US Data Warning: Heightened Risks for Negative Surprises

Amid a multi-month string of positive data surprises – which was mirrored by an improved sentiment towards US assets - and especially following the change in seasonal adjustment factors for data referring to January 2012 onwards – as published by the US Department of Commerce on Wednesday – the near-term risks for negative data surprises have increased substantially. I expect US economic data referring to January and especially to February to disappoint on average! However, it does not alter the medium term trajectory of the US economy nor change my positive view on Eurozone assets (see also 2009 all over again? dated January 23). Rather it should see speculation about QE3 in the US intensifying.

I have stated on several occasions that I think the seasonality of the US economy should have decreased but the actual seasonal factors used to adjust the raw-data have increased (see for example: Growing probability of positive US data surprises dated May 31 2011). Since the onset of the last recession in late 2007 the US economy has lost several million in manufacturing and in construction (approx. 2mln each). On the other side, employment in sectors such as healthcare (+1,5mln) has increased. While the former are highly seasonal, the latter is not. As a result, the seasonality of the US economy should have decreased. However, the seasonal factors which have been used in 2010 and 2011 assumed that the seasonality of the US economy has rather increased! The reason for this is that the seasonal factors are calculated via statistically analysing historical data. The sharp slump in GDP following the bust of Lehman Brothers took place in autumn and winter. Given that this period is the seasonally weak period of the year anyhow (with January being the weakest month), the statistical techniques resulted in larger statistical factors. This can be seen in the chart below which shows the seasonal factors used to adjust the raw data of the ISM manufacturing index.

Seasonal Factors used for the US manufacturing ISM index: higher seasonality in 2011?

Source: ISM, ResearchAhead

The factors for 2007 are shown in blue, those for 2011 in grey and the difference between the two in red. As can be seen, in 2011 the period from November to March (i.e. those months where the financial crisis in 2008/2009 led to a stand-still of global trade) was assumed to be significantly weaker than in 2007 (the seasonal factors are lower). On the other side, the seasonal factors for April-August assumed that the economy would be showing more momentum in 2011 than in 2007. Hence, the seasonal factors assumed in 2011 (and 2010) that the US economy’s seasonality increased significantly. As a result, the published seasonally adjusted data painted too positive a picture for data relating to the November-March period and too negative a picture for the April-August period. I think it is no coincidence that the US stock market topped out in spring 2010 and 2011, i.e. just as the period of artificially positive data came to an end. Furthermore during both years it bottomed in summer, i.e. just as the period of artificially weak data was about to end.  

However, yesterday, the US Department of Commerce published the seasonal factors to be used for the calculation of the manufacturing and non-manufacturing ISM indexes in 2012. It stated that: “In response to concerns that the unusually large declines in autumn 2008 associated with the recent recession that may not have been adequately handled with default settings, this year the Department of Commerce used lower thresholds (critical values) for detecting outliers. “

Seasonal Factors used for the US manufacturing ISM index: lower seasonality in 2012
 
Source: ISM, ResearchAhead

As a result, the seasonal factors which are to be used for this year’s ISM releases have been changed materially as the chart above shows which compares the factors for 2011 and 2012. Especially the seasonal factors relating to January-March have been increased significantly (and those for May-October lowered significantly). In turn, the seasonal factors have moved closer again to where they were before the financial crisis.
The result though is significant. For today’s release of the January ISM index, the difference between the 2011 seasonal factors and the 2012 numbers amounts to approx. 0,6 points in the headline number (i.e. the 2012 number should be 0,6 points lower, all else equal) and a full 2 points for the February release! The difference is the largest for the New Orders component where the seasonal factor rose from 0,944 in 2011 to 0,999 in 2012 which depresses this sub-component by approx. 3 points! For the non-manufacturing index, the January 2012 numbers should be 1 point lower than in 2011 purely due to the change in the seasonal factors.
Given that US economic data has surprised positively in the second half of 2011 (see chart below for the Citigroup US economic surprises index), sentiment towards US risky assets and economic forecasts have improved also. However, coupled with the changes in the seasonal factors, this should lead to a significant downside risk in economic data over the next weeks, starting with data relating to January and intensifying for data relating to February!

US Citigroup Economic Surprise Index: multi-months positive surprises should by now be reflected in improved forecasts

 Source: Bloomberg

2009 all over again?

