Friday, May 30, 2014

Analysts zero in on ECB's potential actions

As we approach the June ECB meeting, investors are increasingly focused on what the central bank could be contemplating (see discussion). It is clear that the ECB's focus will be credit expansion in the euro area. Along the way, Draghi and company may also want to talk down the euro. As discussed recently, the money supply growth in the Eurozone has stalled (see chart), which is the direct result of tight credit conditions. Furthermore downward pressure on prices persists, as we saw with Italy's inflation report today (see chart). Here is BofA's take on the situation:
BofA: - Laurence Boone notes the following measures could be announced to boost lending next week:
  •  LTRO conditional on lending with fixed rate & for an extended period [the ECB will provide cheap money to banks if they agree to lend it out to small and mid-sized businesses - see post]
  •  Changing the regulatory capital requirement [on banks] for holding ABS [this would be aimed at boosting consumer finance via the securitization market - see post]
The LTRO program may end up being similar to the UK's Funding for Lending Scheme.
FT: - The ECB is expected to announce a fixed-rate offer of cheap central bank funds, often referred to as a longer-term refinancing operation, according to two people familiar with the matter. Under the LTRO, banks could borrow as much as they wanted from the central bank in the form of loans with maturities of a number of years.

The ECB has used LTROs to pump €1tn into the eurozone’s financial system, though the amount offered this time could be lower as banks’ demand for central bank cash has waned. People familiar with the matter say the fixed rate will depend on banks’ commitments to support credit creation in certain areas. The LTRO is expected to ape the design of the BoE’s Funding for Lending Scheme, which allows banks to shrink their balance sheets and still benefit from the cheap loans, so long as the level of contraction is not too large.
This, according to BofA, would be accompanied by a rate cut, potentially moving deposit rates into negative territory.
FT: - Most analysts expect a cut of 10 or 15 basis points to the ECB’s main refinancing rate, now 0.25 per cent, to be matched by a cut to its deposit rate, which stands at zero. A move into negative territory in effect imposes a levy on reserves held at the ECB – a change that policy makers hope will spur lending from banks in the region’s core to those in the periphery, as well as weakening the euro.
Once again, a note of caution. If the ECB fails to deliver an easing action in the magnitude that markets expect, we are going to see some nasty volatility across global markets.
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Thursday, May 29, 2014

Lower mortgage rates unlikely to boost the housing market

Housing in the US continues to lag the nation's overall economic expansion. Today's pending home sales report was quite disappointing (see chart), with month-over-month growth of 0.4% vs. the expectations of 1%. While the "post-winter" recovery has taken place across much of the US economy (see chart), it remains absent in the housing sector. To be sure, apartment construction and rental business is doing quite well. The single family unit market however continues to struggle.

Mortgage rates have declined sharply recently, with the 30-year fixed rate approaching 4%. Jumbo rates are even lower. The question is whether this will provide some much needed relief to the housing sector.
Source: Mortgage News Daily

The markets however are dismissing any significant benefits from these reduced mortgage rates. Here are a couple of indicators: 

1. Shares of home-builders continue to underperform the broader market.

Blue = homebuilder index; orange = S&P500  (total return; source: Ycharts)

2. Moreover, lumber futures are touching fresh lows for the year, as markets point to expectations of persistent slack demand.

July lumber futures (source: barchart)

The reasons for this skepticism remain the same. While credit conditions have eased for auto and credit card financing, they have tightened for mortgages (particularly nonstandard loans). Furthermore, many households remain uneasy about job stability and lack the confidence to buy - even when they qualify for a loan. Family formation rates are still subdued, especially in the under-30 age group. And the "rent generation" culture has been firmly in control.
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Wednesday, May 28, 2014

Staging the QE exit

Fed officials are hinting that the rate hike could take place before the Fed ends the policy of reinvesting securities that pay down or mature. The order of events would look something like this:

1. Securities purchases end later this year but the Fed maintains its balance sheet at constant level.
2. The rate hike takes place (some time in 2015)
3. The Fed begins to allow securities to mature (or amortize for MBS) without replacing the declining notional.
William Dudley: - ... it would be desirable to get off the zero lower bound in order to regain some monetary policy flexibility. This goal would argue for lift-off occurring first followed by the end of reinvestment, rather than vice versa. Delaying the end of reinvestment puts the emphasis where it needs to be—getting off the zero lower bound for interest rates. In my opinion, this is far more important than the consequences of the balance sheet being a little larger for a little longer.
Fed officials are afraid that if the balance sheet begins to naturally decline, the markets will interpret this as additional tightening. But once again, by delaying step 3, the Fed introduces incremental uncertainty. The markets and the media will be buzzing with "when does the reinvestment policy end?" question. The reality is that this delay will have a minimal impact on the trajectory of the massive balances at the central bank.

