Why should rates rise?
- because they seem really low, don't they?
Why should rates stay low?
- bonds remain in a secular bull market
- there's no evidence of any catalysts that would prompt higher rates (the theory that there will be a flight away from bonds due to fears about the Fed running its printing press remains in the same category as the theory early in the year that huge budget deficits would cause rates to sky-rocket)
- though nominal rates are low relative to historic norms, real rates are very much consistent with historic averages (and, if anything, long Treasuries look cheap)
- the swamp of new Treasury issuance was early this year, and the market digested that, and now there will be less prospective new issuance of longer-dated Treasuries;
- plus there's a new buyer, the Fed, which, if it intends to expand its balance sheet by $1 trillion, could digest virtually all new supply
- as long as the Chinese and OPEC need to recycle the dollars they get from their bilateral trade surpluses with the U.S., there will be foreign buyers of bonds
- easy monetary policy is here to stay as long as unemployment remains high and inflation remains low
- unemployment will remain high and inflation will remain low as long as economic growth remains below potential growth (and even for a not insignificant period of time after growth exceeds potential, as it will take a long time for the output gap to close)
- other asset markets are much riskier than bond markets, so, despite all the talk of a bond bubble, bonds as an asset class, with a guaranteed rate of return if held to maturity, will remain in demand, particularly with LDI, etc.
- the fixed income portion of household balance sheets remains low, and aging boomers will continue to need income-producing assets and more stable portfolios
- the banks have been big buyers of bonds, and as long as they're reluctant to increase their lending to households, they'll continue to be motivated to make money off the yield curve
what have I missed (for either argument)?
Showing posts with label rates. Show all posts
Showing posts with label rates. Show all posts
Tuesday, October 26, 2010
Tuesday, August 24, 2010
Predictions (in prep for next forecast meeting)
"Low-probability" events that I currently predict:
- U.S. is experiencing a balance sheet recession, much like the Japanese did, which leads to very different outcomes than do typical inventory-led recessions, meaning that this will be a bump-along, virtually no-growth era, albeit with lots of volatility
- the wide output gap will persist; economic slack will continue to be disinflationary
- U.S. housing STILL has not bottomed; houses remain overvalued and with the excess supply of homes, even ignoring shadow inventory, (months supply of existing homes now at 12.5 months), pressure on prices will resume
- the U.S. household balance sheet continues to have very much more debt than can be serviced given incomes and nonexistent income growth (median household income adjusted for inflation has not grown since 1997); there will be many more write-offs, loan loss provisions need to increase, which will hit earnings, and deleveraging will persist for a LONG time
- as households delever, deflation picks up (deflation is the contraction of money and credit; though prices as calculated in the CPI are not yet falling, M3 IS, thus deflation)
- with excess capacity and no demand growth, there's no impetus for production growth (other than very short-term inventory cycles), so there is no impetus for employment growth
- waning of inventory rebound and of federal fiscal stimulus will not just no longer add to growth, but will detract from growth, as will the state & local budget cut-backs
- if the U.S. does not double-dip, it will only be because the NBER decides the recession starting December 2007 hasn't actually ended yet (a mid-recession bounce off the lows that does not reclaim the old peak before the down-trend resumes may not justify an end-of-recession call)
- Canada will not decouple from the U.S. going forward any more than it did in 2008/09
- Canada has its own internal imbalances (consumer credit, household debt, housing activity & prices) which makes it not just vulnerable via external shocks, but vulnerable too to unsustainable domestic demand
- China does not just contribute to global imbalances, but has its own severe internal imbalances, which are unsustainable and thus won't be sustained, and China will suffer the same fate as Japan in the 1990s and the U.S. now in the aftermath of the crash of an asset bubble (though many believe the Chinese government has plenty of ability to fine-tune the economy and keep growth near double-digit range, there is not much precedent for successful central planning economies)
- stocks remain in a secular bear market, despite the cyclical swings; stocks will fall below 800 as current very rich valuations (based on cyclically-adjusted P/E ratio and Q-ratio, as opposed to forward P/E) are predicated on robust earnings growth due to robust economic growth, neither of which will materialize; in fact, if fair value is 850ish, and given that stock markets always over-react in each direction, a revisiting of the 600s is not out of the question
- investors will shun stocks and continue to restock the fixed income holdings on their balance sheets, which, for households, remain very low, particulary given the aging baby boomer demographic situation
- Fed will be on hold at least until 2014, likely longer
- BoC will get its overnight rate no higher than 1% while Fed remains at 0%, and I believe it will cut rates again once the shxt hxts the fan again (i.e. once the fact that there's no recovery to speak of becomes obvious)
- the secular bull market in bonds that began in the 1980s has not been broken yet and will not be in the next few years; bond yields will break through the 2009 lows, getting closer to Japanese levels in 2011; US10s will get below 2%, Canada 10s under 2.5% and long bonds to 3%
Context: "Low probability" events that I have previously predicted:
- in late 2006, anticipated not just U.S. housing stalling, but crashing; a recession in 2007; an S&L-type financial crisis
- in Q1/2007, I thought the economy would be in recession in Q2, if it was not already (wrong; but it was by the end of the year)
- in Q2/2007, I predicted a Minsky moment, that the debt bubble would burst (and though I sold most of my non-bank ABCP, I foolishly rationalized not selling my one last piece as it was just a 2-month maturity)
- and that the S&P would fall below 1000 (I was the only in-house predictor of negative stock returns in 2008; however, I was also the only predictor of negative stock returns for the rest of 2007, which was incorrect; early again, like with the recession)
- it was in Q3/2007 that I first started predicting that the U.S. would likely, due to a cratering asset bubble and large private sector debt burden, have an outlook similar to Japan in the 1990s
- in late 2007/early 2008, I predicted that the Fed would drop rates to the old low of 1%
