Markets signaling return of economic weakness in China

In addition to property market challenges and the unexpected slowdown in manufacturing expansion, we continue to see markets signaling a significant loss of momentum in China's economic growth. Earlier in the year the country's economic trajectory was quite uncertain. This was followed by a strong pickup in manufacturing activity early this summer and economists suggested that the worst is over. But it seems that China is once again facing significant headwinds.

The nation's industrial commodities are hitting new lows, particularly iron ore and the Shanghai-traded steel rebar.

Iron Ore 62% Fe, CFR China; Jan-2015 contract (barchart)

SHFE Steel Rebar January 2015; Jan-2015 contract (barchart)

Other commodities linked to construction, such as fiberboard, have been declining as well. Moreover, the recent stock market rally has stalled. Perhaps the most telling sign of weakening fundamentals in China has been the nation's rates market. Rates implied by SHIBOR-based interest rate swaps have declined materially over the past month. More importantly the yield curve has become inverted.

Swap rates by maturity (yrs)

As discussed before, economic weakness in China is reverberating globally - from Australia to the Eurozone - and is in part responsible for the bond yield compression across developed economies. We are likely to see the central government step in with more stimulus in order to stabilize the situation. However, as Beijing is beginning to realize, limited new stimulus directed at boosting growth is becoming less effective. A much larger effort may be required.

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Market reaction to weakening fundamentals in Germany

The German business climate index tracked by the Ifo Institute declined more than expected this month, making it the 4th drop in a row.

The Guardian: - German business sentiment dropped for a fourth straight month in August as concerns about the Ukraine crisis and the effect of sanctions against Russia swept through corporate boardrooms in Europe's largest economy.

The Munich-based Ifo thinktank's business climate index, based on a monthly survey of about 7,000 companies, fell to 106.3 from 108, below the Reuters consensus forecast of 107.

A large part of the decline was of course due to the Ukraine crisis, but that was not the only cause of Germany's deteriorating private sector growth. Slowing exports to the rest of the euro area nations due to weaker demand as well as persistent economic headwinds in China (see discussion) have contributed as well.

This means that Germany is unlikely to support any further sanctions on Russia and will make a concerted effort to stabilize the situation (in spite of any pressure from the US).

The market reaction was swift, with the 10-year Bund yield hitting another record low.

Investors also piled into the three-year government notes, sending those yields into negative territory for the first time since 2012. The German government is now getting paid to hold your euros for three years.

In fact the nominal yield curve is in the negative territory all the way through the three-year point and showing signs of inversion - with the 1-year yield higher than the 3-year.

The euro dropped below 1.32, with rising expectations of diverging monetary policies between the US and the Eurozone. This was fueled in part by the Jackson Hole conference where Janet Yellen's speech was not as dovish as some had expected. The currency weakness will deliver some much needed relief for the euro area by helping the exporters and by providing some support to import prices. Currency weakness is one way to arrest deflationary pressures – the Japanese way.

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Watching for signs of economic deterioration in Brazil

Staying with the South America theme, we are seeing signs of economic troubles in Brazil. To be sure, the nation is still an economic powerhouse – the 7th largest economy in the world. Yet the end of the China-driven commodity supercycle has created significant headwinds for Brazil's economic growth.

Here are some key indicators economists are watching for signs of further deterioration:

1. In recent months industrial production has been declining at the fastest rate since 2009.

2. The labor markets remain under pressure, resulting in declines in consumer confidence.

Source: Reuters

3. While the consolidated public sector accounts (including state-owned enterprises) remain in the black, the surplus levels continue to shrink. Fiscal deterioration remains a major risk.

Source: Credit Suisse

4. Even though the nation's banking system has been relatively sound, credit extended by banks to the housing sector has exploded in over the last 5 years. If the economy stumbles, this could become an issue.

h/t @cigolo

With economists now projecting Brazil's GDP growth of just 0.79% for 2014 and the national elections approaching, the central bank is injecting new liquidity into the banking system. As usual, central bankers are asked to solve what amounts to structural problems - which they try to address with the only tools they have.

