The jump in U Michigan sentiment index is driven by consumer expectations

The US economic news last week was not all negative - in fact it was more of a "mixed bag". The positive news came from the U.Michigan index of consumer sentiment.

Reuters: The Thomson Reuters/University of Michigan's final reading on the overall index on consumer sentiment rose to 75.0 from 69.9 the month before. It was the highest level since February 2011.

The current index level takes us back to where the sentiment measure was in early 2011, before the Eurozone crisis took hold of the financial markets. One question worth considering is how did the sentiment index decline of 2011 compare to a similar period in 2008?  The low point was August of 2011, a month that combined the US budget negotiations, the US debt downgrade, and the escalation of problems in the Eurozone. The sentiment in August was about as low as it was in November of 2008 - the lowest point of the financial crisis. This seems a bit surprising and not at all intuitive, with anecdotal evidence suggesting that 08 felt far worse than 2011.

U Michigan Consumer Sentiment

What drove the sentiment index to levels comparable to 2008? The index actually has two components: the Current Conditions Index and the Consumer Expectations Index. And it was the "expectations" component that pushed the whole index to this low point. In fact according to U Michigan, when it came to consumer expectations, the "end of the world" was coming in August of 2011 - a point on the index that was in fact lower than the expectations measure in 2008 (as shown in the chart below). This is puzzling. Were consumers reacting to all the market driven media frenzy in August that wasn't as prevalent in 2008? Were consumers not as focused on the state of the financial markets in the past as they are now?

On the other hand the "current conditions" component did not dive anywhere close to its 08 lows, which is more in line with other economic indicators.

Components of the U Michigan Sentiment Index

As a comparison let's take a look at another gauge of US consumer sentiment - the Conference Board Consumer Confidence Index. That index was behaving closer to the U Michigan Current Conditions component (above), with a dip that did not rival the 08 levels.

Conference Board Consumer Confidence Index

Some of this difference between these two gauges of consumer confidence was pointed out back in the 80s by some OSU researchers.

Researchers on index comparison:    Thus, it appears that the Index of Consumer Sentiment is capturing consumer reactions to what is happening with financial related factors (e.g., prices and interest rates) and to a lesser extent, such variables as the work week, the stock market, and the employment picture. In contrast, the Index of Consumer Confidence is picking up some additional information on employment related variables, such as the length of the work weeks the accession-layoff rate, and disposable income.

One therefore has to be careful in interpreting the U Michigan consumer sentiment indicator because it is a combination of current conditions as well as expectations. And when things turn ugly in the financial markets, it is more the expectations that drive the index lower, even if current conditions have not deteriorated as dramatically. Just as important is the fact that when markets improve rapidly as they recently have and the index spikes, it is driven more by expectations and not as much by a rapid improvement in current conditions of the US consumers.

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Four facts behind the Q4 US GDP miss

Source: LA Times

The big US economic news last week was that the GDP growth number came in below expectations.

LA Times: The gross domestic product rose at a 2.8% annual rate in the fourth quarter as consumers bought more cars and other goods, the Commerce Department said Friday. That was below the 3% figure many analysts had projected. But it was up from a feeble 1.8% the quarter before.

However it is worth noting that the headline number does not tell the full story.  Here are four facts behind this GDP miss that should be considered:

1. The nominal GDP (vs. the real GDP), which is an important indicator of corporate profit growth was up 3.2%. Many believe that we need 4.0% nominal GDP growth to maintain robust corporate profitability growth. In that sense the nominal GDP number was even more disappointing.

2. A great deal of the GDP growth came from inventory build.

LA Times: More than half resulted from businesses increasing their stockpiles of products rather than from sales of goods and services, which reflect actual demand.

This is not great, because inventory builds are less likely to be repeated soon. This bodes poorly for GDP growth in the current quarter.

3. The Q4 inflation measure used to convert the nominal GDP into the real GDP was quite benign, only 0.4%.  That may explain the Fed's complete comfort with further accommodation.

4. The biggest drag on growth was a 3.7% quarterly decline in government spending. This is clearly a good indication from the government budget deficit's perspective, but is also a sign of what is to come as the US embraces more austerity measures. Without the impact of declining government spending, the nominal GDP measure was actually 4.9% (vs. 3.2% with government spending included).

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Contraction in Eurozone's repo markets is driving M3 decline

Yesterday the ECB released its monetary aggregates measures for the Eurozone through Dec-2011. The following chart shows the absolute level of Eurozone's M3 aggregate, a broad measure of money stock. (Note that at times it is helpful to look at monetary indicators on an absolute basis rather than as percent changes as economists tend to do.)  The upward trend in the money supply growth has reversed, mostly during the last quarter of 2011.

