Thursday, February 27, 2014

Ukraine's currency in free fall

Ukraine's financial situation continued to unravel today as the currency gave up another 10% - and seems to be in free fall.


With fresh promises of aid from the West, including possibly the IMF, the near-term financial situation could potentially be stabilized. The political realities however look grim. It is not clear if the revolutionaries in Kiev will support the Parliament and the interim government.  It is also not entirely clear if the nation as a whole supports the revolution. The probability of more violence - possibly on a broad scale - remains high.

History is not on Ukraine's side. The Ukrainian people have been under some form of control of one or several of their neighbors for centuries. Other than during the years following the collapse of the Soviet Union and a short period at the beginning of the 20th century, the nation has almost no history of independence. It may take more than an ouster of an unpopular leader to create an independent state with a democratic government. 

Even after the collapse of the USSR, the Ukrainians have had a tough time moving away from the Russian sphere of influence - in large part due to their reliance on Russian energy resources. The Russians in turn are unlikely to just let Ukraine go. That's why the latest developments in Crimea (see story) are especially troubling.

The Russian ruble, which has already been under pressure as a result of the central bank policy (see post), has traded to new lows in part due to potential escalation of tensions in the region. The situation remains quite fluid and more volatility is to be expected.

Source: (chart shows the euro appreciating against the ruble)
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The ECB receives another disinflationary warning

The ECB received another warning today: the German CPI rate came in below expectations. The disinflationary pressures are no longer just about the Eurozone periphery.


Moreover, the euro area private loan balances continue to contract and the broad money supply growth remains weak.
Reuters: - "Weak money supply growth is not only condemning the euro zone to stagnant recovery, but it is raising the odds that the single-currency area could easily slip back into recession again," said David Brown at New View Economics.

"The ECB still needs to think outside the box to get the euro zone motoring into the fast-lane," he added. "A change of heart on quantitative easing still beckons ahead."

The ECB, worried that inflation risks getting stuck in a "danger zone" below 1 percent, is considering whether to take fresh policy action next Thursday to support the economy.
Bunds rallied on the news, with the market still anticipating an easing action from the ECB. The 2-year German note yield dropped down below 10bp again.


While the ECB has been counting on improving business confidence in the Eurozone to stabilize the recovery, surveys may end up being misleading. With a great deal of the euro area expansion relying on exports and China's (and other EM nations) growth slowing, sentiment can turn very quickly.
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Wednesday, February 26, 2014

PBGC pension bailouts continue

In 2011 we discussed the sad state of affairs at PBGC, the government agency responsible for bailing out private pensions (see post). Back then the debate centered around the bankruptcy filing by American Airlines and the fate of its pension. Now the agency is back in the news. Today's Bloomberg article discussed PBGC's dealings with the 2013 Hostess failure - the maker of twinkies who shared its pension with its supplier. Needless to say the supplier's employees went through some turbulent times. 

Many other sizable private pensions that pool employees of multiple companies (multiemployer plans) are also not doing so well. As PBGC takes on more failed pensions, its financial deficit - payments to pensioners offset by premiums it charges pensions - gets worse.
Source: PBGC

By the agency's own admission, PBGC will be insolvent in 10-15 years as its capital base dwindles.This means that the US government will be on the hook not just for the failing public plans such as the Social Security Trust Fund, but also for some private pensions as well. Though the total failing private pension liabilities are expected to be small relative to the massive public sector problem, PBGC anticipates to see some 173 pensions fail in the next decade or so.

To avoid another federal agency bailout, three things need to happen:

1. Corporate pensions will need to pay higher premiums to PBGC.
2. Employees will need to contribute more to these plans on an ongoing basis.
3. Employees of bankrupt companies with underfunded pensions will need to take larger haircuts on their payouts.

And it will probably take all three - in addition to steady US economic expansion - in order to avoid any taxpayer involvement.
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Divergence in consumer confidence may be a symptom of income inequality

US consumer confidence indicators show visible improvements since the government shutdown dip back in October (see post) - although confidence measures have stalled this month.

On a longer time scale, confidence, while still significantly below historical averages, has improved tremendously since the Great Recession. There is however a troubling trend. The improvement in the top income bracket has been way ahead of the lower income survey participants. In fact the gap between households with incomes of $35-$50K per year and those with incomes that are above $50K is at record levels over the past few months.

Source: Wells Fargo

Given that confidence is often linked to income growth (including expectations of future income), this could be a further indication of wage stagnation for employees in the lower wage brackets (see discussion). In the long run this growing income inequality may end up creating headwinds for economic expansion in the US.
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Tuesday, February 25, 2014

US household debt - first increase in 4 years

For the first time in 4 years the overall debt of US households rose on a year-over-year basis. Consumer deleveraging seems to be finally slowing.

