ECB contemplating new LTRO - with a twist

As discussed back in September (see post), the ECB may be forced to take further action in an attempt to reignite the area's recovery. The central bank's consolidated balance sheet is continuing to decline and many are blaming this reduced liquidity for the area's weak credit growth as well as tepid and uneven economic expansion.

It was therefore not too surprising to hear that the ECB is in fact discussing taking further non-conventional policy measures.

Reuters: - The European Central Bank is considering a new long-term liquidity operation available only to banks that agree to use the funding to lend to businesses, a German newspaper reported on Wednesday, citing sources.

ECB President Mario Draghi and other Governing Council members have repeatedly mentioned the option of conducting more liquidity operations, or LTROs, to help the fragile euro zone economy and ensure the flow of credit to the private sector.

A few months ago some economists were hoping that the relentless decline in credit growth in the Eurozone may have bottomed. The year-over-year changes in the area's loan balances have turned in the right direction. Unfortunately the latest data show that not to be the case - both in corporate and consumer lending.

Source: ECB

This lack of credit expansion is a dangerous trend that could result in years of Japan-style stagnation. In order to address it, one approach the ECB is contemplating is forcing the banking system to use the new LTRO proceeds to provide capital into the consumer or corporate sector.

Reuters: - The ECB extended more than one trillion euros ($1.36 trillion) of cheap three-year loans to banks through two long-term refinancing operations in late 2011 and early 2012.

But this time, an option under consideration is that the banks would have access to funding via the LTRO only if they agree to pass on the money in loans to industrial, retail and services businesses, Sueddeutsche Zeitung reported on Wednesday.

The new LTRO could also run for only nine or 12 months, the paper said.

The news came after ECB policymakers said last week they were open to taking fresh measures to support the euro zone economy, where inflation is running well below target [see discussion].

It's difficult to know if this program will work. Banks are under pressure to shrink risk weighted assets to comply with the new Basel accord. And retail and corporate (particularly unrated smaller firms) loans tend to attract significant amounts of regulatory capital (risk weight) charges. It's much easier for a Eurozone periphery bank to buy its government's bonds - with almost no regulatory capital impact - than to lend to small firms and households. Therefore many banks may forgo the new LTRO that has such strings attached. Nevertheless it seems that the ECB may be willing to try.

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From our sponsor:

Don't waste that fried turkey oil

For those who fried your turkey in oil yesterday, here is an idea. Depending on where you live, you may be able to get the used cooking oil recycled into biofuel. Here is an example from a couple of counties in the Chicago area:

Chicago Tribune: - On Saturday, 19 suburbs in DuPage and Cook counties will collect used cooking oil to convert it to clean-burning biofuel. School and Community Assistance for Recycling & Composting Education, or SCARCE, a Glen Ellyn-based environmental education nonprofit, organized the collection with oil recyclers Green Grease Environmental and Chicago Biofuels.

Recycling cooking oil is a "win-win-win," SCARCE founder Kay McKeen said. "It saves residents and cities money, keeps water cleaner and generates clean fuel."

Though she hopes more communities will begin offering year-round oil recycling, McKeen said she decided to start with Thanksgiving because so many families deep-fry their turkeys, each using about 4 gallons of oil.

Even though these types of projects remain fragmented across the US, the efforts to manufacture more biofuels are paying off. The latest data show biodiesel production at record levels.

And while it may take decades for biofuels and other alternatives to rival fossil fuels (see post), your Thanksgiving turkey oil should still help.

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From our sponsor:

Brent-WTI spread widens again as the discount shifts to the Gulf for the first time

The spread between crude oil traded in the international markets and the US benchmark, the so-called Brent-WTI spread has blown out once again. It's now approaching levels not seen since February.

What's going on? What happened to the Goldman's forecast of convergence between the two indices, as more US crude is pumped from the Midwest toward the Gulf of Mexico (see post)? In the past the bottleneck was in moving growing US supplies from Cushing, Oklahoma (where WTI settles) to the Gulf. While that problem has been at least partially solved, the oversupply of crude now simply shifted from Oklahoma to Louisiana.

FT: - Surging shale oil production along with severe restrictions on exports has led the US oil market to diverge from the global market in recent years. This week US benchmark West Texas Intermediate crude fell to a five month low of $91.77 per barrel, almost $20 per barrel less than the global marker Brent.

But until recent months infrastructure constraints have made it costly to move oil from inland shale formations to the country’s main refining hubs in Texas and Louisiana, limiting the benefits of low prices to the wider US economy. With more oil now able to flow through pipelines, the Gulf Coast market is also diverging from Brent. On Thursday, Louisiana Light Sweet, the Gulf Coast benchmark, hit a low for the year of $95.30 per barrel. Its discount of $16.01 per barrel to Brent, was easily the highest on record in Reuters data going back twenty years. Traditionally LLS has traded at a premium to Brent, reflecting its superior quality and the cost of shipping to the US.

