Please, click here to read this article in pdf format: march-25-2010

Where to start today? There is plenty to discuss, so we will try to summarize, if possible. Unfortunately, we think it is possible. Indeed, perhaps the most commented news yesterday, aside from the European summit beginning in Brussels today, was the drop of the 10-yr US swap into negative territory (chart below, source: Bloomberg).

Many explanations have been suggested. Let’s first describe what we mean by negative US Swaps. The swap is the difference between the 10-yr implied Libor and 10-yr Treasury. When this spread is below zero, it implies (=the operative word here) that the market prefers private risk over Treasury risk. It implies deterioration in Treasury risk. But it does not mean there is one, not at least this time, in our view. More likely, we think, the negativity of this spread is driven by a technical, namely the rush to hedge fixed-rate positions. In this we agree with some analysts, and believe the negativity is a result of the recent increase in long term issuance.
How can we summarize this? This move in swaps would be consistent with the following chain of events: Ongoing recovery –> Higher interest rates –>refinancing wave (last chance) in corporate credit (long-term for short-term)–> hedging needs driving long-term swaps negative –> credit spreads underperforming swaps –> stocks pushing higher –>gold lower

Consistent with this line also, we show stocks vs. gold (chart below, source: Bloomberg), in Canadian terms (TSX 60, represented by the ETF XIU.CN vs. IGT.CN, gold in Canadian dollars). This is a relationship we suggested on March 4th and which is proving us right, for it makes money.

Two last comments: We are not showing the corresponding chart today, but we want to bring your attention to the latest upwards move in Libor. This was widely expected, even before the Fed announced its intention to pay interest on reserves. The other comment we want to make goes back to our letter from March 4th (www.sibileau.com/martin/2010/03/04 ) and is also in line with the chain of events above. It is about Canada and the Canadian dollar. With Canada’s less problematic (on relative terms) fiscal situation and public refusal to regulate as much as the rest of the world, the Canadian dollar/market is increasingly getting the “safe haven” bid. This is reflected in the EURCAD cross, in our view. The bottom line here is that “mercantilist” explanations (=Canadian strength explained by commodities strength, foreign trade) will be less relevant going forward. Even with higher interest rates in the US, the Canadian dollar should do well, ceteris paribus. Of course, nothing is ever ceteris paribus. But if you ask, we think that the changes about to come, affecting the European Union, are actually supportive of the CAD too. What could derail Canada’s path? Canadians! Yes, the Canadian government, and therefore we worry every time we read Mr. Carney’s “mercantilist” concerns on Canadian productivity vs. a strong CAD. It makes no sense to us.

Martin Sibileau