Friday, January 31, 2014

5 reasons the ECB will act in the months ahead

It may be something symbolic such as a small rate cut or possibly a more substantial move such as a new LTRO program (discussed here), but the European Central Bank will be forced to loosen monetary policy in the near future.  Here are the reasons:

1. Liquidity:  The ECB's (technically the consolidated Eurosystem's) balance sheet is stll declining - down 28% since the middle of 2012. Excess reserves of the euro area banks are down nearly 80% over that period.

2. Credit:   Private lending in the euro area continues to fall - see chart.

3. Monetary aggregates:   Lack of loan growth has resulted in progressively weaker growth in the broad money supply. Most recent M3 print came in significantly below expectations - see chart.

4. Disinflation:  The euro area's price index growth is at the lowest level since the Great Recession and significantly below the ECB's target. Moreover, the growth rate seems to be deteriorating.

Furthermore, this disinflationary trend is not limited to the Eurozone periphery nations. Even Germany is showing signs of a slowdown in its inflation rate.

The last time Mario Draghi spoke on the topic, he hinted that this extraordinarily low inflation rate is an aberration. But that explanation is starting to get old. 

5. Emerging markets mess: While the ECB officials are denying that EM contagion will spread to the Eurozone (see story), the recent selloff in European equities says otherwise. Knock-on effects are inevitable, given the vulnerability of the Eurozone's recovery combined with the area's significant exports to emerging market nations.

Aside from these 5 reasons, the short term rate markets are now reflecting a policy change by the ECB, though the timing remains unclear. The June Euribor futures have spiked - indicating a lower implied Euribor rate -

Source: Eurex

... and German short-term government yields fell materially. These are signs of the markets' expectation of lower short-term rates going forward.

Over the next few meetings we should see a shift by the ECB toward a looser monetary policy. Otherwise the central bank will be toying with deflation risks.

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Thursday, January 30, 2014

PCE inflation rate lowest since 2009 - key to future Fed policy

Economic indicators continue to point the Fed staying the course with the policy of "small taper" (see post) - a gradual reduction in securities purchases. Behind all the noisy economic data over the past month, one key measure is telling the central bank to remain cautious. The Fed's preferred inflation measure, the so-called PCE price index has grown less than 1% over the past year (chart below) - the lowest quarterly growth in inflation since 2009. At this rate of price increases, many economists refer to the current situation as "disinflationary".

PCE Price Index YoY

To be sure, there is more to this story than weakness in US inflation. It is important to point out that we are seeing quite a divergence between key components of the PCE index. Growth in the cost of services declined after the financial crisis but stabilized at around 2% per year more recently - which where the Fed wants to see the overall index. On the other hand, prices for durable goods in the US peaked in the mid-90s and have since been undergoing a secular decline (chart below), becoming a major detractor from the overall inflation index growth. Furthermore, price declines on durable goods have accelerated somewhat over the past quarter.

PCE Price Index (level): blue = Durable Goods, red = Services

One specific item worth pointing out is the growth in healthcare costs. When people think of rising prices on services, they often point to healthcare. While healthcare costs have historically grown much faster than the overall service sector, that is no longer the case (chart below). Given the massive public (and private) sector future liabilities that are linked to healthcare expenditures (see post), in the long run this trend is absolutely critical for the US.

PCE Price Index (YoY % changes): blue = Healthcare, red = All Services
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Wednesday, January 29, 2014

HY bond market weathering the storm

The US corporate high yield market remains incredibly resilient in the face of increasing global volatility. Year to date the broad HY index has outperformed the S&P500 by over 4.25%.

SPY = SPDR S&P 500 ETF; JNK = SPDR Barclays High Yield Bond ETF (source: Ycharts)

One reason for this stability is the strong performance of the treasury market this month. Also many investors have become quite comfortable (perhaps too comfortable) with junk debt. Part of the reason is the low default rates recently as well as vibrant primary markets that have been willing to refinance (roll) maturing debt. In addition, supply of new bonds has been relatively light, while fund inflows remain robust (see story). As a result HY spreads are less than 10bp higher than they were at the end of last year.

Experienced analysis and investors in this space openly admit that it's just a "matter of time" before this market "cracks". It simply needs a catalyst, such as a large unexpected corporate default. Maybe a major event in the sovereign bond market could dislodge HY. Short of that, junk bonds could remain at frothy valuations for some time. 

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Tuesday, January 28, 2014

What does Istanbul have to do with AAPL?

Today the Turkish central bank took an unprecedented action, jacking up the overnight rate by 425 basis points to 12% (see post) - which sent the lira up by over 3%. Higher rates make a currency more attracive and more expensive to short.

While this move will be covered in the media for weeks to come, it's not the point of this discussion.

We've gotten numerous comments from US investors who question the need to track what's going on in a place like Turkey - other than for curiosity. How does the value of the lira impact the price of AAPL or MSFT? Well folks, in these highly interconnected global markets, it does. The chart below shows what happened to the S&P500 futures in response to the lira rally. The days of US investing in isolation are over - something we learned from the Eurozone crisis.
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Russia bucks the trend - talks the ruble lower

Central banks of several nations who are experiencing sharp currency declines are taking action to stabilize the situation.
NY Times: - The Reserve Bank of India unexpectedly raised its benchmark interest rate on Tuesday by 0.25 percentage point, but it said that if consumer price inflation eased as projected, it did not foresee further raises.
Reuters: - Turkey's central bank governor raised expectations for an emergency interest rate hike on Tuesday, denying he was hostage to political pressures and vowing decisive action to fight rising inflation and a tumbling lira.
Bloomberg: - Brazil’s real strengthened from a five-month low as the central bank planned to support the currency by rolling over the remaining foreign-exchange swaps that mature next month.
But not the Russians. The nation's central bank likes the weak ruble because the currency decline boosts the domestic proceeds from Russia's energy exports. This is particularly important to them as energy prices remain subdued (Brent is down 3% this month).
RIA Novosti: - Elvira Nabiullina [governor of the Bank of Russia] said in a television interview on Channel One that there were no intrinsic problems with the ruble, which has slid to historic lows against the euro and the dollar in recent weeks.

