Across the Curve

Long Bond at Zero Yield?

August 1st, 2016 11:30 pm

Bloomberg reports that analysts at Nomura expect that a search for yield by japanese investors will drive US Long Bond yields to zero in two years. So this is your last chance to climb on board that train before it rumbles out of the station.

Via Bloomberg:
Highest Treasury Yield to Evaporate in Nomura’s Vicious Circle
William Finbarr Flynn
August 1, 2016 — 10:07 PM EDT
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Expects ‘Japanese money’ will flow into other bond markets
BOJ may consider cutting JGB purchases in its review: Nomura

 

The yield on 30-year Treasuries could drop to almost zero within two years as investors seeking higher income streams shift funds from Japanese government bonds into the U.S., according to the Asian nation’s biggest brokerage.

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“Japanese money” will move into the government bonds of other major economies as about 900 trillion yen ($8.8 trillion) of JGBs offer negative yields, Toshihiro Uomoto, Nomura Holdings Inc.’s chief credit strategist in Tokyo, wrote in a report on Monday. The decline in global yields will weigh on consumer sentiment, put pressure on banks’ interest income, and may result in more stimulus from central banks, according to Uomoto, ranked as Japan’s top credit analyst by Nikkei Veritas for three of the past four years.

“The trend toward declining interest revenues from falling rates will accelerate and give birth to a vicious circle,” he wrote. Uomoto said by phone Tuesday that he didn’t see Treasury yields going negative because the Federal Reserve isn’t in the market buying bonds, unlike the Bank of Japan.

U.S. debt due in 30 years yielded 2.26 percent as of 10:50 a.m. Tuesday in Tokyo, down from 3.02 percent at the end of 2015. Equivalent-tenor Japanese notes yielded 0.31 percent, while the rate for 10-year JGBs was minus 0.07 percent.

The Bank of Japan, which first took its key interest rate below zero on Jan. 29, last week unveiled limited additional stimulus measures that didn’t lower the benchmark further or increase its bond buying program. BOJ Governor Haruhiko Kuroda has also ordered a review of the central bank’s policy framework due to uncertainty about the inflation outlook. While the BOJ has been targeting 2 percent inflation since 2013, Japanese consumer prices in June fell for the fourth month in a row.

One potential choice for the BOJ is to reduce purchases of JGBs if it judges that its negative-interest rate policy has sufficiently flattened the yield curve, according to Uomoto.

Money moving out of Japanese government bonds and stocks will also move into credit investments and real estate, according to Uomoto. He urged corporate debt investors to take risk early and said credit spreads will probably stay low for the next one or two years.

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T Bill Dearth

August 1st, 2016 11:25 pm

Via Bloomberg:

Liz McCormick
mccormickliz
July 31, 2016 — 7:00 PM EDT

The U.S. government’s attempt to alleviate the short supply of T-bills is about to get a little harder.

After years in the making, a post-crisis rule to prevent a run on the money-market industry will finally take effect this October. It will force funds that oversee about $600 billion to abandon a fixed $1-a-share price and float their net asset value. But because businesses and state governments treat the funds like bank accounts, the prospect of prices falling below a buck is causing a big shift into money-market funds that buy only government debt.

To cope, the Treasury Department stepped up bill issuance and boosted supply by almost a quarter-trillion dollars after its share of U.S. government debt fell to multi-decade lows last year. That still might not be enough. Estimates suggest between now and mid-October, the influx may produce an extra $400 billion or more in demand for short-term government securities and put a squeeze on a sizable chunk of the $1.51 trillion bill market.

“There may be just enough bills out there to be handling this now,” said Gennadiy Goldberg, an interest-rate strategist at TD Securities. “But if there is another $400 billion inflow into government funds that could put more pressure” on bill supply, he said.

Nobody is saying all that money will cause the market for bills, which mature in a year or less and make up 11 percent of U.S. Treasuries, to malfunction. After all, the government-only funds can also buy repurchases agreements, debt issued by federal agencies or put cash into the Federal Reserve’s reserve repo program. But that’s not to say there aren’t real consequences.

 

Depressed rates in the $2.6 trillion money-market fund industry stand to deprive savers of income even as the Fed moves to gradually raise interest rates. Some analysts say the Treasury may even be compelled to introduce two-month bills, which could hamper its goal of extending maturities to lock in long-term borrowing costs while they’re still near historic lows.

For decades, the rock-solid $1-a-share NAV has been the cornerstone of money-market funds — the thing that made them as good as cash in the eyes of investors. And prime funds, which invest in riskier assets, have been a favorite among state and corporate treasurers because they delivered slightly higher returns than government-only funds.
Hard Lessons

But on Oct. 14, institutional prime funds, which are big buyers of bank debt like commercial paper and certificates of deposits, will be required to float their NAVs. In recognition of the hard lessons learned in the dark days of Lehman Brothers Holdings Inc., they will also be allowed to impose liquidity fees and limit withdrawals in times of crisis. While the rules were adopted to make money-market funds safer, they’re spurring an exodus from prime funds and a stampede into government-only funds, which are exempt.

“When it comes to Treasurers and their roles and responsibilities, the last thing they want is uncertainty,’’ said Brandon Semilof, a managing director at StoneCastle Cash Management, which manages more than $10.6 billion and works primarily with the nation’s community banks.

