On the week, benchmark Treasury yields fell 3-6bp, leaving them a couple of basis points higher than Thursday's close after big losses Friday and Monday that were in large part drive by worries about this week's supply were largely reversed when the auctions went well. The 2-year yield fell to 1.06%, 5-year 3bp to 2.64%, 7-year 6bp to 3.34%, 10-year 6bp to 3.89%, and 30-year 6bp to 4.75%. After some typical volatility around quarter-end, financing rates have settled down at their recently more elevated levels over the past week-and-a-half. The overnight Treasury general collateral repo rate averaged about 0.20% for the week and effective fed funds marginally lower, which represents effectively about 8bp rate hike from the 0.12% level that prevailed before the SFP program began draining reserves in late February. Excess reserves have declined from a peak daily average of $1,194 billion in the two-week period ending February 10 to $1,094 billion in the two weeks ending April 7. This initial start to the Fed's liquidity draining will end Thursday, however, when the last weekly SFP bill raising new money settles. After that, the weekly $25 billion SFP bill auctions will just be rolling over the $200 billion in outstanding supply. And the Fed still hasn't taken delivery of about $50 billion of its MBS purchase yet, so excess reserves will likely see some renewed upside starting after mid-month. TIPS had a very good week, significantly outpacing the nominal gains even with flat oil prices after a reversal of significant early week gains as the dollar rallied. The 5-year TIPS yield fell 10bp to 0.35%, 10-year 13bp to 1.54%, and 30-year 11bp to 2.11%. This boosted the 10-year inflation expectation 7bp to a two-month high of 2.34%. Supply pressures contributed to underperformance of Treasuries versus swaps and mortgages on the week. The benchmark 10-year swap spread swung back into negative territory, falling 3bp to -1.5bp. Current coupon mortgage yields fell about 10bp to near 4.5%, with Fannie 4.5% MBS outperforming Treasuries by about a third of a point. A bit of moderation in interest rate volatility, which has been fairly stable recently after correcting somewhat from cycle lows hit just before the mid-March start of the big market sell-off, was MBS-supportive. 3-month x 10-year normalized swaption volatility fell a couple of basis points on the week to 101bp, up about 11bp from the lows since November 2007 hit in the middle of last month, but significantly down still from near 125bp at the end of 2009 and over 200bp at the 2009 highs hit in June.
Volatility in risk markets also remains quite low, but for stocks at least this has been marked by a return in the past week to the recently familiar pattern of persistent small daily moves mostly to the upside, cumulating to decent gains. For the week, the S&P 500 gained 1.4% to end the week at another new high since September 2008 after extending its year-to-date gain to +7.1%. Financials and consumer discretionary stocks, boosted by the strength in chain store sales, were the best sectors on the week with gains of a bit less than 3%. These two sectors are also among the three best performing so far this year, along with industrials seeing rallies over 14%. Credit seemed to be more negatively impacted by Greece spread pressure and ended little changed, with the investment grade CDX index flat at 86bp. High yield did better with about a 25bp tightening to near 510bp. The new series 14 leveraged loan LCDX index started trading and surged out of the gate, moving from a dollar price near 97 on Monday to 99 on Friday, while the series 13 only gained about 1 point. There was an important change in the specifications of the latest LCDX index that apparently investors were putting a high value on. In series 14 LCDX, even if no syndicated or secured loans are available for a component company, it will remain in the index until maturity barring a credit event, eliminating â??optional early termination rights' in previous LCDX series if all loans were paid off by a company, which made valuation more difficult. Meanwhile, the rally in non-agency mortgages continued to gather momentum since the White House announced its principal forgiveness plan to add to prior mortgage delinquency mitigation programs. The AAA subprime ABX index surged 7% over the past week for a 13% gain the past two weeks and 18% rise for the year. This is far ahead of the commercial mortgage CMBX market, where the AAA index gained 1% this week for a 4% year-to-date rally. The muni bond MCDX market saw a bit of widening in sympathy with Greece, but the impact was muted, and spreads remain quite tight despite a continued negative flow of news on state and local government finances. The 5-year MCDX index hit a midweek high of 138bp and was near 135bp Friday, not too far from the low for the year of 124bp hit Monday and well below the wide for the year of 180bp reached in early February when Greece was last under major widening pressure.
