Fed Goes Looking For Evidence Of Broken Treasury Market, Decides Everything Is Fine

One doesn’t have to look very far to find evidence that the Fed’s monumental attempt to corner the Treasury market is producing all manner of distortions and anomalies.

For example, one could point to episodic instances of acute collateral shortages manifested by "immensely" special repo rates. If that’s too esoteric for you, just go and have a look at a 10Y chart from October 15 of last year and ask yourself what happened there. Put simply, when someone comes along and does a multi-trillion dollar bellyflop into any market - even one that could previously be described as the deepest and most liquid on the planet - there are bound to be far-reaching repercussions for market function and that’s precisely what’s happening, and not only in USTs but in JGBs and most recently in German bunds. 

Apparently someone at the NY Fed decided that with everyone in the financial universe suddenly screaming about liquidity (or a lack thereof) it was time to take a cursory look at the issue and make a half-hearted, slightly disingenuous attempt to find out if there’s really a problem. 

So that’s exactly what Tobias Adrian, Michael Fleming, Daniel Stackman, and Erik Vogt did. There results are posted on the NY Fed’s blog and we present some of the highlights below. 

Bid-ask spreads suggest ample liquidity

One of the most direct liquidity measures is the bid-ask spread: the difference between the highest bid price and the lowest ask price for a security. As shown in the chart below, bid-ask spreads widened markedly during the crisis, but have been relatively narrow and stable since.

Of course bid-asks aren’t really the best way to assess this - market depth is. That is, the question is this: can you transact in size without accidently causing some kind of catastrophe?

On that question the NY Fed is a bit less optimistic.

But other high-frequency measures point to some deterioration

Other measures paint a less sanguine picture of Treasury market liquidity. The chart below plots order book depth, measured as the average quantity of securities available for sale or purchase at the best bid and offer prices. Depth rebounded healthily after the crisis, but declined markedly during the 2013 taper tantrum and around the October 15, 2014 flash rally. It is not unusually low at present by recent historical standards.

Measures of the price impact of trades also suggest some recent deterioration of liquidity. The next chart plots the estimated price impact per $100 million net order flow as calculated weekly over five-minute intervals; higher impacts suggest reduced liquidity. Price impact rose sharply during the crisis, declined markedly after, and then increased some during the taper tantrum and in the week including October 15, 2014. The measure remained somewhat elevated after October 15, but is not now especially high by recent historical standards.

The authors' takeaway from the above is that "high-frequency liquidity measures provide a mixed message regarding the state of Treasury liquidity." And while that doesn't sound particularly comforting, we shouldn't worry because the Fed doesn't think those are actually the right measures. When one looks at another set of indicators, everything is actually ok. To wit: "...the daily measures we consider are more consistent." 

As an aside, it would have helped if, in the depth chart shown above, they hadn't plotted the 10Y on the same chart with the 2Y because as you can see from the following, the picture looks a little different when the 10Y is plotted on its own.

All in all, the authors conclude that "the current state of Treasury market liquidity [is] fairly favorable," but do concede that "the events of October 15 and similar episodes of sharp, seemingly unexplained price changes in the dollar-euro and German Bund markets have heightened worry about tail events in which liquidity suddenly evaporates." 

Why yes, yes they do "heighten worries" because as you can see from the following, market depth just seems to disappear out of the clear blue nowadays.

We also noticed that at the end of the article, the authors promise to ferret out the causes of such anomalous events "in a future blog post."

To the NY Fed we say this: we know the good folks at 33 Liberty have more important things to do (like running the equity plunge protection team) than spending time searching for the culprits behind the Treasury flash crash, so we'll go ahead and point you in the right direction. First, look in the mirror, next refer to the graphic shown below.

Mystery solved. You are welcome.

Submitted by Tyler Durden [1] on 07/22/2015 19:40

China's Record Dumping Of US Treasuries Leaves Goldman Speechless

On Friday, alongside China's announcement that it had bought over 600 tons of gold in "one month", the PBOC released another very important data point [12]: its total foreign exchange reserves, which declined by $17.3 billion to $3,694 billion.

We then put China's change in FX reserves alongside the total Treasury holdings of China and its "anonymous" offshore Treasury dealer Euroclear (aka "Belgium") as released by TIC, and found that the dramatic relationship which we first discovered back in May [13], has persisted - namely virtually the entire delta in Chinese FX reserves come via China's US Treasury holdings. As in they are being aggressively sold, to the tune of $107 billion in Treasury sales so far in 2015.

