Monday, March 31, 2014

Jumbos still cheaper than conforming mortgages

For years mortgage rates on "jumbo" loans (definition) have been higher than for traditional (conforming) mortgages (definition). Since jumbo loans were larger than the upper limit permitted to be packaged and sold to Fannie and Freddie, banks would typically charge a premium for "illiquidity" on these products. But starting last year conforming mortgages became more expensive for borrowers than jumbo loans.

Source: Barchart

This distortion persists today and is directly related to the Fed's quantitative easing program. Since conforming loans are funded via agency MBS (bonds that Fannie and Freddie sell to fund purchasers of pools of conforming loans from banks), the pricing on these loans is directly linked to MBS yields. And as discussed last year (see post) the Fed has been dominating the MBS market via QE3. As the Fed's taper expectations took hold (after Bernanke's May 22nd speech), MBS yields rose sharply. With that, conforming mortgage rates also increased.

Jumbo mortgage rates on the other hand rose more slowly because these loans tend to stay on banks' balance sheets and are not funded with MBS. Moreover banks are happy to get paid a lower rate on loans to these higher net-worth creditworthy clients. Banks fund themselves with near-free deposits and charge jumbo clients 4.25%, keeping the spread. And unlike conforming loans that get sold at "market" levels, banks don't have to mark jumbo loans to market (banking book accounting treatment is based on accruals unless there is an impairment). The dynamics of conforming mortgages being more directly tied to MBS pricing (which is impacted by the Fed's securities purchases) and different accounting treatment have resulted in 30-year jumbos being some 20 basis points cheaper than standard mortgages.
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Sunday, March 30, 2014

Why is the ECB hesitating on monetary easing?

The Eurozone's unemployment rate is at 12% and holding while the area's youth unemployment is at staggering 24%. Private lending is still contracting (see post) and disinflationary pressures persist even within the "core" states (see chart). The price stability situation in the "periphery" is starting to look outright deflationary - see chart.  The euro is still at mulit-year highs, putting pressure on the area's export businesses. At the same time monetary conditions continue to tighten as the area's central banking system balance sheet approaches pre-LTRO levels.
unit = mm € (source: ECB)

Given the situation, most central bankers would take action. A simple policy change for example could be to suspend the sterilization of securities already held by Eurosystem - see post. But the ECB is hesitating. Why? Here are some reasons:

1. This may upset some folks but the reality is that the ECB is notoriously indecisive as it is pulled into various directions by the member states. Many forget that the institution is relatively new (just over 15 years in existence) and the shock of the recent crisis had left the organization a bit paralyzed. It rarely takes a decisive action unless it's forced by the markets to do so. The decision to "save the euro" only arose as Spain approached the point of "no return".

2. The ECB is also somewhat distracted as it prepares to take on the massive task of regulating the area's banking system - a responsibility that was not initially part of the central bank's charter.

3. The ECB does not have the dual mandate of the Fed and is only focused on price stability. The central bank views the area's horrible unemployment problem as being outside of its "jurisdiction". While technically correct, many central bankers would regard this narrow interpretation of the rules as shortsighted.

4. The hawks at the ECB continue to view the disinflationary pressures in the euro area as transient.
Reuters: - The ECB is running official interest rates at a record low but unlike other major central banks has resisted calls to follow that move with outright "quantitative easing" to pump more money into the economy.

[Bundesbank President Jens] Weidmann said that about two thirds of the falloff in euro zone inflation to 0.7 percent, the lowest since the economy was deep in recession in 2009, could be attributed to falls in energy and food prices.

"Monetary policy should respond to such factors only in the event of second round effects," he told a conference in Berlin, saying he would not talk about current monetary policy ahead of the ECB's monthly policy meeting next Thursday.

"With regard to the rate of inflation at the moment, the euro area is not in a self-enforcing downward spiral of price decreases, which is nominally the definition of deflation," he said.
5. The ECB has been heavily focused on the recent improvements in corporate growth, particularly the PMI indicators. Markit indices for example show a steady recovery from the 2012 lows.