FT: - Brazil has made its second multibillion-dollar injection into the banking system in less than a month as the government struggles to boost the economy ahead of hotly contested presidential elections.

The central bank on Wednesday eased rules on reserve requirements, freeing up about R$10bn ($4.5bn) for new lending. Just over three weeks ago, it injected R$45bn into the economy by easing compulsory deposit rules and changing the risk calculation of some loans.

While the nation faces a number of economic headwinds, the near-term risk for Brazil stems from the US monetary policy. If rates in the US rise faster than expected, we may revisit the volatility of 2013 (and early this year), as taper fears and capital outflows had sent the Brazilian currency and debt sharply lower (the 10-yr yield reached 13.5%).


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Argentine peso hits record lows on increased uncertainty

Argentina is showing signs of stress, as the official exchange rate has the US dollar now quoted 8.4 pesos - a new record.

Chart shows USD appreciating against ARS (source: Investing.com)

The "parallel" exchange rate also hit a record, with the dollar quoted at 14 pesos - a 67% premium to the official rate. Note that before the first devaluation in 2002 (see this NY Times story) it was one peso to the dollar.

Source: Dolar Blue

As discussed earlier (see post), this peso decline should not be a surprise. The latest development in the default saga however is Argentina's recent attempt to pay the "non-holdout" bondholders by allowing them to convert to local bonds.

NY Times: - The government moved on Wednesday to push legislation through its Congress that would give foreign investors in the country’s debt the ability to swap their defaulted bonds for new ones subject to local law, thus skirting a United States court order that has blocked its ability to make bond payments.

But it seems quite unlikely that these investors will want to convert, leaving this matter unresolved.

NY Times: - But the draft of the legislation, which was first announced on national television late Tuesday by Cristina Fernández de Kirchner, Argentina’s president, has raised more questions than answers among investors who are looking for a solution to the country’s debt predicament.

The uncertainty, combined with deteriorating economic fundamentals is sending depositors and investors out of the country, pressuring the peso. Foreign reserves are likely to dwindle materially by the end of the year as a result, further exacerbating the crisis.
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Deutsche Bank: Ignoring food price pressures could be a mistake

Economists and central bankers tend to be less focused on what consumers pay at the grocery store because food and energy prices have historically been more volatile - remember, it's just "noise". However what they can't ignore is how shoppers view inflation - i.e. inflation expectations. And food prices have a significant impact on households' views on future inflation.

Deutsche Bank: - ... food prices factor significantly into households’ perceptions of overall price pressures. This is illustrated in the following figure, which shows year-ahead inflation expectations from the University of Michigan Survey of Consumer Sentiment versus CPI food. In fact, it is worth noting that CPI food demonstrates a higher degree of correlation with one-year price expectations than either the headline or core metrics — and it similarly surpasses energy, core goods, core services and shelter. ...  while forecasters are focusing on service-sector inflation in general and shelter inflation more specifically, they should be careful to not ignore mounting food price pressures, because this category could provide important insight toward the evolution of inflation expectations. If food price inflation accelerates, as we project, the stability of inflation expectations could degrade - and this would be a vexing development for monetary policymakers.

Source: Deutsche Bank

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A look behind the headline housing starts report for the United States

As discussed in yesterday's post on residential construction, today's report on US housing starts indeed showed significant improvements.

Investing.com

However, this is only part of the story. The number of housing starts for single-family units remains to a large extent range-bound (see chart). A great deal of the new housing growth instead is coming from multi-family construction (see chart). And that's driven by the rapidly rising demand for rental housing in the US, as shortages become more pronounced (see post). Rental vacancies are now at the lowest level in 17 years and falling.

