Late last night some news came out that some economic statistics for China had been miscalculated. Before I get onto the how and why of that particular event it is plain that this news has unsettled equity markets this morning. The Shanghai Composite Index has fallen today by some 4.27% to 2427 and this is now quite a significant drop from the heady heights of early April when it looked as if it might challenge 3200. Other Asian equity markets also fell and European markets have joined in with the German Dax having fallen some 2% as I type and the UK FTSE 100 dropping below 5000. Personally I find the FTSE’s behaviour interesting in that it looked like we were rallying from the recent lows and trying to go higher and now we find it back where it started the rally, as in below 5000. I know that it has been distorted by the performance of BP and that the “FTSE 99” would presumably have put in a superior performance but I find this “stealth fall” intriguing.
Government bond markets
One corollary of concerns over economic performance has been the recent price and yield moves in some government bond markets. I have mentioned the way that the German government bond market has rallied in the articles I have written on the peripheral struggling government bond markets such as Greece. When one looks at one of the measures for government bonds within the euro zone it has since it began been common to use the German bund or government bond as a benchmark. One factor in the problems for Greece, Spain,Portugal, and Ireland on this measure has been that German yields have fallen. In other words even if Spanish yields to use a specific example had remained where they were the spread would have widened. Last night German ten-year bonds closed with a yield of 2.58% and for comparison I have looked up what they were some 3 months ago (i.e before this phase of the crisis) and they were 3.14%. At such levels this is quite a move and provokes two thoughts.
1. If one raises ones nose from the grindstone and thinks ahead for ten years to the maturity of the bond what does such a yield imply?
2. It provokes me to wonder about the timeframe for investing in a government bond currently.
The answer to the question I pose does disturb me a little. If you were someone holding a German bund to maturity you must have quite an apocalyptic view on likely economic events over the next ten years if you are willing to accept a return of 2.58% a year. You must for example think that economic growth prospects are poor at best and may well think that they are dreadful. You must be quite optimistic on inflation as even an inflation level of 1% per annum would reduce your real return quite substantially. In essence anybody who is holding such instruments for the longer term must to my mind believe that the European (and probably the world) economy is going to return to recession in what has become called the “double-dip”. Not many publically espouse such views although the UK fund manager Hugh Hendry is an example of someone who does and if you see him being interviewed it is often worth watching as you do not have to agree with him to find him logical in his thoughts and often quite entertaining.
If we move now to the shorter-term I thought that it might be possible to construct a more optimistic scenario but as I analyse it someone who purchases a German bund at this time must be ridden with fear and uncertainty to invest in such an instrument at this time. At some point of course a foreign investor could conclude that the fall in the Euro as a currency has gone far enough and anticipate gains from this but otherwise one is left with the “flight to quality argument” and fear.
There is another type of investor who may buy a bund yielding 2.58% to make a profit from someone willing to buy it at a lower yield level. I will leave readers to construct their own economic scenario of why the new buyer may be willing to do this as we are now moving into a more apocalyptic situation…
Other Government Bond Markets
The worlds biggest government bond market that of the United States has experienced a similar situation. In some respects it is even more surprising and extreme than the German one. After all this is the same United States with its enormous fiscal deficits and a President who has recently been espousing the virtues of fiscal expansion implying a higher future path for deficits. The same United States where many of the individual states are in financial trouble. Yet the ten-year US Treasury Bond yield has dropped from 3.87% 3 months ago to 3.05% last night. I have a friend who is a technical analyst (chartist) who predicted this move some six weeks ago and I say this for two reasons, one is a hat tip to him the other is that it shows that sometimes analysing a market on its own merits can be swamped in the short-term by events elsewhere. There has been a type of financial tsunami where money has flowed into government bond markets on a vast scale which has made them go to what I believe are yields levels which are only sensible if you feel that the world will “double-dip”.
My own country the UK has seen a similar and in many respects even more surprising move. The reason for it being more surprising is that we have shown ourselves to be prone to inflation even after a year where our economic output has fallen by 5%. So our likely “inflation path” appears to be higher than that of our peers and competitors. So any nominal yield from a UK gilt or government bond is likely to find inflation reducing the real yield. Indeed currently there is not a conventional gilt which provides sufficient yield to cover the rate of inflation as measured by the Retail Prices Index. Many shorter-term gilts yield very little for example we have one which expires in January 2015 which currently has a redemption yield of 2.1%, which compared to likely UK inflation feels very low to me. Returning to ten-year yields and comparing them with 3 months ago gives a move for the UK from a yield of 3.98% to 3.37%. Of the moves I have described today I find this the most extraordinary of all.
