Friday, August 31, 2012

Goldman: US faces $8 trillion budget shortfall through 2022

Goldman's latest analysis of the US budget shows a staggering gap of $8 trillion in the next 10 years. This materially diverges from the latest White House projection as well as from the CBO's "baseline".
GS: - Through 2022, we forecast a cumulative deficit of roughly $8 trillion (3.9%) under a "business as usual" assumption that envisions extension of most current policies but no further deficit reduction measures.

Source: GS

Monetary expansion, the US dollar, and commodity prices

Economists continue to insist that there is no connection between the Fed's monetary expansion programs and increases in commodity prices, particularly agricultural products globally (discussed here). Here is a typical comment:
If it is commonly believed that the FOMC can cause a worldwide food shortage then we are truly in a dark age of macro. The FOMC has no ability to raise the price of commodities relative to national income, and I can't even imagine the rationale that monetary expansion could somehow increased prices internationally (that is, denominated in foreign currencies). The only way they could raise food prices in real terms is if they could spur increased food consumption domestically, which would be much more likely if they strengthened the dollar than if they weakened it. The FOMC can cause a lot of trouble, but this is just not on the list of problems they can cause, and certainly not via monetary expansion.
Unfortunately macroeconomic theory here diverges from market experience. Monetary expansion in the recent past corresponded with significant dollar weakness. The chart below shows the dollar weakening during both QE1 and QE2. "Twist" on the other hand did not involve monetary expansion and only focused on reducing the average duration of treasuries.

Source: BNP Paribas

Dollar weakness to any commodity trader is a signal to buy - which is not necessarily linked to demand fundamentals. Those who don't believe this should only take a look at the following chart comparing the dollar (DXY) with the CRB commodity index.

Source: Bloomberg
What's important to point out here is that the commodity price movements have been much larger than the dollar movements. In fact on a percentage basis the CRB range in the graph above is almost double the dollar range. That means even for currencies that are not in any way tied to the dollar (although a number of emerging market currencies are), when the dollar weakens, commodity prices move higher even if denominated in these other currencies. Commodity price increases due to dollar weakness therefore propagate globally even in nations whose currencies are not linked to the dollar. This empirical relationship drives global commodity markets even if supply/demand fundamentals don't warrant such adjustments. But when one faces tight and uncertain supply conditions to begin with (as we have now for agricultural commodities), dollar weakness will force an even larger commodities swings to the upside.

In 2011 the CIA was chastised for not being able to see the Arab Spring coming. Where did all that pro-democracy fervor come from all of a sudden? Why wasn't the CIA able to see key signs of the movement earlier? The answer has less to do with zeal for democracy and more to do with not being able to buy food. As food prices spiked across the Arab world, so did the protests.

Source: Bloomberg

Certainly in the long run macroeconomic fundamentals should play out. But we don't live in "the long run". Global markets take seconds to reprice, usually far overshooting/distorting the "fundamentals". And, as the Arab Spring showed, people don't wait for these fundamentals to settle to their expected levels.

BOJ is helpless in the face of Japan's structural issues

Japan's economy is once again slipping into a deflationary mode as concerns mount about another recession. The nation has become accustomed to "rapid fire" economic downturns and price uncertainty.

Japan GDP (Bloomberg)
Bloomberg: - Japan’s consumer prices slid at a faster pace in July and industrial production unexpectedly slumped, raising the danger that the world’s third-largest economy has slipped back into a contraction.

The benchmark price gauge, which excludes fresh food, fell 0.3 percent in July from a year before, putting the central bank’s 1 percent inflation goal further from reach, a government report showed in Tokyo. Industrial output fell 1.2 percent. A private measure of manufacturing for August was the lowest since the aftermath of the record March 2011 earthquake.

Japan CPI
Today’s releases reflect diminishing demand overseas for the nation’s exports amid the European crisis and exchange-rate appreciation, and the end of incentives for vehicle purchases. With Prime Minister Yoshihiko Noda’s government today predicting it will miss a deficit-reduction target, pressure may rise on the Bank of Japan (8301) to expand stimulus and sustain the recovery.

“The risk of a contraction in the second half of the year is increasing,” said Junko Nishioka, chief economist at RBS Securities Japan Ltd. in Tokyo, who previously worked at the Bank of Japan. “The downside risks on the economy are increasing, and could push the BOJ to further expand its asset- purchase program next month.”
The "core" CPI numbers are also deep in the negative territory. In an attempt to combat deflation and avoid another economic downturn, the Bank of Japan is continuing with an almost perpetual "money printing" policy. The monetary base recently rose to record levels and is expected to rise again next month (per article above).

BOJ monetary base (unit = ¥100mm)

Weak domestic consumption and stagnant incomes (which will decline as population ages) force Japan to rely on exports. And with a stubbornly strong yen (yen is up some 32% in the past 5 years) as well as weak global demand, export growth is not meeting expectations.
BNPParibas: - Real exports fell 1.4% m/m in July, a third straight decline. Exports had been moving sideways since last summer [2011], but the slowdown in the global manufacturing cycle seems to have caused the trend to weaken of late.
It's becoming clear that at this stage (similar to the case in the US), the central bank can do little to improve growth in any material way. Raising bank excess reserves further via QE is simply not going to solve the structural issues faced by Japan.

Thursday, August 30, 2012

It's not just about corn: world food prices jump 10 percent

In July after the post on the drought conditions causing food inflation globally (see this discussion), we've gotten a number of comments stating that it's a North American problem. In particular emails from India and the Middle East stated adamantly that many poor regions of the world rely more on rice - therefore corn prices in the US would not be an issue. The statement about rice is in fact correct. But it's not just about corn (see discussion on soy), and stable rice harvests are not going to prevent global food inflation that is threatening a number of nations. Unfortunately it will be the poor communities that will be hit the hardest.