This demand is also visible in the latest report on inflation, which came out today as well. Rent expenses are now growing considerably faster than the CPI as well as US wages - a dangerous trend.

Rent inflation vs. Core CPI

The trend of rental units dominating housing starts growth is likely to continue as homeownership rates decline. Adequate supply of new multifamily housing will be critical in years to come.

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Signs of improvement in residential construction

Despite tepid wage growth in the US and Dodd-Frank-driven headwinds for mortgage lending (see post), two signs point to moderate improvements in residential construction.

1. The homebuilder optimism index recovered more than forecast.

2. Lumber futures have risen materially from their lows in June.

Sep lumber futures contract (barchart.com)

At this point it is difficult to say whether this construction improvement relates to new home purchases or new rental units. Given the looming rental market shortage in the US (see post), we are certainly going to see more apartments built in the near-term.

And while nobody expects a major boom in construction employment across the country, there is definitely room for improvement.

US construction jobs

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10-year JGB yields near 0.5%

The 10-yr government bond yield in Japan is now around 0.5%, following an almost linear decline that started in 2006. The only way to rationalize buying 10-yr JGBs at 0.5% is believing that Japan will have a deflationary environment over the next decade and/or the central bank will absorb (or even monetize) the bulk of new issue bonds.

Moreover, these record low yields will do some serious damage to the Government Pension Investment Fund, which invests two thirds of its assets into local bonds. A significant portion of the population will tap the pension fund in the next 10 years. There will also be pain for Japan’s insurance industry that now faces a nasty asset/liability mismatch.

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Further signs of China's slowing property markets

China's official housing index now shows home price appreciation slowing faster than some had anticipated.

Source: Investing.com

Other indicators are also pointing to weakness in China's housing markets. For example the number of cities with falling prices has spiked sharply.

Source: Scotiabank

Furthermore, the steel rebar futures in Shanghai - an important real-time indicator of construction demand - remain under pressure.

Jan steel rebar futures in Shanghai (barchart.com)

Related to the trends in residential housing, China's commercial floor space and the number of commercial buildings sold has declined materially recently (based on official reports).

Source: National Bureau of Statistics

There is no question that Beijing has the wherewithal and the will to support the housing market should things unravel faster than the government likes. Nevertheless, given how pervasive property markets are in the nation's overall economy, concerns among global investors are rising with respect to China's housing slowdown.

Scotiabank: - On the theory that where there’s smoke there's fire (and it’s not just because I’m BBQing), weak company financing and concerns surrounding potential defaults in the shadow banking sector coupled with — and likely driven by — further evidence of falling property prices will only amplify the concerns.

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Rate hike expectations in the UK shift further into 2015

The UK's latest inflation report has shifted the expectations of the first rate hike by the Bank of England.

The Guardian: - August inflation report laid bare the dilemma over the timing of the first rise faced by the Bank's policymakers, who are struggling to reconcile rapidly falling unemployment and record employment with very weak wage growth [see chart].

On the one hand, members of the Bank's rate-setting monetary policy committee (MPC) revised down their estimate of spare capacity in the economy to 1% of GDP from a May forecast of 1-1.5%, as employment growth rockets.

The Overnight Index Swap (OIS) curve shift shows the impact of the inflation report on the timing of the first 25bp hike.

When combined with the current geopolitical uncertainty, the UK inflation report should keep the BOE on hold well into 2015. The fear of rate normalization has been pervasive across major central banks and dovish attitudes are likely to prevail at Jackson Hole (see quote). Once again, the longer the central banks delay the start of this process, the more difficult and disruptive the exit will ultimately be.

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The Beveridge Curve hysteresis and the long-term unemployed

The US Beveridge Curve has undergone a full cycle, with the job openings rate now matching the highest level over the past decade. Yet the return path has been consistently shifted from the trajectory the curve took going into the recession. We now have far more unemployed and underemployed workers for the same level of job openings.

