Tuesday, July 31, 2012

Tremendous demand for ABS paper

Asset backed securities (ABS) continue to hit the market in volume, with both high quality as well as subprime paper in high demand.

Top quality:
Bloomberg: - Nissan Motor Co. sold $1.4 billion of bonds tied to auto loans at the lowest rate ever as the Federal Reserve’s efforts to spur economic growth reduce borrowing costs.

The company issued the top-rated securities with an average life of 1.49 years to yield 0.481 percent, the lowest financing rate for an auto company in the asset-backed market on record, according to data from Citigroup Inc. (C), the lead manager of the transaction. Though spreads on the debt were narrower in 2006, the higher lending benchmarks boosted the cost, the data show.
Subprime:
Bloomnerg: - Sales of bonds tied to payments on subprime car loans are accelerating at the fastest pace in five years as investors seek high yields amid speculation the Federal Reserve will keep interest rates at record lows until mid-2015.

Led by Santander Consumer USA, issuance of $10 billion this year in asset-backed debt linked to vehicle loans to borrowers with spotty credit records compares with $8.2 billion in the same period of 2011, according to Barclays Plc. Top-ranked securities backed by the loans yield between 15 and 25 basis points more than benchmark swap rates, versus 5 to 8 basis points for similar debt of prime borrowers, Deutsche Bank AG data show.
The demand is also seen in the asset backed CDS rally - the "AAA" tranche of asset backed CDS index called ABX (chart below) is up 18% since May.



Analysts are tracking this index and the ABS market in general quite closely because the development/recovery of ABS is critical to US economic growth (these markets freezing was the whole reason behind TALF).



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Office rental market in the US has stalled; some metro areas remain tight

The recovery in US office property rental market some were expecting has not materialized. The market is stable, but vacancy rates have stalled and net absorption rate (the rate at which rentable properties are leased out) declined in Q2.

Source: Reis Reports
Reis Reports: - High hopes for an ongoing recovery in the U.S. office sector were frustrated in the second quarter as vacancy remained unchanged at 17.2%, this despite a respectable 4 million plus square feet increase in occupied space. Expectations for higher rents were similarly dashed with the quarter’s feeble showing of just 0.3% gains in both asking and effective averages. As a result, rents still remain stuck at levels last seen in 2007.
The tightest rental markets in the US continue to be in DC and NYC. The chart below shows vacancy percentages by area. Some may find it a bit surprising to see Tucson (instead of say Minneapolis) on that list.

Office vacancy rates





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Twist is Fed's most effective policy tool right now

The most probable outcome of the FOMC meeting currently under way is the continuation of "Operation Twist" and possibly the extension of the current “exceptionally low… through late 2014” rate guidance to "mid 2015."

Other policy changes are much less likely. A drop in the rate paid on bank reserves is possible but not preferable because it could destabilize money markets functioning (potentially pushing repo rates deep into negative territory with a sharp drop in liquidity). A UK style policy to lend to banks below market rates (to encourage lending) is also unlikely because of legal limitations and political ramifications of the Fed lending to banks again. And there is almost no chance that any sort of unsterilized asset purchases (QE3) will be announced.

The Fed should be quite happy with the impact of the Maturity Extension Program (Twist). The central bank has taken a considerable amount of duration out of the treasury market. This happened just as demand for treasuries rose due to escalating problems in the Eurozone as well as negative rates in the "safer" European nations. This combination has created the most accommodative long-term rate environment in recent US history. The 10-year zero coupon real yield is at record low of negative 82bp.

US 10y zero coupon real yield  (source: Bloomberg)

Many would argue that this extraordinarily accommodative policy is not feeding through to the economy. But there is very little the Fed could do about that other than possibly shifting to MBS "Twist" (which is a distinct possibility down the road). Increasing bank reserves via QE3 will NOT make conditions any more accommodative than they already are. That's why Twist, and later sterilized purchases (which may at some point involve nontraditional sterilization techniques such as issuing Federal Reserve bills), will continue to be the primary tool for easing.



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China's index of leading indicators points to further economic erosion

A couple of months ago some analysts from Credit Suisse took a trip across Asia to conduct a survey of China's steel industry. They later wrote in their report that the sector is in worse shape than it was in 2008. We got a number of e-mails suggesting that this report surely must be erroneous. It turns out that it wasn't.
FT: - Chinese steelmakers saw their profits plunge by 96 per cent in the first half compared to a year ago, a Chinese official said on Tuesday, as the economic slowdown turned the industry into a “disaster zone”.
And it doesn't look like the situation is getting any better. In spite of the recent pop in the manufacturing PMI number, key indicators are pointing to a continuing slowdown. The Index of Leading Indicators hit a post-2009 low today,

China National Bureau of Statistics Leading Indicators Index, 1996=100 (source: Bloomberg)


... and so did the equity market. China's major cyclical sectors that depend so heavily on double digit growth are in trouble.

Shanghai Stock Exchange Composite Index (source: Bloomberg)

Bloomberg: - China’s stocks fell to the lowest level in more than three years amid concern the slowing economy will hurt earnings growth. Foreign-currency denominated B shares dropped for their biggest two-day loss in almost a year.

Chinese steelmakers, including Baoshan Iron & Steel Co. and Angang Steel Co., slid after posting a 96 percent drop in first- half profit. Kama Co. led declines by B shares on concern stricter rules by the exchange may lead to companies being delisted.



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Food inflation spreading across developing nations

As the world's financial markets focus on the Fed and the ECB, another threat to global growth is showing up across emerging markets. Food inflation is spreading much faster than anyone had anticipated.

