Monday, September 30, 2013

US CDS widens as shutdown looms

The US sovereign CDS spread has risen in the past couple days with the government shutdown becoming more real.

Source: DB

But it's not the shutdown itself that's driving the US default probability higher. It's the fact that the shutdown sets a precedent for the upcoming debt ceiling debate (see video below). US politicians are showing willingness to "play chicken" and they may do it again when it comes to the debt ceiling decision (in mid October). But unlike the shutdown, the inability to raise the debt ceiling could result in a payment default (in addition to a slew of other nasty consequences). While the probability of such an event is quite low, it's enough to widen the CDS spread.
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Sunday, September 29, 2013

Eurozone's falling excess reserves - is another round of LTRO required?

The euro area banking system excess reserves are continuing to decline - touching the lowest level since 2011.

Just to put this in perspective, the chart below shows excess reserves in the US. With the Fed continuing to pump liquidity into the system, these swelled above $2.3 trillion last week - a new record.

The reason the Eurozone reserves are declining has to do with the area's banks gradually repaying what they have borrowed from the Eurosystem via MRO and LTRO loans.

Source: ECB

Some economists view this decline in excess reserves as an indication of tighter monetary conditions in the Eurozone. They point to weak consumer credit growth and a severe contraction in corporate lending.

YoY change in loans to euro area households (source: ECB)

YoY change in loans to euro area companies (source: ECB)

A few economists have called for Mario Draghi to offer up another round of LTRO lending or lower the rates on MRO (short-term) loans in order to boost excess reserves. The thought is for the ECB to follow the Fed's and the BOJ's lead at the October meeting and expand its balance sheet.

Such action however is unlikely at the next meeting. Certainly if these declining excess reserves push up rates, the ECB will have to act. But the central bank does not have the Fed's dual mandate and is not as focused on the Eurozone's dangerously high unemployment levels. Instead Draghi will concentrate on forward guidance of maintaining low overnight rates for the foreseeable future. The ECB will want to keep the LTRO tool in its back-pocket in case the crisis flares up again. After all, there is a nonzero risk of the German Constitutional Court ruling against the OMT program (ECB's commitment to directly purchase government bonds of periphery nations). Other issues, such as political uncertainty in Italy (see post), could potentially reignite the crisis as well.

For now Draghi will want to see if the Eurozone's credit markets can begin to "heal" themselves. The members of the Governing Council are following a number of business surveys which seem to point to stabilization in the area periphery nations.

Source: Econoday

If however lending volumes do not show a visible improvement in the next few months, another LTRO program could be in the works at a later date.
Bloomberg: - Frederik Ducrozet, an economist at Credit Agricole CIB in Paris says an LTRO is unlikely until December. The central bank could boost its forward guidance by putting a definite end date for loans at a particular cost, by issuing an LTRO with a fixed rate, he said. The previous loans were charged at the average of the ECB benchmark over the maturity.

‘‘A properly-designed LTRO would have the potential to kill several birds with one stone by enhancing forward guidance, keeping excess liquidity higher for longer, and further boosting the use of collateral from small businesses,’’ Ducrozet said.

ECB officials including Executive Board member Benoit Coeure have played down the short-term likelihood of a new round of long-term loans, saying that while it remained an option, it hasn’t been specifically discussed. The ECB’s Governing Council convenes in Paris on Oct. 2 for its monthly rate-setting meeting.
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Demand-driven inflation remains elusive in Japan

Japan's National Statistics Bureau published the latest inflation figures last week. As expected, prices continue to rise, presumably lifting the nation from its prolonged cycle of deflationary pressures.

Source: Statistics Bureau

But as discussed earlier, prices are generally not rising due to stronger domestic demand - which is what the nation really needs. Instead a large portion of price increases is generated by weaker yen and costlier imports. And that could undermine consumer confidence.
Reuters: - Some analysts expect core consumer inflation to exceed 1 percent by the end of this year mostly on rising energy and food prices. That may weigh on personal consumption, which would also feel the pain from an expected sales tax hike in April.

"The rise in prices of daily necessities is negative for household sentiment and consumption," said Yoshiki Shinke, chief economist at Dai-ichi Life Research Institute in Tokyo.
Source: Statistics Bureau

On the other hand prices on many domestically manufactured products (such as household appliances) as well as domestic services continue to fall.

