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Some encouraging developments



Sometimes it is difficult to see signs of improvement in the aggregate data until a trend is clearly underway. Changes on the margin can be hard to detect, and nothing is for sure until things are clear, but of course by then it may be too late to get on board. Here are some charts of relatively obscure developments that are looking very good on the margin. 


This chart compares the yield on 2-yr Spanish (white line) and Italian (orange line) bonds. The outlook for Spain has improved dramatically in the past three weeks, with yields plunging from 6.1% to 3.7%, thanks to what looks like an emerging political consensus that supports austerity measures. Things have even improved for Italy, with yields falling from 7.7% to 5.5%. Italy may not have the austerity consensus that Spain does, but Italy's deficit is less than 5% of GDP, so the fundamentals have never been even close to awful. As a caveat to this otherwise good news, I note that 2-yr Eurozone swap spreads are still hovering around 110 bps, and that is very high. There has been some piecemeal improvement in the Eurozone, but not enough to make a significant difference to the overall level of systemic risk facing the banking industry. But a few more bits of good news like this could mark a tipping point of sorts.


The Vix index today fell to its lowest level since the August eruption of bad news from the Eurozone. I've called this "panic exhaustion," but it could also be the result of the simple passage of time, since that gives markets an opportunity to brace for bad news. Markets do not stand idle when challenges and risk present themselves. Given time, those with too much risk exposure can lighten up, while others with more risk appetite can marshall their resources, and that in turn improves the market's fundamentals. I see this decline in underlying risk as a very healthy development, a precursor of real fundamental changes in the outlook.


As the chart above shows, a decline in the Vix suggests that we could see some improvement in equity prices going forward.


The ongoing decline in weekly claims for unemployment is also pointing to higher equity prices. An improving U.S. economy goes a long way to negating the Eurozone headwinds.


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