It was a light week for economic data, but the positive recent trend continued in the non-manufacturing ISM, chain store and wholesale trade reports. The composite non-manufacturing ISM index surged 2.4 points in March to 55.4, a four-year high. Manufacturing continues to lead the recovery, but activity in non-manufacturing has started to pick up sharply in early 2010. Big upside in March was seen in the business activity (60.0 versus 54.8) and orders (62.3 versus 55.0) components. Employment (49.8 versus 48.6) saw less improvement but reached its least negative level since the recession began in December 2007. Growth was very broadly based by industry, with 14 of 18 sectors reporting expansion in March, up from 9 in February and 4 in January and matching the best result (last seen in 2007) in the five years of data.
Meanwhile, upside in consumer spending and inventory accumulation pointed to a stronger trajectory for all of 1Q at the same time that the robust run of March results provides a strong starting point for further upside in 2Q. Chain store sales results were extremely strong in March, and while they were significantly helped by the earlier Easter, even accounting for this the results were far better than expected, with weighted average same-store sales showing their biggest gain in a decade as most of the biggest companies posted double-digit increases. Along with the surge in auto sales last week, the March retail sales report should be very strong. We boosted our 1Q consumption forecast to +3.5% from +3.4% as a result, and with such a strong likely starting point for 2Q, not too much in the way of further sequential upside will be needed from April to June to see a similar sized gain in 2Q. Meanwhile, wholesale inventories rose a much-higher-than-expected +0.6% in February, and January was revised up to +0.1% from -0.1%. Incorporating this upside, we now see inventories adding 1.1pp to 1Q GDP growth instead of +0.7pp. Even with the bigger gains in recent months, wholesale inventories are not keeping up with robust gains in wholesale sales of 0.8% in February and 0.9% in January, so the I/S ratio has fallen to a near-record low 1.16 early this year. This is true broadly - even with a further 1.1pp add to GDP in 1Q on top of a 3.8pp add in 4Q, the rate of inventory accumulation would remain unsustainably low in a growing economy, and more upside will be needed to stabilize currently low economy-wide I/S ratios over the rest of the year. Combining the better outlooks for consumption and inventories, we raised our 1Q GDP forecast to +3.0% from +2.5%.
The economic calendar is a lot busier in the coming week. The biggest data focus will be the retail sales report on Wednesday. There is another heavy schedule of Fed speakers, including Chairman Bernanke testifying on the economic outlook on Wednesday. The Fed will also release the Beige Book prepared for the upcoming FOMC meeting on Wednesday, which should have a positive tone given the upside seen in the March data so far. Other data releases due out include Treasury budget Monday, trade balance Tuesday, CPI and business inventories Wednesday, IP Thursday, and housing starts Friday:
* We expect the Treasury to report a $63 billion budget deficit in March, far smaller than the $192 billion reported a year ago, though mostly as a result of a non-cash accounting change. The CBO has indicated that the Treasury will lower its projected TARP cost by $114 billion - and that all of this adjustment will show up in the March budget statement (note: most budget items are measured on a cash basis, but a present value approach was used to derive the budget impact of the TARP). Even excluding this special item, the March results should still be some underlying improvement, driven by a jump in tax receipts. We estimate that withheld income and payroll taxes rose 6%, the first increase in a year-and-a-half. Corporate payments also showed a big gain, up an estimated 34%.
* We look for the trade deficit to widen by $1.5 billion in February to $38.8 billion, with exports up 0.7% and imports up 1.4%. Imports should be boosted by a surge in services from the royalty payments for Olympic broadcast rights. Port data point to renewed upside in non-energy goods imports also after a pause last month, but lower prices should offset higher volumes to keep petroleum imports little changed. On the export side, factory shipments figures pointed to a good rise in capital goods, but lower prices should restrain food and industrial materials.