The major US media outfits are focusing on US-based food price increases of a few percent and the fact that burgers in the US will end up costing more. This is certainly painful for the US consumer, but pales in comparison with the havoc food inflation will create across developing nations. What's particularly troubling is that the North American drought has coincided with a number of other droughts globally such as those in Russia, India, and even North Korea. Here are a few examples of what may look like separate news events, but are actually part of this global trend. Food inflation is setting in.

Brazil
Reuters: - Brazil's broadest inflation index, the IGP-M, rose 1.34 percent in July, up from a 0.66 percent increase in June, the Getulio Vargas Foundation research group said on Monday.

The index was expected to increase 1.23 percent, according to the median forecast of 13 economists polled by Reuters. 
Brazil IGP-M inflation (YoY) (source: Bloomberg)
GS: - Consumer price inflation rose to 0.25% in July on higher food price inflation and the fading impact of the IPI tax cuts on auto prices (this more than offset the seasonal decline in apparel prices). In yoy terms, IGP-M inflation accelerated to 6.7% more than double the 3.2% March print.

China
Business Insider: - The drought in the American Midwest has sent corn prices soaring. And this is a very worrisome sign for Chinese pork prices.

Societe Generale analysts Michel Martinez, Wei Yao, and Jaroslaw Janecki write that nearly 90 percent of changes in Chinese domestic pork prices can be attributed to "global corn prices lagged by one quarter, and soybean prices lagged by two quarters".

Russia
Bloomberg: - Russia’s drought, which is cutting grain yields, may increase food prices and push inflation above the central bank target of 6 percent this year, according to Renaissance Capital.

Inflation may reach 6.5 percent “due to the unanticipated, and temporary, food price shock,” Ivan Tchakarov, Moscow-based chief economist for Russia and the Commonwealth of Independent States at the bank, wrote in a report today.

India
IRIS: - As delayed monsoons hurt production of vegetables, cereal and oilseeds, she expects WPI food (primary and manufactured) inflation, which is currently 9% y-o-y, to rise into double digits in the coming months. This will keep both WPI and CPI inflation elevated above the central bank`s comfort zone.

Indonesia
NASDAQ: - The country also is facing price pressures as drought in the U.S. pushes up soybean prices, and demand for food is elevated during the Ramadan fasting month. "With increasing prices of meat (products) and soybean, (on-month) inflation could be above 0.7% in July," Mr. Martowardojo said.

Sri Lanka
Reuters: - Sri Lanka's annual inflation rate may have accelerated to a 42-month high in July as a drought pushed up local food prices and a weaker rupee aggravated import bills.

Annual inflation is expected to have accelerated to 9.4 percent in July, its highest since January 2009, a Reuters poll of 13 analysts showed. In June, prices rose 9.3 percent from a year earlier.

"We will see the impact of the drought and rupee depreciation in food prices this month, too," one analyst said on condition of anonymity.

Food accounts for more than 40 percent of the basket of items used to compile inflation figures.

Other countries such as Malaysia and South Korea will see a spike in food prices as well. And of course nations like Iran will experience severe food shortages that could turn an already tense situation into an explosive one.

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Monday, July 30, 2012

Did Draghi act on his own?

We've all heard ECB's president Mario Draghi's pledge to do "whatever it takes to preserve the euro."  Risk assets have rallied dramatically on this announcement. Spanish 10-year bonds moved up over 7% in price for example.

Everyone of course assumes that the ECB has put together some type of plan to change its policy course. But did this statement come from the ECB (similar to the announcements of the FOMC) or is Draghi trying to do this on his own? Did the Governing Council of the ECB actually agree on this policy move of incremental asset purchases?

Apparently this announcement came as a total surprise to some at the ECB.
DER SPIEGEL: - ... experts at the central banks of the euro zone's 17 member states had no idea what to do with the news. Draghi's remark was not the result of any resolutions, and even members of the ECB Governing Council admitted that they had heard nothing of such plans until then.
This is a bizarre action by a head of a central bank - a statement that is interpreted as a policy shift that apparently has not been vetted by the governing body. It seems that Draghi, possibly without consulting his colleagues, has succumbed to political pressures.
DER SPIEGEL: - Now Draghi is apparently prepared to lend a hand to the hapless politicians. Under his plan, which essentially creates a new form of cooperation between governments and monetary watchdogs, both of Europe's bailout funds -- the temporary European Financial Stability Facility (EFSF) and the permanent European Stability Mechanism (ESM) -- and the ECB will intervene jointly in the bond markets in the future to bring yields down.
Now the ECB has been painted into a corner. They can either follow Draghi's lead without fully agreeing with him or they pause to deliberate on this matter and disappoint the markets. Both outcomes seem rather unsettling.



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Sentiment surveys vs. growth - some observations

Deutsche Bank analysed the recent Pew Research publication called "Pervasive Gloom About the World Economy" (which is quite informative).  In particular DB looked at the past GDP vs. the surveys of current conditions as well as forecast GDP vs expected conditions.

1. Current conditions:

Source: DB

2. Expected conditions

Source: DB ("WO" stands for World Outlook - DB's internal forecast)

Here are some observations.

1. Sentiment surveys seem to correlate reasonably well with the actual growth as well as economic forecasts.

2. People of the Eurozone periphery seem to be well aware of their economic predicament.

3. Some emerging market nations, with younger populations and limited recent memories of recessions maybe too optimistic about future growth. And by the way so is the DB's growth forecast for emerging markets (by their own admission).

4. Germans feel good about the nation's current conditions, which according to DB may allow Merkel to push through the necessary aid to the Eurozone periphery.
DB: - Germans feel fairly confident about their country and themselves and seem willing to assist other countries in the context of Chancellor Merkel’s approach of help under strict policy conditionality.
5. But given the expectations of German growth grinding to a halt in the next 12 months, Merkel may not have much time.


