Watching the 'China taper'

Chicago Tribune: - "Emerging markets should be much more concerned about the 'China taper' than the Fed taper" -  Crossborder Capital Managing Director Mike Howell.

Indeed, while the rate of US taper is modest and reasonably well defined, signs point to slower economic expansion in China. And even in the near-term there is little visibility on that country's growth. The January HSBC services PMI print this morning was quite weak. One of the explanations seems to be that services have slowed due to Beijing forcing government officials to go easy on the extravagant "entertainment" that has become so prevalent in recent years (see post). Once that is dealt with things should improve? Perhaps.

Hongbin Qu/HSBC (published by Markit): - The slower expansion of services activities in January reflected soft manufacturing growth and the impact of Beijing's latest measures to curb official extravagance. As business sentiment remains stable, we expect services growth to bounce back a little in the coming months. Yet a meaningful improvement relies on stronger growth of manufacturing sectors and the implementation of reforms to boost service sectors.

Source: Investing.com

Other measures from China are consistent with slower growth as well.

Reuters: - A similar services PMI released by the China's statistics authority earlier this week showed growth in the sector sagged to a five-year trough in January as business confidence retreated to four-year lows.

Two separate PMIs for China's factories also showed manufacturing growth slipping to six-month lows in January.

Analysts polled by Reuters believe China's economy will grow 7.4 percent this year, far ahead of other major economies but still its worst performance in 24 years.

The trajectory of emerging as well as many developed economies going forward will depend on whether we see an uptick in China's economic activity after the holidays. For now the global equity markets remain skeptical.

Source: Ycharts

• ^DJWO - Dow Jones global equity index
•   IEMG - Core emerging markets
•   FXI - China's large cap shares

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What's behind the latest natural gas rally?

After years of oversupply driven weakness, US natural gas prices are finally rebounding.

March Nat Gas Futures (source: Barchart.com)

What's different this time? Most of the rally is due to the cold winter in eastern/central US (chart below), with significantly higher than average demand for heating.

Source: NOAA

While natural gas production in the US continues to grow (particularly shale - see chart), the recent weather-related demand spike has reduced the amount of gas in storage to levels that are below the range we've seen over the past 5 years.

Spot and the front futures contract prices rose sharply, but the rest of the curve remains below $5/MMBtu. The market views the current spike as temporary - although the whole curve is higher than it has been in quite some time.

At these elevated prices, US production could easily rise, capping further price increases.

CSM: - If prices stay above $5/MMBtu there will certainly be an increase in the number of drilling rigs returning to the gas patch, after many of them migrated westward in search of more lucrative natural gas liquids and oil. The spike is likely temporary though, with April futures prices down to $4.65/MMBtu – still high by the standards of the last half decade, but lower than what we are seeing this winter.

The current elevated price levels are certainly temporary (prices are already beginning to fall as the weather extremes dissipate - hopefully), but we are unlikely to go back to the lows we've seen in 2012 (see post). The US demand for gas is picking up, as more households, businesses, and utilities switch to natural gas. In the long run, increased usage of liquefied natural gas (LNG), including exports, will add to the overall demand.

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Private construction payrolls continue to show resilience

There wasn't anything particularly special about today's ADP private payrolls number. The company estimates that about 175,000 private sector jobs were added in January. The slowdown in manufacturing (see post) resulted in some job losses in that sector - which remains volatile. The one area that continues to show resilience however is construction.

Source: ADP

Over the past 5 months the proportion of jobs from construction has remained unusually stable - from 10 to 15% of total new monthly private payrolls.

Source: FRED

As discussed earlier, construction spending is at such low historical levels relative to the overall economy, that it would take only a small increase to create a significant jump in new construction payrolls. The chart below shows the number of US construction jobs (in thousands) per one billion of GDP (in 2009 dollars).

Source: FRED

Clearly nobody expects this to get to the pre-recession levels any time soon, but there is still a great deal of room for growth. And unlike many new service jobs that suppress wage growth in the US (see post), construction employment could actually improve the situation.

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Did FRFA crowd out EU banks?

