Category Archives: Economy

The ECB can deal with bank funding problems

Benoît Cœuré from the ECB is usually the best when it comes to writing (and speaking) about the transmission mechanism and market operations. Since he’s responsible for Market Operations; Payments & Market Infrastructure; and Research that’s probably not too weird.

He gave a speech today in Dublin, which concludes:

In the nearer term, how can the impediments to bank funding of SMEs be addressed? In essence, these impediments are of three types: the banks’ own funding conditions, their perception of the credit risk of their clients, and lack of capital. The ECB does not have a magic wand. The central bank cannot compensate for a shortage, or a misallocation of equity. That is something that has to be addressed, in one form or the other, by other stakeholders. Neither can the central bank alter the credit risk of individual borrowers, although governments can have an impact here through reforms that improve the operating environment of those firms – labour and product market regulation for instance. Where the central bank has a direct role, within its mandate, is primarily with respect to bank funding conditions. Indeed, the ECB has taken and will continue to take appropriate measures to ensure that bank funding is not a source of financial fragmentation or an impediment to bank lending. It is reasonable to think that simultaneous action on all three counts, by the relevant stakeholders in each case, would be mutually reinforcing.

While I’m not entirely convinced that the ECB can’t do more than “continue to take appropriate measures to ensure that bank funding is not a source of financial fragmentation,” I guess he might be using ECB speak to tell us they can. Or maybe not. His slides are important, though. They show some very interesting trends (although not really breaking news): Screen Shot 2013 04 11 at 5.04.21 PM The ECB can deal with bank funding problems Screen Shot 2013 04 11 at 5.04.29 PM The ECB can deal with bank funding problems Screen Shot 2013 04 11 at 5.04.48 PM The ECB can deal with bank funding problems Screen Shot 2013 04 11 at 5.04.59 PM The ECB can deal with bank funding problems

And finally, a chart showing how SMEs fund themselves. This is interesting when thinking about QE in the eurozone as opposed to the EU. The liabilities side of the balance sheet of European corporates is very different:

Screen Shot 2013 04 11 at 5.04.55 PM The ECB can deal with bank funding problems

All slides here.

Two-tiered Europe, redux

Relatively silence from this end as of late, given other commitments (mostly exams.) I did stump upon this paper from the ECB yesterday, though, which elaborates on the discussion of the two-tiered Europe. A couple of nice graphs:

Screen Shot 2013 03 26 at 1.01.11 AM Two tiered Europe, redux

Screen Shot 2013 03 26 at 1.01.13 AM Two tiered Europe, reduxAbstract:

The Euro area economic activity and banking sector have shown substantial fragility over the last years with remarkable country heterogeneity. Using detailed data on lending conditions and standards, we analyse how financial fragility has affected the transmission mechanism of the single Euro area monetary policy during the crisis until the end of 2011. The analysis shows that the monetary transmission mechanism has been time-varying and influenced by the financial fragility of the sovereigns, banks, firms and households. The impact of monetary policy on aggregate output is stronger during the financial crisis, especially in countries facing increased sovereign financial distress. This amplification mechanism, moreover, operates mainly through the credit channel, both the bank lending and the non-financial borrower balance-sheet channel. Our results suggest that the bank-lending channel has been partly mitigated by the ECB nonstandard monetary policy interventions. At the same time, when looking at the transmission through banks of different sizes, it seems that, until the end of 2011, the impact of credit frictions of borrowers have not been significantly reduced, especially in distressed countries. Since small banks tend to lend primarily to SME, we infer that the policies adopted until the end of 2011 might have fallen short of reducing credit availability problems stemming from deteriorated firm net worth and risk conditions, especially for small firms in countries under stress.

Borrowing in Spain and Italy is expensive — let’s securitize it away

One of the main problems for Europe is the broken transmission mechanism. It’s been a problem for quite some time.

When the ECB cut its rate, it won’t pass through to the areas of Europe that need it: the periphery. There is thus a world in which it is easy to get cheap credit (the core) and a world in which it is expensive (the periphery) — no matter how low the refi rate is.

With that in mind, here’s a Goldman Sachs graph from an excellent note by Huw Piil:

Lending rates in Europe GS Borrowing in Spain and Italy is expensive    lets securitize it away

Here’s Goldman’s explanation of the graph (their emphasis):

Exhibit 1 illustrates the latest data, demonstrating the persistence of the gap between lending rates in the ‘core’ countries (Germany and France) that remain well integrated into Euro financial markets and the ‘peripheral’ countries (Spain and Italy). Indeed, in the January data, this specific measure points to a widening of the gap, despite the success of the ECB’s OMT programme in stabilising government debt markets and narrowing sovereign spreads.

Taking a somewhat longer perspective, it is apparent that the ECB’s easing actions over the past 18 months (the rate cuts in November 2011 and July 2012; the implementation of 3-year LTROs in December 2011 and February 2012; and the announcement of the OMT in September 2012) have passed through to lower bank lending rates in Germany and France, whereas, at best, these measures have only served contain the rise in bank lending rates in Spain and Italy.

