Author Archive for Sober Look

Don’t bet on the Treasury Bond Rally to Continue

By Sober Look

Treasuries rallied sharply last week, mostly on the back of the sell-off in equities as well as in response to the Fed’s seeming backpedaling on the timing of rate hikes.

Treasury rally


10y Treasury Note Futures (source:

While the equity market pullback makes sense for a number of reasons (including increased leverage and momentum driven activity in a number of shares), the treasury market rally does not. Reading the dovish tea leaves of the FOMC minutes is counterproductive. The Fed’s reluctance (see story) to support its own FOMC members’ projections of higher rates by the middle of next year – which are quite realistic – simply serves to confuse the market. It’s about time the Fed realizes that the US economy can withstand (and in fact could benefit from) higher rates.

Scotiabank: - We think rate hikes next year are a reasonable thing to expect and that the forecast pace is not unreasonable. Indeed, quite frankly, neither do the majority of FOMC officials themselves. Recall that the projections of FOMC officials became more hawkish at the March 19th FOMC meeting when more Fed officials (10 of 16) projected that the Fed funds target would equal 1% or more by the end of next year. This is reflected in chart 2 which is a recreated version of the Fed’s famous dot plot that shows the fed funds target forecasts of individual FOMC officials. Presumably not all 10 of those individuals think that higher rates will commence late in the year and are more spread out in their forecasts, thus making hikes starting in Q2 or Q3 eminently reasonable. More officials also projected a Fed funds target of 2% or greater by the end of 2016 (12 of 16).

It can’t be both ways by way of talking down the risk of rate hikes while still forecasting them. Suppressing yields in the short-term only aggravates the potential for disruptive market behavior later. The Fed either has a forecast to which the balance of Fed officials are committed, or it doesn’t. I might not have views identical to those of all of my bright, ambitious colleagues surrounding me, and thus emphasize different risks to a house view. But conducting policy gives each individual one vote and that weighted perspective on Fed views is turning more hawkish, full stop and regardless of attempts by the Fed’s communications subcommittee to massage the market outcome.

The big debate among the FOMC members has been around the amount of slack in US labor markets. The focus has been on falling labor force participation which is to some extent due demographics.

Wells Fargo: – Compared to previous decades, cyclical factors have played a larger role in the path of the participation rate in recent years as labor market weakness continues to keep some potential job seekers from looking for jobs. However, the participation rate began to decline in 2001, well ahead of the recession, amid demographic and cultural shifts independent of the business cycle. The secular forces of higher female participation and the baby boomers entering their prime working years that led to a four-decade long rise in labor force participation have now reversed. Female participation peaked in 1999, and in 2001 the first of the baby boomers turned 55 years old—an age at which participation begins to decline notably. We find that demographics alone have accounted for about half of the decline in the labor force participation rate since 2007.

The reality is that as the headline unemployment figures continue to improve and wages begin to pick up, the Fed will be forced to hike rates in spite of weaker labor force participation. And key US employment metrics clearly point to ongoing improvement.

Gallop job creation index

Gallup’s Job Creation Index

For those who have been jumping back into treasuries as a result of the Fed’s perceived dovish stance or as a hedge to equities, be prepared for a disappointment.

Barclays Research: – At current levels, we believe outright short duration offers a good risk reward as well. The market has gone too far in discounting the move higher in the “dots” [individual members' forecasts for higher rates] at the FOMC, which was largely driven by an improving outlook of the labor market.

4 Reasons to Expect a Capex Acceleration

By Sober Look

We’ve received a number of e-mails regarding the recent post on the possibility that rising CAPEX spending in the US is driving corporations to tap their credit facilities, thus increasing loan growth (see post). Most were highly critical of this line of thinking in their comments, using words such as “bogus”, “propaganda”, “head fake”, “delusional”, etc. Thanks for all the feedback. The argument that “things are different this time” understandably meets a great deal of skepticism, especially after a number of false starts and years of uncertainty. But evidence for a significant rise in corporate CAPEX spending continues to build. One could write a dissertation on this topic, but let’s just look at 4 key data points:

1. Diminishing uncertainty. As discussed earlier (see post) federal government policy uncertainty (fiscal and monetary) that has been hounding corporate CEOs and investors for years has finally subsided, at least in the nearterm. Even the politically charged uncertainty around the implementation of Obamacare has been receding (more on this later). We can debate about the merits of the various policies but it is often the uncertainty more than the policy itself that spooks corporate decision makers.

