Thursday, July 31, 2014

The Brookings forecast misunderstanding

This WSJ chart has been bounced around the web a bit with comments pointing to how optimistic Wall Street economists are on US labor markets relative to the Brookings forecast. The reality is just the opposite. Brookings model assumes that as labor markets improve some of those who had left the labor force will return in an attempt to find work. That will increase the unemployment rate (more people "officially" looking for work). Wall Street economists on the other hand don't believe many of those folks are coming back any time soon, as the unemployment rate continues to fall.

Source: WSJ



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Euro area staring at deflation as it waits for TLTRO

The ECB remains behind the curve in routing out the Eurozone's persistent disinflationary trend. The area's CPI is now below 0.5% on a year-over-year basis. Yesterday we saw German CPI hit new lows (see chart) and Italy's inflation rate is now hovering just above zero.

Investing.com
Bloomberg: - Euro-area inflation unexpectedly slowed in July to the weakest in almost five years, underscoring the European Central Bank’s concerns that the economy is too feeble to drive price growth.

Inflation was 0.4 percent compared with 0.5 percent in June, the European Union’s statistics office in Luxembourg said today. That is the weakest since October 2009 and below a median forecast of 0.5 percent in a Bloomberg News survey of 42 economists.
The centerpiece of ECB's latest policy initiative, the TLTRO program, will take some time to fully ramp up. In the mean time the central bank is staring at rising risks of deflation, which may end up being extremely difficult to fight (as the BoJ painfully learned over the years). The Eurosystem's (ECB) balance sheet continues to shrink to pre-LTRO levels resulting in tighter monetary conditions.

Eurosystem balance sheet (ECB)

The most expeditious action the central bank can take at this point is to further weaken the euro, and it has multiple tools to execute such policy. Whatever the case, the time for the ECB to act is now, not over the next couple of years.

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Wednesday, July 30, 2014

Expect higher treasury yields in second half

While many investors refuse to accept this fact, we are clearly marching toward higher treasury yields later in the year and in 2015. Even after today's bond selloff, we are still around the yield levels we had during the dark days of the government shutdown. Here are a couple of key factors that will drive yields higher from here.

1. Many are pointing to record low yields in Europe (see chart), suggesting that on a relative basis treasuries look attractive. Perhaps. But it's important to make that comparison based on real rates rather than nominal. And given the disinflationary environment in the Eurozone (see chart), a significant rate differential between the US and the Eurozone is justified. After all, we've had a tremendous differential in nominal yields between the US and Japan for years. Furthermore, economic growth (and expectations for growth) in the euro area and in the US have diverged significantly (see chart). Today's US GDP report confirmed that trend.

2. The net supply of treasuries is not static. In particular when it comes to treasury notes and bonds (excluding bills), the Fed has been the dominant buyer (see chart). With the Fed tapering, the net supply is expected to rise.

Source: JPMorgan

Foreign buying of notes and bonds has declined and is not expected to replace the Fed's taper. It will be primarily driven by China's rising foreign reserves. But given declining support from the Fed, China is likely to make bills (vs. notes and bonds) a larger portion of its purchases. And bill purchases will have a limited impact on longer dated treasury yields.

To be sure, we are going to have plenty of demand for treasuries going forward. But given such a spike in supply and improved growth expectations, something on the order of 50-75 basis points increase in the 10-year yield in the near-term is not unreasonable. 

It is also worth pointing out that with the dealers remaining cautious holding significant inventory and the Fed out of the picture, higher volatility in treasuries becomes more likely.


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Sunday, July 27, 2014

3 reasons Yellen's FOMC remains dovish

What makes Janet Yellen and a number of other FOMC members so dovish with respect to monetary policy and in particular the trajectory of rate normalization? A Credit Suisse report sites 3 key factors, which Yellen calls  “unusual  headwinds":

1. Tighter fiscal policy.

The combination of lower government spending and tax increases has created a drag on economic growth (see chart). This drag is now diminishing, but given the tepid recovery Yellen still views it as a headwind.



2. Relatively tight credit in the mortgage market.
Janet Yellen: - " ... it is difficult for any homeowner who doesn't have pristine credit these days to get a mortgage. I think that is one of the factors that is causing the housing recovery to be slow. It’s not the only one, but I would agree with that assessment."
A recent study by Goldman compared current lending conditions in the mortgage market with the 2000 - 2002 period (supposedly "pre-bubble" period). The results indeed seem to point to tighter lending standards at this time (see chart).

3. Low household wage growth expectations.

While US wages have been growing at around 2% per year, expectations for growth remain depressed.
Yellen (see House testimony video below): - " ... households have unusually depressed expectations about their own future income gains. And I think weighs on their feelings about their own household finances and is holding back consumer spending."

Source: Credit Suisse






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The US Phillips curve

We've received some questions about the so-called Phillips curve - the relationship between inflation and unemployment. While there are a number of ways to look at the Phillips curve, the services inflation measures are more suitable than the broader price indices in order to assess the relationship. That's because goods inflation in the US can be driven by global trends, while services tend to be more US-specific.

Furthermore, rather than using the headline unemployment rate ("U-3") it is more appropriate to use the "U-5" measure which captures a broader group of unemployed or marginally employed workers. U-5 is defined as "total unemployed, plus discouraged workers, plus all other persons marginally attached to the labor force, as a percent of the civilian labor force plus all persons marginally attached to the labor force".

