Give me a break (even)

Top: TIPS  & UST curves; Bottom: break-evens

Some market participants have described the mechanism through which quantitative monetary policy (read: LSAPs) works or is intended to work to be centered around inflation expectations. The line of thinking is that the Fed is trying to stoke inflation expectations to incentivise purchase of goods today by increasing the rate at which people expect the price level to increase while holding down rates, increasing the gap between yields and expectations of inflation, commonly referred to as the "real rate" and observed in the market for Treasury Inflation Protected Securities (TIPS).

From the TIPS and US Treasury Notes and Bonds curves we can derive what we call "break-evens," or the level of future inflation at which payoffs of both TIPS and regular Treasuries are the same. There's some idiosyncrasies here because there is optionality in TIPS as and a right skew to inflation, and so it is possible (and in my opinion true) that this option is reflected in yields and TIPS holders are willing to pay an additional premium (which is constantly changing) for the embedded option which is ultimately reflected in break-evens, which are often interpreted as "inflation expectations."

5-year, 10-year, and 5-year forward 5-year break-evens (rhs)
YoY All Urban Consumers CPI (lhs)

It is hard to ignore the sudden rise in break-evens coinciding with anticipation for Fed LSAPs (QE), and I am choosing to interpret this reaction as representative of market participant "animal spirits." The sudden rise in break-evens (71bp for 5y!!) means that a level of inflation above the Fed's symmetrical target is now "priced-in" for US Treasuries. Which leaves us with the question, "Will incremental asset purchases by the Fed increase the compounded annual rate of inflation by 0.70% over the next five years?" My opinion is that they will not and break-evens are showing us that there is either panic over what additional LSAPs mean for near-term inflation or there the option embedded in TIPS is being aggressively bought and the rise in break-evens reflects the rising premium of this hypothetical call option.

With both core and headline YoY CPI comparisons below the 2% symmetrical target, core YoY CPI displaying a negative 1st derivative and YoY comparisons getting easier (CPI rate of change peaked last year around August) it looks to me like break-evens are excessively ebullient given the evidence of quantitative policy effects on the general price level over the last 3+ years in the US. It is my belief that quantitative monetary policy alone during a period of deleveraging can not generate the necessary credit growth to drive meaningful price inflation other than through whatever transitory effect a weaker currency has on commodity inputs (which represent a small % of final price).  As I mentioned in The Twist, redux,

While borrowers continue to deleverage, any impact from lower rates will be limited and as mortgage debt outstanding continues to fall, the marginal stimulative power of monetary policy, unfortunately, diminishes.

Additionally,there is evidence to doubt whether lower MBS spreads will be passed on to customers or whether the banks will keep the windfall. Despite current coupons trading at record tight spreads, the "primary-secondary" spread remains, not only stubbornly high, but near all-time record highs! (see lower left). ... This is why, unless we see further expansion of H.A.R.P. (Home Affordable Refinance Program) which increases the pool of homeowners eligible for refinance, I think the ultimate effect of an "MBS Twist" on aggregate demand will be limited and the ultimate economic beneficiaries will be banks and security holders who see their securities increase in price. 

YoY % change in average hourly and weekly earnings
of private sector employees. (source)

That is why, unless the Fed's continuing LSAPs are paired with fiscal stimulus (hopefully in the form of an extension of the HARP program) I have a hard time believing current break-evens will be achieved. Additionally, I have chosen to interpret the Fed FOMC's decision to embark in another round of LSAPs as confirmation the economy remains fragile and the growth outlook has not improved and, with gasoline prices flirting with $5/gal, and real wages still falling, it is hard to see how marginal purchases of mortgage securities (that have marginally diminishing impact) will manage to stoke aggregate demand to a level that drives meaningful inflation in the short term. Keeping mortgage rates low provides an increase in discretionary income for homeowners able to refinance at a lower rate but, if real wages don't grow and gasoline price increases are taking a significant portion of those savings, the beneficiaries are basically just treading water. And, if I had to guess, I would guess that a non-trivial portion of savings from any mortgage refinancing will go towards paying down revolving credit.

That's why, against every piece of folksy advice* I've gotten from veteran traders, I am very much bullish on the 10-year Treasury Note. I bought exposure to this tenor because I think, in no uncertain terms, that inflation expectations have a harsh reality check coming, the embedded call in TIPS is grossly overpriced and--due to their healthy roll, favorable 2s10s steepness and high exposure to inflation expectations--the ten year note is the ideal way to play this thesis. As such, I will continue to buy weakness in the note and concentrate my duration exposure around this particular tenor. The market has become entirely too intoxicated with the promises of QE and has forgotten that monetary base expansion is not inflationary without both credit and wage growth.

