Friday, March 30, 2012

US consumers dipping into savings

Recent data indicates that US consumer spending has picked up steam. But it is also well known that incomes continue to lag. Where is the cash coming from to fund these new purchases?

Source: RTT News

Is it possible the consumer re-leveraging again? The latest data from the Fed shows that is not at all the case. Except for the federally funded student loan issue, consumer credit has stagnated.

US consumer credit - excluding federally funded student loans (Source: The Fed)

The answer sadly is that the consumers are tapping their savings. The data shows US personal savings rate declining sharply during the past month. This has happened before in 2009. After having delayed major purchases for over a year due to the 08 crisis, the consumer did some shopping in late 09. But now the decline in savings rate has resumed.

Savings rate as % of personal disposable income (Bloomberg)

Some of that spending is on necessities such as gasoline as well as an upgrade in durable goods/autos. But spending that is not supported by increases in income is not sustainable, particularly as credit remains tight.
BW: Dales cautioned, though, that at some point, consumers won't be able to draw further on their savings. Further job gains are needed to boost consumers' income.

Some of the higher spending last month reflected surging gas prices. But consumers spent more on other goods and services, too. After excluding inflation, which was due mainly to gas prices, spending rose a solid 0.5 percent.
Another issue with personal savings rate in the US is the lack of incentives to save these days. The stock market and the real estate markets are scary for many people. Fixed income markets now have material interest rate risk. Money market funds are worthless. Most people just keep money at their bank in savings or bank money markets accounts. According to however, the average national money market and savings rate at your bank is 13 basis points - yes, per year.

With inflation rate pushing 2%, the consumer knows that leaving cash at the bank means losing money. The Fed has achieved its goal of disincentivizing the holdings of cash. But it would be far more encouraging to see consumer spending based on better paying jobs than on replacing severely aged vehicles by dipping into savings or attempting to avoid the impact of negative real rates.

Ireland for sale

As strong reactions to the post on Ireland continue to come in, here is something else to consider. Ireland's infrastructure is now for sale. The first set of assets that are being sold are of course the commercial real estate properties that got Irish banks (and the government) into trouble to begin with. The bankrupt property developers have turned the keys over to the banks who passed them on to the National Asset Management Agency (Nama) as part of the "bad bank" bailout program. And the sales must happen quickly.
Bloomberg: The Dublin-based asset manager must sell 9 billion euros of property loans and real estate to meet a 7.5 billion-euro debt- repayment goal by the end of 2013, Chief Executive Officer Brendan McDonagh said in an October interview.
But there is more than real estate properties for sale. The state's share of Aer Lingus for example is being shopped around. Seeing opportunities in Ireland's infrastructure, which is also on the auction block, China now moves in. Cheap infrastructure has always been interesting for the Chinese and Ireland is no exception.
People's Daily: "There are enough opportunities for Chinese companies to invest in infrastructure in Ireland. We have a lot of infrastructure that is publicly owned, and part of it is going to be sold in the next two to three years," said O'Leary.

"They (the assets) are valued at 3 billion euros ($4 billion), including energy, gas, electricity, ports, roads and water," he added.
The sale is on and everything must go.

Is China's slowdown worse than previously estimated?

The seeming slowdown in China's business conditions we saw this year were often attributed to the Chinese New Year holiday, which came early this year. Unlike most holidays in the West, the Chinese New Year actually brings a great deal of manufacturing and other business activities to a halt - often at the expense of timely delivery of customer orders. The tight labor conditions in recent years have made that slowdown even more pronounced.
CNN: During the Chinese New Year... factory output grinds to a halt as many of the migrant workers return to their home provinces during a two- to four-week period.

Large and small companies have adjusted their business models over the years to accommodate the holiday. But those adjustments have not taken into account new economic trends in China, which are whittling down the country's factory workforce. Fewer workers have meant delayed shipments and lost sales for small U.S. companies, some owners complained.
The floating Lunar New Year holiday has made seasonal adjustments quite difficult. With the holiday being  early this year, comparisons to previous years became somewhat unreliable. For example the slowdown in auto sales may have been overstated.

The ISI Group has done some extensive work to adjust for this effect. The chart below shows the March MNI Business Condition Survey in China (blue) and the ISI's seasonal adjustment (purple). According to this adjustment, the survey may be pointing to business conditions that are worse than anything we've seen since 2009.

