Is Japan ready for another currency intervention?

The Eurozone crisis is putting upward pressure on the yen, with traders continuing to view it as a safe haven currency. Strong yen is making it increasingly difficult for Japan to compete in the global markets against nations like Germany who has a weak currency advantage. Even for something like autos manufactured in the US, there is still a component of parts that is brought from Japan.

USD/JPY (Bloomberg)

Japan had a trade deficit in 2011, which is unheard of for that country in recent years. Some of that was clearly driven by the tsunami disaster. There is no question however that a strong yen was a contributor.

Japam trade balance (Bloomberg)

In spite of the tremendously accommodating policy in 2011 including QE and zero rates, industrial production has been declining while equity and property markets are relatively weak. The environment looks deflationary, yet there are no more tools left in the BOJ's monetary toolbox. Except for one, albeit a temporary measure. Japan can intervene in the currency markets again in order to weaken the yen and give its exporters some relief.  This may in fact be BOJ's next move.

Japan would likely want the US and the Eurozone to help them put in place a coordinated move. But neither of their two biggest trading partners has much of an incentive to do so. Nevertheless BOJ may go it alone and find a quiet day to try to punish everyone who has on a speculative long JPY position.

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Freddie Mac's "inverse floater" allowed more loan origination

Everybody is up in arms today about the Propublica story discussing Freddie Mac "betting against the borrowers" (hat tip Mike Konczal). The structured securities Freddie holds tend to be the "interest-only" component of a pool of mortgages. As long as borrowers in the pool keep paying, the holder of these securities receives cash. The more borrowers refinance, the less interest income is left in the pool. A holder of these securities therefore does not want borrowers to refinance and instead just keep paying as long as possible. How diabolical!

NPR: “We were actually shocked they did this,” says Scott Simon, who as the head of the giant bond fund PIMCO’s mortgage-backed securities team is one of the world’s biggest mortgage bond traders. “It seemed so out of line with their mission.”

And more...

Daniel Fisher (Forbes): ... I don’t get it. Freddie Mac did something potentially risky, but it was based on the reasonable assumption that interest rates can’t go much lower, but neither will they rise dramatically. According to the ProPublica story, Freddie bought $3.4 billion in “inverse floaters,” which are mortgage-backed bonds based on the interest payments from homeowners. As ProPublica points out, those securities can lose value when homeowners refinance or “prepay” in mortgage-banking terms. When that happens, investors get the principal portion of the mortgage back to reinvest but the stream of interest payments ends forever.

Freddie holds a massive portfolio of mortgages. Many of these borrowers have negative equity, can't refinance, and therefore pay higher coupon. Freddie can leverage that excess coupon stream via the interest-only securities and generate extra revenue with little capital.

Freddie holds both floaters and inverse floaters (much larger book of inverse floaters than floaters.)  Both are interest-only securities, but inverse floaters tend to be more stable. As rates rise, the coupon decreases, but there is more cash available to pay the coupon because prepayments stop.

With rising rates, Freddie's big mortgage portfolio will fall in value because mortgage durations will extend, paying lower than market coupon (negative convexity). Interest-only securities would do reasonably well because any remaining refinancing in the pool of mortgages will stop and the coupon revenue will extend. These positions therefore will be providing some offset to the mark to market losses in the main book in a rising rate environment. If rates keep rising however, the inverse floaters will indeed get hurt because they will receive an increasingly lower portion of the interest pool. But typically mortgage portfolio managers use interest rate swaps to offset some of that risk.

In a falling rate environment the coupon in the interest-only pool will be reduced due to some prepay, but a big chunk will keep paying because of the borrowers' inability to refinance. The interest-only securities will drop in value but still be reasonably stable, particularly the inverse floaters. Freddie's main mortgage portfolio on the other hand should go up in value because it will be paying above market rates with refinancing speeds contained.

What happens however if the Obama administration launches some sort of a mortgage principal forgiveness program? The probability of this event is remote because many of these troubled borrowers also have home equity loans. It would be legally difficult to force a principal reduction on the "1st lien" mortgages, while "2nd lien" (home equity - often with a different lender) is still outstanding (hat tip Greg Merrill). 2nd lien loans will therefore have to be sorted out before such a program can be effective (and legal). Even if it does happen, it will definitely hurt the interest-only paper, but should be net positive for their main mortgage portfolio because it will reduce default rates.