The you go, that is my thesis for buying dimes. In the words of my friend Kevin Ferry, "book it, time-stamp it, laminate it, decoupage it, roll it up and smoke it!"

* "Don't fight the Fed," "Don't fight the tape," "Don't get married to a position," "There's old traders and bold trades but no old bold traders"

Things EFSF Will Not Fix

Expecting a bunch of bureaucrats to fix a decade's worth of accumulated imbalances in a matter of months with some alphabet soup ain't gonna work. What will work? Peripheral countries deflating with respect to core. Not only will it work, but it is the only thing that will work. Pictures follow. Toodles!

Cumulative Inflation relative to Germany. (i.e. Germany CPI would be a flat line at zero)

Balance of Trade (Exports-Imports) for GIIPS

GIIPS Balance of Trade as a % of GDP

Balance of Trade for selected European economies

Balance of Trade for selected European economies as a % of GDP

How China's Negative Real Rates Depress Consumption

If you've ever caught me ranting about China on twitter, you've seen me carry on about how negative real deposit rates are an implicit transfer of wealth from households to government. You may also recognize that point from Michael Pettis' China Financial Markets blog. In this post I'm going to try to explain how this transfer works. It's not complicated, but if you don't understand how developing economies differ from economies like that of the US it can be hard to see the mechanism at work.


The basics:

• Outside the upper-middle and upper classes, consumer credit is not easily available in developing economies. You can't just call Experian and check someone's FICO. Large amounts of the population is unbanked, underbanked or has no credit history at all.
• The deposit and lending rate (and therefore the spread between them) are set by the central government.
• Michael Pettis has estimated real deposit rates are suppressed by "at least 400-600 basis points" (China Financial Markets)

Negative real deposit rates are a transfer of wealth from depositors and creditors to debtors
Because of the limited access to credit that households have, households are the main source of deposits in the system. Like in other developing and under-banked economies with limited access to consumer credit, in China you need to save money until you have the full price to pay for X good (e.g. durables) which, when combined with inflation, forces the households to accept negative real rates. Accepting a 2% yield when there's 5% inflation may mean -3% real rate, but it's better than the -5% cash yields. Reasons for savings include emergencies, possible medical expenses, savings for a home, vehicle purchase or a child's education or every-day cash management. Remember, the rest of the world doesn't use their Capital One to pay for their groceries. With this kind of saving pattern, real rates have inverse effects on saving because, the more negative real rates are, the higher the savings must be to achieve a savings goal or maintain the real value of the savings balance. Without access to credit, negative real deposit rates force the household sector to save more. Money channeled towards savings by the household sector is money that is not spent on consumption. An approximation of total tax on households--and consumption--would be the product of the average daily balance of total deposits multiplied by times the gap between market and government-set rates multiplied by the percentage of household deposits in the system. That estimate excludes any effect from misallocation of resources by borrowers.


Who are the creditors? Who is receiving the transfer?
In April 2009, the Hong Kong Institute for Monetary Research published a paper which claims that state-owned enterprises (SOEs)--which account for about 37.6% of total value added in their respective industries and 25% of GDP--are only, or mostly, profitable due to a preferential cost of capital. According to the authors, "SOEs’ profits would have been entirely wiped out if SOEs were made to pay the same interest rates as otherwise equivalent private enterprises." How big is the problem? Well, "although SOEs’ contribution to the Chinese GDP was around 25%, they received about 65% of total loans."

Seeing as how a large portion of the SOE are involved in investment-related activities (in the GDP sense) and SOE's account for a majority of Chinese GDP the easy conclusion is that investment is being financed by taxing households through the banking sector. Net-winners? Anyone involved in that supply chain and the SOEs. So the transfer is moving from Households to government and business. Which businesses? Well, since, "about 41% of private enterprises have no access to credit and 56% have no access to bank credit," I'm going to guess big businesses.

Negative real rates impede a growth in household consumption by transferring wealth to government and business as long as households bear the cost of those negative real rates.

This leaves us with one way to increase consumption:

1. reduce the burden carried by households as a result of negative real rates.