Reuters: - World food prices jumped 10 percent in July as drought parched crop lands in the United States and Eastern Europe, the World Bank said in a statement urging governments to shore up programs that protect their most vulnerable populations.
From June to July, corn and wheat prices rose by 25 percent each, soybean prices by 17 percent, and only rice prices went down, by 4 percent, the World Bank said on Thursday.

Overall, the World Bank's Food Price Index, which tracks the price of internationally traded food commodities, was 6 percent higher than in July of last year, and 1 percent over the previous peak of February 2011.
Let's just hope that our friends on the FOMC are keenly aware of this situation and consider the full ramifications of their actions.

Canada's consumer leverage growth is not going to end well

Canada continues to face rising consumer debt levels. Since the post on Canadian housing risks (here), we've gotten a number of comments that Canada's housing is not overpriced (for example if measured in terms of gold). And since there is no "subprime lending" in Canada, consumer debt is not a problem because delinquencies will stay low.

The authorities have since taken some steps to curb potential housing speculation (see discussion). But it seems that Canadian consumers have caught the US debt bug as consumer leverage becomes an increasing concern - particularly for BoC (the central bank). And it's not just about mortgages.
The Epoch Times: - The average non-mortgage total debt of Canadian consumers rose once again last quarter, continuing the trend of the highest debt levels seen to date.

According to a report by credit analysis company TransUnion, the average consumer’s total debt (excluding mortgages) rose by $192 in the second quarter of 2012 to $26,221, a 0.74 percent increase compared to the previous quarter, and a 2.41 percent rise compared to the same quarter last year.

Auto loan debts had the highest rate of increase compared to other credit products, with a rise of 13.25 percent compared to Q2 last year, and 3.67 percent compared to Q1 this year. The average credit card borrower debt declined by 0.93 compared to the same quarter last year, but increased by 2.7 percent compared to the previous quarter this year. Lines of credit and installment loan borrower debts also increased in Q2 2012 by 0.4 percent and 0.95 percent compared to Q2 2011, and 1.13 percent and 2.37 percent compared to Q1 2012, respectively.
Canadian consumer leverage - debt as percentage of personal disposable income - has now far outpaced that in the US, as Americans continue the deleveraging trend (discussed here).

Source: BNP Paribas
At the same time Canadian banks, who pride themselves on being quite resilient in the face of the financial crisis in 2008, are really enjoying this demand for consumer lending products. Canadian banks' profits are soaring and they are increasing dividends.
Bloomberg/BW: - Royal Bank of Canada, Toronto- Dominion Bank and Canadian Imperial Bank of Commerce raised their dividends after reporting third-quarter profits that beat analysts’ estimates on consumer lending.

Royal Bank, the country’s biggest lender, said profit for the period ended July 31 rose 73 percent to a record C$2.24 billion ($2.26 billion). Toronto-Dominion, the second-biggest bank, said net income climbed 14 percent to C$1.7 billion, or C$1.78 a share, while CIBC said profit rose 42 percent to C$841 million, or C$2 a share.

The three Toronto-based lenders join Bank of Montreal (BMO) and Bank of Nova Scotia (BNS) in raising dividends this week as gains in consumer lending and higher trading revenue helped the world’s soundest banks report earnings that topped estimates.
All this is happening at the time when the global slowdown and declining demand for resources (which is Canada's strength) are threatening to dampen Canada's economic growth. The combination of rising consumer leverage and easy profits in the banking system (remember the good old days in the US?) have the makings of a potentially nasty economic downturn for Canada.

German politicians point to rising Russian influence and other geopolitical risks associated with Grexit

As German politicians debate the issue of Greek exit from the Eurozone, Merkel's supporters are raising geopolitical concerns. Greek geographical proximity to the Middle East, destabilization in the whole of southern Europe, and Russia's potential involvement - could all be used to garner support for Merkel's policy of avoiding Grexit.
Reuters: - ... Michael Meister, vice-chairman of Merkel's Christian Democrats (CDU) in the Bundestag lower house, said on Monday such a development could further destabilize the already troubled eastern Mediterranean region.

"I believe we have to open up the debate beyond the purely financial and economic dimensions," he said.

"Just look at the map and see where Greece is located," Meister added, noting its proximity to the Middle East, now racked by civil war in Syria, and to still-fragile parts of the Balkans.

His comments echoed those of another prominent CDU politician, Armin Laschet, who told Reuters at the weekend that a Greek exit could trigger undesirable upheaval in southern Europe.

"(An exit) could lead to instability in a NATO member state. Russia is standing ready with billions to help Greece in such a scenario," Laschet said. "Much more is at stake here than just the question of whether Greece meets the criteria (of its bailout)."
Certainly the Russian influence in Greece is increasing. Travel agencies are reporting a rise in the number of Russian tourists in Athens for example. Russia has already offered  €25bn to support the Greek government. And now with some €90bn having left Greece, the Russians are viewing it as their opportunity. It's not clear if this should be considered a major geopolitical concern, but it certainly points to EU's declining influence in Greece and potentially elsewhere in southern Europe.

China is one of the drivers behind Germany's stance on periphery bailouts

China has been pressuring Germany to get the Eurozone crisis under control. Many in China blame their sharp economic slowdown (see discussion) on the Eurozone crisis - because if it wasn't for the Eurozone, the double digit growth that made so many of China's bureaucrats rich would last forever... And some of the same people believe that China's growth will re-accelerate once the crisis in Europe has been resolved.
Wen Jiabao: - The European debt crisis has continued to worsen, giving rise to serious concerns in the international community. Frankly speaking, I am also worried.

