Sunday, August 23, 2015

6 reasons the FOMC is unlikely to move in September

The majority of economists still expect the Federal Reserve to begin the long-awaited liftoff next month.

However is this dovish FOMC truly prepared to "pull the trigger" this time? Here are some reasons the central bank is likely to delay the first hike.

1. While the Fed officially talks about not being focused on the currency markets, the recent dollar rally should give them some food for thought. The global "currency wars" have sent the trade-weighted US dollar to the highest levels in over a decade. This will continue to put pressure on US manufacturing (and even some services sectors) as US labor and other costs of production rise relative to other nations.

2. Commodity prices, led by crude oil and industrial metals, hit new multi-year lows, reigniting disinflationary pressures. Note that the Bloomberg Commodity Index is at the lowest level since 2002. Some at the Fed continue to view this as "transient", but the full impact of such a move is yet to be fully felt in the economy. Here is a broad commodities index.

Source: barchart

In fact as of Sunday night in NY, WTI futures are trading below $40/bbl.

Source: barchart

3. Driven to a large extent by commodity prices as well as economic weakness in China, US breakeven inflation expectations are declining sharply as well. Does this look like a great environment to begin raising rates?

4. Some point to the recent stability in "core inflation", with CPI ex food and energy remaining around 1.8% and providing support for a less accommodative policy. However the main driver of this stability is the rising cost of shelter. Core CPI excluding shelter is below 1% (YoY).

Source: Source: @boes_ )

5. The biggest argument for a rate hike is the expectation of increasing wage pressures. US labor markets continue to improve and at some point - the argument goes - wage growth will accelerate. However, we haven't seen much evidence for wage pressures thus far, as average hourly earnings continue to grow by about 2% per year (nominal). With the recent dollar strength, US corporations will speed up shifting production abroad - especially Mexico, limiting wage growth in the United States.

Moreover, rising rental costs are squeezing US households - many of whom are being priced out of the rental markets or can not keep up with increasing shelter-related expenses (chart below). The FOMC has to ask itself whether a rate hike will help the situation. The answer may be just the opposite: higher rates may put more upward pressure on rents as the cost of financing rental properties increases or construction of new rental housing slows.

6. Finally some at the Fed have been concerned about bubbles forming in the financial markets. In recent weeks however, the markets took care of that, as a healthy dose of risk aversion returns to the markets (see post).


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A healthy dose of risk aversion returns to US equity markets

With the so-called "currency wars" escalating after Beijing's recent devaluation and China's growth stalling, investors have suddenly become quite jittery. We are now seeing significant signs of stress in US equity markets.

The S&P500 index finally broke out of its trading range,

Source: barchart

... and the VIX (implied volatility) index jumped to levels we haven't seen since late 2011 - the height of the Eurozone crisis.

Source: barchart

The VIX curve has become inverted, which generally indicates a heightened level of risk aversion.

Moreover, gold prices and the euro have risen materially and became more correlated over the past few days, indicating a rising "risk-off" sentiment. Both gold and the euro are viewed as "safe haven" assets.

It's important to point out that risk appetite has been declining even prior to the recent selloff. Here are some indicators:

1. Investment advisors are cutting back equity exposure (as shown by the NAAIM index below).


2. Money market inflows have spiked.

Source: @pkedrosky

3. Single-stock put option activity has risen.

4. Hedge fund managers have been picking more defensive shares.

 Source: @vexmark

5. Leveraged finance markets have been under pressure for some time. The chart below shows the SPDR Barclays Capital HY Bond Index ETF (JNK).

Source: barchart

While these indicators point to rising stress in the markets, in the long run this is actually quite positive. A healthy level of risk aversion is vital for a more rational approach to asset valuation in order to limit the formation of financial bubbles,


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Monday, August 17, 2015

Plan B: the search for a solution to the Greek crisis

Guest post by Marcello Minenna

Yanis Varoufakis’ notorious Plan B is gaining notoriety as Greece’s ex-finance minister now faces criminal charges. Developed with James Galbraith of UT Austin, Plan B outlined the introduction of a "fiscal currency" parallel to the Euro in case of extended gridlock with the Troika. If the ECB cut off Emergency Liquidity Assistance to Greece this parallel currency would relieve Greece's tightened liquidity—and resulting social fallout—during an extended bank holiday. Some still say much ado about nothing but is this really the case?

