Category: Market Action

Bloomberg has some chatter on the Fed derby:

Investors are increasingly seeking advice on how the potential nomination of Lawrence Summers as chairman of the Federal Reserve instead of Vice Chairman Janet Yellen might influence monetary policy and financial markets.

Inquiries about Summers’s chances “are picking up a lot,” said Matthew Benjamin, an analyst at Medley Global Advisors LLC in Washington, a firm that provides political intelligence to hedge funds. “Wall Street is very interested in this, and there is a perception that there is a difference between Yellen and Summers” in their approach to monetary stimulus.
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The possibility of a Summers chairmanship has contributed to the increase in borrowing costs because he is seen as likely to end the Fed’s quantitative easing sooner than Yellen would, said Krishna Memani, New York-based chief investment officer of fixed income at Oppenheimer Funds Inc., with about $208 billion under management.
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While former Treasury Secretary Summers, 58, has no record making monetary policy, he expressed skepticism about the effectiveness of QE in an April conference hosted by Drobny Global Advisors.

By contrast, Yellen’s views are well known after more than a decade at the central bank. Yellen, 67, was a Fed governor from 1994 to 1997, president of the San Francisco Fed from 2004 to 2010 and vice chairman since 2010.

She has been an architect of the current stimulus campaign and Fed communication strategy and has never dissented from a monetary policy decision under Bernanke.

“We know with Yellen that she will continue with their current program,” Memani said. “With Summers it’s a lot less certain.”

Organized labour – such as it is – has indicated a preference for Yellen:

[AFL-CIO President Richard] TRUMKA: Well, what I said is, if you look at history and their records, she seems to have the edge, she seems to be a better candidate from our point of view, and here’s why. One, when things were going wrong in the economy, in each one of those instances, she predicted them accurately. Larry didn’t. Larry we thought at that time was too close to Wall Street, and it allowed him to jade his thought process.
The second thing is, Janet Yellen has been for a balanced approach to the Federal Reserve. That means that – they have two mandates, fight inflation and create full employment. Larry and everyone before, all the way back to Paul Volcker, have said we’re not going to worry about full employment, we’re only going to worry –
[Talking Head Al] HUNT: But Larry does say he worries about full employment.
TRUMKA: Recently. And I hope that that continues on. And if he becomes the – the chair of the Fed, I hope he continues on and – and aggressively enforces that part of his mandate, as he does the inflation mandate.
HUNT: So, therefore, if Obama were to nominate Summers rather than your preference, which would be Yellen, you wouldn’t oppose the Summers nomination?
TRUMKA: I don’t know. It would all depend on what happens, you know, what’s said and what he’s going to do.

The Canadian preferred share market closed the month with another good day, with PerpetualDiscounts winning 40bp, FixedResets gaining 12bp and DeemedRetractibles up 26bp. The Performance Highlights table reflects the move, although it is much shorter than it has been in the past couple of weeks. Volume was on the low side of average.

In the latest tapering chatter:

Tapering talk has already sent 10-year note yields up 120 basis points. Almost the entire increase has been in the real yield, not in inflation expectations. Long-term interest rates aren’t about to retreat if the Fed delays the inevitable until October or December. So if rising long-term rates have policy makers tied in knots, doing nothing buys them time, not yield relief.

The real 10-year yield (from the 10-year inflation-indexed Treasury note) is 0.6 percent. JPMorgan Chase economist Jim Glassman says that before the recession and introduction of the Fed’s unconventional policies, real long-term rates averaged 2 percent to 2.5 percent. The implied five-year forward real rate — the expected real rate five to 10 years from now, which captures the anticipated normalization of monetary policy — is about 1.75 percent, according to Glassman. “That indicates that much of the adjustment in interest-rate markets has been done already,” he says.

Of course, markets tend to overshoot, and there’s no reason to think they won’t this time. But that’s the reaction to any Fed action.

This doesn’t mean “getting it over with” is a good reason to taper; it’s just better than the economic justifications being offered. At the July 30-31 meeting, “almost all members” thought it was too soon to taper. What will have transpired in the six weeks between the July and September meetings? Two more employment reports, that’s what. There is really no quantitative difference between an increase in non-farm payrolls of 162,000 (July) and 199,000 (April). If you don’t believe me, listen to the statisticians at the Bureau of Labor Statistics.

Inflation is below the Fed’s target. The jobless rate, now 7.4 percent, is being driven as much by declining labor-force participation as new hiring. And Fed officials could look at the 13.4 percent decline in new home sales in July as a harbinger and get squeamish about selling some of the central bank’s stockpile of mortgage-backed securities.

