The Brookings forecast misunderstanding

This WSJ chart has been bounced around the web a bit with comments pointing to how optimistic Wall Street economists are on US labor markets relative to the Brookings forecast. The reality is just the opposite. Brookings model assumes that as labor markets improve some of those who had left the labor force will return in an attempt to find work. That will increase the unemployment rate (more people "officially" looking for work). Wall Street economists on the other hand don't believe many of those folks are coming back any time soon, as the unemployment rate continues to fall.

Source: WSJ

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Euro area staring at deflation as it waits for TLTRO

The ECB remains behind the curve in routing out the Eurozone's persistent disinflationary trend. The area's CPI is now below 0.5% on a year-over-year basis. Yesterday we saw German CPI hit new lows (see chart) and Italy's inflation rate is now hovering just above zero.

Investing.com

Bloomberg: - Euro-area inflation unexpectedly slowed in July to the weakest in almost five years, underscoring the European Central Bank’s concerns that the economy is too feeble to drive price growth.

Inflation was 0.4 percent compared with 0.5 percent in June, the European Union’s statistics office in Luxembourg said today. That is the weakest since October 2009 and below a median forecast of 0.5 percent in a Bloomberg News survey of 42 economists.

The centerpiece of ECB's latest policy initiative, the TLTRO program, will take some time to fully ramp up. In the mean time the central bank is staring at rising risks of deflation, which may end up being extremely difficult to fight (as the BoJ painfully learned over the years). The Eurosystem's (ECB) balance sheet continues to shrink to pre-LTRO levels resulting in tighter monetary conditions.

Eurosystem balance sheet (ECB)

The most expeditious action the central bank can take at this point is to further weaken the euro, and it has multiple tools to execute such policy. Whatever the case, the time for the ECB to act is now, not over the next couple of years.

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Expect higher treasury yields in second half

While many investors refuse to accept this fact, we are clearly marching toward higher treasury yields later in the year and in 2015. Even after today's bond selloff, we are still around the yield levels we had during the dark days of the government shutdown. Here are a couple of key factors that will drive yields higher from here.

1. Many are pointing to record low yields in Europe (see chart), suggesting that on a relative basis treasuries look attractive. Perhaps. But it's important to make that comparison based on real rates rather than nominal. And given the disinflationary environment in the Eurozone (see chart), a significant rate differential between the US and the Eurozone is justified. After all, we've had a tremendous differential in nominal yields between the US and Japan for years. Furthermore, economic growth (and expectations for growth) in the euro area and in the US have diverged significantly (see chart). Today's US GDP report confirmed that trend.

2. The net supply of treasuries is not static. In particular when it comes to treasury notes and bonds (excluding bills), the Fed has been the dominant buyer (see chart). With the Fed tapering, the net supply is expected to rise.

Source: JPMorgan

Foreign buying of notes and bonds has declined and is not expected to replace the Fed's taper. It will be primarily driven by China's rising foreign reserves. But given declining support from the Fed, China is likely to make bills (vs. notes and bonds) a larger portion of its purchases. And bill purchases will have a limited impact on longer dated treasury yields.

To be sure, we are going to have plenty of demand for treasuries going forward. But given such a spike in supply and improved growth expectations, something on the order of 50-75 basis points increase in the 10-year yield in the near-term is not unreasonable. 

It is also worth pointing out that with the dealers remaining cautious holding significant inventory and the Fed out of the picture, higher volatility in treasuries becomes more likely.


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3 reasons Yellen's FOMC remains dovish

What makes Janet Yellen and a number of other FOMC members so dovish with respect to monetary policy and in particular the trajectory of rate normalization? A Credit Suisse report sites 3 key factors, which Yellen calls  “unusual  headwinds":

1. Tighter fiscal policy.

The combination of lower government spending and tax increases has created a drag on economic growth (see chart). This drag is now diminishing, but given the tepid recovery Yellen still views it as a headwind.

2. Relatively tight credit in the mortgage market.

Janet Yellen: - " ... it is difficult for any homeowner who doesn't have pristine credit these days to get a mortgage. I think that is one of the factors that is causing the housing recovery to be slow. It’s not the only one, but I would agree with that assessment."