Source: Statistics Bureau

The problem with domestic demand continues to be negative real wage growth. You can't have sustainable inflation without rising household incomes. And serious labor reform may be the only way to correct that trend (see post).
Reuters: - Economics Minister Akira Amari said it was too early to declare an end to deflation, stressing that wages and prices excluding energy costs had to rise more.

"Japan is in the process of emerging from prolonged deflation," Amari told a news conference on Friday.

"An exit from deflation will become distant if we're seeing cost-push inflation, where wages aren't catching up with rising prices," he said.
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Saturday, September 28, 2013

BLS senior management should be added to the initial claims statistic

The chart below shows US initial jobless claims without the seasonal adjustment. See anything wrong with this picture?

Claims count had a sudden unprecedented decline and remains at these low levels (expectations have been that claims should have risen materially this week.) The U.S. Bureau of Labor Statistics (BLS) admitted they had a "glitch" in the benefits systems (see chart), which they claim has been corrected last week. If this is accurate, the nation has had an unprecedented improvement in the job market - seemingly out of nowhere. That means the payrolls data for September should be spectacular. That is unlikely.
WSJ: - MFR Inc. economist Joshua Shapiro said the monthly jobs reports as well as the other data such as withholding tax receipts have pointed to a weaker labor market. "Our belief is that the claims data should not be taken at face value as they are inconsistent with too much other evidence," he said.
Given how critical employment data are in this economic environment - both in terms of monetary and fiscal policy - this is not an error that can simply be ignored. Someone senior a BLS should be added to the initial jobless claims number.
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US consumer under constant uncertainty assault

One can list numerous reasons for tepid economic expansion in the US. One explanation is that the US households and businesses are relentlessly bombarded with issues that generate uncertainty. Many of these issues carry the so-called economic "tail risks" - non-zero probability of a severe economic deterioration. In a vulnerable economy and after facing the financial crisis and the Eurozone crisis, tail risks are no longer brushed off. Unlike in the 90s for example, it doesn't take much these days to slow consumer spending and trigger companies to resume hoarding cash.

If these mini-shocks could be avoided and the economy left to heal itself, chances of growth would improve significantly. Unfortunately the bombardment continues, with the bulk of uncertainty generated by the federal government. One only needs to look at the high-frequency consumer sentiment metrics to see the full picture. And people wonder why the 2013 GDP growth is projected to be around 1.5%.

Source: Gallup
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Thursday, September 26, 2013

A court ruling that threatens the private equity industry in the US

A legal case that has received almost no attention in the mass media could potentially seriously damage the private equity business in the US. In Sun Capital vs. New England Teamsters and Trucking Industry Pension Fund, the First Circuit Court of Appeals ruled that a fund managed by Sun Capital was engaged in a "trade or business" rather than as a passive investor with respect to one of its portfolio companies.

The private equity industry has received considerable attention from many politicians and the media because the offshore funds' incentive fees (carried interest) have been taxed as capital gains rather than ordinary income. While fund managers would hate if these fees were to be taxed as ordinary income, most are prepared for this change - in fact many believe it's only a matter of time. The issue of the "trade or business" treatment on the other hand is far more damaging to the industry than the carried interest tax treatment. And virtually nobody is prepared for how it may play out.

There are a number of reasons many investors have to come into private equity funds through offshore vehicles (such as Cayman Islands based funds for example). If you are the Ontario Teachers Pension or Sunsuper (an Australian pension fund) for example, the last thing you want is to have to file taxes in the US. The same applies to sovereign funds such as China Investment Corp. Such entities usually invest in private US companies via these offshore funds. Some foreign investors already pay taxes in their domestic jurisdictions and do not wish to be double-taxed. Many US tax-exempt entities such as corporate pensions often invest via offshore funds as well.
Bloomberg: - If courts or regulators apply that logic to the U.S. tax code, the changes could jeopardize the structure of the industry by altering some core benefits of private equity. Those are low-taxed carried interest for fund managers, tax-free income for universities and an exemption from U.S. taxes for foreign investors.

“The size of the risk is huge,” said Steve Rosenthal, a visiting fellow at the Tax Policy Center in Washington. “The likelihood of the IRS pursuing this is unclear.
The "trade or business" treatment could force these offshore funds to file taxes in the US. And many foreign pensions would rather forgo investing in the US at all than being forced to deal with the IRS. The same applies to many tax-exempt investors in the US. That means the flow of foreign capital now coming into the US to finance private corporations, will slow dramatically if these funds are ruled by the IRS to be engaged in a "trade or business". Many private equity-backed firms grow quickly and create more jobs than public firms. And a slowdown in job creation due to weaker inflows of foreign capital as well as domestic tax-exempt capital is the last thing the US needs right now.
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Tuesday, September 24, 2013

What do CLO managers and retail investors have in common?

