Wednesday, April 16, 2014

ECB moving closer to unconventional policy

The ECB received another set of disappointing inflation reports today. For some time now the central bank has been betting on the fact the declining inflation figures were driven by food and energy, while the core CPI rate was recovering. Well, that didn't turn out to be the case, at least for now.

Eurozone core CPI (source:

With the euro remaining at lofty levels, the ECB is beginning to prepare the markets for new monetary stimulus, as the various officials discuss "unconventional" policy.

BW: - After building a reputation as a nay-sayer on the European Central Bank’s Governing Council, the Bundesbank president’s [Jens Weidmann's] support for large-scale asset purchases marks a shift that helps the fight against deflationary threats. His tentative backing of quantitative easing will shore up its credibility as officials debate whether they need to implement it.
WSJ: - "Should further monetary accommodation be needed, it is reasonable to consider other operations aimed at lowering the term premium. This is where targeted asset purchases enter the toolset of monetary policy," Mr. [Benoit] Coeure said in prepared remarks to an International Monetary Fund conference.
WSJ: - Mr. [Ewald] Nowotny, who is a member of the ECB’s governing council, signaled that his preference would be for any ECB stimulus to be geared toward Europe’s asset-backed securities market, which may in turn boost the flow of credit to the economy. He said he is open to setting a negative rate on bank deposits parked at the ECB, but raised doubts about the effectiveness of such a move.

“We are preparing all the technical aspects of a range of possible interventions,” Mr. Nowotny told The Wall Street Journal on the sidelines of meetings of the International Monetary Fund.
Of course there doesn't seem to be an agreement on the type of unconventional policy the central bank will undertake. Things like a negative deposit rate for example have been discussed. But if the decision is to buy assets, what types of assets would the central bank focus on? Some of the recent discussions centered around ABS securities and other types of bonds that would provide credit to smaller and medium-sized businesses. The problem with this strategy is the market size. Thanks in part to Basel capital rules, the ABS market in Europe isn't sufficiently large (Basel regulators have referred to these securities as "toxic"). And since only the higher rated paper qualifies for ECB collateral (which is presumably the only bonds that the central bank would be permitted to buy), there isn't enough to have a credible QE program.

Source: DB

It seems the ECB wants to stay away from simply buying sovereign debt, particularly of periphery governments (for obvious reasons). Buying only the core states' bonds on the other hand could be even more problematic. Moreover, lowering government bond yields is unlikely to stimulate private credit growth (after all it hasn't thus far). The central may also stay away from uncovered bank bonds for the same reasons it wants to avoid periphery sovereign paper. This leaves corporate paper - bonds and even direct loans to companies bought in the secondary market. Hard to imagine a central bank buying corporate paper, but it has been done in Japan, so why not in the Eurozone?

Deutsche Bank has compiled an excellent chart of the ECB's options based on the effectiveness of the purchases in stimulating growth (getting capital to where it is most needed) vs. the size of the QE program. The tricky part is that the more effective the monetary transmission, the riskier are the assets.

These are some difficult choices for the ECB and the central bank may want to wait longer to see if the inflation picture improves and/or the euro declines. It may however end up being a long wait.
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Tuesday, April 15, 2014

Has inflation in the US bottomed out?

Some analysts are beginning to suggest that inflation in the Unites States may have bottomed. As discussed earlier this years (see post), US inflation indicators were pointing to the lowest rate since 2009. Are the global disinflationary pressures going to push the rate of price increases in the US to new lows or have we hit the bottom?

First of all, what is the market telling us? Market expectations of future inflation remain subdued, with the so-called breakeven (implied from TIPS) rates still near the 3-year low.

5-year breakeven rate (source: Ycharts)

The situation with consumers is similar - inflation expectations remain low relative to historical data.