Such supplemental currency is uncharted territory for Eurozone Treaties as it would be denominated in euro and would not represent a new currency or the return to the Drachma. Under Plan B Greece could have introduced a de facto system for accounting and transferred household debt owed to Greece’s tax authority to third parties. Once this debt is transferable, Greek citizens could use the newly issued currency to settle transactions: citizens could simply transfer debts for goods and services as they do with traditional currencies. Moreover the Varoufakis-Galbraith plan would have allowed residents to exchange new currency for funds otherwise frozen in bank accounts. Consequently, restored financial transactions would have bypassed liquidity issues and the stifling bank holidays.

The successful circulation of a fiscal currency depends on household debt owed to the tax authority. Debt-based currency issuance, which depends on substantial household debt owed to the sovereign tax authority, would be particularly effective in Greece given the high level of fiscal indebtedness of its citizens . In fact Residents have high fiscal debts and the banking system has recently been recapitalized by about 50% using € 15 billion of Deferred Tax Assets. In other words, such a plan has already been used to keep Greek banks alive and preemptively prevent the Troika from meddling with Greek bank accounts in the future. Similarly, Greece could circulate Public Administration debt owed to the private sector. It is unclear whether Syriza could extend this mechanism to future fiscal debt given the heavy haircut for converting fiscal currency to Euros.

To implement the fiscal currency the Greek government would have used taxpayer information available at the General Secretariat on public revenues. While Greece could easily access such information in normal economic conditions, the necessary management software was provided, and likely controlled, by the Troika. Greece’s creditors would obviously prevent their diffusion of a fiscal currency that would allow Athens to take control of their national monetary base. If implemented, the policy measure would both strengthen Greece’s position in the negotiations and any possible plans of last resort. such as the exit from the Euro, less daunting. Varoufakis has recently highlighted that, with a fiscal currency implemented, the return to the Dracma would been realizable with just a "round of a hat".

However the fiscal currency is not a panacea: it would preserve public order but not to amend Greece’s contracting GDP, consolidated deflation, and their much-feared consequences on debt servicing. Moreover, the fiscal currency would facilitate domestic transactions but be ineffective for international credit payments such those for public debt (about € 320 billion, 180% of the GDP).

The search for a solution to the Greek crisis needs to take a broader perspective. In particular, the Eurozone leadership should seek three goals: reduce sovereign debt spreads between member nations, encourage fiscal transfers that correct financial imbalances and the competitive gaps triggered under the Euro, and help structure effective debt relief for Greece by restructuring at market value.

Just recently, this trio helped Puerto Rico reconcile untenable debt, culminating in default. The negative effects on Puerto Rican GDP measured just one third of those on Greece. Although Puerto Rico is only a US territory but not a State of the Federation, it has benefited from federal transfers more than five times the Eurozone allocated to Greece—a member State of the European Union in every respect. While, the FDIC handled Puerto Rico’s banking crisis under the federal budget for more than $ 5 billion, the EU must help Greek banks recapitalize more than € 25 billion at the expense of depositors.

DTAs in the balance sheet of the main Greek banks (2011-2014)

Weekly Evolution of the Emergency Liquidity Assistance ceiling to Greek banks
(February – August 2015)


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Wednesday, August 5, 2015

Beijing may question the yuan peg as the Fed prepares for liftoff

Today's ISM non-manufacturing report showed US services sector expansion considerably stronger than economists had anticipated. The strength of services sector expansion however has diverged materially from what we see in US manufacturing.

Source: St. Louis Fed, ISM

The reason for the divergence is the strength of the US dollar, which on a trade-weighted basis is at the highest level in over a decade.

