Market reversal, initially triggered by some disappointment on the Euribor fixing

A typical Tuesday reversal, initially triggered by some disappointment on the Euribor fixing which sadly seems to be the only thing that really matters in rates space those days and followed through with some solid economic number from the US. Some ECB members, Nowotny and Coeure, following their mid-month meeting, have also dampened expectations of an interest rate cut in October, as fresh speculations about the effectiveness of the ECB’s new bond buying program are emerging : German tabloid Bild reported that in-house lawyers at the ECB and the Bundesbank were checking both what proportions and duration the program could reach before it might breach EU treaties. Bild said the central banks were preparing for the possibility of the issue being referred to the European Court of Justice. The newspaper did not reveal its sources and neither central bank was willing to comment on the report. This report came a day after David Marsh, chairman and co-founder of the Official Monetary and Financial Institutions Forum (OMFIF), speculated that the Bundesbank might use Article 10 of the ECB’s statutes to limit any bond buys under the OMT once it becomes operational. “Article 10 of the ECB’s statutes says that the one-man-one-vote method should not apply to ECB decisions affecting its capital, transfer of national central banks’ foreign assets, allocations of monetary income and net profits and losses,” Marsh wrote. “If the OMT does indeed get going, the Bundesbank may have some legal tricks up its sleeve to limit its implementation.” There is still nothing like a good Euro area mish mash…

Temasek reconsiders STAN stake (IPOs and Deals)

Temasek has sounded out potential buyers for its £6bn stake in STAN, potentially reigniting talk of a takeover of the EMs bank. It had been judging buyer interest for its 18% shareholding in recent months. Bankers said earlier momentum for a sale fell last month as STAN’s shares dropped 20% on the day it was accused by a US regulator of breaching US sanctions on Iran. After settling the dispute with a $340m payment, the bank’s share price has rebounded. Temasek became STAN’s biggest single shareholder six years ago, buying out the 11.5% stake of the Khoo family for a small undisclosed discount to its then market value of £2.3bn. The family had been the bank’s protector since the 1980s, when it had become the subject of an unwelcome bid from Lloyds Bank. STAN is one of the few globally active banks to be largely unscathed by GFC. It has attracted interest from the likes of JPM and Santander, according to bankers. Although private discussions have taken place, nothing has come of them, largely because STAN’s robust valuation – its market capitalization is £35bn – would make it hard to swallow.

STAN trades at a 1.4X BV at a time when many rivals, particularly in Europe, trade on less than half that. Analysts said Temasek might be keen to take advantage of the relative strength and reduce its exposure to financial services, given the economic uncertainty. Bankers believe any ambition Temasek might have had to engineer a merger between STAN and another of its investments, DBS, has faded, given the complexities and regulatory hostility to big banking mergers. Temasek has hired two western bankers – Greg Curl from BAML and John Cryan, former FD of UBS – to help oversee its stakes in businesses in the US and Europe. People close to the situation stressed that there were no live discussions with any potential buyer. Temasek signaled a move away from its STAN stake a year ago when it issued an innovative CB that would convert into STAN shares under some circumstances. The three-year bond, which raised more than $600m, would potentially shave nearly 1 percentage point off the fund’s total stake if the bank’s shares rise beyond the prerequisite 27% premium to the then share price of £14.29. The shares closed on Monday at £14.81. After the row over sanctions, the bank promised a shake-up of its board, which was criticized by shareholders earlier in the year. Temasek withheld support for the re-election of EDs except CEO Peter Sands and two non-executives.

Greed & Fear Comments on Fed

• The Fed’s action probably tilts the presidential polls further in favour of the incumbent by making it less likely that the stock market collapses in the run up to November. Remember a weak dollar is good for the S&P500. 

• Fed buying of US$40bn of mortgage-backed securities a month means it will take about three years for the Fed to achieve a similar scale of Fed balance sheet expansion as was added in QE1. Still when Operation Twist ends as scheduled on 31 December, it is not beyond the bounds of possibility that Bernanke opts to resume outright purchases of Treasury bonds again.

•  The aggressive Fed easing clearly has potential negative inflationary social consequences for Asia, because it raises the risk of a renewed surge in food prices as well as a new surge of asset inflation.

• Sep. 04’s mortgage tightening action in Hong Kong is a reminder that gold is now a far better hedge against Western monetary expansion than Asian physical property. In Asia prudential policymakers are trying their best to prevent asset bubbles, while the Fed seems increasingly desperate to re-create one.

• Investors should continue to watch Spanish bond yields as the most likely signal for renewed Eurozone tremors. The Eurozone’s growth prospects will not have been helped by the recent rally in the euro courtesy of Ben Bernanke. The relative ugly contest between the US dollar and the euro has now become a nightmare to call.

• The improvement in the sovereign credit has been reflected in a spectacular collapse in both US dollar and peso sovereign bond yields in recent years. The dramatic decline in bond yields is putting pressure on the local asset management and pension fund industries to shift more into equities.

US Housing Recovery Continues, while manufacturing is down..

US housing market sees the general recovery trend continue. The National Association of Home Builders (NAHB) market index hits its highest level in September (40) since June 2006. August housing starts headline comes out softer than the market expected at 750,000 against a downwardly-revised 733,000 in July. August building permits dips to 803,000 from a four-year-high of 811,000 in July. Given the monthly volatility in the building permits and housing starts data, these are small moves and have not changed the story of a general upward trend in the housing market.

