The Fed's Term Deposit Facility comes of age

As discussed earlier (see post), the US monetary base had stopped growing in July and is now in fact lower than it was over the past few months.

Given that the securities purchases continued through October, the flattening of the monetary base was the result of the Fed "draining" some of the reserves. Most of that was due to the reverse repo program (RRP) as well as the Term Deposit Facility (TDF). The TDF is a tool that is quite similar to what the ECB used to sterilize its securities purchase program (SMP) - an initiative the European Central Bank recently terminated (see story). Here is how the Fed describes the purpose of this facility.

Federal Reserve Bank of Philadelphia: - In 2010, the Federal Reserve put in place another method for managing reserves, the Term Deposit Facility (TDF). The TDF works in reverse of the Term Auction Facility [see post from 2009]. In the TDF, the Fed is offering term deposits on an auction basis. When a depository institution purchases a term deposit from the Federal Reserve, the funds are removed from its reserve account at a Federal Reserve Bank, thereby reducing the amount of bank reserves for the specified term of the deposit. Both paying interest on reserves and the TDF provide the Fed with strong tools for reducing aggregate bank reserves and will be very useful when it comes time to tighten monetary policy and reduce the size of the Fed’s balance sheet.

The TDF is still in "experimental" stages but the Fed has recently ramped it up (h/t Econ Brothers) - which is part of the reason for the lower monetary base.

The latest version is a seven-day deposit with an early withdrawal penalty. While the TDF drains reserves, the primary goal of the program is to give the Fed another tool to control short term rates. In fact the TDF could potentially become a more actively used program than the RRP.

In addition to the Fed Funds Target Rate for overnight interbank lending (which has declined in recent years), the the Fed will be setting the rate it pays on excess reserves (IOER), on the reverse repo (RRP), and also on these term deposits (TDF). The rate change announcement will therefore be a complex set of procedures going forward.


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Lower crude oil price in the US does not imply oversupply

Social media has been circulating this chart on US crude oil, that seems to indicate that the US is sitting on excessive inventories. That's simply not true. In fact US crude oil availability in storage, as measured in days of supply, is tighter than it was last year.

Source: EIA

The same holds true for gasoline.

Source: EIA

Furthermore, the WTI futures curve is in backwardation, indicating that the demand for physical crude in the US remains robust (this is not the case for Brent).

Sharply lower crude oil prices is a global phenomenon and is by no means an indication of slack demand or excessive inventories in the US.

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Distinguishing the Fed's securities purchases from monetary expansion

There has been a bit of confusion about what today's FOMC announcement means with respect to Quantitative Easing. The statement says that " the Committee decided to conclude its asset purchase program this month". It's important to point out that while this is the end of the Fed's bond purchases (for now), the US monetary expansion has ended this past summer. The outcome is visible in the the banking system's excess reserves, which flattened out around July.

That in turn resulted in the US monetary base leveling off at just below $4.1 trillion, as the so-called "money printing" effectively ended in July.

This begs the question: How is it that the excess reserves and the monetary base stopped growing this summer while the securities purchases and the balance sheet expansion continued through October? The answer has to do with some other balance sheet items that offset ("absorbed") reserve creation. The key item to consider here is the Fed's reverse repo position, which became more impactful as the securities purchases ebbed.

While the Fed's securities program is just ending now, the US monetary expansion was finished months ago. Therefore, other than its psychological effect, today's announcement should have a limited impact on the economy.

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How well does the CPI measure individuals’ health care burden?

Guest post by Jonathan Bernstein

Medical costs rose at an official rate of 1.7% year on year this past September, but the average increase in medical expenses individuals actually paid could easily be far larger. Most importantly, the CPI, as a pure price index, may not reflect the increased cost of living for families who lose employer paid health care coverage. That’s an all too common predicament, given the substantial fraction of part-time jobs created during the current economic recovery.

Nor does the CPI make it easy to see how reduced healthcare benefits raise the cost of living for those who still enjoy employer sponsored plans. As Aflac reports, 56% of employers offering health plans hiked the employees’ share of premiums or copays in 2013, and 59% expected to do so in 2014. Furthermore, the Affordable Care Act (ACA, or Obamacare) encourages this sort of cost shifting from employer to employee through its 40% excise tax on “Cadillac” plans.