With expectations at the lows, why are some analysts calling the bottom on inflation in the US? Here are a few reasons:

1. Looks like producer prices are showing signs of life, as the latest PPI figure came in above expectations.


The index has recently been changed to include a larger swath of the economy and it was those newer components which showed increases.
GS: - Headline producer prices rose 0.5% in March (vs. consensus +0.1%), while core prices rose 0.6% (vs. consensus +0.2%). The largest contributor to the unexpectedly large gain was trade margins—an implicit profit measure—which rose 1.4%. Within this category, there were large gains in flooring (+8.1%), chemicals (+4.7%), cleaning supplies (+4.0%), and apparel (+3.3%). The stronger March figures in this category followed a 1.0% decline in February, which pulled the core PPI down to -0.2%. The PPI for finished goods ex-food and energy—the "old" core PPI—rose a more typical 0.1%, consistent with subdued pipeline inflation.
Nevertheless this increase got some people thinking.

2. Today's CPI increase was also firmer than expected (see story), a great deal of which was due to rising costs of shelter and food (not great for the US consumer).

3. In spite of the weakness in some commodity prices driven by China's slowdown (see post), commodity indices are generally off the lows.

DJ UBS Commodity Index
CRB BLS Spot Commodity Index (source: Barchart)

In particular, the energy sector rallied recently, with both gasoline and natural gas prices on the rise.

4. Some senior Fed officials are beginning to talk about inflation bottoming out (could of course be wishful thinking).
James Bullard: - "One thing you can say is that while inflation has drifted down ... it kind of bottomed out in the past nine months, and I think it's poised to go higher, back towards our target"
Given the data thus far, it's difficult to make a reasonable projection at this point. With low inflation priced in however, any turnaround will take the markets by surprise.
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Sunday, April 13, 2014

Don't bet on treasury rally to continue

Treasuries rallied sharply last week, mostly on the back of the sell-off in equities as well as in response to the Fed's seeming backpedaling on the timing of rate hikes.

10y Treasury Note Futures (source:

While the equity market pullback makes sense for a number of reasons (including increased leverage and momentum driven activity in a number of shares), the treasury market rally does not. Reading the dovish tea leaves of the FOMC minutes is counterproductive. The Fed's reluctance (see story) to support its own FOMC members' projections of higher rates by the middle of next year - which are quite realistic - simply serves to confuse the market. It's about time the Fed realizes that the US economy can withstand (and in fact could benefit from) higher rates.
Scotiabank: - We think rate hikes next year are a reasonable thing to expect and that the forecast pace is not unreasonable. Indeed, quite frankly, neither do the majority of FOMC officials themselves. Recall that the projections of FOMC officials became more hawkish at the March 19th FOMC meeting when more Fed officials (10 of 16) projected that the Fed funds target would equal 1% or more by the end of next year. This is reflected in chart 2 which is a recreated version of the Fed’s famous dot plot that shows the fed funds target forecasts of individual FOMC officials. Presumably not all 10 of those individuals think that higher rates will commence late in the year and are more spread out in their forecasts, thus making hikes starting in Q2 or Q3 eminently reasonable. More officials also projected a Fed funds target of 2% or greater by the end of 2016 (12 of 16).

It can't be both ways by way of talking down the risk of rate hikes while still forecasting them. Suppressing yields in the short-term only aggravates the potential for disruptive market behavior later. The Fed either has a forecast to which the balance of Fed officials are committed, or it doesn’t. I might not have views identical to those of all of my bright, ambitious colleagues surrounding me, and thus emphasize different risks to a house view. But conducting policy gives each individual one vote and that weighted perspective on Fed views is turning more hawkish, full stop and regardless of attempts by the Fed’s communications subcommittee to massage the market outcome.
The big debate among the FOMC members has been around the amount of slack in US labor markets. The focus has been on falling labor force participation which is to some extent due demographics.
Wells Fargo: - Compared to previous decades, cyclical factors have played a larger role in the path of the participation rate in recent years as labor market weakness continues to keep some potential job seekers from looking for jobs. However, the participation rate began to decline in 2001, well ahead of the recession, amid demographic and cultural shifts independent of the business cycle. The secular forces of higher female participation and the baby boomers entering their prime working years that led to a four-decade long rise in labor force participation have now reversed. Female participation peaked in 1999, and in 2001 the first of the baby boomers turned 55 years old—an age at which participation begins to decline notably. We find that demographics alone have accounted for about half of the decline in the labor force participation rate since 2007.
The reality is that as the headline unemployment figures continue to improve and wages begin to pick up, the Fed will be forced to hike rates in spite of weaker labor force participation. And key US employment metrics clearly point to ongoing improvement.
Gallup's Job Creation Index

