Saturday, August 31, 2013

Two key issues with Abenomics that many economists ignore

On its surface "Abenomics", which is focused on pulling Japan out of its prolonged deflationary environment, seems to be working. The CPI spiked to the highest level since 2009.

Source: Statistics Bureau

But there are two key problems with the way this policy is progressing thus far.

1. Price increases have been driven by weaker yen rather than pricing power improvements of domestic producers. Japan is generating the "wrong" kind of inflation - here are a couple of reasons for this recent spike in CPI.

Source: Statistics Bureau

2. This externally driven inflation is creating negative real wage growth domestically. The concept seems to fall on deaf ears in the economics community - we've received numerous emails from seemingly educated economists who don't see anything wrong with the current trajectory of Abenomics. Japan cannot pursue this policy without some badly needed labor reforms.

Japan's corporate practice of lower (on average) wages for workers who are older than 50 (see chart) combined with rapidly aging population (increasing numbers of employees older than 50) takes wage growth in the wrong direction. The combination of declining or stagnant nominal wages and rising prices is creating serious hardships for the nation's citizens. Here is a passage from the WSJ that zeroes in on the problem with Abenomics.
WSJ: - ... for the average person in the world's third largest economy, the recent budding signs of rising prices have brought more pain than gain amid sluggish income growth.

"I pay more when I go grocery shopping. I also pay more for gasoline," said Noriko Kobayashi, who works at an advertising agency. "As my monthly salary and bonuses haven't increased, the rise in consumer prices hurts me," the 39-year-old said. "I haven't felt any benefits from Abenomics."

Ms. Kobayashi's woes are shared by millions of others across the country who have seen their purchasing power shrink, and demonstrate that in the absence of solid wage growth, inflation isn't a cure-all for the economy.
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Friday, August 30, 2013

Market regime change - is your risk manager even aware of it?

Rising rates should be good for a currency. At least that's the theory. And those who believe it have been disappointed in the last few years, because just the opposite has been true. Since the financial crisis, both the dollar and treasuries have been viewed as "risk-off" assets. When it felt as though the next Eurozone country was about to fail, investors bought treasuries and the dollar. Each dollar rally would typically coincide with stronger treasury prices and lower rates. The dollar-to-interest-rate correlation became more negative as things in Europe became more uncertain. The correlation hit its lowest level (most negative) after Italy's ability to fund its government and the whole of EMU's future was brought into question in late 2011.

But recently we've had what some refer to as a "regime change". Treasuries to some extent lost their status as a "risk-off" asset (see post). The correlation between the dollar and interest rates suddenly flipped into positive territory, which is more in line with the traditional way of thinking about the relationship. In fact the correlation hit its highest level in nearly a decade. US rates recently became the "risk driver" of other asset classes.

Trade Weighted U.S. Dollar Index: Major Currencies (DTWEXM) vs. 10 yr  treasury yield

This regime change plays havoc with many common risk models that banks and even some asset management firms run. These models often drive trading limits, counterparty potential exposure measurements, and bank regulatory capital. The calculations tend to rely on historical relationships - sometimes over a period covering the previous two years (as prescribed by the Basel rules). At this point however some of these models are all but meaningless, as correlations among major asset classes have flipped. Yet these measures continue to be broadly used, with regulators encouraging or even requiring this practice.

So the next time you see a "value at risk" measure, ask the author how she/he addressed the recent regime change in the markets. The answer may surprise you.
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RBI sells dollars directly to oil importers; kicks the can down the road

India's central bank, the RBI, is trying new measures to stabilize the rupee. One of the key sources of pressure on the currency is the nation's need to import fuel. Oil companies have to buy dollars (sell rupees) in order to purchase crude oil in the international markets (including from Iran) to meet the nation's massive energy needs.

Rather than having these oil firms go into the foreign exchange markets to buy dollars (which have become more expensive by the day) the RBI wants to sell them dollars directly. And it would do so at some rate which is better than what these firms can get in the spot market. The goal is to keep these large importers from flooding the market with rupees.
Reuters: - The Reserve Bank of India will provide dollars directly to state oil companies in its latest attempt to shore up a currency that has slumped to a record low, reflecting the stiff economic challenges facing the country in an uncertain global environment.

The Reserve Bank of India announced late on Wednesday a special window "with immediate effect" to sell dollars through a designated bank to Indian Oil Corp Ltd, Hindustan Petroleum Corp, and Bharat Petroleum Corp "until further notice".

The RBI last opened such a window during the 2008 global financial crisis, although it had been widely expected to re-implement the measures after last month telling oil companies to buy dollars from a single bank.

The steps are the latest in a series of extraordinary measures undertaken by the RBI to combat a currency fall of more than 20 percent this year, by far the biggest decline among the Asian currencies tracked by Reuters.
The announcement of this decision stabilized the rupee - for now.

