Category: Market Action

Is there high-closing in the FX market?

In the space of 20 minutes on the last Friday in June, the value of the U.S. dollar jumped 0.57 percent against its Canadian counterpart, the biggest move in a month. Within an hour, two-thirds of that gain had melted away.

The same pattern — a sudden surge minutes before 4 p.m. in London on the last trading day of the month, followed by a quick reversal — occurred 31 percent of the time across 14 currency pairs over two years, according to data compiled by Bloomberg. For the most frequently traded pairs, such as euro-dollar, it happened about half the time, the data show.

The recurring spikes take place at the same time financial benchmarks known as the WM/Reuters (TRI) rates are set based on those trades. Now fund managers and scholars say the patterns look like an attempt by currency dealers to manipulate the rates, distorting the value of trillions of dollars of investments in funds that track global indexes.
…
Because they receive clients’ orders in advance of the close, and some traders discuss orders with counterparts at other firms, banks have an insight into the future direction of rates, five dealers interviewed in June said. That allows them to maximize profits on their clients’ orders and sometimes make their own additional bets, according to the dealers, who asked not to be identified because the practice is controversial.
…
A large proportion of trading at that time is generated by index funds, which buy and sell stocks or bonds to match an underlying basket of securities, the traders said.

Banks that have agreed to make transactions for funds at the 4 p.m. WM/Reuters close need to push through the bulk of their trades during the window where possible to minimize losses from market movements, the traders said. That leads to a surge in trading volume, which can intensify any moves.
…
Fund managers rarely complain about getting a bad deal because they’re assessed on their ability to track an index rather than minimize trading costs, according to consultants hired by companies and investors to help execute trades efficiently.

“Where possible, I would always advise clients not to trade at the fix — but minimizing tracking error is so important to them,” said Russell’s [head of foreign exchange Michael] DuCharme. “That doesn’t seem to be the right attitude to take when you have a fiduciary duty to seek the best execution for pension holders.”

Hurrah for Mr. Ducharme who, unlike most market participants, appears to have retained the brains he was born with. It seems to me that there’s an opening for a market player to run a trade matching service on a subscription basis … orders are put in by subscribers throughout the day, all net imbalances are disclosed (to subscribers only!), all matching orders are filled at the benchmark rate based on time-stamp, all non-matching orders are cancelled. There would have to be a few rules to enforce all this, but it could work…

The portfolio managers have my sympathies – investing or generating significant amounts of cash to meet client orders can have a huge effect, given that indices are calculated at the close. Perhaps what’s needed is indices and portfolio valuations based on VWAP rather than closes … but that’s only going to work in very liquid markets.

It was a modestly good day for the Canadian preferred share market, with PerpetualDiscounts winning 13bp, FixedResets gaining 7bp and DeemedRetractibles up 10bp. There’s a surprisingly lengthy Performance Highlights table, totally disproportionate to the market move. Volume was very high.

The credit rating agencies won a round:

Moody’s Corp. (MCO) won dismissal of a lawsuit by a pension fund claiming the credit ratings firm made false statements about its independence and objectivity.

U.S. District Judge George B. Daniels in Manhattan found that the Teamsters Local 282 Pension Trust Fund failed to establish that Moody’s violated securities laws, according to a ruling issued today.

The pension fund, an investor in New York-based Moody’s, argued the company succumbed to conflicts of interest when it assigned faulty ratings to structured securities products before the financial crisis.

The fund alleged that Moody’s stock dropped after questions arose about the mortgage-backed securities and other products the firm had rated highly. In about 2007, Moody’s and other ratings companies began downgrading those securities.

“Plaintiffs must proffer some evidence demonstrating that Moody’s specific alleged misrepresentations caused the materialization of the risk that Moody’s rating practices were unsustainable,” Daniels wrote. “They fail to do so.”

Isn’t an independent judiciary wonderful?

Chatter of a US housing bubble is very fashionable:

A five-bedroom house in Las Vegas sold in mid-July for $499,000, double the price it went for three months ago. In Phoenix, a similar house sold this month for $600,000, gaining $273,000 since March.

Bubbles are inflating in Nevada and Arizona even as housing in the rest of the country recovers at a more sustainable pace. Gains in the two desert cities are the biggest since the height of the real estate boom, just before their plunge to the bottom of the national housing collapse. This year, Las Vegas and Phoenix have topped the nation in price increases, according to the S&P/Case-Shiller property-value index.
…
In May, Phoenix prices jumped 21 percent and in Las Vegas, they rose 23 percent from a year earlier. Nationally, home prices were up 12 percent from a year ago, the most since the beginning of 2006, according to the S&P/Case-Shiller index of 20 cities.

Inflation is still not a problem in Canada:

Canadian consumer prices advanced 1.3 percent in July from a year earlier on gains in gasoline and shelter, remaining below the central bank’s target for a 15th month.

Inflation quickened from June’s 1.2 percent pace, Statistics Canada said today from Ottawa, while lagging the 1.4 percent median forecast in a Bloomberg survey of 20 economists. The core rate, which excludes eight volatile products, advanced 1.4 percent after June’s 1.3 percent, also trailing forecasts for 1.5 percent inflation.

Who woulda thunk it? Monetary policy is not a cooperative game!

Federal Reserve officials rebuffed international calls to take the threat of fallout in emerging markets into account when tapering U.S. monetary stimulus.

The risk that the Fed’s trimming of bond buying will hurt economies from India to Turkey by sparking an exodus of cash and higher borrowing costs was a dominant theme at the annual meeting of central bankers and economists in Jackson Hole, Wyoming, that ended Aug. 24. An index of emerging-market stocks last week fell 2.7 percent, the steepest in two months, compared with a 0.5 percent gain in the Standard & Poor’s 500 Index.

Such selloffs aren’t an issue for Fed officials who said their sole focus is the U.S. economy as they consider when to start reining in $85 billion of monthly asset purchases that have swelled the central bank’s balance sheet to $3.65 trillion. Even as the Fed officials advised emerging markets to protect themselves, they were pressed by the International Monetary Fund and Mexican central banker Agustin Carstens to spell out their intentions better in the interest of safeguarding global growth.