It’s not that we have a weak ruble, but that the dollar and the euro have strengthened in relation to emerging market currencies,” Nabiullina told interviewer Vladimir Pozner.
As a result, while other EM currencies have stabilized, the ruble continued its slide. In fact it is now at record lows against the euro (Russia exports a great deal of energy products to the EU).
Chart shows the euro appreciating against the ruble (source: Google)

While helpful in the nearterm, this strategy could prove dangerous in the long run. Russia's inflation rate is running at about 6.5% and could easily spike as it did in the late 90s when the ruble was devalued.
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Monday, January 27, 2014

BRICs under pressure

As the emerging markets contagion spreads, the BRIC nations are coming under increasing pressure in the capital markets. As discussed previously Brazil and Russia are witnessing new multi-year/record lows in their currency valuations. The Indian rupee is still above the all-time low (last summer), but at 63.5 rupees to the dollar, we are not far from that record.

BRL = Brazilian real, RUB = Russia ruble, INR = Indian rupee
(chart shows dollar appreciating against these currencies; source:

China of course has a controlled currency peg to the dollar. But participants in the nation's interbank market remain jittery. Recently a rumor was spread that China's banks were instructed to suspend cash transfers. Forbes ran with the story and later removed it from its website, as the rumor turned out to be false (see story). Nevertheless China's overnight interbank rate rose again, showing just how uneasy the market participants have become.

China's overnight interbank rate

Credit fears surrounding a close call with a wealth management trust called “Credit Equals Gold #1” - which was ultimately bailed out - and others like it have infiltrated the markets (see story). It is expected that these incidents - and the corresponding liquidity jitters - will continue, potentially becoming a major problem for China.
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Sunday, January 26, 2014

Argentina's devaluation backfires

Back in early December the government of Argentina raised taxes on credit card purchases in foreign currency to 35% from 20%. Online Christmas shopping abroad became increasingly expensive. However, dollars continued to flow out of the country even with this high levy, pressuring foreign reserves.

Source: GS

The central bank had "printed" enormous amounts of peso in 2013 to fund the public sector. But with the country's fiscal situation still deteriorating (see chart below) and demand for dollars continuing to rise, the Fernandez administration chose last week to devalue the peso.

Source: GS

The gradual depreciation policy that was in place before just didn't work. Even with taxes and other restrictions, the outflows were simply unsustainable - the government could not afford selling dollars below market rate for too long. The idea behind this devaluation was to stem dollar outflows by making the dollar far more expensive (see chart that shows dollar appreciating in the "official" exchange rate).

The goal was to bring the value of the dollar closer to where it trades in the "unofficial" markets. Some clever economists working for Fernandez probably told her that if we make this adjustment, the supply/demand fundamentals will be in balance and the outflows will be halted. Officials even promised to bring the tax on foreign transactions back to 20% after the devaluation. With the dollar now far more expensive, imports and dollar outflows are bound to slow - even with the lower tax. Unfortunately that was wishful thinking.

The devaluation backfired. As the nation's citizens learned about the official devaluation, panic ensued and demand for dollars increased dramatically. Instead of the unofficial-to-official premium on dollars shrinking as planned, it spiked.

About that transaction tax going back to 20% ... the government is now backpedaling.
ABC/AP: - Economy Minister Axel Kicillof told local daily Pagina 12 in an interview published Sunday that the Argentine tax rate on credit card purchases made in dollars will not be lowered Monday from the current 35 percent to 20 percent, as he had announced.

"In the case of currency for tourism and for purchases with a credit card abroad, the 35 to 20 percent move will not be implemented this Monday," Kicillof said. There was no word of when, or if, the tax rate on credit card purchases may be eased.
Now imports will become even more expensive and the central bank will need to print even more pesos to keep the government going. Inflation, already the highest in the Americas, will accelerate further and generate additional demand for dollars - a downward spiral.
GS: - According to our projections, the level of reserves will fall to USD21.6bn by the end of 2014 [vs. $30.9 now], after experiencing a loss in the year of USD9.2bn. We also expect the exchange rate to suffer a yearly depreciation of approximately 55% to finalize the year toward 10 ARS/USD. Additionally, as a result of the discussed additional pass-through effects of this larger exchange rate depreciation, including a higher floor for incoming wage negotiations, we increase our year-end inflation forecast to a range of 35%-40% yoy.
Argentina is not Zimbabwe just yet, but it's only a matter of time.
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Friday, January 24, 2014

Fed's taper and weaker foreign participation will leave domestic investors with higher proportion of treasury purchases

In a couple of earlier discussions (here and here) we talked about a significant buildup of treasury short positions. Since then there are indications that a few of the larger direct players have been covering their short bond exposure, pushing treasury yields lower. If the emerging markets contagion (discussed here) persists, more short covering is expected.

