This week has been really quiet for the US. Two main issues arise: the initial jobless claims surprise on the downside (actual 316K vs expected 330K), and the decline in the durable goods orders. (-2%) in October.
With regard to the first data, although it is clearly good for the economy, it is not enough as the last releases pointed to a negative trend. Moreover, until the participation rate of the economy will not come back to normal or sub-normal level the US labour market data will be less relevant and the labour market will always be considered weak.
With regard to the second data, it shows that US economy is still weak although sentiment indicator has improved this week. We are keen on keeping our outlook on the US economy and on the next meeting. I strongly recommend to read our last week article “What game is the Fed Playing?” and last market recap to gain a better insight on the FED moves for the next December tapering and this week we have provided further insight on the argument with the article “prepare for FED tapering”). In the US, We confirm our positions, for the rationale refers to the last market re-cap (23/11).
Short the S&P 500.
Sell 6m T-Bill, Buy 4Y UST Sell 10Y UST
Receive 5Y, sell 5Y UST.
Strong and positive data for Europe. Let’s start with the focus of the week: Inflation! Europe Inflation surprises on the upside (0.9% vs 0.8% expected) bouncing back from the low of 0.7%. This is a really good data as inflation seems to have stopped the dramatic decline that prompted ECB to cut rates in October. However it is still too early to say that Draghi will not implement further loose monetary policy as the periphery is still lagging back on this side. Italy inflation has surprised on the downside with a 0.6% vs expected 0.8%.
On the economic performance side, this week was positive but the main source of data was sentiment indices. The Gfk Consumer confidence (Germany consumer confidence) surprises on the upside (7.4 vs 7.1) and also the Euro area economic sentiment 98.5 vs 98.0.
Also worth noting was the downgrade of the Netherlands by S&P from AAA to AA+. This leaves only three Eurozone members (Germany, Luxembourg and Finland) which enjoy triple A rating.
To sum up, Euro is doing well in aggregate but the periphery is still lagging back with the particular issue of deflation.
We are still very confident on our position on European financials that we have proposed in our last market re-cap. (23/11)
We believe that ECB priority is to have a strong recovery in the periphery before hiking rates, as an unbalanced recover will be neither strong nor stable. In Europe, we have seen really good performance, both from core and the periphery, starting from late spring this year and we still believe that the trend may continue. However, deflation in the third economy of the area can destroy any recovery path and until this issue is solved, Draghi will not take any hawkish actions.
Given this scenario we believe another round of LTRO may be under discussion and we are keen on receiving 1y Euribor or 1y1y. Another trade is receiving 2y1y as we believe that in the short term the rates will stay very low and can go even lower. So essentially, we believe that Draghi will focus on the importance of avoiding deflation in the majority of the countries and not only in the Euro area in aggregate.
In Germany we witnessed the formation of the coalition between Merkel’s conservatives and the centre-left SPD lead by Gabriel. One important point of this deal was the introduction of the minimum wage at 8.5€/h from 2015. According to the Frankfurter Allgemeine Zeitung, 12.9% of workers will be affected by such an increase. Beyond doubt, these numbers are a considerable part of Germany’s (circa) 41.7 million labour force. On a similar note, tighter regulation was introduced as well for temporary work.
There is definitely wage pressure in Germany, and not just because the minimum wage approval. The main source for wage pressure in Germany stems also from the renegotiation of labor agreements between the powerful trade unions and industrial employers during 2013. The wage negotiations with the biggest impact took place for compensation in the metal and electronics industries (concerning circa 3.4 million employees), in the retail industry (1.3 million), in the wholesale commerce sector (780,000), and in the main construction sector (650,000). Also, the agreement that covers 765k state government workers, is still to be implemented by a 2.95% wage increase next year. Overall, wage increases in Germany have been around 2% in nominal terms so far in 2013.
On the other hand one could account for a tapering event during December or early next year, which might weaken the Euro, and thus might be translated into a higher CPI for Germany.
Basically, we think that break even inflation is now cheap, at 1.42: the lowest level since May 2012. One should keep in mind that there is still risk in this trade. The impact of the above measures on the overall wage dynamics is unclear, and yet their effect on unemployment, or on incentives for companies to invest in technology and lay off staff remains to be seen.
Trade idea: buy 10 – year break-even inflation
In order to trade inflation you have to build the following position: Sell 10y bunds; buy 10-year inflation-linked securities.
Regarding France, we believe the economic situation will continue to worsen on the short and middle term. Despite the announcement of a decrease in unemployment last Thursday, we observe that the job creation comes only from government-subsidized contracts while long term and senior unemployment keeps rising dramatically. Manufacturing has been now negative for more than 30 months and last data releases suggest a coming recession, since France is one of the country in the world with the highest tax burden (46,3% of GDP just blow Denmark and Zimbabwe) the highest public spending (56,1% of GDP) and a large structural deficit.
Government Bond :
The main buyer of French bonds over the past years has been the Swiss National Bank as it wanted to limit the appreciation of the Swiss Franc. If we look closer at the balance sheet we will see that for the first time since mid-2011 the foreign currency reserve start to decrease putting less appreciation pressure on the Swiss Franc. Moreover, the tapering is likely to help in this way too. Therefore we would suggest to long a put option on the french 10-years bond (OAT).
The Treasury was able to place €7 bn in BOTs with a maturity of 6 months, with a yield down to 0.539% from 0.629% of end of October. Slightly lower the bid-to-cover ratio, which stood at 1.77, compared with 1.82 of the previous auction: the decline in demand is probably related to the sharp drop in yields that has occurred in the last period.
On Friday 29th, unemployment remained stable at 12.5%, while preliminary inflation came out lower than expectations.
FTSE Mib closed higher this week, having positively reacted to the good confidence indexes. Besides that, it seems that market has restarted to price fundamental news rather than speculate on political issues. This change is certainly good for investors that hold long positions.
As we have outlined in the European section, in this context long European financials is a great trade, so holding a long position in the Italian financials will be extremely profitable.
This has been an important week for the U.K. Plenty of data has been released and markets have been quite volatile. First of all, UK GDP revised data was released and, contrary to market belief(down revision to 0.7 %), it was confirmed at 0.8 %. Household consumption expenditure was up 0.8 QoQ, strongest rise since Q2 2010. Total Business investment has gone but less than expected, and the same is with mortgage approvals. Contrary to what one could expect from the BoE’s latest minutes, Mark Carney addressed for the first time the possibility of a housing bubble and adopted measures to prevent the frenzy: on Thursday, he said the Central Bank would stop the Funding for Lending Scheme, that had been previously used to boost mortgage lending in the U.K. What Carney is doing is using macro-prudential tools rather than monetary policy tools and this makes us believe that indeed the BoE is not just ready to hike interest rates.
Indeed, we believe that BoE will do something similar to what we think FED will do. The QE programs are creating some bubble before the economic recovery gains strong momentum. Although, the UK data are far better than US ones, the UK recovery still looks like unbalanced with economic performance led more by consumer lending rather than business lending for investments (clearly it is something not good).
As a result, we believe that BOE will tighten the financial condition trough a sort of tapering but will reinsure the markets with a dovish forward guidance.
Given our rationale, we are keen on paying 1y Libor interest rate swap and receive 4y1y. Indeed, because of the tighter financial conditions rates will go up on the front end but then the Dovish forward guidance will lower them in the “belly” (the belly is the central part of the yield curve e.g. 3-7 years. This is the common jargon used on the trading floor).
Sterling has had a great week and our long GBP/JPY trade has played out quite well. The pound has scored various highs: GBP/EUR 3-month high, GBP/USD, GBP/CAD 12-month high and finally the 12 month high in the afore-mentioned GBP/JPY, stabilizing on the 167,00-50 mark.
FTSE 100 ends the November with a 1.2 % decline, and showing a modest increase in the last 3 days. FTSE 250 also gained points in the last 7 days but ended the month lower than the previous. The indexes were boosted by this week’s data, but negatively affected on late hours of Friday by speculation on the FED’s will to start tapering. If the FED were to start tapering in early December, as some fear, long U.K. indexes wouldn’t be a good place to be. As a matter of fact, a butterfly spread with put options could be set up, in order to gain from a possible plunge in the FTSE100. The trade is the following: buy 2 put options respectively at 6550 and 6780, and sell 2 put options at November’s close, 6650. There is a gain if the FTSE100 index remains inside the external boundaries we set up (6550-6780). A Q.E. stop may well lower the level of the index but at the same time it would be kept buoyant by the good data that has come in the past week and should keep on coming in the future.