Source: EIA

Surely at these spreads it is worth shipping US crude from Louisiana to Europe to sell at Brent spot prices. After all, US crude is of the quality that Europe needs (vs. the heavy Saudi crude). It's not so simple however. Back in the 70s, the US Congress made it illegal to export domestically produced crude oil without a permit. And permits are tough to get these days, given how unpopular the notion of US oil export seems to be. So much for the concept of "free trade". Instead US crude oil inventory continues to grow, widening Brent-WTI spread, as domestic production expands.

Source: EIA

And while there is a restriction on crude exports out of the US, selling refined products such as jet fuel and gasoline abroad is allowed.

FT: - The low prices are a boon to Gulf Coast refiners, which can pick up crudes at low local prices and then sell refined, products such as gasoline and diesel, which can be exported from the US freely, into the international market at high prices.

At about 3m barrels a day, exports of finished petroleum products from the US are running at three times the rate of eight years ago, according to US government data.

These changing dynamics in the US energy markets are having two major effects:

1. US refineries are loving this. The government is holding down domestic crude prices by limiting exports, while allowing refiners to sell as much gasoline abroad as they want. Refined products abroad are generally priced based on Brent, allowing the refineries to capture the spread. In effect the US government is subsidizing the refining business at the expense of crude oil producers. And here is how the stock market is reacting to these recent price changes.

TSO = Tesoro Corporation, a major refiner; XLE = diversified energy index ETF

2. This is putting pressure on nations who traditionally sell crude to the US. While in the past they were able to sell their crude close to international prices, they now get paid much less due to Louisiana Light Sweet becoming significantly cheaper than Brent.

FT: - Imports to the Gulf Coast tend to be priced off local benchmarks including LLS and the Argus sour crude index, a basket of four heavier Gulf Coast crudes. With Gulf Coast prices falling, exporters such as Saudi Arabia and Venezuela are receiving less revenue for their sales into the US.

The discounts of US crude show no sign of ebbing with oil inventories continuing to rise as production grows, and many refineries remaining closed for maintenance.

Needless to say, these nations are not happy with the US as they now have to find alternate buyers in order to get the full price for their product. And many in the US are quite happy with this outcome.

When Louisiana crude was trading at a premium to Brent, analysts thought that by improving the transport system from Oklahoma to the Gulf will eliminate the Brent-WTI spread. Instead it simply shifted the discount further "downstream". And with that came other unintended consequences that often result from uneven regulation.

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From our sponsor:

3 key facts about Japan's deteriorating demographics

While there is a great deal of detailed discussion in the blogosphere about Japan's unsettling age demographics (see example), it's worth pointing out three key facts that add some urgency to the issue.

1. With zero immigration and falling birth rates, Japan's working-age population is declining sharply and is now at a level not seen in 30 years. The decline also seems to be accelerating.

Wells Fargo: - While the overall population has only recently begun getting smaller, the labor force has been shrinking for more than a decade. This has serious implications for both the size of Japan’s future workforce and for domestic demand. According to the IMF, the size of the working-age population is projected to fall from its peak of 87 million in 1995 to about 55 million in 2050. If realized that would roughly equal the size of the Japanese workforce at the end of World War II.

2. As a result, the percentage of Japanese who are over the age of 65 has risen above 25% for the first time (and the growth in that ratio also seems to be accelerating.) A quarter of Japan's population is now over 65. That compares to about 14% of Americans who are over 65 (see stats).

Source: Japan Statistics Bureau

Just to put this in perspective, the total sales of adult diapers in Japan is about to exceed that of baby diapers (see story). Also see this amazing story about "a program to promote the use of nursing care robots to meet expected increases in demand in the face of Japan’s rapidly aging population."

3. According to Wells Fargo this is creating some material distortions in Japan's domestic interest rates. In fact (and this is an amazing fact indeed), Japanese seniors are having a greater impact on bringing down JGB yields than BOJ's unprecedented QE effort (see post).

Wells Fargo: - In addition to reducing potential growth, the aging of the population in Japan is having a downward influence on interest rates [chart below]. According to the IMF, elderly households prefer to avoid risk and feel more comfortable with safe assets such as Japanese Government Bonds; so much so that the downward effect on rates from elderly purchases has a bigger impact than purchases by the Bank of Japan.

10y JGB yield (source: Tradingeconomics.com)

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From our sponsor:

All but ignored by investors, the retail sales outlook for this holiday season remains weak

A number of indicators seem to point to a relatively weak holiday shopping season in the US. The Gallup survey index that estimates holiday spending has turned lower (see Twitter chart). As discussed back in August (see post), consumer sentiment peaked this summer and has been declining since.

Conference Board Consumer Confidence (source: Investing.com)

Consumers remain cautious in spite of the stock market's recent gains and improvements in home prices. Some economists blame the lackluster job market and higher rates.

Scotiabank: - 

• Jobs remain part of the problem. Outlooks for employment and income were essentially unchanged on the month. 

• We think that the risk of higher mortgage costs due to rising interest rates is weighing on confidence too. Consumer confidence started dropping in the wake of the government shutdown, but it has been flat since the tapering debate began and interest costs on new mortgages spiked. Is that having an effect too? 