September’s regional manufacturing surveys add more evidences that the US manufacturing remains soft. September's Philadelphia Fed survey headline figure improved to -1.9 against the prior month’s -7.0. Following the weaker-than-expected Empire manufacturing PMI earlier this week, this latest survey raises the risk that momentum in the industry has not yet picked up. The market focus will shift to the Chicago regional manufacturing PMI survey next Friday, which correlates more closely with the national ISM manufacturing PMI than other regional surveys.

The key data this week is the August personal spending that will be fed into the Q3 GDP. The personal spending in nominal terms is likely to have grown last month, backed by strong retail sales and a spike in gasoline prices. The personal income in August is expected to be soft given the flat monthly growth of national hourly earnings released in the prior non-farm payrolls survey report.

The recovery in housing market is still on track, reflected by data outputs in last couple of months.  The manufacturing sector has been on the soft side. Durable goods orders are likely to have fallen in August, after a 4.1% gain in July given soft ISM manufacturing new orders.  Also, the sharp contraction in non-defensive aircraft orders in August will add some downside risk to the headline index.

The Chicago PMI is likely to captures more market attention than other regional PMI surveys as it has relatively high correlation with the national headline release. Its new order sector picked up to 54.8 from 52.9 in August, yet this is softer than the 17-month high of 69.2 seen in February.

2012/09/21

post-QE3 Speculation

QE3 Briefing
The Federal Reserve launched its mini-QE with an expiry date conditional on a labour-market improvement. This conditional expiry date is a major change from the previous QE announcements. This is a clear sign that the FOMC is comfortable with the inflation risks posed by its action and is frustrated with the slow decline in the jobless rate. The Fed will buy USD40bn of mortgage-backed securities (MBS) in addition to the USD45bn worth of US Treasuries (USTs) being bought under Operation Twist every month between now and the year-end. The lack of a specific expiry date is a dovish departure from the previous rounds of QE in our view.

The near-term impact on (Emerging Market) equity is expected to come from (1) increased fund flows and (2) reduced risk premia. Over the longer term, the probable reduction in US mortgage rates will potentially help the housing-sector recovery and consumption of imported goods.  

Portfolio flows to favour equities
According to SCB FX team‟s latest forecast, the implied value of the DXY is 81.35 by year-end, compared to 79.4 currently.  This implies portfolio inflows of USD7bn in 4Q12 and full-year inflows of USD26bn. While solid, this is lower than the USD76bn and USD88bn witnessed in 2009 and 2010, respectively, reflecting lower DXY values in prior periods of QE. In our view, the impact of these inflows will be a reflation of asset values, focussed on equity markets, underpinned by 3 factors: 
(1) policy makers are already making pre-emptive moves to control property values: the Hong Kong Monetary Authority (HKMA) lowered the loan-to-value ratio for second mortgages to 30% on 14 September; 
(2) valuations are near cyclical lows for equities, in stark contrast to stretched housing affordability ratios across key cities in Asia; 
(3) relative to bonds, Asian equities are priced at attractive levels in most markets in the region.

Moderate reduction in equity risk expected
On earnings risk premium (ERP), previous rounds of QE and LTRO have led to improvements in risk appetite. The most notable changed occurred after the Fed expanded QE1 in March 2009 by announcing the purchase of an additional USD750bn of MBS and up to USD300bn of long-term Treasury securities. The greatest impact of this was felt in China, Korea, Thailand and Indonesia, where ERP fell by approximately 3.5ppt over the period. However, it is arguably difficult to distinguish the effects of China‟s large infrastructure stimulus programme from those of QE1. Under QE2, the impact on ERP was between 0.5-1.2ppt across Asia. ERP bottomed out soon after QE2 ended in June 2011, increasing sharply in August 2011 as markets began to worry about the spread of the Euro-zone crisis. At the depth of the crisis, the ECB announced the LTRO financing facility, causing ERP in the region to drop by 0.2-1.0ppt. We expect the impact of QE3 on risk premia in AxJ to be closer to QE2 and LTRO given the absence of large-scale fiscal stimulus in the region. Financial markets have also been anticipating QE3 for a number of months, and ERP had already trended down by 0.2-0.6ppt across the region between the start of 3Q 2012 and the announcement date. 

 

Equity-market impact
While the bullish knee-jerk response to QE3 has faded, we believe equity markets have yet to fully discount the effects of the programme. Reduced tail risk in peripheral Europe, underwritten by the ECB‟s OMT, is also an important step towards providing a floor to investor confidence. However, we are observing that investors are showing greater cynicism and hesitance to embrace risk given the high frequency of central bank actions. We recommend that investors move up the beta curve but focus on quality and valuation rather than on high cyclicality alone.

Under QE3, the Fed will make monthly purchases of USD40bn from the MBS markets for a period of time that is conditional on an improvement in the labour market. While the Fed did not quantify the degree of improvement required, most believe the programme is likely to remain in place well into 2013. This suggests that the fund flow impact on equity markets would be supported in the medium term. While we agree that the impact of QE will be nowhere as large as that experienced in 2009 (when China‟s Rmb4tn stimulus package also provided support), the backdrop of improving earnings outlook (based on our ERI analysis), the rising pipeline of investments in Asia and the liquidity spill over from DM will be positive for EM equities.

Emerging market is expected to outperform developed market in the near term as investors move up the beta curve.  Inflation is a risk to Asia in the medium term, but regional inflation averages 3.8% today, versus 5.3% at the start of QE2. The weak state of global business today relative to late 2010 also suggests that it is too early to worry about inflation.