[14]

We explained all of his on Friday in "China Dumps Record $143 Billion In US Treasurys In Three Months Via Belgium [15]", and frankly we have been surprised that this extremely important topic has not gotten broader attention.

Then, to our relief, first JPM noticed. This is what Nikolaos Panigirtzoglou, author of Flows and Liquidity had to say on the topic of China's dramatic reserve liquidation

Looking at China more specifically, it appears that, after adjusting for currency changes, Chinese FX reserves were depleted for a fourth straight quarter by around $50bn in Q2. The cumulative reserve depletion between Q3 2014 and Q2 2015 is $160bn after adjusting for currency changes. At the same time, a current account surplus in Q2 combined with a drawdown in reserves suggests that capital outflows from China continued for the fifth straight quarter. Assuming a current account surplus in Q2 of around $92bn, i.e. $16bn higher than in Q1 due to higher merchandise trade surplus, we estimate that around $142bn of capital left China in Q2, similar to the previous quarter.

JPM conclusion is actually quite stunning:

This brings the cumulative capital outflow over the past five quarters to $520bn. Again, we approximate capital flow from the change in FX reserves minus the current account balance for each previous quarter to arrive at this estimate (Figure 2).

[16]

Incidentally, $520 billion is roughly triple what implied Treasury sales would suggest as China's capital outflow, meaning that China is also liquidating some other USD-denominated asset(s) at a feverish pace. So far we do not know which, but the chart above and the magnitude of the Chinese capital outflow is certainly the biggest story surrounding the world's most populous nation: what is happening in its stock market is just a diversion.

At this point JPM goes into a tangent explaining what the practical implications of a massive capital outflow from China are for the global economy. Regular readers, especially those who have read our previous piece on the collapse in the Petrodollar [17], the plunge in EM capital inflows, and their impact on capital markets and global economies can skip this part. Those for whom the interplay of capital flows and the global economy are new, are urged to read the following:

One way that slower EM capital flows and credit creation affect the rest of the world is via trade and trade finance. Trade finance datasets are unfortunately not homogeneous and different measures capture different aspects of trade finance activity. Reuters data on trade finance only aggregates loan syndication deals, which have mandated lead arrangers and thus capture the trends in the large-scale trade lending business, rather than providing an all-inclusive loans database. Perhaps the largest source of regularly collected and methodologically consistent data on trade finance is credit insurers (see “Testing the Trade Credit and Trade Link: Evidence from Data on Export Credit Insurance”, Auboin and Engemann, 2013). The Berne Union, the international trade association for credit and investment insurers with 79 members, includes the world’s largest private credit insurers and public export credit agencies. The volume of trade credit insured by members of the Berne Union covered more than 10% of international trade in 2012. The Berne Union provides data on insured trade credit, for both short-term (ST) and medium- and long-term transactions (MLT). Short-term trade credit insurance accounts for the vast majority at around 90% of new business in line with IMF estimates that the vast majority 80%-90% of trade credit is short term.

Figure 4 shows both the Reuters (quarterly) and the Berne Union (annual) data on trade finance loan syndication and trade credit insurance volumes, respectively. The quarterly Reuters data showed a clear deceleration this year from the very high levels seen at the end of last year. Looking at the first two quarters of the year, Reuters volumes were down by 25% vs. the 2014 average (Figure 4). The more comprehensive Berne Union annual volumes are only available annually and the last observation is for 2014. These data showed a very benign trade finance picture up until the end of 2014. Trade finance volumes had been trending up since 2010 at an annual pace of 8.8% per annum (between 2010 and 2014) which is faster than global nominal GDP growth of 6% per annum, i.e. the trend in trade finance had been rather healthy up until 2014, but there are indications of material slowing this year. This is also reflected in world trade volumes which have also decelerated this year vs. strong growth in previous years (Figure 5).

Summarizing the above as simply as possible: for all those confounded by why not only the US, but the global economy, hit another brick wall in Q1 the answer was neither snow, nor the West Coast strike, nor some other, arbitrary, goal-seeked excuse, but China, and specifically over half a trillion in still largely unexplained Chinese capital outflows.