But what about the longer-term outlook for treasuries? As the Fed cuts its buying program, we are left with two major categories of purchasers - foreign and private domestic. Foreign buying is directly linked to growth in current account surplus of key US trading partners, particularly in Asia. And while nations like China and Japan hold enormous amounts of US government paper, it's unclear if they will return to the volumes of purchases from 5 years ago. For example the explosive growth in China's current account surplus through 2009 is no longer there, which should translate to a more modest rate of treasury buying.

Other emerging economies are not faring much better and in fact many are struggling to maintain export growth. As a result fewer dollars on a relative basis will be available to buy treasuries.

The other group of foreigners who have been buying significant amounts of treasuries are the oil exporters. In fact some research links growth in the so-called "petrodollars" (proceeds from energy sales) to higher treasury purchases. But as the US reliance of foreign oil declines, fewer petrodollars should result in relatively smaller purchases of US bonds.

This means that foreign purchases of treasuries are unlikely to grow significantly from current levels. That leaves US domestic investors to pick up the slack left behind by the Fed and foreign buyers. Based on the projections from Sandler O’Neill, domestic buyers will be called upon to buy an increasingly larger share of government paper going forward.

Source: Sandler O’Neill (click to enlarge)

Rising yields in the intermediate and possibly longer term is an inevitability - the only way to attract domestic buyers to this growing supply.
Sandler O'Neill: - In light blue [in reference to chart above] we see the episodic role of foreign purchases, driven heavily by emerging markets’ swelling reserves as trade and current account surpluses exploded until 2006, followed by industrial market buying to escape several phases of the euro crisis. Contemplating the chart carefully. domestic private purchases in dark blue must now take up substantial net demand slack.  ... domestic private buying (retail and institutional) must essentially quintuple back to their levels during the financial crisis. This seems unlikely without additional yield
And it's not just the longer term rates that will increase as the result of this shift to private domestic buyers. Sandler O'Neill points out that as the longer term rates rise, the Fed will be forced to raise the overnight rate. This may end up being less about the US employment situation and more about keeping the yield curve "steepness" (see post) from becoming extreme. One of the reasons short term rate adjustment will be an  imperative is the risk of a new buildup in the so-called carry trade.
Sandler O'Neill: - This also leaves a quandary for short term interest rate policy. Should the 10-Year reach 4%, the spread over Fed Funds will be confronting its well-defined historical peak. In our view, the Fed would be highly likely to adjust the policy rate upwards in this situation to avoid further market distortions and a potential explosion in carry trade and other counterproductive rate arbitrage activity. If this is correct, short term interest rates might no longer be simply anchored to employment metrics.
The Fed's taper, combined with weaker foreign purchases of treasuries, will leave private domestic investors to take on an increasingly larger portion of treasury purchases. The only way to attract more domestic buyers is with higher yields - which will ultimately result in rising rates across the curve.
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Thursday, January 23, 2014

The risk-on trade sends emerging markets currencies to new lows

Today's China-induced "risk-off" trade sent emerging markets currencies into a sharp decline. As discussed before Turkey and South Africa have been hit the hardest recently and today touched fresh all-time lows.

ZAR = South African rand, TRY = Turkish lira
(chart shows dollar appreciating against these currencies; source: 

But even some of the larger emerging markets nations saw their currencies decline to multi-year lows. Brazil and Russia in particular experienced a significant selloff.

BRL = Brazilian real, RUB = Russia ruble
(chart shows dollar appreciating against these currencies; source: 

The "risk-on" currency correction was not limited to emerging markets, as the Australian dollar touched levels not seen since 2009 (at some point hitting US$ 0.874 - vs. 1.05 last spring). It seems that some of the volatility seen in global markets during the Eurozone crisis has returned.
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Eurozone manufacturing expansion accelerates; risks remain

We've had some significant moves in the currency markets this morning. In particular, the euro rose quite sharply on the back of some strong manufacturing numbers out of the Eurozone.


Germany remains the euro area's powerhouse, with manufacturing expansion there accelerating further, driving up the aggregate measure.


European stock markets (followed by the US) however fell in spite of this seemingly good news.

The primary reason for the equity markets' sell-off was the weak manufacturing signals out of China (see Twitter post). As discussed here, China's near-term economic trajectory presents the greatest risk to global growth - particularly for the Eurozone.

The equity markets were also uneasy with the euro strength, which could choke exports from the area. Furthermore, Draghi struck a cautious tone with respect to the area's economic recovery, saying: "All in all, the risk of setbacks is large. I would be very careful not to give an overly optimistic outlook."
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Wednesday, January 22, 2014

Shinzo Abe betting on wage growth

Prime Minister Shinzo Abe: - "Japan’s economy is just about to break free from chronic deflation. This spring, wages will increase. Higher wages, long overdue, will lead to greater consumption."
Wage increases are vital for Abenomics - without them the current policies are simply unsustainable (see discussion). If consumers are squeezed (see post), spending will decline and the nation will face deflationary pressures once again. The government is applying pressure on the corporate sector to boost pay. According to ISI Research, the following 5 firms have announced wage increases.
  • Nidec
  • Nomura
  • Daiwa
  • Orix
  • Fukoku
Is this the beginning of a real trend or just a superficial move by some firms who are trying to boost their image? Many analysts remain skeptical.
The Star: - Japanese companies are unlikely to raise wages significantly this year and inflation will be well below the official target, economists said in a Reuters poll, suggesting tough challenges for Prime Minister Shinzo Abe's drive to end years of falling prices and generate robust growth.