According to CIBC, if this Beveridge Curve gap were to close (the pre-recession and the post-recession paths converged), the unemployment rate would drop to 5.7%. It means that the US already has the jobs to bring the unemployment rate close to the FOMC's long-term forecast but many of those openings remain unfilled.

Source: CIBC

The Beveridge Curve is exhibiting what's known as "hysteresis", most commonly observed in magnetic properties of materials. Here is a good explanation of the process:

Once magnetic field is applied to a piece of metal, the metal will "remember" the orientation of the magnetic particles. When the field is reversed, it takes more strength to undo the existing magnetism before the piece changes polarity. ... This process is typically associated with a curve like the following, where the X axis shows the force being applied (e.g. the magnetic field) and the Y axis shows the effect (e.g. the magnetic orientation of a piece of metal subjected to the field): 

In labor markets the concept of taking "more strength to undo the existing magnetism before the piece changes polarity" is equivalent to requiring more job openings than in the past to return the same number of people to work as was lost during the recession.

The Beveridge Curve downward path has created a tremendous number of long-term unemployed and the nation is having a tough time reabsorbing them back into the workforce - even as job openings improve sharply.

Part of the reason is that companies and even government agencies are uneasy about hiring someone who has been out of work for too long even when there is a significant need to add more employees. Furthermore, many of those in the chart above lack the skills that employers are now looking for (or their skills are viewed to have "gone stale"). In contrast, short-term unemployment levels are now around pre-recession lows.

Note that the downward spikes represent temporary retail holiday hiring
that hasn't been properly seasonally adjusted. 

What we want to watch closely going forward is whether the Beveridge Curve gap begins to close (the top of the hysteresis curve), which would be a possible sign of long-term unemployed workers' "reabsorption". For now however, the skills gap is keeping many without work or out of the labor force altogether.

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Geopolitical risks hit US consumer

Today's University of Michigan consumer sentiment report demonstrated how the current geopolitical uncertainty is impacting US consumers. The "Current Conditions" subindex is now at the highest level since the recession (beating forecasts), while the "Expectations" subindex declined sharply (worse than forecast). US consumers are feeling better about their current situation but have become increasingly jittery about the future.

Apologies for the different time scales - it's the only data that was available (Investing.com)

While the current events in Eastern Europe and the Middle East are likely to have a smaller impact on the US than the EU, Americans have certainly become more cautious. It remains to be seen how much of this decline in sentiment will translate into weaker consumer spending. In the post-recession economic climate it doesn't take much for US households to pull back spending.


Update: See more info and better chart here. Also see similar effect in the ECRI weekly leading index here.
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Eurozone banks hold record amounts if sovereign paper

The Eurozone's financial regulatory framework, combined with the ECB's monetary policy, has created an environment in which holding sovereign bonds is the optimal outcome for many of the area's banks.

Source: Natixis

This has two major consequences:

1. Government bonds crowd out private sector credit, limiting loan growth in a number of countries.

2. Banks are becoming more intertwined with their central governments - something that was part of the cause of the debt crisis. Governments depend on banks for cheap funding and banks depend on their governments for support (bailout) in case of a liquidity crunch.


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Argentina's blue dollar market hits 60% premium to official rate

In the face of inflation running at 25-30% - one of the highest rates in the world - Argentina unexpectedly decided to cut interest rates yesterday. It is difficult to say how the government justifies this madness, but here we are. Combined with the nation's recent default and no settlement on the horizon, the rate decision sent the nation's currency to record lows.

WSJ: - The decision to cut rates will likely be seen as a sign that Economy Minister Axel Kicillof's plans to stimulate the economy are prevailing over central bank Governor Juan Carlos Fabrega's effort to curb inflation, analysts said. ...

Argentina's peso weakened to 13.15 to the dollar on the black market Wednesday, breaking the previous record of 13.10 in January when the government devalued the peso 20%, according to newspaper El Cronista, which tracks black-market exchange rates. The peso was stable at 8.2730 on the regulated exchange market.