Eurozone M3 in EUR billion (seasonally adjusted)

An obvious question here is whether this broad money supply decline is similar to the US during 2008-2010. One key component of M3 driving this contraction in money stock is the amount of repo (secured) lending. The Eurozone repo loan balances have declined materially in Q4 - an issue that is quite different from what had occurred in the US.

Repurchase agreements (repo) component of  Eurozone's M3 in EUR billion (seasonally adjusted)   

Since repo has become the only form of interbank lending in the Eurozone, this is clearly an indication of deteriorating credit conditions. With the ECB providing longer term financing not available in the interbank repo markets, it is often quite attractive or even necessary for many financial institutions to shift their collateral into an ECB facility (ECB secured loans are not included in the monetary aggregates). LTRO term lending for example provides far more funding stability than rolling short-term interbank repo loans. The ECB has also been considerably more lenient with collateral than the current repo markets. The rapid rise in the ECB's balance sheet (EUR 2.7 trillion) "soaked up" a great deal of the collateral out of the repo markets, dampening growth in interbank credit.

ECB consolidated balance sheet (EUR million)

The pie chart below shows the contribution by country to the drop in the Eurozone repo levels over Q4-2011. Nearly half is coming from Italy as Italian institutions shifted financing to the ECB. It is not surprising therefore that Italy continues to deal with tightening credit conditions that are more extreme than the Eurozone as a whole.

Contribution by country to the Q4 drop in repo component of M3

The unprecedented accommodation provided by the ECB is not yet helping to expand the broad money supply. The banking system has shifted a substantial portion of its eligible collateral from the repo markets to the ECB who is providing longer term stable funding. Only once the dependence on the ECB is reduced and the interbank funding markets begin to heal, will we see a stabilization in M3 growth.

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The fundamentals behind strong HY fund flows

Following up on the post about HY fund flows, the amount of new cash hitting the system has not only been unusually high, but also consistent on a daily basis.  As the chart below shows, we only saw one day of net outflows.

Source: EPFR

Here is the year-to-date cumulative net inflow ($7.4 bn YTD.)

Source: EPFR

It is clear that zero rates is one reason for these inflows, but what about fundamentals of the HY market? Are they really that attractive? Three items driving fundamentals are worth mentioning:

1. Defaults continue to stay near record lows and spreads seem interesting on a relative basis.

Source: JPMorgan

2. Leverage on in HY corporations in the US remains stable.

Source: JPMorgan

3. US corporations' liquidity, even at leveraged companies, has been rising steadily in the last few months (hat tip Royal Arse)

Source: JPMorgan

But even with these strong fundamentals, the speed of inflows we are seeing is unlikely to be sustained for long. The trend is somewhat troubling because a good portion of these flows is coming from retail investors. Some of the more leveraged names, particularly in the CCC range are still quite vulnerable to global economic shocks. Given the recent rally (the US JPM HY Index is up 2.8% YTD), the overall sector could sell off sharply with a sudden surprise out of Europe.

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The Fed extended start of tightening by 3 months, not 18

It looks like some in the media are now using the appropriate language with respect to the Fed's latest action. Reuters, who tends to be fairly accurate in their reporting, described the extended low rate environment as being "probable" instead of "certain".

Reuters: The statement by the Fed, which announced on Wednesday it would probably keep interest rates near zero until at least late 2014 - some 18 months later than the Fed had suggested last year.

Given that we are working with probabilities instead of certainties, how did this event change the the timing of expected rate hikes?  After all the general perception (as per Reuters quote above) is that the rate hike has been extended by 18 months.

The best markets to provide visibility into the Fed's future policy are the Chicago Board of Trade Fed Funds Futures contracts. The chart below compares the implied Fed Funds rates prior to the Fed's announcement as well as now.

Fed Funds rate implied by the Chicago Board of Trade Fed Funds Futures (Bloomberg)

The curve has definitely shifted further out, but not by 18 months as is generally believed. The shift is actually only about three months.  The current curve is implying the first rate hike to be in the early part of 2014. So for those who are planning on zero rates throughout 2014 and into 2015, pay attention to the market - it may tell you otherwise.

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Restoring confidence in the Eurozone's sovereign credit markets

Portuguese bonds continue to sell off as the market focuses on Portugal becoming the next Greece. Portuguese spreads have completely decoupled from the rest of the Eurozone periphery.

