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SoberLook

Sober Look is a no-hype financial blog that relies on data analysis and primary sources. Posts are intended to be succinct, to the point, with no self-promoting nonsense, and no long-winded opinions. If you are looking for Armageddon predictions or conspiracy theories, you will be thoroughly disappointed. Topics include U.S. and global economic developments and financial markets. We often cover asset management, energy/commodities markets, derivatives, regulation, and policy - with a particular focus on capital markets and financial risk.

Articles by SoberLook

Why Won’t the Fed Raise Rates?

September 17, 2016

Guest post by Norman Mogil

When the Federal Reserve’s Open Market Committee (FOMC) meets in the coming week, there will be pressure from various quarters to raise the federal funds rate. Jamie Dimon, chairman of JP Morgan, has stated blankly “Let’s just raise rates."  Furthermore, he has said a quarter point is just a “drop in the bucket."  We know where the big money banks stand on the issue. They need higher rates to achieve better profit margins. But even from other financial quarters, there are calls for the Fed to stop speaking and start acting. Many point to that fact that the labour markets have recovered very well from the 2008 crash and that the economy is hovering around full employment. Although the Fed’s inflation target has not yet been reached, there are many who warn that the real risk now lies in getting behind the curve. Once the inflation genie is out of the bottle, they argue, it will be too hard or, at least painful, to put back.  So, why is that the Fed so reticent to start a real move towards ‘normalizing’ credit conditions? The Level of Interest Rates In a speech last week, Fed Governor Lael Brainard offered an insight into this question (1). The clue to her thinking lies in the analysis of the "neutral rate of interest.

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The ECB’s corporate bond purchase programme takes shape

August 29, 2016

Guest post by Marcello MinennaWith the awaited decision of August 4, even the Bank of England has put aside any delay and has steered towards an aggressive expansionary monetary policy to contrast the recessionary pressures due to the Brexit shock on market expectations. Apart from the expected interest rate cut of 25 basis points, different unconventional measures stand out: a 6-months resumption of the government bonds (Gilts) buying programme for a monthly amount of $ 60 billion, to be combined in synergy with the purchase of £ 10 billion of corporate bonds in 18 months.The intervention in the corporate debt markets remains one of the most incisive tools in the hands of the central banks in order to induce a reduction in the funding costs of the non-financial sector and bypass the credit crunch due to a distressed banking system. At the state of the art, corporate bonds purchase programs are active in Japan, UK and in the Eurozone. On many occasions the Bank of japan has accelerated the pace of the purchases, even if now it appears it has reached its limits of intervention: the size of the market is not ample enough to support further expansions of the program, while the big Japanese industrial corporations are able to finance themselves at near zero interest rates (recently Toyota succeeded in placing a 3-years bond by offering a yield of 0.001%).

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What is Behind the Surge in the Corporate Debt

August 29, 2016

Guest post by Norman MogilJust as governments are cutting back on issuing new debt, the corporate sector has taken up the role of being the largest source of new debt in the United States. This shift in debt issuance is readily apparent in Chart 1. Since the crisis of 2008, the growth in government debt has dramatically decreased from nearly 20 per cent annually to less than 5 per cent, more in line with the nominal growth in the economy. Consumers continue to remain wary of increasing their debt load . On the other hand, the corporate bond market has been on a bit of a tear in recent years .That segment of the debt market now outpaces all other debt issuers. The U.S. corporate bond market is valued at nearly US $9 trillion; by comparison, it is larger than the GDP of Germany, France and the U.K. combined. No longer are governments the leaders in generating new debt, it has ceded that title to corporate America.
Chart 1: Growth Rates in Debt of U.S. Non-financial Sector 2010-2015

As investors search for yield, corporate bonds are viewed as the darlings of the debt market, principally due to higher yields offered. As the demand for corporates grows, the spread in yields between corporates and U.S. Treasuries has narrowed, a further sign of the strength of the corporate bond market, thus encouraging more companies to issue debt.

