Thursday, July 17, 2014

Are the monetary policies in the US and the Eurozone diverging quickly enough?

There has been a great deal of discussion about the divergence between the monetary policy trajectories of the Fed and the ECB. Is the Fed behind the curve in exiting QE and beginning rate normalization (see story)? Is the ECB not acting aggressively enough to inject the necessary amount of stimulus (see story)?

One place to look of answers is the so-called Taylor Rule. While the inputs to the calculation can be quite subjective, it's a good relative measure of where policy rates should be given current economic conditions and target inflation rates. The two charts below from JPMorgan show that the Taylor Rule (appropriate) rates are now on the opposite sides of the policy (actual) rates. This would suggest that monetary policies of the ECB and the Fed would indeed have to diverge further. The euro area seems to require non-traditional accommodation (since policy rates generally cannot go below zero), while the Fed should begin rate normalization.



Source: JPMorgan




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Wednesday, July 16, 2014

PBoC follows other central banks in suppressing volatility

Staying with the theme of central banks dampening market volatility, China's central bank (the PBoC) has learned this game as well. China's short term rates had experienced enormous volatility last year, and the PBoC has been focused on suppressing these fluctuations.
Reuters: - China's decision to ease rules used to calculate loan-to-deposit ratios for Chinese banks (LDR) will moderate spikes in seasonal cash demand from regulatory requirements and thus help stabilise money market rates, traders say.

Regulators have been moving to stabilise money market rate volatility after a severe market squeeze in June last year rattled markets around the world, who misread a short-duration rise as a harbinger of money tightening.
It worked. The 7-day repo rate, which represents a fairly active secured lending market in yuan, has seen a substantial decline in volatility.

China 7-day repo rate

The combination of this policy to ease LDR rules and other stimulus efforts from Beijing has resulted in substantial increases in credit growth (see story) and quickened the expansion in broad money supply (see chart). It also translated into lower volatility in China's stock market.

The Shanghai Composite Index - see chart for historical daily volatility

Suppressing volatility has become a trend that is no longer limited to developed economies. Of course lower volatility is sure to result in declining return expectations and increased risk taking.

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Tuesday, July 15, 2014

The low volatility paradigm and diminishing return expectations

What happens in an environment - such as the one we are in currently - that is characterized by prolonged periods of low volatility? One of the effects of diminished price swings is the decline in return expectations. As an example, the chart below shows the spread demanded by investors in US high yield bonds vs. the volatility of total returns in that market.



This low volatility regime originates from the policies of major central banks, policies that have been both highly accommodative and relatively transparent - at least in the intermediate term. And any market conditions that are viewed as a form of tightening or rising uncertainty are often met with further accommodation. This is particularly true in the US. For example the markets’ negative reaction to the Fed’s looming taper last year was met with a delay and a reduction in taper’s size (“small taper”). The risk that monetary policy will materially deviate from markets’ expectations without the Fed making an accommodative adjustment has diminished significantly, resulting in lower volatility across the board.

Some have suggested that this Fed-engineered muted volatility regime is precisely the reason for low real interest rates. The reduced uncertainty around monetary policy trajectory results in lower volatility in fixed income markets, dampening return expectations. These lower return expectations mean that investors are willing to live with lower coupon in return for smaller swings in the value of their investments.
Deutsche Bank: - If pre-crisis rules for financial engagement [Fed’s involvement in the markets] raised both the volatility in the economy and the return in the economy, then reducing that volatility should reduce economic return. QED: the real rate of growth may be permanently both more stable and lower. … Returns in fixed income may depend progressively less on price and more on income.
The other effect of operating in a low volatility regime for prolonged periods is increased risk taking – often in the form of higher leverage. We've seen this manifested in higher NYSE margin debt and growing leverage of LBO transactions for example. Janet Yellen however continues to downplay the potential for asset bubbles and other threats to financial markets resulting from low volatility. The view at the Fed is that, at least for now, financial stability can be achieved through regulation - including containing asset bubbles. That assumption of course remains to be proven, given some of the past failures of sophisticated financial regulation (see example).

For now the markets have faith that regulation will indeed maintain financial stability in the face of highly accommodative monetary policy and low volatility. And as the low volatility regime becomes the norm, return expectations decline across the board and investors become lulled under the warm blanket of asset price stability provided by the central banks.

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Sunday, July 13, 2014

More clarity from the FOMC on the mechanics of liftoff

The latest FOMC minutes provided some clarification on the approach the Fed is expected to take as it begins normalizing short term rates in the US. Here is a quick overview of the Fed's strategy and potential implications.

