Sunday, June 19, 2016

What the Bond Market is Telling Investors

Guest post by Norman Mogil

Over the past month, the global bond markets have been sending out signals that all is not well with the global economies. Initially, the surge in negative nominal rates in Europe and Japan rattled many investors in both the fixed income and equities markets. This historic development suggests that large-scale investors are anticipating low growth and disinflation for many more years. Simultaneously,  the yield curve, especially in the US, has been flattening, again signalling that growth is slowing, giving the policy makers considerable  pause in their deliberations on the course of future interest rates. This blog examines both these developments to help the reader understand the signals coming out of the bond markets around the world.

Nominal and Real Rates of Interest

For more than a year, short to medium term rates of interest in many countries have landed in negative territory. The ECB instituted negative overnight lending rates in an effort to discourage commercial banks from depositing excess reserves with the ECB; instead, these such funds should be made available to their borrowers in the hope of stimulating loan demand throughout the region. More recently, the ECB started to buy, initially, longer dated sovereign debt from member countries in the expectation that long-term rates would fall to stimulate investment growth. Now, the ECB has expanded this quantitative easing program to include investment grade corporate bonds. Purchases of both types of debt exceed 80 billion euros a month, as the ECB pulls out all stops in pursuing its goal of re-inflating the EU economies. The result of this combined effort is shown in Table 1 which reveals that major  European countries and Japan now live under a regime of negative long-term rates.

Of more significance is the measure of real rates of interest--- nominal rates minus the rate of inflation. In some countries, real rates have turned negative ( e.g. Japan, Switzerland, and Canada) and in other countries, the real rates are barely in positive territory ( e.g. Germany and France). The key takeaway from Table 1 is that the industrialized nations now offer 10-year bonds at real rates that are less than 1 percent, well below the long term  historic rate of 2 percent.

Flattening Yield Curve   

The yield curve represents what investors are willing to accept by holding debt over short, intermediate and long-term periods. A typical yield curve is sloping upwards since longer term investors normally require a greater return to compensate for the risks of holding debt over many years. The extra return - referred to as the term premium - reflects the investor's view of future economic growth and inflation among other considerations.  A rising term premium reflects concerns over excess supply of debt, credit quality, and higher inflation in the future; a falling term premium has these factors moving in the other direction.  Over the past year or more, the term premium has fallen significantly, hence the fall in long-term rates.

Changes in the slope of the yield curve signify changes in the economic outlook. Over the past few months, the yields on long-dated US Treasuries, 10 years and up, have fallen and, at the same time short term rates have moved up. ( see  Chart 1)  These two developments are related. Short rates have moved up  in anticipation of the Fed increasing its overnight interest rate. Fed Chairperson, Janet Yellen, has spoken of the need to increase the policy rate in " the coming months" and other members of her committee have voiced similar views. In its most recent policy meeting, the FOMC continues to hold out the possibility for at least one or more rate increases before year's end.  At the same time, investors in the long end of the bond market are saying that any short rate increases will have a detrimental effect on economic growth and that any policy shift must weigh that consideration. In effect, the long end of the curve is saying: increase short rates at your ( Fed`s)  peril.

Chart 2 maps out the change in the spread between 2- 10-year yield. It has narrowed from 170 bps to 90 bps over the past year. In part, the 2-year rate moved up sharply in response to the Fed signalling that it wants the bank rate to move up this year as part of its objective to “ normalize” rates. But it is the falling long-term yields which are most disconcerting. It signifies that the investors expect future growth to be weaker and that they also expect future inflation to be lower than was previously forecasted a year earlier ( Chart 1). It is the change in expectations that we need to focus upon.