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The Big Disconnect in the Pension Industry

July 25, 2016

Guest post by Norman Mogil
When two of the biggest US pension funds reported very disappointing financial results this month,  it became apparent that the pension industry needs a reality check. For the past fiscal year the California Public Employees’ Retirement System earned a merger return of 0.6 percent on its investments; the California State Teachers’ Retirement System did only marginal better, clocking an investment return of 1.4 percent. Both funds had a target rate of return 7.5 percent . To be fair, one year`s result does not make a trend, but the results were so far below target as to warrant an examination of the new world confronting pension fund managers.
Underfunding of Public and Private Funds 
We begin by taking the measure of how far  public pension funds (Chart 1) and corporate pension  funds (Chart 2) are underfunded. Underfunding is a moving target over time and is reflective of several moving parts, such as : shifts in demographics (an aging population); estimates of longevity of retirees;  economic performance (slow growth means lower contributions); and rates of return on various asset classes. In the US, both public and private pensions have experienced a steady erosion in funding status over the past decade and a half. The large public pension plans and large corporations only support 75-80  percent of liabilities today.

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The Looming Shortage in Government Bonds

July 16, 2016

Guest post by Norman Mogil
Ever since the 2008 financial crisis, there has been a persistent shortage of high-quality government debt. More than just a safe haven in times of financial stress— the so-called ‘flight to quality’ —   the supply of  high- quality sovereign debt has been steadily shrinking. This shortage became acutely apparent with the results of the Brexit referendum as investors worldwide bid up bond prices to the point where most long term bond yields reached historic lows in the US, UK , Germany and Japan. Brexit only exacerbated a shortage problem that bond investors have had to contend with for nearly a decade. The current  squeeze in supply is just the latest manifestation of this wider issue in today’s financial markets.
To claim that there is a shortage of government debt must seem counter-intuitive to many readers. After all, there is no end of studies demonstrating that major economies have record high  government debt-to- GDP ratios, signifying that there is too much debt, not too little. Many critics call for governments everywhere to issue less debt, arguing that such high levels of debt ratios contribute to sluggish growth, if not, outright stagnation. European governments continue to exercise spending restraints and, in general, austerity is the byword throughout the industrialized world.

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What the Bond Market is Telling Investors

June 19, 2016

Guest post by Norman Mogil

Over the past month, the global bond markets have been sending out signals that all is not well with the global economies. Initially, the surge in negative nominal rates in Europe and Japan rattled many investors in both the fixed income and equities markets. This historic development suggests that large-scale investors are anticipating low growth and disinflation for many more years. Simultaneously,  the yield curve, especially in the US, has been flattening, again signalling that growth is slowing, giving the policy makers considerable  pause in their deliberations on the course of future interest rates. This blog examines both these developments to help the reader understand the signals coming out of the bond markets around the world.

Nominal and Real Rates of Interest

For more than a year, short to medium term rates of interest in many countries have landed in negative territory. The ECB instituted negative overnight lending rates in an effort to discourage commercial banks from depositing excess reserves with the ECB; instead, these such funds should be made available to their borrowers in the hope of stimulating loan demand throughout the region. More recently, the ECB started to buy, initially, longer dated sovereign debt from member countries in the expectation that long-term rates would fall to stimulate investment growth.

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The fall in commodity prices hits the Canadian banks

June 8, 2016

Guest post by Norman Mogil

With the release of Canadian banks’ second-quarter results, investors are beginning to measure the impact of the oil price collapse on the domestic financial industry. Widespread are the write-downs and other provisions the banks are taking in response to the weakened credit quality of many clients in the oil patch. This blog looks at this issue and its implications for future bank stock performance.

On the whole, the Canadian banks turned in a profitable second quarter, although in some instances profits declined ( e.g. Scotiabank and BMO Montreal). The banking sector continues to show respectable results in its retail and consumer loan divisions. Also, their mortgage portfolio remains healthy, supported, to a great measure, by good loan-to-value measures and mortgage insurance. Finally, the banks’ capital ratios meet international standards as the they continue to improve in this area. Where the banks face the biggest challenge is with their loans to the energy and commodity sectors in Canada and the United States.

Provisions for Loan Losses (PCL). Chart 1 measures the loan losses for the major Canadian banks in terms of a percentage of the average loans outstanding. PCLs represent loans that have been written down for non-performance. There has been a dramatic increase since 2015 Q4 results as the slump in the oil prices take its toll.