And two possible ways of achieving that:

1. Raise real rates
2. Transfer some of the cost of negative real rates elsewhere

Barring a flood of foreign depositors itching to deposit funds into RMB-denominated accounts at negative real rates or holding RMB as FX reserves, option two means either government or business. Analyzing the effect to the SOEs is beyond the scope of this post, but since profits ultimately go back to the state, we can look at SOEs and government as one, and consider that subsidy as a tax. It's simply a way for the government to decide how citizens spend their own money. Unless the government stops trying to do that (fat chance), reduced subsidies to SOEs and government would just require more taxes/state-borrowing or less spending, of which the ultimate recipients are the household sector again.

Essentially, the other two beneficiaries of negative real rates, households and private industry with access to credit, are free-riding on this policy and benefiting from low-cost financing, creating a regressive re-distribution of household wealth. This is one of the many reasons we've seen restrictions, like higher down-payments, placed on mortgages of second and third home purchases.

Suggestions
The simplest fix to the problems caused by negative real rates (under-consumption, regressive redistribution, resource misallocation, asset-price inflation) is simply to raise real rates. Of course, raising real rates could cause a surge in NPLs from SOEs that wouldn't be profitable without the implicit subsidy. In the event of a SOE being rendered unprofitable by having to access capital at market rates, the implicit subsidy could simply be turned into an explicit one if the firm's activities were deemed important enough. Otherwise, the firm would go away or shrink, eliminating the dead-weight loss from misallocated resources. The banking system? The risk is already implicitly (and sometimes explicitly) socialized and the problem won't simply go away if Beijing keeps waiting.

Moving real interest rates up doesn't necessarily have to be contractionary for the economy. Sure, the loss of the implicit transfer from households to SOEs / Government would reduce investment capacity, but at the same time it would increase consumption capacity by an equal amount, although probably not the kind of consumption Beijing would prefer. Given the reduction in losses from negative real rates, households would be more able to absorb tax increases if Beijing wished to keep subsidizing investment.

Additionally, stepping closer towards market rates would allow the expansion of consumer credit. Widespread access to consumer credit wouldn't really co-exist well with real negative rates unless there was exterior financing, which would require major changes to the current account. Notwithstanding Q1 2010 numbers, I simply don't see consistent trade deficits for China in the horizon, so the next the easiest and healthiest road to increasing access to consumer credit is simply positive real rates.

Why increase access to consumer credit? In many ways--although not all--savings can be replaced by access to credit. Many people have savings so that they have enough purchasing capacity in short notice in case of an emergency. Credit can replace that cushion in many cases, reducing the need for short-term time or demand or deposits. Following this logic, giving someone access to credit allows them to spend deposits on consumption because the emergency purchasing power they needed is still there in the form of credit. Just this action, without any actual household borrowing, would shift some savings to consumption by reducing the quantity of household savings that need to be parked at deposit institutions.

China Money Supply: September 2010

To see the latest data please see the label Chinese Money Supply

 

So here's a collection of updated charts with the latest money supply numbers from the People's Bank of China and the National Bureau of Statistics of China. Velocity of Money, YoY growth after the jump.

Please note that, purportedly because of demand for physical currency, there is a significant distortion around the Chinese New Year.

Nominal money supply numbers as reported by the People's Bank of China

China Money Supply: August 2010

To see the latest data please see the label Chinese Money Supply

 

So here's a collection of updated charts with the latest money supply numbers from the People's Bank of China and the National Bureau of Statistics of China. Velocity of Money, YoY growth and some new GDP ones after the jump.

Please note that, purportedly because of demand for physical currency, there is a significant distortion around the Chinese New Year.

 

Nominal money supply numbers as reported by the People's Bank of China.

Indexed growth of the money supply compared to growth in GDP (2005=100)

Chinese Money Supply: June 2010 Reserves keep trending down, loans increase

To see the latest data please see the label Chinese Money Supply

This is the latest money supply data from the People's Bank of China and China's National Bureau of Statistics. The English language version hasn't been updated in quite some time, but the Chinese-language version is regularly updated, although it seems like not in a normal schedule. As I've mentioned before, one of the requirements for a Chinese property bubble would be a large and rapid expansion of credit.

Please note that, purportedly because of demand for physical cash money, there is a significant distortion around the Chinese New Year.

As you can see in the first graph, the reserve rate keeps dropping, indicating an increase in loans, but the second graph shows us that, even if growth is still positive, it is at least no longer accelerating. This is what Pettis described as Beijing's stop-and-go measures in May of this year.