* * *

But wait, because it wasn't just JPM whose attention perked up over the weekend. This morning Goldman Sachs itself had a note titled "the Curious Case of China's Capital Outflows":

China’s balance of payments has been undergoing important changes in recent quarters. The trade surplus has grown far above previous norms, running around $260bn in the first half of this year, compared with about $100bn during the same period last year and roughly $75bn on average during the previous seven years. Ordinarily, these kinds of numbers would see very rapid reserve accumulation, but this is not the case. Partly that is because China’s services balance has swung into meaningful deficit, so that the current account is quite a bit lower than the headline numbers from trade in goods would suggest. But the more important reason is that capital outflows have become very sizeable and now eclipse anything seen in the recent past.

Headline FX reserves in the second quarter fell $36bn, from $3,730bn at end-March to $3,694bn at end-June. While we estimate that there was a large negative valuation effect in Q1 (due to the drop in EUR/$ on the ECB’s QE announcement), there was likely a positive valuation effect in Q2, which we put around $48bn. That means that our proxy for reserve accumulation in the second quarter is around -$85bn, i.e. the actual “flow” drop in reserves was bigger than the headline numbers suggest because of a flattering valuation effect. If we put that number together with the trade surplus in Q2 of $140bn, net capital outflows could be around -$224bn in the quarter, meaningfully up from the first quarter. There are caveats to this calculation, of course. There is obviously the services deficit that we mention above, which will tend to make this estimate less dramatic. It is also possible that our estimate for valuation effects is wrong. Indeed, there is some indication that valuation-related losses in Q1 were not nearly as large as implied by our calculations. But even if we adjust for these factors, net capital outflows might conceivably have run around -$200bn, an acceleration from Q1 and beyond anything seen historically.

Granted, this is smaller than JPM's $520 billion number but this also captures a far shorter time period. Annualizing a $224 billion outflow in one quarter would lead to a unprecedented $1 trillion capital outflow out of China for the year. Needless to say, a capital exodus of that pace and magnitude would suggest that something is very, very wrong with not only China's economy, but its capital markets, and last but not least, its capital controls, which prohibit any substantial outbound capital flight (at least for ordinary people, the Politburo is clearly exempt from the regulations for the "common folk").

Back to Goldman:

The big question is obviously what is driving these flows and how long they are likely to continue. We continue to take the view that a stock adjustment is at work, although it is clear that the turning point is yet to come. We will look at this in one of our next FX Views. In the interim, we think an easier question is what this means for G10 FX. This is because this shift in China’s balance of payments is sure to depress reserve accumulation across EM as a whole, such that reserve recycling – a factor associated with Euro strength in the past – is unlikely to be sizeable for quite some time.

In other words, for once Goldman is speechless, however it is quick to point out that what traditionally has been a major source of reserve reflow, the Chinese current and capital accounts, is no longer there.

It also means that what may have been one of the biggest drivers of DM FX strength in recent years, if only against the pegged Renminbi, is suddenly no longer present.

While the implications of this on the global FX scene are profound, they tie in to what we said last November [17]when explaining the death of the petrodollar. For the most part, the country most and first impacted from this capital outflow will be China, something its stock market has already noticed in recent weeks.

But what is likely the take home message for non-Chinese readers from all of this, is that while there has been latent speculation over the years that China will dump US treasuries voluntarily because it wants to (as punishment or some other reason), suddenly China is forced to liquidate US Treasury paper even though it does not want to, merely to fund a capital outflow unlike anything it has seen in history. It still has a lot of 10 Year paper, aka FX reserves, left: about $1.3 trillion at last check, however this raises two critical questions: i) what happens to 10 Year rates when whoever has been absorbing China's Treasury dump no longer bids the paper and ii) how much more paper can China sell before the entire world starts paying attention, besides just JPM and Goldman... and this website of course.

Finally, if China's selling is only getting started, just what does this mean for future Fed strategy. Because one can easily forget a rate hike if in addition to rising short-term rates, China is about to dump a few hundred billion in paper on a vastly illiquid market.

Or let us paraphrase: how soon until QE 4?

Submitted by Tyler Durden on 08/18/2015 07:53

Indonesia Impaled: Currency Crashes To 1998 Asian Crisis Low As Exports Crater

On Monday we laid out the rather dire road ahead for the world’s emerging economies in the face of China’s entry into the global currency wars. The path ahead is riddled with exported deflation and decreased trade competitiveness for a whole host of emerging economies [and] all of this is set against a backdrop of declining global growth and trade, a trend which many had assumed was merely cyclical, but which in fact may prove to be structural and endemic."