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US labor markets take a turn for the worse

June 6, 2016

Friday’s US payrolls report, which to a large extent represents a latent effect of the US dollar rally over the past couple of years, was dismal. On a relative basis, hiring Americans has become more expensive for global firms. An elevated level of uncertainty, driven in part by risks associated with the US monetary policy as well as the presidential elections, has not helped.

Let’s look at some trends in the labor markets.

1. The job market’s weakness has now spread to the services sector.

 

Source: BofAML

2. After a strong showing over a previous couple of months, US labor force participation has turned lower.

 

3. Even as the headline unemployment rate (U-3) declined to lows not seen since 2007, a broader measure of unemployment, which includes marginally attached workers plus those employed part-time for economic reasons (U-6), has stalled.

 

Below is the ratio of the headline jobless rate to the broad (U-6) unemployment over the past couple of decades. While fewer people are filing for unemployment benefits, the health of the broader labor market has significant room for improvement.

 

4. Related to the above, here is part-time employment for "economic reasons".

 

5. US manufacturing jobs growth has worsened again on a year-over-year basis.

 

6. Wage growth is back below 2.5% (YoY).

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The Decline in Canadian Business Investment

June 6, 2016

Guest post by Norman Mogil

Business Investment  “depends on the prospective yield of capital, and not merely on its current yield” , John Maynard Keynes

One of the many puzzles of the recovery since the 2008 crisis has been the corporate sector’s reluctance to add to a nation’s capital stock. Investment in new plant and equipment along with the construction of new productive facilities has lagged behind the experience of previous recoveries. Throughout the industrialized world, the rate of growth in fixed capital investment has been dismal, resulting in below average rates of growth in national income. The decline in business investment has been quite dramatic. In North America business fixed capital investment is running 20 percent lower that recorded in 2007. (See Chart 1)

 

Source: BIS

This dramatic weakness in capital formation is worrisome given all the factors that one would expect would generate a flourish in capital expenditures. Central banks have implemented unprecedented monetary stimuli in the form of zero interest rate and quantitative easing, contributing to the dramatic fall in long-term interest rates. Corporate profit margins are at historic high, and retained earnings continue to grow.

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Disentangling the nature of Italy’s capital flights

May 9, 2016

The ECB T-LTROs and the QE efforts are fueling significant outflows toward the core countries, driven by the non-banking sector. 

Guest post by Marcello Minenna

Net balances in the Eurozone continue to widen as capital flows from the periphery to Germany and other core countries. Much of the convergence in net balances that took place between 2012 and 2014 has reversed. As for the underlying reasons, we’ll show that empirical evidence points mainly to the combined effects of the new ECB programs of monetary expansion (T-LTROs and Quantitative Easing).  As of March of this year, Italy reported its largest Target 2 net deficit 2012 (€ -263 billion), followed closely by Spain (€ -262 billion) and Greece (€ -95 billion). Germany’s Bundesbank saw its surplus grow to over € +600 billion once again (see Figure 1).

 
Figure 1.

The ECB itself has seen its deficit widen to  € -90 billion due to quantitative easing purchases (see Figure 3).  Around 10% of QE assets are risk-shared between Eurozone countries and thus are accounted as an ECB “debt” towards National Central Banks (NCBs).

 
Figure 2.

This unusual accounting confirms that, also because of complex technicalities involved, a clear explanation of the driving components of this central banks’ accounting method continues to prove elusive.

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Fiscal Policy to the Rescue?

May 9, 2016

Guest post by Norman Mogil

When appearing before their political masters, central bankers, invariably, urge them to adopt an expansionary fiscal policy. Ben Bernanke, and now his successor, Janet Yellen have pleaded with Congress to adopt a more simulative fiscal policy. Mario Draghi continuously stresses the need for fiscal policy in support of the ECB’s easy money policy. Most recently, the head of the IMF, Christine Lagarde, stated that some countries “may have room for fiscal expansion", citing Canada as one country that has "made the most of this space." Indeed, the Governor of the Bank of Canada (BoC) has made it a selling point that they believe that Canada’s latest fiscal stimulus measures will have a positive effect on the real GDP. In part, the fiscal policy shift has allowed the BoC to refrain from cutting its lending bank rate.

