Author Archive for Sober Look

Distinguishing the Fed’s Securities Purchases from Monetary Expansion

By Sober Look

There has been a bit of confusion about what today’s FOMC announcement means with respect to Quantitative Easing. The statement says that ” the Committee decided to conclude its asset purchase program this month”. It’s important to point out that while this is the end of the Fed’s bond purchases (for now), the US monetary expansion has ended this past summer. The outcome is visible in the the banking system’s excess reserves, which flattened out around July.

Excess reserves

That in turn resulted in the US monetary base leveling off at just below $4.1 trillion, as the so-called “money printing” effectively ended in July.

Monetary base

This begs the question: How is it that the excess reserves and the monetary base stopped growing this summer while the securities purchases and the balance sheet expansion continued through October? The answer has to do with some other balance sheet items that offset (“absorbed”) reserve creation. The key item to consider here is the Fed’s reverse repo position, which became more impactful as the securities purchases ebbed.


While the Fed’s securities program is just ending now, the US monetary expansion was finished months ago. Therefore, other than its psychological effect, today’s announcement should have a limited impact on the economy.

The Good, the Bad and the Ugly of Falling Energy Prices

By Sober Look

The recent correction in the price of crude oil should have an immediate positive impact on the US consumer as well as on a number of business sectors. However there also may be a significant economic downside to this adjustment. Here are some facts to consider.

1. The good:

The US consumer is not only about to benefit from materially lower gasoline prices (see chart), but also from cheaper heating oil.

Heating oil

With wages suppressed, the savings could be quite impactful, particularly for families with incomes below $50K per year.

Merrill Lynch: – … consumers will likely respond quickly to the saving in energy costs. Many families live “hand to mouth”, spending whatever income is available. The Survey of Consumer Finances found that 47% of families had no savings in 2013, up from 44% in the more healthy 2004 economy. Over time, energy costs have become a much bigger part of budgets for low income families. In 2012, families with income below $50,000 spent an average of 21.4% of their income on energy. This is almost double the share in 2001, and it is almost triple the share for families with income above $50,000.


Furthermore, with gasoline prices lower, it is unlikely that consumers will be buying significantly more of it than they have been. Historically when oil prices fell, gasoline consumption in dollar terms also fell. Dollars saved on fuel will be redirected elsewhere in the economy.


Moreover, suppressed oil prices will, at least in the near-term, keep inflation expectations lower. That means lower short-term rates for longer (see chart) and therefore lower home equity and adjustable rate mortgage monthly payments. It also means lower longer-term rates and cheaper fixed rate mortgages (see chart). We may even see some new refi activity.

Other benefits include cheaper transport (potentially lower travel costs) and shipping costs (lower UPS/Fedex surcharges), as well as cheaper PVC, nylon, polyester, foam, etc. – all of which should benefit the consumer.

2. The bad:

The US has become a major energy producer, with the sector partially responsible for improving economic growth and lower unemployment in recent years. As an example here is the GDP of Texas as a percentage of the US GDP. This trend is driven in part by the recent energy boom in the state.


If oil prices remain under pressure, this boom could soon be in jeopardy. While large US energy companies are sitting on a great deal of cash, at some point they will begin to cut portions of the higher cost development and production. And private investment into energy and oil services firms, which has been brisk lately, is likely to moderate. For example, here is the private debt and equity capital flowing into various states last month.


While, only a portion of the funds going to Texas is directly energy related, various other Texas firms funded by PE (including some real estate, manufacturing and financial companies) have been benefiting from the energy boom. Soon that flow of private capital may slow dramatically.

To put this into perspective, here are the jobs directly generated from Texas oil and gas extraction in recent years. And this does not include the thousands of jobs that support this industry. Such trend is unlikely to continue if oil prices remain at current levels or fall further.

O&G employees Texas

In fact, while the overall industrial production growth in the US has been strong recently (see chart), a big portion of the gains are energy driven (see chart from Lee Adler). A slowdown in that sector will be quite visible across the US.