“You have to remember that we are a legal creature of Congress and that we only have a mandate to concern ourselves with the interest of the United States,” Dennis Lockhart, president of the Atlanta Fed, told Bloomberg Television’s Michael McKee. “Other countries simply have to take that as a reality and adjust to us if that’s something important for their economies.”

Geez, maybe I should sue Hymas Investment Management. Not only do I have the worst boss ever, but I don’t get paid overtime:

Ontario’s Superior Court of Justice has given the green light to a class-action lawsuit against part of Bank of Montreal’s wealth management group that alleges the bank owes unpaid overtime to hundreds of current and former investment advisers.

The lawsuit alleges BMO Nesbitt Burns Inc. did not keep a proper record of the time employees worked and did not appropriately compensate employees when they worked overtime.
…
BMO Nesbitt Burns denies that the advisers have a claim on overtime pay because the nature of their work is somewhat autonomous and compensation is paid by commission, rather than by hours worked. The bank has always excluded them from overtime policies.

In his reasons for certifying the action, Justice Edward Belobaba said that under Ontario’s Employment Standards Act, even commission-paid employees are entitled to overtime, and that employment standard cannot be contractually waived.

For most employees in Ontario, overtime pay is due after 44 hours of work.

Hell, less than 44 hours is part-time.

I ran across this interesting NY Times piece on Cyclically Adjusted P/E Ratios (the Shiller P/E):

Yet while this version of the P/E ratio, popularized by the Yale economist Robert J. Shiller, correctly signaled frothy markets in 1929, 1999 and 2008, some strategists argue that it may not be as accurate in gauging valuations today as it was in the past.

“There are distortions in this period of time that make it a less useful tool,” says Jeremy Siegel, a finance professor at the Wharton School of the University of Pennsylvania and author of “Stocks for the Long Run.”
…
Based on the past 12 months of earnings, for example, the Standard & Poor’s 500-stock index has a trailing P/E of around 15, which would make the market attractively priced based on historical levels, according to market strategists.

By contrast, the market’s CAPE reading is nearly 22. Although that’s not as elevated as in 1929 or ’99, it is significantly higher than the market’s long-run average of around 16.

“The basic idea of smoothing out earnings over time is excellent,” Mr. Siegel says. But he points out that the current CAPE for domestic stocks includes a 90 percent annual earnings decline in the first quarter of 2009. “You’re averaging in an unbelievable hole in profits,” he says.
…
This isn’t to say that CAPE is telling investors that it’s necessarily time to sell domestic stocks. To be sure, the CAPE of the S.& P. 500 is high by historical standards. But if one’s choice is between investing in domestic stocks or in 10-year Treasury notes, the equities probably still seem the better bet, Mr. Arnott says.

Mr. Shiller adds that based on more than 140 years of history, the market’s CAPE would indicate that investors should expect annualized gains of just under 4 percent a year, accounting for the effects of inflation. That’s worse than the long-run average of real annual returns of more than 6 percent for blue-chip stocks.

“But it’s not extremely low, either,” he says.

I understand that the Shiller P/E is now about 23.6.

There is some moaning in the Globe about Asian corporate debt:

Asian corporate debt as a multiple of EBITDA at the end of 2012 was higher than in any other part of the world, according to Morgan Stanley analysts. Rising funding costs and growing bad loans are prompting banks to rein in new lending. The bond market, which now accounts for over a third of corporate borrowing, is also vulnerable to rising rates and skittish investors.
…
Yet the troubling part of Asia’s corporate debt pile is the speed at which it has grown. The tide of cheap, plentiful liquidity that has washed over the region’s companies for the past four years is now receding. The combination of higher interest rates, slowing growth and falling currencies is bound to leave some companies painfully exposed.

There’s not nearly enough detail in the article to make a judgement. If liquidity suddenly dries up, then the last creditor you want is a bank – the whole point of a bond is to get a fixed term.

In today’s tapering chatter:

Bookings for goods meant to last at least three years decreased 7.3 percent last month, the most since August 2012, after a 3.9 percent gain in June, the Commerce Department said today. The median forecast of economists surveyed by Bloomberg called for a 4 percent drop.

“It’s another data point that indicates a slow recovery,” Eric Teal, who helps oversee $5 billion as the chief investment officer at First Citizens BancShares Inc. in Raleigh, North Carolina, said by phone. “This is all pointing towards less tapering by the Fed, which is probably bullish for the stock market in general.”

It was another very good day for the Canadian preferred share market, with PerpetualDiscounts up 31bp, FixedResets gaining 11bp and DeemedRetractibles winning 45bp. The Performance Highlights table is suitably lengthy, comprised mainly of winners. Volume was average.

The evisceration of five hundred years of bankruptcy law and the politicization of the process is having an effect:

Goldman Sachs Group Inc. (GS) and JPMorgan Chase & Co. (JPM) are among banks whose debt ratings may be cut by Moody’s Investors Service as it examines whether the U.S. would be less likely to ensure creditors are repaid in a crisis.

Morgan Stanley and Wells Fargo & Co. (WFC) also may be downgraded, Moody’s said yesterday in a report. Citigroup Inc. (C) and Bank of America Corp. (BAC) are under review, with the direction of any rating change uncertain, Moody’s said. Bank of New York Mellon Corp. and State Street Corp. (STT) already were under review.

Moody’s and Standard & Poor’s have said downgrades may be needed because the federal government has new tools to wind down banks instead of rescuing them with taxpayer money. Those plans can include forcing debtholders to incur losses or convert stakes to equity. The policies also may have an impact on ratings of the companies’ deposit-taking subsidiaries.

There’s at least one player who thinks Fed jawboning has worked perfectly:

Federal Reserve Bank of San Francisco President John Williams said speculation over tapering of quantitative easing that drove Treasury yields higher may have helped eliminate some “froth” in the bond market.

Some investors “were thinking the Fed was going to keep buying forever, QE infinity,” Williams said today in a CNBC television interview from Jackson Hole, Wyoming. “We had always communicated that that’s not what our plan was.”

“Some of the adjustment in the bond market probably was kind of bringing people back to reality that this was a program that wasn’t going to continue forever,” he said. “And I think that, maybe, eliminates some of the froth in the bond market.”

Treasury 10-year yields touched a two-year high of 2.93 percent earlier this week on speculation the Federal Open Market Committee will slow its large-scale asset purchases next month.
…
Williams, who has never dissented from a policy decision, said whether tapering takes place later this year depends on economic conditions.

