Sunday, September 14, 2014

China about to miss the 7.5% GDP growth target

Economic reports from China continue to disappoint. Here are three recent data points:

1. Fixed asset investment growth, while still quite strong relative to the rest of the world, continues to fall.

Source: Investing.com, National Bureau of Statistics of China

2. Retail sales year-over-year growth fell below 12% again, making the switch from export-based economy to domestic consumption more difficult.

Source: Investing.com, National Bureau of Statistics of China

3. More importantly, China's industrial production growth is at the lowest level since the financial crisis.

Source: Investing.com, National Bureau of Statistics of China

Analysts are suggesting that China may now miss its target of 7.5% GDP growth unless Beijing puts in place outright stimulus programs.
FT: - ANZ said the data “reinforced our view that China’s growth momentum has decelerated faster than anticipated” on the back of a sluggish property market and slowing credit expansion. It added that China generally needs 9 per cent industrial production growth to boost the economy by 7.5 per cent. “Short of outright policy easing, China will likely miss the 7.5 per cent growth target this year, and a sharp economic slowdown will endanger the undergoing structural reforms,” Liu Ligang and Zhou Hao, ANZ economists, wrote in a research note. “Chinese authorities should further relax monetary policy as soon as possible to prevent the growth momentum from decelerating further.”


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Will the FOMC remove "considerable time" language from its statement?

The market's are pricing in the Fed's first rate hike late in the second quarter of 2015 (see chart). Investors' rationale seems to be as follows:
  • QE is expected to end in October.
  • The FOMC's recent statements say that the rate hike will come "considerable time" after the end of QE.
  • "Considerable time" is interpreted to mean at least six months (4 FOMC meetings).
  • This puts us somewhere into June of 2015.
The markets' interpretation of "considerable time" however contains too much certainty about the timing of "liftoff", which until recently had resulted in declining volatility across asset classes. If you know the Fed's timing too precisely, you can value assets with higher precision as well, thus reducing volatility. That certainty has been making the FOMC uneasy. Janet Yellen spoke about it back in June.
Janet Yellen (June 18, 2014): - ... it is important, as I emphasized in my opening statement, for market participants to recognize that there is uncertainty about what the path of interest rates — short-term rates — will be. And that’s necessary because there’s uncertainty about what the path of the economy will be. And I want to emphasize, as I have, that the FOMC will adjust policy to what it actually sees unfolding in the economy over time, and that necessarily gives rise to a certain level of uncertainty about what the path of rates will be. And it is important for market participants to factor that into their decisionmaking.
Recently the FOMC has been attacking this interpretation by the markets, especially since the implied timing of liftoff does not match the FOMC's own forecast. In particular some members have been criticizing the so-called "date-based forward guidance", with preference for language that has a closer link to US economic performance. For example Fed's Charles Plosser and Eric Rosengren have both expressed concern about this "date-based" approach. This preference to change the language had the effect of increasing market volatility (by reducing the certainty of timing) in recent weeks (see chart) as well as raising short-term rates.

US 2-yr treasury notes yield

The question that a number of Fed watchers are trying to answer now is whether the FOMC will remove the words "considerable time" from their statement this week (or later in the year). That simple change in the language could be the key driver of volatility across global markets in the nearterm.

We are going to invite the readers to answer this question via the Quibblo polling system that shows results in real time.






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Friday, September 12, 2014

Bubble forming in US middle market leveraged finance

US middle market leveraged buyout (LBO) transactions are becoming increasingly frothy. According to the latest data from Lincoln International, risk-return fundamentals in the space are worse than they were in 2007. Here are some disturbing facts about leveraged transactions in US middle markets:

1. Leverage multiples (debt to EBITDA) are higher than at the peak of the bubble in 2007. In particular, leverage through the senior debt (dark blue) is now materially higher.



2. Yields on senior leveraged loans for middle market deals are now significantly lower than in 2007. Investors are not getting paid for taking on riskier loans.



