As real estate investing fades, the Chinese jump into stocks

In China, real estate investing has been a bit out of style lately (see chart). What is the latest hot investment? Stocks of course, as the Shanghai Composite makes new multi-year highs. In fact the index is up some 58% over the past 6 months - after being stagnant for years (see post from 2012).

Some of this is of course driven by the Shanghai's linkup with Hong Kong (see story). But there is also a significant increase in domestic demand. China’s brokers have been quite busy, as (according to Reuters) “new A-share account openings topped 500K every week in December”

Source: @vikramreuters

_________________________________________________________________________

SoberLook.com

Sign up for our daily newsletter called the Daily Shot. It's a quick graphical summary of topics covered here and on Twitter (see overview). Emails are distributed via Freelists.org and are NEVER sold or otherwise shared with anyone.

2015 will test the ECB's resolve and independence

In the Eurozone, manufacturing PMI reports last week were for the most part disappointing, as Italian manufacturing contraction unexpectedly accelerated (PMI < 50), while the French manufacturing sector has been in contraction mode for months now. With these poor manufacturing reports in the euro area, falling global commodity prices (see post), falling inflation expectations (see chart), and political uncertainty in Greece, German yields fell to new lows. On the first trading day of 2015, the 5-year Bund yield went negative for the first time.

And the 10-year yield fell below 50bp – also for the first time.

In fact, here is how the German yield curve now compares to that of Japan. The markets now expects the ECB's policy to shift closer to what has been implemented by the Bank of Japan.

Italian and Spanish bonds also welcomed the new year with a rally, as yields hit new lows.

Source: Investing.com

While these falling rates have become a daily occurrence, these market levels are unprecedented. That's why as 2015 opened, the euro fell to the lowest level since 2010.

The ECB is now under pressure to act - without a decisive bond-buying program over the next few months the euro area markets could face a sharp increase in volatility. That's something the area's nations can ill afford. The programs announced by the central bank thus far have been inadequate and a much more aggressive effort will be required to ease monetary conditions in the Eurozone.

Eurosystem (ECB) balance sheet (source: ECB)

However, a number of prominent politicians, particularly in Germany, will be increasingly critical of such efforts by the central bank - especially as risks around Greece keep resurfacing.

Reuters: - A senior member of Angela Merkel's party warned the European Central Bank not to pour money into Greece and other struggling euro zone states through bond purchases, saying this would reduce pressure on them to enact much-needed reforms.

Michael Fuchs, deputy parliamentary floor leader of the German chancellor's Christian Democrats (CDU), told Deutschlandfunk radio on Friday: "We shouldn't pump extra money into these states, but rather make sure they continue along the reform path.

"I'd be grateful if (ECB President Mario) Mr Draghi would make statements along these lines."

2015 is the year this conflict will come to a head as the ECB's reach, resolve and independence will be tested.

_________________________________________________________________________

SoberLook.com

Sign up for our daily newsletter called the Daily Shot. It's a quick graphical summary of topics covered here and on Twitter (see overview). Emails are distributed via Freelists.org and are NEVER sold or otherwise shared with anyone.

The 2015 theme unfolds on the first trading day

2015 started with a fresh US dollar rally, as the DXY dollar index jumped nearly a percent on Friday. The dollar strength and its consequences will be a key theme for the economy and markets this year.

Source: barchart

One of the consequences of course is continuing pressure on commodities markets, as Brent crude futures tumbled below $57/bbl.

Source: barchart

In fact the whole commodity complex took another led gown, as aluminum and copper came under pressure. Here are a couple of broad commodity indices worth following: the CRB BLS Spot Index and the Continuous Commodity Index - both at multi-year lows.

Source: barchart

With commodity prices under pressure again and import prices expected to fall due to stronger dollar, the U.S. 5x5 forward inflation expectation rate (5-year inflation expectation starting 5 years out) hit a 3-year low.

It's difficult to imagine how the Fed could consider raising rates (expected in Q3) in this environment - even if labor markets continue to improve. Consider the fact that monetary conditions have tightened sharply over the past couple of months even without the Fed doing anything, as real rates rose.

While setting the overnight rate at 50bp will by itself  have a minimal effect on the economy, the expectations of higher rate differentials with other developed economies will send the dollar even higher, further weakening inflation expectations and materially tightening monetary conditions.

