Sunday, July 26, 2015

Troika to extend the unsustainable Greek debt by decades

The Euorzone leadership remains uneasy with the third bailout of Greece. This unease can be seen in the recent delay to the start of the negotiations, with the Troika staff in Athens siting "technical issues". The actual reason has to do with the fact that Greece's creditors have yet to reach an agreement among themselves. Apparently some Eurozone nations are still pushing for additional requirements that go beyond the austerity measures the Greek parliament recently passed.

The challenges surrounding the new bailout are severe. The intrusive nature of reform enforcement by the creditors is likely to worsen the already intense animosity in Greece toward the Troika institutions.
Bloomberg: - Previous memorandums committing Greece to enforce reforms on everything from the rules of bank recapitalizations to evaluating the “impact of the changes in milk pasteurization and sale procedures,” have prompted dissenters to claim that Greece has turned into a “debt colony.” Creditors argue that changes are necessary to stabilize the country’s finances and set it on course to sustainable growth.
Furthermore, the negotiations will once again be taking place "under the gun" as the next payment to the ECB of over €3bn is due on August 20th.

Assuming the deal will be completed in August as the can gets kicked much further down the road, Greece is being set up for a massive maturity wall, with little chance of principal repayment. And any form of debt principal forgiveness is off the table.
Natixis: - [Greek debt forgiveness] is unlikely to come about given the opposition of many Member States (Germany notably), the position of the Eurogroup over this issue (“nominal haircuts on the debt cannot be undertaken”) and the legal obstacle (measure would be in breach of Treaty). Under these conditions, this leaves one option, namely a re-profiling of Greek debt without touching the principal.

Out of the EUR82bn-EUR86bn lent by the ESM, part could be applied to repurchase the debt held by the ECB and to repay early the IMF (which in total would represent EUR25bn). [It] follows that the financing requirement of the Greek State, assuming there is a 20-year grace period and repayments are spread over 40 years, would correspond to the primary balances and repayments of principal and interest in respect of market debt held by private creditors (i.e. TBills, GGB PSI, new GGB and debt issued under foreign law)
According to Natixis here is what the liability term structure is expected to look like after the completion of this third bailout. How Troika lenders can possibly get comfortable leaving a small nation with this type of a debt profile is unfathomable. And yet, this is the most likely outcome of the upcoming negotiations.

Source: Natixis


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Saturday, July 25, 2015

Rude awakening for those who ignored the energy markets' warning signs

Back in February (see post) numerous equity investors refused to believe that a crude oil recovery is likely to be unsustainable. Many viewed this as a buying opportunity - just as they did in 2011 when such "bottom fishing" strategy worked. "Look at the declines in oil rigs" many argued - US crude production is about to dive. Even some in the energy business were convinced that crude oil recovery is coming and we will be back at $70/bbl in no time. It was wishful thinking.

There is no question that North American production of crude oil is stalling. However for now it remains massively elevated relative to last year.

Source: EIA

More importantly, many fail to understand just how flexible US crude production has become - the time to bring capacity on/off-line has shrunk dramatically. Furthermore, a great deal of production in the US is now profitable at $60/bbl and even lower as rig efficiency rises. Many view this as unsustainable because new exploration is halted and existing wells are being reused. But there is enough staying power here to continue flooding the markets for some time to come.

Source: EIA

The ability to bring capacity back online quickly is the reason we saw US rig count unexpectedly increased last week. This creates a natural near-term cap on crude prices, above which production can rise quickly.

Source: Baker Hughes

To add to the market's woes, the Iran deal threatens to bring materially more crude into the market in 2016, while immediately releasing a great deal of stored crude the nation currently holds.

Source: WSJ

Moreover, the Saudis are ramping production to record levels, as the OPEC members are left to fend for themselves. The Saudis will attempt to recover some of the lost revenue with higher volumes.

Crude prices in the US fell below $50/bbl in response to some of these developments. So much for the "recovery".

Source: barchart

All of a sudden, as investors realize that crude oil price recovery could take years, energy firms, particularly those focused on exploration and production (upstream), don't look that attractive. The chart below shows the relative declines of the overall energy sector as well a the upstream companies' shares over the past year (down 29% and 51% respectively).

Source: Ycharts

And even those who were betting on the M&A activity providing support to share prices are having second thoughts, now that the Backer Hughes acquisition by Halliburton may face challenges.

