The Yuan Announcement and Market Reactions

This morning's dominant piece of news for financial markets is China's announcement over the weekend that it would adopt a "more flexible" exchange rate policy with the yuan. As a result, commodities and equities are rallying, on the rationale, that the likely appreciation of the yuan will lead to stronger economic growth in the U.S. (and, therefore, stronger corporate profits and demand for commodities), while the bond market is, predictably, taking a hit.

As an initial, broad, assessment of the significance of the move on the yuan, the front page article in today's WSJ ("China Eases Currency peg) is a reasonably adequate one. However, in evaluating the financial markets' reaction to the news, and the sustainability of this morning's price dynamic, some perspective is desperately required.

Despite this morning's fairly substantial rise, by nearly 0.5%, of the yuan against the dollar, the pace of further appreciation is likely to proceed very slowly, with the likely total amount of such appreciation by year end probably limited to the 4% to 5% range. Such a tightly controlled pace of the yuan's rise over the next six months or so is likely to be mostly due to two factors: a) The strong influence of the export lobby in China that will strenuously resist a more substantial pace of appreciation, particularly in an environment where their main export markets are growing at a very unimpressive pace, and b) The fact that the yuan is going to be managed against a basket of currencies, with the euro being one of its key components; if the euro's recent weakness persists, then the rise of the yuan against the dollar will have to be very limited to offset its potential further rise against the euro within the basket.

Against that backdrop, it is hard to imagine the prospect of a more flexible yuan policy ahead, which will probably lead to a further moderate appreciation next year, becoming a game-changer for the outlook of the U.S. economy over the next 12 to 18 months. Actually, the manufacturing sector, which is presumably the sector of the U.S. economy likely to benefit the most by a stronger yuan, has been doing particularly well in the last 9 months, having already become a key driving force of the economic recovery.

But the problem is not the manufacturing sector. The key challenges for the U.S. recovery over the medium-term include a still cautious pace of job creation, tight bank lending standards, any ripple effect from the fiscal turmoil in the eurozone, and the lingering drag from the housing market meltdown. Potentially stronger exports to China over that time frame are not likely to materially alter the outlook for economic growth in the U.S.

As a result, it is questionable whether the stock market's enthusiasm generated by the yuan announcement over the weekend will have long enough legs- that is, beyond a matter of a few days- to sustain a powerful rally in equity prices. It will not be before long when both equities and Treasuries refocus on the underlying realities permeating the current economic environment.

The prospect of only a cautiously optimistic FOMC statement on Wednesday -a reminder that the economic environment is still confronting a number of headwinds-, uneven economic data (with the emphasis on this week's struggling initial claims series and the magnitude of the likely decline in May's durable goods orders) may help put a brake on the stock market rally and the slide in Treasuries by the end of the week.

Anthony Karydakis

Picture-Perfect May CPI But Initial Claims Raise Some Eyebrows

The May CPI report is near-perfect in that it confirms the picture of uneventful price trends, putting to rest any lingering concern about either inflationary, or deflationary, impulses in the current environment.

The 0.2% decline in the overall index last month was the result of a 2.9% fall in the energy component- the latter largely due to a 5.2% drop in gasoline prices. The core CPI's increase of 0.1% for the month, follows a flat reading in April, and represents only the second gain in the series since the beginning of the year. In fact, in the last 6 months to May, the core CPI has been up 0.8%, while in the last three months, it has risen by only 0.4%. Year-on-year, core inflation is up 0.9%.



Source: Bureau of Labor Statistics

In the last three months, the key housing component (which represents 40% of the overall CPI) has been flat (with a 9% drop in fuel oil prices helping offset a 15.8% spike in the "lodging away from home" category), while apparel prices have declined by 4.2% and, even medical costs have risen by a relatively moderate -by the standards of that component- 2.9%.

The impressively benign price picture is hardly surprising, given the abundant amount of slack in the economy and its slow absorption rate in in the midst of a moderate economic recovery, with these factors likely to continue taming price trends over the next 12 months or so.

Inasmuch as the favorable price dynamic should appropriately be viewed as providing the Fed with ample space to delay the onset of the tightening process, it is important to recognize that the monthly inflation data are not likely to be the primary reason that will determine the timing of the Fed's exit strategy. Instead, that is more likely to be shaped by a combination of the Fed's assessment of three factors: a) the economic recovery's prospects -particularly, in the wake of the fiscal turmoil in Europe- b) the ability of the global financial system to withstand the stress that a turnaround in the U.S. interest rate cycle would entail, and c) the degree of restlessness on the ground (i.e financial markets) about the need to see that the Fed remains vigilant vis-a-vis the longer-term inflation risks posed by the liquidity currently in the system.

The 12,000 rise in initial unemployment claims in the week of June 12 to 472,000 would not disconcerting per se, given the inherent volatility of the series, but it does validate a disappointing pattern of an essentially stalled downtrend in claims since the beginning of the year. The 4-week moving average of the series is now at 464,000, not much different compared to five months ag0.

The puzzle with the behavior of claims in recent months is that it stands in sharp contrast with the significant overall turnaround we have seen in the monthly payroll data and most other labor market measures. Although, we should not expect claims and payrolls to go hand-in-hand over the short-term, one would have thought that a nearly six-month period is long enough to have allowed the two series to send a more consistent message.

One explanation for the disconnect is that the payroll data may ultimately be revised downward for the first part of the year during the annual benchmark revisions of the series next spring. Another possible, but not fully satisfactory, explanation is that the last recession has caused profound dislocations among the various sectors in the economy, where some industries continue to shed off jobs at a strong pace (therefore accounting for the still elevated level of lay-offs), while other industries are turning around in a more robust fashion, accounting for the bulk of the hiring reflected in the improved payroll data.

Today's initial claims data were for the survey week of the June employment report and there is usually an attempt to use claims as a hint for what the monthly employment report may look like. The correlation between initial claims during the employment survey week and payrolls for that month is non-existent, but, at times, some loose relationship may exist between new filings and the unemployment rate. Still, there is no meaningful hint that can be derived from today's data, as the 472,000 claims number today was nearly identical to the 474,000 claims number for the survey week in May.

The rise by 88,000 to 4.571 million in the continuing claims for the week of June 5th is also consistent with the broader theme of lack of progress on the front of both initial filings and claims recipients.

Anthony Karydakis

In Defense of the ECB

The ECB has received a considerable amount of criticism in recent weeks, as a result of its decision last month to start buying sovereign debt of some of the euro bloc's most vulnerable countries. The essence of the, at times, surprisingly sharp tone of such criticism is that the ECB has compromised its strongly prized sense of independence and is now succumbing to political pressures to pull out all the stops to contain the fiscal turmoil that has spread ominously across much of the eurozone. Furthermore, the critics argue, by doing so, the ECB is undercutting its much cherished anti-inflation credentials

The ECB's purchases of sovereign, euro-denominated, bonds have been fairly aggressive so far, with a total of over EUR40 billion of such purchases having settled in the first three weeks of the program. ECB watchers expect the program to reach EUR 60 to 70 billion in the foreseeable future. Although no official breakdown is available regarding the issuing countries of the bonds purchased, it is widely believed that the bulk of those purchases involve Greek debt.