- and, at that time, I believed it was too early to be buying credit (but I did not advocate for selling credit, and I certainly did not foresee spreads widening anywhere near as much as they ultimately did)
- in early 2008 I noted that economic growth since the 1980s had been driven by debt growth, with more and more debt required over time to buy each unit of GDP growth, and therefore that in the absence of debt growth there would be no economic growth; and that though the government could fill the void for awhile and offset private sector deleveraging for a time, it could not do so indefinitely, so economy-wide deleveraging would happen
- in 2008 I agreed that subprime was contained --- to planet Earth
- and I predicted, when losses so far were under $400 billion, that credit writedowns would easily exceed $1 trillion
- I also suggested in mid-2008 that the Fed was in a liquidity trap and that monetary policy, though easy, would not be effective (pushing on a string)
- in Sept 2008, when the S&P was at 1200, I expected stocks to go down a further 14% in 2008 and be down 8% in 2009 (down to 800 then up to 1000) (wrong -- they went lower than I anticipated (to 666), then recovered much more than I anticipated (to 1150))
- in late 2008 I predicted that global decoupling was an optimistic myth, that the global economy relied on the U.S. consumer and would be dragged down by it
- in 2008 and 2009 (and still in 2010) I believed that U.S. housing was not yet in a sustainable recovery
- in early 2009 I predicted that unemployment, then at 8.1%, would exceed 10%; I predicted that the Fed would be on hold for quite some time as, though an overnight rate of 0% seemed very accomodative, relative to a Taylor Rule approximation, it wasn't easy enough, and, because it NEEDED to be very easy, it would STAY very easy; I remained in the deflationary camp; that Fed's so-called printing of money through QE was ineffective as it wasn't a helicopter drop into the hands of consumers, but was instead sitting in banks' excess reserves (effectively just an asset swap), so though the Fed could expand the monetary base, as the money multiplier and velocity fell, monetary base expansion would have no effect on P*Q
- in spring 2009, I removed my hedges, assuming stocks would get back to 900 (at which point I started hedging part of my equity exposure again) or 1000 (at which point I became fully hedged); I did not expect the S&P to get above 1000, and did actually expect much lower stock prices in H2/2009 (below the March low --- wrong) (so I became net short equities as stocks got to 1100 and further at 1200)
- in Sept 2009 I predicted that the Universe bond index would return over 6% and the long index around 10% in 2010
- in late 2009, I predicted that bond yields would head higher in the first half of 2010, along with stock prices, as investors assumed the recovery was underway and entrenched, but that yields and stocks would fall in the second half of 2010 as it became obvious that the stimulus-induced and inventory-led recovery was temporary and not sustainable and that underlying demand remained anaemic and the recovery was really no recovery at all
in other words, just b/c a type of event in a normal economic environment might be of "low probability", in a different type of environment, all bets are off, and probabilities need to be significantly re-appraised
- U.S. is experiencing a balance sheet recession, much like the Japanese did, which leads to very different outcomes than do typical inventory-led recessions, meaning that this will be a bump-along, virtually no-growth era, albeit with lots of volatility
- the wide output gap will persist; economic slack will continue to be disinflationary
- U.S. housing STILL has not bottomed; houses remain overvalued and with the excess supply of homes, even ignoring shadow inventory, (months supply of existing homes now at 12.5 months), pressure on prices will resume
- the U.S. household balance sheet continues to have very much more debt than can be serviced given incomes and nonexistent income growth (median household income adjusted for inflation has not grown since 1997); there will be many more write-offs, loan loss provisions need to increase, which will hit earnings, and deleveraging will persist for a LONG time
- as households delever, deflation picks up (deflation is the contraction of money and credit; though prices as calculated in the CPI are not yet falling, M3 IS, thus deflation)
- with excess capacity and no demand growth, there's no impetus for production growth (other than very short-term inventory cycles), so there is no impetus for employment growth
- waning of inventory rebound and of federal fiscal stimulus will not just no longer add to growth, but will detract from growth, as will the state & local budget cut-backs
- if the U.S. does not double-dip, it will only be because the NBER decides the recession starting December 2007 hasn't actually ended yet (a mid-recession bounce off the lows that does not reclaim the old peak before the down-trend resumes may not justify an end-of-recession call)
- Canada will not decouple from the U.S. going forward any more than it did in 2008/09
- Canada has its own internal imbalances (consumer credit, household debt, housing activity & prices) which makes it not just vulnerable via external shocks, but vulnerable too to unsustainable domestic demand
- China does not just contribute to global imbalances, but has its own severe internal imbalances, which are unsustainable and thus won't be sustained, and China will suffer the same fate as Japan in the 1990s and the U.S. now in the aftermath of the crash of an asset bubble (though many believe the Chinese government has plenty of ability to fine-tune the economy and keep growth near double-digit range, there is not much precedent for successful central planning economies)
- stocks remain in a secular bear market, despite the cyclical swings; stocks will fall below 800 as current very rich valuations (based on cyclically-adjusted P/E ratio and Q-ratio, as opposed to forward P/E) are predicated on robust earnings growth due to robust economic growth, neither of which will materialize; in fact, if fair value is 850ish, and given that stock markets always over-react in each direction, a revisiting of the 600s is not out of the question
- investors will shun stocks and continue to restock the fixed income holdings on their balance sheets, which, for households, remain very low, particulary given the aging baby boomer demographic situation
- Fed will be on hold at least until 2014, likely longer
- BoC will get its overnight rate no higher than 1% while Fed remains at 0%, and I believe it will cut rates again once the shxt hxts the fan again (i.e. once the fact that there's no recovery to speak of becomes obvious)
- the secular bull market in bonds that began in the 1980s has not been broken yet and will not be in the next few years; bond yields will break through the 2009 lows, getting closer to Japanese levels in 2011; US10s will get below 2%, Canada 10s under 2.5% and long bonds to 3%
Context: "Low probability" events that I have previously predicted:
- in late 2006, anticipated not just U.S. housing stalling, but crashing; a recession in 2007; an S&L-type financial crisis