The Fed has chosen the interest rate on excess reserves (IOER) as the primary tool to control interest rates during the normalization process. While working with IOER is certainly more effective than the Fed Funds rate, there are a some drawbacks. As banks pay nearly nothing on deposits and earn an increasingly higher rate on reserves, the Fed will be criticised for providing banks with more riskless profits (on some $2.5 trillion of excess reserves).

To mitigate this thorny issue, the Fed will also rely on the reverse repo program (RRP). The FOMC now views RRP as playing a "supporting role" of providing a floor on repo rates. Keeping repo rates from getting too low will allow money market funds to offer higher rates to their clients. At least in theory that is supposed to provide competition for deposits, forcing banks to raise deposit rates and limiting the deposit-to-reserves arbitrage. The FOMC wants to see the spread between IOER and RRP at around 20bp or higher.
Fed Minutes: - The appropriate size of the spread between the IOER and ON [overnight] RRP rates was discussed, with many participants judging that a relatively wide spread--perhaps near or above the current level of 20 basis points--would support trading in the federal funds market and provide adequate control over market interest rates. Several participants noted that the spread might be adjusted during the normalization process.
For example the Fed could set IOER to 50bp and RRP to 30bp. That would put money market rates at say 45-60bp and bank bank deposit rates at something like 25-35bp (currently the national average is 11bp on bank savings accounts), capping the IOER-to-deposit-rate spread.

The FOMC seems to be uneasy about a more aggressive use of the RRP, fearing that in times of crisis the participants will pile all their liquidity into the Fed facility, draining the reserves, and taking liquidity out of the private sector.
Fed Minutes: - Most participants expressed concerns that in times of financial stress, the [RRP] facility's counterparties could shift investments toward the facility and away from financial and nonfinancial corporations, possibly causing disruptions in funding that could magnify the stress.
Some are uneasy with RRP becoming a "window dressing tool", tightening liquidity at quarter- and year-end (see post). The spikes will become particularly severe during periods of financial stress, potentially causing disruptions in private funding markets.

Source: JPMorgan

Some of the Fed officials are also afraid that the Fed could quickly become the dominant player in the repo markets, potentially resulting in some "unintended consequences". RRP will therefore continue to have limits per counterparty and is not expected to persist as a tool much beyond the period of rate normalization.

Some market participants had hoped that the RRP program will release the much needed "quality" collateral into the system, alleviating collateral shortages. The rise in treasury delivery fails continues to plague the markets (see discussion).

Source: JPMorgan

The RRP's impact on collateral shortages however is expected to be limited. Part of the issue (in addition to the RRP being more limited in scope) is that the Fed posts treasury collateral via "tri-party" repo transactions. These securities are held by a custodian bank and will generally not be "reused" as collateral elsewhere.
JPMorgan: - Higher margin requirements as a result of recent regulations on OTC derivative markets, for example, have caused a rise in collateral demand. But securities held within the tri-party system in the US are typically not allowed to be used to satisfy margin requirements. This means that the USTs released via the Fed’s ON RRP facility will not have the same effect in alleviating increased collateral demand stemming from higher margin requirements, than if the Fed had directly sold these UST securities to open markets.
The shortage of collateral will continue to persist even after the end of quantitative easing, which has permanently removed too much collateral from private holders. The only solution is for the Fed to sell some of its holdings, a scenario which remains highly unlikely.

Once the FOMC is ready, the announcement of the rates "liftoff" will be accompanied by the following rate settings:

1. The Fed Funds target and the Discount window rate (traditional tool).
2. The IOER rate
3. The overnight RRP rate (20b or more below the IOER rate) and the size limit per counterparty

Other suggested tools such as term deposits (which the ECB has been using in a limited fashion for some time) are unlikely - too many moving parts for the FOMC.

Assuming things are going OK some time after the "liftoff", the Fed will announce the end of reinvestment, allowing the securities it holds to mature. This will need to happen as soon as possible in order to begin increasing the amount of collateral held by private participants.


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Friday, July 11, 2014

The diminishing returns of fuel efficiency

As vehicles become more fuel efficient, the savings one obtains by further improving the mileage decline substantially. As an example, assume a driver saves $700 per year by switching from a 12 mile/gallon car to a 15 mile/gallon one. Now if that same driver has a car that gets 30 miles/gallon, she would need to switch to a 60 mile/gallon car in order to achieve the same $700 savings. In fact the incremental savings for each additional mile/gallon declines as the inverse square of a car's fuel efficiency.