The forecasts bolster the view that, with a few high-profile exceptions, businesses are cautious about passing on higher profits to employees, which is seen as vital to Abe's hopes for sustained growth in the world's third-biggest economy.

The economists in the monthly survey are also pessimistic that the Bank of Japan can meet its goal of 2% consumer price inflation by next year.
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Monday, January 20, 2014

China's GDP questioned; monetary conditions tighten once again

Markets were not impressed with China's 7.7% annualized 4th quarter GDP, which came in better than expected.


Most economists still anticipate further deceleration in China's economic expansion in 2014.
Reuters: - China's economy narrowly missed expectations for growth to hit 14-year lows in 2013, though some economists say a cooldown will be inevitable this year as officials and investors hunker down for difficult reforms.

The chance that the world's second-largest economy may decelerate in coming months was underscored on Monday by data that showed growth in investment and factory output flagged in the final months of last year.

Waning momentum capped China's annual economic growth at a six-month low of 7.7 percent in the October-December quarter, a slowdown some analysts say may deepen this year as China endures the short-term pain of revamping its growth model for the long-term good.
Moreover, some analysts are questioning the validity of China's growth data.
ISI China Research: - ... from what we have seen, we think it would be a mistake for investors to markedly revise their views on China's economy on the basis of these new data.

So a few comments on the process, and what analysts have to work with from the NBS in monitoring China's economy.

Beijing does not report its GDP data in a way that is consistent with the UN standards for the National Income and Product Accounts - the way data is reported in all of the world's modern economies. A little more data will be provided in the next days, but not sufficient detail for anyone to form a well-reasoned judgment of whether the economy and its important components are doing better, about the same or worse.

Real GDP growth, as reported by Beijing has been, for the most recent 7 quarters, 7.6%, 7.4%, 7.9%, 7.7%, 7.5%, 7.8% and 7.7%. This is, in our view, hard-to-imagine stability since 2Q2012.

China does not report a level of Real GDP, ever. There are no historical data, and no contemporary values either.

There is no way to verify the consistency, or lack thereof, of China's reported % y/y and % q/q growth rates. Frustrated by this opacity, and having found internal inconsistencies in these numbers (as opposed to data), we assign no weight to the % q/q numbers provided.
Complicating matters is the new wave of tightening in China's monetary conditions. Once again short-term rates increased suddenly and the PBoC injected additional liquidity this morning (see story). Given how unpredictable the central bank has been in controlling the interbank rates, investors are clearly nervous.

The combination of slowing economic growth, unease with real estate and credit expansion (particularly shadow banking), stronger currency (hurting exports), lack of direction for the corporate sector (see post), and uncertain/volatile monetary stance is creating jitters in China's equity markets. This morning the Shanghai Composite fell below 2000 again (the peak reached in 2008 was around 6000). The last time we were here was during the first PBoC-induced liquidity crunch last summer (see post).


Many economists view China's growth - or lack thereof - posing the greatest risk to near-term global expansion.
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Sunday, January 19, 2014

Analysis of sovereign CDS

Attached is an interesting paper from HSBC on sovereign CDS. They used cluster analysis to show that correlations in CDS spreads are less about geographic proximity and more about related risk profiles of various nations. The researchers also show how the clustering changed over time.


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Saturday, January 18, 2014

Currencies of natural resource exporters under pressure

Some of the largest natural resource exporters with floating exchange rates have seen their currencies come under significant pressure over the past year.

And it wasn't just the US dollar strength that was responsible for commodity producers' currency adjustments - the dollar (DXY index) is up only about 2% over the same period. Some of these countries clearly have other issues that prompted the currency selloff, but as a whole, it is the decline in demand for natural resources (the end of the "commodities super cycle") that precipitated this weakness. Of course much of this adjustment in demand is driven by slower economic expansion in China.
Bloomberg: - China’s factory output and investment growth probably weakened in December, adding to signs the world’s second-largest economy is losing momentum as analysts forecast 2014 expansion at the lowest in 24 years.

Industrial-production gains slowed to a five-month low of 9.8 percent and gross domestic product grew 7.6 percent from a year earlier in the October-December period, based on the median estimates of analysts before data due Jan. 20. Expansion will moderate to 7.4 percent this year as investment slows and overcapacity is squeezed, according to a survey last month.
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Friday, January 17, 2014

How bank reserves make the gap between deposits and loans disappear

Earlier this week, CNN Money ran a story on JPMorgan's quarterly results. Instead of focusing on the earnings, the author's (Stephen Gandel) discussed the fact that JPMorgan's loan-to-deposit ratio (LTD) hit a new low.
FORTUNE: - The nation's largest banks are healthier than they have been in years. Someone, apparently, forgot to tell their loan officers.

JPMorgan Chase reported its 2013 profits on Tuesday. The news was mostly good -- bottom line: $18 billion -- but there was one significant black spot, not just for the bank, but for the economy in general. A key lending metric, the ratio of the bank's loans-to-deposits, hit a new low.

In 2013, JPMorgan on average lent out just 57% of its deposits. That's down from 61% a year ago and the lowest that ratio has been in at least a decade. Back in 2004, JPMorgan's loan-to-deposit percentage was as high as 88%.
While JPMorgan's LTD is particularly low, the bank is by no means unique. As discussed earlier (see post), LTD in the US is at the lows not seen in decades. On an absolute basis the gap between deposits and loans is now at some $2.4 trillion and growing. This divergence seems completely unique to the post-financial crisis environment.

Red = loans and leases, Blue = deposits (all commercial banks)

As the CNN story suggests, there are a few possible explanations for this trend. Here are four of them.