From a market perspective, Korea, Taiwan and Hong Kong have tended to see the strongest average performance in the three months following large-scale central bank liquidity injections. We believe this is partly because of their higher cyclical sector weightings compared to regional peers (76%, 76% and 59%, respectively). For the purpose of this analysis, we have included domestic cyclical – from consumer discretionary and real estate – sectors, along with our usual cyclical definition, which captures the industrials, materials and IT sectors.

Same markets may be favoured in near term, although higher valuations in Korea and Taiwan suggest that their gains may be short-lived, especially given the lack of any immediately apparent fundamental impact on corporate profitability. Beyond the near-term euphoria surrounding QE3, we believe investors will quickly refocus on Asia‟s economic recovery, which is likely to be led by China and India given the two countries‟ domestic drivers of investment plans and economic reforms. (Korea and Taiwan are likely to be second-order beneficiaries as suppliers to China in the tech and auto supply chain.)

Observable drivers for cyclical sectors

Asia's Inflation Summary of post-QE macro conditions    

 

SCB's View on QE and the Asian markets

QE3 is likely to increase fund inflows and reduce equity risk premia in Asia. Potential improvement in the US economy in 2012 could help offset equity investors' concerns over the short-term headwinds faced by Asian economies. Korea, Taiwan and Hong Kong were beneficiaries of the previous episodes of QE. Nevertheless, investors may refocus on China and India, given the former's larger valuation discount and the latter's sensitivity to foreign flows.

The Island Dispute between the Chinese and Japan, and the Implication on what Stocks to Buy

In recent months, an escalating island dispute over territorial sovereignty between China and Japan is getting more serious..   Japan had taken over the island from China for more than 100 years, and would not to let go that easily. With the USA stands behind, the situation would get even more complex...

Today, we are not judging the right and wrong from a history perspective.  We are not analyzing how this situation is developing either.

BUT, one thing can be sure!    China will SPEND MORE on its MILITARY BUDGET to build its military power for sure!

The following few exclusive stocks that have to do with China's defense are:

AirForce-related Stocks

中航科工（2357) AviChina Industry and Tech

AviChina Industry & Technology Company Limited is engaged in the aviation industry. Through its subsidiaries, the Company is engaged in the development, manufacture, sales and upgrade of aviation products, such as helicopters, trainers, general purpose aircraft and regional jets, and co-development and manufacture of helicopters with foreign helicopter manufacturers. Its aviation products include the Z-8, Z-9, Z-11 and HC-I20 series helicopters; K-8 series and CJ-6 trainers; Y-12 series multi-purpose aeroplanes and the N-5 series agricultural aeroplanes; EC-120 helicopters; CA109 helicopters; ERJ-145 series regional jets; aviation parts and components, and aviation electrical engineering products and accessories. It also engaged in the automobile engine business, which was disposed in March 2011.

中国航天万源 1185  China Energine International 

China Energine International (Holdings) Limited is an investment holding company. It operates in five segments. The Wind Energy Related Products segment manufactures and sales wind energy-related products. Operation of Wind Farm sells electricity from operation of wind farm. REPM Products manufactures and distributes elevator motors. Trading of Materials is engaged in trading of chemical materials. Telecommunication Business develops, manufactures and distributes communication products, information technology services ( ITS), broadband systems, equipment and accessories. In May 2010, it acquired 40% equity interests in Beijing CASC Energine Wind Turbine Co. Ltd., formerly Beijing EWTCASC Directwind Marketingand Sales Co. Ltd. (Directwind Sales). In June and December 2010, it sold a total of its 22.5% controlling interest in Castel Qihua Ltd. (Castel Qihua). In November 2010, its interest in Wuxi CASC Energine Xindali Electricity Co., Ltd (Wuxi Xindali) was diluted from 62.5% to 41.67%.


中国航空工业国际 0232 AVIC Intl

AVIC International Holding (HK) Limited is an investment holding company. During the year ended December 31, 2010, principal activities of the Company’s subsidiaries consisted of the supply of electric and steam power, and the aero-technology related business. It operates in two segments. The electric and steam power supply segment is engaged in the generation and sale of electric and steam power. The Project EC120 segment is engaged in the share of profit from the development, manufacture and distribution of helicopters. Zhejiang Sealand Thermoelectric Share-Holding Co. (Zhejiang Sealand), which is a non-wholly owned subsidiary of the Company, is principally engaged in the supply of electric and steam power in the Linping industrial region of Hangzhou in China. During 2010, the Company sold a total of 24 EC120 helicopters. On December 23, 2010, the Company disposed of part a of its investment in a jointly controlled entity.

Navy-related Stocks

广船国际(00317) Guangzhou Shipyards Intll

Guangzhou Shipyard International Company Limited is principally engaged in shipbuilding business. The Company operates its businesses through the development and building of handy-size ship products, as well as development and building of roll on/roll off (ro-ro) ships, ro-ro passenger ships and semi-submerged vessels. The Company also involves in businesses of steel structure engineering, electromechanical products and others. The Company operates its businesses in domestic and overseas markets, such as the United States, Denmark, Greece and Netherlands. 

