On Friday, the ECRI publicized their call that the U.S. economy was headed for a recession (here). This firm has a respectable track record of forecasting turns in the business cycle, so this is a particularly noteworthy call.
Most of the financial commentary I have read so far has been forecasting a garden-variety recession (should one even occur), with corporate earnings falling 10-15%. While I have yet to be able to quantify the effect on corporate earnings, I take issue with comparisons to historical recessions for a number of reasons.
Starting with the C in Y = C + I + G + X, the consumer is still balance-sheet constrained. Historically, when consumer income fell, consumers would borrow money to smooth their consumption. With the American consumer leverage sitting as high as it is, it is likely that consumer spending will fall more than in historical recessions (higher flow through from falling consumer income).
Moving on to investment, while I am not expecting a total credit market freeze for highly-rated corporates, the high-yield primary market has been effectively closed for nearly three months. Historically, high-yield names have not been a meaningful proportion of total corporate issuance, but in the last two years, we have seen $600B in high-yield issuance, which I suspect has significantly inflated business capital expenditures (admittedly some of this issuance was debt-for-loan swaps). With this group of firms locked out of the primary market (and higher-rated firms behaving in line with historical experience) I expect there to be a larger decline in business investment than has been seen in historical recessions.
Government. Given the hysterical obsession with cutting spending (and taxes) in the House, I cannot see the U.S. passing any marginal stimulus until after the 2012 elections. If this is the case, government expenditures will actually contract relative to 2011. This is in direct contrast to historical recessions, wherein the government traditionally inflates expenditure in an attempt to stimulate the economy.
I do not have any strong feelings on net exports and feel that it is probably a wash.
Throw in European and Chinese tail risks, and the risks to the consensus recession forecast are clearly overweighted on the downside.
I should clarify that I am not saying with 100% certainty that teh U.S. is headed for a recession (although I do believe that a recession is more probable than not), but rather detailing my thoughts on the nature of the recession, should it occur. I will flesh out these thoughts in upcoming posts.
Saturday, October 1, 2011
Thursday, September 29, 2011
European Blow-Up Risk - Hedge Edition
If you were looking to hedge European meltdown risk in the CDS market, who would be your reference entity of choice?
Parsing CDCC data gives us an indication of how others are hedging this type of exposure - French CDS. Initially, I found this surprising: if you are worried about your exposure to Italy or Spain, wouldn't it make sense to go long their respective CDS? On second thought though, this move appears quite rational. Assuming that Italy and Spain are too big too bail out (that is certainly the perception on the street), then it is reasonable to assume that if either of their bond markets collapse, the French government would be the next domino. So why pay a higher spread for Italian or Spanish CDS when French CDS provides essentially the same hedge? I think that my interpretation is strengthened by the fact that net notional exposure to France took off in July and August, as Italy teetered on the brink
Another interesting nuance of the data is that CDS exposure to Greece and Portugual have fallen substantially this year. Could it be the case that all those lawyers that the EU have hired to avoid a technical default are undermining market confidence in whether Greek/Portuguese CDS will actually payout in the event of default?
Parsing CDCC data gives us an indication of how others are hedging this type of exposure - French CDS. Initially, I found this surprising: if you are worried about your exposure to Italy or Spain, wouldn't it make sense to go long their respective CDS? On second thought though, this move appears quite rational. Assuming that Italy and Spain are too big too bail out (that is certainly the perception on the street), then it is reasonable to assume that if either of their bond markets collapse, the French government would be the next domino. So why pay a higher spread for Italian or Spanish CDS when French CDS provides essentially the same hedge? I think that my interpretation is strengthened by the fact that net notional exposure to France took off in July and August, as Italy teetered on the brink
Another interesting nuance of the data is that CDS exposure to Greece and Portugual have fallen substantially this year. Could it be the case that all those lawyers that the EU have hired to avoid a technical default are undermining market confidence in whether Greek/Portuguese CDS will actually payout in the event of default?
Wednesday, September 21, 2011
QE3 Q&A
Seeing as tomorrow is the Fed's big day, I figured I'd briefly give my thoughts on QE3.