I am convinced that the global economy - ever since the financial crisis started in 2007 and put in motion a deleveraging wave - is going through a multi-year cycle which looks in general like this: Weak growth --> low inflation -->  Liquidity glut (emanating from the central banks in the deleveraging economies) --> higher prices for financial assets --> macro-economic stabilisation --> higher commodity prices --> higher inflation -->tighter monetary policy --> lower prices for financial assets --> lower growth --> low inflation.
2010 was the year where financial asset prices imploded and growth/inflation weakened but I think that we are now again in an environment where the liquidity glut intensifies (mainly due to the ECB's 3y LTRO) which leads to a longer-lasting rebound in prices for equities, (risky) bonds as well as commodities.

The financial crisis (especially following the Lehman bankruptcy in 2008) pressured prices for financial and real assets sharply lower and led to a severe global recession. Inflation fell significantly and in turn global central banks coul,d orchestrate a massive easing wave and liquidity injections. This led a rebound in prices for equities, (risky) bonds and commodities which - coupled with significant fiscal easing steps - helped also the economy to recover. But mainly due to higher commodity prices, this also led to higher inflation rates which was mirrored by a wave of central bank tightening in 2010 and 2011 (mainly in emerging market economies but also in the Eurozone). This in turn weakened growth and - also via a tighter liquidity environment in the Eurozone - intensified the Eurozone sovereign and banking crises. However, as growth weakened substantially and prices for equities, (risky) bonds and commodities fell markedly, inflation started to fall back again, allowing a growing number of central banks to start easing monetary policy. Furthermore, as in late 2008/2009, the central banks at the epicentre of the financial crisis (this time the ECB) injected an unprecedented amount of liquidity into the system.
I have mentioned previously that the ECB's 3y LTROs are leading to a liquidity glut in the Eurozone (see: The Eurozone liquidity glut dated  Jan 17) which should put downward pressure on the external value of the Euro and peripheral/credit bond spreads while it strengthens banks' balance sheets. As a sidenote, the ongoing high level of usage of the ECB's deposit facility usage is not a sign of the stress in the banking sector. If the ECB's support measures create excess liquidity then one way or the other it has to find its way back to the ECB (The liquidity does not go away). More important is whether this liquidity is being hoarded by the banks (a sign of stress) or is floating around the system (and drives asset prices higher as this happens). Last year, banks used the ECB's liquidity operations to hoard cash. However, as Draghi has mentioned at the last press conference, now the banks which make heavy usage of the 3y LTRO are not the ones which deposit liquidity at the deposit facility. Hence, the liquidity has started to float around the system and we are in the midst of a liquidity glut environment!
As a result, I am of the opinion that 2012 could well see a (partial) re-run of 2009, the year where financial markets recovered substantially from very depressed levels and growth turned the corner. I expect financial markets to continue pricing out the systemic risk of a Eurozone collapse/wave of sovereign and bank defaults given that the 3y unlimited liquidity provision keeps the banks liquid and increases the incentives to set up carry trades which in turn also keeps the sovereigns liquid. As this happens, the financial sector should outperform (i.e. bank shares should outperform vs. the rest of the market as should bank bonds). In a second phase, the economic prospects should improve (as sentiment data recovers) which should then take cyclicals higher.


In this environment, especially, the valuation of the Eurozone banking sector appears still at too low levels. The chart below shows the price-book ratio of the Stoxx600 Bank index as well as the index itself. The price-book ratio fell to around 0,5 in early 2009 before recovering to approx. 1,2 in late 2009 and trading around 1 until early 2011. Last year it fell again towards 0,5 and is currently around 0,6. In order to justify these levels, the market assumes that banks either have to take significant losses (which lowers the book-equity) or have to raise new equity at values significantly below book-equity. The first appears unlikely in the short term, given that prices for peripheral bonds (where banks hold a significant exposure) have risen substantially over the past weeks. With the liquidity glut significantly reducing the probability of a default wave, it is difficult to see the banks suffering from such big losses which would lower their book equity. Furthermore, the banks had to present how they plan to fulfil the capital requirements as defined by the latest EBA stress tests until last week and further large rounds of external financing - which dilutes existing shareholders - should be limited. Finally, the ECB essentially injects a two-digit billion Euro amount into bank equity over the next three years without diluting existing shareholders. Following the collapse of Lehman Brothers, markets for bank bonds were shut and banks issued bonds with state guarantees. These bonds had a 3-year maturity (and are expiring this year) and carried an average coupon of 3.5%. Adding to that a fee for the state guarantee, the cost of this funding should have amounted to approx. 4%. If we take this 4% as an average funding cost, then a Eur 500bn take-up at the LTRO for 1% would result in a reduction in financing costs (and hence an improvement in the P&L) of EUR45bn over the next 3 years. In turn, I think that the recovery in prices for financial shares (as well as bank bonds) has further to run.