Portugal vs. Italy 5y spread to Germany

But Portugal is not trading down in a vacuum - the valuation of the nation's bonds is tied to the outcome of the Greek restructuring process.  The markets are not only reacting to Portugal's insolvency but also to the market structure uncertainty. The sovereign credit markets in Europe are broken and two key events must take place to restore confidence.

1.  The ISDA Committee must do the right thing and trigger the Greek CDS (call this a "credit event"). Even without the Collective Action Clause on Greek bonds, this is a default and should be treated as such. The impact on the market may actually be positive because it will mend (at least in part) the broken sovereign CDS market. This has implications for Portugal as investors will once again view sovereign CDS as potent protection against default (similarly to stock put option holders having the ability to exercise their puts). At least in some cases, holders of Portuguese bonds may choose not to dump their holdings because of the availability of a reliable CDS market (which now trades at 39 points upfront).  Just as important is the fact that banks who are lenders to Portuguese corporations will have a reasonably liquid hedge for their assets. Since there is little CDS traded on Portuguese corporate bonds, a reliable sovereign market could be a good proxy.

2. The ECB must take the same haircut on Greek bond holdings as the private bond investors. It's bad enough that the market views sovereign bond holders as being subordinated to the IMF, the EFSF, and in the future to the ESM. Now also being subordinated to the ECB makes the sovereign bond market look completely rigged. A BNP Paribas research note put it quite eloquently:

BNP Paribas: The ECB has no legal right to be treated as a preferential creditor. Others who bought Greek debt at the time, or who held onto debt they already held, should have been appraised of the ECB’s preferential treatment. The ECB’s standing should have been made clear in law. Not to have done so in advance is not only unfair, but it also distorted the markets. If the ECB knew in advance that it would be treated more favourably than the private sector sellers it bought its bonds from, then it acted unfairly and abused an asymmetric information advantage;

Yes, Germany and others in the Eurozone will be upset because the ECB's loss in Greek debt will wipe out more than a year's worth of earnings and may require an injection of public funds.  But the ECB must take a loss in order to assure investors that private holdings are pari passu with the ECB's positions. Otherwise investors will be constantly worried about the amount of ECB's holdings to determine the size of the ECB's "senior tranche" vs. their "junior tranche". The same bonds having two seniority levels depending on who holds them is not a viable market. Not only will this further impair existing Portuguese bonds, but will make it impossible for Portugal and Greece to return to the markets even after they restructure.

The Eurozone must take other steps as well to restore confidence in the sovereign credit markets, but these two actions are critical not just for Portugal but for the rest of the euro area periphery.

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The chase for yield is on

The US high yield (HY) market is starting to look somewhat frothy. We've had over $7 billion of fund inflows this month with $2.5 billion this week alone. Of the $2.5bn, roughly $1.5bn went into HY mutual funds and $1bn into HY ETFs. That compares to about half a billion into mortgage-backed bond funds and $700mm into muni funds (according to EPFR Global). With the Fed on hold for a while, investors are chasing yield.

For HYG (HY ETF) for example, the growth in the number of shares has been unprecedented, and the ETF again now trades at a 2% premium.

HYG Shares Outstanding (Bloomberg)

One can also see rising risk appetite in the HY primary market as well.  Some new issues that hit the market are quite risky.  For example Realogy, a company that nobody would look at a month ago, comfortably sold new bonds.

LCD News: Realogy's return to market was met with strong demand, with both tranches of secured notes pricing tight to talk, and the paper is volatile this morning in post-break trading. The 9% intermediate-lien notes due 2020, for instance, are pegged at 100/100.25 in the Street, against a break around 101 and trades earlier this morning at 100.375, according to sources. Pricing was at par.

Realogy's 7.625% notes due 2020 also priced at par, and this morning's markets are generally at 100.5/101, sources said. Meanwhile, the previously outstanding 11.5% exchange notes due 2017 are trading at 95.75 this morning, versus 95 yesterday but 90 before the new issue hit the market, trade data show.

The company is highly leveraged and is extremely vulnerable to economic shocks. (For those interested in learning more about Realogy's "distressed" past, read this excellent post).

Spreads are still above last summer's lows and the fundamentals are strong, but we could easily see a pullback in this market. 

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Cap-and-Trade is dead, even in California

With the collapse of the CCX carbon credit trading, the only viable market based program for carbon emissions reduction has been developed at a state level in California. In conjunction with Cap and Trade, California implemented a law called California’s Low Carbon Fuel Standard (LCFS). Recently however Judge Lawrence O’Neill issued an injunction to stop LCFS from proceeding as planned.

The sticking point seems to be the discriminatory nature of the program against power generated outside the state that is viewed as hampering interstate commerce. This is why such programs are difficult to implement at the state level vs. nationally.

