US loan growth rate the highest since the recession

US credit growth continues to accelerate, reaching the highest year-over-year pace since the Great Recession.

In 2012 the growth was primarily driven by corporate debt (chart below) as banks remained cautious on real estate and consumer lending. While corporate loan growth remains strong - at around 11% per year - other sectors are now experiencing faster credit expansion.

In a complete contrast to the situation in the Eurozone, both real estate (particularly commercial) and consumer credit growth rates have improved materially this year. Consumer credit is no longer just driven by autos, with credit card debt picking up as well.

The only major headwinds for this trend currently are some of the geopolitical risks (Iraq, Russia, etc.). Consumers, companies, and banks are still fairly jittery and it won't take much to dampen the supply of and/or the demand for credit.

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Two indicators explain some of the recent volatility

For those looking back at the last couple weeks and scratching their heads about all the volatility in US equity markets, here is a thought. Yes, we've had some new geopolitical risks such as the Russia sanctions as well as some fresh economic data from the US. But if you step back and look at the situation, very little has actually changed as far as market and economic fundamentals since the end of last month. So why such (relatively) sharp market moves? Here are a couple of indicators that may shed some light on this volatility.

Leverage in the equity markets has reached new highs recently as shown by margin debt levels. Even as a fraction of the overall market cap, margin buying has been quite significant. While such activity doesn't necessarily lead to a significant correction (as some have been suggesting), it's a sure way to get some real volatility going.

Another indicator that has been pointing to an environment that is ripe for some good market swings is the IMX index. It is basically a measure of how aggressively accounts are positioned across the TD Ameritrade platform. Unlike the bull/bear surveys, this index actually tells us what retail accounts are doing rather than how they feel about the market. And up to the last week of July, positioning has been increasingly aggressive.

When these measures are released for the month of August, they are likely to show a (temporary) reduction in risk taking. 

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Credit card debt growth exceeds wage growth in the US

Over the past three months, the year-over-year growth in credit card debt has exceeded wage growth in the United States. This is the first time we've seen this trend since the Great Recession. While it clearly indicates improved US consumer confidence (and all the spending helps boost China's trade surplus), in the long run this is not going to be sustainable.

Year-over-year growth in credit card deb minus growth in average hourly wages 

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Latest dynamics in US energy markets

Here are two major trends currently underway in the US energy markets:

1. Cushing, Oklahoma inventories (the location for settlement of WTI futures) are falling to new lows. The crude backlog that existed in recent years has been resolved. Oil now moves in sufficient quantities (via Seaway and other infrastructure) to the Gulf Coast as well as to Midwest refineries to stabilize and even cut inventory in storage. Also Cushing is now often bypassed, with crude moved directly to the Gulf via rail.

2. US refineries are now pumping at record levels, as lower US crude feedstock costs contribute to refinery profitability.

Source: EIA

Oil & Gas Journal: - Refinery inputs reached a record-high of 16.8 million b/d in each of the past 2 weeks, exceeding the previous record from summer 2005, according to the US Energy Information Administration. Inputs at refineries in the Midwest and Gulf Coast have been particularly high, reflecting these refineries' access to lower-cost crude oil, expansions of refining capacity, and increases in both US demand and exports.

These dynamics are part of the reason we see outperformance in shares of firms like Tesoro for example.

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A stream of poor economic reports from the Eurozone may be more than just the "Putin factor"

A slew of negative economic surprises across the Eurozone is pointing to significant challenges the area faces on its road to recovery. Three of these surprises are listed below:

1. Italy's GDP unexpectedly contracted last quarter putting the nation into a third recession in since the financial crisis.

WSJ: - Italy has slipped into its third recession since 2008, data showed Wednesday, in an unexpected setback that threatens to restrain the broader euro zone's fitful recovery.

Italy's economy contracted at an annualized rate of 0.8% in the quarter ending June 30, according to a first estimate by national statistics institute Istat—the latest sign of how parts of Europe are still struggling to escape the legacy of the global financial crisis. It was the second successive quarter of falling Italian output, which meets the common international definition of a recession.

2. The area's retail sector took an unexpected turn for the worse last month.

Markit: - The eurozone retail sector started the second half of the year on a weaker footing. The fragility of consumer spending was exposed by the PMI, particularly in France and Italy where the data showed sharper downturns in sales. Even in Germany, the one area of relative strength, there was an appreciable slowdown from June’s recent peak. Retailers underperformed relative to their targets to the greatest extent since March 2013, leading to further accumulations of unsold stock and the prospect of greater discounting ahead.