A recent study by Goldman compared current lending conditions in the mortgage market with the 2000 - 2002 period (supposedly "pre-bubble" period). The results indeed seem to point to tighter lending standards at this time (see chart).

3. Low household wage growth expectations.

While US wages have been growing at around 2% per year, expectations for growth remain depressed.

Yellen (see House testimony video below): - " ... households have unusually depressed expectations about their own future income gains. And I think weighs on their feelings about their own household finances and is holding back consumer spending."

Source: Credit Suisse

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The US Phillips curve

We've received some questions about the so-called Phillips curve - the relationship between inflation and unemployment. While there are a number of ways to look at the Phillips curve, the services inflation measures are more suitable than the broader price indices in order to assess the relationship. That's because goods inflation in the US can be driven by global trends, while services tend to be more US-specific.

Furthermore, rather than using the headline unemployment rate ("U-3") it is more appropriate to use the "U-5" measure which captures a broader group of unemployed or marginally employed workers. U-5 is defined as "total unemployed, plus discouraged workers, plus all other persons marginally attached to the labor force, as a percent of the civilian labor force plus all persons marginally attached to the labor force".

10 years of data (orange = current levels)

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The current ECB programs create a QE-like environment, setting up for moral hazards

In spite of weakening economic growth, persistent credit contraction, and dangerously low inflation rate in a number of member states (chart below), the ECB continues to resist calls for Fed-style outright securities purchases. Instead the central bank is betting on the recently announced TLTRO program (see post).

Source: Investing.com

The key reason for avoiding outright quantitative easing is, supposedly, the ECB's fear of creating a moral hazard. With a ready buyer of government debt and low market rates, some member states would no longer focus on cutting deficits.

Natixis: - The ECB’s problem is that it does not want to create incentives for governments to refrain from correcting fiscal deficits or avoid improving their public finance situation. What is rejected by the ECB is the moral hazard that would result from the central bank buying government bonds.

Fair enough. But a recent report from Natixis argues that the combination of the TLTRO lending and the OMT backstop program creates conditions that are nearly identical to quantitative easing.

Any QE program aims to increase the monetary base (by raising banks' excess reserves) and to push down longer term interest rates via securities purchases. As an extreme example of this, consider Japan's massive QE effort (see post). Both objectives have been met: long-term rates are at ridiculously low levels (0.53% on 10-year JGBs) while the monetary base is at a record.

Source: Investing.com, BOJ

Similarly (though not to the same extent) the ECB's programs will mimic QE without actually buying any government securities. Here is how:

1. Long term rates across the Eurozone are already at incredibly low levels. The ECB's forward guidance, weak growth, and recent geopolitical risks have pushed German rates to new lows (see chart). On the other hand the OMT program, often called the "Draghi put", has suppressed periphery yields. Furthermore, with short-term rates near zero and low capital requirements to hold sovereign bonds, the euro area banks have been loading up on this paper in a massive carry trade - pushing yields even lower.

Source: Investing.com

2. But what about increasing the monetary base? The expectations are that the TLTRO program will soon increase the Eurosystem balance sheet by as much as €700 billion. €300 billion of lending is expected to hit the banking system in September and the rest over the next couple of years. The monetary base will begin rising quickly.

The combination of the two items above is effectively QE. So how are the Eurozone member states reacting to this? Natixis argues that the QE-like environment has already created something of a moral hazard by encouraging these governments to pay less attention to their fiscal situation. If borrowing is easy and cheap, the temptation to keep on spending is too great for many politicians. 2014 deficits in a number of the member nations show minimal improvements.

Source: Natixis

Natixis: - The ECB accepts to go very far in the choice of expansionary monetary policies (very long-term repos [4-year TLTRO loans], de-sterilisation of the SMP [see post], forward guidance, purchases of ABS in the future), but for the time being it rejects the idea of quantitative easing with purchases of government bonds. The explanation is the risk that, if the ECB buys government bonds, governments may be encouraged to no longer reduce their fiscal deficits.