The problem summarised by Piil:

Given the weak macroeconomic situation in the periphery, there is a concern that monetary stimulus is not being transmitted to the countries where it is most needed — this is the essence of the impairment to monetary policy transmission that so consumes ECB policymakers. And there is an important sectoral dimension to this impairment, in addition to the cross-country element that has been emphasised thus far: larger companies with access to capital markets are able to issue debt at narrow spreads to sovereigns (and therefore now at reasonable rates even in the periphery), but SMEs are dependent on banks and thus face the elevated rates shown in Exhibit 1. These two dimensions interact and amplify each other: the Spanish and Italian corporate sectors are both dominated by the SME sector.

There are thus two reasons: 1) peripheral countries are more risky and banks (and companies) are increasingly trying to match assets and liabilities on a state-line instead of on a euro zone basis, and 2) the sectoral composition of companies who need credit, where the peripheral have more SMEs without access to capital markets.

So how to ease? As Piil suggests, the ECB could use its collateral framework to support financial innovation. By now, most will probably react like this guy when they hear ‘financial innovation’, but the idea is quite good.

By relaxing the collateral the ECB accepts to include asset-backed securities where the underlying is loans from SMEs in the peripheral, the securitization could start to work.

If the loans could be packed into ABS that could be pledged at the ECB as collateral, it might increase the amount of lending in the peripheral at rates closer to the core. Obviously haircuts would have to be low enough to make it worthwhile, but not so low as to make Weidmann go crazy.

To make ABS backed by peripheral SME loans eligible as collateral might be a way for the ECB to alleviate the problems of structural differences across the monetary zone.

For reference, here’s the ECB’s website on collateral eligibility; and their website on their newly established ABS loan-level initiative.

Cost of currency collapse

‘Currency collapses and output dynamics: a long-run perspective’ by Camilo E. Tovar. A couple of years old, but worth reading. It’s short, too.

Here’s the abstract:

Currency collapses, defined as large nominal depreciations or devaluations, are associated with permanent output losses on the order of 6% of GDP on average. In this feature, we argue that the fact that these losses tend to materialise before a drop in the value of the currency indicates that it is not the large depreciation as such that is costly but the factors leading to the currency collapse. Taken on its own, the drop in the exchange rate actually has a positive effect on output.

Long equities, short commodities, short duration in high yield

I have a new must read blog. From two recent posts, one by Barnejek and one by Mark Dow (who is equally excellent), a few interesting trade ideas.

Here’s the UST 2s-10s. A steepening of the curve is a good sign for risk taking:

2s and 10s Long equities, short commodities, short duration in high yield

Mark points out that along with the steepening 2s-10s UST curve, some currency pairs (EURAUD and EURCHF) are showing sign of normalisation. I’d add Denmark to that list (although not in a currency sense, but in negative deposit rate sense). In addition, we’re seeing mortgage rates moving higher:

Mortgage rates Long equities, short commodities, short duration in high yield

And here’s his comments (my emphasis):

Mortgage rates (above) look set to go higher. Wait. Isn’t this bad for housing and therefore for the overall US recovery?

Answer: no, for two reasons. One, from a financial point of view it shows investors are moving out the risk spectrum. And two, price hasn’t been holding buyers back. Down payments, job security, and tighter lending standard have. Levels are still plenty low enough for solid borrowers who can make the down payment to buy.

If indeed this is the structural shift in risk taking that it appears to be, it will be more about normalizing financial risk appetite than a rapid acceleration in growth—either here in the US or globally. This means the reflexive reach for commodities and commodity proxies (e.g. AUD) that has accompanied every risk impulse for the past five years may come a cropper this time—particularly since we have seen behind the Great Monetary Curtain and realize the machine is being run by mortals (i.e. The broader money supply is endogenous, and is driven by risk appetite and not money printing).

The portfolio implication for the investor? Structurally long equities, hedged with structural commodity shorts.

So over to Barnejek. Annoyed at analysts, he points us the UST spot curve and the 1y forward of that:

UST 10y and 1y forward Long equities, short commodities, short duration in high yield

And what does that mean (his italics, my bold emphasis)?

As you can see, the market is pricing in a shift up of the UST curve by around 27bp in the 10y. In other words, this means that if you sell the 10y bond here and the yield doesn’t go up by at least 28bp in the next twelve months, you effectively lose money. The forward curve is the quickest and the simplest approximation of the carry of the position. You don’t just have to guess the direction but you also have to beat the forwards.

Disclaimer for geeks: I know that simply subtracting 10y yield from the 1y forward is not exactly the same thing as a carry but it will have to do for the purpose of this post.

If you think that 10y US yields will sell-off by 30bp or so then guess what – the market is already pricing that in and nothing spectacular has happened (yet!). Oh and also, in 2011 the difference between the 1y forward 10y yield and spot 10y yield was at times as high as 50bp.

A rise of 30-50 bps would be good for EM debt, he says. Three reasons: 1) it would mean a pick up in activity, but not enough to cause inflationary pressure, 2) US economy will have accelerated but not enough to unwind QE, and 3) problems in the eurozone will be contained.

Now, if we see a reemergence of financial crises in the eurozone, yields will not rise. Also, I’m not so sure about the whole QE unwind, but that’s for another post. Now, how to trade this (my emphasis)?