1. Demand for credit remains weak due to economic uncertainty, large amounts of cash on corporate balance sheets, jittery labor markets, poor wage growth expectations, general unease with taking on debt, etc.

2. Regulatory uncertainty and tighter (and to some extent unknown) capital requirements are preventing banks from extending more credit.

3. Exceptionally low rates make some forms of lending unprofitable.

4. Banks are running unusually large excess reserve positions with the Fed that are "crowding out" lending.  These reserves are effectively "loans" to the Fed paying 25bp, funded with bank deposits that pay near zero, creating riskless profits with zero regulatory capital requirement.

There are arguments to be made for all four. The last one however is particularly intriguing because the $2.4 trillion gap between deposits and loans is a familiar number. The excess reserves in the banking system is now ... also around $2.4 trillion.

The chart below adds bank reserves held with the Fed to loans and leases - and the gap "disappears" (here we use total reserves vs. just the excess reserves, but the difference is not material to this trend.)

Red = loans and leases + bank reservesBlue = deposits (all commercial banks)

Coincidence? Perhaps. But if there is any validity to the explanation #4 above, it would suggest that QE, which is directly responsible for the $2.4 trillion in excess reserves, was not helpful (and possibly harmful) to credit growth in the US.
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Thursday, January 16, 2014

Bond bears seem overextended

Directional investors/traders remain heavily short or under-invested in the bond market. For example the CFTC commitment of traders shows speculative investors, particularly the smaller ones, being quite short the 10y note futures.

Source: Barchart (thousands)
"Comm" stands for "commercial" futures participants, such as dealers who use futures to hedge their positions

Institutional investors are also heavily under-invested in bonds. The so-called "real money", such as pensions, endowments and insurance firms were overweight duration (holding higher bond positions than their targeted allocations) when yields were the lowest (back in 2012). Now with higher yields, these same investors (after being whipsawed by the market) are running duration levels that are the lowest since 2008.

Source: DB

These technical factors should provide some support to treasuries in the near term in spite of the Fed's taper - particularly if the equity market does not perform as well as many are expecting. 

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Wednesday, January 15, 2014

TruPS CDOs now exempt from the Volcker Rule

Yesterday, after some intense industry pressure, US regulators (OCC, FDIC, SEC, etc.) collectively announced that the bulk of the so-called TruPS CDO securities issued prior to May 19, 2010 will be exempt from the Volcker Rule. Let's take a quick look at the issues around this decision.

1. What are TruPS?

Trust Preferred Securities, issued mostly by banks, are longer-term fixed maturity securities that pay a fixed quarterly coupon. They are junior to any bonds but senior to common equity (similar to preferred stock). Securities issued by banks prior to May 19, 2010 qualify for tier-1 capital and were a good way for many smaller banks to raise capital.

2. What are TruPS CDOs?

TruPS issued by multiple banks were pooled for diversification and funded by issuing "tranched" CDO debt. The coupon payments from the TruPS pool are used to repay this debt, with the higher rated tranches having a priority claim on these payments over the lower rated CDO debt.

3. How does the media explain this exemption from the Volcker Rule?

Here is an example from the WSJ.
WSJ: - Banks had been seeking changes to a provision of the Volcker rule that would have forced firms to sell such debt investments by July 2015 to avoid violating the regulation.

The so-called Trups CDO provision had sparked heated opposition from community bankers, who said the rule would unfairly harm hundreds of small banks that bought the investments by forcing them to take immediate write-downs on their holdings.
4. Do community banks really invest in TruPS CDO?

While some smaller banks do have CDO holdings, it's not that common, and the explanation from the WSJ is simply wrong.

5. So how was the banking industry able to pressure the regulators into this exemption?

Community banks were allowed to raise tier-1 capital by issuing TruPS. But small banks could not access the broader capital markets to sell this paper. It would be the equivalent of a local community bank attempting a rated bond issuance or an IPO. That just doesn't work. So CDO managers would privately transact with small banks and pool their TruPS in a portfolio that could be financed in aggregate (as oppose to each bank having to find investors for its trust preferred securities).

The American Bankers Association and other industry groups argued that if you allow small banks to raise capital using TruPS that could only be efficiently financed via CDOs, you can't prohibit other banks from buying/holding these securities. This "inconsistency argument" worked and banking entities in the US are now allowed to invest in (pre-May 19, 2010) CDOs primarily consisting of TruPS collateral.

6. What's next?

The next on the chopping block are CLOs, where the industry is arguing that if corporate loans are good enough for banks, some of the debt issued against portfolios of corporate loans should be allowed as well. No comment from the regulators so far.
Reuters: - The Loan Syndications and Trading Association (LSTA) urged US regulators on Wednesday to modify the Volcker Rule concerning collateralized loan obligations (CLOs) to prevent upheaval in the industry and potentially big losses for US banks.

Elliot Ganz, the LSTA's executive vice president, told the House Financial Services Committee that the definition of "ownership interest" in the final Volcker Rule will have significant unintended consequences for the CLO market, including material losses for US banks and restrictions on the availability of credit for US businesses.