But this explanation is of a dogmatic and not an empirical nature: the measures already taken by the ECB have already encouraged governments to no longer improve their public finances. 

While optically the ECB's programs look different from QE, in reality the central bank has already launched a QE-like set of programs, setting up for a moral hazard which it has been desperately trying to avoid.

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Are the monetary policies in the US and the Eurozone diverging quickly enough?

There has been a great deal of discussion about the divergence between the monetary policy trajectories of the Fed and the ECB. Is the Fed behind the curve in exiting QE and beginning rate normalization (see story)? Is the ECB not acting aggressively enough to inject the necessary amount of stimulus (see story)?

One place to look of answers is the so-called Taylor Rule. While the inputs to the calculation can be quite subjective, it's a good relative measure of where policy rates should be given current economic conditions and target inflation rates. The two charts below from JPMorgan show that the Taylor Rule (appropriate) rates are now on the opposite sides of the policy (actual) rates. This would suggest that monetary policies of the ECB and the Fed would indeed have to diverge further. The euro area seems to require non-traditional accommodation (since policy rates generally cannot go below zero), while the Fed should begin rate normalization.

Source: JPMorgan

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PBoC follows other central banks in suppressing volatility

Staying with the theme of central banks dampening market volatility, China's central bank (the PBoC) has learned this game as well. China's short term rates had experienced enormous volatility last year, and the PBoC has been focused on suppressing these fluctuations.

Reuters: - China's decision to ease rules used to calculate loan-to-deposit ratios for Chinese banks (LDR) will moderate spikes in seasonal cash demand from regulatory requirements and thus help stabilise money market rates, traders say.

Regulators have been moving to stabilise money market rate volatility after a severe market squeeze in June last year rattled markets around the world, who misread a short-duration rise as a harbinger of money tightening.

It worked. The 7-day repo rate, which represents a fairly active secured lending market in yuan, has seen a substantial decline in volatility.

China 7-day repo rate

The combination of this policy to ease LDR rules and other stimulus efforts from Beijing has resulted in substantial increases in credit growth (see story) and quickened the expansion in broad money supply (see chart). It also translated into lower volatility in China's stock market.

The Shanghai Composite Index - see chart for historical daily volatility

Suppressing volatility has become a trend that is no longer limited to developed economies. Of course lower volatility is sure to result in declining return expectations and increased risk taking.

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From our sponsor:

The low volatility paradigm and diminishing return expectations

What happens in an environment - such as the one we are in currently - that is characterized by prolonged periods of low volatility? One of the effects of diminished price swings is the decline in return expectations. As an example, the chart below shows the spread demanded by investors in US high yield bonds vs. the volatility of total returns in that market.

This low volatility regime originates from the policies of major central banks, policies that have been both highly accommodative and relatively transparent - at least in the intermediate term. And any market conditions that are viewed as a form of tightening or rising uncertainty are often met with further accommodation. This is particularly true in the US. For example the markets’ negative reaction to the Fed’s looming taper last year was met with a delay and a reduction in taper’s size (“small taper”). The risk that monetary policy will materially deviate from markets’ expectations without the Fed making an accommodative adjustment has diminished significantly, resulting in lower volatility across the board.

Some have suggested that this Fed-engineered muted volatility regime is precisely the reason for low real interest rates. The reduced uncertainty around monetary policy trajectory results in lower volatility in fixed income markets, dampening return expectations. These lower return expectations mean that investors are willing to live with lower coupon in return for smaller swings in the value of their investments.

Deutsche Bank: - If pre-crisis rules for financial engagement [Fed’s involvement in the markets] raised both the volatility in the economy and the return in the economy, then reducing that volatility should reduce economic return. QED: the real rate of growth may be permanently both more stable and lower. … Returns in fixed income may depend progressively less on price and more on income.