Here is a situation in which the policy itself will have no material impact on anything except that it introduces more uncertainty - something the US economy doesn't need. The Fed should just finish the QE program, stop buying any more securities, and focus on normalizing rates. Staging this process is a bit like ripping off the bandaid slowly rather than getting it over with, particularly when the bandaid is no longer of much use.
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Monday, May 26, 2014

The Daily Shot

Dear Friends,

Based on requests from a number of Sober Look readers, we are now distributing a free daily summary newsletter called the Daily Shot. It's a simple, concise and informal chart-based summary of the topics discussed here and on Twitter. As usual, we cover the global economy and financial markets - often from a risk management rather than a purely economic perspective. See example here.

To subscribe, please enter your e-mail address here:

* indicates required

Given the graph-heavy nature of the letter, please make sure your e-mail software allows you to view embedded charts.

Thanks you for continuing support.

Spreads on AAA CLO tranches not budging

Top rated investment grade US corporate bonds now trade at or even below pre-recession levels. Depending on the maturity and the type of issuer, new issue paper clears the market at spreads (to treasuries) of 30-80bp for AAA bonds.

Securitized corporate paper for similar maturities on the other hand continues to trade at a significant premium. AAA CLO bonds clear the market at 145-155 basis points spread to LIBOR - unchanged from two years ago. The two (typical) CLO deals below show that while lower rated tranches have tightened significantly (BBB for example tightened about 200 basis points over the same period), AAA spreads for standard tenor deals have not budged (and in fact are higher in some instances).

DM means effective spread
(some tranches  are issued at discount; L="LIBOR"; source: LCD/S&P)

Some attribute this premium to higher risk of structured credit relative to single name bonds. However it is important to note that not a single AAA CLO bond lost principal through the financial crisis. The elevated spread is primarily driven by regulatory pressures and funding markets. The new FDIC rules for example penalize banks for holding these bonds (this is in addition to the Basel rules). Ironically these same rules may encourage banks to move toward riskier CLO tranches with higher yields in order to compensate for the increased FDIC charges.

Normally when there is a market dislocation such as this one, hedge funds find a way to take advantage of it. But LIBOR+150 is not yieldy enough for hedge funds and these bonds are nearly impossible to leverage in order to boost yields. So hedge funds and others in search of yield stick to the lower-rated tranches. Non-US participants, in particular yield-starved Japanese institutional investors, have been the only consistent buyers of AAA CLO paper recently. This makes the primary market vulnerable to disruptions if these investors decide to exit.
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Fresh lows for industrial commodities, other indicators still point to persistent risks to growth in China

In spite of what appeared to be an improvement in China's manufacturing sector (see chart), China's economic picture remains cloudy. A number if indicators point to rising uncertainty and slowing industrial demand.

Investors are becoming increasingly uneasy with the nation's property markets, which JPMorgan called "a major macro risk". Volumes of unsold real estate are now at record levels and sales continue to slow. Nomura's researchers are convinced "that the property sector has passed a turning point and that there is a rising risk of a sharp correction". Of course since the authorities can easily intervene, the situation may not be as dire as Nomura predicts. Nevertheless, the nation's property markets continue to pose significant risks.

Moreover, some high frequency indicators are once again flashing warning signals. According to the ISI Group research, exports to and sales in China by US corporations have turned materially lower after remaining stable since early 2013 - indicating weakening demand. Anecdotal evidence suggests that a similar slowdown has also occurred for Japanese and euro area firms selling to China.

The most worrying indicators however are the key industrial commodity prices. Futures on iron ore sold at China's ports fell below $100 for the first time in years.
June China iron ore futures contract (source:

And steel rebar futures on the Shanghai exchange are also continuing to fall. Some of these declines are of course related to declining construction activity.

June China steel rebar futures contract (source:

Once again, most economists do not expect a "hard landing" for PRC because the government has enormous resources to "backstop" the nation's economy. Nevertheless, a number of indicators from China still point to persistent risks to growth.
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Friday, May 23, 2014

Fed's experimental reverse repo program ramps up

Growth in US reserve balances (funds that banks hold at the Federal Reserve) has stalled recently. Part of the reason for the slower growth is of course the Fed's taper. Yet the Fed's balance sheet is still increasing, albeit at a slower rate. Which means that bank reserves should be growing as well, unless of course some reserves have been "drained".

