Sunday, December 14, 2014

The Fed launches Term Reverse Repo Program "experiment", moves short-term rates

The Federal Reserve has been aggressively testing the various monetary tools that will give it additional flexibility during the rate normalization process. In addition to the Term Deposit Facility (see post), the Fed recently started testing the term reverse repo facility (Term RRP - see statement). Note that this is in addition to the Overnight RRP. For those who want to track this program, follow the updates here (see the spike at the end?) The Fed will provide a total of $300bn under the program, with the first such offering completed on Dec-8th. It was a 28-day "secured deposit" paying 10bp (annualized) for $50bn.

Source: NY Fed
At the same time the US Treasury has issued a larger than usual amount of treasury bills recently. Since the Term RRP with the Fed is effectively the same as purchasing a treasury bill (particularly at 10bp), the Fed's $300bn program (combined with the existing facilities) effectively "crowded out" the bills market. This ended up pushing short-term treasury yields higher - while yields on longer-dated treasuries kept falling (see chart).

The Fed's latest monetary tools "experimentation" has also drained some reserves and lowered the monetary base.

For those who still track the Fed’s total balance sheet, don’t – the balance sheet doesn't tell you much about the monetary stance when you have these new forms of “sterilization”. Of course all this is viewed as temporary and the reserves may yet return to their peak levels next year. And judging from current disinflationary pressures (see chart), the actual liftoff - when these tools are going to be implemented on a more permanent basis - may be as long as a year away. For now however these monetary experiments have been sufficiently large to raise short-term interest rates.

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Saturday, December 13, 2014

Draghi now has all the ammunition he needs for QE. Implementation still a problem.

If Mario Draghi was lacking ammunition to initiate an outright quantitative easing program in the Eurozone, he certainly has it now. Even the staunchest opponents will have a tough time arguing against the need for a more aggressive approach to monetary easing. Here are five reasons:

1. The take-up on ECB's TLTRO offering (see post) fell far short of the ECB’s goals. Indeed the demand in the second round of the offering came in at €130 bn, putting the total take-up at €212bn - well below the €400 billion allowance. Since the TLTRO financing is linked to bank lending, the program to some extent relies on demand for credit from businesses and consumers. And that demand has been lackluster in the past couple of years. Therefore the initiatives announced by the ECB last summer, including ABS and covered bond purchases, are simply insufficient for the type of monetary expansion (of about €1 trillion) the central bank would like to see in the Eurozone.

Eurosystem consolidated balance sheet (source: ECB)

2. Some Economic data out of the Eurozone shows recovery stalling. Italian industrial production and French labor markets are just two examples.



3. With the collapse of oil prices, the Eurozone is bracing for deflation. German 5-year breakeven inflation expectations are now at zero. And Europe's central bankers are fearful of repeating Japan's decade-long struggle with deflation.

Source: @PlanMaestro

4. While the euro has declined significantly against the dollar, it remains quite strong on a trade-weighted basis. This is putting downward pressure on prices (via cheaper imports) and is disadvantaging some of the Eurozone-based exporters. A more aggressive easing effort would force the euro lower.

TWI = "trade-weighted index" (source: @TenYearNote)

5. Finally, the euro area's sovereign risks are resurfacing once again - triggered by new political uncertainty in Greece.
The Guardian: - Mounting concerns over Greece’s ability to weather a presidential election, brought forward in a surprise move by the prime minister, Antonis Samaras, continued to unnerve investors ahead of the first round of the vote in the Greek parliament next week.

Under Greek law failure to elect a new head of state by the ballot’s third round on 29 December could trigger a general election. The stridently anti-bailout main opposition party, Syriza, is tipped to win that poll. The radical leftists have made a debt writedown and the end of austerity their overriding priorities if voted into office.