The main worries are two-fold: first is whether Greece will leave the eurozone...The second is whether Italy and Spain will take comprehensive rescue measures. Resolving these two problems rests with whether Greece, Spain, Italy and other countries have the determination for reform.
Angela Merkel on the other hand wants to comply with China's demands. There is a great deal at stake as German trade deficit with China has basically disappeared this year - for the first time since the 90s. Germany can not afford to jeopardize its sales to China which have been a key driver of Germany's export growth.

Source: GS

Merkel, having asserted her leadership in the Eurozone by completely dismissing Grexit and by supporting ECB's plans to bail out periphery nations, is now in a position to tell China that Germany is doing all it can. Her visit to China was well timed. When people try to understand Germany's about-face with regard to the periphery bailouts, China is one of the explanations.

For money market funds risk aversion comes at a cost

Fitch's latest update on US prime money market funds shows increasing exposure to non-Eurozone banks (Nordic, Swiss, and the UK) as well as to Japanese banks. Eurozone exposure is now minimal.

Source: Fitch

Lending to European banks is increasingly executed via secured transactions (repo).
Fitch: - MMFs continue to exhibit risk aversion. While MMF allocations to European banks increased moderately since end-June, the proportion of secured exposure in the form of repurchase agreements (repos) also continued to climb (see chart, Repos Continue to Rise). As of end-July, repos represent about 36% of MMF allocations to European banks.
Source: Fitch

The retail money markets business is now completely subsidized in order to keep customers that are invested or considering investing in other products of the mutual fund firm. For investors with under $250K in cash, there is no reason to use a prime fund because an FDIC insured savings account at a bank will pay more - with no risk. Fidelity's retail money fund (SPRXX) is paying 1bp per year just to say it's not zero. The institutional prime money fund (FIPXX), with minimum investment of $10 million, pays 16bp per year. Risk aversion comes at a cost.

Wednesday, August 29, 2012

Policy of targeting "monetary transmission" by the ECB looks good in theory, but questions about independence remain

Here is a quick look at the concept of "monetary transmission" that has basically become the catch phrase to justify periphery bond buying by the ECB.
MNI: - Joerg Asmussen [member of the ECB's Executive Board] said the ECB's new bond-buying plan will aim to improve monetary policy transmission that is severely hampered. Currently "monetary signals, like we for example set with the July interest rate cut, filter through to the real economy either unevenly or not at all."
The lack of rate transmission is clear. Portugal's rates for consumer loans for example have remained stubbornly high (discussed here). But the transmission issue is really driven by liquidity conditions that are not balanced across the Eurozone. Ambrose Evans-Pritchard discussed it back in December of last year (see discussion) as Italy's M3 showed alarming declines, while Germany's money stock increased (see discussion). And since a great deal of the lending across the Eurozone (except to some of the larger firms) is done by domestic institutions (Spanish citizens and companies tend to borrow from Spanish banks), liquidity issues of the domestic banking system translate into fewer loans and higher rates in that nation.

Here is an example. Deposits at Italian banks (surprisingly) have been quite stable recently. Spain on the other hand had a run on its banks.

Source: JPMorgan

This contributed to (though is not the only cause of) uneven growth in bank lending.

Source: JPMorgan

It makes sense therefore to target monetary policy by country in an attempt to even out credit conditions. The belief that monetary policy in the EMU could be managed centrally the way it's done in the US proved to be flawed.

But there are issues with implementation. If "monetary transmission" is indeed the goal, how does the ECB justify making it conditional?
WSJ: - If the bond buying program is really about transmitting monetary policy to certain countries, it's hard to justify making that conditional at all. By imposing conditions, the ECB implies that support could be withdrawn in the future. But apart from the practical difficulties of walking away after loading up on Spanish or Italian debt, the conditions themselves suggest that there are circumstances under which the ECB would pull the plug—the opposite of what Mr. Asmussen says the bank is trying to achieve.
And there are significant risks associated with targeted policy conditions.
WSJ: - One of the unanswered questions about the ECB's next round of bond buying is what conditions it will impose on the countries that benefit. But one only has to look at Greece to see how double-edged conditionality can become. Two and a half years after being bailed out, Athens is hopelessly behind every target. And yet European and IMF officials aren't considering whether to take Greece off the bailout drip, only how best to fudge the bailout's failure.
Fixing monetary transmission is certainly a sound concept in theory. But in this case is seems to be nothing more than a justification for periphery bailouts by the ECB. The conditional implementation actually looks more like an ESM-style bailout than a central bank monetary policy. To some, this makes the ECB a tool of the European Commission.

Feeling the heat when pressed on ECB's independence, Draghi fired back.
RTT: - "It will remain independent. And it will always act within the limits of its mandate,...yet it should be understood that fulfilling our mandate sometimes requires us to go beyond standard monetary policy tools"

Latest on China: all is well and "economic growth is stabilizing"

Here are some of this morning's key economic news coming out of China. Given that China has been the largest component of the global GDP growth, the situation is worth monitoring closely.

1. China's stock market hit a new post-2009 low. It seems that the PBoC is not in a hurry to implement a massive stimulus program, sending stocks lower. The global stimulus addiction continues (see discussion)
Reuters: - Mainland Chinese markets underperformed after the People's Bank of China surveyed demand for a new long-term money market instrument, suggesting it remained reluctant to resort to blunter policy measures such as reducing bank reserve requirements.

This apparent lack of aggressive policy disappointed market players, who see any "formal" easing measures as crucial to shoring up onshore Chinese markets.

The Shanghai Composite Index slid 1 percent to 2,053.2, its lowest close since February 2009. The CSI300 of the top Shanghai and Shenzhen listings shed 1.1 percent.
The "long-term money market instrument" would presumably be used to sweep out liquidity, which is already relatively tight (see discussion).