- in Q1/2007, I thought the economy would be in recession in Q2, if it was not already (wrong; but it was by the end of the year)
- in Q2/2007, I predicted a Minsky moment, that the debt bubble would burst (and though I sold most of my non-bank ABCP, I foolishly rationalized not selling my one last piece as it was just a 2-month maturity)
- and that the S&P would fall below 1000 (I was the only in-house predictor of negative stock returns in 2008; however, I was also the only predictor of negative stock returns for the rest of 2007, which was incorrect; early again, like with the recession)
- it was in Q3/2007 that I first started predicting that the U.S. would likely, due to a cratering asset bubble and large private sector debt burden, have an outlook similar to Japan in the 1990s
- in late 2007/early 2008, I predicted that the Fed would drop rates to the old low of 1%
- and, at that time, I believed it was too early to be buying credit (but I did not advocate for selling credit, and I certainly did not foresee spreads widening anywhere near as much as they ultimately did)
- in early 2008 I noted that economic growth since the 1980s had been driven by debt growth, with more and more debt required over time to buy each unit of GDP growth, and therefore that in the absence of debt growth there would be no economic growth; and that though the government could fill the void for awhile and offset private sector deleveraging for a time, it could not do so indefinitely, so economy-wide deleveraging would happen
- in 2008 I agreed that subprime was contained --- to planet Earth
- and I predicted, when losses so far were under $400 billion, that credit writedowns would easily exceed $1 trillion
- I also suggested in mid-2008 that the Fed was in a liquidity trap and that monetary policy, though easy, would not be effective (pushing on a string)
- in Sept 2008, when the S&P was at 1200, I expected stocks to go down a further 14% in 2008 and be down 8% in 2009 (down to 800 then up to 1000) (wrong -- they went lower than I anticipated (to 666), then recovered much more than I anticipated (to 1150))
- in late 2008 I predicted that global decoupling was an optimistic myth, that the global economy relied on the U.S. consumer and would be dragged down by it
- in 2008 and 2009 (and still in 2010) I believed that U.S. housing was not yet in a sustainable recovery
- in early 2009 I predicted that unemployment, then at 8.1%, would exceed 10%; I predicted that the Fed would be on hold for quite some time as, though an overnight rate of 0% seemed very accomodative, relative to a Taylor Rule approximation, it wasn't easy enough, and, because it NEEDED to be very easy, it would STAY very easy; I remained in the deflationary camp; that Fed's so-called printing of money through QE was ineffective as it wasn't a helicopter drop into the hands of consumers, but was instead sitting in banks' excess reserves (effectively just an asset swap), so though the Fed could expand the monetary base, as the money multiplier and velocity fell, monetary base expansion would have no effect on P*Q
- in spring 2009, I removed my hedges, assuming stocks would get back to 900 (at which point I started hedging part of my equity exposure again) or 1000 (at which point I became fully hedged); I did not expect the S&P to get above 1000, and did actually expect much lower stock prices in H2/2009 (below the March low --- wrong) (so I became net short equities as stocks got to 1100 and further at 1200)
- in Sept 2009 I predicted that the Universe bond index would return over 6% and the long index around 10% in 2010
- in late 2009, I predicted that bond yields would head higher in the first half of 2010, along with stock prices, as investors assumed the recovery was underway and entrenched, but that yields and stocks would fall in the second half of 2010 as it became obvious that the stimulus-induced and inventory-led recovery was temporary and not sustainable and that underlying demand remained anaemic and the recovery was really no recovery at all
in other words, just b/c a type of event in a normal economic environment might be of "low probability", in a different type of environment, all bets are off, and probabilities need to be significantly re-appraised
Friday, May 21, 2010
June or July?
Will the BoC hike on June 1, as had been widely expected as of a few weeks ago?
Or will they wait for the July meeting, given they had previously "committed", and reiterated that commitment numerous times, contingent on their inflation projections, to be on hold until the end of the second quarter... and given that economic and market uncertainty --- b/c of the situation in Europe, as well as FinReg in the U.S. --- prevails?
I tend to think that if the Bank was meeting today, given what the ECB is doing, and given what currencies are doing, and given that concerns about the possibility of a global economic double-dip may have mounted in the last couple of weeks, that it would be relatively costless for the BoC to take a wait-and-see approach for another month, whereas it would potentially look odd to hike in two weeks and then perhaps regret it.
That is, of course, if the decision were made today, in the midst of this recent turmoil. But the decision is not today. So that raises the question of what is the likelihood that some meaningful resolution of the European debt crisis is made in the next couple of weeks? In my estimation, this is a problem that is not going away; there is no short-term fix.
That said, there may be band-aids that could be applied that satisfy the market for a while, leading to a bounce-back from the currently oversold condition in stock markets and overbought condition in bond markets. In which case, that raises the question of what is the likelihood that the ECB and European politicians --- who have gotten the market so rattled in recent days and weeks --- actually come to an adequate resolution to satisfy the markets for awhile. Once again, in my estimation, the odds aren't that good; why would they change their stripes over the next week or two?
But let's leave the Euro situation off the table for now. What are the reasons the BoC might hike despite the Euro, and what are the reasons the BoC might hold off?
Hike now:
- by hiking, the Bank would not be tightening so much as starting the process of normalizing rates, and, even with a few hikes, could remain relatively accomodative for some time
- Taylor Rule estimates, based on current levels of CPI and employment, finally suggest that a rate north of 50bp is appropriate
- Q1 GDP is projected to come in up nearly 6% on an annualized basis, following Q4's rise of 1.2% (or 5% annualized)
- Canadian leading economic indicators are up 3% in the 3mths through April and 11% over the last year
- according to the Labour Force Survey, employment has climbed a whopping 148k over the last 3 mths (through April), and even the less volatile Survey of Employment Payrolls and Hours suggests employment has climbed 44k in the 3mths through Februay (pretty consistent with what the LFS said through Feb.)