The criticism of the ECB on this issue has been unfair and, by most reasonable standards, widely off-the-mark.

Despite the ECB's much publicized single mandate of keeping inflation in the eurozone "below, but close to, 2%", it is always the unspoken, but paramount, responsibility of any central bank to preserve the integrity of the financial system in the country/zone of its operation in periods of pronounced stress. That is exactly what major central banks have always done under such circumstances in recent history, with the most dramatic such episode being the 2008-09 global financial crisis.

In response to the crisis, both the Fed and the ECB took a number of unprecedented measures, some of which were going directly against the traditional concept of a central bank as the ultimate inflation fighter. It was precisely in that context that the Fed engaged in a program of purchasing $300 billion of Treasury securities, crossing a line that was nearly unthinkable in the past- namely of debt monetization; and this, before including the massive program of purchasing mortgage-backed and agency securities, totaling $1.4 trillion. During that period, the ECB conspicuously refrained from purchasing any sovereign debt of its member countries and limited itself to purchasing a total of EUR 60 billion of "eligible covered bonds" in the open market.

That the ECB is coming now under fire for moving aggressively to help extinguish the fire ignited by the fiscal turmoil that has threatened the integrity of the euro, is a serious misreading of its true mission. Meeting the inflation target "over the medium term" is certainly critical, but, first, Mr. Trichet needs to keep the eurozone in one piece to be able to conduct monetary policy with the objective of meeting his single mandate on inflation. There would be no role for the ECB to play if the eurozone collapsed. In fact, it would be negligence, bordering on serious monetary policymaking malpractice, for the ECB to refrain from taking significant special measures in the midst of the bloc's intense fiscal crisis.

As far as the potential inflation repercussions of the ECB's recent program of sovereign debt purchases, the risk appears quite limited. The HICP (Harmonized Index of Consumer prices) for the eurozone is running at 1.5% in the 12-month period to April and is expected to tick higher to 1.6% after the release of the May data tomorrow (6/16/10). Although it does represent an appreciable upturn compared to its low point six months ago and it is still comfortably below the 2% target. Besides, it would be unreasonable to believe that the projected modest pace of eurozone GDP growth in 2010-11 of about 1.5% represents a risk of generating any inflationary impulses.

Mr. Trichet's anti-inflation credentials have been impeccable in the last six and a half years at the helm of the ECB. Inflation is running close to its lowest since the inception of the euro and is lower than the rate prevailing in most legacy countries prior to the creation of the common currency. If anything, he has often been criticized in the past for being overly committed to the ECB's official inflation target, often at the expense of growth in the eurozone and with a steady bias toward keeping monetary policy a notch or two tighter than circumstances might have warranted at various points. (After all, the intense criticism he received for being in a tightening mode in early July 2008 -having raised the ECB's overnight rate by 25 basis points to 4.25% in just two months prior to the Lehman affair- is still fresh).

The ECB and Jean-Claude Trichet have built enough capital with their strong anti-inflation credentials over the years that they should not be viewed with suspicion as to whether they are compromising their commitment to price stability with their bond purchase program in response to an exceptional set of circumstances that they have been confronted with. They deserve more credit than that. Doing otherwise simply highlights the sad reality that markets have, indeed, very short memory.

Anthony Karydakis

The Real Problem With An Early Fed Tightening Move

The Kansas City Fed President, Thomas Hoenig, has been an increasingly vocal proponent of the view that that the Fed should no longer offer financial markets the promise of zero short-term rates for an "extended period" of time- having dissented in each FOMC meeting since the beginning of the year over the use of such language in the official statement. In recent days, and on two separate occasions, he has upped the ante by arguing that the Fed should raise the fed funds rate to 1% by the end of summer. (http://www.reuters.com/article/idUSN0810408120100609)

Mr. Hoenig's rationale is a fairly straightforward one: short-term rates are at unustainably low levels, setting the stage for inflationary complications over the long run, and the economic recovery has already gained sufficient traction to withstand a series of modest steps that would signal the beginning of the normalization process for rates. Furthermore, according to that view, monetary policy is meant to be anticipatory and leaving rates at zero for too long would risk planting the seeds for the next bubble that could destabilize the financial system again; therefore, it needs to act soon before any such clouds appear on the radar screen.

A limited number of other Fed officials also appear to be showing signs of uneasiness recently about the possibility that the Fed may be creating some risks by delaying the beginning of the exit strategy; Philadelphia Fed President Plosser and St. Louis Fed President Bullard have made some "soft" comments along those lines in the last few weeks.

On the face of it, it is hard to disagree with Mr. Hoenig's argument on this issue. The U.S. economic recovery is moving forward in the context of a broader, albeit uneven, turnaround in the global economy and the financial system. Although the latter is still confronted with seemingly never-ending challenges (the latest one being the sovereign debt market turmoil), it has admittedly come a long way since the heady days of 18 months or so ago. Against such a backdrop, how damaging a relatively modest increase of 75 to 100 basis points in the fed funds rate- or beginning the unwinding of the Fed's massive portfolio- can be to the economy or the financial system?

This view, though, does suffer from a serious flaw in that it vastly underestimates the potentially disproportionate negative reaction that financial markets will show to concrete actions signaling that the interest rate cycle is turning. The Fed's raising of the fed funds target, as well as the interest it pays on bank reserves, by as much as 100 basis points in a series of quick moves over the next couple of months (the latest time frame proposed by the Kansas City Fed President) is likely to lead to a major selloff in the bond market, as participants, in typical fashion, will front run the prospect of further tightening by the Fed. After all, the funds rate would still be at an extremely low 1% and, by most people's standards, the concept of normalization of short-term rates would envision a road toward a funds target in the 3% to 4% range.

The bulk of such a selloff in response to the Fed's first shot across the bow would be heavily skewed toward the front end of the market, causing a severe flattening of the yield curve, which, in turn, would undercut one of the key factors that have contributed to the healing and return to relative profitability of the banking system in the last several quarters. In view of the recent doubling of the 3-month Libor rate to over 50 basis points- a direct reflection of the anxiety percolating in the European banking system due to the sovereign debt situation- an abrupt further increase in short-term rates that would be set off by any Fed tightening can prove dangerously destabilizing for the global financial system in the current setting.

Inflation in the U.S. and eurozone remains at extremely low levels and, given the unimpressive forward momentum of the economic recovery in both regions, it is unlikely to show any upturn over the next 12 months or so. With regulatory financial reform in the offing, both in the U.S. and Europe, and the threat of a default by some countries (the debt of which is largely held by European banks) lurking in the background, the global banking system is finding itself again at a key juncture.

