Sunday, December 21, 2014

If energy prices remain near current levels, Canada's economy is in trouble

And so it begins… Collapsing crude prices are starting to make their way through the North American energy sector, as the most unprofitable oil & gas rigs are mothballed. Those flashing red numbers are not just on your screen any more.

Source: Baker Hughes

The closures have been particularly acute in Canada, where some 40 oil & gas rigs have been taken out of operation recently. In fact it's not clear if economists fully appreciate what's about to transpire with the Canadian economy. This decline in rig count is just the beginning.

Consider for example the situation with the Canadian oil sands - one of the more expensive sources of crude production. Even if prices recover somewhat, oil sands production will be winding down - nobody wants to operate money-losing businesses for a prolonged period. And those who believe crude will be back above $80/bl any time soon is deluding themselves.

Source: FT

Up until now, production from oil sands has fueled growth in other sectors, including for example transportation and housing in Alberta. This is about come to a screeching halt.

Alberta housing situation (source: Alberta Treasury Board and Finance)

The national situation is not significantly better. Housing markets across the country have continued to rally, even as homes south of the border had undergone an unprecedented price adjustment. While many point out that the reason for avoiding a US-style housing crash has been a stronger mortgage market, that's only part of it. The global commodity boom in which Canada successfully participated is the main reason.

Source: Multiple Listing Service

Now as the commodity super-cycle has ended and energy prices collapsed, Canadian households are caught with near-record levels of leverage.

Source: National Post

Some have been pointing out that Canadian mortgage debt service ratio has continued to improve. However that measure is misleading, as it excludes principal payments. In reality the situation is much worse (see chart, h/t @ac_eco).

There is also the argument that Canada's economy is "diversified". Perhaps. But just to put the situation in perspective, take a look at the breakdown of the nation's trade balances.

Source: @Earthed ,  Maclean's

While economists will attempt to analyze the impact of energy prices on various sectors separately, when it comes to Canada, a number of economic components are quite difficult to decouple from one another. What's clear is that this exposure to energy is going to damage the labor markets, squeezing the nation's overextended households. And the knock-on effect won't be limited to a severe slowdown in residential construction growth. Consider for example the expenditures on renovations - something that's been supporting parts of manufacturing and other sectors. This is not going to end well.

Source: Scotiabank

The markets are already sensing the contagion effect from energy on the housing market, as Canadian property REITs take a hit. If oil prices remain anywhere near the current levels for a prolonged period - something the Saudis are aiming for (see post) - Canada's economy is in serious trouble.

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Sunday, December 14, 2014

The Fed launches Term Reverse Repo Program "experiment", moves short-term rates

The Federal Reserve has been aggressively testing the various monetary tools that will give it additional flexibility during the rate normalization process. In addition to the Term Deposit Facility (see post), the Fed recently started testing the term reverse repo facility (Term RRP - see statement). Note that this is in addition to the Overnight RRP. For those who want to track this program, follow the updates here (see the spike at the end?) The Fed will provide a total of $300bn under the program, with the first such offering completed on Dec-8th. It was a 28-day "secured deposit" paying 10bp (annualized) for $50bn.

Source: NY Fed
At the same time the US Treasury has issued a larger than usual amount of treasury bills recently. Since the Term RRP with the Fed is effectively the same as purchasing a treasury bill (particularly at 10bp), the Fed's $300bn program (combined with the existing facilities) effectively "crowded out" the bills market. This ended up pushing short-term treasury yields higher - while yields on longer-dated treasuries kept falling (see chart).

The Fed's latest monetary tools "experimentation" has also drained some reserves and lowered the monetary base.

For those who still track the Fed’s total balance sheet, don’t – the balance sheet doesn't tell you much about the monetary stance when you have these new forms of “sterilization”. Of course all this is viewed as temporary and the reserves may yet return to their peak levels next year. And judging from current disinflationary pressures (see chart), the actual liftoff - when these tools are going to be implemented on a more permanent basis - may be as long as a year away. For now however these monetary experiments have been sufficiently large to raise short-term interest rates.

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Saturday, December 13, 2014

Draghi now has all the ammunition he needs for QE. Implementation still a problem.

If Mario Draghi was lacking ammunition to initiate an outright quantitative easing program in the Eurozone, he certainly has it now. Even the staunchest opponents will have a tough time arguing against the need for a more aggressive approach to monetary easing. Here are five reasons:

1. The take-up on ECB's TLTRO offering (see post) fell far short of the ECB’s goals. Indeed the demand in the second round of the offering came in at €130 bn, putting the total take-up at €212bn - well below the €400 billion allowance. Since the TLTRO financing is linked to bank lending, the program to some extent relies on demand for credit from businesses and consumers. And that demand has been lackluster in the past couple of years. Therefore the initiatives announced by the ECB last summer, including ABS and covered bond purchases, are simply insufficient for the type of monetary expansion (of about €1 trillion) the central bank would like to see in the Eurozone.

Eurosystem consolidated balance sheet (source: ECB)

2. Some Economic data out of the Eurozone shows recovery stalling. Italian industrial production and French labor markets are just two examples.