Source: Credit Suisse

While this overall increase could be interpreted as a sign of improved credit conditions and stronger consumer confidence, a more detailed look tells us there is more to this story. Below is the full breakdown of household debt outstanding over time.

Source: NY Fed

Here are some observations:
  • Mortgage balances were basically flat on a year-over-year basis, though the steady multi-year declines have been halted.
  • Credit card balances remain fairly flat as well.
  • Auto loans showed improvement, particularly with longer dated and sub-prime loan volume picking up (see post).
  • Student loans on the other hand increased by a whopping $114 billion for the year.
CS economists summarized the situation quite well:
Credit Suisse: - This development can be interpreted as 1) an indication that household risk tolerance is on the rise and income confidence has improved and 2) a sign that bank lending conditions are loosening up.

Both conclusions, while legitimate, are tempered by the fact that most of the increased debt taken on by households over the past year has been in the form of generous student loans provided by the federal government –not generous consumer loans provided by commercial banks.

And the pickup in net mortgage debt outstanding in recent months is due to reduced foreclosures and bank loan write-offs, as opposed to increased new mortgage production.
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Monday, February 24, 2014

China’s raw materials bubble bursts

Steel, iron ore futures in China tanked on bloated (all-time high) inventories and apparent lending curbs by Chinese banks.

Source: CME

It seems that banks and regulators have been spooked by falling industrial demand, lower prices, and speculative activities of commodity traders. Anecdotal evidence suggests that many commodity importers have been using their inventories as collateral to bet on the yuan appreciation against the dollar. In fact some have borrowed dollars converted them to yuan and held the money in "high yielding" accounts. Some simply used the forwards market to take advantage of the rate differential between the two currencies. As long as the government stuck to its policy of gradual appreciation, it was "free money".  Moreover, some traders supposedly used the same iron ore and steel inventory with multiple counterparties at the same time (equivalent to taking out multiple mortgages on the same house at once).

With banks cutting back lending in this sector and the yuan actually declining recently, that gravy train has stopped. Traders are being forced to dump inventory. That is sending prices lower and even pressuring some mills to close.

Lending curbs have also been extended to other sectors related to property development, such as cement. All this points to tighter credit, weaker demand, and slower industrial activity going forward.
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Sunday, February 23, 2014

FRFA may provide relief to product-starved US money markets

Expectations of future shortages in quality liquid bonds in US debt markets continue to persist (see story). These shortages however are likely to be more acute for short-term paper. As a percentage of total government debt for example, treasury bills outstanding continue to decline.

Source; Barclays Research

Similarly, commercial paper volumes remain subdued relative to historical levels, as banks and corporations no longer want to rely on money-markets-based funding to finance their operations.

At the same time the US broad money supply has almost doubled in the past 10 years. Savers are looking for more relatively safe short-term product that can compete with bank deposits. That is why the Fed's reverse repo facility (FRFA - see post) is going to be so critical in the next few years. The Fed now holds nearly $4 trillion in securities, which the central bank can "sterilize" by taking in short-term deposits. These deposits in turn will be a good alternative to treasury bills and bank deposits, providing some relief to product-starved US money markets.
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Risks of Abenomics "stalling out"

This coming Thursday Japan's Ministry of Public Management will be releasing the January CPI figures. The report will be closely watched to determine the progress of "Abenomics", as the nation tries to work its way out of the persistent long-term deflationary environment.

However, a number of analysts continue to be skeptical of Abenomics succeeding.
Derek Holt/Scotiabank - Here comes another round of Abe-hype, only this time, CPI inflation is expected to fall from the recent 1.6% y/y peak and that would further feed impressions that Abenomics is stalling out. The upturn in CPI inflation by December was still being heavily influenced by utility prices that were up 5.5% y/y due to the effects of yen depreciation on imported natural gas and oil prices, and higher electricity prices in the face of Japan’s continued shutdown of all of its nuclear reactors. Take energy and food — which is also probably under upward pressure in part due to yen depreciation — out of CPI and it is only up 0.7% y/y as food prices themselves are up 2.2%. Most of the CPI effects of the Bank of Japan’s efforts to depreciate the yen remain confined to a relative price shock to food and energy that crowds out spending power elsewhere in the economy on future second-round effects in the absence of a pickup in wage growth or credit access. 

In spite of high expectations, the boost to exports generated by weaker yen has been more than offset by the rising value of imports (see chart). With the sales tax hike looming and wages remaining stagnant, the risks of Abenomics "stalling out" remain high.
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Natural gas in focus again

Another cold front bringing frigid temperatures and snow to central and eastern US has sent natural gas prices higher again. Even the April futures contract broke through $5 MMBTU - something we haven't seen in quite some time.

April-2014 Henry Hub futures (source: Barchart)

Traders are watching US natural gas stockpiles falling way below the 5-year range as demand for gas remains high.

