Tuesday, December 31, 2013

One of these things is not like the other ...

This is the time when everyone is making financial and economic forecasts for the upcoming year and beyond. Here is a simple forecast from Sober Look that did not require much analysis. By the end of 2014, student loan balances held by the federal government will exceed $850 billion and by the end of 2015 the number will be above a trillion. And this is on top of some half a trillion of loans that are not directly held but guaranteed by the federal government.
Source: FRB

So what? We've gotten numerous e-mails asking this question. The problem of course is government-subsidized and rising consumer debt burden - all on the back of the taxpayer. When the government is involved on such a large scale, there are usually unintended consequences and market distortions (elevated tuition costs for example). But it's the borrowers who are stretched to the limit due to outsize student loans and limited employment opportunities that is the growing problem - both for the borrowers and the taxpayers.

Remember the old song from Sesame Street: "One of these things is not like the other..."? The chart below from Wells Fargo shows the one thing that is definitely not like the other.

Source: Well Fargo

Happy New Year!

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Monday, December 30, 2013

When it comes to current account imbalances, one nation stands out

Over the past few decades there has been a great deal of focus on the large trade imbalance between the US and Asia - first with Japan and more recently with China. While that is still an issue, we may be facing a new imbalance that is starting to grab the attention of politicians, economists, and the markets. The chart below shows the current account balance as a percentage of each nation's GDP. And one nation clearly stands out - Germany.

Source: Tradingeconomics.com, Merrill Lynch

According to Merrill Lynch the massive German current account surplus will manifest itself in two major ways:

1. It is bound to generate friction within the Eurozone, particularly as German assets appreciate, while the periphery is experiencing deflationary pressures.
Merrill: - Germany’s surplus holds a deeper meaning for financial markets in 2014. First, it signifies the difficulty faced by ECB monetary policy. It should not be easy to achieve a balance between Germany with its growing current account surplus and where real-estate prices have started turning up [see Twitter chart from the ECB], and the periphery countries that are facing disinflation despite having somewhat reduced their current account deficits as a tradeoff for low growth. Whether it happens in 2014 or not, eurozone fiscal policy discussions will be necessary at some point, though politically difficult. Eurozone financial issues could still destabilize global financial markets at some point in the future.
2. This imbalance is likely to have an impact on the currency markets, especially with respect to the yen.
Merrill: - The second implication is for the exchange rate issue with Japan. While Germany’s current account surplus has expanded, it is Japan’s current account that has deteriorated sharply. Comparing Japan’s balance of trade in 2010 and 2013 (Jan- Nov for both years), reveals that it has fallen by ¥16.1tn (3.2% of GDP). Around half (¥7.5tn) of this is in non-energy trade. Of that ¥7.5tn, more than ¥2tn is due to trade with the EU, and the rest is versus Asia. Japan is expected to post a ¥11-12tn (1.2- 1.4% of GDP) trade deficit for 2013. Although its income balance will keep the current account positive, the surplus will likely be less than 1% of GDP.

...the change in current account imbalances seems consistent with our FX strategy team’s projection that the leeway for a rebound in the JPY is relatively limited versus the EUR, and the JPY should continue to weaken versus USD in 2014.
2014 should see an increased focus on this topic, as Germany's current account surplus continues to stand out.

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Sunday, December 29, 2013

Is the treasury curve artificially steep?

The treasury yield curve remains quite steep by historical standards. Typically such steepness is driven by expectations of higher inflation in the future. But as discussed earlier, that is not the case in the US (see post). Instead it is the expectation of the Fed's "taper" that has been influencing the shape of the curve. Measured as the difference between the 10-year and the 1-year yield, the US curve is now steeper than those in most developed economies, including Canada, Germany, France, the UK, Japan, and Australia.

The only developed economies with steeper government curves are in the Eurozone periphery - the result of lingering credit concerns.

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Daily price data underestimates stock beta

Those who manage market neutral equity portfolios spend a great deal of time estimating betas (see definition) of individual holdings. The goal is to measure the amount of index-equivalent exposure needed to offset the "market-sensitive" component of each stock's volatility. This often becomes more of an art than a science, with dozens of different (and often proprietary) approaches. These include splitting the measure into the "up-side" and the "down-side" beta based on observations that some companies' share price responds differently to rising vs. falling markets. Another approach used by some risk managers is to look at "stress beta" - a measure of how a stock responds to extreme movements in the market.

There is however one overriding mistake that many portfolio managers make in their estimates of beta. For those who have holding periods of longer than a day, it probably does not make sense to use daily movements in stock prices to estimate beta. Daily data contains a significant amount of noise that tends to dampen the relationship between a stock and the overall market. Daily responses to news about a particular company are sometimes exaggerated, and adjust within the next few days to trade more in tandem with the overall market. On days when the overall market has little direction, stocks of some companies temporarily decouple from the market. All this could lead to erroneous results in measuring beta.