Source: ISI Group (click to enlarge)

As more March economic numbers come out, we should be able to get a clear picture of the growth trend in China. The MNI survey however may be an early sign of a more severe slowdown than previously estimated.

Thursday, March 29, 2012

The escalation of Spain's regional debt

As the Spanish government spreads grind higher, it is becoming increasingly clear that Spain will have a difficult time reaching its target of 5.3% debt to GDP this year and particularly the 3% targeted for next year. Goldman's latest report is forecasting this year's number to be 6.8% and next year to be double the target of 6%. Achieving targeted fiscal consolidation will be nearly impossible, at least in the near term.

Recent movements in 5yr  Spain-Germany spread (Bloomberg)

But a more dangerous development in Spain's fiscal conditions is the increasing leverage of regional governments, which account for close to half of public spending in Spain. As the central government tries to reign in spending, the local governments attempt to pick up the slack. Regional government debt as a percentage of regional GDP has spiked materially in the last few years.

Source: GS

And the situation seems to be getting far worse with current regional budget balances all in the red.

Source: GS

Spain's central government is trying to pressure regional governments to contribute to the overall debt reduction. But the regions' local politicians are often not incentivized to comply. The tension between the regional and the national governments have been escalating.
Reuters: ... following Sunday's regional election result, which denied Rajoy the absolute majority he had hoped would reinforce his mandate for spending cuts, the prime minister will have to measure his next steps to avoid sparking more protests.
The Law for Budget Stability which is going into effect later this year should help apply pressure on the regional governments to control spending increases. But ultimately it looks as though the central government will need to bail out a number regional governments just to allow them to pay their bills. That is not expected to be constructive for Spain's overall fiscal consolidation.
Reuters: Police presence was particularly heavy around parliament where lawmakers were due to debate measures to help heavily indebted local and regional governments pay money owed to suppliers.
For further developments on the regional debt problem, see this BBC video

The rapidly shifting supply fundamentals in US natural gas

The story of US natural gas is a good example of how quickly the supply begins to adjust to changes in demand when free markets are allowed to work. Here are the facts.

1. Supply of natural gas is now substantially above the 5-year range. At this time of the year the cycle of withdrawal from storage ends and the injection cycle begins (the inflection started earlier this year).

Source: EIA

2. Prices adjust violently to the news of oversupply in storage.

Natural gas futures price (Bloomberg)

3. The market action quickly translates into an adjustment to the "real economy" as the number of natural gas rigs declines (within months).

Source: Barclays Capital

At the same time demand for natural gas is increasing, with gas replacing coal for some of the US power generation. Natural gas will even replace gasoline for certain applications over time. Ultimately this should lead to the leveling off of supply and the stabilization of natural gas prices. The market is already pricing that in via a very steep futures curve. Gas prices are expected to almost double two years out.

Nat gas futures curve (Bloomberg)

Wednesday, March 28, 2012

US coal production declines as the industry faces further stress

Here is a follow-up to the post on the declining US coal demand. As natural gas hits a new low today, the pressure on US coal industry increases further.

Natural gas nearby futures contract (Bloomberg)

The impact is unmistakable. The latest data from EIA is showing 2012 coal production levels materially below the 5-year range for this time of the year.

Making things even worse for the coal industry is the new EPA proposal to reduce carbon emissions by electricity companies. This proposal would turn the new coal-fired power plants into money losing investments.
Reuters: The first-ever U.S. proposal to restrict carbon dioxide emissions would have once been a major shock to electricity companies by making it uneconomic to build new coal-fired power plants.
But the irony is that the essence of the EPA's proposal has effectively already been usurped by low natural gas prices, which also turn coal-fired plants uneconomic.
Reuters: But the discovery of abundant supplies of cheap natural gas means that many of those plants won't get built anyway - making the Obama administration's plan, while painful for the coal industry, much less relevant.

Eurozone periphery governments "encouraging" banks to buy sovereign debt

Bloomberg: “There’s a moral hazard element to this,” Ken Wattret, chief European economist at BNP Paribas SA in London, said in a telephone interview. “The ECB is clearly worried that in some countries the lower the risk premium on sovereign debt, the less urgency there will be to make some changes.”
The ECB should be concerned. The Eurozone periphery governments are effectively telling their banks: don't worry about your customers for now. We ARE your main customer. Get your 1% 3-year ECB loans and buy our government debt - keep the rates low.