USD/INR (source:

Many observers view this action as having only a temporary effect. According to Reuters, the RBI will "sterilize" the dollars it provides to India's large energy firms. As it sells dollars to the oil companies, it will simultaneously buy dollars in the forward market to replenish its foreign reserves in the future. The central bank is doing what it can to avoid a repeat of 1991, when foreign reserves dwindled - forcing India to seek help from the IMF (see post).
Reuters: - Officials familiar with RBI thinking told Reuters the dollar sales for state-run oil companies would be offset by positions in forward markets.

That means that although the RBI would need to dip into its currency reserves, it had the prospect of replenishing the lost dollars at a future date by redeeming the forward contracts from oil companies when the rupee stabilises.

The offsetting positions would essentially make these dollar loans, designed to reduce concerns about reserves that at $279 billion, cover only about seven months of imports.

The action further cements the role the central bank is taking to combat the fall in the rupee, as the government has yet to unveil steps that can convince markets it can stabilise the rupee and attract foreign investment.
However when those forwards mature, the RBI will take the dollars back and release the rupees into the market, putting downward pressure on the currency again. Of course the central bank can roll the forwards for a long time, but the more dollars it sells to the oil firms, the more dollars it will need to purchase in the forward market. The RBI is simply kicking the can down the road, creating a growing overhang of rupees that will eventually have to hit the market (as RBI gets the dollars back.)  The hope is that by then the pressure on the currency won't be as great as it is now.
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High frequency sentiment indicators point to weakening consumer confidence

As discussed earlier (see post), improvements in the US consumer sentiment that we've been seeing earlier this year seem to have stalled. The high frequency polling indicators from Gallup and Rasmussen are both showing this reversal in trend.

Source: Gallup

The August measure is a simple average of daily polling results through Aug-30th
(source:  Rasmussen)

Given the timing of the inflection, the cause is likely due to increases in interest rates and stock market volatility. Also energy prices started rising in July, which may have contributed to further declines in sentiment. Moreover, we are unlikely to see consumer attitudes improve in the near-term, given the situation in Syria and the upcoming federal budget battle.
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Wednesday, August 28, 2013

Credit growth remains the weakest link in Eurozone's recovery

In spite of some positive economic signals out of the Eurozone (see Twitter chart), the area continues to struggle with credit growth. The latest loan growth measures still look quite bleak. We may however be seeing the first signs of the bottoming out of consumer credit, although the "improvements" are by no means compelling.

YoY loan growth to householdsadjusted for sales and securitizations
(source: ECB) 

This slight increase in consumer credit (above) is mostly due to lower declines in credit card and auto debt, as the euro area consumer is still deleveraging but at a slower rate.

YoY consumption loan growth to individuals (source: ECB)

Growth in the Eurozone mortgage loans however continues to weaken.

YoY loan loans for house purchase (source: ECB)

Not surprisingly a great deal of this weakness in mortgages is generated by Spain (chart below) and Italy to some extent. The collapse in mortgage growth from the peak of 27% per year during the pre-financial crisis years demonstrates the massive housing bubble that Spain is still unwinding.

YoY loans for house purchase in Spain (source: ECB)
Different time scale from the chart above

In contrast to household credit, which may have on aggregate bottomed out in June, corporate loan declines in the Eurozone have actually accelerated, generating a 1.4% total credit contraction in the area.

YoY loan growth to corporations adjusted for sales and securitizations
(source: ECB) 
The explanation for this trend is quite clear:
Reuters: - With much of the euro zone periphery still in recession, investment and spending is subdued, while banks are restraining lending to repair their balance sheets - a combination that risks condemning the bloc to an anemic and uneven recovery.

Adjusted for sales and securitization, the drop in loans to the private sector was 1.4 percent on an annual basis, the biggest on the record.

An ECB survey released in July showed that euro zone banks, facing tougher capital requirements, tightened lending standards for both companies and home loans in the second quarter even though their access to funding eased.
With credit still contracting, it was not unexpected to see growth in the area's broad money supply (M3) stalling. The ECB's extraordinary support for the banking system and low interest rates have not achieved the sufficient "monetary transmission" to stimulate lending.

Source: Econoday

None of this has been much of a surprise to economists, given the area's pressured banking system, weak corporate loan demand, and a relentless real estate-driven credit contraction in Spain. In spite of some recent progress (see Twitter chart on consumer confidence), it's going to be a tough and uneven road to recovery.
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US-Syria saber-rattling is already damaging the economy

Even if the US threat of a potential military intervention in Syria is just a bluff, it is already doing damage to the global economy. Brent crude just broke through $117/barrel. Imagine just for a minute what this does to emerging economies whose currencies have been decimated recently (see post). They still have to pay for oil in dollars.

Brent crude October contract

Back in the US, businesses and consumers alike are dealing with a sharp spike in interest rates and a massive federal budget fight. Potential outcomes of the fiscal showdown could include cuts in federal spending (potentially impacting numerous government contractors and their employees), higher taxes, or even a federal government shutdown. Also it's important to keep in mind that it's been less that a year since the Eurozone-related fears began to subside. And now the country has to deal with elevated energy prices?

Those who live in the Northeast and have no access to natural gas to heat their homes will cringe when looking at the chart below - the January heating oil futures. That's money directly out of consumers' and businesses' pockets. The situation with gasoline is similar.

