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Daily Agenda: Investors Confronted by Shifting Political Currents

Election results in France and Venezuela deal a blow to ruling parties; Chinese FX reserves decline; SEC to probe CDS Market.

Investors returned to work today greeted by an altered geopolitical reality. Recent terrorist attacks in Paris and California put pressure on governments in France and the U.S. to address shifting political sentiment. In the U.S., Sunday night’s address by President Barack Obama on terrorism was greeted with derision by Republican Presidential candidates. Separately, regional elections in France on Sunday dealt a huge blow to French President Francois Hollande’s Socialist party, with gains by Nicolas Sarkozy’s Republicans and, particularly, the euro-sceptic National Front. A sudden hard right turn among French voters carries major implications for the European Union as it struggles with issues of security and humanitarian response. Meanwhile, voters in Venezuela delivered the first congressional majority for an opposition alliance in 16 years. The upset came days after the Organization of the Petroleum Exporting Countries confirmed no reduction in production levels that might support higher oil prices desperately needed by the Central American nation. In trading overnight, oil continued to decline with front-month West Texas intermediate grade crude futures slipping below $40 per barrel as markets digested the news.

Chinese FX reserves dip lower. The People’s Bank of China on Monday announced that foreign exchange reserves at the central bank declined by $87.2 billion at month end November to $3.44 trillion. This brings the total reported decline in the bank’s coffers year-to-date to $405 billion due to efforts to support the yuan.

German factory activity weaker than forecast. Data from the German Ministry of the Economy this morning indicated that headline industrial production was lower than consensus expectations by economists for September, expanding by 0.2 percent for the month. Despite failing to meet expectations, the figure was the first positive reading in three months.

GE investors protest securities swap. Media reports late last week indicated that a group of institutional holders of preferred equities in the financial unit of Fairfield, Connecticut’s General Electric will fight a $5 billion swap into debt they claim is of lesser value. The transaction is part of the conglomerate’s ongoing divestiture of its financial services assets. Separately, the company announced Monday that it has ended discussions with Swedish Electrolux to sell its household appliance franchise for a reported $3.3 billion, after regulators raised antitrust concerns.

Supreme Court to hear Puerto Rico debt case. On Friday, the U.S. Supreme Court agreed to hear a case which will decide whether the government of Puerto Rico may revive a law that allows public utilities to restructure their debt. The ruling, which may arrive by the summer of 2016, will cover $22 billion in municipal bonds. Separately, the Puerto Rican unit of Wal-Mart Stores filed a lawsuit Friday against the territory’s government claiming that a sharp increase in the tax on goods imported by local companies with revenues of morethan $2.75 billion from offshore affiliates is unfair. In the suit, Wal-Mart alleges that the higher tax regime would consume more than 91 percent of its net revenues. The Puerto Rican government is engaged in a wide number of efforts to restructure its way out of a crushing debt load.

SEC to probe CDS market. On the same day the European Commission dropped a multiyear investigation into possible collusion among banks acting as primary dealers in the credit-default swap-market, multiple media reports indicated that the Securities and Exchange Commission has initiated an independent probe. Unlike the charges of manipulation brought against market makers in interest rate and currency benchmarks in the past, a number of industry analysts predict that regulators will have a more difficult time due to the more subjective and opaque nature of estimating the creditworthiness of corporations.

Portfolio Perspective: The Case for U.S. Bear-steepeners as a Tail-risk Hedge

In our view, an underpriced risk in the market is the potential for a sell-off in rates that is led by the long end. The consensus view in the market is that any sell-off in rates is likely to be led by the belly or the front end of the curve. This is largely because of an expectation that long-end rates are well-priced for normalization and that the term premium is unlikely to rise. However, the term premium has historically been volatile and has contributed substantially to moves in long-end rates.

Further, with inflation expectations in the U.S. near historic lows, there is considerable upside risk to inflation expectations and, consequently, for a steepening of the curve. A case in point is the price action on Thursday: As the ECB disappointed the market, the euro curve sold off, the U.S. dollar strengthened and the U.S. curve bear-steepened as inflation expectations widened.

Amrut Nashikkar is a vice president in rates and forex research at Barclays in New York.

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