Well don’t look now, but trade just collapsed for Indonesia as exports and imports plunged 19.2% and 28.4% (more than double to consensus estimate), respectively in July.

Imports of raw materials dove 24%. Manufacturing and palm oil exports fell 7.1% and 2.4%, respectively, nearly tripling June’s declines. Oil and gas exports fell nearly 8%.

Meanwhile, Bank of Indonesia kept its policy rate on hold at 7.5% and indeed the bank looks to be stuck in a dilemma similar to what we described earlier this month when we noted that "EM central bankers are grappling with slumping exports and FX-pass through inflation or, more simply, bankers are caught between a 'can’t cut to boost the economy' rock and a 'can’t hike to tame inflation' hard place. The rupiah, like the Malaysian ringgit, is trading near multi-decade lows and hit its weakest level since August 1998 earlier in the session.Depressed commodity prices and slumping demand from China aren’t helping. 

And neither is Beijing's devaluation of the yuan which means that suddenly, Indonesia has lost export competitiveness to China while anything China imports from Indonesia will now cost more. 

"We believe there is a strong case for the central bank remaining on hold this year," Barclays notes, adding that "BI is visibly more reluctant to weaken the IDR in the near term, to avoid stoking imported price pressures[and] the commodity drag due to weaker demand from China has not subsided." Similarly, Toru Nishihama, EM economist at Dai-ichi Life Research Institute says the "hurdle is higher for BI to cut rate due to the rupiah’s move even though inflation will slow toward year-end due to base effect from last year’s fuel price increase." Of course cuts, even if they do come, are now less effective in terms of boosting exports as the yuan devaluation puts upward pressure on regional NEER. 

In other words, there are no right answers. Just more pain and further pressure on the beleaguered economy and severely battered currency and further evidence that between China's entry into the global currency wars, depressed global commodity prices, the threat of an imminent Fed hike, and a generally lackluster environment for global demand and trade, the world's emerging markets face a perfect storm with no end in sight.

Goldman Weighs In On America's Pension Ponzi: Contributions Must Rise $100 Billion Per Year

Over the past several months, we’ve taken a keen interest in the deteriorating condition of state and local government finances in America. 

Moody’s move to downgrade the city of Chicago to junk in May put fiscal mismanagement in the national spotlight and indeed, the Illinois Supreme Court ruling that triggered the downgrade (in combination with a subsequent ruling by a Cook County court which struck down a bid to reform the city’s pensions), effectively set a precedent for other states and localities, meaning that now, solving the growing underfunded pension liability problem will be that much more difficult. 

Just how big of a problem is this you ask? Well, pretty big, according to Moody’s which, as we noted last month, contends that the largest 25 public pensions are underfunded by some $2 trillion. 

It’s against that backdrop that we present the following graphic and color from Goldman which together demonstrate the amount by which state and local governments would need to raise contributions to "bring plans into balance over time."

From Goldman:

Unfunded pension liabilities have grown substantially. There are several factors behind this, led by

- Lower than expected investment returns and

- Insufficient contributions from state and local governments to the plans.

The two issues are related. The assumed investment return is used as a discount rate to determine the present value of liabilities. The higher the discount rate, the lower the estimated liability, and the lower the periodic payment into the fund a state or local employer is expected to make. There is, of course, no clear answer about what the discount rate ought to be, though the fact that the average assumption used by private plans has continuously declined for more than a decade suggests that the rates have probably been too high and that the current average assumption of 7.7% may come down further.

Contributions have also generally been lower than necessary to stabilize or reduce unfunded liabilities because of the rules around how those unfunded liabilities are amortized. Payments into pension plans are generally meant to account for the future cost of benefits accrued during the current year, as well as catch-up payments equal to some fraction of the unfunded liability left from prior years. Many plans target payment amounts that would work off this underfunding over 30 years, though some use shorter periods. However, the amounts of these payments are often backloaded, with the result that even if the “required” payment is made in full the unfunded liability often grows.

A separate but related issue is that some states have simply declined to make even the “required” contribution, which is probably lower than it should be in any case due to the factors just noted. For example, over the last few years New Jersey has made on average only around 40% of the expected payment. New accounting rules promulgated by the Government Accounting Standards Board (GASB) will penalize underfunded plans with a lower discount rate, but the change is fairly minor and, in any case, affects only the accounting; it will not impose any new legal requirements to make the contributions.