There are a couple of ways the Fed can drain the reserves: sell securities or take in deposits/borrow. It turns out that the Fed is doing the latter by borrowing overnight via reverse repo (RRP). The newly established Overnight Fixed-Rate Reverse Repurchase Agreement program that the Fed has been testing (discussed here) has become quite popular. There is a limit of $10bn per participant (here is the list of counterparties allowed to participate), with the Fed now rolling about $200 bn of reverse repo daily. The experimental program has been ramping up and $200 bn has been drained from the reserves as a result. That's why we see bank reserves growth stalling (chart above).

The demand makes sense because this program allows money market funds to earn overnight rates that are higher than treasury bills. Federal Reserve officials are signaling their support for employing this new tool as a way to control the overnight rates.
Reuters: - Dudley said that "early evidence" shows that the Fed's new reverse repo facility  ... "would help strengthen our control over money market rates."

That's important, he said, because better control over short-term rates is likely to help the Fed keep a lid on inflation and inflation expectations. Under the facility, which the Fed has been testing for a year, banks, dealers, and money market funds effectively make overnight cash loans to the central bank, eliminating that liquidity from the system.
That's why when we finally hear the Fed announcing a rate hike, the central bank will be setting the Fed Funds Rate, the Discount Rate (which is more symbolic at this point), and the RRP Rate - with the latter being the most impactful for the overall economy.
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Thursday, May 22, 2014

Risk of disappointment from the ECB in June remains high

The euro area recovery continues to be uneven. The economy is clearly expanding, but while growth accelerated in the service sector, it is slowing in manufacturing (based on Markit's Purchasing Managers Index report.) Some are blaming the slowdown in manufacturing on weakness in the export sector - driven by factors such as China and the strong euro.

Eurozone Markit PMI (source: Markit/

Moreover, growth has been uneven across the region, with France now shifting back into contraction mode.
Reuters: - An earlier PMI from Germany showed Europe's largest economy was again the driving force - its composite PMI held steady at 56.1. But it was a different story in France, the euro zone's second largest economy, where the composite PMI slumped back below the 50 mark after just two months in growth territory.
French Markit PMI - note that a reading below 50 indicates contraction (source: Markit/

As France slows, the Eurozone's ability to pull out of the current disinflationary mode will be limited.
WSJ: - ...with the French economy struggling to generate even modest growth, any pickup in the euro zone as a whole is unlikely to be strong enough to boost consumer prices and end a period of low inflation that stretches back to October.
However, the fact that the Markit report continues to show expansion in aggregate increases the risk that the ECB may stay on the sidelines in June. Alternatively the action could end up being limited in scope. That will certainly generate a sell-off across fixed income markets in the EU and even in the US. It's one of the reasons euro government bond yields have backed up in recent days (see chart).
Markit: - Deflationary pressures remain a major issue ... and the ongoing fall in average prices charged for goods and services adds to the likelihood of the ECB taking action to boost the economy at its June meeting. However, policymakers will also be minded of the steady recovery the region appears to be undergoing, suggesting that anyone expecting any aggressive policy initiatives may be disappointed.
In fact, Bundesbank is still ambivalent about the need for the ECB to act next month. The risk of a major "disappointment" in June remains high.
WSJ: - The jury is still out on whether the European Central Bank will need to take action at its next policy meeting in June, ECB governing council member Jens Weidmann said in an interview with the daily Sueddeutsche Zeitung.

"It's not clear if we even need to act," Mr. Weidmann was quoted as saying.

His remarks diverge somewhat from a message earlier this week offered by ECB executive board member Yves Mersch, who said the probability of action by the ECB has risen considerably.
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Quick presentation on major central banks' challenges and next steps

Attached presentation provides a quick overview of some post-cricis actions and challenges faced by the three major central banks: the BOJ, the Fed, and the ECB.

Central banks in the post-crisis world
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Wednesday, May 21, 2014

Putin's motives and next steps

Recently Sam Zell, a major US investor, made some comments on the dangers of Vladimir Putin's unpredictable behavior and Russia's aggressive foreign policy. Zell's point was that investors are simply not paying enough attention to Putin's dangerous ambitions, which could further raise geopolitical risks and adversely impact asset valuations.