The high heating bills this year will be creating a temporary drag on US consumer spending - it's not just about the snow keeping shoppers home. This sharp decline in gas inventory has also brought into focus the expected spike in natural gas exports (see Greg Merrill's post).

Source: EIA

Very soon large amounts of natural gas will be flowing out of the US, providing support for prices.
FOX News: - Dozens of facilities are set to sprout up along the Louisiana and Texas coasts to liquefy natural gas from shale formations as far away as Pennsylvania and Ohio for export around the world. The energy boom, which is turning the U.S. into a net exporter, could drive liquefaction capacity to an eight-fold increase in the next five years alone, experts say. That could mean hundreds of thousands of new jobs along the Gulf Coast, by some estimates.
More than 110 liquefied natural gas (LNG) facilities now operate in the U.S., some exporting the super-cooled liquid, while others turn natural gas into an energy form that occupies up to 600 times less space than natural gas for vehicle fuel or industrial use. Worldwide, LNG trade is expected to more than double by 2040, according to the Energy Information Administration.
Up to a dozen long-term deals, each worth billions of dollars, have been signed by American natural gas producers with companies in China, Japan, Taiwan, Spain, France and Chile, according to Reuters. The federal Energy Department has authorized companies to export up to 8.5 billion cubic feet per day of liquefied natural gas, about 13 percent of current daily production. Given the entrenched oil and gas industry, access to shipping and regional resources, the Gulf Coast is set to become the epicenter of the coming liquefaction boom.
This means that the days of the $2 - $3 natural gas prices are over. In the years to come, it will no longer be just about the weather.
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Saturday, February 22, 2014

Credit Value Adjustment (CVA) implementation comes of age

Guest post by Nandita Jhajharia and Lev Borodovsky

In banking, particularly recently, one often hears the term “Credit Value Adjustment” or CVA. Is it a new fashion trend in the world of finance world is it there more to it? Why are traders, quants, and risk officers at large institutions feverishly trying to deal with this topic all of a sudden? It turns out that the increased focus on counterparty risk after the financial crisis as well as the new Basel requirements for bank capitalization (see document) have added urgency to the CVA implementation by international banks, forcing them to focus on the topic.

What is CVA? Those researching CVA for the first time may find it a daunting task simply because a great deal of technical literature has been written on this concept - see this for example. According to Wikipedia, CVA is defined as “the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of counterparty’s default. In other words, CVA is the market value of counterparty credit risk.” This assessment of credit exposure is determined by the bilateral nature of transactions and fluctuations in asset prices. Other factors contributing to CVA valuation include market volatility and correlations across markets as well as legal settings and collateral agreements.

Imagine that you bought two long-dated over-the-counter call options on IBM. One was from JPM and the other from Joe's 1st National Bank - the same amount, strike, maturity, etc. Imagine that both options are in-the-money and your handy Black Scholes calculator says they are each worth $100 (premium value). But the Black Scholes model knows nothing about who you bought these from and what the likelihood is that you will get your money upon exercising the options. So if you try to sell them prior to exercise, the one that will be paid out by Joe's 1st National Bank will sell at a discount to the one from JPM because of the different counterparty risk. That price differential between the "riskless" counterparty and the "risky" one - when applied to a single position or a whole portfolio - is the CVA.

Indeed those who were facing Lehman as a counterparty in 2008 were asking themselves why they weren't differentiating among the dealers when pricing their swap contracts. It was time to start doing so.

The CVA measure is different from the concept of standard Credit Risk because it combines the uncertainty of exposure with the bilateral nature of exposure. It measures the risk that the counterparty to a financial contract will default prior to its expiration and will not make the specified payments. At the same time the amount of those specified payments may have increased due to market movements.

Different types of financial contracts will have different potential future exposure (see definition) profiles (due to different sensitivity to markets). Consider an interest rate swap for example. The longer the swap the more tame rates have to move and the more exposure one has to the counterparty. But as time goes on, the amount of exposure declines as the swap approaches maturity (shorter swap would have lower exposure to the market). That's why the maximum potential future exposure for a swap is about a third of its term.

On the other hand a currency swap that exchanges principal (one currency for another) at maturity will have its potential future exposure grow with time. Unlike a rate swap, the market risk on a currency swap does not diminish with time.

This potential future exposure is then combined with the probability of default of the specific counterparty over time in order to determine the CVA. That process is usually performed via a Monte Carlo simulation, particularly in situations when the counterparty credit quality is correlated with the specific market exposure in a contract. For example if you execute a long-dated gold swap with a mining firm, the potential future exposure of the swap cannot be analyzed separately from the credit quality of the mining firm.