- retail sales are up 9% YoY through Q1, including up 5.5% ex-autos & gas; retail sales are not just climbing strongly off trough levels, but have surged past the pre-recession peaks
- housing starts and building permits are up significantly off their 2009 lows, and basically back to 2007-type levels
- the Senior Loan Officer Survey says that banks have been easing lending conditions over the last couple of quarters (after a couple years of tightening)
- the Business Outlook Survey suggest future expectations are as positive as they've been over the last decade
Wait and see:
- as of the end of Q4, real and nominal GDP remain 2.5% and 4.4%, respectively, below the peak levels attained in 2008, so even with recent strong growth, the output gap remains substantial
- recent strong growth may be illusory and unsustainable, given that personal consumption accounts for 58% of GDP while personal income accounts for 53% of GDP, so consumption continues to be driven by debt growth;
- similarly, residential investment accounted for 6.9% of GDP at the end of Q4, presumably higher in Q1, and historically has always peaked right around that 7% level, which may portend a housing market due for some cooling
- C$, trading at 94 cents now, is below the BoC's forecasted level of 96-98 cents --- admittedly, it has only been below the Bank's forecast level for a few days, and, admittedly, a lower C$ should actually be stimulative for the economy, giving more reason for the Bank to remove accomodation, but the fact remains that a sharp fall in currency levels could be a telling indicator for the Bank
- further to last, for instance, oil prices have retreated to $70, the lowest level since last July --- which is good for the domestic demand side of the economy, but is a net negative for a net- exporter of oil, and is reflective of commodity prices more generally
- though merchandise trade exports are, through Q1, up 19% from the 2009 trough, they remain 24% below the 2008 peak --- and are sensitive to commodity prices, which have recently been heading down, as noted, and global economic activity, which is at risk
- similarly, wholesale trade is up 9% from the trough, but still down 5% from the previous peak
- though there has been recent job growth, and the number of unempoyed people, at 1.5 million, is down 6% from the worst point in 2009, there are still 42% more unemployed than at the start of the recession; and the unemployment rate, though down to 8.1% from the peak of 8.7%, remains well above the 5.8% pre-recession rate
- both core and headline CPI in Canada are below the Bank's target of 2%, and with the prevailing output gap and the other trends already mentioned, and with U.S. CPI below 1%, there's no clear reason to believe CPI would be escalating rather than be tame or even falling
- that is especially so given that though monetary reserves are up 30% YoY, M1 is up less than half that, at 13.5% YoY, M2 is up about half that, at 6.7% YoY, and M3 is up less than half that, at 2.9% YoY --- so the money multiplier and monetary velocity continue to decline
- indications of a consumer debt bubble in Canada include the facts that mortgage debt as a % of personal income has surged through the 100% level to 116% (vs. a 1990s peak of 84%) and household debt to 170% of GDP, up from 115% in 2000 (apparently Canadians learned nothing from the U.S.)
- the Fed has reiterated that it "continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period", and it is an open question as to how much the BoC can hike without the Fed hiking without currency movements adversely affecting the domestic economy (more than the Bank would be comfortable with)
Really, what it comes down to is how sure is the Bank that recent strong economic trends off recession lows are likely to be sustained?
Personally, I don't buy into the back-to-normal theory, continue to believe that:
- further leveraging (debt growth) in the Canadian economy will make the fall all the worse when it comes
- the U.S. economy has been living off of federal government stimulus for the last year and will soon fall back when (a) that stimulus wanes, and (b) the next round of credit strains (Alt-A and Prime mortgage delinquencies, defaults and related foreclosures) ramps up, and (c) the crisis at the state and municipal levels becomes impossible to ignore
- China is a bubble waiting to burst (details in earlier posts) --- and the recent stock market moves in China may be suggesting that process is underway
- even if Canada, the U.S. and China didn't have their own inherent risks, the linkages in the global economy are too significant for European retrenching not to become problematic for the global economy at large, and European retrenchment will be not just necessary in the PIIGS, but, because of the prevailing bailout mentality, will bring down the European core countries as well (though German exporters will certainly benefit from a weaker Euro, that won't help Canadian or Chinese exporters, so there will be feedback loop impacts)
So, at the end of the day, what do I forecast?
- the Bank does nothing June 1 other than change its commentary to indicate its intention to hike
- the Bank hikes 50bp in July
- the Bank hikes by 25bp once more in early September
- by autumn, things will be visibly messy again
- there will be a European recession, and a double-dip U.S. recession, a significant China slowdown, and, consequently, another Canadian recession
- though domestic demand in Canada will not lead, it will follow; Canadian domestic demand will be the tail, not the dog --- the Canadian recession will not be driven solely by external demand, but the housing and debt bubble in Canada will be pricked by the next global recession
- further BoC hikes will be off the table for a long while, not until the Fed hikes
- the Fed won't hike until perhaps 2014 (yes, Dorothy is not in Kansas anymore; like The Vapors, she, and the FOMC, are Turning Japanese)
p.s. see Canadian Economic Review
Or will they wait for the July meeting, given they had previously "committed", and reiterated that commitment numerous times, contingent on their inflation projections, to be on hold until the end of the second quarter... and given that economic and market uncertainty --- b/c of the situation in Europe, as well as FinReg in the U.S. --- prevails?
I tend to think that if the Bank was meeting today, given what the ECB is doing, and given what currencies are doing, and given that concerns about the possibility of a global economic double-dip may have mounted in the last couple of weeks, that it would be relatively costless for the BoC to take a wait-and-see approach for another month, whereas it would potentially look odd to hike in two weeks and then perhaps regret it.
That is, of course, if the decision were made today, in the midst of this recent turmoil. But the decision is not today. So that raises the question of what is the likelihood that some meaningful resolution of the European debt crisis is made in the next couple of weeks? In my estimation, this is a problem that is not going away; there is no short-term fix.
That said, there may be band-aids that could be applied that satisfy the market for a while, leading to a bounce-back from the currently oversold condition in stock markets and overbought condition in bond markets. In which case, that raises the question of what is the likelihood that the ECB and European politicians --- who have gotten the market so rattled in recent days and weeks --- actually come to an adequate resolution to satisfy the markets for awhile. Once again, in my estimation, the odds aren't that good; why would they change their stripes over the next week or two?
But let's leave the Euro situation off the table for now. What are the reasons the BoC might hike despite the Euro, and what are the reasons the BoC might hold off?
