Author Archive for Sober Look

Expect Higher Treasury Yields in Second Half of 2014

By Sober Look

While many investors refuse to accept this fact, we are clearly marching toward higher treasury yields later in the year and in 2015. Even after today’s bond selloff, we are still around the yield levels we had during the dark days of the government shutdown. Here are a couple of key factors that will drive yields higher from here.

1. Many are pointing to record low yields in Europe (see chart), suggesting that on a relative basis treasuries look attractive. Perhaps. But it’s important to make that comparison based on real rates rather than nominal. And given the disinflationary environment in the Eurozone (see chart), a significant rate differential between the US and the Eurozone is justified. After all, we’ve had a tremendous differential in nominal yields between the US and Japan for years. Furthermore, economic growth (and expectations for growth) in the euro area and in the US have diverged significantly (see chart). Today’s US GDP report confirmed that trend.

2. The net supply of treasuries is not static. In particular when it comes to treasury notes and bonds (excluding bills), the Fed has been the dominant buyer (see chart). With the Fed tapering, the net supply is expected to rise.

Net supply of treasuries


Foreign buying of notes and bonds has declined and is not expected to replace the Fed’s taper. It will be primarily driven by China’s rising foreign reserves. But given declining support from the Fed, China is likely to make bills (vs. notes and bonds) a larger portion of its purchases. And bill purchases will have a limited impact on longer dated treasury yields.

To be sure, we are going to have plenty of demand for treasuries going forward. But given such a spike in supply and improved growth expectations, something on the order of 50-75 basis points increase in the 10-year yield in the near-term is not unreasonable.
It is also worth pointing out that with the dealers remaining cautious holding significant inventory and the Fed out of the picture, higher volatility in treasuries becomes more likely.

3 reasons Yellen’s FOMC remains dovish

By Sober Look

What makes Janet Yellen and a number of other FOMC members so dovish with respect to monetary policy and in particular the trajectory of rate normalization? A Credit Suisse report sites 3 key factors, which Yellen calls  “unusual  headwinds”:

1. Tighter fiscal policy.

The combination of lower government spending and tax increases has created a drag on economic growth (see chart). This drag is now diminishing, but given the tepid recovery Yellen still views it as a headwind.

US gov spending

2. Relatively tight credit in the mortgage market.

Janet Yellen: – ” … it is difficult for any homeowner who doesn’t have pristine credit these days to get a mortgage. I think that is one of the factors that is causing the housing recovery to be slow. It’s not the only one, but I would agree with that assessment.”

A recent study by Goldman compared current lending conditions in the mortgage market with the 2000 – 2002 period (supposedly “pre-bubble” period). The results indeed seem to point to tighter lending standards at this time (see chart).

3. Low household wage growth expectations.

While US wages have been growing at around 2% per year, expectations for growth remain depressed.

Yellen (see House testimony video below): – ” … households have unusually depressed expectations about their own future income gains. And I think weighs on their feelings about their own household finances and is holding back consumer spending.”

Wage increase expectations

The Diminishing Returns of Fuel Efficiency

By Sober Look

As vehicles become more fuel efficient, the savings one obtains by further improving the mileage decline substantially. As an example, assume a driver saves $700 per year by switching from a 12 mile/gallon car to a 15 mile/gallon one. Now if that same driver has a car that gets 30 miles/gallon, she would need to switch to a 60 mile/gallon car in order to achieve the same $700 savings. In fact the incremental savings for each additional mile/gallon declines as the inverse square of a car’s fuel efficiency.

SavingsThis does not bode well for the future of alternative fuel automobiles. Saving $700 a year, as the example below shows, may not be worth paying additional few thousand dollars for a car that may be less convenient to “fill up”.

Furthermore, as traditional gasoline cars become more fuel efficient, the savings associated with switching fall off sharply. In another few years, unless gasoline prices shoot through the roof (which is not likely), alternative fuel cars (such as electric) will increasingly be more of a “luxury” item rather than a money saving form of transportation. It’s just basic math. 

EIA: – As light-duty vehicle fuel economy continues to increase because of more stringent future greenhouse gas emission and Corporate Average Fuel Economy (CAFE) standards through model year 2025, standard gasoline vehicles are expected to achieve compliance fuel economy levels of around 50 mpg for passenger cars and around 40 mpg for light-duty trucks. Diminishing returns to improved fuel economy make standard gasoline vehicles a highly fuel-efficient competitor relative to other vehicle fuel types such as diesels, hybrids, and plug-in vehicles, especially given the relatively higher vehicle prices projected for these other vehicle types.

Fuel efficiency

Window Dressing with Fed’s Reverse Repo Program

By Sober Look

If you are a bank or even a money market fund, you probably want your financials to show the maximum amount of your overnight liquidity placed with the Fed’s RRP rather than with other banks. Your balance sheet looks less “risky” this way. And since most financial reporting is done at quarter end (with mid-year and year-end being the most important dates), you want to place your cash with the Fed on the last day of the quarter for one night and then take it out.


Why not leave your liquidity with the Fed for a longer period? Because the Fed’s current RRP rate pays 5 basis points, while the private repo market is paying about double that. Of course as cash is pulled out of the repo markets for quarter-end and moved to the Fed or elsewhere, rates in the private markets rise. Once the cash comes back to the private markets at the start of the new quarter, the rates return to normal.


GC repo


The larger the RRP program becomes, the stronger this quarter-end effect will be. Welcome to the wonderful world of window dressing.

Fixed Income Risk Appetite Headed for Euphoria

By Sober Look

The global appetite for fixed income remains strong, driven by ongoing accommodation from central banks. The 10-year Bund yield touched fresh lows for the year today. The situation is similar for shorter maturities.

10 Bund yield

This yield compression is not limited to bonds. As an example, Asian commercial property yields are at new lows as well. For those who want some background on the meaning of “property yield”, here is a good overview.

Asia propery yields (2)

The Credit Suisse Duration Risk Appetite Index is once again headed for euphoria after being in panic territory just a year ago. 


Duration appetite index


The index measures investors’ appreciate for being long fixed income product – as they shift from taper fears last summer to frenzied buying today. The longer the current environment persists, the more difficult it will be for central banks to begin rate normalization.

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.