Wednesday May 31

Stocks fell slightly for the second consecutive day. The S&P 500 fell less than 0.1% to 2,411 and the Dow Jones lost 0.1% to 21,008. The KBW Bank index fell 1.2% while utilities gained 0.5%. Banks have been hurt from a flattening of the yield curve, and utilities have benefitted from a rally in Treasury yields. Robert Kaplan of the Dallas Fed spoke today and came across as slightly hawkish, saying that he is prepared to stick to his plan in spite of signs that inflationary pressures may be receding. Falling oil prices continued to weigh on sentiment. Stocks in the UK are also trading at record highs on pound weakness. Investors for the rest of the week will be paying close attention to the ADP report tomorrow, the May NFP number on Friday, and ISM manufacturing data. Heading into that data heavy calendar the market for Fed funds futures sees an 88% chance of higher rates in June. On that backdrop the two year Treasury yield fell 1bp to 1.28%. The ten year Treasury yield fell 1bp to 2.20%. 2yr vs 10yr remains very flat at 0.92%. The dollar was weaker on the day for the most part but the pound bucked the trend. USD fell 0.4% against EUR to $1.1242. USD fell 0.2% against JPY to Y110.76. USD rose 0.6% against GBP to $1.2889 after polling data suggests that Theresa May may not get as strong of a result in next week’s elections as previously expected. Oil prices had a tough day as well. WTI fell 2.7% to $48.33. Brent fell 3% to $50.29.

Venezuelan debt has risen a bit since the country struck a deal with Goldman Sachs. Last week Goldman bought $2.8bn in PdVSA bonds from the Venezuelan central bank at a deep discount of $865mm. That represents a discount of just 31 cents on the dollar. The bonds were issued in 2014 and are due in 2022, and for Goldman it represents an annual return in excess of 40% if they are paid back in full. Goldman is experiencing blowback from this deal from people that claim that this deal perpetuates a dictatorship that starves the country’s people. Venezuela hasn’t been able to raise money in public capital markets for years due to the deep contraction of its economy. It is struggling to find dollars to pay back investors, but these types of deals may be one way for the country to get some money. Banks in Venezuela are estimated to own just under $16bn in debt, and it wouldn’t be beyond the scope of this government to seize those assets in return for notes denominated in bolivar (which would virtually be worthless). That would give the government more assets to be able to sell, and they would be able to raise a few billion US dollars from those sales. While it does little to help them resolve deep seeded issues in the country, it would help the government keep the lights on for a little longer. As a result Venezuelan debt prices have risen somewhat in recent days due to the hopes that more private deals like these could support the government in the short term. The government has also done deals with hedge funds similar to this in recent months.

Portuguese debt has been the biggest beneficiary of the rally in European sovereign debt in recent months. The 10 year Portuguese yield is currently 3.09% many investors are optimistic on the country’s outlook. Earlier in the year it was a much more shaky picture as investors were concerned about political risk in the eurozone leading up to the French election. At its peak in February Portuguese 10 year bonds yielded 4.30%. However since the French election Portuguese bonds have rallied and have benefitted more than any other country with the exception of Greece. That has benefitted Portuguese equities as well. In addition to the reduction of political risk, investors have also been paying attention to Portugal’s economic recovery. Portugal was one of the most hardly hit countries during the sovereign debt crisis and subsequent economic downturn. However it has made a recovery and in the first quarter growth was an annualized 2.8%. That number is expected to stabilize between 1 and 1.5%. The deficit that was formerly 10% has decreased down to 2% due to effective cooperation by a coalition government. Businesses report optimism in the country which is also leading investors back driven by growth in real estate and tourism. However several key risks remain. Due to the country’s high debt to GDP ratio all main rating agencies hold Portugal’s debt as junk rated. Only DBRS considers Portugal’s debt as investment grade rated. If it were to lose that designation, then the ECB could no longer include Portugal in its quantitative easing program. That, in addition to the unwinding of QE, could be very bad for financial markets in Portugal since as a smaller and riskier market it is more dependent on the ECB program. Another risk point is the banking sector. After the eurozone crisis countries such as Spain and Ireland cleaned out their banking sector of nonperforming loans, which helped facilitate the recovery in those countries. However Portugal’s banking sector is still plagued by 17% of their loans being non performing. That inhibits the creation of credit which could be damaging to growth and investment over the long term.

Tighter opinion polls ahead of the UK election next week have made the pound the worst performer against the dollar this month. Investors initially seemed to like Theresa May’s approach to the Brexit as she emphasized that maintaining trade relations with the EU would be her first priority. That is why the pound rallied in April when she called for a snap election in which many investors and political analysts believed she would be able to strengthen her hand and reduce the influence of more conservative members who wanted a harder Brexit. However opinion polls have showed that she may not garner as much support as she might like. Whereas before investors were expecting her party’s majority to be extended by 100-150, now they are eying the risk that the majority will only increase to 50 or even less. That would be a very unfriendly outcome for the British pound. However it goes without saying that opinion polls have been wrong before leading up to these types of elections, and they will be wrong again in the future. The reason why she has lost some support seems to be that she flipped her view on an important social issue that swayed some voters out of her favor. Bond markets in the UK have also been pricing in recent pessimism. Yields in the UK have been decreasing and bonds therefore have outperformed peers in the US and in the eurozone. UK gilts have produced a total return of 0.75% this month compared with 0.53% and 0.54% for Treasuries and euro area bonds respectively. A broader measure of debt in the UK including corporate bonds have produced returns of 0.9%. That suggests that fixed income investors are expecting a more negative outlook that will result in lower growth and inflation.

Wednesday May 31

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