It is also important to note that Freddie retained many of these positions from the secularization transactions in which it sold pools of mortgages. Often there simply weren't many "natural" investors in inverse floaters. But this securitization process gave Freddie more balance sheet to originate new loans.

Securitization of mortgage pools ("Gold Collateral" refers to pools of mortgages in Freddie's deals called Gold MACS)

It is true that Freddie has a responsibility to the mortgage borrowers. However it has a bigger responsibility to the tax payers who own the organization. And that responsibility includes managing the portfolio risk as a fiduciary. The interest-only securities are not hurting the borrowers, yet they capture some of the revenue back to the taxpayer. According to CBO, the US Treasury spent some $300 billion to prop up the GSEs. Shouldn't the taxpayers have the right to get some of this money back?

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Can Germany decouple from Eurozone's "double-dip" recession?

Source: TheLocal

Staying on the topic of sentiment indicators, let's now turn to Europe for a quick look at Germany and the European Commission Economic Sentiment Indicators (ECESI). ECESIs are monthly indicators that use business and consumer surveys to assess the levels of economic "optimism". They combine current conditions as well as expectations (similar to the U Michigan index for US consumers.)

EC: The monthly economic sentiment indicator reflects general economic activity of the EU. This indicator combines assessments and expectations stemming from business and consumer surveys. Such surveys include different components of the economy: industry, consumers, construction and retail trade.

The chart below compares the ECESI Eurozone with the Eurozone year-over-year GDP. ECESI definitely seems to be a good leading indicator for GDP growth.

ECESI Eurozone vs. Eurozone GDP

Now let's look at the ECESI by country.  The index clearly shows Germany decoupling from France and Italy. If ECESI is a decent predictor of the GDP growth as the chart above shows, we should see German economic growth decouple from the bulk of the Eurozone. 

ECESI for Germany, France, and Italy

Another sentiment indicator of German economic optimism is pointing to a similar trend. It is called the ZEW Germany Expectation of Economic Growth (computed by ZEW, a German nonprofit center for European economic research). The chart below shows the index net change. Just as was the case with the U Michigan Consumer Expectations index, ZEW is based on survey of expectations, while current conditions measures may not necessarily indicate economic expansion.  Therefore one should be cautions when interpreting movements in this index.

ZEW Germany Expectation of Economic Growth

Nevertherless the surveys are pointing to a potential for Germany to avoid a "double-dip" recession, which is inevitable for many other Eurozone states.

ZEW: On average the experts estimate a likelihood of 71 per cent that the German GDP will grow during the first quarter 2012. If this comes true, Germany will not slide into a recession for the time being. A recession – speaking in technical terms – does only exist if the quarterly GDP decreases for two consecutive times.

Here are five reasons that may explain some of this economic optimism in Germany.

1. Mild winter has helped German construction industry from shutting down.
2. Similar to US firms, German companies have restructured since 08 and are in a much better position to withstand a Eurozone downturn.
3. Public finances are generally healthy (better than the situation in the US) - for now.
4. German domestic demand continues to be strong.
5. The weak euro is helping the export sector compete more effectively on the international markets.

Clearly risks to German economic expansion are tremendous, particularly if further assistance for periphery nations (via ESM or IMF) or German banks will be required. But if these survey based indicators are reasonable predictors of GDP growth, Germany may indeed achieve at least a partial decoupling.

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The jump in U Michigan sentiment index is driven by consumer expectations

The US economic news last week was not all negative - in fact it was more of a "mixed bag". The positive news came from the U.Michigan index of consumer sentiment.

Reuters: The Thomson Reuters/University of Michigan's final reading on the overall index on consumer sentiment rose to 75.0 from 69.9 the month before. It was the highest level since February 2011.

The current index level takes us back to where the sentiment measure was in early 2011, before the Eurozone crisis took hold of the financial markets. One question worth considering is how did the sentiment index decline of 2011 compare to a similar period in 2008?  The low point was August of 2011, a month that combined the US budget negotiations, the US debt downgrade, and the escalation of problems in the Eurozone. The sentiment in August was about as low as it was in November of 2008 - the lowest point of the financial crisis. This seems a bit surprising and not at all intuitive, with anecdotal evidence suggesting that 08 felt far worse than 2011.

