Author Archive for Sober Look

Betting Against the FOMC Could end Badly

By Sober Look

In spite of the dovish tone from Janet Yellen at the press conference last week, the short term rates markets are betting that the Fed will become even more dovish in the months to come. Fed funds rates trajectory implied by the futures markets is significantly below the median projection by the FOMC.

Fed funds vs the Fed

Fed funds and eurodollar futures traders are playing the carry game – going long futures a couple of years out and riding them down the curve. The strategy had worked in the past. But is the Fed really going to turn more dovish? Barclays researchers believe that just the opposite will occur and the trajectory of rate hikes will steepen.

Barclays: – The “dots” also showed a faster pace for the hiking cycle. Notably, this occurred despite the fact that the revisions to the Fed’s inflation and UR [unemployment rate] projections were not very aggressive. We believe revisions are likely to continue in the same direction, i.e., lower UR and higher inflation; in turn, the path for the funds rate implied by the “dots” should continue to steepen.

The spread between the market and the FOMC is now close to extreme levels. The Fed’s projected rate “dots” have been rising, while the futures traders continue to ignore it.

Fed vs market

At some point however this is going to come to a head.

Barclays: – … on balance, the Fed’s embedded economic projections are not too aggressive. While Fed Chair Yellen’s dovish stance may be playing a role in keeping rate hike expectations muted for now, if inflation surprises to the upside, Fedspeak can take a far less dovish tone (note the abrupt change by the BoE).

Is the Recent US CPI Increase Just Noise?

By Sober Look

At her press conference yesterday, Janet Yellen dismissed the stronger than expected CPI report, as “noise”. She was quite clear. Inflation remains below the Fed’s target and is likely to stay there for some time.

Inflation sensitive assets such as gold however rallied in reaction to this dovish stance from the Fed.


If the CPI report from the US Bureau of Labor Statistics was “noise”, is there another indicator that can give us a sense of where prices are headed? Today’s Philly Fed report provided one such an indicator. The Manufacturing Prices Paid Index clearly showed firmer upstream prices.

Philly Fed Manufacturing Prices Paid Index

And market-based inflation expectations, while still relatively low, have definitely moved up recently.

5y Breakeven


Certainly the Fed wants to see this trend sustained for some time. After all, inflation remains at dangerously low levels in the euro area and we could see price increases stalling in Japan later this year (see discussion). But we have clear indications that at least for now, firmer inflation in the US is not just “noise”.

The BoJ’s Balance Sheet is About to go Parabolic

By Sober Look

The Bank of Japan’s balance sheet continues to expand at a fairly constant pace. Relative to the size of the GDP, this is already the largest QE program in the world. Yet some analysts believe that the BoJ will accelerate securities purchases later this year.

BOJ balance sheet

Here is why. Credit Suisse for example projects that Japan’s inflation rate has peaked and is about to begin declining. In fact CS researchers see a complete divergence between the BoJ’s own projection of inflation and reality. A number of other researchers (for example Scotiabank) agree.

Inflation projections

This potential decline in inflation dramatically raises the risk of Japan slipping back into deflation – something that the BoJ and the Abe administration have been desperately trying to avoid. As inflation begins to lag the BoJ’s projections, the central bank will accelerate QE to new highs.

CS: – As long as it sticks to its original commitment to achieve +2% CPI inflation by summer 2015, the BoJ is likely to decide on additional monetary easing once underperformance of the actual CPI inflation rate against its projection becomes visible.

The reason many researchers believe Japan’s inflation may have peaked has to do with the yen.



Chart shows dollar appreciating against the yen in 2013 (yen weakening)

As discussed earlier (see post), a great deal of the recent inflation improvements in Japan was the result of weaker yen, which declined sharply in 2013. But more recently the yen has been range-bound (and in fact strengthening against the euro), which will halt a great deal of the price increases we saw earlier. The inflation rate is therefore expected to begin declining.

But can inflation in Japan be sustained without further weakness in the currency? Such an outcome remains unlikely because there is no evidence that labor costs will begin increasing any time soon. It is difficult to sustain price increases without labor costs and wages rising as well.

CS: – We think policymakers are on the wrong track: we refuse to be optimistic about inflation being close to target at end-year given that unit labor costs fell by 2.5% over the last 12 months and seem set to be unchanged for the next year.

This tells us that at some point later this year, the BoJ will shift into an even higher gear. The central bank’s already bloated balance sheet will go “parabolic” in order to get back on track with the much publicized inflation target of 2%. The success if Abenomics depends on it.

Is the Bank of England about to surprise markets with a rate hike?