This does not bode well for the future of alternative fuel automobiles. Saving $700 a year, as the example below shows, may not be worth paying additional few thousand dollars for a car that may be less convenient to "fill up".



Furthermore, as traditional gasoline cars become more fuel efficient, the savings associated with switching fall off sharply. In another few years, unless gasoline prices shoot through the roof (which is not likely), alternative fuel cars (such as electric) will increasingly be more of a "luxury" item rather than a money saving form of transportation. It's just basic math. 
EIA: - As light-duty vehicle fuel economy continues to increase because of more stringent future greenhouse gas emission and Corporate Average Fuel Economy (CAFE) standards through model year 2025, standard gasoline vehicles are expected to achieve compliance fuel economy levels of around 50 mpg for passenger cars and around 40 mpg for light-duty trucks. Diminishing returns to improved fuel economy make standard gasoline vehicles a highly fuel-efficient competitor relative to other vehicle fuel types such as diesels, hybrids, and plug-in vehicles, especially given the relatively higher vehicle prices projected for these other vehicle types.

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Thursday, July 10, 2014

Watching for signs of US housing market activity

The US housing market remains sluggish, as wages, at least at the national level, have not kept up with the recent price appreciation (see post). The reason for these higher prices is that housing inventories remain tight, particularly in the more desirable areas. A great deal of the inventory has been picked up by "cash buyers" that include domestic and foreign investors (including professional investment firms). These investors accounted for over 40% of the homebuyers in the first half of 2014.

Source: Capital Economics

The hope is that with this tight inventory levels we will see more residential construction, even if a great deal of it will go to meet rental housing demand. The recent recovery in lumber futures suggests that construction, which has stalled recently, may be improving again.

Sep-14 futures (source: Barchart)

Another indicator suggests that US homeowners are taking advantage of the tight inventory. The prepayment speeds on 30Y FNMA MBS securities with low coupon have picked up again. The 2.5% and 3% 30Y MBS contain mortgage pools of loans with interest that is significantly below current mortgage rates. Therefore prepayments in these pools mean that these homeowners are selling their homes (nobody would want to refinance into a higher rate mortgage). Sales were expected to pick up this time of the year, but some analysts have been a bit surprised at how quickly prepayment speeds recovered.

Source: JPMorgan

Both of these signs point to improving activity in the US housing market. It remains to be seen however whether this is sustainable or simply a temporary response to lower mortgage rates.

30y fixed mortgage rate (source: bankrate)


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Speculative activity in WTI

Crude oil technicals are not looking great, as the speculative accounts are becoming increasingly net long WTI futures. This is “fast money” chasing a quick Iraq-driven spike. What if it doesn't happen?



While the Iraq risks are quite real, the market remains well supplied and significant price declines are quite possible.

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Tuesday, July 8, 2014

The skills mismatch remains a fixture in US labor markets

The Beveridge Curve, a scatter plot of job openings vs. the unemployment rate, continues to show a structural shift in US job markets.

See this for the definition of the U-5 unemployment rate 

A large part of this shift is the skills mismatch. Companies are increasingly looking for skilled and experienced workers and are having a tough time filling those openings. If you are in retail for example, you will have no problems getting part and full time workers to stock the shelves in your store or run the cash register. On the other hand finding someone with the skills to run a store, even a really small one, is becoming more of a challenge. You'll get dozens of resumes to be sure, but very few with the right qualifications.

One can see this effect in the small business survey data, as more firms are having a tough time filling openings. The US has millions of unemployed or "marginally attached" workers, yet these are not the workers companies want.


Some would say that the reason firms are not getting the workers they want is poor pay. But if you are unemployed - and those of us who have been there know - low pay generally beats the unemployment benefits. Furthermore, at least across small businesses, pay is on the rise. No, it's nothing like it was before the recession, but those days are long gone.

Source: NFIB

Another sign of the American skills mismatch is small business consistently complaining about the quality of labor - something that was much less of an issue a year ago.

Source: NFIB

We can see other examples of this broadening skills gap here and here.

Wages for skilled workers will rise faster than the national average as demand grows. Unfortunately those with limited skills will continue to struggle with stagnant wages and limited opportunities. The days when unskilled workers could easily get a well-paying job in construction are not coming back for some time. Welcome to the New Normal.

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