Although Samaras called the election in a bid to expunge the political uncertainty engulfing Greece, the slim majority held by his government, compounded by the leader’s repeated warnings of Greece leaving the eurozone if Syriza assumes power, has accelerated investor nervousness.
The nation's stock market is down 20% over the past 5 days as investors flee.

red = Euro STOXX 50, blue = Athens Composite

And Greek sovereign debt sold off sharply. In fact the 3-year government paper yield went from roughly 3.5% in September to 11% now. This situation alone would make most central bankers consider some form of monetary easing.

Mario Draghi now has five solid reasons to argue for QE and many expect the central bank to announce such an initiative in the next 2-3 months. However, while most economists covering the euro area agree on the need to take a more aggressive monetary action, the problem of implementation remains. Since the Eurosystem's (ECB's) balance sheet is in effect owned by member states, many in the core economies are worried about having to become the proud owners of large quantities of their pro rata share of periphery nations' debt. For the Germans in particular, the ownership of such debt is a major issue. A solution that is even remotely politically palatable across the Eurozone remains elusive. The ECB's independence and the euro area's legal structure is about to be tested once again.

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Sunday, December 7, 2014

The Fed's policy trajectory is tied to global recovery

The latest US payrolls report presents a challenge for the Fed. As discussed back in April (see post), US labor markets are continuing to heal, suggesting that the rate "normalization" should be a serious consideration for the central bank. However the recent deterioration in commodities, especially energy, is "importing" global disinflation to the US (see post). In particular, the Saudi commitment to retake lost market share has sent shock waves through the oil markets (see post).

GCC is a diversified commodity index (source: barchart)

As a result, longer-term market-implied inflation expectations have fallen substantially.

The latest declines in expectations came after the recent FOMC minutes already showed increasing concerns at the central bank:
FOMC: - “Many participants observed the committee should remain attentive to evidence of a possible downward shift in longer-term inflation expectations.”
At the same time payrolls in the US are growing at a rate approaching the pre-recession peak (though still materially below what we saw in the 90s).

In fact the divergence between payrolls growth and inflation expectations is currently unusually high. Payrolls are driven by stronger US domestic economy, while inflation expectations are impacted by external factors, which creates this disconnect.

Red dot represents the current situation

This mismatch is causing a dissonance for policymakers and market participants, adding to the disagreement on the timing of liftoff. Current market expectations for the first hike now point to Q3 of 2015.

Source: CME

However if inflation expectations persist at these levels or worsen, it will be nearly impossible for the Fed to move on rates - irrespective of how much labor markets improve. The bet represented in the chart above is that energy prices will stabilize and/or growth in wages improves substantially by next summer - pushing breakeven expectations higher. But such an outcome, driven to some extent by factors external to the US, is far from certain.

What makes the timing of liftoff particularly difficult to estimate is the value of the US dollar.

Source: barchart

With a number of major central banks either easing or expected to begin easing monetary policy (diverging from the Fed), the rise in the relative value of the dollar will continue. That will bring inflation expectations even lower by weakening US import prices and pressuring commodities. If the strong dollar can make goods and to some extent services from abroad cheaper, there is less incentive for US-based firms to raise wages. Tapping cheaper markets abroad becomes more profitable.

And as the expectations of liftoff draw closer, the dollar will strengthen further, making it more difficult for the Fed to pull the trigger (what some refer to as a "self-correcting" mechanism). It's hard to envision the Fed acting unilaterally in the sea of looser monetary policy worldwide. The policy trajectory of the US central bank is therefore tied to a large extent to the global recovery, which remains elusive for now.

The Fed officials are keenly aware of premature policy tightening by a number of central banks, who were forced to reverse their decisions later.

Source: @themoneygame (Business Insider), Deutsche Bank

What some of these central banks didn't count on was the global nature of disinflation, over which they had little or no control (see chart). In the Fed's case, such a reversal would severely undermine the FOMC's credibility, sending policymakers back to the drawing board.
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Sunday, November 30, 2014

Think homebuilder optimism is irrational? Think again.

The chart below (and similar comparisons) has been circulated widely in the media and the blogosphere. It shows homebuilder optimism (as measured by the NAHB) far outpacing sales of singly-family homes in the United States. Naive reporters and bloggers have been arguing that builders are simply out of touch with reality. How could homebuilders possibly be almost as optimistic as they were prior to the housing recession if new single-family home sales are near multi-decade lows?