_________________________________________________________________________

SoberLook.com

Sign up for our daily newsletter called the Daily Shot. It's a quick graphical summary of topics covered here and on Twitter (see overview). Emails are distributed via Freelists.org and are NEVER sold or otherwise shared with anyone.

If energy prices remain near current levels, Canada's economy is in trouble

And so it begins… Collapsing crude prices are starting to make their way through the North American energy sector, as the most unprofitable oil & gas rigs are mothballed. Those flashing red numbers are not just on your screen any more.

Source: Baker Hughes

The closures have been particularly acute in Canada, where some 40 oil & gas rigs have been taken out of operation recently. In fact it's not clear if economists fully appreciate what's about to transpire with the Canadian economy. This decline in rig count is just the beginning.

Consider for example the situation with the Canadian oil sands - one of the more expensive sources of crude production. Even if prices recover somewhat, oil sands production will be winding down - nobody wants to operate money-losing businesses for a prolonged period. And those who believe crude will be back above $80/bl any time soon is deluding themselves.

Source: FT

Up until now, production from oil sands has fueled growth in other sectors, including for example transportation and housing in Alberta. This is about come to a screeching halt.

Alberta housing situation (source: Alberta Treasury Board and Finance)

The national situation is not significantly better. Housing markets across the country have continued to rally, even as homes south of the border had undergone an unprecedented price adjustment. While many point out that the reason for avoiding a US-style housing crash has been a stronger mortgage market, that's only part of it. The global commodity boom in which Canada successfully participated is the main reason.

Source: Multiple Listing Service

Now as the commodity super-cycle has ended and energy prices collapsed, Canadian households are caught with near-record levels of leverage.

Source: National Post

Some have been pointing out that Canadian mortgage debt service ratio has continued to improve. However that measure is misleading, as it excludes principal payments. In reality the situation is much worse (see chart, h/t @ac_eco).

There is also the argument that Canada's economy is "diversified". Perhaps. But just to put the situation in perspective, take a look at the breakdown of the nation's trade balances.

Source: @Earthed ,  Maclean's

While economists will attempt to analyze the impact of energy prices on various sectors separately, when it comes to Canada, a number of economic components are quite difficult to decouple from one another. What's clear is that this exposure to energy is going to damage the labor markets, squeezing the nation's overextended households. And the knock-on effect won't be limited to a severe slowdown in residential construction growth. Consider for example the expenditures on renovations - something that's been supporting parts of manufacturing and other sectors. This is not going to end well.

Source: Scotiabank

The markets are already sensing the contagion effect from energy on the housing market, as Canadian property REITs take a hit. If oil prices remain anywhere near the current levels for a prolonged period - something the Saudis are aiming for (see post) - Canada's economy is in serious trouble.

_________________________________________________________________________

SoberLook.com

Sign up for our daily newsletter called the Daily Shot. It's a quick graphical summary of topics covered here and on Twitter (see overview). Emails are distributed via Freelists.org and are NEVER sold or otherwise shared with anyone.

The Fed launches Term Reverse Repo Program "experiment", moves short-term rates

The Federal Reserve has been aggressively testing the various monetary tools that will give it additional flexibility during the rate normalization process. In addition to the Term Deposit Facility (see post), the Fed recently started testing the term reverse repo facility (Term RRP - see statement). Note that this is in addition to the Overnight RRP. For those who want to track this program, follow the updates here (see the spike at the end?) The Fed will provide a total of $300bn under the program, with the first such offering completed on Dec-8th. It was a 28-day "secured deposit" paying 10bp (annualized) for $50bn.

Source: NY Fed

At the same time the US Treasury has issued a larger than usual amount of treasury bills recently. Since the Term RRP with the Fed is effectively the same as purchasing a treasury bill (particularly at 10bp), the Fed's $300bn program (combined with the existing facilities) effectively "crowded out" the bills market. This ended up pushing short-term treasury yields higher - while yields on longer-dated treasuries kept falling (see chart).

The Fed's latest monetary tools "experimentation" has also drained some reserves and lowered the monetary base.

For those who still track the Fed’s total balance sheet, don’t – the balance sheet doesn't tell you much about the monetary stance when you have these new forms of “sterilization”. Of course all this is viewed as temporary and the reserves may yet return to their peak levels next year. And judging from current disinflationary pressures (see chart), the actual liftoff - when these tools are going to be implemented on a more permanent basis - may be as long as a year away. For now however these monetary experiments have been sufficiently large to raise short-term interest rates.