U Michigan Consumer Sentiment

What drove the sentiment index to levels comparable to 2008? The index actually has two components: the Current Conditions Index and the Consumer Expectations Index. And it was the "expectations" component that pushed the whole index to this low point. In fact according to U Michigan, when it came to consumer expectations, the "end of the world" was coming in August of 2011 - a point on the index that was in fact lower than the expectations measure in 2008 (as shown in the chart below). This is puzzling. Were consumers reacting to all the market driven media frenzy in August that wasn't as prevalent in 2008? Were consumers not as focused on the state of the financial markets in the past as they are now?

On the other hand the "current conditions" component did not dive anywhere close to its 08 lows, which is more in line with other economic indicators.

Components of the U Michigan Sentiment Index

As a comparison let's take a look at another gauge of US consumer sentiment - the Conference Board Consumer Confidence Index. That index was behaving closer to the U Michigan Current Conditions component (above), with a dip that did not rival the 08 levels.

Conference Board Consumer Confidence Index

Some of this difference between these two gauges of consumer confidence was pointed out back in the 80s by some OSU researchers.

Researchers on index comparison:    Thus, it appears that the Index of Consumer Sentiment is capturing consumer reactions to what is happening with financial related factors (e.g., prices and interest rates) and to a lesser extent, such variables as the work week, the stock market, and the employment picture. In contrast, the Index of Consumer Confidence is picking up some additional information on employment related variables, such as the length of the work weeks the accession-layoff rate, and disposable income.

One therefore has to be careful in interpreting the U Michigan consumer sentiment indicator because it is a combination of current conditions as well as expectations. And when things turn ugly in the financial markets, it is more the expectations that drive the index lower, even if current conditions have not deteriorated as dramatically. Just as important is the fact that when markets improve rapidly as they recently have and the index spikes, it is driven more by expectations and not as much by a rapid improvement in current conditions of the US consumers.

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Four facts behind the Q4 US GDP miss

Source: LA Times

The big US economic news last week was that the GDP growth number came in below expectations.

LA Times: The gross domestic product rose at a 2.8% annual rate in the fourth quarter as consumers bought more cars and other goods, the Commerce Department said Friday. That was below the 3% figure many analysts had projected. But it was up from a feeble 1.8% the quarter before.

However it is worth noting that the headline number does not tell the full story.  Here are four facts behind this GDP miss that should be considered:

1. The nominal GDP (vs. the real GDP), which is an important indicator of corporate profit growth was up 3.2%. Many believe that we need 4.0% nominal GDP growth to maintain robust corporate profitability growth. In that sense the nominal GDP number was even more disappointing.

2. A great deal of the GDP growth came from inventory build.

LA Times: More than half resulted from businesses increasing their stockpiles of products rather than from sales of goods and services, which reflect actual demand.

This is not great, because inventory builds are less likely to be repeated soon. This bodes poorly for GDP growth in the current quarter.

3. The Q4 inflation measure used to convert the nominal GDP into the real GDP was quite benign, only 0.4%.  That may explain the Fed's complete comfort with further accommodation.

4. The biggest drag on growth was a 3.7% quarterly decline in government spending. This is clearly a good indication from the government budget deficit's perspective, but is also a sign of what is to come as the US embraces more austerity measures. Without the impact of declining government spending, the nominal GDP measure was actually 4.9% (vs. 3.2% with government spending included).

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Contraction in Eurozone's repo markets is driving M3 decline

Yesterday the ECB released its monetary aggregates measures for the Eurozone through Dec-2011. The following chart shows the absolute level of Eurozone's M3 aggregate, a broad measure of money stock. (Note that at times it is helpful to look at monetary indicators on an absolute basis rather than as percent changes as economists tend to do.)  The upward trend in the money supply growth has reversed, mostly during the last quarter of 2011.

Eurozone M3 in EUR billion (seasonally adjusted)

An obvious question here is whether this broad money supply decline is similar to the US during 2008-2010. One key component of M3 driving this contraction in money stock is the amount of repo (secured) lending. The Eurozone repo loan balances have declined materially in Q4 - an issue that is quite different from what had occurred in the US.