2. Imported iron ore prices are collapsing, pointing to extreme weakness in industrial demand. Steel and coal prices remain weak as well. There have been speculations that this is a coordinated attempt by China to control commodity inflation and stick it to the Australians. It's not clear if there is merit to these rumors.

China import Iron Ore Fines 62% Fe spot (CFR Tianjin port) 
USD/metric tonne

3. China's Index of Leading Indicators declined further, suggesting that the slowdown is not over.

Source: ISI Group

4. At the same time food prices continue to rise. It's interesting that the news on food prices is coming directly from the official sources.
China Ministry of Finance: - The price of eggs in Beijing, Shanghai and Guangzhou saw an increase of 6.8%, 5.9% and 2.9% as compared with that of the previous week. The wholesale prices of 18 vegetables rose by 1.2% compared with that of the previous week, 1 percentage points lower than that of the same period, of which eggplant, Chinese cabbage and celery were up by 7.5%, 7.1% and 5.1% as compared with that of the previous week. The wholesale price of meat was widely on the increase, of which the price of pork rose by 0.8% as compared with that of the previous week, still decreased by 22.7% [YoY]. Pork price in Chongqing, Beijing and Xiamen rose by 3.7%, 2.3% and 0.6% respectively compared with that of the previous week; beef, chicken and lamb rose by 0.6, 0.3 and 0.2% respectively. The wholesale price of 8 aquatic products were up by 0.3% as compared with that of the previous week, of which crucian carp, grass carp and carp up the most, saw an increase of 1.4%, 1.2% and 0.4%. Retail price of grains and oil maintained a steady rise, of which peanut oil, rapeseed oil and soybean oil were up by 0.5%, 0.3% and 0.2% respectively compared with that of the previous week; the price of rise was up by 0.3%; while the price of rice and wheat flour remained unchanged.
Note that the year-over-year decline in pork prices has to do with the Chinese government dumping a big slug of its 220,000-ton strategic pork reserves into the market last year. Now meat prices are on the rise again. Vegetable prices have now increased for a 6th consecutive week. The spike in global soy prices is yet to propagate through China's wholesale food markets. Further increases are coming (see discussion) and this is likely the reason that the PBoC remains cautious on additional monetary easing.

5. It seems China's government is more interested in providing stimulus on the fiscal side via tax reform and tax rebates.
Reuters: - Finance Minister Xie Xuren also told parliament that the government would continue to revamp its tax system by carrying out various reforms, including expanding property ownership tax and deepening reforms of resource tax and consumption tax.

He also pledged to quicken the disbursement of export tax rebate and further expand the use of export credit insurance to support the battered export sector, repeating Premier Wen Jiabao's position set out over the weekend.

"In the next stage, we will continue to implement proactive fiscal policy to promote stable economic growth and will push ahead with fiscal and tax system reform," Xie told the top legislature.
6. But of course according to government officials, all is well and China's economy is stabilizing.
Xinhua: - "The current situation shows that the government's policies and measures have been effective. Economic growth is stabilizing at a slow pace," Zhang said, commenting on the performance of China's economy in the first half of the year.

Tuesday, August 28, 2012

Consumers remain uncertain in spite of increased net worth

The weak consumer sentiment number today was a surprise. After all, the S&P500 index is up 13.7% year to date (including dividend). The recent equity market rally should have boosted the consumer net worth and improved consumer confidence.

A quick empirical analysis (below) shows that a large portion (r^2 =84%, beta = .33) of the change in consumer net worth is explained by the moves in the stock market. This is a recent relationship, as the US consumer exposure to equities has been larger over the past 20 years than previously (the relationship was weaker during the previous 30 years: r^2 = 68%, beta = .18).

Source: Bloomberg

In fact the US consumer wealth has increased considerably since the financial crisis, to a large extent driven by the stock market (particularly given that housing has been stagnant until very recently).

Source: ISI Group

But increased wealth does not seem to be improving how consumers feel. Actually over the past few months the divergence between consumer sentiment and the equity market (which reflects improved net worth) is quite striking.

Source: Bloomberg

Something is spooking the consumer enough to cancel out the effects of the market rally. And the divergence is not just with the market. The recent uptick in the Citi Economic Surprise Index - indicating better overall economic data - is also not reflected in the sentiment trend.
WSJ: - Perhaps more worrisome, though, is the divergence between some of the hard economic data – such as jobs, manufacturing and housing reports – compared to soft data such as sentiment surveys. Much of the hard data have gotten better this summer, as measured by Citigroup’s Economic Surprise Index, which has risen in each of the last four straight weeks. But sentiment surveys are still lagging.
Part of the explanation is that the consumer is not as worried about the current situation (including a strong stock market) as she is about the future. The "present situation" portion of the Conference Board index was basically flat, while the "expectations" component was down 7.9. The consumer is not confident in her ability to retain this improved net worth.
LA Times: There was little change in how consumers viewed their current situation. For example, 34.4% of people surveyed said business conditions right now were bad, the same percentage as in July. And 40.7% of those surveyed in August described jobs as "hard to get," down slightly from 41% a month earlier.

But consumers' long-term view headed south. The percentage of respondents who expected business conditions to improve over the next six months dropped to 16.5%, from 19% in July. And 23.4% of those surveyed in August said they expected the economy to produce fewer jobs in the same upcoming period, up from 20.6%.
Not surprisingly the poor "forward looking" sentiment is also visible in the increased steepness of the VIX curve (discussed earlier).