The answer is, they both love senior leveraged loans...

The amount of US leveraged senior secured debt outstanding has risen sharply this year. According to LCD this market is now some $630bn in size.

Source: LCD
(the fluctuations include new loans/refinancings as well as partial or full prepayments)

Yet that doesn't seem to be enough. While the M&A activity has picked up this year (Heinz, Dell - see story), the volumes are not nearly sufficient to feed retail investors and CLO managers.
Reuters: - Retail money keeps flooding into loan funds, marking 66 straight weeks of heavy inflows, according to Lipper data. Loan funds pulled in $1.3 billion in the week ended September 18, during which the Fed surprised the markets with its plan to keep on buying $85 billion of bonds weekly to keep rates low and boost economic growth.

Loan fund inflows accelerated over the summer on expectations that the U.S. central bank was about to reduce those bond purchases this month, keeping interest rates rising. Issuance of collateralized loan obligations (CLO), another key source of demand for leveraged loans, at $57 billion so far this year already topped last year's issuance.
This demand continues to keep loan valuations elevated. In spite of the recent selloff across fixed income markets, the leveraged loan index has been pushed to new highs.

Source: LCD

At a recent CLO conference nobody seemed to be too concerned about this. Participants just complained about not getting enough new allocations from the banks running loan syndication. But there are some troubling signs in this market. While leverage on new deals remains well below the 2007 levels, it is starting to creep up as buyers are willing to accept higher risk.

Source: Forbes

Other loan "features" are beginning to look more like 2007 as well.
Reuters: - Conference attendees did note more risky leveraged loan features including payment-in-kind (PIK) toggles, dividend limitations and looser terms cropping up as more investors hunger for relatively higher-yielding assets.
But CLO managers insist that the credit environment remains benign and none of this is a problem.
John Popp (manages CLOs for Credit Suisse): - "At the end of the day, we're most concerned about being paid back, and our outlook from a fundamental credit perspective remains quite benign at present."
All is well -  until someone isn't "being paid back" ...
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BOJ's aggressive QE finally brought down JGB yields

The Bank of Japan was able to lower Japanese government bond yields after an unexpected spike earlier this year (see post). The 10yr JGB is now yielding around 70bp, corresponding to about minus one percent of real yield.

The central bank continues to control this market, accelerating bond purchases since the new governor took the helm. Sooner or later that forces yields lower.

The goal is to make cash and government bonds so unattractive (negative real yield) that investors do something else with their money - hopefully stimulating growth in the process. The effectiveness of this program however is yet to be demonstrated. The recent economic gains were mostly the result of a weaker yen instead of more spending and investment. And the type of inflation generated by BOJ's policy is hardly what the central bank had in mind (see post).
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Monday, September 23, 2013

Gauging the trajectory of the US housing market

One set of economic data that shocked some economists last week was the existing home sales report. In spite of sharply higher mortgage rates, sales rose in August.

Source: Econoday
NYTimes: - Sales of existing houses climbed 1.7 percent in August to a six-and-a-half-year high, and factories grew busier in the mid-Atlantic region this month, providing signs that rising borrowing costs are weighing only modestly on the economy.

The National Association of Realtors said on Thursday that existing houses were selling at an annual rate of 5.48 million units, the highest level since early 2007, when a housing bubble was deflating and the economy was sliding toward its deepest recession in decades.

The report surprised analysts who had expected higher interest rates would lead to a decline in resales. Mortgage rates have risen more than a percentage point since the Federal Reserve’s chairman, Ben S. Bernanke, hinted in May that the central bank could begin reducing its economic stimulus soon. On Wednesday, however, the Fed said it would maintain its $85 billion monthly purchases of Treasury and mortgage-backed securities.
One could argue that home-buyers are ignoring higher rates, but that doesn't seem likely. Is this spike driven by capitulating buyers who had been waiting on the sidelines for mortgage rates to drop? That strategy had certainly worked in the past and buyers are realizing that this time it's different.

One reason to think that the jump in existing home sales is transient is the decline we've seen in new home sales - which most are attributing to higher rates. The divergence shown below is unlikely to be sustainable.