Shut-up, WSJ: Bernanke Puzzled by Gold Rally

The WSJ reports:

“I don’t fully understand movements in the gold price,” Mr. Bernanke admitted. But he suggested it might be another example of investors fleeing risky assets and flocking to assets that are perceived as less risky, not only Treasury bonds, but also ones like gold.

It also might have to do with that quantitative easing (e.g. money printing) thing. Or maybe that competitive devaluation (e.g. fiat currency race-to-the-bottom) thing we are experiencing. We havn't seen major effects in price-levels as a result of the money printing because of both a lack of demand for loans, which has kept the money supply from materially increasing, but that doesn't mean people like it when you indiscriminately print money to buy $2 Trillion of shitty agency paper, Mr. Bernanke. Or, maybe, it's just a bubble.

In case you think you are just so smart buying gold to protect yourself from inflation and stick it to the man, you are not. The collectibles tax on bullion is 28%. That means that if the currency collapses and gold goes up 500% your nominal gain is 360%. If prices increase by 400% in addition to this, your real return is actually -8%.

China, bubbles, trade wars and balance of payments

Let's start with the alleged "property bubble," I still have doubts about that big crash coming, increases in property prices have been high, but accounts of high inflation would mean that catastrophic nominal price declines are doubtful. Property prices may lower or stagnate in real terms, but a high rate of inflation--which has its own, different problems--would keep nominal paper profits intact, reducing the risk of widespread loan defaults and huge banking losses that would lead to US-style crash and subsequent balance-sheet recession. Double digit inflation has its problems, but Latin American and other emerging economies have been doing it for many, many years, and they're OK--it's not catastrophic.

Putting aside events that have not happened yet, it's important to look at a bigger picture. As Pettis so eloquently put it last week:

5. If Europe’s current account surplus grows, there must be one or both of two automatic consequences.  Either the current account surplus of surplus countries like China and Japan must contract by the same amount, or the current account deficits of deficit countries like the US must grow by that amount, or some combination of the two.
6. If the Chinas and Japans of the world lower interest rates, slow credit contraction, and otherwise try to maintain their exports – let alone try to grow them – most of the adjustment burden will be shifted onto countries that do not intervene in trade directly.  The most obvious are current account deficit countries like the US.

What we are seeing here is a tough problem for China. On one side it needs to tighten to get a hold on on inflation and prevent potential asset-price bubbles but, on the other hand, doing so would transfer more of the global adjustment burden to itself, losing exports and hurting local businesses. If China decides to keep interest rates low to defend its exporters, potentially negative real interest rates would inevitably create mal-investment and fuel potential bubbles. If it doesn't, then it would risk a recession and widespread pain to its exporters as the result of drastic drops in imports by trade deficit countries as they try to curtail said deficits or even become net exporters. The money-supply data posted earlier is indicative that Chinese "tightening" still leaves pretty loose monetary policy. It really looks like China is in a real bind as a result of its unsustainable attempt to grow at the cost of other nations.

Pettis argues that because China has seen de facto revaluation as a result of the EURUSD drop, China could buy Euros, lots and lots of them, strengthening the Euro vs the Yuan. The problem I see, and Pettis describes, is that trade deficit countries are trying to lower their deficits or even become exporters, but too many people are trying to do the same thing at once, and China, the country with the largest trade surplus, doesn't want to give part of it up. The scary thing I see here is that depressing one's own currency is being seen as the key to exports and therefore prosperity, but if everyone is playing that game, what we'll be left with is a fiat-currency race to the bottom--something I hope never to see in my lifetime, as I don't like guns or canned food.

In my opinion, what China could to do is develop a larger domestic demand for its products. Playing a little game of this thing that looks like that thing, the current practice of exporting stuff and importing money seems a tad Mercantilist, in my opinion. Maybe instead of exporting stuff and importing money (debt, actually) they could import and export stuff. Or keep more of their goods at home, allowing for a larger accumulation of goods by the Chinese people--after all, value creation is not a zero-sum game. Moreover, I firmly believe that the people of China would be better served by working on their country instead of building us trinkets. By that, I mean that the marginal utility of undertakings like education (child and adult alike), immunization, water-treatment, waste disposal, infrastructure improvements and investments in whatever increases quality of life is higher than that of factory work making trinkets for sale in the US. Sometimes I really wonder if policymakers understand that the best and most sustainable path to increasing your wealth is not to take someone else's, it's to create your own.

