Brief updates on the two issues dominating the world's attention

Friday 10th July 2015

Brief updates on the two issues dominating the world's attention :

Greece :  Greece last night put forward a raft of proposals to creditors aimed at securing a new three year, 53.3 bn euro aid package, by all accounts embracing demands for pension cuts, tax rises and labour reforms. Eurozone officials will be studying the details today, their finance ministers meet tomorrow and their findings will be passed to EU leaders for the meeting on Sunday, at which point the final decision will be made.

PM Tsipras should get the proposals rubber-stamped by the Greek parliament easily enough, but is likely to face some stern opposition from the hard left of his own Syriza party, which could signal domestic political problems for Mr Tsipras in the future. As for the rest of the Eurozone, some will need to pass any new deal through their own parliaments before ratification. Debt restructuring (lower interest , longer maturities) is one thing, but for many debt forgiveness is not an option.

Understandably, this whole affair has often been referred to as a tragi-comedy. To continue the theatrical analogy, one could view certain elements of the crisis as having more in common with the Theatre of the Absurd. Last Sunday, the Greek people were asked to vote on whether to accept an offer that was no longer on the table. Last night, the Greek government effectively accepted conditions that it had campaigned against and which 61% of voters had rejected. One could argue that given the deterioration in the economy even since capital controls were introduced, in relative terms the conditions are even tougher.  

China : Another day of recovery for China's stock markets .... the Shanghai composite finished about 4.5% higher. Those tempted to believe that the tide has turned should be a little cautious. Nearly 50% of stocks are still closed for trading, and even after the recent rout the market is still 75% higher than a year ago. The quite extraordinary measures taken by the Chinese government to stop the bleeding cannot remain in place forever .... or can they ? Plainly the authorities are both able and prepared to act in ways that just couldn't happen in any other major market, but whether that is a valid reason for confidence is a moot point. If China's 90m mainly retail investors take the view that the government will not countenance major market falls (madness in itself), and that buying shares is almost a one-way bet,  then surely the next bubble is only round the corner.

The Yield Curve .... Flatter is the modern norm, but don't make too many assumptions

"Rate rise prospect revives spread conundrum" , The Financial Times, p.32

First of all, forgive the ABC reminder ..... In normal circumstances, longer-term debt commands a greater yield than shorter-term. Thus a chart of yield levels against length of maturity (the Yield Curve) shows an upward path. If the yield premium commanded by longer-dated instruments over shorter-dated ones narrows, the curve flattens. Of course, countless factors go into determining relative yields, but you can't get away from the fact that most fundamentally it is entirely logical that lenders should desire a greater return to lend for longer ..... which is not to say that the curve can't go flat, or even in extremis invert, but generally speaking an upward yield curve is desirable, especially to central bankers.

Back in 2005, then Fed Chairman Alan Greenspan described as a "conundrum" the fact that yields on longer dated Treasury bonds (10 years +) had remained largely unaffected by rises in the Fed's benchmark interest rate (Fed Funds), a flattening of the yield curve. In essence, he was admitting that he was powerless to do anything about it . As the Fed now prepares to start its rate-rising cycle (though we don't know exactly when) , it looks as though current Chairwoman Yellen is facing the same problem. The spread of 30 year Treasury bond yields over the 5 year equivalent has widened slightly recently to 149 basis points, but is still well below the level of 250bp in 2013 and over 300bp towards the end of 2010.  There has been an increase in those that think that the direct link between the Fed Funds rate and long-term yields has been weakening for some time, which they reasonably argue is logical since longer-term instruments are affected by longer-term factors, such as economic outlook, inflation forecasts, the level of savings etc. 

Now some take the view that increases in short-term rates may actually have the opposite effect on bond yields. Rate hikes would signify a determination to keep a lid on inflation, and thus be good for bonds, pushing down yields and flattening the curve. On the face of it, there are no obvious flaws in this logic.

But those betting on continued yield curve flattening (or even inversion) need to have a care. In 2005, Mr Greenspan had few tools at his disposal to engineer a steepening of the curve. Ms Yellen on the other hand is sitting on a veritable boatload of longer-term securities that the Fed has taken on board through its Quantitative Easing process. In an ideal world, it would let as many of these as possible just mature. But if it felt the need to steepen the curve, it certainly has the ammunition to start a programme of sales that would push longer bond prices lower and therefore yields higher.

Any notions that the curve is pre-ordained to go flatter and flatter might be taking too much for granted.