Hike now:
- by hiking, the Bank would not be tightening so much as starting the process of normalizing rates, and, even with a few hikes, could remain relatively accomodative for some time
- Taylor Rule estimates, based on current levels of CPI and employment, finally suggest that a rate north of 50bp is appropriate
- Q1 GDP is projected to come in up nearly 6% on an annualized basis, following Q4's rise of 1.2% (or 5% annualized)
- Canadian leading economic indicators are up 3% in the 3mths through April and 11% over the last year
- according to the Labour Force Survey, employment has climbed a whopping 148k over the last 3 mths (through April), and even the less volatile Survey of Employment Payrolls and Hours suggests employment has climbed 44k in the 3mths through Februay (pretty consistent with what the LFS said through Feb.)
- retail sales are up 9% YoY through Q1, including up 5.5% ex-autos & gas; retail sales are not just climbing strongly off trough levels, but have surged past the pre-recession peaks
- housing starts and building permits are up significantly off their 2009 lows, and basically back to 2007-type levels
- the Senior Loan Officer Survey says that banks have been easing lending conditions over the last couple of quarters (after a couple years of tightening)
- the Business Outlook Survey suggest future expectations are as positive as they've been over the last decade
Wait and see:
- as of the end of Q4, real and nominal GDP remain 2.5% and 4.4%, respectively, below the peak levels attained in 2008, so even with recent strong growth, the output gap remains substantial
- recent strong growth may be illusory and unsustainable, given that personal consumption accounts for 58% of GDP while personal income accounts for 53% of GDP, so consumption continues to be driven by debt growth;
- similarly, residential investment accounted for 6.9% of GDP at the end of Q4, presumably higher in Q1, and historically has always peaked right around that 7% level, which may portend a housing market due for some cooling
- C$, trading at 94 cents now, is below the BoC's forecasted level of 96-98 cents --- admittedly, it has only been below the Bank's forecast level for a few days, and, admittedly, a lower C$ should actually be stimulative for the economy, giving more reason for the Bank to remove accomodation, but the fact remains that a sharp fall in currency levels could be a telling indicator for the Bank
- further to last, for instance, oil prices have retreated to $70, the lowest level since last July --- which is good for the domestic demand side of the economy, but is a net negative for a net- exporter of oil, and is reflective of commodity prices more generally
- though merchandise trade exports are, through Q1, up 19% from the 2009 trough, they remain 24% below the 2008 peak --- and are sensitive to commodity prices, which have recently been heading down, as noted, and global economic activity, which is at risk
- similarly, wholesale trade is up 9% from the trough, but still down 5% from the previous peak
- though there has been recent job growth, and the number of unempoyed people, at 1.5 million, is down 6% from the worst point in 2009, there are still 42% more unemployed than at the start of the recession; and the unemployment rate, though down to 8.1% from the peak of 8.7%, remains well above the 5.8% pre-recession rate
- both core and headline CPI in Canada are below the Bank's target of 2%, and with the prevailing output gap and the other trends already mentioned, and with U.S. CPI below 1%, there's no clear reason to believe CPI would be escalating rather than be tame or even falling
- that is especially so given that though monetary reserves are up 30% YoY, M1 is up less than half that, at 13.5% YoY, M2 is up about half that, at 6.7% YoY, and M3 is up less than half that, at 2.9% YoY --- so the money multiplier and monetary velocity continue to decline
- indications of a consumer debt bubble in Canada include the facts that mortgage debt as a % of personal income has surged through the 100% level to 116% (vs. a 1990s peak of 84%) and household debt to 170% of GDP, up from 115% in 2000 (apparently Canadians learned nothing from the U.S.)
- the Fed has reiterated that it "continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period", and it is an open question as to how much the BoC can hike without the Fed hiking without currency movements adversely affecting the domestic economy (more than the Bank would be comfortable with)
Really, what it comes down to is how sure is the Bank that recent strong economic trends off recession lows are likely to be sustained?
Personally, I don't buy into the back-to-normal theory, continue to believe that:
- further leveraging (debt growth) in the Canadian economy will make the fall all the worse when it comes
- the U.S. economy has been living off of federal government stimulus for the last year and will soon fall back when (a) that stimulus wanes, and (b) the next round of credit strains (Alt-A and Prime mortgage delinquencies, defaults and related foreclosures) ramps up, and (c) the crisis at the state and municipal levels becomes impossible to ignore
- China is a bubble waiting to burst (details in earlier posts) --- and the recent stock market moves in China may be suggesting that process is underway
- even if Canada, the U.S. and China didn't have their own inherent risks, the linkages in the global economy are too significant for European retrenching not to become problematic for the global economy at large, and European retrenchment will be not just necessary in the PIIGS, but, because of the prevailing bailout mentality, will bring down the European core countries as well (though German exporters will certainly benefit from a weaker Euro, that won't help Canadian or Chinese exporters, so there will be feedback loop impacts)
So, at the end of the day, what do I forecast?
- the Bank does nothing June 1 other than change its commentary to indicate its intention to hike
- the Bank hikes 50bp in July
- the Bank hikes by 25bp once more in early September
- by autumn, things will be visibly messy again
- there will be a European recession, and a double-dip U.S. recession, a significant China slowdown, and, consequently, another Canadian recession
- though domestic demand in Canada will not lead, it will follow; Canadian domestic demand will be the tail, not the dog --- the Canadian recession will not be driven solely by external demand, but the housing and debt bubble in Canada will be pricked by the next global recession
- further BoC hikes will be off the table for a long while, not until the Fed hikes
- the Fed won't hike until perhaps 2014 (yes, Dorothy is not in Kansas anymore; like The Vapors, she, and the FOMC, are Turning Japanese)
p.s. see Canadian Economic Review
Saturday, May 23, 2009
Reality vs. Perception
subtitle: have i f'd up?
or, alternatively: my convictions wavering?
Back in December, when the US 10 yr flirted with 2%, I figured that I'd been right to predict/worry that the housing depression, the blowing up of the debt bubble, the stock market collapse, the dismal economy, and the consequent imminent risk of deflation implied a period of structural lower government bond yields, a la Japan.
How fleeting that feeling was!
With the exception of a brief rally in late March after Ben announced implementation of Q.E., rates have been steadily trending higher almost all YTD, with the 10-yr now back to 3.45.