The US fiscal cliff (see discussion), the Eurozone uncertainty (particularly with the scary looking September calendar), the upcoming election, and weak labor markets are some of the more common explanations for poor consumer expectations.
WSJ: - “Households continue to worry about a difficult job market, the European debt crisis, the upcoming ‘fiscal cliff,’ and the political wrangling in Washington and in the presidential campaign,” says Steven Wood, chief economist at Insight Economics.
But the spike in gasoline prices and the expectation of rising food prices due to the drought could be even more damaging to confidence, because consumers face these cost increases on a daily basis. Related to this, the US consumers are also concerned about the possibility of QE3, which may exacerbate the "headline inflation" (fresh in consumers' memory from 2011). As discussed before (see this post), even the anticipation of asset purchases by the Fed could have negative ramifications on the US consumer (in spite of driving equity prices higher).

Whatever the case, the divergence between economic indicators that have trended up recently (particularly the equity markets) and consumer confidence can not continue indefinitely. Something's got to give. The concern of course is that consumer sentiment in the long run could end up being more accurate than other forward looking indicators.
WSJ: - At some point, both sets of data points will start moving closer in tandem. “By its very nature this divergence is unlikely to persist,” ... “Our expectation is that the convergence will be toward the sentiment indicators, suggesting that the current upturn in economic momentum could prove fleeting.”

German economy converging with the Eurozone's

So much for the hopes and dreams of German decoupling from the Eurozone's economic troubles. How things have changed in just six months (see this discussion)! Germany's growth trajectory is now converging with the rest of the euro area's weakened economic conditions.

Source: JPMorgan
JPMorgan: - At the country level, the PMIs continue to point to a convergence in economic performance. Once again this month, the PMI improved in France and also in the periphery, whereas it slid further in Germany. At 47.0, the German composite PMI is now barely above the Euro area average and is pointing to a 0.5%q/q saar decline in GDP this quarter, pending the arrival of official activity data (e.g., IP) to help us fine-tune our estimate (+0.3%). This week’s 2Q GDP report confirmed that German domestic demand has now been stagnant for almost a year. The modest upward trend in consumer spending remains in place, with higher wages feeding through to gradually rising incomes. But, the uncertainties of the sovereign crisis and weaker external demand are manifested in reduced business capital spending, which is offsetting the modest increases in consumer spending. Notably, the German manufacturing PMI export orders index slid to a strikingly low level of 39.5 this month.
At this stage it's only a matter of time before Germany's GDP (which is a lagging indicator) turns negative.

Source: Markit

Spain's regional rescue fund is quickly put to use

As expected, more of Spain's regions are asking for a bailout. The program to help the regions was set up in July (see discussion) to create Spain's internal version of the "Stability Bond". With the regional fiscal problems escalating (see this discussion from March), the urgency of the situation could not be overstated.
Boston Globe: - Spain’s northeastern region of Catalonia, a hub of industry and business, said Tuesday it will seek €5.02 billion ($6.29 billion) in aid from the central government, adding to the country’s financial troubles as it struggles to avoid needing a sovereign bailout.

Catalonia, which has Barcelona as its capital, became the third region after Valencia and Murcia to officially solicit aid. Valencia said it will seek €3.5 billion and Murcia is to ask for up to €300 million.

Many of the 17 semi-autonomous regions are struggling with the recession, the country’s second in three years, following a real estate crash in 2008 that has pushed the unemployment rate to near 25 percent.

Because the regions are unable to borrow on financial markets to repay their huge debts, they are being forced to impose severe cutbacks. When that is not enough, they must ask the central government for help.
Because this action was anticipated, Spanish debt did not move materially - the current 10y is down half a point (on price). But this event clearly demonstrates that Spain's funding needs are greater than originally thought (see discussion). And as today's GDP number shows, Spain's recession is continuing to deepen, worsening the fiscal conditions of the regions.

Spain's GDP (Bloomberg)

It's the demographics, stupid

Analysts continue to base their forecasts for the US housing market on the economic conditions. It no longer works (see discussion). Rephrasing James Carville's quote, "it's the demographics, stupid".

Case-Shiller Comp-20 housing index MoM vs. forecast (Bloomberg)

USA Today: - The situation is "being created by smaller inventories" of homes for sale, said Everett King, president of ERA King Real Estate in Birmingham. Pent-up demand and fewer homes on the market are letting sellers charge about 5% more than six months ago, he said. "Anything between $350,000 and $400,000 just goes at the asking price."

Monday, August 27, 2012

ECB's bond purchases should start with Portugal

Given that the ECB has realized it is unable to target policy in some periphery nations (see this discussion), the central bank - assuming it does what people expect it to do - will focus on repairing the "monetary transmission" (transmitting low rate policy to the periphery). It really can't do too much with Greece at this point, but the central bank could focus on Portugal first. Portugal is supposedly on track with its fiscal plan (at least they have satisfied the Troika requirements). Yet the low rate policy transmission is broken, as short-term rates (as well as effective household borrowing rates) remain stubbornly high.

Periphery sovereign curves (Bloomberg)

JPMorgan: - The case for ECB intervention to aid monetary transmission [to Portugal] is clear. The case for action in other program countries is less clear: Irish yields are relatively low, while Greek compliance with program conditionality remains in doubt ahead of the Troika’s latest review. Action based on the rationale of repairing monetary transmission arguably has the best prospect of sustaining a majority on the Governing Council. And on that basis, we expect intervention in Portugal to begin after the Governing Council meeting has concluded.
As discussed (here) the ECB will target short-term rates - possibly up to three years. The goal is to lower rates in such a way as to reduce funding costs for households yet make sure the market "disciplines" the periphery governments on the long end of the curve. The ECB will then sterilize the purchases by offering term deposits.

Again, all this assumes that the ECB actually takes the logical steps based on Draghi's announcements. If the ECB does not start buying Portugal's paper fairly soon, it will be a signal that the markets have misinterpreted Draghi's intentions to fix the "monetary transmission". And it is entirely possible the central bank ends up delaying this bond purchasing program (discussed here) or morph it into something entirely different. But if all goes "according to plan", Portugal should be their first stop on the SMP-II program.