“The decision when and if to taper later this year will depend on the data, and specifically are we still seeing signs of positive momentum,” Williams said. “I’m not going to speak about what meeting or not, but I do think that if the data continue to progress as we’ve seen, then I do agree that we should edge down or taper our purchases later this year.”

But on the other hand:

Federal Reserve Bank of Atlanta President Dennis Lockhart said he wouldn’t rule out a September move by the central bank to start tapering its bond-buying program as long as the economy’s performance justifies it.

“I’m looking at the data as whether they are denying or undermining the outlook I have in my head” for moderate growth, Lockhart said in an interview today on Bloomberg Television with Michael McKee from Jackson Hole, Wyoming, where the Kansas City Fed is hosting a conference. “You can take a cautious first step,” which the Fed could conceivably do, he said.

They were worrried about that!

The minutes from the Fed’s July 30-31 meeting reveal policy makers’ anxiety. They describe “volatile” financial markets in response to “policy communications” and economic data, and U.S. interest-rate increases that signaled “heightened financial-market uncertainty about the path of monetary policy.”

Fed officials were “broadly comfortable” with Bernanke’s plan to start reducing bond buying later this year if the economy improves yet decided against adding any more information about the outlook for asset purchases in their July policy statement. They “judged that doing so might prompt an unwarranted shift in market expectations,” according to the minutes, which were released Aug. 21.

There is speculation that all this tapering talk is having a real effect:

Purchases of new U.S. homes plunged 13.4 percent in July, the most in more than three years, raising concern higher mortgage rates will slow the real-estate rebound.

Sales fell to a 394,000 annualized pace, Commerce Department figures showed today in Washington. The reading was the weakest since October and was lower than any of the forecasts by 74 economists Bloomberg surveyed.

A jump in borrowing costs over the past three months may be prompting buyers to hold back, showing the difficult job ahead for Federal Reserve officials as they try to wean the economy from monetary stimulus while sustaining growth.
…
“It’s definitely a rate shock,” said Doug Duncan, chief economist at Fannie Mae in Washington. “You could see another month or two of weak sales or it could go longer. This is a sustainable recovery, but we’ve also said it’s not robust. Along the way, there will be some hiccups. This is certainly a hiccup.”

Naturally, you could spend a week reading all the sell-side chatter:

RBC economist David Onyett-Jeffries is correct to point out that new home sales are only 8 per cent of total residential transactions – the rest are existing homes. In that sense, the disappointment may not be that big a deal for the housing market as a whole.

But, existing home sales don’t help the construction industry much. Even at much larger numbers, existing sales are not as big a benefit to overall U.S. gross domestic product.

Perhaps more disturbing, the inventory of unsold homes is increasing rapidly. CIBC’s Andrew Grantham writes that “with the number of homes for sale rising and months’ supply increasing to 5.2, from 4.3, the decline certainly seems to be more of a demand than a supply issue.”

Is anyone surprised? The politicization of auto insurance means more regulation:

Ontario’s Liberal government will take two years to cut auto insurance rates by 15 per cent – double the time demanded by the New Democratic Party in its budget deal with the Liberals earlier this year.
…
The government will crack down on insurance fraud by licensing clinics that invoice insurance companies and put in place stricter accident benefit guidelines. Mr. Sousa also appointed a retired judge to study reforms to the insurance dispute resolution system, which suffers from long backlogs that make insurers’ profits unpredictable.

S&P, with a certain amount of obvious self-interest is touting Multi-Asset Solutions in Indexing:

The second trend involves investors thinking more and more of risk factors or risk premia as the building blocks of asset allocation, rather than asset classes. There has been a growing recognition that systematic risk factors explain the majority of long-term portfolio returns, and that a significant portion of the alpha delivered by active managers and alternative managers can be attributed to systematic risk factors (e.g., Ang et al, 2009). The true alpha from pure manager skills accounts for a smaller portion of portfolio returns. In such context, there has been increased interest in using low-cost systematic strategies to capture risk premia. Notably, many so called “alternative beta” or “smart beta” strategy indices have been developed to capture the most well-known systematic risk premia such as value, low volatility and quality in equities, momentum and roll yield in commodities and carry/value/momentum in currencies.
…
The case for index investing traces back to the simple but profound insight that, in aggregate, active management is a zero-sum game before costs and a negative-sum game after costs. Beta can be captured by traditional market benchmarks with very low cost, while alpha is scarce and expensive.

In recent years, the concepts of alpha and beta have been evolving. Investors increasingly recognize that alpha should not be defined as the excess return over the market benchmark. A significant portion of the excess return from active management may come from exposures to systematic risk premia. In such context we have witnessed the development of many alternative beta/smart beta strategies that aim to capture systematic risk premia.

Multi-asset solutions can potentially push the boundary of index investing beyond asset class beta and systematic risk premia. As multi-asset solutions become more mainstream in the asset management industry, the potential role of indices in underlying pre-packaged multi-asset investment products may warrant more discussion. Theoretically, index based multi-asset investment vehicles may have the potential to reduce the cost of constructing multi-asset solutions (e.g., management fees, advisor fees). Many empirical studies have investigated whether mutual fund managers or institutional investors have asset allocation / market timing skills. The results are mixed but overall suggest that only a minority of managers possess significant asset allocation / market timing skills. Nevertheless, it remains one of the significant challenges that investors essentially need to be comfortable with delegating the asset allocation tasks traditionally handled by asset allocators and financial advisors alike to index based multi-asset vehicles.

Our research indicates that, beyond the well-established asset class beta and systematic risk premia, there is potentially value in passive multi-asset index solutions. The field will attract further research and it is likely to be an area of future product development and innovations in the index investment industry.

The Ang paper is Ang, Andrew, William N. Goetzmann, and Stephen M. Schaefer. 2009. “Evaluation of Active Management of the Norwegian Government Pension Fund – Global” and is published by the Norwegian government. Too bad we never see anything like this in Canada.

And, holy smokaramas, the Canadian preferred share market is on fire! PerpetualDiscounts won 66bp today, FixedResets gained 39bp and DeemedRetractibles were up 51bp. The Performance Highlights table is suitably lengthy. Volume was merely on the high side of average.