_________________________________________________________________________

SoberLook.com

Sign up for our daily newsletter called the Daily Shot. It's a quick graphical summary of topics covered here and on Twitter (see overview). Emails are distributed via Freelists.org and are NEVER sold or otherwise shared with anyone.

Draghi now has all the ammunition he needs for QE. Implementation still a problem.

If Mario Draghi was lacking ammunition to initiate an outright quantitative easing program in the Eurozone, he certainly has it now. Even the staunchest opponents will have a tough time arguing against the need for a more aggressive approach to monetary easing. Here are five reasons:

1. The take-up on ECB's TLTRO offering (see post) fell far short of the ECB’s goals. Indeed the demand in the second round of the offering came in at €130 bn, putting the total take-up at €212bn - well below the €400 billion allowance. Since the TLTRO financing is linked to bank lending, the program to some extent relies on demand for credit from businesses and consumers. And that demand has been lackluster in the past couple of years. Therefore the initiatives announced by the ECB last summer, including ABS and covered bond purchases, are simply insufficient for the type of monetary expansion (of about €1 trillion) the central bank would like to see in the Eurozone.

Eurosystem consolidated balance sheet (source: ECB)

2. Some Economic data out of the Eurozone shows recovery stalling. Italian industrial production and French labor markets are just two examples.

Source: Investing.com

Source: Investing.com

3. With the collapse of oil prices, the Eurozone is bracing for deflation. German 5-year breakeven inflation expectations are now at zero. And Europe's central bankers are fearful of repeating Japan's decade-long struggle with deflation.

Source: @PlanMaestro

4. While the euro has declined significantly against the dollar, it remains quite strong on a trade-weighted basis. This is putting downward pressure on prices (via cheaper imports) and is disadvantaging some of the Eurozone-based exporters. A more aggressive easing effort would force the euro lower.

TWI = "trade-weighted index" (source: @TenYearNote)

5. Finally, the euro area's sovereign risks are resurfacing once again - triggered by new political uncertainty in Greece.

The Guardian: - Mounting concerns over Greece’s ability to weather a presidential election, brought forward in a surprise move by the prime minister, Antonis Samaras, continued to unnerve investors ahead of the first round of the vote in the Greek parliament next week.

Under Greek law failure to elect a new head of state by the ballot’s third round on 29 December could trigger a general election. The stridently anti-bailout main opposition party, Syriza, is tipped to win that poll. The radical leftists have made a debt writedown and the end of austerity their overriding priorities if voted into office.

Although Samaras called the election in a bid to expunge the political uncertainty engulfing Greece, the slim majority held by his government, compounded by the leader’s repeated warnings of Greece leaving the eurozone if Syriza assumes power, has accelerated investor nervousness.

The nation's stock market is down 20% over the past 5 days as investors flee.

red = Euro STOXX 50, blue = Athens Composite

And Greek sovereign debt sold off sharply. In fact the 3-year government paper yield went from roughly 3.5% in September to 11% now. This situation alone would make most central bankers consider some form of monetary easing.

Mario Draghi now has five solid reasons to argue for QE and many expect the central bank to announce such an initiative in the next 2-3 months. However, while most economists covering the euro area agree on the need to take a more aggressive monetary action, the problem of implementation remains. Since the Eurosystem's (ECB's) balance sheet is in effect owned by member states, many in the core economies are worried about having to become the proud owners of large quantities of their pro rata share of periphery nations' debt. For the Germans in particular, the ownership of such debt is a major issue. A solution that is even remotely politically palatable across the Eurozone remains elusive. The ECB's independence and the euro area's legal structure is about to be tested once again.

_________________________________________________________________________

SoberLook.com

Sign up for our daily newsletter called the Daily Shot. It's a quick graphical summary of topics covered here and on Twitter (see overview). Emails are distributed via Freelists.org and are NEVER sold or otherwise shared with anyone.

The Fed's policy trajectory is tied to global recovery

The latest US payrolls report presents a challenge for the Fed. As discussed back in April (see post), US labor markets are continuing to heal, suggesting that the rate "normalization" should be a serious consideration for the central bank. However the recent deterioration in commodities, especially energy, is "importing" global disinflation to the US (see post). In particular, the Saudi commitment to retake lost market share has sent shock waves through the oil markets (see post).