None of this suggests that the Fed should remain sidelined out of fear of potentially disturbing the fledgling economic recovery and delicate balance of the banking system. Short-term rates are indeed unsustainably low and the gradual unwinding of the Fed's balance sheet may indeed start taking place later this year, before any other overt tightening policy action is announced.

But it is imperative to recognize that the view Mr. Hoenig has been openly advocating has a major hidden risk, as it is not about just a series of modest steps that would still leave the funds target at a historically very low level- therefore unlikely to be very consequential to the broader environment. A series of modest such rate hikes by the Fed will translate into a potentially massive back up in yields that would far exceed the actual Fed action. And for that to be absorbed relatively smoothly (that is, with only a reasonable amount of noise), without throwing everything up in the air and creating renewed sources of anxiety and turmoil, the Fed needs to be highly confident that the time is ripe for such action.

The inevitable change in the FOMC's language from the current "extended period" wording will be the first test of the markets' ability to handle stress over the next few months, on the account of a perceived risk of real tightening down the road. But, arguing that the overall economic and financial environment is ready at this point to accept the blow of actual Fed tightening over the next couple of months is a proposition somewhat disconnected from the realities on the ground as to how markets function.

Anthony Karydakis

Is Global Growth Slowing After All?

The presumption that the Eurozone fiscal crisis will be a pivotal factor that will have an adverse effect on global economic growth ahead has been widely adopted by financial markets in recent weeks. While such a potential risk cannot be dismissed, we remain skeptical as to how significant its negative effect on the U.S. (or, global, for that matter) economy will ultimately be.

The OECD, for one, is not so sure. Two weeks ago, it released an upward revised estimate for economic growth in its member countries for 2010 and beyond compared to its previous forecast issued in November 2009. In its latest forecast, it now expects growth to rise by 2.7% this year versus 1.9% in its previous, "pre- Eurozone fiscal crisis" estimate, while it has also revised higher its growth estimate for 2011 to 2.8% from 2.5% previously.
(http://www.oecd.org/document/9/0,3343,en_2649_201185_45303817_1_1_1_1,00.html)

The OECD's upgraded forecast, while acknowledging the growing risks stemming from the instability in sovereign debt markets, is based on the reality of rising global trade flows. This trend is, to a considerable degree fueled by the sharp fall of the euro since late last year and the ongoing strength in growth in China and other key emerging market economies.

Even in the eurozone, which has been squarely in the eye of the fiscal storm recently, it is still not clear whether the net effect of the fiscal austerity measures sweeping its member countries will have a bigger contractionary effect on growth than the benefit to growth derived from the boost to the bloc's exports to other non-euro countries- courtesy of the weaker euro. The latter effect, is in fact, quite powerful, as the euro has not declined by over 20% since late last year against the U.S. dollar alone but also against the yuan, allowing eurozone exports to gain competitive ground globally at the expense of China.

The news coming out of Germany (the world's second biggest exporter) in the last two days highlights that ambiguity best. Factory orders surged in April by 2.8%, after an upward revised 5.1% increase in March, driven by a 5.5% spike in export orders from countries outside the euro area. Also, just this morning, Germany's industrial production numbers showed a solid gain of 0.9% in April, suggesting that the economic recovery in the biggest eurozone economy (and a global exports powerhouse) is moving forward at a good clip.

The single most important channel via which any protracted sovereign debt market instability can influence the U.S. economic recovery is the sharp pullback in equities and its possible adverse effect on consumer spending in the months ahead. Again, the uptrend in personal spending is unlikely to be derailed by a 10% or so erosion in the equity market- particularly if this proves to be a relatively short-lived affair. Moreover, a partial offset to the adverse impact of equities on household spending is provided by the recent sharp increase in mortgage refinancing activity- again, the direct result of the eurozone' fiscal crisis having led to lower market and mortgage rates lately.

Risks to the prospects for the U.S economic recovery do exist and the extend to which the sovereign debt situation deteriorates requires close monitoring in the months ahead. However, in the heat of the moment, there is at times a tendency to underestimate the resilience and complexity of the U.S. economy, and this is a risk we also need to guard against.

Anthony Karydakis

May Employment Report: Underwhelming, But Not Ominous

With the emphasis traditionally placed on the headline nonfarm payroll number, today's employment report can only be described as disappointing. The census-bloated payroll increase of 431,000 in May included only a modest 41,000 gain in private payrolls compared to gains of 218,000 and 158,000 in April and March respectively. On such grounds, the Treasury market's initial reaction to the report is fully understandable, and, on some level, perhaps justified.

However, a more dispassionate look at the specifics of the data still points to an ongoing underlying improvement in labor market conditions, albeit at a pace that, overall, still falls short of expectations for this phase of the economic recovery.

Some of the silver lining, that merits attention in the May report includes:

a) A 29,000 increase in manufacturing jobs, which brings the cumulative gain in that category in the last 5 months to 126,000. This is fully consistent with the strong showing of the employment component in the ISM recently, which confirms that the sector is moving ahead at a solid clip.

b) The gain in the workweek for all employees continues to rise, edging up again to 34.2 hours, a classic precursor to more hiring ahead. The series has been showing a steady uptrend since late last year.


Source: Bureau of Labor Statistics


c) In the household survey, the number of persons employed part-time for economic reasons (the so-called involuntary workers) fell by 343,000 last month to 8.8 million. A downtrend in this series should be viewed as a direct reflection of an improving labor market landscape, as employers are increasingly more willing to employ full-time workers in the midst of a turnaround in the overall economic climate.


The drop in the unemployment rate to 9.7% last month from 9.9 in April, is of little material importance, as it essentially returns the series to its Q4 2009 level, and it was mostly the result of a somewhat counter-intuitive fall in the number of unemployed re-entrants to the labor market by 286,000 in May.


Without downplaying the disappointingly slow pace of net new hiring in the private sector, it appears that, apart from the notoriously noisy nonfarm payroll number itself, there is little reason to conclude from today's report that the recovery is in danger of stalling. Such conclusions would represent an overly hasty take on a set of data that tend to be more nuanced than the disproportionate degree of attention paid to a single number (that also enjoys a well-deserved reputation for being the subject of, at times, extreme revisions in subsequent months).

Based on the broader set of economic indicators released in recent weeks, there is little reason to scale down appreciably our earlier "penciled-in" forecast that we are likely to see average monthly private payroll gains in the vicinity of 200,000 in the third quarter.

Anthony Karydakis

A Note On The Housing Market

A short Caribbean vacation will interfere with the posting of any new articles in the coming days. The next article will be posted on June 4th, discussing the employment report. - AK

________

The Mortgage Bankers Association's index of weekly new mortgage applications is often a more useful gauge of the state of the housing market than the monthly new and existing home sales reports. This point was validated again this morning with the release of both the latest weekly MBA data and the 14.8% surge in new home sales for April.

