Monday, March 2, 2015

The Eurozone: on the road to recovery with a lingering risk

Posted by Walter

Back in September the idea that the Eurozone's economy could potentially undergo a recovery (see post) was met with some skepticism. And yet here we are. The EuroStoxx50 index is up 14% for the year while the Dow is up 2.5%. We now see plenty of indicators showing strengthening economy in the euro area.

To begin with, the area's credit conditions continue to improve as loan growth is about to turn positive for the first time since the middle of 2012.

Source: ECB,

Corporate and household loan expansion, while still terrible relative to the US, is on the right path. This is particularly true after the conclusion of the ECB's stress tests (which were a major source of uncertainty in 2013).

Source: ECB

The area's bank deleveraging is ending (see post) and the strongest evidence of that can be seen in the acceleration of the broad money supply growth. The M3 expansion trend has been fairly consistently beating economists' forecasts.

Source: ECB/

Both business and consumer sentiment surveys, which soured significantly after the Russia sanctions went into effect, showed marked improvements recently. Part of the reason is the decline in fuel prices.

Source: TradingEconomics


Moreover, the labor markets are exhibiting signs of stabilization. Just to be clear, the declining unemployment is highly uneven across the various states and nobody claims the job situation in the Eurozone is in good shape.

By any measure, the job markets in some of the periphery nations are dreadful. But on a relative basis, hiring across the euro area has been improving.
RBS: - Baby steps. The Spanish labour market has enjoyed its best year since 2007 - a start on a 23.4% unemployment rate.
Source: RBS

A number of these surprises to the upside are reflected in the Citi Economic Surprise Index, which shows the Eurozone diverging from the US.

Source: ‏ @sobata416, @valuewalk, @HedgeLy 

Going forward, the sharp deterioration of the euro and the ECB's expected massive bond buying program should halt deflationary pressures (although just as the case in Japan, inflation is likely to remain below the ECB's target for a while). Weaker euro may also help the area's exporters.


But the euro area's economy is not out of the woods yet. The greatest and the most immediate risk to the recovery remains the developments in Greece. While the Eurogroup has kicked the can down the road, the situation could deteriorate quickly even before the bridge financing matures. Depositors are continuing to withdraw money out of Greek banks.

Source: @Schuldensuehner

Nobody wants to get caught with a Cyprus type situation where people's property was confiscated by the state via deposit haircuts. An even worse scenario would be having deposits forcibly converted into drachmas that will find no bid in the FX market. The Greek government is already taunting the Eurogroup with creative drachma notes designs (Greece will need take lessons from Zimbabwe and add a few zeros to some of these notes).

Source: @AmbroseEP

As these deposits leave, Greek banks lose their limited sources of private funding and increasingly rely on the Bank of Greece for the emergency liquidity assistance (ELA) loans. In fact investors have little confidence that the banks are sufficiently capitalized after the last bailout to withstand this transition. That's why today alone, the banking sector took a 10% hit.

Why does this relatively small nation present such a risk to the Eurozone's nascent recovery? The ELA loans are financed via Target2 as the Bank of Greece borrows from the Eurosystem. In a Grexit scenario the Bank of Greece will be unable (or unwilling) to repay these loans, forcing the Eurosystem (the ECB) to take a significant hit.

There is no question that the EMU will easily withstand such an event - it's not a great sum of money in the larger scheme of things. But the loss of confidence and the political nightmare associated with recapitalizing the ECB as well as the fears of contagion to other periphery nations may send the euro area back into recession. Will depositors in Italy, Portugal, and Spain begin to move their deposits out as well in order to avoid being "drachmatized"? Economists often forger, it's less about the specific euro amounts and more about the psychology of fear.

If however the Eurogroup manages to somehow stabilize the Greek situation, a steady economic recovery could be in store for the Eurozone. The next few months will be crucial.


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Sunday, March 1, 2015

China's rate cut insufficient: investors expect more PBoC stimulus and yuan devaluation

Posted by Walter

China's central bank followed up with a second rate cut this year. While many believe this is a step in the right direction, the move alone will do little to reduce high real rates and tight effective monetary policy.

Source: TradingEconomics

In fact money market rates in China have been rising. Here are the overnight and the 1-week SHIBOR (interbank) rates for example.


At the same time inflation has been moving lower, with CPI hitting 0.8% YoY in the last report.