The other trend that is often overlooked when discussing corporate spending in the US is the recent period of relative calm in the Eurozone. While the area’s current economic malaise isn’t great for US firms, it is important to remember that during 2011 – 2012, the risk of the monetary union’s collapse was quite real. Imagine trying to make a major corporate expenditure decision when the world is concerned about Italy’s or Spain’s ability to roll government debt, as these nation’s banking systems teeter on the verge of insolvency. Many of the structural issues that caused this crisis are still with us today, but the ECB’s backstop dramatically reduced the nearterm uncertainty.

The constant barrage of scary news is receding, as the news-based uncertainty index finally drops to its pre-financial-crisis levels.

Uncertainty indexSource: Economic Policy Uncertainty

2. Corporate infrastructure is aging. From software to planes to telecommunications equipment, companies have severely underinvested in recent years, and it’s time to start upgrading. Consider the fact that the average age of fixed assets such as factories, storage facilities, etc. is at levels not seen in nearly 50 years.

Fixed assets ageSource: BofA/Merrill Lynch

Moreover, some economists argue that slow productivity growth in recent years (discussed here) is a direct result of weak corporate spending. With plenty of cheap labor one didn’t need to be too efficient in order to be profitable. But at some point companies will need to upgrade their aging technology and infrastructure in order to improve worker productivity.

3. CEO confidence. Based on the analysis done by Charles Schwab, CEO confidence tends to lead key CAPEX expenditures. And CEO confidence has risen sharply in recent months.

CEO confidence vs investmentSource: Charles Schwab

4. Investors.  Shareholders are demanding that companies begin using more of their massive cash balances toward CAPEX. The chart below from Merrill Lynch is quite compelling.

Cash usageSource: BofA/Merrill Lynch

It seems that the stage is set for corporate spending to finally accelerate. And yes, the experiences of recent years make this possibility hard to accept for some. But evidence continues to mount.


6 reasons US M&A activity will see strong growth this year

By Sober Look

US M&A activity is picking up steam. Deal volume in the first quarter of this year was the highest since 2007 (in dollar terms). The total of $278bn of transactions includes high profile deals such as Time Warner, Forest Laboratories, and WhatsApp.

MandA trend


Moreover, M&A transaction volume growth for both large and middle market firms is poised to accelerate this year. Here are some reasons:

1. US corporations currently hold record amounts of cash (see story) and shareholders want to see action. While dividends and stock buybacks have been popular recently, many firms are looking toward growth strategies.

2. The market has recently rewarded companies that are doing deals by giving them higher valuations (Facebook was an exception), encouraging CEOs to be more aggressive with acquisitions.

3. Financing costs are still quite attractive. US high yield spreads for example hit another post-2007 low last week as fixed income investors (including “shadow” banking participants) look to buy corporate paper. This allows for more leveraged buyouts even at higher valuation multiples.

HY spread

HY spread to treasuries
4. Private equity funds, particularly some of the larger ones are having a fairly impressive start this year with their fund raising efforts (see example). The first quarter has been the strongest since 2008 according to Preqin with some $95bn raised. This capital has to go somewhere.

5. A great deal of near-term fiscal and monetary policy uncertainty has been removed from the market (see post). The macroeconomic environment in the US should support M&A activity.

6. The US stock market strength, while making target companies more expensive, is providing more buying power for strategic acquisitions. Companies will be using their (sometimes overvalued) shares as “currency” to do deals.

Eurozone’s credit contraction continues

By Sober Look

Private loan balances in the euro area continue to decline. Last month’s drop of 2.2% from the previous year was worse than had been expected by economists.

Private loans

The area’s banks are undergoing a sharp deleveraging exercise with balance sheets shrinking due to both loan write-downs and extraordinarily weak lending. Maturing loans are not being fully replaced with new credit. Pressure from the ECB’s 2014 stress testing of banks (similar to what the Fed just completed) is also discouraging credit expansion.

