power. Wage inflation is failing to keep pace with inflation, keeping pressure on both consumers and politicians.

So what is the difference between Haldane and Carney? To be fair, Haldane refers to “partial withdrawal of the additional” policy measures from last summer – i.e. rates can go back to where they were prior to last year’s vote, back to 0.5%. But the current environment of decreasing consumer spending power and the uncertainty over the Brexit negotiations are not a great backdrop for rate rises – Carney’s point. Furthermore, the election has thrown a “dust cloud of uncertainty”, to borrow from Haldane. The politics of austerity are in the spotlight too, with dwindling Tory enthusiasm for it along with the fallout from the Grenfell Tower tragedy. Despite likely looser fiscal policy it also feels more likely that a soft rather than hard approach to monetary policy is on the cards.

“How’s that reflation stuff working out for ya?”

In the pantheon of American leaders, Sarah Palin does not obviously spring to mind.  Nonetheless she did have a good barb at then President Obama in the early stages of his administration when the economy wasn’t going so well when she asked a tea party convention in Nashville (aren’t you sorry you missed that?): “How’s that hopey, changey thing working out for ya?”

From a government bond market perspective, reflation is everywhere but in the price.

A few charts illustrate the buoyant state of economic confidence.

Source: JP Morgan as at 30 April 2017

Global business confidence is not only high, it is coordinated with all of the major developed markets performing well.

This is mirrored in consumer confidence with a particularly marked rise in emerging markets – note the equity performance of luxury goods manufacturers such as Richemont and LVMH for a cross-check on this.


Source: JP Morgan as at 30 April 2017

In this world, one would expect higher government bond yields, steeper yield curves and higher breakeven rates of inflation.  Now admittedly if we take mid-2016 as a starting point all of these conditions are fulfilled.  However, recent government bond price action suggests at least a pause in the “reflation stuff”.

The Federal Reserve started the current rate rise cycle on December 16, 2015.  On that day the 10yr US bond yield traded at 2.29%.  There have been two further increases in rates since then and more are expected.  The current 10yr US bond yield is 2.29% (spooky, no?)

A flattening of the yield curve tends to be a late cycle phenomenon.  The gap between the yield on US 2yr notes and US 10yr bonds is around 102bps.   This spread is close to the flattest it has been since the financial crisis.  Government bonds are anticipatory assets, they provide signals of expectations for future economic activity.

The breakeven rate of inflation is the gap between the yield on an inflation-protected bond and a nominal bond.  The spread provides an indication of the balance between inflation and deflation fears.  In early 2016 deflation fears dominated and this spread fell to around 1.12%.  This spread did react in mid-2016 in anticipation of a stronger global upswing.  However, this spread peaked just below 2.10% at the beginning of 2017 and the level is now 1.84% – not a massive endorsement of “reflation stuff”.

History Repeating – divergent economic data

History has a habit of repeating itself.  We often hear “it’s different this time” only to find that events at least rhyme if not repeat the past.  A good example is US GDP data: Q1 GDP data has been weaker than expected in the US in each of the last few years and it proved to be so again this year. The latest GDP report showed only 0.7% growth on an annualised basis – which was below the consensus forecast of 1%, even after downward revisions to those expectations in recent weeks.  This was the latest in a series of data “misses” in the US so far this year.

Interestingly these disappointments have occurred as economic data elsewhere has remained robust.  The chart below shows the difference between the economic surprises in the US compared to Europe (how many data releases come in either above or below the “official” consensus).


Source: Bloomberg as at 2 May 2017

So what’s going on?  Is the US now lagging Europe?  The answer is “not necessarily” – it has a lot to do with the level of expectations. The optimism that followed the US election pushed both consumer and business confidence surveys to multi-period highs and left expectations overblown.  The inevitable normalisation in this “soft data”, along with some misses on the hard data side, has driven the surprise indices lower.

In Europe the opposite is true – expectations have been so depressed for so long that the recent uptick in data (from a low base) has been enough to beat the consensus.  This feels like the start of the European economy entering into a new phase where investors will need to be focussed more on upside rather than downside risks.

For the US, it’s not all doom and gloom.  The Fed commented last night that they see the weaker data in Q1 as “transitory” with their growth forecasts still in place.  With expectations having been pared back in recent weeks, maybe the scene is set for the US economy to now surprise on the upside.