3. German factory orders contracted at the fastest pace since 2011.

Deutsche Welle: - German industrial orders fell for the second consecutive month in June at a rate of 3.2 percent, following a similar 1.6 percent contraction in May, the economics ministry in Berlin said Wednesday. According to the data, orders contracted at their fastest pace since September 2011, disappointing analysts who had predicted gains of 0.9 percent in a consensus forecast.

While many are blaming these economic headwinds on the uncertainty related to Russia/Ukraine as well as the sanctions, some analysts are pointing to problems closer to home.

The Telegraph: - After what was dismissed as an irregular drop last month, Germany’s factory orders have seen another surprise fall in June. But the downturn has not been solely down to German exposure to ongoing tensions in Russia and Ukraine. Much of the poor performance is explained by crumbling demand from eurozone peers. Evelyn Herrmann, European economist at BNP Paribas, said that “the weakness was mainly driven by orders from within the eurozone” which fell by 10.4pc in June. Non-eurozone orders were stagnant in that month.

The collapse in German government bond yields accelerated in response, reaching another record low.

Moreover, the yield curve is beginning to show signs of inversion in the front end. This is not what the yield curve of a healthy economy is supposed to look like.

The so-called "Putin factor" has certainly shaken confidence of the area's consumers and added uncertainty to the corporate boardrooms (giving Putin additional leverage over western nations). But the Eurozone's challenges seem to go beyond that. As the ECB prepares for another meeting shortly, these issues are sure to be brought up. Draghi's last bullet - direct asset purchases by the ECB - may no longer be as easily dismissed by the Governing Council.


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Tight rental market holding back household formation

The latest data on US households is out (through Q2) and the story remains the same. Household formation has stalled. US population is growing at about 0.7% per year while households grew at an annualized rate of 0.34% over the past two years.

Source: US Census

Part of the problem is weak residential construction spending which is keeping the supply of rental housing relatively tight.

Construction spending as % of GDP (units: 20 means 2% of GDP)

As a result, rents are now rising at over 1% per year faster than wages, pricing many potential households out of the market. The chart below shows the rent component of the CPI minus the year-over-year average hourly wage growth in the US.

The longer this goes on, the more out of reach affordable rental housing will become for new households. As discussed before (see post), this is going to become a major issue for the US in years to come.

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Argentina default Q&A

We've had a number of questions on Argentina's latest default. Here is an overview of the situation in a Q&A format.

Q:  Is Argentina officially in default?
A:  While Argentina's government deposited the dollars for distribution to Discount bond holders, the interest was not distributed as scheduled last week. Missed coupon payment represents default, at least as far as S&P is concerned (classified as “selective default”).

Q:  Does Argentina recognize that it is in default?
A:  No. The Economy Minister Kicillof made it clear that as far as Argentina's government is concerned there is no default because it has and will continue to make deposits with BNY Mellon (the trustee) to pay the coupon. The government blames the missed coupon payment on Judge Thomas Griesa's ruling. That ruling held back payments to the bondholders who had accepted the renegotiation of Argentina’s debt in 2005 and 2010.

Q:  Why haven't the funds been distributed?
A:  Funds would have been released if Argentina settled with the "holdouts" (those who didn't agree to the 2005/2010 settlement). The holdouts sued for $1.6bn and the negotiations with the government failed to produce a settlement before the deadline last week, preventing the cash from reaching the bondholdrs.

Q:  Has the sovereign CDS (credit default swap) been "triggered" (have we had an "event of default")?
A:  It is likely that we do indeed have an event of default under the ISDA guidelines. The event would fall under the category of "Failure to Pay". Having deposited funds with the trustee does not prevent default under ISDA because Argentina has an obligation to make sure coupon payments reach the bondholders. And by choosing not to settle with the holdouts on time, the nation failed to deliver such payments. Ultimately it will be the ISDA Determination Committee that will make that call.

Q:  Can a settlement still be reached?
A:  Yes. The government is highly incentivised to reach an agreement in order to be able to access international debt markets. However prospects of a near-term solution are uncertain and the legal ramifications of a settlement are unclear. A number of analysts are suggesting that a settlement will not take place until at least early 2015.

Q:  Would an eventual settlement have an impact on the CDS?
A:  No. The coupon payment has been missed and that should be enough for the event of default trigger. However depending on the timing of the settlement, it could impact the recovery value on the CDS (by impacting the bond prices prior to the CDS settlement).

