Sunday, November 29, 2015

A contrarian perspective on the short euro trade

As the euro continues to drift lower, it has become the accepted wisdom that we are headed for parity with the dollar.


Indeed it is widely expected that the ECB will expand its securities buying program in size, duration and scope (the ECB has been exploring buying municipal bonds for example). The central bank is also expected to cut the benchmark rates, pushing deeper into negative territory. The chart below shows the Euribor futures trading significantly above par as the market expects sharply lower interbank rates.


This of course differs sharply from the monetary policy in the US where markets now assign 70%+ probability of a rate hike next month (as discussed here back in October). There is no question that such divergent policy trajectories should push the euro lower. But has a great deal of this divergence been priced into the markets?

As the Euribor chart (above) shows, the market could now be "priced to perfection". The expectations for a "bazooka" new stimulus from the ECB are also manifested in the record low Eurozone bond yields. For instance, here is Germany's 5-year government bond yield which is clearly pricing in much more demand ahead.

These expectations have resulted in the short euro position becoming a crowded trade once again. The chart below shows speculative accounts' net euro futures positions. What happens if the announcement from the ECB is not quite the "shock and awe" that markets expect?


What could push the ECB to come out with a more modest stimulus increase? Here are some possibilities.

1. In spite of the VW scandal and the Paris attacks, German business sentiment remains strong. The Ifo industrial sentiment exceeded economists' forecasts while the service sector climate hit record highs (below). While the China slowdown certainly created a drag on German GDP growth, the impact has not been as severe as many economists were expecting.

Source: Ifo

2. Moreover, we are seeing significant fiscal stimulus from Germany as the nation's government is addressing the refugee influx.

Source: Deutsche Bank

3. At the Eurozone-wide level we see the composite PMI also beat consensus, touching multi-year highs. The ECB has been known to monitor such PMI indicators.

Source: Markit/

4. The euro area credit situation is improving, albeit gradually. The deleveraging in the banking system has been over for some time as loan balances continue to grow.

Source: ECB (adjusted for sales and securitization)

We can see signs of stronger bank lending showing up in the Eurozone's broad money supply, which increased more than expected.


5. Finally, the euro area's core CPI rose more than consensus in the latest report. While this is still far from the ECB's target, some central bankers looking at the chart below may want to pause before introducing massive amounts of new stimulus.


This latest core CPI report will therefore increase pressure from some of the more hawkish council members to proceed with a more modest/gradual program when introducing new stimulus.
Jens Weidmann (FT): -  The core inflation rate stands at 1% and should gradually increase towards our definition of price stability, which is – let me remind you – a medium-term concept.

Crucially, the decline in oil prices is more of an economic stimulus for the euro area than a harbinger of deflation.

Lower oil prices reduce energy bills for both households and firms. That frees up financial resources which can then be put to use elsewhere – for consumption, investment or for reducing the debt overhang. All of this is good for the economies of the euro-area countries.
There is no question that the fundamentals for the euro remain bearish, especially vs. the US dollar. However, given some of the trends discussed above, a contrarian approach would suggest more caution on that crowded short euro trade.


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Wednesday, November 25, 2015

 Canada Need Not Fear Deficit Financing

As the new Liberal Government takes shape, all eyes will be focussed on how it proposes to finance its ambitious agenda . Deficit financing will be at the centre of all discussions concerning jobs and economic growth over the next five years. In its latest Economic and Fiscal Update (November, 2015), Canada's Finance Department recognizes  the damage that has already occurred from plunging commodity prices, the deterioration in the country's terms of trade and the worldwide slowdown . The major question facing the Government is : to what extent can it  undertake deficit financing to achieve its economic goals.? What is the capacity of the Federal finances to meet this challenge? 

Fiscal Outlook

 Table 1 is a summary of the fiscal outlook to financial year 2021 prepared by Finance Canada, the department responsible for the national budget.  Their budget projections used the former (Harper) government’s 2015 fiscal framework , updated to November, 2015. None of the new government's revenue or  expenditure programs are included.