Mario Draghi has been speaking about these improvements lately but he continues to ignore some warning signs hidden in these numbers.
Markit: - Policymakers will be encouraged by the survey in terms of the signs of sustained recovery. However, concerns will persist regarding the deflationary forces, especially in the periphery. With prices charged by manufacturers and service providers both falling again in March, there remains an argument for further stimulus, especially if the rate of growth of activity cools again in April.
6. The central bank is also hanging its hat on improving sentiment surveys in the euro area - see Twitter post. The thought is that if consumers and businesses are happy, credit growth will somehow stabilize. Perhaps. But the mood of these crisis-weary survey participants can easily turn if the area's labor markets do not heal soon.

7. The policymakers are also betting on the fact that the rapidly falling long-term rates in the Eurozone periphery will provide some "natural" stimulus to the area's economy. Indeed, as the markets perceive lower risks of default, the yield declines on longer-dated periphery sovereign paper have been quite spectacular. The OMT backstop provided by the ECB has certainly helped.


The reason behind these recent sharp declines in yield however has to do with bets on disinflationary pressures and a subsequent easing action by the ECB.
Reuters: - Spanish, Italian and Portuguese bond yields hit multi-year lows on Thursday, with speculation about further European Central Bank monetary policy easing prompting investors to seek the bigger returns offered by lower-rated assets.
Should the ECB fail to act, these yields will inevitably rise. It is also important to note that low government borrowing costs are no guarantee of stimulus to the private sector. The private sector can not or is unwilling to borrow, reducing the impact of lower benchmark rates.

Ultimately the ECB could be right and some day, as the banking system is "restructured", the Eurozone's economy will heal itself. But that was also the attitude in Japan years ago when the nation undertook its banking reform. Yet deflation in Japan persisted for years since then, becoming heavily entrenched in the economy. Is the ECB now willing to take that chance?

Update: More CPI results from the Eurozone are out this morning.

a. Here is the latest aggregate euro area CPI result.
b. Below is the CPI measure for Italy:

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Saturday, March 29, 2014

US benefiting from reduced policy uncertainty

It is becoming increasingly clear that the Fed's taper, the slowdown in the central bank's balance sheet growth (chart below), is unlikely to damage credit expansion in the US.

Fed's balance sheet (YoY)

In fact - and many economists find this counterintuitive - the certainty of taper trajectory (which is effectively on autopilot) seems to be stimulating loan growth. In the post-financial-crisis world, periods of shifting government policy (both fiscal and monetary) had been quite damaging for the economy. The reduction in nearterm uncertainty with respect to the US fiscal impasse (see story on federal budget and on debt ceiling) is likely to be helping the situation as well. Loan growth acceleration in recent weeks has been quite pronounced.

Total loans in the US banking system (YoY)

This stabilization stands in sharp contrast to what is taking place in the Eurozone (see post) and seems to be fairly broad based. Small US banks, where credit growth had slowed materially in the wake of the US government shutdown, are now showing improvements in non-cash asset growth, especially corporate loans.

To be sure, much of this sudden recovery has less to do with banks suddenly easing credit and more to do with improving demand, especially in the corporate sector. That's because banks typically don't turn on a dime - they loosen credit policies far more gradually as a whole. This trend is therefore more indicative of bank credit facilities being drawn, particularly for working capital. Having said that, the Fed's senior credit officer survey does indicate lending standards easing in Q4 of 2013.

The data on loan growth is supported by high frequency survey results. Last week's ISI Bank Loan Survey index rose to the highest level since 2008. It is increasingly likely that the US economy will not only be able to withstand the gradual conclusion of QE3 but may actually benefit from the reduced monetary policy uncertainty.
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Friday, March 28, 2014

Eurozone's credit contraction continues

Private loan balances in the euro area continue to decline. Last month's drop of 2.2% from the previous year was worse than had been expected by economists.

The area's banks are undergoing a sharp deleveraging exercise with balance sheets shrinking due to both loan write-downs and extraordinarily weak lending. Maturing loans are not being fully replaced with new credit. Pressure from the ECB's 2014 stress testing of banks (similar to what the Fed just completed) is also discouraging credit expansion.
Reuters: - Lending to households and firms in the euro zone shrank further in February and money supply growth remained subdued, adding to the European Central Bank's list of concerns ahead of its policy meeting next week.
The ECB's health check of the euro zone's largest banks' balance sheets before it takes over banking supervision in November is exacerbating the situation, with lenders reluctant to take on more risk and trying to slim their loan books instead.

Bank balance sheets declined by around 20 percentage points of gross domestic product last year, partly in anticipation of the health check, ECB President Mario Draghi said on Tuesday.