Challenging consumption in the US

We should not totally dismiss the weakness in Q1 GDP in the US. Private consumption disappointed – no question about it – while inventories detracted 1% over the quarter. But there were also reasons to celebrate. We saw a healthy increase in investments – and since an improvement in productivity requires capital investments, this is the main route to higher potential growth and a higher neutral rate of interest.

Furthermore, in contrast to the hard data, the soft data has not dipped materially and still points towards 2-2.5% growth, a level of growth that will continue eroding the limited amount of slack that exists in some areas of the economy. More globally, GDP growth ex-US is around 3.5%, a level of activity very much towards the upper-end of the range since the global financial crisis.

Arguably, the most relevant piece of data that we got on Friday (28 April) was the Employment Cost Index, which increased by 0.8% in the quarter (a level not seen since 2007) versus market expectations of 0.6%. This data, along with hiring relative to job openings from the JOLT report (the ratio continued moving lower) and the hiring difficulties across several districts highlighted in the latest Beige Book, point towards a full employment market – and one that could finally see pricing pressures (i.e. wage inflation).

We are likely to continue to see unemployment coming down (currently at 4.5% versus the 4.7% long-run level according to the Fed). The three-month average nonfarm payroll is still above 170k, a number that should naturally come down towards 50-100k as the Fed has been signalling for a while. Some might say this will be countered by a meaningful increase in the participation rate. But I think this is unlikely. The structural reasons that brought it down are not going away – after all, the baby boomers are not getting any younger.

Putting all the above together – healthy employment, better compensation along with elevated confidence – challenges the validity of the weak private consumption figures in last Friday’s Q1 US GDP release.

To reinvest or not to reinvest

Last night the US Federal Reserve debated its $4.5 trillion balance sheet. This discussion has started to gain momentum with the change of politics on Capitol Hill at the end of 2016, and with one of the Fed governors William Dudley already indicating that 2018 may start to see a reduction of the Fed’s balance sheet.

Despite the end of Quantitative Easing being in sight QE “continues” here in the UK as well as in the US through the reinvestment of maturing bonds which has the effect of maintaining a static nominal balance sheet. That doesn’t hit the headlines as this is regarded as the small print and quietly forgotten – but it is material and going forward is up for grabs.

So for example, in 2018 the Bank of England will continue QE to the tune of £18bn as it reinvests maturing bonds. Policymakers to date have chosen to reinvest redeeming bonds in order to keep their nominal balance sheets constant – in the UK’s case £435bn of Gilts and in the US a total of $4.5 trillion.  For the UK there is no plan or policy to reduce the amount of bonds held by the Bank Of England, but the Federal Reserve has pushed it up its agenda.

Previously, US Federal Reserve Chair Janet Yellen had suggested it was a secondary consideration, but with rates anticipated to be up another 0.5% by year-end, it seems like reducing the Fed’s balance sheet will become part of the policy mix. We see this as being a material part of likely policy and market debates over the coming months. Previously the bond markets had anticipated that the Federal Reserve would start reducing its balance sheet when short rates (Fed funds) were around 2%. It is likely that as short rates are pushed up we will also see the cessation of reinvestments. Being a reversal of QE is implicitly monetary tightening and may well help elongate the gentle rate cycle we currently see. It may also be part of the Fed’s desire to provide a natural counter balance to a more expansionary fiscal policy from the Trump administration. Either way this suggests the Fed continues to believe the US economy is gaining strength.

Pointing to healthy levels of economic growth

The March survey PMIs (Purchasing Managers’ Index) continue to point towards healthy levels of economic growth. Encouragingly, the pick-up in activity is very broad-based across developed and emerging market economies.

In GDP terms the current level is associated with a global real GDP above 4% (global nominal GDP above 6%). This level of output compares positively versus recent years.

Below we provide a summary of the Global Manufacturing PMIs.


Source: Bloomberg as at 9 February 2017

In the latest dataset, over 75% of the countries’ PMI indices were above 52, showing a good level of expansion, while just three economies were below 50, a level associated with a contractionary environment. This compares to a year ago when the proportion of countries above 52 was less than 50%.

In the coming months we will find out if this is simply a cyclical improvement or we are finally moving towards a structurally healthier level of global activity.

But for now the story is very encouraging.

French politics – where the mud sticks

In France, the National Front is stronger than ever. The rejection of the elites, the international military tensions (Chinese sea, NATO troops in Romania and in Poland) and the effect of globalisation could lead Marine Le Pen to an important score in the looming French presidential elections.