Source: @cigolo, Reuters

There are a couple of key reasons for the NAHB index decoupling from new single-family home sales:

1. Builders are targeting higher-end and luxury homes - a market where mortgage availability is less of an issue. That it why the median price of new homes sold is far above the pre-recession peak and continues to rise.

Source: @NickTimiraos

2. US homebuilders are also focused on multi-family structures - rental as well as some high-end condos.

Source: @NickTimiraos

Tighter credit conditions and some consolidation have resulted in reduced competition among homebuilders, with a number of local and regional players closing down after the recession. At the same time rental housing demand is on the rise (see post). Those well positioned in this space will do fine. Therefore, while it is quite popular to poke fun at the "giddy" homebuilders, one should rest assured these businesses are acting quite rationally. And so are their investors. Homebuilder shares have outperformed the broader market since the October correction (see chart).

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Saturday, November 29, 2014

At current prices Bakken and Permian Basin are in the red

Although OPEC's decision to maintain current crude production quotas was not entirely unexpected (see post), the market reaction was violent. WTI crude fell by 10% over the last two days of the week.

At $66 per barrel North American producers have real problems on their hands. While Eagle Ford is still profitable, both Bakken and Permian Basin are in now the red.
Scotiabank: - Based upon an analysis of more than 50 oil plays across Canada and the United States, we estimate that ‘mid-cycle breakeven costs’ in the North Dakota Bakken (1.05 mb/d) are roughly US$69 per barrel and in the Permian Basin in Texas (1.63 mb/d) about US$68. While some producers have hedged forward at higher prices, if WTI oil remains around US$70 for more than six months, it appears likely that drilling activity will slow in more marginal areas of these plays as 2015 unfolds. Funding for independent oil producers will also tighten. However, the ‘liquids-rich’ Eagle Ford (1.45 mb/d) will be little impacted, with breakeven costs averaging only US$50.
That's why we've had such an extreme sell-off in US oil & gas shares on Friday (see chart) and Canadian shares underperformed (see chart). If prices persist at current levels for months to come, the Saudis will achieve their objective of dealing a blow to North American oil production. Current expectations of the US outpacing Saudi Arabia as the number one oil producer (see chart) will be shelved for some time. And the only thing the US government could do at this point to support the domestic oil industry is to begin increasing the Strategic Petroleum Reserve. Of course such a measure would be temporary and if global demand does not improve, prices will begin falling again.

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Wednesday, November 26, 2014

Learning about Black Friday from Google Trends

As usual, economists will be paying close attention to Black Friday shopping, trying to get a glimpse of the overall retail sales this holiday season. Expectations this year are more optimistic than what we saw the last couple of years (see chart).  Can we learn anything from Google search frequency statistics about trends for Black Friday? Here are some results.

1. Global search for Black Friday has been rising steadily since 2005.

Global trend

2. As expected, most searches originate in the US, but not all. The second on the list is Romania.

"Black Friday" relative search frequency by country

Why Romania? Starting around 2011 some retailers in Romania picked up on the US tradition and got consumers hooked on it (across the country).

"Black Friday" search in Romania
There is a similar pattern in the Bahamas (since 2009) and Jamaica (since 2007), though search frequency is no longer growing there. In Paraguay, Black Friday saw a one-time spike in 2012 and limited activity since.

3. Back in the US we see search frequency for Black Friday leveling off over the past three years - probably due to saturation.

"Black Friday" search in US

4. The most interesting piece of information is where in the US the "Black Friday" search is coming from. Here are the top rankings by state.