It becomes particularly important to use simulations when a bank has multiple contracts in different markets with a single counterparty. This requires a calculation that simulates multiple markets that are correlated with each other. This makes such analysis quite challenging technically, particularly when one has hundreds of counterparties with contracts across multiple markets. There are 3 components of calculating the distribution of counterparty level credit exposure.
  • Scenario Generation – future market scenarios are simulated for a fixed set of simulation dates using evolution models of risk factors
  • Instrument valuation (revaluation under varying market conditions) 
  • Portfolio aggregation
There are numerous advanced ways to compute CVA and determining which methodology to adopt is often based on an organization`s ability to access appropriate technology, data, and resources. The back of the envelope approach involves:
  • calculating the mark to market of the derivative contract (MTM without CVA),
  • adjusting the discount rates by incorporating the credit spread (counterparty`s credit spread if the derivative is an asset or processing organization`s credit spread if the derivative is a liability),
  • calculating the mark to market applying the new discount rates.
  • The difference between the two mark to markets (one that includes the probability of default and one that does not) is the CVA.
The calculation often has to be timely in order to provide a quote to a counterparty on a specific transaction. When a bank quotes a rate swap to a client these days, the CVA is included in the price. This need for speed, combined with increasing regulatory requirements makes the implementation of processes and systems that compute Credit Value Adjustment an urgent and complex issue in the banking sector.

CVA is the premium charged on a specific derivatives contract or a portfolio of contracts that takes into account both the volatility of the contract(s) as well as the probability of the counterparty’s default. Major banks view the implementation of this measurement as one of their top strategic priorities. In the next discussion on CVA we plan to have an overview of the Basel regulation that is adding urgency to CVA implementation at banks as well as special cases that make this implementation particularly challenging.
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Friday, February 21, 2014

4 signs of economic slowdown in China

The thesis of China facing weaker nearterm economic growth is widely accepted at this point.  Moreover, the slowdown in the nation's manufacturing sector this month (see chart) has provided some support for this view. But as we have seen in recent years, it could be a temporary correction related to some seasonal patterns. Given the difficulty in obtaining reliable data out of China, what other evidence do we have that the nation's economy is actually slowing? Here are four signs that seem to support the "slowdown"  thesis.

1. For the first time China's "insiders" are calling for weaker growth:
WSJ: - China’s state media have long accused foreign analysts of being too bearish on the Chinese economy. Those analysts looking in from the outside are often said to be too eager to be “chanting decline”—chang shuai—when it comes to the economy’s prospects.

This time around, China’s own economists seem to be chanting a pessimistic tune about growth prospects. Perhaps they are not quite as negative as those pesky foreign counterparts—who according to at least one report China’s state media are being told to avoid—but they are increasingly outspoken about slowing growth and rising financial risk.

“We are now in a painful stage,” economist Wang Luolin told a seminar this week. “Let’s not try to dress things up,” said the consultant to the Chinese Academy of Social Sciences, a government think tank.

Yu Bin, a senior researcher at the influential Development Research Center under the State Council, took a similarly pessimistic view.

“The fact is, China’s economic growth is facing substantial downward pressure,” he said. “I don’t think we should get our hopes up for this year’s growth.”

2. The nation's central bank has once again halted the currency appreciation. The authorities tend to do this during periods of economic uncertainty in order to provide some support for China's exporters.

Chart shows USD appreciating against CNY (Source: Reuters)

3. Australian coal prices have been under some pressure - mostly due to mediocre demand from China.

Australian thermal coal price (source: Ycharts)

Similarly iron ore price has been weaker recently, with China having stockpiled massive amounts of the commodity (inventories at highest level since 2010). This could be an indication of slack in industrial demand.

4. Perhaps the most significant indicator of slowing growth in China is the decline in longer term interest rates combined with an inverted yield curve.

Why is the yield curve inversion (short term rates higher than long term rates) so important to watch? In many countries an inverted yield curve is often a harbinger of an economic slowdown. Just to put this in perspective, here is what the US yield curve looked like in the middle of 2007 (about six months before the start of the Great Recession).

Of course nobody is calling for a major recession in China, but a slowdown looks increasingly likely.
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Thursday, February 20, 2014

ECB still ignoring the disinflationary trend

So far the ECB has not responded to the disinflationary risks building in the euro area. Some Governing Council members dismissed the calls for action from numerous economists, referring to the analysts' reports as the "Anglo-Saxon" irrational fear of deflation. Perhaps. But is doing nothing then a "rational" policy? While the ECB has been on the sidelines, the balance sheet of the Eurosystem has been contracting fairly sharply - all in the face of unusually tight credit conditions (see post).

While many Governing Council members insist that the recent trend of below-target inflation is transient, the data tells us otherwise. For example, the latest report shows the German PPI consistently in the red for several months in a row.

Source: Statistisches Bundesamt

Similarly the French CPI figures are also significantly below historical averages, with the core rate declining particularly quickly.