Has "worship of stocks" turned into "reverence for bonds"?

The trend started in early 2009. Net flows into fixed income mutual funds began to rise, while equity funds stayed flat. The trend continues through today, although equity ETFs have fared better than mutual funds (see discussion). But even within the ETF universe, flows into fixed income accelerated while equity ETFs grew quite gradually if at all.

Shares outstanding for SPY (S&P500 ETF)  vs LQD (investment grade bond ETF) (Bloomberg).

Given that the corporate bond market is smaller and less liquid than the equity market, that imbalance in growth of cumulative flows has driven yields/spreads to historical lows. Now some analysts are asking if corporate credit is overpriced relative to equities. One way to assess this is by looking at corporate bond yields vs. equity dividend yields.

The spread between the two has collapsed recently. One gets almost the same income holding corporate bonds as buying the S&P500 stocks. Is this the "new normal" according to PIMCO? Has the "worship of stocks" turned into the "reverence for bonds" (which is of course what Bill Gross wants)? Or are we simply looking at a market dislocation?

Source: CS

The US housing market is not "a chicken-and-egg problem"

An article appeared in the NY Times last week that describes the sad state of the US housing market as a closed system that is stuck in a "negative feedback loop":
NY Times: - The economy will not recover until the housing market recovers, and the housing market will not recover until the broader economy recovers — a chicken-and-egg problem reflected, once again, in national housing figures.
And that may indeed be the case if it wasn't for the US demographics. It's hard for many to accept the fact that the US population did not stop growing after the financial crisis. At the same time new home construction has stalled, forcing inventories to shrink. The author of course argues that there is a massive number of homes yet to hit the market - people are just waiting until their equity values turn positive.
NY Times: - High unemployment, poor jobs, stagnating wages and tight lending standards keep buyers away, while many sellers — especially the estimated 13 million homeowners who owe more on their mortgages than their homes are worth — are waiting for a price rebound.
Of course there are millions waiting to sell their home. But once these homes are no longer "underwater" and the owners sell them, where are they going to move? The sellers will go out and buy another home - maybe somewhere else in the US. Some argue that many families will start renting once they get rid of their "underwater" house. Unlikely, but those who do will find a tight rental market - there are not many homes for rent and rents are up materially. And to put more rental homes on the market the landlords have to buy these properties somewhere - taking them out of the available inventory.

The point is that the US demographics now drive the housing market - more so than the US economic growth. It is not the closed system that the NY Times describes because the demand grows with population. With new home construction remaining weak, there are simply fewer places to live - only so many people can live in someone's basement. Available housing inventory per working-age person in the US is now at a 30-year low (at least).

Source: ISI Group

It is not "a chicken-and-egg problem". The housing market and the US economy are now far less coupled together than in the past, when strong housing markets generated construction based growth. And just as demographics more than the economy now drive improved demand for homes, a better housing market will not have the same positive impact on the economy as it did before the financial crisis.

Deposits at US commercial banks approaching $9 trillion

Here is another reason QE3 will do little to change bank behavior or encourage lending. US commercial banks are awash with liquidity these days as deposits hit a new high (approaching $9 trillion).

Deposits at US commercial banks (source: FRB)

Banks are already struggling to put cash to work. The rate of deposit growth exceeds that of new loan demand and credit approvals. The bottleneck is not the availability of liquidity - there is $1.77 trillion of available lending capacity waiting on the sidelines. If the Fed were to implement a new asset purchase program, the level of liquidity in the banking system would increase even further without any material change in the rate of credit expansion.

China's industrial profits decline; market skeptical on stimulus

China's industrial firms reported continuing declines in revenues.
Xinhua: - Major Chinese industrial firms posted enlarged declines in their profits in July, official data showed Monday.

Profits for major industrial companies, or those with annual revenues of more than 20 million yuan (3.2 million U.S. dollars), slipped 5.4 percent year on year to 366.8 billion yuan in July, the National Bureau of Statistics (NBS) said in a statement.
Foreign owned companies saw particularly strong declines due to a slowdown in export activity.
Xinhua: - During the period, foreign-funded enterprises and those invested by businesses from Hong Kong, Macao and Taiwan saw profits drop 12.6 percent year on year to 609 billion yuan.
It is no wonder that Wen Jiabao said recently that China needs measures to promote export growth. But so far the domestic market remains skeptical that any meaningful measures will actually be implemented. The Shanghai Stock Exchange Composite Index hit a new post-financial crisis low this morning.

The Shanghai Stock Exchange Composite Index (Bloomberg)

Time is Money and other Fetishes

Guest post by Marc Chandler (

Doesn't the idea that "time is money" capture the spirit of modernity? Yet the Greek Prime Minister is suggesting that all Greece needs is some breathing room, given the depth of the economic contraction. It does not need any more money, he tries to reassure.

The Troika will not find this believable. Press reports suggest the IMF projects that even without the 2-year extension that Samaras is pleading for, Greece will need another 13-14 bln euros to cover the 2015-2016 period. If a 2-year extension is granted, the IMF reportedly projects Greece needs to be twice this.

Samaras may be better served by being more direct. He inherited a mess and is making every effort to fix it. The excesses took many years to build and they cannot be unwound in a day. It is unreasonable for the creditors to make a fetish of arbitrary time frames and targets. If it takes Greece another couple of years and another 30 bln euros to set its house right, isn't this preferable to the hundreds of billions of euros that are at stake in any exit scenario?

Sunday, August 26, 2012

Damage from possible QE3 has already started

Those (including some of the dovish members of the FOMC) who still think that the policy of a new round of asset purchases is a low risk proposition should only take a look at US gasoline futures. They hit a multi-year high within the past couple of hours (Sunday night).

