Notes From Underground: “It Was the Best of Times. It Was the Worst of Times”

As 2014 draws to a close, the financial landscape is definitely a tale of two disparate economies as the U.S. reports 5 percent GDP while Europe struggles to maintain zero growth and avoid “recession.” (I despise the official definition of a recession being two consecutive quarters of negative growth.) In Spain, Italy, Greece Portugal, France and other countries, double-digit unemployment defines a recession and the potential it brings for political turmoil.

The proof lies in the movement of yield curves. The U.S. 2/10 curve is flattening but it is a bearish flattener as the short end is climbing in yield while the long end remains bid. U.S. 10-year notes and 30-year bonds have been in demand as the European recession has sent global  investors searching for premium investments with a higher yield than in the European sovereign debt market. German bunds are yielding 170 basis points less than the comparable U.S. 10-year note. If you are a European investor you get the added gain of an appreciating dollar (the classic carry trade).

The Italian and Spanish 10-year notes are also yielding 40 basis points more than the U.S., which lends further support to American sovereign debt and providing the support to the long-end of the yield curve. The European curves are flattening as bond yields tumble in investors’ anticipation of a QE program and/or a continued deepening of the recession and possible deflation. In a severe deflationary spiral the fall in prices creates a rise in real yields. (If inflation becomes negative by one percent a nominal interest rate of 1.5 percent becomes a real yield of 2.5 percent.)

The rise in real yields was what kept Japanese long bonds a desirable investment of domestic Japanese investors for the past two decades. The current flattening in the European yield curves is the exact opposite of the flattening that prompted Mario Draghi to make his famous, “NO TABOOS AND WHATEVER IT TAKES” pledge to European and international investors. In July 2012,the European curves were BEAR FLATTENERS as the world was concerned about the entire EU project and were selling two-year notes in fear of several of the PIIGS leaving the EURO. The curve FLATTENED for fear of a funding crisis for several of the European peripheral states.

The recent action in the European curve is not a sovereign debt crisis but a fear of deflation and it is this fear that is keeping Draghi searching for an accord with the Bundesbank leaders to secure an agreement on a genuine QE program. Investors and domestic European banks are aggressively purchasing the long-end of the curve driving down long yields. The German, French, Belgium, Netherlands curves are all flatter than during the 2012 funding crisis. The Spanish and Italian 2/10 curves are still wider than the dark days of July 2012 when their 2/10s had narrowed to 75 basis points. Draghi has to be very concerned that the yield curve complex with no QE in place is signaling a renewed slowdown with deflation a real possibility. In a European economic system saddled with large amounts of debt a deflation scenario good have severe political ramifications. This is the landscape as we enter 2015.

The U.S. situation is much different as improved economic performance has led to a decrease in unemployment  and other economic barometers. As the rest of the world has struggled to increase growth the U.S. has been the recipient of investors search for higher yields and greater possible returns in equity markets. The U.S. dollar has by default become the investment choice and the stronger dollar has been able to push import prices lower causing the FED to be concerned about inflation falling to levels not commensurate with its “dual mandate.” Low inflation gives Chair Yellen a reason to keep present ZIRP in place.

The minutes from the December FOMC meeting (to be released January 7) will be an important measure of the FOMC‘s concern for the strength of the dollar and the decline in the global economic performance. If the MINUTES reflect a growing concern about Europe the two-year note yield will drop and the 2/10 U.S. curve will steepen as the front end has been pricing in a more aggressive Fed raising rates in the end of the first quarter or early second.

The FED has been nonchalant about the European situation except that Treasury Secretary Lew has warned Brussels about competitively devaluing the euro in any attempt to gain a trade advantage in violation of previous G-20 agreements. If the U.S. curve flattening is a result of fear of European economic problems the Fed cannot be treating it with benign neglect. The factors I have put forward are why  the yield curves will be extraordinarily important in the coming year. What we will pay attention to is the possible trades that can arise from the TALE Of TWO YIELD CURVES.

***Friday, the precious metals had a sizable rally even as the SPOOS and other equity markets powered upward. The reason given for the rally was a report of China waiving reserve requirements for some deposits. “Commercial lenders won’t be required to set aside reserves for the savings that they hold for non-deposit-taking financial institutions ….” (Bloomberg) The proposed change is to loosen the lending guidelines and allow more liquidity into the banking system easing tightening conditions in the credit markets. The Chinese use the reserve requirement as a tool to constrict or broaden the flow of credit in the economy. The Bloomberg article reports that the change may “… add 7 trillion yuan ($1.1 trillion) of money [that] will be classified as deposits ….” (Not an inconsiderable amount.)