Let's look at an example. In the chart below, the y-axis represents the daily returns for Alcoa Inc., a large US firm focused on aluminum products (website). The x-axis shows the daily returns for the S&P500 index (here we are using SPY because many managers trade this ETF as a liquid proxy for the S&P500). The red line is the regression fit to this scatter plot. The classical way of estimating beta is simply using the slope of this red line, resulting in a measure of 1.63. This means that on average Alcoa shares will move 1.63 times as much as the S&P500. The company by its nature is cyclical and carries a significant amount of leverage, resulting in share price movements that are higher than the index (sometimes referred to as a "high-beta" stock).

In theory if someone is long $10 million worth Alcoa shares and decides to short $16.3 (10 x 1.63) million worth of S&P500 against it, the market exposure should be "hedged". That means the long/short position should exhibit the lowest possible volatility one could achieve by hedging with S&P500.

But most portfolio managers don't hold stocks for just a day. Using weekly as opposed to daily price data results in a beta of 2.05, a materially different outcome (see chart below). It means that in order to minimize the volatility over several days, one needs to short $20.5 million worth of S&P500 against $10 million worth of Alcoa - not $16.3 . The "daily beta", represented by the red line below would have resulted in higher losses during large market corrections than the weekly measure (green line).

Weekly data is based on each Thursday's close

Portfolio managers have numerous options for beta calculations. But one key factor for those who do not turn over their holdings daily is making sure to avoid using daily returns data for these measurements. Betas derived from daily stock prices could significantly underestimate the overall market exposure of a stock portfolio.

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US broad money supply growth slows

The US broad money supply expansion has slowed materially in the last few months, with the year-over-year growth now at the lowest level since mid 2011. Except for certain components of M2 such as money market funds, the broad money supply is an indicator of the nation's overall credit expansion. This may, at least in part, explain the relatively low inflation the US has experienced in recent months (see post).

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Thursday, December 26, 2013

Turkey's political stability in question; yield breaches 10%

Turkey's government is in disarray. It is quite common for governments, particularly in countries with an authoritarian leadership (and Turkey's leadership has been acting in that fashion), to blame whatever the mess the country is facing on corruption (see example). And the more the Turkish Prime Minister Erdogan loses grip on power, the more he will blame "corruption" for his predicament. With Erdogan's cabinet reshuffled (see story from NBC), as ministers resign (some of whom are calling for his resignation), Turkey's near-term political stability has been called into question.

The central bank has been desperately trying to defend the lira as the current account deficit can no longer be financed with foreign capital inflows. But selling foreign reserves has been ineffective and a hike in short-term rates may be the next step. However, rising rates may further damage the nation's economy that has been weakened by capital outflows in recent months (see post).

Investors are not taking any chances, with the lira, the stock market, and the country's government bonds all taking a severe beating. The chart below shows the dollar appreciation against the lira as the currency hits record lows. What worries many investors is that renewed weakness in the nation's currency could accelerate inflation, causing further social unrest.
Source: Investing.com

Turkish 10-year bond yield has breached 10%, as the selloff that started a couple of months ago accelerated.

Source: Investing.com

With investors already jittery about emerging markets in the face of tighter monetary conditions and higher rates in the US, the situation in Turkey has become precarious. While the media has not focused on this angle, the situation also presents a significant geopolitical risk, given the regional importance of Turkey, a member of NATO, for the US and the EU.

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Wednesday, December 25, 2013

US credit risk appetite hits euphoria

Per earlier post (see discussion and chart), corporate spreads in the US are grinding lower - with new post-recession lows for both IG and HY spreads. The Merrill HY Index spread is now below 400bp and the investment grade equivalent is below 130bp. For those who track fixed income ETFs, the following chart comparing treasuries with corporate bonds (LQD vs. IEF and HYG vs. IEI) illustrates the extend of spread compression.

In fact US corporate credit is outperforming other forms of credit assets such as commercial real estate (see post). A good way to see that outperformance vs. global risk assets is in the components of the Credit Suisse Risk Appetite Index. For the first time since Bernanke began hinting about taper, US Credit Risk Appetite is at the level of "euphoria".

Source: Credit Suisse

But some argue that these credit spread levels are justified given where the US stock market is currently valued. The scatter plot below shows the S&P500 index vs the HY index spread over the past 10 years. The last time spreads were at these levels (2007), equities were priced much lower (S&P500 was around 1550). Of course corporate revenue has grown substantially since then making this comparison less relevant. Nevertheless some are suggesting that it's the stock market which is overvalued relative to credit.

Whatever the case, as monetary conditions in the US begin to tighten and interest rates rise, credit spread compression has to slow or reverse. The current trend is simply not sustainable.

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Tuesday, December 24, 2013

The unintended consequences of Abenomics

As discussed earlier (see post), Japan continues to struggle in its endeavor to generate demand-driven inflation. To a large extent price increases have been the result of costlier imports due to weaker yen, particularly items related to food and energy. Outside of those sectors, prices remain soft.