This results in real rates that are are multi-year highs (chart below) in a slowing economy. The situation in the repo markets is similar. The effective monetary policy is just too tight and these real rates are not sustainable - many more cuts will be needed.

Source: @georgemagnus1

The PBoC pointed out that the reason for the cut was to achieve "real interest rate levels suitable for fundamental trends in economic growth, prices and employment". Market participants and economists remain a skeptical.
Deutsche Bank: - The rate cut is not enough to stabilize the economy. We believe growth will continue to weaken in March and Q1 GDP will drop to 6.8% (consensus 7.2%). The key issue is whether the central government will loosen fiscal policy significantly and quickly enough to offset the slide of fiscal spending on local government side. We do not see signal of such easing yet. Without meaningful pickup of fiscal spending, growth momentum will likely weaken further.
Source: @georgemagnus1, IMF

The expectations are that a whole series of cuts could be coming as China's growth slows further. That's why just as the short-term rates rose recently, markets view these rates falling significantly in the longer term. The rate swap curve has become even more inverted over the past month.

With recent talk of a US rate hike in 2015, this puts the Fed and the PBoC on a diverging policy trajectories. That exerts further downward pressure on the yuan which now trades at the lowest levels since 2012. The chart below shows USD appreciating against CNY.

Source: barchart

Many now believe that Beijing will soon let the USD/CNY peg go. With rate cuts alone insufficient to stabilize growth, weaker currency may be just the medicine China's economy needs.


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Sunday, February 22, 2015

Market expectations of the first Fed rate hike seem unrealistic

Posted by Walter

The Fed Funds futures continue to point to the first Fed rate hike in late Q3/early Q4 of 2015.

The debate is now focused on whether this timing is unrealistic. To be sure, whether we have a hike in September of 2015 or in January of 2016 will have little direct impact on near-term growth. But could an earlier hike exacerbate disinfaltionary pressures in the United States and globally?

Some argue that the weakness in inflation has been driven by energy markets and once we have some stability in that sector, price growth will speed up again. However we are also seeing signs of slowing inflation in the "core" measures:

Core CPI:

Core PPI:

Moreover, this slowdown is coming from a variety of sectors - for example healthcare:

Source: Credit Suisse

Therefore even if we see some gradual increases in energy prices (which may take some time), inflation measures may remain significantly below the Fed's target for a while. So what could prompt the Fed to act in the next few months? Some argue it will be wage pressures.

While we've had a number of forward looking indicators pointing to higher wage growth ahead, we haven't seen that trend in the official figures thus far. Americans are certainly working longer hours, but the pay per hour continues to grow at 2% per year. That in no way constitutes wage pressures - at least not yet.

One of the arguments for higher wages going forward is poor productivity growth in the US. Companies will be forced to hire more people and pay them more - the argument goes - in order to compensate for difficulties they are having in achieving growth with their existing workers (via technological and process improvements, etc.). Perhaps.

Source: Evergreen GaveKal

But even if we see a modest improvement in wage growth in the next few months, the FOMC remains concerned about pushing the dollar higher and destabilizing global economic conditions - the equivalent of another "taper tantrum". For example, it's important to keep in mind that the Greece situation is likely to resurface again in 4 months or earlier.
The FOMC: - ... the increase in the foreign exchange value of the dollar was expected to be a persistent source of restraint on U.S. net exports, and a few participants pointed to the risk that the dollar could appreciate further. In addition, the slowdown of growth in China was noted as a factor restraining economic expansion in a number of countries, and several continuing risks to the international economic outlook were cited, including global disinflationary pressure, tensions in the Middle East and Ukraine, and financial uncertainty in Greece.
And for those who still believe that the Fed is too domestically focused, just take a look at what occupies a good chunk of Janet Yellen's time these days.

Source: WSJ

At this point we would need to see a major shift in domestic wages and inflation indicators as well as a more stable international economic picture in order for this dovish FOMC to move on rates. The expected rate hike in the next 6-7 months indeed seems unrealistic.


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Diverging developments in oil markets vs. energy shares

Posted by Walter

Let's take a look at the recent developments in the US energy markets and the seemingly contradictory reaction by equity investors.

First of all, while we continue to see significant declines in the US rig count (both oil and gas),  ...

Source: Banker Hughes

... American crude oil production remains at record levels and still rising. It's going to take time for this momentum to turn.

Source: EIA

Part of the reason is the increasing productivity of new rigs in the US.