January heating oil contract

Worst of all is the tremendous uncertainty associated with rising tensions in the Middle East. An environment such as this is not conducive to investing in growth and hiring. While the situation in Syria is tragic, the US economy simply can not afford a massive blow that would result from this conflict.
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Tuesday, August 27, 2013

Latest on India: rupee in free fall, stagflation setting in, risks of sovereign downgrade and investor panic rising

This is beginning to sound like a broken record, but India's currency has come under severe pressure - again. India's central bank, the RBI, seems to have completely lost control over the rupee. The currency broke through 67 to the dollar this morning - a level that was difficult to fathom just a few months ago.

Dollar rising vs. the rupee (source:

This is hitting the domestic economy hard. Just when the Indian consumer spending has slowed, prices are about to rise - potentially rapidly. Here is an example.
The Economic Times: - Indian companies such as Whirlpool of India Ltd say they can't plan more than a couple of months out as a fast-falling rupee currency drives up the cost of imports, forcing them to raise prices even as consumer spending crumbles.

The timing is particularly tough for consumer companies that were counting on India's September-to-December holiday season to spur sales. India's consumers, whose spending helped see the country through the global financial crisis in 2008, are closing their wallets, squeezing companies from carmakers to shampoo sellers.

Companies that import finished goods or raw materials are the worst hit as they scramble to hold onto margins while balancing the need to raise prices without deterring buyers.
"We are now planning for a month or three months at best unlike six months or a year earlier," said Shantanu Dasgupta, vice president for corporate affairs and strategy at Whirlpool of India, the local arm of Whirlpool Corp, the world's largest home appliance maker.
One would think that with this type of currency depreciation, India's exports should help with economic growth. Not quite.
BW: - It’s standard macro-economics: When a country’s currency declines, its exporters should soon get a boost as the lower currency makes their goods more competitive. By that rule, India should be enjoying an export boom. Since the start of May, the currency has dropped 23 percent, making it one of the world’s worst performers. Sure enough, exports did go up in July, rising 11.6 percent year-on-year, the best increase in more than 12 months.

Consumers worldwide shouldn’t expect to see a surge in Made-in-India products in the coming months, however. The July increase comes after a period of weakness: India’s exports dropped 1.8 percent in the 2012-13 fiscal year. And while the currency has been steadily weakening for two years, the decline of the rupee hasn’t helped narrow India’s current-account deficit. Instead, the trade gap has just gotten bigger, hitting 9 percent of gross domestic product in the first quarter. “The sustained and large depreciation of the [rupee] since mid-2011 does not appear to have had any near-term impact on the current-account deficit,” Mumbai-based Goldman Sachs economist Tushar Poddar wrote in a report published on Aug. 26. Chances of a short-term rebound driven by a weaker currency are “doubtful,” he added.
And now two risks of serious collateral damage from this devaluation are becoming increasingly real:  (1) a sovereign ratings downgrade and (2) the equity market collapse due to foreign investors' full blown panic.
JPMorgan: - The stagflationary impact of such depreciation is well-known. But, more worryingly, markets have now begun to question whether the currency has entered a zone that could prompt more serious events. Two clear event risks are now appearing on the horizon. First, more currency weakness and its damaging consequences on the fiscal deficit have re-ignited concerns about a sovereign rating downgrade. Second, the risk of a sharp equity outflow has increased. Foreign equity investment is four times that of debt in India, and sustained corporate stress and slowing growth is testing equity investors’ patience. 
At this stage, rising prices, sharply higher interest rates (see post), and a loss of confidence within the business community will bring the economic growth to a standstill, potentially pushing the country into a full blown stagflation.
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Argentina tries to avert default - again

Last week the US appeals court ruled in favor of the NY-law bond houldouts (a group of bondholders who did not participate in the swap some years back when Argentina defaulted), forcing Argentina to make payments on these bonds. And paying these dollars will be a material burden on Argentina, who has limited foreign reserves.
WSJ: - A U.S. appeals court ruled in favor of Argentina's holdout creditors in their bid to be paid in full on long-defaulted bonds.

That sets the stage for a Supreme Court showdown and increases the odds that Argentina will default for the second time in just over a decade.

The U.S. Second Circuit Court of Appeals in New York ruled Friday that if Argentina keeps up its payments to creditors who accepted a discounted restructuring offer, then it also must pay a group of holdout bondholders 100% of the roughly $1.33 billion they are owed in principal and accrued interest. However, it kept a stay in place on enforcement of the ruling while the U.S. Supreme Court decides whether to review the case.

"It's a tough ruling, and it seems they accepted all the plaintiffs' arguments," said Eugenio Bruno, an attorney at Argentine law firm Estudio Garrido, which represents several creditors that accepted the swap offers.
Today Argentina is proposing to swap the NY-law bonds for domestic paper.
Reuters: - Argentina's government is proposing a voluntary bond swap on its foreign debt, shifting payments to Buenos Aires, if it cannot overturn U.S. court rulings that threaten to trigger its second debt crisis in just over a decade.