While the overall index new mortgage apps rose 11.3% in the week of May 21, this was the noisy result of a 17% spike in the refinancing component (the direct beneficiary of the rally in the Treasury market and associated fall in mortgage rates); the key purchase component of the index fell 3.3%- following sharp declines in the prior two weeks- to its lowest level in 13 years.



Source: www.calculatedriskblog.com

The behavior of the purchase component recently highlights two important issues regarding the underlying dynamic in the housing market:

a) The expiration of the home-buying incentives in April has caused a sharp drop-off in the demand for homes in May. This suggests that, taking into account both the tax incentive-related spike in mortgage applications for purchases in April and the subsequent sharp decline so far in May, "true" demand remains essentially moribund during the key spring season. The most that can be said is that some kind of a bottom is being formed but with no credible signs of a turnaround yet.

b) Contrary to the popularly held belief, demand for housing is poorly correlated with the level of mortgage rates. The average 30-year mortgage rate declined again last week to 4.80% from 4.83% in the prior week (and over 5% in April). Still, as evidenced by the string of declines in the purchase component in the last few weeks, demand for homes has been unresponsive. In fact, it is a point often missed by analysts, that the collapse of the housing market since 2006 has been accompanied by a strong downtrend in mortgage rates.

The explanation for this seeming paradox is a fairly straightforward one: Demand for homes is above all a function of levels of employment and income growth and not mortgage rates- the latter representing a largely peripheral (and, at times, irrelevant) factor. Differently put, when people are unemployed, or seriously concerned about their job security, they will not undertake the major decision to buy a house simply because mortgage rates are low. Even a 1% mortgage rate would do nothing to make it plausible for an unemployed person to buy a home.

In fact, it is somewhat ironic, but analytically sound, to argue that demand for homes will only strengthen when the economic recovery has been meaningful enough over a longer period (2-3 years), as employment levels improve, wage gains increase and mortgage rates are on the rise.

In the current environment, with unemployment levels still very high, despite the unmistakable turnaround in underlying labor market conditions, households remain reluctant, or unable, to make the leap to by a home, irrespective of the historically low mortgage rates. Combining this dynamic with a still heavy inventory of unsold homes in most regions of the country, it is unlikely that any material turnaround in the housing market is in the offing over the next 6 to 12 months.

Anthony Karydakis

The Consumer Remains Unfazed

Although hardly the most important item on the markets' mind this morning, the strength in the May Consumer Confidence Index deserves some attention, at least briefly.

The surge in the index to 63.3 from 57.7 in April is a testament to the steadily improving domestic economic environment and, particularly, of the consumer sector. The expectations component turned out the biggest increase, up 7 points to 77.4, while the current conditions component rose 2 points to 30.2. The spike is even more remarkable in that it took place in the midst of a period where the stock market's performance has been dismal.



Source: Action Economics

Both of the key barometers of consumer psychology (Conference Board's Consumer Confidence Index and the Reuters/University of Michigan Consumer Sentiment Index) are highly sensitive, on a short-term basis, to stock market behavior and sharp swings in gasoline prices. Over a somewhat longer period, perceptions of the job market situation tend to be more influential in driving those measures. While it is true that job market conditions have improved markedly in recent months, they have not done so in a spectacular enough way, as evidenced by the near cycle-high unemployment rate of 9.9%, to fully justify the decidedly upbeat consumer attitudes that evidently overrun any anxiety associated with the recent stock market turmoil.

All in all, this means only one thing, that is that there has been a dramatic turnaround in the way the economic environment is perceived by households, and this fuels a sense of optimism and growing confidence in the future. It appears that consumers are less willing, at this point, to let significant short-term noise in the stock market shape their view of where the economy is headed. This speaks volumes of the credibility of the economic recovery's forward momentum- at least for as long as the global financial market anxiety does not transform itself in to a full-fledged crisis.

Looking ahead, and as the economic recovery unfolds further, the Consumer Confidence Index is bound to move much higher from its current, historically low, levels. However, the series may still suffer a modest pullback in June, particularly if the unsettled stock market environment persists. Furthermore, the University of Michigan Sentiment Index for the entire month of May (to be released Friday) may slip from its early-month reading of 73.3 to 72.0 or so, under pressure from the ongoing stock market erosion.

Anthony Karydakis

Long-term U.S. Treasury Yields: Reaching For a 2% Handle?

The massive rally that has pushed long-term Treasury yields lower by over 85 basis points (as of this writing) since early April has spectacularly confirmed the unique status of that market as a safe haven in periods of anxiety and global financial turmoil. It has also set into motion a dramatically different dynamic and created a new reality on the ground.

What started as a localized fiscal crisis of a small, profligate, eurozone economy (Greece) morphed quickly into a major debt crisis engulfing a number of the bloc's economies. The turmoil that was set off in an expanded part of the sovereign debt market universe has shaken the foundation of the euro as a currency, calling into question the momentum of the economic recovery in many countries. In such a precipitously deteriorating environment, equity markets have taken a major hit around the world, making U.S. Treasuries the obvious place to be.

In an attempt to offer a perspective as to where this new dynamic may be leading the Treasury market, a number of points need to be recognized:

1) The underlying reasons that triggered the powerful Treasury market rally in the last several weeks are unlikely to disappear any time soon and an appreciable risk exists that they may actually become broader in scope and/or intensify. Although the headline risk related to the eurozone fiscal crisis as such may follow an "ebb and flow" pattern, the factors currently supporting Treasuries are multiple and intertwined, at the core of which is essentially a major repricing of global risk.

This leads to #2.

2) Even if one of those factors were to "normalize" somewhat in the coming weeks (say, a partial rebound of the euro or equities), any resulting damage to Treasuries is unlikely to be severe enough to send yields back close to their levels prior to the start of this rally. This was actually validated- on a smaller scale- on Thursday this week, where a rebound of the euro from its previously reached 4-year low against the dollar did not prevent Treasuries from pushing ahead with a strong rally for the day.

In other words, the current yield levels are slowly gaining legitimacy, as a reflection of broader concerns about the outcome of the deeply unsettled state of global financial markets, and may no longer be closely influenced by any single factor.

This paves the way for #3.

3) The key issue of whether the current financial market turmoil will end up having actually a significant adverse impact on the U.S. economic recovery (a view we do not fully subscribe to, yet:http://economistscorner.blogspot.com/2010/05/on-beleaguered-euro.html) will require time to be sorted out, one way or another. Until then, the Treasury market participants will probably find "room" to front-run the prospect of an economic slowdown, which should continue to underpin the market.

And this brings us to #4.

4) There is a clear element of asymmetry as to how the Treasury market is likely to react to the various economic releases in the period ahead. Solid economic data will probably tend to be downplayed on the grounds that they do not yet reflect the slower growth that the market is implicitly pricing in. (This is especially likely to be the case if the unsettled conditions in equities, the euro, and sovereign debt markets persist). However, unexpectedly weak economic data will be quickly be viewed as validating the underlying narrative that the pace of the recovery is cooling.