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Crop damage sending agricultural commodity prices to new highs

Crop conditions across the US are still deteriorating, with less than a quarter of the corn crop now in "good or excellent" conditions.

Percentage of corn crops in "good or excellent" conditions

What's even more troubling is that the weather is not cooperating. The National Weather Service forecast for the continental US over the next 1-2 weeks looks dreadful. The precipitation levels...

Precipitation 8-14 Day Outlook (source: NOAA/ National Weather Service)

... and the temperature are both expected to be significantly worse than historical averages. This is threatening to cause further crop damage.

Temperature 8-14 Day Outlook (source: NOAA/ National Weather Service)

On the back of these weather forecasts and crop damage estimates, agricultural commodity prices are hitting records again.
Bloomberg: - Corn surged to a record, heading for the biggest monthly gain since 1988, as the worst drought in at least a generation lingered in the U.S., threatening yields in the world’s biggest grower and exporter. Soybeans and wheat also rallied.

Corn futures for December delivery climbed 2.5 percent to $8.1275 a bushel on the Chicago Board of Trade, after touching an all-time high of $8.1725. The most-active contract has surged 28 percent in July.

Soybean futures for November delivery gained 2.6 percent to $16.4375 a bushel on the CBOT. The oilseed, which reached a record $16.915 on July 23, is up 15 percent in July. Wheat futures for September delivery rose 1.8 percent to $9.14 a bushel in Chicago. The grain, which can replace corn in livestock feed, has surged 21 percent this month.

Corn nearby futures contract  (source: Bloomberg)

And as discussed before, high food prices are already propagating through emerging markets economies.
The Times of India: - It's not only the prices of staples, edible oils and vegetables that have been rising. Prices of eggs and chicken (protein food items) may also rise in the coming months. Scanty rainfall and higher global prices have led to a huge increase in average prices of poultry feed in the country, which is also an early indicator of the potential impact a drought may have on food inflation.

Average prices of poultry feed - consisting of oilseed cakes, rice bran, grounded maize and soya - rose by 69% year-on-year in July up from 18% in June, due to lack of rainfall and higher global prices, a Nomura research says. These price increases outpaced those during the 2009 drought. Feed is a key input in poultry farming, and this sharp price increase suggests that prices of eggs and chicken (protein food items) may rise sharply in the coming months, the note adds.
This is a dangerous development for two reasons. We will see more civil unrest across emerging markets - particularly in the Middle East. Also the large emerging markets nations (and some developed nations as well) will be unable to stimulate their economies effectively because of inflationary concerns,  resulting in a significant hit to global growth.





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Argentina's dollar deposits down 42.3% from the October peak

In spite of Argentine authorities' repeated denials with regard to touching peoples dollar deposits, the "pesoization" fears in that country persist. Argentina's dollar depositors are quickly taking dollars out of the banking system. Most funds are moving into banks abroad, while some get placed "under people's mattresses" in the form of notes. The chart below shows private sector dollar deposits since the beginning of May.



Argentina's private sector dollar deposits are now 42.3% below the $14.8bn peak reached in October of 2011 and down 29% from the beginning of May 2012.

As the government gradually takes control of the energy industry, depositors and investors are not waiting around to find out who the Fernández de Kirchner's administration will target next.

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Proposed EU sovereign CDS regulation is useless

EU regulators (the European Commission) are putting in place a new set of regulations (in the works for some time now) on sovereign CDS. The goal is to prohibit "naked shorting", requiring that all CDS purchases be "covered". These types of proposals have been circulating in the US for a few years as well.

The EU rule applies to protection buyers, while protection sellers can do whatever they want. Under these rules a CDS is said to be covered if it is used to hedge a specific exposure. "Permitted exposure" that is allowed to be hedged with CDS can be the following:

1. Sovereign debt
2. Public sector entities debt
3. Private sector debt (if the the debt will be materially affected by the sovereign default)
4. Derivatives mark to market exposure (counterparty risk)

Basically as long as the buyer can identify any exposure in a specific country that is deemed "correlated" to sovereign debt, CDS buying is permitted. "Correlated" is loosely defined and is required to meet some quantitative or qualitative criteria. CDS size has to be "proportional" to the exposure size. CDS market makers are exempt if the protection they hold is part of "market making activities".

Just as an analogy to the equities markets, this rule is the equivalent of requiting that investors can only buy put options if they hold the underlying stock, while short selling of put options would be permitted. And shorting the stock directly is also permitted. Most equity investors would find such rules rather bizarre.

It's not clear what if anything the regulators will be able to accomplish with these rules. If they wish to reduce the shocks to sovereign debt prices, they only need to look at CDS volumes. CDS net notional is a tiny fraction of all the sovereign debt. CDS on Spain for example is less than €14bn vs. hundreds of billions of Spanish debt outstanding. The widening of Spanish spreads to record levels recently had nothing to do with CDS and everything to do with the risk that Spain may be unable or unwilling to meet its obligations. And the CDS widening was simply the "canary in a coal mine".

Investors who want to short sovereign debt will end up doing it through reverse repo (shorting actual sovereign bonds) or simply moving the CDS transactions offshore. A hedge fund for example would be able to buy protection on Italy in an Asian jurisdiction to circumvent these rules.

There are so many ways the sovereign CDS market could be improved (for example changing the ISDA committee process). Unfortunately this set of rules will not be one of those improvements. Most analysts expect this rule to have very little impact on sovereign CDS or bond spreads or even investor behavior. Instead it will introduce tremendous bureaucracy, allowing EU regulators to hire armies of people to monitor compliance.


CDS Regulation Summary

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Sunday, July 29, 2012

Alpha generation becoming difficult as risk asset correlations rise

Over the past decade (and some would argue longer) average (pairwise) correlation among "risk assets" has been on the rise.