Changing Expectations 

There has been a dramatic shift in the way consumers' view future inflation.  The University of Michigan surveys reveal that there has been a persistent decline in the expected rate of inflation over the next  5- 10 years (Chart 3). In the 1990s, consumers expect annual inflation to exceed 4 percent; by 2010-15,  consumers' expectations have dropped down to well under 3 percent. In its most recent survey, U of M discovered that consumers expect inflation to average just 2.3 percent for the next 5 years

Investors have also adjusted their inflation expectations. One measure of inflation expectation is the 5-year breakeven inflation rate. This is the difference between the 5-Year Treasury bond rate and the yield on an inflation-protected security with 5-years remaining to maturity ( so-called TIPS). Chart 4 shows how these expectations have dropped considerably from around 2.8 percent in 2012 to 1.6 percent today.  In fact, investors have adopted a greater downward revision to their expectations than in the case of consumer groups. It is the investors who are driving the bus on the yield curve road.

Other Factors Affecting Long-term Bond Yields.

 Ben Bernanke has maintained for some time that the global savings rate is too high and that excess savings is fuelling the demand for debt instruments, especially quality sovereign debt. There is a lot of merit in this argument when one looks at the high savings rates in the emerging markets - often in excess of 25 percent of GDP. Even in the industrialized countries savings are relatively high. Or, alternatively, consumption is too low. Either way, excess loanable funds have to be channeled into investment, and this generates a growing demand for credit instruments worldwide.

Another explanation for the fall in  long-term rates is related to liquidity in the international bond markets. Barry Eichengreen  argues that ``international liquidity has plummeted from nearly 60 percent  of global GDP in 2009 to barely 30 percent today.` The most important form of bond liquidity is the US government bonds which are held by banks, large institutions, and foreign central governments. Recent auctions for US Treasuries feature large oversubscriptions, and this has driven yields lower. There is more than just a temporary flight to safety to quality debt; there appears to be a major shift in asset preference in favour of high-quality debt issued by the US, Germany, Japan,  and  UK governments . To the extent that new government debt issued is immediately taken up by these institutions and are essentially held to maturity rather than traded, means that there is less liquidity in the marketplace. Scarcity will drive up bond prices.

What can we learn from the recent behaviour of the yield curve? 

Low yields are a symptom of  economic malaise . Although there have been many criticisms of central bankers for introducing negative short interest rates, the central bankers are not responsible for the decline in long-term interest rates. Negative interest rates are not the problem. Slow growth and disinflation are driving longer rates to historic low levels. These bond yields are not the problem but are the symptom of widespread economic weakness that is not expected to improve over the next decade.

Low inflationary expectations are well-entrenched. Clearly, the negative nominal and real rates of interest are sending a powerful signal that those economies are going to experience very low growth without inflation for the next 5 to 10 years. There is a well-entrenched view that inflation and growth will remain very subdued over the next decade.

Shortage of quality debt.There is growing evidence that quality debt remains in strong demand and highly sought-after. The decline in the term premium on long-dated government bonds demanded by institutional and central bank investors supports this assertion.

Long term rates to remain low. The combination of strong demand and supply restraints will keep long bond yields at these levels or even lower for many years. Any change in the current direction of bond yields will not come from within the market itself. Rather yields will rise only if governments resort to aggressive fiscal policies that promote growth and higher inflation. As yet, there is no sign of any policy shift in that direction, especially in the US and the EU.


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Unconventional Policies and Their Effects on Financial Markets

Guest post by $hane Obata


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Tuesday, June 7, 2016

The fall in commodity prices hits the Canadian banks

Guest post by Norman Mogil

With the release of Canadian banks’ second-quarter results, investors are beginning to measure the impact of the oil price collapse on the domestic financial industry. Widespread are the write-downs and other provisions the banks are taking in response to the weakened credit quality of many clients in the oil patch. This blog looks at this issue and its implications for future bank stock performance.

On the whole, the Canadian banks turned in a profitable second quarter, although in some instances profits declined ( e.g. Scotiabank and BMO Montreal). The banking sector continues to show respectable results in its retail and consumer loan divisions. Also, their mortgage portfolio remains healthy, supported, to a great measure, by good loan-to-value measures and mortgage insurance. Finally, the banks’ capital ratios meet international standards as the they continue to improve in this area. Where the banks face the biggest challenge is with their loans to the energy and commodity sectors in Canada and the United States.

Provisions for Loan Losses (PCL). Chart 1 measures the loan losses for the major Canadian banks in terms of a percentage of the average loans outstanding. PCLs represent loans that have been written down for non-performance. There has been a dramatic increase since 2015 Q4 results as the slump in the oil prices take its toll.