Five US bank regulatory agencies on Tuesday approved a tweak to the rule that would allow banks to keep interests in certain funds backed by trust-preferred securities, but they did not address CLOs.
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Tuesday, January 14, 2014

The Fed preparing markets for the reverse repo facility (FRFA)

The Fed's "full-allotment overnight reverse repurchase agreement facility" (FRFA) - a mechanism to control short-term rates (see post) - is no longer just an academic exercise. Given how dysfunctional the interbank market has become (see post), using the fed funds target as the only post-QE monetary tool is no longer an option. FRFA allows the Fed to set a floor under the overnight secured lending rate (repo) by offering to borrow funds from a broad array of market participants - not just banks - at a fixed rate. Because this facility is effectively a riskless deposit with the Fed (legally it's a loan to the Fed), there shouldn't be any meaningful private transactions at rates below the FRFA rate - thus the rate floor. This mechanism also prevents the overnight rates from becoming negative - as was the case in some markets in Europe - to make sure that money market funds continue to function.

The Fed has been testing the facility since last September and seems to be happy with the results. The demand for the facility picks up sharply when the FRFA rate is about 4-5 bp below the private market repo rate. That's the discount that investors are willing to accept on their "deposit" rate in order to keep their money with the Fed rather than with a private institution.

Source: NY Fed (GCF stands for General Collateral Financing,
meaning that any treasuries can be used as collateral as opposed to specific securities)

Late last year the Fed raised the maximum FRFA bidding amount to $3bn from $1bn, as testing progresses to the next phase. When the program becomes fully operational, these amounts would increase dramatically.

One by one the Federal Reserve officials are preparing the markets for the FRFA implementation. Once QE winds down, the FRFA fixed rate becomes the next monetary policy tool.

1. Simon Potter (last month):
WSJ: - ... Simon Potter, who runs the New York Fed's markets group, gave a big thumbs up the reverse repo program based on what he's seen with the testing.

He said in his speech the overnight reverse repos "may strengthen the floor for short-term interest rates and, with it, the Federal Reserve's control of money market rates, by surmounting the competitive and balance sheet frictions seen in money markets and by extending the central bank's payment of interest to a wider universe of relevant counterparties."
2. Bernanke:
CBS: - Looking into the years ahead, Bernanke said the central bank has the tools -- including adjusting the rate on excess bank reserves and so-called reverse repurchase agreements, or repos -- to return to a normal policy stance without resorting to asset sales.

"It is possible, however, that some specific aspects of the Federal Reserve's operating framework will change,” he said. On the economy, Bernanke noted unemployment remains elevated at 7 percent, and said the number of long-term unemployed Americans “remains unusually high.”
3. Dudley:
BW: - Dudley said the Fed may decide to extend a program involving so-called reverse repurchase transactions aimed at giving it greater control over short-term borrowing costs.

The new tool, called the fixed-rate, full-allotment overnight reverse repurchase facility, is intended to put a floor under short-term money-market rates. It allows banks, broker-dealers, money-market funds and some government-sponsored enterprises to lend the Fed unlimited amounts of cash overnight at a fixed rate in exchange for borrowing Treasuries in reverse repo transactions.
4. Williams:
BW: - Federal Reserve Bank of San Francisco President John Williams said reverse repurchase transactions may be an effective way for the Fed to control interest rates when it starts withdrawing unprecedented stimulus.

“This is potentially a very useful tool,” Williams said to reporters today after a speech in Phoenix. “It allows us to manage short-term interest rates more directly even at the same time that we have a very large balance sheet and lots of excess reserves.”
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Sunday, January 12, 2014

An explanation for persistent weakness in China's stock market

There have been numerous theories attempting to explain China's stock market's lackluster performance in recent years.

 China Stock Market (SSE Composite) - source:

One of those explanations focused on the need for reform. Once the economy and the markets undergo some key reforms, the market will take off. At least that was one of the theories. So now that some major reforms have been announced (see story), why hasn't the market responded? Donald Straszheim of the ISI Group wrote a comment this weekend that provides a hint...
ISI: - This week, PM Li said that China has entered a transition period - from 'high growth' to 'medium-high growth'. He's got the direction right. Li also indicated that China is losing its competitive edge in low- and medium-level (tech) products. He's right, sharp wage gains are eroding the Middle Kingdom's competitiveness. His solution - China must rely more on technological innovations to drive future growth. Unfortunately, innovation is and will remain, we believe, China's weak point. In other words, if innovation is China's future - that future is grim. China is a technology adaptor; it is not an innovator. Li made the above remarks at an annual government-sponsored meeting which highlights major accomplishments (and makes monetary awards) in the science and technology arena.
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Growth in loans at US banks continues to weaken

Loan growth in the US continues to slow. Credit expansion is certainly not nearly as bad as what has transpired in the Eurozone (discussed here), but the slowing trend is unmistakable. The current rate of loan growth is now significantly below the nominal GDP expansion.

Source: FRB (adjusted for the FASB 140 accounting change)

One exception may be the corporate sector, where loan growth has been robust (see story). But as percentage of banks' total balance sheets, business loans are not growing. In fact much of the corporate debt growth is actually coming from outside the banking system (see post on shadow banking).

Many expect that bank balance sheets will remain constrained by the new regulatory framework (Basel II, etc.), with loan growth continuing to stay weak. As a result, the increases in US broad money supply (M2) have slowed as well.

This is one of the reasons inflation in the US has been subdued in spite of massive injections of liquidity by the Fed.
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Friday, January 10, 2014

Today's jobs report: a wake-up call or an aberration?

Today's payrolls shocker (see story) sent treasury yields sharply lower. As discussed last month (see post), speculative investors have piled into the market and were forced to cover their shorts after the jobs report. Going forward, until there is more visibility on the labor markets, investors will be more cautious shorting treasuries.

The shape of the treasury curve move has become fairly predictable, with the "belly" experiencing the largest moves (see post).