Kentucky has switched the cash that it’s earmarked for debt payments into government-only funds, according to Stephen Jones, deputy executive director of the commonwealth’s office of financial management.

If we’re late on those payments, “we have a real serious problem, so we can’t take the chance on a prime fund on that,” he said in an interview.

 

Since June of last year, assets in all funds that focus on buying government debt have ballooned by more than a half-trillion dollars and now stand at about $1.5 trillion, according to Crane Data LLC, which specializes in money-market research. That influx is likely to accelerate in coming months. Bank of America Corp. predicts half the $300 billion to $500 billion leaving prime funds will flow into the safer money-market alternatives.

Some distortions have already begun to emerge. The premium on three-month commercial paper has surged to a four-year high versus similar-maturity bills, which yielded 0.24 percent today. The same is true for the three-month London interbank offered rate, which touched the highest level since 2009.

“The inflows to government funds should mean relatively lower Treasury bill yields and repo rates,” said William Marshall, an interest-rate strategist at Credit Suisse Group AG.

Bill rates rose from rock-bottom levels in the lead-up to the Fed’s rate increase last December, but they’ve held steady since. Across all maturities, they average 0.28 percent, data compiled by Bank of America show.

More bill issuance from the Treasury and the Fed’s reverse repo program will help mitigate any supply-demand issues, according to Michael Pak, a fixed-income trader at TCW Group Inc., which oversees $195 billion.

The Treasury will add about $188 billion in additional bill supply during the next two quarters, based on overall U.S. debt sales and how much cash on hand it plans to hold, according to Stone & McCarthy Research Associates.

“Finding the high-quality securities will not be a problem,” Pak said. “The Treasury’s stated desire is to issue more bills and run up a higher cash balance.” In addition, the Fed’s reverse repos are “almost like a safety net.”

In recent months, the Treasury has said it would keep long-term debt issuance stable as it increases bill supply. In February, it also discussed adding a two-month bill, partly to deal with the rise in money-market demand.

That runs counter to the government’s long-term goal of pushing out debt maturities to take advantage of a one-in-a-lifetime opportunity with yields so low. The Treasury has lengthened the average maturity of U.S. government debt to a near-record 5.8 years from 4.1 years in 2008. But it’s decreased in two of the past three quarters.

Whatever happens to bill supply, money-market providers are bracing for big redemptions from prime funds. For the biggest institutional prime funds tracked by Crane Data, the weighted average maturity of their holdings fell to a record 18 days last week.

“We expect some fairly large outflows,” said Peter Yi, director of short-term fixed income at Northern Trust Corp., which manages $906 billion. “We don’t want to find ourselves selling credit instruments into a distressed market.”

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Financial Repression

August 1st, 2016 11:21 pm

Via the WSJ:

By James Mackintosh
Updated Aug. 1, 2016 5:08 p.m. ET
9 COMMENTS

The money markets are screaming about a global shortage of dollars. Financial stress indicators are flashing yellow. The Bank of Japan on Friday took special measures to help its banks access greenbacks, and interbank borrowing rates for dollars are at the highest level since 2009.

In the 2008 and 2011-12 panics, the money markets acted as a warning of a credit crunch, as trust between lenders and borrowers broke down. This time, though, the signs of stress are a result of something else: The campaign by governments to direct financing to themselves, limiting access by the private sector.

In the U.S., there are legal changes under way in the money markets, which is prompting money to shift from “prime” funds, which buy short-term debts issued by companies, to instead buy short-term debt issued by the U.S. Treasury.

This is merely the latest example of what academics call financial repression, a broad category of government policies adopted to encourage or require savings to be lent cheaply to the government. Repressive policies were the norm in Western markets for decades following World War II. That was until the financial liberalization was begun by Margaret Thatcher in the U.K. and then-President Ronald Reagan in the U.S.

New rules since the Lehman Brothers failure have again tightened the screws on lending to the private sector, while favoring government financing in multiple, complex ways, most obviously through exempting banks from holding capital against government debt.

There are, of course, good reasons for most of the restrictions on the financial sector, including on money funds. Don’t forget that, after Lehman, the U.S. government bailed out the money markets with a guarantee against losses.

The aim of the overhauls is to prevent a repeat of the panic selling of prime funds, akin to a bank run. The most eye-catching rule will stop institutional funds from offering an unchangeable $1 net asset value for each dollar on deposit. This is designed to reduce the psychological impact of “breaking the buck,” or falling below $1, which can lead to widespread withdrawals.

All money funds also will be given an option to restrict or impose a fee on withdrawals when a fund’s easy-to-sell assets are depleted. This makes explicit that in times of stress it might be impossible to access one’s money. This has prompted assets in prime funds to drop below $1 trillion for the first time this century.

So far, so sensible. But there is a wrinkle. Money funds that buy government paper are exempt from the new rules, on the basis that Treasury bills are always easy to sell and there is no risk of default. The rule makers seem to have forgotten the near default in 2010 and the downgrade of the U.S. debt rating, not to mention the accidental failure to pay some Treasury bills in April 1979 due to paperwork backlogs.

The effect of the exemption is that money has poured in to government funds as investors worry that they might not always be able to access cash in prime corporate funds.

Carmen Reinhart, a finance professor at Harvard University’s John F. Kennedy School of Government, says governments across the developed world are interfering more with private flows of cash as their financing needs soar. Directing money to the state at the same time as the central bank keeps interest rates below inflation to boost growth amounts to a subsidy of the government by savers, a hidden tax.