Repurchase agreements (repo) component of  Eurozone's M3 in EUR billion (seasonally adjusted)   

Since repo has become the only form of interbank lending in the Eurozone, this is clearly an indication of deteriorating credit conditions. With the ECB providing longer term financing not available in the interbank repo markets, it is often quite attractive or even necessary for many financial institutions to shift their collateral into an ECB facility (ECB secured loans are not included in the monetary aggregates). LTRO term lending for example provides far more funding stability than rolling short-term interbank repo loans. The ECB has also been considerably more lenient with collateral than the current repo markets. The rapid rise in the ECB's balance sheet (EUR 2.7 trillion) "soaked up" a great deal of the collateral out of the repo markets, dampening growth in interbank credit.

ECB consolidated balance sheet (EUR million)

The pie chart below shows the contribution by country to the drop in the Eurozone repo levels over Q4-2011. Nearly half is coming from Italy as Italian institutions shifted financing to the ECB. It is not surprising therefore that Italy continues to deal with tightening credit conditions that are more extreme than the Eurozone as a whole.

Contribution by country to the Q4 drop in repo component of M3

The unprecedented accommodation provided by the ECB is not yet helping to expand the broad money supply. The banking system has shifted a substantial portion of its eligible collateral from the repo markets to the ECB who is providing longer term stable funding. Only once the dependence on the ECB is reduced and the interbank funding markets begin to heal, will we see a stabilization in M3 growth.

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The fundamentals behind strong HY fund flows

Following up on the post about HY fund flows, the amount of new cash hitting the system has not only been unusually high, but also consistent on a daily basis.  As the chart below shows, we only saw one day of net outflows.

Source: EPFR

Here is the year-to-date cumulative net inflow ($7.4 bn YTD.)

Source: EPFR

It is clear that zero rates is one reason for these inflows, but what about fundamentals of the HY market? Are they really that attractive? Three items driving fundamentals are worth mentioning:

1. Defaults continue to stay near record lows and spreads seem interesting on a relative basis.

Source: JPMorgan

2. Leverage on in HY corporations in the US remains stable.

Source: JPMorgan

3. US corporations' liquidity, even at leveraged companies, has been rising steadily in the last few months (hat tip Royal Arse)

Source: JPMorgan

But even with these strong fundamentals, the speed of inflows we are seeing is unlikely to be sustained for long. The trend is somewhat troubling because a good portion of these flows is coming from retail investors. Some of the more leveraged names, particularly in the CCC range are still quite vulnerable to global economic shocks. Given the recent rally (the US JPM HY Index is up 2.8% YTD), the overall sector could sell off sharply with a sudden surprise out of Europe.

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The Fed extended start of tightening by 3 months, not 18

It looks like some in the media are now using the appropriate language with respect to the Fed's latest action. Reuters, who tends to be fairly accurate in their reporting, described the extended low rate environment as being "probable" instead of "certain".

Reuters: The statement by the Fed, which announced on Wednesday it would probably keep interest rates near zero until at least late 2014 - some 18 months later than the Fed had suggested last year.

Given that we are working with probabilities instead of certainties, how did this event change the the timing of expected rate hikes?  After all the general perception (as per Reuters quote above) is that the rate hike has been extended by 18 months.

The best markets to provide visibility into the Fed's future policy are the Chicago Board of Trade Fed Funds Futures contracts. The chart below compares the implied Fed Funds rates prior to the Fed's announcement as well as now.

Fed Funds rate implied by the Chicago Board of Trade Fed Funds Futures (Bloomberg)

The curve has definitely shifted further out, but not by 18 months as is generally believed. The shift is actually only about three months.  The current curve is implying the first rate hike to be in the early part of 2014. So for those who are planning on zero rates throughout 2014 and into 2015, pay attention to the market - it may tell you otherwise.

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Restoring confidence in the Eurozone's sovereign credit markets

Portuguese bonds continue to sell off as the market focuses on Portugal becoming the next Greece. Portuguese spreads have completely decoupled from the rest of the Eurozone periphery.