The other effect of operating in a low volatility regime for prolonged periods is increased risk taking – often in the form of higher leverage. We've seen this manifested in higher NYSE margin debt and growing leverage of LBO transactions for example. Janet Yellen however continues to downplay the potential for asset bubbles and other threats to financial markets resulting from low volatility. The view at the Fed is that, at least for now, financial stability can be achieved through regulation - including containing asset bubbles. That assumption of course remains to be proven, given some of the past failures of sophisticated financial regulation (see example).

For now the markets have faith that regulation will indeed maintain financial stability in the face of highly accommodative monetary policy and low volatility. And as the low volatility regime becomes the norm, return expectations decline across the board and investors become lulled under the warm blanket of asset price stability provided by the central banks.

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More clarity from the FOMC on the mechanics of liftoff

The latest FOMC minutes provided some clarification on the approach the Fed is expected to take as it begins normalizing short term rates in the US. Here is a quick overview of the Fed's strategy and potential implications.

The Fed has chosen the interest rate on excess reserves (IOER) as the primary tool to control interest rates during the normalization process. While working with IOER is certainly more effective than the Fed Funds rate, there are a some drawbacks. As banks pay nearly nothing on deposits and earn an increasingly higher rate on reserves, the Fed will be criticised for providing banks with more riskless profits (on some $2.5 trillion of excess reserves).

To mitigate this thorny issue, the Fed will also rely on the reverse repo program (RRP). The FOMC now views RRP as playing a "supporting role" of providing a floor on repo rates. Keeping repo rates from getting too low will allow money market funds to offer higher rates to their clients. At least in theory that is supposed to provide competition for deposits, forcing banks to raise deposit rates and limiting the deposit-to-reserves arbitrage. The FOMC wants to see the spread between IOER and RRP at around 20bp or higher.

Fed Minutes: - The appropriate size of the spread between the IOER and ON [overnight] RRP rates was discussed, with many participants judging that a relatively wide spread--perhaps near or above the current level of 20 basis points--would support trading in the federal funds market and provide adequate control over market interest rates. Several participants noted that the spread might be adjusted during the normalization process.

For example the Fed could set IOER to 50bp and RRP to 30bp. That would put money market rates at say 45-60bp and bank bank deposit rates at something like 25-35bp (currently the national average is 11bp on bank savings accounts), capping the IOER-to-deposit-rate spread.

The FOMC seems to be uneasy about a more aggressive use of the RRP, fearing that in times of crisis the participants will pile all their liquidity into the Fed facility, draining the reserves, and taking liquidity out of the private sector.

Fed Minutes: - Most participants expressed concerns that in times of financial stress, the [RRP] facility's counterparties could shift investments toward the facility and away from financial and nonfinancial corporations, possibly causing disruptions in funding that could magnify the stress.

Some are uneasy with RRP becoming a "window dressing tool", tightening liquidity at quarter- and year-end (see post). The spikes will become particularly severe during periods of financial stress, potentially causing disruptions in private funding markets.

Source: JPMorgan

Some of the Fed officials are also afraid that the Fed could quickly become the dominant player in the repo markets, potentially resulting in some "unintended consequences". RRP will therefore continue to have limits per counterparty and is not expected to persist as a tool much beyond the period of rate normalization.

Some market participants had hoped that the RRP program will release the much needed "quality" collateral into the system, alleviating collateral shortages. The rise in treasury delivery fails continues to plague the markets (see discussion).

Source: JPMorgan

The RRP's impact on collateral shortages however is expected to be limited. Part of the issue (in addition to the RRP being more limited in scope) is that the Fed posts treasury collateral via "tri-party" repo transactions. These securities are held by a custodian bank and will generally not be "reused" as collateral elsewhere.

JPMorgan: - Higher margin requirements as a result of recent regulations on OTC derivative markets, for example, have caused a rise in collateral demand. But securities held within the tri-party system in the US are typically not allowed to be used to satisfy margin requirements. This means that the USTs released via the Fed’s ON RRP facility will not have the same effect in alleviating increased collateral demand stemming from higher margin requirements, than if the Fed had directly sold these UST securities to open markets.

The shortage of collateral will continue to persist even after the end of quantitative easing, which has permanently removed too much collateral from private holders. The only solution is for the Fed to sell some of its holdings, a scenario which remains highly unlikely.