3. The ugly:

A significant number of middle market energy firms in the US – many funded via private capital (above) – are highly leveraged. The leveraged finance markets are becoming quite concerned about the situation – even for larger firms with traded debt. Here is the yield spread between the energy sector loans in the Credit Suisse Leveraged Loan Index and the index as a whole.

Energy loans

Rumors have been circulating of a number of energy (and related services) firms getting ready to “restructure”. There are also stories that some large funds are gearing up to scoop up distressed debt of levered energy firms. However, in spite of the ample liquidity out there, bets on companies with significant commodity exposure will be limited going forward – at least until stability returns to the oil markets. Defaults, layoffs, and cancelled projects in the energy space may be in store in the near-term. And that is sure to have a negative impact on the US labor markets and the economy as a whole.

Finally, this is terrible news for the development of alternative energy sources. At these prices, fossil fuels are becoming increasingly difficult to compete with.

Implied Vol Dislocation

By Sober Look

The recent spike in volatility has created a “dislocation” in US equity options markets. VIX, which is a measure of implied volatility for large cap shares is now higher than RVX – the small-cap equivalent. This is highly unusual, since small caps tend to be more volatile. Part of the issue is the outsized spike in the volatility of large energy shares due to the recent sell-off in crude oil.


How Close are the US labor Markets to Normalization?

By Sober Look

As discussed here back in April, US labor markets continue to heal, with Friday’s payrolls gains putting 2014 on track to be the best year for job growth since the late 90s. Now many are asking just how far is the employment situation from “normalizing”. Of course it all depends on the metrics used. The chart below for example shows that the headline unemployment rate is now well within the normal range (based on long-term historical data).

Unemployment rate

But as we know, that’s only part of the story. A broader gauge of unemployment, the so-called U-6 rate, which includes marginally attached workers and those employed part time for economic reasons, suggests the labor markets have some room for improvement.


Within the U-6 metric it is particularly important to track the percentage of those employed part time for economic reasons. The current number of these workers (at just over 4.5% of the labor force) is not unusual by historical standards but is still quite elevated. It’s not at all clear however if we are ever returning to the lows of the decade that preceded the Great Recession.

Part time for economic reasons

Another measure of labor markets’ health is an estimate of the “job finding rate” from Credit Suisse. At least based on the data since 1990 (which may not be a sufficiently long range), that metric is currently far below average. We do see signs of significant improvements recently but the red line in the chart below may no longer be our target for what is “normal”.

Probability of finding a job

We’ve also seen a great deal of focus on falling US labor force participation rate. The non-demographic component of the post-08 declines in participation rate is of particular importance. How much is due to aging US population vs. the discouraged workers exiting the labor force?

Participation rate

There are hints that the non-demographic decline in participation has been halted, albeit at a relatively low level. The fact that the non-demographic participation level has fallen doesn’t say much about what it will take to return to “normal”. That’s because the pre-recession housing bubble had generated unsustainable demand for labor (particularly unskilled labor). That demand isn’t coming back any time soon as we look to establish the “new normal” in participation rate. We also see other factors impacting participation such as more disability claims and higher college enrollment rates.

Finally we want to take a look at wage growth as an indicator of demand for labor. Wage growth in the US remains remarkably steady, anchored at 2% per year. While this growth is certainly weak relative to recent history, it is quite respectable relative to other developed economies. Once again, how far is wage gowth away from “normal”? Most economists believe that if payrolls continue to increase at the current pace, wage growth will improve. Perhaps. But we are unlikely to see sustained wage growth at levels the US experienced prior to the recession. Given weaker wage inflation globally (and wage deflation in a number of EU states), the 2% or slightly higher may be the new “normal”.

Wage growth

While many continue to insist that we are years away from normal labor markets in the US, it may be time to adjust our expectations. We could be much closer to the “new normal” than we had hoped.

