Another Day, Another Sovereign Debt Worry

by: Macro Man

Man, it seems like finance has been reduced to shift work these days, doesn't it? After being snowed in for a few days in greater NY last week, Macro Man finally made in front of his screens today....only to find much of Asia, the US, and even those pesky Greeks off for public holidays today.

Your author's sequesterment in a hotel room with little accompaniment (he only packed enough for an overnight trip) offered him a new perspective on the spending habits of the fabled American consumer, as he watched a few hours of television. Perhaps it hasn't really changed that much since Macro Man was resident in the US, but man oh man: at every (frequent) commercial break, the viewer was exhorted to spend his cash on a dizzying array of items that could be best described as "crap." Perhaps a four-piece "diamond" jewelry set from JC Penney (NYSE:JCP) for $49.99 really does say "I love you"....though if Macro Man were to present Mrs. M with such a gift, he suspects an altogether different message would be conveyed.

Equally jarring were the drug ads; given the ongoing debate about health care reform, Macro Man wonders how much of the prohibitive cost of prescription drugs goes to feed the pharmaceutical firms' advertising budgets. (Sure, he knows it's not large, but the contrast to the rest of the world, where drug advertising is not permitted, nevertheless jars the senses.) In any event, having watched more American advertising over the past few days than he had over the past decade or so, it really struck your author where America's relative manufacturing advantage lies. While US business isn't that great at manufacturing goods, they are second to none at manufacturing demand.

Anyhow, normal service has resumed today, albeit in the context of reduced participation. Another day, another sovereign-y debt worry, with rumours swirling about Dubai World debt holders receiving a "#1 all over" haircut on their holdings. While it seemed last night that this would submarine markets today, Macro Man has been surprised by the relative lethargy displayed on his screens.

One development that bears are watching is the trend at the short end of the curve. While your author remains firmly planted in the "Fed doesn't hike in 2010" camp, Bernanke's comments on the discount rate have muddied the waters a bit. Moreover, it is curious to observe that sterling LIBOR has begun ticking higher again after the BOE did not this month.

At some point, playing the short end is going to get very, very tricky, for the simple reason that LIBORs are, for all intents and purposes, a complete fiction, a political construct. How much three month money do you think is being lent in the dollar market at 0.25%? Macro Man's guess is that the answer rhymes with "zero." Ditto sterling.

So if LIBORs don't really reflect underlying supply and demand conditions, how can you tell when they are going to move, and how far they will go? Will supply and demand return as a driver first? Will we need to see reserves drained to effect that transition? What, if any, impact will a discount rate hike have, both literally and as a signalling mechanism?

These are the questions that Macro Man is trying to wrap his head around. In the meantime, looking at 2y yields provides a handy guidepost to the relative richness/cheapness of short ends. To be sure, they are impacted by things like the sovereign wobbles at the periphery, but still; they give a decent flavour for where the risks lie.

And to Macro Man's reading, the risks lie skewed to somewhat higher short-end yields, particularly if and as the Greek situation fades from prominence. Such a shift need not be seismic, nor indeed particularly painful. Still, if Macro Man were long the front end (which, alas, he is not), he'd be inclined to book some profits relatively soon.

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