Reuters: – Lending to households and firms in the euro zone shrank further in February and money supply growth remained subdued, adding to the European Central Bank’s list of concerns ahead of its policy meeting next week.

The ECB’s health check of the euro zone’s largest banks’ balance sheets before it takes over banking supervision in November is exacerbating the situation, with lenders reluctant to take on more risk and trying to slim their loan books instead.

Bank balance sheets declined by around 20 percentage points of gross domestic product last year, partly in anticipation of the health check, ECB President Mario Draghi said on Tuesday.

And more is to come this year.

UniCredit, for example, posted a record 14 billion-euro loss this month due to huge writedowns on bad loans and past acquisitions as it moved to clean up its balance sheet.

The ECB welcomed the move and encouraged other banks to not to wait with any corrective measures until the review’s results are released in October.

Some have pointed to a “glimmer of hope” in the household lending balances which showed a small uptick in credit expansion.

Household loans

Eurozone household loan growth (YoY); Source: ECB

The increase however came from a slightly slower decline in consumer credit (credit cards, auto loans, etc.), which continues to fall (year-on-year change is firmly in the red). This contraction to a large extent is driven by weak demand.

Consumer credit

Eurozone consumer credit growth (YoY); Source: ECB (apologies for the different time scale)

Furthermore, growth in mortgage loans remains anemic, making this household lending uptick less of a reason to celebrate.

Mortgage growth

Eurozone mortgage loan growth (YoY); Source: ECB

 Moreover, the area’s corporate loan balances are continuing to see sharp declines – down 3.1% from the same time last year. Weak demand remains the culprit here as well.

Corporate loan growth eurozone

Eurozone corporate loan growth (YoY); Source: ECB

In February Mario Draghi blamed credit weakness on banks’ “window dressing” exercise of trimming balance sheets before year-end financial reporting.

Draghi: – “One would not rule out a certain behavior by the banks that would like to present their best data by the end of 2013, which means that this is going to affect credit flows, which means that we may have different figures in the coming weeks …”

It would be interesting to see what Mr. Draghi will come up with this time to explain the ongoing contraction in euro area’s private credit.



5-year treasury cheapest in years after selloff

By Sober Look

The five-year treasury yield hit a multi-year high relative to the average of the two- and the ten-year rates (the 5-year treasury is cheap on a relative basis). The chart below shows a measure of how “concave” the treasury curve has been over time (negative indicates the curve is convex).

butterfly spread


2 x (5yr yield) – (10yr yield) – (2yr yield)

Given that the five-year tenor is sensitive to the trajectory of the Fed’s rate policy in the intermediate term, this is where we should see quite a bit of volatility (see post).  We’ve come a long way from the days when the 5-year treasury was highly overpriced relative to the rest of the curve (see story from 2012) and the market was pricing in “perpetual” QE.

US monetary policy moving in the right direction

By Sober Look

The Fed struck a somewhat more hawkish tone yesterday – certainly enough to spook the markets. Expectations for the first rate hike have shifted forward by nearly a quarter, pointing to late spring of 2015 as the starting point.

Fed funds futures


This monetary stance, combined with another $10bn taper was the right move. Here are the reasons:

1. The $10bn cut per meeting removes much of the remaining uncertainty around taper trajectory. The reductions are on autopilot. Often it’s not the policy itself but the uncertainty surrounding it that creates issues for the economy. That was one of the key problems with this open-ended QE – the fear of a painful exit put the economy on hold.

2. It is unclear if extremely low rates stimulate credit growth at all, and in fact some argue it could be the opposite. At the same time, savers, including many retirees, have been punished by negative short term real rates for years. This zero rate policy needs to end.

3. The US economy is stronger than is commonly believed. “How dare you say that, you heretic – don’t you read all the financial blogs?” That has been the response from many. Perhaps. But it may behoove some folks to pay attention to the data … More on this later. The point here is that the US economy will be fine without QE and with higher interest rates.

4. The current environment has created such hunger for yield that investors are increasingly taking higher risk in order to target the same performance they experienced in the past. Insurance firms, pensions, individuals – the behavior can be seen in a number of areas. The Fed’s exit should help adjust some of the distortions.

What’s behind the sudden improvement in US loan growth?