For those who have been jumping back into treasuries as a result of the Fed's perceived dovish stance or as a hedge to equities, be prepared for a disappointment.
Barclays Research: - At current levels, we believe outright short duration offers a good risk reward as well. The market has gone too far in discounting the move higher in the “dots” [individual members' forecasts for higher rates] at the FOMC, which was largely driven by an improving outlook of the labor market.
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Friday, April 11, 2014

Shifting bottlenecks in US energy markets

With the startup of TransCanada's Cushing Marketlink pipeline and increased rail shipping of crude directly to the US Gulf Coast (bypassing Cushing, Oklahoma), a new dynamic in the US energy markets is taking shape. The glut of crude at Cushing (see post form 2012) that used to put downward pressure on WTI is over.

With the transport backlog to the Gulf Coast diminishing, crude supplies at Cushing (the delivery point for WTI futures) fell significantly, once again contributing to tighter Brent-WTI spread. Lower supplies at Cushing raised WTI prices while Libya resuming crude exports lowered Brent prices.

Brent-WTI spread (source: Ycharts)

This development however created another bottleneck. The oversupply of crude has shifted from Oklahoma to the US Gulf Coast.

Source: EIA

Bloomberg: - Houston and the rest of the U.S. Gulf Coast have more crude oil than the region can handle. Stockpiles in the region centered on Houston and stretching to New Mexico in the west and Alabama in the east rose to 202 million barrels in the week ended April 4, the most on record, Energy Information Administration data released yesterday show.
One of the key issues is the US crude oil export restriction. Back in the 70s, the US Congress made it illegal to export domestically produced crude oil without a permit. And permits are tough to get these days, given how unpopular the notion of US oil exports seems to be. The Jones Act which restricts shipping among US ports is also adding to the bottleneck. 
Bloomberg: - Storage tanks are filling as new pipelines carry light, sweet oil found in shale formations to the coast and U.S. law keeps companies from moving it out. Most crude exports are banned and the 13 ships that can legally move oil between U.S. ports are booked solid. The federal Jones Act restricts domestic seaborne trade to vessels owned, flagged and built in the U.S. and crewed by citizens.
Now it's the refineries who will need to clear this inventory and ultimately export the excess product. And that's exactly what is taking place currently, as idle US refining capacity hits a multi-year low.

Source: EIA
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Thursday, April 10, 2014

Renewed pressure on the ECB

Pressure continues to build on the ECB to act. As discussed earlier (see post), the central bank may remain on the sidelines for some time, but the latest developments (listed below) make this inaction increasingly difficult.

1. Declines in liquidity have been quite sharp. The Eurozone banks' excess reserves are still declining, touching the levels not seen in years.

Source: ECB

2. The French inflation report that came out today shows price increases which are materially below the central bank's target and seem to be trending lower (see chart). Disinflationary risks remain.

3. The euro is grinding higher, which is not great for the area's exporters and will put further downward pressure on prices.

EUR/USD (source: MarketWatch)

4. China's slowdown will also have a negative impact on the area's economy because China represents the Eurozone's third largest export market outside of the EU. The fact that China's imports unexpectedly fell by 11% is not great news for the euro area's recovery.

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Wednesday, April 9, 2014

4 key reasons for CAPEX accelerating

We've received a number of e-mails regarding the recent post on the possibility that rising CAPEX spending in the US is driving corporations to tap their credit facilities, thus increasing loan growth (see post). Most were highly critical of this line of thinking in their comments, using words such as "bogus", "propaganda", "head fake", "delusional", etc. Thanks for all the feedback. The argument that "things are different this time" understandably meets a great deal of skepticism, especially after a number of false starts and years of uncertainty. But evidence for a significant rise in corporate CAPEX spending continues to build. One could write a dissertation on this topic, but let's just look at 4 key data points:

1. Diminishing uncertainty. As discussed earlier (see post) federal government policy uncertainty (fiscal and monetary) that has been hounding corporate CEOs and investors for years has finally subsided, at least in the nearterm. Even the politically charged uncertainty around the implementation of Obamacare has been receding (more on this later). We can debate about the merits of the various policies but it is often the uncertainty more than the policy itself that spooks corporate decision makers.