* We forecast a 1.3% surge in overall retail sales in March and a 0.8% gain ex autos. Unit sales of motor vehicles posted a sharp jump in March, so the auto dealer component of retail sales is likely to show a solid rise. Meanwhile, chain store results were also very strong, and thus we look for big gains in categories such as general merchandise and home electronics. However, the Easter calendar shift represents an important wildcard, meaning that it will probably be necessary to average the March and April results before drawing any conclusions on underlying sales momentum. Gasoline prices were little changed in March (on a seasonally adjusted basis), so we look for only a fractional uptick in the service station component. Finally, the key retail control gauge that feeds directly into the calculation of personal consumption is expected to be +0.8%.
* We look for fractional 0.1% increases in both the headline and core consumer price index in March. The run-up in gasoline prices seen during the month was just about in line with seasonal norms, so the energy category is expected to be little changed on an adjusted basis. Meanwhile, the core is expected to round up to +0.1%, as continued softness in shelter acts as a major restraint. Otherwise, we expect some flattening in the apparel category following an unusually large dip in February. Also, tax increases are expected to lead to a modest boost in the tobacco sector. Still, the core is expected to slip to +1.1% on a year-on-year basis.
* Based on the results from the manufacturing and wholesale sectors, overall business inventories are expected to rise 0.5%, the sharpest gain since mid-2008. However, sales are keeping pace. So, the I/S ratio should be unchanged at 1.27.
* We look for a 1.0% surge in March industrial production. The employment report showed a very sharp increase in hours worked within the manufacturing sector. Also, auto industry assembly schedules point to a solid gain in the motor vehicle sector. As a result, the key manufacturing category is expected to post a rise of +1.3% - best since last July. The headline reading would be even stronger were it not for a weather-related pullback in utility output.
* We expect housing starts to edge a bit lower in March to a 565,000 unit annual rate after a nearly 6% drop in February. While there was a sense that weakness in February might reflect unusually severe weather conditions in parts of the nation, the report revealed that the declines were concentrated in the South and West. So we don't see much likelihood of a weather-related rebound in March. However, the multi-family category is so depressed, relative to historical trends, that it may show a bit of upside in March.
What's new: The outcome of the teleconference among the euro area finance ministers (i.e., the Eurogroup), together with the ECB and the European Commission, is that Greece will get up to â?¬30 billion in the first year from the euro area countries alone, if it asks for financial help. The IMF's contribution is unclear at this stage, but it was once again mentioned that the split two-thirds from the euro area governments and one-third from the IMF is a "correct order of magnitude".
There was no decision to activate the financial aid package, as Greece did not ask for any financial help to date. Should it be activated, the various euro area governments will make the funds available through bilateral loans for a three-year period at an interest rate of around 5% (3-month Libor + 300bp + one-off charge of 50bp to cover for operational costs). A further 100bp will be charged for amounts outstanding for more than three years. The ECB will be the paying agent.
The procedure to activate the package is as follows (as was mentioned in a previous statement from the euro area head of states and governments):
1. Greece has to seek financial help and declare that it cannot access market financing;
2. The European Commission and the ECB have to establish that this is indeed the case and that Greece is on track with all the fiscal consolidation measures it has been asked to implement;
3. All the euro area countries have to decide unanimously on the bilateral loans.
Point #3 has already happened, i.e., there is unanimous agreement. So, bearing in mind that point #2 will require some time to be executed, all that needs to happen for the disbursement is point #1, i.e., Greece has to declare it cannot access market financing.
Bottom line: The interest rate is more or less in line with what could reasonably be expected, neither too high nor too low, for the European part. The amount of the package is bigger than expected. Press reports over the past few days mentioned something around â?¬25 billion in total. The bigger-than-expected magnitude of the package - especially considering that there will also be IMF funds available - was probably meant to â??shock' the market by showing that there are substantial resources on the table to support Greece in the short term. Of course, whether this will have the desired effect remains to be seen, but we acknowledge that the magnitude of the package is quite substantial: the maximum that the euro area governments might disburse (â?¬30 billion) plus an IMF contribution of, say, â?¬45 billion, would amount to almost 20% of Greece's GDP.