Source: EIA

Moreover, outside the US some major oil producing nations such as Russia and Iraq - desperate for hard currency - will maximize production in the months to come. Global production will therefore continue to rise.

The second key development has been a relatively steep crude oil futures curve (contango).

Source: barchart

This is encouraging crude investors to store oil. The arb involves buying spot crude, simultaneously selling forward, and storing for delivery at a future date (Profit = Forward Price - Spot Price - Storage Cost - Financing Cost). If the arb persists, the trade can be rolled. That's why this past week we saw the largest spike in volume of crude in storage.


Moreover, the absolute levels of crude in storage are now at the highest level in some 80 years.

Source; EIA

As a result, analysts expect Cushing, OK (the WTI crude delivery/storage hub) to run out of storage soon.

Source: @jenrossa

Crude in storage is on the rise outside the US as well. As an example, Iran just launched a huge floating oil storage unit in the Persian Gulf (built by Samsung). This facility stores 2.2 million barrels of crude.

Tehran Times

The most important development in 2014 of course was the historic shift in the crude oil production cost curve, capping crude prices at $75-$80/bbl for some years to come.

Business Insider: @themoneygame

Now, with these production fundamentals in place, rapidly growing amounts of crude in storage, and longer-term prices capped way below milti-year averages, why are energy firms' shares still relatively expensive? For example, over the past couple of years spot crude oil is down 45%, while the energy component of the S&P500 is up 2%.

And forward P/E ratios are more than double the historical averages - these are some of the most expensive large cap shares in the market.

Equity markets seem to be betting on a quick decline in production and sufficient recovery in crude prices to return the energy industry to stronger profitability in the nearterm. There is also the view that some energy firms will remain resilient due to their midstream operations - storage, transport, and refining. And we've all heard talk of consolidation and M&A activity in the space which may also support share prices (see story). A number of analysts have turned constructive on the sector.

Source: Goldman Sachs

Furthermore, from the technical perspective many portfolio managers have been heavily underweight the energy sector for months and some believe that the eventual rebalancing will drive up share prices.

These are all solid arguments. However given the current lofty valuations, if we don't see a major improvement in crude prices in the next few months, energy shares may take another leg down. One can see this nervousness in the credit markets as HY energy credits remain near historical wides to the rest of the market (chart below). For those who wish to jump in at these levels, be prepared for significant volatility and deleveraging in the energy sector.

Source: Credit Suisse


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Saturday, February 21, 2015

The ECB’s QE: a mix of credit derivatives fostering the EZ disaggregation

Guest post by Marcello Minenna

The purchase programme of the ECB pushes towards the nationalisation of risks in the short-term, and in the long-term reduces the interests of the member States in keeping the Euro alive.

On the 22nd of January this year, the European Central Bank (ECB) launched a Quantitative Easing programme (QE) of more than 1 trillion bonds, which will be shared in a buying programme of 60 billion a month for a duration of 18 months. Ignoring for simplicity’s sake the fact that in the more than one trillion there are also private debt bonds, the QE will have an impact on inflation, but it will be reasonably heterogeneous in the Eurozone; in fact, it can be suspected that it will be more difficult for peripheral banking systems to transmit liquidity into the real economy. Overlooking the possible reactions of the other central banks, it is conceivable that the Euro will reach the value of the dollar, an equality which will, however, massively favour the big exporting economies. In any case, the weakness of the QE is the allocation of risks which could be neglected if the hypothesis of the ‘break-up of the Euro’ was sure to rule out relying on the anti-spread shield. The issue is that to activate the shield – if it were ever necessary – a political convergence on a full sharing of the risks at a European level would be needed, but there are no signs on the horizon.

To understand what the risks are to which we are referring, it is appropriate to take a step backwards to investigate why the purchase of government bonds has not been decided according to the best practice of the central banks of the world, namely without paying interests to the ECB and without discriminatory treatment on the risks of public debts of different member countries. Behind the tensions that led to this decision there is the German-made theory that a different intervention from the ECB would have created an undue mixture between monetary and fiscal policy and encouraged the moral hazard of the periphery. By not paying interest to the ECB, a member country could have, for example, reduced taxes or increased public spending, and thus have used the measure of the European monetary policy to national tax ends. Similarly, imagine the loss in value of the government bonds issued by a member country and bought by the ECB; such a loss concerning a national state would have been reversed on all Eurozone taxpayers. But the moral hazard theory is not supported by the facts.