The banks of course are ready to oblige. After all it is a profitable trade even at these lower yields, particularly since there is no capital charge currently for banks holding their nation's government debt.

Italian banks' net purchases of Italian government bonds
and 3m moving average (Source: Credit Suisse)

Spanish banks' net purchases of Spanish government bonds
and 3m moving average (Source: Credit Suisse)

This poses two major problems for the Eurozone periphery:

1. The government bonds effectively crowd out lending to private customers (both corporate and households). There is no incentive for these banks to lend to private clients when they can just buy government paper. This will push the Eurozone further into recession.

2. As the Bloomberg quote points out, the artificial lowering of yields takes away the urgency/incentives needed to get government spending under control for periphery nations.

The Billion Dollar Club of hedge funds

Here are the latest statistics on the largest hedge funds, the so called Billion Dollar Club - funds with over $1bn in AUM. The "club" was unchanged from a year ago in terms of the number of "members", while the overall AUM came down slightly.

Here is how the largest funds did as measured by their AUM changes:

Below are the "club winners" who gathered the most AUM on a percentage basis:

There were a number of hedge funds however that really took a pounding. The reduction in AUM for many of these funds was due to poor performance as well as investor redemptions.  This included a number of high profile funds.

Overall the industry is having trouble growing, particularly as 2011 turned out to be one of the most challenging years on record.

Correction:     Senator Investment Group AUM was $3.6B as of Jan 2012 (ht grizz)

Tuesday, March 27, 2012

Bankers are telling corporate clients this is their chance to refinance

The chart below overlays this year's High Yield bond issuance on top of last year's. This is the picture that bankers are showing their corporate clients. They are telling them your opportunity is now - the window of cheap financing is open. Many new issue HY bonds are being done below 6% (remember this is for "high yield" bonds), and if you have debt to refinance in the next year or so, the banks are telling you this is your chance.

And the corporations are listening. Fears of either rising rates or widening spreads are pushing firms into an already heavy HY calendar. LYB, GTI, Hindery, VFC are among the corporate names tapping this market. Whether this rush to refinance is justified remains to be seen, but in the mean time the banker fees are rolling in.

Some Irish banks unable to qualify for LTRO are tapping Bank of Ireland's ELA

The Emergency Liquidity Assistance (ELA) are temporary loans provided by the Eurozone's National Central Banks (NCBs) to banks in their jurisdiction. These loans are outside of those provided by the ECB, such as the LTRO program. The idea was to allow for some discretion for the NCBs to help their domestic institutions in a crisis situation that is specific to that nation, as opposed to a Eurozone-wide issue managed by the ECB. Unlike the ECB's lending programs where the risk is shared by the Euro-system, the NCBs bear the risk on ELA loans. The ECB can in fact stop the NCBs from providing specific ELA assistance if it is deemed to interfere with the ECB's overall policy actions.

With the massive LTRO lending program by the ECB, one would expect that the Eurozone banks would repay their ELA loans and roll them into the ECB's 3-year loans. That seems to be what in fact happened for some nations such as Belgium, but the roll was only partial for Ireland. The Central Bank of Ireland still has some €45 bn of ELA loans outstanding.

Source: GS
So why would Irish banks not roll their ELA into the 3-year 1% LTRO? There is only one explanation. In spite of the much looser collateral requirements under the latest LTRO program, the collateral posted by the Irish banks under the ELA loans just doesn't qualify for LTRO. These Irish banks still need the liquidity but simply don't have the collateral the ECB would find palatable.

This is an important development to watch because it indicates continuing stress in the Irish banking system - with some banks so tapped out, they don't have enough ECB-eligible collateral. It also poses a risk to the Central Bank of Ireland that is not shared by the Eurozone (for now), particularly given that Ireland is in no position to bail out its central bank.