荣盛重工 1101  China Rongsheng Heavy Industries 

China Rongsheng Heavy Industries Group Holdings Limited is an investment holding company. The Company is engaged in the businesses of shipbuilding, marine engine building, offshore engineering and engineering machinery focusing on oil and gas related customers and markets. The Company operates in four segments: shipbuilding, offshore engineering, engineering machinery and marine engine building. It manufactures a variety of vessels for international and domestic customers at its shipyard in Nantong. Its offshore engineering segment involves the manufacturing of development units, production units and offshore support vessels for the offshore oil and gas industry. It operates its marine engine building business through Hefei Rongan Power Machinery Co. Ltd. During the year ended December 31, 2010, it commenced its operations in the engineering machinery segment. Through Zhenyu Machinery, it manufactures 16 varieties of hydraulic excavators and two varieties of hydraulic crawler cranes.
Electric Equipment manufacturers could play a significant role in developing nuclear weapons:

哈尔滨电气 1133 

Harbin Electric Company Limited is an investment holding company. The Company, through its subsidiaries is engaged in manufacturing and selling of various kinds of power equipment and provision of power station engineering services. The Company operates in five segments: main thermal power equipment, which is engaged in manufacture of main thermal power equipment; main hydro power equipment, which is engaged in manufacture of main hydro power equipment; engineering services for power stations, which is engaged in the provision of engineering services for power stations; ancillary equipment for power stations, which is engaged in the manufacture of ancillary equipment for power stations, and alternating current/direct current (AC/DC) motors and others, which is engaged in manufacture of AC/DC motor and others. On July 1, 2011, the Company changed its name to Harbin Electric Company Limited from Harbin Power Equipment Company Limited.
上海电气 2727 , Shanghai Electric Group

Shanghai Electric Group Company Limited is principally engaged in design, manufacture and distribution of electric power and industrial equipment. The Company’s main business is new energy business, including the manufacture and sale of wind turbines and components and nuclear power equipment; efficient and clean energy business, including the manufacture and sale of thermal power equipment and power transmission and distribution equipment; industrial equipment, including the manufacture and sale of elevators and motors; modern service industry, including the contracting of construction projects of thermal power and transmission and distribution projects, as well as other businesses. The Company mainly operates its businesses in domestic and overseas markets. 

东方电气 1072,  Dongfang Electric Corporation Limited

Dongfang Electric Corporation Limited is principally engaged in the manufacture and distribution of energy generation equipment. The Company's main products consist of thermal power generation equipment, including heating steam turbines, air-cooled steam turbines, air-cooled heating steam turbines and air-cooled turbine generators; hydroelectric power generation equipment, including mixed flow generators, axial flow generators, impact generators, and tubular-type turbine generators, as well as wind power generation equipment, nuclear power generation equipment, and gas power generation equipment. The Company is also engaged in related project and services. The Company also involves in the research, manufacture and distribution of flue gas desulfurization and denitrification equipment for power plant boilers. The Company distributes its products to both domestic market and overseas markets. 
中广核资源 CGN Mining 1164

CGN Mining Company Limited, formerly Vital Group Holdings Limited, is an investment holding company. The Company and its subsidiaries are engaged in the selling, distributing and manufacturing of pharmaceutical and food products, and property investment. The Company operates in two segments: pharmaceutical and food segment, which is engaged in the selling, distributing and manufacturing of pharmaceutical and food products, and property investment segment, which is engaged in leasing, developing and selling of office premises and residential properties. The Company's subsidiaries include Ever Power Holding Inc., Gainful Plan Limited, Vital BioTech (Hong Kong) Limited and Yugofoil Holdings Limited. 

Bank of Japan invoked further easing, motivated by a slow down in overseas economy.

Overnight, The Bank of Japan has invoked further monetary easing. It has expanded the size of its fund for asset buying by Y10 tln to Y80 tln (split Y5 tln in JGBs and Y5 tln in Treasury discount bills). The BoJ reported its decision was motivated by a slowdown in the overseas economy. As a consequence of that it downgraded its overall economic assessment. It's rate action was to ensure Japan's economy returned to a sustainable growth path, it said. In Europe, Juncker did not waver from the script with regard to Spain – the conditions imposed on Spain for financial assistance would be 'very tough.' Interestingly, for all the suggestions from Spain that it was in preliminary discussions as to what a hypothetical program might look like, Juncker seemed to suggest that very little had been talked over. On Spain’s subject S&P said it is unlikely to be cut to non-investment grade in the near future. S&P currently have them at BBB+.

All this sort of laid the ground for a Fixed Income rally in Europe but we believe the key driver has again been the deluge of corporate issuance and a very low 3M fixing (-0.6 bps, a drop twice the size of the expectations). BHP Billiton, KfW, Cades, OMV to only name a few have hit the market with several billions in sometimes long dated paper. As most of it has been swapped to floating, duration hedging fuelled the futures rally while ASW were down another 2 bps, which is a result given the sizes involved. In the middle of all this the Schatz auction was pretty much a non event.

Tomorrow European PMIs are published, a modest rebound is expected but only a strong deviation would get the market excited. We do not expect any breach of the last 2 days range on the Bund, the short end will depend on the behavior of the fixings.

QE3 until unemployment comes down? (Forecast vs. Conditionality)

According to Fed, new MBS purchases will be continued, increased or combined with additional easing programs should the labour market fail to improve “substantially”.

But here comes the question:  How much should the labor market improve to be considered as improving 'substantially'?
Anyway, this mini-QE would appear to be marginally below market consensus regarding additional QE, and the extension of exceptionally low rates was broadly expected. What is of most interest about this move is the introduction of 'economic conditionality' to decide when it will end or even be enlarged. This means that we are likely to see continuously accommodative policy as the norm well into 2013 unless there is a sharp improvement in the labour market. We for now assume that “substantial improvement” will be interpreted as below 7% and falling for the official unemployment rate. This program is notably smaller than QE1, when purchases of between USD 95bn and USD 145bn were made, and QE2, which saw purchases of USD 75bn. However, the amount of purchases currently being made in the OT2 program could morph into further MBS or UST purchases should the recovery continue to be lackluster.