Before anybody gets too excited, though, remember just how much ground there is to make up! CPD closed at $15.98 today. Add back about $0.06 dividends that went ex today, call it $16.04. That’s above the close of August 12 ($15.98) but below August 9 ($16.07), to say nothing of July 31 ($16.46). And every single member of the PerpetualPremiums index is, at today’s “last” bid, expected to migrate to PerpetualDiscounts at the August month-end rebalancing.

There was a NASDAQ whoopsy today:

Computer breakdowns shook American equity markets again today as malfunctioning software that feeds data between exchanges prompted Nasdaq Stock Market to halt trading in thousands of stocks and options.

Trading will resume in some stocks at about 2:45 p.m. with the remainder returning by 3:10 p.m. New York time, the company said in a statement on its website.
…
The action froze stocks both on Nasdaq’s platforms and dozens of other markets around the country that trade securities it lists. Companies from Bats Global Markets Inc. in Lenexa, Kansas, to Jersey City, New Jersey-based Direct Edge Holdings published notices saying they were adopting Nasdaq’s halt.

I have no idea why trading in these securities at other exchanges was halted – the BATS notice doesn’t provide any information, nor does the Direct Edge website. What’s the point of a network if a single-point failure can bring down the system?

I haven’t seen anything to indicate that this problem is affecting the lunatic decision to move towards centralized counterparties for derivatives and repos, either.

The SEC is determined to enhance the safeguards necessary for justifying increased regulation:

The continuous and orderly functioning of the securities markets is critically important to the health of our financial system and the confidence of investors. Today’s interruption in trading, while resolved before the end of the day, was nonetheless serious and should reinforce our collective commitment to addressing technological vulnerabilities of exchanges and other market participants. The Commission is determined to enhance the safeguards necessary for strong market systems. As one step, I will work to advance rules that the Commission proposed earlier this year regarding new standards for the trading and other systems that are central to the integrity of our markets. I also will shortly convene a meeting of the leaders of the exchanges and other major market participants to accelerate ongoing efforts to further strengthen our markets.

The SEC is making some cosmetic changes to ethics guidelines:

Hundreds of U.S. Securities and Exchange Commission lawyers and examiners face new obstacles to cashing in on their agency experience under an expanded ethics rule to take effect in January.

The change targets the practice of regulators moving to jobs at law firms and investment banks where they capitalize on their SEC relationships. The ethics rule, which previously affected only the most senior officers, will now be applied to everyone who earns more than $155,440 a year, according to a copy of an agency announcement.

The employees will be banned from contacting old colleagues for one year after leaving the SEC when the policy becomes effective in January. Commissioners and division directors have long faced such limits.

The Canadian preferred share market was on fire today, with PerpetualDiscounts winning 78bp, FixedResets up 72bp and DeemedRetractibles gaining 26bp. The Performance Highlights table is suitably enormous, with Enbridge FixedResets notable amongst the many winners. Volume was extremely high.

Goldman Sachs had an options whoopsy yesterday:

For all the efforts to shore up electronic markets in the aftermath of one of America’s biggest trading catastrophes, yesterday’s options malfunction by Goldman Sachs (GS) Group Inc. shows the dangers haven’t gone away.

A programming error caused the firm to send unintentional stock options orders in the first minutes of trading, pushing prices on dozens of contracts to a dollar each, according to a person briefed on the matter yesterday and data compiled by Bloomberg. Any losses for Goldman Sachs, the fifth-largest U.S. bank by assets, won’t be known until exchanges determine which contracts should be canceled, said the person, who requested anonymity because the information is private.
…
An internal system that Goldman Sachs uses to help prepare to meet market demand for equity options inadvertently produced orders with inaccurate price limits and sent them to exchanges yesterday, according to the person familiar with the situation. Some of the transactions have already been voided, data compiled by Bloomberg show.

A “large number” of trades from the session’s first 17 minutes for tickers beginning with the letters H through L are being examined and most of the transactions may be canceled, according to a statement yesterday from NYSE Euronext (NYX)’s U.S. options business. NYSE and Nasdaq OMX Group Inc. said today that they have completed the trade reviews, according to e-mailed statements from the exchanges.

Cancelling trades is a good policy: it gives the regulators more power and therefore larger paycheques, while the big firms find it more important to hire ex-regulators to lobby their buddies. After all, the purpose of capital markets is to provide good jobs for regulators, right?

Here’s one good way to reflate the economy:

Chancellor of the Exchequer George Osborne’s plan to boost the U.K. housing market is winning his Conservative Party votes at the risk of creating a property bubble, economists say.

Help to Buy is designed to let cash-strapped buyers purchase a home with a deposit of as little as 5 percent of the value of the property. The first phase — interest-free loans for buyers of newly built homes — began in April and has already stoked the strongest housing market since the financial crisis. Guarantees meant to spur 130 billion pounds ($204 billion) of mortgage lending will be available for all homes starting in January.
…
A home-value gauge compiled by the Royal Institution of Chartered Surveyors rose to the highest in almost seven years in July. Halifax, the mortgage unit of Lloyds Banking Group Plc, estimates values rose for a sixth month to an average 169,624 pounds. Mortgage lending rose 29 percent from a year earlier to the highest level since the collapse of Lehman Brothers Holdings Inc. in 2008, the Council of Mortgage Lenders said yesterday.

Since Help to Buy began, 10,000 reservations for new homes have been made, according to figures published on the Department for Communities and Local Government website this month.

Rob Wood, an economist at Berenberg Bank and a former Bank of England official, forecasts house prices will rise 15 percent by the end of 2014.
…
The program, announced in the March budget, is designed to help people who lack enough cash for a deposit, with the government lending 20 percent of the value of a newly built home up to 600,000 pounds, interest-free for five years. The lender provides 75 percent, meaning the purchaser has to raise a down payment of 5 percent compared with about 20 percent previously.

The second phase, set to run for three years, will provide 12 billion pounds of government guarantee to encourage lenders to offer mortgages with loan-to-value ratios of up to 95 percent. The program applies to new and existing homes and excludes buyers of second properties.

The initiative, which follows the Funding for Lending Scheme run by the Bank of England, has drawn a warning from the International Monetary Fund for its potential to stoke home prices and been described as “moronic” by Societe Generale SA analyst Albert Edwards for encouraging Britons to add to already high debt levels. U.K. households owed about 1.3 trillion pounds on their mortgages in June, according to the Bank of England.