Nearby gasoline futures (Bloomberg)

Some are blaming this on the Tropical Storm Isaac, others on the Amuay plant explosion in Venezuela. The reality however is that these price increases are for the most part in anticipation of QE3:
Bloomberg: - Bernanke Boosts Oil Bulls to Highest Since May: Energy Markets

By Asjylyn Loder Aug. 27 (Bloomberg) -- Hedge funds raised bullish bets on oil to a three-month high on signs that Federal Reserve Chairman Ben S. Bernanke will take measures to bolster U.S. economic growth and spur a rally in commodities.

Money managers increased net-long positions, or wagers on rising prices, by 18 percent in the seven days ended Aug. 21, according to the Commodity Futures Trading Commission’s Commitments of Traders report on Aug. 24. They were at the highest level since the week ended May 1.
Let's not pretend that central bank asset purchases and commodity prices are unrelated as some have suggested. QE3 carries with it risks of a spike in headline inflation that will end up damaging an already fragile consumer sentiment and completely negating any positive effects from additional liquidity. In fact the damage to the economy from elevated fuel prices has already started.

The soy price shock in the US will reverberate across China

The Chicago Board of Trade soy futures hit a new record Sunday evening as attention now shifts from corn to soy. Traders are coming to the realization that soy supply may not last long enough to be replenished by crops from South America.
Bloomberg: - “Corn was the story going into the crop tour and now soybeans are the story after leaving the fields this week,” Peter Meyer, a senior director of agriculture commodities at PIRA Energy Group in New York, said in an interview in Owatonna, Minnesota, after completing his sixth Pro Farmer tour. “Mother Nature shut down the soybean crop well before it reached its potential. The U.S. may run out of soybeans before the start of the South America harvests in February.”
Soy nearby contract (Bloomberg)

Again, a number of analysts continue to argue that the North American drought should not have a significant impact on Asia. That is just not true. Some economists simply don't appreciate just how global agricultural markets have become.
Bloomberg: - China, the world’s largest buyer and consumer, purchased 165,000 metric tons of soybeans and 55,000 tons of soybean oil from the U.S., the USDA reported yesterday. China may import a record 59.5 million tons of soybeans in the year that begins Oct. 1, the agency said Aug. 10.

World soybean supplies may shrink by 33 million to 35 million tons in September to February, compared with a year earlier, forcing China to reduce imports by 4 million tons, researcher Oil World said Aug. 21.
Tight global supply of soy will translate into government subsidies and/or food inflation in China and elsewhere in Asia. Fear of food inflation is one of the reasons China has not been as aggressive with its stimulus programs in spite of slowing economy. Here is a quote from the LA Times that describes how these skyrocketing soy prices will reverberate across China.
LA Times: - Construction laborer Yi Jichun has never heard of Illinois or Iowa. But the migrant worker's favorite comfort food comes straight out of the U.S. Midwest: soybean oil.

The world's biggest consumers of edible oils, Chinese households have developed a taste for the stuff that would make a county fair fry cook proud. Be it a simple stir-fry, poached fish or deep-fried pork ribs, many Chinese diners love their grub covered in an oily sheen. Jugs of the golden liquid make popular gifts for Chinese New Year.

"Without the oil, it would taste too plain," Yi said as he tucked into a lunch of sliced cucumbers and chicken drumsticks slathered with grease. "I wouldn't want to finish it."

And that has officials in Beijing worried. The worst U.S. drought in half a century is sending global grain prices soaring. The fallout is almost certain to be felt at dinner tables across China. The No. 1 foreign buyer of American soybeans, which are pressed into cooking oil and used for animal feed, China last year purchased about half of U.S. exports, more than $10.4 billion worth, according to the American Soybean Assn. China has also stepped up purchases of U.S. corn and wheat to feed the nation's growing appetite.

Poor U.S. harvests could fuel Chinese food inflation and social discontent. China has already begun tapping its grain reserves to ensure price stability. The government has ordered the nation's biggest cooking oil producers twice in recent months to keep their prices in check. And it's scouring the globe for alternative supplies.

It won't be easy. More than two-thirds of cooking oil consumed in China comes from soybeans, and most of those soybeans are supplied by the U.S., according to Ma Wenfeng, an analyst with Beijing Orient Agribusiness Consultant Co. For now, Chinese consumers are bound to the fortunes of farmers in the American heartland.

"Soybean oil is the most important edible oil in China ... which makes us vulnerable to the drought" gripping the U.S., Ma said.

Big inflows into gold ETPs generate a rally, but one should remain cautious

Gold lease rates declined across the curve in the last few days (flattening the forward curve somewhat). The bullish sentiment has forced some gold short-sellers out, reducing demand to "borrow" gold.

Source: Kitco

The bullish sentiment is visible in the recent jump in GLD shares outstanding, indicating significant inflows into gold ETPs.

GLD shares outstanding (Bloomberg)

Bloomberg: - Gold ETP holdings overtook France’s reserves on Aug. 21 after rising 90.4 tons this year to 2,447.1 tons, data compiled by Bloomberg show. Only the U.S., Germany and Italy hold more, International Monetary Fund data show. The IMF itself holds 2,814 tons of bullion, placing it between Germany and Italy.