What's next: While short-term liquidity risks have diminished (i.e., the difficulty or inability to rollover the debt), long-term solvency risks remain firmly in place, in our view. Basically, the financial aid package, if needed, should support Greece's funding programme, especially in the light of a heavy redemption schedule this month and next. However, the situation will likely get even more challenging next year in terms of long-term solvency risk, as the redemption schedule will be even heavier, the unemployment rate higher, the economy weaker, and the government will have to push through further fiscal austerity measures. At this stage, we remain bearish on the Greek economy, and think that it will contract outright this year, to the tune of 2.5% - way below the consensus forecast of around half a percentage point.
Given the terms of the deal, and if Greece applies for it, what matters is whether this will be enough to act as catalyst for private capital flows into Greece. Looking at previous IMF programmes, the evidence for them acting as a catalyst is very mixed. Clearly, the better this works, the less daunting the debt burden becomes. The magnitude of the interest rate relief is key. As an illustrative example, if the interest rate turns out to be 200bp below market rates for a â?¬30 billion loan, it would save something close to â?¬1 billion, or about 8.5% of last year's interest expenses.
What to watch: There is a T-bill auction for about â?¬1.2 billion on April 13. On the policy front, there is an informal Ecofin Council meeting on April 15-16.
Statement on the Support to Greece by Euro Area Member States, Brussels, April 11, 2010
Following the statement by the Heads of State and Government of the euro area on March 25, euro area member states have agreed upon the terms of the financial support that will be given to Greece, when needed, to safeguard financial stability in the euro area as a whole.
Euro area member states are ready to provide financing via bilateral loans centrally pooled by the European Commission as part of a package including International Monetary Fund financing.
The Commission, in liaison with the ECB, will start working on Monday, April 12 with the International Monetary Fund and the Greek authorities on a joint programme (including amounts and conditionality, building on the recommendations adopted by the Ecofin Council in February). In parallel, euro area member states will engage the necessary steps, at national level, in order to be able to deliver a swift assistance to Greece.
Euro area member states will decide the activation of the support when needed and disbursements will be decided by participating member states.
The programme will cover a three-year period. The euro area member states are ready to contribute for their part up to â?¬30 billion in the first year to cover financing needs in a joint programme to be designed with and cofinanced by the IMF. Financial support for the following years will be decided upon the agreement of the joint programme.
In order to set incentives for Greece to return to market financing, euro area member states' loans will be granted on non-concessional interest rates. The pricing formula used by the IMF is an appropriate benchmark for setting euro area member states' bilateral loan conditions, albeit with some adjustments. Variable-rate loans will be based on 3-month Euribor. Fixed-rate loans will be based upon the rates corresponding to Euribor swap rates for the relevant maturities. A charge of 300bp will be applied. A further 100bp is charged for amounts outstanding for more than three years. In conformity with IMF charges, a one-off service fee of a maximum 50bp will be charged to cover operational costs. For instance, as of April 9, for a three-year fixed-rate loan granted to Greece, the rate would be around 5%.
The Eurogroup is confident that the determined efforts of the Greek authorities and of its European Partners will allow them to overcome the fiscal and structural challenges of the Greek economy. In this context, the Eurogroup welcomes the budget execution in the first months of the year, which shows that the measures taken so far are bearing fruit.
The general election has been called for Thursday, May 6. The odds are on a change of government and this is implied by the latest polls too. The UK has not had a change in government since 1997 (when Labour, under Tony Blair, came to power) and before that since 1979 (when the Conservatives came to power under Margaret Thatcher). However, the UK's first-past-the-post system makes translating the polls into election outcomes especially tricky. Assuming a uniform swing in votes across constituencies, many recent polls look consistent with the opposition Conservative Party gaining the most seats, but without an absolute majority - in other words, a â??hung parliament'. While such outcomes are commonplace in many other economies, the UK has little recent experience of hung parliaments (the last was in 1974). Hence, investors are understandably nervous about such an outcome.
What the latest polls imply: The average of the last eight polls shows the Conservative Party on 39% of the vote, Labour on 30% and the Liberal Democrats on 19%, with â??others' on 8%. Note that the polls can be quite variable.