Four months of tapering chatter has given wannabe sellers adequate notice. The deed itself seems fully priced into the market, and time isn’t on the Fed’s side.

But it looks like business has cranked up issuance of cheap debt in advance:

Company debt loads in the U.S. are approaching the highest level since the aftermath of the financial crisis as borrowing to finance mergers and shareholder payouts exceeds earnings growth.

Debt levels have increased faster than cash flow for six straight quarters, boosting the obligations of investment-grade companies in the second quarter to 2.09 times earnings before interest, taxes, depreciation and amortization, according to JPMorgan Chase & Co. That’s up from 2.07 times in the first three months of 2013 and compares with 2.13 in the third quarter of 2009, when it peaked after the deepest recession since the Great Depression.
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While heavier debt burdens have been supported by a Fed policy that pushed average U.S. corporate-bond yields to a record-low 2.65 percent in May, JPMorgan strategists said they expect issuance to slow as interest rates increase. Speculation is mounting that Chairman Ben S. Bernanke will reduce the central bank’s $85 billion in monthly debt purchases as soon as next month.

With a greater sense of urgency to tap debt markets before rates climb higher, companies may continue to increase leverage through the end of the year, Bank of America Corp. debt strategist Yuriy Shchuchinov said in an Aug. 26 note.

There’s an interesting allegation about CMHC lending:

A friend who is an economist further went on to say that when lending rules were liberalized to take into account two incomes in a household it in effect imprisoned families to needing two incomes to afford a house. This did not help families, but rather increased the price of housing, with the outcome that young families are hard pressed not to farm out their children to daycare or grandparents. Single-income households need a really high single income or they face very limited housing options. As individuals, families and a society we’re not any better off, and the outcome only has been higher prices.

A recent article by Canso Investment newsletter reported one troubling trend – “gaming” with CMHC’s online automated appraisal system, EMILI. The system was created in 1996 to allow lenders to quickly check if the house price involved in a mortgage transaction was reasonable. According to Canso, while this streamlined the process of mortgage insurance and origination, it also removed any human check and balance.

EMILI uses an algorithm which looks at the address, and particularly the postal code, and metrics of the house to be insured. The key variables are “the square footage of the house and the prior sale prices for the geographic area of the house.”

According to Canso, “there has been extensive ‘gaming’ of this system and excessive prices generated by this system. If a higher price is required for CMHC insurance coverage, the square footage, which is input by the lender and supplied by the mortgage broker, can be increased as required.”

“Gaming” is a polite term. What this really looks like is fraud. Having said that, the impact of this fraud will, for the most part, be limited to excessive lending on a single property, as opposed to the greater problem of excessive money supply for mortgages. This excess money supply has floated the buyers’ market to extraordinary heights with very few real winners. Recent homebuyers may be able to afford their mortgage payments – providing interest rates remain low during the amortization term. But some amortization terms in the past decade have reached 40 years and it’s unreasonable to expect interest rates to remain low three to four decades down the road.

I believe that the CMHC is a major part of the problem: they’re insuring far too many mortgages and Canadian banks now have record amounts of mortgage debts on their books, both in absolute terms and in terms of the proportion of their assets. They can do this because the mortgages are insured – or, at least, they can be counted as insured until they default and CMHC suddenly gets more interested in the house’s square footage!

Eliminate the insurance and – business risks aside – the risk weight will go up. Risk Weight goes up, Risk Adjustjed Assets go up. Risk Adjusted Assets go up, capital requirement goes up. Capital Requirement goes up, banks’ cost of funds goes up. Cost of funds goes up, mortgage rates go up. Mortgage rates go up, mortgage demand goes down.

NASDAQ has provided an explanation for last week’s shutdown:

The malfunction began when NYSE Arca sent more than 20 “connect and disconnect sequences” as well as a stream of quotes for inaccurate stock symbols, according to Nasdaq’s summary. At one point, Nasdaq received over 2 1/2 times more data per second than the system’s tested capacity.

After being inundated with orders, the flaw in the SIP software prevented redundancy that is built into the system from “failing over cleanly” to a backup program, it said.

It was another day of modest advance in the Canadian preferred share market, with PerpetualDiscounts gaining 2bp, FixedResets up 8bp and DeemedRetractibles full steam ahead with a win of 46bp. The Performance Highlights table was heavily weighted towards winners. Volume was high.