The BLS does not measure insurance costs directly when compiling CPI-MED, the CPI’s health care component (h/t Doug Short). Instead BLS assumes that insurance costs rise commensurately with the prices of medical goods and services, plus or minus a margin for profit and administrative costs. Since CPI-MED measures changes in medical prices faced by consumers, it calculates changes in net prices charged to consumers after insurers, if any, have paid their share. As individuals and families pay an increased percentage of their healthcare costs, the BLS will account for that by increasing the weight of CPI-MED within the overall CPI; currently CPI-MED accounts for 5.825% of the overall CPI. Increases in the share of medical expense paid by individuals (as opposed to their insurers), will not affect CPI levels.

Therefore, when the BLS re-benchmarks the CPI this coming February, we can probably expect CPI-MED to carry a larger weight than in the past. An increase in the weight would then tell us how much BLS estimates that the average consumer’s medical care expenses increased as a percent of his or her total expenses.

 To state the obvious: when a family loses their coverage, they could easily go from paying a $300 monthly share of an employer’s plan, to paying $1,200 or more monthly for a “gold” plan, depending on the parents’ ages and number of children. Alternatively, the family could buy a less expensive plan (or no plan at all), and consequently pay more of their medical bills out of pocket. Again, that shock, if experienced by enough people, will eventually show up in weight changes, but not in the CPI level.

Either way, for many if not most families, the resulting increase in health care costs works out to a double digit percentage increase in total monthly expenses. Increases in deductibles, premiums or copays for those who have employee coverage presumably hurt less, but would also boost the employee’s health care costs over and above this year’s 1.7% increase in CPI-MED. And let’s not talk about those who lose employer paid coverage but whose income is low enough to qualify for the Obamacare insurance premium subsidy. In that situation, one can’t afford the out of pocket cost for much non-emergency treatment, and emergency treatment cost may put one at risk for bankruptcy.

In sum: while the BLS tells us how fast medical costs are rising, the CPI’s headline numbers may not reflect how healthcare costs actually affect the cost of living. If you want to know why many people feel that they are falling behind despite benign official statistics, here’s one place to look.



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The Saudis have the staying power to undercut the competition

According to Deutsche Bank, the Saudi government can sustain itself for almost 8 years with Brent crude at $83/bbl. The nation's government has accumulated sufficient "rainy day funds" to withstand a prolonged period of budget deficits driven by low oil prices.

Source: DB

Armed with such staying power, Saudi Arabia is undercutting the competition in order to expand market share. They know they have the funds to outlast most of the competitors. The goal is to pressure OPEC cheaters as well as to shake out US "tight oil" producers. The Saudis could presumably deal with the notion of US "energy independence", but having Americans export large amounts of crude (currently being debated in the US) and compete head on with OPEC is not acceptable. While Saudi Arabia cannot entirely stop the growth of North American production, it is going to try slowing it.

The Saudis launched their attack with the comment that the nation "will accept oil prices below $90 per barrel, and perhaps down to $80, for as long as a year or two". With energy markets already soft, the selloff acceleration ensued.

Another recent development shows that the Saudis are also willing to back their statement with action. With OPEC already producing 700-900K bbl/d above its quota, Saudi Aramco started undercutting the competition by lowering prices.

Deutsche Bank: - ... we can observe that the differential of Saudi Arabia’s Arab Light blend versus the Oman/Dubai average for Asian deliveries has fallen sharply from a premium of USD1.65/bbl for September loadings to a discount of USD1.05/bbl for November loadings. This suggests that Saudi Aramco is determined to maintain current levels of exports at the expense of sales prices achieved. This represents the sharpest discount since the -USD1.25/bbl level observed in December 2008, during a quarter in which global oil demand contracted by 3.0 mmb/d, in contrast to the current quarter when we still expect oil demand to grow by 0.8 mmb/d.

Source: DB

The November OPEC meeting is expected to be tense, with a number of nations pushing for production cuts. But ultimately the Saudis will prevail and the pressure on high-cost crude producers will continue. Pain will be felt in Iran, Russia, Venezuela, as well as across the North America's energy sector.

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The "Save our Swiss gold" initiative is incompatible with the EUR/CHF peg

This is every gold bull's dream. The Swiss just might force their central bank to begin accumulating massive amounts of gold via the so-called "Save our Swiss gold" referendum. The Swiss National Bank (SNB) unwound a large portion of its gold holdings prior to the financial crisis and now it could be forced to buy it back over the next five years. Here is what the accumulation is likely to look like assuming the rest of the balance sheet stays constant.

