Monday, September 1, 2014

Once again we wait for "shock and awe" from the ECB

The ECB (Eurosystem) balance sheet continues to decline as the LTRO/MRO loans to the banking system are repaid. We've seen a decline of about one trillion euros in the past year and a half.

Eurosystem consolidated balance sheet (source: ECB)

Anywhere else this would have been considered a massive tightening of monetary policy (imagine the Fed selling $1.3 trillion of bonds). But not in the Eurozone. In fact the area has experienced some significant easing recently. Both the euro and the long-term rates have fallen far below ECB's own forecast. The ECB achieved Japan-style easing without the Japan-style QE.

Source: Scotiabank

Source: Scotiabank

Near-term German rates are now firmly in the negative territory (see chart) - you now have to pay the German government to hold your money for 2-3 years. The central bank was able to loosen conditions while reducing its balance sheet as a result of unexpectedly soft economic reports from the area, falling inflation (see chart) and inflation expectations (see chart), as well as Draghi's jawboning.

The ECB got this round of easing "for free", but now markets will be expecting a follow-through from the central bank. And unless we get what amounts to "shock and awe" from the ECB, some of this easing (lower rates and lower euro) could see a sharp reversal.

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Japan moves from Paul Krugman's liquidity trap to Haruhiko Kuroda's "indefinite QE" trap

Japan's 10-year government bond yield is hovering around 0.5%, an all-time low.



Clearly this is the result of the Bank of Japan's unprecedented securities purchases via the ongoing quantitative easing (QE) program that was accelerated last year.

BoJ's holdings of Japanese government securities (source BOJ) 

While a number of economists such as Paul Krugman fully support this effort as a way of exiting the so-called "liquidity trap", the central bank's purchases are eroding the JGB market.
The Economist: - The BoJ is buying ¥7 trillion ($67 billion) of JGBs a month. It now owns a fifth of the government’s outstanding debt. Trading volumes have fallen dramatically, as has volatility in prices. One day in April there was no trading at all in the most recent issue of the benchmark ten-year bond.
Last year's QE acceleration started to take more securities out of the private market than is being issued by the government.

Source: Deutsche Bank

The Bank of Japan was hoping that as yields decline, the banking system will begin replacing JGBs it holds with loans to the private sector, thus stimulating growth and releasing more bonds into the market. But banks have been slow to get out of JGBs.
The Economist: - Part of the reason that bond prices remain high is that financial institutions have not sold as many JGBs as the BoJ had hoped. It had assumed that falling yields would prompt banks to shift their holdings into riskier assets, stimulating the economy. Although Japan’s biggest banks sold JGBs in the months immediately following the BoJ’s first purchases in 2013, they have now largely stopped. Regional banks, the most notorious JGB-addicts, hung on to their bonds, and are now purchasing more.
With rates on private sector loans now also at historical lows (around 0.8%–0.9% according to DB) and the overall private inventory of government paper declining, JGBs remain attractive on a relative basis, even at current rates. In fact, measured in terms of returns on regulatory capital, private sector lending looks terrible. Just as the case in the Eurozone, holding government paper is quite rational for banks.

Moreover, markets are pricing in an ongoing QE effort for the foreseeable future, which will end up taking even more paper out of private hands.
Deutsche Bank: - ... note that implied volatility in the JGB futures market is now abnormally low, which would appear to reflect a general expectation that the BOJ will persist with its massive bond-buying operations indefinitely. Put simply, very few market participants currently believe that the central bank is capable of achieving its +2% "price stability target", and therefore assume that it will remain in easing mode for the foreseeable future.
Exiting this program in a market that has become increasingly dysfunctional will be more difficult and disruptive with time. And given the government's unparalleled debt problem, is exit from QE even possible without nudging the "unsustainable equilibrium" (vicious circle of rising rates and rising debt burden)?



Japan has moved from Paul Krugman's liquidity trap to Haruhiko Kuroda's "indefinite QE" trap.