Monetary policy is reaching its limits in terms of stimulating economic activity and has carried that burden well beyond what was envisioned immediately after the 2008 crisis. This blog looks at the issue of fiscal policy, especially the fiscal multipliers that are considered to be the drivers behind the movement towards fiscal expansion.

The Multipliers

The Keynesian multiplier is at the centre of  the analytical debate regarding the impact of a central government’s budget on promoting growth.

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Understanding Negative Interest Rates

April 11, 2016

Guest post by Norman Mogil

When the central banks of three European countries and the European Central Bank (ECB) itself introduced negative interest rates (NIR)  in mid -2014, many considered it be a temporary measure, a new experiment in monetary policy. But when the Bank of Japan did the same in January 2016  and when the ECB  pushed rates further into negative territory in March 2016, the international investment world stood up and took notice. Policy makers are now prepared to test this unconventional technique in an effort to stimulate growth and tackle deflation.

The financial press is full of articles on the dangers of this policy. These unconventional moves have provoked a lot of criticism, especially from the banking community who fear a strangulation of normal banking activities. A lot has been written about the dangers that NIR  pose to the stability of banks and to the possible harm to savers and investors alike. This article is an attempt to put the whole question of NIR into a more balanced perspective. To begin with, it is important to have some background to why and how NIRs have come to characterize so much of government debt.

How Pervasive are NIRs?

According to the JP Morgan international bond index, approximately 25% of its government bond index is in negative territory ( see Chart1).

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Canada`s Fiscal Policy Shift

March 24, 2016

Guest post by Norman Mogil

After nearly a decade of fiscal policy taking a back seat to monetary policy, the newly elected Liberal Government moved public spending into the driver`s seat with its first budget since the election last October. Canada will now use fiscal deficits to re-invigorate its limping economy. It has launched a policy of fiscal stimulus, lead by large infrastructure investment for at least the next five years. While the political analysts argue as to which election promises were kept and which were broken, the principle issue in the budget concerns the role of deficits in generating economic well-being.Deficit financing has been used in Canada several times over the past four decades, as successive governments contended with economic downturns (Chart 1). Recovery from the severe recession of 1980-82 and again in  1991-93, Canada ran very large deficits – in excess of 4% of GDP. From 1997 to 2008 government finances returned to the black, only to be hit hard with the 2008 global crisis, necessitating a return to deficits in the order of 3% of GDP . That deficit position was ultimately eliminated by 2014-15.

Once again, Canada faces a very difficult economic environment and now turns to deficit financing to clear a path towards higher economic growth.

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Canada`s Changing Financial Landscape, Part 3: Lifecos and Real Estate

March 14, 2016

Guest post by Norman Mogil

LifecosAlthough innocent bystanders in the 2008 financial crisis, the life insurance companies were most impacted by the knock-on effects of the fall in equity prices, declines in long-term interest rates, poor credit quality of debt and a general decline in economic activity.As Table 1 demonstrates, the industry remains permanently ( i.e. long lastingly) impaired. Share prices of the major lifecos are, largely, below pre-2008 levels and/or have not participated in the upswing of equity prices enjoyed by other financial institutions. Major lifecos, such as Manulife and Sunlife, remain well below levels of a decade ago. More importantly,  prior to the 2008 crisis, the industry commanded price-to-book values  of 2.5 times, only to see that metric drop down to 1.5 times today. The industry continues to face a challenge of repairing  balance sheets and of tailoring their products to reflect the changes in today`s economic environment.
Above all else, the lifecos have suffered at the hands of today’s low-interest rate world. They are in a constant struggle to match  the return on assets to the requirements of future liabilities. Re-investing fixed income assets at successively lower rates, in effect, increases the risk of long-term liabilities. In particular, the liabilities most at risk are annuities and guaranteed income products.