Monday, March 26, 2012

The Economic Surprise Index is now trending down

Notice how the US economic data coming out lately has been quite mediocre relative to expectations? For example, today's pending home sales came in -0.5% vs. +1% expected. Dallas Fed manufacturing activity came in at 10.8 with 16 expected. Citi has an index that tracks economic data surprises. Here is the definition:
The Citigroup Economic Surprise Indices are objective and quantitative measures of economic news. They are defined as weighted historical standard deviations of data surprises (actual releases vs Bloomberg survey median). A positive reading of the Economic Surprise Index suggests that economic releases have on balance beating consensus. The indices are calculated daily in a rolling three-month window. The weights of economic indicators are derived from relative high-frequency spot FX impacts of 1 standard deviation data surprises. The indices also employ a time decay function to replicate the limited memory of markets.
The index is now trending lower as the negative surprises are starting to weigh it down. The US economic forecasters have gotten a bit ahead of themselves, which may indicate a need for caution.

Citigroup Economic Surprise Index (Bloomberg)

Sunday, March 25, 2012

34% chance of ObamaCare to be ruled unconstitutional this year, 50% by end of next year

A US Supreme Court ruling that would make ObamaCare unconstitutional by the end of 2012 is trading at 34% on Intrade. By the end of 2013, the number is close to 50% (there are two separate contracts). If such an event were to take place before this year's US presidential election, it would be a major threat to Obama's reelection chances. After all the president's signature piece legislation ruled unconstitutional would give Republicans some powerful ammunition.

But before the US Supreme Court can make a ruling on the constitutionality of ObamaCare, it needs to determine if it can even make that ruling now. The judges will consider tomorrow if the decision on the constitutionality of the law has to wait until 2014 when ObamaCare is expected to take effect. The strange thing about this case is that both parties actually want the Court to decide now, not in 2014.

At the heart of the issue is the requirement for everyone in the US to buy health insurance, which many people don't support - and the piece of legislation that the Supreme Court will focus on. But another part of the law prohibits insurance companies from denying care due to a preexisting condition, which many of the same people support. But you can't force insurance companies to take on sick people without also giving them a bunch of healthy clients - otherwise they will go broke. This means that if the portion of the law that forces people to buy insurance is ruled unconstitutional, the rest of the law effectively falls apart. The stakes for Obama are high - the administration won't be able to modify the law and still keep it in place if the "insurance for everyone" requirement is ruled unconstitutional. And if ObamaCare falls this year, so will the president's chances for reelection.

Update: This post was removed from Reddit/Economics by the moderator with the following comments - obviously got someone really upset:
First thing, saying 'ObamaCare' makes you sound like a partisan tool.

Second thing, "This means that if the portion of the law that forces people to buy insurance is ruled unconstitutional, the rest of the law effectively falls apart." is false -- one of the issues before the Court is whether the individual mandate is severable from the rest of the law, they could find that part beyond the authority of the commerce clause but the rest of the law perfectly constitutional.

Third thing, whatever something is trading on 'Intrade' has nothing to do with the chances of it becoming unconstitutional, that's retarded.
Since SoberLook has no opportunity to respond to this on Reddit, we'll respond to these comments here:

1. ObamaCare is a perfectly good expression - it's quite descriptive. Plus the Obama administration itself uses it openly.
2. You missed the whole point. Even if the individual mandate is severable, the law falls apart because the insurance companies can't function without the individual mandate but with the rest of the law in place.
3. This may surprise you, but the markets are the best predictors of events - from recessions to elections outcomes. Even 9/11 was signaled in the markets.

Signs of demand destruction: the US consumer is saying NO to high gasoline prices

The NYMEX gasoline futures price hit another recent high last week and is sure to push up gasoline prices at the pump. This development will add to the lingering concerns about the nascent US consumer recovery.

NYMEX gasoline nearby contract (Bloomberg)

Crack spreads (spread between distillates and crude oil price) have recovered from the lows of December. It means that refinery margins are now quite high, with refineries enjoying fat profits once again. As an example Valero Energy (VLO), a major US refiner is up 27.6% year to date on a total return basis.

WTI 321 crack spread 1m

But it seems there is only so far the US consumer can be pushed before demand declines and possibly demand destruction sets in. As prices have risen over time, US gasoline demand visibly came off. US drivers are just buying less of it these days.

Source: Barclays Capital

And that trend is starting to be reflected in the levels of gasoline inventories. According to the latest EIA data, US gasoline inventories are materially above the 5-year range for this time of the year. Given the warm US winter, this can not be blamed on the weather.

