Monday, September 22, 2014

Time for a contrarian view: Eurozone's economy is turning the corner

The take-up of the ECB's TLTRO program announced back in June was materially lower than expected. About €83bn worth of cheap long-dated loans was picked up by the area's banking system. Many had expected €150bn and even greater. Part of the reason is that banks that are not quite ready to deploy the funds don't want to sit on cash with negative rates. As a result some have concluded that the Eurozone's credit contraction will worsen from here and economic conditions will deteriorate further.

As views of doom and gloom envelop the Eurozone, it may be time time for a contrarian view: the euro area's economy is turning the corner. Yes, it's difficult to imagine such a thing and we are sure to get numerous angry emails and comments. Ultimately it's about the data.

First of all we start with the Eurozone's inflation expectations which continue to fall. That combined with a weaker than expected TLTRO take-up will keep the ECB highly active in its easing efforts, potentially even considering QE.

Market-implied inflation expectations 5 years out (source: DB)

It's important to keep in mind that the ECB is trying to replace at least in part the 3yr LTRO and MRO loans that banks have been repaying. These repayments have resulted in an unprecedented reduction in the central bank (Eurosystem) balance sheet since the beginning of last year.

Eurosystem (central bank) balance sheet (source: ECB)

Without a strong take-up in the TLTRO, the ECB will consider other options to expand the balance sheet. The planned ABS purchases will hardly make a dent because the new Basel Accord has all but destroyed that market. Therefore there will be pressure on the ECB to do something else in order to stem the decline in its balance sheet. Plus we are already seeing EU institutions calling on the BIS to loosen regulatory capital rules for structured credit issuance. All of this is positive for the Eurozone banks and will likely expand liquidity in the system. That's in part why we've had a nice pop in euro area bank shares recently.

FTSEurofirst 300 Banks Index Index Price (source: MarketWatch)

Interestingly, a number of analysts have been pointing out that the Eurozone bank deleveraging is over. Credit contraction in the area is ending. One can see glimpses of this in the area's money supply measures which have stabilized recently.

Euro area M3 money supply (source: ECB)

To some extent Mario Draghi has already generated some degree of stimulus for the area's economy by repricing the euro (via negative domestic deposit rates). This is a gift for German and other exporters who can now more effectively compete on the international markets.

EUR/USD (source: TradingView)

We may already be witnessing the impact of weaker euro, as German trade balance jumped recently, resulting in better than expected German industrial production report.


Improved German exports (see chart) combined with several other factors have resulted in higher than expected growth in industrial production for the Eurozone as a whole.


There is no question that the Eurozone's economy continues to struggle. Issues such as the recession in Italy, manufacturing stagnation in France, and massive unemployment across the area are not going away anytime soon. China's economy and the situation in Ukraine continue to pose risks. Surveys still show worsening business and consumer sentiment. But the expectations around the area's performance have been so bad lately, surprises to the upside are increasingly likely (see example). The ECB's aggressive easing stance as well as stronger trade and industrial activity data tell us that for now the worst of the euro area slowdown may be over.

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Sunday, September 21, 2014

Ukraine on the brink

While we see a great deal of media coverage of Ukraine-related geopolitical risks, there hasn't been sufficient discussion about the dire economic and fiscal conditions the nation is facing. Writing about men in masks fighting in eastern Ukraine sells far more advertising than covering the nation's economic activity. However it's the economy, not the Russian army that has brought Ukraine close to the brink. And just to be clear, some of Kiev's economic and fiscal problems were visible long before the spat with Russia (see post from 2012).

Ukraine is now in recession. Deep economic ties with Russia have resulted in painful adjustments in recent months. The nation's exports are down some 19% from last year in dollar terms and expected to fall further. A great example of Ukraine's export challenges is the Antonov aircraft company known for its Soviet era large transport planes as well as other types of aircraft.