Eurozone banks still appear undervalued

Source: Bloomberg

The Eurozone liquidity glut

The ECB is orchestrating a Eurozone liquidity glut on an unprecedented scale via their measures to support bank liquidity. It helps the banks to remain liquid and improve their net-interest margin (which in turn helps profitability). Additionally, it also lowers the pain from the significant amount of bank bond redemptions this year and eases the need for banks to deleverage. Furthermore, it has the effect of driving down the external value of the Euro (thereby helping the Eurozone to gain market share and the weak peripheral economies to regain competitiveness at least vs. the non-Eurozone countries) and depressing short-end yields across the credit spectre (thereby easing the pain for the weak peripheral economies and helping the sovereigns to place their new issues). Finally, the resulting higher prices for peripheral bonds strengthens banks' balance sheets. Overall, I think that the second 3y LTRO at the end of February could see a massive take-up and that the ECB's measures are still underappreciated in the market.

I already mentioned in The ECB's XMas Present dated Dec. 19 that I regard the new 3y LTRO by the ECB as an "extremely positive development" and that I expect a huge take-up in the two announced LTROs. In the meantime, the first LTRO took place which resulted in a take-up of EUR 489bn and a net liquidity injection of a bit more than EUR 200bn. Additionally, judging from last week's press conference, ECB president Draghi seemed relaxed about this result and hence we should not expect the ECB to tighten their stance on the upcoming second LTRO at the end of February. For this liquidity operation, I expect an even larger take-up than in December. The easing of the collateral rules which now allow to pledge bank loans meeting specific criteria were not in effect in December given that the national central banks did not yet produce the necessary paperwork. However, Eurozone banks hold approx. EUR7trn in bank loans out of which probably around a fourth to a third might be eligible. Given the very low interest rate on the LTRO of currently 1%, banks don't seem to be able to get cheaper financing of such rather illiquid assets elsewhere. Hence, it makes a lot of sense to fund as much as possible via the upcoming LTRO in order to a) secure financing b) lower financing costs and c) free higher-quality collateral to be used for other transactions. The direct effects will be that the bank system liquidity is secured and the funding pressures on the Eurozone credit markets will ease.
There are approx. EUR 800bn in bank bonds (senior & covered bonds as well as government guaranteed bank bonds) coming to maturity this year. Out of which almost EUR 200bn are government guaranteed paper which were originally issued following the bankruptcy of Lehman Brothers and carried an average coupon of 3.5%. Hence, the effect on the net-interest-margin of Eurozone banks and thus P&L should be substantial. Assuming a total take-up in both operations of EUR700bn (i.e. assuming a net liquidity injection of EUR500bn at the end-of-February LTRO) and using the government-guaranteed cost of funding of 3,5% (which clearly underestimates the true savings in financing costs) suggests a reduction in financing costs of 2,5% p.a. which would equal EUR17.5bn p.a. or approx. EUR50bn over the life of the 3y LTROs.

For the markets, this should have several effects:
a) The external value of the Euro should continue to fall given the rising Euro-glut. The chart below shows the ECB's balance sheet vs. the EUR-USD exchange rate as well as vs. the trade-weighted Euro. As can be seen, during periods of a rising ECB balance sheet (mainly on the back of the liquidity support measures for the banking system), the Euro was in a downward trend which should remain the case. A weaker Euro would also help the Eurozone export sectors to gain market share.

ECB balance sheet vs. external Euro value

Source: Bloomberg, ResearchAhead

b) Short-end carry products should be in demand. Despite the recent fall in yields, the average yield of 3y Belgium/Italy/Spain government bonds is still around 3.4%, i.e. banks can buy these bonds in the secondary market, finance it via the ECB and earn 2.4% p.a. In turn, this should be seen as the main reason why peripheral spreads have tightened markedly over the past weeks.

2-10y Box spreads: Curve normalisation following announcement of 3y LTRO

Source: Bloomberg

c) The higher valuation of government bonds supports bank balance sheets. Given that Eurozone banks hold a significant amount of government bonds on their balance sheets, the fall in government bond prices has weakened bank balance sheets substantially and hence the sovereign crisis also resulted in a banking crisis. Now, however, as sovereign bond prices are rising (given that banks have come back on the buying side), the banking sector balance sheets appear stronger again.

The ECB is orchestrating an unprecedented Euro glut which supports the banks and sovereigns alike. The demand for funds at the second 3y LTRO at the end of February should be very large and its impact should not be underestimated!

