Tired of hearing about the ECB Deposit Facility? Here is some good news.

A chart from Barclays Capital just may limit media coverage of the ECB Deposit Facility. The badly needed chart (below) shows Barcap's projections for what's called the "liquidity surplus" in the euro-system.

Euro-system Liquidity Surplus (source: Barcap)

The "liquidity surplus" represents the Deposit Facility balances plus banks' excess reserves. Excess reserves are the banks' current accounts (reserve accounts) at the ECB less the required reserves.  That amount fluctuates as banks "front load" their accounts to make sure the period average exceeds the required reserve amount.

Source: ECB

The excess reserves could be either positive or negative depending on where one is in the cycle. Therefore according to Barcap's chart, the Deposit Facility should be quite stable going forward except for the excess reserve cyclicality. Since the liquidity surplus is driven by the amount borrowed from the ECB (not banks hoarding cash), Barcap's forecast must assume that the net lending to banks by the ECB has stabilized.  With the 3-year LTRO significantly extending the average maturity, banks are not expected to repay their loans for a while. This will keep the net Deposit Facility balances reasonably stable, declining slightly over time.

And that is good news for those who don't want to hear about this facility any more. Since the facility is not expected to change for a while, it should result in the mainstream media staying away from covering the topic. It's just not going to be sensational enough going forward.

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EIA's latest energy projections for the US

The EIA today released their abridged version of the 2012 Annual Energy Outlook. Here are three key highlights.

1. Net US consumption of "liquid fossil fuels" in the US is expected to stay almost unchanged through 2035. The domestic supply however is expected to grow, reducing the gap currently filled by imports from 49% in 2010 to 36% in 2035.

Source: EIA

This is not significantly different from their earlier forecasts.

2. The picture for natural gas however gets interesting.  This post in early December pointed out the risks to the downside of Natural gas.  As the weather stayed warm, that is in fact what happened.  Today we finally saw a reversal (an 8% pop) to what has been a relentless decline in price. EIA's forecast shows continuing growth in natural gas production in the US driven by shale gas. 

Source: EIA

The outcome of this growth in gas production has to involve significant US exports. As the chart below shows (hat tip Greg Merrill), liquifying natural gas and exporting it will allow companies to capture a massive spread differential.

EIA: The United States is projected to become a net exporter of liquefied natural gas (LNG) in 2016, a net pipeline exporter in 2025, and an overall net exporter of natural gas in 2021. The outlook reflects increased use of LNG in markets outside of North America, strong domestic natural gas production, reduced pipeline imports and increased pipeline exports, and relatively low natural gas prices in the United States compared to other global markets.

3. One surprising projection in the report is the continuing reliance on coal for power, given the vast amounts of cheap natural gas.  Natural gas usage to generate power is expected to increase by only 3%.  The chart below shows projected sources of electricity generation in the US, with coal usage dropping from 45% to 39%. The US should be able to have a bigger reduction, given the nasty effects of coal generated smog.

Source: EIA

Growth in renewables is expected to increase from 10% to 16%, still likely driven more by tax incentives rather than economics.

Enjoy!
2012 EIA projections

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Two data points on US housing

Two recent data points add support to our thesis of the US housing market bottoming this year. The first one is from the National Association of Home Builders (NAHB).  NAHB publishes an index that represents builder perception of the market conditions.  Here is how they determine the index,

Derived from a monthly survey that NAHB has been conducting for more than 20 years, the NAHB/Wells Fargo Housing Market Index gauges builder perceptions of current single-family home sales and sales expectations for the next six months as 'good,' 'fair' or 'poor.' The survey also asks builders to rate traffic of prospective buyers as 'high to very high,' 'average' or 'low to very low.' Scores from each component are then used to calculate a seasonally adjusted index where any number over 50 indicates that more builders view conditions as good than poor.

The recent moves in the index certainly have not reversed the loss of the "happy days" for builders since 2006, but it has been rising.

NAHB Index (Bloomberg)

This is what NAHB had to say when the latest number was released last week:

NAHB: “Builders are seeing greater interest among potential buyers as employment and consumer confidence slowly improve in a growing number of markets, and this has helped to move the confidence gauge up from near-historic lows in the first half of 2011,” noted NAHB Chief Economist David Crowe. “That said, caution remains the word of the day as many builders continue to voice concerns about potential clients being unable to qualify for an affordable mortgage, appraisals coming through below construction cost, and the continuing flow of foreclosed properties hitting the market.”

There is no question that lack of financing and a large distressed inventory continue to weigh on the market. Builders are in fact still quite cautions, but they don't see the situation as dire as they did just a few months back. And low levels of new construction will cap the housing inventory growth, helping markets recover.