Perhaps. But let's take a closer look at Vladimir Putin and what ultimately drives him. It's important to point out that the Russian leader sees almost no opposing views within the nation's government. From Russia's parliament to its central bank to the country's mainstream media, when Putin says "jump", the answer is always "how high?". The risk of course is that without any opposing views he could put the country on a dangerous path. We've seen this before with popular authoritarian leaders around the world. But there is one potentially opposing voice that Putin does listen to. It's his domestic popular support.

Vladimir Putin is driven by power. But he is also keenly aware that power requires popular support and after running the country for such a long time, popular support is not a given. The Orange Revolution in Kiev is just a reminder of how much a significant loss of popularity could cost an authoritarian ruler. In fact, prior to the takeover of Crimea, Putin's popularity was on the decline, and the annexation of the region improved his standing dramatically. It wasn't just one of Russia's favorite vacation spots where scores of wealthy Russians own property that made that decision popular. It solidified Russia's control over the strategically important port as well as the massive oil and gas reserves in the Black Sea (which Ukraine has now lost).

As discussed before (see post), Russia is not concerned about any serious economic sanctions, making Crimea well worth damaging the relations with the West - for now. Eastern Ukraine is another story however. While the majority of Russians supported the Crimea move, there is far less appetite among the population to move into other regions of Ukraine. And the inhabitants of eastern Ukraine may not be as welcoming as those in Crimea - in spite of all the pro-Russian activism in the area. For a shrewd survivor like Putin, that matters. We therefore see Russia taking a much more cautious approach in eastern Ukraine.

Moreover, the longer the impasse with the West lasts, the more precarious Russia's economic situation becomes. Both foreign and domestic investment has slowed and confidence took a beating. A tighter monetary stance (higher rates) instituted to support the ruble has not helped. In fact Goldman's leading index is now showing Russia's economy beginning to contact. And for a BRIC nation accustomed to years of growth, this is a big deal. In the intermediate term this slowdown is bad news for Putin, as his post-Crimea popularity will soon start to fade.

That is why we see Mr. Putin taking a trip to Beijing. Closing the $400bn natural gas deal with China is a sure way to help the economy at home. Getting some support from China on the Ukraine situation is also helpful. All this puts "points on the board" for the Russian leader at home.

Fairly soon we should see Russia pull back the troops from the eastern Ukrainian border. Putin has plenty of operatives on the ground in Ukraine to know exactly what's going on, giving him the ability to tactically redeploy troops as needed. Moreover, in months ahead he will reach out to Western Europe through unofficial channels and try to engineer some sort of an agreement with the goal of normalizing relations. If Europe goes for it, the US will have to follow. Putin's goal will be to restore investor confidence in order to keep the economy from slipping into a recession and damaging his popular support. In spite of Sam Zell's warnings, further Russian aggression in the near-term is therefore unlikely.

Having said this, it is important to understand that the Russians view the Ukraine territory (as well as Belarus) as a their "western buffer". Based on Russian history (whether it was 1812 or 1941), the need for that buffer, combined with the mistrust of the West, is ingrained in the Russian psyche. That's why when the idea of Ukraine joining NATO was brought up several years ago at a conference, it panicked some Russian generals. Western leaders should therefore understand that the thought of Ukraine joining the EU is a highly sensitive issue for the Russians, in spite of the new leadership in Kiev pushing to accelerate the process. And any sudden moves in that direction in the near-term could escalate tensions with Russia.
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Saturday, May 17, 2014

"Generation rent" raising demand for multifamily housing

One of the reasons we continue to see negative signals from the US housing market (see post) is the weakness in the single family housing sector. The strong housing report yesterday was driven by surging apartment construction. That trend is expected to continue.
Reuters: - The housing starts report suggested building activity would likely continue to rise for some time as permits to build homes jumped 8.0 percent to a 1.08-million unit pace in April, the highest since June 2008.

Permits for single-family homes, however, rose just 0.3 percent and continue to lag groundbreaking, suggesting single-family starts could decline in the months ahead. A survey on Thursday showed confidence among single-family home builders slipped to a one-year low in May.

In contrast, permits for multi-family housing soared 19.5 percent. Multi-family permits are running well ahead of starts, which could indicate delays in getting projects started. Permits for buildings with five or more units were the highest since June 2008 - [see Twitter post]
Americans are adjusting to this new rental culture, as the number of single family housing starts falls to new lows relative to the total new housing construction.
1-unit housing starts as a fraction of total housing starts (source: St. Louis Fed)

To be sure, home construction in the US is still far below what the nation will need in years to come and it's only a matter of time before the US faces the same type of housing shortage that exists in the UK (see post).