There are more liquidity problems in US Corporates:

The lowest volumes for U.S. corporate-bond trading since 2008 are underscoring the potential for market disruptions as regulations prompt dealers to retreat.

August trading volumes have plummeted to a daily average of $14.1 billion, down 9 percent from the corresponding period last year, even as the amount of company debt outstanding has soared by 12 percent. Bonds have lost 5 percent since the end of April on the Bank of America Merrill Lynch U.S. Corporate Index, the worst stretch since the credit crisis as the Federal Reserve considers curtailing its record stimulus.

Exiting from fixed-income securities is getting tougher as the world’s biggest bond dealers respond to new capital standards, reducing inventories of the debt by 76 percent since the peak in 2007. Even as lenders from Goldman Sachs Group Inc. to UBS AG create electronic-trading platforms, investors are failing to find relief from waning liquidity, according to a July report by the Treasury Borrowing Advisory Committee.

“You’ve got to be very wary of getting into a crowded position,” Stephen Antczak, the head of U.S. credit strategy at Citigroup Inc. in New York, said in a telephone interview. “If everybody has the same mandate, who’s going to take the other side of the trade? If far more guys are mark-to-market sensitive than they used to be and you overlay the lack of liquidity, that kind of exacerbates the problem.”
…
The unprecedented growth of funds that publish market prices of their assets daily has changed the dynamic of credit markets, with investors more inclined to redeem funds as sentiment deteriorates, Antczak said. The funds now account for more than 40 percent of the debt’s owners from about 25 percent in 2007, Citigroup data show.

So you’ve got TRACE, you’ve got capital constraints … electronic trading platforms aren’t going to help any, they’re going to hurt: it’s well known that transparency creates smaller spreads, but a thinner, more brittle market … at some point, regulators are going to have to sit down and ask themselves what bond markets are for. Are they to allow borrowers to access lenders? Or are they to be ‘fair’, whatever that means? Because right now, the public corporate bond market is being destroyed.

Yield increases are spreading through the economy:

Mortgage rates are again on the rise in Canada, increasing the likelihood of a slowdown in the national housing market.

On Wednesday, Royal Bank of Canada hiked its five-year, fixed-rate mortgage by 20 basis points to 3.89 per cent, one day after the Bank of Montreal raised its benchmark rate to 3.79 per cent.

It was a very good day for the Canadian preferred share market, with PerpetualDiscounts winning 43bp, FixedResets gaining 26bp and DeemedRetractibles up 31bp. The Performance Highlights table is suitably lengthy, with FixedResets being notable at both ends of the spectrum. Volume was high.

So, everybody’s wondering – is this a dead cat bounce or the start of a major rally? I’m preparing a three month forecast … readers will understand that due to the complexity of the problem, I won’t have it ready for about 90 days.

PerpetualDiscounts now yield 5.91%, equivalent to 7.68% interest at the standard conversion factor of 1.3x. Long corporates now yield about 4.9%, so the pre-tax interest-equivalent spread (in this context, the Seniority Spread) is now about 280bp, another significant increase from the 270bp reported August 14.

The story so far:

The yield on the benchmark 10-year Treasury note rose to 2.88 percent late yesterday, reaching two-year highs for a third consecutive day, as investors become increasingly convinced the Fed next month will reduce how much stimulus it pumps into the economy. The yield had been as low as 1.63 percent on May 2.

Yields on U.S. corporate bonds from the riskiest to most-creditworthy borrowers have climbed to 4.23 percent from a record-low 3.35 percent on May 2, according to the Bank of America Merrill Lynch U.S. Corporate & High Yield Index. They reached a one-year high of 4.3 percent on June 25.

So far this year, rising yields have been accompanied by improving confidence. The Bloomberg Consumer Comfort Index early this month reached the highest reading since January 2008. The New York-based Conference Board’s confidence gauge in June and July also had the strongest two months in more than five years. The Thomson Reuters/University of Michigan’s measure in July reached a six-year high, before falling this month.

Some spreads have narrowed:

About $50 billion of collateralized loan obligations may be refinanced in the next two years, rewarding holders of the most speculative portions of the funds at the expense of AAA investors, according to Royal Bank of Scotland Group Plc. (RBS)

BlackRock Inc. (BLK), Ares Management LLC and other firms have refinanced more than $2 billion of CLOs this year, and an additional $8 billion sold in 2011 will be able to cut interest payments by the end of 2013, according to RBS. Restrictions preventing more than $40 billion of 2012 investments from doing the same will be lifted in 2014, according to the bank.

Yield premiums on new-issue CLOs shrank to the lowest levels in at least three years as more investors piled into the debt seeking better returns than similarly-rated asset classes. Rising demand helped push CLO issuance to $60.6 billion globally this year, the most since 2007, according to JPMorgan Chase & Co.

The BoC has published a very dense paper by Selma Chaker titled Volatility and Liquidity Costs:

Observed high-frequency prices are contaminated with liquidity costs or market microstructure noise. Using such data, we derive a new asset return variance estimator inspired by the market microstructure literature to explicitly model the noise and remove it from observed returns before estimating their variance. The returns adjusted for the estimated liquidity costs are either totally or partially free from noise. If the liquidity costs are fully removed, the sum of squared high-frequency returns – which would be inconsistent for return variance when based on observed returns – becomes a consistent variance estimator when based on adjusted returns. This novel estimator achieves the maximum possible rate of convergence. However, if the liquidity costs are only partially removed, the residual noise is smaller and closer to an exogenous white noise than the original noise. Therefore, any volatility estimator that is robust to noise relies on weaker noise assumptions if it is based on adjusted returns than if it is based on observed returns.
…
There are many possible extensions to this work. For instance, it would be interesting to allow for endogenous and non i.i.d. residual noise. Potentially, a nonlinear or an index model of liquidity costs would capture more noise than a linear one. Indeed, nonlinearities are well documented in market microstructure theory. Another extension would be to add jumps in the frictionless-price dynamics. There is evidence of jumps in the data, so accounting for discontinuities should be explored.

In addition to the estimation of volatility-type objects, this paper’s approach to decontaminate high-frequency prices from liquidity costs could be used to study whether the current stylized fact of the reversal of weekly returns (see Gutierrez Jr. and Kelley 2008) is still present for returns that are adjusted for liquidity costs.