The danger of Japan's current policy (Abenomics) is that the outcome could turn out to be the exact opposite of what was originally intended. With wages stagnant, these import-driven price increases are hitting the Japanese consumer quite hard. As a result, spending on domestically produced goods and services could end up falling, constraining domestic prices instead of increasing them.
Scotiabank: - Key here is that the Japanese CPI inflation figures continue to showcase evidence of a relative price shock driven by imported food and energy price spikes significantly related to yen depreciation. Most CPI components not related to food and energy either continue to fall or remain soft as shown in the accompanying chart. The big gainers are prices for fresh food, utilities due to soaring electricity prices in the wake of the Tōhoku disaster coupled with rising imported energy costs, and the energy impact on rising transportation prices. CPI ex-food-and-energy remains largely flat. We maintain the year-long view that Abenomics would impose a relative price shock that would force wage- and credit-constrained consumers to spend more upon what they have to (food and energy) by restraining spending elsewhere in the economy in disinflationary fashion on the second- and third-round effects. That’s a very different inflation dynamic than would be the effects of a generalized increase in economy-wide prices in that it counsels future effects that will be bearish for the outlook for Japanese consumers. At the same time, the other main supposed benefit of Abenomics is an improvement in the trade account by stimulating export growth through yen depreciation, yet this is only evident via a price effect as export volumes remain weak [see post]. 

One sad consequence of Abenomics is the impact on Japan's elderly, whose ranks are swelling rapidly (see post). Isolation combined with rising prices on food and electricity makes survival for many older Japanese citizens a struggle. According to the National Police Agency survey, shoplifting incidents accounted for close to 10 percent of all crimes. And the number of shoplifting offenses is only growing among people 65 and older - with 68 percent of those cases representing food items. The latest 18.6 trillion yen stimulus package from the government is supposed to (among other things) provide additional help for the elderly, but it remains unclear how sustainable such efforts will ultimately be.

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Monday, December 23, 2013

Growth rates in consumer spending and income diverge

Consumer spending in the US accelerated in November, boosting projections for the GDP growth in the fourth quarter. While incomes grew as well, the rate of increases from the same period last year has slowed. With confidence improving, consumers have increased spending while wages have not kept up.

YoY % changes.
Note: The spring 2008 spike in income is due to the last of the Bush administration's tax cuts (The Economic Stimulus Act of 2008). The spike late last year is due to income harvesting (dividends and capital gains) in preparation for tax increases taking place 1/2013.

This divergence in the growth rates of spending and income is resulting in declines in personal savings rate.

There is a great deal of debate around whether this slower savings rate is a positive for the US economy in the intermediate to long-term period. With the holiday week upon us, this may be a good time to revisit this debate through a very clever video called "Deck the Halls with Macro Follies".


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Reduction in fiscal stimulus creates tight monetary conditions in China

China's short-term rates have spiked again. In a replay of this summer's liquidity squeeze (see post), term money market rates (SHIBOR and repo rates) have risen across the board. The PBoC had to inject liquidity to stabilize the situation.
WSJ: - The People’s Bank of China said Friday it had been forced to inject more than 300 billion yuan (US$49.2 billion) into China’s money markets over a three-day period after the interest rates banks charge each other for short-term loans surged to 8.2%. The injection helped bring down rates to 5.6% by Monday morning.

Last week’s levels were the highest since June’s cash squeeze sent short-term rates soaring above 28%. Then, China’s lenders were caught in a credit squeeze caused by a combination of factors, ranging from lower capital inflows and seasonal tax payments to a mismatch between banks’ short-term funding and longer-term lending. The PBOC let the problem fester before stepping in, to teach banks a lesson.
Source: China Foreign Exchange Trade System & Nation Interbank Funding Center

The explanation this time around seems to be reduced government spending. The banks and the economy as a whole rely on seasonal fiscal stimulus, which is not nearly as potent this time around. Reforms focused on reducing "unnecessary" government spending are being put in place.
WSJ: - Those seasonal factors have come into play now as well. But “the recent rate spike is, to a large extent, a reflection of the government’s tighter stance on spending,” Citigroup economist Ding Shuang said.

The Chinese government usually draws down fiscal deposits — the amount of funds the government keeps in the financial system—more quickly in December, as it speeds up spending and fiscal disbursements before the end of the year, UBS economist Wang Tao said in a recent note.

That boost in government spending adds liquidity to the banking system, and the PBOC normally withdraws liquidity at the end of the year to offset the inflows. This time, though, the government’s tighter fiscal policy means year-end spending has been restrained, Ms. Wang said.

China’s Communist Party has launched a campaign this year to crack down on unnecessary government spending, from official banquets to investment projects. Even budgeted investment projects that are deemed unnecessary won’t get funding, Citigroup’s Mr. Ding said.
Withdrawal from years of stimulus is bound to have its side effects. And tight monetary conditions are likely to be just a part of the overall impact.

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Sunday, December 22, 2013

BDCs vs. REITs

The chart below compares the recent total return performance of BDCs and REITs, which show significant divergence recently. Investors are betting that middle market sub-investment grade corporate debt will outperform commercial property and real estate debt in this higher rate environment.

click to enlarge

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Saturday, December 21, 2013

The big steepener unwind

Since the Fed announced the reduction in securities purchases ("small taper"), the treasury curve has undergone some strange adjustments. Here is what the impact has been since the close on December 17th. Why would the 5-year note sell off the most while the long bond rallied?