A Bubble is Forming in US Middle Market Leveraged Finance

by Sober Look

US middle market leveraged buyout (LBO) transactions are becoming increasingly frothy. According to the latest data from Lincoln International, risk-return fundamentals in the space are worse than they were in 2007. Here are some disturbing facts about leveraged transactions in US middle markets:

1. Leverage multiples (debt to EBITDA) are higher than at the peak of the bubble in 2007. In particular, leverage through the senior debt (dark blue) is now materially higher.


2. Yields on senior leveraged loans for middle market deals are now significantly lower than in 2007. Investors are not getting paid for taking on riskier loans.


3. Furthermore, private middle market company valuations (as a multiple of EBITDA) are at record levels.


4. Banks have all but exited leveraged loan origination, as institutions (shadow banking) have taken over. These institutions include loan funds (mutual funds and closed-end funds), BDCs, CLOs, hedge funds, insurance firms, pensions, etc. However, since the Fed is mostly looking at banks’ balance sheets, the central bank seems to be unconcerned about the froth in this market.

Source of capital

5. According to Lincoln International, there are signs that leveraged middle market firms are experiencing margin compression. That is worrisome given the amount of leverage these firms have.

Lincoln International: – While over 50% of companies are seeing revenue growth, the fact that over 50% are experiencing EBITDA declines suggests margin compression. For the sixth consecutive quarter, more middle market companies experienced EBITDA declines than gains.

The Fed has allowed for bubble to build in the US corporate sector – particularly in leveraged middle market companies. A broad hit to revenues could create a massive wave of failures, as firms become too leveraged to withstand such a shock. At the same time investors could face significant losses without being compensated for the risk they are taking. Let’s hope someone on the FOMC is paying attention.



Deutsche Bank: Ignoring Food Price Pressures Could be a Mistake

By Sober Look

Economists and central bankers tend to be less focused on what consumers pay at the grocery store because food and energy prices have historically been more volatile – remember, it’s just “noise”. However what they can’t ignore is how shoppers view inflation – i.e. inflation expectations. And food prices have a significant impact on households’ views on future inflation.

Deutsche Bank: – … food prices factor significantly into households’ perceptions of overall price pressures. This is illustrated in the following figure, which shows year-ahead inflation expectations from the University of Michigan Survey of Consumer Sentiment versus CPI food. In fact, it is worth noting that CPI food demonstrates a higher degree of correlation with one-year price expectations than either the headline or core metrics — and it similarly surpasses energy, core goods, core services and shelter. …  while forecasters are focusing on service-sector inflation in general and shelter inflation more specifically, they should be careful to not ignore mounting food price pressures, because this category could provide important insight toward the evolution of inflation expectations. If food price inflation accelerates, as we project, the stability of inflation expectations could degrade – and this would be a vexing development for monetary policymakers.

Food prices

Source: Deutsche Bank

Further Signs of China’s Slowing Property Markets

By Sober Look

China’s official housing index now shows home price appreciation slowing faster than some had anticipated.

China housing price appreciation

Other indicators are also pointing to weakness in China’s housing markets. For example the number of cities with falling prices has spiked sharply.

China housing

Furthermore, the steel rebar futures in Shanghai – an imporant real-time indicator of construction demand – remain under pressure.

Jan Steel Rebar

Jan steel rebar futures in Shanghai (

Related to this trend, China’s commercial floor space and the number of commercial buildings sold has declined materially (based on official reports).

Floor space and commercial buildings

There is no question that Beijing has the wherewithal and the will to support the housing market should things unravel faster than the government likes. Nevertheless, given how pervasive property markets are in the nation’s overall economy, concerns among global investors are rising with respect to China’s housing slowdown.

Scotiabank: – On the theory that where there’s smoke there’s fire (and it’s not just because I’m BBQing), weak company financing and concerns surrounding potential defaults in the shadow banking sector coupled with — and likely driven by — further evidence of falling property prices will only amplify the concerns.

US loan growth rate the highest since the recession

By Sober Look

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

Loans and leases

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

Corporate loans (1)

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

Real estate

Consumer loans

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