The bond swap would allow Argentina to keep paying the creditors who agreed to restructure the country's sovereign debt after a record $100 billion default in 2002, President Cristina Fernandez said in a televised address on Monday night.

Investors in international markets would have the option to swap their foreign debt for Argentine bonds if ongoing appeals of the U.S. court rulings are rejected, a government source told Reuters on condition of anonymity.
Of course the devil is in the details, but on the surface this violates the U.S. Second Circuit Court of Appeals ruling which is telling Argentina to make contractual payments on the current bonds. As expected, the NY-law bondholders are skeptical at this stage. Foreign holders know that should there be a problem in the future, they don't stand a chance with some puppet court in Buenos Aires. The ability for foreigners to take their money out of the country is also a potential issue.
Reuters: - But Fernandez's proposal of a new bond swap raised questions about whether investors would be interested in taking Argentine bonds in lieu of foreign debt, given strict currency and capital controls that the left-leaning Fernandez government has imposed.

"Changing the location of the payments to Buenos Aires is going to be extremely complicated amid the currency controls," said Jorge Todesca, a former deputy economy minister who is now head of the Finsoport economic consultancy.
This is particularly painful given Argentina's bloated official exchange rate - the "unofficial" rate now has the peso at 37% discount (around 9 pesos to the dollar - chart below). And given this uncertainty, the unofficial peso is expected to continue weakening further.

Source: El Dolar Blue

Market participants clearly view these events as raising the probability of Argentina's technical default and are awaiting the details of the proposed swap. If the proposal is not acceptable, the nation is likely to default - again. Argentina sovereign CDS premium jumped, with points upfront now approaching 50% (for every $100 of protection you need to pay some $50 in premiums).
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Putting recent treasury losses in perspective

The histogram below shows the total return of long-dated treasuries over a rolling 4-month period since 2007. The rationale for using a 4-month period is that the climb in long-term rates started 4 months ago (a 3-month period produces a very similar result.) The leftmost bucket contains five periods that constitute the worst treasury losses since 2007. All five of these periods ended within the past 10 days, indicating that the recent losses are the worst in at least 6 years.

For those who have access to this index on a total-return basis going back further that 2007, it would be interesting to see how far back one actually has to look to find an equivalent correction to bond prices.
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Monday, August 26, 2013

Speculative treasury positions are now net short and growing

Speculative money has become visibly short rate products. As discussed this weekend (see post) there still seems to be a broad bearish sentiment on treasuries - in spite of the massive selloff. The charts below show speculative net positions in LIBOR futures ("ED") and the 10yr note futures ("10s"). LIBOR futures are often uses to take a speculative view on long-term interest rates (usually via a "strip" of futures extending out a number of years - effectively mimicking a rate swap). The 10yr note future is the most common way of betting on rates in the futures market.

In the last couple of months positions flipped from net long to net short. If the economy or the Fed were to disappoint, the resulting treasury rally could prove painful for these investors.

Source: JPMorgan
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A steeper VIX futures curve

One helpful risk indicator worth tracking is the steepness of the VIX futures curve (see description). In particular the spread between the December and the September futures provides a measure of risk premium that should in theory encompass both the Fed action and the budget/debt ceiling fight in Washington. Based on the recent spread movements, the market seems to be mostly just concerned with the Fed right now. Will the curve steepen further once the risk of this potential government shutdown becomes more real?
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Soy, corn futures spike on scorching Midwest weather

Here we go again. While the early part of the US Midwest summer has been fairly benign for crops, farmers' luck has run out in late August. The central part of the US is experiencing a broad heat wave, putting a number of crops at risk.


After what happened last summer (see post), this is particularly an unwelcome development. Crop conditions have been decent through early August, but all that is about to change.

Corn crop conditions by years (source: USDA) - Crop conditions in many key areas may be going from bad to worse in the next few days. Temperatures will scrape the triple-digits around the nation's center to begin this week. With the exception of a quick pass-through by a "weak cool front" bringing some spotty showers later in the week, the weather will remain hot and dry for the next week and a half or so, forecasters say.
Prices on soy, corn, wheat, and other grains spiked this morning as a result - with the soy crop being particularly vulnerable at this stage. Here are the most active contracts for corn and soy.

Source: barchart

This does not bode well for emerging economies who import some of these products and have recently experienced significant currency depreciations.
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Emerging economies sought semi-hot money through currency manipulation

As we look across major emerging economies, even some of the strongest have not been spared. Consider Turkey for example. The lira is now toying with the 2-to-the-dollar level - even after the central bank has taken a number of steps to stabilize the currency.
Hurriyet Daily News: - The Turkish central bank said it would apply more monetary tightening by not holding one-week repo auctions, halting funding from its policy rate and opening forex-selling auctions of at least $350 million.
At this point the central bank is desperate, adjusting its policy each week or even more than once a week. It is however having little success, as the currency slides, ...

Turkish lira to one dollar (source:

... the stock market is now in full retreat, ...

