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WILL THE YIELD-CHASING BID RETURN TO MEXICO ANYTIME SOON?

Takeaway: Domestic and international headwinds are weighing on Mexican capital markets and that’s not something that we see reversing anytime soon.

SUMMARY BULLETS:

 

  • Mexican capital markets are getting hammered from both sides – domestically on political risks and internationally on rising duration risk – and that’s not something that we see reversing anytime soon – at least until President Nieto’s reform agenda gets firmly back on track. Using the yield on the 10Y US Treasury as a proxy for financial repression in the US, it’s no surprise to see that Mexican 10Y yields have a +0.85 positive correlation to their American counterparts on a trailing 3Y basis.
  • Additionally, with no trustworthy way of modeling intraparty and interparty political risk, we have deferred to our quantitative risk management signals, which have confirmed a TRADE & TREND breakdown in the Mexican equity market. We have interpreted that to mean there is a high probability of more political consternation ahead.
  • With super-sovereign yields backing up globally now (review our detailed thoughts HERE, HERE, HERE and HERE), it’s no surprise to see one of the favorite yield chasing plays of US and Japanese investors throughout recent years is getting tattooed. Moreover, with everything we now know about EM crises cycles (CLICK HERE for our 120+ page presentation), it’s getting a lot easier to spot these risks in real-time and reallocate assets before it’s too late.
  • We’ve obviously been the bulls on domestic equities and USD exposure in the YTD, but for those of you who must remain invested in emerging markets, we continue to like consumption-oriented markets like the Philippines, India and Indonesia in lieu of commodity/inflation oriented markets such as Russia, Brazil, South Africa and Peru. If you’re looking to play our thesis in the FX market, we continue to warn of material downside across the currencies of Latin American and African commodity producing nations.

 

Two weekends ago, National Action Party (PAN) Chairman Gustavo Madero decided against his party’s wishes to remove 45-year-old former Finance Minister Ernesto Cordero from his post as PAN Senate leader (24 of the PAN's 38 senators signed a letter in support of Cordero). The internal struggle atop the PAN, one of Mexico’s three main political parties, has accentuated the divide between PAN lawmakers willing to work with the ruling Institutional Revolutionary Party (PRI) and those who believe the party must mount a robust opposition to the galvanizing Pena Nieto in order to mitigate the risk becoming irrelevant (i.e. Cordero and the 24 senators that openly support him).

 

The key issue with this is that President Pena Nieto's PRI, which remains short of a majority in Mexican Congress, needs support from the conservative PAN to advance his economic reform agenda, which includes re-working the Mexican Constitution to overhaul state oil behemoth Pemex and to broaden the tax base. It would be hard to argue that President Nieto’s reform agenda has not been the primary driver of positive sentiment among international investors surrounding Mexico’s economic outlook in the YTD, so to the extent this creates a sustained rift within the PAN, you could see incremental selling pressure upon Mexican capital markets.

 

All that being said, some solace should be taken in the fact that Madero has openly stated that removing Cordero was merely an attempt to improve relationship between PAN party leaders and senators, insinuating that the move was unrelated to differences about party’s future in the  “Pact For Mexico” alliance (i.e. the tri-party political vehicle responsible for streamlining economic reforms). At any rate, it’s tough to see how much of the reform agenda is permanently derailed by this act until the political dust settles, which, last month, included allegations of corruption upon PRI officials at the state level.

 

With no trustworthy way of modeling intraparty and interparty political risk, we have deferred to our quantitative risk management signals, which have confirmed a TRADE & TREND breakdown in the Mexican equity market. Specifically, we have interpreted that to mean there is a high probability of more political consternation ahead.

 

WILL THE YIELD-CHASING BID RETURN TO MEXICO ANYTIME SOON? - 1

 

Since early last week, the Mexican political scene has been relatively quiet with no major developments regarding the now-shaky Pact For Mexico and President Nieto’s economic reform agenda. What has weighed on Mexican capital markets in recent days has been rising investor expectations that the Federal Reserve’s QE program is poised to be pared back at some point over the intermediate term.

