China's central bank's inaction can have dire consequences - this is not a game

It is remarkable that China's central bank has been unable or unwilling to contain the spike in short-term rates, as the interbank liquidity squeeze continues. This is roughly the equivalent of the Fed not being able to control the fed funds rate. You can certainly have fluctuations, but within a couple of days a major central bank should be able to inject enough liquidity into the system to bring down rates - unless of course the central bank wants the rates higher.

Something is amiss here. China is risking a recession unless the PBoC can bring this under control. Both the repo and the SHIBOR rates have risen to new highs in the past few days.

Source: Reuters

1-week SHIBOR

Some have suggested that the PBoC is in fact trying to tighten liquidity in the financial system in order to put the brakes on the rapidly growing shadow banking sector (see discussion). While an admirable goal, creating a liquidity squeeze in the banking system and sending short term rates to multi-year highs is NOT the way to achieve that. This is especially scary in the face of an already "moderating" economic growth.

Reuters: - China's short-term funding costs surged on Wednesday, with the benchmark money market rate hitting a multi-year high, and authorities postponed the market's close by 30 minutes to give banks extra time to complete their borrowing.

The money market squeeze that began early this month has worsened this week, forcing banks and other financial institutions to trim non-essential businesses, such as wealth management and arbitrage, traders said.

That response may be welcomed by the central bank, which has adopted a hawkish stance towards market liquidity since May, partly to clamp down on an increase in risky shadow banking activities, traders said.
...
The interbank market decided to extend the trading time to 5 pm as many banks failed to obtain enough short-term money needed for business at the normal closing time of 4:30 pm, traders said.

Such trading extensions have occurred several times recently amid the acute squeeze, traders said. "Everybody is disappointed at the central bank's non-action," said a dealer at an Asian bank in Shanghai.

It's not clear if people fully appreciate the potential impact of this liquidity squeeze - including folks at the PBoC. This is not a game. These tight conditions and high rates over a longer period can easily derail lending activities across the country while potentially putting a number of financial institutions at risk and sending the economy into a tailspin. With the Eurozone still struggling in the aftermath of the crisis, let's see what a recession in China (12% of world's GDP) can do for global growth. Mr. Bernanke and company may need to go back to the drawing board very soon.

SoberLook.com

From our sponsor:

Brazil feeling the heat: 3 reasons for the sell-off on Paulista Avenue

Continuing with the emerging markets underperformoance theme (see discussion), Brazil's stock market hit new post-recession lows today. We haven't seen the Bovespa index this low since the spring of 2009.

But Brazil's financial market correction is not limited to equities. The 10yr government bond yield rose to 11.43% today (chart below).

Source: Investing.com

And the Brazilian Real (BRL) fell to 2.23 per dollar. As with equities, we haven't seen USD/BRL at these levels since the first half of 2009.

USD/BRL (Source: MarketWatch)

There are three key reasons for these violent market "adjustments".

1. Brazil's economy has been weakened by slowing global demand, particularly from China and the Eurozone. The nation's current account has been in the red for some time and is deteriorating.

The Economist: - FAILING to meet low expectations is becoming a habit for Brazil’s economy. Figures published on May 29th showed that in the first quarter of this year it grew by just 0.6% (2.4% annualised), well short of the recovery analysts had expected. For the first time in years the country is running a trade deficit. Its primary fiscal surplus (ie, before interest payments) is shrinking and government debt is growing. Other emerging economies are also cutting growth forecasts, as China slows and the euro zone slumps. But Brazil’s woes started earlier than most and seem to be home-grown. Inflation close to 6.5% despite low growth suggests domestic rigidities are the main problem, rather than weak foreign demand.

2. Brazil's economic weakness has generated a wave of social unrest. Over the past decade Brazil experienced tremendous growth, which ended up masking a number of structural and social issues. Now these issues are coming to the surface and spooking many investors.

Reuters: - After more than a week, the biggest series of protests to sweep Brazil in more than two decades continued in major capitals and moved into smaller cities. Focused at first in cities like Sao Paulo, Rio de Janeiro and the capital, Brasilia, demonstrations in more than 70 smaller cities were expected across the country on Thursday.

Wednesday's protests in Sao Paulo, the site of the most frequent marches, followed overnight demonstrations that led to looting and vandalism. Police arrested more than 63 people after protesters torched a police facility, tried to storm City Hall and broke windows and ransacked stores.

3. The Fed is now looking to slow the pace of massive amounts of stimulus being added to the system in the US each month.

Bernanke: - “If the incoming data are broadly consistent with this forecast, the committee currently anticipates that it would be appropriate to moderate the pace of purchases later this year,... We will continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.”

As a result, rising rates have generated a broad "risk-off" market sentiment, with active investors dumping anything that feels risky. Brazil is high on that list.