Source: Bloomberg

To make matters worse, many energy firms continued to borrow as prices declined. With no recovery in sight, credit markets are becoming much less forgiving. In traded credit markets for example we see spreads widening out again - with oil services and equipment getting hit particularly hard.

Source: Credit Suisse

The US energy industry is undergoing its most challenging period in decades and for many firms the worst is yet to come.


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Saturday, July 11, 2015

Canada’s “Atrocious” Turn of Events

Guest post by Norman Mogil

The Governor of the Bank of Canada (BOC), Stephen Poloz, was not kidding when he warned that the first quarter of 2015 would be “atrocious.” After a respectable fourth quarter in 2014, the Canadian economy took a turn for the worse: domestic demand fell by 1.7%, owing to a huge drop in business investment, while the other components of GDP barely registered positive results (see Chart 1).

 Chart 1:  Canada Real GDP 

Canada is still suffering from the oil price shock, as much of this drop in business investment is from cancelled oil projects and lowered expected future production. Anticipating a weak first quarter, the Bank of Canada lowered its overnight bank rate from 1.00% to 0.75% in January both as insurance against a particularly bad performance and to weaken the Canadian Dollar. The BOC hoped that lower borrowing costs and a cheaper currency would sufficiently increase capital formation and improve Canada’s trade balance—especially with the U.S—to offset expected energy-related contractions.

Did the BOC purchase enough insurance?

Capital Formation Slumps

In a separate survey Statistics Canada said capital spending in the non-residential sector is expected to decline a further 4.9% from 2014, while investment in energy is expected to decline by another 10%. Clearly, cutting the bank rate is not generating the new capital formation that the BOC desired, and it is becoming apparent that Canada cannot count on new investment to turn the economy around. With business reducing investment and consumers spending less, the two major engines of growth are idle at this important juncture. Can Canada rely on exports to revive the economy?

Current Account Deficits Widen

Canada has one of the world’s most ‘open’ economies (surpassed only by Germany in the G7), where exports compose about 30% of total national income. Thus, lower export cost should yield strong growth effects. As mentioned above, the BOC weakened the Canadian dollar by cutting rates in January. The Dollar has fallen almost 20% in the span of 6 months and remains under pressure.

Chart 2 US $ soars against the "Loonie" 2014-2015
Source: Bloomberg News

Despite this effort to improve balance of trade, Canada continues to generate widening trade deficits.

Chart 3 Canadian Exports and Imports  
Source : Statistics Canada, July 7,2015

China’s weakening demand has put renewed pressure on Canadian exports: the export volume of metals and related products are down by 7%; volumes of minerals ore fell by 9%; and energy volumes were down 6.5%. The only bright spot was a modest increase in automotive exports. Overall, the merchandise trade deficit widened to $3.3 billion and Canada ran a trade deficit with the US in May—its first since 1990.

Does the Canadian Dollar need to fall further to stem the outgoing tide of widening trade deficits? Economists at CIBC, tried to determine a ‘fair value’ for the Dollar and explain why the currency devaluation has failed to reduce the current account deficit: their model showed that the Canadian Dollar has been overvalued by 10% since 2009. The overvalued currency served as a form of monetary tightening. As the economists conclude: “given that we spent over 70% of the time since 2009 with core CPI under 2%, it shouldn’t be a huge surprise that our analysis suggests that monetary conditions have been tighter than the BOC’s official rate.” * It is apparent from this analysis and recent trends that Canada is in need of monetary loosening.

Summing  Up

  • The Canadian economy is no longer the darling of the G7, now that it is experiencing recessionary conditions;
  • To a large extent, the weakness is due to totally exogenous forces and out of the hands of Canadian policy makers, e.g. the  stunning decline in all commodity prices ;
  • To a lesser extent, a relatively tight monetary policy combined with an overvalued exchange rates are well within in the purview of the policy makers.

    On July 15th the BOC meets to set the bank rate. Upper most in their minds will be the ‘atrocious’ first quarter and, in particular, the weakness in the external sector, so vital to the health of the Canadian economy. A lot will be riding on that meeting. Stay tuned.

To avoid the technical measure of a recession, the economy needs to record increases of 0.2% and 0.3% in May and June, respectively---- a tall order given the performance to date. Analysts are whispering among themselves on the probability of a full recession by the end of the summer.