 

Mexico, due to its proximity and economic integration with the US (as opposed to a recessionary Europe and structurally slower China; the US accounts for 80% of Mexican exports) has been a darling for yield-chasing capital during the Ben S. Bernanke financial repression era. As such, we’re really starting to see Mexican capital markets break down in recent weeks amid the recent backing up of global interest rates. Through yesterday’s close:

 

  • Mexico’s benchmark IPC Index fell -4.2% MoM and -9% on a trailing 3M basis;
  • The Mexican peso (MXN) dropped -1.1% WoW vs. the USD and -2.6% MoM;
  • 3M Implied Volatility on the USD/MXN increased +16.9% WoW and +24.4% MoM through yesterday’s closing price of 11.485 – the highest level since last SEP;
  • Yields on 2Y sovereign peso bonds are up +21bps WoW and 14bps MoM; and
  • Yields on 10Y sovereign peso bonds are up +39bps WoW and +68bps MoM.

 

Net-net, Mexican capital markets are getting hammered from both sides – domestically and internationally – and that’s not something that we see reversing anytime soon – at least until President Nieto’s reform agenda gets firmly back on track. Using the yield on the 10Y US Treasury as a proxy for financial repression in the US, it’s no surprise to see that Mexican 10Y yields have a +0.85 positive correlation to their American counterparts on a trailing 3Y basis.

 

With super-sovereign yields backing up globally now (review our detailed thoughts HERE, HERE, HERE and HERE), it’s no surprise to see one of the favorite yield chasing plays of US and Japanese investors throughout recent years is getting tattooed. Moreover, with everything we now know about EM crises cycles (CLICK HERE for our 120+ page presentation), it’s getting a lot easier to spot these risks in real-time and reallocate assets before it’s too late.

 

We’ve obviously been the bulls on domestic equities and USD exposure in the YTD, but for those of you who must remain invested in emerging markets, we continue to like consumption-oriented markets like the Philippines, India and Indonesia in lieu of commodity/inflation oriented markets such as Russia, Brazil, South Africa and Peru. If you’re looking to play our thesis in the FX market, we continue to warn of material downside across the currencies of Latin American and African commodity producing nations.

 

Best of luck navigating these globally-interconnected risks.

 

Darius Dale

Senior Analyst


CHART DU JOUR: MACAU GROWTH ACCELERATING?

  • Our math suggests that July GGR could grow 20% YoY due to an easy comparison and the recent VIP volume growth
  • We expect May to come in at +13% growth with June slightly higher
  • These numbers are likely to keep the momentum going in the Macau stocks
  • MPEL remains our top pick

CHART DU JOUR: MACAU GROWTH ACCELERATING? - ggr


European Banking Monitor: Mixed

Below are key European banking risk monitors, which are included as part of Josh Steiner and the Financial team's "Monday Morning Risk Monitor".  If you'd like to receive the work of the Financials team or request a trial please email .

 

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European Financial CDS - Though unremarkable, European financial swaps were broadly wider last week with a median increase of 8 bps. Barclays (+13 bps), Deutsche Bank (+10 bps) and UBS (+8 bps) showed the largest deterioration, while DNB of Norway, Investor AB of Sweden and Danske Bank of Denmark were all tighter.

 

European Banking Monitor: Mixed - tt. banks

 

Sovereign CDS – Sovereign swaps were mixed last week with Italy and Spain widening by 15 and 8 bps, respectively, while Germany and France tightened by 2 and 4 bps. Meanwhile, Japan widened 7 bps to 72 bps. The U.S. was unchanged at 30 bps, one basis point narrower than Germany.

 

European Banking Monitor: Mixed - tt. sov 1

 

European Banking Monitor: Mixed - tt. sov 2

 

European Banking Monitor: Mixed - tt. sov 3

 

Euribor-OIS Spread – The Euribor-OIS spread tightened by 1 bps to 13 bps. The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States.  Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal.  By contrast, the Euribor rate is the rate offered for unsecured interbank lending.  Thus, the spread between the two isolates counterparty risk. 

 

European Banking Monitor: Mixed - tt. euribor

 

ECB Liquidity Recourse to the Deposit Facility – The ECB Liquidity Recourse to the Deposit Facility measures banks’ overnight deposits with the ECB.  Taken in conjunction with excess reserves, the ECB deposit facility measures excess liquidity in the Euro banking system.  An increase in this metric shows that banks are borrowing from the ECB.  In other words, the deposit facility measures one element of the ECB response to the crisis.  

 

European Banking Monitor: Mixed - tt. facility

 


Early Look

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What’s Up With the Swissy?