Against that backdrop, and with the 10-year yield having already in its sights the 3% mark, regaining a 2% handle for the first time since April of last year is now a reasonable probability. Further continuation of the Treasury rally should continue to be led by the long end, leading to additional curve flattening, with the 2s/10s spread compressed to the 235-240 basis points range. The front end's upside potential will continue to be restrained by the fact that, after all is said and done, the fed funds rate is already at zero and there is an exit strategy somewhere looming in the horizon.

Anthony Karydakis

April CPI: The Disinflationary Trend Remains Intact

The April CPI highlights dramatically the reality that the nearly two-year old disinflationary dynamic remains very much in place. Although the 0.1% decline in the overall index can be summarily brushed aside as the direct effect of noise related to energy prices for the month (-1.4%), the impressive part of the report is the behavior of the core component, which was flat in April. A 0.1% drop in the key housing category (42% of the overall CPI) and another sizable decline in apparel prices (-0.7%) were instrumental in producing the flat reading in the core index last month.

In fact, the core CPI has remained essentially flat in the last three months and is now up only 0.9% on a year-on-year basis. Putting it in a context, the series has now dipped below its year-on-year gain recorded in the prior distinct disinflation episode in the 2002-03 period, where it never fell below 1%.

The ongoing downtrend in core CPI in recent months is hardly surprising, given the very nature of inflation as a lagging indicator and the enormous amount of slack that has resulted from the severity of the 2007-09 recession. Despite the credible economic recovery under way, it is inconceivable to imagine any negotiating power by labor that would put any upward pressure on wages and salaries (and, by extension, the "services" part of the CPI that accounts for 60% of the index). Moreover, any increase in production costs associated with the rising commodity prices recently is quickly absorbed by manufacturers and retailers in the form of narrower profit margins.

On that score, it is telling of the near uniform absence of even a hint of upward price pressures that both the "services" and "commodities, ex. food and energy" parts of the CPI have been up by only 0.8% and 1.2% respectively from a year ago.

At the very minimum, the April CPI data continue to provide ample room for the Fed to delay the timing of implementing the process of rate hikes, until the economic recovery has picked up enough momentum and the absorption of the current slack is well under way. Despite any possible changes in the language of the FOMC statement over the next couple of meetings in relation to the "extended period" part, the working assumption should remain that any rate hike by the Fed prior to the end of the year is a very low probability outcome.

Anthony Karydakis

The Beleaguered Euro

To say that the euro is experiencing its most serious existential crisis since its inception is a pretty salient statement by now, given the barrage of media coverage in the last two months in the midst of the eurozone's intensifying fiscal debt crisis.

In that environment, talk of a possible break-up of the euro bloc's common currency is gathering steam, and the resulting strong downward pressures exerted on the currency pushed it briefly today to a 4-year low against the dollar. While a euro break-up is no longer in the realm of fiction and is gaining increasing legitimacy as a possible outcome, it is always helpful to put the entire issue and its implications into some context.

Four points need to be highlighted:

1) If the eurozone member countries prove ultimately unable to regain the credibility demanded by markets that they will manage to enforce a true convergence of fiscal policies among all member-countries moving forward, then a real risk exists that the euro may disintegrate as a currency. However, the stakes for all countries involved are much too high for such an outcome to occur without all other measures to rescue the common currency have been exhausted first. Already loud voices have been raised from the powers-that-be (Germany and France) in support of a more centralized mechanism of coordinating fiscal policies for all member countries of the bloc.

In other words, any breakup of the euro is unlikely to be the result of panic and disarray within the eurozone in the midst of a crisis, but rather the product of a very deliberate and time-consuming process by the member-countries involved. The issues that need to be sorted out by each country in any decision to revert to their original national currencies are complex and multidimensional (setting new exchange rates, sorting out the payments on existing debt denominated in euros, handling of outstanding international trade transactions and contracts, and so on) and they can not be made in a rush. So, any suggestion that a euro break-up is a plausible outcome in the next few months is totally unrealistic (as Goldman Sach's Chief Global Economist, Jim O'Neil, has also pointed out; see link http://www.bloomberg.com/apps/news?pid=20601087&sid=aw._c97.VLVc&pos=4).

2) Perhaps, a more likely, but considerably less disruptive, outcome of the current crisis in the euro zone would be that, at some point, some of the weaker member-countries of the bloc are forced, via some indirect process that will need to be put in place, to abandon the euro. Still, this is not a likely solution in the midst of the current intense phase of the bloc's fiscal crisis, as it would tend to add fuel to the already raging fire. First, the bloc will need to put out the fire (that is, stabilize the dismal debt picture of many of its member countries) and, then, at a later point, deal with potentially more radical measures that might involve the expulsion of some countries.

3) Despite its precipitous decline in the last three months or so, the euro is not remotely close to its lowest level reached against the U.S. dollar since its inception. Such a level was reached in 2000-01 at approximately 0.82, while the euro today stands around 1.23 (but with an admittedly downward momentum in place). So, the current levels of the euro against the dollar are not alarming per se; it is simply the persistence and intensity of the sell off that bear close monitoring in the weeks ahead.

Source: ECB

4) Much has already been made about the likely adverse effect that the slower pace of economic growth in the eurozone ahead will have on the U.S. economy (as the direct result of more fiscal austerity measures adopted by most member countries for this year and next ). While it is true that more than $15 billion a month of U.S exports have as their destination a eurozone country and that such exports will suffer somewhat, it is important to remember the following:

a) The main driving engine of the U.S recovery in this phase remain the consumer, capital spending, and the inventory cycle. Net exports, which represent a relatively modest amount of overall GDP (about 12%) to begin with, are unlikely to constitute a major risk of derailing the U.S economic recovery. The slower pace of GDP growth in the eurozone may represent an additional moderate headwind for the U.S economy but, most probably, not a defining factor. b) Although most of the focus so far has been on the contractionary effect of fiscal austerity on growth in the eurozone countries, it is often unrecognized that a portion of that will be offset by stronger exports from the bloc- the direct benefit of a weaker currency.

Anthony Karydakis

Consumer Spending Has Good Momentum (and a note on Deutsche Bank's Payroll Forecast for May)

The implications of this morning's retail sales data can be summarized as follows:

a) The o.4% increase in both overall retail sales and ex-autos, suggests a healthy momentum of personal spending entering the second quarter and broadly lays the foundation for an annualized gain of 3 1/4-3 1/2% in consumption in the current period. This points to another solid pace of GDP growth in Q2, which, at this distance, is tracking in the 3 1/2 to 4% range.

b) The revisions to the previous few months of retail sales point to an upward revision to first quarter's pace of personal consumption to 3.8% from 3.6% initially reported. This should lead to an upward revision to Q1 GDP growth to 3.5 or 3.6% from the earlier estimate of 3.2%.

c) Combining the above two points, GDP growth is on a 3 3/4% or so track in the first half of 2010, validating the premise of a recovery moving ahead at a sound clip.

d) The consumer remains unfazed in the face of still rising home foreclosures, a stubbornly high unemployment rate, and ongoing tightness in bank lending standards.