The August number for new home sales (to be released this Wednesday, 10AM ET) will be critical to gauge the trajectory of the US housing market. On Thursday we will also be getting the pending home sales index that should provide a glimpse into sales going forward.
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Sunday, September 22, 2013

Bakken crude shipments to the East Coast benefit railroads

US East Coast (PADD 1) "unaccounted-for" supply of crude oil delivered to refineries has spiked this year. The only explanation is crude delivered by rail.

EIA: - While EIA does report inter-PADD domestic barge and tanker movements of crude oil, the intra-PADD shipment of crude that has been railed to Albany, New York and then shipped intra-PADD by barge to East Coast refineries is not captured and is included in the unaccounted-for supply. Refineries in eastern Canada have also gained access to Bakken crudes via rail and by barge/ship from Albany.

Trade press and company reports indicate that crude-by-rail infrastructure is continuing to expand on the East Coast. The Phillips 66 Bayway refinery in Linden, New Jersey is already processing Bakken crude that is shipped to the refinery by rail and then by barge, and has plans to process more, once a 50,000-bbl/d rail offloading facility at the refinery is completed. Philadelphia Energy Solutions, a partnership between The Carlyle Group and Sunoco Inc., is developing crude-by-rail unloading facilities at their refinery in Philadelphia. Enbridge Inc., along with other partners, is developing the Eddystone Rail Company, a crude-by-rail terminal designed to provide 160,000 bbl/d of domestic crude to refineries in Philadelphia by mid-2014.
Rather than moving gasoline and jet fuel up from Louisiana refineries, Bakken (North Dakota) crude is brought in by rail directly to refineries in the East. And East Coast refinery capacity is quickly being upgraded. Railroads have played a major role in this rapid shift in US fuel transport markets and rail shares have been the beneficiaries.
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Bank shares sell-off may be signaling weaker credit growth ahead

The FOMC announcement to hold the status quo on securities purchases resulted in a flatter yield curve.

While this surprising decision by the Fed helped a number of "risk-on" assets, it was a negative for banks. Bank shares rallied initially with equity indices, but sold off sharply later in the afternoon and the following day - creating a 2% underperformance gap (h/t George H).

red=S&P500; blue= bank index ETF

The yield curve slope benefits banks because they typically fund themselves through short-term instruments (mostly through deposits), while lending longer term. The higher the spread between the two, the greater the banks' net interest income (see story from May). The market is signaling reduced profitability and potentially weaker lending growth (discussed here). With higher capital requirements (under Dodd Frank, Basel III, Leverage Ratio rule, etc.), banks need to generate larger margins to achieve the same return on capital (ROC). If the curve is not steep enough, some loans no longer meet the ROC threshold.

But what about the lower mortgage rates improving demand for residential loans? Shouldn't that help banks originate more loans and sell them to the GSEs? Unfortunately the Fed's action resulted in just a 14bp decline in the 30y mortgage rate (see post). That's not nearly enough to stimulate demand. The FOMC's decision is therefore likely to be a net negative for US credit growth.
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Obamacare and the labor markets

The impact of the Affordable Care Act (ACA) on US employment remains a hotly debated topic - particularly as the budget deadline looms. When it comes to the impact on job creation nationally, there is no smoking gun. While many point to growth in part-time employment as evidence for changing patterns in hiring, the Obamacare complexity and the latest payrolls data make it difficult to demonstrate a causal relationship.

Source: FRED

Nevertheless any regulatory uncertainty, particularly one that is this complex and broad, is generally not helpful to business expansion and hiring. Furthermore, numerous recent surveys continue to suggest that the impact of ACA on payrolls growth has indeed been quite negative.
Sal Guatieri/BMO Capital Markets: - ... a number of surveys strongly suggest that the ACA has curbed employment and will continue to do so. According to the Economist, more than 10% of firms (surveyed by Mercer, a consultancy) plan to reduce workers’ hours because of the health care act. A Gallup poll found that 41% of small companies have frozen hiring because of the ACA, while 19% have already cut staff. The New York Times reports that some California agricultural growers plan to lay off workers or shift workers to part-time status to avoid paying an estimated $1 per hour more per worker to meet the health plan rules. The Fed’s February 2013 Beige Book noted that “Employers in several Districts cited the unknown effects of the Affordable Care Act as reasons for planned layoffs and reluctance to hire more staff.” A Philadelphia Federal Reserve survey found that 2.8% of firms have already laid-off workers or slowed hiring because of the ACA, 5.6% have shifted full-time workers to part-time status, and 11.1% have outsourced work.6 Moreover, the latter three figures jump to 5.6%, 8.3% and 18.1%, respectively, when the companies are asked about planned changes in the year ahead.
Whatever the case, a government shutdown that could result from this debate will not be helpful for job growth either. The good news is that the public is finally beginning to pay attention to the situation. The Google Trends search frequency for "Obamacare" and "Shutdown" have both risen in the past few days - although the shutdown risk may not be fully sinking in just yet.
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Consumers' view of inflation diverges further from market-implied CPI