Borsa Istanbul National 100 Index (source: Bloomberg)

... and rates have gone vertical, as the three-year notes punch through 10% - more than doubling in yield since May.

Turkey 3yr government bond yield

How did we get here? How is it that the Fed's actions, which had to take place sooner or later, precipitated a severe market squeeze on one of the strongest emerging economies - among others? An interesting answer came from Donald Kohn, the former Fed vice-chair, who presented at Jackson Hole.
FT: - With cheap capital flowing in, some emerging markets failed to run a disciplined economic policy, or carry out reforms to boost future growth. Those are the economies that now face the greatest difficulties.

One argument at Jackson Hole, although expressed with much diplomacy and politesse, was whether those imbalances in emerging markets are an inevitable result of easy monetary policy in the US and elsewhere, or the fault of developing country policy makers.

“The recipient countries have considerable control over how this works out and what stability conditions are inside their own countries,” said Donald Kohn, the former Fed vice-chair, now at the Brookings Institution. “One of the ways that monetary policy from the United States was transmitted to the rest of the world was by resistance to exchange rate appreciation in many other countries.”
By holding down their currencies, these nations allowed semi-hot money to flood their economies. In a fully flexible exchange rate mechanism these currencies would have appreciated sufficiently to make it less attractive (more expensive) for this capital to enter. That would limit the semi-hot money and force these nations to grow in a more sustainable manner. Unfortunately this hasn't been the policy for a number of nations. Now the semi-hot money is rapidly exiting, leaving these countries with economic damage that could potentially become severe.
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Sunday, August 25, 2013

Can the Fed's proposed overnight facility reduce pressure on the repo markets?

Repo rates in the US have seen sharp declines this year and are currently at levels not seen since 2011.

There are several reasons for this decline:

1. Excessive liquidity in the financial system (induced by the Fed) is chasing "secured deposits". Reverse repo provides a way to deposit funds with a bank, but receive collateral in return in order to mitigate counterparty risk. With demand on the rise, rates paid on these deposits have declined.

2. With the Fed buying up the exact same collateral sought by these reverse repo "depositors", the collateral pool is more limited. That competition for collateral suppresses the rates repo providers are willing to pay on secured deposits. The problem is too much cash and not enough collateral.

3. Recent bank regulation proposals (see post) are also beginning to discourage banks from building large repo books with clients.

4. More recently, a wave of short-sellers pushed repo rates even lower by looking to borrow and short increasing amounts of treasuries and agency MBS. Some are betting on rising rates while others simply hedge fixed income portfolios. Given the demand to borrow this paper, banks are paying less on cash proceeds that result from short-selling these securities (note that the repo process is the same as # 1 above except traders look to borrow a specific bond to short rather than accepting "general collateral").

5. It's also important to point out that treasury issuance is expected to drop off significantly in September (roughly $25bn in bills alone). Furthermore with the debt ceiling approaching and with the US Treasury having accumulated substantial cash positions, treasury issuance will fall further (see chart). That is one of the reasons the Fed should feel comfortable reducing its purchases in September - smaller purchases will not increase the overall supply of treasuries substantially.

In light of these developments, market participants are quite supportive of the Fed's proposed "full-allotment overnight reverse repurchase agreement facility" (discussed here) as a method to overcome some of the challenges. The Fed will commit to take as much in deposits as the market wants as long as participants accept the Fed's rate on this facility (some refer to this facility as "all you can eat" or "buffet" .) It will allow market participants that are long cash, such as money market funds, the GSEs, and some corporations to circumvent banks altogether in depositing their cash.

The Fed's new facility will likely be executed via a triparty repo that will not allow the Fed's securities to be used as collateral elsewhere (no "re-lending" of securities). Typically the Fed's bonds will be held by custodians such as JPM, BNY Mellon, and State Street. However by significantly reducing demand in the market for general collateral reverse repo, the program should free up a great deal of this collateral which banks currently use for this purpose. And that will end up easing some of the collateral shortages we've experienced in recent years. The rate on this facility should set a floor on general collateral repo rates because large participants will only execute reverse repo with banks (vs. the Fed) if banks pay a higher rate.

Unfortunately it may be a while before this facility is in place, since it will effectively sweep liquidity out of the system, reducing bank reserves. And it is unlikely that the Fed will want to reduce reserves via this program while increasing reserves via the securities purchases. That means the tightness in the repo market (low repo rates) may persist for some time, as cash rich market participants look for safe places to park their money.
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Is the treasury sell-off overdone?

ETF Trends recently published an article called "Treasury ETFs: The Ultimate Contrarian Trade" (here). It seems that from the near-term technical perspective, treasury yields may have peaked. That is certainly possible, as portfolio managers - including some sovereign funds and other foreign institutions - have been indiscriminately dumping US government paper each time they hear the word "taper". One can even see the public's strong focus on the topic: the search frequency for the term "tapering" on Google has spiked to record levels (chart below). Furthermore, as the article points out, only "23% of investors are bullish on bonds" - the lowest level since early 2011. This has the makings of a contrarian indicator.

