Sunday, October 19, 2014

The good, the bad and the ugly of falling energy prices

The recent correction in the price of crude oil should have an immediate positive impact on the US consumer as well as on a number of business sectors. However there also may be a significant economic downside to this adjustment. Here are some facts to consider.

1. The good:

The US consumer is not only about to benefit from materially lower gasoline prices (see chart), but also from cheaper heating oil.
Source: barchart

With wages suppressed, the savings could be quite impactful, particularly for families with incomes below $50K per year.
Merrill Lynch: - ... consumers will likely respond quickly to the saving in energy costs. Many families live “hand to mouth”, spending whatever income is available. The Survey of Consumer Finances found that 47% of families had no savings in 2013, up from 44% in the more healthy 2004 economy. Over time, energy costs have become a much bigger part of budgets for low income families. In 2012, families with income below $50,000 spent an average of 21.4% of their income on energy. This is almost double the share in 2001, and it is almost triple the share for families with income above $50,000.
Source: Merrill Lynch

Furthermore, with gasoline prices lower, it is unlikely that consumers will be buying significantly more of it than they have been. Historically when oil prices fell, gasoline consumption in dollar terms also fell. Dollars saved on fuel will be redirected elsewhere in the economy.

Source: Scotiabank

Moreover, suppressed oil prices will, at least in the near-term, keep inflation expectations lower. That means lower short-term rates for longer (see chart) and therefore lower home equity and adjustable rate mortgage monthly payments. It also means lower longer-term rates and cheaper fixed rate mortgages (see chart). We may even see some new refi activity.

Other benefits include cheaper transport (potentially lower travel costs) and shipping costs (lower UPS/Fedex surcharges), as well as cheaper PVC, nylon, polyester, foam, etc. - all of which should benefit the consumer.

2. The bad:

The US has become a major energy producer, with the sector partially responsible for improving economic growth and lower unemployment in recent years. As an example here is the GDP of Texas as a percentage of the US GDP. This trend is driven in part by the recent energy boom in the state.

Source: @M_McDonough

If oil prices remain under pressure, this boom could soon be in jeopardy. While large US energy companies are sitting on a great deal of cash, at some point they will begin to cut portions of the higher cost development and production. And private investment into energy and oil services firms, which has been brisk lately, is likely to moderate. For example, here is the private debt and equity capital flowing into various states last month.

Source: CAZ Investments

While, only a portion of the funds going to Texas is directly energy related, various other Texas firms funded by PE (including some real estate, manufacturing and financial companies) have been benefiting from the energy boom. Soon that flow of private capital may slow dramatically.

To put this into perspective, here are the jobs directly generated from Texas oil and gas extraction in recent years. And this does not include the thousands of jobs that support this industry. Such trend is unlikely to continue if oil prices remain at current levels or fall further.



In fact, while the overall industrial production growth in the US has been strong recently (see chart), a big portion of the gains are energy driven (see chart from Lee Adler). A slowdown in that sector will be quite visible across the US.

3. The ugly:

A significant number of middle market energy firms in the US - many funded via private capital (above) - are highly leveraged. The leveraged finance markets are becoming quite concerned about the situation - even for larger firms with traded debt. Here is the yield spread between the energy sector loans in the Credit Suisse Leveraged Loan Index and the index as a whole.

Source: Credit Suisse

Rumors have been circulating of a number of energy (and related services) firms getting ready to "restructure". There are also stories that some large funds are gearing up to scoop up distressed debt of levered energy firms. However, in spite of the ample liquidity out there, bets on companies with significant commodity exposure will be limited going forward - at least until stability returns to the oil markets. Defaults, layoffs, and cancelled projects in the energy space may be in store in the near-term. And that is sure to have a negative impact on the US labor markets and the economy as a whole.

Finally, this is terrible news for the development of alternative energy sources. At these prices, fossil fuels are becoming increasingly difficult to compete with.

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Friday, October 17, 2014

Big move for vol of vol

Staying with the volatility theme, the latest jump in VIX was clearly dwarfed by what we saw in 2008 or even in 2011. However that's not true for the volatility of VIX - the so-called "vol of vol". The CBOE's VVIX Index, "an indicator of the expected volatility of the 30-day forward price of the VIX" (see description), has been comparable to or higher than what we saw during those high stress periods. The possibility of VIX doubling or even tripling ("tail" risk) does not seem outside of the realm of possibilities these days - even from the current elevated levels. And traders are willing to pay a relatively high premium to be able to take advantage of such moves.