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Our friends at Deutsche Bank put out a research note yesterday, that has already circulated extensively, predicting a 475,000 nonfarm payroll gain for May. The forecast is based on the entirely reasonable assumption that- given the pattern of hiring observed in the 2000 Census- census workers are likely to show a spike of 250,000, and possibly, more, in May. Then, essentially, this leaves the private payroll gain at about 250,000 for the month, similar to the 231,000 increase in April.

The "warning" for the risk of a high nominal payroll print in May is fair and understandable, but, in a way, the "point" should be almost "pointless" for market participants, as every one's true focus in the last few months has been the ex-census number, which is instantaneously subtracted from the overall print at the moment the data are released. In reality, the attention that the sensible, and obvious, point made by the Deutsche Bank note yesterday, was much ado about nothing, as no one was going to take a census-bloated payroll number in May as anything other than what it is- an utterly immaterial piece of noise.

The only question that remains is whether a 225,000-250,000 private payroll gain is indeed in the cards for May and the answer to that, based on overall labor market trends lately, is a qualified yes.

Anthony Karydakis

The Budget Deficit Is Stabilizing

Despite the biggest monthly budget deficit on record reported for April ($82.7 billion), the fiscal situation appears to be slowly stabilizing; in fact, an argument can be made confidently that it is already turning the corner.

A direct comparison of last month's deficit with April 2009 is somewhat disheartening, as it represents a nearly $62 billion deterioration- the combined result of a 8% decline in revenue and a 14% increase in spending. On the revenue side, the weakness in individual tax receipts (-$30billion) far exceeded a $9 billion gain in corporate receipts. On the spending side, the increase in April was, to a large extent, artificial due to the acceleration of payments certain payments to April 30th from May 1st, due to the involvement of a weekend.

In the first seven months of the current fiscal year, the deficit has totaled $799.7 billion, essentially identical to the cumulative $802 billion deficit in the first seven months of fiscal 2009. But the steadily improving pace of economic activity and the quick rebound of the corporate sector underway are all setting the stage for relatively robust June and September tax payments, which should help solidify the picture of the overall deficit having turned the corner. Adding to the broader improving fiscal dynamic is the dwindling pieces of last year's fiscal stimulus spending program.

Although it does not sound like a development worth celebrating, the budget deficit is at this point on track to total $1.3 trillion this year, versus $1.42 trillion last year. The risk, if anything is that it may turn out to be slightly below the $1.3 trillion mark. In fact, such an outcome would be fully in line with the Congressional Budget Office's most recent forecast issued in January.

As a direct result of that improvement, the recently announced reductions in the size of the Treasury's 3- and 10-year note auctions are likely to be expanded to cover other coupon maturities by the end of the third quarter. However, given the Treasury's underlying bias to increase its reliance on longer-maturity debt, its slowly declining borrowing needs in the coming months are likely to be manifested primarily in the short end of the yield curve. By the end of the calendar year, the cuts in the size of all auctions will have become more aggressive, given a deficit that is currently projected to be smaller by as much as 1/3 in 2011 compared to the current fiscal year.

Anthony Karydakis

April Employment: Solid Evidence of a Labor Market Rebound

The April employment report (http://www.bls.gov/news.release/pdf/empsit.pdf) provides further strong evidence that labor market conditions are turning around in a convincing manner.

Not only did ex-census nonfarm payrolls increased by a robust 224,000 last month (overall payroll gain of 290,000, including 66,000 census workers) but both March and February were revised upward for a net cumulative gain of 121,000. The direct implication of these numbers is that in the last two months, nonfarm payrolls, excluding census workers, have averaged a gain of 203,000- which is very close to what can reasonably be expected to represent the medium-term trend in payroll growth in this expansion.


Nonfarm Payrolls (monthly seasonally adjusted, incl. census workers)


Source: BLS


Adding credibility to the picture of steadily improving labor markets, the gains in the establishment survey were broad-based among the various categories: an apparently irrepressible manufacturing sector added another 44,000 jobs (third consecutive gain), retail trade 12,000 (also third consecutive gain), leisure and hospitality 45,000, education and health services 35,000, even the troubled construction industry generated 14,000 jobs following a 26,000 gain in March.

The average workweek for all employees inched higher again to 34.1 hours, validating a steady uptrend since the beginning of the year, and pointing to the sustainability of the latest pick up in hiring in the months ahead. The index of aggregate hours worked also rose a healthy 0.4%, replicating its gain in March.

The seemingly disappointing rise in the unemployment rate to 9.9% is actually the result of a 805,000 surge in the size of the civilian labor force that overran an impressive gain of 550,000 in household employment last month and caused the rate to increase.

The expansion of the labor force in the early phase of an economic expansion is a classic phenomenon and should be viewed as evidence that perceptions about the state of labor market conditions among prospective workers are improving quickly, motivating them to start looking for employment (and, therefore, be counted as part of the labor force again). Employment, as measured by the household survey has actually soared by a total of 814,000 in the last two months, despite its spectacular inability to make the unemployment rate move in a more encouraging direction. Still, as the distortions related to the interplay between labor force growth and employment in this phase of the cycle runs its course, the unemployment rate should be on a decisive downward trend in the second half of the year.

The labor market has convincingly turned the corner, inasmuch as, given the enormous slack that has been created by the depth of the last recession, such an improvement can never come fast enough. Payroll growth though is acquiring a respectable momentum and, as the residual caution of the business sector's hiring plans slowly subsides, the potential clearly exists for payroll gains to remain on a 200,000+ path later this year.

Anthony Karydakis

Spain and Friday's Employment Report: A connection

In the last several days, Spain has surpassed Portugal as the next most vulnerable country in the Eurozone, stepping into the eye of the fiscal storm that is sweeping the bloc.

This development, on the face of it, is somewhat counter-intuitive, as Spain's total debt stands at a relatively benign 55% of its GDP, making it a rarity within the Eurozone as a country that is still in compliance with the requirement that such a ratio not exceed 60% of GDP. However, that ratio is rising quickly for Spain and, given the large current and anticipated budget deficits over the next couple of years, is expected to approach 80% of its GDP by 2013.

Still, even such prospect would not be particularly ominous, if it weren't for two highly disturbing characteristics of the Spain situation. First, the reluctance of the Spanish government to implement so far aggressive fiscal austerity measures to convey a reassuring message to global financial markets. This is the direct result of the country's extremely limited room for maneuver in the midst of the current crisis, given an already exorbitantly high unemployment rate of over 20%. Imposing a credible fiscal austerity package would send the unemployment rate sharply higher, with potentially cataclysmic consequences of social unrest. Second, the dramatic spike in Spain's borrowing costs in recent days, raises the specter of the country finding itself soon unable to access capital markets at an acceptable cost and approaching the downhill path that Greece was forced to take.