• Plans to buy automobiles, homes, and major appliances all fell — bad news ahead of the holiday shopping season.

And anecdotal evidence for a poor holiday season continues to mount as retailers become increasingly aggressive with promotions:

• WSJ: - On Tuesday, Abercrombie became the first of the larger teen retailers to discuss its third-quarter results. The company also updated its forecast for the rest of the fiscal year, saying it now expects to report a low double-digit decrease in same-store sales for the fiscal fourth quarter, which includes the critical holiday season.

• FT: - Walmart warned of a tough Christmas shopping season for US retailers as it forecast weak sales amid the most intense competition it had ever seen. Despite improvements in the US economy, the world’s biggest retailer by sales blamed the jobs market, political gridlock in Washington and the end of some food stamp benefits for its tepid forecast.

• CNBC: - Tilly's Inc. shares plunged in extended trading Tuesday after the clothing and accessories retailer reported disappointing third-quarter revenue and gave a dismal earnings forecast for the quarter that contains the holiday shopping season.

Wells Fargo points out that while total sales should increase by 3.7% (vs. 4.1% the previous year), dollars spent per shopper will see the first decline since 2009 (chart below). They blame the federal government dysfunction as well as a shorter holiday season.

Source: Well Fargo/National Retail Federation’s holiday spending survey

Wells Fargo: - The lower-per-person spending suggests that consumers will continue to remain cautious and look for deals, including online deals. In a continuation of prior years’ trends, the average individual plans to do 39.5 percent of their shopping online compared to 38.8 percent last year.

While several factors will likely play a role in restraining consumer spending this holiday season, the two main factors are the ongoing uncertainty around federal fiscal policy and the shorter holiday shopping calendar. The fiscal policy uncertainty in Washington has negatively affected consumer confidence and will likely serve as a headwind to holiday shopping. With federal government funding set to run out in mid-January, December likely will be another politically contentious month of debate that could have negative spillover effects on consumer spending. Another headwind facing retailers is the shorter holiday shopping calendar this year due to the later-than-usual Thanksgiving holiday. This year there are six fewer days between Thanksgiving and Christmas, the shortest holiday season in more than a decade. In response to the shorter shopping season, retailers have moved up discounts to spur earlier holiday shopping.

The question of course is - how are the markets reacting to this anticipated weakness in retail spending? The simple answer is that investors in general are simply ignoring the situation - for now. Retail shares continue to outperform the broader market (chart below). The view seems to be that either the season isn't going to be as bad as some of the forecasts show or that retailers will make up for this weakness in the near future due to improving US economic conditions. Whatever the case, we seem to have a disconnect here.

XRT= retail ETF, SPY = S&P500 ETF

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From our sponsor:

Why Fed's taper is essential to stabilize agency MBS liquidity

While we've discussed some of the economic implications of the Fed's current policy, let's now take a quick look at the impact of QE on the overall mortgage bond market.

Here is a simple fact: the amount of mortgage-related securities in the US has been declining since 2008 - after reaching just over $9 trillion at the peak.

Source: SIFMA

The reason is simple. With a large portion of all mortgages funded via the bond markets, the ongoing decline in total mortgages outstanding results in smaller MBS balances. Of course as the population grows and more homes are built (albeit very slowly) this trend should reverse.

And now with these market dynamics as the backdrop, put the Fed into the mix. At it's current pace the Fed is taking about half a trillion of MBS securities out of the market. In fact the Fed is now removing more than 100% of the paper that is being issued. The supply of agency (Fannie and Freddie) MBS securities in the market is declining sharply as the Fed reduces the total "tradable float".  According to Credit Suisse, without the Fed's anticipated taper in Q1, the demand for agency paper could outstrip the supply by $340bn in 2014, creating a liquidity problem.

CS: - Liquidity in the MBS market could come under pressure in the coming months due to Fed’s settled purchases exceeding 100% of gross issuance of non-specified conventional 30-year pools. Tradable float in conventional 30-year MBS should decline between 6% and 30% during the year, increasing the risk of a potential liquidity disruption in the market under longer taper delay scenarios.

As a result some of the private participants, particularly banks, have been reducing their agency MBS holdings. The chart below shows the year-over-year changes in MBS holdings by commercial banks.

Here is what the conventional 30-year agency MBS float will look like under the taper vs. no-taper scenarios (chart below). Without the taper, the float in these bonds will decline by 30% from the October levels. These are dangerously low levels for what used to be one of the largest bond markets in the world.

Source: Credit Suisse

Taper therefore becomes essential in order for liquidity to stabilize and for more private market participants to begin returning to this market.

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From our sponsor:

Investors love Obamacare

Some of the most unpopular policies often create tremendous opportunities. Take the Affordable Care Act for example. While the public is complaining bitterly about this legislation, some investors will be (or already have been) profiting handsomely. Venture capital firms for example are expected to rake it in by funding companies that provide healthcare-related software services (see story). At the same time, the equity markets have been bidding up the whole sector with the view that Obamacare will make healthcare firms more profitable. More subscribers and more people receiving care means higher revenues and outperformance for healthcare shares.