French politics look awful with a peak of mediocrity into the coming elections with all the “affaires” surrounding the candidates. It created some space for some fresh, out of the box, faces like Emmanuel Macron or Benoît Hamon but also reinforced Marine Le Pen (mud only sticks to moderate candidates).

In a tail risk scenario where Marine Le pen gets elected, OATs could widen 20-25%, using 2011-12 as a template to price Eurozone breakup and redomination risks. On the other hand, if the populist candidate does not win, France would outperform the periphery and the focus would move onto tapering.

For now Spanish sovereign debt is not affected compared to OATs, investors seem to only be focusing on French risks and show a disbelief for the dismantlement of the Eurozone. The fact is that even if Marine Le Pen gets elected, she would have a hard time in the parliament election of June and she would not be able to rule as she wishes.

In a positive election outcome, France would need deep structural reform in order to heal and become once again the co-motor of the Eurozone.

Reforms are much needed but they are challenging to implement given the sociological context of the country. One way would be to do a big package of reform simultaneously in order to diversify the pain that they would engender. As the class struggle culture is really important in France pedagogy would be necessary.

On the latest polls (15/03/17), Marine Le Pen remains ahead of the vote for the first round of the presidential election, with 26.5%, followed by Emmanuel Macron (25.5%) and François Fillon (18.5%).  In the second round, Emmanuel Macron is predicted to beat Marine Le Pen, with 61.5% against 38.5%. The socialist Benoît Hamon declined by 0.5 points, to 13.5%, while Jean-Luc Mélenchon is stable, at 11.5%. 72% of the French people wants to keep the euro as the national currency.

A dovish rate rise

As anticipated by every single economic forecaster, the Federal Reserve raised rates last night.  Their range for interest rates was increased by 25 basis points to 0.75% to 1%.  The 2017 and 2018 median dots were unchanged with two more rate rises anticipated by the end of 2017.  The 2019 dots nudged up an eighth to finish at 3%, with the long term rate (AKA terminal rate or r*) at 3%. Yellen reminded Fed watchers that the 2% inflation target is symmetrical and economic indicators are panning out as the Fed predicted.

Overall, this was a more dovish rate rise than most anticipated which was clear by the 10bps rally in 10 year US Treasuries.  But we have seen this tune being played before last year when Yellen talked about running the economy “hot” in the autumn, then pulled back from that later.  The Fed is trying to manufacture a Goldilocks tightening cycle and will continue to manipulate the markets one way or another to suit their own agenda. That is after all their job.

On the not insignificant issue of the $4.5trn Fed balance sheet it is still deemed tomorrow’s problem and will only start to be reduced once rates have “normalised” (new normalised – sic) a bit further.

Going dotty tonight

At 6pm GMT it is widely anticipated that the Federal Reserve will raise interest rates by 25 basis points.  It would be a huge market surprise if they did not increase rates and an absolute shock if they moved by 50bps.  What matters more is the language around the move. How bullish on the economic outlook the Fed will be and how hawkish on the path for interest rates.  Fed officials’ best estimates of where they expect interest rates to be in the future are covered in their “dot plot.”

Clearly there are differing opinions from the various officials, but the median for the end of 2017 is 1.375%.  I anticipate a general upward movement in the dots, however the median is not expected to shift yet with 6 voting members currently on 1.375% it would currently need 4 of them to move to mathematically increase the median.  2018 and 2019 may well see increases though. The bigger movement upwards in the dots (i.e. rate expectations) are likely to come if Trump follows through on an ambitious expansionary fiscal policy.  Until then I hope you will enjoy joining the dots tonight!

Very low government bond yields seem much more likely than higher yields

We don’t share the common view that government bond yields are heading materially higher. Indeed, very low government bond yields seem much more likely than higher yields.

Data from the National Bureau for Economic Research says that the current 90-month economic expansion from the trough of June 2009 is the third longest since they began measuring such things in 1854. But just because it has been a long cycle, does not mean it must end. And it is worth investigating what actions central banks may have to take to respond to any future downturn.

The US Federal Reserve is still raising rates, but I doubt it will be able to raise Fed funds above 2% without provoking a significant slowdown in the economy (the current rate is 0.75%). So any future easing will have very few interest rate ‘bullets’ to fire and even more ‘unconventional’ monetary easing would be likely. In this context the risk of negative US rates seems higher than the prospect of ‘normalisation’.