And more is to come this year.

UniCredit, for example, posted a record 14 billion-euro loss this month due to huge writedowns on bad loans and past acquisitions as it moved to clean up its balance sheet.

The ECB welcomed the move and encouraged other banks to not to wait with any corrective measures until the review's results are released in October.
Some have pointed to a "glimmer of hope" in the household lending balances which showed a small uptick in credit expansion.

Eurozone household loan growth (YoY); Source: ECB

The increase however came from a slightly slower decline in consumer credit (credit cards, auto loans, etc.), which continues to fall (year-on-year change is firmly in the red). This contraction to a large extent is driven by weak demand.

Eurozone consumer credit growth (YoY); Source: ECB (apologies for the different time scale)

Furthermore, growth in mortgage loans remains anemic, making this household lending uptick less of a reason to celebrate.

Eurozone mortgage loan growth (YoY); Source: ECB

Moreover, the area's corporate loan balances are continuing to see sharp declines - down 3.1% from the same time last year. Weak demand remains the culprit here as well.

Eurozone corporate loan growth (YoY); Source: ECB

In February Mario Draghi blamed credit weakness on banks' "window dressing" exercise of trimming balance sheets before year-end financial reporting.
Draghi: - "One would not rule out a certain behavior by the banks that would like to present their best data by the end of 2013, which means that this is going to affect credit flows, which means that we may have different figures in the coming weeks ..."
It would be interesting to see what Mr. Draghi will come up with this time to explain the ongoing contraction in euro area's private credit.
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Wednesday, March 26, 2014

5-year treasury cheapest in years after selloff

The five-year treasury yield hit a multi-year high relative to the average of the two- and the ten-year rates (the 5-year treasury is cheap on a relative basis). The chart below shows a measure of how "concave" the treasury curve has been over time (negative indicates the curve is convex).

2 x (5yr yield) - (10yr yield) - (2yr yield) 

Given that the five-year tenor is sensitive to the trajectory of the Fed's rate policy in the intermediate term, this is where we should see quite a bit of volatility (see post).  We've come a long way from the days when the 5-year treasury was highly overpriced relative to the rest of the curve (see story from 2012) and the market was pricing in "perpetual" QE.
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France vs. Germany - a Eurozone puzzle

Here is a puzzle. We are seeing an unexpected divergence in private sector activity indicators for Germany and France. The manufacturing report for France came in materially better than was forecast by economists while the one for Germany was worse.

Source: & Markit

The services sector PMI measures show a similar divergence to those for manufacturing. What's particularly puzzling is how broad based this divergence has been.
  • Markit (France): - Expansion was broad-based across the service and manufacturing sectors. Services activity increased for the first time in five months during March. Growth was at a 26-month high, albeit modest overall. Manufacturers reported a solid rise in output that was the sharpest since May 2011. [ - see story]
  • Markit (Germany): - The easing in the rate of activity growth was broad-based, with both manufacturers and service providers indicating weaker expansions than seen in February. Companies in the goods producing sector reported the slowest rise in output since November, while growth in the service sector eased to a two-month low. [- see story]
Thoughts, comments?
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Tuesday, March 25, 2014

The changing face of commercial property lenders

US commercial real estate prices have firmed up recently although the recovery remains uneven across the various sectors.

Source: Real Capital Analytics

Improvements in pricing are giving rise to higher deal volumes as investors chase yield-generating assets. Anecdotal evidence suggests that commercial property transaction volume remains robust for the current quarter. Commercial real estate investing is popular once again.

Source: Real Capital Analytics (note: the big pop in Q4 of 2012 was tax-related)

On the other hand, the amount of commercial real estate mortgage backed securities (CMBS) outstanding is still declining after peaking in 2008. Total balances are now at the lowest levels in seven years.