Source: SNB

If the proposal passes in November, the SNB will also need to repatriate its physical gold holdings stored abroad (particularly in the US and the UK) back to Switzerland. The most difficult part of the law is that once the SNB buys any gold, it would no longer be permitted to sell the holdings at any time.

The law would require the SNB to hold at least 20% of its assets in gold (from less than 8% currently), likely forcing the central bank to unwind some of its foreign reserves.

Source: SNB

To understand why the SNB would need to sell its FX reserves, let's start with a bit of background. The reason the SNB's foreign reserves are so elevated is to a large extent the result of the 2008 financial crisis and more importantly the Eurozone crisis. Since the default of Lehman and through the euro area debt turbulence, depositors/investors moved assets out of the Eurozone into Switzerland. They feared a potential collapse of EMU banks, haircuts on euro-denominated deposits (which is what ultimately happened in Cyprus), and even the breakup of the euro - followed by redenomination back to pre-euro currencies and devaluation of the lira, drachma, escudo, etc.

Many moved assets to the relative safety and independence of the Swiss franc, which resulted in Swiss currency's sharp appreciation against the euro (the chart below shows the euro depreciating against the franc).

The currency spike made Swiss products/services much more expensive in the Eurozone, driving Switzerland toward recession.

Moreover, the currency strength had generated deflation in Switzerland that was as severe as what we saw right after the financial crisis.

The Swiss National bank had to arrest the franc's appreciation, which it did by imposing a currency peg to the euro. But in order to maintain the peg while everyone wanted to buy the Swiss franc, the SNB was forced to do the opposite - sell the franc and buy the euro. That's why the SNB foreign reserves spiked during the eurozone crisis (see post from 2012) - with nearly half the reserves in euro.

Now back to the situation with the SNB's gold holdings. It's unlikely that the SNB would use Swiss francs to buy gold if forced to do so.  That's because the SNB would need to "print" the currency (similarly to the Fed buying treasuries via QE), which would result in the central bank's balance sheet expanding. But gold reserves would have to stay at 20% of total assets, forcing the SNB to buy more gold than planned due to larger balance sheet.

That means the central bank would need to sell something and replace it with gold in order to avoid unwanted balance sheet expansion. The SNB is therefore likely to sell foreign currencies, particularly the euro. And that could potentially put pressure on the EUR/CHF peg discussed above by weakening the euro.

Furthermore, if there is another "run on the euro" and the SNB is forced to defend the peg by buying more euros, the central bank would be also forced to buy more gold (by selling the euros). Such downward pressure on the euro is actually quite possible, should the ECB embark on a new QE effort on order to arrest disinflationary pressures.

In such a situation, large market participants would simply go long gold while shorting massive amounts of euro against the Swiss franc (possibly via options). If the SNB buys a great deal of euros to keep the peg fixed, it would also be forced to buy gold. In such a scenario the traders win on the gold appreciation. If the SNB gives up the peg and no longer buys gold, the euro falls sharply against the franc and the traders win - again. The peg becomes unsustainable.

The "Save our Swiss gold" initiative is therefore simply incompatible with the longer term EUR/CHF stability objectives.

Over the long run, the inability to sell any gold could in theory force the SNB's balance sheet to be 100% gold. If the central bank assets for example grow to 5 times the current size (with the 20% rule in place), and then shrink back to their original size, the Swiss National Bank would be holding nothing but gold. It would no longer have the ability to do much of anything, especially address deflationary pressures. 

What's the likelihood that the "Save our Swiss gold" proposal passes? According to the GFS Bern poll for the November 30th referendum, 44% of respondents currently support it, 39% are against it and 17% are not yet decided. This is obviously too close to call, but the possibility of a "yes" vote is now quite real.


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Gap between wages and rents continues to grow

Here is a quick follow-up to the discussion on the looming rental crisis in the US. The gap in growth rates of rental costs vs. wages continues to widen. This divergence is creating a drag on the GDP growth by suppressing household formation, consumer spending, and labor mobility. Over time this trend will also increase homelessness.

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Last week's volatility and the economy

US consumers remain jittery. As expected, households actually paid attention to last week's market volatility and the Ebola fears. As many have pointed out, some of what we've heard last week was blown out of proportion. But any increased uncertainty, perceived or real, can have an immediate and a very real impact on the economy these days.

Source: Investing.com

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No hard-landing for China's economy for now

China's GDP growth is gradually slowing as expected - at least according to the official reports.