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Thursday, October 16, 2014

Implied vol dislocation

The recent spike in volatility has created a "dislocation" in US equity options markets. VIX, which is a measure of implied volatility for large cap shares is now higher than RVX - the small-cap equivalent. This is highly unusual, since small caps tend to be more volatile. Part of the issue is the outsized spike in the volatility of large energy shares due to the recent sell-off in crude oil.






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Convergence

The ECB can continue to argue that economic conditions in the Eurozone are nothing like those in Japan. The markets say otherwise ...





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Tuesday, October 14, 2014

Disinflation spreads to the UK

Italian consumer inflation remains in the negative territory (see chart), as the nation's economy struggles to grow. But Italy is not unique - the rest of the world is catching the Eurozone's disinflationary flu. China's latest CPI print for example came in below that of the US - something we haven't seen until recently (see chart).

The UK is also facing weakening inflation. Prices continue to fall at the wholesale level, with British firms still having little pricing power (see chart). It's difficult to raise prices when everything is marked down across the Channel. For the UK's consumers, inflation is now at the lowest level since the Great Recession - for both the headline and the core CPI.


It's difficult to see how the Bank of England can begin raising rates in such an environment - even with the housing market remaining strong (see chart). With oil prices collapsing, inflation is only going to move lower. Just as the case with the Fed (see post), the forward rates markets are pricing in an increasing delay in liftoff. The BoE is on hold at least until next summer as disinflation spreads to the UK.

Markets' expectations of the UK overnight rate (source: BoE)


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From our sponsor:

Do Central Counterparty Clearing Houses (CCPs) have enough capital? A closer look at the CME.

Guest post by Jasper Tamespeke

I was bemused to read the other day a news report that ISDA chair Stephen O’Connor has stated that the major CCPs (LCH and CME) ‘probably’ have enough capital. Bemused because as far as I can see CME Group doesn’t have any real capital at all.

To understand this, we have to do a bit of forensic accounting. Not very exciting, but given the central role the CCPs have been given in clearing OTC derivatives in the future, it is important.

According to CME Group’s 10-K for 2013 the group had stockholders equity of $21.6 billion, which appears to be very healthy. However, when regulators and credit analysts look at a Financial Institution they will critically assess the assets on the balance sheet and deduct from capital any assets that cannot be readily realised in a crisis (which is when we need capital). They particularly focus on intangible assets such as goodwill (what someone pays to buy a company above the tangible value its assets, the franchise value). In CME Group’s case, there are a lot of intangibles: goodwill of $7.6 billion, other intangibles of $2.7 billion and a whopping $17.2 billion relating to Trading Products. In total these amount to $27.5 billion and therefore tangible equity is about $6 billion negative.

The most important number here is the trading products. This is the ‘brand value’ of futures contracts acquired in the mergers with other futures exchanges, particularly CBOT and NYMEX. These have been capitalized on the basis that such products have to be licensed by the CFTC and the license has no expiry date. In theory, it is not difficult to create rivals to CME’s valuable contracts, but anyone who remembers Eurex’s attempts to set up a rival to the Eurodollar Future a decade ago knows that CME’s franchise is implicitly protected. However, there is no guarantee against a less monopolistically inclined regulatory framework being developed in future, and it seems to me that this accounting is really just window dressing: the ‘mergers’ (really takeovers) naturally generated a lot of goodwill, but if it is rebranded ‘Trading Products’ this sounds much better and makes the balance sheet look superficially stronger.

To me, this is a sobering thought for Sober Look readers : possibly the largest CCP in the world (certainly the largest clearer of exchange traded derivatives) has no capital.

But how can this be? CCPs are regulated so surely they must be required to have capital? CME Group Inc. is the holding company of the group and not itself the CCP, and therefore (I presume) not directly subject to the CFTC’s capital requirements. The CCP is a division of its most important operating subsidiary, CME Inc. CME Inc. does have about $1 billion of capital. How is this possible, given that CME Inc. is wholly owned by CME Group? As far as I can see, this is achieved through a bit of alchemy called double leverage. CME Group has about $2.85 billion of long and short term debt and part of this is used to provide equity capital for CME Inc. CME is not regulated under the Basel regime, which has been subject to much criticism, at lot of it justified. However it does at least require that capital requirements are met on a consolidated basis, which would stymie this sort of manoeuvre.