Gross  Impairment of Loans (GILs). Another way to look at the impact of the oil sector is to examine the increase in GILs. GILs are loans that are non-performing loans that a bank will have to either write off or sell at a discount to a debt collector who will likely seize the collateral. Either way, bank profits will be negatively impacted. Chart 2 graphs the substantial increase over the past 12 months in GILs, especially Canada’s largest domestic bank, RBC.

Chart 3 demonstrates the combined effects of both PCLs and GILs. RBC attributes the increases in both ratios to the sustained low oil price environment. Furthermore, these ratios could well deteriorate further the longer oil prices remain around these levels.

The banking industry is most exposed to the highest risk segment of the energy sector. Fully 82 percent of RBCs energy sector loans go to exploration, production and drilling activities; loans to the integrated and refining segments remains relatively small. And, geographically, the bank’s exposure is roughly split evenly between Canada and the United States.

Capital Market  Revenues(CMRs). CMRs are closely related to the commodity sector performance. The banks generate a significant proportion of total revenues from such activities as M&A, trading in equity and fixed incomes, IPOs,  and advisory services, all of which have suffered declines over the past few years.( Chart 5). Moreover, this segment of the industry has come under heavy regulatory scrutiny, adding to the cost of operations at a time when revenues are declining.  Where CMRs used to generate between 15- 20 percent of total bank revenues, this activity now generates about between 11-16 percent, more importantly, the trend has been steadily declining as the industry grapples with a weak investment environment and rising costs.

The Outlook. The Canadian banks continue to perform reasonably well as their core segments--- retail and mortgage markets--- hold up well. Nevertheless, they face considerable headwinds as Canada contends with weak oil and commodity prices and declining business investment. ( Recent surveys by Statistics Canada point to continued declines in additions to  capital stock. The Bank of Canada anticipates that this erosion in business investment will contribute to a lower potential GDP growth and that , in turn, will impact future wage and profit growth--- both of which will be felt by the banks going forward.


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Monday, June 6, 2016

US labor markets take a turn for the worse

Friday's US payrolls report, which to a large extent represents a latent effect of the US dollar rally over the past couple of years, was dismal. On a relative basis, hiring Americans has become more expensive for global firms. An elevated level of uncertainty, driven in part by risks associated with the US monetary policy as well as the presidential elections, has not helped.

Let's look at some trends in the labor markets.

1. The job market's weakness has now spread to the services sector.

Source: BofAML

2. After a strong showing over a previous couple of months, US labor force participation has turned lower.

3. Even as the headline unemployment rate (U-3) declined to lows not seen since 2007, a broader measure of unemployment, which includes marginally attached workers plus those employed part-time for economic reasons (U-6), has stalled.

Below is the ratio of the headline jobless rate to the broad (U-6) unemployment over the past couple of decades. While fewer people are filing for unemployment benefits, the health of the broader labor market has significant room for improvement.

 4. Related to the above, here is part-time employment for "economic reasons".

5. US manufacturing jobs growth has worsened again on a year-over-year basis.

6. Wage growth is back below 2.5% (YoY). Unless the non-demographic component of labor force participation begins to climb again, it's difficult to see a significant jump in hourly earnings growth. It is worth pointing out, however, that given slow inflation, real wage growth in the US is reasonable relative to a number of other developed economies.

7. The next chart shows the average weekly hours worked by US employees on a year-over-year basis. Even with a positive hourly wage growth (above), declining hours could mean less cash in households' pockets.

8. For what it's worth, the headline unemployment rate is now below the 'Natural Rate of Unemployment". According to classical economic theory, inflation should begin to rise at this point. But given some of the labor market challenges shown above, price increases - outside the recent increase in energy and agricultural commodities - should remain benign.

Separately, the ISM Services PMI weakened in May. This provides more evidence that the soft patch in the US economy is not limited to manufacturing and energy.