Blue: healthcare index ETF, red: S&P500 ETF

By the way, is it time to take profits?

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From our sponsor:

Behind Brazil's strong employment numbers is a deteriorating economy and an impending debt downgrade

A great deal has been said recently of Brazil's declining unemployment rate - which is now less than 40% of what it was a decade ago. Impressive indeed. But is this an indication of stabilization in the nation's economic growth?

Hardly. It turns out that Brazil is experiencing a decline in the overall labor force, causing improved unemployment statistics.

Source: Credit Suisse

Furthermore, the nation's real wage growth has been slowing.

Real wage bill growth (source: Barclays Capital)

In spite of the seemingly strong unemployment numbers, Brazil's overall economic growth remains weak. The good old days of China-driven commodity boom are over.

Financier Worldwide: - In recent years, Brazil has benefited significantly from enormous rises in commodity prices. However, analysts have suggested that these price increases were entirely artificial, driven by record low interest rates in the US and the huge demand for commodities from China. The commodity price boom is over and, with the prospect of the US Federal Reserve stimulus package soon being phased out, there is likely to be a great deal of concern across all emerging economies, including Brazil.

Further contributing to the county’s domestic woes, strong local demand for commodities served only to push prices upward, while inflation is approaching the upper limit of the official target set at 6.5 percent. President Rousseff, who faces re-election in 2014, has passed numerous tax cuts and incentive packages to try to stir Latin America’s largest economy back into the fast growth that made it an investor favourite during the 2000s. However, with industry shrinking rapidly, household consumption growing at its worst rate since the third quarter of 2011 and inflation now running at 6.46 percent on an annual basis, the Brazilian Central Bank has found itself in the uncomfortable position of needing to raise its base interest rate to 9 percent despite slow economic growth, highlighting imbalances in the economy.

Both the current account and the government balance are now firmly in the red. And forecasts show further deterioration.

Source: Barclays Capital

As a result, market participants are increasingly convinced that Brazil's government debt will soon be downgraded. Bloomberg investor survey results are shown below.

Source: Bloomberg

Bloomberg: - Investors have never been more pessimistic about Brazil President Dilma Rousseff’s policies, with only 10 percent saying the nation can avoid a credit-rating downgrade in the next year, a Bloomberg Global Poll shows.

Fifty-one percent say they are pessimistic about Rousseff’s policies, compared with 22 percent when she took office in January 2011, according to the poll of 750 analysts, investors and traders who are Bloomberg subscribers. The world’s second-largest emerging market will offer one of the worst opportunities over the next year compared with the U.S., U.K., European Union, Japan, India, Russia and China, respondents say.

Brazil's worsening budget deficit, political corruption (see story), excessive government spending, and prolonged inflation - combined with the Fed's upcoming taper - have resulted in deteriorating confidence in the nation's government debt. The 5-year bond yield is approaching 12.5% - a multi-year high.

So when you hear the country's president Dilma Rousseff make statements such as “We are the only major country with full employment" and "Whoever bets against Brazil will always lose", don't pay attention. She is trying to keep her job as the national elections approach. The reality is far worse than the employment numbers would suggest and 2014 is bound to be a rough year for Brazil.

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From our sponsor:

Watching the trajectory of the Beveridge Curve

A number of economists continue to talk about the "structural shift" in US labor markets that took place during the Great Recession. For example, back in September, Georgetown University published a report called Failure to Launch: Structural Shift and the New Lost Generation (see document). The paper focuses on changes with respect to youth employment that appear to be structural (long-term) rather than cyclical.

But how does one measure the degree to which the labor markets deviate from historical norms? The simplest indicator of this shift remains the Beveridge Curve (see discussion). It's a scatter plot of job openings versus the unemployment rate (here we use the U5 rate). More job openings should result in lower unemployment. But the path and the slope of the curve tells us something about the current situation relative to recent history. The data captures structural effects such as:

1. Weak labor mobility - with mortgages underwater, many workers for example can't simply move to North Dakota where the job market is vibrant.
2. Skills mismatch - workers with a college degree often go on unemployment rather than taking a low-paying job in the fast food industry for exmple. At the same time workers with specialized skills may be difficult to find (see example).
3. Part-time vs. full-time mismatch - many workers who receive unemployment benefits do not accept part-time work.
4. Impact of long-term unemployment - workers who have been out of work for a long time have trouble reentering the workforce even if there are job openings.
5. Some argue that increased poverty creates barriers to entry into the labor markets for certain groups.
6. One reader suggested that unlike in the past, job openings are not always for immediate hires. Openings could persist for some time without resulting in a job creation.

What's powerful about this simple measure is that it can be updated on a monthly basis. And in spite of arguments to the contrary (here) recent results seem to suggest an ongoing divergence from historical behavior in the post-recession economy.