The answer has to do with how the market was positioning prior to this event. Many traders had two expectations:
  1. Taper is coming next year and the impact should raise long-term rates
  2. The Fed will keep short term rates near zero for a long time
The trade that takes advantage of this view is the so-called "steepener" trade - long short-term treasuries and short long-term treasuries. And that's how the market was positioned going into the announcement. But a combination of the "early" taper, stronger than expected economic data (below), and a less than stellar 5-year note auction made some question the #2 assumption above.

Source: Investing.com

After what we've seen over the past five years it is difficult to imagine this scenario, but what if the US economy unexpectedly accelerates? The Fed will be forced to begin pushing short-term rates up faster than originally expected. The market started to price in a higher probability of just such an event. As an illustration, take a look at the June-2015 fed funds futures contract. The steepener trade had pushed the first rate hike expectations further out in time (higher futures price = lower expected fed funds rate). But the announcement, combined with improved economic data, forced a selloff in the contract - with the market now expecting the first hike by the middle of 2015.

This earlier-rate-hike scenario impacts shorter-term treasuries more than it does longer-dated notes/bonds. The adjustment in expectations forced an unwind of the steepener trade, creating the "flattening" move in the yield curve we see in the first chart above. Anecdotal evidence suggests that this unwind ended up being quite painful for a number of market participants who had piled into the trade.

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Friday, December 20, 2013

Another look at labor force participation

DB's chart of the US unemployment rate (below) received numerous comments on Twitter. Clearly the projection of the linear decline continuing at the same rate is a bit aggressive. But many of the comments were dismissive of the measure altogether - arguing that these falling unemployment levels are not that meaningful in the face of the declining labor participation rate.

There is no question that labor force participation in the US has been falling as more people drop out of the workforce. But that measure could be misleading because as the population ages, the workforce will shrink naturally. For example Canada is also experiencing declines in its headline labor force participation rate. But when adjusted for aging, its labor force participation is actually growing (see chart).

Perhaps a better measure to use here is the so-called "activity rate" which is often used by OECD researchers to compare labor markets across different countries. It is defined as "the active population (employed plus unemployed) divided by the working age population." In other words, what proportion of the "working age" population is either working or is officially listed as unemployed. A decline in that rate would indicate "working-age" people leaving the workforce. And as the next chart shows, that is indeed the case (note: for those who are not happy with the 15-75 age range, rest assured that other similar ranges for working age population yield very similar results.)

This tells us that about 3.5% of the working-age population has left the labor force since the start of the Great Recession. Should those people be also counted as unemployed? If so, here is what the unemployment rate trend would look like:

It's not clear however if the orange line above represents "true" unemployment. For example teenagers had far greater employment opportunities in the 90s than they do now, with youth labor force participation having declined sharply over the past decade. But should a 17 year-old who lives with her parents and can't find part-time work be classified as "unemployed"? Evidence suggests that a great number of the labor force "dropouts" were in the 16-19 age group. This would indicate that the "effective unemployment" rate (depending how one defines "unemployed") is somewhere between the orange and the blue charts above, with DB's projection representing the lower boundary.

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Thursday, December 19, 2013

Goldman loses the Volcker Rule battle over credit funds

About a year ago we discussed the argument made by Goldman's lawyers that under the Volcker rule, banks should be allowed to invest in credit funds (see post). The rationale is that if banks can lend to companies directly, why can't they invest in funds who make the same types of loans? In particular, Goldman was defending its lucrative mezzanine fund business which provides junior capital to companies. Goldman and other banks compete with private equity firms such as Blackstone in managing credit portfolios for clients.

The final Volcker Rule regulation seems to indicate that Goldman has lost that argument. (See great summary on Volcker Rule pertaining to private funds from Simpson Thacher - below)
Simpson Thacher: - the Agencies were unpersuaded by industry comments that ... credit funds (which are generally formed as partnerships with third-party capital that invest in loans or make loans or otherwise extend the type of credit that banks are authorized to undertake on their own balance sheet) should also be excluded.
That means Goldman and other banks will be limited to the standard 3% investment in the mezzanine or other credit funds they manage. And clients generally expect banks to commit significantly more of banks' own capital to funds they manage in order to avoid potential conflicts (such as having banks stuff these funds with bad investment banking transactions).

This is a big win for private equity firms who will be able to grab market share of this business from banks. However it's not a great outcome for companies who rely on this type of financing, as lender competition declines.

STB Volcker Memo

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Tuesday, December 17, 2013

Inflation measures point to Bullard's "small taper"

Inflation measures provide key data points for the Fed in deciding on the timing and the magnitude of taper. Last week's PPI and today's CPI numbers continue to show a fairly benign inflation environment.

Source: Econoday

However CPI and similar measures tend to be "lagging" indicators, motivating the FOMC to also look at market-based inflation expectations. In particular the committee tracks TIPS-based break-even figures, which also remain subdued.

Source: Ycharts

When adjusted for the so-called "risk premium" using a calculation performed by the Cleveland Fed (see paper), expectations of future inflation are even lower. What may be of concern for the Fed is that even 10 years out, expectations are comfortably below the 2% target rate.