“The way we have revamped regulation has clearly favored government debt,” she said. “The regulation creates the captive audience, and the monetary easing creates the ‘tax.’ ”

Outside Iceland, Greece and Cyprus, the West remains far less financially repressed than in the 1950s or 1960s, when capital controls meant Britons couldn’t take more than £50 ($66) out of the country, while Americans were still forbidden from investing in gold.

But subtle rules funnel more bank and insurance-company savings to government paper, by assuming it is always easy to buy and sell and will never default. Accounting shifts have encouraged corporate pension plans out of volatile stocks and into bonds, and several countries have grabbed assets from state pension funds.

There is hope. Financial repression is on the rise, but savers still can avoid it. Prime money-market funds might look less attractive under the new rules, but the economic reality of what they own remains unchanged, as do the risks. Just because a fund can now suspend withdrawals or impose a fee in a crisis doesn’t mean that under the old rules money would have magically been available.

Other options remain open, too. While rates may be low everywhere, cash still can be sent abroad and pays more in some countries. Finally, anyone worried enough about financial repression to want to avoid government paper entirely can switch into gold. So long as that remains an option, financial repression isn’t complete.

Write to James Mackintosh at [email protected]

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Secular Stagnation Lives

August 1st, 2016 6:41 am

Via Bloomberg:

Sid Verma
@_sidverma
August 1, 2016 — 6:05 AM EDT

You can now add the rates strategy team at Deutsche Bank AG to the growing list of Wall Street analysts who reckon the U.S. economy is probably ensnared in secular stagnation.

In a research note published on Friday, Deutsche Bank strategists, led by Dominic Konstam, say the Federal Reserve risks a “big policy error” if it hikes interest rates in September as the latest GDP numbers mark an imminent labor market-driven slowdown for the U.S. economy.

The world’s largest economy expanded by just 1.2 percent in the second quarter while first-quarter expansion was revised down to 0.8 percent from an initial 1.1 percent estimate. The second-quarter rate of expansion was less than half the advance forecast by economists in a Bloomberg survey.

“If the economy can only muster growth in the vicinity of 1 percent when the labor market is at full employment, one must take the secular stagnation thesis more seriously,” the Deutsche Bank analysts write. “In other words, perhaps the 2.1 percent average growth rate of the present cycle has been an over-performance. If productivity continues to underwhelm, we will likely see downward revisions to potential growth, telling us after the fact that we have been closing the output gap faster than we thought.”

Secular stagnation is the contentious view that economic growth and the natural rate of interest for the U.S. economy is structurally low or in negative territory, and promoting full employment — in the absence of sustainable final demand — risks financial stability.

The Deutsche strategists paint a negative picture on U.S. productivity prospects, noting that the “non-consumer portion of the economy is shrinking not only in real terms but also in nominal terms.”

With real GDP growing at just 1.2 percent over the last four quarters, the strategists reckon a labor market slowdown — in which low productivity forces firms to defend profit margins by firing workers, who are also consumers — is nigh. This would depress aggregate demand, and further constrain margins for businesses, the analysts write.

The odds of a September rate hike, according to federal funds futures contracts, have dropped to 18 percent compared with 28 percent before the second-quarter read. A traditional driver for U.S. monetary tightening economy — as the labor market tightens, wage inflation should eventually increase, as per the Phillips curve — is now rendered less likely given second-quarter data, Deutsche strategists write, forecasting no rate hikes this year.

Signs of healthy consumer spending continue to feed confidence among Fed officials about the underlying strength of the U.S. economy. On Thursday, Federal Reserve Bank of San Francisco President John Williams said two interest-rate increases this year could be warranted, despite the lower-than-expected GDP number for the second-quarter.

Underscoring the divergence between Fed officials and market expectations for U.S. growth and policy rates — with the 10-year U.S. Treasury yield on a downtrend since mid-2015 — Deutsche analysts conclude “there is little evidence that productivity is ready to do the heavy lifting in terms of stimulating faster growth,” with with labor-input growth now yielding diminishing returns on output growth.

“In the four quarters ending in the first quarter of 2016, productivity has grown at just 0.7 percent. Meanwhile, aggregate hours growth slowed from a cyclical peak of 2.8 percent in first quarter of 2015 to just 1.5 percent a year later.” Since labor-input growth will probably slow to 1 percent, “productivity will have to accelerate several tenths in order to maintain ‘trend’ growth.”

“Meanwhile, the growth contribution of fixed investment is basically zero, a development that in the past has been a reliable predictor of recession,” the strategists add. “Even if we do not fall into recession, the lack of investment is expected to weigh on productivity, with consumption growth eventually slowing along with labor input growth. The concern is that the economy will then rebalance along a lower real growth trajectory.”

One bright spot is the improving net capital to labor ratio — a measure that indicates the capital intensity of businesses — which tends to lead uptrends in productivity, they conclude.

The extraordinary weakness of investment relative to consumption, and the relationship between the two, is a theme taken up by Joseph Calhoun, chief executive officer at Alhambra Investment Partners. He wrote in a research note on Sunday that the quarterly slowdown “marks a change that needs to acknowledged.” Over the past two years, first-quarter growth disappointments have been offset by rebounds in the second and third quarter. However, “this cycle was a kind of mini inventory cycle within the larger business cycle,” Calhoun notes.