Source: St. Louis Fed

Strengthening US currency has generated a significant drag on growth in the manufacturing sector. We've all read the headlines.

But haven't we seen this divergence between the services and the manufacturing sectors elsewhere? Indeed just yesterday Markit published a similar chart for China.

Source: Markit

This of course is more than a coincidence. China's currency tie to the US dollar resulted in a similar dynamic of manufacturing sector significantly underperforming. Unlike the US however, China's manufacturing is more sensitive to exports, making the slowdown far more pronounced - resulting in an outright contraction (PMI below 50 in the chart above).

In recent months the yuan has been firmly pegged to the dollar. There are a number of reasons for this linkage, including China's wish to make the yuan part of the so-called Special Drawing Rights (SDRs), a basket of currencies constructed by the IMF and held by various central banks. Beijing reasoned that the yuan's stability would help them with that cause.

Source: barchart

However, yesterday we got this headline.

Source: Reuters

Time to give up the peg? There are of course other reasons China may want to maintain the link to the dollar - one of them is to continue "rebalancing" the economy.

Source: MRB

This policy however could prove to be too costly, as competitors whose currencies have been devalued may take market share from China. Here is how the yuan has appreciated against the Mexican peso for example (chart below). With margins tightening in a number of industries, when a manufacturer decides where to build a factory, Mexico (and a number of other countries) may now be a cheaper solution.

It's unclear if China will ultimately let the peg go or if the yuan will continue tagging along with the US dollar. Will China want to wait until the 2016 IMF decision on the SDR inclusion? With the Fed getting ready for "liftoff" in September while most central banks are easing, the dollar could continue marching higher. This could slow China's economic growth materially below the current ("reported") 7% per year. In effect the tightening of monetary conditions in the US will be transmitted to China via the peg. If the dollar indeed moves higher as US rates rise, will Beijing finally run out of patience?


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Sunday, August 2, 2015

Housing in Canada: A Tale of Two Markets

Guest post by Norman Mogil

Canada’s housing market has diverged in recent years: Vancouver and Toronto joined other international real estate markets such as New York, London, and Sydney, while prices in other major cities remain subdued. Vancouver and Toronto housing now costs double that of comparable homes in Ottawa, Montreal and Calgary as the two most expensive cities continue to experience the fastest increase in prices and pull further away from all other regions in the country. Let’s look at the changes in buyers, housing stock, and credit creation that are behind this tale of two markets.

Table 1: Real Estate Prices in Canada 2014-2015
Source: Canadian Real Estate Assoc. July, 2015

Stable Housing Supply

Unlike the US, Canada has no recent history of overbuilding. The ratio of housing starts to household formation is roughly in balance at 1.2 starts per formation, which has allowed Canadian construction to avoid the boom/bust cycle often associated with housing. Furthermore, stable housing supply reduces the risk to lenders and has encourages continued orderly expansion of the housing stock. Since housing supply has not driven climbing prices in Vancouver and Toronto, we focus on housing demand below.

Population Changes

Canada is a "young" country. The working population is one of the most important components of housing demand. Chart 1 compares the working age population (ages 15-64) as a percentage of total population. Canada’s working age population is nearly 69% of the total population and exceeds the ratio in the US and the average for all OECD countries. Furthermore, the population aged 25-34 is growing at a rate of 2% y/y ; the age group of 30-34 is growing at even a faster rate of 2.6% y/y. These groups underpin the market of first-time buyers 1.

Chart 1:  Working Age Population as a % of Total Population
Source: OECD

Immigration accounts for about 75% of the population growth in Canada . Over half of Canada’s 260,000 annual immigrants make their way to Vancouver and Toronto alone. Recent work by CIBC reveals that immigrants aged 25-45 years have dominated the estimated 770,000 non-permanent Canadian residents. Moreover, immigrants living in Canada for more than 10 years have a higher rate of home ownership than native Canadians, thereby exerting more demand pressure 2.