In isolation these disinflation signals may be fine, but on the whole the trends across multiple countries could spell trouble. This is especially important as China's economic growth slows (see story), making it more difficult for the Eurozone to export its way into stronger growth (as some member nations have been doing). An economic slowdown in the Eurozone at this stage could tip the balance, pushing the whole euro area into a deflationary environment.
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Wednesday, February 19, 2014

Is China "trading" treasuries?

China reduced its holdings of treasuries in December by the largest amount since 2011, raising some eyebrows among economists and debt investors. The sentiment among analysts is that this reduction is related to Fed's taper, which of course doesn't bode well for treasuries in the near-term.
Bloomberg: - “The Chinese move to sell suggests central banks are becoming more wary of taking duration risk now with the Federal Reserve firmly into the tapering process,” said Aaron Kohli, an interest-rate strategist ... at BNP Paribas ... “If China continues to sell again in the next month or two, than more worries will arise as to who will buy the country’s debt.”
What's interesting however is that China's treasury position "adjustments" throughout last year seem to follow treasury prices (inverse of yields). This is akin to a retail investor buying high and selling low - chasing the market with everyone else. While analysts often assign some degree of sophistication to China's investment strategy, the positioning in the chart below resembles a fairly incompetent trading behavior, an unsuccessful attempt to "time" the market.

Source: The US Treasury
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3 reasons for the Russian ruble's decline to record lows

In spite of the recent strength in the energy sector (Brent is up around 4% this month) as well as the relative calm across major emerging markets in the past few weeks, the Russian ruble continues to slide, hitting new post-devaluation lows.

Chart shows the euro appreciating against the ruble (source:

There are several explanations for this decline:

1. The Russian economy is barely growing, with the GDP growth projection falling below that of the US.
Reuters: - Russia's central bank said on Tuesday the country's economic growth rate may reach the level of 1.7 to 2.0 percent in 2015-16.

The forecast, in a quarterly monetary policy report, implies a downward revision compared with its earlier predictions. It said in the previous quarterly report that it saw Russia's medium-term growth potential as 2-2.5 percent.

The bank predicted this year's growth at between 1.5 and 1.8 percent, down from a forecast of 2 percent made last quarter.
While such GDP trajectory may be OK for some developed economies, growth below 2% is a problem for a BRIC nation.

2. As discussed earlier (see post), unlike its counterparts among emerging economies, the Russian central bank has no intention of supporting the ruble. In fact many in Russia want to see the currency decline further in order to extract more rubles from the nation's energy exports.

3. We are also seeing some spillover from the Ukrainian mess (see story). Given the ties between the two countries and the escalating tensions in Kiev, there is some risk that Russia could become more entangled with its neighbor. That engagement could take various forms, some of which are not too palatable for the capital markets (see discussion).
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Sunday, February 16, 2014

US commercial banks' changing asset mix

Here are some updates to the recent discussion on loan growth weakness relative to rising deposit balances at US commercial banks (see post).

1. Loan growth rate in the US, while better than in the Eurozone, remains on a downward path. The latest figures suggest that loans are increasing at less than 2%, while deposits continue to grow at 6-7% per year.

2. Loan-to-deposit ratio in the banking system hit a 35-year low recently.

3. Loans as a percentage of banks' total assets are at 52.2% - the lowest level on record. Just to put this into perspective, here is the breakdown of bank assets now vs. 10 years ago.

Source: FRB (note that derivatives and trading assets were not tracked separately 10 years ago)

Source: FRB (note that the bulk of "cash" assets are excess reserves held with the Fed)
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Saturday, February 15, 2014

Taking it to the streets in Caracas

Conditions in Venezuela are reaching boiling point. Venezuelans - particularly students - are taking it to the streets, as protests sparked by worsening living conditions have turned violent (see story). Inadequate supplies of food and medicine are becoming a serious issue. Suppression of free speech by jailing students is adding to protesters' fury. The Maduro administration of course is blaming all this on what they call the "rebirth of neo-Nazi movement" that is trying to orchestrate a coup d'é·tat.

The markets have responded as expected. In the "unofficial" currency markets, which Maduro will be shutting down, the dollar is now trading at record premium - 87 bolivars per dollar or some 1,300% above the official exchange rate. The government bond market is having trouble finding bids, as the longer dated bonds now trade above 15.5% in yield - the highest since the financial crisis.

Source: Barclays Research

Foreign reserves are now at a 10-year low as the government desperately tries to find dollars to keep the government running.
Bloomberg: - At least three airlines have grounded flights to and from Venezuela so far this year, in part because the nation's government owed the carriers $3.3 billion in foreign exchange they need to pay operating costs. The government suggested it could pay them with government bonds and cheap fuel, but precious little cash. This should do wonders for getting planes flying again.
Credit default swaps spreads are moving into "distressed" territory, with the markets increasingly betting on some form of debt restructuring. Years of economic mismanagement and populist/socialist policies (see discussion) are about to come home to roost.