Inventory contractions can be followed by periods of compensatory expansions but that’s hard to see when the inventory-to-sales ratio — a measure of the stock of inventory as a proportion of sales fulfilled — remains elevated, he says. The latter indicates weak consumer demand, and, by extension, low incentives for businesses to ramp up production.

 

Calhoun also notes that gross private domestic investment is down 2.5 percent in the second quarter compared with the corresponding period last year, a rare occurrence in periods of expansion. “The U.S. economy is not in recession – yet – but it is surely slouching slowly in that direction. The drop in investment is very concerning since it is investment that leads; consumption is a consequence of growth not a driver of it.”

Calhoun concludes: “I have never bought into the secular stagnation theory but for now, this may be as good as it gets.”

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FX

August 1st, 2016 6:38 am

Via Marc Chandler at Brown Brothers Harriman:

Drivers for the Week Ahead

• The Reserve of Bank of Australia meets
• Investors are more confident of the outcome of the Bank of England’s meeting than the RBA meeting
• Japan’s Prime Minister Abe seemingly hurriedly confirmed some details of his fiscal plan.
• The US July employment report caps the week

The dollar is mostly firmer against the majors.  The Swiss franc is outperforming while sterling and the Loonie are underperforming.  EM currencies are mostly firmer.  KRW and MYR are outperforming while RUB and CNY are underperforming.  MSCI Asia Pacific was up 0.8%, with the Nikkei rising 0.4%.  MSCI EM is up 1.2%, despite Chinese markets being down nearly 1%.  Euro Stoxx 600 is down 0.4% near midday, while the Euro Stoxx Bank Index is down 2% in the wake of the stress tests.  S&P futures are pointing to a lower open.  The 10-year UST yield is up 3 bp at 1.48%.  Commodity prices are mixed, with oil down over 1%, copper up 0.5%, and gold down 0.3%.

There are four events this week that will command the attention of global investors.  

1. The Reserve of Bank of Australia is first.  It is a close call, though the median in the Bloomberg survey favors a cut, including most of the banks in Australia that participate in the poll.

The case for it is that price pressures are weakening, and credit growth is slowing.  The currency has begun appreciating again, and the Federal Reserve cannot be counted on to lift US rates until the end of the year, at the earliest.  

The argument against the RBA moving is that there is no urgency to exit the “watch and wait” mode.  A rate cut would not necessarily weaken the currency as Australia would still offer highest policy rate (after New Zealand) among the high income countries. It is also not clear that the record low interest rates are a constraint on credit growth. Better keep the powder dry and see how events evolve, though it can be fairly confident that New Zealand will cut interest rates later in August.  

2, Investors are more confident of the outcome of the Bank of England’s meeting than the RBA meeting.  After the recent dismal survey readings, indicative prices suggest that a 25 bp rate cut is fully discounted.  A newswire survey found 95% of the sample anticipates a rate cut, and of those, 95% expect a 25 bp cut in the base rate.

There are two other measures that the BOE is expected to consider.  A little more than 80% of those who expect the BOE to do more than cut rates expect the funding for lending scheme to be extended.  Participants are nearly evenly split on the prospects for a new round of asset purchases.  About half of those that expect a new round of QE expected it to be between GBP25 and GBP50 bln.  Outside of that ranges the response were heavily in favor of a larger than a smaller Gilt buying program.  

Sterling eased to the lower end of a $1.30-$1.35 trading range as the market priced in the easing of monetary policy.  It may firm back toward the upper of the range as the soft US dollar environment we anticipate, coupled with “sell rumor, buy fact” type of activity.  In the futures market, speculators have a near record short gross sterling position and have a record net short position.  

3.  Japan’s Prime Minister Abe seemingly hurriedly confirmed some details of his fiscal plan.   If he intended on cajoling the central bank into joining the fiscal stimulus with a large dose of monetary support, it was insufficient.  Abe is expected to provide more details of the fiscal package.  The cabinet will formally approve it, and it is not clear whether the cabinet will do so before or after it is reshuffled, and the sequence may not matter.  

Reports already indicate that the only about a quarter of the headline JPY28 trillion will be real fiscal spending.  The freshwater number may also include spending associated with a supplemental budget that Japan habitually announces.  Even a slimmed down estimate needs to be discounted because frequently all the earmarked spending goes unused.  At the end of the day, the large fiscal package is not so large really, and it may not provide as much stimulus as head figure of around 6% of GDP suggests.  

And even if there was greater real spending, it is not clear that it would change investors’ views.  At its best, government spending would create a short-run demand shock, and even given a reasonable multiplier, one cannot be very optimistic.  The recent data shows domestic demand (overall household spending) and foreign demand (exports) are weak and falling.  

It is not as if this is priming the pump in the popular Keynesian image or that the Japanese economy has been starved of public investment as some European countries.  Japan has recorded an average budget deficit of 8.1% of GDP per annum in the last six years.  The deficit has been below 8%of GDP for the last two years when it has averaged 7.2%.  This year’s deficit was to come in below 6% before this latest round of stimulus, and the details will help economists and investors update their forecasts.  

Expanding the monetary base by JPY80 trillion a year (more than 15% of GDP) is not stimulating inflation expectations or actual inflation.  Running a significant and sustained budget deficit has been unable to push the world’s third largest economy onto a self-reinforcing growth path.  Observers may differ on precisely what Japan should do, but many appear to be growing increasingly convinced that it is not a question of a marginal tweak.  