Growth is now at the lowest level since 2009, but so far the Bloomberg China GDP Tracker forecast of a sharp correction this quarter has not materialized.

Source: @M_McDonough

In fact, the nation's industrial production growth, which continues to decline, came in better than expected.

Fixed asset investment growth shows a similar slowing pattern - now growing at 16% per year.

Have the various hard-landing predictions (many focused on the worrisome credit expansion in China) been too draconian? From a number of recent indicators it seems that China's economic growth is gradually grinding lower - perhaps toward something like a 4% per annum in 2020 (see report). Unless of course China's official economic reports are completely flawed - which is always a possibility.

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Update on crude oil markets

Crude prices came under pressure again today. According to Reuters (from last week), the Saudis “will accept oil prices below $90 per barrel, and perhaps down to $80, for as long as a year or two”. Their goal is to shake out some of the high-cost competition (such as the US). The Saudis also do not want to choke off the economies of their customers by cutting production. Current production levels are likely to stay unchanged unless there is a significant price move to the downside from here. Spot crude is now holding right in the middle of the Saudis’ preferred range at around $85/bbl. Both OPEC and non-OPEC producers are not particularly happy with Saudi Arabia right now (particularly Russia, Iran and Venezuela) – these countries all want to see production cuts.

A significant difference remains in the demand profile between the international crude markets and those in the US. While both of the futures curves shifted sharply lower, the WTI curve, unlike Brent, remains in backwardation. It means that US crude oil market participants have an incentive to take oil out of storage rather than storing it. This indicates a more robust US spot crude demand than exists globally.

Source: Deutsche Bank

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From our sponsor:

The good, the bad and the ugly of falling energy prices

The recent correction in the price of crude oil should have an immediate positive impact on the US consumer as well as on a number of business sectors. However there also may be a significant economic downside to this adjustment. Here are some facts to consider.

1. The good:

The US consumer is not only about to benefit from materially lower gasoline prices (see chart), but also from cheaper heating oil.

Source: barchart

With wages suppressed, the savings could be quite impactful, particularly for families with incomes below $50K per year.

Merrill Lynch: - ... consumers will likely respond quickly to the saving in energy costs. Many families live “hand to mouth”, spending whatever income is available. The Survey of Consumer Finances found that 47% of families had no savings in 2013, up from 44% in the more healthy 2004 economy. Over time, energy costs have become a much bigger part of budgets for low income families. In 2012, families with income below $50,000 spent an average of 21.4% of their income on energy. This is almost double the share in 2001, and it is almost triple the share for families with income above $50,000.

Source: Merrill Lynch

Furthermore, with gasoline prices lower, it is unlikely that consumers will be buying significantly more of it than they have been. Historically when oil prices fell, gasoline consumption in dollar terms also fell. Dollars saved on fuel will be redirected elsewhere in the economy.

Source: Scotiabank

Moreover, suppressed oil prices will, at least in the near-term, keep inflation expectations lower. That means lower short-term rates for longer (see chart) and therefore lower home equity and adjustable rate mortgage monthly payments. It also means lower longer-term rates and cheaper fixed rate mortgages (see chart). We may even see some new refi activity.

Other benefits include cheaper transport (potentially lower travel costs) and shipping costs (lower UPS/Fedex surcharges), as well as cheaper PVC, nylon, polyester, foam, etc. - all of which should benefit the consumer.

2. The bad:

The US has become a major energy producer, with the sector partially responsible for improving economic growth and lower unemployment in recent years. As an example here is the GDP of Texas as a percentage of the US GDP. This trend is driven in part by the recent energy boom in the state.

Source: @M_McDonough

If oil prices remain under pressure, this boom could soon be in jeopardy. While large US energy companies are sitting on a great deal of cash, at some point they will begin to cut portions of the higher cost development and production. And private investment into energy and oil services firms, which has been brisk lately, is likely to moderate. For example, here is the private debt and equity capital flowing into various states last month.

Source: CAZ Investments

While, only a portion of the funds going to Texas is directly energy related, various other Texas firms funded by PE (including some real estate, manufacturing and financial companies) have been benefiting from the energy boom. Soon that flow of private capital may slow dramatically.

To put this into perspective, here are the jobs directly generated from Texas oil and gas extraction in recent years. And this does not include the thousands of jobs that support this industry. Such trend is unlikely to continue if oil prices remain at current levels or fall further.

In fact, while the overall industrial production growth in the US has been strong recently (see chart), a big portion of the gains are energy driven (see chart from Lee Adler). A slowdown in that sector will be quite visible across the US.