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China’s Wealth Management Products, a Q&A

March 7, 2016

We’ve had a number of questions regarding the growth and the risks surrounding China’s Wealth Management Products (WMPs). Here is an overview in a Q&A format.Q: What are the reasons for the continuing demand and proliferation of WMPs in China?1. China’s bank deposit rates have been extremely low over the past decade and until recently have been artificially capped by the nation’s central bank, the PBoC. The reason for these low rates is Beijing’s effort to make sure that the banking system has access to cheap financing in order to stimulate credit growth.
Source: Tradingeconomics, PBoC

These days, awash with deposits, many banks pay even less than the latest rate set by the PBoC. Here is one example showing why China’s depositors have been desperate for yield.
Source: Bank of China (one of the 5 biggest state-owned commercial banks in China)

2. Another reason for the explosion in WMPs in China is the rapid growth in money supply, with limited options to deploy all the new cash. The chart below shows China’s  broad money supply (M2), now 15 times the size it was at the end of 1999. That’s a great deal of liquidity sloshing around.

3. More money poured into WMOs last year after the massive "correction" in China’s stock market, as investors looked for other sources of yield.
Q. What rates do banks offer to their WMP customers?
A.

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Canada’s Changing Financial Landscape: Part 2, Banking

March 6, 2016

Guest post by Norman MogilCanadians generally take pride  that their banks have been able to weather the 2008 storm well and continue to exhibit solid performance . Recent financial results point to growing profits, increases in dividends and improvements in reserve requirements. Yet, the industry is aware of serious challenges from the collapse of oil prices as well as the challenges that all banks worldwide face from a low or negative interest rate environment. In this blog we will look at what will influence the performance of the Canadian banks in the near term.For the benefit of our American readers, we should point out there are significant differences  between the Canadian and US banking systems. The industry in Canada is dominated by six large banks ( Big Six) which are national in scope, each having as many as one thousand branches throughout the country and each providing a full range of commercial and personal banking services ( much like the money centre banks in the US) . There are  dozens of much smaller banks that operate only regionally or in specific market segments In the US, even after a consolidation ,post-2008, there are about 7000  commercial banks and savings institutions , the majority of which operate independently only in local communities and have no national presence.

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The Fed could be back in play in 2016

February 28, 2016

One or more rate hikes by the Federal Reserve in 2016 remains a real possibility. Why would the Fed consider such a policy action given the recent collapse in inflation expectations?Over the past couple of months many analysts and the futures markets have assigned a rather high probability to the so-called "one and done" – no change in policy in 2016. Indeed, here is what we’ve heard recently from St. Louis Fed President James Bullard:
Reuters: – The Federal Reserve must act to stop inflation expectations from getting too low, St. Louis Fed President James Bullard said on Wednesday, reiterating his concerns about continuing to raise interest rates.The U.S. central bank cannot let low inflation expectations "get out of hand," he told a dinner of bond traders here, adding he "can’t stomach" currently low readings. "It’s just that they’ve fallen so far that it’s got to be a concern."

Source: @auaurelija

However a number of researches have suggested that with a relatively stable core inflation in the United States, oil prices would need to collapse to levels that are neither consistent with today’s forward curve nor sustainable. Therefore, these studies argue, the current market-based inflation expectations are simply irrational.1. Here is the latest analysis from Goldman Sachs.

Source: Goldman Sachs

2. Also, a study from the St. Louis Fed shows a similar result.

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Canada`s Changing Financial Landscape, Part 1: the Securities Industry

February 21, 2016

Guest post by Norman Mogil

The worldwide collapse in commodity prices is now working its way through the financial markets in Canada.  Canada is just now experiencing  fundamental changes in the financial community, the sector  better known as F.I.RE  ( Finance, Insurance and Real Estate ) . This sector accounts for approximately 20% of national income and employs more than one million workers, providing a  broad spectrum of  services to all parts of the economy. One subsector, in particular, the investment or securities industry has been hardest hit of late.. This blog examines the adjustments in the securities industry; future blogs will look at the banks, life insurance and real estate markets.To appreciate just how much the F.I.R.E. industry has suffered , we turn to the TSX and its major components as listed in Table 1.  In the period 2007 to 2014, the Canadian stock market as a whole fell by 4%. However, the  financial sector as a whole  performed relatively well increasing by some 21%, largely on the back of the commercial banks, supported by good loan  growth and capital market activities.  However, within the investment community, independent investment houses have taken quite a beating. The two publicly traded companies, GMP and Canaccord, have seen their corporate value been  truly been decimated ( a price drop of  80%) .