3. Furthermore, private middle market company valuations (as a multiple of EBITDA) are at record levels.



4. Banks have all but exited leveraged loan origination, as institutions (shadow banking) have taken over. These institutions include loan funds (mutual funds and closed-end funds), BDCs, CLOs, hedge funds, insurance firms, pensions, etc. However, since the Fed is mostly looking at banks' balance sheets, the central bank seems to be unconcerned about the froth in this market.


5. According to Lincoln International, there are signs that leveraged middle market firms are experiencing margin compression. That is worrisome given the amount of leverage these firms have.
Lincoln International: - While over 50% of companies are seeing revenue growth, the fact that over 50% are experiencing EBITDA declines suggests margin compression. For the sixth consecutive quarter, more middle market companies experienced EBITDA declines than gains.
The Fed has allowed for bubble to build in the US corporate sector - particularly in leveraged middle market companies. A broad hit to revenues could create a massive wave of failures, as firms become too leveraged to withstand such a shock. At the same time investors could face significant losses without being compensated for the risk they are taking. Let's hope someone on the FOMC is paying attention.


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Thursday, September 11, 2014

Middle Market CLO Primer

Here is a great middle market collateralized loan obligation (CLO) primer from Wells Fargo.



Enjoy!

MM CLO Primer



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Sunday, September 7, 2014

Markets expect negative overnight rates in the Eurozone through mid 2016 as reserves become a "hot potato"

Last week's unexpected decision by the ECB to set the rate on bank excess reserves to -0.2% is sending liquidity holders scrambling. The idea behind negative rates is to penalize cash position holders. The amount of reserves in the Eurosystem is constant at any one time, so the penalty-carrying reserves just bounce around from bank to bank like a "hot potato". The ones stuck with liquidity overnight will pay the 20bp penalty. The ECB hopes this will force the banking sector into more lending, with some lenders preferring extra credit risk over the pain of holding reserves.

Of course a great deal of this is wishful thinking, as undercapitalization and deleveraging (combined with tepid demand) will continue to plague credit creation. Quite soon the Eurozone banks will be forced to raise massive amounts of equity capital in order to improve leverage ratios (see story) and additional lending would require even more capital raising. The timing is not great.

So what are banks doing with their cash? The easiest option is to buy sovereign debt, particularly short term notes. Government paper has minimal to no impact on regulatory capital needs and does not cost banks the 20bp charged by the ECB. That's why banks (and others) are willing to (in effect) pay the German government to hold some of their excess liquidity. Below is the chart of German 6-month bill yield.



Banks are also trying to lend to each other as liquidity sloshes through the system. Taking bank credit risk does raise capital requirements, but if limited to the higher rated banks, the marginal capital needs for those loans are relatively small. Of course the better rated banks are taking advantage of this situation by funding themselves in the interbank market at zero to negative rates. The chart below is the EONIA (overnight) interbank rate (equivalent to the Fed Funds rate in the US).

Source: ECB


Moreover, the forward markets are now pricing EONIA rates to stay firmly planted in the negative territory through at least the mid-2016. The chart below shows the forward curve before and after the ECB action.

Source: Natixis

As the ECB expands its balance sheet via the TLTRO program, excess reserves in the banking system will grow. This liquidity will become increasingly expensive due to sheer size of cash balances that are costing banks 20bp. That's why the market expects even lower EONIA rates going forward, as banks pay more to avoid getting stuck with large overnight reserve balances.

Just as Japan is getting caught in what is becoming a perpetual quantitative easing program (see discussion), the Eurozone is looking at negative rates for some time to come. The unprecedented monetary experiments by global central banks will be with us far longer than originally expected.


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Saturday, September 6, 2014

US labor markets Q&A

The media is generating a great deal of noise around the US labor markets and it's worth going through some key facts, issues and trends. Let's do it in a Q&A format for clarity.

Q: What's the deal with Friday's unexpectedly poor payrolls report?

A: Friday’s payrolls report was clearly a disappointment - far below expectations. However some have attributed the weakness (at least in part) to notoriously unreliable August seasonal adjustments as well as to the New England’s Market Basket labor mess. If that’s indeed the case, we should see this reverse in September.
WSJ: - A management fight and worker revolt at a New England grocery store chain helped drag down U.S. payrolls during the month of August, the Labor Department said Friday.