As the military cooperation with Russia ended, Antonov was in trouble. It had to take a $150 million hit recently by not delivering the medium-range An-148 planes to the Russian Air Force. The Russians will find a replacement for this aircraft, but in the highly competitive global aircraft market, it's far less likely that Antonov will find another client.

Here are some key indicators of Ukraine's worsening situation:

1. The nation's GDP is down almost 5% from a year ago and growth is expected to worsen.

2. Ukraine's retail sales are falling at the rate we haven't seen since the financial crisis.

3. And industrial production is collapsing.

4. The most immediate concern however is the nation's currency, which has been trading near record lows in spite of currency controls. In fact Friday's fall in hryvnia was unprecedented (over 11%), as Kiev fails to stem capital outflows.

Intraday exchange rate (source: Bloomberg)

Those who have spend any time in Ukraine during the winter know how harsh the weather can get. And at these valuations, hryvnia isn't going to buy much heating fuel from abroad. Furthermore, it's not clear if the government will have the wherewithal to provide sufficient assistance to the population.

5. Inflation rate is running above 14% and will spike sharply from here in the next few months if the currency weakness persists. Real wages are collapsing.

6. Finally, Ukraine's fiscal situation is unraveling. In its attempts to defend the currency, Kiev has been using up its foreign exchange reserves. It is only the access to some IMF funding that has allowed Ukraine's government to maintain some semblance of order in its FX markets.

Moreover, public debt levels continue to rise as the government attempts to keep the Ukrainian banking system afloat.
Fitch Ratings: - Government debt (including guarantees such as NBU liabilities to the IMF) to GDP has quadrupled since 2008, reflecting exchange rate depreciation, fiscal deficits, low growth and below-the-line costs such as recapitalisation of banks and Naftogaz. There is high dollarisation and foreign-currency exposure, making government solvency, banks' balance sheets and the overall economy vulnerable to sharp depreciation.
A number of economists now believe that given worsening economic crisis, the country's public debt problem is simply unsustainable and default is becoming increasingly likely.
Goldman: - We continue to see downside risks to activity and to our forecast for a contraction of output of 8% this year and for growth of 1% next year. As we recently argued, this severe economic weakness is likely to cause public debt to rise to 70% this year and 77% next year, above the IMF’s “high-risk threshold” for debt sustainability. These downside risks to our forecasts further call into question the sustainability of Ukraine’s debt trajectory.

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Thursday, September 18, 2014

PBoC joins other major central banks with unconventional monetary policy action

Softer than expected economic growth in China (see discussion) has finally spurred the PBoC into action. However, rather than undertaking asset purchases that would inject reserves into the overall banking system, the PBoC forced liquidity directly into state-owned banks.
NY Times: - With industrial production growing at the slowest pace since the worst of the global financial crisis and foreign direct investment in a tailspin, China appears to have taken the unusual step of using monetary stimulus in an attempt to forestall further economic weakness.

China’s central bank has lent 100 billion renminbi, or $16.2 billion, to each of the country’s five main, state-controlled banks, bankers and economists said Wednesday, although the central bank and the five banks involved stayed silent. The seemingly stealthy decision to inject a total of $81 billion into the banking system this week came as the Chinese economy, like many economies in Europe, has slowed over the summer, although still expanding at a pace that would be the envy of most countries around the world.
This is probably the least effective QE-style action, as state-owned lenders are unlikely to efficiently deliver capital into the private sector. But the fact that the PBoC has taken this action tells us this could be the start of a longer monetary stimulus effort. The markets are not expecting a near-term economic improvement and instead pricing in a prolonged battle to accelerate growth. China's SHIBOR rate swap curve has become more inverted than a month ago with expectations of further rate declines.

Some form of stimulus was already being priced in, which is in part what generated the recent stock market rally.


Now the PBoC joins other major central banks in expanding "unconventional" monetary policy efforts. The impact of such actions on economic growth however remains highly uncertain, particularly in the face of softening property markets and weaker corporate balance sheets.

Source: Reuters

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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:, 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:, National Bureau of Statistics of China

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

Source:, 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.


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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