Source: JPMorgan

A number of possible causes for this trend have been proposed. So far JPMorgan's write-up on the topic from over a year ago still provides the most reasonable explanation.
JPMorgan (May-2011): - Globalization of capital markets, and new risk-management and alpha extraction techniques have driven the secular increase of cross-asset correlations. 
This means that global macro events increasingly drive world financial markets, as investment professionals focus more on central banks than their specific investment mandates. Trading between "risk-on" and "risk-off" dominates valuations across asset classes. Consistent "alpha extraction" is becoming far more difficult and the choice of beta (risk appetite) rather than investment selection differentiates fund managers. The following quote describes quite well the investment climate dominated by rising correlations across risk assets.
JPMorgan (27-Jul-12): - Many investors say they lack conviction, and find it harder to gauge value and market direction amid so much political uncertainty. This uncertainty is breeding inactivity. The steady rise in correlation between risk assets is making it harder to find diversified sources of alpha. US equity managers are having their worst year since 1995 in trying to beat the S&P500, underperforming on average by 1.11% YTD. Hedge fund managers have delivered only some 2% YTD, after fees, pushing them way down in the YTD return hit parade. This lack of active returns is forcing many to stay close to their benchmark and to take less risk.

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Defensive stocks becoming overvalued

The Russell 1000 Defensive Index touched a multi-year high on Friday, while the Morgan Stanley Cyclicals Index continues to lag (discussed in this post). The performance gap over the past two years is now 20%, showing an ongoing defensive posture of US equity investors.

US equities: defensive vs cyclical (including dividends; click to enlarge)
 (source: Bloomberg)

As with other defensive asset classes such as USD or US Treasuries, defensive US equities are potentially becoming a "crowded trade". Barclays' Sector Rank Index shows defensive stocks significantly overvalued relative to cyclicals and the overall equity market.

Source: Barclays Capital (click to enlarge)
Barclays: - A crowded trade. Our chart of the week shows that the defensive sector trade in the US is at prior peak levels. We are not convinced we’ve seen the bottom in equity markets but would be prepared to exit these “high-flying” sectors on improvements in the macro environment. In anticipation of any such unwind, our Data Miner highlights defensive stocks that have significantly outperformed, and are trading at premium valuations vs the overall market and their sector peers






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Saturday, July 28, 2012

ESM armed with a banking license - the ultimate bailout "bazooka"

Should the ESM, the Eurozone's permanent bailout facility, be granted a banking license? Apparently some within the ECB believe that it should.
Bloomberg: - European Central Bank council member Ewald Nowotny said there are arguments in favor of giving Europe’s rescue fund a banking license, reviving the debate on bolstering its firepower as leaders face the prospect of a full-scale Spanish bailout.

“I think there are pro arguments for this,” Nowotny, who heads Austria’s central bank, said in an interview in his office in Vienna yesterday. “There are also other arguments, but I would see this as an ongoing discussion,” he said, adding he’s “not aware of specific discussions within the ECB at this point.”
It's a powerful concept because being a bank, the ESM could tap the ECB's unlimited lending facilities to leverage its holdings of sovereign paper. By granting the ESM a banking license, it can effectively buy Spanish and Italian bonds "on margin", with the ECB being the margin provider. This entity would wield buying power several times larger than the Eurozone's original ESM commitment, making it the ultimate bailout "bazooka".


So far Mario Draghi had not been supportive of the idea - at least officially.
Bloomberg: - ...ECB President Mario Draghi said on May 24 that such a move amounts to the central bank financing governments, which is prohibited by European Union law...
The issue of EU laws is a major one, but it's not without a precedent. As the Bloomberg article points out, "publicly-owned credit institutions such as the European Investment Bank (EIB) are exempt". In fact the EIB has been involved in buying government debt of Eurozone nations for some time, even ending up stuck with some Greek bonds (see this post).
Bloomberg: - The EIB, which was founded in 1958 and is owned by the member states of the EU, was granted access to ECB refinancing in July 2009. Nowotny said the fact that the ESM has missed a July deadline to become operational is a “weakness that has to be overcome.”
However there is a political problem with this scenario. The ESM now has a €500bn cap on total debt purchases. That means no matter what leverage is available to the entity, it can only purchase bonds of up to the amount of the cap. An increase in its buying power would require (among other things) Germany's approval. And with the elections coming up in Germany next year, the chances of German politicians agreeing to this increase are quite low.
Barclays Capital: - From a political perspective and in view of the German national elections scheduled for September 2013, we do not see much of a chance that the German government would agree to another increase in the ceiling until then, or to more fundamental changes implying the mutualisation of national, public debt. This constraint may be relaxed if the crisis picks up pace rapidly and moves into the core.
Nevertheless the rumors of the ESM being armed with a banking license are flying (and even moving the "risk" markets on Friday).
CNBC: - Reports (vague rumors) that ECB head Mario Draghi may have reached out to Bundesbank head Jens Weidmann moved the Dow more than a hundred points in the middle of Friday's trading day.

It certainly wouldn't be surprising that they talk, but the rumor mill threw in a rich tidbit: that they had discussed giving the EU's permanent bailout fund (the ESM) a banking license.
The danger of course is that after this buildup, the "bazooka" and other expectations from the Eurozone may not materialize. Without a decisive follow-through, the "risk" markets may retrace their recent gains and then some. After all when it comes to the Eurozone crisis, the EU leadership has a knack of over-promising and under-delivering.


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US manufacturing activity is hampered by declining orders and rising inventories

Markit flash (preliminary survey results) PMI suggests a material slowdown in US manufacturing. The US manufacturing advantages of relatively low labor costs (discussed here) and inexpensive energy have failed to prevent the slowdown.