Source: DB
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Friday, February 14, 2014

The shrinking MBS market

As discussed earlier, the supply of mortgage-backed securities (MBS) continues to fall behind the potential demand - even with the Fed's taper in place. New issuance has steadily declined over the past year, with the Fed becoming an increasingly larger proportion of that market.

Source: SIFMA
Mortgage Daily: - For nine straight months, agency issuance of mortgage-backed securities has moved lower -- though there was an uptick at the Government National Mortgage Association. Securitization volume now stands at its lowest level in more than two-and-a-half years.

Combined issuance of fixed-rate MBS at the Federal National Mortgage Association, the Federal Home Loan Mortgage Corp. and Ginnie Mae totaled 7 percent less in January than in December.

Securitizations have been lower each month since April 2013, has fallen by more than half compared to January 2013 and was the lowest since July 2011.
At the same time the Fed is to continue purchasing large amounts of this paper through the end of the year, albeit at a slower pace.

Some of the decline in new issuance has been due to the drop in mortgage refinancing - old securities don't amortize as quickly and fewer new securities are issued. But part of the reason for the lower volume of these securities remains the supply of mortgage loans. The total mortgage debt outstanding is barely growing - with a great deal of that growth coming from multi-family residence (apartment) financing.

Source: FRB

As a consequence, MBS paper outstanding has been shrinking since the peak reached back in 2007.

Source: SIFMA (includes CMBS)

Some of that of course is due to the collapse in private label MBS market, including sub-prime. But the amount of agency (government-backed) MBS has not grown much either.

While some would say that $9 trillion of MBS paper should be sufficient, one has to keep in mind that the US and the global economy is now substantially larger than it was in 2007. MBS, particularly agency bonds, are becoming a smaller portion of the overall capital markets, worsening the shortage of higher quality bonds (see story). Liquidity in that market has also suffered, with average daily trading volumes at the lowest levels in nearly a decade (see chart). These are some of the reasons the Fed should return the MBS market to the private sector by exiting its purchases as soon as possible.
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Thursday, February 13, 2014

Ukraine on the brink

Ukraine's sovereign CDS spread is approaching the high reached right before the Russian bailout was announced. The currency is nearing the pre-bail-out lows.

Source: DB

The market is all but discounting the nation's ability to obtain the next batch of bailout funds - wherever it comes from - before defaulting.
Euronews: - Financial experts have warned Ukraine is on the brink of default with some saying currency reserves are enough for only two months. Russia has provided the first three billion dollar tranche of a loan. With the political stand off the rest has been frozen.
There are no easy answers here, as the nation faces a daunting challenge of obtaining cash to run its government for the next few months. Many view the country as a victim of tensions between the West - who prefers to see a certain type of government there - and Russia, who is not too interested in Ukrainian sovereignty. Some analysts warn that Russia could escalate its pressure on the former Soviet republic.
WSJ (Stephen Blank): - Behind its coercive diplomacy in Ukraine is the threat of force, either incited by Russia or carried out by it. Recent reports of pro-government militant groups forming in eastern Ukraine, calls in the Crimean legislature for Russia to "rescue" them from Ukraine's anti-government uprising, and repeated discussions in the Russian media about partitioning Ukraine, all point to a pattern of escalating pressure from Moscow—a pattern that paves the way for the use of force.
In the mean time, the tensions on the streets are rising, as both sides - the protesters and the authorities - harden their stance (see story). Time is running out for Ukraine.
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Tuesday, February 11, 2014

Assessing the health of US labor markets remains a challenge

We continue to see debate around the trajectory of US labor markets. Measures such as the employment-population ratio have completely diverged from the "headline" unemployment rate.

The explanation of course is reduced labor "activity", as individuals exit the labor force (see discussion). However, various studies indicate that the answer is not as clear-cut - due among other things to changing demographics. Historically older workers who are still of working age are far more likely to leave the workforce. As the US workforce gets older, there is some natural attrition that would have taken place even without the massive shock to the system from the financial crisis. Some researchers at the NY Fed did a good job in attempting to quantify that effect (see chart/link).

These same dynamics are responsible for a portion of the decline in labor participation rate. BMO has done some good work in the area, which we try to summarize here. The historical trend looks quite unsettling, as the chart below shows.

Source: BMO

But there is an enormous difference in the "natural" labor force participation rate of a 55-year-old vs. say a 35-year-old - that is unrelated to the Great Recession.

And as we get more 55-year-olds in the workforce, the participation rate "naturally" declines.
BMO: - An aging population will continue to press down on the part rate, as persons 55 and over participate at only half the rate of prime-age workers (25 to 54), while persons 65 and over participate at just one-quarter the rate. If the downward pull from aging overwhelms the expected upward push from discouraged workers and college students returning to the labor force, then the part rate will decline further.
BMO lists other reasons for declining participation that are unrelated to demographics. Instead these effects seem to be the result of government policy.

