Bond Yields On the Rise in Spain and Italy...

Good day…and welcome to another Tuesday morning. I didn’t realize that I had written so much yesterday until I got my email copy, but I guess that’s what happens when I have all weekend to think about stuff. Well, the two-day party in the currency market got busted up yesterday morning. It wasn’t anything major, but investors were left wandering the streets again looking for something to do. As I mentioned in passing, I wouldn’t be surprised to see the European story and fallout from QE3 go back and forth into the foreseeable future, so yesterday was a perfect example.

The market action of the past several days reminded me of driving in stop and go traffic on the highway, where things are moving along without a hitch and then as you come over a hill, you see nothing but brake lights. So, last week was smooth sailing in the fast lane but Monday morning brought about a traffic jam that left us wondering what’s causing the slowdown. Renewed concern surrounding Europe was the culprit this time, so let’s take a look and see what caused of the rubbernecking.

It looks as though disappointment surrounding the European finance ministers meeting acted as the stalled car in the middle of the road. An agreement on bank regulation, which included discussions on more banking sector unification, along with terms and conditions of future bailout requests wasn’t attained, so this disjunction really caught the attention of the various financial markets. While the ECB did come up with the plan to buy bonds, many were hoping to see more definition as to their role going forward. At this point, I think the ECB is just doing what it can to keep bond yields from going through the roof.

Yields on the Spanish 10-year bond did rise to as high as 6.01% and the similar Italian yield did rise to 5.11% at one point, both of which aren’t in red line territory, but any sharp intraday increases do get investors anxious. As I mentioned yesterday, there is growing public backlash over additional austerity measures, which includes raising the retirement age and changing some of the tax structure. As our debt levels continue to mount, I can’t help but think how long it’s going to take before US citizens will be in this position.

We also had one of the ECB members, Luc Coene, stir the pot a little bit by explaining that any additional increase in Spanish yields would force the nation into a bailout, thus making it mandatory to accept the applicable terms which is obviously more austerity. He went on to say if the markets see that Spain isn’t preparing for a bailout, then it won’t be long before spreads will rise again and essentially force their hand. He then went on to say that not all members were on board with the bond purchase program, since he feels it doesn’t fix the basis of the problem, which is spending beyond means. Spanish yields soared to a record 7.75% toward the end of July, which triggered Draghi to take the “do whatever it takes” stance Coene was referring to.

To top it all off, the results of euro-area exports fell 2% in July and is just another sign we could see a recession if third quarter growth yields another negative reading, which is coming off of a decent first half for the export sector. The early estimates from some economists are calling for the eurozone economy to match the second quarter by contracting 0.2%, which puts them into recession. The hub of European manufacturing, Germany, experienced a 4.2% fall in exports for July.

With not much in the way of economic news globally, the markets took a breather and decided to stare at Europe for most of the day, so that’s why I had to spend so much time across the pond today. If we gave Monday a label, it would be considered a “risk off” day and the only report here in the US didn’t help matters. At one point yesterday morning, I looked out the window and it felt like I was sitting in a window seat on a plane that was flying through a cloud. It was just gloomy, rainy, and I couldn’t see any of the usual landmarks since the clouds were very thick and low, so not exactly a pleasant Monday.

The lone ranger yesterday, Empire Manufacturing, was more than disappointing as it fell five times more than expected and was nearly twice as bad as the August result. Manufacturing in the New York area fell to its lowest level since April 2009 as the index came in at a paltry -10.41, which was considerably lower than the estimate of -2 and the previous month’s reading of -5.85. The headline figure is more of a sentiment gauge, but nonetheless, it does reinforce the recent theme of continuing weakness.

If we dig deeper in this report, several of the key components continued to fall. The gauge of new orders, which fell to its lowest level since November 2010, along with measures of shipping and employment all came in lower than the August reading. The fiscal cliff and uncertainties about the tax situation are to blame for a good part of this, but a general slowdown globally acts as the kicker. The surprising aspect of the report came from higher optimism about the future, which doesn’t make much sense to me especially since orders are almost at a two-year low.

Is it just me, or are we seeing more and more reports reverting back to the lows that we haven’t seen since 2009, or at least on a multiyear basis. Anyway, it’s going to be interesting to see the results of the national ISM manufacturing report on October 1. If these regional reports continue to show rot on the vine, we could very well see it fall even further and show contraction for a fourth straight month. If we go back to the emergence from recession, it was manufacturing leading the way so what do we have that can pick up the slack.