Source: Markit

It seems that at least some of the decline is due to falling exports, as Europe undergoes a recession and China has slowed.
Chris Williamson (Markit): - “The U.S. manufacturing sector is clearly struggling under the pressure from falling exports, which showed the first back-to-back monthly decline for almost three years in July. Growth of production is slowing closer to stagnation as a result, and rising levels of unsold stock may mean companies seek to scale back production in coming months unless demand picks up again.
This trend of declining orders and rising inventories is now clearly visible in the data. Last year a decline in orders corresponded to a correction in inventories as companies quickly adjusted to lower demand. This time around however inventories have climbed even as orders fell. That's a worrying sign because firms will need to work through the inventories before production picks up again.

Source: Markit/JPMorgan






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Friday, July 27, 2012

Long term US real rates hit record lows

As discussed earlier (see this post), US real long-term yields are continuing to move deeper into negative territory. Zero coupon real yield is defined as the difference between zero coupon nominal treasury yield and zero coupon inflation swap rate.

The 10-year real yield touched a record low today of negative 82bp. Declines in inflation expectations simply have not kept up with the declines in nominal yields. The risk of holding long-term treasuries is increasing and if QE3 expectations are not fully materialized, treasury investors could be in trouble.

US 10y zero coupon real yield  (source: Bloomberg)



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The Fed is being too transparent in its agency paper purchases

One of the problems with asset purchases by the Fed is how transparent Fed's actions can sometimes be. And when that happens, the Fed will overpay while someone on Wall Street will make easy money. Here is an example. Last year the Fed announced that it will maintain a constant balance of MBS positions. That means as securities' principal declines due to prepayments (mortgage refinancing), the Fed buys more (see this post). 

Here is the pattern of buying the 30y Fannie Mae paper. The Fed is decreasing its purchases of the 3.5% coupon paper (green) and moving into the lower coupon (on the run) 3% coupon bonds (blue). The central bank is no longer buying the 4% bonds (red). It's fairly easy to predict the next set of purchases. A skilled agency bond trader could take advantage of this.

Fed's 30y Fannie Mae bond purchases (Source: BNP Paribas)

And if the Fed commits to increasing its MBS holdings through further asset purchases, it's pretty clear that the central bank will lean on the 3% coupon bonds and the 2.5% when it becomes the on the run bond. Transparency is great, but the taxpayer needs to be protected while the asset purchase program is in place. Being just a bit less obvious would go a long way in making sure the "front-running" is limited.


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Thursday, July 26, 2012

Gun manufacturer in the market today

It's a bit ironic that as the US tries to cope with the Colorado tragedy, a major firearms manufacturer is in the market raising money today. Freedom Group who owns brands like Marlin, Remington, Bushmaster, DPMS/Panther Arms is out there trying to raise debt capital.
LCD: - FGI Operating/Freedom Group approached lenders this afternoon via Bank of America Merrill Lynch and Deutsche Bank for a $75 million fungible add-on to its covenant-lite institutional loan that will be used in part to redeem preferred equity held by Cerberus Capital Management, its controlling shareholder, sources said.
It's also interesting that the proceeds are used to partially take Cerberus out of its position. Why not, since the market for corporate debt is hot and apparently so is the market for guns. And these days Cerberus probably wants out.




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Swiss base money spikes as the SNB defends the peg

The Swiss National Bank (SNB) continues to "print" Swiss francs (CHF) in response to the flow of capital out of the Eurozone. As Eurozone residents exchange euros for CHF, the SNB buys these euros and sells (the newly "printed") francs to maintain the 1.2 CHF to EUR peg. As a result Switzerland's monetary base has spiked to record (CHF 274bn).

Swiss base money (CHF MM)

But Switzerland can afford to explode its monetary base for now because the broad money supply (M3) has been growing at 7.4% YoY (within the range of the last 4 years) and inflation has been negative. In fact this the situation looks deflationary given that core inflation is at record lows
GS: - "... despite moderate economic growth, the deflation risk for Switzerland is non-negligible. With the starting point of inflation already so low, a deterioration in the external environment could easily push the Swiss economy into recession, putting further downward pressure on prices.
Switzerland CPI (white) and core inflation (green)


That's why the SNB will vigorously defend the 1.2 peg for the foreseeable future and base money will continue to grow. In fact given the Swiss franc's appreciation in the past few years (up 36% since 2008), some are saying CHF is significantly overvalued and the peg should be greater than 1.2.

CHF per 1 euro (Swiss franc has strengthened by 36% since 2008)
Bloomberg: - The Swiss currency remains 36 percent overvalued against the euro, based on purchasing power parity as calculated by the Organization for Economic Cooperation and Development. That compares with 24 percent for Denmark’s krone.


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China's coal "barometer" is pointing to continued weakness

More signs of China's weakening economic conditions are once again showing up in overbuilt coal inventories.

Coal piling up at the Qinhuangdao Port [Photo/Xinhua] (source: www.china.org.cn)

Xinhua: - The China Coal Price Index shows that China's benchmark power-station coal price fell for the 11th week as stockpiles at the Qinhuangdao Port in Hebei province, which boasts one of the country's highest export volumes, rose the most in six months on slowing demand.

Rising inventories are now translating into sharp price declines,

Qinhuangdao 6000 kc GAD fob Steam Coal Spot Price/China (source: Bloomberg)

... hurting domestic coal producers.
Xinhua: - Guo Xutian, CEO of Xinshi Coal & Coking Co. Ltd., in north Shanxi province, China's second-largest coal production base, said the entrapped coal mine selling has resulted in lay-offs for two-thirds of workers.