The question now (6 years after the start of the Great Recession) is whether we will start seeing a shift toward normalization. It's a critical issue for monetary and fiscal policy decision makers because the curve tells us something about the "natural rate of unemployment". That's effectively the long-term unemployment rate under the best case scenario. At least in theory no matter how much the economy improves, the unemployment rate will not decline below the "natural rate" without igniting significant inflation. In the chart above for example if the structural shift persists, the best outcome for U5 unemployment is now about 2% higher than in the past. If however we see some normalization, the natural rate could potentially go lower. If the overall unemployment rate continues to fall in the next few months, we should be able to tell more about the trajectory of the Beveridge Curve and the expected level of the natural rate of unemployment.

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From our sponsor:

Corporate credit markets back to frothy levels

This summer's growing fears of the Fed's impending policy change hit a number of fixed income sectors quite hard. While corporate credit was the best performer on a relative basis, it too was hit by some sell-off and a decline in liquidity. In September however an event in the bond markets brought investors back. Verizon's massive bond sale went so well, the whole investment grade universe perked up.

FT: - Verizon sold $49bn worth of bonds in a combination of fixed and floating-rate debt spread across six maturities that ranged from three to 30 years. The bonds jumped in secondary markets, rewarding investors who bought the securities at discount prices. The gains generated up to $2bn in profit for investors on the bonds in 24 hours, analysts estimated.

Verizon’s successful sale helped end the summer sell-off and paved the way for an upswing in the market for US corporate bonds. The Fed’s decision later in September to keep its bond-buying programme in place added a new enticement to corporate borrowers as well as investors in fixed income assets.

“There were talks earlier this year about a ‘great rotation’ out of fixed-income and into other asset classes,” says Alex Gennis, a credit strategist at Barclays. “Indications point to a very strong and healthy appetite for paper in the corporate bond market. The ‘great rotation’ has yet to happen.”

As the equity markets resumed their rally, corporate spreads - including high yield - began to tighten again. All of a sudden we find ourselves back in the frothy corporate credit environment that existed before the Fed struck a more hawkish tone in May (see discussion).

Source: FRED

SFGate: - The extra yield company bonds offer over Treasuries approached the narrowest level in six years as Federal Reserve Chairman Ben S. Bernanke said interest rates will stay low and investors sought ways to boost income.

Even within the middle-market credit space, pricing is looking quite rich. BDCs (public investment firms that focus on middle market debt - see discussion) have seen a nearly 60% total return over the past two years. In order to keep paying the same dividend they have been historically, BDCs are increasingly reaching for yield, flooding credit markets with more capital.

11/21/2011 = 100

Perhaps some of the more publicized signs of corporate credit markets overheating have been the loosened underwriting standards in the syndicated loan market. The so-called "cov-lite" loans often limit the lenders' ability to take corrective action with the borrower when the company takes a turn for the worse. And the number of such deals has reached new highs.

Source: Barclays Capital

Just as in the past, eventually someone will be suing the banks for selling these products. We will hear institutional investors testifying in court on how they were mislead by unscrupulous bankers about the "hidden" risks. And some shareholders will be complaining about the amount of leverage the lenders put on the company. Everyone will all of a sudden develop amnesia about how these assets ended up in their portfolios in the first place. And those with capital and the ability to work out distressed situations will make a fortune.

 

For now however investors don't seem to care - as long as it's rated corporate credit it's got to be good. It's not 2006 quite yet, but we are certainly moving in that direction.

 

 

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From our sponsor:

OECD warns of Eurozone deflation risks; suggests ECB consider non-conventional measures

As a follow-up to an earlier discussion on rising deflationary risks in the Eurozone (here), it seems that the OECD is now also growing concerned about this issue. The latest economic report is openly suggesting that the ECB consider non-conventional policy measures (such as LTRO or securities purchases). Below is a good summary of OECD's assessment of the situation in the euro area.

OECD: - In the euro area, recovery is lagging and uneven, unemployment – especially among the young – remains very high and inflationary pressures are very subdued. The ECB should consider further policy measures if deflationary risks become more serious. Current account adjustment is advancing in the periphery but price adjustment alone will not work given the impossibility of reconciling deflation, needed to regain competitiveness, and achieving nominal growth to support debt sustainability. Much less adjustment, if any, is taking place in surplus countries. More durable and symmetric adjustment is needed through reforms to labour and product markets, including liberalisation of services in Germany that would strengthen and rebalance demand.

Weakness in the banking system remains a major drag on growth in the euro area. The Asset Quality Review and stress tests in 2014 must be implemented rigorously – and followed up by bank recapitalisation where needed – to restore the transmission of monetary policy, strengthen financial-system stability and get credit moving again to enhance the effectiveness of structural reforms and support growth. Failure to use this opportunity could impair confidence in European banks and sovereigns. There is progress towards banking union but the transition promises to be complex and delicate as the criteria and responsibility for regulation, supervision, and resolution of banks have to be clarified.

OECD's chief economist, Pier Carlo Padoan, said that the Eurozone deflationary risks "may be slowly increasing" and "the ECB must be very careful and be prepared to use even non-conventional measures to beat any risk of deflation becoming permanent."