Source: Google Trends

But what about the fundamentals? Where should the 10yr yield be if for example Goldman's recent forecast (see post) of roughly 3% nominal GDP (1.8% real) for Q3 persists for much longer? - not an unrealistic scenario. It turns out there is a long-term relationship between treasury yields and preceding GDP growth. The correlation is not that strong (r^2 =0.4), but thankfully this is a blog post instead of an academic publication.

The quarterly data is from 1962 to today and the points in the negative GDP territory are from the Great Recession. One can see that the Fed (as well as the Eurozone crisis to some extent) had recently pulled the yields down from the more "natural" level. Based on this fit, the 10y treasury should be yielding about 4%. This was roughly the situation during the recovery from the 2001 recession - a 3% trailing nominal GDP and a 4% treasury yield. It tells us that based on long-term history and without the Fed's interference, we could easily go up another 100bp on the 10yr - in spite of tepid GDP growth.

The Fed however will be in play for some time, even as it slows the pace of purchases. It is therefore possible that the oversold technical indicators described by ETF Trends may indeed be valid in the near-term - at least while the Fed continues to apply downward pressure on yields - and growth remains subdued. We could stay just above the "QE3 cluster" on the scatter plot.
ETF Trends: - “This isn’t to say Treasury yields will nearly undo their entire surge this year or that they won’t eventually climb above 3% in response to expectations of a less-generous Fed or a pickup in economic growth,” [Michael Santoli] notes. “But for now, the yield advance has arguably overshot, and the sectors pummeled as a result have suffered from investors planning for a rapid and relentless climb in rates that isn’t likely to happen.”

A pullback in 10-year Treasury yields here also makes sense from a technical perspective. Chris Kimble at Kimble Charting Solutions points out that the rally has lifted the 10-year yield to the top of its long-term channel resistance, while momentum is the most overbought [on yield basis, oversold on price basis] in seven years.
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Saturday, August 24, 2013

The end of cheap US cash claims another victim: Indonesia

In a fashion similar to what became known as the "Asian Contagion" in the late 90s, the current stress in emerging economies has been spreading. One of the nations to experience financial stress recently has been Indonesia, Southeast Asia’s largest economy. The impact of capital outflows from emerging economies on Indonesia's financial markets has been swift and severe. Here are the key financial indicators:

1. Indonesia's equity markets are down 17% in the past 3 months (note that the market peaked in late May, corresponding to this event) -

The Jakarta Stock Exchange Composite Index 

2. The government bond market (sell-off also started around the same time) -

10yr gov bond yield (source:

3. Currency (the exchange rate went vertical last week) -

Dollar rising against the rupiah (source:

4. Sovereign CDS isn't very liquid but is still showing signs of financial stress.

The question some are asking is whether this is just a contagion-driven panic or are there fundamental flaws in the economy? Just as the case with India (see post), trade imbalance in Indonesia is behind some of this adjustment. In the past, foreign investment covered up the problem, but the party is now over. Investors - not surprisingly - have become uneasy with the chart below:

A massive structural problem like this is an invitation for a punishment from the markets. Indonesia (just as Brazil and others) is trying to plug the trade gap hole.
NYTimes: - Indonesia announced a package of policy measures on Friday to reduce imports and bolster investment in labor-intensive industries as it struggles to revive confidence and consumer spending in its economy, Southeast Asia’s largest.

The intervention by President Susilo Bambang Yudhoyono comes after a punishing week for emerging markets, with currencies from Brazil to India hit hard by fears of higher global borrowing costs and a reduction in cheap cash from the United States.

Indonesia has faced sell-offs in the rupiah, stocks and bonds after an unexpectedly large second-quarter deficit in its current account — a measure of foreign trade and investment — prompted fears that the weak global economy would only further erode exports at a time when a surge in inflation is crimping domestic demand.

The country’s chief economic minister, Hatta Rajasa, said the government would increase the import tax on luxury cars, seek to reduce oil imports and provide tax incentives for investment in agriculture and in metal industries.
With China being one of the large clients for Indonesia's natural resources, fixing the trade balance issue is going to be easier said than done. A few tax adjustments are simply not going to do the trick - at least not in the near-term.  The nation remains vulnerable to further market pressure.
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Some expect the political game of chicken to keep the Fed on hold in September

The sell-side research community remains divided over the timing of the Fed's first securities purchase program reductions. While economists almost universally believe tapering will begin this year, the split is mostly between the September and the December crowd.

Source: Scotiabank

A few economists believe that the US economy is too soft to begin reductions in September. But given the lack of progress over the past year, would waiting another three months make much of a difference? In fact prolonging the uncertainty could do more damage.

The main reason a number of economists think the Fed will be on hold in September is the mess surrounding the federal budget fight. It seems that everything is on the table at this stage and the fight could indeed become ugly.
Politico: - Republicans will also aim to include other items to please the base, including the building of the Keystone XL pipeline, various energy policies and revising parts of Obamacare, including the individual mandate.