Based on the latest report from Fitch, US money market funds' exposure to European banks - dollar denominated commercial paper and repo loans to EU banks - declined by some 10% (in dollar terms) from the previous month (h/t Kostas Kalevras - @kkalev).

Source: Fitch

Fitch had a possible (and somewhat surprising) explanation. Could the Fed's reverse repo program called FRFA that is currently being tested (see post) be crowding out European commercial paper?

Fitch: - The December decline in MMF allocations to European banks was largely offset by repo exposure to the Federal Reserve Bank of New York (FRBNY). The FRBNY has been periodically conducting overnight reverse repurchase agreement (RRP) exercises with market participants, including MMFs, to test how these operations might function as a policy tool for managing short-term interest rates. This technical exercise, in which FRBNY serves as the fund’s repo counterparty, accounted for 3.7% of all MMF assets within Fitch’s sample at end-December. By comparison, the MMF’s allocation to European banks declined by 3.8% (i.e. expressed as a percentage of MMF assets) in the course of December. It is unclear whether the FRBNY exercise might have crowded out some of the MMF allocations to European banks or whether the European reduction reflects a new equilibrium taking hold.

Another explanation is window dressing for year-end. Many investors review their money markets allocations once a year, often paying attention just to the year-end report. Showing a lower EU bank allocation number on that report could provide a marketing benefit.

Nevertheless this is something banks, both in the US and abroad, will need to consider going forward. As the FRFA's scope increases, banks' commercial paper and repo rates will need to rise in order to compete with the Fed for money market funds' dollars. That of course is the purpose of the program - using the broad money market investor base to manage short-term interest rates.

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ECB's next steps could involve suspending SMP sterilization - instant QE

Today Credit Suisse confirmed our earlier assessment that the ECB will be shifting toward a looser monetary stance in the near future (see post).

CS: - There are increased risks that the ECB acts earlier and (possibly) more aggressively than we expected. ... our economists lowered their inflation forecasts, with March now projected at 0.4% yoy (vs. 0.7%) and the 2014 average lowered to 0.7% from 1.0%. It seems hard to believe the ECB will remain idle against the backdrop of a sharply lower inflation path. They now expect the following:

• The depo rate to go to -0.1% accompanied by a token key policy rate cut in March or April.
• The threshold for balance sheet expansion has fallen. As shown [here] the ECB balance sheet has been contracting with accelerated LTRO repayments and is in stark contrast to the Fed and BoJ. Removing the SMP sterilization (liquidity injection of €175.5bn) would be an effective way of providing stimulus and buys the ECB time to work out logistics of other measures. We would also see suspension of the SMP sterilization as a powerful signal that the ECB could engage in outright asset purchases if inflation continues to fall.

What does CS mean by "suspension of the SMP sterilization"? Between 2010 and 2012 the ECB purchased over €200bn of EMU member states' government securities in order to help contain rising interest rates in the periphery nations (this included some Greek bonds that ultimately defaulted.) The program was called the Securities Markets Programme (SMP). Some bonds have since matured, leaving €175.5bn on the central bank's balance sheet.

Source: Wikimedia

But unlike the outright securities purchases that the Fed, the BOJ, and the BOE have been undertaking, the ECB had "sterilized" its purchases by taking in the equivalent amount in term deposits. In effect the ECB funded SMP purchases with deposits it took in rather than with excess reserves as did the other central banks (discussed here). Many economists have argued that sterilized purchases run a lower risk of inflation than outright quantitative easing.

Source: ECB (unit = €million)

What CS is suggesting is that the ECB can easily turn these sterilized securities holdings into outright QE by letting the term deposits mature, returning the funds, and not accepting any more deposits (stopping the Fixed Term Deposit auction process). That would automatically increase bank reserves by €175.5bn, resulting in a quick and a relatively large monetary easing action. While in the past the Bundesbank would vigorously object to such a move, given the disinflationary pressures in the Eurozone, CS believes it would not be an issue this time around.

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Market correlations shift back to risk-on/off pattern

The chart below compares the performance of long-term treasuries (TLO) to emerging market bonds (EMB) over the past year.