The other trend that is often overlooked when discussing corporate spending in the US is the recent period of relative calm in the Eurozone. While the area's current economic malaise isn't great for US firms, it is important to remember that during 2011 - 2012, the risk of the monetary union's collapse was quite real. Imagine trying to make a major corporate expenditure decision when the world is concerned about Italy's or Spain's ability to roll government debt, as these nation's banking systems teeter on the verge of insolvency. Many of the structural issues that caused this crisis are still with us today, but the ECB's backstop dramatically reduced the nearterm uncertainty.

The constant barrage of scary news is receding, as the news-based uncertainty index finally drops to its pre-financial-crisis levels.

Source: Economic Policy Uncertainty

2. Corporate infrastructure is aging. From software to planes to telecommunications equipment, companies have severely underinvested in recent years, and it's time to start upgrading. Consider the fact that the average age of fixed assets such as factories, storage facilities, etc. is at levels not seen in nearly 50 years.

Source: BofA/Merrill Lynch

Moreover, some economists argue that slow productivity growth in recent years (discussed here) is a direct result of weak corporate spending. With plenty of cheap labor one didn't need to be too efficient in order to be profitable. But at some point companies will need to upgrade their aging technology and infrastructure in order to improve worker productivity.

3. CEO confidence. Based on the analysis done by Charles Schwab, CEO confidence tends to lead key CAPEX expenditures. And CEO confidence has risen sharply in recent months.

Source: Charles Schwab

4. Investors.  Shareholders are demanding that companies begin using more of their massive cash balances toward CAPEX. The chart below from Merrill Lynch is quite compelling.

Source: BofA/Merrill Lynch

It seems that the stage is set for corporate spending to finally accelerate. And yes, the experiences of recent years make this possibility hard to accept for some. But evidence continues to mount.
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Monday, April 7, 2014

Non-student-loan consumer credit growth leveling off

Consumer credit growth for February came in considerably better than expected in spite of the economic soft patch this winter.
BW: - The $16.5 billion advance in credit exceeded all estimates in a Bloomberg survey of economists and followed a revised $13.8 billion gain in the previous month, Federal Reserve figures showed today in Washington. The median forecast in the Bloomberg survey called for a $14 billion increase.
It is important to point out however that in order to track the actual private sector consumer credit measures, one must remove the government-sponsored student loans that have been distorting these reports. The non-student-loan consumer credit growth has leveled off recently, rising at around 2.5% per year (as opposed to over 5.5% when student loans are included).


This spring we will probably see an improvement in this rate, especially as auto loan demand picks up. However with wage growth remaining subdued at just above 2% per year (see chart below), it should not be a surprise that consumer credit growth has leveled off. Households still remain cautious on leverage.

Non-student-loan consumer credit outstanding was growing at a rate that is in the neighborhood of 6% during the years preceding the financial crisis. With wage growth constrained for now, there is little chance we are returning there in the near future.
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Disinflationary pressures beyond the euro area

According to the Conference Board, disinflationary pressures are not limited to the Eurozone and can be seen across a large number of the "developed economies". The so-called "Harmonized Indexes of Consumer Prices" or HICP (a measure of inflation that has been standardized based on the EU definition) seems to show consumer prices weakening broadly, with only a couple of exceptions.
The Conference Board: - “While the Euro Area has been nearing the deflationary boundary over the past several months, countries outside the monetary union are not spared that same concern,” said Elizabeth Crofoot, Senior Economist with the International Labor Comparisons program at The Conference Board. “Price growth is nearly zero in Denmark and Sweden, and has once again reached deflationary territory in Switzerland, last seen in May 2013. In contrast, after years of having the lowest inflation rate, Japan—together with Norway—is experiencing the highest inflation among the countries compared.”
Source: The Conference Board

In the US the TIPS market seems to agree with this assessment as the breakeven rates remain subdued (see chart). The HICP trend in the next two months will be critical. It will drive the monetary policy trajectory across key economies, particularly in the Eurozone which is now coming to terms with the possibility of QE (see story).
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