Some at the Bundesbank will likely oppose any such action by the ECB. But it's becoming increasingly difficult for German central bankers to argue that deflation is not a threat to the area's economy. Today we saw the German PPI number fall below analysts' expectations, with the year-over-year measure moving deeper into negative territory.

Econoday: - The ongoing softness of both the headline and core PPI continues to bode well for subdued CPI inflation (1.2 percent in October) over coming months. As such, today's report will do nothing to deter speculation in financial markets that November's ECB ease will not be the last of the cycle.

If this continues, the ECB will be under increasing pressure to take further (and most likely unconventional) policy action.

The Independent: - The eurozone must follow the examples of the UK, US and Japan by turning to the printing presses to avoid the threat of damaging deflation, according to an assessment by a leading economic think-tank [OECD].

OECD Economic Outlook press conference


More on the OECD report here.

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From our sponsor:

Key trends in US mortgage markets

The recent increase in long-term rates is causing major changes in the mortgage markets. Here are some key trends:

1. Refinancing activity continued to decline through Q3. The proportion of mortgage applications for purchase vs. refi has doubled this year (and that's not because of higher demand for homes).

Source: DB

2. A number of lenders who focused on mortgage refinancing such as US Bank, Provident Funding, and Flagstar are struggling (although the largest banks such as Chase and Wells seem to be less affected). This may result in an increase in the number of riskier mortgages.

DB: - Lenders who specialized in refinancing transactions have experienced dramatic loss of market share and either will have to become more competitive on rates in growth sectors such as ARMs to regain market share or loosen credit standards.

3. While a larger number of buyers now prefer ARMs, the dynamic within the fixed rate universe is a greater demand for 30-year mortgages vs. 20 or 15. That's because the monthly payments on 30-year mortgages are lower (slower principal repayment) and buyers are looking for the cheapest solution.

DB: - As interest rates have risen and volume has dropped, the product mix has shifted sharply ...  30-year mortgages are much more popular with homebuyers—more than 50% of 30-year mortgages are used for purchase transactions but less than 20% of shorter-term mortgages. As a consequence, the share of 15-year mortgages fell from 20% in September to 17% in October as the share of 30-year lending rose to 63% from 59%. Meanwhile, the ARM share has doubled to more than 5% since June as HARP’s share of lending has fallen to 3% from a high of 7% this spring.

4. As a result, MBS bond markets are taking a hit in the form of lower volumes. The sharp decline in refinancing activity has reduced the need to issue new agency mortgage bonds. New issuance is the lowest in years.

Source: SIFMA (note: this includes CMBS but the bulk of the activity is agency MBS)

Similarly, trading volumes in MBS have dropped off to new lows.

Source: SIFMA

Here is a summary on US mortgage markets from Freddie Mac (who, just as Fannie Mae, has been issuing fewer bonds):

Frank Nothaft, Freddie Mac Chief Economist: - With the close of 2013 will also come a major transition in the housing finance industry. For the first time since 2000, we're going to see the mortgage market dominated by purchase activity as the refinance share drops below 50 percent. And with mortgage rates rising, we're also going to see the home-sales gains as well as the impressive house price growth begin to moderate to more sustainable levels.

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From our sponsor:

5 years of QE and the distributional effects

As we approach the fifth anniversary of the start of the first quantitative easing program, some are asking the thorny question about the so-called "distributional effects" of these unprecedented programs. Who really benefited since the first QE was launched? There is a great deal of debate on the topic, but here are a couple of facts. Financial asset valuations, particularly in the corporate sector have seen sharp increases. For example the S&P500 index total return (including dividends) has delivered 144% over the 5-year period. Those who had the resources to stay with stock investments were rewarded handsomely.

Source: Ycharts

But what about those who didn't have such an opportunity? For example savers, particularly retirees who had to stay in cash? They were hurt severely by record low interest rates (negative real rates - see post). And those who had neither the savings nor significant stock investments, relied on house price appreciation or growth in wages. The housing recovery has certainly been helpful (for those who kept their homes), but according to the S&P Case-Shiller Home Price Index, US housing is up less than 5% over the past five years. Not much of a "wealth effect" for those without stock portfolios. And when it comes to wage growth, the situation isn't much better. The chart below shows hourly earnings growth of private sector employees.

It therefore shouldn't be a surprise that the three rounds of quantitative easing over the past five years rewarded those who had the wherewithal to hold substantial equity investments. Everyone else on the other hand - which is the majority - was not as fortunate.

Perhaps the best illustration of these distributional effects is in the chart below. It shows the relative performance of luxury goods shares with wealthier clients vs. retail outfits that target the middle class. The benefits of QE are clearly not felt equally by the two groups.

Source: JPMorgan

So as we prepare for the Janet Yellen's ultra-dovish Fed (see story), it's worth thinking about the past five years and the cost of growing distributional effects in the United States. For now there is plenty more cheap money to help those with large stock portfolios.

JPMorgan: - There are debates about whether a 0% cost of money helps anything except financial asset prices ... All we know is that the Fed has a story to tell (“cheap money is good”) and they are sticking to it.