There are interesting snippets of news about BAM:

Brookfield Asset Management Inc. has another $1-billion (U.S.) under management, after wrapping up fundraising for a timber fund that met hotter-than-expected demand.

Brookfield set out to raise $750-million to invest in timberland and said commitments exceeded the target. Toronto-based Brookfield also put in $250-million of its own money.
…
The fund comes not long after another Brookfield manager, Brookfield Infrastructure, got out of the timber business, which it called a “lower yielding” asset, to focus on other areas.

… and the Loblaws / Shoppers deal:

Loblaw Cos. Ltd., which is offering $61.54 a share to buy Shoppers Drug Mart Corp., initially bid much less – $45 a share – for the drugstore chain in early 2011.

Loblaw increased the bid to $48 a share a few months later, but talks fell apart in June of that year partly because of the grocer’s concerns about the effects of generic drug reforms, which have eaten into drugstores’ profits and forced them to cut costs and shift strategies.

Wonder of wonders, it was a modestly positive day for the Canadian preferred share market, with PerpetualDiscounts gaining 5bp, FixedResets up 6bp and DeemedRetractibles winning 12bp. A choppy market, with a very long (considering the overall moves) Performance Highlights table, featuring FixedResets and BAM amongst both winners and losers. Volume was extremely high.

There are worries about more unintended consequences of tighter regulation:

Regulations aimed at reducing the risk of another financial crisis are starting to upend a key part of the bond market that expedites trading in everything from Treasuries to junk bonds.

The U.S. repurchase, or repo, market where banks and investors borrow and lend Treasuries and other fixed-income securities shrunk to $4.6 trillion daily outstanding last month, down 35 percent from a peak of $7.02 trillion in the first quarter of 2008, based on Federal Reserve data compiled from its 21 primary dealers.

From fewer repos to lower inventories of bonds, financial institutions are responding to more stringent capital standards imposed by regulators around the world. Already, the group of dealers and investors that advise the U.S. Treasury say that they see declines in liquidity in times of market stress, including wider gaps between bid and offer prices and the speed of completing trades. The potential consequences are higher borrowing costs for governments, companies and consumers.
…
Even though Fed data show primary dealers trade almost $600 billion of Treasuries each day on average, making the market the deepest, most liquid in the world, prices suggest constraints on bank balance sheets are having an impact on trading.

The difference between the prices at which dealers buy and sell Treasury futures contracts is about 2/32, or 63 cents per $1,000 face amount, or double what it was in the five years before the bankruptcy of Lehman Brothers, according to data compiled by Bloomberg.
…
The difference in yields between the newest Treasuries auctioned by the government and older bonds show investors are increasingly concerned about getting stuck with less liquid bonds, forgoing some yield in the process.
…
In Europe, heightened regulations are also affecting the ability of financial institutions to facilitate bond trades. The region’s biggest banks must cut 661 billion euros ($883 billion) of assets and generate 47 billion euros of capital to comply with new regulatory capital requirements, according to an analysis by Royal Bank of Scotland Group Plc.

“Before the crisis, we were able to execute clips of 20 million euros worth of corporate or covered bonds in just one or two minutes,” Stefan Kreuzkamp, the co-head of fixed income for Europe at Frankfurt-based Deutsche Asset & Wealth Management said in an Aug. 15 telephone interview. “These days, it could take a couple of hours,” said Kreuzkamp, whose firm has about 1 trillion euros in assets.

At the same time, 11 European Union states have agreed to a financial transaction tax, known as the FTT, that the European Commission estimates may raise as much as 35 billion euros a year. Stock and bond trades would be taxed at a rate of 0.1 percent and derivatives at 0.01 percent. The levy on bond transactions would include overnight transactions.

If the FTT is imposed in the current form, it will end the repo market in Europe, said Richard Comotto, a senior visiting fellow at the University of Reading’s International Capital Market Association Center in southern England who has published reports on the implications of new bank regulations. The ICMA estimates that to cover the tax, a repo market maker would have to charge a spread on an overnight repurchase agreement of 72.05 percentage points.

“While a lot of regulation is worthwhile and long overdue, it is coming too far and too much in a short space of time,” Comotto said in an interview. “Most of them are not well thought out.”

Amen to that, Mr. Comotto. Amen to that.

KER-RUNCH! The Canadian preferred share market got pasted today, with PerpetualDiscounts losing 130bp, FixedResets off 73bp and DeemedRetractibles down 97bp. There doesn’t seem to be much point looking for a pattern in the enormous Performance Highlights table, although it is interesting that FixedResets are prominent among the big losers. Volume was very high.

The Great White Short?:

Foreign investors went on an unprecedented selling spree of Canadian bonds in June, offering further evidence of Canada’s fading international appeal.

A record $19-billion decline in foreign-held bonds, more than double the previous high set a decade ago, slashed what has become a reliable source of investment driven by Canada’s stellar reputation for financial outperformance.
…
Recent years saw a consistent net inflow of foreign funds into Canadian securities in excess of $100-billion annually. But of late, the global investing community has grown leery of Canadian real estate, slowing growth and vulnerability to softening commodity prices. Hedge funds lined up to bet against Canada – the trade dubbed the Great White Short.

Over the first half of this year, net spending on Canadian bonds by non-residents amount to $16-billion, “a fraction of the net inflow chalked up during the first half of each of the prior five years,” Warren Lovely, an economist at CIBC World Markets, said in a research note.
…
The Canadian dollar would certainly feel the effect of any sustained deterioration in the demand for Canadian bonds. That relationship could also help explain some of the dramatic currency volatility seen from mid-June to early July, when the Canadian dollar dropped by four cents against its U.S. counterpart, [chief currency strategist at Bank of Nova Scotia] Ms. [Camilla] Sutton said.

Just in time for Christmas:

Samsung Electronics Co. (005930) will introduce a wristwatch-like device named the Galaxy Gear next month that can make phone calls, surf the Web and handle e-mails, according to two people familiar with the matter.

The Galaxy Gear will be powered by Google Inc.’s Android operating system and go on sale this year to beat a potentially competing product from Apple Inc. (AAPL), the people said.