Source: SIFMA

Something is off. We know that property purchases are almost always leveraged (very few buy commercial properties with cash - the rental yield is just too low). So who is providing the mortgage financing? In the past many of the large banks would arrange these loans, pool them across multiple properties, and then sell them as CMBS. The securities would be sold in tranches, with cash from mortgage payments following a predetermined "waterfall" (senior tranche would get paid first and so on). It seems that in recent years the use of CMBS as a financing tool has become far less prevalent even as commercial property deal volumes pick up.
Bloomberg: - ... sales of commercial-mortgage backed bonds are falling short of predictions for the best year since 2007: Issuance slumped to $14.6 billion from $20 billion in the same period last year, according to data compiled by Bloomberg. Bank of America Corp. cut its forecast last week for deals tied to single loans, typically backed by the higher-quality properties that insurers target, as sales plunged 66 percent from last year’s record $9.1 billion.
Part of the trend has to do with securitization being out of favor in general. Banks for example can't hold material amounts of CMBS on their books for regulatory reasons but can on the other hand hold a portfolio of real estate loans. It's the same type of risk but the "optics" are different.

Another reason is competition for direct loan assets. Many institutional investors have been getting into direct investing and direct lending. Insurance firms for example often act like bankers these days: competing for rates, arranging loans, charging fees, etc. Except they are funding assets with premiums from insurance sales rather than with deposits. And many of these institutions are so hungry for yield that they undercut banks on pricing. Great for property buyers, bad for the CMBS market.
Bloomberg: - Insurers are offering 10-year loans with interest rates as low as about 4 percent, compared with 4.9 percent on new debt that will be packaged into bonds, according to Alan Todd, a debt analyst at Bank of America. Insurers are increasing those investments because they performed well for them during the credit crisis and its aftermath, Woodwell said.
MetLife, the largest U.S. life insurer, has increasingly turned to real estate to bolster profits and support long-term obligations as the Federal Reserve holds interest rates close to zero for more than five years. Last year, MetLife boosted lending for commercial properties 19 percent to a record $11.5 billion, funding loans including $450 million to Shops at Columbus Circle in the Time Warner Center in Manhattan and $500 million against its own New York headquarters at 1095 Avenue of the America.
Even some pensions are moving into direct lending as this "shadow banking" market picks up steam. So if you are looking for a mortgage to fund your commercial property purchase, these days your banker won't necessarily be a bank.
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Monday, March 24, 2014

Russian government controls some 60% of the market - good luck to foreign shareholders

Some investors have been jumping into Russian equities in the wake of the recent selloff. After all it's one of the BRICs that is now up "for sale" - assets that would have been in high demand just a year ago. But before getting too excited about this investment opportunity, consider the structural issues that smaller (particularly foreign) investors would face in Russia.
Barrons: - Russia's concentration of economic power means the state can hold its oligarchs for ransom and force enterprises to forgo profits at the bidding of politicians. A 2012 study by Troika Dialog Research estimated that the Russian state owns 30% of the equity market, with another 30% held by oligarchs and domestic "businessmen." Russia's 10 richest men own $25 billion in publicly listed Russian companies, according to Wealth-X, which tracks individuals of ultra-high net worth. The Russian stock market has a total valuation of $150 billion. Many of these rich individuals owe their wealth to Putin, so they aren't likely to defy him. 
This means that in effect the state controls some 60% of the market because the Russian oligarchs will follow Kremlin's lead - simply to preserve their wealth and often their freedom (Khodorkovsky, who has been a leading financier of Russian opposition parties got 14 years in prison a few years back). In fact the situation could be getting worse as the oligarchs have bought additional shares in recent weeks to gain an even greater percentage of the market.

And just in case you are still considering making a long-term strategic investment into some Russian shares, remember that minority shareholders can be squeezed simply by not being a member of the elite "club" - see this story for example. It's no wonder that analysts have now labeled the Russian stock market a "frontier" rather than an "emerging" market (similar to many African markets except for poor economic growth - see story)

Foreign investors are especially vulnerable. With so much control of the market in the hands of the government, if Western sanctions tighten further and tensions escalate, Putin's retaliation could easily involve exacting pain on certain foreign shareholders. For those who wonder what a retaliation like that could potentially look like, here is an example from another emerging markets nation with an authoritarian government.
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Sunday, March 23, 2014

Markets dismiss the risk of higher rates inhibiting growth

Many continue to argue that the rate normalization taking place now will slow business activity in the US. Good luck betting on that however. There is no question that corporate America had benefited tremendously from extraordinarily low rates. Many US firms have locked in these rates over the past couple of years by refinancing - interest expense savings that go directly to the bottom line. But what will happen now as rates "normalize"?