FOMC forecasts
The FOMC increased its central tendency forecasts for GDP in 2013 to 2.5-3.0% (2.2-2.8% previously) and for 2014 to 3.0-3.8% (3.0-3.5% prior), while shading the forecast for 2012 to 1.7-2.0% from 1.9-2.4%.  It shows that they are expecting that their policy actions will be positive. There was a tightening of the range in the central tendency for unemployment in 2013 to 7.6-7.9% against 7.5-8.0% and no change in 2012 at 8.0-8.2%. There was more optimism about 2014, which is now expected to average at the bottom of the prior range of 6.7-7.3% against 7.0-7.7%. There was minor tweaking of the core PCE forecasts, but with the most drastic change being the lower bound of 2014 being raised, to 1.8-2.0% from 1.6-2.0%, there is clearly little inflation concern. Unemployment forecasts will become even more important when we know what unemployment level the FOMC is targeting. 

Operation Twist with open-ended mini-QE - 09/14/2012

Key Alerts:

• FOMC launches more QE with an expiry date conditional on labour-market improvement.
• This conditional expiry date is a major change from previous QE announcements Fed combines 

The Federal Reserve has decided to err on the aggressively dovish side, introducing a fresh round of stimulus and threatening more if the situation warrants it. This is a clear sign that the FOMC is comfortable with the inflation risks of its action and is very frustrated with the slow decline in the jobless rate. The post-meeting Statement says that the Fed will buy USD 40bn of Mortgage Backed Securities (MBS) in addition to the USD 45bn worth of US Treasuries (UST) under Operation Twist currently being conducted each month between now and year-end. On its own, this round of quantitative easing (QE3) appears to be a smaller version of QE1 and QE2. However, the new MBS purchases will be continued, increased or combined with additional easing programs should the labour market fail to improve “substantially”. This is a very dovish departure from previous rounds of QE, giving no particular expiry date.

The key is now defining “substantial”. We expect 150,000 additional net monthly hires through end-2012 and 170,000 from 2013. This will mean only slow progress in bringing the unemployment rate down given that the number of new entrants to the job market each month is around 100,000. 

Unemployment currently stands at 8.1%; we look for guidance from the FOMC as to a suitable target, as the FOMC forecasts do not look for 7% to be breached until end-2014. The announcement was accompanied by the extension of the commitment to exceptionally low rates through at least mid-2015. 

Fed unleashed QE3

Highlights:
- Fed unleashed QE3. Fed will buy 40 billion mortgages a month, with no specified end date, and will continue with Operation Twist as is. Forward guidance was extended to “mid 2015”. Inflation concerns were largely marginalized; the clear focus of the Fed is on improvement in employment.
- The reaction in risky assets was traditional QE: equities up 1.5%, gold up 2%, dollar index down 60bp.
- Fixed income reaction was much more mixed. Initially, FI sold of 10bp in 10y yields to a high of 1.825%. Despite the extension of the forward guidance, 2015 Libor forward rates jumped by 14bp. The back end of the yield curve initially flattened. But all this was quickly reversed, and by the end of the day 10y yields are nearly all the way back to pre-FOMC levels, as are the 2015 Libor forwards. 10/30s reversed substantially and goes out over 4bp steeper on the day, back at its highest level since May.
- Bernanke did have the desired impact on mortgages. MBS-UST spreads compressed massively, by over 15bp. Current coupon mortgage yields, the “at the money” secondary market mortgage bond yields, tumbled over 23bp to its lowest ever level, 2.13%. By some measures, the MBS basis is at its tightest level ever.
- 5y5y breakeven inflation gapped higher on the decision. At one point breakevens were 10bp higher with nominal yields unchanged, and at their highest level since Aug of 2011 (when the market was building operation twist expectations ahead of Jackson Hole).
- The swap spread curve flattened massively after the FOMC decision. 5/10s spread switch quickly flattened by 2bp, as the lack of additional UST buying cheapened up USTs versus everything else, and particularly in the long end, where this is little clarity about Fed sponsorship after OT ends.
- Swap spreads tightened to the lowest levels in months. As the front end screamed (reds are up 5bp, now pricing in Libor in Mar 2014 effectively flat to today), 2y spreads compressed to 13.5bp. 5y and 7y spreads held their ground, tightening only marginally if at all, as that sector is clearly the favorite part of the curve to buy given today’s news. 10y and 30y spreads collapsed, with 10y spreads getting to 6.5, its lowest level since March, and 2.5bp tighter on the day. 30y spreads did not tighten as much, as the 30y sector was a favorite whipping boy in both cash and swaps.
- Tenor basis continued to collapse. Today it was 6s3s turn. 5y 6s3s has fallen nearly 2bp in 2-3 days, mostly today. As 6mL has remained sticky while 3mL has rapidly declined, the spot basis has widened sharply of late. The market is now beginning to price a rapid decline in that basis, and thus a rapid decline in 6mL.