Following on the Friday’s announcement from the Chinese, in tomorrow’s Financial Times there is an article, “China Zombie Factories Kept Open to Give Illusion of Prosperity.” The thrust of the article is that the Chinese have industrial over capacity that is generating no profit but being propped up by state and local government. The threat of Chinese mass exports at loss generating prices will act to be a damper on global inflation. This is also acting to drive yield curves flatter. The Japanese currency devaluation is also having an impact on global prices as multinational corporations struggle to maintain market sure against foreign-based firms with a competitive advantage of a weakened currency.


It is not inflation that drives investors to seek safe havens but the uncertainty of unconventional measures based only on academic theory. It was easier to land a spacecraft on a speeding comet than to undo the years of poor economic policy. After all, economic theory is truly not rocket science not matter how sophisticated the models.

Happy New Year from Notes From Underground.

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17 Responses to “Notes From Underground: “It Was the Best of Times. It Was the Worst of Times””

  1. asherz Says:

    After too many years of ZIRP and QE (real or anticipated [whatever it takes]) without having providing a substantial economic fillip, the Princeton theorist, his successor and their cohorts may at some point begin to suspect that these nostrums just aren’t going to work. The increasingly elephantine sovereign debts is the etiology of deflationary pressures. A Draghi trilion dollar contribution to this sterile effort will keep the asset balloon expanding and the poor, dented can being kicked further down the road with income disparities between the haves and have-nots continuing to widen. What might work? Make big government smaller and shrink annual trillion dollar US national debt increases, eliminate governmental regulatuions that is strangling many businesses, fiscal encouragement of small business creation, and encouraging free markets.
    Let’s see what worked in the past and not repeat measures that have not worked and expect a different result (Einstein defined that one correctly.)

  2. nate Says:

    “… And I’ll take any risk to turn back the hands of time…”

  3. Chicken Says:

    True, we know it’s not rocket science b/c in rocket science the landings are planned in advance of lift off.

  4. GreenAB Says:

    Greece makes the ECB-QE drama very interesting. i still doubt that Germany will ever give green light. but lets say Draghi (w/ majority) intends to move ahead anyway – what will they do with Greek elections around the corner, which will take place Jan. 25th. I don´t see the ECB buying sovereign bonds, when there´s a chance that Greece might be cut off the bailout programmes or even leave the Eurozone.

  5. Yra Says:

    Green–this is a very interesting point and if I were Draghi I would not wait for the ECB–do it now and not buy Greek bonds–doesn’t really matter with greek tens at 9% and no two year note–the market has absorbed one restructuring it may as well finish the job and let the ECB get ahead of it,if in fact the QE actually takes place

  6. GreenAB Says:

    Yra, thank you for your opinion! Do you think it would be possible to start QE, but let Greek bonds out of it? The legality of European QE is in doubt anyway. But if you do it and then leave a Eurozone member out of it – wouldn´t that make the programme look even more suspicious? Could the Greek even challenge such a mistreatment of theirs in court? Thanks!

  7. yra Says:

    GreenAB–yes,yes yes and yes which is why Draghi may as well do it and take the pain.As Karl sitting next to me just noted—the 3/10 Greek curve is inverted by 300 basis points—the market is telling you that your thinking is correct

  8. Chicken Says:

    Not sure what the ECB has done, doesn’t seem to be effective.

  9. Yra Says:

    Chicken–president Draghi did save the peripherals by halting the rise in yields with the whatever it takes speech–that is a fact–driving down sovereign yields was very important as it has slowed the bleeding

  10. Chicken Says:

    Ahh, yes good point Yra. Lower rates should relieve some debt burden.

  11. GreenAB Says:

    should we pay attention TED again?$ted

  12. yra Says:

    greenab–good question and I would be quick to say–YES–but a lack of treasuries and the need for collateral for repo–it is a difficult read but maybe it can in fact reveal some crack in the foundation

  13. Chicken Says:

    Is it not true that currency war is really a battle over where to assign excess savings, and must lead to unemployment in the country whose assets are most assiduously collected by central banks?

  14. Yra Says:

    Chicken–the logic of Michael Pettis is showing through your feathers

  15. Chicken Says:

    It makes sense to me, he was able to explain it. We’ve been discussing globalization and the impact on the middle classes of developed nations, access to easy money.

  16. Chicken Says:

    Yra, also by reading M. Pettis it seems the US choice to depart from the gold standard has enabled these capital flows and bubble blowing.

  17. Yra Says:

    Chicken–I agree and it has been a problem but especially that guy Nixon figured out where are all keynesians now but as usual in his simplistic way he forgot part of the equation and it has been downhill ever since–John Kennedy was a much better steward of the economy but he was after all a Boston Bond guy

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