When markets open across Asia and Europe tomorrow, expect to see some major adjustments among emerging markets in those areas as well. But Brazil, being squeezed from all sides, probably takes the cake for the worst financial markets turbulence among major emerging market economies - for now.

SoberLook.com

From our sponsor:

Emerging markets underperformance worsening

Emerging markets underperformance that started in late 2011 is continuing. While part of the gap has been due to US equities generally outperforming global shares, we now have some 60% dispersion between emerging markets and the S&P500.  

CNBC: - Investor confidence in emerging markets is continuing to plummet, with a recent fund managers' survey showing that equity investment in the group of countries has fallen to its lowest level since December 2008.

The BofA Merrill Lynch Fund Manager Survey for June showed that about 9 percent of asset allocators were underweight emerging market equities - the first underweight reading since 2009 and down from a 3 percent overweight position in May.

SoberLook.com

From our sponsor:

Residential construction recovery has a long way to go

New housing construction in the US has increased substantially since the lows of the Great Recession, but remains near pre-recession lows.

Given the population growth since the recession, improvements in household formation, cheap mortgages, and relatively high rent, one would expect construction to be significantly stronger. Even if households can't afford to buy a new home, they need a place to rent. That means someone should be building a rental unit.

Something is holding back construction. Anecdotal evidence suggests that local and regional banks who used to fund residential construction are still holding back. In fact hundreds of banks who used to be in that businesses have been shut down by the FDIC because the construction firms they financed magically "disappeared" in 2008. And those banks that are still around seem to be rather gun-shy, as memories of the great real estate bubble are still fresh on credit officers' minds. When it comes to housing developments, unless you are Toll Brothers, financing is not easy to come by.

With financing tough to come by, while we've seen improvements in residential construction spending, it is still at 1998 levels.

And hiring in residential construction remains anemic.

People point to strong outperformance by homebuilders vs. the broader market since early 2012. That is true - many larger construction firms have seen their earnings increase sharply. But consider the fact that since the beginning of the housing recession in 2006, homebuilder shares are still lagging the S&P500 by over 60%.

Source: Ycharts

The original enthusiasm for residential construction growth has moderated somewhat. One can see it for example in the recent relative weakness in lumber futures. While prices are significantly higher than the 2011 levels, we have witnessed quite a correction lately.

Source: Barchart

Residential construction has a long way to go to see full recovery - even to the "pre-bubble" years.

SoberLook.com

From our sponsor:

IMF points to major risks in Portugal's path to recovey

As the IMF approved its latest tranche of bailout funds for Portugal last week, the organization pointed out significant risks to the nation's economy and its deficit reduction targets.

The IMF (report attached): - The solid social and political consensus that to date has buttressed strong program implementation has weakened significantly. Economic recovery is also proving elusive. And with the program bereft of tools to boost competitiveness in the near-term, there is a high risk that adjustment will continue to take place through more demand compression with too little compensating expenditure switching due to higher exports—particularly in light of still difficult euro area economic environment.

For a while it looked as though Portugal could potentially export its way out of the mess it was in. But those hopes have been dashed recently, as the nation's net trade balance growth has stalled. What happened? Slow global demand softened growth in exports. At the same time, domestic demand, stung by austerity measures, keeps declining at 6-8% annually.

Source: Barclays Capital

With the risk of a sharper slowdown elevated, the IMF focused on four stress tests that were applied to Portugal's debt to GDP projection: growth shock, rate spike, decline in potential (as opposed to actual) GDP growth, and contingent liabilities.  Here they are.

The IMF: -

1.  A growth shock that lowers the output by cumulative 5 percentage points in 2013 – 15 would raise the debt peak by 7 points to 131½ percent of GDP.

2.  An interest rate spike of 400 bps on all debt in 2013 – 15 would not have a large immediate effect, but it would slow down the rate of debt decline in the medium term, so that by 2020 the debt-to-GDP ratio is 5 points higher compared with the baseline.

3. A reduction in potential growth (from two to one percent in real terms) will have an impact that is numerically similar to the impact of an interest rate spike noted above.

4.  Realization of contingent liabilities (15 percent of GDP...) would immediately push debt close to 140 percent of GDP; debt would fall below 120 percent of GDP only in 2023 [this includes the 9 percent of GDP in debt of the SOEs that are classified outside the general government - see post on the topic]

And here is what the results look like. The combination of these factors looks particularly ominous with government debt to GDP growing to 150%.

Source: IMF

The risk of Portugal running into at least some of these headwinds - which would result in potentially higher/longer bailout requirements - remains elevated. The IMF has already loosened some fiscal consolidation targets for Portugal, but given the uncertainties involved, many economists remain skeptical.

WSJ: - The fund Wednesday approved a loosening of the country's deficit-reduction targets, giving Lisbon more time to tighten the country's budget.

Portugal's economy is struggling with imposed austerity—including tax increases, wage cuts and cuts in the health and education sectors—and healthy growth is nowhere in sight. Output is expected to shrink 2.3% this year after a 3.2% contraction in 2012, while unemployment is close to 18%.