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Saturday, August 30, 2014

Markets signaling return of economic weakness in China

In addition to property market challenges and the unexpected slowdown in manufacturing expansion, we continue to see markets signaling a significant loss of momentum in China's economic growth. Earlier in the year the country's economic trajectory was quite uncertain. This was followed by a strong pickup in manufacturing activity early this summer and economists suggested that the worst is over. But it seems that China is once again facing significant headwinds.

The nation's industrial commodities are hitting new lows, particularly iron ore and the Shanghai-traded steel rebar.

Iron Ore 62% Fe, CFR China; Jan-2015 contract (barchart)

SHFE Steel Rebar January 2015; Jan-2015 contract (barchart)

Other commodities linked to construction, such as fiberboard, have been declining as well. Moreover, the recent stock market rally has stalled. Perhaps the most telling sign of weakening fundamentals in China has been the nation's rates market. Rates implied by SHIBOR-based interest rate swaps have declined materially over the past month. More importantly the yield curve has become inverted.

Swap rates by maturity (yrs)

As discussed before, economic weakness in China is reverberating globally - from Australia to the Eurozone - and is in part responsible for the bond yield compression across developed economies. We are likely to see the central government step in with more stimulus in order to stabilize the situation. However, as Beijing is beginning to realize, limited new stimulus directed at boosting growth is becoming less effective. A much larger effort may be required.

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Monday, August 25, 2014

Market reaction to weakening fundamentals in Germany

The German business climate index tracked by the Ifo Institute declined more than expected this month, making it the 4th drop in a row.
The Guardian: - German business sentiment dropped for a fourth straight month in August as concerns about the Ukraine crisis and the effect of sanctions against Russia swept through corporate boardrooms in Europe's largest economy.

The Munich-based Ifo thinktank's business climate index, based on a monthly survey of about 7,000 companies, fell to 106.3 from 108, below the Reuters consensus forecast of 107.
A large part of the decline was of course due to the Ukraine crisis, but that was not the only cause of Germany's deteriorating private sector growth. Slowing exports to the rest of the euro area nations due to weaker demand as well as persistent economic headwinds in China (see discussion) have contributed as well.



This means that Germany is unlikely to support any further sanctions on Russia and will make a concerted effort to stabilize the situation (in spite of any pressure from the US).

The market reaction was swift, with the 10-year Bund yield hitting another record low.



Investors also piled into the three-year government notes, sending those yields into negative territory for the first time since 2012. The German government is now getting paid to hold your euros for three years.



In fact the nominal yield curve is in the negative territory all the way through the three-year point and showing signs of inversion - with the 1-year yield higher than the 3-year.



The euro dropped below 1.32, with rising expectations of diverging monetary policies between the US and the Eurozone. This was fueled in part by the Jackson Hole conference where Janet Yellen's speech was not as dovish as some had expected. The currency weakness will deliver some much needed relief for the euro area by helping the exporters and by providing some support to import prices. Currency weakness is one way to arrest deflationary pressures – the Japanese way.




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Sunday, August 24, 2014

Watching for signs of economic deterioration in Brazil

Staying with the South America theme, we are seeing signs of economic troubles in Brazil. To be sure, the nation is still an economic powerhouse – the 7th largest economy in the world. Yet the end of the China-driven commodity supercycle has created significant headwinds for Brazil's economic growth.



Here are some key indicators economists are watching for signs of further deterioration:

1. In recent months industrial production has been declining at the fastest rate since 2009.



2. The labor markets remain under pressure, resulting in declines in consumer confidence.

Source: Reuters

3. While the consolidated public sector accounts (including state-owned enterprises) remain in the black, the surplus levels continue to shrink. Fiscal deterioration remains a major risk.

Source: Credit Suisse

4. Even though the nation's banking system has been relatively sound, credit extended by banks to the housing sector has exploded in over the last 5 years. If the economy stumbles, this could become an issue.

h/t @cigolo

With economists now projecting Brazil's GDP growth of just 0.79% for 2014 and the national elections approaching, the central bank is injecting new liquidity into the banking system. As usual, central bankers are asked to solve what amounts to structural problems - which they try to address with the only tools they have.
FT: - Brazil has made its second multibillion-dollar injection into the banking system in less than a month as the government struggles to boost the economy ahead of hotly contested presidential elections.