Once the FOMC is ready, the announcement of the rates "liftoff" will be accompanied by the following rate settings:

1. The Fed Funds target and the Discount window rate (traditional tool).
2. The IOER rate
3. The overnight RRP rate (20b or more below the IOER rate) and the size limit per counterparty

Other suggested tools such as term deposits (which the ECB has been using in a limited fashion for some time) are unlikely - too many moving parts for the FOMC.

Assuming things are going OK some time after the "liftoff", the Fed will announce the end of reinvestment, allowing the securities it holds to mature. This will need to happen as soon as possible in order to begin increasing the amount of collateral held by private participants.


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From our sponsor:

The diminishing returns of fuel efficiency

As vehicles become more fuel efficient, the savings one obtains by further improving the mileage decline substantially. As an example, assume a driver saves $700 per year by switching from a 12 mile/gallon car to a 15 mile/gallon one. Now if that same driver has a car that gets 30 miles/gallon, she would need to switch to a 60 mile/gallon car in order to achieve the same $700 savings. In fact the incremental savings for each additional mile/gallon declines as the inverse square of a car's fuel efficiency.

This does not bode well for the future of alternative fuel automobiles. Saving $700 a year, as the example below shows, may not be worth paying additional few thousand dollars for a car that may be less convenient to "fill up".

Furthermore, as traditional gasoline cars become more fuel efficient, the savings associated with switching fall off sharply. In another few years, unless gasoline prices shoot through the roof (which is not likely), alternative fuel cars (such as electric) will increasingly be more of a "luxury" item rather than a money saving form of transportation. It's just basic math. 

EIA: - As light-duty vehicle fuel economy continues to increase because of more stringent future greenhouse gas emission and Corporate Average Fuel Economy (CAFE) standards through model year 2025, standard gasoline vehicles are expected to achieve compliance fuel economy levels of around 50 mpg for passenger cars and around 40 mpg for light-duty trucks. Diminishing returns to improved fuel economy make standard gasoline vehicles a highly fuel-efficient competitor relative to other vehicle fuel types such as diesels, hybrids, and plug-in vehicles, especially given the relatively higher vehicle prices projected for these other vehicle types.

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Watching for signs of US housing market activity

The US housing market remains sluggish, as wages, at least at the national level, have not kept up with the recent price appreciation (see post). The reason for these higher prices is that housing inventories remain tight, particularly in the more desirable areas. A great deal of the inventory has been picked up by "cash buyers" that include domestic and foreign investors (including professional investment firms). These investors accounted for over 40% of the homebuyers in the first half of 2014.

Source: Capital Economics

The hope is that with this tight inventory levels we will see more residential construction, even if a great deal of it will go to meet rental housing demand. The recent recovery in lumber futures suggests that construction, which has stalled recently, may be improving again.

Sep-14 futures (source: Barchart)

Another indicator suggests that US homeowners are taking advantage of the tight inventory. The prepayment speeds on 30Y FNMA MBS securities with low coupon have picked up again. The 2.5% and 3% 30Y MBS contain mortgage pools of loans with interest that is significantly below current mortgage rates. Therefore prepayments in these pools mean that these homeowners are selling their homes (nobody would want to refinance into a higher rate mortgage). Sales were expected to pick up this time of the year, but some analysts have been a bit surprised at how quickly prepayment speeds recovered.

Source: JPMorgan

Both of these signs point to improving activity in the US housing market. It remains to be seen however whether this is sustainable or simply a temporary response to lower mortgage rates.

30y fixed mortgage rate (source: bankrate)

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From our sponsor:

Speculative activity in WTI

Crude oil technicals are not looking great, as the speculative accounts are becoming increasingly net long WTI futures. This is “fast money” chasing a quick Iraq-driven spike. What if it doesn't happen?

While the Iraq risks are quite real, the market remains well supplied and significant price declines are quite possible.

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From our sponsor:

The skills mismatch remains a fixture in US labor markets

The Beveridge Curve, a scatter plot of job openings vs. the unemployment rate, continues to show a structural shift in US job markets.