Spain may be at the threshold of another downgrade by the ratings agencies, which could actually come as early as Friday, adding more fuel to the already raging fire in the Eurozone's sovereign debt crisis. It is after all the fourth biggest economy in the Eurozone, accounting for approximately 12% of its output. Spain is not Greece and the entire fiscal crisis in the Eurozone may well be entering a new phase, if Spain finds itself effectively shut out of sovereign bond market financing.

All of this brings us squarely to Friday's employment report in the U.S.

Depending on the headlines on the Spain (and, to a somewhat lesser degree, Portugal) debt front by Friday, the U.S. Treasury market's response to April's nonfarm payroll data may deviate appreciably from the more "traditional" one. This means that the typically adverse reaction to a potentially above-consensus, "ex-census", payroll number may be mitigated by any negative developments on Spain's debt status. A deteriorating situation in Spain may well keep European sovereign bond and equity markets on the defensive, providing a bid for Treasuries that can overrun, or moderate, the natural instincts of the market to sell off on a strong employment report.

If the payroll report is underwhelming, as hinted at by the ADP number today (which, itself though, needs to be viewed somewhat cautiously, given its generally poor correlation with nonfarm payrolls) and Spain continues to slide over the next 48 hours, then the U.S. Treasury market may be set up for a potent rally, breaking through the lower end of its yield range since the beginning of the year.

Anthony Karydakis

The Trouble With the Savings Rate

In the flurry of economic reports released this morning, one particular piece of data received relatively attention: the decline of the personal savings rate to 2.7% in March.


Source: www.calculatedrisk.com

Although the Q1 GDP report last Friday had already shown a drop in the savings rate to 3.1% for the entire quarter- from 3.9% in the prior two quarters and a cycle-high of 5.4% in Q2 2009- this morning's drop to the lowest monthly level in 18 months is a telling development.

The decline in the savings rate in March confirms a downward trajectory in the series over the last six to nine months and validates the earlier suspicion that the spike in the rate around the middle of 2009 was largely a reflection of circumstantial factors- namely, income transfers related to the fiscal stimulus, and a more defensive approach of households in the midst of a deepening recession.

As personal consumption started coming alive in the second half of last year and reached a robust annualized rate of 3.2% in the first quarter of 2010, the savings rate has been steadily drifting lower, gravitating again toward the disappointingly low 2.0 to 2.5% range that had prevailed for the better part of the last 10 years. The downtrend in the rate dispels any hopes expressed in some quarters last year that a new paradigm of an overall higher savings rate may be emerging, which, although it might act as a headwind for the fledgling recovery, would tend to correct one of the major imbalances in the U.S. economy in the last two decades.

At the time, we had expressed reservations as to whether a deeply entrenched into the psyche of the American consumer culture of spending was about to enter a truly new, more prudent phase (http://economistscorner.blogspot.com/2009_10_07_archive.html). Inasmuch as the savings rate is a notoriously revisable series (often after many years following the originally released data) it now appears that with the increasing recognition of an improving economic environment, consumers are slowly reverting to past habits, the only redeeming value of the latter being that they are helping to solidify spending and the impetus of the recovery at this juncture.

Anthony Karydakis

The Recovery Is Moving Forward

This morning's economic reports provide solid encouragement to the premise that the economic recovery is moving forward at a good clip.

Here's some key points to be highlighted:

1) Despite the seemingly underwhelming pace of GDP growth in Q1 (3.2% annualized), the most important aspect of the report was that the two pivotal engines of GDP are indeed making a credible comeback. Personal consumption rose by a robust 3.6%- following moderate gains in the prior two quarters- confirming that the consumer is plowing ahead, underpinned by a somewhat less ominous labor market picture and an impressive stock market rally.

2) After a two-year period of a "slash-and-burn" reaction of the corporate sector to the severity of the economic downturn, capital spending is back. It rose at a 4.1% annual rate in Q1, following a 5.3% pace in the prior quarter, with the all-important equipment and software category rising by a solid 13.4%.

3) With personal consumption and capital spending on the rebound and the inventory cycle still in full force (inventories contributed nearly $51 billion to last quarter's growth, after a contribution of a staggering $129 billion to the prior quarter's GDP), the recovery has adequate fuel to offset the headwinds stemming from tight lending standards and a struggling housing market and has the potential to move ahead at a 3.5-4.0% clip in the balance of the year.

4) The five-point spike in the April Chicago PMI to 63.8- its highest level in five years- suggests that the turnaround of the manufacturing sector in the last nine months or so remains intact. This, if broadly validated by the ISM report on monday, sets the stage for a solid increase in this month's industrial production and also for moderate job gains ahead in a sector where employment had been literally decimated in the prior three years.

Anthony Karydakis

The U.S Economy and the Eurozone Fiscal Crisis

Now, that the race to contain the fire set off by the implosion of the Greek economy has entered the home stretch, with an announcement of the specifics of an IMF-led bailout expected this weekend, here's a brief assessment on any likely impact of this episode on the U.S. economy.

The already unambitious forecast of about 1.5% GDP growth in the Eurozone bloc this year will need to be downgraded moderately, in the wake of the fiscal crisis that has engulfed a number of its member countries. The issue is no longer economic growth in Greece per se, where a contraction in output by as much as 7% is in the cards following the austerity measures that will be mandated jointly by the EU and IMF. The real issue is that the new dynamic that the Greece situation has unleashed, is likely to trigger enhanced fiscal austerity measures in the other vulnerable Eurozone countries (Spain, Portugal, Ireland, and Italy), as they struggle to fend off the specter of becoming the next Greece. In fact, their already sharply elevated borrowing costs in the last couple of months will inevitably necessitate offsetting domestic cuts, which will slow economic activity further in those countries, and, by extension, in the entire Eurozone.

U.S. exports to the Eurozone countries are running at over $15 billion a month and the demand for such exports is bound to be curtailed in the balance of the year and into 2011. This should have a non-negligible impact on the manufacturing sector in this country, given its export-oriented profile. However, the adverse impact of an export slowdown to the Euro countries on the overall U.S. economy is likely to be more mute, perhaps costing U.S. GDP growth 0.2 to 0.3% over the next four quarters. The export sector represents, after all, a relatively small part of U.S. GDP (12-13%).

On the other side of the ledger, there is an often unrecognized, inadvertent, benefit for the U.S. as a direct result of the fiscal upheaval in several Euro countries: the prospect that long-term yields will remain lower than otherwise, as the Treasury market continues to benefit from the lingering uneasiness about the creditworthiness of some Eurozone sovereign debt.