The central bank on Wednesday eased rules on reserve requirements, freeing up about R$10bn ($4.5bn) for new lending. Just over three weeks ago, it injected R$45bn into the economy by easing compulsory deposit rules and changing the risk calculation of some loans.
While the nation faces a number of economic headwinds, the near-term risk for Brazil stems from the US monetary policy. If rates in the US rise faster than expected, we may revisit the volatility of 2013 (and early this year), as taper fears and capital outflows had sent the Brazilian currency and debt sharply lower (the 10-yr yield reached 13.5%).


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Friday, August 22, 2014

Argentine peso hits record lows on increased uncertainty

Argentina is showing signs of stress, as the official exchange rate has the US dollar now quoted 8.4 pesos - a new record.

Chart shows USD appreciating against ARS (source: Investing.com)

The "parallel" exchange rate also hit a record, with the dollar quoted at 14 pesos - a 67% premium to the official rate. Note that before the first devaluation in 2002 (see this NY Times story) it was one peso to the dollar.


Source: Dolar Blue

As discussed earlier (see post), this peso decline should not be a surprise. The latest development in the default saga however is Argentina's recent attempt to pay the "non-holdout" bondholders by allowing them to convert to local bonds.
NY Times: - The government moved on Wednesday to push legislation through its Congress that would give foreign investors in the country’s debt the ability to swap their defaulted bonds for new ones subject to local law, thus skirting a United States court order that has blocked its ability to make bond payments.
But it seems quite unlikely that these investors will want to convert, leaving this matter unresolved.
NY Times: - But the draft of the legislation, which was first announced on national television late Tuesday by Cristina Fernández de Kirchner, Argentina’s president, has raised more questions than answers among investors who are looking for a solution to the country’s debt predicament.
The uncertainty, combined with deteriorating economic fundamentals is sending depositors and investors out of the country, pressuring the peso. Foreign reserves are likely to dwindle materially by the end of the year as a result, further exacerbating the crisis.
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Tuesday, August 19, 2014

Deutsche Bank: Ignoring food price pressures could be a mistake

Economists and central bankers tend to be less focused on what consumers pay at the grocery store because food and energy prices have historically been more volatile - remember, it's just "noise". However what they can't ignore is how shoppers view inflation - i.e. inflation expectations. And food prices have a significant impact on households' views on future inflation.
Deutsche Bank: - ... food prices factor significantly into households’ perceptions of overall price pressures. This is illustrated in the following figure, which shows year-ahead inflation expectations from the University of Michigan Survey of Consumer Sentiment versus CPI food. In fact, it is worth noting that CPI food demonstrates a higher degree of correlation with one-year price expectations than either the headline or core metrics — and it similarly surpasses energy, core goods, core services and shelter. ...  while forecasters are focusing on service-sector inflation in general and shelter inflation more specifically, they should be careful to not ignore mounting food price pressures, because this category could provide important insight toward the evolution of inflation expectations. If food price inflation accelerates, as we project, the stability of inflation expectations could degrade - and this would be a vexing development for monetary policymakers.
Source: Deutsche Bank
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A look behind the headline housing starts report for the United States

As discussed in yesterday's post on residential construction, today's report on US housing starts indeed showed significant improvements.

Investing.com

However, this is only part of the story. The number of housing starts for single-family units remains to a large extent range-bound (see chart). A great deal of the new housing growth instead is coming from multi-family construction (see chart). And that's driven by the rapidly rising demand for rental housing in the US, as shortages become more pronounced (see post). Rental vacancies are now at the lowest level in 17 years and falling.



This demand is also visible in the latest report on inflation, which came out today as well. Rent expenses are now growing considerably faster than the CPI as well as US wages - a dangerous trend.

Rent inflation vs. Core CPI

The trend of rental units dominating housing starts growth is likely to continue as homeownership rates decline. Adequate supply of new multifamily housing will be critical in years to come.


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