TRADE Call (3 weeks or less): The CHF remains overvalued versus the USD and EUR; expectations that the SNB could shift the floor in the EUR/CHF or cut rates to negative may burn the CHF lower. (etf: FXF)

 

TREND Call (3 months or more): We’re bullish on the USD versus the CHF as our #StrongDollar remains intact. However, the CHF could strengthen against major currencies if it moves back to “safe-haven” status, especially should we experience another round of sovereign or banking risk scares out of the Eurozone, and/or if the SNB does not cut below 0%.

 

The Swiss Nation Bank (SNB) meets next on June 20th to discuss its interest rate policy. There’s speculation based on comments from the SNB’s head Thomas Jordan last week that it could implement negative interest rates and shift the floor in the EUR/CHF. [Last Wednesday the EUR/CHF hit 1.2614, the weakest level for the franc since May 2011].  We believe over the immediate term TRADE there’s more weakness in the EUR/CHF and USD/CHF. Beyond the potential policy moves by the SNB, we’ve seen investors pulling assets from the “safe-haven” trade and we remain grounded in our #StrongDollar call.

 

As we show in the first chart below, beginning in September 2011 (following the CHF appreciating to an all-time high in August) the SNB bought foreign reserves to maintain a floor in the EUR/CHF at 1.20 francs. Since September 2011 the SNB has increased its FX reserves by +125%, and we have reason to believe that the SNB wants to get involved in the global currency war. Both a cut to the 3M target interest rate (currently at 0%) into negative territory, and continued FX buying and/or an adjustment in the EUR/CHF higher could burn the CHF lower versus the EUR and USD, at least over the near term.  

 

What’s Up With the Swissy? - YY. FX RESERVES

 

What’s Up With the Swissy? - YY. CHF LT

 

 

Policy Challenges


In many ways the SNB is in a tough spot to manage the economy. These challenges include:

  • Swings in the currency to and from safe-haven status
  • Steady deflation
  • Low interest rates

The amount of FX buying from the SNB shows just how terrified it is of a strong currency. The worry here is two-fold -- that a strong currency 1.) will cripple export demand and 2.) force domestic companies to lower prices to ward off cheaper imports.

 

With about 60% of exports destined for the EU, it’s interesting to note that there’s a relatively weak relationship between the overall price of the currency and export demand. Below we show that the correlation between the CHF/EUR and Swiss Exports is +0.41. We think some of the weakness in this correlation can be explained by its basket of export goods, with a heavy mix of pharmaceutical and luxury exports, which command pricing power.

 

So while rhetorically there might be great emphasis placed on the threat of a strong CHF on exports, we do not think it holds up. 

 

What’s Up With the Swissy? - YY. EXPORTS

 

On deflation, Switzerland has been hit by a steady level of deflation since late 2011, with CPI falling for 19th straight months (currently at 0.40% Y/Y). We believe that while Switzerland has benefitted from falling energy prices from a stronger USD, the Bank wrestles with its policy to promote inflation. It fears that under an environment of steady deflation consumers will put off purchasing, assuming prices will go lower in the future.

 

So, while the Bank is hardly worried about stoking inflation with a rate cut, it’s aware of the policy risks around cutting from 0%:

  • further taxing savers
  • stoking a mortgage and housing bubble
  • chasing away safe-haven assets
  • no ability to guarantee that negative rates will incentivize banks to increase lending

While we’ve yet to see signs of a dangerous expansion in the mortgage and housing market (the SNB cut to 0% in August 2011), this threat remains on the minds of policy makers. We’re also seeing investors park less of their assets in Francs or Franc-denominated assets as the risk climate in the Eurozone improves.

 

One big question mark that remains is the extent to which banks, especially if the SNB cuts to negative rates, increases their lending to seeks a better return on money.  

 

What’s Up With the Swissy? - YY. CPI

 

 

Broader Fundamentals Appear Strong, Relatively


Below is a snapshot of Swiss GDP. Our call-out here is that with GDP low to depressed across much of the region, we think Switzerland’s relative outperformance will continue to anchor a market of strong investment despite low interest rates.  A weaker CHF versus its trading partners on the margin will also remain a positive.

 

Swiss GDP is forecast to rise +1.3% this year versus -0.50% in the Eurozone. With a Swiss budget surplus of +0.3% of GDP in 2012 and debt of 53% of GDP last year, its fiscal house remains in order and could quickly transition back to its safe-haven status should we get another round of sovereign or banking risk scares out of the Eurozone.