Source: JPMorgan

With recent spikes in gasoline prices, the consumer has been able to adjust the driving patterns as well invest in more fuel efficient vehicles.
NEW ENGLAND CABLE NEWS: MasterCard SpendingPulse says gasoline consumption across the United States has been on the decline every week for the past year, showing a total drop of 4.2 million gallons. That's a 3 percent decline.

Higher gas prices seem to be the main factor. AAA puts the average price of a gallon at $3.89 today. That's the highest ever for this time of year, and analysts say it could reach $4.25 by the end of April. That's prompting Americans to make fewer daily trips and staying closer to home when they take vacations.

But the man who oversees MasterCard SpendingPulse's weekly consumption report says that's not the only factor. John Gamel points to rising sales of fuel-efficient vehicles.

A recent survey by J.D. Power and Associates found new-vehicle owners rated good gas mileage higher than reliability, stylishness or a great deal in their car buying decisions.
This pattern, if continues, will cap crack spreads and limit profits for companies such as Valero (might be time to take profits). But as a whole, the concept of gasoline being an "inelastic" commodity in the US is starting to change. The consumer is now able to dial down the demand (only partially of course) when prices rise too far. In the long run the introduction of Compressed Natural Gas (CNG) as an alternative fuel for US transport, (initially as a diesel substitute for trucks) will create competition for US refiners.

China tightening the screws on Iran

China is starting to pressure Iran by reducing oil purchases from that nation (substituting with Saudi oil). Iran sells 65% of its oil to Asian nations, with China taking a large portion of that. China has two reasons to reduce purchases from Iran. One is the obvious pressure from the West that could give the US a national security based reason to slap penalty tariffs on Chinese-made goods (or at least threaten to do so). The second reason is to force Iran to ultimately sell them crude at below market prices - which may make dealing with the US threats more worthwhile (for more on such strategy see this post).

Source: JPMorgan
Other Asian nations have apparently joined in this effort as well.
CNN: China, South Korea and Japan dramatically cut their oil imports from Iran in February following intense US efforts to persuade Asian buyers to comply with Washington sanctions on Iran's central bank.
The next round of nuclear talks is likely to be held in April (with the so-called 5+1 group the US, Britain, France, Russia, China, and Germany). Iran's authorities are desperate to get this issue resolved while still saving face. Cut off from external capital, oil revenues dwindling, inflation running close to 25%, and food shortages becoming commonplace - all putting pressure on the government to ease the sanctions. The rhetoric out of Tehran will be escalating as the talks draw closer and the internal situation within Iran's borders becomes more dire.
Tehran Times: It’s clear that the unilateral sanctions imposed on the Central Bank of Iran and other Iranian institutions and the call for a boycott of Iranian oil were the last cards that the West had left to play before the negotiations with Iran. In this situation, Iran has the upper hand in the nuclear talks and can put diplomatic pressure on the West. And if the upcoming nuclear negotiations fail, the big losers will be the Western camp not Iran.

The new Greek yield curve

The Greek PSI (new) bonds are now actively quoted. Prices vary with maturities - roughly between €17 and €25 (17 to 25 cents on the euro). Here are the latest mid quotes by maturity.

Latest quotes on Greek PSI bonds

Using Bloomberg these can be converted to yield, producing the following yield curve. This is a unique sovereign curve even for a distressed name because it starts in 2024, with nothing actively quoted prior to that.

The new (post-PSI) Greek yield curve (Y-axis = yield in %)

It is naturally an inverted curve that is pricing in a significant probability of a second default. Depending on the recovery assumptions, the probability of default priced into these bonds in the next 10 years is near certain (the higher the recovery assumption, the higher the implied default probability). Being subordinated to the EU/IMF rescue loans, these bonds don't stand to recover much the next time around.

The great asset class rebalancing

Here is the latest data from DB on fund flows for the major asset classes:

Equity mutual funds are continuing to lose ground to ETFs. The US domestic equity mutual funds have lost some $100bn since Jan of 2009, while equity ETFs are up around $50bn during this period.