3. The ugly:

A significant number of middle market energy firms in the US - many funded via private capital (above) - are highly leveraged. The leveraged finance markets are becoming quite concerned about the situation - even for larger firms with traded debt. Here is the yield spread between the energy sector loans in the Credit Suisse Leveraged Loan Index and the index as a whole.

Source: Credit Suisse

Rumors have been circulating of a number of energy (and related services) firms getting ready to "restructure". There are also stories that some large funds are gearing up to scoop up distressed debt of levered energy firms. However, in spite of the ample liquidity out there, bets on companies with significant commodity exposure will be limited going forward - at least until stability returns to the oil markets. Defaults, layoffs, and cancelled projects in the energy space may be in store in the near-term. And that is sure to have a negative impact on the US labor markets and the economy as a whole.

Finally, this is terrible news for the development of alternative energy sources. At these prices, fossil fuels are becoming increasingly difficult to compete with.

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Big move for vol of vol

Staying with the volatility theme, the latest jump in VIX was clearly dwarfed by what we saw in 2008 or even in 2011. However that's not true for the volatility of VIX - the so-called "vol of vol". The CBOE's VVIX Index, "an indicator of the expected volatility of the 30-day forward price of the VIX" (see description), has been comparable to or higher than what we saw during those high stress periods. The possibility of VIX doubling or even tripling ("tail" risk) does not seem outside of the realm of possibilities these days - even from the current elevated levels. And traders are willing to pay a relatively high premium to be able to take advantage of such moves.

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Implied vol dislocation

The recent spike in volatility has created a "dislocation" in US equity options markets. VIX, which is a measure of implied volatility for large cap shares is now higher than RVX - the small-cap equivalent. This is highly unusual, since small caps tend to be more volatile. Part of the issue is the outsized spike in the volatility of large energy shares due to the recent sell-off in crude oil.

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From our sponsor:

Convergence

The ECB can continue to argue that economic conditions in the Eurozone are nothing like those in Japan. The markets say otherwise ...

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Disinflation spreads to the UK

Italian consumer inflation remains in the negative territory (see chart), as the nation's economy struggles to grow. But Italy is not unique - the rest of the world is catching the Eurozone's disinflationary flu. China's latest CPI print for example came in below that of the US - something we haven't seen until recently (see chart).

The UK is also facing weakening inflation. Prices continue to fall at the wholesale level, with British firms still having little pricing power (see chart). It's difficult to raise prices when everything is marked down across the Channel. For the UK's consumers, inflation is now at the lowest level since the Great Recession - for both the headline and the core CPI.

It's difficult to see how the Bank of England can begin raising rates in such an environment - even with the housing market remaining strong (see chart). With oil prices collapsing, inflation is only going to move lower. Just as the case with the Fed (see post), the forward rates markets are pricing in an increasing delay in liftoff. The BoE is on hold at least until next summer as disinflation spreads to the UK.

Markets' expectations of the UK overnight rate (source: BoE)

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Do Central Counterparty Clearing Houses (CCPs) have enough capital? A closer look at the CME.

Guest post by Jasper Tamespeke

I was bemused to read the other day a news report that ISDA chair Stephen O’Connor has stated that the major CCPs (LCH and CME) ‘probably’ have enough capital. Bemused because as far as I can see CME Group doesn’t have any real capital at all.

To understand this, we have to do a bit of forensic accounting. Not very exciting, but given the central role the CCPs have been given in clearing OTC derivatives in the future, it is important.

According to CME Group’s 10-K for 2013 the group had stockholders equity of $21.6 billion, which appears to be very healthy. However, when regulators and credit analysts look at a Financial Institution they will critically assess the assets on the balance sheet and deduct from capital any assets that cannot be readily realised in a crisis (which is when we need capital). They particularly focus on intangible assets such as goodwill (what someone pays to buy a company above the tangible value its assets, the franchise value). In CME Group’s case, there are a lot of intangibles: goodwill of $7.6 billion, other intangibles of $2.7 billion and a whopping $17.2 billion relating to Trading Products. In total these amount to $27.5 billion and therefore tangible equity is about $6 billion negative.