The scatter plot below compares UMichigan consumer inflation expectations to the 2yr market-implied inflation expectations from the Cleveland Fed (the 2-year TIPS are sufficiently liquid to prove a useful measure of short-term inflation expectations from the market.) The data is monthly and covers roughly the past 30 years.

Except for periods of unusually high inflation (highlighted in yellow), there doesn't seem to be a stable relationship. The consumer and the market seem to be disconnected.

Source: UMichigan, Cleveland Fed

Part of the issue of course is that the UMichigan survey focuses on what consumers think about general price increases going forward, while the Fed's market-implied measure is based specifically on the CPI (TIPS are tied to CPI). Consumer surveys are often criticized because consumers tend to respond to recent price increases, particularly the ones that are most visible. Market-based (breakeven) measures on the other hand tend to price the CPI going forward.
Wikinvest: - Typically, beliefs of households about future inflation are much higher than normal, and have a smaller role in impacting future inflation than investor expectations of inflation. The former is true because households tend to base their estimates of future inflation based solely on previous inflation, rather than on previous inflation in addition to other factors, like changing supply or demand.
It's easy to discount households as not being fully capable of "estimating" inflation changes going forward. A question for the academic community however is whether the consumer may simply be "sensitive" to a different "basket" of goods and services than what is covered by the CPI (it may be worth regressing the UMichigan survey against components of the CPI for example.) If so, what is that basket, and how does it interact with consumer sentiment? The basket may for example assign a higher weight to prices of gasoline, healthcare, rent, etc.

When the consumer is over 70% of the US GDP, someone should be asking about which products or services households are most sensitive to when it comes to price changes. That's a very different measure from the CPI, which is supposed to gauge price changes of the overall household consumption. Consumers may care more about prices of milk than of cell phones, even though both are consumed by households and included in the CPI.

Getting to the bottom of this question is particularly important now, as over the past couple of years the divergence between these two measures has become acute. The correlation between monthly changes in the UMichigan survey and the 2yr market-based inflation expectations is at the lowest level in 30 years. US consumers may be seeing/experiencing something the economists are not. Simply ignoring the consumer's view of inflation and relying on projections of the CPI may not be prudent, especially given the Fed's current monetary stance.

Source: UMichigan, Cleveland Fed
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Friday, September 20, 2013

Could rising rates fuel credit growth in the US?

This may seem counterintuitive, but Deutsche Bank’s researches argue that "moderately" higher rates may actually improve lending. This certainly contradicts the traditional school of thought followed by the Fed, who seemingly became spooked by the recent rate spike.

In fact loan growth was beginning to slow even as rates touched historical lows. As the chart below shows the 10yr treasury yield of under 1.5% (weekly average) was reached around the time the rate of growth in US lending had peaked. With a steeper yield curve lending becomes more profitable for banks and return on capital starts to make sense for certain credits that could not be underwritten at lower rates. Is it possible that letting rates rise instead of continuing with the “pedal to the metal” stimulus approach, will actually benefit credit growth?
DB: - … moderately higher rates are allowing lenders to ease credit standards for borrowers. In point of fact, last month’s Fed Senior Loan Officer Survey (SLOS) showed an easing of standards across all four major lending categories (i.e., commercial/industrial, consumer, residential and commercial real estate loans). To the extent that higher interest rates allow banks to earn a higher return on their investment—it is notable that most of the rise in rates has been due to a steepening of the curve—then higher yields can actually galvanize lending. In other words, extremely low rates will not stimulate the economy much if banks are only lending to their most creditworthy customers. Consequently, higher rates should correspond to more credit provisioning, which all else being equal should be supportive to real GDP growth. With the supply and demand for credit increasing, we view this as a potentially very powerful tailwind to the economy over the next year or so. The fact that credit is more available, albeit at a higher price, is more stimulative to the economy than when the price of credit was cheaper but unavailable.
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Thursday, September 19, 2013

US corporate credit growth slowing

One bright spot in the story of US loan growth since the recession has been corporate credit. Loans to companies had experinced relatively light default volumes and banks grew this part of their balance sheets faster than other types of credit. But even the corporate sector loan volume has barely kept up with bank deposits. The so-called "loan - deposit ratio" growth for corporate loans has been tepid.  Moreover, this ratio seems to have peaked this summer. 