*Rich Loonie to Slow Poloz,  N. Exarhos and A. Shenfeld, CIBC Dept. Of Economics, July, 2015


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Sunday, June 28, 2015

Have the Saudis miscalculated the impact of lower crude prices on US production?

In 2014 the Saudis could no longer accept the loss of crude oil market share as the North American production levels shot up sharply over a three-year period.
Source: Yardeni Research

The Saudi response was quite rational. Rather than cutting production to support crude oil prices, the Saudis announced that output will remain the same. In private they were planning to actually increase production in order to meet rising domestic demand as well as to regain market share. The idea was to put a squeeze on the high-cost North American oil firms, halting production growth and ultimately getting prices back into a more profitable range. Other OPEC nations reluctantly agreed to play along.
CNN (November, 2014): - One motivation is to squeeze higher-cost producers in North America, including the booming U.S. shale industry that has reshaped the global energy landscape.

It's a move Tony Soprano would be proud of. OPEC is betting lower oil prices will force U.S. producers to throw up the white flag and cut back on production because they won't be able to turn a profit.

"The gauntlet has been thrown down for Western Hemisphere producers like Brazil, Canada and the United States," Bespoke Investment Group wrote in a note to clients on Friday.
Is it working? So far the results have been less than what the Saudis had hoped for. After a bounce from the lows, crude oil has been trading in a relatively tight range, with WTI futures fluctuating around $60/bbl.

Source: barchart

How is this price stability possible when the common wisdom was that oil prices below $70/bbl will force most US producers to close shop and North American production would collapse? After all we've seen a spectacular decline in active oil rig count. The answer has less to do with rigs that have been taken offline and more with the technology that remains. After the inefficient rigs have been shut, US rig count is starting to stabilize.

Source: BH

US crude producers are achieving record efficiency with the remaining equipment. The charts below show new-well oil production per rig.

Source: EIA

From multi-well padding (multiple wells in a single location) to superior drill bits, technology is helping to keep production levels high. Well completion costs and the speed of drilling have improved to levels many thought were not possible.

Source @PlanMaestro

With the inefficient rigs mothballed, the remaining capacity is quite lean. It seems that $60/bbl can now sustain a good portion of current production capacity and even turn a profit.
Platts: - ... [US oil producers] have wrung astonishing efficiencies from their operations in a very short period of time, as the number of days to drill a well keeps contracting while initial well production rates and estimated hydrocarbon recoveries expand.

Also, corporate efficiencies, coupled with cost concessions of around 15%-25% granted by oil services and equipment providers this year, have also lowered well costs and driven up internal return rates in the best plays to the point that operators appear comfortable with the current price environment, even if they privately hope for an eventual return to $80/b oil.
To be sure, there is a significant chance that US production slows in the coming months. Thus far however the results of the recent Saudi efforts to diminish US production have been less than satisfactory.

Source: EIA


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Saturday, June 20, 2015

Managing Greek default risks

Many in Europe continue to believe in the permanence of the Eurosystem. The Bank of Greece is controlled by the ECB and its assets and liabilities will always be consolidated into the Eurosystem. By this argument, the collateral held by the Bank of Greece as part of the ECB's financing of Greek banks belongs to the Eurosystem. Therefore if the Greek banking system were to fail, at least the Eurozone's central banking system can keep the collateral.

Let's be clear: if Greece were to exit the currency union, the Bank of Greece and its assets would be immediately expropriated by the Greek government (making them part of the "new" Bank of Greece). Many in Europe are pointing out how such action would be illegal. There nothing "legal" about Grexit to begin with - the system was designed to have laws for "marriage" but no laws for "divorce". And with the Bank of Greece exiting so would go the collateral. To assume that the Bank of Greece is a permanent fixture of the Eurosystem is not prudent credit risk management. Therefore the Eurosystem's exposure to Greece should be added to the €323bn of other debt.

Having said that, Target2 debt owed by the Bank of Greece to the Eurosystem has no maturity and requires no immeduate payments. Therefore a standalone Bank of Greece may choose to keep the liability outstanding in order to get access to the euro payment system. The Eurozone's political leadership may however demand a timely repayment of these balances, given the size of the exposure.

Source: Barclays Research

This central-bank-to-central-bank exposure is now rising rapidly as the ECB approves a new limit increase for emergency funding (ELA) on a daily basis. This is what a run on the Greek banking system looks like.