The second data point is the convergence of the median cost of rent (monthly payments) with the median mortgage payments (monthly principal and interest). 

Source: Capital Economics

We are now at the levels where for some people it may make sense to purchase a house, possibly as an investment in a rental property.  Even at distressed prices, these transactions transfer assets from weaker holders to stronger ones, providing longer term support to the market.

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Interpreting the divergence of HY spreads and VIX

The following chart shows the average high yield bond spread (as measured by the JPMorgan HY index) vs. VIX. The divergence seems to indicate that credit is cheap (wide) relative to implied vols.

HY Index spread (STW) vs. VIX

But if the HY market really caught up to VIX, what would these bonds look like?  The answer is that with the 5-year treasuries yielding 0.92%, HY bonds would have an absolute yield of about 6.3% (540bp +92bp).  Even in this low rate environment investors may have a tough time buying non-investment grade bonds at 6.3% yield.  In fact 6.7% has been the floor on absolute yield in the HY market historically, no matter what the spread was.  The yield touched this "floor" level in the low rates environment / boom period of 2005 and again in the first half of 2011 during the euphoria of QE2.  

Absolute yield (YTW) for the JPM HY Index (Bloomberg)

Therefore as spreads continue to tighten, investors will start looking more at absolute yields on HY bonds, potentially putting a floor on these yield levels.  And until treasury yields rise substantially, we may be finding a floor on HY spreads as well.

As far as VIX is concerned, the recent drop definitely looks overdone relative to other risk indicators. This suggests that if the deviation between HY spreads and VIX begins to recede, the next leg of the convergence will be more from rising VIX levels than significant tightening in spreads.

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Google Insights for Search and the contagion effect

Google Insights for Search allows one to track the frequency of searches for a particular word or phrase in the Google search engine.  This gives one an indication of public's interest in a specific subject matter over time.  Results for the phrase "euro crisis" are shown below.  Note that the peak of search volume was in early December.

Google Insights for Search interest in phrase "euro crisis" - relative index

If one looks at the Italian 5-year yields for example as a comparison, the shapes are similar but the yields on Italian debt peaked a little earlier.

Italy 5-year yield

A natural assumption would be that the general public using Google reacts to global events on a delayed basis. But let's take a closer look at who is actually doing the searching.  Insights for Search produces the following distribution of users.

Google Insights for Search relative interest in phrase "euro crisis" by country

Of the top five countries Ireland, Netherlands, and the UK searching for the phrase "euro crisis" makes sense - particularly given this is an English phrase (the Dutch are quite proficient in English). But Singapore and India concerned with the Eurozone crisis more than the US for example?  What exactly was going on in those countries in December to make them want to learn more about the situation in Europe?  The simplest way to assess this is to look at the two nations' stock markets.

SGF - Singapore CEF

SENSEX - India

It turns out these countries' stock markets dropped to their lows in December, coinciding with the higher frequency of searches for "euro crisis". The market correction also took place in other Asian nations but they would be less likely than India and Singapore to search for an English phrase. That means the public in these countries was viewing this sell-off as a contagion effect driven by the Eurozone crisis.

The US on the other hand was number nine on the list because the US stock market was not as impacted by the same events - a lower contagion effect.  Here are some possible conclusions that can be drawn from this exercise:

• Google Insights for Search can be a useful indicator to track global public's interest in financial events.
• It allows one to drill down to see exactly who is doing the searching in order to understand why there is interest in a specific phrase.
• The most intriguing possibility is that this tool - particularly the rankings by country - may be used to track levels of contagion, as the public links events in their region (the stock market sell-off in Asia) to another global event (the crisis in Europe.)

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The latest actions in the Eurozone's "war"

The Eurozone bureaucrats and the ECB are trying to use an economic equivalent of the Powell Doctrine in fighting the crisis. Finally they are starting to realize the need for employing all available resources that are politically viable in the current environment.  Here are some of the latest monetary and fiscal actions:

• The ECB lowered bank reserve requirements from 2% to 1%.  That’s a release of EUR 100bn into the banking system, which we should see showing up in the ECB Deposit Facility.

• Draghi is gearing up for LTRO-II.  The demand is expected to be high, though the amount is still capped by the availability of eligible collateral.  The ECB will have to make exceptions for some banks on the types of collateral the central bank can accept.  Many banks will simply shift some of what they currently have on the overnight basis with the ECB into the new LTRO.