Comment:
The highlights above summarize the nature of the day. The Fed definitely pulled out the stops and proved that its recent signaling (minutes, Jackson Hole, media) was not all smoke and mirrors. Ben Bernanke decided to tackle the stagnant job market head on, particularly by targeting market expectations about the duration of low rates and more importantly, mortgage rates. At least on Day 1, he has succeeded, pushing secondary market mortgage rates to their lowest ever yields, with the clear expectation that this should spill over to the primary mortgage rate as well. By choosing to target mortgages specifically, the Fed is doing its best to bypass the stagnant credit channel, and reach consumers as directly as possible. While many in the market felt QE was “priced in” the reaction in various asset classes shows that it clearly was not entirely priced in. Most notably, many mortgage market practitioners were proclaiming that QE was 90-98% priced in, yet this market reacted more violently than any other to the news. The reaction was initially read as a disappointment, as UST yields quickly sold off 10-15bp as some initially regarded the 40 billion per month rate as “not enough.” The 200 day moving average, which in the middle of August served as the braking point for the selloff, once again served that role. Treasury yields came all the way back and actually go out lower on the day 10y years and shorter, with the 5-7y sector being the best performer. In his Q&A, Bernanke was repeated asked to clarify the conditionality that would signal an end to the new round of bond buying, but repeatedly insisted that there is no specific number, and that the Fed will be looking for signs that the economy is strong enough to sustain labor market improvement. Essentially, he suggested that the Fed is keeping the labor market on life support, but does not have the ability to nor does it intend to nurse the market back to health (ie they won’t keep buying until the economy reaches full employment).

The question now is whether this initial reaction will persist, or begin to quickly fade away as it did after QE1, QE2 and Operation Twist. Given the new guidance, the search for yield will continue to move further out the curve, and we will likely see the 7y sector remain rich. Further, buy buying mortgages the Fed will be taking out duration from the market that resides in the “sweet spot” of the curve, with regards to carry and rolldown, and this will push investors further out the risk curve. This will be supportive of narrower swap spreads, which we saw today. Position wise, we will keep things pretty neutral for now, until the market shows a trend. Carry trades may be the best performer for the near term. In spreads, we are neutral now.

George Soros: Why Germany should lead or leave

Europe has been in a financial crisis since 2007. When the bankruptcy of Lehman Brothers endangered the credit of financial institutions, private credit was replaced by the credit of the state, revealing an unrecognised flaw in the euro. 

By transferring their right to print money to the European Central Bank (ECB), member countries exposed themselves to the risk of default. Commercial banks loaded with weaker countries' government bonds became potentially insolvent.

There is a parallel between the ongoing euro zone crisis and the international banking crisis of 1982. Back then, the International Monetary Fund (IMF) saved the global banking system by lending just enough money to heavily indebted countries; default was avoided, but at the cost of a lasting depression.

Germany is playing the same role today as the IMF did then. The setting differs, but the effect is the same. Creditors are shifting the entire burden of adjustment on to the debtor countries and avoiding responsibility.

EUROPE DIVIDED

The euro zone crisis is a complex mixture of banking and sovereign-debt problems, as well as divergences in economic performance that have given rise to balance-of-payments imbalances within the euro zone. 

The authorities did not understand the complexity of the crisis, let alone see a solution. So they tried to buy time. Usually, that works. But not this time, because the financial problems were combined with a process of political disintegration.

When the European Union (EU) was created, it was the embodiment of an open society - a voluntary association of equal states that surrendered part of their sovereignty for the common good. The euro zone crisis is now turning the EU into something fundamentally different, dividing member countries into two classes - creditors and debtors - with the creditors in charge.

As the strongest creditor country, Germany has emerged as the hegemon. Debtor countries pay substantial risk premiums for financing their government debt.

To make matters worse, the Bundesbank remains committed to an outmoded monetary doctrine rooted in Germany's traumatic experience with inflation. As a result, it recognises only inflation as a threat to stability, and ignores deflation, which is the real threat today.

There is a real danger that a two-tier Europe will become permanent. Both human and financial resources will be attracted to the centre, leaving the periphery permanently depressed. But the periphery is seething with discontent.

Europe's tragedy is not the result of an evil plot, but stems, rather, from a lack of coherent policies. Germany, as the largest creditor country, is in charge, but refuses to take on additional liabilities; as a result, every opportunity to resolve the crisis has been missed

The crisis spread from Greece to other deficit countries, eventually calling into question the euro's very survival. Since a break-up of the euro would cause immense damage, Germany always does the minimum necessary to hold it together.

Most recently, Chancellor Angela Merkel has backed ECB President Mario Draghi, leaving Bundesbank President Jens Weidmann isolated. This will enable the ECB to put a lid on the borrowing costs of countries that submit to an austerity programme under the supervision of the Troika (the IMF, the ECB and the European Commission).

That will save the euro, but it is also a step toward the permanent division of Europe into debtors and creditors.

The debtors are bound to reject a two-tier Europe sooner or later. If the euro breaks up in disarray, the common market and the EU will be destroyed. The later the break-up, the worse the ultimate outcome. So it is time to consider alternatives that until recently would have been inconceivable. 

AVERT DEPRESSION

In my judgment, the best course of action is to persuade Germany to choose between either leading the creation of a political union with genuine burden-sharing, or leaving the euro.

Since all of the accumulated debt is denominated in euros, it makes all the difference who remains in charge of the monetary union. If Germany left, the euro would depreciate.

Debtor countries would regain their competitiveness; their debt would diminish in real terms; and, with the ECB under their control, the threat of default would disappear and their borrowing costs would fall to levels comparable to that in the United Kingdom.