As it stands now, housing is nowhere near ready to fill the void and consumer spending isn’t reliable enough with 8% unemployment, so where do we go from here. We’ll see a light sprinkling of data today with the current account balance, TIC flows, and a general housing index. Unfortunately, the first two I mentioned have fallen numb to the markets and nobody really cares about these reports anymore. As far as the current account balance, we’ll see the results of the TIC flows data from July, which measures foreign investment in US securities.

If we look back to July, the crisis in Europe was nearing a boiling point so there was a lot of money flowing into Treasuries seeking so-called havens. As a result, I would expect to see a significant rise from the rather meager June report. Other than that, we’ll see a housing report that is expected to show a slight gain. If we look ahead to tomorrow, it’s going to be a total domination from housing as we see August housing starts, building permits, and existing home sales. All in all, the experts are calling for more evidence in the way of improvement.

As I was scouring the news sources, I came across an interview with Richmond Fed president Jeffrey Lacker that I found interesting and coincides with our sentiments exactly. He explained that QE3 probably won’t do much to address the labor market and that while it’s tough to gauge, it looks to have a greater effect on inflation than anything. In fact, he hasn’t agreed with any of the Fed decisions made so far this year and was the only one against additional stimulus in the way of bond purchases.

I also came across a Fed Reserve study that basically concluded unemployment would be around 7% if it weren’t for the lack of consumer confidence. I don’t know if I’ll go as far as calling this the Mr. Obvious report of the week, but it went a little more in depth as far as explaining a fundamental difference between past recessions and the current situation. The big difference comes down to the fact that the Fed has never painted itself into this type of corner when it comes to interest rate policy. In other words, the Fed is out of bullets, but we already knew that.

Moving on to the currency market, the dollar started the day with a slight strengthening bias and became stronger as the day progressed. It wasn’t an all-out rout, but the high yielders sold off as risk aversion was in control. The only currency that finished in positive territory was the pound sterling (GBP). It looks as though prospects of higher inflation had traders looking for a break in the UK stimulus program. We’ll see the minutes of the September policy meeting and some are also anticipating some type of hint that November will bring about a pause for the cause in terms of the bond buying program.

On the opposite end of the spectrum, the Brazilian real (BRL) lost about 1% on the day as government officials were at it again. The central bank took action in the currency market by selling reverse currency swaps, which means they intervened and sold the real to artificially induce depreciation. The finance minister also piled on with some jawboning of his own by saying they aren’t going to let the real appreciate and they hope the currency continues moving in that direction. I wouldn’t anticipate officials stepping away from this stance, especially with QE3 in place.

I had a conversation with one of our long time account holders yesterday about the prospects of this currency, and while there is still a decent interest rate differential, the Brazilian government just doesn’t want to see any type of appreciation from these current levels. The question marks are just too prominent at this point for me to feel comfortable not only with the currency, but also any additional policy action.

We also saw Citigroup cut China’s economic growth forecast to 7.6% from the previous estimate of 8%, so that was another feather in the cap of the risk aversion crowd. If we also take into account last week’s fall in imports and industrial production, the prospects of global growth have taken a hit since China has been the growth engine for quite some time. The Chinese government has indicated more willingness to focus on price stability, which in turn, reduces prospects of more accommodative policies.

As I came in this morning, the dollar has added to most of its gains from yesterday on the same premise at play, which is the renewed concern over Spain. They’re trying to prolong assistance measures as long as possible since austerity will need to be stepped up as a condition for the funds. The market is becoming more convinced as each day passes that Spain will need to come knocking on the ECB’s door for help at some point.

Then there was this… The abrupt $3 drop in the price of oil has triggered a CFTC inquiry. The US Commodity Futures Trading Commission is trying to determine the reason oil prices dropped more than $3 a barrel in a matter of minutes yesterday, Commissioner Scott O’Malia said. Traders said a malfunctioning computer-trading program might have caused the drop, but O’Malia said it wasn’t clear whether high-frequency trading was involved.

To recap… Investors stopped in the middle of the highway to get a better look of what’s going on in Europe. A meeting of European finance ministers over the weekend didn’t yield any tangible results, so traders shifted focus back to the peripheral debt problems. As a result, bond yields in Spain and Italy were on the rise, but renewed speculation that Spain may need a bailout was the talk of the day. Manufacturing took another hit as the Empire manufacturing index fell to a 2009 low. We’ll see which way the current account deficit moved in the second quarter and we should see a rise in foreign investment with the TIC flows data. Brazil intervened in the currency market again and thoughts of more moderation to the Chinese economy added to risk aversion.

Mike Meyer
for The Daily Reckoning