By Sober Look

Credit growth in the US seems to have stabilized and may be on the rise. It’s worth mentioning that the bottom in loan growth just happened to correspond to the start of Fed’s taper. Coincidence?

Loans and leases yoy


Total loan growth rate YoY

Whatever the case, this may be a sign of improving demand for credit and banks’ willingness to accommodate. The key to this change in trend is that improvements in loan growth have been primarily driven by a sudden jump in corporate lending.

Corporate loans

Corporate loan growth rate YoY

Why is corporate America increasing its borrowing all of a sudden? The most likely answer is the improvement in capital expenditures (capex), which is evidenced by firmer capital goods spending by US companies. We saw initial signs of that improvement back in February (see story). There were other indications as well. ISI’s latest corporate survey provides further support to this thesis.

ISI Research: – Survey strengthened over the past two weeks with U.S. orders now a solid 61.5. Areas of strength include equipment tied to trucks, rail, aerospace, and construction.

Whether using their massive cash reserves or tapping bank credit facilities (increasing bank loan balances), the time has come for higher capital expenditures by US firms. Here is why.

Barron’s: – Capital expenditures [have been] just 46% of operating cash flow for nonfinancial companies in the S&P 500. The average since 1989 is 57%. Capex can’t remain low forever. Already, the average age of U.S. structures is the highest it has been since 1964. Equipment hasn’t been this old since 1995, and intellectual-property products, like software, since 1983. In a report issued this past week, Bank of America Merrill Lynch predicts U.S. capex growth will more than double over two years, to 5.7% in 2015, from 2.6% last year. Beyond mounting cash and aging plants and equipment, it cites some new factors. Economic growth is picking up, giving business managers more confidence and less spare capacity. Congress even passed a budget this year—one less thing for business leaders to worry about.

Barron’s goes on to say that many shareholders are now pushing firms to increase capital expenditures. Much of the capex spending behavior in the post-recession era has been driven by uncertainty. Recently in the US we’ve had two major sources of such uncertainty: the Fed’s taper and the federal government budget/debt ceiling. Both of these macro risks frightened corporate management enough to hold back on capex. The Fed’s taper however is now on a slow, fairly predictable “autopilot” and as Barron’s points out, the budget deal has removed the risk of a near-term federal impasse. As far as corporate CEO’s are concerned, the major uncertainties related to the US federal government have clearly receded – for now.

Thus the similarities in timing of the bottoming of loan growth in the US and the start of Fed’s taper may not be a coincidence after all.

Latest Data Confirm China Slowdown

By Sober Look

As a confirmation of a significant downward adjustment to China’s growth (discussed here), a battery of economic reports this morning all came in materially below expectations.

1. Fixed asset investment:

Fixed Asset Investments


2. Industrial production:

Industrial Production


3. Retail sales:

Retail Sales


Clearly there is a seasonal component to these indicators, which may have been impacted by the New Year’s holiday. But on a year-over-year basis much of that should have been reflected in the forecasts.

BW: – “The fairly dramatic slowdown is unusual in Chinese economic history of the last decade” and the figures were “shockingly weak,” said Dariusz Kowalczyk, senior economist and strategist at Credit Agricole CIB in Hong Kong. “It points to a major deceleration of momentum in the beginning of 2014,” wrote Kowalczyk in a research note.

Not surprisingly, over the past few days the equity market has been reflecting these worsening fundamentals.

FXI China large cap ETF


Large cap PRC equities ETF (ticker: FXI) – down 6% in 5 days

Don’t bet on dollar weakness

By Sober Look

The US dollar has been surprisingly weak recently. In fact we are at the lows not seen since just after the US government shutdown when treasury default jitters (see post) sent investors fleeing.


Why is the dollar so weak? Reasons include some economic improvements in the Eurozone and the ECB’s persistent hawkish stance. That’s been driving up the euro. But the main reason has been the barrage of soft economic data out of the US in the past couple of months.

US economic surprise index

However, as discussed earlier (see post), the soft economic patch in the US could be transient. We saw a sign of that in the latest US employment report (see story), which is the justification the Fed needs to continue reducing securities purchases. As the weather across the US improves, economic activity should pick up (some leading indicators already support this thesis) and longer term rates are likely to move higher. And with that we should see the dollar strengthen.


