It's The Economy Stupid: Twist & Shout

Okay first the economic news.  Mortgage Applications were up 3.8% in the week ending May 18^th.  The House Price Index was better than expected, the House Price Purchased Index was better than expected, New Home Sales were better than expected.  So, real estate is better than expected.  If anyone cares.

 

Twist & Shout

 

Not the Beatles.  John, Paul, George, Ringo & Bernanke???    The Fed’s Operation Twist is scheduled to expire.  What is Operation Twist you ask?  Okay, you didn’t really ask and you don’t really care, but I am going to write this piece anyway, so we may as well get down with it.  (Get it, Operation Twist, get down with it?)  The Fed owns a ton of Treasuries.  In Operation Twist they sell their short to medium term Treasury notes maturing in 2 to 5 years, and buy 10-year Treasury notes.  The theory is that they drive down the yield of the 10-year Treasury note because that is the benchmark most often used to price other financial instruments.  Okay, so the Twist is supposed to come to an end, unless it doesn’t.  The 10-year Treasury is below 1.75%, Mortgage rates are near record lows, the Dollar is strong, the Euro is weak, God/Allah/Yahweh/SupremeBeingOfYourChoice is great, beer is good, people are crazy.

 

The $64 Thousand question is this:  If the Fed allows Twist to end, can bank & private lending sustain the current economic expansions need for capital and at what rate?

 

My guess is yes, but at a somewhat higher rate.  Why a higher rate?  Ever met a banker who wasn’t interested in expanding his lending margin? 

 

Greece Anyone?

 

There’s a lot to like about Greece. The food, the beaches, the islands, the antiquities, the beaches, the islands, the food.  However, the leading candidate in the June 17^th election is Alexis Tsipras a far left wing radical politician.  He’s not a socialist, that would require a softening of his positions.  His party and his views are anti-capitalist, anti-materialist and anti-establishment. He is left of the communists.  If he wins, the probability of Greece exiting the Euro goes somewhere around 75%.  Not a slam dunk, but not a 3-pointer either.  More like a LeBron James 10 foot jump shot. 

 

Why do we care about a country whose economy is no bigger than Delaware, but not nearly as healthy as Delaware’s?  One word, contagion.  European banks are sitting on $1.19 trillion of debt to Spain, Portugal, Italy and Ireland.  They are likely facing a wave of losses if Greece abandons the euro when the other weak links in the Euro take hits to their debt.  While lenders have increased capital buffers, written down Greek bonds and used central-bank loans to help refinance their banking units, they remain vulnerable to the contagion that might follow.  And some of these countries are already experiencing outflows of deposits from their banking systems. 

 

If Greece leaves the Euro, and if the contagion comes to fruition, then the stronger economies of Europe are in for some pain.  And if Europe is in pain, the U.S. is likely to experience a lot of discomfort. 

  

 

John Broussard

Assistant State Treasurer

Chief Investment Officer

State of Louisiana

Department of the Treasury