See this for the definition of the U-5 unemployment rate 

A large part of this shift is the skills mismatch. Companies are increasingly looking for skilled and experienced workers and are having a tough time filling those openings. If you are in retail for example, you will have no problems getting part and full time workers to stock the shelves in your store or run the cash register. On the other hand finding someone with the skills to run a store, even a really small one, is becoming more of a challenge. You'll get dozens of resumes to be sure, but very few with the right qualifications.

One can see this effect in the small business survey data, as more firms are having a tough time filling openings. The US has millions of unemployed or "marginally attached" workers, yet these are not the workers companies want.

Some would say that the reason firms are not getting the workers they want is poor pay. But if you are unemployed - and those of us who have been there know - low pay generally beats the unemployment benefits. Furthermore, at least across small businesses, pay is on the rise. No, it's nothing like it was before the recession, but those days are long gone.

Source: NFIB

Another sign of the American skills mismatch is small business consistently complaining about the quality of labor - something that was much less of an issue a year ago.

Source: NFIB

We can see other examples of this broadening skills gap here and here.

Wages for skilled workers will rise faster than the national average as demand grows. Unfortunately those with limited skills will continue to struggle with stagnant wages and limited opportunities. The days when unskilled workers could easily get a well-paying job in construction are not coming back for some time. Welcome to the New Normal.

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From our sponsor:

South Africa's increasing economic uncertainty

When looking at risks across some of the larger emerging markets nations, South Africa stands out, with a number of analysts and rating agencies increasingly ringing alarm bells. Here are some key risk factors to consider:

1. The recent labor strikes, particularly in the mining sector, have been devastating to the nation's economy. And more strikes are on the way.

VoA: - A strike by 220,000 engineers and metalworkers has dealt major blow to South Africa's economy.

The labor dispute has been marked by violent clashes between police and striking workers and reports of looting and intimidation by union members.

The strike comes just a week after settlement of a five-month-long strike by platinum workers. The walkout cost three main platinum mining firms $2.25 billion in lost revenue

General Motors South Africa halted operations last week because a strike at the parts supplier paralyzed it production (see story). Unions are becoming increasingly militant, with communist-based rhetoric often sounding like what we had heard in Zimbabwe. "Wealth redistribution" language is catching on.

2. The nation's debt levels - both private and public - are rising faster than it peers. With weak currency, this problem is expected to only worsen in the nearterm.

Source: Fitch Ratings

3. Simultaneously banks are tightening credit in fear of rising defaults, as the consumer comes under pressure.

Source: Barclays Capital

4. The consumer situation has not been helped by rising inflation, which is a direct result of the South Africa's currency depreciating over 30% during the past two years. Inflation has exacerbated demands for higher wages, leading to some of the labor strikes we see today.

5. The nation's unemployment rate (officially at 25%) has worsened, and some are calling the current labor situation a "ticking bomb".

US News: - The unemployment figures for South Africa's youth are staggering. Officially, youth unemployment (ages 15-34) has gradually risen to 36 percent. Many believe that real unemployment among that population is closer to 50 percent. Only 37 percent of the youth labor force has a high school degree. Of those who failed to get a high school degree, unemployment is at 47 percent, officially. A decade ago, a person with a high school degree had a 50 percent chance of getting a job. Today, that figure is 30 percent. Census estimates are that more than 3.2 million young South Africans between the ages of 15-24 are neither employed or engaged in education or job training. According to South Africa's Labour Force Survey for the last quarter of 2013, two-thirds of all unemployed South Africans were under the age of 35. This is a ticking time bomb in the belly of the nation.

To be sure, South Africa, a nation of incredible beauty and abundant mineral resources, remains a mining powerhouse. Yet after years of underinvestment, its energy infrastructure is increasingly inadequate to support the economy - with constant brownouts/blackouts becoming a part of life. Skilled professionals continue to leave the country in droves, generating a significant "brain drain". And land redistribution programs have brought up concerns over a Zimbabwe-style land reform. Moreover, a recent drive by some populist politicians to nationalise the country's mines raises the risk of declining investment and further economic deterioration.