• The combination of the ESM and the EFSF will be set at EUR 500bn capacity for now.  Some member states such as Slovakia are uneasy about taking it higher at this stage.  However the Board of Governors of the ESM will have the ability to increase it if needed as part of the new Eurozone treaty. Depending on how the crisis progresses however, the EUR 500bn may not be enough. There has been some talk of the IMF increasing its lending capabilities to supplement the ESM. For now that’s off the table because the US, who has a veto power at the IMF, will not agree to an additional Eurozone exposure. And of course the issue of subordination will be on bond investors' minds as the ESM structure is finalized.

• The latest draft of the Eurozone treaty will call for funds from member states in five annual installments of EUR 80mm in order to capitalize the ESM.  As soon as the ESM gets to 90% of the target size, it will be made operational.
  
  
• Only the member states that have started modifying their constitutions to comply with the new treaty will be eligible for any ESM support.  The treaty effectively holds a gun to the heads of the periphery states, forcing them to begin the push toward balanced budgets. Countries who have not complied with the treaty budget modification requirements will not only be shut out of the ESM, but will also be brought before the European Court of Justice. The latest draft of the Eurozone treaty will make this process almost automatic. Repeat violators will have to pay a substantial penalty directly to the ESM. The idea is to diminish any ability of the periphery politicians to derail unpopular austerity measures.

The Eurozone treaty will become law once 12 out of 17 member states ratify it, ushering in a massive deleveraging process of the periphery states. It is gearing up to be an extended process with some potential casualties, made particularly treacherous by the onset of a Eurozone-wide recession.   

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Gingrich victory gives Obama an edge

Newt Gingrich's victory in South Carolina GOP presidential primary demonstrated once again that the Republican party is uneasy with Mitt Romney. This trend has pushed Romney's nomination chances down sharply.

Mitt Romney chances of GOP nomination

But with all the noise around the Gingrich victory that CNN calls "a new ballgame", another trend is emerging. Obama's chances of getting reelected have jumped on the news.

Barack Obama's chances of reelection

The market is sensing the divisions within GOP and the difficulties Gingrich would face taking on Obama.  After all whether or not one agrees with all the baggage Gingrich brings to the table, the media and campaign managers will have a field day with this nonsense. All of which is clearly giving Democrats an edge.

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Treasury yields likely to rise in 2012

This week we finally saw a sell-off in longer term treasuries after a relentless rally. With a great deal of new supply hitting the market, US treasuries will be under further pressure going forward.  Here are six reasons that make higher yields more likely in 2012:

1. In 2010 the onset of QE2 pushed treasury yields lower (within a month of the Jackson Hole announcement the 5yr yield was lower by 16bp).  As discussed earlier however, the probability of a quantitative easing redux has declined markedly.

2. Operation Twist which has been providing support to longer term treasuries is expected to end this summer.

3. Many managers who were short or under-invested in treasuries (such as PIMCO) have capitulated, as treasuries continued a powerful rally in 2011. Investors have been trying to short US treasuries for some time with the view that QE programs will ultimately debase the dollar and accelerate inflation. These projections did not materialize and the capitulation trade caused treasuries to rally further. The chart below shows shares outstanding of the ProShares Treasuries 20+ Year UltraShort ETF (ticker: TBT). It allows investors to easily short longer dated treasuries on a leveraged basis. The capitulation trade is clearly visible in the decline of the number of shares outstanding.

TBT shares outstanding (Bloomberg)

The Long Bond became known in some trading circles as the "widow maker" because of the losses numerous traders endured trying to short it. Many have since said "no more!"  Now with fewer shorts in the market, there will be less support for treasury prices going forward.

4. Treasury yields have decoupled from "risk assets" such as equities. This is unlikely to be sustainable going forward.

5. Between the Fed's Liquidity Swap and the numerous actions by the ECB, the funding pressures in the eurozone have receded materially. Yet treasuries have not adjusted accordingly. The chart below compares 10-year treasury yield with the 3-month EUR/USD basis swap rate.

10-year treasury yield vs. EUR/USD 3m basis swap spread (Bloomberg)

6. Even though foreign private investors continue their love affair with treasuries, it seems that foreign central banks may be losing their appetite for US government debt. Treasuries holdings at the Fed by foreign central banks are showing declines.

Foreign banks' holdings of US treasuries at the Fed  (Bloomberg)  

There is no shortage of new supply, as the US Treasury is expected to hit the market with net new issuance of about $81bn/month excluding what the Fed is expected to purchase (see Businessweek - forecast by Credit Suisse). Clearly an unexpected shock in Europe could trigger a new rally in this market, but absent such an extreme event, longer term treasury yields should rise in 2012.

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