"Sales were never a problem, but now, look at the coal piling up on the ground," Guo sighed, saying the company has been on limited production since April. X "The price dived by 80 yuan to 120 yuan a metric ton, even though we didn't put the brakes on production. We are barely making ends meet, gaining zero profit," said Ma Zhi, chairman of Jinhuagong coal mine's trade union with Datong Coal Mine Group
And China's shipping industry is beginning to struggle as well.
Xinhua (different article from above): - China's shipping industry is grappling with a recession caused by waning demand and higher costs, and many small businesses are facing bankruptcy, the Ministry of Transport said Thursday.
...
Qinhuangdao Port on China's northern coast, the nation's coal-shipping center which is also seen as a barometer of the economy, should have experienced a busy July, as daily transport capacity was at least 50 vessels per day in the past. However, only one-quarter of that capacity was achieved this July, and inventories hovering near the maximum storage capacity piled up.
In spite of Goldman's interpretation of the latest PMI number as "a very strong reading", things on the ground in China continue to look weak.


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Draghi sends crowded shorts running for cover

As discussed last weekend, the short euro position has been a crowded trade for some time now. Short Spanish and Italian debt and long treasuries and Bunds was getting there as well. To provide relief to Spain, Draghi threatened the markets. "Believe me, [my actions] will be enough [to hurt the shorts]".




In response, the euro went vertical with all the short covering.

EUR (dollars per one euro) intraday

There are not many "bullets in Draghi's gun", and threatening to do something major was one of them. He just used it. If there is no follow-through, his credibility is shot. Here is some commentary on the topic.






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Wednesday, July 25, 2012

US money market funds moving into "safer" assets; returns suffer

The latest Fitch report on US money market funds is showing three key trends:

1. On the non-US allocations, exposure to the Eurozone continues to decline, replaced by Australia, Canada, and Japan. This is one of the main reasons Eurozone banks are exiting US businesses.

Source: Fitch

2. Increasingly transactions with European banks are executed via repo (secured loans). We discussed this earlier.

Source: Fitch

3. This risk aversion is becoming increasingly costly for the fund managers as yields on the "safer" products fall below funds expenses.

Source: Fitch

The risk aversion is translating into near zero returns even for the "prime" money funds that carry more risk than government funds. As an example the Vanguard Prime Money Market Fund (VMMXX) returns less than 4 basis points per year. Treasury funds are of course even worse. Fidelity US Treasury Money Market Fund (FDLXX) yields 1 basis point a year.  (Some Europeans would consider this return to be excellent given their negative rates.) The fund is subsidized by Fidelity because with full fees the return would in fact be negative. Fidelity also closed this fund to small investors by requiring $25,000 minimum. These are difficult times to be in the money market funds business.



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Basel III requirements hurting some European bank shares

Published Basel III-based capital measures are exposing European banks who will need to raise the most amounts of capital to meet the latest regulatory capital requirements (see attached Basel III handbook). There is also an expectation from investors, analysts, and some regulators that these banks will need to meet the minimum Basel III based Tier 1 ratio of 8% before the year-end. 

But when it comes to European banks, it's not only the Eurozone periphery institutions that are in a race to improve their capital ratios. It turns out that some Swiss institutions, particularly Credit Suisse (CS) will look undercapitalized once Basel III becomes official.

Common Equity Tier 1 capital under Basel III

Responding to recent comments from the Swiss National Bank, CS announced an aggressive capital raising program.
Barclays Capital: - Credit Suisse acknowledged this challenge on 18 July when it announced a new set of capital enhancing measures in response to pressure from the Swiss National Bank. As of March 2012, Credit Suisse had a fully-loaded Basel III CET1 [Common Equity Tier 1 ] ratio of just 5.3%, among the weakest in Europe. In its 2012 Financial Stability Report published on 14 June 2012, the Swiss National Bank highlighted the weaker capital position of the Swiss banks relative to international peers, and that of Credit Suisse in particular. The SNB recommended that both CS and UBS increase their loss-absorbing capital buffers, which in the case of Credit Suisse had to be done in a ‘substantial’ manner and ‘during the course of the current year’. Reacting to these pressures, Credit Suisse announced last week a set of immediate capital measures for up to SFR8.7bn, expected to boost the bank’s fully-loaded Basel III CET1 ratio by 1.5pp and additional measures totalling SFR6.6bn to be implemented by the end of 2012, when the bank’s Basel III CET1 ratio will increase to 8.6% (fully-loaded). Although anecdotal so far, the SNB move indicates that, in practice, the Basel III transition period will be much shorter than scheduled. In our opinion, the focus regarding capital is shifting from the strength of reported ratios to the weakness of ‘fully-loaded’ ratios.
This year banks have been boosting capital ratios by improving core equity capital (in many cases via retained earnings but in some instances issuing equity) as well as reducing Risk Weighted Assets (RWA) - roughly in equal amounts. Credit Suisse's goal of catching up to its peers in terms of Basel III based capitalization this year will be difficult. Shutting down capital intensive businesses (that will involve significant layoffs), selling assets (which will cut into earnings) and possibly issuing more equity (diluting existing investors) does not bode well for the share price. That's one of the key reasons CS shares just hit a 20-year low.

Credit Suisse share price

UBS and some other banks are struggling with this issue as well.

Basel III will clearly improve bank capitalization, but some institutions will end up with significantly lower share valuations as a result of trying to meet their target capital ratios.



Accenture-Basel-III-Handbook


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Goldman's bullish call on China may be premature

So far markets' reaction to the latest increase in China's manufacturing PMI has been quite muted (h/t Avi Cohen). Here are four market indicators as well as two other factors demonstrating that it's way too early to call for a bottom in China's economic activity.

1. SHIBOR 1-year swap rate declined last night and is hovering near the recent lows. As discussed before, this swap rate is a measure of short term rate expectoration going out to 1 year. Just as in teh US, expectations of material improvements in economic growth would have resulted in the swap rate increase.