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From our sponsor:

Merkel goes to China to halt German economic slowdown

The yield spread between US treasuries and German government bonds hit a new high last week (see chart). Was this divergence in rates simply a response to the ECB action last month (see post) in combination with stronger jobs data in the US or is there more to it?

Part of the answer has been softer than expected economic data out of Germany. The nation that had pulled the euro area out of its recession has been experiencing some headwinds. Germany's recent expansion has been partially driven by exports - both to the Eurozone and to elsewhere. And while the nation's domestic demand remains relatively strong (see German retail PMI), weakness in exports is beginning to show.

Source: Barclays Research

Signs of this growth moderation have been visible for some time now, including the manufacturing PMI report (see chart), softening economic sentiment (chart below), and even weaker employment figures (see story). Most economists did not anticipate this, and some have attributed it to weaker growth in China.

Source: Zentrum für Europäische Wirtschaftsforschung GmbH (ZEW)

To be sure, German economic growth remains strong on a relative basis. Many also expect a better second half, as China's economy picks up (see chart). Some of this optimism comes from the fact that the US consumer is finally tapping those credit cards (see chart) and driving up imports (see chart). Moreover, the German government remains heavily focused on business expansion abroad, particularly given the recent slowdown (what a novel idea - a business-focused administration).

Xinhua: - Angela Merkel is paying another visit to China this weekend - her 7th trip to the Asian powerhouse as German Chancellor, leading a high-level economic delegation.

German analysts believed Merkel's trip is aimed at keeping the dynamic in the current Sino-German relations going further. Given that the bilateral economic relationship has quickly developed, economy is widely regarded as the focus of the chancellor's visit.

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The Bank of Japan's QE program diverges sharply from other central banks

Many investors seem unaware of just how large Japan's QE program has been relative to other central banks. While the Fed, the ECB, and the BOE have roughly converged to the same level (as a proportion of their GDP), the Bank of Japan's balance sheet is more than double that of its counterparts abroad.

Source: BIS

The official goal of course is to stimulate credit growth to the private sector by lowering longer term rates and boosting excess reserves in the banking system. The 10-year Japanese government bonds now yield 0.57% and the reserves have indeed spiked.

Source: BOJ

But while we've seen small improvements in bank lending, credit growth in Japan remains tepid.

The primary reason for this trend has to do with the lack of demand for credit. Both households and companies are loathe to take on debt. One can't blame them of course - taking on fixed liabilities with looming risks of deflation is dangerous (imagine watching your assets depreciate, while liabilities remain fixed.) And as we saw in the US (see chart), other than during periods of frozen credit markets, quantitative easing has not been shown to be very effective in stimulating credit expansion.

As a prerequisite to get people to borrow, one needs a stable inflation rate. And while the BOJ has achieved higher inflation, question linger about its stability. A great deal of the price increases has been achieved by weakening the yen (see post). The yen depreciation however has been halted, with USD/JPY exchange rate remaining remarkably stable.

Chart shows US dollar appreciating against the yen (yen depreciating) during 2012-2013

In order to have a sustainable inflation rate, Japan needs stable economic growth that supports wage increases. But economists continue to question the nation's ability to maintain momentum.

CNBC: - "Economic activity has indeed picked up since the QE program began early last year, but there are now serious warning signs that this progress may not be maintained," Adam Slater, senior economist at Oxford Economics wrote in a report.

In the short video below Takuji Okubo questions a number of assumptions regarding the economy and wages in Japan.

All this will come to a head in October of this year, when growth and in particular the inflation rate will be benchmarked against the BOJ's target levels. If the projections are unsatisfactory, as some expect, the BOJ will be forced to accelerate the quantitative easing program. The already massive divergence between BOJ's balance sheet and that of the other major central banks will increase further.

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Some thoughts on slowing house price appreciation in the US

As discussed earlier (see post), home price increases in the US are slowing. One of the reasons for the slowdown is the continuing weakness in wage growth. The latest data seem to indicate that in spite of the overall improvements in job creation, wage growth remains subdued - hovering around 2% per year over the past 3 years or so.