While the "natural" cyclical forces of an unfolding economic recovery might have exerted some moderate upward pressure on Treasury yields later in the year, that dynamic may countered by the global appeal of Treasuries as a relatively safer place to be for some time. Yes, it is true that the rumored 120-140 billion euro rescue package that Greece will be receiving is, by far, the most massive bailout operation even undertaken by the IMF and its partners (by comparison, the total IMF-led bailout of a number of countries during the Asian financial countries in 1997 was $120 billion, or roughly the equivalent of 90 billion euros). But this will not settle the background risk for a possible default of Greece down the road and the anxiety over how successful Portugal/Spain/Ireland/Italy will be in putting their own house in order.

In fact, the Asian financial crisis is a pertinent reference in attempting to evaluate the impact of the current Eurozone fiscal crisis on the U.S. economy. At the time, the immediate reaction to the crisis by most analysts was that the collapse of a bloc of countries representing nearly 1/3 of our exports market was bound to be highly detrimental to U.S. growth. However, funds fleeing the turmoil in Asia quickly found shelter in the U.S. Treasury market, driving long-term yields down by approximately one percentage point, producing a moderate stimulative effect on the U.S. economy in the first half of 1998.

On the assumption that the fiscal saga in the Eurozone does not lead to an outright blow-up of additional countries, the net effect of the Greek affair on the U.S. economy will likely be marginal. If, however, the instability emanating from this episode afflicts severely the macroeconomic picture of a longer list of countries and reignites fears about the fragility of European and global banks, then things can quickly take a more ominous turn.

Anthony Karydakis

The Eurozone's Fiscal Saga: Shifting Focus?

Since the Greek fiscal drama took center stage in January, the widespread expectation was that it would ultimately lead to the country's bailout, which would put out the intense flare ups of anxiety that were afflicting the sovereign debt markets. Although the moment of the all-but-inevitable bailout for Greece has arrived, it is now far from certain that the markets' apprehension toward European sovereign debt will subside any time soon.

As negotiations over the specifics of the fiscal austerity plan between the Eurozone/IMF and Greece continue, fears that the sheer magnitude of the country's total debt burden is unmanageable and will lead to a restructuring of its existing debt (over 300 billion euros), have intensified. It has also become increasingly likely that the initial amount earmarked for the bailout- a total of 45 billion by the Eurozone countries and the IMF- will prove to be insufficient and bound to increase.

The specter of a Greek default later this year will continue lurking in the background and become a source of variable anxiety for the Eurozone bond, as well as equity, markets. While a period of relative "calmness", in terms of headlines, may succeed the announcement of the Eurozone/IMF agreement with Greece in the coming days, attention is likely to quickly turn to the other two Eurozone countries that seem the most vulnerable after Greece: Portugal and Ireland.

Until now, the overwhelming urgency of Greece's predicament had essentially shielded those two countries from becoming the target of the global bond markets' wrath, although their borrowing costs have risen sharply since the beginning of the year. In relative terms, Ireland may be in a somewhat better position, given an aggressive fiscal austerity program it announced pre-emptively late last year and has been given the benefit of the doubt in terms of the country's commitment to implementing it so far. Portugal is in a more vulnerable state as its economy suffers from a structural lack of competitiveness- just like Greece's- and a debt burden that is almost 10% of GDP. To make matters worse, a set of measures to address these challenges that were announced a couple of months ago were viewed as of dubious effectiveness and the country's prospects for economic growth this year are particularly poor.

And all of this, without even considering complications with the fiscal picture in Spain and, conceivably, Italy at some point.

With the risk of a Greek default not disappearing convincingly any time soon and two other members of the PIIGS slowly coming under increasing scrutiny, the situation in the Eurozone is not likely to return to normal in the foreseeable future. What can also contribute to the tension surrounding the increased attention that some of these countries will now be receiving is the likely growing resistance by Germany and France -in that order- toward the prospect of engineering a series of additional Greek-style bailouts. Voices that have already been raised in Germany about ultimately forcing some of the weaker countries to leave the euro bloc may gain traction, and this is not exactly a dynamic that would make any questions about the future of the euro itself go away easily.

Anthony Karydakis

Treasury Yields: The New Equation

Recently, in this space, we criticized the view expressed by Morgan Stanley, that 10-year Treasury yields are headed for 5 1/2% this year, as too simplistic because it was relying heavily on the argument that the government's massive borrowing needs will inevitably push yields sharply higher. The behavior of Treasury yields in recent days warrants revisiting briefly this topic.

After briefly piercing the 4% mark earlier this month, the 10-year Treasury yield has returned again comfortably to the middle of its 3.60% to 4% range that has prevailed since the beginning of the year. On the face of it, such a resilient performance runs contrary to the general perception that strengthening economic activity and an unprecedented (and relentless) onslaught of new supply can become key drivers for Treasury yields. Those factors, although analytically intriguing, have a very mixed track record in terms of validating what is expected of them- and this is so even in relatively "normal" times.

But the current environment is all but normal. It is dominated by a set of complex factors, originating from multiple sources, which, hard as they are to incorporate into any model with the well-intended ambition to forecast interest rates, do nonetheless play a pivotal role in affecting Treasury yields.

A low-grade anxiety over the Greece fiscal saga that continues to reverberate within global financial markets and its implications for the Eurozone, compounded by the headlines related to the Goldman affair have again reasserted the prominent role of Treasuries as the place to be in periods of uncertainty. As a result, they have decidedly trumped any uneasiness over the increasing credibility of the economic recovery and record issuance of government debt. So much so, that a string of solid economic data in the last couple weeks and the Treasury's announcement today that it plans to sell a record of $129 billion of Treasury securities (including $11 billion TIPS) next week, have failed to disturb the solid underpinning of the Treasury market in this environment.

All in all, even the broader, more classic, fundamentals are not that hostile to Treasuries either. Strengthening economic data are not inherently negative for the Treasury market but only to the extent they are viewed as a proxy for future inflationary pressures. However, with core inflation continuing to drift lower- the direct result of both the great inertia of price trends and the huge amount of slack to be absorbed from the last recession- and the Fed squarely reassured by such a benign inflation dynamic, the steadily firming economic data are non-threatening to the Treasury market.

Long-term Treasury yields will ultimately break-out of their 40-basis point range so far this year; this is, after all, an unsustainably narrow range over a longer period. However, the risk is about even that such a breakout in yields will occur on either side of the range. Intensification of the uneasiness over the Eurozone fiscal situation, or a technical correction in the stock market, can cause a breakout to the downside, while the opposite is likely if things are uneventful on those two fronts and the monthly payroll data pick up steam unexpectedly reigniting more visceral fears among Treasury market participants.

For the time being, until something significant changes in the configuration of the current environment, the 4 to 4 1/4% zone for the 10-year Treasury yield needs to be approached as a buying opportunity.

One would like to think that, setting aside the short-term noise, fundamentals will ultimately reassert themselves as the main driving force for long-term yields. This brings up the need though to expand the menu of fundamentals to be considered in an environment where there are multi-layered forces influencing Treasury yields. Supply and economic data alone are just not enough any more.

Anthony Karydakis