 

What’s Up With the Swissy? - YY. GDP

 

Below is a graphic illustrating our levels on USD/CHF via the etf FXF. We outline the intermediate term TREND line that the FXF violated. We view this as a bearish signal and expect weakness into the SNB’s June 20th meeting. Should the bank act, either in cutting rates, and/or adjusting the floor, or setting future expectations for either, we’d expect further weakness. 

 

What’s Up With the Swissy? - XX. FXF

 

The Swiss Market Index (SMI) is up 20.5% YTD, leading the pack as the best performing European index YTD. The SMI is up 4.6% MTD and as we outline in the chart below (via the etf EWL), is in a bullish formation. 

 

What’s Up With the Swissy? - XX. EWL

 

 

Matthew Hedrick

Senior Analyst

 

 

 

 


HEARD ON THE AM CALL: GOT YIELD?

Takeaway: Our Central Planner in Chief is not bullish enough on growth.

(Excerpt from this morning's Hedgeye conference call)

 

Just to show you how horrendous being long no-growth “yield” is performing, here’s the score:

 

  1. Utilities (XLU) are down -6.3% in May
  2. Financials (XLF) are leading the S&P 500 up +5.5% in May

That is a huge divergence.

 

So, why are utilities getting crushed, while financials (and US Treasury Yields) are ripping higher? Simple. Because one likes growth, and the other doesn’t like Bernanke.

 

The market is now – explicitly and implicitly – betting against the Chairman of the Federal Reserve. The bottom line here? Ben Bernanke is not bullish enough on growth.

 

#GrowthAccelerating

 

HEARD ON THE AM CALL: GOT YIELD? - xlf.xlu


TUESDAY MORNING RISK MONITOR: TEMPERING ENTHUSIASM

Takeaway: The risk monitor has turned somewhat bearish on a short term basis. We're keeping an eye on high yield for indications of a change.

Key Takeaways:

 

Overall, our gauges of risk show broad deterioration on an immediate term basis, though remain bullish on an intermediate and long term basis. The recent back-up in High Yield, Municipal Credit and widening in U.S. Financial swaps are all an inflection from the YTD trends. 

 

* High Yield (YTM) Monitor – High Yield rates rose 16.0 bps last week, ending the week at 5.47% versus 5.31% the prior week.

 

* Sovereign CDS – Sovereign swaps were mixed last week with Italy and Spain widening by 15 and 8 bps, respectively, while Germany and France tightened by 2 and 4 bps. Meanwhile, Japan widened 7 bps to 72 bps. The U.S. was unchanged at 30 bps, one basis point narrower than Germany.

 

* U.S. Financial CDS -  Swaps widened for 22 out of 27 domestic financial institutions. The large cap financials were all wider, by an average of 5 bps. Credit card companies AXP and COF widened by a comparable 7 bps and 6 bps, respectively. Meanwhile, mortgage insurers MTG and RDN widened on the week by a modest 12 and 7 bps, respectively, but that marks the second week in a row of no improvement for one of the most levered plays to the housing recovery.

 

Financial Risk Monitor Summary

 • Short-term(WoW): Negative / 0 of 13 improved / 6 out of 13 worsened / 7 of 13 unchanged

 • Intermediate-term(WoW): Positive / 8 of 13 improved / 1 out of 13 worsened / 4 of 13 unchanged

 • Long-term(WoW): Positive / 4 of 13 improved / 1 out of 13 worsened / 8 of 13 unchanged

 

TUESDAY MORNING RISK MONITOR: TEMPERING ENTHUSIASM - 15

 

1. U.S. Financial CDS -  Swaps widened for 22 out of 27 domestic financial institutions. The large cap financials were all wider, by an average of 5 bps. Credit card companies AXP and COF widened by a comparable 7 bps and 6 bps, respectively. Meanwhile, mortgage insurers MTG and RDN widened on the week by a modest 12 and 7 bps, respectively, but that marks the second week in a row of no improvement for one of the most levered plays to the housing recovery.

 

Tightened the most WoW: MMC, AGO, MBI

Widened the most WoW: AXP, ALL, COF

Tightened the most WoW: MBI, AGO, RDN

Tightened the least MoM: MET, ACE, TRV

 

TUESDAY MORNING RISK MONITOR: TEMPERING ENTHUSIASM - 1

 

2. European Financial CDS - Though unremarkable, European financial swaps were broadly wider last week with a median increase of 8 bps. Barclays (+13 bps), Deutsche Bank (+10 bps) and UBS (+8 bps) showed the largest deterioration, while DNB of Norway, Investor AB of Sweden and Danske Bank of Denmark were all tighter.

