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25 June 2010
E u r o p e a n R a t e s S t r a t e g y | W e e k l y
Andrew Roberts
Head of European Rates Strategy+44 20 7085 1702andrew.roberts@rbs.com
Giles Gale
Derivatives Strategy+44 20 7085 5971giles.gale@rbs.com
Harvinder Sian
European Rates Strategy+44 20 7085 6539harvinder.sian@rbs.comwww.rbsm.com/strategy
European RatesWeekly
Overview (p2):
Get ready for the cliff-edge. Be maximum long duration of nominal government bonds in safe haven markets. This means US, UK,Germany, in that order, and perhaps others. Be long gold. Think the unthinkable.Get ready for sub 2% on 10-yr USTs; sub 2% on 10-yr bunds; and the UK not far behind, 2.5% 10-yr Gilts. We strongly believe that a cliff-edge may be around thecorner, for the global banking system (particularly in Europe), and for the globaleconomy (particularly in the US/Europe). We like the risk/reward. Surely risksassociated with us being wrong are low (ie, rates just stay where they are, yieldsback up a little bit). But risks associated with us being right are >10% returns in10-yr USTs at the same time that equities/commodities will collapse far beyondwhat even some equity bears anticipate.
Euro Area (p5):
The run-off of the 1y LTRO is unlikely to see marked impact onperiphery short end or a material rise in EONIA, though the OIS curve cansteepen. In addition to this subject, in this issue we looked at the Peripheryvulnerability via external debt.
UK (p8):
we update funding numbers post-Budget. We still like Gilts againstEurope as a trade & theme, but acknowledge the mere meeting of Budgetexpectations, coupled with quieter market with less events risks, implies a slower outperformance.
European Auction Calendar (p10) Coupons and redemptions (p11)
European repayment monthly calendar (p13)
Trade Portfolio Weekly Performance (p15)
+262.94
bps YTD
Macro Forecasts (p17)Through July and August, we are moving the European Rates Weekly tobiweekly publication. This starts now, so there will be no weekly nextFriday. Our publication dates are: 9, 23 July and 6, 20 August.
The Royal Bank of Scotland
E u r o p e a n R a t e s S t r a t e g y | W e e k l y | 2 5 J u n e 2 0 1 0
2
Overview: cult of the equity willdisappear. Sub 2% US 10s
Get ready for the cliff-edge.
Be
maximum long
duration of nominalgovernment bonds in safe haven markets. This means US, UK, Germany, inthat order, and perhaps others. Be long gold. Think the unthinkable – wealways do, and you should ask yourself why the consensus refuses to do so,and seems perpetually on the ‘everything is ok’ side of events. If I was anymore bond bullish we would explode, this is identical to 2008, including theincredible complacent (and we believe wrong) consensus.
Get ready for sub 2% on 10-yr USTs; sub 2% on 10-yr bunds; and the UKnot far behind, 2.5% 10-yr Gilts
. Our long held
US$2000 gold
view as a tradefor the breakdown of the financial system looks increasingly ok. We cannotstress enough how strongly we believe that a cliff-edge may be around thecorner, for the global banking system (particularly in Europe), and for theglobal economy (particularly in the US/Europe). We have been wrong before,but we think the risks associated with us being wrong are low (ie, rates juststay where they are, yields back up a little bit, after all we are not about toenter a new global economic upswing!). The risks associated with us beingright are >10% returns in 10-yr USTs at the same time thatequities/commodities will collapse far beyond what even some equity bearsanticipate.
For instance, rather than say non-financial corporate balance sheets look fine(which they do, but that does not mean much when the consumer and thegovernment balance sheets are bombed out and we should start focusing onwhat happens when the consumer turns down), let us sit back and take ahistorical perspective on risky asset valuations. Especially when consensushas been arguing all year (as it always has done) that equities are a goodinvestment. Last time we looked S&P500 total return YTD: -2.8%, Eurostoxx -7.9%, NIKKEI -6.2%, and what of those allegedly better investments of emerging markets we are told will decouple? China is -21.4%, and the bigpicture global EM ishare is -8.2%.