The ECB's XMas Present

I regard the new 3y Tender by the ECB (first one to be conducted this Wednesday and the next one in February) as an extremely positive development. The unlimited fixed-rate tender provides the banks with the option to redeem all or part of the acquired liquidity in 1 years’ time. Hence, banks keep flexibility over their collateral usage. More importantly, the ECB eased collateral standards (ABS down to A rating are eligible as are loans to small and medium sized enterprises).

I see the following main advantages of this tender:
1. During the next year a significant amount of bank bonds will reach maturity (around EUR 800bn). Approximately one quarter of this are government guaranteed bonds which were issued after the Lehman bankruptcy and carried an original maturity of around 3 years. Currently, banks face a very difficult environment to issue bonds (even for covered bonds) and most likely would need to revert to a new scheme of government guarantees. However, in those countries where even the sovereigns face a challenging environment to issue bonds, government guarantees would provide only a limited insurance function. However, as banks can now fund themselves for 3 years at 1%, this ECB tender should go a long way in easing the refinancing burden during 2012. It secures medium-term bank liquidity at a very low rate. Furthermore, it eases the pressure for governments as the likely size of needed government guarantees drops. Hence, via this tender, the liquidity provision for banks via sovereigns is being substituted by the ECB!
2. Banks can fund illiquid SME loans at extremely favourable conditions (1% at present). The drawback though is that the necessary legal paperwork so far has apparently not been finished yet and hence it is not clear whether this applies already for this week’s tender or only for the next one in February. This has several effects. For one, banks don’t need to fund these loans anymore in unsecured markets. Hence, it takes the pressure of unsecured funding markets. Furthermore, it increases the positive carry of the bank loan book as funding costs drop sharply. Finally, it frees higher-quality collateral which banks can use for other secured transactions.
3. The refinancing costs for Eurozone banks should fall sharply (as they fund an increasing part of their balance sheet at 1%). This increases realized margins and should help to restore equity over time, improving bank solvability.

I am convinced that the easing of banks’ funding pain is also behind the improvement in the short-end dynamics of the Eurozone periphery over the past week. Especially for small and midsized banks which a) are not part of the EBAs Stress Tests and b) hold large shares of SME loans, this tender should significantly reduce the need to deleverage and on the margin improve the demand for (domestic) government bonds, especially those that trade above 1% yields and mature in around 1-3 years.
Overall, I expect the two tenders to result in a very large take-up by Eurozone banks. However, it is likely that the February tender will be significantly larger given that so far the necessary legal paperwork for accepting bank loans seems not to be finalised yet. However, I do not think that this action is enough to break the adverse feedback loop and the real test will happen from around mid-January onwards, when the sovereign funding spree starts in earnest.


I wish all my readers a happy festive season and a good start for 2012!

Financial Repression

I have been advocating that the ECB should be buying peripheral government bonds for quite some time (see Monetary easing in the wrong places or will the real ECB please stand up? dated 17 November 2010), however, that does not seem to be forthcoming. I have co-authored a research piece which proposes a different solution. It is based on the following:

1. There are no good solutions left

2. We are in the midst of a devastating debt-deflation spiral. While such a downward spiral starts with an insolvent borrower (in our case Greece) it also affects solvent borrowers and via the negative feedback loop (higher yields = higher deficit/lower growth = lower solvability = lower rating =higher yields) it ultimately destroys even the healthiest borrower (for every frequent borrower, there is a level of yield which it can not afford for a prolonged period of time).

3. What directly follows from the above is that we are in a state of multiple equilibria. One equilibria is the one where we are headed to now which will destroy all the sovereign borrowers of the Eurozone/the Euro. Another equilibria is if government bond yields can be lowered enough to restore fiscal solvability (via lower yields) and improve Eurozone bank balance sheets (via higher prices for government bonds).

4. Hence we need to find a very large buyer for Eurozone government bonds. If the ECB does not want to buy and the EFSF is not large enough (and remember as the EFSF has no banking licence, hence it needs to issue bonds itself to get cash before it can buy government bonds in the secondary market), then our solution is to use financial repression. More specifically, we would force banks to substantially increase their liquidity buffers over the next four years with only Eurozone public sector exposure allowed in this liquidity buffer. 

If complemented by a stability union, the prevention of further voluntary/forced haircuts on government bonds as well as the exclusion of Eurozone government bonds from further stress tests by the EBA then we are convinced that this will be able to break the debt-deflation spiral.

