With the world watching, Bernanke gives a go-ahead to the currency war

In the past few weeks global markets have focused on the weakening yen, as politicians and business leaders, particularly in Europe have called for a halt in Japan's "weak currency" policy. Tokyo's efforts to stimulate it's export sector have become front and center topic in the financial media, as global businesses become increasingly concerned about the currency war. In fact the number of FT articles containing the word "yen" hit a record recently.

Number of FT articles containing “yen” (source: Merrill Lynch)

Similarly, Google search frequency for "JPY" rose recently as well.

Google Trends for "JPY"

Public's attention has therefore turned to the G20 meeting this week, where some have hoped Japan would be asked to moderate its policy. The Eurozone is particularly concerned that the relative strength of the euro will delay its exit from the economic malaise. Germany for example is in direct competition with Japan in auto sales, and a relatively small change in the EUR/JPY levels could result in major differences in sales and profit margins.

But with the world watching and the Germans hoping for action against Japan, the US quickly stepped in to support Japan's policy. After all the US has been following a similar policy itself. This NY Times article described the situation quite well:

NY Times: - Ben S. Bernanke, the Federal Reserve chairman, strongly indicated on Friday that the United States did not intend to censure Japan for weakening its currency over the last several months, something that has aided Japanese exporters and angered its competitors.

Mr. Bernanke spoke in brief introductory remarks at a conference in Moscow of the Group of 20, a club of the world’s largest industrial and emerging economies.

At issue are stimulus programs backed by Prime Minister Shinzo Abe, who is also maintaining pressure on the Bank of Japan to keep interest rates near zero and flood the economy with money to support Japanese manufacturers. As a result, the yen has lost about 15 percent of its value against the dollar over the last three months, meaning products made in Japan, like some Sony electronics or models of Toyota cars, are relatively cheaper.

Japan’s maneuver touched off fears that other countries and the European Union might follow suit in a so-called currency war, which has been the main topic of the Group of 20 meeting here, which runs through Saturday.

Initially, it seemed the world’s largest economies might agree on a firm statement at the end of the meeting to condemn a currency war, or competitive devaluations. This tactic is now widely seen as a beggar-thy-neighbor approach to creating growth that would ultimately harm a global recovery and is understood to be a cause of the lingering nature of the depression in the 1930s.

This is likely to drive a further wedge between the Fed's and the ECB's policy, while angering many politicians in Europe. Through his statements at the G20 meeting, Bernanke in effect just gave his nod to the continuation of the currency war.

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Source: Bahl & Gaynor

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Some BDCs are experiencing spectacular rallies, but at some point the music will stop

When discussing the world of so-called "shadow banking" (see post), one should not forget the entities called Business Development Companies (BDCs). These are hybrids between investment and operating companies that can obtain up to 1:1 leverage on investors' capital in order to lend to (and sometimes invest in) mid-sized businesses in the US. The interest on the loans is used to pay periodic (for example quarterly) dividend. With demand for yield continuing to drive valuations, some public BDCs have done tremendously well. NYSE-listed Triangle Capital (TCAP) for example is up over 63% on a total return basis (capital appreciation plus dividends) over the past year (vs. under 16% for the S&P500). A number of other BDCs have also had a spectacular performance recently.

Source: Ycharts

But as the middle market loan spreads decline, BDCs' portfolio quality will decline as well. That's because in order to be able to pay the same dividend, these companies have to increase the risk profile of their portfolios. They are finding it harder these days to underwrite quality companies' debt at reasonable rates in this very competitive market - the pipeline of good deals is shrinking. Investors however just can't seem to get enough of these shares, as the Fed continues to pump liquidity into the market. At least in some instances, valuations already seem frothy - which may not end well, particularly when the flood of central bank stimulus stops (and possibly long before then).


BDC Basics from Southerland

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Jobless claims numbers should be interpreted with caution

The strong jobless claims data released today certainly represents a positive trend for the US economy. Combined with the US housing market recovery (see story from CNBC), the data may be pointing to material improvements in the labor markets in the near future.

Bloomberg: - Claims for jobless benefits plunged last week, showing U.S. employers have little need to trim staff as demand improves. Applications for unemployment insurance payments decreased by 27,000 to 341,000 in the week ended Feb. 9, fewer than any of the 49 economists surveyed by Bloomberg projected, according to Labor Department data issued today in Washington.

