Economy Archives - Page 67 of 135 - the patient investor

August 9, 2014

Why is the Yield Curve Flattening? | PRAGMATIC CAPITALISM

Interesting view from Cullen Roche:

Most fixed income traders view long rates as a function of the economy and short rates as a function of the Fed’s views on the economy. So, when the Fed increases rates it means that the Fed thinks the economy is improving and needs some tightening so it doesn’t cause the Fed to create too much inflation and overheat the economy. But fixed income traders account for this and front-run the Fed’s thinking by trying to anticipate their views on the economy. Said more simply – long rates are a function of short rates for the most part. And the fact that long rates are remaining low means that fixed income traders increasingly believe that we’re in a permanent state of low interest rates.

July 31, 2014

What caused the Dow sell-off?

Dow Jones Industrial Average fell 1.88% to close at 16563, breach of 16750 warning of a secondary correction. Decline of 21-day Twiggs Money Flow below zero would strengthen the signal. Breach of primary support at 15500 is unlikely and the trend remains upward.

Dow Jones Industrial Average

* Target calculation: 16500 + ( 16500 – 15500 ) = 17500

The S&P 500 also fell sharply. Reversal below 1950 warns of a test of medium-term support at 1900. Breach of primary support at 1750 again appears unlikely.

S&P 500

* Target calculation: 1500 + ( 1500 – 750 ) = 2250

The CBOE Volatility Index (VIX) spiked up, but remains below 20 — values normally associated with a bull market.

VIX Index

What caused the sell-off? Commentators seem puzzled. Theories advanced vary from Argentinian default to developments in Eastern Europe. Neither of these seem to hold much water: the market has been aware of the risks for some time and they should be largely discounted in current prices. My own preferred theory is the expectation of a rate rise from the Fed. With good GDP numbers and falling unemployment the Fed may be tempted to tighten a lot sooner than originally expected. Even oil prices are falling. High crude prices is one of the reasons for the cautious Fed taper so far.

Nymex Light and Brent Crude

Which makes me suspect that this correction is going to end like the last “taper tantrum” — with a strong rally when the market realizes that economic recovery will lift earnings.

July 31, 2014

China: The best way to manipulate GDP is to lower inflation

From George Dorgan:

The best way to push real GDP upwards is, hence, to understate inflation via the GDP deflator. Lombard Street Research assumes that Chinese officials followed that approach:

Via Wall Street Journal Blogs
Lombard Street Research, a London economic research firm that takes a bearish view on China, constructs its own version of the country’s GDP. Lombard’s conclusion: China’s economy grew just 6.1% in the fourth quarter of 2013, year-over-year, down from 7.5% the previous quarter. That compares with the 7.7% fourth-quarter increase reported by China’s statistics bureau, which was down a smidgen from 7.8% in the third quarter.

The main difference between Lombard’s numbers and the official numbers, said Lombard economist Diana Choyleva, is the estimation of China’s inflation. GDP is reported in real—that is, inflation adjusted — terms. If China’s inflation is higher than reported, its GDP growth will be lower.

July 30, 2014

Shilling: Big Banks Shift to Lower Gear | The Big Picture

Gary Shilling describes how US regulators are getting tough with big banks:

Break-Up

Like unscrambling an egg, it’s hard to envision how big banks with many, many activities could be split up. But, of course, one of the arguments for doing so is they’re too big and too complicated for one CEO to manage. Still, there is the example of the U.K., which plans to separate deposit-taking business from riskier investment banking activities – in effect, recreating Glass-Steagall.

In any event, among others, Phil Purcell believes that “from a shareholder point of view, it’s crystal clear these enterprises are worth more broken up than they are together.” This argument is supported by the reality that Citigroup, Bank of America and Morgan Stanley stocks are all selling below their book value Chart 5. In contrast, most regional banks sell well above book value.

Push Back
Not surprising, current leaders of major banks have pushed back against proposals to break them up. They maintain that at smaller sizes, they would not be able to provide needed financial services. Also, they state, that would put them at a competitive disadvantage to foreign banks that would move onto their turf.

The basic reality, however, is that the CEOs of big banks don’t want to manage commercial spread lenders that take deposits and make loans and also engage in other traditional banking activities like asset management. They want to run growth companies that use leverage as their route to success. Hence, their zeal for off-balance sheet vehicles, proprietary trading, derivative origination and trading, etc. That’s where the big 20% to 30% returns lie – compared to 10% to 15% for spread lending – but so too do the big risks.

Capital Restoration
….the vast majority of banks, big and small, have restored their capital….Nevertheless, the FDIC and Federal Reserve are planning a new “leverage ratio” schedule that would require the eight largest “Systemically Important Banks” to maintain loss-absorbing capital equal to at least 5% of their assets and their FDIC-insured bank subdivisions would have to keep a minimum leverage ratio of 6%. This compares with 3% under the international Basel III schedule. Six of these eight largest banks would need to tie up more capital. Also, regulators may impose additional capital requirements for these “Systemically Important Banks” and more for banks involved in volatile markets for short-term borrowing and lending. The Fed also wants the stricter capital requirements to be met by 2017, two years earlier than the international agreement deadline….