Housing starts as fraction of US population (source: St. Louis Fed)

But the so-called Generation Rent is in no hurry to go out there and get a mortgage and is willing to pay up for the mobility offered by rentals (forgoing mortgage tax deduction). Given the demand, apartment owners on the other hand are not shy about getting a mortgage for rental properties. The proportion of multifamily mortgages continues to rise - a trend that started in 2006.
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Considerations in quantifying hedge fund portfolio risks

 "And now for something completely different ..."
                                                                      John Cleese

We've been asked about quantification and monitoring of risk for hedge fund managers. It's a process that tends to be dramatically different from what banks or insurance firms undergo. Hedge funds develop risk measures that are both highly dynamic and practical in nature. Here is a generic list of considerations (sent by a Sober Look reader)- a more comprehensive list would of course vary by strategy.

                Measuring portfolio leverage and directionality
o   Gross vs. net leverage measures
o   Beta adjusted vs. net notional exposure (are you long or short?)
o   Combining credit and equity risks into a single exposure
o   The use/limitations of basic spread and rate risk measures (portfolio duration, CS01, etc.)

        Working with beta measures
o   Asymmetry
o   Stability
o   Can beta methodology be effectively applied to credit?
o   Managing basis risks
o   Choosing a benchmark index for the portfolio

·           Working with highly nonlinear portfolios
o   Developing practical portfolio scenarios,  including historical simulations
o   Practical uses of portfolio option greeks.
o   Tracking portfolio duration under various conditions :
§  prepayment speeds,
§  spread shocks,
§  yield curve slope, etc.

·           Measuring “tail risks”
o   Conditional (“tail”) value-at-risk
o   Spectral risk measures (overweighing certain adverse outcomes)
o   Managing macroeconomic stress tests – what’s considered “extreme but realistic”?

·          Exploring hedging techniques
o   Treasuries or currencies as macro hedges
o   Credit CDS indices (CDX) and credit swaptions
o   Equity options, binary options,  and other overpriced products etc.
o   Other

 Assessing and managing liquidity risk
o   Stress testing margin requirements and leverage sustainability
o   Assessing investor redemption risks
o   Determining liquidation periods for portfolio components
o   Assessing cash balance requirements

Tracking countrparty risk
o   Measuring the health of swap counterparties and prime brokers
o   Cash and fully-paid-for securities segregation and monitoring

Note: risk adjusted performance measures and performance attribution will be discussed at a later stage.

We would like to hear from Sober Look readers. What's missing? What should be expanded?
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Friday, May 16, 2014

6 reasons treasury yields should be higher

It remains difficult to reconcile treasuries trading at the same yields we saw during the US government shutdown (see post) with broadly stronger economic conditions in the US. Economic indicators suggest yields should be materially above the lows we saw last October. Here are some of the key trends:

1. Leading indices are all stronger - ECRI is at pre-recession levels.

Source: Economic Cycle Research Institute

2. Labor markets are clearly improving. Initial jobless claims clocked below the 2006 level this week (see Twitter post).

Source: Gallup

3. Small business surveys show owner sentiment, which had remained weak for years, finally on the rise.

4. Credit expansion in the US has accelerated.

5. Inflation is picking up (see post) and inflation expectations are higher as well.

5y breakeven inflation expectations (Ycharts)

6. And even the housing market, which had stalled this year, surprised to the upside today. Both housing starts and permits came in above expectations.


Clearly there are geopolitical tensions over the Ukraine crisis and all the search for yield in the face of the ECB's expected easing action is putting downward pressure on rates globally. The US consumer remains jittery, generating a drag on growth. Furthermore, equity investors are using treasuries as a proven form of downside protection. Yet in the face of strengthening economy and relative to the uncertainty of the US government shutdown and debt ceiling impasse last year, current low yields are difficult to understand.
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Thursday, May 15, 2014

When was the last time treasury yields were this low?

We've had an unprecedented compression in US (and global) government bond yields in a short period of time. Here is one surprising fact: Treasury yields are now at the level they were during the US government shutdown. The level of uncertainty has diminished dramatically since then and the employment picture continues to improve (see Twitter post). Yet here we are again. This time however it's the global chase for yield and expectations of ECB's monetary easing driving rates to new lows.