One should be careful however when extrapolating the path of US economic growth based on these numbers. First of all there is a great deal of noise associated with this data, especially on the seasonal adjustments.

Reuters: - But some economists said a blizzard that slammed the East Coast late last week and difficulties smoothing out the data for seasonal fluctuations could have artificially depressed claims.

While they were encouraged by the decline, they urged caution against reading too much into the data.

"Claims may not be giving a reliable signal about the labor market," said Daniel Silver, an economist at JPMorgan in New York.

It is particularly troubling to see some analysts draw a straight line through the seasonally adjusted initial jobless claims to determine how quickly the US labor markets may reach pre-recession levels. Stepping away from the seasonal adjustments, improvements in the claims number have been anything but linear. In fact a simple non-liner fit (from 2/7/09 to 2/9/13) shows a steady drop in the rate of declines.

There are other factors making this trend less reliable as a measure of the labor market strength, such as a large pool of workers who no longer qualify for these benefits. We are clearly moving in the right direction here, but it's important to interpret the results with some degree of caution.

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Looking for the next financial bubble? Just follow the quants.

The latest in the LIBOR scandal once again shined some light on RBS, the UK taxpayer-owned bank. The firm's culture that ultimately forced the UK government to execute one of the most expensive financial rescues in history was even worse than many imagined.

WSJ: - RBS's former head of investment banking, Johnny Cameron, who left the bank in early 2009, said traders at banks involved in the attempted rate manipulation had more in common with each other than other bank workers, and that their behavior seemingly had little to do with the firms they worked for.

It is "as much about the culture of traders and people who trade things than any bank," Mr. Cameron said in his testimony to the committee.

He said RBS's risk managers failed to recognize the potential for traders to influence submissions used to help set interest-rate benchmarks, and that the failure highlighted why traders need "tight and close management."

"I do think that traders have a particular approach to life and need much tighter controls. By and large, those controls are imposed. What happened in this case was that the risk managers didn't recognize this as a risk, and those controls were not there," Mr. Cameron said.

But RBS had a hefty risk management department back then, with some of the most sophisticated financial risk modelling in the industry and numerous risk analysts running around the firm "measuring" risk. The head of the market risk group (as well as quantitative analysis) at the time was Riccardo Rebonato (see bio on Wikipedia). So how is it that the exposures (particularly in mortgage portfolios at the subsidiary called Greenwich Capital) as well as trading practices at the firm were allowed to spin out of control under the watchful eye of Dr. Rebonato? It so happens that Dr. Rebonato did not seem to be too concerned with how to keep the bank from collapsing and instead was focused on writing his new (at the time) book called Plight of the Fortune Tellers. In fact the book was published while Dr. Rebonato was still at RBS (in 2009).

So "who cares?", one may ask. If Dr. Rebonato has done such a stellar job at RBS during the housing bubble, one should be asking "where is he now?"  It turns out that he has a new role, this time at PIMCO. And it is likely that he is working on his new book - to be released after the next financial correction. This and similar hires at the large fixed income asset managers (such as Blackrock, who is actively hiring quants in the risk management area) may be pointing to the next financial bubble (see discussion).

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h/t Armand

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The market is shrugging off sequestration - for now

As the so-called sequestration approaches, jitters among defense contractors are becoming quite visible. 50% of the cuts are expected to hit the Pentagon budget. States like Virginia, where the defense industry is a major portion of private employment as well as a key source of tax revenue, are also becoming uneasy.

Source: ABC News

The markets however seem to be shrugging off the impact of sequestration.  Over the past few months (including the post-election period) a basket of major defense stocks has performed in line with the S&P500. And in spite of sequestration's overall negative impact on the GDP, the broad market is near multi-year highs.

Source: Ycharts

Market expectations seem to indicate that these cuts will be avoided - possibly at the last minute. For now however it looks as if sequestration may potentially go into effect.

Bloomberg: - Democrats and Republicans in the U.S. Congress are nowhere near a plan to avert $1.2 trillion in spending cuts about two weeks before they are set to begin.

It’s the latest in a series of fiscal deadlines created by Congress that in the past two years took the U.S. to the brink of a debt default, a government shutdown and middle-class tax increases that neither party wanted. Unless lawmakers act, the across-the-board spending reductions will begin March 1.