Now comes the debate on whether this jobs report was a fluke.
LA Times: - Analysts were shocked by Friday's Labor Department report that the economy added just 74,000 net new jobs in December, about one-third what many had forecast. The bad weather in parts of the country last month apparently played a role, and there were unusually big payroll drops in the movie industry and at accounting firms.

Still, that doesn't fully explain why the hiring was so weak. The healthcare sector was flat, as was transportation and warehousing, for example. On the whole, job growth was not only the lowest in almost three years, it was incongruous with the latest string of positive economic data -- on exports, homebuilding, consumer spending -- indicating an economy and job market gathering steam.
Is this a wake-up call on more weakness in the US labor markets or simply an aberration? Thoughts, comments?
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Thursday, January 9, 2014

Is the next wave of job growth in the US coming from construction?

One of the interesting aspects of the latest ADP private payrolls report is a surprising pickup in construction jobs.

Source: ADP

Growth in construction payrolls was certainly expected, but we are talking almost 50K of new jobs added in December. Some analysts remain skeptical.
MarketWatch: - ADP reported that private-sector construction employment expanded by 48,000 jobs last month, the most since February 2006, and more than double November’s gain of 21,000 jobs. Given particularly chilly recent weather, ADP’s report had some economists scratching their heads.

“The ADP estimate for December Construction Payrolls is a remarkable +48,000,” analysts at Stone & McCarthy Research Associates wrote in a note. “The 48,000 increase seems high to us, especially in light of the unusually cold weather in later November and early December.”

However, Mark Zandi, chief economist of Moody’s Analytics, which prepares the report using ADP’s data, said conditions weren’t stormy enough to hit jobs.

“People still put up homes in the cold. A lot of construction does not go up in cold-weather areas anyway,” Zandi said.
While there are questions around this December estimate, it is possible that we are seeing a real acceleration in US construction employment growth. Consider the fact that current US construction spending as percentage of the GDP is significantly below what it was at any time over the past 20 years, possibly much longer. Nobody is saying that this percentage will return to some historical average. But even an adjustment from the current level (chart below) to 6% of the GDP would add about $100bn per year to construction spending in the US. That could certainly generate some jobs.

To put it another way, over the past 10 years the number of American construction jobs has declined by 13%.  Over the same period, the US real GDP has grown by over 18%. That's quite a gap and even a moderate degree of normalization could have a significant effect on the labor markets.
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Wednesday, January 8, 2014

Global wheat markets seem to be well supplied

US wheat futures fell to new lows today not seen since 2012. Some had hoped  wheat prices would stabilize as Egypt, the world's largest wheat buyer, entered the market.
WSJ: - Egypt's less-frequent purchases has been a reason why wheat futures were one of the worst-performing commodities of 2013, when they slumped 18% on the year.

Analysts are now optimistic that prices are low enough to mean the North African country will continue ramping up its purchases this year in a bid to avoid public discontent with food shortages.

At the weekend Egypt's state-owned wheat buyer, the General Authority for Supply Commodities, bought 535,000 metric tons of Ukrainian, Russian, French and Romanian origin wheat at an average price of $317 a ton. This is one of the North African country's biggest purchases in the international market in recent years, topping a 475,000-ton Black Sea order in September 2012 and a 420,000-ton purchase of Russian wheat a year before.
Another factor providing support for wheat in recent days has been the frigid weather in the US, which may pose risks to dormant wheat in the Midwest (see story).

Nevertheless the March-2014 CBOT wheat futures declined some 1.4% today.

March 2014 whet futures

It seems that increased production in Canada and Australia may keep the global markets well-supplied. Stronger dollar due to better than expected ADP employment report today (see story) is not helping overall commodity prices either.

Note: Here is an interesting article discussing how low wheat and corn prices could be damaging to some Republican candidates in the upcoming elections.
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So far the ECB is not responding to ultra-low inflation readings

The Euro area inflation indicators are pushing into dangerous territory. The core CPI measure in particular is trending sharply lower. The ECB has so far been taking a "wait and see" attitude, though some on the Governing Council are apparently getting concerned.
Chicago Tribune: - Core inflation, which strips out volatile costs like food and energy, hit a record low of 0.7 percent.

The readout will heighten concerns at the ECB about entrenched price weakness taking hold, though strong company activity towards the of last year will give them some comfort.

"Obviously they are worried, but it's not significantly lower than it was a month earlier," Anders Svendsen at Nordea said. "I don't think it's enough to prompt a new rate cut but I do think it's enough to keep them dovish and ready to act."

Of course it's no longer about lowering the overnight rate. Given the persistent credit contraction in the euro area (see post), there is pressure on the ECB to add liquidity to the banking system by potentially providing another round of LTRO financing. The current LTRO balances are nearly half what they were after the last 3-year financing program was offered in 2012 (see story).

€ million  (source: ECB)

But many analysts believe the ECB will be on hold for some time because of seeming economic improvements in the Eurozone periphery (see chart below) as well as stronger data out of the US.