The most important number here is the trading products. This is the ‘brand value’ of futures contracts acquired in the mergers with other futures exchanges, particularly CBOT and NYMEX. These have been capitalized on the basis that such products have to be licensed by the CFTC and the license has no expiry date. In theory, it is not difficult to create rivals to CME’s valuable contracts, but anyone who remembers Eurex’s attempts to set up a rival to the Eurodollar Future a decade ago knows that CME’s franchise is implicitly protected. However, there is no guarantee against a less monopolistically inclined regulatory framework being developed in future, and it seems to me that this accounting is really just window dressing: the ‘mergers’ (really takeovers) naturally generated a lot of goodwill, but if it is rebranded ‘Trading Products’ this sounds much better and makes the balance sheet look superficially stronger.

To me, this is a sobering thought for Sober Look readers : possibly the largest CCP in the world (certainly the largest clearer of exchange traded derivatives) has no capital.

But how can this be? CCPs are regulated so surely they must be required to have capital? CME Group Inc. is the holding company of the group and not itself the CCP, and therefore (I presume) not directly subject to the CFTC’s capital requirements. The CCP is a division of its most important operating subsidiary, CME Inc. CME Inc. does have about $1 billion of capital. How is this possible, given that CME Inc. is wholly owned by CME Group? As far as I can see, this is achieved through a bit of alchemy called double leverage. CME Group has about $2.85 billion of long and short term debt and part of this is used to provide equity capital for CME Inc. CME is not regulated under the Basel regime, which has been subject to much criticism, at lot of it justified. However it does at least require that capital requirements are met on a consolidated basis, which would stymie this sort of manoeuvre.

So there appears to be some clever creative accounting going on here. But does this really matter? Anyone who has spent more than 5 minutes studying CCPs knows that capital is not really relevant in protecting them against counterparty credit risk, which is what they are about. The main line of defence is Initial Margin, and to a lesser extent the Default Funds, which are there as a top-up if extreme losses run through the margin deposits. And CME has a veritable wall of money here: nearly $120 billion at end 2013. So $1 billion of capital, whether it is real or not, gets lost in the roundings.

I think it does matter for a number of reasons. The money of members and their clients may be the primary mitigants against a CCP’s credit risk, but what happens if there is an operational failure (e.g. if systems errors lead to a CCP having an unbalanced position, creating losses in a volatile market)? Here the primary loss absorber should be capital. Double leverage makes a group more fragile if there are problems. The holding company’s debt has to be serviced by upstreaming dividends from its subsidiaries, but if they are subject to prudential capital requirements this may not be possible, increasing the risk of default (although at the moment CME does generate prodigious cash flow).

Also it is important that CME’s shareholders have skin in the game. Most of the CCPs these days are public, profit seeking companies and it is important that they operate with the right incentives (not that the banks and brokers can complain too much about this, as they opportunistically sold their seats and relinquished control in the course of the last decade in pursuit of a quick buck).

It matters most of all because we are concentrating so much potentially lethal risk in 3 or 4 critical nodes in the financial system. G-20 politicians made a fateful decision in 2009,moving from the (arguably reasonable) declared aim of requiring credit derivatives to be cleared to the much more ambitious mandate that all standardized OTC derivative are centrally cleared (for reasons which as far as I know are largely unexplained). In my opinion this is just one manifestation of the failure of politicians and the regulatory community who serve them to learn the right lessons from the Financial Crisis: they want to centralise the risk so that it is easy to see and control. However surely the moral of Too Big to Fail was that it is an illusion that we can control everything in human affairs, in this case by confidently assuming that margin at 99.5% with a top up based on stress tests will make us bullet-proof against the unknown unknowns. Instead of concentrating risk in the massive CCPs and the equally massive small number of banks with the economies of scale to afford to be clearing members, in my view it would have been better to diversify risk around the system, to minimise the impact of the things we can’t control. However, it is probably too late to reverse these decisions now, but it is certainly emphasises the need for CCPs to be stable, strong institutions with good governance.


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Ruble for sale

Currencies of most emerging economies rallied against the dollar today, as expectations for the first rate hike in the US shift out to a year from now. There was one major exception - the Russian ruble.

Russia is facing stagflation while the central bank remains helpless. A number of relatively well-off Russian citizens - some after getting burned in Cyprus - have been trying to abandon the ruble.

WSJ: - “Those who have any savings have lost all illusions about the ruble and are trying to protect their money,” said a senior executive at one of Russia’s largest banks, speaking on condition of anonymity.

Her bank has seen clients buying tens and hundreds of thousands of dollars in recent days and storing the funds in cash in safe-deposit boxes for fear that sanctions, possible capital controls or bank failures could limit their ability to access money kept on account. That is while dollar-starved Russian banks are offering rates on dollar and euro deposits as high as 4.5% for one-year certificates of deposit.