For a counter consensus look at just
how rich equities actually are
if we areright about the economy, and how far they can fall, look at Robert Shiller’s 10-yr real adjusted P/E ratio on the S&P500, which uses ten year smoothedearnings. We have used this as our marker for proper (unbiased) long-termvaluations for many years – and is freely available to all investors to look for themselves on his Yale website – and it sits at 20.0. One pillar of our framework is that sometimes it is right to buy equity; sometimes it is right to sellequity. And call us old fashioned, but we will buy at low PEs, and sell at highPEs. So a PE now of 20, sits very uncomfortably right at the TOP of its range if we take out the pre-first great depression spike in 1929 and Nasdaq 2000spike. We argued in 2007/08 pre crunch that we would buy equities againwhen they looked cheap, which would be at 6-8 PE on this metric. That is anequity fall of 60-70% from here. Fine, call us mad with such big numbers if youdesire, and say we will miss the big equity rally on a structural view (what rally,having been short for 10 years, S&P500 total return since 1Jan2000 is actually-8.1%!). Meanwhile an investment in 30yr USTs has returned you +126%. Youdo not have to see -60-70% off risk assets to be cautious here, we are justsuggesting this is what the numbers say are attainable if certaincircumstances prevail, using a 120 year snapshot. The big turnover in the USeconomy will lead to dramatic turns down in valuations we suspect – and
may
Andrew Roberts
The Royal Bank of Scotland
E u r o p e a n R a t e s S t r a t e g y | W e e k l y | 2 5 J u n e 2 0 1 0
3
Source: BoE
US housing downside coming . . .finally destroy the world’s worst cult:
the cult of the equity
, which has nobasis in fact, or history, but yet seems universally accepted.
This all sounds somewhat doomsdayish, so we should update how the realeconomy/banking is panning out for us. It is saying:
the end-gameapproaches.
First, we have been waiting for the last of the US fiscal easings, the first timehomebuyer tax credit, to pass, and have been arguing strongly for someweeks to investors to get ready for the violent turn down which is about tooccur. And the trigger (not the only reason, but the trigger) is the US housingmarket. This is all falling into place lovely. Last week saw the NAHB housingindex dip; housing starts at -10%mom (6.3% under consensus), and buildingpermits -5.9%mom (8.4% under consensus). This week has seen existinghome sales -2.2% (8.2% under consensus); and new home sales -32.7%mom(14% under consensus). Our theme is building. The BoE financial stabilityreport today shows there is a surplus of 1.75m housing units built since 2006and even with normal household creation, this will take two years to remove.So the weak housing theme should now pollute its way into consumers, andkickstart the rebuilding of the savings rate (just 3.6% and delayed fromrebuilding by the fiscal/monetary shock and awe).
Second, the European banking system faces problems. We have seendowngrades continue in Europe this week. We discussed in last week’s weeklyoverview about the US$450bn shortage of dollar asset funding for non-USbanks, and why the Fed had to reopen swap lines. We are amazed there is notnow immense market & media focus on the new letters that will
bring forwardthe end-game
and
worsen it
:
2a-7
.
What is this? The new (well ‘new’, it comes in on 30 June but has been knownfor a year despite no-one discussing it at all) SEC rule. This forces US moneymarket funds – up to now the provider of USD liquidity to those who need it –to become ‘safer’. The SEC puts it thus: ‘
The amendments tighten the risk-limiting conditions imposed on tax exempt money market funds by rule 2a-7…the amendments are designed to reduce the likelihood that a tax exempt fund will not be able to maintain a stable net asset value
.’ (source: SEC). Our short-term strategists plan a piece next week. The key for us in FI is that theseUS$2.8trn of 2a-7 funds now have to a) own 30%, not 5%, of assets in sub 7day liquid paper; b) weighted average maturity of fund has to fall to 60 from 90days. We can all see the logic – the sovereign defaults from EMU have thepower to hit EMU banks badly, and the USA does not want to repeat thecalamitous ‘breaking the buck’ problem when in 2008 Reserve Primary Fundwrote down its Lehman assets, took its net asset value sub $1, caused a runon money funds which then forced them to sell their assets, cutting NAV for other funds, etc.
Contagion.
From what we can see, the
USA is basically pulling up the drawbridge andretreating into its fortress,
trying to protect its financial system from comingEuropean banking problems. But the consequence is clear. Banking is aboutconfidence. If you are reliant on markets to fund yourself and that confidencewanes, a total stop can occur immediately/within days. Northern Rock (75%reliant on wholesale markets) was the first example of this in the UK, thoughnot the last. Once we apply 2a-7 (and the ability of US money funds to ‘put’their EMU bank assets back to the issuer EMU banks within 7 days on signs of trouble, since the US money funds will from now on increasingly own 1yr securities with a 7 day put) to our economic slowdown/deflation themes, thismeans one thing. If there is a slowdown and sovereign trouble,
the problems
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