Portugal vs. Italy 5y spread to Germany

But Portugal is not trading down in a vacuum - the valuation of the nation's bonds is tied to the outcome of the Greek restructuring process.  The markets are not only reacting to Portugal's insolvency but also to the market structure uncertainty. The sovereign credit markets in Europe are broken and two key events must take place to restore confidence.

1.  The ISDA Committee must do the right thing and trigger the Greek CDS (call this a "credit event"). Even without the Collective Action Clause on Greek bonds, this is a default and should be treated as such. The impact on the market may actually be positive because it will mend (at least in part) the broken sovereign CDS market. This has implications for Portugal as investors will once again view sovereign CDS as potent protection against default (similarly to stock put option holders having the ability to exercise their puts). At least in some cases, holders of Portuguese bonds may choose not to dump their holdings because of the availability of a reliable CDS market (which now trades at 39 points upfront).  Just as important is the fact that banks who are lenders to Portuguese corporations will have a reasonably liquid hedge for their assets. Since there is little CDS traded on Portuguese corporate bonds, a reliable sovereign market could be a good proxy.

2. The ECB must take the same haircut on Greek bond holdings as the private bond investors. It's bad enough that the market views sovereign bond holders as being subordinated to the IMF, the EFSF, and in the future to the ESM. Now also being subordinated to the ECB makes the sovereign bond market look completely rigged. A BNP Paribas research note put it quite eloquently:

BNP Paribas: The ECB has no legal right to be treated as a preferential creditor. Others who bought Greek debt at the time, or who held onto debt they already held, should have been appraised of the ECB’s preferential treatment. The ECB’s standing should have been made clear in law. Not to have done so in advance is not only unfair, but it also distorted the markets. If the ECB knew in advance that it would be treated more favourably than the private sector sellers it bought its bonds from, then it acted unfairly and abused an asymmetric information advantage;

Yes, Germany and others in the Eurozone will be upset because the ECB's loss in Greek debt will wipe out more than a year's worth of earnings and may require an injection of public funds.  But the ECB must take a loss in order to assure investors that private holdings are pari passu with the ECB's positions. Otherwise investors will be constantly worried about the amount of ECB's holdings to determine the size of the ECB's "senior tranche" vs. their "junior tranche". The same bonds having two seniority levels depending on who holds them is not a viable market. Not only will this further impair existing Portuguese bonds, but will make it impossible for Portugal and Greece to return to the markets even after they restructure.

The Eurozone must take other steps as well to restore confidence in the sovereign credit markets, but these two actions are critical not just for Portugal but for the rest of the euro area periphery.

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The chase for yield is on

The US high yield (HY) market is starting to look somewhat frothy. We've had over $7 billion of fund inflows this month with $2.5 billion this week alone. Of the $2.5bn, roughly $1.5bn went into HY mutual funds and $1bn into HY ETFs. That compares to about half a billion into mortgage-backed bond funds and $700mm into muni funds (according to EPFR Global). With the Fed on hold for a while, investors are chasing yield.

For HYG (HY ETF) for example, the growth in the number of shares has been unprecedented, and the ETF again now trades at a 2% premium.

HYG Shares Outstanding (Bloomberg)

One can also see rising risk appetite in the HY primary market as well.  Some new issues that hit the market are quite risky.  For example Realogy, a company that nobody would look at a month ago, comfortably sold new bonds.

LCD News: Realogy's return to market was met with strong demand, with both tranches of secured notes pricing tight to talk, and the paper is volatile this morning in post-break trading. The 9% intermediate-lien notes due 2020, for instance, are pegged at 100/100.25 in the Street, against a break around 101 and trades earlier this morning at 100.375, according to sources. Pricing was at par.

Realogy's 7.625% notes due 2020 also priced at par, and this morning's markets are generally at 100.5/101, sources said. Meanwhile, the previously outstanding 11.5% exchange notes due 2017 are trading at 95.75 this morning, versus 95 yesterday but 90 before the new issue hit the market, trade data show.

The company is highly leveraged and is extremely vulnerable to economic shocks. (For those interested in learning more about Realogy's "distressed" past, read this excellent post).

Spreads are still above last summer's lows and the fundamentals are strong, but we could easily see a pullback in this market. 

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