Chinese money-supply April update

To see the latest data please see the label Chinese Money Supply 

The Chinese money-supply data for April has been released. While it shows no further increases in the rate of growth, with YoY growth levels steady from March, it still shows significant expansion. The M1 measure showed a 31% YoY growth, a decline from its record-setting 39% in January, but still quite elevated; M2 growth dropped by 1% MoM to 21%, down 9% from its October record of 30%; M0 continued its increase at 16%; and the Money Multiplier increased 0.03 points to 5.9, an all-time high. The increasing MM is indicative of a continuing increase in lending, even as reserve-requirements increase (more below) and corroborates the "property bubble" story, but can not be considered evidence. What is clear from this is that there is still increasing demand for loans. While the numbers are nothing radically different from what we've seen in the last couple of months, the M0 growth is quite elevated and indicative of loose monetary policy, a little surprising considering the tightening--via reserve requirement increases--in January and February. It'll be interesting to see the May and June numbers considering the additional increase in reserve-requirements in May, as the numbers do indicate a heated economy.

Please note that, purportedly because of demand for physical cash money, there is a significant distortion around the Chinese New Year.

Chinese money-supply growth slows, reserves inch lower

To see the latest data please see the label Chinese Money Supply
 
Hot on the heels of my complaint about the People's Bank of China not publishing money-supply statistics, the numbers have been published to their Chinese-language website, although still no 2010 data in the English-language version. It's becoming clear that there is evidence of overheating, although--as the second graph suggests--the government's efforts in slowing down growth have worked. In particular, the changes seen between Q1-2009 and Q2-2009 are indicative of overheating. Particularly notable, the M1 changes seen in the last 3 quarters signal the credit-expansion I was referring to last time I wrote about China.

The fact that M1 is still growing at an accelerating pace is worrysome. Just today, Bloomberg reported increasing inflation, hot on the heels of monetary tightening over the past couple of months. While this might sound counter-intuitive, it is well-covered by "Charles" on M Pettis' website. Part of his point being that when people are working towards a target sum by a certain date, lowering the discount rate will only serve to increase the savings rate as people have to make up lost interest income, or that when people have most of their savings in bank deposits instead of other assets, a decrease in the discount rate will have a negative wealth effect. That neat little digression aside, the point I am trying to make here is that these cultural differences in saving and spending behavior coupled with fears about declining purchasing-power of money could lead to an increasing demand for hard-assets, leading to additional upward pressure on prices.

For now, though,  I still think the Chinese "real-estate bubble" is a little too hyped up. Their banking rules require lower LTVs and their bank reserve-requirements are higher, making a US-style housing implosion unlikely. Asset prices may drop or stagnate, but I doubt a full-on implosion leading to a banking crisis is possible without the fuel provided by zero-downs, neg-ams etc. What I would love to see is some data as to what % of bank assets real-estate backed loans compromise and their average LTV. If one is to find evidence of a bubble or lack there-of, it'd be there.

Chinese Money Supply: Record Low Reserves (17%)

To see the latest data please see the label Chinese Money Supply

Note that the numbers available from the PBC only go from Jan2004-Dec 2009. As soon as the 2010 numbers are available I'll post an update. Also, if you are perplexed by that spike in reserves, there is a very simple explanation: Chinese New Year.

Traditionally, Red envelopes or red packets ... are passed out during the Chinese New Year's celebrations, from married couples or the elderly to unmarried juniors ... Red packets almost always contain money, usually varying from a couple of dollars to several hundred.

Wikipedia: Chinese New Year

Chinese Money Supply

When China announced on January 12, 2010 that they were going to raise reserve requirements by 50 basis points everyone broke out in a panic about it. People speculated there would be crashes, that that there was a crazy China bubble or that the Chinese banks were driving asset-price bubbles through insane leverage. While the Chines Money Supply has indeed been growing faster than before as of late, that makes sense. Last year assets were depressed, leaving room for upside, and credit was hard to get. The Chinese central bank dropped reserve requirements by 50 basis points, which encouraged lending. As things settled down people resumed lending and borrowing. Nothing really crazy is going on. If you are part of the Minsky club, like I am, you consider a significant credit boom an essential part of a bubble. So, let's see if there really is some crazy Chinese bubble or if the Central Bank was just returning things to normal.
Please also note how high their reserves are. American banks keep only 10% of reserves on their transaction deposits (checking accounts). Savings accounts, and CDs are time deposits and have no mandated reserve requirement. Do your homework people. It's not that hard.
Sources:
People's Bank of China
Reserve Requirements (NY Fed)