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The Drama Isn’t Over

I am not sure what game it is that equity investors are watching. Overnight, Greece formally asked for aid from the EU and the IMF. Stocks rallied, I suppose on the theory that the drama is finally over. But of course, the drama is just beginning (I think that in Greek tradition the drama isn’t over until someone marries his mother). It would be over if the EU’s pledge had been backed by actual commitments from legislatures, and if the money was easily disbursed, and if, in fact, there was money to disburse. This is evidently false:

  • Bloomberg cited the Belgian magazine L’Echo as saying the country may find approval of their tranche of the loan “problematic at the very least.”
  • German Prime Minister Merkel said that Greece needs to finish talking with the IMF before money is disbursed, and that the money will be tied to “very strict conditions,” including approval by the EC of the assistance and a recovery plan drawn up by the IMF. “Only when these two steps have been completed, can we talk about concrete assistance, including what kind of aid and how much.” (AP) Really? I thought there was already a concrete assistance plan! Whoops.
  • The Prime Minister of the Netherlands said the “need for restructuring Greek finances has increased.”

None of this sounds like the response I thought the market was expecting, which was more like “Where do we send the cheque?” At this point, two things can happen: (1) European governments can close ranks and start talking again about how yes, there is a deal – in which case we will get to start reading about all of the groups who are going to fight it on basis of the anti-bailout provision of Maastricht, or on country-first arguments (“why are we sending our money to Greece?”). Or (2) the EU can change its mind and say no (or are unable to reach a united opinion). Either way, the drama hasn’t ended; it has barely begun, and there are more PIIGS (and investors therein) who are waiting to see the outcome. And how long will capital stay in Greece, waiting to hear the outcome? This can still turn to crisis quickly, which isn’t to say that it will but that the potential range of near-term outcomes is widening. In my view, the “assistance” proffered by the EU was mostly an expression of confidence designed to persuade investors to buy Greek debt, thinking there was a “backstop.” But no one ever got legislative approval, so the confidence game was fairly transparent. Greece is actually pulling on that lifeline, and I think we will shortly find that it wasn’t tied off. In the meantime, however, stocks wrestled higher on the day, finishing with a gain of 0.7%.

Bonds were a little lower on a slight diminishing of a flight-to-quality bid when they were smacked by an early-morning report by CNBC that a “growing bloc of the FOMC” wants to sell assets and reduce its balance sheet. As I’ve noted here before, such a decision would be likely to lead to much higher interest rates; instead of last year’s Treasury issuance, minus Fed purchases, you would have this year’s issuance (higher anyway, since the deficit is larger and more debt is maturing) plus Fed sales. Moreover, if the Fed is selling and rates start to rise, then the banks will need to start lightening up on their hoard of Treasuries too, rather than continuing to pull more down in the auctions. In short, rates appear to be currently in equilibrium but it is a very unstable, very top-heavy equilibrium. 10-year Note futures closed with a loss of 12/32nds, with the 10y yield at 3.81%.

Prices are determined at the margin, and from past market experience we know that much smaller changes in supply dynamics can lead to large changes in yields. Mortgage-related convexity phenomena in the early 2000s led to a couple of 100bp swings in rates in somewhat-illiquid markets in Q4 of several years. Between November 12th, 2001 and November 21st, 2001, 10-year yields rose from 4.30% to 5.01%: 71bps in 7 trading days. Between October 9, 2002 and October 17th, 2002, 10-year yields rose from 3.57% to 4.20%: 63bps in 6 trading days. In 2007, the month of November saw 10-year yields decline relatively gently from 4.47% to 3.94%. We do not need to review what happened in 2008.

While market liquidity conditions right now are not what they were in 2008, in relative terms they may well be similar to a typical Q4. The overall float being held by ‘traders,’ if you include banks and the Fed, is positively massive compared to the underlying volumes. As long as movements are slow and stately, liquidity is more than adequate. I have very little confidence, however, that liquidity would respond to a 50bp selloff in any way other than to flee like King Arthur’s knights confronting the killer rabbit.


Wow, was I ever wrong on my skepticism about Durable Goods! Core Durables not only registered the biggest gain in a couple of years (+2.7%), but last month’s number was revised upward as well. Transportation orders pulled the headline figure down to -1.3%, but the strength in core Durables for consecutive months is impressive. New Home Sales also surged more-than-expected, although it is still being kind to call the pace “anemic” at 411k. The combined pace of Existing Home Sales and New Home Sales (see chart below, source Bloomberg) definitely has ticked higher, and even though the sales figures are still muddied by the tax credits it seems likely that the worst sales rates are behind us. Knock wood.

The latest bounce is noticeable, but not impressive yet.

Now, I don’t think that means that housing is about to take off, mind you, but if it is then inflation can’t be too far behind since the main thing holding measured inflation down is the decline in housing costs. As I have written (a few times) before, core ex-housing is already in a multi-year rising trend (it recently peeked over 3% before dipping back). All that is needed for that trend to begin asserting itself in the overall inflation figures is just for housing prices (and therefore rents, with a lag) to stop falling. Q3-Q4 is looking good for a bottom in core inflation.

The only scheduled event of note on Monday (aside from the Dallas Fed Manufacturing Activity Index, which which doesn’t usually move markets) is the $11bln 5y TIPS auction. The issue, like all April 5y TIPS issues, is expensive because the market overvalues the “deflation put” and undervalues the seasonality, but it doesn’t seem too expensive for an April 5y TIPS issue. It may be hard to believe that the Treasury can sell $11bln at a real yield of only 0.50%, but your alternative is a 2.59% nominal 5y note. The only way that note outperforms TIPS is if inflation is in the narrow range of 0%-2% over that 5-year period; if it is below 0%, they’ll perform about the same since they both pay off par, while if inflation is above 2% or so then the TIPS clearly win. That mainly speaks to how expensive Treasuries are, that only unlikely inflation scenarios make 5y notes pay off, but I think the auction will go fine. (That may be a first for me. I usually hate the 5y TIPS auction!) There are a lot of people who want to invest in inflation-linked assets, but are not comfortable buying real duration at these yields. To them, the current low yield is an opportunity cost of waiting, a lot like the subzero yields of TBills during the crisis was a cost of waiting for better investing conditions. If I am right about that, then buying a liquid on-the-run note that is short in duration will be attractive right now, in the way that buying only 5-year inflation protection rarely is.

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