The creditor countries, by contrast, would incur losses on their claims and investments denominated in euros and encounter stiffer competition at home from other euro zone members. The extent of creditor countries' losses would depend on the extent of the depreciation, giving them an interest in keeping the depreciation within bounds.

After initial dislocations, the eventual outcome would fulfil John Maynard Keynes' dream of an international currency system in which both creditors and debtors share responsibility for maintaining stability. And Europe would avert the looming depression. 

The same result could be achieved, with less cost to Germany, if Germany chose to behave as a benevolent hegemon. That would mean implementing the proposed European banking union; establishing a more or less level playing field between debtor and creditor countries by establishing a Debt Reduction Fund, and eventually converting all debt into euro bonds; and aiming at nominal GDP growth of up to 5 per cent, so that Europe could grow its way out of excessive indebtedness.

Whether Germany decides to lead or leave, either alternative would be better than creating an unsustainable two-tier Europe.  (source: PROJECT SYNDICATE)

by George Soros

George Soros is Chairman of Soros Fund Management and of the Open Society Institute.

Market Commentary: Federal Constitutional Court's Ruling Backs Euro Bailout Fund - 09/13/2012

In Karlsruhe, German, the Federal Constitutional Court reject concerted efforts by numerous parties to block the eventual ratification of the European Stability Mechanism (ESM). This decision was expected, to date the court has never impeded European Integration, but has always maintained that Germany cannot accept unlimited liability for other EU member states. The €500bn scheme is vital to the ambitions of Angela Merkel and the majority of European leaders in stemming the rot in the European Union. The judges said the Bundestag can ratify the €190bn capped contribution to the ESM, but Berlin must include the caveat that it won’t exceed the cap without the court’s prior consent. The ratification of the ESM is vital because it’s needed to replace the European Financial Stability Facility (EFSF), which is expected to expire by mid-2013.

In a detailed summary of their decision, Chief Justice Andreas Vosskuhle said that the ESM must be banned from borrowing from the ECB, or depositing bonds as collateral. German rules ban the central bank from buying government bonds on the secondary market circumventing the capital markets in the funding of EU member states. Justice Vosskuhle went on to say, “The relevant factor for adherence to the principles of democracy is whether the Bundestag remains the place in which autonomous decisions on revenue and expenditure are made......No permanent mechanisms may be created under international treaties which are tantamount to accepting liability for decisions by the will of other states, above all if they entail consequences which are hard to calculate.”

The court’s decision was expected but the uncertainty up to that point continued to depress Bund yields somewhat, the resulting market moves were orderly (in current market environment) and logical, with Bunds dropping 100 ticks, this is an important technical level, if it breaks 139.20 area and holds the break, we could see a large sell off. The EUR continued its recent appreciation, with the €$ spot FX at 1.29 by mid afternoon London, it rallied as far as 1.2937 post the court’s decision, 1.30 is an obvious level to watch as we expect the euphoria surrounding the OMT and today’s decision to continue for a short period, if this is broken and holds we could see a move to 1.3250 in a short period of time. The OTC IRD markets reacted accordingly, with the € 2y, 5y and 10y swap yields jumping 3bps, 6bps and 8bps respectively as we write. European Indices were sanguine about the news from Karlsruhe, ending flat to up 1.4% by 4pm London.

Market Commentary: the Drop of UK's Jobless Claims.. Perplexed?!

Economists were perplexed by a second day of above par data in the UK’s. The ONS’s Jobless claims surprisingly dropped the most in more than two years, falling 15k to 1.57m, the ONS’s claimant count dropping from 4.9 to 4.8%. Using the International Labour Organization (ILO) calculations, the unemployed population dropped 7k for the quarter ending July. The total working population increased by 236k over the same quarter to 29.6m, due to this rise the ILO’s unemployment rate rose from 8% to 8.1% for July. A plethora of theories surround the contradiction between the growth rate and job creation in recent times, some arguing that those made unemployed are moving into self employment were there are diseconomies of scale, therefore the total capacity of the UK economy could theoretically shrink and employment increase as productivity drops, whatever the reaction the Cameron/Osborne/Clegg team was buoyant in PM questions today.

Market Commentary - 09/13/2012

• The Federal Reserve is likely to announce a third round of bond purchases tomorrow, while extending its zero-interest-rate policy into 2015, economists predict.
• U.S. import prices probably climbed 1.5 percent in August from a month prior, when they unexpectedly fell 0.4 percent, 8:30 a.m.
• Germany’s top constitutional court cleared the way for ratification of the 500 billion-euro ESM rescue fund. The EU unveiled plans for bank oversight that require unprecedented cooperation between the ECB and national regulators; EU’s Barnier holds press conference, 8 a.m.
• France’s inflation rate climbed to a four-month high of 2.4 percent in August from 2.2 percent in July. Consumer prices rose 0.7 percent in the month.
• The French current-account deficit shrank to 2.5 billion euros in July from a revised 4.8 billion euros a month earlier, a separate report showed.
• German inflation climbed in August for the first time in six months. The inflation rate, calculated using a harmonized EU method, accelerated to 2.2 percent from 1.9 percent in July, the Federal Statistics Office said. Consumer prices gained 0.4 percent in the month.
• Sweden’s unemployment rate limbed to 4.8 percent in August from 4.6 percent the previous month, the Public Employment Service said today.
• Spain’s core inflation rate, which excludes energy and fresh foods, was 1.4 percent in August, unchanged from a month prior, the National Statistics Institute said today. This was in line with analysts’ forecasts. Prices rose 0.2 percent from July.
• Slovakia’s inflation rate remained at 3.7 percent in August, unchanged from July, and in line with forecasts. Consumer prices rose 0.1 percent month-on-month.
• Japanese machine orders climbed 4.6 percent in July from the previous month, after gaining 5.6 percent in June. The median estimate of economists in a Bloomberg survey was for a 2 percent rise. Orders gained 1.7 percent annually.
• Australian consumer confidence rose 1.6 percent to 98.2 in September on the Westpac sentiment index.
• Indian industrial production climbed 0.1 percent in July from a year earlier, after a 1.8 percent slide in June. The median estimate of 33 analysts in a Bloomberg survey was for a 0.5 percent gain
• Indian industrial output rose less than forecast in July.