1. Since the onset of the Great Recession many more Americans have started collecting disability (from the Social Security Disability Insurance program) than in the past (see discussion).
BMO: - In addition to the downward pull from demographics, disability rolls could continue to climb. Macroeconomic Advisers estimates that the Social Security Disability Insurance program, by discouraging participation, could have reduced the part ["part" is short for participation] rate by about 0.1 ppts on average from 2006 to 2013 [notice that this represents some hefty numbers on an absolute basis]. 
2. Now that the extended unemployment benefits ended, more people are counted as having exited the labor force altogether because they are not officially "unemployed". See this chart (from WSJ) on what happened in North Carolina after it cut benefits.
BMO: - The expiration of the extended UI benefits program will also depress the part rate this year. Assuming one quarter of the 1.3 million people who lost emergency benefits on December 28 find work and another quarter leave the labor force, the part rate could fall 0.2% in 2014. This accords with the additional decline in North Carolina’s participation rate, relative to the national average, after the state decided to end extended benefits five months earlier. 
3. Many analysts are suggesting that Obamacare will detract from labor force participation as well by making health insurance cheaper for those who have minimal income and incentivizing some to leave the workforce.
BMO: - According to the CBO, the Affordable Care Act will likely also reduce the part rate, as new federally-subsidized private health insurance plans will reduce the incentive to seek employer-sponsored plans. Quantifying this impact, however, is virtually impossible. 
The hope is that the expected economic improvements over time will counteract some of these trends. The challenge for the FOMC of course is which employment measures to use for policy decisions and guidence. Clearly the traditional unemployment rate benchmarks are inadequate. The "activity" measures such as participation are driven by multiple factors, some of which are not directly related to the health of the economy. When is the employment situation in good enough shape to start raising rates for example and which measures do we rely on to make that call? This assessment challenge makes the Fed's "dual mandate" a particularly daunting task.
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Sunday, February 9, 2014

Japan's current account firmly in the red

Japan's current account continues to deteriorate, with the December number coming in below expectations - hitting a new low. For the whole of 2013 Japan showed the lowest surplus on record.


Energy imports and weaker yen continue to be the key culprits. Should oil prices rise further, the nation's deficit could worsen.
Bloomberg: - The yen’s slide and increased demand for foreign energy due to nuclear plants closures are causing imports to outstrip exports. A surplus in overseas investment income is staving off the risk of a sustained deficit that could undermine investor confidence in a nation with the world’s largest debt burden.
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Auto loan competition heating up

The Fed's banking survey seems to indicate that senior bankers on the whole see slower demand for auto loans in the US - see chart. The real issue here however is less with auto borrowers' demand and more about increasing competition. Even the largest lender in the space, the TARP-funded Ally Financial (formerly GMAC) is facing competitive headwinds as it loses its cozy relationship with Chrysler (while its GM contract is about to expire). And more banks are jumping into auto financing recently - particularly now that the mortgage refi gravy train has ended.
WSJ: - An exclusive contract with Chrysler to provide so-called subvented, or promotional rate loans, to car buyers ended last April after the auto maker struck a new financing partnership with lender Santander Consumer USA Holdings Inc.

A similar agreement with GM was set to expire at the end of 2013, but Ally President William Muir said during the call Thursday that the companies have extended their existing agreement and are working on completing a new agreement.

Competition in the auto-lending business has intensified during the last two years as more banks have increased their focus on the business amid a rise in loan demand.
Competition is especially heating up in the sub-prime auto lending - with companies such as Santander expanding into the business.
Reuters: - Santander Consumer offers loans through 14,000 car dealers across the United States and has about $25.6 billion of loans outstanding. A majority of the company's loans are subprime, which have higher yields but also higher default rates.
The demand for yield combined with ample liquidity has created a bid from shadow banking in the form of sub-prime auto ABS (asset-backed securities). The sub-prime ABS outstanding has increased significantly since the end of the recession.

Source: SIFMA

Of course all this competition means lower rates, riskier loans, and higher delinquencies.
Automotive News: - Subprime financing -- and delinquencies -- are likely to grow in 2014, says Melinda Zabritski, senior director of automotive credit for Experian Automotive.

Vehicle loan terms, which hit an average of 65 months for new cars during the first 10 months of 2013, also will continue to stretch out.
With more aggressive lenders in the market, many bankers are indeed experiencing less demand - particularly if they want to maintain their margins. The question is - at what point does this market become overheated?
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Why JPMorgan is back in the CLO market

JPMorgan is once again hunting for primary CLO bonds. The bank made enormous profits since 2009 buying the higher rated tranches that provided great spreads above the bank's funding costs. After the "London Whale" fiasco the bank pulled back on its CLO buying, but now JPMorgan appears to be back.
Asset-Backed Alert: - J.P. Morgan is again showing interest in the senior pieces of newly issued collateralized loan obligations. The bank, which had been among the world’s largest buyer of those securities, retreated from the market early last year. But in the past two weeks, it has resumed discussions with managers that have deals in the works.
Why is this renewed interest in CLO paper? Here are some possible explanations:

1. New CLO bonds are still coming to market with attractive pricing. According to LCD, a recent CLO deal from ING (see press release from Fitch) priced the AAA (the largest tranche) at LIBOR + 150bp. A regular AAA corporate bond would typically price at (equivalent of)  L+20 to L+40bp. While there is clearly more risk with structured paper, the discount is attractive on a relative basis. CLOs also look attractive relative to other structured credit bonds (see post).