One approach is to see what the markets are telling us. To start, let's look for example at the 5-year tenor where a great deal of corporate America borrows. Over the past year, the 5-year treasury yield has almost tripled.


The markets however do not seem to imply slower growth. For example one indicator of corporate activity expectations is the Dow Jones Transportation Index (DJTI) - the oldest equity index that is still in use (launched in 1884). Increased transport usage is thought to precede improvements in industrial activity. When the DJTI outperforms the Dow Jones Industrial Average, the market is expecting stronger corporate performance going forward. And in spite of significantly higher rates (chart above), the DJTI outperformance has been quite pronounced.


Some would say the markets are undergoing a bout of Greenspan's "irrational exuberance". Perhaps. But here we are not talking about the market's lofty absolute levels - only the transport shares' outperformance. Other cyclical shares have been outperforming as well (see chart).

At the same time the current treasury yield curve shows the 5-year yield to almost double over the next two years based on implied forward yield (see methodology). Significant rate increases are therefore already priced in. This tells us that at least for now the markets don't view higher rates (rate normalization) as inhibiting growth.
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Saturday, March 22, 2014

Shifting focus in the treasury markets

Treasuries once again experienced what amounts to a sharp curve flattening in recent days. The market action resembled what took place after the initial announcement of taper back in December (see post). The yields in the "belly" of the curve have risen sharply as the market prepares for rate "normalization".

Treasury yield moves from close of 3/7/2014 to close of 3/21/2014

MarketWatch: - The yield curve’s violent reaction to the Federal Reserve on Wednesday shouldn’t be thought of as a first-day fluke by Chairwoman Janet Yellen. Rather, the rise of intermediate-term Treasury yields is one step in a monetary policy normalization process that will characterize the rest of the year, according to mammoth investment management firm BlackRock.

If last year was all about longer-duration Treasury yields moving higher — the 10-year Treasury yield rose more than a full percentage point and now trades at 2.78% – this year is all about the rise at the front end of the curve, according to Rick Rieder, chief investment officer of Fundamental Fixed Income for BlackRock.

“I think this is a very different year for managing fixed income,” he said in a press briefing Thursday.
The MarketWatch article proceeds to describe in detail how rates had moved this year vs. last year. It all however comes down to a single chart which shows daily treasury yield volatility across the curve this vs. last year. A picture is worth, well you know...

Market focus is shifting from taper to the near-term trajectory of the overnight rates, which is impacting the intermediate and shorter maturities. The first rate hike, while still some time away, is becoming a reality.
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The bitter medicine of quantitative easing

Barry Ritholtz wrote an opinion piece on Bloomberg today arguing that it's hard to criticize the Fed's QE programs simply because we don't know what would have happened without them. Since this is not a "controlled" experiment in which we can compare a patient taking experimental medication with the one taking a placebo, there is no way to tell if the therapy had worked. All we know is that the patient has undergone a slow recovery and according to the "doctor" may have been worse off without the "treatment".
"If you are testing a new medication to reduce tumors, you want to see what happened to the group that didn't get the test therapy. Maybe this control group experienced rapid tumor growth. Hence, a result where there is no increase in tumor mass in the group receiving the therapy would be considered a very positive outcome."
This argument was used a number of times in recent years, including for example with the American Recovery and Reinvestment Act of 2009 - the $840 billion "stimulus" bill. There are all sorts of estimates on how many jobs the bill saved/created and how many GDP points were added. Was it effective relative to other job creation programs? We of course will never know because we can't peer into an "alternative universe" where the stimulus bill had not passed.

But maybe we are asking the wrong question. Let's for a moment stay with the medication analogy that Mr. Ritholtz introduced. Experimental medication is usually applied in dire cases when the patient's health is deteriorating and traditional therapies had not worked. The use of the first round of quantitative easing, QE1, was just such a case. It was necessary to stabilize the banking system that was frozen - an extreme problem that called for radical measures. But what about QE3? Mr. Ritholtz argues that with other parts of the federal government dysfunctional, the Fed was simply the only game in town to get the economy moving.

However was the US economy in such a disastrous shape in the summer of 2012 that it called for another extreme intervention? Clearly growth was uneven and the labor markets remained wobbly. Nevertheless a recovery was taking place. A patient who is getting better, albeit slowly, is generally not given an ever larger dose of experimental medication in hopes of miraculously accelerating the recovery.