The ongoing rout in crude oil is expected to strain Russia's fiscal and trade balances. Russia (similar to some other energy producers) failed to diversify its economy and is now paying the price. According to Bloomberg, "Russia’s central bank intervened in the past 10 days to stabilize the currency, central bank Governor Elvira Nabiullina told lawmakers in Moscow today." In spite of spending some $6bn in FX reserves, it failed. The ruble hit a record low against the euro over the past few days as capital outflows continue.

Chart shows EUR appreciating against RUB

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The Fed on hold for a year according to the futures market

Futures markets have shifted expectations for the Fed's liftoff further out in time. The July-15 Fed Funds futures contract is only pricing a 12bp Fed Funds rate increase from the current levels - not enough for a full hike.

Source: barchart

In fact the mean expectation for the rate increase timing priced into the Fed Funds futures market is roughly a year from now.

Source: CME

This should slow the appreciation of the US dollar, as the Fed tries to avoid getting too far ahead of other developed economies in its normalization strategy.


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The Bank of Japan may put further easing on hold

Expectations of Bank of Japan accelerating securities purchases at the October meeting have fallen considerably. Majority of economists now expect any type of change in policy to take place no earlier than December/January, if ever. In fact an increasing proportion of Japan watchers are suggesting that faster securities purchases are unlikely to take place at all. The chart below shows the percentage of those who believe further easing is imminent.

Source: Credit Suisse

This relatively sudden change in views is not due to any significant economic improvements in Japan. Japan's consumption tax hike has created a material drag on growth, with industrial production starting to decline again.

The BoJ in fact admitted that a substantial slowdown is taking place and the tax hike is to blame.

WSJ: - The Bank of Japan said Tuesday that industrial production was showing signs of weakness, acknowledging for the first time since the sales tax was raised in April that the move has had a notable negative impact on a key driver of economic growth.

The admission confirms what private economists have been stressing for months—that the higher tax rate has taken a significant toll on the economy. It also comes as a separate government indicator pointed toward the possibility that Japan may have already entered a recession.

In a statement released after a two-day meeting, the BOJ’s policy board maintained its assessment that the economy “continues to recover moderately as a trend,” but that “some weakness, particularly on the production side, has been observed.”

Moreover, the central bank's 2% inflation target remains elusive. Inflation expectation (breakeven) implied by the 10-year JGBs is barely above 1%.

Source: Japan Bond Trading Co

So why do many economists now think the central bank is not going to accelerate QE - at least not in the nearterm? The reason has to do with the increasing uncertainty around the benefits of a weak yen (discussed here). While large exporters benefit from currency depreciation, smaller businesses and consumers are hurting.

Bloomberg: - Debate is increasing over the costs and benefits of the weakening yen, which is increasing costs for importers and households while it bolsters profits for some companies. Further depreciation could risk support for the Bank of Japan’s unprecedented stimulus program, even as the government says there is no gap with the BOJ in its stance on the yen. ...

Exchange-rate depreciation has raised the cost of imported products including energy, something that’s helped end Japan’s deflation and stoked profits for companies with earnings abroad. Smaller businesses have become increasing vocal in opposing the fall, even as Kuroda says that the negative effects are outweighed by the positive.

Kuroda was told by business leaders in the industrial city of Osaka last month that the yen’s slide was boosting costs of imported fuel and raw materials and may spell trouble for the economy. 

With wage growth remaining sluggish (particularly for non-union workers), rising import costs could undermine consumer demand - particularly in the face of higher consumption taxes. Given these headwinds, there may be sufficient political pressure to put the BoJ into a holding pattern.

It is important to point out however that even without adjusting its policy, the BoJ's current QE effort is by far the most ambitions monetary expansion program by a developed economy in recent history.

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China's local government debt binge curtailed

Over the years China's local governments have become dependent on financing themselves via land sales and more recently the so-called Local Government Financing Vehicles (LGFV). Times were good, as property developers grew wealthy via sales of new urban housing while enriching local governments and often government officials. But over the past three years growth in the nation's property markets has cooled. This slowdown is clearly visible in the decline of prices for steel rebar which is primarily used in construction. This slowdown has accelerated this year.