The fund said it can't say with high probability that Portugal's debt is sustainable over the long term, and noted the country's finances are vulnerable to potential distress such as a deteriorating growth outlook and higher borrowing rates.

IMF Portugal Report

SoberLook.com

From our sponsor:

China's economy: new warning signs

China's consumer confidence declined sharply in May to 99.0 from 103.7 in April. Of course household spending in China represents only around 35% of the GDP (according to the World Bank), while the US consumer is over 70%. Nevertheless taken together with China's manufacturing PMI, we may be seeing signs of renewed economic weakness.

Source: National Bureau of Statistics of China, Markit

China's stock markets also sold off in the last few weeks (now at a 6-month low). These are all indicators of potentially slower growth ahead. And slower growth poses a number of risks that have been masked by the nation's booming economy. One of the key risks of course is the size and health of the shadow banking system. Fitch in particular has been ringing some alarm bells with respect to China's private credit growth.

Forbes: - With a shadow banking system that is becoming increasingly prominent, the rise of bundling of assets and securitization, and an acceleration of policy tightening, over-indebted local governments and institutions will feel the pain of a rising cost of capital, prompting Fitch Ratings to raise red flags about the future growth prospects of the Chinese economy. At Nomura, where they noted that liquidity tightening is dangerous in a highly leveraged economy, they increased their probability that a risk scenario could push GDP growth below 7% this year, threatening social stability.
...
A major problem is that much of this incredible surge in credit has been channeled through the shadow banking sector, which is very closely connected to the banks. Total non-loan credit hit $5.6 trillion in 2012, with nearly $2 trillion of that credit extended by opaque non-bank financial institutions, Fitch’s research shows. Furthermore, more than $2 trillion were connected to informal securitization of bank assets in so-called wealth management products (WMP).

Perhaps the most ominous indicator of China's potential slowdown is the nation's inverted long-term interest rate curve. The chart below shows the latest quotes on domestic interest rate swaps. Inverted yield curves often signal an economic downturn in the near future.

Just to put things in perspective, this is what the US treasury curve looked like about 9 months prior to the start of the Great Recession.

SoberLook.com

From our sponsor:

Chart that seems to violate key principles of money creation

The chart below shows a clear divergence in trends of the total loans and leases on US banks' balance sheets and the broad money supply measure (M2). Loan balance growth is slowing, while the money supply keeps growing at a steady rate of around 7%.

Source: FRB (H.8)

This is enough to give some economists nightmares. That's because they may view this divergence as a violation of principles they hold dear. Many still believe that bank loan balances and M2 money supply have to be tightly linked because the creation of deposits (the money supply) is entirely tied to lending. And this chart shatters that belief.

But in spite of the divergence in the chart above, the "loans create deposits" axiom still stands - deposits are still created through bank credit. What's at play here is shadow banking. Two key developments explain much of this divergence without violating these principles.

1. Loans on banks' balance sheets do not represent the entirety of credit creation. Loans originated by banks increase deposits, but banks often sell some loans into the shadow banking system, such as Fannie and Freddie. A material portion of these mortgages then ends up back on banks' balance sheets in the form of Agency MBS. These securities are exempt from the Volcker Rule, allowing banks to hold substantial amounts. That process reduces total loan balances without reducing deposits, thus contributing to the divergence in the chart above.

2. As discussed before, M2 includes another form of shadow banking - retail money market funds. These funds have seen their AUM rise recently due to increased risk aversion, particularly in fixed income (see last chart in this post). That development has added to M2 growth without increasing loans on banks' balance sheets.

So our friends in the economics profession should be able to sleep well at night. The divergence between the trajectories of M2 money supply and bank loan balances has explanations that do not violate key principles of money creation.

SoberLook.com

From our sponsor:

The Great Rotation has not worked out as planned

As discussed in the previous post, outflows from fixed income funds have been quite severe. However in spite of the various forecasts, the so-called "Great Rotation" out of bonds and into equities (see CNBC story from May) has not materialized. In fact just as investors put money into both bonds and stocks at the beginning of the year, more recently they have been exiting both asset classes concurrently.

Source: Investment Company Institute

The only markets that have been spared the selloff are short-term fixed income instruments (money markets) such as treasury bills. Bill rates remain near the lowest levels of the year as institutional investors who have reduced their fixed income and equity exposure, moved into the short end of the treasury curve (see discussion).

Furthermore, as institutional investors bought treasury bills, retail investors moved into their brokerage money market accounts. Retail money market funds' assets have risen sharply.

Retail money market funds total assets
(source: Investment Company Institute)

It may be a disappointment to some forecasters, but the only "great rotation" taking place recently has been out of both fixed income and equities and into money markets and other cash instruments.

SoberLook.com

From our sponsor: