My Diary 351 --- A “De & Reflation” Yield Curve, It’s Default Cr

My Diary 351 --- A “De & Reflation” Yield Curve, It’s Default Crack Spreads, The A-Shares Sun Falls, Give Dollar A Hand, Why Oil is Not Hurting

 

November 8, 2007

The market is losing steams, struggling between deflation and reflation. Across the planet, risk assets were coming down, even the anti-gravity A-shares. The US Dollar fell and reached another new all-time low against the Euro (1.4669). UST 2yr yields declined another 16bp and touch a new cycle low at 3.55%.

Other assets classes were up on the back of weaker Dollar. Oil prices finished slightly below yesterday’s high, closing at $96.58/bbl for December WTI. Gold is 832$/Ounce and I heard that some rich Chinese have bought out all the gold bars sold in domestic banks’ counters.

I start to think who can feed the buying appetite of Chinese consumers; if someday in the future, their desire to spend money is waken up…it will be quite an inflationary story, but I will leave it alone today by jumping into the UST yield curve…

A “De & Reflation” Yield Curve

Today, the gap between 2yr and 10yr UST yields has increased to the widest level since 2005 due to a decline in stock markets and forecasts of deeper mortgage-related losses raised the appeal of US government debt.

The fall of front end yields also can be attributed to the St Louis Fed Chief William Poole, saying a housing slump may make further interest-rate cuts necessary, along with the BBG headline regarding that US banks and brokers may face another $100 billion of write-downs. In the future market, traders are betting 70% odds of a 25bp cut in next month.

In the other hand, inflation expectations are close to the highest since June, as measured by the yield difference of nominal bonds over TIPS. 10yr treasury notes yielded 2.40% more than similar-maturity TIPS, compared with 2.19% BE inflation in early September. I think what the markets try to tell the Fed is that … we are struggling between deflation and reflation as result of US consumer and housing woes, while you are sitting in a “wait and see” mode...

 

It’s Default Crack Spreads

Credit spreads recently have been nearly perfectly correlated with financial stocks with the correlation between CDX IG9 and the SP500 Financial Index was over 95% over the last 6 months. One of the many reasons is that as stocks and subprime-related credits continued to sell-off, the costs of going short these assets have become increasingly prohibitive. As a result, investors switch to these cheaper index products as hedging instruments.

Beyond that is the Asian credit spread once again touch its record high (+200bp) and some investors are asking when the corporate spreads are going to crack. I think the answer is “default rates”, which is the only thing that scares credit markets more than anything else. What ruined the bond spreads in 2001 and 2002 are the two IG-rated bonds, WorldCom and Enron, defaulted ... Same story today, as subprime meltdown - investment grade rated CDOs turned out to be another “WorldCom and Enron”. And many investors realized today that counting on the credit agencies/or AAA ratings proved to be costly and a avoidable mistake.

But I think while the front pages of the financial press were filled with commentaries on the mega-sized loss on subprime-based securities, ppl missed the real story - that these large transactions were being financed by a huge shadow economy that was not recorded on the books of any financial institution, was as leveraged as LTCM was 10 years ago, and was operating completely beyond the reach of regulators. The financial fate of the credit markets was once again left in the hands of a relatively small group of self-interested ppl whose incentives were structured in a way that could best be described as -- Gain is mine, Loss is yours… what a yummy deal!!!

 

The A-Shares Sun Falls

The ever-sunny A-shares markets had one of the worst performances in 5 months with SH and SZ Comps dived 4.86% and 4.23%, respectively; as rumor is telling that CSRC has asked local mutual funds to suspend their fund subscription to public. Without the institutions’ fresh bloods, the top 20 mkt-cap  stocks  drop 5.8% on average, including PetroChina (-5.54%), Sinopec(-7.10%) and China life (-6.5%)…Well, when liquidity wanes, A-shares dies…

Hong Kong side, H-shares shared the same fall as HIS dropped 948 ppts (3.19%) after losing 1526 ppt (5.01%) on this Monday. News that China may delay DII investors to buy HK-listed equities along with the resurfacing of subprime woes in the US triggered a perfect storm for Chinese investable stocks and the Hong Kong equity market over the past few days.

The critical question now is whether there is a fundamental shift in the driving forces behind H-shares and I think NO. There is no doubt the authorities will continue to liberalize capital accounts, but question is whether the earnings’ growth can maintain at+ 60% yoy pace. As a result, the damage could last for a while because the markets remain extremely overbought. Moreover, the recent market performance told us that both A-shares and H-shares can be "engineered" down on policy risks and uncertainties.

Overall, my sense is the recent turmoil is unlikely to be the start of a major reversal in H-shares by swinging investors’ sentiment from greed to fear. Also, the massive valuation gap (60% premium) between A&H suggests that H-shares are more attractive for long-term domestic investors and foreign investors who want to maintain a “China exposure” in their portfolios… Stay cool…

 

Give Dollar A Hand

The USD's recovery against Euros appears to owe mostly to corrective pressures. Fundamentally, the market maintains its broadly negative view on the dollar and that has been augmented by the reduction in risk appetite. It is actually quite interesting to note that those sentiments persist despite the fact that last week's key US economic data, the Q3 GDP and October NFP reports, measurably outstripped expectations.

In the Screen, the US Dollar has declined almost 5% on a trade-weighted basis since the financial market turmoil became visible in mid-July. The long-term question now is that although the decline will help cushion the US economy in a period of slowing domestic demand growth, most other currencies (gaining against USD) are creating strains on their domestic growth, including Canada and the Euro area. Good news is that strong economic growth in the emerging world are better positioned these countries to absorb currency strength.

While the Dollar decline makes sense in the context of our global growth forecast, the continued climb in oil prices does not. For North America and Western Europe, higher domestic energy prices will reinforce the negative demand outlook that already is in train from credit market tightening and the slump in the US housing market. This raises the possibility that the combined effect of these two demand whammy, and whatever knock-on effect they have on markets, could produce an outsized demand response in the developed economies. It is difficult to believe in that the EM economies would accelerate to offset this ... So give the USD a hand now ...

Why Oil is Not Hurting

Talking about falling US Dollar and global growth, we have to look at Oil. Oil prices has exceeded 98$ /bbl early this week. Surprisingly enough, so far global growth has stayed remarkably resilient to high oil prices. I think there are a few number of reasons: 1) the oil intensity of growth is falling in industrialized countries, while China's industrialization is backing up the global growth momentum. The estimates of the potential impact of incremental increases in oil prices on GDP have been notoriously incorrect over the last 3-4 years.

More importantly, there are two mitigating factors – 2) price controls/ fuel subsidies plus 3) weak Dollar. Price controls and fuel subsidies, particularly in Asia, have protected consumers from the full impact of price increases. However, they come with a cost, either fiscal or to the profitability of the oil marketing and refining sector, and are unlikely to be sustainable in the longer term.  Last week, China raised domestically fuel prices is a good example, despite previous assurances that prices would not be raised given concerns over inflation. The second factor is the weakening USD, as while oil prices have risen 64% yoy in USD terms, they are up just 44% in EUR.

Bottom-line is the near-term Oil impact will be felt either in inflation, or if companies can't pass through costs, corporate profitability.

Good night, my dear friends