Sunday, July 27, 2014

3 reasons Yellen's FOMC remains dovish

What makes Janet Yellen and a number of other FOMC members so dovish with respect to monetary policy and in particular the trajectory of rate normalization? A Credit Suisse report sites 3 key factors, which Yellen calls  “unusual  headwinds":

1. Tighter fiscal policy.

The combination of lower government spending and tax increases has created a drag on economic growth (see chart). This drag is now diminishing, but given the tepid recovery Yellen still views it as a headwind.



2. Relatively tight credit in the mortgage market.
Janet Yellen: - " ... it is difficult for any homeowner who doesn't have pristine credit these days to get a mortgage. I think that is one of the factors that is causing the housing recovery to be slow. It’s not the only one, but I would agree with that assessment."
A recent study by Goldman compared current lending conditions in the mortgage market with the 2000 - 2002 period (supposedly "pre-bubble" period). The results indeed seem to point to tighter lending standards at this time (see chart).

3. Low household wage growth expectations.

While US wages have been growing at around 2% per year, expectations for growth remain depressed.
Yellen (see House testimony video below): - " ... households have unusually depressed expectations about their own future income gains. And I think weighs on their feelings about their own household finances and is holding back consumer spending."

Source: Credit Suisse






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The US Phillips curve

We've received some questions about the so-called Phillips curve - the relationship between inflation and unemployment. While there are a number of ways to look at the Phillips curve, the services inflation measures are more suitable than the broader price indices in order to assess the relationship. That's because goods inflation in the US can be driven by global trends, while services tend to be more US-specific.

Furthermore, rather than using the headline unemployment rate ("U-3") it is more appropriate to use the "U-5" measure which captures a broader group of unemployed or marginally employed workers. U-5 is defined as "total unemployed, plus discouraged workers, plus all other persons marginally attached to the labor force, as a percent of the civilian labor force plus all persons marginally attached to the labor force".

10 years of data (orange = current levels)


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Thursday, July 24, 2014

The current ECB programs create a QE-like environment, setting up for moral hazards

In spite of weakening economic growth, persistent credit contraction, and dangerously low inflation rate in a number of member states (chart below), the ECB continues to resist calls for Fed-style outright securities purchases. Instead the central bank is betting on the recently announced TLTRO program (see post).

Source: Investing.com

The key reason for avoiding outright quantitative easing is, supposedly, the ECB's fear of creating a moral hazard. With a ready buyer of government debt and low market rates, some member states would no longer focus on cutting deficits.
Natixis: - The ECB’s problem is that it does not want to create incentives for governments to refrain from correcting fiscal deficits or avoid improving their public finance situation. What is rejected by the ECB is the moral hazard that would result from the central bank buying government bonds.
Fair enough. But a recent report from Natixis argues that the combination of the TLTRO lending and the OMT backstop program creates conditions that are nearly identical to quantitative easing.

Any QE program aims to increase the monetary base (by raising banks' excess reserves) and to push down longer term interest rates via securities purchases. As an extreme example of this, consider Japan's massive QE effort (see post). Both objectives have been met: long-term rates are at ridiculously low levels (0.53% on 10-year JGBs) while the monetary base is at a record.

Source: Investing.com, BOJ

Similarly (though not to the same extent) the ECB's programs will mimic QE without actually buying any government securities. Here is how:

1. Long term rates across the Eurozone are already at incredibly low levels. The ECB's forward guidance, weak growth, and recent geopolitical risks have pushed German rates to new lows (see chart). On the other hand the OMT program, often called the "Draghi put", has suppressed periphery yields. Furthermore, with short-term rates near zero and low capital requirements to hold sovereign bonds, the euro area banks have been loading up on this paper in a massive carry trade - pushing yields even lower.

Source: Investing.com

2. But what about increasing the monetary base? The expectations are that the TLTRO program will soon increase the Eurosystem balance sheet by as much as €700 billion. €300 billion of lending is expected to hit the banking system in September and the rest over the next couple of years. The monetary base will begin rising quickly.

The combination of the two items above is effectively QE. So how are the Eurozone member states reacting to this? Natixis argues that the QE-like environment has already created something of a moral hazard by encouraging these governments to pay less attention to their fiscal situation. If borrowing is easy and cheap, the temptation to keep on spending is too great for many politicians. 2014 deficits in a number of the member nations show minimal improvements.

Source: Natixis

Natixis: - The ECB accepts to go very far in the choice of expansionary monetary policies (very long-term repos [4-year TLTRO loans], de-sterilisation of the SMP [see post], forward guidance, purchases of ABS in the future), but for the time being it rejects the idea of quantitative easing with purchases of government bonds. The explanation is the risk that, if the ECB buys government bonds, governments may be encouraged to no longer reduce their fiscal deficits.

But this explanation is of a dogmatic and not an empirical nature: the measures already taken by the ECB have already encouraged governments to no longer improve their public finances
While optically the ECB's programs look different from QE, in reality the central bank has already launched a QE-like set of programs, setting up for a moral hazard which it has been desperately trying to avoid.

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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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