Though it’s not named in the closely watched jobs report, the company almost certainly is Tewksbury, Mass.-based Market Basket, a family-owned chain that operates 71 stores across Massachusetts and New Hampshire.

The June dismissal of popular chief executive Arthur T. Demoulas, amid a long-running battle with his cousin Arthur S. Demoulas, led to weeks of turmoil as workers demanded his return, a battle covered in detail by the Boston Globe. At one point in August, thousands of part-time workers had their hours cut, some to zero.
Source: abqjournal.com


Q: How is the jobs recovery going on a longer time scale?

A: The current labor market recovery is the longest on record but clearly not the strongest. Given the latest trends in job openings (see chart), the labor markets improvements are likely to continue, albeit slower than in past recoveries. Under the circumstances that's a good outcome.

Source: @NickTimiraos @EricMorath

Q. What's going on with falling labor force participation?

A: US labor force participation for ages 25-54 has leveled off. This is the key index to watch for signs of stabilization in participation instead of the overall working-age population measure.




Q: Isn't long-term unemployment another major problem for US labor markets?

A: The number of US long-term unemployed is falling quickly but is still higher than at any time prior to the Great Recession. This tells us that the healing process has ways to go.



Q: Are wages stagnating in the US?

A: US wage growth remains anchored at 2% per year - with remarkable stability. Of course as discussed before, wages for many skilled workers are rising much faster than 2% while pay for unskilled labor continues to stagnate or is even declining.



Q: Where are the jobs coming from?

A: Here are the latest job creation numbers by sector.

Source: RBS

One final note. Comparing current labor markets to 2006 or similar periods (such as this chart on temp labor) is not always a productive exercise. It assumes that in 2006 things were somehow “normal” and the period can be used as a benchmark for the current situation. It could however be argued that the current environment is closer to “normal” because 2006 was an aberration driven by the credit/real-estate bubble. As much as some miss those good old days, we are unlikely to see such an environment return in the near future.

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Friday, September 5, 2014

Market reaction to the ECB announcement

The ECB rolled out the big guns today but stopped short of an all-out quantitative easing. In addition to the TLTRO, there will be ABS and mortgage bond purchases. However these markets are relatively small in Europe – particularly the higher rated paper that would qualify for the ECB purchases.

The deposit rate on bank excess reserves was set to -20bp. With Germany continuing to resist full QE, Draghi’s best two options are to try stimulating consumer and business credit (via ABS purchases and TLTRO) as well as to push down the euro (via negative deposit rates). So we got a “bazooka lite”.

The euro took the biggest single-day hit in over two years in response to the decrease in deposit rate.



And the French 2-year government bond yield went negative for the first time.



But without the full QE in place, longer dated bond yields actually increased, as yield curves steepened. This carried over to the US where long-term yields rose as well.



And by the way here is one reason Germany remains uneasy with an all-out QE program –

Source: ECB

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Monday, September 1, 2014

Once again we wait for "shock and awe" from the ECB

The ECB (Eurosystem) balance sheet continues to decline as the LTRO/MRO loans to the banking system are repaid. We've seen a decline of about one trillion euros in the past year and a half.

Eurosystem consolidated balance sheet (source: ECB)

Anywhere else this would have been considered a massive tightening of monetary policy (imagine the Fed selling $1.3 trillion of bonds). But not in the Eurozone. In fact the area has experienced some significant easing recently. Both the euro and the long-term rates have fallen far below ECB's own forecast. The ECB achieved Japan-style easing without the Japan-style QE.

Source: Scotiabank

Source: Scotiabank

Near-term German rates are now firmly in the negative territory (see chart) - you now have to pay the German government to hold your money for 2-3 years. The central bank was able to loosen conditions while reducing its balance sheet as a result of unexpectedly soft economic reports from the area, falling inflation (see chart) and inflation expectations (see chart), as well as Draghi's jawboning.

The ECB got this round of easing "for free", but now markets will be expecting a follow-through from the central bank. And unless we get what amounts to "shock and awe" from the ECB, some of this easing (lower rates and lower euro) could see a sharp reversal.

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