If state and local governments are ultimately forced to devote more resources to these obligations, the effect on state and local spending would be noticeable. Exhibit 8 shows the states’ pension contributions, as a share of gross state product, with two potential additions. The first is the level that would be required to simply meet the “actuarially required contribution.” To bring the plans back into balance over time, further contributions would be necessary. In aggregate this would raise government pension contributions by something like $100bn per year (0.6% of GDP), lowering spending in other areas (or raising taxes) by a similar amount. In theory, OPEB costs could push this adjustment a bit higher.

 

The Baby Boom Will Never Retire - Half Have No Retirement Savings At All

Some of you might remember the glossy highly produced advertisements back in the early 1980s when Wall Street decided it was time to turn American retirement plans into casinos.  The slow and agonizing death of the pension plan was supposed to be replaced by the beautiful and wonderful world of the 401(k) plan.  Save for 30 years and in the end, you will be a millionaire just like your friends on Wall Street that sincerely care about your financial future.  Of course since then, we have found out about junk bond scandals, mutual fund fees that make loan sharks look conservative, and of course the financial shenanigans of giving people toxic mortgages that were essentially ticking time bombs of destruction.  This was the industry that was put in charge of helping you plan for your future.  We are now a generation out from those slick ads and the results have been disastrous for most Americans.  A recent analysis found that half of US households 55 and older have no money stashed away for retirement.

The new retirement is no retirement

Planning for retirement takes time.  Saving money is a slow process.  There was a time when simply stashing money into CDs and savings bonds was enough to have a nice nest egg if you were diligent enough.  Yet for the last decade, most banks are paying close to zero percent on their savings accounts thanks to the Fed’s low rate policy to juice the markets.  Since the true inflation rate is much higher, you are essentially letting your money rot away.  So the only other option is for people to invest in the stock market or try to leverage into real estate.

The stock market is largely an arena for the wealthy.  Half of Americans own no stocks at all.  Now after a generation, we are finding out that most people did not follow in the footsteps of those glossy over produced retirement ads:

Source:  GAO

“(Raw Story) Are we all in denial or is it simply impossible to save enough for retirement? Is it some kind of toxic combination of the two? Whatever the reason, yet another study – this one from no less an authority than the non-partisan US government accountability office (GAO) – is here to remind us that we’re woefully unprepared, financially speaking, for retirement. While we may all have dreams about how we’d like to spend our retirement years – fishing, golfing, writing that great American novel – the truth is that as many as half of all households with Americans 55 and older have no retirement savings at all . Nothing. Zip. Nada. Not a dime.

And the news gets worse, the GAO reports. Because households headed by older Americans that don’t have retirement savings like 401(k) plans or IRA accounts also are less likely to have other sources of income that they can rely on when they retire, such as pensions or even plain old savings accounts. About 29% have absolutely nothing : no pension plan, no savings, no 401(k), nothing.”

The idea that all older Americans own their home free and clear is simply not true.  Only 35 percent own their home free and clear from debt (and this does not mean they don’t have expenses like taxes, insurance, and maintenance).  24 percent are still saddled with mortgage debt.  And 41 percent do not own a home meaning they have to pay rents that continue tooutpace any wage gains.

The median net worth of those 55 and older is $34,760.  This is basically one small illness from bankrupting this family.  The median annual income of those 55 and older is $18,932 which makes them part of the new low wage America cohort.

On the retirement side 48 percent have some retirement savings (not much).  29 percent have no pension or retirement savings.  And 23 percent have a pension but no retirement savings.  In the end, it is a tough situation for many older Americans.  And that is why older Americans rely heavily on Social Security as their primary source of income into old age:

If it were not for Social Security, half of retirees would be out in the street bringing back another Great Depression like atmosphere.  This is in stark contrast to that 401(k) dreams pushed by Wall Street investment banks of endless Margaritas and walks on nameless sunny beaches.

The sad reality is that retirement is no longer what people think.  And keep in mind this is happening to the baby boomer generation that lived through some mega US prosperity and stock market bull runs.  What about young Americans today that are starting in an even more precarious position thanks to the insane cost of going to college and the mountain of student debt?  

Many people are realizing that retirement is a luxury only a few can afford.