Source: Barclays Research

While some accounts are moving abroad and into other assets (including European bonds held in foreign accounts and even into bitcoin), much of the withdrawal activity is simply converting deposits into banknotes. Anecdotal evidence suggests that many in Greece are leaving a minimal amount at the bank to keep the account open and the rest is in cash stored under the kitchen tiles, etc. Greece is quickly becoming a cash economy. Capital controls could be the next logical move by the Greek government and the population and businesses are simply protecting themselves.

Source: Barclays Research

Here is an example:
Bloomberg: - Dorothea Lambros stood outside an HSBC branch in central Athens on Friday afternoon, an envelope stuffed with cash in one hand and a 38,000 euro cashier’s check in the other.

She was a few minutes too late to make her deposit at the London-based bank. She was too scared to take her life-savings back to her Greek bank. She worried it wouldn’t survive the weekend.

“I don’t know what happens on Monday,” said Lambros, a 58-year-old government employee.
There is hope however for a less-than a disastrous outcome. These near-panic conditions could be sufficient to bring the nation's leftist government back to the negotiating table this weekend. However, time is fast running out as €1.6bn is due to the IMF in less than 10 days.

Moreover, there is a good possibility that Greece could default without leaving the currency union. With a strong support for the euro, Greeks could push for a referendum to form a more centrist government that would re-engage the creditor institutions. Here is a summary from Barclays Research:

Source: Barclays Research


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Tuesday, June 16, 2015

Reasons behind homebuilder optimism

Yesterday a report from the National Association of Home Builders showed that US homebuilders have turned rather optimistic again. Given the recent weakness in construction spending some have dismissed this survey data.

Recently we did however see some signs of improving homebuilder activity in the markets as lumber futures stabilized in mid-May after months of declines.

Source: barchart

Moreover, homebuilder shares have outperformed the broader market over the last few days.

And today we learned the reason for the renewed builder optimism. They are going to have a busy year as new home construction permits spiked to levels not seen since 2007.

Source: Federal Reserve Bank of St. Louis

Does this mean US families are finally getting mortgages and buying new homes? Not exactly. While demand for new homes continues to gradually improve, it is concentrated in the "luxury" sector (larger and more expensive homes). In general single-family housing as a percentage of the overall homebuilding activity continues to decline.

Source: Federal Reserve Bank of St. Louis

Instead, most of the demand is coming from multifamily housing as the need for rental units continues to increase. This is the sector that has been boosting builder optimism and where we are about to see increased construction activity.

Source: Federal Reserve Bank of St. Louis


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Shedding light on recent bond volatility in the Eurozone

Guest post by Marcello Minenna

Typically the technical details of open market operations of the central banks are not known. The unpredictability prevents in fact opportunistic behaviors of banks and alterations in market microstructure.

The ECB’s Public Sector Purchase Program (PSPP) ignores these principles with the following results:
  • bank lending tends to zero;
  • the interest rate volatility of the Eurozone Sovereign Bonds (EZ govies) has considerably increased;
  • banks have achieved almost 13 billion euros of capital gains in return for their national central banks (NCBs).
The first point is self-explanatory and the evidence can be found in the data published by the ECB in April 2015 ( ); QE at least for now is not loosening the credit crunch.

The second point simply comes from an analysis of the options implied volatility on Bund's futures.

With regards to the estimates of the banks' capital gains, some further considerations are required.

First, the fact that bonds with yields lower than the deposit facility rate are not eligible under the PSPP.

The reason of this floor is to avoid that through the monetary policy there could occur undue fiscal transfers within the system. To explain this let’s consider first what happens in a simplified currency area where we have only one Central Bank and one private bank. The private bank sells a bond to the Central Bank, let’s say at 100 euros, and this bond has a coupon rate of 5%. Hence, by buying the bond the Central Bank receives a coupon of 5 euros. The private bank pours the money cashed (from selling the bond) on its deposit account at the Central Bank and it gains a yield on the money deposited. In order to avoid that the Central Bank would experience a loss obviously the deposit account should pay at most an interest of 5%. Let’s move now to the present situation where interest rates are negative and, hence, we have to fit a little bit the reasoning as follows. The Central Bank buys from the private bank the bond at premium (that is with an implied negative coupon) meaning that the Central bank gets losses due to this investment. On the other side it gets a gain from the negative yield on the deposit account of the private bank (currently -0.20% within the Eurosystem). From the point of view of the Central Bank this game rules out losses as long as the interests it receives on the deposits of the private bank are higher or equal to the implied coupon of the bond purchased. Hence it is clear why the PSPP requires that the eligible Govies should have yields higher or equal to -0.2%.