"Black Friday" relative search frequency by state

Note that except for Ohio, this list represents the six poorest states in the nation. While there is no direct proof, this data would suggest that poverty is an important determinant of interest in Black Friday offers/sales. Therefore the shopping volumes we see later this week may not be representative of the overall holiday sales this year.
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Sunday, November 23, 2014

The Fed concerned about "importing" disinflation

The latest Reuters poll is showing 24 out of 43 economists projecting the first rate hike in the US by June of next year. The futures market is pricing liftoff by September. Citi's latest analysis puts it in December. And all of these forecasts are running way behind the so-called Taylor Rule, which is suggests that the Fed Funds rate should already be at 1.5%.

Source: @Schuldensuehner, Citi

In fact the US economy can easily handle non-zero short-term rates at this point. The banking system is quite healthy and can easily manage funding costs of 1.5%. Corporate borrowers can deal with slightly higher rates as well. And as far as mortgages are concerned (to the extend higher short-term rates extend to longer maturities), borrowers for whom payments become prohibitive at 5% vs. 4% should not be taking out a mortgage to begin with. Furthermore the issue with the housing market these days has more to do with tighter mortgage credit rather than rates.

But it's no longer as much about the US economy as it is about external factors. The international situation has made the Fed's policy planning much more complex. The monetary policy divergence among the major central banks is the issue at hand. With the BoJ suddenly accelerating its QE program, the PBoC cutting rates, and Mario Draghi hinting at a potential QE program in the Eurozone, the Fed is becoming increasingly isolated in its plans to begin rate normalization. Even India's RBI, who has kept rates elevated for some time, may begin to ease soon as the nation's inflation and money supply growth slows.

As a result of this divergence, the US dollar has been on the rise this year.

Of course the recent increase in and of itself is not tremendous relative to historical levels. However, given the disinflationary pressures around the world, the rising US dollar effectively "imports" disinflation into the US. Moreover, the massive drop in energy prices, caused by a combination of a significant rise in North American production and weaker demand globally (as well as the Saudi "dumping"), is adding to slower inflation. In fact, in recent months a paradigm shift has taken place. Weakness in inflation is no longer viewed as a temporary phenomenon as the longer-dated market-based inflation expectation measures turn sharply lower.

Furthermore, professional forecasters are also downgrading their long-term inflation projections.

Source: Deutsche Bank

Even consumer expectations of long-term inflation have shifted.
Reuters: A Thomson Reuters/University of Michigan survey released last week showed that consumers see inflation averaging 2.6 percent a year five to 10 years from now, down from 2.8 percent predicted last month and the lowest reading since March 2009.
It's not going to be about jobs going forward, in spite of the comments we continue to hear from the FOMC. The Fed's focus has shifted to inflation and inflation expectations. And no matter how low the unemployment rate falls, it will be difficult for the Fed to pull the trigger on rates, risking further strengthening of the dollar and more downward pressure on prices. It is possible the Fed will wait for growth in other major economies to stabilize before liftoff in the US. Which is why some economists (like those at Citi) are pushing rate hike expectations further out in time. Unfortunately the longer it takes to get there, the more disruptive the effect of normalization will be on global financial markets - as the Fed's zero rate policy moves into its 6th year and possibly beyond.

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Wednesday, November 19, 2014

Hidden story in US PPI increase

The US core PPI surprised to the upside yesterday.


Improved pricing power for US firms? Hardly. Did you ever have the feeling of being ripped off at the gas station when oil prices are falling while prices at the pump barely move? Well, it’s not just a feeling.
GS: - The headline PPI rose 0.2% in October (vs. consensus -0.1%). The surprise was entirely due to core prices, which rose 0.4% (vs. consensus +0.1%), while energy prices declined 3.0%. Within the core, the volatile trade services category—which measures retail and wholesale margins—rose 1.5%, adding three-tenths to the core. Drilling down further, a sizable part of the jump in trade services came from a huge 26% month-on-month increase in fuel retail margins (i.e., gasoline stations). While counterintuitive in light of the decline in energy prices on the month, the increase in this category reflects retail prices declining more slowly than wholesale prices. On balance, we would heavily discount this month's report in light of the volatility in trade services. The core PPI according to the "old methodology"—finished goods less food and energy—increased a more modest 0.1%.
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