 

TUESDAY MORNING RISK MONITOR: TEMPERING ENTHUSIASM - 2

 

3. Asian Financial CDS - Asian financial swaps widened across the board last week, increasing by an average 6 bps. Increases were controlled, with all but two falling in the single digit basis point range. 

 

TUESDAY MORNING RISK MONITOR: TEMPERING ENTHUSIASM - 17

 

4. Sovereign CDS – Sovereign swaps were mixed last week with Italy and Spain widening by 15 and 8 bps, respectively, while Germany and France tightened by 2 and 4 bps. Meanwhile, Japan widened 7 bps to 72 bps. The U.S. was unchanged at 30 bps, one basis point narrower than Germany.

 

TUESDAY MORNING RISK MONITOR: TEMPERING ENTHUSIASM - 18

 

TUESDAY MORNING RISK MONITOR: TEMPERING ENTHUSIASM - 3

 

TUESDAY MORNING RISK MONITOR: TEMPERING ENTHUSIASM - 4

 

5. High Yield (YTM) Monitor – High Yield rates rose 16.0 bps last week, ending the week at 5.47% versus 5.31% the prior week.

 

TUESDAY MORNING RISK MONITOR: TEMPERING ENTHUSIASM - 5

 

6. Leveraged Loan Index Monitor – The Leveraged Loan Index fell -1.1 points last week, ending at 1804.6.

 

TUESDAY MORNING RISK MONITOR: TEMPERING ENTHUSIASM - 6

 

7. TED Spread Monitor – The TED spread fell 0.6 basis points last week, ending the week at 23.5 bps this week versus last week’s print of 24.1 bps.

 

TUESDAY MORNING RISK MONITOR: TEMPERING ENTHUSIASM - 7

 

8. Journal of Commerce Commodity Price Index – The JOC index rose 0.6 points, ending the week at 3.82 versus 3.2 the prior week.

 

TUESDAY MORNING RISK MONITOR: TEMPERING ENTHUSIASM - 8

 

9. Euribor-OIS Spread – The Euribor-OIS spread tightened by 1 bps to 13 bps. The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States.  Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal.  By contrast, the Euribor rate is the rate offered for unsecured interbank lending.  Thus, the spread between the two isolates counterparty risk. 

 

TUESDAY MORNING RISK MONITOR: TEMPERING ENTHUSIASM - 9

 

10. ECB Liquidity Recourse to the Deposit Facility – The ECB Liquidity Recourse to the Deposit Facility measures banks’ overnight deposits with the ECB.  Taken in conjunction with excess reserves, the ECB deposit facility measures excess liquidity in the Euro banking system.  An increase in this metric shows that banks are borrowing from the ECB.  In other words, the deposit facility measures one element of the ECB response to the crisis.  

 

TUESDAY MORNING RISK MONITOR: TEMPERING ENTHUSIASM - 10

 

11. Markit MCDX Index Monitor – Last week spreads widened 4 bps, ending the week at 61.7 bps versus 57.7 bps the prior week. The Markit MCDX is a measure of municipal credit default swaps. We believe this index is a useful indicator of pressure in state and local governments. Markit publishes index values daily on six 5-year tenor baskets including 50 reference entities each. Each basket includes a diversified pool of revenue and GO bonds from a broad array of states. We track the 16-V1. 

 

TUESDAY MORNING RISK MONITOR: TEMPERING ENTHUSIASM - 11

 

12. Chinese Steel – Steel prices in China fell 0.8% last week, or 27 yuan/ton, to 3,536 yuan/ton. We use Chinese steel rebar prices to gauge Chinese construction activity, and, by extension, the health of the Chinese economy.

 

TUESDAY MORNING RISK MONITOR: TEMPERING ENTHUSIASM - 12

 

13. 2-10 Spread – Last week the 2-10 spread tightened to 169 bps, -4 bps tighter than a week ago. We track the 2-10 spread as an indicator of bank margin pressure.

 

TUESDAY MORNING RISK MONITOR: TEMPERING ENTHUSIASM - 13

 

14. XLF Macro Quantitative Setup – Our Macro team’s quantitative setup in the XLF shows 2.3% upside to TRADE resistance and 2.5% downside to TRADE support.

 

TUESDAY MORNING RISK MONITOR: TEMPERING ENTHUSIASM - 14

 

Joshua Steiner, CFA

 

Jonathan Casteleyn, CFA, CMT

 

 


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