The SEC and five other agencies in the US alphabet soup have release a securitization risk-retention rule for comment:

The original proposal generally measured compliance with the risk retention requirements based on the par value of securities issued in a securitization transaction and included a so-called premium capture provision. The agencies are now proposing that risk retention generally be based on fair value measurements without a premium capture provision.

As required by the Dodd-Frank Act, the proposal would define “qualified residential mortgage” (QRM) and exempt securitizations of QRMs from risk retention. The new proposal would define QRMs to have the same meaning as the term qualified mortgages as defined by the Consumer Financial Protection Bureau. The new proposal also requests comment on an alternative definition of QRM that would include certain underwriting standards in addition to the qualified mortgage criteria.

Similar to the original proposal, under the new proposal, securitizations of commercial loans, commercial mortgages, or automobile loans of low credit risk would not be subject to risk retention. Further, the rule would recognize the full guarantee on payments of principal and interest provided by Fannie Mae and Freddie Mac for their residential mortgage-backed securities as meeting the risk retention requirements while Fannie Mae and Freddie Mac are in conservatorship or receivership and have capital support from the U.S. government. This provision also is unchanged from the original proposal.

The agencies are requesting comment on the revised proposed rule by Oct. 30, 2013.

Some of us might observe that it was risk-retention that caused the problem in the first place, but logic never stopped Congress and regulators from doing anything.

What makes this interesting, however, is the dissenting statement from SEC Commissioner Michael S. Piwowar:

As a general principle, I believe that regulatory agencies should make greater use of reproposals. Reproposals offer regulators the opportunity to improve the efficiency and effectiveness of their rulemaking processes and provide the public the regulatory transparency and accountability they deserve. Such a measure of discipline is critically important in connection with Dodd-Frank, which requires regulators to promulgate hundreds of new, complex, and interrelated rules that affect every American by impacting capital formation, job creation, and economic growth. I am pleased that the agencies approving today’s release saw fit to repropose the rule to take into account public comment. However, because of my concerns about two serious deficiencies in this particular reproposal, I cannot support it and I respectfully dissent.

The Agencies Issuing The Reproposal Did Not Perform Necessary Economic Analyses
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The FSOC Report concludes that the macroeconomic implications of credit risk retention requirements are complex and cautions that “[I]f overly restrictive, risk retention could constrain the formation of credit, which could adversely impact economic growth. The challenge is to design a risk retention framework that maximizes benefits while minimizing its costs.”[7] Notably, the reproposal does not contain any analysis of the macroeconomic implications identified in the FSOC Report.

The failure by the Rulemaking Agencies to articulate necessary economic analyses to support the reproposal is a significant omission and fundamental flaw that cannot be overlooked.

The Reproposal Does Not Adequately Consider Alternatives to Credit Risk Retention Requirements
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In my view, the reproposal should have included disclosure requirements that, contingent on the availability of information regarding secondary market transactions,[14] could facilitate better, more informed decisions by both regulators and investors. Mandatory disclosure also would have the potential to directly reduce informational asymmetries and moral hazard problems. The Rulemaking Agencies could have, for example, proposed and sought comment on enhanced disclosures of loan level characteristics along with mandatory disclosures of the amount, type, and duration of the credit risk that the originators and securitizers voluntarily retained in each ABS.

The reproposal also should have given further consideration to subordinated performance fees that have components dependent on the performance of the overall pool or on junior tranches. Such fees could potentially mitigate concerns about misaligned incentives between originators, securitizers, and investors.

There’s also a dissenting statement from SEC Commissioner Daniel M.Gallagher.

Isn’t the US system great? They actually recognize that intelligent people can disagree, and that dissent is a sign of strength, not weakness. How unlike the pablum we get fed here in Canada.

It was another modestly good day for the Canadian preferred share market, with PerpetualDiscounts gaining 9bp, FixedResets up 18bp and DeemedRetractibles winning 19bp. Today’s Performance Highlights table is quite lengthy by normal standards, but is much shorter than we have been used to lately. Volume was quite high.

PerpetualDiscounts now yield 5.81%, equivalent to 7.55% interest at the standard equivalency factor of 1.3x. Long corporates now yield about 4.8% (maybe a little under), so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 275bp, a slight (and perhaps spurious) decline from the 280bp reported August 21.

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.
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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.
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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.
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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.
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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.
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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.”
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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.
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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.
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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.
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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.
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“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.
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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.
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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.
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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.
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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.
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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.
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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.”
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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.
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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.
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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.
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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.
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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.
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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.