Table 1  Fiscal Outlook

A couple key metrics standout. First,  over the next three years ( 2016-19) the Federal deficit will average 0.1% of GDP--- well within a comfort zone and not out of line historically.  Expected economic growth, although modest over the  next 5 years, will likely provide sufficient revenues to absorb the annual deficits so that the level of Federal debt at the end of period remains largely unchanged.

Second, the Federal debt as a percent of GDP actually falls from 31% in 2015/16 to 25.2% by 2020/21.  Comparing these levels of debt/GDP , the levels represent the lowest in over  30 years, especially in periods of good economic growth in the latter half of the 1990s. ( see Chart 1).  .

Chart 1   Federal Debt as % of GDP


 Canada has always been well-received in the capital markets at home and abroad ; bond auctions continue to be  well covered and receive firm bids.  More importantly, as Chart 2 demonstrates, the entire  Canadian government yield curve has shifted downwards , a reflection of low inflation expectations and confidence in the quality of the security sold. Of late, there has been shift towards issuing longer dated bonds to take advantage of the falling long term rates ( 10-30 year terms). Accordingly, the weighted average rate of interest on public  market debt has fallen to 2.37 per cent in 2013–14 ; this average rate , now stands above the current yield  for bonds  10years and up. Any additional long-term issuance will  contribute to a reduction in refinancing risk at a low cost .

Chart 2

The IMF refers to 'fiscal space' as " the room in a government's that allows it to
provide resources for a desire purpose without jeopardizing the sustainability of its financial position" . Canada is  in no way jeopardizing the Federal budget , given the low interest rate environment. More importantly, should the fiscal restraints be relaxed to accommodate additional borrowing aimed at developing infrastructure projects, these projects can  pay for themselves over the longer term.

Comparison to US Stimulus Programs

 Parliament opens the first week of December at which time Canadians will learn more of the programs and policies that will constitute the Federal budget and hence the anticipated future deficits. At this point we can assume that the Liberal's platform , featuring infrastructure spending,  individual spending programs, and  tax changes aimed at the redistribution of income will be at the centre of the next Federal budget. The platform  anticipates a budget deficit not to exceed $10 billion in any year.  

American readers  should note that what is proposed by the Canadian  government is quite different from  the American Recovery and Reinvestment Act, 2009( Stimulus Bill ) . That bill was designed  as an emergency measure to kick start the US economy after the financial crisis of 2008. The main thrust was tax relief for  the individuals  and corporations to save and create new jobs;  a much small component included  spending on new infrastructure . A secondary goal was to provide immediate relief to those state and local governments hardest hit by the steep recession. 




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Wednesday, November 18, 2015

Eurozone reacts to anticipated fed rate hike

Guest post by Marcello Minenna

Almost without warning, the Eurozone government bonds and the Euro experience spikes in volatility this past month. These abrupt movements are clearly correlated with the mayor announcements of a change in monetary policy by, initially by the ECB and then, by the FED. The European banks had been actively pursuing front-running strategies which try to anticipate ECB's moves until the beginning of Quantitative Easing program (PSPP). Not always with success, as experienced with the “flash crash” of April and June. The new game plan spectacularly backfired with the hawkish statement of Ms. Yellen during the FOMC of the 28th of October. This igniting a massive sell-off of Eurozone bonds with an intensity comparable to the previous “flash crashes”.

At the October 22 meeting, Draghi has clearly anticipated an acceleration of the monetary easing policies. He hinted at cutting the deposit facility rate (now at -0.2%) by at least 10 basis points and at increasing the pace of asset purchases. Finally, the ECB strongly suggested that the PSPP program may be extended for another 6 months. Both policy moves were designed to counter a strengthening Euro.

Figure 1.

In August it has become apparent to the European policy makers that a stronger Euro was having an adverse effect on the Eurozone’s balance of trade (Figure 2), thus harming the export driven recovery envisioned by the ECB.

Figure 2.

Since a rising currency was not seen then with favor by the ECB, the market began to evaluate a further monetary easing by the ECB as very likely, especially a reduction of the ECB deposit facility rate. This, in turn, resulted in the European banks resuming their hoarding of government bonds and pushing yields to very low levels in the following month. Even issues characterized by negative rates slipped below the deposit facility rate (Figure 3) thus becoming ineligible for the ECB purchase under the PSPP.