Contrary to what may seem from this post, I am actually quite concerned about a sell-off in USTs, mainly because of the convexity effect related to mortgage papers. It is totally conceivable that one day a huge flow goes through the market and the said 28bp happens in a few hours rather than a year, like the market implies. Therefore, I still think that investors need to be careful about duration in emerging markets, particularly the ones where you see some signs of activity picking up. I would very much rather own short duration debt of high yielding countries (think 3y Ghana) than long duration debt of low yielding countries (think Poland). That being said, given the technical position of many funds, my base case scenario is that a US-induced sell-off in EM debt will be a good opportunity to go long.

On this Carney + Draghi day

I think the best (and brief) explanation is from Macro Man, so I’ll just copy-paste:

ECB day – TMM felt that the last ECB meeting was dominated by Dr Aghi’s valedictory performance not unlike a returning Caesar entering Rome after defeating the Ursine tribes. All that was missing was the laurel wreath. SO where do we go from here? Data is indeed improving but as always markets are not about working out what will happen its about marrying what you expect to happen against what everyone else expects will happen and though TMM are comfortable that Europe is economically on the mend we do feel that EL Dottore and those piling straight back into Euro  may have over counted their chickens even before they have hatched.

Carney Day – Similarly, but conversely re market positioning, ahead of Mr. Carney’s testimony to the Treasury select committee. We wrote a post on our longer term thoughts on Carney last week but the hype is that he will give an outright dovish performance with some expecting him to go completely BoJ over policy. TMM can see him doing as little as possible to rock the boat as we are still four months off his official arrival and it would be foolhardy to lay the foundations for commitments that may well need to change before he takes up his post. Why paint yourself into a corner when you could have a free option instead.

So marrying these two events we suppose we should really be short of EUR/GBP into them.

Oil shocks just aren’t what they used to be

So says Lúcio Vinhas de Souza, Sovereign Chief Economist of Moody’s Investor Services over at VoxEU.

Commodity price shocks are frequently considered among the most important potential threats to the global economy. However, since the second half of the 1980s, energy prices have experienced very large changes, with arguably limited effects on global GDP developments. This column presents evidence that oil shocks just aren’t what they used to be when it comes to macroeconomic effects.

The article is here, and has a lot of graphs.

That is a bold statement, Mr. Rajoy

From the FT:

Mr Rajoy insisted that any doubts over the current state of the Spanish banking system were misplaced. “I am absolutely convinced that Spanish financial institutions will not require any more funds than were given already,” he said, arguing that Spain’s lenders had already been forced to reveal all their problematic assets in a “complete striptease”.

We’ll see…

Small firms vs. big ones

Kate Mac over at FT AV has a nice post on how small firms are being squeezed by larger ones.

This is, in particular, spot on (my emphasis):

The thing is, as any first year economics student should know, although ‘competition’ is the much vaunted key to free market capitalism, most actual capitalists (owners of capital) don’t like competition happening to them. Why would they?

Leads one’s mind to stories like this. That probably happens in Europe, too… [insert sarcasm if you didn't get it.]

QE — very different in the UK

Toby Nangle from Threadneedle has a note on why QE is very different in the UK compared to the US. The argument is as follows:

In the UK, companies borrow much more on a short term basis (0-10 years) and with variable rates. This means that the monetary easing that comes from buying bonds with long maturities (over 10 years) is much less, because the real easing has already happened with rates so low. The positive effect is thus much less.

On the other hand, UK companies have large defined benefit pension schemes, where the liabilities are discounted back using long-term safe bonds. QE pushes down yields, thus increasing the liabilities of the companies. The monetary easing that comes from lower yields on long-term bonds is thus not enough to off-set the increase in liabilities.

Here’s Nangle’s conclusion:

This leads us to an interesting and counter-intuitive conclusion.

• In the US, falling long-dated bond yields are associated with an easing in monetary conditions. Given the term structure of the US balance sheet, there is good reason to believe that this conventional wisdom is correct.

However, given the term structure of the private sector balance sheet in the UK, whereby companies and household borrowing is overwhelmingly skewed to either floating rate debt or 0-10 year fixed rate debt, and companies must mark their longterm pension obligations to market on an annual basis for the purposes of the Pensions Regulator assessing scheme viability and PPF scheme levies, it is more than feasible that monetary conditions are loosest when short-term bond yields are low, but long-term bond yields are high. This insight flies against the conventional and accepted understanding of how monetary conditions should be assessed, and leads to the conclusion that Bank of England purchases of long-dated bonds that depress their yields might serve to tighten rather than loosen monetary conditions.

• The Chancellor’s move to potentially change the way in which pension scheme viability is assessed may go some way to remove monetary tightening that we believe has been delivered as a result of the confluence of a regulatory environment for pension funds that effectively marks-to-market the present value of their liabilities. But this does introduce new risks for taxpayers in the event that the solvency of PPF is at some point in the future threatened, and political calculations force the taxpayer to come to its rescue.

And a couple of graphs to show why the monetary easing already happened with low rates:

UK borrowing QE    very different in the UK