GCC is a diversified commodity index (source: barchart)

As a result, longer-term market-implied inflation expectations have fallen substantially.

The latest declines in expectations came after the recent FOMC minutes already showed increasing concerns at the central bank:

FOMC: - “Many participants observed the committee should remain attentive to evidence of a possible downward shift in longer-term inflation expectations.”

At the same time payrolls in the US are growing at a rate approaching the pre-recession peak (though still materially below what we saw in the 90s).

In fact the divergence between payrolls growth and inflation expectations is currently unusually high. Payrolls are driven by stronger US domestic economy, while inflation expectations are impacted by external factors, which creates this disconnect.

Red dot represents the current situation

This mismatch is causing a dissonance for policymakers and market participants, adding to the disagreement on the timing of liftoff. Current market expectations for the first hike now point to Q3 of 2015.

Source: CME

However if inflation expectations persist at these levels or worsen, it will be nearly impossible for the Fed to move on rates - irrespective of how much labor markets improve. The bet represented in the chart above is that energy prices will stabilize and/or growth in wages improves substantially by next summer - pushing breakeven expectations higher. But such an outcome, driven to some extent by factors external to the US, is far from certain.

What makes the timing of liftoff particularly difficult to estimate is the value of the US dollar.

Source: barchart

With a number of major central banks either easing or expected to begin easing monetary policy (diverging from the Fed), the rise in the relative value of the dollar will continue. That will bring inflation expectations even lower by weakening US import prices and pressuring commodities. If the strong dollar can make goods and to some extent services from abroad cheaper, there is less incentive for US-based firms to raise wages. Tapping cheaper markets abroad becomes more profitable.

And as the expectations of liftoff draw closer, the dollar will strengthen further, making it more difficult for the Fed to pull the trigger (what some refer to as a "self-correcting" mechanism). It's hard to envision the Fed acting unilaterally in the sea of looser monetary policy worldwide. The policy trajectory of the US central bank is therefore tied to a large extent to the global recovery, which remains elusive for now.

The Fed officials are keenly aware of premature policy tightening by a number of central banks, who were forced to reverse their decisions later.

Source: @themoneygame (Business Insider), Deutsche Bank

What some of these central banks didn't count on was the global nature of disinflation, over which they had little or no control (see chart). In the Fed's case, such a reversal would severely undermine the FOMC's credibility, sending policymakers back to the drawing board.
_________________________________________________________________________

SoberLook.com

Sign up for our daily newsletter called the Daily Shot. It's a quick graphical summary of topics covered here and on Twitter (see overview). Emails are distributed via Freelists.org and are NEVER sold or otherwise shared with anyone.

Think homebuilder optimism is irrational? Think again.

The chart below (and similar comparisons) has been circulated widely in the media and the blogosphere. It shows homebuilder optimism (as measured by the NAHB) far outpacing sales of singly-family homes in the United States. Naive reporters and bloggers have been arguing that builders are simply out of touch with reality. How could homebuilders possibly be almost as optimistic as they were prior to the housing recession if new single-family home sales are near multi-decade lows?

Source: @cigolo, Reuters

There are a couple of key reasons for the NAHB index decoupling from new single-family home sales:

1. Builders are targeting higher-end and luxury homes - a market where mortgage availability is less of an issue. That it why the median price of new homes sold is far above the pre-recession peak and continues to rise.

Source: @NickTimiraos

2. US homebuilders are also focused on multi-family structures - rental as well as some high-end condos.

Source: @NickTimiraos

Tighter credit conditions and some consolidation have resulted in reduced competition among homebuilders, with a number of local and regional players closing down after the recession. At the same time rental housing demand is on the rise (see post). Those well positioned in this space will do fine. Therefore, while it is quite popular to poke fun at the "giddy" homebuilders, one should rest assured these businesses are acting quite rationally. And so are their investors. Homebuilder shares have outperformed the broader market since the October correction (see chart).

_________________________________________________________________________

SoberLook.com

Sign up for our daily newsletter called the Daily Shot. It's a quick graphical summary of topics covered here and on Twitter (see overview). Emails are distributed via Freelists.org and are NEVER sold or otherwise shared with anyone.