Source: Markit

There is some concern, paticularly in Germany that if the ECB's policies diverge from the Fed's, the euro could weaken significantly - potentially causing prices to rise more than desired. Germany's traditional fear of inflation and unease with unconventional tools seem to have permeated the ECB's thinking (particularly now with Ilmars Rimsevics joining the Governing Council). Doing nothing however is also a risky policy because ultra-low inflation and weak credit conditions are a recipe for Japan-style deflationary trap (see story).
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Monday, January 6, 2014

No growth in global M&A activity in 2013

2013 saw the first annual decline in global mergers and acquisitions (M&A) activity since the financial crisis. Mergermarket notes that in spite of historically low volume of "lapsed bids" (deal proposals that didn't go through) and the massive Verizon Wireless transaction, M&A growth just hadn't materialized.
Mergermarket:- [2013 ended] as the third static year for deal value, down 3.2% at US$ 2,215.1bn compared to US$ 2,288.8bn in 2012. 2013 has been the slowest year since 2010 (US$ 2,089.6bn). Mega-deals totalling US$ 397.9bn, Verizon’s US$ 124.1bn deal value, a US recovery and the lowest number of lapsed bids on record, have failed to spur on significant growth.
Source: Mergermarket

A major headwind for M&A has been the decline in private equity exits (see example), which was down 9% in 2013. This is in spite of a fairly vibrant IPO market (see story). When private equity firms have trouble "harvesting" their portfolios, there is less "recycled" institutional capital available for new transactions (including new commitments to private equity funds).

In dollar terms, the biggest M&A increase was in Telecommunications, Media and Technology (TMT) - driven of course by Verizon and a few tech deals, particularly within the cloud computing/SaaS space. The largest decrease was in the energy/mining sector, as natural resources demand from China weakened and commodities came under pressure (see post).

Source: Mergermarket
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Sunday, January 5, 2014

Venezuela's "radicalization of the economy" has brought the country to the brink

News out of Venezuela continues to be quite grim, pointing to further economic deterioration. This is truly astonishing, given that Venezuela has the highest proven oil reserves in the world - even larger than Saudi Arabia's. Here is the the latest:

1. Foreign reserves are down 28% since the end of 2012 (currently at $21.4 billion). Part of the decline was caused by lower gold prices, which impacted the value of Venezuela's bullion holdings. The country has $18 billion in short-term debt - with some $7bn coming due shortly.

2. Not surprisingly the rating agencies have downgraded the nation's debt with negative outlook (see Moody's statement). S&P called what is taking place in Venezuela "growing radicalization of the economy".

3. The recent effort to borrow dollars from private investors has not been received well. The central bank was only able to raise US$24.3 out of $100mm of securities auctioned.

4. Venezuela's inflation rate spiked to 56.2% (not a typo) during 2013.

5. With the Venezuelan bolivar buying power collapsing, demand for dollars has accelerated. Black market dollars are now trading at some 1,000% above the official exchange rate.
GS: - The supply of dollars to the economy at both the CADIVI [Commission for the Administration of Currency Exchange] and SICAD [the central bank] outlets have been insufficient to meet the large pent up demand for foreign exchange in the economy which is leading a significant pressure in the non-official market where the VEF/USD [bolivars per one dollar] is trading above 60 (or about a large 1,000 percent premium over the official 6.3 parity).
6. The government's answer to this out of control inflation has been to take over businesses, jail the executives/owners, and force discounting. Over 1000 businesses were ordered to cut prices. The government calls this their fight against "speculators".

7. 2013 was marked by empty store shelves (in part as a result of #6 above, as price controls often create scarcity). For those who remember the long lines and scarcity of products in Eastern Europe a few decades back, the situation in Venezuela is significantly worse. While the media has focused on the lack of toilet paper, the more critical issue is food. Items such as corn oil have become difficult to find. The central bank's so-called scarcity index (discussed here) reached new highs in 2013 - see chart below.

Source: Central Bank of Venezuela

President Nicolas Maduro's repose?  He is simply blaming it all on what he calls “parasitic bourgeoisie” as he attempts to consolidate power (see post).
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Saturday, January 4, 2014

Slowdown in productivity growth still a puzzle

The call for comments on the post about taxation (here) has generated an excellent discussion - with comments that are both thoughtful and informative. Thanks everyone! Since the process seemed to work so well, let's try something like that again.

The topic this time is the recent decline in labor productivity growth in the US.

Source: BLS (PRS85006093)

The slowdown seems to be a puzzle, with a variety of explanations, none of which seem to be entirely satisfactory. Here is what Ben Bernanke had to say about it yesterday:
Ben Bernanke: - Although the Federal Reserve, like other forecasters, has tended to be overoptimistic in its forecasts of real GDP during this recovery, we have also, at times, been too pessimistic in our forecasts of the unemployment rate. For example, over the past year unemployment has declined notably more quickly than we or other forecasters expected, even as GDP growth was moderately lower than expected a year ago. This discrepancy reflects a number of factors, including declines in participation, but an important reason is the slow growth of productivity during this recovery; intuitively, when productivity gains are limited, firms need more workers even if demand is growing slowly. Disappointing productivity growth accordingly must be added to the list of reasons that economic growth has been slower than hoped. (Incidentally, the slow pace of productivity gains early in the recovery was not evident until well after the fact because of large data revisions--an illustration of the frustrations of real-time policymaking.) The reasons for weak productivity growth are not entirely clear: It may be a result of the severity of the financial crisis, for example, if tight credit conditions have inhibited innovation, productivity-improving investments, and the formation of new firms; or it may simply reflect slow growth in sales, which have led firms to use capital and labor less intensively, or even mismeasurement. Notably, productivity growth has also flagged in a number of foreign economies that were hard-hit by the financial crisis. Yet another possibility is weak productivity growth reflects longer-term trends largely unrelated to the recession. Obviously, the resolution of the productivity puzzle will be important in shaping our expectations for longer-term growth.

Thoughts? Comments?
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