What's changed? Not the economic reality. The economy has contracted at a fast rate over the last two quarters (having fallen faster to a lower level now than anyone in mid-December must have been thinking likely), and though its contracting at a slower rate now (+ve 2nd derivative), the contraction is not yet over (still -ve 1st derivative).
The housing market has shown blips, but its done that off-and-on for two years. So the housing recession is also not yet over, for reasons I've cited before: home prices still too high relative to incomes or rents; still too much excess supply and shadow inventory; credit is constrained, particularly at lower end, which prevents the whole process of sellers at the lower end moving up to be buyers at the higher end. The debt bubble has burst, and a new credit cycle has not been restarted; it will take a long time yet to digest the excessive (private) debt already in the system, an unhealthy portion of which is bad. Particularly given that unemployment keeps rising and incomes are stagnating (at best). Similarly, the consumer retrenchment, as hard as it is psychologically for Americans to give up their spendthrift ways, also won't be over with just a few months of paring back. In a deleveraging world, and one in which repaying debt is prevalent because asset prices are no longer rising, then spending will be constrained to something less than incomes, which themselves are contracting. Corporate profits have tanked, margins are constricted, cost cutting is the order of the day, capacity utilization is awfully low, etc. There don't seem to be many areas in which there is pricing power.
So, for all those reasons, the deflationary forces are as pertinent today as they were in December, if not more so.
But what HAS changed is the market's perception of government's approach to dealing with all this. As Karl Denninger says in U.S. credit rating under fire:
Inflation fears in this regard are somewhat misplaced, because there is a black hole of defaulting credit into which one is attempting to issue, but it is perceptions that counts in a fiat currency world, and the perception in the market is that the US Government has lost control of its deficit and budget process, and The Fed has lost control of the money supply.
Perhaps the bond vigilantes really ARE back!
Denninger believes foreign central banks are selling into Ben's bid, and, if that's so, the game is up --- there will be a bond market implosion and an economic collapse. (Denninger's been warning of this for over a year, of course, which means he was warning of it with yields north of 4%, well over where they are now. I don't believe he foresaw them dropping as low as they did at the end of last year, so the sell-off we've experienced recently still doesn't get us back to levels at which he was saying bonds were doomed. That said, maybe his concerns back then took some time to become widely perceived, but, now that they are, this sell-off, which is already nearing 150bps, could go a long ways yet if Denninger is right. And, needless to say, its views of his type that test my convictions.)
My impression has always been that Denninger's concerns are totally valid, but the question is one of timing. I saw David Walker's Fiscal Wake-Up Tour material while he was still Comptroller General at the GAO (before leaving to work on the same crusade at the Peterson Institute), so I know Denninger is right: the U.S. simply cannot afford to pay off its debts, not while also maintaing the commitments it has made through all its non-funded liabilities, particularly healthcare. At least, it can't do so with dollars that are worth something! The burden is just too big: as Walker's GAO material pointed out, it added up to $170,000 PER PERSON, or $440,000 per household --- and that was as of the end of 2006!! As per the Peterson Foundation, the burden is now $184,000 per person and growing.
But, in the meantime, deleveraging and debt contraction and deflation and the historically very low proportion that bond holdings represent of the U.S. household sector's balance sheets and the relative near-term safety of government debt relative to riskier assets which have taken a drubbing, all meant that there was plenty of room for incremental new internal domestic bond demand to take up the incremental new supply (as Rosenberg argued repeatedly). And even low nominal yields look okay in a disinflationary or deflationary period --- this is one of those rare times that real yields are actually higher than nominal yields.
Meanwhile, though foreign central banks certainly realize the risk to their appreciable U.S. holdings, they're stuck between a rock and a hard place. They may not want to throw good money after bad, but if they stop buying U.S. debt now, not only do they guarantee a loss on their existing positions, but their currencies, which they've been holding down relative to the US$ with those past purchases, would go the other way, killing their own export-dependent economies. And, to the extent that they have trade surpluses with the U.S., they need to do something with the dollars they receive. Would they rather exchange those greenbacks for Euros? Pounds? Yen? Swiss Francs? Lats? Lira? Roubles?
Besides, I'm really not sure Denninger is correct that foreign C.B.s are indeed cutting back on their purchases. Brad Setser is the expert in this field, and he says that central banks still (heart) dollar reserves. Now, it is true that the U.S. trade deficit has declined, in part because oil prices have fallen, and in part because personal consumption has fallen, so imports have fallen faster than exports. And to the extent that the trade deficit is smaller, that implies a smaller net outflow from the U.S. of dollars to the world (to pay for imports relative to received for exports). So less currency recycling is necessary just as the government is ramping up issuance.
But, according to Setser, central banks have actually increased their Treasury holdings at the Fed by almost twice as much as required to finance the trade deficit. However, they are indeed shortening the maturities of the U.S. debt they purchase. So maybe they don't (heart) long bonds. But Setser believes that as the yield curve has steepened significantly, we'll soon get to a point where those foreign buyers will once again look at the paltry yields they're getting on their bills and notes and opt again for the higher yields on bonds.
All told, my convictions have been sorely tested, but, perhaps naively, I don't think I've f'd up too badly. Just like last year when the markets were all gung-ho about commodity-driven inflation, the markets this year are now gung-ho about money-printing-driven inflation. And, just like last year when government bonds rallied in the second half, I remain convinced, like the Van Hoisingtons and Gary Shillings of the world, that we'll have another significant rally coming.
Where my conviction has been most sorely tested, and maybe even lost, (which isn't much help for tactical trading), is how high yields might get in the meantime. But, as I suggested in my May 4 notes about 1998 Japan (In Japan in 1998, long-bond yields declined fairly steadily from 2.70 in January to 1.16 in October, then spiked back to 2.97 by year-end and 3.53 in February. They then fell back below 2 by May.) I think these so-called "green-shoots" type periods will hurt bonds, but, ultimatley, all the bond-friendly factors will prevail, albeit with remarkable volatility in the interim.
or, alternatively: my convictions wavering?