Figure 3.

This buying behavior would have made sense only if banks were expecting an interest rate cut. In fact, only bonds with a yield higher that the deposit facility rate are eligible for PSPP purchases: by lowering the deposit rate, the ECB is automatically widening the pool of purchasable bonds. In this scenario, the owner of the now eligible bonds would have been in the best position to exploit the jump in the value that one should expect due to the increased demand, as the ECB steps in.

Evidently, the chance of a rate cut was in the air. After the Draghi declarations, markets experienced a manic buying that has depressed yields to deep negative levels never experienced before (Figure 4 and Figure 5).

Figure 4.

Figure 5.

Clearly traders were pricing in the hinted cut of at least 10-15 basis points and were taking long positions on the short part of the Eurozone government term structures. The EUR / USD weakened accordingly, down of 20 pips.

Then, something happened that European banks were not expecting . At the FOMC meeting of 28th of October, MS Yellen released a hawkish view; expectations of a rate hike were brought forward to December. This can be easily appreciated by looking at the probability of a rate rise as inferred from the Futures' Prices on FED Funds (Figure 6). In a single day, the odds of a rate hike surged from 35% to 50%.

Figure 6.

This sudden reversal, from the previous FOMC meeting in September, had a clear impact on both the Euro and the ECB interest rate policy. The EUR / USD slipped another 20 bps; almost, instantaneously, the currency fell below the threshold of 1.1. This renewed trend towards a weaker Euro (-7% in two weeks, Figure 7) has unintended consequences for the front-running strategy of European banks: in fact less pressures on the exchange rate have given immediately more room to the ECB to delay or partially scrap the idea of a “QE on steroids”. Suddenly, the strategy of storing ineligible bonds with deep negative rates to front-run the future (but not so certain anymore) deposit rate cut was no longer attractive to Eurozone banks. A selling spree ensued immediately after Ms. Yellen’s speech.

Figure 7.

This pattern was further reinforced after the release of the stronger than expected data on unemployment and payrolls in the US for October. Traders adopted a 70% probability of a US rate hike in December. Predictably, the EUR / USD took another hit downwards of almost 20 bps. The sell-off of Eurozone bonds with negative yields accelerated in the following days (Figure 8).

Figure 8.

What will be the probable dynamics of the Eurozone government bonds in the coming weeks? As the ECB proceeds with the QE program, the pool of eligible assets will continue to shrink at a rapid pace; it’s not a case that the ECB is considering for purchases also municipal bonds issued by the main European cities. The illiquidity of a contracting market and the ever-changing expectations about the delivery of a QE 2.0 will surely put Eurozone bonds under further stress in the coming weeks.


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Sunday, November 15, 2015

Canada's Growth Potential: Tempering Our Expectations

Guest post by Norman Mogil


How fast can the Canadian economy grow? What can Canadians expect now that commodity prices have plunged and the country is running a trade deficit?

These questions take on greater significance with the shift in political power to the Liberals who campaigned on growth through fiscal stimulation and government deficits.  Government revenues are tied closely to a nation’s capacity to growth; higher incomes provide room to stimulate the economy without generating deficits. This blog discusses Canada's potential  and expected growth against weakened commodity prices, a slowing international economy, and accompanying deflationary pressures.

Estimating a nation's potential GNP is simple: combine yearly changes in the labour force  with yearly changes in labour productivity. More workers and greater efficiency increases potential output. The gap between potential and actual GNP growth is the unemployment rate. Falling short of potential growth results in underemployment.

What is behind Canada's Poor Economic Performance

Both Canadian labour force and productivity have grown by 0.9% annually. The combined growth of 1.8% , however, is insufficient to provide full employment; unemployment averaged 7.2% over the period well above conventional estimates of full employment around 5%.

Changes in the labour force are basically predetermined by demographic trends, but changes in productivity are quite variable. Capital investment and technological innovation affects the efficiency of every worker. Human capital in the form of worker skill and experience also generates greater labour efficiency.