Even on an absolute basis (as opposed to fraction of deposits), growth in loans to companies continues to slow. Part of this is driven by poor demand for credit from stronger firms who are hoarding cash. Some of the slowdown is due to banks' reluctance to underwrite weaker credits due to regulatory capital constraints. Whatever the case, the downward trend, which started about a year ago,  remains intact.
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Who benefits from the Fed's decision?

The FOMC's decision yesterday to continue buying securities at the same pace moved a number of markets. But who exactly benefited from these moves (h/t George H)?  Here are a few select markets.

Stock investors got a nice boost and precious metals investors enjoyed a strong spike. These folks should be quite happy. But then we also saw copper spike almost 4%. It's not difficult to predict how US manufacturers and building contractors feel about that.

Mortgage rates declined - a full 14 basis points. So that's the impact on the "real economy" of delaying "taper"? To make matters worse the decline in jumbo mortgage rates was higher than in conforming mortgages. Between the pop in investment portfolios and the drop in jumbo rates, those who are well off to begin with are more likely to benefit from this policy decision. Was that the intent?
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China's growth helped by property bubble

Recent stream of positive economic data from China indicates the nation's growth has stabilized (see discussion). There has been some debate around the reasons behind this sudden improvement. One of those reasons is the government's recent push into new infrastructure projects as well as additional funding for existing projects.
Reuters: - "We will quicken building steps on projects under construction, actively push forward new projects and make preparations for follow-up projects," the cabinet said.
Policymakers have already stepped in with several measures aimed at stabilising the economy and building a platform for urbanisation in the face of a slowdown in growth, including quickening railway investment and building public housing.

Recent economic data have shown some of the impact of those policies, with factory output in August hitting a 17-month high and retail sales growing at their fastest pace this year.

As part of its plans, China will finish building 73,000 km of sewage pipelines and will raise the volume of sewage treated in cities to 85 percent by 2015, besides completing 80,000 km of gas pipe networks.
Government stimulus has certainly been effective. But there is another driver of stronger growth in China: the property bubble. Just as was the case in the US, property bubbles can provide an enormous boost to the economy. Of course we all know how that movie ends. But China's increasingly affluent middle class just doesn't seem to care. Their priority is not be be "left behind", as prices take off to new highs.
Time: - Prices for new homes in China rose in August to their highest level this year, challenging efforts by the government to cool the market while supporting one of the economy’s most robust sectors.

New housing costs rose in 69 out of 70 major Chinese cities. The three largest — Beijing, Shanghai and Shenzhen — saw prices soar by 15-19% compared to last year, well above the national average of 8.3%, according to data released by the National Bureau of Statistics on Wednesday.
Some analysts feel that the concerns are overblown because with increasing numbers of people moving into urban areas, demand should remain strong.
CNN: - ... other analysts insist that fears of a bubble are overstated. Hundreds of millions of Chinese are expected to move from rural areas to cities over the next decade, they say, and demand is likely to remain strong.
Perhaps. But it is unlikely that most people moving into China's cities will be able to afford these prices - particularly if speculative buying continues at the current rate. Consider for example how housing prices have risen in the largest cities over the past year.

The ISI Group: - We see the property sector as continuing to be as dangerous in 2013 as in 2012. On-going official ad hoc interventions make anticipating the winners and the losers more about guessing Beijing’s policy steps than about basic company fundamentals.
The improvement in China's economic growth is certainly welcome news for the global economy. Nations such as Australia, South Korea, Brazil and others are sure to benefit. But it is also important to understand what's driving that growth and how sustainable the expansion may be going forward. That's why the frothy property markets in China should be a cause for concern.
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Wednesday, September 18, 2013

Angela Merkel to be reelected; outcome should help the Eurozone

While the upcoming German elections are getting limited coverage by the press outside of Europe, it is quite an important event. The Eurozone's structure going forward to a large extent depends on Germany's leadership. From the EMU banking union to Portugal's debt restructuring - there is no shortage of extremely difficult problems to solve.

And the Eurozone is in a way quite lucky because the union of Germany's two key conservative parties - Christian Democratic Union (CDU) and Christian Social Union of Bavaria (CSU) - under Angela Merkel are likely to return to power on Sunday. That will provide the much needed continuity/stability to the area in order face some of the daunting challenges.