Source: Deutsche Bank

But the equity asset class as a whole is losing AUM. Some of this capital is of course flowing into fixed income funds. Investment grade corporate bond mutual funds and ETFs have gained $131bn ($42bn into ETFs and $89bn into mutual funds) for the same period, while HY funds picked up $48bn ($20bn into ETFs and $28bn into mutual funds). Given the demographic changes in the US that favor fixed income as well as the loss of confidence in equity mutual funds, this trend is expected to continue.

Saturday, March 24, 2012

With a 50% drop TVIX snaps back to NAV

Shorting equity volatility has been an amazing trade in recent months. For example here is a chart of VXX, the VIX futures ETF, collapsing below the pre-2011-crisis levels. ETFs like VXX roll the nearby futures contracts, and as the VIX futures curve steepened, the cost of this roll (the "negative carry") rose. The increased cost of the roll was on top of the general collapse in the VIX index, sharply lowering the value of the ETF. A great deal of money has been made on this short.

VXX share price (Bloomberg)

But as discussed a few days back, why settle for the 1x VIX futures when you can short 2x via TVIX. Except TVIX is not an ETF - it's an exchange traded note (ETN). The manager does not have to issue new shares if the security trades at a premium to NAV (see this post for the ETF mechanics). With the number of participants taking short positions rising, a short squeeze ensued last week.

TVIX short interest

The press and apparently the SEC (though this has not been verified) gave the manager a wake-up call.
WSJ: Credit Suisse AG (CS) on Friday reopened issuance of a leveraged exchange-traded note tied to the market's fear gauge, a month after the bank suspended new issues following a rush of demand.

The reissuance of shares follows a month of unusual market performance in the VelocityShares Daily 2x VIX Short-Term ETNs (TVIX), capped by a two-session decline during which time the ETN hemorrhaged half its market value.

Friday, TVIX fell 30% to close at an all-time low of $7.16.

Credit Suisse said in a news release late Thursday it will resume issuance Friday on "on a limited basis," after the bank suspended new issues on Feb. 21, citing "internal limits on the size of the ETNs."

TVIX shares outstanding

Under pressure, CS issued more shares, which hit the market all at once, collapsing the premium to NAV - price dropping by some 50% in a couple of days.

TVIX price vs. NAV

It is likely the SEC will have a few things to say about this. Arbitrarily changing or holding constant the number of shares outstanding, no matter what the reason is, causes tremendous market distortions. Products like these may be deemed inappropriate for retail investors, particularly when the manager can effectively manipulate the price.

Cracks forming in Argentina's economic miracle

By all accounts Argentina has made an enormous progress since their default and restructuring some years back. A policy of currency depreciation to raise competitiveness and a good amount of government spending (including tapping central bank profits), allowed Argentina to achieve strong growth and put people to work. Argentina's unemployment (assuming one believes the government figures) is significantly below the unemployment rate in the US.

Argentina unemployment rate (Bloomberg)

But it seems that cracks are beginning to develop in Argentina's economic miracle.
Reuters: Argentina's industrial production growth in February fell short of market expectations, underlining an economic slowdown in Latin America's No.3 economy, official data showed on Friday.

Factory output rose 2.7 percent year-on-year but declined 1.4 percent from January, falling for a second straight month.

Argentina's economy has boomed in the last nine years at China-like rates, but activity is now cooling, led by sharply slower growth in the industrial sector.
With depreciating currency and higher energy costs, inflation continues to be a problem. Consumer inflation is close to 10% and wholesale inflation is over 12%. External commerce activity has slowed materially, with both imports and exports pace of growth at levels not seen since 2008.

Source: JPMorgan

The beginning of this year also brought a large decline in vehicle sales (also comparable to 2008), indicating weakness in domestic consumption.

Argentina vehicle sales (Bloomberg)

In fact the consumer confidence indicator is also registering a sharp decline.

Argentina consumer confidence (Bloomberg) 

But a major leading indicator pointing to a rapid slowdown actually happens to be Argentina's cement sales. As one would expect, cement sales are highly correlated to construction activity. Growth in cement sales has stalled and construction growth is expected to follow. That in turn points to a slowdown in industrial production.