This bodes well for Bullard's "small taper". The idea is to begin reducing purchases soon in recognition of improving labor markets, but move cautiously to avoid declines in inflation.
James Bullard: - A small taper might recognize labor-market improvement while still providing the committee the opportunity to carefully monitor inflation during the first half of 2014. Should inflation not return toward target, the committee could pause tapering at subsequent meetings.

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Two key reasons for Japan's record trade deficit

Japan's Ministry of Finance just released the nation's trade balance numbers, showing the trade deficit hitting a new record.

unit = ¥ trillion (source: Investing.com)

While there are a number of reasons for this trend, two key items stand out:

1. Yen weakness has not generated the expected benefits in terms of exports due to slow global growth and challenging competitive landscape.

2. Recently domestic import demand has grown considerably, as buyers try to get ahead of next April’s consumption tax hike.

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What happens to banks' balance sheets during a downturn

Credit underwriters pride themselves in their ability to cut lending when they sense that economic fundamentals have changed for the worse. For example one often hears bankers talking about passing on deals in 2007 because of "not liking the fundamentals" or "the markets looked stretched". But historical data suggests otherwise. At least during the past 6 downturns, lenders increased balance sheets during the onset of each recession. And loan portfolios continued to grow, with lending often slowing only closer to the end of (and/or after) the recession.

Above the red line (100) indicates an increase since recession's start (source: FRB)

But banks continue to insist that they will see the next recession coming and reduce exposure before the downturn. These "expected" balance sheet declines have been reflected in the stress tests that banks have been providing to the Fed, resulting in a more benign outcome. Given that the data clearly shows balance sheets rising, the Fed has decided to apply its own assumptions to how banks' loan portfolios will change in the next downturn.
WSJ: - The Fed will now make its own projections about how bank balance sheets will fluctuate during a future recession, rather than rely on the banks for that data. The change is likely to produce different results in the 2014 tests, the Fed said. For instance, the central bank is likely to find bank assets will grow in a downturn, rather than contract as banks had projected in previous years. That could require firms to have more loss-absorbing capital or limit rewards to shareholders, though results will vary for each bank.
It seems that in reality, lenders (at least on average) tend to be terrible at calling the next downturn. And often by the time underwriting standards actually tighten, the worst of the slowdown is already over.

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Monday, December 16, 2013

Is the treasury market oversold?

When it comes to treasuries, there is no shortage of bearish news. The budget deal is done, the third quarter GDP was better than expected (inventory build issue aside), and the US labor markets are supposedly getting better. Expectations of an "early taper" are running high, with the Fed poised to pull the trigger on cutting back securities purchases sooner than was originally thought. Moreover, bond funds outflows continue, with many investors dumping anything that has a fixed coupon. And if the fundamentals aren't bad enough, technicals for treasuries look terrible as well. Moving averages and other technical indicators are all screaming "sell".

Based on daily trend (source: Investing.com)

That's precisely what many investors have been doing since October, as treasuries resumed the decline which began last spring.

Source: Investing.com

Now consider the following chart. It shows the aggregate speculate investor positioning in dollar rate-sensitive futures. The measure is duration weighted, assigning a higher weight to the 10y note futures than to bill futures for example.

Source: Credit Suisse

This tells us that "speculative" investors are building up what amounts to a large (relative to recent history) short treasuries position. And why not - so far all signs have pointed to this being the right trade. Until some of these trigger-happy traders begin to cover.

With all the bearish news out and everyone - including retail investors - talking about rising rates, the contrarian view would put the near-term risk in treasuries to the upside.

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Germany and France economic divergence

The Eurozone recovery continues to be uneven, powered primarily by a pickup in export-driven manufacturing and with only some nations participating. In particular we are witnessing a significant divergence between the area’s two largest economies, Germany and France. As German manufacturing firms gain momentum (see post), the French recovery has stalled.
The Telegraph: - Figures showing private sector growth across the Eurozone have underlined the widening chasm between the bloc's economic giants, Germany and France, with the latter increasingly looking like the "sick man of Europe". …

… looking at the separate surveys, it is clear that Germany is pulling away from France. Germany's manufacturing sector grew at its fastest clip in 30 months, and services are expanding too. But in France, both sectors are in a sharpening decline.

it's the unbalanced nature of the upturn among member states that is the most worrying. France looks increasingly like the new 'sick man of Europe', as a second successive monthly contraction may translate into another quarterly decline in GDP, pushing the country back into a technical recession. In contrast, the December survey data round off a solid quarter of growth in Germany, in which GDP looks set to rise by 0.5pc.
The following chart of manufacturing PMI trends tells the story of divergence. Note that a reading below 50 represents a contraction in the manufacturing sector.

Source: Investing.com

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Sunday, December 15, 2013

Noise in claims data makes the measure useless for now

The US initial jobless claims measure has often been difficult to interpret due to seasonal and other effects, but it has been all but useless lately. The latest spike (last week) has to do with the fact that Thanksgiving was late this year and the seasonal adjustment was simply incorrect.


