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It's still all about Europe



The market's wild reaction to the FOMC's announcement yesterday (gold down, dollar up, euro down, T-note and T-bond yields down, equities down, commodities down) begs an attempt to diagnose what is going on. One explanation that seems to make sense is that what the market was really looking for from the FOMC was a QE3, not an Operation Twist 2. Increasing the duration of the Fed's Treasury holdings doesn't do much of anything for the economy, but deciding to no longer pay interest on excess reserves, for example, would have been a clear move to an easier policy stance, and that might have relieved some of the pressures in Europe, or at least so the thinking goes. By not announcing a true easing of monetary policy, the FOMC's announcement could thus have sparked fears that the deterioration in Europe was increasingly likely to result in some sort of economic destruction. 

So here's my guess as to mindset behind the market moves these past several days: The market's desire for Treasury bonds has gone way up because there is huge demand for a safe asset that still pays interest and is assured of having a buyer for the next 10 months. Plus, as indicated in my previous post, the mortgage market's negative convexity is adding significantly to the market's desire for duration, thus accentuating the decline in Treasury yields. The demand for euros fell because Europe is now seen to be in worse trouble—not even the Fed can help, and the dollar is the only safe-haven that is still cheap. Gold wasn't favored because if the Eurozone economy collapses, then inflation is more likely to go down than up (recall that gold fell in the second half of 2008); this message is also seen in the 30 bps drop in forward breakeven inflation spreads since last week.

Equities everywhere are down because the market fears that a Greek default is imminent and it will be contagious and that could result in a global financial crisis and/or a global economic slump similar to what followed in the wake of the Lehman collapse in 2008. Commodities are down because of the widespread fear that a global economic slump/collapse is just around the corner, and because speculators everywhere have been burned by huge volatility.

At the core of all these concerns is Eurozone sovereign debt default risk, as I noted here and here

To balance these fears, and to flesh out some of the price action, consider the following updated charts:


Since late 2009, the number of U.S. persons receiving unemployment insurance (above chart) has dropped by 5.2 million, or more than half (i.e., down 55% from a peak of 11.5 million). Over this same period, the unemployment rate has declined from 10.1% in Oct. '09 to 9.1% today.  Fewer people being supported by unemployment insurance equals more people with a greater incentive to find and accept a job. In the end, that is a good thing.


Over that same time frame, the number of new claims for unemployment insurance has been falling steadily. On an unadjusted basis (see chart above), new claims were only 350K in the week ending Sept 16th, down from 382K in the same week last year. There is no sign here of any imminent or emerging collapse in the U.S. economy or the jobs market.


On a seasonally-adjusted and smoothed basis, the trend in weekly claims appears to still be declining. Recessions are always preceded by a substantial increase in claims, but that is manifestly not the case today.


The index of Leading Indicators continues to rise, up 6.5% over the past year. Every recession for the past 50 years has been preceded by a significant decline in the growth rate of this index; that is not the case today. To be sure, this index is not always a good leading indicator, but it is not even close to signaling impending doom or even a modest recession.


The behavior of swap spreads—excellent leading indicators of systemic risk—is the clearest indicator that it is Europe that is facing the big problems. There is now a huge and unprecedented divergence between U.S. and Eurozone swap spreads. Systemic risk in the U.S. remains within a "normal" range, but eurozone swap spreads are over 100 bps, a sure sign of imminent and painful problems there.


The dollar has been the main beneficiary of the recent panic crisis, but it is still quite low from an historical perspective. It's recent strength derives mainly from the new-found weakness in the euro, not from any effective tightening on the part of the Fed. Maybe a QE3 could have helped Europe, but that is far from obvious, and in any event there are no other signs that dollars are in short supply relative to demand.


The most recent data on residential and commercial property prices (June and July, respectively) shows that prices have been roughly flat for the past two and a half years. The bursting of the commercial property price "bubble" is quite obvious here, but now that it has burst, prices are no longer declining.


The recent plunge in copper prices is typical of many commodities: very painful, but not by any means unprecedented, and prices are still quite elevated from an historical perspective. Speculators of all stripes have been burned in many ways with all the volatility sweeping the markets these days. It's not surprising that commodity prices have corrected.


Gold has suffered a nasty, $180 decline from its recent, all-time high, but from a long-term perspective it looks like a simple correction. Gold only got as high as it is because it has been pricing in lots of devastating news; this recent decline could be an indication that although the recent news has sparked a panic in bond and equity markets, it's not as bad as gold investors had expected.


To date, the drop in the S&P 500 from its recent highs has been about 15%. Prices are still almost 70% above the Mar. '09 lows. It's a panic, to be sure, but not nearly a collapse. Corporate profits have doubled from their year-end 2008 lows, the average PE ratio is only 12.3, according to my Bloomberg, and those facts provide a strong safety net for prices.

Taking everything into consideration, it's quite apparent that the source of the recent angst is the increasing likelihood of a major sovereign default (e.g., Greece), and the fear that this might prove contagious and eventually escalate to the level of a global financial and economic panic. There's no denying that Greece is almost certainly going to default, and that it will be the biggest sovereign default on record. Whether that is big enough to bring down the entire world is the question at hand. I just don't see it.

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