... The dollar has been especially coveted for the last three years, given rampant government spending that has fueled one of the highest rates of inflation in the world.

Currency controls were imposed almost three years ago to prevent foreigners and locals from depleting the central bank's reserves by changing their pesos into dollars.

The black market peso continued to slide this afternoon, with quotes hitting 13.3 pesos per one dollar. The so-called "blue dollar" is the unofficial market for US dollars in Argentina (there is also the "blue euro" market).

At this rate the blue dollar is at a 60%+ premium to the official exchange rate (dollars cost 60% more in the black market).

Unless we see some sort of settlement on the defaulted debt and the resumption of coupon payments to all the bondholders (see post), Argentina will unravel rapidly. Another official currency devaluation becomes increasingly likely, pushing inflation to new highs and making Argentina look increasingly like Zimbabwe. With no ability to access international debt markets, foreign reserves will begin to run out and shortages of imported goods will become commonplace. Violent unrest is sure to follow.


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What has been supporting gold prices?

As the chart from Reuters shows, gold has outperformed all the major asset classes this year.

Most explanations for these results point to the various geopolitical risks that have generated jitters across a number of markets. However there is another explanation. Expectations that monetary policy will remain loose across major economies longer than originally anticipated have been driving gold higher. Here are some key indicators supporting this thesis:

1. As discussed earlier (see post), China's monetary policy continues to be quite supportive for credit expansion.

2. Japan's growth will likely fall short of BOJ's projections (see chart), prompting the central bank to accelerate QE or at least maintain it over a longer period. Credit Suisse: "We see additional BoJ easing coming in November."

3. The Australian unemployment rate has been considerably higher than expected (see chart), suggesting that the risk to the RBA rates is to the downside (or at least low for a longer period of time).

4. Economic reports from the euro area continue to point to a slowdown (chart below), and while the ECB is unlikely to undertake outright QE or other such measures, the expected period of accommodation has clearly been extended. This is particularly true with inflation rates in a number of member states at dangerously low levels (see chart).

Source: Centre for European Economic Research (ZEW)

5. While the US recovery remains stable and the Fed continues to taper securities purchases, the "effective" monetary policy has become looser that it was a year ago. One can gauge this by looking at longer-term real (as opposed to nominal) rates. The 10-year real rates in the US for example have been declining, now below 20bp. That is clearly an accommodative trend.

6. Even in the UK where we had some saber rattling from the BOE about potentially raising short-term rates in 2014, real yields of government bonds remain deep in the negative territory across the curve.

The level of monetary accommodation in world's major economies remains quite high, with little indication of near-term withdrawal. That has provided substantial support for gold prices and may continue to do so in the near future.

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Loose policies from Beijing help pump the credit bubble

If you read most media reports on People's Bank of China's latest monetary policy direction, it would seem that the central bank has only been focused on some targeted stimulus initiatives.

Want China Times: - China's central bank said on Wednesday that it will continue to implement a targeted approach in monetary policy in the second half of 2014 and shore up weak links in the economy.

More financial support will be provided to rural areas and small businesses to reduce their financing costs, according to a statement on the website of the People's Bank of China.

But are the central bank's initiatives truly as limited in scope as these stories would make us believe? Recently the PBoC has been experimenting with some unconventional policy tools that make it rather difficult to assess how loose the overall policy has been.

Xinhua: - The People's Bank of China has developed two or three monetary tools to guide short- and medium-term interest rates via an effective monetary policy transmission mechanism, said PBOC Governor Zhou Xiaochuan on the sidelines of the China-US Strategic and Economic Dialogue in Beijing on July 10.

Pledged supplementary lending [PSL], a lending instrument backed by collateral, is a new monetary tool to guide medium-term interest rates.
...
"The PBOC is becoming increasingly reliant on innovative monetary tools. It's trying not to adjust interest rates or the reserve requirement ratio, because these aren't good measures to control the direction of capital flows. So the central bank is putting greater emphasis on targeted adjustment by using tools like re-lending and PSL," Zhu said.