1-year SHIBOR rate swap

2. The Renminbi (CNY) continues to weaken. Clearly Bejing has the ability to control it but the government is allowing the currency to float within some range. This weakness may be an indication of some capital outflows.

CNY (per 1 dollar)

3. China's equity market hit another recent low, showing lack of confidence in corporate profit growth.

Shanghai Stock Exchange Composite Index

4. Imported iron ore prices (discussed earlier) are experiencing a sharp decline as well and are now nearing the three-year support level. A good indicator of demand decline for industrial commodities in China would be a breach of this support level the next few days.

China import Iron Ore 62% Fe spot (CFR Tianjin port)
USD/metric tonne (Bloomberg, Steel Business Briefing)

A couple of other indicators also support the slowdown thesis, negating the jump in the manufacturing PMI. One is the ISI Company Survey Index of China Sales, which is now at 2009 levels and is not showing signs of bottoming out.

Source: ISI Group
Another is today's Caterpillar (CAT) call which hinted that the firm is continuing to see soft machinery demand in China. CAT announced that they have no intentions of bung back stock at least in part due to lack of confidence in China's growth. The stock sold off in response.

CAT shares intraday

These indicators clearly tell us that yesterday's Goldman bullish call on China, based on the July flash PMI reading, may be premature.





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Natural gas up 44% from the lows

The temperature forecast for the US is not looking great. The bulk of the nation is expected to have above normal temperatures in August exacerbating the drought conditions. This weather pattern has been driving up agricultural commodity prices but is now also impacting natural gas valuations. As residential and corporate electricity users crank up the air conditioning, the demand for power goes up, pushing utilities to burn more natural gas.

Probability of temperature being above normal in August (Source: NOAA)

The amount of gas in storage is still rising and the market is still oversupplied, but the inventory is approaching the 5-year range for this time of year.

Gas inventories vs. 5y range: (source: EIA)

This trend is giving natural gas price a boost, with the futures rising above 3 dollars. This increase may not seem like much, but consider the fact that the nearby futures contract is up 44% from the lows - mostly driven by the ongoing heat wave.

Nat gas futures




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Tuesday, July 24, 2012

Three research groups' views of China's manufacturing PMI

China's manufacturing PMI (flash) unexpectedly increased in July. Production and new orders showed improvement. Is it possible that China's slowdown has ended and manufacturing growth is beginning to re-accelerate? Here are views from three research groups that focus heavily on China:

1. Goldman is quite bullish, pointing out that this will translate into a strong industrial production number.
GS: - We see this as a very strong reading. Unlike the official PMI, the HSBC/Markit PMI does not have obvious seasonality problems. The index still rose by 1.3 ppt after making a standard x12 seasonal adjustment. This magnitude of rise in one month is significant.

Contrary to popular interpretation, the fact that the level of the index was below the 50% threshold does NOT mean manufacturing activities were experiencing negative growth/contraction. Conceptually, a sub-50% reading means “there was a larger number of respondents who said their production was down from the month before than those who replied production was up”. This is not necessarily the same as “the level of production of all the companies surveyed fell”. While the relationship is not totally stable, historically, when the HSBC/Markit PMI is at the 50% levels, yoy and mom industrial production (IP) growth tends to be in the low 10% levels, which is a very long way off from a contraction (interestingly, the PMI is more closely correlated with yoy IP despite the fact the survey asks companies about changes compared with the previous month, which should correspond with mom IP). When sequential IP falls to sub-zero levels, the PMI would be at around 45%.
Source: HSBC

2. HSBC views this as a stimulus driven improvement, pointing to continued weak demand and employment. But they believe that low inflation will allow China to push through more easing and materially improve growth.
HSBC: - “July's headline PMI picked up modestly to a five-month high of 49.5, suggesting that the earlier easing measures are starting to work. That said, the below-50 July reading implied demand still remaining weak and employment under increasing pressure. This calls for more easing efforts to support growth and jobs. We believe the fast falling inflation allows Beijing to do so and a more meaningful improvement of growth is expected in the coming months when these measures fully filter through.”
3. The ISI Group is not ready to say that the slowdown is over. They also attribute this PMI jump to China's recent easing measures and expect more stimulus to come because of weak demand and employment. But they don't anticipate a material improvement in growth.
ISI Group: - Finally an uptick but we are not ready to call this the turn...According to HSBC, July’s Flash PMI picked up modestly to hit a five-month high of 49.5, suggesting that the earlier easing measures are starting to work. However, the below-50 reading implies weak demand and employment pressures. More easing is necessary. This still soft PMI reading is consistent with our below-consensus GDP forecast. It is not consistent with a hard-landing. We expect the PMI to move roughly sideways in 2012. China’s economy is still growing, but no return to the sustained 9-10% growth rates of the past.


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CFTC coming under pressure to finalize derivatives regulation

Here is an update on the implementation of the Dodd-Frank derivatives regulation (part of the financial reform and consumer protection law) from JPMorgan (see attached document). For active derivatives end-users the clearing requirement deadline seems to be the end of this year. A good number of them are not even close to being ready and the implementation deadline will likely slip once again.

Source: JPMorgan

Of course this is only for products that can be cleared. What happens to derivatives that are not expected to be cleared, at least initially? The CFTC of course is going to impose certain high margin requirements on those (these margins can't be lower than those applied to cleared products.)

But the "non-cleared" margins can't be applied just to US banks because if margins for non-US swaps dealers are lower, US banks will not be able to compete. It means that these margin requirements have to be fairly uniform across jurisdictions, with other regulators playing in the same sandbox. And that's (one of the many areas) where the CFTC is running into difficulties.
IFR: - ... foreign regulators and banks have joined the chorus of disapproval, focusing on the potentially damaging effect margin requirements for uncleared swaps could have.