The ISM Non-manufacturing Employment Index is consistent with Friday's poor payrolls report (above). The ISM services sector new orders index is also shown. Is this consistent with the projected 2.5%-3.0% US GDP growth in Q2?

In response to the weak jobs report (and to some extent the ISM Non-manufacturing PMI) the June rate hike is off the table according to the futures market. The July contract rose above the pre-Fed-minutes levels (it was the Fed minutes that temporarily resurrected the chances of the Fed doing something in June.)

Here is what Friday's economic reports did to the implied rate hike expectations in 2016. Another weak jobs report will send the probability of "no hikes" to 100%.


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Sunday, June 5, 2016

The Decline in Canadian Business Investment

Guest post by Norman Mogil

Business Investment  “depends on the prospective yield of capital, and not merely on its current yield” , John Maynard Keynes

One of the many puzzles of the recovery since the 2008 crisis has been the corporate sector’s reluctance to add to a nation’s capital stock. Investment in new plant and equipment along with the construction of new productive facilities has lagged behind the experience of previous recoveries. Throughout the industrialized world, the rate of growth in fixed capital investment has been dismal, resulting in below average rates of growth in national income. The decline in business investment has been quite dramatic. In North America business fixed capital investment is running 20 percent lower that recorded in 2007. (See Chart 1)

Source: BIS

This dramatic weakness in capital formation is worrisome given all the factors that one would expect would generate a flourish in capital expenditures. Central banks have implemented unprecedented monetary stimuli in the form of zero interest rate and quantitative easing, contributing to the dramatic fall in long-term interest rates. Corporate profit margins are at historic high, and retained earnings continue to grow. And, equity prices remain quite elevated--- all these developments should provide the corporate sector with the enthusiasm to undertake capital investments. Yet, that sector continues to display weakness, contributing to what the IMF characterizes as the`` new mediocre`` growth performance. What lies behind the failure of business investment to expand?

The Decline in Corporate Profits  

The first clue to this answer lies with the slump in corporate profits and corporate profitability. Chart 2.1 and 2.2  shows the significant fall-off in the level of corporate profits in the United States and Canada over the past two years. The principal reason for this decline is the failure for the revenue to grow. Profits would have been even weaker had wage growth not been contained.

The Canadian Experience

The Canadian experience exemplifies what lies behind this profit weakness. If we look at the rates of return on equity and on capital employed, we see that there has been a steady decline in returns to investment for all industries and in particular for non-financial industries. (See Chart 3). Whereas the Canadian non-financial companies return on total capital employed registered  6.7 percent in 2104, by the first quarter of 2016 these returns fell a full 100 bps. Clearly, the capital employed was not churning out profits as before, casting doubt on the effectiveness of the investment already in place, let alone what could be expected on new ventures.

A recent survey by Statistics Canada on capital spending paints a very disquieting situation. Total spending intentions are expected to fall by 4.4 percent led by a decline of 9.3 percent in the private sector which accounts for about two-thirds of total capital investment. Moreover, expenditures in manufacturing are poised to drop by 11 percent. It is no wonder that the forecasts for the Canadian economy remain tepid. The real engine of growth is badly misfiring.

In addition, there is considerable excess capacity in all sectors. Capacity utilization ratios are currently running at 75 percent compared to the longer-run average of 80 per cent. (See Table 1). With excess capacity and falling rates of return, Canadian corporations have no real incentive to undertake capital investment.

The Longer Term Impacts
The Bank of Canada, in its most recent monthly report ( April, 2016) concluded that Canada's potential GDP growth has weakened over the past year.Potential GDP is comprised of the growth in the labour force plus the growth in labour productivity. The Bank downgraded Canada's  potential GDP growth from 1.8 percent to 1.5 percent.( see Table 2).  Labour productivity growth will exhibit a marked decline over the next three years, according to the report.  The Bank argues that since

" the trend in labour productivity influences the outlook for potential output, the current weakness in trend labour productivity reflects the decline in business investment."
Thus, we come full circle: the lack of new business investment leads to poor productivity performance which, ultimately, leads to a lowering of the country's potential growth rate. The slowdown in business investment and its implications are now well- embedded in the economy for the next three years at least.


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