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Swiss deflation

While the Eurozone is concerned about disinflationary pressures, Switzerland is dealing with outright deflation. Persistently strong Swiss franc and weak economic growth in the euro area are putting downward pressure on prices.

Switzerland PPI (source:

Some are suggesting that the Swiss National Bank follow the ECB's lead in (potentially) loosening monetary policy via "unconventional" tools. Otherwise it will become increasingly difficult to arrest these falling prices.
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Wednesday, May 14, 2014

More signs of US inflation stabilizing

Since our last discussion on the issue (see post), more evidence has emerged that inflation in the US has bottomed out. While the treasury markets seem to be completely ignoring this inflection point, core PPI came in materially above expectations today. We know that food prices have been on the rise recently (see Twitter post), but this PPI measure excludes food and energy. Complacency about inflation seems to be rampant - both among fixed income investors as well as at the Fed.
Reuters: - "We think a number of policymakers at the Fed and many market participants are overly complacent on the outlook for inflation," said John Ryding, chief economist at RDQ Economics in New York. "We are not sounding an inflation alarm at this point but ... concerns about deflation or too low of an inflation rate seem quite misplaced at this point."

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Tuesday, May 13, 2014

Markets expect June action from the ECB

Economic sentiment in Germany showed another decline this month, as measured by the Centre for European Economic Research (ZEW) Index. This is a widely watched indicator and it further raised expectations of an ECB monetary easing action.

Source: ZEW

Moreover, rumors are circulating that Bundesbank, which in the past resisted additional monetary stimulus, may now in fact support such an action by the ECB. The euro, which started declining after Draghi's speech on May 8th (see post), traded lower.
Reuters: - Selling of the euro accelerated on Tuesday after a report from Dow Jones, citing a person familiar with the matter, said the Bundesbank, Germany's central bank, was willing to back an array of stimulus measures from the European Central Bank next month.

The measures could include backing a negative interest rate on bank deposits and ECB purchases of packaged bank loans if needed to boost inflation.

German government yields also fell to lows not seen in about a year, with the market now pricing in some form of an easing action from the ECB next month.


Now the ECB is under the gun to come up with something in June to maintain its credibility. The risk of course is that if we hear the same old "wait and see" approach, yields across the euro area will back up violently.
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Monday, May 12, 2014

Investors cheer upcoming changing of the guard (and policies) in Argentina

Staying with the Argentina theme, it seems that investors are no longer as concerned about a technical event of default. Argentina CDS continues to tighten.

Source: DB

Moreover, investors are looking beyond this legal battle toward a potential changing of the guard in Argentina. Demand for Argentina bonds has been quite strong lately.
Bloomberg: - The country’s dollar bonds have returned 46 percent over the last year on bets a more market-friendly government will replace President Cristina Fernandez de Kirchner when her term ends in 2015 and as she moves to improve relations with international community.
Argentina's law says that by the end of 2015 Fernández de Kirchner will no longer be President, as she finishes her second consecutive mandate. And many hope that some of her populist policies (see discussion) will go as well. The present economic situation - with inflation rate estimated at over 30% and expected to go higher later this year - is simply not sustainable (note that Argentine authorities have not released the latest inflation results as required by the IMF). The current adminisration in Argentina is fully responsible for getting the country into this mess. It is time for them to go.

Argentina YoY inflation rate
(source: Barclays Research)
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Fox News wins the Hype Award for the Argentina debt story

It is sad to see Fox News publish a horribly written story called "Litigious investors ask US Supreme Court to deny Argentina a 'do-over' on $1.4B debt ruling" from the Associated Press (here). First of all in the US taking someone who defaulted on debt to court is not "litigious", it is standard practice. Americans are generally quite proud of that right. But this clearly pro-Argentina story continues with more nonsense.
Fox News: - The "Aurelius Respondents," another group of hedge funds and holding companies based in the Cayman Islands and the U.S. state of Delaware to avoid taxes and scrutiny, urged the justices to deny Argentina's "do-over" request, saying "a chorus of disinterested parties has recognized that Argentina is without peer in its mistreatment of private-sector creditors."
Just to be clear, the Cayman entities are in the Cayman Islands because they are either owned by foreign organizations who are not supposed to pay US taxes (such as Canadian pensions) or by US corporate pensions who are tax exempt. As far as Delaware, those owners will certainly pay their share of taxes because these are pass-through entities. Fox News - check out something called Schedule K-1. And with respect to avoiding "scrutiny", the managers of these entities are Registered Investment Advisors regulated by the SEC. And for those who have been through an SEC RIA audit know there is no shortage of scutiny there.