Judge O’Neill: "California is attempting to stop leakage of GHG emissions by treating electricity generated outside of the state differently than electricity generated inside its border. This discriminates against interstate commerce.”

Legal experts now believe that this injunction will also derail California's Cap and Trade program.

Marten Law: With respect to electricity, the cap-and-trade program imposes requirements on emissions of fossil fuel-based generation in California, requiring an allowance to be submitted for each ton of regulated GHG emissions in California. In order to avoid leakage of emissions to other states, California has imposed an allowance requirement on imported electricity representing the emissions of GHGs imputed to such electricity.

California Air Resources Board who sponsored these initiatives will appeal the LCFS injunction, but for now the whole program has been put on hold.

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With Hollande in the lead, France may be making a shift to the left

With a dimming employment picture in France, chances of a potential regime change in that nation have increased substantially. Sarkozy, should he decide to run again, will be opposed (among other candidates) by the Socialist candidate, François Hollande, who was chosen by his party in the October primaries.

Based on Intrade probabilities, Hollande now has an over 65% chance of winning the presidential election this spring (although trading volumes have been quite low.)

Probability of Hollande winning the 2012 presidency

The opinion polls on the most likely scenario of Hollande vs. Sarkozy (in the second round of voting) paint a similar picture.

Source: BNP Paribas

WSJ: The poll, carried out by CSA Jan. 23-24, showed that 31% of potential voters would chose Hollande if elections were held now, while 25% of them would pick Sarkozy, CSA said. Hollande gained two percentage points, while Sarkozy lost one point since the last comparable poll held by CSA Jan. 9-10.

Other candidates such as a centrist Francois Bayrou could change the political landscape (it's not a two-party system like the US.)  Also the far-right candidate Marine Le Pen, who would push for France's exit from the Eurozone, has gained some ground. But for now it looks like Hollande is ahead. This is a significant development for the financial markets in France and may have implications for the Erozone as a whole. 

Bloomberg: “We must make an effort for more fairness and to rein in the financial industry,” Hollande said today as he detailed his campaign platform in Paris. “We will separate the speculative sector from the credit sector.” 

Hollande will clearly push for new French laws that would be similar to Vicker's recommendations in the UK. Other financial regulation such as prohibiting stock options could be considered as well .

Reuters: "In the battle ahead, my main adversary has no name, no face and no party. He will never run as a candidate. He will never be elected, but he rules inspire of all that. My adversary is the world of finance," Hollande said to a standing ovation in a packed conference hall on the northern outskirts of Paris.

Hollande would be the first Socialist president since Francois Mitterrand. Mitterrand too was not very fond of financial services:

Reuters: Mitterrand, who ruled France for 14 years, won power in 1981 a decade after he became Socialist Party leader with a similar tirade against what he then called the "power of finance, finance that corrupts, finances that buys, flattens and ruins, finance that rots through to the very conscience of man."

This election is particularly important given the pressure on Eurozone banks, the new Eurozone treaty and subsequent implementation of the ESM. Such change of leadership in France may even shift the balance of power in the Eurozone and potentially challenge the current state of Franco-German relations. In particular Hollande may pressure the Germans to have the ECB embark on quantitative easing involving direct purchases of sovereign bonds. This in what Hollande calls tackling "speculation efficiently".  Because to a true Socialist any negative market reaction is just another form of speculation.

Bloomberg: “I know how much you hold dear the rules on the independence” of the ECB, Hollande told delegates at the German socialists’ annual convention. “But equally I want it to take more notice of the situation in the world of the real economy.” The ECB must use its powers “fully” to combat the crisis, “expanding its role as a credit source to tackle speculation efficiently,”

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The squeeze on dollar funding in the Eurozone continues

The latest data on US money market funds is continuing to show reduction in holdings of Eurozone banks' commercial paper (CP). Again, money funds do not sell their CP, they just let it mature without rolling into new paper from the same banks.  Instead money market funds are buying Australian, Canadian, Japanese, and some UK bank paper (in addition to their holdings of US CP).

Non US holdings by US money market funds (Source: Fitch)

These Eurozone banks in turn are replacing their dollar funding with dollar loans from the ECB via the Fed's liquidity swap.

Fed Liquidity Swap

The impact of this transition will be a substantial reduction of dollar assets and even whole dollar businesses at European institutions. US corporations, real estate firms, US energy projects (where some European banks used to be active), etc. should not expect to see substantial new lending from  Eurozone banks going forward.  Dollar lending business will now be dominated by US banks who have easy access to dollar funding.   

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