It was a mixed day for the Canadian preferred share market, with PerpetualDiscounts off 3bp, FixedResets gaining 5bp and DeemedRetractibles down 22bp. The performance highlights table is as lengthy as we have come to expect recently: insurers are notable on the losers’ end, but somebody has decided they really, really like BAM! Volume was well above average.

The sale of Aviva’s US unit to Apollo has been approved with substantially the same conditions as the Sun Life – Guggenheim deal:

The key heightened policyholder protections to which Apollo agreed include:

Heightened Capital Standards. Apollo has agreed that Athene will maintain Aviva New York’s Risk-Based Capital Levels (RBC Levels) at an amount not less than 450 percent. (Capital serves as a buffer that insurers use to absorb unexpected losses and financial shocks – better protecting policyholders.)

Backstop Trust Account. Apollo has agreed that Athene will establish a separate backstop trust account totaling approximately $35 million to provide additional protections to policyholders above and beyond the heightened capital levels. If Aviva New York’s RBC levels fall below 450 percent, the funds in the backstop trust account will be used to replenish (“top up”) Aviva New York’s RBC levels to at least 450 percent. The $35 million in the trust account will be held separately from other Aviva New York’s funds for seven years and dedicated to the sole purpose of protecting policyholders.

Enhanced Regulatory Scrutiny of Operations, Dividends, Investments, Reinsurance. Apollo has agreed that any material changes to Athene’s plans of operations of Aviva New York, including investments, dividends, or reinsurance transactions will require the prior written approval of DFS.

Stronger Disclosure and Transparency Requirements. Aviva New York will file quarterly RBC level reports to DFS – rather than just the annual reports required under New York Insurance Law. Additionally, the insurer will disclose to DFS necessary information concerning corporate structures, control persons, and other information regarding the operations of the company.

The Bank of Canada has released the Bank of Canada Review – Summer 2013 with articles:

• CSI: A Model for Tracking Short-Term Growth in Canadian Real GDP
• The Accuracy of Short-Term Forecast Combinations
• Monitoring Short-Term Economic Developments in Foreign Economies
• Big Data Analysis: The Next Frontier

Nothing very interesting, I’m afraid – I didn’t read any of them.

Bonds got hit today:

Yields (USGG10YR) on 10-year notes, a benchmark for corporate and consumer borrowing rates, climbed above 2.8 percent for the first time in two years as reports showed U.S. initial jobless claims declined last week to the lowest level in almost six years and confidence among U.S. homebuilders rose in August to the highest level since 2005. Treasury data showed private investors abroad sold a record amount of notes and bonds in June, when Fed policy makers indicated they are considering a slowing of their quantitative-easing policy.

Yields on Canadian 5s, 10s and 30s were all up 4bp.

And, logically enough (which is not always the case) the Canadian preferred share market got thumped today, with PerpetualDiscounts losing 85bp, FixedResets off 16bp and DeemedRetractibles down 50bp. The performance highlights table is suitably enormous. Volume was extremely high.

Vasco Cúrdia (San Francisco Fed) and Andrea Ferrero (New York Fed) write a provocative note titled How Stimulatory Are Large-Scale Asset Purchases?:

In November 2010, the Fed’s policy committee, the Federal Open Market Committee (FOMC), announced a program to purchase $600 billion of long-term Treasury securities, the second of a series of large-scale asset purchases (LSAPs). The program’s goal was to boost economic growth and put inflation at levels more consistent with the Fed’s maximum employment and price stability mandate. In Chen, Cúrdia, and Ferrero (2012), we estimate that the second LSAP program, known as QE2, added about 0.13 percentage point to real GDP growth in late 2010 and 0.03 percentage point to inflation.

Our analysis suggests that forward guidance is essential for quantitative easing to be effective. Without forward guidance, QE2 would have added only 0.04 percentage point to GDP growth and 0.02 to inflation. Under conventional monetary policy, higher economic growth and inflation would usually lead the Fed to raise interest rates, offsetting the effects of LSAPs. Forward guidance during QE2 mitigated that factor by making it clear that the federal funds rate was not likely to increase.

Our estimates suggest that the effects of a program like QE2 on GDP growth are smaller and more uncertain than a conventional policy move of temporarily reducing the federal funds rate by 0.25 percentage point. In addition, our analysis suggests that communication about when the Fed will begin to raise the federal funds rate from its near-zero level will be more important than signals about the precise timing of the end of QE3, the current round of LSAPs.
…
The second feature in our model concerns the transmission from the risk premium to the economy. We consider an economy with two types of investors. The first can invest in both short- and long-term assets. For them, a lower risk premium prompts them to reallocate their portfolios, but doesn’t change their spending behavior. If all investors behaved this way, a change in the risk premium would not affect the economy.

The second type of investor buys only long-term bonds, for example to match asset duration with life events, such as retirement date. If long-term yields fall, these investors have less incentive to save and may allocate more money to consumption or investment in nonfinancial assets. This boosts aggregate demand and puts upward pressure on inflation.

These two types of investors represent a form of financial market segmentation, allowing for the risk premium to affect economic activity. The degree of segmentation is determined by what fraction of investors buy only long-term bonds. The higher the proportion of such investors, the more LSAPs affect the real economy.
…
Asset purchase programs like QE2 appear to have, at best, moderate effects on economic growth and inflation. Research suggests that the key reason these effects are limited is that bond market segmentation is small. Moreover, the magnitude of LSAP effects depends greatly on expectations for interest rate policy, but those effects are weaker and more uncertain than conventional interest rate policy. This suggests that communication about the beginning of federal funds rate increases will have stronger effects than guidance about the end of asset purchases.

I don’t find it entirely convincing but it is, after all, only a letter. Consider the first type of investor, the non-segmented one:

The first can invest in both short- and long-term assets. For them, a lower risk premium prompts them to reallocate their portfolios, but doesn’t change their spending behavior. If all investors behaved this way, a change in the risk premium would not affect the economy.

OK, so they reallocate their portfolios, but what do they buy? And, more importantly, what do the people they buy from do with their money?

One thing that they buy on reallocation, of course, is Apple Corporation bonds. Apple doesn’t need the money, they just stick it in the bank. No gain there. What does the bank do with the money? Ideally, they would lend it to a smaller business – or an expanding business – which will then buy equipment, hire staff, and produce YouTube videos of kittens and make immense profits.