On the issue of interests, some decisions made by the ECB certainly have fiscal policy implications but the terms are different. In the two-year period 2010-2012, with the Securities Market Programme (SMP), the ECB increased its budget of around €220 billion of bonds issued by Eurozone Peripheral Countries (EZPC). Considering the bonds expired in the last 24 months and the sterilisation performed on the secondary market, in December 2014 around €160 billion of government bonds – based on the decision of June 2014 – were not placed back on the market leading to an increase in the monetary base. What’s unusual about the SMP is that, unlike what happened with the buying programmes of the FED, Governments are required to pay interest to the ECB. In total, a flow of around ten billion Euros a year is estimated, which is then distributed pro rata in the Eurosystem (Germany 18%, France 14%, Italy 12% and so on). In other words, Germany through the Bundesbank receives nearly 4 billion of interests from the EZPC. So thus far, the monetary policy has induced fiscal transfers between member States, but from the periphery to the centre, not vice-versa.

On the issue of credit risk, i.e. the loss in value of a government bond, the solution of the buying programme decided on the 22nd January is that – with the aim of not creating undue mixtures – the ECB will directly purchase government bonds of the Eurozone for around 100 billion (8% of the QE), hence mutualising the associated risks, and it will provide liquidity to the central banks for 1 trillion to allow for the purchase of government bonds (80% of the QE) and of bonds issued by supranational European institutions (12% of the QE), including the ESM, i.e. the former sovereign bailout fund, which will likely have a relevant share.

The purchase of bonds will be based on the share of each Eurosystem country (see above).

At the end of the purchase, the national central banks will have the bonds as assets and in the liabilities a debt owed to the ECB for the same amount. This means that the national central banks are ensuring the ECB from risks of losses in value which could occur on that portion of the public debt of member States that will be interested in the programme. For example, imagine that the Bank of Italy buys 100 billion Euros of Italian government bonds. Then, if in the future Italy were to devalue the debt by 60%, in the assets of the Bank of Italy there would only be 40 billion Euros (or, equivalently, 100 billion Lira) and in the liabilities there would continue to be 100 billion worth of debt owed to the ECB. In practice, the mechanism with which the national central banks will lend the guarantee could also be different from the one suggested previously, but the basic reasoning does not change. In other words, by finishing in the assets of the national central banks, those government bonds become de facto subjected to foreign law, and as such, if the member country were to leave the Euro it could not reduce the value of the bonds by redenominating in the new national currency and then devaluing them, but it would be required to repay their full face value in Euros to the ECB.

From the financial point of view, the scheme adopted for the QE is therefore that of credit derivatives. In more explicit terms, the national central banks are selling a credit default swap to the ECB and they are cashing the premium. Obviously, it could be debated at length how a national central bank can issue guarantees on the public debt of its own state given the “connection” of the risks between the two entities.

Quantitative analysis based on the so-called “Italy risk”, applied to the amount of government bonds that the Bank of Italy should purchase through the programme, allows us to say that Italy should cash, for a similar insurance, more than 1 billion Euros a year until the maturity of the bonds purchased.

By taking on these risks, the national central banks will be remunerated through the interests on the government bonds purchased, therefore according to the same criteria of asymmetric distribution followed for the risks. The interests retained by the national central banks compensate for the guarantees given to the ECB for the risks of national public debt of the Eurozone included in the programme.

As for the purchase of bonds issued by European institutions (12% of the total), including an important role that will be taken on by the ESM, any loss in value will instead be borne by the member States according to their percentage of participation to the Fund (27% Germany, 20% France, 18% Italy and so on), given that the risks related to these bonds have been shared. In reality, at least for the bonds issued by the ESM, if one takes into account that for this Fund the risks have already been shared out by statute, the QE creates a sort of mutualisation to the square. Therefore, it is important to investigate the reasons for a similar decision. A possible explanation comes from the composition of the risks of the ESM that sees a significant amount occupied by the public debt of Greece. Its restructuring would determine losses in excess of the capital base of the ESM; therefore it seems that, in the doubt that in the future a member state may decide not to participate in the recapitalisation of the Fund, the QE will have pre-emptively resolved the problem by securely transferring the risks of such excess losses to the national central banks.