How the polls translate into seats won: There is no easy way to translate the share of the vote won into seats won in the UK's first-past-the-post system. In general, a lead of around 10pp of the popular vote is thought likely to give a workable majority in parliament. However, smaller leads in the popular share of the vote have resulted in working majorities in the past. For example, in the last election Labour won a 64 seat majority with only a 3pp lead. Using uniform swing analysis, even a 10pp lead for the Conservative party wouldn't necessarily be consistent with an absolute majority Conservative victory; this would also depend on the scale of the vote for the Liberal Democrats and other smaller parties.
A change in government is implied by the polls, but a hung parliament is a distinct possibility: The polls look consistent with a Conservative win in the upcoming election, but it is not clear that this would be a majority Conservative victory.
Box: Some Background on Hung Parliaments
What is a hung parliament? A hung parliament simply means a situation where no single party has an absolute majority. This is a relatively common occurrence in some other economies, but is relatively unusual in the UK.
Labour will have â??first refusal': Gordon Brown, as the incumbent prime minister, has the right to try to form a new government, but always with the need to ultimately be able to win a confidence vote in parliament. In the case of a hung parliament where the Conservative Party has won more seats than the Labour Party and by a clear margin, we think it is unlikely that Gordon Brown would try to form a government.
Different types of government possible: There are several different â??formations' of government that could result from a hung parliament: 1) a minority government; 2) a minority government with explicit backing for major planks of policy from other parties; and 3) a coalition government with another party.
Government formation likely to take days rather than weeks: Given that hung parliaments are relatively unusual in recent UK history, it is unclear how long it might take before the form of any new government was clear. The UK electorate (and media) are used to knowing very quickly the result of an election and the pressure to form a new government quickly will therefore be very strong, in our view. In the 1974 election, the result of negotiation was known after only a few days. Our central case is that a similar timescale seems likely again. However, we recognise that in other economies this process can take weeks rather than days, so the balance of risk is strongly towards a more drawn-out process than a quicker one. During the process of government formation, â??significant' policy decisions are unlikely to be taken.
Implications of the Election for the UK Economy
The economic implications in terms of spending cuts and deficit reduction may not be that different no matter who wins the election. The parties' positions do not look vastly different to us, and we think some investors worry too much about a lack of fiscal tightening in a â??hung parliament'. In particular: 1) A hung parliament might increase the chances of cross-party agreement on the scale/method of deficit reduction, which could increase its chance of success. 2) If markets don't like the outcome of the election and fiscal policy proposals that emerge from it, they will likely force a more aggressive fiscal tightening on the government of the day.
Policy Round-Up: What the Main Parties Are Promising
Details on many policies of the three largest parties are still sketchy and changes or additions may well be announced over the coming weeks.
The main difference between the two major parties' fiscal consolidation plans is that the Conservatives want to begin sooner and do more consolidation than Labour. The Conservatives also want to carry out the consolidation using a mix that is more weighted towards spending as opposed to tax measures than Labour has proposed. The Liberal Democrats do not want to tighten as quickly as the Conservatives, though they have stressed the need to begin tightening as soon as the economy permits it.
All three parties have promised to protect some areas of expenditure and to limit increases in public sector pay.
The main difference between the parties looks to be their tax policies. The Conservatives have said that they would reverse the effects of Labour's planned rise in National Insurance contributions (using savings from efficiency gains) and would view the new top tax rate as only being â??temporary'. They also plan to make cuts to corporation tax. The Liberal Democrats plan to raise the threshold at which people start paying income tax to £10,000 and fund this partly from changes in capital gains tax. All parties have denied that an increase in VAT is part of their plans, though none have ruled it out emphatically.
Hung Parliaments: How Worried Should We Be?
We recognise that market movements may be very varied, given different election outcomes. However, the ultimate policy outcomes may not look that different, particularly with all major parties committed to significant deficit reduction and the market itself likely to act as a disciplining force against inaction.
Why people worry about hung parliaments: Some investors express the concern that in a hung parliament little will get done in terms of deficit reduction:
1) A hung parliament could mean a more protracted negotiation on a fiscal platform.
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