While Canadian capital investment varies from year to year, investment has steadily declined over the past few years.  The trend is for increases in  capital expenditures to continue to decline, especially in the resource sector. This steady reduction in the growth of investment contributes to the mediocre labour productivity.

One reason for the slowdown in capital expenditures relates to capacity utilization. As long as there is excess capacity, a corporation does not feel compelled to expand its facilities. Chart 2 shows the persist decline in the capacity utilization rates for Canada. Lower operating capacity means lower output levels and a reduction in the work force. The combined effect of low capacity utilization and jobs losses puts Canada even further below its potential growth path.   

On the demand side, Canada continues to struggle. Gross Domestic Product over the past 12 months has increased by just 1%; industrial production rose only 0.6%; and the unemployment rate moved up slightly to 7.1%. Canada continues to operate below potential in part because domestic demand is insufficient to restore economic growth.

Destroying Capacity

This has been a major concern of the Bank of Canada (BoC). In its October 2015 Monthly Policy Report, the BoC raised the issue of how capacity continues to be destroyed.

The BoC points out that the boom in commodity prices since 2001 generated strong investment in the extraction sector, increasing demand for labour, raising wages, and attracting workers from other sectors. This significantly raised production capacity, especially in Western Canada.

However the energy sector's expansion resulted in other sectors contracting. Over the same period,  non-energy sectors struggled mightily against the appreciating Canadian dollar.  Industry Canada estimates that 300,000 manufacturing jobs have been lost in Ontario and Quebec since 2004. The BoC argues that "in the non-resource traded-goods sector, firm exit was widespread and some physical capacity was destroyed which would, therefore, be not available for subsequent expansion." Estimates for the amount of destroyed capacity range as high as 5% of total economic capacity.

The Canadian Association of Petroleum Producers estimate that in 2015 the industry will suffer 150,000 job losses. Furthermore the industry expects losses to continue and lowered its production forecast by 20% for 2030 because of large cuts in capital investment (Bloomberg News, Oct 29, 2015).

Canada’s productive capacity is experiencing a ‘double whammy'. Non-resource sectors have a long way to recover from a higher Canadian Dollar in 2001-14, and now the resource sector must contend with 'blowback' from the collapsing commodity markets. In sum, the nation's industrial capacity has been whipsawed and potential growth remains constrained.

Viewed differently, the cumulative effect of more than a decade of industrial capacity reductions has taken a heavy toll on the nation's growth potential. Underinvesting reduces growth capacity, and idle workers reduce cannot develop the skills and experience necessary to improve productivity. Together, weak capital and labour reduce long term growth prospects.

Future Potential

What are the near- to medium-term prospects of enhancing Canada's potential?

The BoC believes that "in the current environment, declines in investment in the resource sector are occurring faster than increases in investment in other sectors… the differences in timing  of the response… imply that potential output growth is more likely to be in the lower range of estimates." In a word, our expectations have to be tempered.  The BoC estimates that the best the economy can generate is growth of 1.8% annually and that will still result in about 1.5% slack each  year until 2017 .The danger lies in continuously growing below potential. That implies that there is continuous underinvestment, slack in the labour market, and a general underutilization of available resources. Should these conditions persist, then potential will decline further.

Concluding Remarks

1. Canadian growth potential has been lowered in large part because of dramatic changes in the world markets for our goods , both energy and non-energy.

2. Non-energy firms need to improve their competitive positions and take advantage of the lower Canadian dollar with greater exports.

3. The resource extraction sector will continue undergoing painful adjustments as it aligns future capital investment to meet the reduced demand for oil, gas, and other commodities.

4. The big issue concerns the fiscal side. As the economy adjusts to slower growth, the concern is that governments at all levels will be challenged to generate revenues to meet voter expectations for new expenditure programs. Yet without greater fiscal stimulus the economy will not be able to return to move positive growth path.


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Wednesday, November 11, 2015

The China Path - (What recent events in China tell us about the way forward) by Matt Garrett

The China Path">


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