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The case for “global quantitative tightening”

February 14, 2016

Guest post by Marcello MinennaIn January 2016, global foreign reserves (FX) continued their decline after an absolute peak in June 2014, declining significantly in distressed emerging countries and some notable oil-producing economies (see Figure 1).Figure 1.

China and Saudi Arabia, the leading owners of foreign reserves outside the OECD circle, both experienced an outflow greater than 5% of their outstanding reserves in less than 6 months (see Figure 2). A common factor explains these drawdowns: both the countries are struggling to defend their currency peg to the Dollar. The pressures on the exchange rates can be traced back to three intertwined drivers: the (still to come) interest rate hike cycle in the US, the low oil price and the China slow growth. While the “US rate hike tantrum” can be considered as a symmetrical shock for all the worlds currency different from the Dollar, the other factors have hit the distressed countries in differentiated ways.From the Chinese side, the worsening growth’s prospects and strong capital outflows are forcing the People bank of China (PBOC) to employ its FX reserves with the aim to manage a controlled, but unavoidable, devaluation. Meanwhile, the persistent slump oil price (that depends a lot from China’s slowdown) have decimated the revenues of the Saudis.

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The Golden Age

February 8, 2016

Guest post by $hane ObataSome people say that gold is dead. They point to deflationary pressures and a bear market that started back in September of 2011. The bulls have been wrong for years; however, that may be about to change…At present, there are multiple reasons to consider gold:Sentiment is very negative and almost everyone is underweight
Supply & demand fundamentals are positive
Chinese demand continues to rise
Gold is a means to portfolio diversification
The main risks to prices are overblown

In the next sections, we will examine the bull case for gold and the risks facing it. In conclusion, we will try to answer the following question: Is this the beginning of a new golden age?Sentiment & PositioningIn the latest Barron’s Big Money Poll, only 3% of respondents thought that gold was the most attractive asset class. Moreover, 71% were bearish on the yellow metal. Volume traded in $GLD (the SPDR Gold Trust ETF) has come down dramatically, which indicates a lack of interest in gold bullion. Volume traded in $GDX (miners) and $GDXJ (junior miners) has been increasing; however, interest in “gold mining stocks” has been falling since mid-2011. This suggests that traders are trying to catch the falling knife, even though investors are not convinced that gold is undervalued.In terms of positioning, market participants are heavily underweight materials and commodity stocks.

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Canada Adjusts to the Oil Price Shock

February 7, 2016

Guest post by Norman Mogil

What does the oil price  collapse mean for Canada?  A simple question with an  the answer  that is anything but simple. As the Governor of the Bank of Canada (BoC), stated  the "oil price shock  is complex because it sets in motion several forces " that will alter the  path of Canada’s economic future. The Governor  goes on to argue that "it may take up to three years for the full economic impact to be felt, and even longer for all of the structural adjustments to take place.”  Just what are the structural and time factors that we need to understand as we adjust to the new environment of lower commodity prices?We start out by considering the structure of the  Canadian economy. This will  help identify how the various sectors of the economy will be impacted in the future. Broadly speaking, Canada is a service-based economy (70% of output) and only selectively a goods-producing  country (30%). The largest component of services is the finance, insurance and real estate (FIRE) which now comprises about 20% of national income. These industries surpass the contribution of mining, oil/gas and energy distribution (17%) and manufacturing (10%). The strength of the services sector blunts much of the pain of falling oil prices.

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US consumer is the last defense against strong dollar drag on the economy

January 30, 2016

We continue to receive questions about the impact of the recent dollar strengthening on the US economy. The most immediate impact of course is on trade, which has created an immediate drag on the GDP growth.
Source: St Louis Fed, Goldman Sachs

We know that the impact on US industrial production in particular has been terrible.

On the other hand this currency appreciation, combined with weaker energy prices, is supposed to improve consumption as imports become cheaper.
The chart shows US import price index

And of course all the cheap fuel (combined with a warmer winter) should be providing material support to US households.
US average gasoline price

Will that be enough to give US consumer spending a boost? Goldman outlines two potential scenarios, the second one of which leads to a contraction in US gross output.
Source: Goldman Sachs

The full impact of the US dollar rally thus depends very much on the behavior of the consumer in the months to come. From a balance sheet perspective US households certainly don’t seem to be "stressed", as the Financial Obligations Ratio remains near multi-decade lows.
Source: @SoberLook, FRB

Moreover, high-frequency economic sentiment data, while showing some stock-market induced jitters, remains robust.
Source: Gallup

Whether this will translate into stable spending patterns remains a question.