By Sober Look

It could happen sooner than markets currently expect …
Bank of England’s Mark Carney, June 13, 2014

Carney of course is talking about an interest rate hike in the UK. Indeed, as UK’s unemployment rate drops to new post-recession lows (see chart) and home prices continue to rise, the time to begin rate normalization is fast approaching. The Bank of England’s (BOE) policy trajectory is diverging sharply from that of the ECB – as reflected in short-term rate markets.

UK vs Germany 2y rates

The spike in the 2y UK gilt yield (above) was in reaction to Carney’s comment, while the drop in 2y German yield was in reaction to Draghi’s recent announcement of negative rates. Currencies had a similar reaction, as the euro tanked against the pound.


When do markets anticipate this first rate hike in the UK? According to the forward overnight index swap (OIS) curve, we are looking at early 2015 for the first increase – followed by a steady pace of hikes for at least 2 years. This is about half a year earlier than the expectations of the first rate increase in the US.

Forward rates

While some view this timing as appropriate or even too optimistic, Carney could in fact take action even sooner. The reason has to do with real rates (rates adjusted for inflation expectations). In spite of UK’s higher rates relative to other developed economies, the Bank of England’s current policy remains highly accommodative. Unlike in the US for example, where implied real government rates for maturities longer than 6 years are positive, the UK’s entire real yield curve is in the negative territory. This level of BOE accommodation puts additional pressure on Carney to pull the trigger on rates – and potentially surprise the markets.

UK real rates curve


 Citi (Michael Saunders): – In our view, this speech marks an important change of tone from the Governor, removing any sense that the MPC [Bank of England's Monetary Policy Committee] is on auto-pilot and locked into inaction until some distant preset date. We continue to expect that strong economic growth and the tightening labour market will prompt the MPC to start to hike before year end, with rates rising earlier, further and faster than markets currently price in.

Will China Avoid a Severe Housing Market Correction?

By Sober Look

Staying with the topic of residential property markets, let us now take a look at China. Investors continue to be concerned about the nation’s builders who have been under pressure lately. As housing price appreciation slows, some media outlets are calling the situation an outright “panic” (see video). Others are pointing to tight credit conditions hitting property developers:

Want China Times: – There is ample liquidity in the inter-banking market since overnight rates and seven-day repurchase agreement rates are both at low points, but borrowing rates continue to climb, signaling higher costs for businesses, the newspaper stated.

The banks’ more cautious attitude has resulted in liquidity not being channeled into the real economy, the newspaper said.

The property sector is expected to bear the brunt under the government’s financial reform plans, according to UBS chief China economist Wang Tao, since the current market downturn, unlike those in the past, is caused by oversupply, the government’s anti-corruption campaign, and the growing number of investment options.

Some are also concerns about the “wall” of maturing debt in China’s property sector.

Bloomberg: – The amount of dollar-denominated bonds that must be repaid in 2015 will jump to $2.83 billion, the most in data compiled by Bloomberg going back to 1993. Most Chinese builders listed on the mainland or in Hong Kong are behind fiscal-year sales targets and achieved less than 33 percent of their target in the first four months, analysis based on Bloomberg data show.

There is little doubt that we are going to see some failures among developers. The question is what will this do to the housing market in China. Is a severe correction on the horizon? According to Deutsche Bank, this is simply a part of another housing cycle – a third one in 6 years.

 Property prices in ChinaSource: Deutsche Bank

DB feels that buyers are simply waiting for discounts and will begin to move back into the market once prices are cut.  DB’s economists make the following points:

1. Chinese property buyers/investors have seen this downturn a couple of times before in the last few years. This is not a panic. In the past, discounts of 20% on new properties brought buyers back and cleared excess inventory in a few months. We could definitely see a correction as we did in the past two cycles, but nothing too severe.

2. Current inventory levels and price increases are fairly close to their historical averages.

3. Some correction will likely occur in the “tier 2″ cities, where inventory levels are elevated. That’s also where we may see some developers fail. Unsold inventory in Beijing, Shenzhen, Guangzhou, and Shanghai on the other hand is at moderate levels.

4. Wages in China have been growing faster than housing prices, making properties more “affordable” (though a great deal of the new housing is not accessible for the bulk of urban residents).

5. Nearly half of China’s urban population lives in “pre-housing-reform” dwellings. Given the horrible quality/conditions of many of these structures, they will need to be replaced soon. Such buildings get demolished, taking housing stock out of the market.

6. There are estimates that some 150 million more people will be migrating into the cities in years to come, increasing the demand.

As China’s population ages, construction is expected to slow in the long run. But for now DB does not see anything other than a cyclical adjustment.

DB: – We think this replacement or upgrading demand coupled with the migration of at least another 150mn people to the cities could support urban residential construction at about last year’s level for many more years.

… our perspective on the property market sees the current difficulties as primarily cyclical – tightening credit, slowing growth and over-exuberance on the part of some developers – rather than structural.