Also in this case the scheme follows the financial point of view of the credit derivatives. What’s the related premium? Well, taking the risk of Greece as a proxy for excess and neglecting the laughable returns of the ESM bonds, in the case of Italy – just to make an example – the premium associated with the purchase of bonds issued by the ESM would be around 1 billion Euros a year. This time however, without substantial compensations to the Bank of Italy for the insurance provided.

The argument can now be completed by referring to the 8% of the purchase of government bonds carried out directly by the ECB and whose risks are therefore shared at a European level. In this case, the credit derivative is sold by the ECB and bought by the member states of the Eurozone. By conducting quantitative analysis similar to those carried out so far we can see, for example, that in the case of the Italy the insurance for the 8% of “shared” risk on the Italian government bonds is worth around 100 million Euros a year.

The decision announced on the 22nd January is therefore not financially fair, nor are there “gifts” to “weak” countries of the periphery, and has little taste of United States of Europe. Rather, it is in line with the previous decisions, including that of mid-January which has set forth the possibility of relieving the Fiscal Compact in the presence of a recession not only in the Eurozone but also in the individual countries. This was also certainly a useful decision, but which does not address why the founding fathers of the Eurozone did not take into consideration the idea that the economic cycles of the member States could be misaligned. It will be random, but at this very moment the European regulators who deal with the risks in the balance sheets are saying that it is time to discriminate the government bonds of the different Eurozone members. For some time a metamorphosis of the European Union to the sum of the member States has been underway, and unfortunately the monetary policy did not intervene as it could have done.

- Paul De Grauwe, Yuemei Ji (2015), “Quantitative easing in the Eurozone: It's possible without fiscal transfers,, 15 January.
- Minenna, M (2014), “The European Public Debt Refinancing Program - Why the ECB Quantitative Easing Should Envisage Euro-Zone Government Bonds,” Rivista di Politica Economica forthcoming 
- Sinn, H W (2014), “Responsibility of States and Central Banks in the Euro Crisis”, CESifo, volume 15, no. 1
- Winkler, A, (2014), “The ECB as Lender of Last Resort. Banks versus Governments”, LSE Financial Markets Group, Special Paper Series, February.


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The Gap Before China's Soft Landing

Posted by Sam

Favorable terms of trade and eager investment in manufacturing and real estate has propelled Chinese growth in recent years. Now, a high debt burden from overinvestment, rising manufacturing costs, and an appreciating currency are signs of stress on this successful growth model.

Source: The Economist

Source: Trading Economics

Source: Trading Economics

This stress appeared in troublingly low GDP last month due to weakness in both real estate and manufacturing markets.

Source: Trading Economics

Source: Trading Economics

Source: Trading Economics
Aside from a 30% YoY jump in FDI last month, we have seen large capital outflows from China and slowing foreign direct investment over a longer period. Reuters highlights two important considerations for why there be more to January's numbers than meets the eye:
But analysts cautioned about reading too much into economic indicators for January alone, given the strong seasonal distortions caused by the timing of the Lunar New Year holidays, which began on Jan. 31 last year but start on Feb. 19 this year.

Earlier data showed FDI in China rose just 1.7 percent in 2014, the slackest pace since 2012. The weak performance underscored a cooling economy which is spurring more Chinese firms to plow money into assets overseas in a trend that is soon set to overtake inbound investment.
In reaction to poor economic news and large capital outflows, the PBoC lowered banks’ reserve requirement ratios (RRR) by 50 basis points on February 4th and has framed recent poor numbers in the context of development growing pains. The government assures that China will experience a soft landing during the economy's transition from export and investment-driven growth to internal consumer-driven growth. Now the question remains as to whether China will effectively encourage private consumption and service sector expansion before their old growth model runs out of steam. Though the World Bank has only posted GDP data through 2013, we don’t quite see this transition of household consumption replacing investment and exports quite yet:

Source: World Bank
On the production side, we should expect a shift from low-end manufacturing to services. There is evidence that services is growing faster than manufacturing:

Source: National Bureau of Statistics of China

Yet services have quite a way to go:

Source: National Bureau of Statistics of China
China must rely on careful monetary and fiscal policy to prevent the gap between growth models from causing a hard landing. David Dollar at the IMF did a great job over the summer outlining China’s long-term reform agenda including infrastructure investment, financial liberalization, and opening up China’s service sector to competition. Now, we must see whether China advances with these reforms or falls back to debt-driven investment in manufacturing and real estate.


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