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From our sponsor:

Canada's rising dependence on commodities trade makes it vulnerable to price declines

Canada's economy remains vulnerable to weakening energy and other natural resources prices. WTI crude oil price for example has dropped significantly over the past two months, making some economists wonder if the nation's recent economic stability can be sustained.

Here is what's driving this dependence on commodities exports. Canada continues to struggle with lagging labor productivity. Anecdotal evidence suggests that businesses are avoiding opening labor-intensive operations in Canada due to high costs.

Source: BMO Capital Markets

As a result, manufacturing employment and output failed to grow over the past decade - and in fact have been declining. Without growth in manufacturing, Canada has been increasingly dependent on natural resources for growth. While exports (though still below pre-recession levels) are gradually recovering,

Canadian international merchandise trade (source: Statistics Canada)

... the non-energy component of Canada's trade has declined sharply over the past decade.

Source: BMO Capital Markets

In short, Canadians export energy and other natural resources while importing a great deal of everything else. This dependence of course is not limited to energy. For example Canada is the third largest aluminum producer in the world. That position worked quite well when China was driving industrial metals prices to new highs. But that is no longer the case.

Douglas Porter of BMO describes the situation quite well.

BMO Capital Markets: - For much of the past decade, the underlying weakness in Canadian export volumes, productivity and manufacturing was papered over by the boom in commodity prices. (Some would argue that the boom in fact partly caused the weakness in real exports et al, but that’s getting into the realm of the Dutch Disease debate.) With prices drifting steadily lower since the spring of 2011, it seems safe to conclude that commodities are not going to bail us out this time—the Super Cycle is over. While global growth will likely be just firm enough to put a floor under resource prices in 2014, Canada simply cannot rely on improving terms of trade to lift incomes further, or to turn around a weak trade performance. The dramatic rise in U.S. oil and gas production further complicates the picture by putting downward pressure on North American energy prices.

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Banks piling into auto loans as demand picks up

After less that two years of modest but positive growth, real estate loans in the US banking system have recently gone into the red again. Lower demand and banks' unease with real estate keep this sector from growing.

Source: FRB

On the other hand, banks are making a big push into auto loans. Auto loan portfolios are up 6.4% from a year ago as car sales remain brisk. Note that non-bank (shadow) lenders including ABS buyers (see post) are also a major part of this market (just check Carfinco's shares on the Toronto Stock Exchange for example).

Source: FRB

Crain's Cleveland Business: - Columbus-based Huntington Bank enjoyed a record quarter in originations in indirect auto lending, the industry's term for when borrowers secure financing from a lender through a dealership. The bank's originations totaled $1.2 billion in the third quarter of 2013, up 10% from the year-ago period and nearly 19% from the third quarter of 2011.
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Auto loan growth also has accelerated in 2013 at Firefighters Community Credit Union in Cleveland. Its auto loan balance in this year's third quarter was 13.6% higher than the year-ago quarter. That's a greatly improved performance over the 3.3% increase Firefighters recorded in the third quarter of 2012 over the like quarter in 2011, and the 7.5% decrease it saw in the third quarter of 2011 versus the third quarter of 2010.

Given the relatively low default rates in auto loans, banks' credit departments have loosened lending requirements. And as the average age of light vehicles in the US continues to rise (above 11 years), auto sales pick up (with US baby boomers now dominating sales - see story).

Detroit Free Press: - A boom in auto loans continues to support a resurgence in U.S. car buying that has hit its highest sales pace since 2007. The total amount of outstanding auto loans topped $782.9 billion as of Sept. 30, up $103 billion from the same period last year, according to Experian Automotive’s quarterly report.
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[Experian] said the availability of credit, combined with consumers’ strong track record of repaying loans, is helping banks justify greater access to loans and helping to boost U.S. automotive sales.

Through October, consumers have purchased 13 million new cars and trucks in the U.S., up 8.4 percent from the same period last year. The auto industry remains on track to sell about 15.5 million new cars and trucks this year - the most since 2007

But of course as the auto loan boom replaces the real estate boom of 7 years ago, signs of excessive lending and risk taking by banks are beginning to appear. Just as real estate lending was "safe" back then, auto lending is "safe" now.

Detroit Free Press: - Banks have become increasingly willing to provide loans to sub-prime customers and are allowing consumers to finance over a longer period, with some loans extending as long as eight years.

Indeed, longer dated auto loans are becoming increasingly common.

Montgomery Advertiser: - More new-car buyers are stretching out their loan payments for as many as seven years, and some experts worry that’s another financial time bomb.

While Not so long ago, remember the days when ads touted 48-month loans. Today the biggest growth is coming in loans lasting up to 84 months — That’s longer than most people are expected to want to keep their new car.

The longest-term new-car loans — 73 to 84 months — have jumped 25.1 percent in the past year and now make up 19.5 percent of total new-car lending, according to Experian Automotive. All other loan-length categories, in fact, have become less popular as buyers shift to longer terms to get lower payments.

The next-shorter category — 61 to 72 months, considered a very long loan only a few years ago — now is 41.7 percent of new-car loans, Experian says. That’s down 3.2 percent from a year ago, but it’s still by far the biggest single loan-length category.