So there appears to be some clever creative accounting going on here. But does this really matter? Anyone who has spent more than 5 minutes studying CCPs knows that capital is not really relevant in protecting them against counterparty credit risk, which is what they are about. The main line of defence is Initial Margin, and to a lesser extent the Default Funds, which are there as a top-up if extreme losses run through the margin deposits. And CME has a veritable wall of money here: nearly $120 billion at end 2013. So $1 billion of capital, whether it is real or not, gets lost in the roundings.

I think it does matter for a number of reasons. The money of members and their clients may be the primary mitigants against a CCP’s credit risk, but what happens if there is an operational failure (e.g. if systems errors lead to a CCP having an unbalanced position, creating losses in a volatile market)? Here the primary loss absorber should be capital. Double leverage makes a group more fragile if there are problems. The holding company’s debt has to be serviced by upstreaming dividends from its subsidiaries, but if they are subject to prudential capital requirements this may not be possible, increasing the risk of default (although at the moment CME does generate prodigious cash flow).

Also it is important that CME’s shareholders have skin in the game. Most of the CCPs these days are public, profit seeking companies and it is important that they operate with the right incentives (not that the banks and brokers can complain too much about this, as they opportunistically sold their seats and relinquished control in the course of the last decade in pursuit of a quick buck).

It matters most of all because we are concentrating so much potentially lethal risk in 3 or 4 critical nodes in the financial system. G-20 politicians made a fateful decision in 2009,moving from the (arguably reasonable) declared aim of requiring credit derivatives to be cleared to the much more ambitious mandate that all standardized OTC derivative are centrally cleared (for reasons which as far as I know are largely unexplained). In my opinion this is just one manifestation of the failure of politicians and the regulatory community who serve them to learn the right lessons from the Financial Crisis: they want to centralise the risk so that it is easy to see and control. However surely the moral of Too Big to Fail was that it is an illusion that we can control everything in human affairs, in this case by confidently assuming that margin at 99.5% with a top up based on stress tests will make us bullet-proof against the unknown unknowns. Instead of concentrating risk in the massive CCPs and the equally massive small number of banks with the economies of scale to afford to be clearing members, in my view it would have been better to diversify risk around the system, to minimise the impact of the things we can’t control. However, it is probably too late to reverse these decisions now, but it is certainly emphasises the need for CCPs to be stable, strong institutions with good governance.


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Monday, October 13, 2014

Ruble for sale

Currencies of most emerging economies rallied against the dollar today, as expectations for the first rate hike in the US shift out to a year from now. There was one major exception - the Russian ruble.



Russia is facing stagflation while the central bank remains helpless. A number of relatively well-off Russian citizens - some after getting burned in Cyprus - have been trying to abandon the ruble.
WSJ: - “Those who have any savings have lost all illusions about the ruble and are trying to protect their money,” said a senior executive at one of Russia’s largest banks, speaking on condition of anonymity.

Her bank has seen clients buying tens and hundreds of thousands of dollars in recent days and storing the funds in cash in safe-deposit boxes for fear that sanctions, possible capital controls or bank failures could limit their ability to access money kept on account. That is while dollar-starved Russian banks are offering rates on dollar and euro deposits as high as 4.5% for one-year certificates of deposit.
The ongoing rout in crude oil is expected to strain Russia's fiscal and trade balances. Russia (similar to some other energy producers) failed to diversify its economy and is now paying the price. According to Bloomberg, "Russia’s central bank intervened in the past 10 days to stabilize the currency, central bank Governor Elvira Nabiullina told lawmakers in Moscow today." In spite of spending some $6bn in FX reserves, it failed. The ruble hit a record low against the euro over the past few days as capital outflows continue.

Chart shows EUR appreciating against RUB


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From our sponsor:

The Fed on hold for a year according to the futures market

Futures markets have shifted expectations for the Fed's liftoff further out in time. The July-15 Fed Funds futures contract is only pricing a 12bp Fed Funds rate increase from the current levels - not enough for a full hike.

Source: barchart

In fact the mean expectation for the rate increase timing priced into the Fed Funds futures market is roughly a year from now.

Source: CME

This should slow the appreciation of the US dollar, as the Fed tries to avoid getting too far ahead of other developed economies in its normalization strategy.


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