Tuesday, January 18, 2011

Do Oil Shocks Have Any Predictive Value?

By Grant de Graf

James Hamilton, a Professor of Economics at the University of California, San Diego, has recently completed a paper showing the correlation between oil shocks and economic recessions. The publication is impressive and demonstrates the strong relationship between oil shocks and the business cycle. The real question is whether the data can be of predictive value in forecasting peaks and troughs of a business cycle from the implied correlation. In other words, are the oil shocks a function of economic recessions [or the boom that precedes a recession] or is an economic recession a consequence of an oil shock?

[click on chart to enlarge]

Hamilton concludes from his paper: "The correlation between oil shocks and economic recessions appears to be too strong to be just a coincidence (Hamilton, 1983a, 1985). And although demand pressure associated with the later stages of a business cycle expansion seems to have been a contributing factor in a number of these episodes, statistically one cannot predict the oil price changes prior to 1973 on the basis of prior developments in the U.S. economy (Hamilton, 1983a). Moreover, supply disruptions arising from dramatic geopolitical events are prominent causes of a number of the most important episodes. Insofar as events such as the Suez Crisis and first Persian Gulf War were not caused by U.S. business cycle dynamics, a correlation between these events and subsequent economic downturns should be viewed as causal. This is not to claim that the oil price increases themselves were the sole cause of most postwar recessions. Instead the indicated conclusion is that oil shocks were a contributing factor in at least some postwar recessions."

In an attempt to disassociate the oil shocks from the business cycle, the paper uses the examples of the Suez Crisis and the Persian Gulf War, as specific incidents that preempted a downturn. The study thus concludes that oil shocks do contribute to recessions, but acknowledges that their impact is not absolute.

Historically, strong demand for crude evident at the peak of a cycle, has played a significant role in price escalation. One ponders over whether [bar for the Suez Crisis and Persian Gulf War] the majority of oil shocks were not just a function of business cycle peaks that ultimately evolved into a downturn, as a natural consequence of the business cycle. Irrespective, what is strikingly evident from this paper, is that oil prices may be an efficient mechanism in which to measure the peak of a cycle.

Monday, January 17, 2011

EU Crisis Creates Arbitrage Opportunity

By Grant de Graf

Yield Spread: Portuguese 10-year vs. Bund 10-year

The Euro Zone is the unwilling master to a relatively new set of developments: a Greek tragedy, a howling Celtic tiger and a wind swept Algarve. But in the wake of the unfolding financial woes that are sweeping across Europe, one cannot ignore the opportunities that are flashing across screens, especially in the arena of bonds and the yields they are producing.

If the new bond issues by Portugal and Spain indeed carry with them the guarantee of the EU as is being proclaimed, it is difficult to understand why the German bund and the Portuguese bond for example, are trading at different yields. Although the 10-year spread between these bonds has narrowed after reaching a 429 point historic high, following the successful sale of Portugal's bonds last week, there still remains a significant gap. Seemingly, if both bonds assume the same risk, given the EU's guarantee for non-default or a bailout, the obvious trade would be to short the German bund and long the Portuguese bond, anticipating that the spread will narrow. There are however, a few things that could go wrong with this trade.

Firstly, the extent and terms of the guarantee by the EU against Portugal's default need to be established. The guarantee may not necessarily amount to a contractual obligation, but rather an indication of sentiment, which is not a premise that will persuade investors. Secondly, speculation about Portugal's financial demise could advance a sell-off of Portuguese bonds, even if the bonds are "guaranteed". No one wants to necessarily have to test the strength of a commitment.

Still, the fact that there exists a spread to such an extent between the yields is puzzling, if in fact the risk for the bonds is similar. This also suggests that investors have doubts about the extent of the EU's commitment to salvage Portugal, if the need should arise. Alternatively, the market suspects that the possibility of a Portuguese bailout could result in contagion to Spain, a country that in the words of economist Nouriel Roubini "Is too big too fail and too big to bail." Let's not even go there.

Thursday, January 13, 2011

Portugal Will Resist Bailout

[click on image to enlarge]

By Grant de Graf

So, everyone is breathing a sigh of relief that the Portuguese bond auction went smoothly and that the average yield for the long term bonds was below the anticipated rate. Of course what players are ignoring is that the buyers of the bonds were in fact the EU, fronted by major investment banks. No harm done. This was the correct and optimal approach. It is in everyone's interest that the EU participate in providing greater stability through market instruments, rather than formulating a side deal, which would have merely served to increase speculation and uncertainty. Naysayers continue to talk Portugal into resorting to a bailout, however a bailout appears to be far from certain. Portugal recently closed on a 1.1 billion private placement with China. Additionally, Portuguese Prime Minister Jose Socrates has indicated that he will resist an EU bailout.

Pundits are suggesting that the 6.716% avereage yield achieved at the auction is too high to facilitate strong growth levels in GDP, which the Bank of Portugal are suggesting for 2012. This is not necessarily a deal breaker, as world economies have historically succeeded in achieving high growth, in a high interest rate environment.

The focus will really be on how Portugal can achieve economic rejuvenation, given the softening of global demand. If the country is to achieve its projected levels of growth, then essentially it will need an export lead recovery. This will be very difficult to achieve if the country is tied to the Euro and if it does not enjoy a competitive advantage, which under normal conditions could have been achieved through the devaluation of its currency through the market mechanism.

Tuesday, January 11, 2011

Investors in Portugal to Receive Back-Room Massage

By Grant de Graf

As anticipated, Portugal and Spain are in focus and at the tip of the scale which is once against testing the strength of the Euro currency and Eurozone. Until now the Euro has survived a number of runs. Initially Greece, then Ireland and now Portugal. The primary trigger was the lack of liquidity experienced by central governments seeking to meet bond obligations and current financial needs. Due diligence reports, compiled when these central governments went to the market to increase their debt exposure, revealed that they were in pretty bad shape. Public reaction ranged from mass panic to demonstrations and even riots. The race was on to target victims who could take the rap.

The Central European Government has achieved a remarkable degree of success, together with the IMF in providing bail-out funds and containing the problem. Their future was at stake. The stronger member countries like Germany, and to a lesser extent France are the paymasters who have been left to hold the can. In response they have sought the imposition of strict austerity measures on ailing countries. Now Portugal is faced with a similar dilemma. Within several weeks, a significant size of of its bond portfolio will become due for repayment. To avoid defaulting, the Portuguese government will need to go to the market to raise additional funds. In boom times this would have been like kicking a ball on to a kid's playground. After the credit crunch and austerity, there is no ball and not too many players who are looking for a game. When investors show their face at the forthcoming auction, in when Portugal is seeking to raise funds in the market through additional bond issues, they will ask many questions and request a show of the books. Portugal officials may well be left pursing their lips and offering investors another glass of wine. This will not satisfy. That is why the European Central Bank is likely to pitch in at the auction with covering bids, mainly to keep bond yields lower than what they otherwise may have been. Secondly, their presence at the auction will also serve to underwrite the bond offers that are being made and to reduce upward pressure on the bond yields. This is like offering investors, the potential bidders for the bonds, with a back room massage to stimulate interest and alleviate concerns.

Of course, like any injury, a massage is always a short term solution to a long term problem.