Although Abenomics is usually associated with the three arrows of fiscal and monetary stimulus and structural reforms, there was a fourth component.  Pension funds, including the government’s gigantic GPIF, diversified overseas and with apparently low hedge ratios…initially. Some suggest that it was these outflows that helped drive the yen’s decline.  Reports now suggest that since that hedge ratios are being increased, this is one of the important drivers of the appreciating yen.  It may be a bit of a vicious cycle.  As the yen appreciates, pressure mounts on Japanese global investors to buy yen as a hedge, driving it higher, requiring more hedging.  

4.  The US July employment report caps the week.  Economists do not expect a repeat of June’s 287k jump, not that they had expected that either.  The median guesstimate is for an increase of around 175k, which is above the three and six-month averages (147k and 172k respectively).  The unemployment rate may tick down to 4.8%.  Average hourly earnings need to increase by 0.2% to maintain the 2.6% year-over-year pace.

In the aftermath of the disappointing Q2 GDP estimate, we suspect the markets will have an asymmetrical response to US data.  The markets are more likely to respond to negative surprises than positive surprises.  For all practical purposes, no matter how strong the data surprises could be would sufficient to get the market to believe a hike in September is anything but an extremely small tail risk.  On the other hand, disappointing data could prompt more investors to give up on a hike at all this year.  

That said, our impression is that the low Q2 GDP was more teeth-gnashing for investors than the Federal Reserve.  Past comments by Yellen suggests a focus on GDP excluding inventories and exports.  Consumption, which was identified in June as a concern, rose at 4.2% annualized pace in Q2 after a 1.5% clip in Q1.  Consumption added 2.8 percentage points to GDP.  The other components of GDP, (government spending, business investment, and net exports) subtracted 1.6 percentage points from GDP.  The result was 1.1% GDP, adjusted for rounding.  

Inventories are not a large part of GDP, but they are volatile, and seemingly a challenge to forecast accurately.  The introduction and dispersion of better inventory management (e.g., just-in-time inventories, register-to-inventory interface) apparently has not ended the inventory cycle’s role of driving the larger business cycle.  The three-quarter drawdown in inventories is probably the single most important factor behind the nine-month streak of growth below 2% (for the first time four years).  

The rundown in inventories, however, is expected to lead to greater output, especially if demand holds up.   An increase in July auto sales (17.2 mln annualized pace vs. 16.61 mln in June) points to a solid start for Q3.  It should not be surprising if economists shift some of the growth they had anticipated for Q2 into the second half.  

In many ways, it seems that the August cake is already baked.  The BOJ and ECB have signaled reviews in September.  The September FOMC meeting is late in the month, which arguably makes the July high frequency data less significant, and in any event, is unlikely to boost expectations for a September hike.  

Yellen’s presentation at the Jackson Hole confab at the end of the August may be more important than the data per se.  Advance reports should make the first estimate of GDP more accurate, and time will tell, but for the time being it, investors need to keep in mind that it is often subject to statistically significant revisions.  The first revision is due August 26.  

The European Bank stress tests results were announced after the North American markets closed for the week.  The only bank whose capital would be wiped out was Monte Paschi, who hours before announced a new plan, approved by the ECB.  It made the stress test result immaterial.  Only one other bank that tested, Allied Irish, had a “fully loaded capital ratio” of less 5.5%, which is regarded as an important threshold.  The Euro Stoxx Bank Index is down 2% so far today, underperforming the broader European markets.      

Several banks will likely raise capital, but officials will find solace in that large banks appear more resilient to economic stress.  Perhaps more of more immediate concern to investors is not the stress situation as much as the continued grind of the status quo.  Negative interest rates, weak growth in lending to businesses and households, and a new regulatory environment that is exerting pressure to de-lever creates formidable challenges.  Capital gains, for some investors, may blunt the sting of negative interest rates, but this is not the purpose of fixed income investment for many.

Final manufacturing PMI readings for the Eurozone showed a slight improvement.  Eurozone manufacturing PMI rose to 52.0 from the 51.9 preliminary.  Germany’s improved from 53.7 to 53.8, while France’s was steady at 48.6.  Both Italy and Spain saw downward revisions to 51.2 and 51.0, respectively.  

The euro trended lower from early May through the UK referendum on June 23, dropping seven cents to roughly $1.0915.  Speculators in the futures market accumulated a large gross and net short euro position.  We suspect that a correction has begun that may carry the euro toward $1.1350-$1.1400 in the coming weeks.

EM ended last week on a firm note, helped by the weaker than expected US Q2 GDP report as well as the small bounce in oil.  That continues this week.  With the RBA and BOE expected to ease this week, the global liquidity backdrop remains favorable for EM and “risk.”  

We got our first glimpse of the Chinese economy for July with the manufacturing PMI readings.  The official PMI was weaker than expected at 49.9, but the Caixin reading was firmer than expected at 50.6.  This puts it above 50 for the first time since February 2015.  EM CPI data this week should underscore the low global inflation theme.  Indonesia, Thailand, and Peru CPI readings all came in lower than expected today.  More EM central banks are likely to join the easing parade in H2.