Q:  Why hasn't Argentina's government settled with the holdouts?
A:  There are a number of reasons, the most important of which is the government's unwillingness to look politically weak by paying $1.6bn to some US hedge funds - far more than it paid other bondholders. Furthermore, it is Argentina's current law that it can't pay more to the holdouts than to the rest of the holders. Of course the law can be changed, but the government is unwilling to do so at this point.

Q:  What is the RUFO clause and what are its implications?
A:  RUFO stands for Rights Upon Future Offer, a clause written into the renegotiated bonds during the restructuring some years ago. It says that if Argentina's government voluntarily offers better terms to the holdouts it would need to match those terms for all the bondholders. This sounds like another reason for Argentina not to settle, but it's just an excuse. That's because the "voluntary" term in the clause would keep RUFO from being triggered - since the settlement with the holdouts is not voluntary but mandated by the US court.

Q:  What are the economic consequences of Argentina not settling this by year-end or beyond?
A:   The consequences could be quite grim. As it is, the Argentina's GDP is contracting again.

And the nation's current account is deep in the negative territory.

Without access to international debt markets many domestic firms will struggle to survive and the country will slip into recession. Currency will come under further pressure and the spread between the official FX rate and the "parallel" exchange will widen sharply (currently the "unofficial" exchange dollars already trade at a 26% premium to the official rate). FX reserves would continue to decline, forcing a second devaluation. Inflation, which is believed to around 25-30%, will spike further. Violent social unrest is sure to follow. This is why Argentina should have every incentive to settle with the holdouts as soon as possible. Sadly, the risk that it won't remains quite high.


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The Fed to pay foreign banks to keep the Fed Funds market alive

The FOMC continues to insist that the Fed Funds Target rate rather than the reverse repo program (see discussion) will play a central role in the upcoming rate normalization. Let's revisit the concept of the Fed Funds arbitrage (discussed in item 4 here) to show why that's a problem.

The Fed Funds rate (currently at about 9bp) is determined by the overnight interbank lending market in which banks provide liquidity to each other.

The market has shrunk dramatically since the financial crisis (see post), with the activity now limited to a few players with specific needs. US federal home-loan banks (FHLBanks) who, unlike commercial banks, do not receive interest on excess reserves at the Fed are the largest participants. In order to earn any interest at all on their excess liquidity they lend it to a handful of banks that use the funds for arbitrage. In particular foreign banks operating in the US have been active in this game, which nets them around 16bp in riskless profits.

It's easier for foreign banks to engage in this activity because many do not take in US deposits and therefore are not subject to FDIC fees. Because Fed Funds arbitrage involves increasing the balance sheet (and leverage) of the borrowing bank, US depositary institutions engaging in this are subject to higher FDIC fees. Foreign institutions on the other hand may not be as concerned about this.

Bloomberg: - The situation is complicated further by the reluctance of domestic banks to engage in arbitrage in the fed funds market, because Federal Deposit Insurance Corporation insurance fees increase proportionally with bank leverage, reducing the profitability of the trades.

“The only people that are really arbitraging at the moment would be the foreign banks without domestic deposits that need to get insured,” said David Keeble, head of fixed income strategy at Credit Agricole in New York. “Ultimately, you're allowing the arbitrage to continue and giving money” to foreign banks rather than domestic ones, he said.

Let's put this another way. The Fed is paying foreign institutions to participate in this market and bank federal home-loan banks' overnight liquidity.

Moreover, as regulation of foreign banking institutions in the US tightens, even these banks may decide to walk away from this strategy. The Fed may have to juice up the spread between the Fed Funds rate and the interest it pays on excess reserves (IOER) in order to keep these banks participating (the current 16bp of riskless profits may not be enough). Note that this "encouragement" comes at taxpayers' expense because it raises the Fed's effective funding rate, reducing the amount the Fed remits to the US Treasury.

Bloomberg: - To help keep that market alive, the Fed will have to pay those banks a premium to continue trading in it, which will eat into the profits the central bank remits to the U.S. government each year. And even then, foreign banks may be unwilling to continue their trades as stricter regulations on leverage take effect.

The whole policy of targeting the Fed Funds rate now depends on a handful of foreign banks' willingness to participate in this game - just as we approach the first rate hike in years. Is this really the Fed's best monetary policy tool going forward?

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