But here’s where the fight begins: A senior Obama administration official said there is nothing that will compel the White House to negotiate over the debt ceiling — including the sequester. The White House doesn’t believe the Republicans will push the nation into default if they don’t get their way.
We may not get to the point of "default", but there is no question we are about to see another political "game of chicken" as both sides dig in. What is particularly troubling is that the public and to some extent market participants don't seem to care. The Google search frequency for the phrase "federal budget" is at the lowest level in a decade.

Source: Google Trends

With everyone fully expecting a last minute resolution in spite of the saber-rattling, a government shutdown for example could send a shock-wave through the economy and the markets. As discussed before (see post) "tail risks" encompass the unexpected. And a possibility of such a scenario could be the only thing holding back the Fed in September.
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Friday, August 23, 2013

Ecstatic homebuilders having trouble selling homes - what's wrong with this picture?

Today's news of a sharp decline in new home sales has left many economists scratching their heads, trying to understand the trajectory of the US housing market. And here is what they are struggling with:

With the homebuilder survey showing tremendous optimism while new homes not selling well, there is clearly a disconnect. Just as other economists, Goldman's research team is having a tough time reconciling the two. GS also points out that new home sales represent a somewhat more timely indicator than the existing home sales number - which was quite strong in July (see this post).
GS: - Based on contract signings rather than closings, new home sales are a slightly more timely indicator of housing activity than the stronger-than-expected July existing home sales data released earlier this week. The recent weakness is concerning in light of the rise in mortgage rates in recent months and drop in new purchase mortgage applications. However, the weakness in new home sales stands sharply in contrast to the NAHB homebuilders index, which points to more favorable prospects for housing starts and new home sales in coming months.
In spite of the conflicting data, Goldman's research team decided to downgrade its forecast for the 3d quarter GDP to 1.8%.  Long-term interest rates may be having a far deeper impact on the economy than previously thought.

It is worth mentioning that this forecast does not bode well for the success of the Fed's latest round of monetary easing:
  • Including the current quarter and Goldman's forecast above, the 4 quarters since the start of QE3 have generated 1.2% average annualized GDP growth in the US.
  • The 4 quarters immediately prior to QE3 have generated 3.2% annualized GDP growth.
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Consumer sentiment in the US has peaked

With a sharp rise in interest rates (see chart) and with gasoline prices still elevated after a spike this summer (see chart), it is increasingly important to track the US consumer sentiment. Given the anemic post-recession growth, additional weakness in consumer spending could be bad news for the economy. And while confidence remains near multi-year highs, a number of sentiment measures seem to indicate that American consumer confidence has peaked earlier this summer. Here are three measures that seem to support that thesis:

1. The Thomson Reuters/University of Michigan consumer confidence, the most broadly tracked consumer sentiment index, showed a surprising drop in August.

The Guardian: - Consumer confidence in the US fell unexpectedly in August as higher interest rates and a dip in the rate of economic growth appeared to sap optimism.

The Thomson Reuters/University of Michigan's preliminary reading of consumer sentiment slipped from a six-year high of 85.1 in July to 80.0. The figure was well below the 85.5 reading expected by economists.

Friday's figure follows a series of disappointing results from US retailers including Walmart and Macy's that have caught economists by surprise. "The expectation was that we were going to have a good August," said economist Ken Goldstein of the Conference Board. "Clearly that was wrong."
2. Bloomberg Consumer Comfort Index (which came out today), also showed a decline.
Econoday: - Consumer confidence fell last week to the lowest level in two months as Americans' views on the economy deteriorated. The Bloomberg Consumer Comfort Index fell to minus 28.8 for the period ended August 18 from minus 26.6. The two-week decrease from a more than five-year high reached in early August has been the steepest in a year. The monthly Bloomberg consumer economic expectations gauge held in August at minus 5, a five-month low.
3. Gallup's Economic Confidence Index points to consumer confidence having peaked as early as late May to early June - before the major spike in rates and gasoline prices.
Gallup: - Gallup's Economic Confidence Index was -13 last week, declining to the levels seen during most of July and August, after a slightly better reading two weeks ago. The current index reading is 10 points lower than the peak reached in late May and early June.
While not necessarily a full measure of consumer confidence, there is another indicator worth mentioning. The Knapp-Track Index which tracks the chain dinner house/theme restaurant market is down 3.5% last month -  supporting the theme of consumer sentiment in the US is beginning to turn.

Update:  For completeness it is also worth including the Rasmussen Consumer Index. While the full August number is not yet available, the chart below includes MTD daily average for this month. This index also supports the thesis discussed above.
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Wednesday, August 21, 2013

Dividend shares still ahead of the S&P500 on a year-to-date basis

With rising rates there has clearly been some rotation out of high dividend shares in the US.
StarTribune: - This exodus out of bond funds has touched the stock market in two different ways, investors say, starting with dividend-paying stocks.

Shares in industries such as utilities, pharmaceuticals and telecommunications are often purchased because they provide a higher-than-normal dividend. As Treasury yields rise, it makes all dividend-paying stocks less attractive to investors. That's because Treasuries can provide a similar return with significantly less risk.