Argentina is mocking the US legal system by appealing the court decisions in this case and then saying it won't comply with any final court ruling if it is not in Argentina's favor. Of all the news agencies it is particularly surprising that Fox News did not check the facts on this and is in effect buying Cristina Fernandez's propaganda on the issue. Congratulations on winning the Sober Look Hype Award.
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Small businesses remain pessimistic, but their retirement accounts say otherwise

The NFIB small business "pessimism" index has been stuck in the doldrums since the recession as these companies continue to report lackluster business confidence.

Source: NFIB

However the retirement accounts of small business employees (which includes the owners) tell a somewhat different story. A recent report from Fidelity found increased IRA/401K contributions vs. last year and significantly larger balances since the recession (based on over 200,000 accounts):

Source: Fidelity

This is telling us that US small business confidence is actually improving in spite of the overall NFIB indicator. And even the recent NFIB print is showing signs of life with what Wells Fargo called "a strong gain in sales expectations".

Source: NFIB
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US housing sector stalling

The US housing recovery continues to face headwinds. Here are the key factors contributing to weakness in the sector.

1. We've had a sharp decline in housing affordability due to higher prices and higher mortgage rates. The decline in mortgage rates recently should help somewhat, but buyers remain cautious.

Source: Deutsche Bank

2. Banks have tightened lending standards. The important trend here is the tightening in the "nontraditional" mortgages (ignore the "subprime" component - it's not a meaningful portion of the market). If you don't fit into the traditional mortgage "box", getting a loan is now more difficult.

Senior Loan Officer Opinion Survey on Bank Lending Practices (Federal Reserve Board)

3. Household formations have stalled. It will be difficult to get the demand going until growth in households picks up again.

Source: U.S. Census Bureau

This weakness in housing is already reflected in the equity markets as shares of homebuilders underperform.

Orange=S&P500 ETF, Blue=Homebuilder index ETF (source: Ycharts)
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Sunday, May 11, 2014

The EU's ties to Russia rule out any serious sanctions

Many were outraged recently when the trade data showed Russian exports actually rising in the face of the so-called "sanctions".
Bloomberg: - The world’s largest energy producer shipped 2 percent more gas to Europe in the first three months of 2014 than it did in the same period last year, government data show.
But the reality on the ground is that the EU has no appetite for any real sanctions against Russia. Here are some reasons:

1. It's well known that in the post-Soviet era, the EU had developed an unprecedented dependence on Russian energy.

Source: Wikipedia

Given the vulnerability of the Eurozone's economy, there is zero appetite for an energy disruption at this point.
Bloomberg: - Russia’s energy shipments are unlikely to be curbed because the country and its Western buyers are too dependent on each other for there to be an interruption ... Europe imports about 30 percent of its gas from Russia, half of which crosses Ukraine.
2. The EU's exports to Russia are worth some $246bn per year. There is no chance the Europeans will want to risk disrupting this gravy train. In contrast, the US exports only about $11bn worth of goods per year to Russia.

3. An even more important factor is the European banking system's exposure to Russia. If Russian companies are told to stop servicing debt to Western banks (in retaliation for example), it will send the European banking system into a tailspin. And as discussed before (see post), the Russian authorities have enormous control over the nation's corporations.

Source: Deutsche Bank

French banks are particularly exposed.

Source: Deutsche Bank

4. There are also historical reason that some EU nations, particularly Germany, do not want to rock the boat with Russia. Here is a good article from BBC on the topic.

That's why Putin can operate with impunity in Ukraine - his only focus these days is what domestic polls are saying (see article from the FT). Without the EU leadership, there is very little that Western nations can realistically do about this situation.
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Saturday, May 10, 2014

The diminishing usefulness of the Fed Funds rate

As the massive over-liquidity in the US banking system reaches new highs, the amount that banks borrow from each other continues to decline. In the past some banks borrowed from other banks in order to meet their reserve requirements, but these days excess reserves are so large, the need for interbank financing has dramatically diminished.
Barclays Research: - The overnight market for unsecured bank loans has shrunk considerably since the Fed’s asset purchases expanded the level of bank reserves to nearly $3trn. With no short base left in the market and massive over-liquidity, banks no longer to need to borrow from each other or the GSEs to meet their reserve requirements. Indeed, overall bank reserves are now 34x bigger than required reserves.