If you take the view that government bond investors are logical then the three government bond markets I have discussed above give us a very disturbing view for world economic prospects. The way I see it they as a collective group must either now be very concerned about a “double-dip” or have such great fears about other markets so they have fled to perceived safety. Otherwise why would a logical investor trade at such yield levels?
There is some hope in my view that this whole move has been something of a bubble. In itself this is concerning as it is hardly reassuring that a hopeful view is that investors are misguided! However markets may well have “overshot” in the type of fashion that Rudiger Dornbusch introduced to economic theory back in 1976. An example of this was the dot-com boom earlier this century when in a trading market which showed signs of being a frenzy prices for some shares rose to ridiculous levels before a bust. There is a share about to be issued in the UK that delivers groceries to many of my neighbours that appears to suffer from many familiar characteristics so perhaps we are back in such an environment.
One side effect of these moves has been the change in the relationship between the UK and the Spanish government bond markets. Three months ago if we compare ten-year government bond yields Spain’s were 0.16% below the UK’s last night they closed 1.18% higher. You would think it was Spain with inflation way above target. If you think as to why the UK might be better off you might feel that it is because she has her own exchange rate but she had that 3 months ago. Regular readers will know that I have written several article on Spain’s economic problems but the UK has her own not so dissimilar ones.
D-Day for the European Central Bank
Tomorrow is a big day for the European Central Bank as it is the last day for one of its extraordinary measures. These were introduced as a response to the financial crisis and in general were ways of supplying liquidity to the markets. I have discussed them many times in my section on the euro zone crisis. Tomorrow’s event matters because of its size. You see this Long-Term Refinancing Operation (LTRO) found itself with 442 billion Euros and as it is the last day all of it needs a new home.
There were in essence two reasons to do this if you were a bank.
1. You needed liquidity and this group was probably mostly consisted of weaker banks who needed cash.
2. You were taking part in the euro zone “carry trade”. In other words you took funds from the ECB and using the cheap money you were given you immediately invested it in higher yielding government bonds, for example in Greece. So this represented stronger banks (or at least they were stronger until the carry trade hit trouble).
What has changed?
Due to events the carry trade group is now likely to be small to non-existent. In simple terms it went bust. There is of course an irony in this as it is on yield terms alone it is much more attractive now than it was then but of course the view in terms of the perceived risk has changed (we are back to my discussion on government bonds above I think….). However the first group is likely to be larger this time as more banks are in trouble and the use of the ECB’s deposit facility has been rising.
Where can they go?
The ECB has a 3 month LTRO for banks to go into should they choose. There is a fair bit of debate as to how many will do so. The catch with the 3 month LTRO is that the interest rate on it of 1% is much higher than that available in the markets. So here is the rub. Taking it up on a large-scale implies that you cannot get cheaper money elsewhere. In other words it would be a signal that banks are refusing still to trade in interbank markets with those who they consider to be weak. So the size of take-up of this LTRO will be watched like a hawk by markets.
Also the interest rate for interbank markets or Euribor will be watched like a hawk for developments.
Just in case they read this If I was the ECB I would be flooding the markets with cash tomorrow and the day after to ease any transition problems. Also so much for your planned exit strategy.
Chinese Economic Statistics
I have written very little about China’s economy in this blog because as regular readers know it is my philosophy to be cautious about economic statistics. I am particularly cautious about those that have been emanating from China. I notice on this front that the Conference Board has revised its index for measuring leading indicators in the Chinese economy for April from +1.7% to +0.3% for April. I believe that this is a factor in today’s equity market falls. Trust is a tenuous concept but if you lose it then it is hard to regain.
Just a thought
I have pointed out before that I am a fan of the Yes Minister and Yes Prime Minister books and TV series which have proved somewhat prescient. Accordingly the expulsion of some spies by the United States makes me smile as according to these writings you take such actions to hide some other unpleasant news. If anybody has some thoughts as to what the unpleasant news is please let me know.
Todays falls in equity markets have led to further bond market rallies such that the yield on the ten-year US Treasury Note has fallen below 3% to 2.9867%. This is for those who follow such events quite a significant move.