5 Signs of China’s Weakening Credit Markets

By Sober Look

China’s corporate sector has been hit with escalating credit problems. Here is the latest:

1. Shanghai Chaori Energy Science and Technology is about to miss a coupon payment on its bond (see story).

2. As a result, Suining Chuanzhong Economic Technology Development and 2 other companies scrapped their bond offerings – demand for new issue corporate bonds has dried up.

3. Secondary corporate bond trading has also slowed materially. This is fairly new for China since it has never really experienced large scale credit problems in its nascent bond markets.

4. There are indications that banks are cutting back lending as a result. In particular lines have been cut to natural resource wholesalers, traders, and importers (iron ore, steel, cement, etc.). These borrowers in turn are forced to sell inventory that is ofren used as collateral for these loans. Inventory sales depress prices of some of the raw materials, generating further losses for these businesses. This is compounded by the nation’s slack industrial demand, with steel mills now running at 50-70% of capacity.

Iron Ore April Futures


Iron ore April futures contract (source: barchart).

5. With banks cutting back on lending, demand for interbank funding fell materially, sharply lowering China’s money market rates. Both 7-day repo and the 1-week SHIBOR are at lows not seen in quite some time. While lower money market rates are good for banks, at this point there is ample liquidity in the system with far less demand.

China 7-day repo

7-day repo rate (source: chinamoney)


1 week SHIBOR

These developments are quite negative for China’s economy. Confidence in the nation’s credit markets – both bank lending and corporate bonds – has taken a hit. It remains unclear however just how pervasive these problems could become – some think this is just the tip of the iceberg (see story).

Two myths about the Ukrainian conflict

By Sober Look

Myth # 1: Those who believe that Putin’s actions with respect to Ukraine could hurt Russia economically should think again. Global tensions have generally been good for Russia and the current situation is no exception. Russia is not afraid of US administration’s sanctions threats. More dollars are about to start flowing to Putin and his friends (see story).



Brent oil futures (source:

Myth # 2: Similarly those who don’t believe that the Ukrainian conflict will have a major impact on the US (see story) may want to rethink their position. Ignoring these major geopolitical developments just because Ukraine doesn’t have a direct economic link to the North America is shortsighted.

Gasoline futures


US gasoline futures (source Barchart)

The Shrinking MBS Market

By Sober Look

As discussed earlier, the supply of mortgage-backed securities (MBS) continues to fall behind the potential demand – even with the Fed’s taper in place. New issuance has steadily declined over the past year, with the Fed becoming an increasingly larger proportion of that market.


Source: SIFMA

“Mortgage Daily: – For nine straight months, agency issuance of mortgage-backed securities has moved lower — though there was an uptick at the Government National Mortgage Association. Securitization volume now stands at its lowest level in more than two-and-a-half years.

Combined issuance of fixed-rate MBS at the Federal National Mortgage Association, the Federal Home Loan Mortgage Corp. and Ginnie Mae totaled 7 percent less in January than in December.

Securitizations have been lower each month since April 2013, has fallen by more than half compared to January 2013 and was the lowest since July 2011.”

At the same time the Fed is to continue purchasing large amounts of this paper through the end of the year, albeit at a slower pace.

MBS held by Fed


Some of the decline in new issuance has been due to the drop in mortgage refinancing – old securities don’t amortize as quickly and fewer new securities are issued. But part of the reason for the lower volume of these securities remains the supply of mortgage loans. The total mortgage debt outstanding is barely growing – with a great deal of that growth coming from multi-family residence (apartment) financing.

Mortgage debt


As a consequence, MBS paper outstanding has been shrinking since the peak reached back in 2007.

MBS securities


Some of that of course is due to the collapse in private label MBS market, including sub-prime. But the amount of agency (government-backed) MBS has not grown much either.

While some would say that $9 trillion of MBS paper should be sufficient, one has to keep in mind that the US and the global economy is now substantially larger than it was in 2007. MBS, particularly agency bonds, are becoming a smaller portion of the overall capital markets, worsening the shortage of higher quality bonds (see story). Liquidity in that market has also suffered, with average daily trading volumes at the lowest levels in nearly a decade (see chart). These are some of the reasons the Fed should return the MBS market to the private sector by exiting its purchases as soon as possible.