What will happen?
The market is expecting 'Operation Twist', whereby the Fed reinvests the maturing portion of their portfolio of short-term Treasuries (and MBS) into the long end of the curve, thereby lowering long term interest rates without altering the size of the Fed's balance sheet. Given their commitment to low-for-long the last time around (which guarantees that the short-end will remain flat), Operation Twist strikes me as the most reasonable policy expectation for this FOMC.
Will it happen?
I see this as about 50/50. While the Fed is looking to do more to stimulate the economy, the 5x5 year inflation expectations (the Fed's favorite measure of inflation) are much higher than they were at the initiation of QE1 and QE2. This gives them less cover when the politicians inevitably start harping on about currency debasement and the inflation that will follow (I personally do not see this as a likely consequence). It is important to remember the backlash from both sides of the aisle in response to QE2, which at the margin will make Bernanke more reluctant to act. On the other hand, unemployment - the other half of the Fed's dual mandate - remains unacceptably high.
Will it be effective?
With 10-year U.S. Treasuries trading at their lowest yields in 60 years, it is hard to imagine that Operation Twist, if implemented, will have a meaningful impact on the long end of the curve (25 or 50 bps at most). I am of the mind that the problem the United States is facing is a shortage of demand for credit, rather than supply (as Fed policy assumes). Therefore, I do not expect Operation Twist to have a measurable impact on the economy.
What will be the impact on asset markets?
This is a tougher question to answer, but it strikes me that Operation Twist is largely priced into asset markets. I suspect that commodity bulls will try to sell the QE1 and QE2 redux story - ie higher commodity prices, but since there is no net liquidity going into the system, I think the market will see through this. Selling the news is also a possibility here (but carries a considerably lower probability than the 'little marginal impact' outcome). Finally, given market pricing, should the Fed not implement Operation Twist, I foresee a significant sell-off in risk markets and the inevitable concomitant flight to quality. However, this flight to quality will be balanced by the sell-off in the long end, as people have bought in anticipation of Operation Twist. Therefore, I would expect the yield curve to steepen significantly.
What will happen?
The market is expecting 'Operation Twist', whereby the Fed reinvests the maturing portion of their portfolio of short-term Treasuries (and MBS) into the long end of the curve, thereby lowering long term interest rates without altering the size of the Fed's balance sheet. Given their commitment to low-for-long the last time around (which guarantees that the short-end will remain flat), Operation Twist strikes me as the most reasonable policy expectation for this FOMC.
Will it happen?
I see this as about 50/50. While the Fed is looking to do more to stimulate the economy, the 5x5 year inflation expectations (the Fed's favorite measure of inflation) are much higher than they were at the initiation of QE1 and QE2. This gives them less cover when the politicians inevitably start harping on about currency debasement and the inflation that will follow (I personally do not see this as a likely consequence). It is important to remember the backlash from both sides of the aisle in response to QE2, which at the margin will make Bernanke more reluctant to act. On the other hand, unemployment - the other half of the Fed's dual mandate - remains unacceptably high.
Will it be effective?
With 10-year U.S. Treasuries trading at their lowest yields in 60 years, it is hard to imagine that Operation Twist, if implemented, will have a meaningful impact on the long end of the curve (25 or 50 bps at most). I am of the mind that the problem the United States is facing is a shortage of demand for credit, rather than supply (as Fed policy assumes). Therefore, I do not expect Operation Twist to have a measurable impact on the economy.
What will be the impact on asset markets?
This is a tougher question to answer, but it strikes me that Operation Twist is largely priced into asset markets. I suspect that commodity bulls will try to sell the QE1 and QE2 redux story - ie higher commodity prices, but since there is no net liquidity going into the system, I think the market will see through this. Selling the news is also a possibility here (but carries a considerably lower probability than the 'little marginal impact' outcome). Finally, given market pricing, should the Fed not implement Operation Twist, I foresee a significant sell-off in risk markets and the inevitable concomitant flight to quality. However, this flight to quality will be balanced by the sell-off in the long end, as people have bought in anticipation of Operation Twist. Therefore, I would expect the yield curve to steepen significantly.
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