Leaving the cuts in place would shave U.S. economic growth this year by 0.6 percent and cost 750,000 jobs by the fourth quarter, Congressional Budget Office Director Doug Elmendorf said yesterday at a hearing.

About half the cuts would affect defense spending, and military leaders are pressuring lawmakers to avoid them. Allowing the reductions, known as sequestration, to take effect would mean less training for Army personnel and fewer purchases of Navy vessels and Air Force fighter jets, the leaders said.

“It’s pretty clear to me that the sequester’s going to go into effect,” Senate Minority Leader Mitch McConnell, a Kentucky Republican, said yesterday.

And it seems that a number of politicians actually want to see sequestration activated.

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What drove the 30yr mortgage rate higher?

After this post in early December discussing the possibility that MBS, particularly the 30yr FNMA had become a "crowded trade", we've received numerous e-mails arguing that based on the Fed's recent actions, agency MBS has more upside. Furthermore, the US consumer got so used to mortgage rates constantly moving lower, the reversal (discussed in that post) of that trend seemed unfathomable to many. But that is in fact what happened as the 30yr mortgage rate stopped declining.

Source: Bankrate.com

This reversal in mortgage rates was in fact driven by the sell-off in long-dated agency MBS, which many argued would not happen this quickly - yet here we are.

Source: Mortgage News Daily

There are a number of reasons for the sell-off and the recent (mild) rise in the 30y conventional mortgage rates:

1. Dealers have built up a massive inventory of this paper, making it a bit more vulnerable to a correction.

2. Treasuries have sold off materially since early December (about 35bp yield increase on the 10y note), dragging MBS with them.

3. Some institutional investors are preparing for the Fed's eventual exit by unwinding their MBS holdings.

Reuters: - The PIMCO Total Return Fund, the world's largest bond fund run by Bill Gross, decreased its mortgage holdings to its lowest level since mid-2011, ahead of the prospect of higher interest rates and emerging inflationary pressures.

4. The Fed's purchases have been increasingly focused away from the 30yr FNMA, which they probably view as overpriced, and more on the GNMA and the shorter maturity FNMA (such as 15yr) bonds.

Source: JPMorgan ("Conv." stands for "conventional")

That's one of the reasons the 15yr mortgage rate has not moved up as much as the conventional 30yr.

Going forward, the direction of agency MBS paper is less clear, particularly given the tremendous dependence on the Fed who will be growing its balance sheet to unprecedented levels. The upcoming US sequestration cuts could in fact push treasuries higher (by slowing economic growth), with MBS following. On the other hand institutions will certainly become more cautious on their MBS holdings, given the increased rate risk.

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With currency controls in place, black market for dollars develops in Egypt

The Egyptian pound continues to weaken, as the central bank attempts to stem the run on the currency by imposing among other measures a tight trading range. Anecdotal evidence suggests that a number of wealthy individuals and businesses are quietly converting savings into hard currency and to the extent possible depositing funds abroad. Some are buying gold as inflation accelerates (see BW story).

Source: Investing.com

Any time currency controls are imposed, a black market usually develops. And Egypt is no exception.

Fox Business: - A run on Egypt's pound has left foreign currency in short supply and driven some dealers into the streets in search of people with U.S. dollars to sell, spawning a new black market.
...
"There are no dollars. Everyone that walks in asks for dollars but supply is scarce," said one of the dealers.

The central bank took steps last week to manage the rate including narrowing the pound's trading band. It was last bid at 6.71 [actually it's 6.73 now] to the dollar on Sunday in interbank trade.
...
The pound's decline has been reflected in a drop in Egypt's foreign reserves, which fell to $13.6 billion at the end of January - below the $15 billion level needed to cover three months' imports. The reserves stood at $36 billion on the eve of the uprising against Mubarak.

Complicating a business climate already weighed down by political unrest, some importers say they are having to source their foreign exchange needs from what they call the parallel or open market.

One senior executive at an Egyptian company that imports goods from abroad said companies were able to source their dollar needs from the black market, but forecast that supply would tighten further in the coming weeks.

Egypt desperately needs the IMF loan that was arranged last year but is yet to be disbursed. However the IMF wants to make sure that political stability is reached and the government implements the measures it had promised, such as certain tax increases. In the mean time - in a classic "chicken-or-the-egg" situation - foreign reserves continue to dwindle.

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