2. There is speculation that when it comes to CLOs, the US regulators may provide some Volcker Rule relief (see discussion - Item # 6). Below is the video from the latest congressional hearing on Voclker Rule implementation below.
Asset-Backed Alert: - ... some industry players believe J.P. Morgan now is part of a contingent that expects the Commodity Futures Trading Commission, Comptroller of the Currency, FDIC, Federal Reserve and SEC to ease Volker Rule restrictions for CLOs in the coming weeks.
3. JPMorgan is in effect hedged on its CLO holdings. If the new regulatory framework ends up being damaging to the CLO market by restricting banks' participation, the CLO bond issuance would decline materially.
BW: - Morgan Stanley cut its collateralized loan obligation [2014] forecast by as much as 27 percent to $55 billion as issuance slowed last month because of questions about the Volcker Rule’s impact on the funds that finance buyouts.
This reduction in supply would over time result in strong secondary demand for the highest-rated tranches. And banks will be given ample time to reduce their holdings. Either way, JPMorgan comes out ahead on this.

Hearing:  “The Impact of the Volcker Rule on Job Creators, Part II”
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Saturday, February 8, 2014

Consumer credit and deleveraging

US consumer credit showed an impressive increase at the end of last year as Americans went shopping. Consumer credit outstanding, excluding real-estate debt, stood above $3.1 trillion in December, rising in a nearly linear fashion since 2011.
Reuters: - U.S. consumer credit in December grew by the most in nearly a year due to a sharp increase in credit card usage, a potentially positive sign for the economy.

Total consumer credit rose by $18.8 billion to $3.1 trillion, the Federal Reserve said on Friday. That was the biggest gain since February.
But let's put this number in perspective by making a couple of adjustments. First let's look at consumer credit trend without the government-held student loans. As discussed before, student loans are not market-based and do not represent private sector credit expansion. A very different trend emerges - with non-student-loan consumer credit barely rising until mid 2013. One could argue that student debt is in effect "crowding out" private credit.

Not seasonally adjusted (source: FRB)

Even the ex-student loan measure does not tell the whole story. The overall US economy (and the population) has grown since the financial crisis and in order to make a fair comparison one needs look at the trend relative to the nation's GDP. A very different picture emerges - one of significant consumer deleveraging that is only now beginning to stabilize.

Not seasonally adjusted (source: FRB)

While the absolute level of consumer credit indeed had a nice pop in December, one needs to look beyond the headline numbers to see the full picture.
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Friday, February 7, 2014

Watching the 'China taper'

Chicago Tribune: - "Emerging markets should be much more concerned about the 'China taper' than the Fed taper" -  Crossborder Capital Managing Director Mike Howell.
Indeed, while the rate of US taper is modest and reasonably well defined, signs point to slower economic expansion in China. And even in the near-term there is little visibility on that country's growth. The January HSBC services PMI print this morning was quite weak. One of the explanations seems to be that services have slowed due to Beijing forcing government officials to go easy on the extravagant "entertainment" that has become so prevalent in recent years (see post). Once that is dealt with things should improve? Perhaps.
Hongbin Qu/HSBC (published by Markit): - The slower expansion of services activities in January reflected soft manufacturing growth and the impact of Beijing's latest measures to curb official extravagance. As business sentiment remains stable, we expect services growth to bounce back a little in the coming months. Yet a meaningful improvement relies on stronger growth of manufacturing sectors and the implementation of reforms to boost service sectors.

Other measures from China are consistent with slower growth as well.
Reuters: - A similar services PMI released by the China's statistics authority earlier this week showed growth in the sector sagged to a five-year trough in January as business confidence retreated to four-year lows.

Two separate PMIs for China's factories also showed manufacturing growth slipping to six-month lows in January.

Analysts polled by Reuters believe China's economy will grow 7.4 percent this year, far ahead of other major economies but still its worst performance in 24 years.
The trajectory of emerging as well as many developed economies going forward will depend on whether we see an uptick in China's economic activity after the holidays. For now the global equity markets remain skeptical.

Source: Ycharts
  • ^DJWO - Dow Jones global equity index
  •   IEMG - Core emerging markets
  •   FXI - China's large cap shares
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