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Currency Realignment and Export Growth

January 24, 2016

Guest post by Norman MogilThe realignment of currencies in the past 18 months has been the most dramatic in decades.  A perfect storm is occurring:  Federal Reserve tightening; Eurozone and Asian monetary easing; and  a collapse of major commodities, all conspire to drive  just about every currency in the world to lower values against the USD. Governments are anticipating that this re-alignment will revive economic growth, lead by the external sector.  How likely is to happen?Two recent studies, from the IMF and OECD,  draw attention to the question of
how effective are devaluations in changing the fortunes of "open" economies. The term "open" refers to those economies which generate  a significant portion of national income from exports, such as Germany, Canada, and several Asian economies.  Before reporting on the studies, it is helpful to get a sense of the reasons behind devaluations, the extent of currency adjustments  and the importance of exports to major trading nations.Table 1 groups these devaluations by size and by importance as measured by the contribution of exports to national income.* Depreciation in excess of 25% The greatest depreciations has happened in those countries that are highly dependent on commodity exports, — Russia, Canada, Australia and South Africa.

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Big Bad China

January 20, 2016

Guest post by $hane Obata

It seems like every day we are inundated with news out of China. Investors are already concerned. The offshore renminbi (CNH) is more international than the onshore one (CNY), which is tightly managed by the government. As such, the rising spread (CNH-CNY) between the two may be indicative of mounting skepticism about China’s economy and its markets. Likewise, capital is fleeing the country as hot money flows have accelerated:
Source: @vikramreuters

In the following sections we will attempt to analyze China’s markets and determine the biggest risks facing its economy. Lastly, we will try to answer the following question: does it matter to us?Financial MarketsAs the first week of trading in 2016 came to an end, the Chinese markets had already been halted twice. Newly minted circuit breakers, which have since been suspended, were triggered when China’s main equity index, the CSI 300, fell 7% on two separate occasions. The first selloff was triggered by a rumor that the China Securities Regulatory Commission (CSRC) was planning to suspend a short sale ban that has kept a reported ~$185 billion off the market. Subsequently, the CSRC decided to extend the ban in order to calm the markets. The second drop followed a significant devaluation of yuan by the People’s Bank of China (PBOC). China has also backtracked on that move.

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Canadians Start the New Year with Some Trepidation

January 17, 2016

Canadians Look to 2016 with TrepidationGuest post by Norman Mogil Trepidation is often defined as a worry or fear of what is going to happen. This best describes the feeling many Canadian investors have regarding the  economic outlook for 2016. It all started with the dramatic collapse of world oil prices in 2014, the continued decline through 2015 and  then  into January 2016.  To get a better appreciation of why there is growing concern for 2016, let us review the basic developments of 2015 and how they may impact on developments in  2016.Table 1 identifies some of the key economic developments of 2015 that are now weighing on our minds as we launch into 2016.

* Economic growth. The year 2015 started off badly as the economy contracted, and, by the summer GDP  had fallen for two consecutive quarters, technically a recession. The Q4 will likely be slightly positive, but for the year as a whole, observers expect GDP will be near 1%. Not a good handoff to 2016* Unemployment. The unemployment rate crept up during 2015 from 6.8% to 7.1%. More significantly, the quality of job creation leaves a lot to be desired. In December,  for example,  the economy created 23,000 additional  jobs;  however there was a loss of  17,000 full time paying jobs against a gain of 40,000 self-employed  workers.*Inflation.