Top News: Fed Seen Starting QE3 While Extending 0 Rate Forecast to 2015

(Bloomberg) -- The Federal Reserve is likely to announce a third round of bond purchases tomorrow, according to almost two-thirds of economists in a Bloomberg survey, while also extending the duration of its zero-interest-rate policy into 2015. 

    Chairman Ben S. Bernanke and his colleagues on the Federal Open Market Committee will once again roll out unconventional policies to bolster economic growth of less than 2 percent in the second quarter and bring down unemployment stuck above 8 percent for 43 straight months, the survey showed. 

    “The Fed clearly wants to do more,” said Nick Sargen, a former San Francisco Fed economist who oversees $40 billion as chief investment officer at Fort Washington Investment Advisors in Cincinnati. “The economy is looking lackluster, and the Fed has said all along that they feel it’s almost immoral that the unemployment rate is as high as it is.”

    Two rounds of bond purchases totaling $2.3 trillion have failed to breathe life into the labor market, which Bernanke said last month is a “grave concern.” That means policy makers will probably announce a new open-ended plan tied to a sustained improvement in the economy rather than specify an amount of purchases and an end-date, according to 32 of the 73 economists
in the survey. Twenty-two expect a fixed duration and amount.

    The FOMC plans to release a statement tomorrow at about 12:30 p.m. after a two-day meeting. At 2 p.m. the Fed will release policy makers’ forecasts for unemployment, inflation and the expected path of the federal funds rate over the next several years. Bernanke plans to hold a press conference at about 2:15 p.m.

Stocks Rallied

    Stocks and commodities have rallied on expectations of easing by the central bank. Since Aug. 1, the S&P 500 Index has risen 4.3 percent to 1,433.56, near the four-year high reached last week. The S&P GSCI Spot Index that tracks the price of 24 commodities has risen 6.8 percent.
    Most economists predict that in a new round of easing the Fed would buy a mix of Treasury notes and mortgage-backed securities.
    The central bank would buy $300 billion in Treasuries and $400 billion in mortgage debt, according to the median estimates of economists who expect a fixed sum of purchases.
    Economists expecting open-ended asset-buying predict monthly purchases of $30 billion in government debt and $35 billion in housing debt. After a year, the Fed would expand its balance sheet by a total of $780 billion.

                         

New Purchases

    Policy makers may forgo new bond purchases at this meeting to solidify a consensus on the issue among themselves or to better prepare the public for the move, said Michael Hanson,
senior U.S. economist at Bank of America Corp. in New York.
    “One reason for waiting would be if the Fed is thinking of structuring this not as a fixed quantity but as a more open- ended plan, but they don’t have the details together yet and don’t have consensus on how to do that,” said Hanson, a former economist at the Fed board in Washington.
    San Francisco Fed President John Williams, Chicago’s Charles Evans and Boston’s Eric Rosengren have called for open- ended purchases. St. Louis Fed President James Bullard said Aug. 31 he prefers the open-ended approach yet would like to see more data before taking action.
    In the first round of bond buying, the Fed in November 2008 began purchasing $1.25 trillion of mortgage-backed securities, $175 billion of agency debt and $300 billion of Treasuries to provide further stimulus after the benchmark rate was cut almost to zero in December 2008.

                        

Second Round

    In the second round, announced in November 2010 and lasting through the following June, the Fed bought $600 billion of Treasuries.
    Bernanke said Aug. 31 in a speech in Jackson Hole, Wyoming, that a Fed study found that large-scale asset purchases may have raised the level of economic output by almost 3 percent and boosted private payroll employment by more than 2 million jobs. U.S. gross domestic product expanded 2.4 percent in 2010 after contractions of 0.3 percent in 2008 and 3.1 percent in 2009.
    Bernanke didn’t describe the options for future quantitative easing.
    Some Fed officials have spoken so enthusiastically about new easing that a decision to keep policy unchanged tomorrow could trigger a downturn in markets, said Neal Soss, chief economist for Credit Suisse Group AG in New York.
    “Disappointing the markets doesn’t seem like a good strategy, but it’s not obvious how much more GDP to expect if they fulfill market expectations for more action,” said Soss, a former New York Fed economist.
                  

Near Zero

    Central bankers are also poised to extend until 2015 their forecast that economic conditions will probably warrant holding interest rates near zero through late 2014. Sixty-eight percent of economists surveyed expect an extension at tomorrow’s meeting.
    At the July 31-Aug. 1 FOMC meeting, a few participants wanted to replace the calendar date with guidance linked to the economic conditions that would warrant raising rates, according to minutes of the gathering. Fifteen percent of economists said the central bank will probably tie the low-rate policy to the performance of the economy.