Billionaire John Paulson raised his stake in the SPDR Gold Trust, the biggest gold ETP, by 26 percent in the second quarter and George Soros more than doubled his holdings, U.S. Securities and Exchange Commission filings showed Aug. 14. Investors will buy 150 tons through ETPs this year and next, Barclays Plc estimates.
In spite of the reductions in short positions and tremendous inflows into ETPs, gold has not yet reached a speculative frenzy such as the one that existed in the short euro positioning or investment grade bonds last month. Should gold become a "crowded trade", we would be able to see it in the futures markets net positioning.
Bloomberg: - The increase in prices and ETP holdings has yet to be reflected in speculative wagers in U.S. futures markets. Hedge funds and other money managers cut bets on a rally by 58 percent since the end of February, U.S. Commodity Futures Trading Commission data show. The net-long position fell 4 percent in the week to Aug. 14 and is near the lowest since 2008.
So far the long gold bet seems to focus primarily on global stimulus, particularly from the Fed (as well as the ECB and PBoC). And clearly not everyone is sold on this easing being timely or large enough to weaken the dollar sufficiently and generate material incremental demand for gold. In fact short-term downside risks to gold remain if the expectations of Fed's "QE3" prove to be wrong.

There is also talk that the Republican party is going to make the return to gold standard in the US part of their campaign agenda. According to some estimates, returning to gold standard would send gold prices to $10K/oz, which encouraged some recent retail buying.
WSJ: - The committee drafting the Republican Party's platform before next week's convention included a proposal to establish a commission exploring the United States' return to a gold standard.

Republicans in Tampa, Fla., citing President Ronald Reagan's commission "to consider the feasibility of a metallic basis for U.S. currency," this week included the creation of "a similar commission to investigate possible ways to set a fixed value for the dollar," according to language of the proposal provided by a Republican National Committee spokeswoman. The Reagan commission "advised against such a move," the proposal noted.
Doing so is a nice idea in theory but it simply can not be implemented. There isn't enough gold out there for the Fed to buy in order to support the USD monetary base ($2.56 trillion). And any attempt to do so will destroy the US international competitiveness. It is a purely political move on behalf of the GOP to appeal to Ron Paul's supporters (which is also a good idea, but is not going to translate into higher gold prices).
Chicago Tribune: - Instead of planning for a gold standard return, the Republicans are trying to placate supporters at next week's RNC and to gain more firepower in the party's promoting responsible U.S. fiscal and monetary policies in the upcoming federal elections in November, analysts said.

Minutes from the Federal Reserve's latest meeting suggests the U.S. central bank will adopt stimulus fairly soon unless economic conditions improve dramatically. Some expect Fed Chairman Ben Bernanke could use his speech at the central bank's gathering in Jackson Hole, Wyoming, at the end of this month to send a strong message to markets.
At the same time gold demand fundamentals (outside of the QE expectations and the gold standard idea) have been fairly weak.
Bloomberg: - Physical demand is slowing elsewhere, with sales of American Eagle gold coins by the U.S. Mint dropping 49 percent to 30,500 ounces last month, the lowest since April. The mint sold 21,500 ounces so far in August, data on its website show.

Gold imports in India, last year’s biggest buyer, are set to fall as much as 50 percent in the September to December period from a year earlier, Prithviraj Kothari, president of the Bombay Bullion Association, said Aug. 21. Local prices reached a record today, data compiled by Bloomberg show. That may crimp demand at a time when a below-average monsoon in the country threatens rural incomes.
Gold should be a part of a long-horizon diversified portfolio, particularly given the developed nations' central banks willingness to (over)compensate for their governments' inability to generate growth and improve labor markets. Japan and the UK central bank balance sheets are growing, the ECB is getting ready to do the same, and the FOMC seems to be "trigger happy" as well. But in the short-term, given the risk of "disappointment" from the Fed and even from the ECB as well as weak physical demand fundamentals (particularly from emerging markets), one should remain cautious.

Saturday, August 25, 2012

The crash of the Dutch housing market reminds us of a much older market bubble

From the country that brought us the tulip mania - roughly on the 375th anniversary of the tulip bubble crash - comes the latest property market correction in the Eurozone.
WSJ: - The slump in the Dutch housing market deepened in July as prices posted the steepest drop on record, highlighting the challenges facing the Netherlands ahead of next month's general elections.

With prices now plumbing levels last seen in 2004, the downturn is weighing heavily on household consumption and has raised concern about the country's huge mortgage debt pile, among the largest in Europe
So far this is not nearly as bad as the property market corrections in Spain or Ireland, but this was certainly unexpected. And now just as in the US, there is no shortage of blame to go around.
WSJ: - Regulators blame loose lending practices in the late 1990s and early 2000s and a tax relief program for home buyers that distorted the Dutch housing market. As a result, they say, the country's banks have become too reliant on wholesale funding to finance their large mortgage books. At around €640 billion ($790 billion), Dutch mortgage debt is roughly the size of the country's entire economic output last year.

The Dutch central bank warned earlier this year that a prolonged slump poses a risk to the financial system as banks could face rising loan losses and more trouble securing funding. It could also squeeze public finances, as the Dutch government guarantees around €140 billion in home loans.d concern about the country's huge mortgage debt pile, among the largest in Europe
What got banks, politicians, and regulators really spooked was the sharpness of the correction. It is also an indication that the Eurozone "core" is not immune to the crisis.

Source: Credit Suisse

Similar to the political backlash that took place in the US after the housing crisis, the Dutch government remains vulnerable to significant changes that could have a Eurozone-wide impact.
CS: - We think that negative headlines could arise during the process of forming a new government. The Socialist are leading in the polls and they could become the strongest party. They propose a longer time frame – 2015 instead 2013 - to reach the 3% budget deficit. They also reject the European fiscal pact.
And similar to the tulip crash, it is the leverage that makes this housing correction so dangerous.
CS: - Dutch household liabilities are the highest in Europe, mainly due to the high residential mortgage debt. Therefore, the adjustment in the housing market has a negative wealth effect which should have a relatively larger impact on household spending, and thereby, on GDP growth.
With 80% of the Netherlands' GDP coming from exports, the nation is already highly exposed to global growth. This housing market decline could tip the Dutch economy into a recession.

More on the Dutch housing market from Rabobank
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