Source: barchart

At the same time Beijing started scrutinizing the banking system (including state-owned banks) where the volume of bad loans had been on the rise. Moreover, many of the earlier infrastructure projects initiated as part of the 2008 stimulus have not yielded the revenue levels that were originally projected. With slower land sales, more stringent bank lending, and a taste for credit, China's local governments increased their borrowing via LGFV as well as other non-traditional sources (see chart).

Source: Scotiabank

This borrowing by municipalities, combined with growing corporate debt (a great deal of it from developers), resulted in China's total debt-to-GDP ratio increase of over 70% since 2008. Worried about local governments' growing large-scale credit bubble, Beijing  has recently decided to put an end to these forms of financing. Here is a comment from Beijing's mouthpiece, the People's Daily:

People's Daily: - Funding sources for local governments will change dramatically. Shadow banks and corporate bonds are out: local government bonds are in, for both existing and new debt. This will immediately cure the maturity mismatch risk for local government debt, as local government debt has a longer maturity. The interest burden will also be reduced: Yields on municipal bonds are close to treasury yields and much lower than bank lending rates or trust yields. In the long run, this could strengthen market discipline for local government borrowing, as municipal bonds tend to have stricter requirements on disclosure of fiscal balance sheets and monitoring than shadow banks.

Of course shifting to muni bonds is not going to be easy. Demand for muni paper is limited precisely because of lower yields and the fact that the market remains heavily regulated. Furthermore, Beijing is prepared to allow local governments to fail - an outcome that is becoming increasingly possible.

WSJ: - Local governments have had a tough time this year repaying debt as fiscal revenue growth has slowed in the face of a weaker national economy and China’s property market downturn. China’s combined central and local fiscal revenue rose 6.1% in August from a year earlier, compared with a year-over-year increase of 9.2% in August 2013, data from the finance ministry showed.

Almost 40% of the 17.9 trillion yuan in local government debt and guarantees will mature by the end of this year, placing huge pressure on local governments to make repayments, according to a report released by the state auditor late last year.

In fact many municipalities are already bankrupt and survive only on their ability to "roll" exiting debt. Numerous infrastructure projects financed by local governments are being curtailed, creating a drag on the nation's growth. There will also be a hit to funding for education, healthcare, and other services provided by local authorities. While this restructuring is a positive development in the long term, the immediate effect will materially raise the risks to China's (and ultimately global) near-term growth.

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The FOMC takes dollar strength into account; liftoff expectations shift to a year from now

The Fed is finally expressing unease with the world outside the US borders and its impact on the US economy.

FOMC Sep-14 Minutes: - "During participants’ discussion of prospects for economic activity abroad, they commented on a number of uncertainties and risks attending the outlook. Over the intermeeting period, the foreign exchange value of the dollar had appreciated, particularly against the euro, the yen, and the pound sterling. Some participants ex-pressed concern that the persistent shortfall of economic growth and inflation in the euro area could lead to a further appreciation of the dollar and have adverse effects on the U.S. external sector. Several participants added that slower economic growth in China or Japan or unanticipated events in the Middle East or Ukraine might pose a similar risk. At the same time, a couple of participants pointed out that the appreciation of the dollar might also tend to slow the gradual increase in inflation toward the FOMC’s 2 percent goal."

In a single paragraph the FOMC minutes conveyed the concerns about the rising US dollar and risks of further dollar appreciation due to economic weakness across major economies. Strong dollar hurts US exporters and reduces dollar denominated revenues for firms that conduct a great deal of business abroad. It also puts downward pressure on inflation (see post), elevating disinflationary risks. This is clearly visible in TIPS-based inflation expectations (breakevens) that continue to decline.

The FOMC's projections for US GDP growth a couple of years out have shifted lower in part because of slower economic expansion around the world.

Source: FRB

The markets interpreted the minutes as a clear signal that the Fed is in no hurry to normalize rates. Even though the US foreign exchange policy is under the control of the US Treasury (instead of the Fed), the FOMC would clearly like to avoid a significant dollar appreciation and will remain on hold should the rally continue. With events in the rest of the world now becoming a greater part of the FOMC's playbook, the expectations for liftoff have shifted further out in time. The chart below shows the July-2015 Fed Funds futures spiking after the release of the minutes (reducing Fed Funds rate expectations for next summer). The markets are now pricing in the first hike taking place about a year from now.

Source: CME

Equities, treasuries, many commodities, credit - all rallied in response. The FOMC is telling us that with the rest of the world in relatively poor shape economically, the stimulus party in the US continues for a while longer.


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