And wage growth is a key determinant in home price valuation. Merrill Lynch for example shows that current home prices may already be above where they should be, based on Merrill's "fair value" index (that is driven to a large extent by wages).

Source: BofA

The other issue holding back home prices from accelerating is credit. Credit conditions for mortgages remain relatively tight and in fact have worsened for non-traditional mortgages.

That's why it remains challenging for the housing sector to maintain momentum, as we see residential construction spending stall.

Of course this is the situation for the nation as a whole. Underneath all this we have quite a bit of variability. Skilled workers are more likely to have higher paying jobs, are able to get mortgages, and are buying homes. House prices in certain areas are rising much faster than what we see in the national averages. In many cases there are simply not enough homes. Yet in other areas, the situation remains stagnant in terms of wages, credit, and the housing market. This divergence, although not visible at the national level, is growing.

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Window dressing with the Fed's reverse repo program

If you are a bank or even a money market fund, you probably want your financials to show the maximum amount of your overnight liquidity placed with the Fed's RRP rather than with other banks. Your balance sheet looks less "risky" this way. And since most financial reporting is done at quarter end (with mid-year and year-end being the most important dates), you want to place your cash with the Fed on the last day of the quarter for one night and then take it out. And that’s exactly what’s taking place currently.

Why not leave your liquidity with the Fed for a longer period? Because the Fed's current RRP rate pays 5 basis points, while the private repo market is paying about double that. Of course as cash is pulled out of the repo markets for quarter-end and moved to the Fed or elsewhere, rates in the private markets rise. Once the liquidity comes back to the private markets at the start of the new quarter, the repo rates return to normal.

Source: DTCC

The larger the RRP program becomes, the stronger this quarter-end effect will be. Welcome to the wonderful world of window dressing.

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Reasons for the spike in M&A activity

As predicted back in April (see post), US M&A activity accelerated in Q2, resulting in the most active first half since 2007.

WSJ: - Indeed, there have been 20 merger deals valued at more than $10 billion this year, the biggest total for the period since the first half of 2007, according to Dealogic. Most bankers, whose near-term views of the market are informed by the pipeline of unannounced deals they are working on, are optimistic the second half will be strong too. Many cite the possibility the big-deal boom—which has been largely confined to the telecommunications, media and technology and health-care sectors—will broaden.

Reasons for the spike vary from low financing rates and easy access to debt capital markets to strong equity prices, with shares used as acquisition "currency". Limitations to internal costs cutting also drove companies to consolidate externally.

WSJ: - There are a number of currents driving the increase in deal activity, bankers say. Among them: low interest rates, which make it relatively easy to borrow cash for acquisitions; lofty stock prices, which give companies a strong currency to pay for deals; and encouragement from shareholders, who have been lately bidding up the stock prices of companies that have made takeover bids. What is more, companies did a lot of internal restructuring during the M&A lull—building up big cash piles in the process—and there is less of that to do now, bankers say. That means that, in many cases, companies must search externally for cost-cutting opportunities, like acquisitions of rivals with overlapping operations that can be shed

Source: MergerMarket

The greatest reason for increased M&A activity however has been the decline in uncertainty (see chart). While many economists, bloggers and the media continue to ignore this factor, policy uncertainty - more than any specific policy - has been the key drag on economic activity in general and deal making in particular.

WSJ: - ... unlike in recent years, when a seemingly endless parade of ... concerns presented themselves, starting with the financial-markets meltdown and leading up to the European debt crisis and budget battles in Washington. At least for now, such impediments to deal making are largely dormant, they say.

Gregg Lemkau, the co-head of global M&A at Goldman Sachs said that, in recent years, when he would pitch possible deals to clients, they would often say: "Good idea—come back in six months and we'll discuss it."

"There was always some looming event, real or contrived, that companies wanted to wait to get past," added Mr. Lemkau. Now, he said, "There's no obvious macroeconomic event out there that people are waiting to get beyond."

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