CEO remuneration is largely driven by bank size rather than profitability, so you can expect strong resistance to any move to break up too-big-to-fail banks. Restricting bank involvement in riskier enterprises — as with UK plans to separate deposit-taking business from riskier investment banking activities — may be an easier path to protect taxpayers. Especially when coupled with increased capital requirements to reduce leverage.

July 28, 2014

Platinum founder warns on property “act of faith”

By Leith van Onselen

The founder of Platinum Asset Management, billionaire investor Kerr Neilson, has released an interesting report warning about Australia’s frothy house price valuations and the risks of a correction once “conditions change, [and] a lot of the assumptions are found wanting”.

The report highlights four “facts” about Australian housing:

1. Returns from housing investment are often exaggerated and flattered by inflation.
2. Holding costs of rates, local taxes and repairs are estimated to absorb about half of current rental yields.
3. Long-term values are determined by affordability (wages + interest rates).
4. To be optimistic about residential property prices rising in general much faster than inflation is a supreme act of faith.

It then goes on to examine each of these facts.

On returns, the report notes that “the rise in the price of an average home in Australia…[has] been about 7% a year since 1986. In dollar terms, the average existing house has risen in value by 6.3 times over the last 27 years. No wonder most people love the housing market!”

But rental returns have gotten progressively poor:

…we earn a starting yield of say 4% on a rented-out home or if you live in it, the equivalent to what you do not have to pay in rent. But again, looking at the Bureau of Statistics numbers, they calculate that your annual outgoings on a property are around 2%. This takes the shape of repairs and maintenance, rates and taxes, and other fees. This therefore reduces your rental return to 2%, and what if it is vacant from time to time?

And the prospect for future solid capital growth is low due to poor affordability:

…the last 20 or so years has been exceptional. Australian wages have grown pretty consistently at just under 3% a year since 1994 – that is an increase of about 1% a year in real terms.

Affordability is what sets house prices and this has two components: what you earn and the cost of the monthly mortgage payment (interest rates).

…even though interest rates have progressively dropped, interest payments today absorb 9% of the average income, having earlier been only 6% of disposable income.

Today, houses cost over four times the average household’s yearly disposable income. At the beginning of the 1990s, this ratio was only about three times household incomes. As the chart over shows, this looks like the peak.

Finally, the report argues that for Australian home prices to significantly outpace inflation over the next ten years, as they have in the past, “would require a remarkable set of circumstances”, namely a combination of:

1. Continuing low or lower interest rates.
2. Willingness to live with more debt.
3. Household income being bolstered by greater participation in the income earning workforce.
4. Average wages growing faster than the CPI.

The last point is improbable seeing that wages and the CPI have a very stable relationship, while the other points are not very likely.

Reproduced with kind permission from Macrobusiness.

July 28, 2014

Is unemployment really falling?

US unemployment has fallen close to the Fed’s “natural unemployment rate” of close to 5.5%. Does that mean that all is well?

Chart: The unemployment rate vs. Fed's measure of "natural" unemployment rate (NAIRU) over the past 20 years – pic.twitter.com/zq2fxtcHLt

— SoberLook.com (@SoberLook) July 28, 2014

Not if we consider the participation rate, plotted below as the ratio of non-farm employment to total population.

Employment Participation Rate

Participation peaked in 2000 at close to 0.47 (or 47%) after climbing for several decades with increased involvement of women in the workforce. But the ratio fell to 0.42 post-GFC and has only recovered to 0.435. We are still 3.5% below the high from 14 years ago.

When we focus on male employment, ages 25 to 54, we exclude several obscuring factors:

the rising participation rate of women;
an increasing baby-boomer retiree population; and
changes in the student population under 25.

Employment Rate Men 25 to 54

The chart still displays a dramatic long-term fall.

July 28, 2014

A compassionate conservative: Arthur C. Brooks

Bill Moyers interviews the American Enterprise Institute’s president Arthur C. Brooks on how to fight America’s widening inequality.

“The problem is we have a bit of a conspiracy between the right and left to have people now who are tending to be more part of the machine…We need a new kind of moral climate for our future leaders.”

Bill Moyers seems a bit light on the economics of the Walmart situation. Raising the minimum wage would reduce welfare payments to Walmart employees, but WMT is a rational entity with the primary goal of maximizing profits and shareholder value. An increase in the minimum wage would increase the appeal of automation and result in a reduction in staff numbers, causing an increase in unemployment, or alternatively WMT will pass on the additional cost in the form of increased prices to consumers, causing a rise in inflation. The only sustainable long-term solution is not an easy one: to increase economic growth and employment so that market-driven wage rates rise. Interference with the pricing mechanism in a market — whether through legislated minimum wages, price controls or Fed interest rates — is misguided and unsustainable. It may defer but also amplifies the original problem.

July 27, 2014

Work for the Dole doesn’t work – but here is what does

From Jeff Borland, Professor of Economics at University of Melbourne:

…95% of the time a government spends thinking about unemployment should be spent thinking about ways to promote economic growth.