Most economists believe that the trend in US jobless claims is still downward sloping. One positive sign in particular has been the recent drop in the number of Americans receiving extended unemployment benefits.
Bloomberg: - The continuing claims figure does not include the number of Americans receiving extended benefits under federal programs. Those job-seekers declined by almost 102,000 to 1.25 million in the week ended Nov. 23.
Whatever the case, the initial claims numbers are currently not very meaningful and should be ignored.

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Treasury FRN issuance will eat into supply of bills

In January the US Treasury will auction off the first set ($10-15bn) of floating rate notes (FRNs). These are two-year notes with quarterly payments based on the 3-month treasury bill rate plus (or minus) some small spread. The notes will be auctioned off at par, with the premium/discount built into the spread (see term sheet below). It has been some 17 years since the US Treasury has introduced a new product. The demand for "floaters" has been strong as fixed income investors grapple with rising rates. The rally in senior leveraged loans for example (see post) has been driven to a large extent by the fact that the coupon on these products rises as rates increase. And now the Treasury will attempt to take advantage of this demand.

The 3-month treasury bill rate is currently around 7bp vs. the 2-year note yielding about 34bp. So why would someone accept such a low rate on a 2-year product when they can lock in a higher rate with a fixed rate note? The reason is that the market expects the 3-month bill rate to rise quite sharply in the next couple of years. Therefore while the expectation is that the FRN buyer will make much less at the beginning, at some point the coupon will rise above the current 2-year note rate to compensate investors for the lower initial yield. Ultimately (in an "arbitrage-free" world), the expected effective yield on a 2-year FRN and a 2-year fixed-rate note issued by the US Treasury should be roughly the same.

Who will buy these products? The biggest demand will come from money market investors - those who currently buy bills. Because the FRNs are equivalent to "rolling" a three-month bill, rated money market mutual funds now have permission from the rating agencies to buy the notes. S&P released a statement recently saying that the "new U.S. Treasury Floating-Rate Notes are consistent with our principal stability fund ratings criteria".

There is some concern however that this FRN program will reduce the amount of treasury bills available in the market, particularly as the Treasury attempts to lengthen the average maturity of total debt outstanding.
JPMorgan: - Going forward, we expect Treasury to err on the side of caution, and our forecast assumes $10bn in monthly FRN issuance until the program is more developed. Furthermore, our issuance forecast shows FRNs as a substitute for Treasury bill issuance, consistent with the goal of lengthening the weighted-average maturity (WAM) of the Treasury debt.
As discussed back in July (see post), treasury bills as a percentage of total government debt have been on a decline for some time, and the new FRNs are expected to further reduce this supply.

Source: JPMorgan

FRN Term Sheet

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US debt ceiling risk: out of sight, out of mind

The impasse over the US debt ceiling came and went - and with it the public's interest in the subject. The short-term treasury curve which became inverted back in October (see post) went back to normal.

There is a budget deal now in place that should prevent another government shutdown for the next couple of years and the issue of the debt ceiling faded into the background. Because the budget fight took place around the same time the debt ceiling was reached, the public bunched the two issues into one - and many now believe that debt ceiling won't be a problem for two years.

Google Trends: search frequency for "debt ceiling"

And yet the budget deal last week did nothing to avert another debt ceiling fight next year.
CNN: - The [budget] deal would help Congress avert budget brinksmanship for awhile. But it does nothing to prevent another bruising battle over the debt ceiling, which lawmakers must address in just a few months.

The bargain lawmakers struck in October to end the federal government shutdown included a provision to suspend the nation's borrowing limit for a few months. It lets the Treasury Department continue borrowing new money through February 7 without regard to the debt limit. Then, on February 8, the debt limit will automatically reset to a higher level that reflects how much Treasury borrowed during the nearly 4-month suspension period.

At that point, if Congress hasn't agreed to raise the ceiling, Treasury can use "extraordinary measures," the special accounting maneuvers that let it keep paying the country's bills without going over the debt limit and risking default on the nation's obligations.

But those measures are expected to run out sometime between March and June, although Treasury Secretary Jack Lew has warned that based on where things stand now they are not likely to last more than about a month.
The can has been kicked down the road for a few months, and except for the somewhat elevated US sovereign CDS spread (see chart), all is well. The fact that just two months ago the US federal government was toying with the notion of a technical default (see discussion) is now just a bad dream. Out of sight, out of mind.

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Saturday, December 14, 2013

If QE is "heroin", what is "methadone" and how do we avoid "side effects"?

The Federal Reserve remains concerned about exiting the massive bond buying program that has been in place for over a year now. The program has become a bit of a trap (see post), creating a dependence on unsustainable levels of stimulus. The concern is that in an environment where inflation is at historically low levels, cutting back on monetary stimulus could put significant downward pressure on prices, creating deflationary pressures and forcing the Fed to resume or even increase the program (similar to Japan). Using the addiction analogy (see this video for example), this is the equivalent of a relapse risk for those suffering from substance abuse. It turns QE from an extraordinary crisis fighting mechanism meant to be used only under extreme situations into an ongoing monetary policy tool. The Fed desperately wants to return to the days of simply adjusting short-term rates to drive policy.