And there are other indicators of China's monetary policy, such as loans to the private sector (below) and the exchange rate policy.

Bloomberg has developed an index that combines some of these measures in order to assess just how loose the overall monetary policy has been. The results seem to indicate that the level of stimulus has actually been significantly higher than one would surmise from the media reports.

BW: - China loosened monetary conditions last quarter at the fastest pace in almost two years, a Bloomberg LP gauge showed, testing the waning effectiveness of credit in supporting economic growth.

Bloomberg’s new China Monetary Conditions Index -- a weighted average of loan growth, real interest rates and China’s real effective exchange rate -- rose 6.71 points to 82.81 in the second quarter from the previous three months. That’s the biggest jump since the July-September period of 2012, with May and June’s numbers the first back-to-back readings above 80 since January 2012.

With the inflation rate subdued (chart below) the PBoC has been free to let the flow of credit going full speed.

In fact the overall credit expansion across China - including the so-called "shadow banking" - has been tremendous.

Source: Scotiabank

And while some have been expecting a slew of defaults this summer by a number of overextended companies, the availability of easy credit allowed firms to simply roll their debt - for now.

Scotiabank: - One reason why the feared wave of summertime defaults out of China’s shadow banking system has yet to emerge is that China’s credit cycle is not slowing down and so credits are generally being successfully rolled over. That’s a short-term plus but hardly counters concerns that China’s credit cycle remains far too loose.

China's policies, including the PBoC's activities, continue to facilitate flows of enormous amounts of stimulus into the economy via credit expansion. It's no longer the direct injection of capital that Beijing used to undertake, nor is it the reserve ratio targeting by the PBoC. Instead, the nation has developed an incredible appetite for debt and the authorities in Beijing are happy to oblige in order to maintain economic growth targets.

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Dodd-Frank creates a drag on residential mortgage growth

Staying with the theme of credit expansion, one area where growth has been more constrained lately is residential mortgage lending. And one potential culprit seems to be the Consumer Financial Protection Bureau's Ability-to-Repay and Qualified Mortgage Standards Under the Truth in Lending Act (ATR/QM rule). These rules are part of the Dodd-Frank Act. In their zeal to avoid a repeat of the subprime crisis, politicians and regulators have made it tougher (and more complex) for banks to lend to anyone who either doesn't have a stellar credit or seeking a loan that is larger than the "conforming" limit (a "jumbo" loan). Banks, particularly smaller ones, are reporting that the ATR/QM rule has negatively impacted the likelihood of them approving such a loan.

Here are the results of the latest survey from the Fed:

1.  For loans that are of "conforming" size but with the borrower's FICO credit score below 680, almost 36% of all banks and half of small banks report "lower" or "somewhat lower" approval rate due to the rule.

2.  For jumbo mortgages the number is a whopping 52% (and 57% for smaller banks).

But what's particularly surprising is that even for conforming loans the number is 31% for all banks and 44% for smaller banks. That means that even agency-eligible loans are impacted by ATR/QM.

Source: Board of Governors of the Federal Reserve System

As a result, it seems that at least in part, these new regulations have materially reduced production of new loans, completely halting net new agency (Fannie, Freddie) MBS securities issuance.

Source: Deutsche Bank

Deutsche Bank: - Since January 10, banks have had to originate loans according to the Consumer Financial Protection Bureau’s Ability-to-Repay (ATR) and Qualified Mortgage (QM) rules. The Fed survey suggests that the rules have put a drag on all mortgage production. Since the rules went into effect shortly before net production tumbled, the possibility of a link is worth considering.

The ATR/QM rule has certainly not helped the housing market and may have created a drag on the US GDP. Welcome to the world of unintended consequences.

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