… In the near term, the cyclical downturn that began late last year is likely to continue at least a few more months. But we are confident that once developers start cutting prices meaningfully – 20% seems a reasonable guess – demand will revive.

Consolidation among property developers is inevitable. A severe housing correction however seems unlikely.

Is the Emerging Markets Underperformance Ending?

By Sober Look

The underperformance of emerging markets equities (see discussion from a year ago) over the past couple of years has been quite spectacular. Valuations of developed markets shares, particularly in the US, have diverged dramatically from those in emerging economies.

Emerging markets underperformance


Blue = S&P500 ETF, Orange = iShares MSCI Emerging Markets Index ETF (total return; source: Ycharts)

Is this trend expected to persist? Investment consulting firm deVere Group is seeing a shift, as their clients show increasing appetite for emerging markets shares. The firm provides 3 key reasons for this change in investor sentiment:

Nigel Green (deVere): – “First, as developed markets approach old highs, or surpass them, the valuation discount of emerging stock markets has become more compelling.

“Secondly, the tapering of QE has not resulted in higher US Treasury yields and more expensive borrowing costs for emerging market countries. The persistent low yields on US Treasuries is something of a mystery, but it is nevertheless a ‘fact on the ground’ that supports risk assets.

“Thirdly, political uncertainty has eased a little. Russia has not invaded Ukraine; India has voted overwhelmingly for a new prime minister, Mr Modi, who is unambiguously dedicated to the cause of economic reform; whilst China has shown itself willing to step in to prevent the collapse of large savings trust companies, and a wave of bad debt coming from Chinese property-related companies and banks has not, so far, materialised.”

The jury is still out on the China property bubble situation and there is a real risk that rates in fact do rise in the US later this year. Nevertheless, this renewed interest in the asset class should not be dismissed. Nobody expects a massive rotation into emerging markets at this point, but given the underperformance, we could certainly see some rebalancing taking place this year.

Gold Weakness is Inconsistent with Loose Monetary Conditions in the US

By Sober Look

Gold has been selling off sharply recently.

Spot Gold


Investors have been reacting to a number of factors which include the following:

1. The easing of tensions with respect to the Russia/Ukraine crisis – the so-called “Putin factor” (as discussed here).
2. Continued strength in US equity markets
3. The economic slowdown in China and increased tariffs on imported gold in India have reduced physical gold demand
4. The US dollar has been firmer recently, which is generally a bearish sign for gold and other commodities
5. Reduced fiscal and monetary policy uncertainty in the US (see chart)

In spite of all the headwinds for gold, one factor remains puzzling. US real rates have collapsed recently. The 5-year treasury real (inflation-adjusted) yield is now deep in the negative territory and the 7-year real yield is approaching zero. It means that those who hold 5-year treasuries right now are losing money after inflation is taken into account – even if treasury prices remain stable.

This is telling us that the monetary policy in the US has become even more accommodative – in spite of the Fed’s taper.

real rates


At least in theory, low or negative real yields make gold more attractive. And as US inflation picks up (see chart), real yields could move even lower. Moreover, if the ECB embarks on a new round of aggressive easing (see post), the euro area monetary stance will become highly accommodative as well.

The recent weakness in gold price is inconsistent with these looser monetary conditions in the US and potentially in the Eurozone. If you have a view on the topic, please answer this single-question survey. Results will be published shortly.

Staging the QE Exit

By Sober Look

Fed officials are hinting that the rate hike could take place before the Fed ends the policy of reinvesting securities that pay down or mature. The order of events would look something like this:

1. Securities purchases end later this year but the Fed maintains its balance sheet at constant level.

2. The rate hike takes place (some time in 2015)

3. The Fed begins to allow securities to mature (or amortize for MBS) without replacing the declining notional.

William Dudley: – … it would be desirable to get off the zero lower bound in order to regain some monetary policy flexibility. This goal would argue for lift-off occurring first followed by the end of reinvestment, rather than vice versa. Delaying the end of reinvestment puts the emphasis where it needs to be—getting off the zero lower bound for interest rates. In my opinion, this is far more important than the consequences of the balance sheet being a little larger for a little longer.

Fed officials are afraid that if the balance sheet begins to naturally decline, the markets will interpret this as additional tightening. But once again, by delaying step 3, the Fed introduces incremental uncertainty. The markets and the media will be buzzing with “when does the reinvestment policy end?” question. The reality is that this delay will have a minimal impact on the trajectory of the massive balances at the central bank.

Projection for feds balance sheet


Here is a situation in which the policy itself will have no material impact on anything except that it introduces more uncertainty – something the US economy doesn’t need. The Fed should just finish the QE program, stop buying any more securities, and focus on normalizing rates. Staging this process is a bit like ripping off the bandaid slowly rather than getting it over with, particularly when the bandaid is no longer of much use.