Rather than Mr. Ritholtz's tumor analogy, let's think about QE as delivering excessive doses of experimental pain killers. Yes the patient may feel better at first, but as we all know, prolonged use could create some nasty side effects. The key side effect of course is addiction - which over a long period of time requires one to administer ever larger doses in order to obtain the same effect. And now you are not just fighting the disorder but also the withdrawal symptoms. That is precisely what is taking place these days (see post). Furthermore, the uncertainty surrounding the QE "withdrawal symptoms" is what had put some of the economic activity on hold, activity that is only now beginning to return (see post).

What's particularly troubling about QE is that even after the "injections" are taken away, the nation's banking system is saddled with the "long-term side effect". The US monetary base is now near $4 trillion, with some $2.5 trillion of it sitting on banks' balance sheets in the form of excess reserves - a situation with no precedent. Removing it would require the Fed to sell its securities holdings - something the central bank is not planning to do. This bloated monetary base is going to be with us for a while even as the Fed's securities purchases end - an "experimental drug" whose long-term effects remain unknown.
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Wednesday, March 19, 2014

US monetary policy moving in the right direction

The Fed struck a somewhat more hawkish tone today - certainly enough to spook the markets. Expectations for the first rate hike have shifted forward by nearly a quarter, pointing to late spring of 2015 as the starting point.

This monetary stance, combined with another $10bn taper was the right move. Here are the reasons:

1. The $10bn cut per meeting removes much of the remaining uncertainty around taper trajectory. The reductions are on autopilot. Often it's not the policy itself but the uncertainty surrounding it that creates issues for the economy. That was one of the key problems with this open-ended QE - the fear of a painful exit put the economy on hold.

2. It is unclear if extremely low rates stimulate credit growth at all, and in fact some argue it could be the opposite. At the same time, savers, including many retirees, have been punished by negative short term real rates for years. This zero rate policy needs to end.

3. The US economy is stronger than is commonly believed. "How dare you say that, you heretic - don't you read all the financial blogs?" That has been the response from many. Perhaps. But it may behoove some folks to pay attention to the data ... More on this later. The point here is that the US economy will be fine without QE and with higher interest rates.

4. The current environment has created such hunger for yield that investors are increasingly taking higher risk in order to target the same performance they experienced in the past. Insurance firms, pensions, individuals - the behavior can be seen in a number of areas. The Fed's exit should help adjust some of the distortions.
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Tuesday, March 18, 2014

Jump in rig count should be a positive for jobs

In another sign of improving momentum in the US economy, the active oil and gas rig count started rising in recent weeks. This is after a major decline in 2012 and a stagnant 2013.
Source: Baker Hughes

A big part of the drop in 2012 was due to the sharp decline in natural gas prices. Production in certain situations became unprofitable - particularly for some of the more leveraged projects.

Source: barchart

Now that gas prices have firmed up and likely to stay that way (see post), some of the extraction projects make sense again - especially as technology improves. Should conversion from gas to liquids become less expensive (see story), rig count will increase further.

Like it or not, oil and gas jobs tend to be high-paying - which should help with US wage stagnation. The industry also generates a decent job multiplier effect through the various peripheral sectors that support it (housing, manufacturing, transportation, etc.) If sustained, this jump in rig count could therefore provide a meaningful contribution to the US economic expansion.
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Saturday, March 15, 2014

What's behind the sudden improvement in US loan growth?

Credit growth in the US seems to have stabilized and may be on the rise. It's worth mentioning that the bottom in loan growth just happened to correspond to the start of Fed's taper. Coincidence?

Total loan growth rate YoY

Whatever the case, this may be a sign of improving demand for credit and banks' willingness to accommodate. The key to this change in trend is that improvements in loan growth have been primarily driven by a sudden jump in corporate lending.