Source: JPMorgan

In addition some questionable government policies and president Fernández' falling popularity are adding to concerns about Argentina's immediate future.
Macleans: ... the Fernández period, which was marked first by economic recovery, has lately come to be known for skyrocketing inflation, a growing wealth gap, rifts with neighbouring countries, and distrust of the government. Growing discontent was recently met with an attempt to ramp up patriotic fervour by reigniting the old Falkland Islands dispute with Britain—right on time for the 30th anniversary of a botched military invasion by Argentina’s dictators.
Some of these policies aimed at improving public's support for the government are becoming increasingly desperate. One such action in particular, that has raised eyebrows internationally, involves tapping central bank reserves for more government spending.
Reuters: Argentina's lower house approved a bill on Wednesday to free up more central bank reserves for debt payments, a move that paves the way for the government to keep spending high but which has been criticized as inflationary...
At the same time Argentina has been trying to issue bonds to foreign investors - something they have been unable to do for years since the default/restructuring (which is still tied up in courts abroad). With these economic and political trends, issuing foreign debt will prove to be difficult and the nation will continue relying on its central bank to help fund government programs. As the global economy is expected to grow considerably slower than in the past decade, Argentina is becoming vulnerable. It is looking as though Argentina's recent economic miracle will be coming under increasing threat going forward.

Friday, March 23, 2012

Implied volatility distortions for short-dated calls are not real

Someone sent us this Bloomberg chart that shows the SPY (ETF) equity option "skew" (implied volatilities across different strike levels) for options with a 1-month maturity. Strike price is shown as a percentage of the current price of SPY. It looks as though the implied volatility on the up-side has spiked dramatically. One explanation proposed has been that as the equity rally stalled and people have sold some of their equity positions, they also bought back the covered calls they shorted earlier - bumping up implied vols.

1 month SPY SKEW: Today, 3 days ago, 1 week ago

But there is a simpler explanation. The deep out-of-the-money options for a 1 month maturity are quoted at a couple of pennies but there are no trades at these levels. As SPY sold off a bit during the week, the options were still quoted at roughly the same levels and there were still no trades.

Call option quotes (Source: Bloomberg) 

Now if options are "priced" at a constant level while the underlying drops, the implied volatility will increase. When options are quoted in pennies and little or no trading takes place, seeming distortions in implied volatility become common. But it's hardly an indication of anything fundamental going on in the market. With the 3-month maturities for example, where option premiums have real value, this distortion no longer exists.

3 month SPY SKEW: Today and 1 week ago (Bloomberg)

Economic forecasters have been too sanguine on Eurozone

A worrisome widening in Spanish and Italian bonds is making the news again.
WSJ: Spanish bonds extended a slide that was triggered earlier this month after the country was chided by euro-zone authorities over the government's unilateral decision to revise up its budget deficit target for this year. With concerns over Greece abating after a crucial debt exchange went through, Spain is increasingly being seen as the next flashpoint in the euro zone.

The economy is stuttering, unemployment is rampant, and the market is losing confidence in the government's ability to mend its finances. If the sell-off in Spanish bonds were to accelerate, Italy might not be left unscathed either.

Spanish and Italian 5yr bond spreads to Germany

All of a sudden economists and forecasters (such as this CS forecast) are realizing they've underestimated the level of the periphery recession. One can see the forecast mistakes coming through the latest Eurozone manufacturing PMI.

Eurozone manufacturing PMI

It is difficult to imagine anything but a depression-style economy in Spain for example, when nearly a quarter of the population is out of work.

Spain's unemployment (Bloomberg)

And the news media is only now catching on...
BW: Europe’s economy may struggle to regain strength after shrinking 0.3 percent in the fourth quarter as governments toughen budget cuts, rising oil prices erode consumers’ purchasing power and global demand weakens.

Thursday, March 22, 2012

US natural gas hits another all-time low

The super-early spring in the US is bringing with it two things: terrible allergies due to high pollen count and really low natural gas prices due to too much inventory. Natural gas hit another low today with a 4% drop.

Natural gas futures contract (Bloomberg)

It is important to note that this is a US-specific phenomena. Globally natural gas prices remain elevated and the spread between the US gas price and prices elsewhere has been rising rapidly. "Lake Charles" refers to the Lake Charles terminal (Louisiana pipeline).

Natural gas prices (Source: Barclays Capital)

The only real way to arbitrage this divergence is with Liquefied Natural Gas (LNG) that can be delivered to these offshore locations. And it will be a while before the capability is there to export LNG on any significant scale.
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