10 years of data (orange = current levels)


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Thursday, July 24, 2014

The current ECB programs create a QE-like environment, setting up for moral hazards

In spite of weakening economic growth, persistent credit contraction, and dangerously low inflation rate in a number of member states (chart below), the ECB continues to resist calls for Fed-style outright securities purchases. Instead the central bank is betting on the recently announced TLTRO program (see post).

Source: Investing.com

The key reason for avoiding outright quantitative easing is, supposedly, the ECB's fear of creating a moral hazard. With a ready buyer of government debt and low market rates, some member states would no longer focus on cutting deficits.
Natixis: - The ECB’s problem is that it does not want to create incentives for governments to refrain from correcting fiscal deficits or avoid improving their public finance situation. What is rejected by the ECB is the moral hazard that would result from the central bank buying government bonds.
Fair enough. But a recent report from Natixis argues that the combination of the TLTRO lending and the OMT backstop program creates conditions that are nearly identical to quantitative easing.

Any QE program aims to increase the monetary base (by raising banks' excess reserves) and to push down longer term interest rates via securities purchases. As an extreme example of this, consider Japan's massive QE effort (see post). Both objectives have been met: long-term rates are at ridiculously low levels (0.53% on 10-year JGBs) while the monetary base is at a record.

Source: Investing.com, BOJ

Similarly (though not to the same extent) the ECB's programs will mimic QE without actually buying any government securities. Here is how:

1. Long term rates across the Eurozone are already at incredibly low levels. The ECB's forward guidance, weak growth, and recent geopolitical risks have pushed German rates to new lows (see chart). On the other hand the OMT program, often called the "Draghi put", has suppressed periphery yields. Furthermore, with short-term rates near zero and low capital requirements to hold sovereign bonds, the euro area banks have been loading up on this paper in a massive carry trade - pushing yields even lower.

Source: Investing.com

2. But what about increasing the monetary base? The expectations are that the TLTRO program will soon increase the Eurosystem balance sheet by as much as €700 billion. €300 billion of lending is expected to hit the banking system in September and the rest over the next couple of years. The monetary base will begin rising quickly.

The combination of the two items above is effectively QE. So how are the Eurozone member states reacting to this? Natixis argues that the QE-like environment has already created something of a moral hazard by encouraging these governments to pay less attention to their fiscal situation. If borrowing is easy and cheap, the temptation to keep on spending is too great for many politicians. 2014 deficits in a number of the member nations show minimal improvements.

Source: Natixis

Natixis: - The ECB accepts to go very far in the choice of expansionary monetary policies (very long-term repos [4-year TLTRO loans], de-sterilisation of the SMP [see post], forward guidance, purchases of ABS in the future), but for the time being it rejects the idea of quantitative easing with purchases of government bonds. The explanation is the risk that, if the ECB buys government bonds, governments may be encouraged to no longer reduce their fiscal deficits.

But this explanation is of a dogmatic and not an empirical nature: the measures already taken by the ECB have already encouraged governments to no longer improve their public finances
While optically the ECB's programs look different from QE, in reality the central bank has already launched a QE-like set of programs, setting up for a moral hazard which it has been desperately trying to avoid.

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Thursday, July 17, 2014

Are the monetary policies in the US and the Eurozone diverging quickly enough?

There has been a great deal of discussion about the divergence between the monetary policy trajectories of the Fed and the ECB. Is the Fed behind the curve in exiting QE and beginning rate normalization (see story)? Is the ECB not acting aggressively enough to inject the necessary amount of stimulus (see story)?

One place to look of answers is the so-called Taylor Rule. While the inputs to the calculation can be quite subjective, it's a good relative measure of where policy rates should be given current economic conditions and target inflation rates. The two charts below from JPMorgan show that the Taylor Rule (appropriate) rates are now on the opposite sides of the policy (actual) rates. This would suggest that monetary policies of the ECB and the Fed would indeed have to diverge further. The euro area seems to require non-traditional accommodation (since policy rates generally cannot go below zero), while the Fed should begin rate normalization.



Source: JPMorgan




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Wednesday, July 16, 2014

PBoC follows other central banks in suppressing volatility

Staying with the theme of central banks dampening market volatility, China's central bank (the PBoC) has learned this game as well. China's short term rates had experienced enormous volatility last year, and the PBoC has been focused on suppressing these fluctuations.
Reuters: - China's decision to ease rules used to calculate loan-to-deposit ratios for Chinese banks (LDR) will moderate spikes in seasonal cash demand from regulatory requirements and thus help stabilise money market rates, traders say.

Regulators have been moving to stabilise money market rate volatility after a severe market squeeze in June last year rattled markets around the world, who misread a short-duration rise as a harbinger of money tightening.
It worked. The 7-day repo rate, which represents a fairly active secured lending market in yuan, has seen a substantial decline in volatility.

China 7-day repo rate

The combination of this policy to ease LDR rules and other stimulus efforts from Beijing has resulted in substantial increases in credit growth (see story) and quickened the expansion in broad money supply (see chart). It also translated into lower volatility in China's stock market.

The Shanghai Composite Index - see chart for historical daily volatility

Suppressing volatility has become a trend that is no longer limited to developed economies. Of course lower volatility is sure to result in declining return expectations and increased risk taking.

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