One of the problems with risk management departments at banks is that they often "fight the last war". As a new asset class becomes in vogue - sometimes because of historically low default rates, banks pile into it and profits flow. With competition heating up, lending standards suffer, and risks of another systemic credit problem rise.

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Bitcoin goes vertical in speculative frenzy

Bitcoin valuation has gone vertical in the past month or so. The speculative frenzy is truly astounding. Some have attributed this to the "scarcity" issue due to reduced reward per block of bitcoin mining (see discussion). That's utter nonsense. This is speculation - pure and simple. As more players jump on the bandwagon, prices take off. And as bartenders begin to give you advice about investing in bitcoin (which some readers have reported), you know there is a problem. Just to put this into perspective, bitcoin is up 3,772% from a year ago.

Part of the reason for the recent spike is the mass entrance of Asian speculators, particularly out of China. With gold pressured by the Fed's impending taper and China's stock market not going anywhere, many in China are looking for action.

South China Morning Post: - Mainland Chinese are among the biggest bitcoin believers. The currency lets them avoid capital controls and move the equivalent of thousands of yuan outside the financial system.

They keep on buying in spite of the well known risks associated with bitcoin intermediaries. Bitcoin brokerage firms and exchanges are popping up everywhere. And some are disappearing as quickly as they show up.

The Standard: - A local firm operating a bitcoin trading platform for mainlanders was shut suddenly last week, with investors losing up to 25 million yuan (HK$31.8 million).

GBL, a local firm which set up the trading platform for bitcoin in June, attracted nearly 1,000 mainland investors. However, many users held off from trading in September as the bitcoin price kept surging and the firm suffered from a lack of cash flow.

Both the Hong Kong and the mainland authorities are not sure what to make of this craze. Right now they are looking to see what the US will do. And in the US bitcoin is quickly becoming a major controversy.

Wired: - On Monday, bitcoin and other digital currencies will come under the glare of the Senate Committee on Homeland Security and Governmental Affairs. And ahead of next week’s hearings, the five federal agencies with the most skin in the virtual currency game sent the Committee their take on this hot-button issue. According to letters penned by the agencies — which the Committee made available on Friday  — all five are watching these currencies very closely, though some realize internet money has very legitimate uses that have nothing to do with criminal activity.

Ironically that Senate action may itself be driving some of the frenzied buying, as market participants prepare for potential restrictions/controls on the virtual currency. Federal regulators have already been applying pressure on bitcoin intermediaries in the US.

Wired: - Earlier this year, the DHS [Department of Homeland Security] seized about $5 million in bank accounts belonging to the world’s largest bitcoin exchange, Mt. Gox. Since then, the exchange has found itself shunned by much of the international banking community, and it has had difficulty moving money to its U.S. customers.

Bitcoin businesses — particularly those involved in trading bitcoins for dollars — sometimes complain that they operate in a grey area, where it’s not entirely clear how or if they are in compliance with a patchwork of state and federal regulations.

In spite (and possibly because) of all the regulatory risk, investors keep buying. While there is no ambiguity about the classic commodity bubble forming in this market, bubbles can last for a long time. Speculators are betting that as more people come into the Ponzi scheme, they will be able to unload their bets to this ever-growing number of entrants. Until the last set of suckers are left holding the bag.

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Deflationary risks rising in the Eurozone; time for LTRO redux?

The euro area may be facing renewed deflationary pressures. Inflation measures are now near multi-year lows and falling.

Source: Investing.com

The area's already uneven economic recovery has stalled in a number of countries. We've seen the French GDP growth dip into the red again (see Twitter chart). The employment situation in France also remains shaky.

French payrolls (source: Tradingeconomics)

Similarly, growth in broad monetary aggregates (M3 money stock) has turned lower. This has been driven by tight credit conditions (some of which is due to poor demand), with loan growth remaining extraordinarily weak (see discussion).

Source: ECB

Perhaps the most alarming indicator that may give Mario Draghi nightmares is the German housing index. German economic conditions remain quite stable as the nation continues to show strong export growth (see discussion). Nevertheless the German housing market is exhibiting signs of a correction (chart below). Bundesbank has been warning that the nation's housing market may be overvalued - so a correction may indeed be in order. But based on the experiences in Japan and the US, a sharp housing correction from bubble levels could quickly ignite deflationary pressures.

Source: Investing.com

Some are attributing these risks to the fact that the ECB (Eurosystem) balance sheet has seen a massive decline this year. While this is a positive development since it was caused by the area's banks repaying MRO and LTRO obligations, some view the reduction in the size of the central bank balance sheet as a form of monetary policy tightening.

Putting together the data discussed above would suggest that the ECB will be moving toward another non-traditional monetary policy action. With the overnight rate near zero (25bp), there is little room for lowering rates further. Setting the rate on excess reserves to negative could be one option. But a more likely outcome is another longer dated LTRO program (see discussion) or even a new securities purchases initiative (Fed-style QE). While the effectiveness of another nontraditional monetary easing program could be debated, the ECB may soon be running out of options.

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