3. With the collapse of oil prices, the Eurozone is bracing for deflation. German 5-year breakeven inflation expectations are now at zero. And Europe's central bankers are fearful of repeating Japan's decade-long struggle with deflation.

Source: @PlanMaestro

4. While the euro has declined significantly against the dollar, it remains quite strong on a trade-weighted basis. This is putting downward pressure on prices (via cheaper imports) and is disadvantaging some of the Eurozone-based exporters. A more aggressive easing effort would force the euro lower.

TWI = "trade-weighted index" (source: @TenYearNote)

5. Finally, the euro area's sovereign risks are resurfacing once again - triggered by new political uncertainty in Greece.
The Guardian: - Mounting concerns over Greece’s ability to weather a presidential election, brought forward in a surprise move by the prime minister, Antonis Samaras, continued to unnerve investors ahead of the first round of the vote in the Greek parliament next week.

Under Greek law failure to elect a new head of state by the ballot’s third round on 29 December could trigger a general election. The stridently anti-bailout main opposition party, Syriza, is tipped to win that poll. The radical leftists have made a debt writedown and the end of austerity their overriding priorities if voted into office.

Although Samaras called the election in a bid to expunge the political uncertainty engulfing Greece, the slim majority held by his government, compounded by the leader’s repeated warnings of Greece leaving the eurozone if Syriza assumes power, has accelerated investor nervousness.
The nation's stock market is down 20% over the past 5 days as investors flee.

red = Euro STOXX 50, blue = Athens Composite

And Greek sovereign debt sold off sharply. In fact the 3-year government paper yield went from roughly 3.5% in September to 11% now. This situation alone would make most central bankers consider some form of monetary easing.

Mario Draghi now has five solid reasons to argue for QE and many expect the central bank to announce such an initiative in the next 2-3 months. However, while most economists covering the euro area agree on the need to take a more aggressive monetary action, the problem of implementation remains. Since the Eurosystem's (ECB's) balance sheet is in effect owned by member states, many in the core economies are worried about having to become the proud owners of large quantities of their pro rata share of periphery nations' debt. For the Germans in particular, the ownership of such debt is a major issue. A solution that is even remotely politically palatable across the Eurozone remains elusive. The ECB's independence and the euro area's legal structure is about to be tested once again.

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Sunday, December 7, 2014

The Fed's policy trajectory is tied to global recovery

The latest US payrolls report presents a challenge for the Fed. As discussed back in April (see post), US labor markets are continuing to heal, suggesting that the rate "normalization" should be a serious consideration for the central bank. However the recent deterioration in commodities, especially energy, is "importing" global disinflation to the US (see post). In particular, the Saudi commitment to retake lost market share has sent shock waves through the oil markets (see post).

GCC is a diversified commodity index (source: barchart)

As a result, longer-term market-implied inflation expectations have fallen substantially.

The latest declines in expectations came after the recent FOMC minutes already showed increasing concerns at the central bank:
FOMC: - “Many participants observed the committee should remain attentive to evidence of a possible downward shift in longer-term inflation expectations.”
At the same time payrolls in the US are growing at a rate approaching the pre-recession peak (though still materially below what we saw in the 90s).

In fact the divergence between payrolls growth and inflation expectations is currently unusually high. Payrolls are driven by stronger US domestic economy, while inflation expectations are impacted by external factors, which creates this disconnect.

Red dot represents the current situation

This mismatch is causing a dissonance for policymakers and market participants, adding to the disagreement on the timing of liftoff. Current market expectations for the first hike now point to Q3 of 2015.

Source: CME

However if inflation expectations persist at these levels or worsen, it will be nearly impossible for the Fed to move on rates - irrespective of how much labor markets improve. The bet represented in the chart above is that energy prices will stabilize and/or growth in wages improves substantially by next summer - pushing breakeven expectations higher. But such an outcome, driven to some extent by factors external to the US, is far from certain.

What makes the timing of liftoff particularly difficult to estimate is the value of the US dollar.

Source: barchart

With a number of major central banks either easing or expected to begin easing monetary policy (diverging from the Fed), the rise in the relative value of the dollar will continue. That will bring inflation expectations even lower by weakening US import prices and pressuring commodities. If the strong dollar can make goods and to some extent services from abroad cheaper, there is less incentive for US-based firms to raise wages. Tapping cheaper markets abroad becomes more profitable.

And as the expectations of liftoff draw closer, the dollar will strengthen further, making it more difficult for the Fed to pull the trigger (what some refer to as a "self-correcting" mechanism). It's hard to envision the Fed acting unilaterally in the sea of looser monetary policy worldwide. The policy trajectory of the US central bank is therefore tied to a large extent to the global recovery, which remains elusive for now.

The Fed officials are keenly aware of premature policy tightening by a number of central banks, who were forced to reverse their decisions later.

Source: @themoneygame (Business Insider), Deutsche Bank

What some of these central banks didn't count on was the global nature of disinflation, over which they had little or no control (see chart). In the Fed's case, such a reversal would severely undermine the FOMC's credibility, sending policymakers back to the drawing board.
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