So how does one minimize the impact of taper to reduce the probability of returning to "unconventional" programs? One approach is something that opiate addiction clinicians have been using for some 30 years. An effective treatment for heroin addiction is the use another, less dangerous opiate called methadone. It reduces withdrawal symptoms without creating intoxicating or sedating results, helping many addicts quit. So if heroin is analogous to the Fed's QE program for the economy, what is the equivalent of methadone?

Many are arguing that lowering the Interest on Excess Reserves rate (IOER) could potentially counteract some of the QE withdrawal symptoms. IOER is currently at 25 basis points, and while that was considered to be extraordinarily low back in 2008 when it was introduced, in the days of record low short-term rates many view it as being too high. That's because banks are quite comfortable paying near-zero on deposits (including deposits from the Federal Home Loan Banks) and receiving 25bp on reserves - a riskless way to generate revenue (see post). That spread according to some is holding back credit expansion in the US. The chart below shows growth in non-cash assets of all banks operating in the US - an unsettling trend for many economists.

By making it less profitable to hold on to cash, some argue that lowering the rate on reserves should "dislodge" the barrier to a more vibrant credit expansion.
Reuters: - The [IOER] rate has been criticized, however, for encouraging banks to park cash idly with the central bank instead of using funds to lend to companies and consumers that many say is needed to stimulate the economy and reduce unemployment.

Yellen, who has been nominated to succeed Fed chair Ben Bernanke at the end of January, said on Thursday that cutting excess reserves is "something that the FOMC has discussed, and the board has considered, on past occasions, and it is something we could consider going forward."
When cutting this rate simultaneously with the first series of cuts in securities purchases, the Fed could attempt to blunt the "withdrawal symptoms". This may avoid the "cold turkey" taper, which many view as dangerous given the disinflationary trends in the United States (see Twitter chart) and elsewhere in the developed world. So why hasn't the Fed already taken this step? As with any medication, this form of "methadone treatment" may have some side effects.

Europe found out the hard way that setting the rate on reserves to zero can severely damage the money markets industry - which is basically what happened in the euro area after Mario Draghi's rate announcement in July of 2012 (see post). While we've received emails arguing that money market funds are irrelevant, one has to keep in mind that in the US and offshore the industry holds $2.7 trillion of dollar deposits. Nobody wants havoc in that sector, particularly as taper takes hold.

That's why the Fed has been working on a way to avoid this potentially dangerous complication. It is called the Overnight Reverse Repo Facility (discussed here). This tool gives the Fed some control over the short-term rates outside the banking system to make sure money market rates do not dive below zero. Money market funds would be allowed to effectively deposit cash directly at the Fed (technically they would be lending to the Fed) and earn rates that are above zero. The program would set a floor on the overnight rates and in the long run the facility could be used in conjunction with (or even instead of) the fed funds rate to drive monetary policy.
Reuters: - Market speculation that the Fed may be nearer to acting on a cut also increased on Thursday after influential firm Medley Global Advisors said in a report that the Fed may cut the excess reserve rate, noting that it has more flexibility to do so now that it has been testing its reverse repurchase agreement program.

In reverse repos, the Fed temporarily drains cash from the financial system by borrowing funds overnight from banks, large money market mutual funds and others, and offering them Treasury securities as collateral. This helps the Fed control short-term rates as the supply of collateral can stop market disruptions from rates falling to zero or into negative territory as cash floods into short-term markets.

The Fed has been testing this program since September.

"The logic for cutting the IOER now, would be to better align the IOER with other short-term rates and hopefully encourage greater market-based lending," said Kenneth Silliman, head of short-term rates trading at TD Securities in New York.

"With the creation of reserve draining facilities, like the Overnight Reverse Repo Facility, the Fed now has the ability to better align rates without destabilizing money markets given that the Fed can essentially put a 'floor' on short-term rates by injecting collateral/draining reserves into the market. This would have a stabilizing effect," he said.
We could therefore see the Fed execute all three policy changes at the same time:
1. Taper (weaning the economy and the markets off QE "heroin")
2. Reduction in the IOER rate to encourage lending (methadone treatment for reducing withdrawal symptoms)
3. Introduction of the Overnight Reverse Repo Facility to keep the overnight rates from dropping below zero and destabilizing money markets (managing medication side effects).

Of course it is not entirely clear if lowering the IOER rate will encourage significantly more lending. However such action will certainly send lenders to seek out other sources of revenue in order to replace the easy money generated by the current spread between IOER and deposit rates.

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Wednesday, December 11, 2013

Inventories pose near-term risks to US growth

In spite of some relatively strong economic data coming out of the US (see post), risks to near-term growth remain. One of those risks comes from higher than expected inventory build. We saw this come through in the latest GDP numbers.
TD Economics: - While the headline certainly looks good, the significant upward revision to inventories is not great from the point of view of the fourth quarter. The accumulation in inventories appears somewhat excessive for the quarter. After the 1.8 pp contribution in Q3, we believe inventories alone will likely subtract close to a percentage point from Q4 real GDP growth. In addition to the drag on government spending from the shutdown in October, this will likely amount to fairly modest economic growth at the close of 2013.
The high inventory accumulation among US firms is clearly visible in the monthly data as well.