The most important response to watch for will not be from any individual country’s banking supervisor or US industry group, but from the European Commission’s lead regulator on Internal Market and Services, Michel Barnier.

“We are particularly concerned with potential CFTC margin requirements for swaps that are not cleared through a central counterparty,” Patrick Raaflaub and Mark Branson, the CEO and head of banking regulation at the Swiss Financial Market Supervisory Authority, wrote in a letter to the CFTC in early July. “If such margin requirements are applied to a Swiss-based entity, this may duplicate the requirements and may possibly conflict with international and domestic capital adequacy rules, thereby producing inefficiencies.”

“Due to [this] concern, we cannot exclude that FINMA may have to deny financial institutions permission to supply certain information or grant direct access to U.S. supervisors,” they warned.

That statement could be perceived as a shot across the CFTC’s bows in what could become a power-struggle between international regulators, said a regulatory lawyer in New York. FINMA is implying that it would deny Swiss banks the right or ability to comply with certain US regulations, even if Gensler mandated it. The effect of such a move by FINMA could mean a regulatory stalemate for Swiss banks looking to engage in swaps with US persons or their affiliates after Dodd-Frank is fully implemented in the US, the lawyer said.
This is not a surprise given that the CFTC has trouble regulating futures brokers in the US - which has been its main job. Now they are trying to dictate global regulation on something the agency has little experience with. Even in the US people are beginning to ask questions.
IFR: - The US Chamber of Commerce submitted a letter this month warning Gensler that foreign regulators may feel the impulse to extend the scope of their derivatives regulations back into the US due to the “extraterritorial application of derivatives regulation”. David Hirschmann, the author of the letter, added that an “overly broad” application could put foreign branches of US firms at a competitive disadvantage – criticism US banks have repeatedly raised.
This process has been fraught with problems from the beginning. Zealous, politically motivated, and an inexperienced group has been at this for years, introducing tremendous uncertainties into the implementation process and incremental risks into the derivatives market as a whole.

Enjoy! J.P. Morgan Regulatory Update Slides July 2012

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iTraxx - CDX spread blows out again

This is not a surprise, but the market is now assigning a significantly higher probability of default to European investment grade corporate credits than to US firms. The chart below compares iTraxx Europe (European corporate CDS index) with IG CDX.

Markit iTraxx Europe vs IG CDX (click to enlarge)

We've seen this widening in the fall of last year during periods of extreme stress and it is back close to the highs again. This spread is turning out to be good indicator of the Eurozone stress level.

Note that back in 2009 the spread was negative, as US firms were perceived to be riskier than their European counterparts. Amazing how much things have changed in three years.

Spread between iTraxx Europe and IG CDX 


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Eurozone banks are pulling out of the US

Back in December we discussed how lack of access to dollar funding will push Eurozone banks out of the US. That's not because these banks don't like US lending. It's simply due to the fact that European banks generally rely on domestic euro deposits for funding (exacerbated by increased capital requirements). To obtain dollar funding however they used to issue commercial paper and sell it to US money market funds. But US money market funds walked away from this CP last year to avoid exposure to the Eurozone. This left Eurozone banks with no access to dollars except via the Fed Liquidity Swap (or converting euros into dollars and hedging the position via currency basis swap, which became extremely expensive). Here are a couple of posts on the topic: Post 1, Post 2.

This unwind of US assets is in fact now taking place and US banks are the beneficiaries.
FT: - France and Germany, led by BNP Paribas and Deutsche Bank, still have some of the biggest foreign operations in the US. But French financial groups including BNP, Crédit Agricole and Société Générale have announced plans to shrink their balance sheets.

US assets owned by German banks have fallen from their $427bn peak in 2007, to $267bn as of March. Assets held in the US by French bank-owned offices have fallen from $420bn in December 2007 to $373bn, according to the latest Fed data.

The pullback by banks from smaller eurozone countries is even more stark, as their banking systems come under severe pressure. US assets owned by Irish banks plunged from $130bn in September 2008 to $3.6bn as of March.

Wells has been one of the more active US banks in buying assets from European competitors. The company recently snapped up a $6bn loan portfolio from WestLB, the troubled German Landesbank, as well as the North American energy business of France’s BNP.



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Structured products for nervous investors

Structured products for retail investors are back. For those who have some extra money, there are always structured CDs (like this one from Goldman). And then we have exchange traded structured notes for everyone else. Like this note called eUnit (ticker symbol ETUA) from Eaton Vance.
WSJ: - It is the eternal investor dilemma: How to invest in the stock market, without the risk?

Eaton Vance Corp. thinks it has a solution. The Boston-based company, with $192 billion in assets under management, earlier this year launched an unusual structured product with returns that are tied to the Standard & Poor's 500-stock index. Experts say it could be the first of similar products to follow.

Called an eUnit Trust, the investment limits the amount of losses an investor can sustain, but also caps the earnings during the lifetime of the investment—a period of two years.
How does Eaton Vance put one of these together? Actually it's quite simple. They take investors' money and do 4 things with it:
1. Buy 2-year treasuries.
2. Buy a 2-year in-the-money call on the S&P500 index.
3. To reduce the cost of the purchased call, they sell an out-of-the money call on the S&P500.
4. And of course charge 75bp per year

The timing is good because implied volatility is relatively cheap. Here is what the payout looks like.

eUnits payout structure

Below is the performance so far (underperforming the S&P500). Because of movements in implied volatility and the note trading at premium/discount to assets, one needs to hold it to maturity in order to get the full benefit of the payout structure.

eUnits vs. S&P500

So far there isn't much liquidity in these notes (maybe 1,500 shares per day). The product can certainly be replicated in a brokerage account that permits buying and shorting options. But one would need to put on size to do better than 75bp per year. That's why if this works out for Eaton Vance, there will be more products like this in the market.

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