Corporate loan growth rate YoY

Why is corporate America increasing its borrowing all of a sudden? The most likely answer is the improvement in capital expenditures (capex), which is evidenced by firmer capital goods spending by US companies. We saw initial signs of that improvement back in February (see story). There were other indications as well. ISI's latest corporate survey provides further support to this thesis.
ISI Research: - Survey strengthened over the past two weeks with U.S. orders now a solid 61.5. Areas of strength include equipment tied to trucks, rail, aerospace, and construction.
Whether using their massive cash reserves or tapping bank credit facilities (increasing bank loan balances), the time has come for higher capital expenditures by US firms. Here is why.
Barron's: - Capital expenditures [have been] just 46% of operating cash flow for nonfinancial companies in the S&P 500. The average since 1989 is 57%. Capex can't remain low forever. Already, the average age of U.S. structures is the highest it has been since 1964. Equipment hasn't been this old since 1995, and intellectual-property products, like software, since 1983. In a report issued this past week, Bank of America Merrill Lynch predicts U.S. capex growth will more than double over two years, to 5.7% in 2015, from 2.6% last year. Beyond mounting cash and aging plants and equipment, it cites some new factors. Economic growth is picking up, giving business managers more confidence and less spare capacity. Congress even passed a budget this year—one less thing for business leaders to worry about.
Barron's goes on to say that many shareholders are now pushing firms to increase capital expenditures. Much of the capex spending behavior in the post-recession era has been driven by uncertainty. Recently in the US we've had two major sources of such uncertainty: the Fed's taper and the federal government budget/debt ceiling. Both of these macro risks frightened corporate management enough to hold back on capex. The Fed's taper however is now on a slow, fairly predictable "autopilot" and as Barron's points out, the budget deal has removed the risk of a near-term federal impasse. As far as corporate CEO's are concerned, the major uncertainties related to the US federal government have clearly receded - for now.

Thus the similarities in timing of the bottoming of loan growth in the US and the start of Fed's taper may not be a coincidence after all.
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Friday, March 14, 2014

Exogenous shock from artificially high euro

For the first time the ECB has admitted that disinflationary pressures present a problem for the central bank. Draghi is blaming the downward pressures on prices in the Eurozone on the unusually strong euro.
WSJ: - "The strengthening of the effective euro exchange over the past one-and-a-half years has certainly had a significant impact on our low rate of inflation and, given current levels of inflation, is therefore becoming increasingly relevant in our assessment of price stability," Mr. Draghi said Thursday in a speech in Vienna.
Indeed the euro has been strengthening beyond most analysts' expectations.

EUR/USD (source:

The euro's lofty levels, combined with softening demand from China (see post), is creating headwinds for the euro area. Part of the problem is that a good portion of the Eurozone's recovery has been driven by exports rather than domestic demand. Moreover, the yen's relative weakness is not helping matters, as Japanese exporters have a pricing advantage over Germany.

The confluence of the euro's strength and weak domestic demand is exacerbating disinflationary risks in the Eurozone - as seen in today's German CPI number.


Ironically some of the euro rally is rumored to be the result of China's rebalancing its FX reserves toward the euro, trying to diversify out of the US dollar. That's driving up the euro to levels not justified by the fundamentals.
CNBC: - "While the technical outlook and European domestic fundamentals look quite shaky for the single currency right now, there could be one external factor that may help to prop up the single currency in the face of these challenges: China," said Kathleen Brooks, research director at
The timing for Draghi is terrible. The ECB has been arguing for some time now that disinflation in the area is transient. But this artificial euro strength could be creating an exogenous shock, potentially dampening the area's nascent recovery and putting further downward pressure on prices.
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Thursday, March 13, 2014

Latest data confirm China slowdown

As a confirmation of a significant downward adjustment to China's growth (discussed here), a battery of economic reports this morning all came in materially below expectations.

1. Fixed asset investment:


2. Industrial production:


3. Retail sales:


Clearly there is a seasonal component to these indicators, which may have been impacted by the New Year's holiday. But on a year-over-year basis much of that should have been reflected in the forecasts.
BW: - “The fairly dramatic slowdown is unusual in Chinese economic history of the last decade” and the figures were “shockingly weak,” said Dariusz Kowalczyk, senior economist and strategist at Credit Agricole CIB in Hong Kong. “It points to a major deceleration of momentum in the beginning of 2014,” wrote Kowalczyk in a research note.
Not surprisingly, over the past few days the equity market has been reflecting these worsening fundamentals.

Large cap PRC equities ETF (ticker: FXI) - down 6% in 5 days
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Why all the pessimism in the NFIB Small Business Optimism Index?

The NFIB Small Business Optimism Index is still significantly below its long-running historical averages. A technical analyst would say that the index is unable to break a specific resistance level (dashed line below). The question is - what's capping small business sentiment in the United States?