The publication can be found here:
English: Enhanced Liquidity Buffer Framework
Deutsch: Rahmenvereinbarung über erhöhte Liquiditätspuffer

A fundamentally more dovish ECB

I have to admit that I did not expect the ECB to cut rates already at today's meeting as I thought the governing council would not deviate from its script it has followed over the past 12 years.
So far the ECB has always set the repo rate for the average of the Eurozone, i.e depending on the outlook for inflation and growth for all of the Eurozone. Additionally, they never cut the repo rate when the nominal growth rate of the Eurozone was still so much above the repo rate as it is now. At the start of the cutting cycle in 2001, the spread between nominal growth (for the previous 12 months) and the repo rate was almost 0 and in 2008 it was negative. Currently, nominal growth is running significantly above the repo rate (+3% yoy up to June 2011). Even assuming zero real growth in both Q3 and Q4, nominal growth only drops to 2,1% by year end. Besides, the repo rate is currently already at low levels.

Nominal Growth vs. ECB Repo Rate: Spot the difference

 

Source: Bloomberg, ResearchAhead

However, while having been wrong with the repo rate cut forecast, I think it will facilitate the rebalancing process within the Eurozone. In those countries where the credit creation process/the monetary transmission mechanism is working (i.e. those without a sovereign debt/banking crisis), the lower repo rate will support domestic growth. The countries are in the North-Eastern part of the Eurozone, most notably Germany, and have been growing at a healthy rate already. The lower repo rate pressures real yields even lower from already historically low levels. With that it will support domestic investment and pressure the savings ratio lower. Furthermore, with wage pressures already building in Germany, inflation should also stay above 2% over the medium term. A stronger domestic German economy supports the overall Eurozone economy while a higher German price level renders it easier for the periphery to regain competitiveness.

Overall, the ECB seems to have moved towards a fundamentally more dovish interpretation of its mandate which threatens price stability in the "strong" Eurozone countries but at the same time helps to restore internal balance in the Eurozone. I stick to my long held multi-year bullish view on the German economy which has just received additional support.

Underwhelmed?

The European politicians have delivered yet another package to break the Eurozone sovereign debt and banking crisis. Having read a few reports by the sell-side I get the impression that in general there is some relief that the  politicians managed to get a deal done but besides that the analyst community does not see that the low point in the crisis has been reached already. Reasons given are that the plan lacks details, does not solve the sovability issues on the table and essentially largely kicks the can down the road again.
Personally, I beg to differ. First, it was clear from the start that the plan would lack details (what else could one have expected?), but this does not make it any worse. Yes, uncertainty surrounding the Greek PSI deal as well as the likely success of the changes in the EFSF will prevail and yes, we are likely to get more bad news from several Eurozone countries/banks. However, a voluntary Greek solution is far better than a hard default would have been and given the bank recapitalisation scheme should not threaten the banking system. Furthermore, The ECB provides unlimited term funding (with the 13m tender in December lasting into 2013), engages in a new covered bonds buying programme to kickstart primary market issuance and some Eurozone countries will likely reintroduce state guarantess for new bank bonds. Additionally, the new EFSF wil be able to insure new issuance by Italy, Spain and Belgium for about the next three years (if it has to insure all new issuance). This drastically reduces the risk of a buyers strike for these countries. Given that all three countries at current yields do not suffer from insolvency but rather from the risk of illiquidity, these measures - together with the ability of the ECB to continue buying bonds in the secondary market - have the ability to break the sovereign debt-deflation spiral. In turn, this would also provide some relief for the asset side of the banking system.
Overall, I see a substantial probability that (on the assumption the ECB can continue with its SMP and Italy adheres to the promised structural reforms) the joint Eurozone sovereign debt and banking crisis has reached a tipping point. With that the markets should turn their focus away from a systemic financial crisis and move towards a focus on growth and inflation. Here the news out of the US remains constructive and I also expect the Asian central banks to take their foot from the brake as inflation slows down markedly over the next 3-6 months. In the Eurozone, the risk of a wave of state and banking defaults has been reduced drastically (as states and banks are being kept liquid) but the price will be more austerity/structural reforms and hence weak growth in the affected countries. Italy and Spain promise to be in recession in 2012 and I expect French growth to be weak (albeit above 0%). However, I remain optimistic for the German economy given that German corporates should continue to gain market share in world markets and the domestic German economy should see an increasing contribution to growth amid high employment, increasing wage pressures and record low real interest rates. As a result, overall Eurozone growth should be relatively low but positive and I do not see a Eurozone recession. In this environment, I expect the ECB to continue with its liquidity provision measures and SMP buying. However, I do not expect the ECB to cut rates anytime soon.