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Repo Market Jitters

August 1st, 2016 12:56 am

Via WSJ:
By Katy Burne
Updated July 31, 2016 4:41 p.m. ET
7 COMMENTS

J.P. Morgan Chase & Co.’s retreat from a mundane but crucial settlement role in the $13 trillion U.S. Treasury market poses a fresh challenge for regulators seeking to bolster the market’s capacity to withstand shocks.

The New York bank’s decision, announced July 21 and due to be complete next year, leaves rival Bank of New York Mellon Corp. as the lone firm handling the settlement of U.S. government debt for big bond brokers.

Having just one firm in the business of making sure traders deliver cash and securities as expected will pose a fresh test for a sprawling market whose functioning has come under scrutiny since the financial crisis. Many analysts already worry that liquidity, the capacity to trade quickly without moving prices, has been falling when markets come under stress.

Following J.P. Morgan’s exit, Bank of New York will settle transactions including the majority of Treasury debt sold at U.S. government auctions, the majority of Treasurys traded in the secondary market and most U.S. government debt exchanged in the overnight “repo” market, a key source of funding in which financial institutions use the bonds as collateral for cash loans.

Officials at both banks said they had been in touch with the Federal Reserve and the Treasury Department to reassure them the moves wouldn’t disrupt trading in U.S. Treasurys or the $2.2 trillion daily market for repos. But the move could inflame concerns that there already weren’t enough options for traders, potentially exposing the market to a shutdown in the event of an outage at a large settlement firm.

“You have all your eggs in one basket here, and if you’re the Fed, that has to be a little disconcerting, because you don’t want any hiccups in this market,” said Ray Stone, a former New York Fed researcher and head of Stone & McCarthy Research Associates.

The change, deep in Wall Street’s financial plumbing, reflects pressure from new regulations as well as banks’ efforts to cut back less-lucrative activities.

There were about half a dozen providers of settlement services in the Treasurys market before consolidation whittled the market down to two in the 1990s.
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But for more than a decade, banks that operate as “primary dealers” in the Treasury market have only had two options for settling trades—Bank of New York and J.P. Morgan.

Bank of New York is prepared to work with dealers that want to move to its platform and expects to be able to handle the extra volume, spokeswoman Cheryl Krauss said.

J.P. Morgan said it would continue to provide other related services, like managing government bonds as collateral for client trades.

The Treasury is “confident that Treasury securities will continue to settle and trade in the usual manner,” a Treasury spokesman said.

The Fed and others have been concerned for more than a decade about Bank of New York’s large market share—now 85%—for settlement in a $1.6 trillion part of the repo market.

The central bank worried as far back as 2006 that concentration could present systemwide risks and considered forming a utility as a backup, people briefed on the matter said. J.P. Morgan’s announcement may restart those discussions, the people said.

The Fed also is holding Bank of New York to higher operating standards due to its share of the market.

“A single provider of settlement services—or a new entrant, should there be one—will be expected to operate in a safe and sound manner that supports market functioning and that is resilient to stress,” said Darren Gersh, a spokesman for the central bank in Washington.

One concern is damage to infrastructure. The 2001 terror attacks, for example, hit Bank of New York’s telecommunications lines close to the World Trade Center, causing payment disruptions. Since 2001, the bank has strengthened and diversified its disaster recovery procedures, said Ms. Krauss, the bank’s spokeswoman.

“If they have a technical glitch, what happens if the collateral can’t be sent back or the money can’t be sent? That’s wild business,” said Bruce English, who ran the repo desk at Aubrey G. Lanston & Co., which previously was a primary dealer.

Bank of New York has $29.5 trillion in assets under custody or administration. It already handles settlement for all but four of the 23 primary dealers that trade bonds directly with the Fed.

Primary dealers handle the majority of bonds sold in U.S. government auctions. Most subsequent trades in the market also involve primary dealers, and settle at either J.P. Morgan or Bank of New York, although smaller dealers and alternative providers do exist.

Citigroup clears trades of government securities for clients such as hedge funds. BMO Harris Bank, a Chicago based unit of BMO Financial Group with $104 billion in assets under management, is considering expanding its government securities settlement and custody services to broker dealers.

“We think there’s further opportunity,” said Scott Ferris, head of the financial institutions group at BMO Harris.

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Dudley Speech

July 31st, 2016 9:36 pm

Federal Reserve Bank of New York President William Dudley spoke this evening in Indonesia. He created a gaggle of headlines.

Here is a link to the speech.

 

Here are some of the headlines:

*        01-Aug-2016 09:15:00 AM – NEW YORK FED’S DUDLEY SAYS U.S. CENTRAL BANK SHOULD BE CAUTIOUS IN RAISING INTEREST RATES, FLATTER TIGHTENING PATH APPROPRIATE
*        01-Aug-2016 09:15:00 AM – FED’S DUDLEY SAYS PREMATURE TO RULE OUT U.S. RATE HIKE BEFORE END OF 2016
*        01-Aug-2016 09:15:00 AM – DUDLEY SAYS EXPECTS FED TO HIKE MORE THAN ONCE BEFORE END OF 2017
*        01-Aug-2016 09:15:00 AM – FED’S DUDLEY SAYS MEDIUM-TERM RISKS TO U.S. ECONOMIC GROWTH SKEWED TO DOWNSIDE
*        01-Aug-2016 09:15:00 AM – DUDLEY SAYS FED MUST BE A BIT MORE CAREFUL ABOUT TIGHTENING EARLY VS LATE
*        01-Aug-2016 09:15:00 AM – FED’S DUDLEY SAYS RISKS REMAIN ‘ASYMMETRIC’ BECAUSE INTEREST RATES STILL CLOSE TO ZERO
*        01-Aug-2016 09:15:00 AM – DUDLEY SAYS FED EXPECTS LESS AGGRESSIVE TIGHTENING IN PART DUE TO GLOBAL MONETARY EASING, RISING U.S. DOLLAR
*        01-Aug-2016 09:15:00 AM – FED’S DUDLEY SAYS BREXIT AFTERSHOCKS POSE MEDIUM-TERM DOWNSIDE RISKS TO GLOBAL ECONOMY
*        01-Aug-2016 09:15:00 AM – FED’S DUDLEY SAYS U.S. ELECTION UNCERTAINTY COULD FURTHER SOFTEN U.S. BUSINESS INVESTMENT
*        01-Aug-2016 09:15:00 AM – FED’S DUDLEY SAYS INCREASINGLY CLEAR THAT SOME POST-CRISIS HEADWINDS LIKELY PERSISTENT
*        01-Aug-2016 09:15:01 AM – FED’S DUDLEY SAYS EXPECTS 2 PCT U.S. GDP GROWTH OVER NEXT 18 MONTHS AFTER ‘SLUGGISH’ Q2
*        01-Aug-2016 09:15:01 AM – FED’S DUDLEY SAYS CONFIDENT U.S. INFLATION TO RETURN TO CENTRAL BANK’S 2 PCT GOAL OVER MEDIUM TERM

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Aging Baby Boomer Alert

July 31st, 2016 9:29 pm

This week marks the 50th anniversary of the great Beatles album “Revolver”. It followed the even better “Rubber Soul”and preceded one of the greatest rock albums ever, “Sgt.Peppers Lonely Hearts Club Band”. Hard to believe that was half a century ago.

https://en.wikipedia.org/wiki/Revolver_(Beatles_album)

 

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Oil Patch Angst

July 31st, 2016 9:21 pm

Via Bloomberg:
Oil Giants Find There’s Nowhere to Hide From Doomsday Market
Joe Carroll

Exxon posts worst profit in 17 years, missing estimates
Chevron’s third straight loss capped longest streak in decades

 

Exxon Mobil Corp. and Royal Dutch Shell Plc this week reported their lowest quarterly profits since 1999 and 2005, respectively. Chevron Corp.’s third straight loss marked the longest slump in 27 years, and BP Plc lodged its lowest refining margins in six years.

Welcome to year two of a supply overhang so persistent it’s upsetting industry expectations that the market would return to a state of balance between production and demand. It’s left analysts befuddled and investors running to the doorways as the crude market threatened to tip into yet another bear market, dashing hopes that a slump that began in mid 2014 would show signs of abating.

Exxon missed analyst estimates by 23 cents a share and fell as much as 4.5 percent on Friday before recouping some of that decline. Chevron posted a surprise $1.47 billion loss after booking $2.8 billion in writedowns. The company’s per-share loss of 78 cents was in stark contrast to the 19- to 41-cent gains expected by analysts. BP and Shell registered similarly gloomy outcomes.

“What we’re seeing is that there’s just no place for the supermajors to hide,” Brian Youngberg, an analyst at Edward Jones & Co. in St. Louis, said in an interview. “Oil prices, natural gas, refining, it all looks very bad right now.”

Crude prices dropped during the quarter from a year ago amid a global glut in the $1.5 trillion-a-year market. With diesel and gasoline prices also slumping, the companies were deprived of the tempering effect oil refining typically provides during times of low crude prices.

Given the plunge in crude and natural gas markets, “you cannot recover, no matter how efficient you are,” Fadel Gheit, an analyst at Oppenheimer & Co., said during an interview with Bloomberg Television. “The industry cannot survive on current oil prices.”

Shell reported its weakest quarterly result in 11 years and missed analysts’ estimates by more than $1 billion. BP said earnings tumbled 45 percent amid the lowest refining margins for the second quarter since 2010. U.S. margins, based on futures contracts, plunged 30 percent to a second-quarter average of $17.12 a barrel from $24.42 a year earlier.

Refining profits will continue to be under “significant pressure,” BP said. Although Brent crude’s rebound provided some relief compared with the first quarter, CEO Bob Dudley still faces a difficult road ahead as the rally fades amid slowing demand growth and returning production from Canada to Nigeria.

BP’s profit, adjusted for one-time items and inventory changes, dropped to $720 million from $1.3 billion a year earlier, the company said on July 26. That missed the $819 million average estimate of 13 analysts surveyed by Bloomberg. Downstream earnings, which include refining, declined 19 percent.
Output Hurt

Exxon, the world’s biggest oil explorer by market value, said wildfires that ravaged the oil-sands region of Western Canada, along with aging wells, reduced output. Its U.S. oil and natural gas wells lost an average of $5.6 million a day during the quarter.

At Shell, the largest oil producer after Exxon, profit adjusted for one-time items and inventory changes sank 72 percent from a year earlier to $1.05 billion, less than half the $2.16 billion analysts had expected.

Shell Chief Executive Officer Ben Van Beurden, who this year completed the record purchase of BG Group Plc, has vowed to boost savings from the acquisition following the two-year slump in crude.