July 27, 2014

World wakes to APRA paralysis | Macrobusiness

Posted by Houses & Holes:

Bloomberg has a penetrating piece today hammering RBA/APRA complacency on house prices, which will be read far and wide in global markets (as well as MB is!):

Central banks from Scandinavia to the U.K. to New Zealand are sounding the alarm about soaring mortgage debt and trying to curb risky lending. In Australia, where borrowing is surging, regulators are just watching.

Australia has the third-most overvalued housing market on a price-to-income basis, after Belgium and Canada, according to the International Monetary Fund. The average home price in the nation’s eight major cities rose 16 percent as of June 30 from a May 2012 trough, the RP Data-Rismark Home Value Index showed.

“There’s definitely room for caps on lending,” said Martin North, Sydney-based principal at researcherDigital Finance Analytics. “Global house price indices are all showing Australia is close to the top, and the RBA has been too myopic in adjusting to what’s been going on in the housing market.”

Australian regulators are hesitant to impose nation-wide rules as only some markets have seen strong price growth, said Kieran Davies, chief economist at Barclays Plc in Sydney.

…“The RBA’s probably got at the back of its mind that we’re only in the early stages of the adjustment in the mining sector,” Davies said. “Mining investment still has a long way to fall, and also the job losses to flow from that. So to some extent, the house price growth is a necessary evil.”

…The RBA, in response to an e-mailed request for comment, referred to speeches and papers by Head of Financial Stability Luci Ellis.

…The RBA and APRA have acknowledged potential benefits of loan limits “but at this stage they don’t believe that this type of policy action is necessary,” said David Ellis, a Sydney-based analyst at Morningstar Inc. “If the housing market was out of control and if loan growth, particularly investor credit, grew exponentially then it’d be introduced.”

What do you call this, David:

Reproduced with kind permission from Macrobusiness

July 21, 2014

Jon Cunliffe: The role of the leverage ratio….

Sir Jon Cunliffe, Deputy Governor for Financial Stability of the Bank of England, argues that the leverage ratio — which ignores risk weighting when calculating the ratio of bank assets to tier 1 capital — is a vital safeguard against banks’ inability to accurately model risk:

….. while the risk-weighted approach has been through wholesale reform, it still depends on mathematical models — and for the largest firms, their own models to determine riskiness. So the risk-weighted approach is itself subject to what in the trade is called “model risk”.

This may sound like some arcane technical curiosity. It is not. It is a fundamental weakness of the risk based approach.

Mathematical modelling is a hugely useful tool. Models are probably the best way we have of forecasting what will happen. But in the end, a model — as the Bank of England economic forecasters will tell you with a wry smile — is only a crude and simplified representation of the real world. Models have to be built and calibrated on past experience.

When events occur that have no clear historical precedent — such as large falls in house prices across US states — models based on past data will struggle to accurately predict what may follow.

In the early days of the crisis, an investment bank CFO is reported to have said, following hitherto unprecedented moves in market prices: “We were seeing things that were 25 standard deviation moves, several days in a row”.

Well, a 25 standard deviation event would not be expected to occur more than once in the history of the universe let alone several days in a row — the lesson was that the models that the bank was using were simply wrong.

And even if it is possible to model credit risk for, say, a bank’s mortgage book, it is much more difficult to model the complex and often obscure relationships between parts of the financial sector — the interconnectedness — that give rise to risk in periods of stress.

Moreover, allowing banks to use their own models to calculate the riskiness of their portfolio for regulatory capital requirements opens the door to the risk of gaming. Deliberately or otherwise, banks opt for less conservative modelling assumptions that lead to less onerous capital requirements. Though the supervisory model review process provides some protection against this risk, in practice, it can be difficult to keep track of what can amount to, for a large international bank, thousands of internal risk models.

The underlying principle of the Basel 3 risk-weighted capital standards — that a bank’s capital should take account of the riskiness of its assets — remains valid. But it is not enough. Concerns about the vulnerability of risk-weights to “model risk” call for an alternative, simpler lens for measuring bank capital adequacy — one that is not reliant on large numbers of models.

This is the rationale behind the so-called “leverage ratio” – a simple unweighted ratio of bank’s equity to a measure of their total un-risk-weighted exposures.

By itself, of course, such a measure would mean banks’ capital was insensitive to risk. For any given level of capital, it would encourage banks to load up on risky assets. But alongside the risk-based approach, as an alternative way of measuring capital adequacy, it guards against model risk. This in turn makes the overall capital adequacy framework more robust.

The leverage ratio is often described as a “backstop” to the “frontstop” of the more complex risk-weighted approach. I have to say that I think this is an unhelpful description. The leverage ratio is not a “safety net” that one hopes or assumes will never be used.

Rather, bank capital adequacy is subject to different types of risks. It needs to be seen through a variety of lenses. Measuring bank capital in relation to the riskiness of assets guards against banks not taking sufficient account of asset risk. Using a leverage ratio guards against the inescapable weaknesses in banks’ ability to model risk.