But that’s kind of risky, so what they do – especially in Canada – is lend the money to government employees so they can buy larger houses. There’s not really all that much of a gain there, either.

I really have trouble conceptualizing the path of monetary stimulus throughout the economy, but I find it hard to believe that the asset reallocation of Investor #1 has zero effect, although I’m willing to believe that it may be small. I will also suggest that there is a third type of investor, such as pension funds and insurance companies, that get hurt to some extent (depending on how well they are hedged) by lower yields and actually have to reduce distributions and increase contributions when yields fall. Negative convexity! I hesitate to estimate the importance of this group, though – it might be just a rounding error.

Another problem is the nature of business today. How much capital do businesses really need in order to make their widgets? It’s not like the 1950’s, where you had to build a factory and the factory needed steel, so somebody else had to build a foundry. While capital is still needed – remember the price-tag on the Energy East pipeline? – I suggest that it is less important than it used to be.

I mean, look at my business! I would love to expand and I will, as soon as enough of youse guys get off your duffs and send me large quantities of money to manage. So what do I need to expand? A few computers … technically a capital expense, but in business terms it’s petty cash. Premises – that will come out of revenue. Salaries – that will come out of revenue. What do I need capital for? My decision as to whether to expand or not has absolutely nothing to do with the Prime Rate.

There are two types of business to be in: you can make things, or you can make entertainment. Entertainment (more formally, “services”) is not all that much capital intensive, and entertainment is taking over the economy. So how can you stimulate an economy with money if the system doesn’t need money? At least not directly. One might object – particularly if you are an economics lecturer hoping for tenure – that it does need education and therefore tenured professors and therefore lots of money. But, I say to that, we’re already saturated in education. It’s a very tricky question and someday I’ll take a rock-solid economics course so I can get a better handle on things.

Maybe my economics course should start with a piece from S&P titled Repeat After Me: Banks Cannot And Do Not “Lend Out” Reserves:

• Many talk as if banks can “lend out” their reserves, raising concerns that massive excess reserves created by QE could fuel runaway credit creation and inflation in the future. But banks cannot lend their reserves directly to commercial borrowers, so this concern is misplaced.
• Banks do need to hold reserves (as a liquidity buffer) against their deposits, and banks create deposits when they lend. But normally banks are not reserve constrained, so excess reserves do not loosen a reserve constraint.
• Banks in aggregate can reduce their reserves only to the extent that they initiate new lending and the bank deposits created as a result flow into the economy as new banknotes as the public demands more of them.
• QE does aim to ease financial conditions and spur more bank lending than otherwise would have occurred, but the mechanisms by which this happens are much more subtle and indirect than commonly implied.
• If the excess reserves created by QE were to be associated with too much credit creation, central banks could readily extinguish them.

…
To understand the first issue, note the composition of a central bank’s balance sheet (see table 1) and note an identity linking the two sides. Abstracting from the central bank’s capital (5) and some other possible minor items, the central bank balance sheet identity is:

Assets (A) = Reserves (R) + Banknotes in circulation (BK) + Government deposits (GD).
…
There you have it. This being an identity and reserves being a liability of the central bank, their aggregate level can change in three, and only three, ways (6). Reserves go up (or down) when:

(1) The central bank increases (decreases) its assets;

(2) The public decreases (increases) the amount of cash (banknotes) it wants to hold;

(3) The government reduces (increases) its deposits at the central bank because it makes net transfers to (receives net transfers from) the private sector (7).

Most importantly, banks cannot cause the amount of reserves at the central bank to fall by “lending them out” to customers. That possibility is not allowed for in the identity because bank lending does not enter into it. Assuming that the public does not change its demand for cash and the government does not make any net payments to the private sector (two things that are both beyond the direct control of the banks and the central bank), bank reserves have to remain “parked” at the central bank. To express wonder that banks don’t lend out their reserves or that they park them at the central bank is to fundamentally misunderstand the balance-sheet mechanics of credit creation and how QE works.
…
None of this is to say that the unwinding of QE and other nonconventional policies will be smooth and will not cause volatility in financial markets. Volatility is to be expected and needs to be managed both by policymakers and by market participants. But fears that banks stand to “lend out” the excess reserves that they currently have “parked” at central banks is not something that anyone, least of all central banks aiming to speed up the recovery or defend their inflation targets today, should worry about. I doubt that Keynes would have.

There’s an interesting piece on Bloomberg about the Fed Governor Sweepstakes … it seems my preference for Summers is not widely shared:

Federal Reserve Vice Chairman Janet Yellen is the most qualified and most likely candidate to run the central bank, according to the majority of private economists in a Bloomberg News survey that showed Lawrence Summers trailing by wide margins in both categories.

Sixty-five percent said Yellen probably will be President Barack Obama’s selection to replace Chairman Ben S. Bernanke, while 53 percent said she would do the best job, according to an Aug. 9-13 poll of 63 economists. Twenty-five percent said Summers, Obama’s former top economic adviser, would be the nominee, while 10 percent said he would be best. Six percent said former Fed Vice Chairman Donald Kohn is most likely choice.
…
Ward McCarthy, chief financial economist at Jefferies Group LLC in New York, said that Summers isn’t the best pick because he hasn’t served at the central bank and “has no experience with monetary policy.”
‘
“This is an important job, and as brilliant as he may be I don’t think this is a time for on-the-job training,” McCarthy said. Yellen and Kohn both “are the perfect choices for Fed chairman,” said McCarthy, a former Richmond Fed economist.

“They’re very credible,” he said. “They’re also very familiar with what the Fed is doing now so there’s no learning curve. They’ve committed their lives to monetary policy so there’s an accumulated body of knowledge and understanding and expertise that’s unparalleled.”

It was another mixed day for the Canadian preferred share market, with PerpetualDiscounts down 48bp, FixedResets up 23bp and DeemedRetractibles gaining 12bp. There was no clear pattern in the Performance Highlights table, except that there were a fair number of PerpetualDiscounts in the bad part. Volume was very high.

PerpetualDiscounts now yield 5.73%, equivalent to 7.45% interest at the standard equivalency factor of 1.3x. Long corporates now yield about 4.75%, so the pre-tax interest-equivalent spread is now about 270bp, a slight (and perhaps spurious) increase from the 265bp recorded August 7 but well above the post-Crunch, pre-Tapering average of around 200bp.