Dividend-paying stocks have been hurt the past month. The S&P Utilities index is down nearly 5 percent while the S&P Telecommunications index is down 4 percent. Another type of investment that got hit in recent weeks was real estate investment trusts — investment companies that focus on buying and managing real estate. An index that tracks REITs, as real estate investment trusts are commonly known, is down nearly 8 percent.
Yes, many fixed-income-like assets such as utilities shares and REITS have taken a beating. But in spite of that, companies that have focused on consistently paying higher dividends over time are still outperforming the S&P500 on a year-to-date basis. The chart below compares the total returns of two ETFs: SDY (based on the S&P High Yield Dividend Aristocrats® index) and SPY (S&P500).

Source: Ycharts

While dividend shares become less attractive relative to bonds after rates rise, in an environment of economic uncertainty there is still demand for firms who are able to pay consistent dividend. And there is no shortage of economic uncertainty these days.
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The FOMC minutes exacerbate emerging markets rout

Emerging markets currencies are getting hammered across the board today on the back of the FOMC minutes. Many are touching multi-year or even all-time lows. Here are some examples of the dollar strengthening against some major EMG currencies:


Rumors persist of some very large emerging markets hedge funds taking significant losses, as Brazil's 10-year government bond yield punches through 12%.

Brazil 10y gov yield (source:

This provides further confirmation that the Fed's recent monetary stimulus effort and the artificially low dollar rates have been responsible for a great deal of capital flows into emerging markets. Now we are seeing a sharp and to some extent an uncontrolled reversal of these flows. And many of these nations' central banks find themselves quite helpless in the face of this correction.
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Fed contemplates creating "overnight reverse repo facility"

Today investors focused on the broad support for tapering in the July FOMC minutes, driving treasury yields sharply higher.

10yr treasury yield (source:

There was however another passage in the minutes that wasn't broadly covered in the mass media.
July FOMC minutes: - In support of the Committee’s longer-run planning for improvements in the implementation of monetary policy, the Desk report also included a briefing on the potential for establishing a fixed-rate, full-allotment overnight reverse repurchase agreement facility as an additional tool for managing money market interest rates. The presentation suggested that such a facility would allow the Committee to offer an overnight, risk-free instrument directly to a relatively wide range of market participants, perhaps complementing the payment of interest on excess reserves held by banks and thereby improving the Committee’s ability to keep short-term market rates at levels that it deems appropriate to achieve its macroeconomic objectives.
It's an interesting development because this project could potentially achieve three objectives:

1. The "full-allotment overnight reverse repurchase agreement facility" can provide competition for bank deposits. While deposits of under $250K rely of the FDIC insurance, corporate and institutional depositors remain concerned about bank credit risk because in a bankruptcy depositors become unsecured creditors. By allowing non-banks to participate, the Fed creates a deposit account that is free of counterparty risk (currently the only way to achieve this is by purchasing treasury bills).

2. Instead of just changing the interest paid on bank reserves to manage short-term rate policy (in addition to the fed funds rate), the Fed would now have another monetary tool - adjusting rates paid on these types of broadly held accounts.

3. By accepting broader deposits, the Fed can effectively "soak up" excess liquidity and "sterilize" some of its securities holdings. And by adjusting these rates, the central bank could fine-tune how much liquidity these accounts attract. This reduces the need to sell securities in order to drain liquidity from the system.
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"Panicked" homebuyers rushed to close in July

We now have a confirmation that US housing demand in July was boosted by fear of higher rates (discussed here). July existing home sales spiked to a new post-recession high.

Source: NAR

NAR: - Mortgage interest rates are at the highest level in two years, pushing some buyers off the sidelines... The initial rise in interest rates provided strong incentive for closing deals. However, further rate increases will diminish the pool of eligible buyers.
The less "official" statement from NAR's Chief Economist Lawrence Yun was: "So the increase in rates I think panicked some buyers into wanting to close the deal before the rates perhaps would rise further. The initial phase of an interest rate increase generally provides a sense of urgency to close."

Clearly this demand can not be sustained going forward and we should see a decline in sales in the next few months.
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Tuesday, August 20, 2013

Global retail investor behavior remains a great contrarian indicator

Below is a graph showing the performance of the S&P Developed Broad Market Index (BMI). It represents stocks of some 26 developed markets around the world. Just like the S&P500 in the US - though not to the same extent - the index has had a tremendous rally since the beginning of 2009.

The S&P Developed BMI (source: S&P)

The question is - who really participated in this rally? Te next chart shows exactly what happened.

Source: Barclays Capital (DM = "Developed Markets";
Light Blue = "Retail Investors", Dark Blue = "Institutional Investors")

Until very recently, as institutions were putting money into the market, retail investors were pulling out (keep in mind that globally the situation has been a bit different than in the US). Effectively retail accounts were "suckered" into selling shares to institutions at low prices. Early in 2013, retail investors stopped pulling money out and in the summer, just when equity prices hit new highs, they started putting some money in. That is why retail investor behavior remains a great contrarian indicator.
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