U.S. equities sank lower again on Friday on concerns that the European bailout package would curb global economic growth given the significant austerity measures that are required in the region. More telling is the steady rise in 1, 3, 6 and 12 month Libor rates suggesting that European banks are reluctant to lend to one another for lack of trust. Specifically, European banks own a significant amount of European sovereign debt, creating significant counterparty fears. Recall that Libor was the key metric that foretold the U.S. credit crisis, so it is very important to keep any eye on what it does. In regards to the contagion fears, U.S. banks don’t own much in the way of Greek debt, bet they do have exposure to other European sovereign debt and significant exposure to European banks. Should the European crisis turn into a European banking crisis, there is a good probability that the U.S banks could be in some trouble as well. It is premature to think this will occur, but is certainly a story worth following.
On the treasury front, yields ended the week very close to where they started the week, despite significant volatility in between. Interestingly, two year treasury yields declined to its lowest level of the year as market participants rethink the outlook for interest rates. It is looking more and more likely that the Fed is not going to raise short-term rates this year, particularly in light of the aforementioned European fears. Recall that last week the Federal Reserve opened up swap lines for foreign firms through foreign central banks. The net result of this move was an expansion of the Fed’s balance sheet to $2.34 trillion, close to a record and up from less than $2 trillion back in August. Clearly the Fed is cognizant of the potential severity of the European situation and is going to do whatever they deem necessary to thwart another U.S. banking crisis. Consequently, I believe this precludes the Fed from raising short-term rates and from selling mortgage backed securities (mbs) from its balance sheet until the European problems no longer represent a threat to the U.S., which in my opinion will bleed into 2011.
On the economic front, the following calendar will shape trading this week:
Monday May 17: Empire Manufacturing, Net Long-Term TIC Flows, Total Net TIC Flows, NAHB Housing Market Index
Tuesday May 18: Producer Price Index (Mom and YoY), Housing Starts, Housing Starts MoM%, Building Permits, Building Permits MoM%, ABC Consumer Confidence
Wednesday May 19: MBA Mortgage Applications, Consumer Price Index(MoM and YoY), CPI Core Index SA and NSA, Mortgage Delinquencies, MBA Foreclosures, FOMC Meeting Minutes
Thursday May 20: Initial Jobless Claims, Continuing Claims, RPX Composite 28dy Index, Philadelphia Fed, Leading Indicators
Friday May 21: No Data
Keep an eye on the inflation data on Tuesday and Wednesday, which is expected to be tame, along with the claims data on Thursday for a tell on the employment picture.
On the fixed income front, corporate bond spreads stabilized toward the latter part of the week, with some financials gapping wider as a result of the issues highlighted above. As such, we think there is an opportunity to once again selectively add shorter-term corporates to the portfolio. In regards to mbs, prices are close to their all time highs again on lack of supply and Wall Street demand coupled with the unlikelihood that the Fed will begin selling any time soon. We continue to recommend selling inferior structures into the strong bid side environment. For those that need collateral, focus on well structured 15 and 20 year mbs pools or well structured one time callable agencies.