The reason Angela Merkel will be reelected is simple. It goes back to James Carville's "it's the economy, stupid" that helped Bill Clinton win the presidential election in the US. Germany's economy has been incredibly resilient through the euro area recession and is now showing signs of strength. The nation's unemployment rate is at the lowest level in at least 20 years.

Consumer confidence remains quite strong in spite of a downtick this month.

German Consumer Confidence Index (Source:  FocusEconomics/ The GfK Group)

And the ZEW indicator of economic sentiment shows decent positive momentum.

Source: Zentrum für Europäische Wirtschaftsforschung

With economic indicators like these, incumbents really have to mess up not to get reelected.

The Eurozone needs a strong economy in Germany. This is important not only to economically stabilize the area as a whole but to convince investors that Germany is able (even if not always willing) to provide further support to troubled periphery nations should that become necessary again. And in one form or another Germany will likely be called upon to do just that. As much as some periphery nations like to vilify Germany and Angela Merkel (see photo), they need that nation's leadership in order for the EMU to remain intact.
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Digging a deeper hole

Looks like our assessment has been wrong. The current FOMC, who has chosen to stay the course on securities purchases, is even more dovish than many had predicted. The Fed is following a dangerous path. Nevertheless the markets love it.

We've seen the damage even a hint of exiting this program did to emerging markets. The deeper the US central bank gets into this hole, the more difficult the eventual exit will become.
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Tuesday, September 17, 2013

Charles Evans got his inflation wish. Taper is on.

As discussed earlier (see post), the Chicago Fed President Charles Evans and other senior Fed officials have been looking for indications that the unusually low PCE inflation rate (see post) is in fact temporary. The Fed is concerned about "turning Japanese" - a deflationary environment that is extremely difficult to correct.

It seems that Charles Evans got his wish. The Fed is just as focused on inflation expectations as on the actual inflation measures that tend to be "backward looking". And according to the Fed's own measure of inflation expectations (breakeven measure adjusted for "risk premium"), inflation expectations have risen. The August numbers were released today.

Source: Cleveland Fed

In fact the increase has been across the curve, with the near-term expectations rising the most.

Source: Cleveland Fed

This means that the last potential obstacle to the tapering of the Fed's securities purchases has been removed. The FOMC members can sleep well at night knowing that they are not causing deflation (for now) by taking this action.
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Rents rising faster than inflation; could hurt seniors

The cost of primary residence rentals has risen by 3% on a year-over-year basis last month. That's roughly double the headline CPI increase from a year ago. The culprit is some combination of higher rates, a cultural shift toward renting (see post), and insufficient growth in the supply of rental properties nationally.

Source: BLS

If continued, this trend could be particularly difficult on seniors who rely on Social Security payments for income. These payments are linked to the CPI measure, and the headline inflation divergence from the increasing cost of rent could become an issue over time. And the so-called "chained CPI" proposal is likely to make Social Security payments rise even slower (see story).

For many elderly Americans, rent represents a large component of their total expenditures. On the other hand, seniors, who rely on a different "basket" of goods and services than the general population, are less likely to benefit significantly from some components of the CPI for which prices are falling. "Personal computers and peripheral equipment" category, which shows a steady price decline, is one example. It is important to track how some vulnerable groups are impacted by what the economists consider "benign" inflation conditions.
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Monday, September 16, 2013

Retail money markets AUM and fund flows

The chart below shows the amount of retail money markets funds outstanding. The spike at the end of last year was due to harvesting of capital gains in preparation for a higher tax regime. The current spike is retail exiting assets that are impacted by higher rates, such as munis, long-dated treasuries and other fixed income products (and to some extent equity funds as well). Both situations corresponded to net outflows from "risky" funds.

Source: FRB

Movement in money markets AUM provides a useful indicator for the behavior of retail investors. And while it doesn't say anything about the types of assets retail investors are entering or exiting, it signals the overall level of retail risk aversion - whether the risk is coming from the Eurozone, higher taxes, or the Fed taper. The chart below compares retail money markets AUM (which is available on a weekly basis) with total fund flows across fixed income and equity funds. The relationship - particularly in recent years - is hard to ignore.
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Sunday, September 15, 2013

Yellen's nomination is not a done deal

The Obama administration was hit by another setback this weekend. Realizing that the Larry Summers nomination as the next Fed chairman was going to face some tough opposition in Congress, the president decided to pick someone else.
Reuters: - "Earlier today, I spoke with Larry Summers and accepted his decision to withdraw his name from consideration for chairman of the Federal Reserve," Obama said in a statement.
Of course the next obvious candidate is Janet Yellen, who is a highly accomplished economist but is thought to be even more dovish than Ben Bernanke. This took the markets by surprise, sending equities, precious metals, and "risk-on" currencies higher. Treasuries rallied as well on expectations of a more dovish Fed policy. Oil fell on a potential diplomatic solution for Syria.