Back in December, when the US 10 yr flirted with 2%, I figured that I'd been right to predict/worry that the housing depression, the blowing up of the debt bubble, the stock market collapse, the dismal economy, and the consequent imminent risk of deflation implied a period of structural lower government bond yields, a la Japan.
How fleeting that feeling was!
With the exception of a brief rally in late March after Ben announced implementation of Q.E., rates have been steadily trending higher almost all YTD, with the 10-yr now back to 3.45.
What's changed? Not the economic reality. The economy has contracted at a fast rate over the last two quarters (having fallen faster to a lower level now than anyone in mid-December must have been thinking likely), and though its contracting at a slower rate now (+ve 2nd derivative), the contraction is not yet over (still -ve 1st derivative).
The housing market has shown blips, but its done that off-and-on for two years. So the housing recession is also not yet over, for reasons I've cited before: home prices still too high relative to incomes or rents; still too much excess supply and shadow inventory; credit is constrained, particularly at lower end, which prevents the whole process of sellers at the lower end moving up to be buyers at the higher end. The debt bubble has burst, and a new credit cycle has not been restarted; it will take a long time yet to digest the excessive (private) debt already in the system, an unhealthy portion of which is bad. Particularly given that unemployment keeps rising and incomes are stagnating (at best). Similarly, the consumer retrenchment, as hard as it is psychologically for Americans to give up their spendthrift ways, also won't be over with just a few months of paring back. In a deleveraging world, and one in which repaying debt is prevalent because asset prices are no longer rising, then spending will be constrained to something less than incomes, which themselves are contracting. Corporate profits have tanked, margins are constricted, cost cutting is the order of the day, capacity utilization is awfully low, etc. There don't seem to be many areas in which there is pricing power.
So, for all those reasons, the deflationary forces are as pertinent today as they were in December, if not more so.
But what HAS changed is the market's perception of government's approach to dealing with all this. As Karl Denninger says in U.S. credit rating under fire:
Inflation fears in this regard are somewhat misplaced, because there is a black hole of defaulting credit into which one is attempting to issue, but it is perceptions that counts in a fiat currency world, and the perception in the market is that the US Government has lost control of its deficit and budget process, and The Fed has lost control of the money supply.
Perhaps the bond vigilantes really ARE back!
Denninger believes foreign central banks are selling into Ben's bid, and, if that's so, the game is up --- there will be a bond market implosion and an economic collapse. (Denninger's been warning of this for over a year, of course, which means he was warning of it with yields north of 4%, well over where they are now. I don't believe he foresaw them dropping as low as they did at the end of last year, so the sell-off we've experienced recently still doesn't get us back to levels at which he was saying bonds were doomed. That said, maybe his concerns back then took some time to become widely perceived, but, now that they are, this sell-off, which is already nearing 150bps, could go a long ways yet if Denninger is right. And, needless to say, its views of his type that test my convictions.)
My impression has always been that Denninger's concerns are totally valid, but the question is one of timing. I saw David Walker's Fiscal Wake-Up Tour material while he was still Comptroller General at the GAO (before leaving to work on the same crusade at the Peterson Institute), so I know Denninger is right: the U.S. simply cannot afford to pay off its debts, not while also maintaing the commitments it has made through all its non-funded liabilities, particularly healthcare. At least, it can't do so with dollars that are worth something! The burden is just too big: as Walker's GAO material pointed out, it added up to $170,000 PER PERSON, or $440,000 per household --- and that was as of the end of 2006!! As per the Peterson Foundation, the burden is now $184,000 per person and growing.
But, in the meantime, deleveraging and debt contraction and deflation and the historically very low proportion that bond holdings represent of the U.S. household sector's balance sheets and the relative near-term safety of government debt relative to riskier assets which have taken a drubbing, all meant that there was plenty of room for incremental new internal domestic bond demand to take up the incremental new supply (as Rosenberg argued repeatedly). And even low nominal yields look okay in a disinflationary or deflationary period --- this is one of those rare times that real yields are actually higher than nominal yields.
Meanwhile, though foreign central banks certainly realize the risk to their appreciable U.S. holdings, they're stuck between a rock and a hard place. They may not want to throw good money after bad, but if they stop buying U.S. debt now, not only do they guarantee a loss on their existing positions, but their currencies, which they've been holding down relative to the US$ with those past purchases, would go the other way, killing their own export-dependent economies. And, to the extent that they have trade surpluses with the U.S., they need to do something with the dollars they receive. Would they rather exchange those greenbacks for Euros? Pounds? Yen? Swiss Francs? Lats? Lira? Roubles?
Besides, I'm really not sure Denninger is correct that foreign C.B.s are indeed cutting back on their purchases. Brad Setser is the expert in this field, and he says that central banks still (heart) dollar reserves. Now, it is true that the U.S. trade deficit has declined, in part because oil prices have fallen, and in part because personal consumption has fallen, so imports have fallen faster than exports. And to the extent that the trade deficit is smaller, that implies a smaller net outflow from the U.S. of dollars to the world (to pay for imports relative to received for exports). So less currency recycling is necessary just as the government is ramping up issuance.
But, according to Setser, central banks have actually increased their Treasury holdings at the Fed by almost twice as much as required to finance the trade deficit. However, they are indeed shortening the maturities of the U.S. debt they purchase. So maybe they don't (heart) long bonds. But Setser believes that as the yield curve has steepened significantly, we'll soon get to a point where those foreign buyers will once again look at the paltry yields they're getting on their bills and notes and opt again for the higher yields on bonds.
All told, my convictions have been sorely tested, but, perhaps naively, I don't think I've f'd up too badly. Just like last year when the markets were all gung-ho about commodity-driven inflation, the markets this year are now gung-ho about money-printing-driven inflation. And, just like last year when government bonds rallied in the second half, I remain convinced, like the Van Hoisingtons and Gary Shillings of the world, that we'll have another significant rally coming.