It is also helpful to understand intuitively where the capital gains of private banks come from.

To this purpose, it has to be observed the evolution of the yields’ term structure of the two major member countries of the Eurozone from the PSPP’s first informal announcement (of the 18 November 2014) and up to the 20 April 2015, date on which their yields have reached their all-time low.

There is no doubt that those who had in their portfolio Eurozone sovereign bonds wouldn’t have had no difficulty in achieving capital gains within of a Eurosystem as redesigned by the QE.

Within the core Eurozone countries since mid-April – that is in an environment of zero (or even negative) rates,  with less and less eligible securities for the PSPP, with vanishing liquidity in the secondary market and with new bullish expectations on inflation – banks could easily push up the term structure of interest rates.

Also because if rates were not risen it would have been more difficult to implement trading strategies that could profit from the reduction in interest rates determined by the NCB's purchases.

And after all the rise in interest rates also met the ECB’s desires since at that time about 25% of the Eurozone Govies was displaying negative rates and was no longer eligible for the PSPP by increasing the risk that the program could run out.

It is the first flash crash and, as expected, after the upward jump followed bearish retracements of the interest rate term structure with higher volatility as it happens in an increasingly less liquid market.

Confirmations of this interpretation of the market behaviors arrive in early June with a second flash crash that exhibits the same pattern.

Following these trading schemes within the Eurosystem, banks have earned almost 13 billion euros; a new phenomenon arises: the QE’s brokerage. Within this scheme of course Germany has done the lion’s share thanks to the higher ECB’s capital key and the fact that Bund yields were the lowest of the member states.

The complex architecture of the QE needed to avoid undue transfers between member countries does not seem to be on the right path.

The QE’s brokerage is recapitalizing the banking system leading Eurozone banks' balance sheets to a scheme in which - for all the duration of the PSPP - Govies will be replaced by other Govies.

Meanwhile the ECB decision to delegate the bonds’ purchases to the NCBs continues that process of nationalization of the public and private debts’ risk, which began with the 1 trillion LTROs of late 2011-early 2012.

In fact LTROs started this process through the nationalization of public debt (i.e.: every banking system took care to buy the government bonds of its own country) and the settlement of inter-bank debts recorded on TARGET2.

In short, the ECB once again becomes a gear of this mechanism that adds centrifugal forces within the Eurosystem in which each member country has to undertakes its own risks.

It is perhaps appropriate to review the PSPP rather than waiting for its end (Autumn 2016) when the banks (once recapitalized through the QE’s brokerage) will probably take care of the real economy.


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Sunday, June 14, 2015

US skills gap becoming more acute

The latest report from Job Openings and Labor Turnover Survey (JOLTS) shows that job openings in the United States are at a 15-year high. By the looks of the chart below, one could conclude that there is no slack in US labor markets. But as we know, that's not yet the case.

Moreover, the NFIB small business survey shows US businesses increasingly struggling to find "quality labor" as the labor force skills gap (discussed here a year ago) becomes acute.

Source: NFIB

The percentage of small businesses with unfilled job openings is now above the pre-recession levels. To be sure, those trying to hire are getting dozens of applications. But the applicants lack the skills businesses are looking for.

Source: NFIB

We can see more evidence of the skills mismatch in the latest US Beveridge curve that shows that the number of unemployed and "marginally attached" workers is much higher for the same number of job openings than prior to the recession.

With all those discouraged workers who had left the labor force, shouldn't all these openings be filled quickly? They are not. That's because those without work are usually not the people businesses are looking for. Prior to the recession a great deal of the unskilled labor was absorbed in housing-related industries such as construction. Didn't finish college? No problem - there is a well-paying construction job waiting for you. But those jobs disappeared with the end of the credit bubble.

One area where the skills gap is especially pronounced is manufacturing. Modern manufacturing often utilizes specialized equipment and various forms of automation that require training and experience. However after years of offshoring, the US has gutted its manufacturing base, creating a large deficit of skilled manufacturing workers. The skills gap therefore is likely to persist for years to come, creating a material drag on economic growth.


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