Source: Ycharts

The relationship between US rates and emerging market assets (particularly bonds and currencies) has shifted. Last year both were responding the big unknown of the Fed's tapering of QE3 - and moving roughly in the same direction. Now that taper is a reality and we have some certainty around the magnitude of the reductions in the near-term, the correlation has reversed. The current environment is once again based on risk-on/risk-off dynamics as was the case during the Eurozone crisis. Risk-on pushes prices of treasuries higher and emerging market assets lower. This trend that was quite visible yesterday, with a partial reversal taking place today (chart below compares Brazil vs. US rates in recent weeks).

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An overreaction to the ISM manufacturing report?

Today's ISM manufacturing PMI number spooked jittery US equity investors, sending stocks sharply lower (with VIX climbing above 20). The headline number came in about 9% below expectations.

Source: Investing.com

In particular, the markets reacted negatively to the "new orders" component of the ISM index. It registered the largest one-month decline in some 33 years.

Source: Institute for Supply Management

Has the US manufacturing sector experienced a significant decline in January? As discussed before (see post), the ISM measure tends to be volatile and often diverges from other manufacturing indicators. Alan Tonelson (MarketWatch) had a nice write-up on the topic this morning. The ISM index overshot on the way up and is potentially overshooting on the way down.

MarketWatch: - The ISM seems to do a good job capturing huge swings in manufacturing output and employment reported by the Fed and the BLS. But any finer changes too often contrast strikingly with the government numbers — which are both based on much bigger, more varied sets of evidence than the ISM’s survey of 400 member companies. These discrepancies, plus the anomalies in the institute’s own figures, strongly suggest that anyone serious about following American manufacturing’s fortunes needs to look far beyond the ISM.

The best place to look beyond the ISM report, particularly where we get timely data, is the Markit Manufacturing PMI. And indeed there has been a downward move in manufacturing growth, but nothing as extreme as what we heard from the Institute for Supply Management.

Chris Williamson, Chief Economist at Markit: - Survey respondents reported the weakest growth of output and new orders for three months in January, but with many companies blaming exceptionally cold weather for production and supply chain disruptions, the underlying trend looks to have remained robust.

The ongoing expansion suggests that the goods producing sector is on course to contribute to another quarter of solid economic growth in the first quarter, and is also helping sustain a decent rate of job creation. The survey is broadly consistent with ... 10,000 jobs being created per month in the manufacturing sector which, added to the signal from the flash services PMI, points to non-farm payroll growth in the region of 200,000 in January.

It seems that some of the manufacturing softness is the result of the knock-on effects from the frigid weather we've seen earlier. If so, we should see a rebound in February. Whatever the case, the market reaction to the ISM numbers may be a bit premature.

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Latest developments in Venezuela - a crisis in the making

As a followup to our recent discussion on Venezuela, here are the latest developments:

1. The government has since created two exchange rates in order to stem rampant dollar outflows - essentially devaluing the currency - see story. Only essential goods are permitted to be imported using the original rate. The weaker exchange rate (more expensive dollars - nearly 2x the original rate) is used for everyone else. Black market dollars trade at some 10x the original rate.

2. Oil exports have fallen to the lowest level since 1985. A great deal of the oil the country does export is shipped to China to cover the billions of dollars worth of loans - see story.

3. Government bonds have sold off sharply in January, with long-term rates now above 15%.

15y gov bond yield (source: Investing.com)

4. According to the central bank, core inflation is running at close to 60%, although given the shortages it's difficult to measure.

4. Shortages of basic goods persist - see story (quite sad).

5. Dollar debt to the private sector is now over 60% of FX reserves  - see story (in Spanish).

6. Foreign reserves are dwindling.

The Economist: - Venezuela is running out of dollars to pay its bills. Although payments to its financial creditors of around $5 billion this year do not appear to be at risk, the country’s arrears on non-financial debt are put at over ten times that sum. These include more than $3 billion owed to foreign airlines for tickets sold in bolívares, and around $9 billion in private-sector imports that have not been paid for because of the dollar shortage. “Under the current economic model, and with this economic policy,” says Asdrúbal Oliveros of Ecoanalítica, “this [debt] looks unpayable.”

7. The country's sovereign CDS volume has picked up as traders smell profits, and the spread hit a new high. This is what a crisis in the making looks like.

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