Spreads on AAA CLO Tranches not Budging

By Sober Look

Top rated investment grade US corporate bonds now trade at or even below pre-recession levels. Depending on the maturity and the type of issuer, new issue paper clears the market at spreads (to treasuries) of 30-80bp for AAA bonds.

AAA spreads


Securitized corporate paper for similar maturities on the other hand continues to trade at a significant premium. AAA CLO bonds clear the market at 145-155 basis points spread to LIBOR – unchanged from two years ago. The two (typical) CLO deals below show that while lower rated tranches have tightened significantly (BBB for example tightened about 200 basis points over the same period), AAA spreads for standard tenor deals have not budged (and in fact are higher in some instances).

CLO spreads


DM means effective spread
(some tranches  are issued at discount; L=”LIBOR”; source: LCD/S&P)

Some attribute this premium to higher risk of structured credit relative to single name bonds. However it is important to note that not a single AAA CLO bond lost principal through the financial crisis. The elevated spread is primarily driven by regulatory pressures and funding markets. The new FDIC rules for example penalize banks for holding these bonds (this is in addition to the Basel rules). Ironically these same rules may encourage banks to move toward riskier CLO tranches with higher yields in order to compensate for the increased FDIC charges.

Normally when there is a market dislocation such as this one, hedge funds find a way to take advantage of it. But LIBOR+150 is not yieldy enough for hedge funds and these bonds are nearly impossible to leverage in order to boost yields. So hedge funds and others in search of yield stick to the lower-rated tranches. Non-US participants, in particular yield-starved Japanese institutional investors, have been the only consistent buyers of AAA CLO paper recently. This makes the primary market vulnerable to disruptions if these investors decide to exit.

6 Reasons Treasury Yields Should be Higher

By Sober Look

It remains difficult to reconcile treasuries trading at the same yields we saw during the US government shutdown (see post) with broadly stronger economic conditions in the US. Economic indicators suggest yields should be materially above the lows we saw last October. Here are some of the key trends:

1. Leading indices are all stronger – ECRI is at pre-recession levels.



2. Labor markets are clearly improving. Initial jobless claims clocked below the 2006 level this week (see Twitter post).

Job Creation


3. Small business surveys show owner sentiment, which had remained weak for years, finally on the rise.

Small business index


4. Credit expansion in the US has accelerated.

Loans and leases


5. Inflation is picking up (see post) and inflation expectations are higher as well.



(5y breakeven inflation expectations via Ycharts)


6. And even the housing market, which had stalled this year, surprised to the upside today. Both housing starts and permits came in above expectations.



Clearly there are geopolitical tensions over the Ukraine crisis and all the search for yield in the face of the ECB’s expected easing action is putting downward pressure on rates globally. The US consumer remains jittery, generating a drag on growth. Furthermore, equity investors are using treasuries as a proven form of downside protection. Yet in the face of strengthening economy and relative to the uncertainty of the US government shutdown and debt ceiling impasse last year, current low yields are difficult to understand.

When Was the Last Time Treasury Yields Were This Low?

By Sober Look

We’ve had an unprecedented compression in US (and global) government bond yields in a short period of time. Here is one surprising fact: Treasury yields are now at the level they were during the US government shutdown. The level of uncertainty has diminished dramatically since then and the employment picture continues to improve (see Twitter post). Yet here we are again. This time however it’s the global chase for yield and expectations of ECB’s monetary easing driving rates to new lows.

US 10y bond yield

The unprecedented chase for yield

By Sober Look

The major market surprise of 2014 so far has been the extent of investors’ appetite for yield in the developed fixed income markets. It has been quite spectacular. The Eurozone in particular has been a key beneficiary of this trend. We’ve seen German government bond yields hit a low not seen in almost a year (see Twitter post), but the real action has taken place in the periphery bonds. We are seeing multi-year and even all-time lows in government bond yields.

Spain Portugal Italy 10y yield

And this trend is not limited to sovereign paper. European corporate high yield bonds are now yielding  just over 3.6% on average – a record low. Let’s just put this in perspective – this is sub-investment-grade paper trading at these levels.

Euro high yield

While European fixed income markets clearly feel frothy, it is not clear if there is a near-term catalyst to bring about a correction. With the Eurozone inflation still MIA, capital seems to be chasing anything with a reasonable yield. The shift in attitudes from just two years ago is unprecedented.

Bloomberg: – “We’re still in a world where investors are starved of return,” said John Wraith, a fixed-income strategist at Bank of America Corp. in London. “People are still happy to diversify their holdings and buy bonds that not so long ago they would have shied away from. The slightly better data helps reassure people that finally some of these weaker countries are turning a corner.”