Source: Investing.com

This could be especially problematic if retail sales weaken. While it is difficult to say how retail sales are faring in December, at least one indicator is pointing to less than stellar performance (see chart).

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Sunday, December 8, 2013

Banks outperform the market, with regional banks pulling ahead

The US banking sector continues to outperform the broader market. Furthermore, for the first time this year, regional bank shares are outperforming the overall bank index, which is driven primarily by the largest banks.

Red = S&P500; Green = S&P total banking sector index ETF; Blue = S&P regional banks index ETF

The key reason for the strong performance among US banks remains the steepening treasury curve. Banks pay next to nothing on deposits while charging a rate that is often linked to treasuries on the loans they make. The steeper the curve, the wider the "margin". And given the leverage inherent in the banking system, even a small margin increase materially improves the return on equity.

The treasury curve has been steepening sharply in recent weeks - as seen from the spread between the 10y and the 2y yields (as well as 30y and 2y).

What's driving this steepening? Historically, rising longer dated bond yields were caused by higher inflation expectations. That's not the case this time around. In fact as the chart below shows, longer-term inflation expectations have been declining.

Dow Jones Credit Suisse 10-Year Inflation Breakeven Index

The rise in yields is instead mostly driven by higher expectations of earlier and faster reductions in securities purchases by the Fed. In particular, some at the Fed have been happy to see a bit of stabilization in monthly payrolls growth (at around 200K).

The sustainability of this trend is yet to be proven, but combined with better GDP figures (see chart) and improved new home sales (see chart), these data may be sufficient to push even this dovish FOMC into launching its exit sooner than expected. The fact that corporate spreads are at the levels not seen since 2007 (see post) doesn't help the case for maintaining the current pace of QE either.

At the same time, Bernanke was quite clear that it will be some time before the Fed will begin pushing up short-term rates - even after QE ends. We therefore have the short-term rates (and therefore bank deposit rates) remaining near zero, while longer term rates rising due to expectations of taper. This is resulting in significant curve steepening, a great environment for banks.

The next question is why all of a sudden we are seeing regional banks outperforming the overall banking sector. The answer has to do with the changing regulatory landscape, as the Volcker Rule is about to go into effect.
WSJ: - Barring a last-minute surprise, the votes will result in tighter restrictions on certain trading activities that go beyond what regulators had agreed to just a few weeks ago, according to people familiar with the matter. Since then, regulators have been locked in tense negotiations that threatened to upend the provision.

Under the final rule, regulators are expected to closely track trading activities with an eye on whether certain trades known as hedges are designed to post a profit rather than offset risks that accompany trading with clients. The finished version of the Volcker rule is likely to require that hedges be designed to reduce specific risks, according to a portion of the proposed rule reviewed by The Wall Street Journal.

Hedging activity should shrink or alleviate "one or more specific, identifiable risks" such as market risk, currency or foreign-exchange risk, and interest-rate risk, the language says.

"This is the new era of Big Brother banking," said Michael Mayo, an analyst with CLSA Americas. "Now banks' fortunes are more closely tied to the government."
This "Big Brother banking" will have a far greater effect on the largest financial institutions than on the regional or smaller banks. The inability to trade in "prop" accounts is already resulting in reduced liquidity and weaker market making capability among the larger banks. As a result, in the US bond markets for example, banks often do little more than act as "introduction brokers" for a quarter-point spread. In some instances this is far cry from the high volume market-making activities banks used to be involved in. All this is resulting in declining "sales & trading" revenue for the largest banks.
Bloomberg: - The $44 billion at stake represents principal trading revenue at the five largest Wall Street firms in the 12 months ended Sept. 30, led by New York-based JPMorgan, the biggest U.S. lender, with $11.4 billion. An additional $14 billion of the banks’ investment revenue could be reduced by the rule’s limits on stakes in hedge funds and private-equity deals. Collectively, the sum represents 18 percent of the companies’ revenue.
Not facing these same headwinds, regional banks are now outperforming.

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Friday, December 6, 2013

US corporate spreads lowest in 6 years

While everyone talks about the "great rotation" from bonds to equities, we've had a different type of rotation taking place within the US fixed income universe - the rotation from treasuries into credit. Here is a simple comparison of total returns between high yield and treasury bonds over the past few months. Corporate credit outperformance has been remarkable.

The result of this "rotation" has been the collapse in corporate spreads, which has been persistent across the credit spectrum. Both investment and non-investment grade bond spreads have not been this tight since the bubble years.

Of course as corporate spreads come in, there is increasingly less cushion to compensate investors for the losses due to rising yields. And yields are likely to rise in 2014. There is no question that at least within corporate credit we are moving into "bubble" territory.
BW: - Spreads on U.S. investment-grade and junk bonds have contracted by almost 700 basis points from a peak of 896 in December 2008, about three months after the collapse of Lehman Brothers Holdings Inc. helped spark a seizure in credit markets, Bank of America Merrill Lynch index data show.

After average annual returns of 10.8 percent since the end of 2008, investors have been left with spreads that are 8 basis points below the average 208 basis points during the 10 years ended 2007, the index data show. That may leave investors with too thin of a cushion against losses should benchmark interest rates climb.

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