Table 2: Housing Starts in Canada 2010-2014
Source : Statistics Canada

Credit-driven Growth

Total mortgage lending has increased by 30% since 2010, primarily attributable to commercial bank lending. In the past 6 months, the banks have eased off on this growth pattern, but levels remain relatively high. As non-bank funders also aggressively move into this market, both builders and buyers are finding easy financing.

Chart 2
Source : Statistics Canada

Credit growth has not been isolated to mortgages. Statistics Canada shows that household debt including mortgages, consumer credit, and non-mortgage loans reached 163 per cent of disposable income as of June 2015. The IMF warns that “although household debt levels appear to have stabilized recently, they have increased to historical highs in the past decade... one of the highest among countries of the OECD.” Just as easy credit allowed Canadian households to enter the housing market and push prices higher, there is now concern that high debt poses the risk of a major housing market correction. By way of comparison, US ratio of debt to real disposal income reached 172% in 2014. Canadians are less indebted than their American neighbours.

Debt should always be measured against assets to get a measure of the degree of risk assumed (Table 3). In real terms, the growth of household debt did accelerate to an annual average rate of 5.3% in 2000-2011, compared to 3.1% , in the 1980s, and 3.7%, in the 1990s. However, the ratio of debt to assets has barely changed. In the 1980s it stood at 16% and now it averages 17.6%. Overall, the accumulation of household debt has kept in line with the growth of household wealth . Put differently, Canadians have not increased their leverage from prior decades in any meaningful way. Finally, given that current interest rates are at a historical low, debt service is within a manageable range. And, with no anticipated interest rate increases, these debt levels do not pose a threat to the housing sector.

Table 3: The Growth of Household Debt and Assets 1980-2011, Canada *

The Influence of Foreign Capital

Canada continues to benefit from inflows of international capital. Investors from Hong Kong and mainland China have been buying up real estate in Vancouver and Toronto, contributing to the bidding wars in both cities. While there are no official data documenting purchases by non-residents, realtors have provided statistics and anecdotal evidence to support this argument. We must caution the reader that much better data and greater research are needed before any conclusions can be reached regarding the role of Asian investors in influencing housing costs in Canada.

More Fuel is Added

The pressure on the housing market in both Vancouver and Toronto contradicts Canada’s oil-driven economic slowdown over the past six months and has complicated the Bank of Canada’s recent monetary policy decisions . The central bank has cut rates twice this year. In its latest move, the BoC stated:
“Of particular note are the vulnerabilities associated with household debt and rising housing prices. And we must acknowledge that today’s action could exacerbate these vulnerabilities.”
The Bank recognized that, although its policy moves were necessary to stimulate overall growth, it runs the risk of further inflating Vancouver and Toronto housing markets.

Is There is a Correction Coming?

The rise in house prices has prompted many analysts to say that a correction is inevitable. Simply put, they argue that growth in market demand is unsustainable and thus a major correction must follow. Before arriving at that conclusion, it is important to bear in mind that both cities feature:
  1. Diversity in employment and industrial makeup, so that they can weather a downturn in oil and other commodities , as they did in the oil crash of mid-1980s;
  2. Population growth will continue at the current rates and there is no sign of change in government policy regarding immigration flows;
  3. Interest rates not only remain low, but show no sign of increasing given the current economic environment, eg 5 year mortgage rates are 2.50%;
  4. And, both cities face land scarcity, especially in the core areas.


1. Canada has a split housing market; Vancouver and Toronto, overwhelming skewed the average home price in the Canada; looking at the rest of Canada, prices are stable and values remain relatively low.

2. The growth in housing stock has risen to match the growth in population and household formations; there is a relatively good demand/supply balance in place.

3. Household debt measured against the growth in assets indicates that the ratios today are within the historical averages.

4. There is concern, however, should the Canadian economy weaken further and employment and growth deteriorate that housing prices and values could be at risk.

1 Robert Kavic, Business in Canada, April 14, 2014
2 Benjamin Tal and Andrew Grantham CIBC, “Many Faces of the Canadian Housing Market” June, 2015


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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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