But is this rally a bit premature? Here are some potential issues with taking the Yellen nomination for granted:

1. President Obama tends to select candidates for key posts that he knows and often had worked with in the past. Neither he nor other senior members of the administration know Yellen well or had worked with her in any capacity.

2. Obama will be looking for someone who had demonstrated strong ability to deal with a major crisis. While Yellen is certainly capable and had accomplished a great deal during the financial crisis, there will be questions raised about her ability to lead the central bank and the financial system through another 2008.

3. Janet Yellen's dovish views could galvanize a number of  Senate Republicans, setting the administration up for another damaging confirmation fight.
CS: - Yellen’s rhetoric occasionally comes across as more dovish than Bernanke’s, and some wonder whether, as chair, she would advocate tolerating a higher rate of inflation in pursuit of job growth.
As of this weekend, the president's job approval remains relatively low. The administration may not want to rock the boat by nominating someone they may deem to be controversial. That is the reason they dropped Larry Summers to begin with.

There could be another candidate at play here. And this other candidate may not be viewed to be as accommodative in terms of monetary policy. So before jumping into risk-on assets, keep in mind that Janet Yellen's nomination is not yet a done deal.
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Spain-Italy 10-year spread drops below zero

In the spring of 2012, Spain's 4th largest bank Bankia requested a bailout of €19 billion and it became clear that the whole of Spanish banking system will need government support. The world's markets had suddenly shifted their attention from Italy to Spain as the next hot spot in the Eurozone crisis. Spain-Italy 10yr government bond spread spiked, quickly turning positive.

In recent days however the spread became negative again. Italy is now viewed as being riskier than Spain.

This trend seems a bit surprising since the fiscal situation of Spain is thought to be worse than that of Italy. While Italy's current debt levels are higher in absolute terms as well as a percentage of the GDP, Spain's government deficit is far worse.

Source: Scotiabank

At this stage however Italy's poor economic recovery and political mess make Spain a better risk - on a relative basis of course. Both nations are struggling with an extraordinarily long economic contraction that started in 2011. But it recently became clear that Italy's recovery is materially slower of the two.

Source: Eurostat

And last week Italy surprised the markets with a sharp downturn in industrial production that contributed to the poor result for the euro area as a whole (see Twitter chart).

Source: Eurostat

But how does one reconcile all this with the fact that Spain runs just over 26% unemployment rate, while Italy's rate is around 12%? This takes us back to the question of how Spain got its ridiculously high unemployment to begin with. It has to do with the nation's high temporary workforce which provides corporations with better labor flexibility (see post). And this ability to lay off workers and lower prices during a slowdown and quickly rehire them when the situation improves makes Spanish firms more competitive on average.  This competitive advantage is in part why Spain's export growth has outpaced that of Italy.

Source: Scotiabank

It also doesn't help Italy's case when political uncertainty raises the risk of another debt crisis flaring up. And as always, Italy's most powerful crook, Berlusconi (see post), is at the center of it all.
Reuters: - European Union officials warned Italy on Sunday not to let politics ruin recovery prospects and upset debt markets in a week that could signal the end of Erico Letta's fragile five-month-old government.
"I believe it is of paramount importance to keep political stability in the country to ensure a recovery, mainly because the latest data show the economy remains relativity weak, without clearly indicating a return to growth," Rehn, the EU's top economic official, told Italian business daily Il Sole 24 Ore.

Italian industrial output was much weaker than expected in July, falling 1.1 percent and undermining expectations that the country might emerge from its longest post-war recession in the third quarter.

Political instability has thwarted attempts to make the economy more competitive and whittle down Italy's government debt burden, one of the world's biggest.

Berlusconi's centre-right allies have threatened to sink the government if Wednesday's vote goes against him.
While both nations are far from economic stability, political uncertainty and weak recovery make Italy's situation look worse than Spain's. Sensing this dynamic, markets took the Spain-Italy spread into negative territory.
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