This presents a problem for the Fed. The central bank's main policy tool for setting short-term rates involves targeting the Fed Funds Rate - effectively the average rate at which banks lend to each other overnight. With such lending having declined so dramatically (chart below), the Fed needs other tools to impact short-term rates on a broader scale. Otherwise the central bank would be attempting to influence rates by targeting a relatively narrow set of transactions among a few banks.

There are two other tools the Fed can potentially use as it prepares to exit the zero-rate policy. One is the interest it pays on excess bank reserves, which is currently at 25bp. If that rate increases, banks would be expected to increase the rates at which they lend out short term funds. That's because banks would always charge more on loans to the private sector than on "lending" to the Fed. And higher rates to the private sector would be the goal of this policy.

The other tool is the Fed's experimental reverse repo facility (fixed rate full allotment reverse repo facility or FRFA) - see post. The advantage of this program is that it broadens the set of counterparties beyond the banking system (see full list here), making a rate increase more effective. In particular FRFA gives money market funds a good alternative to treasury bills (3-month treasury bill now yields 3 basis points). If money market funds can increase yields by lending to the Fed (via FRFA), depositors will be able to earn more on cash. And that in turn will force banks to increase rates on deposits to keep customers from switching from savings accounts into something like the Vanguard Federal Money Market Fund. This program also allows the Fed to drain some of the bloated excess reserves by taking cash out of the system overnight.

With treasury bills near zero, it's not surprising that demand for the reverse repo facility is quite high even at the testing stage.
WSJ: - In her testimony, Ms. Yellen said when the Fed begins tightening credit, it will use a “number of complementary tools” that will collectively “push up the general level of interest rates.” She listed the reverse repos as one of tools that will “likely” be in the mix.

That’s a fairly strong endorsement for the still-experimental reverse repos.

Even in tests, the facility is popular: Operations over recent days have seen the Fed draining around $200 billion a day as participating firms navigate a shortage of short-term Treasury issuance related to the April 15 tax filing deadline and the government’s improving financial position.
Fed's testing of the reverse repo facility is generating considerable demand
(source: Board of Governors of the Federal Reserve System)

Both of these tools, the interest paid on bank reserves and the reverse repo facility, are currently on the table as the Fed debates their potential uses. When the central bank finally hikes interest rates, it won't be just about the Fed Funds Target Rate.
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Friday, May 9, 2014

As dealer inventories decline, fixed income markets face higher volatility

Dealer inventories in fixed income products remain quite low and have seen especially sharp declines in credit products such as corporate bonds and ABS (treasuries/agencies are Volcker-rule exempt, most other bonds are not).

Source: Credit Suisse

US bank regulators keep insisting that as banks are forced out of market making, someone else will step into their place - either electronic exchanges or buy-side market makers such as hedge funds. That belief is highly misguided. As an example, Blackrock tried an electronic trading platform for bonds in 2012 and failed. Electronic exchanges that have any liquidity these days are either dealer-sponsored or have dealers heavily involved in providing quotes. When it comes to credit in particular, a pure buy-side to buy-side exchange is a pipe dream for now.

What this means is that as dealer inventories shrink to the lows not seen in over a decade, bond trade execution becomes more like a brokered transaction, particularly for the "off-the-run" issues (bonds that have been issued a while back). It goes something like this: You call your favorite dealer desk looking to sell a bond. Your coverage, let's call him Jerry, is a 25-year-old, whose previous job was at Best Buy (he was hired as the bank gutted its sales and trading group). Jerry in turn calls a few of the bank's mutual fund accounts who may or may not show him a bid. If they do, he'll call you back with his bid which has some spread built in. Jerry knows little about the credit (the company that issued this bond), has no market view on the bonds, and has no authority or balance sheet to take any risk on it. He has to have the other side in order to transact. In a crunch situation, there is no other side.

As a result, credit markets have become vulnerable to large uncontrolled market moves.
Credit Suisse: - Declining dealer balance sheets: risk aversion, prudential regulations and capital rules have caused dealers to reduce balance sheets in risk assets. 
Smaller balance sheets raise volatility risk: during times of one way trading, less elastic dealer balance sheets suggest more volatility during periods of forced selling. The sell-off in late spring 2013 may only be a precursor of sharp swings in fixed income markets.
With credit spreads now at pre-recession levels, a great deal of the paper out there is "priced to perfection". Combine that with this lack of market making capabilities and you are asking for trouble.
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