Where my conviction has been most sorely tested, and maybe even lost, (which isn't much help for tactical trading), is how high yields might get in the meantime. But, as I suggested in my May 4 notes about 1998 Japan (In Japan in 1998, long-bond yields declined fairly steadily from 2.70 in January to 1.16 in October, then spiked back to 2.97 by year-end and 3.53 in February. They then fell back below 2 by May.) I think these so-called "green-shoots" type periods will hurt bonds, but, ultimatley, all the bond-friendly factors will prevail, albeit with remarkable volatility in the interim.
Thursday, March 19, 2009
Updated Interest Rate Forecast
At the beginning of the year, I had penciled ranges of:
US10s 1.5-3.0
US30s 2.0-3.5
Can10s 2.25-3.35
Can30s 2.95-3.95
With the high yields in Q1 and the low yields in H2
My low yields were framed in the context of the Japanese experience under ZIRP and QE and deflation, whereby the whole Japanese curve traded under 1% in 2003, and even before that in 1998 their 10s got to 0.8% and their 20s to 1.3%
Obviously I didn’t foresee US longs backing up 130 bps from their December low of 2.50 (I thought up to 100)
I’m sticking with my US 10s forecasted range, though my US longs ceiling needs raising to 3.70
And I’d stick with my low yields for Canada (though I think there’s a risk we go even lower --- US10s went to 2.05 in December; now that Canada is likely to also go to ZIRP and to QE, and given that I think Canadian GDP and other economic data will be at least as horrid as the US), but would drop my highs to 2.95 on 10s and 3.70 on longs (given that economic data has deteriorated even faster in Canada than I would have anticipated, increasingly the likelihood of Canadian QE)
As such, the relative duration bets I’d advocate, pending further consideration and debate, would be:
2.25 – 0.2 short
2.35 – 0.1
2.45 - neutral
2.55 +0.10
2.65 +0.20
2.75 +0.30
2.85 +0.40
2.95 +0.50 long
US10s 1.5-3.0
US30s 2.0-3.5
Can10s 2.25-3.35
Can30s 2.95-3.95
With the high yields in Q1 and the low yields in H2
My low yields were framed in the context of the Japanese experience under ZIRP and QE and deflation, whereby the whole Japanese curve traded under 1% in 2003, and even before that in 1998 their 10s got to 0.8% and their 20s to 1.3%
Obviously I didn’t foresee US longs backing up 130 bps from their December low of 2.50 (I thought up to 100)
I’m sticking with my US 10s forecasted range, though my US longs ceiling needs raising to 3.70
And I’d stick with my low yields for Canada (though I think there’s a risk we go even lower --- US10s went to 2.05 in December; now that Canada is likely to also go to ZIRP and to QE, and given that I think Canadian GDP and other economic data will be at least as horrid as the US), but would drop my highs to 2.95 on 10s and 3.70 on longs (given that economic data has deteriorated even faster in Canada than I would have anticipated, increasingly the likelihood of Canadian QE)
As such, the relative duration bets I’d advocate, pending further consideration and debate, would be:
2.25 – 0.2 short
2.35 – 0.1
2.45 - neutral
2.55 +0.10
2.65 +0.20
2.75 +0.30
2.85 +0.40
2.95 +0.50 long
Tuesday, January 6, 2009
2009 Interest Rate Forecast
Premise
- early year Obama confidence equity rally, combined with bond supply concerns will cause yields to temporarily sell off (much the same way market was focused on commodity-fueled inflation last spring) from recent virtual-record lows
- economic data will continue to deteriorate, as will corporate profits
- credit crunch will not go away any time soon, nor will housing recession end in 2009
- liquidity trap will prevent traditional monetary policy from being effective, while credit crunch (and U.S. making same mistakes Japan did with respect to zombie banks) will prevent experimental Fed policy from gaining traction
- Fed can print money, but can’t force people to borrow/lend or spend; velocity will drop, as will broad money measures, as contraction in credit more than offsets expansion of monetary base
- Tightened credit conditions and spreads blowing out means Fed has been pushing on a string, which means there really has been no monetary stimulus to offset all the economy’s problems
- global growth will underperform even the recently-downgraded projections, with the fall-off in emerging markets being the most surprising, as global trade effectively shuts down
- even if we don’t get 2 consecutive quarters of negative growth in near-term, by any other measure, Canada’s economy is already in recession, joining most of the OECD
- U.S. recession will last years (if one looks through stimulus-induced bounce which will prove to lead to a double-dip) (with unemployment exceeding 10% in 2010) until the misallocations of the past 15 years are finally adjusted to (too much overcapacity in housing, in CRE, in banking, in autos; too much debt: too much personal debt at household level; too much junk debt in corporate sector; too much leverage in financial sector (way more writedowns coming)
- Fed will remain at effectively 0 into 2010; BoC will cut to 0.50 (if not lower; like BoE, may also need to resort to ZIRP and QE at some point)
Government Rates
2008 Hi Low Now
CAN 2s 3.75 1.05 1.20
CAN 10s 3.95 2.55 2.90
CAN 30s 4.30 3.35 3.65
US 2s 3.05 0.65 0.85
US 10s 4.10 2.05 2.55
US 30s 4.70 2.50 3.10
Historical Comparison
1994 Hi 1998 Low 2003 Low
Japan 2s 3.40 0.40 0.05
Japan 10s 5.00 0.80 0.50
Japan 20s 5.25 1.30 0.95
Other Considerations
- typical seasonality may play well into thematic approach above, as yields typically rise in first half of year and fall in second half; CAN10 peak yields occurred in 2001 in May, 2002 in March, 2003 in April, 2004 in June, 2005 in March, 2006 in July, 2007 in June, 2008 in Feb/June/July
2009 Forecast
H1 High H2 Low
CAN 2s 1.35 0.75
CAN 10s 3.35 2.25
CAN 30s 3.95 2.95
US 2s 1.10 0.40
US 10s 3.00 1.50
US 30s 3.50 2.00
- Spreads --- narrow in Q1 with stock market rally, re-widen to new wides in H2 as bankruptcies and defaults spike and as deflation and depression look inevitable
- 2010 risk --- disorderly resolution of global imbalances à all U.S. $ assets get killed (which should actually be good for C$ assets, including bonds, as foreigners who hold US$ diversify)
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