If one looks at the overall corporate sector in the US, the CEO confidence, though quite volatile in the post-recession era, has stabilized. The recent shocks correspond to the Eurozone crisis as well as the US federal government's periodic budget games. In spite of all the uncertainty however, CEO confidence is at a reasonable (though lower) level relative to the pre-recession period (chart below). In contrast, that's certainly not the case with the NFIB's index (chart above).

Source: Vistage

Why hasn't the NFIB index participated in corporate CEOs' improvements in confidence? Part of the answer has to do with the fact that the majority of NFIB members are really small businesses - much smaller than what one would call "lower middle market".  According to the NFIB, 60% of its members have 5 or fewer employees and 55% of members have gross sales of $350,000 or less. That means that the overall sentiment of those surveyed may be closer to that of the US consumers as a whole than the more traditional corporate CEOs. And at least according to some surveys, the US consumer sentiment has not fully recovered. The U.Michigan sentiment index for example is still significantly below historical averages.

Sources: St.Louis Fed,

One can point to other reasons for this persistent weakness in the NFIB index. Small business sales growth has remained poor relative to many larger firms, resulting in slower hiring. Both of these factors are reflected in the index.

One of the key drivers of what some have been calling the "small business pessimism index" however is the uncertainty with respect to current federal government policies. It's no secret that the NFIB has been unhappy with Obamacare and that its members are heavily impacted by the prospects of rising taxes in the US. These issues continue to be the survey participants' top concerns. There is also some anecdotal evidence suggesting that at least some of the pessimism has less to do with business growth expectations and more to do with the frustrations with the Obama administration.


There is however a silver lining for the overall economy in these data. Small businesses are beginning to complain about "quality of labor" - something they weren't doing much a year ago. Hopefully that's a sign of US labor markets and demand for quality workers firming up a bit.
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Wednesday, March 12, 2014

Xu Shaoshi says all is well with China's economy

China's propaganda machine went into full gear as it sets its sights on foreign economic forecasters who are continuing to profess slower economic growth for the nation. Is the West is picking on China again? Creating all this negative publicity?
People's Daily: - Among a number of foreign investment banks and international media, prophets of doom on the Chinese economy have begun to find their voices once more.

How should we view this negative publicity, and what is China's current economic situation? On March 5, Xu Shaoshi, head of the National Development and Reform Commission made clear that the Chinese economy has made a good start to the year and that future prospects are favorable. On the sidelines of the "two sessions" - the annual sessions of the National People's Congress (NPC) and the Chinese People's Political Consultative Conference (CPPCC) - reporters interviewed NPC deputies and CPPCC members.
Are the Western analysts just "prophets of doom" hyping up the China-slowdown story? While a severe recession in China remains an unlikely outcome, there is no question we are seeing PRC face some serious headwinds.

First of all it is well known that many of China's insiders, analysts working for Chinese organizations, seem to be just as bearish on China's economic expansion as their counterparts abroad. Moreover, key economic data continue to indicate that growth is below expectations - see the latest export figures for example. And while one could debate the veracity of such data due to seasonal effects and other biases, it's harder to argue with the markets. Commodities that are sensitive to China's industrial demand, particularly iron ore (see chart), steel (see chart), and copper (chart below) have been hit unusually hard. Clearly something is wrong here.

China's authorities certainly have the wherewithal to stabilize growth through either fiscal or monetary stimulus. They've done it before. The central government however has been trying to wean the country from both in order to contain the buildup of market bubbles in areas such as wealth management ($6 trillion shadow banking balance sheet), corporate credit, and real estate. And if all was well with the nation's economy, Beijing would be staying the course here.

Lately however China's central bank has become quite accommodative. It stopped appreciating the yuan - in fact the currency has been allowed to depreciate (see chart) to help the nation's exporters. It is also allowing short term rates to decline. Some of that decline is due to falling demand, as banks pull back on lending into certain sectors. Partially it is the result of PBoC injecting liquidity via unsterilized dollar purchases (yuan sales). Whatever the case, the outcome is a sharp decline in interbank rates - a loosening monetary stance.

1-week and 2-week SHIBOR

One could debate the reasons for each of these trends. But taken as a whole, it is hard to argue that it is business as usual in China - even if Xu Shaoshi made it perfectly "clear that the Chinese economy has made a good start to the year and that future prospects are favorable."
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