It was Chevron’s third straight quarterly loss, the longest slump for the company since at least 1989, according to data compiled by Bloomberg.

 

Chevron Chairman and CEO John Watson said the company continues to adjust to the lower-price environment. He has responded to the market-driven cash squeeze by shrinking drilling programs, writing off discoveries that were too costly to develop at current prices and firing one-tenth of the workforce. The company is seeking to bolster its balance sheet by raising $5 billion to $10 billion from asset sales.

Despite the rout, and credit-rating cuts, Chevron greenlighted a $36.8 billion expansion of a key Central Asian oilfield earlier this month. This week, the company committed to distribute a $1.07-a-share dividend that will eat up about $2 billion in cash when paid out to investors in September.

Exxon Chairman and CEO Rex Tillerson has been looking beyond the current downturn in energy markets to augment the company’s gas and oil portfolios from the South Pacific to Africa. The company also is plowing money into expanding refining and chemical complexes from Singapore to The Netherlands, betting that regional demand for products used in automobile tires, engine oil and plastics will grow over the long term.

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Apple Floods Market With Debt

July 30th, 2016 8:08 pm

Via Bloomberg:
July 29, 2016 — 1:13 PM EDT

Debt investors’ irrepressible appetite for Apple Inc. turned the company into the biggest corporate-bond issuer in the world as it raised more than $80 billion in just four years. Now, some analysts are asking whether that’s too much, too fast.

On Thursday, Apple sold $7 billion of bonds, its seventh multi-billion dollar offering since 2013 and third this year. Investors flocked to the sale, allowing the iPhone maker to reduce yields it initially offered to pay on the securities. Bond buyers shrugged off concerns that the company might be borrowing too zealously to back share repurchases rather than financing the move by repatriating the $215 billion of cash it holds overseas.

Starting from almost nothing in 2012, Apple’s borrowings have risen nine times faster than its cash, according to data compiled by Bloomberg. The debt has allowed the company to buy back $116 billion in shares over a five-year period through March 2016. Investors have gladly funded the buybacks, with demand so overwhelming that the company has been able to lower its borrowing costs each year.

“You kind of take a look and do a sanity check,” said Gerald Granovsky, an analyst at Moody’s Investors Service. It doesn’t make sense for Apple to have that much debt “no matter where the cash balance is.”

Josh Rosenstock, a spokesman for Apple, declined to comment.

Through the first quarter of 2016, Apple bought back more than twice as much stock as any other S&P 500 company, according to data from S&P Dow Jones Indexes. “I don’t think anyone is near Apple’s stratosphere on what they buy back on an annual basis,” said Granovsky, who assigned the bonds an Aa1 rating, the second-highest rank.

 

Apple, which generates almost two-thirds of its revenue from iPhones, has been relying on share buybacks to help boost its stock price as the global market for smartphones cools. Growth in the smartphone industry will slow to 3.1 percent this year, down from 11 percent last year and 28 percent in 2014, according to researcher IDC. Apple shares have dropped more than 15 percent from their peak a year ago.

Apple this week said a slump in iPhone sales eased in the three months ended June 25, helped by demand for its new SE model, a low-end device aimed at consumers in China and other emerging regions. Still, iPhone unit sales were down 15 percent from a year earlier.

“Apple is just a fairly risky company from a business perspective,” said Jordan Chalfin, an analyst at debt research firm CreditSights, who has the equivalent of a sell rating on Apple bonds. “If they miss a trend or somebody comes out with something better, it makes it very difficult for them to maintain market share.”

In a note analyzing Apple’s bond offering, Chalfin advised clients to hold on to their cash for Microsoft Corp., which he described as “a much safer credit than Apple.” Microsoft and Oracle Corp., have also sold debt this year to fund shareholder rewards.

Still, Apple’s frequent issuance remains a draw for investors. John Majoros, a money manager at Wasmer, Schroeder & Co., which manages $6.2 billion, including Apple bonds, said the regularity of the deals meant the bonds were more attractive than other AA rated notes.
Trade Cheap

“We believe they have a lot of value,” Majoros said. “They trade cheap to their rating, there’s no question about it.”

The longest portion of Apple’s $7 billion sale on Thursday was $2 billion of 3.85 percent 30-year bonds that yield 1.63 percentage points above comparable government debt, according to data compiled by Bloomberg. That compares with an average spread of 1.13 percentage points on bonds of similar ratings and maturities, according to Bank of America Merrill Lynch index data.

S&P Global Ratings isn’t concerned about Apple’s growing debt pile. The ratings firm maintained its equivalent AA+ credit grade on Apple’s long-term debt and gave the new bonds the same ranking in a note reviewing the bond sale on Thursday. S&P described Apple’s financial risk as “minimal” and labeled its financial policy “conservative.”

“Although we expect total shareholder returns to exceed free operating cash flow on occasion, robust overall cash generation affords the company the flexibility to return large amounts of cash to shareholders without detracting from the overall credit quality,” S&P analysts led by Andrew Chang wrote.

Moody’s Granovsky says that Apple’s credit quality may not always be as strong. Slowing iPhone sales, a challenging market for refinancing or investor wariness toward technology company bonds “may not be congruent with an Aa1 stable rating,” in future, he said. “We have to recognize that if there’s such a concept of ‘weakly positioned’ at that rating level, it’s probably it.”

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