That is why we don’t share the common view that government bond yields are increasing significantly. The current 10-year US treasury yield is 2.4%. If the current business cycle runs for another three years it will be the longest expansion ever. The market pricing of the 10-year US treasury yield in three years’ time is around 3%. Unless business cycles have been abolished (and we don’t believe they have) the US will at some point experience an economic downturn. At this point the conventional tools available are likely to be much less than has typically been required in the past.

To read the full article, click here: http://kamescapital.com/facing-up-to-the-next-us-recession.aspx

What’s wrong with the bond market?

The last few months have seen some dramatic changes. Lots of attention has been paid to the Trump team line up; much political capital spent on Britain’s Brexit Bill being pushed through the UK Parliament. Given these events along with upcoming European elections, you would expect the bond market to be experiencing unprecedented volatility. But you would be wrong. Since mid-November the 10-Year US Treasury has traded in a range of 30 basis points – eerily similar to the UK’s 10-year Gilt as well as Germany and Switzerland’s benchmark issues. Likewise, the ‘term structure’ of yield curves for 30-year bonds compared to five or 10-year bonds for all these major markets are not dramatically different.

Also cross market valuations are not distinctly different over the last three months. European markets (Germany, UK and Switzerland) have become a little more expensive compared to US treasuries.

So what are the bond markets telling us? They are reminding us that they are forward looking and efficient. With 10-year US treasuries priced at 2.45% and 10-year Gilts at 1.3% all the action was in the previous three months. That action was driven by Brexit and Trump – with neither event anticipated by markets.

Thus, bond markets rapidly assessed a material change in outlook; Gilts almost trebled in yield from mid-August to November with a logical and unemotional assessment of higher inflation and further political challenges for the UK. Likewise, for the US, expectations of Trump shaking the political tree in Washington were rapidly priced in the days after his election. For Europe a similar story, Bunds were unchanged over this period but political stress signals are starting to be priced into the valuation of French and Italian bonds.

So what are the bond markets missing? Not much bar the politics – witness the underperformance in French bonds. Expect volatility if populism really does become a European phenomenon; Wilders in The Netherlands and Le Pen in France are still regarded as unlikely winners by markets but swathes of people voting for them can readily change that.

But the central case is that Europe rattles on with the European Central Bank in the driving seat. Slightly higher inflation and moderate growth across the EU, Switzerland and US are what the bond markets are currently expecting. However, a political shock from Europe has the capacity to shake the bond market from its current complacency.

A million miles apart

The scores were in today for Europe’s 2016 GDP. A mildly disappointing 0.4% growth in last quarter took the full year’s growth in 2016 to 1.7%. Not bad but short of the achievements in the US and UK where growth measured more than 2% for 2016.

Digging deeper and an odd fact occurs – at the bottom of the European growth pile for Q4 2016 – Greece and Finland. Growth contracted by 0.4% in Greece and 0.5% in Finland. Whilst both economies contracted, all eyes are on Greece, again. Deterioration in Finland’s finances are not the stuff of market volatility. Fundamentally there is trust in Finland to honour its liabilities. This is encapsulated by Finland’s 10 year bond yield of 55bps – a mere 20bps higher than Germany’s – impressive for a country with one fifteenth of the population.

Whilst Greek debt to GDP has barely increased from c. 175% over the last 5 years we are about to enter the fourth round of negotiations over Greece’s debt burden since 2010. For Finland that debt has increased by over 50% over the same time period to 63%, but ranking number 50 in the world’s most indebted countries (measured by debt/GDP) it isn’t the stuff of default nightmares. However, for the IMF, the EU and ECB (the “troika”) Greece’s position continues to be systemically problematic.

Finland is rated AA+ and Greece is CCC (technically having not defaulted in 2011). Greek 10 year debt at 7.3% yield is 6.75% more than Finland. The ECB currently supports Finland’s debt through its QE purchase programme, keeping Finnish yields low. The ECB judges it has already used its QE pro-rata firepower for Greek debt back in 2011 with previous programmes of Greek support.

There are two age-old debt market facts. Number 1) Borrowers who are committed to repaying can access funds at the cheapest terms. Finland. Those who aren’t committed, struggle. Greece. Number 2) If your debt is big enough it’s the lenders problem not yours i.e. the EU which owns around two thirds of Greek debt. 2017 represents another stab for the EU in an attempt to deal with Greece’s debt and a recalcitrant Greek government.  There may only 1,500 miles between Athens and Helsinki but they are still a million miles apart.