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Bets against the dot plot go into overdrive

January 17, 2016

Continuing with our earlier discussion, betting against the FOMC’s dot plot accelerated on Friday, as the Fed Funds futures spiked. With the equity markets and crude oil pummeled (as deflationary risks rise again), the January 2016 contract trading volume shot to new highs, with the contract price rising sharply (implied Fed Funds rate fell).
Source: barchart

Source: Investing.com

Bets against the FOMC’s forecast gained momentum after significantly worse-than-expected US industrial production and NY manufacturing reports. In fact the NY Fed manufacturing figure was so bad, many initially thought it was an error. Welcome to the world of strong US dollar …

As a result, the implied probability of 4 (or greater) rate hikes in 2016 (as predicted by the dot plot) dropped from 4.7% on Wednesday to under 1% on Friday. On the other hand, the probability of no hikes this year doubled in just two days.
Source: CME

This has significant implications for the US dollar and risk assets. If the Fed is indeed on hold for some time, with possibly just one hike this year (if that), we should see the dollar come under pressure and commodity prices stabilize.

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6 reasons why markets discount the FOMC’s rate forecasts for 2016

January 11, 2016

As discussed in the previous post (here), the markets have completely discounted the stellar US payrolls report when projecting the Fed’s policy path in 2016. Futures-implied probability of 4 rate hikes (or higher) is only 6.5%. Why is the market so "dovish" relative to the FOMC?As a backdrop, we now know from the FOMC minutes that the Committee members were quite jittery about disinflationary pressures, with many being ambivalent in their decision to raise rates in December.
Source: FOMC Minutes, FRB

Is the long-awaited jump in inflation about to make itself visible? Market participants remain skeptical. Here are some key reasons.1. Most analysts have been forecasting – for some time now – a significant increase in US wages as the labor markets tighten. However thus far we have seen little evidence for this "acceleration", with wages persistently growing below 2.5% per year.
2. With US crude oil prices below $33/bbl, many believe the energy impact on inflation is yet to be fully reflected in the official figures. Moreover, some think that weak energy prices will even partially bleed into the core PCE inflation measure (on a delayed basis).
Source: Investing.com

3. China’s ongoing devaluation will continue putting pressure on prices in the US as well.
As an example, the December jump in iron ore prices has been nearly fully reversed as China-related worries returned.

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Four rate hikes in 2016? Markets say “nonsense” even after the strong payrolls report

January 10, 2016

On Friday the US Department of Labor report on US payrolls was significantly stronger than expected. Given such excellent economic news one would think the FOMC is going to continue on its path of steadily raising rates.
Source: Investing.com

Fixed income markets however don’t believe that to be the case. The chart below shows the January 2017 Fed Funds futures contract over the past 3 days. The higher the value the lower the implied Fed Funds rate. The contract initially sold off sharply upon the announcement of the jobs figures but rallied shortly after. It ended up higher than it was prior to the report, indicating that the market expects the Fed to actually be less, not more aggressive in raising rates – even in the face of this strong employment report.
Source: barchart.com

The FOMC dot plot in December indicated that the Fed will hike rates four times in 2016. Surely with such an unexpected improvement in jobs, the Fed has to follow up on its "promises".
Source: FRB

Nonetheless, markets are completely discounting this projection, assigning only a 6.5% probability to a 4 or higher number of hikes in 2016. The chart below shows the futures-implied probability of rate hikes in 2016, with the horizontal axis representing the number of rate increases. This 4-or-higher probability is in fact materially lower than it was a couple of days prior to the payrolls report.

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Watch the Fed’s RRP facility uptake jump at year-end

December 20, 2015

The Fed’s policy announcement to raise rates had one technical detail that didn’t get much media attention but is actually quite important. The reverse repo (RRP) rate was not only raised from 5bp to 25bp but the Fed also removed the cap on the RRP facility (which was at $300bn). It means that the program participants such as banks and money market funds can place nearly unlimited amounts of liquidity with the Fed overnight and earn 25bp. For now the Fed made $2 trillion of treasuries available for the RRP operations.This sets the overnight riskless rate at 25bp which becomes the floor for the Fed Funds rate (and other money market rates such as commercial paper and private repo).The immediate demand to place overnight funds with the RRP facility has been relatively modest at $143bn (note that we should see the reserves at the Fed drained by the uptake amount in the next H.3 report).
Source: NY Fed

Instead of using RRP, many market participants are enjoying the tightness in the private repo markets as general collateral (GC) repo now clears about 20bp above the RRP rate. The key reason for this relatively elevated spread is the increased regulatory pressure on banks to cut back on their balance sheet usage.
Source: DTCC

However the RRP demand is expected to spike at year-end as banks focus on window dressing.

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