PrefBlog

The more things change, the more they stay the same:

The U.S. bond market is defying the Federal Reserve again.

The central bank has raised short-term interest rates four times beginning in December 2015 and pushed up the key policy rate by one percentage point. Yet the yield on the benchmark 10-year Treasury note settled at 2.198% on Tuesday, below the 2.269% where it settled before the Fed’s first rate increase since 2006. Yields fall as bond prices rise.

The tension reminds some investors of the “conundrum” described by Alan Greenspan, then Fed chairman, in February 2005. Mr. Greenspan was puzzled by long-term Treasury yields that were ticking lower despite increases in the federal-funds target rate.

It’s nice to see one of my prejudices get support:

Companies with a higher proportion of scientists and engineers are more productive than their peers, even when those workers aren’t directly involved in the research-and-development tasks that drive the most obvious forms of innovation, a new paper from the National Bureau of Economic Research suggests.
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Mr. Freeman and co-authors Erling Barth, of the Institute for Social Research in Norway, James Davis, of the U.S. Census Bureau, and Andrew Wang, of Harvard Law School’s Labor and Worklife Program, were curious about the influence science and engineering professionals wield outside of R&D. Most previous research has focused on jobs where scientists and engineers were inventing new products.

Analyzing employee and production data from manufacturing establishments between 1992 and 2007, the authors found that the value scientists and engineers bring even to non-R&D roles derives from their training, says Mr. Freeman.

When a manufacturer needs to fix the airflow in its factories, for example, “you need someone who knows about the flow of air currents, the right equations to use and other well-established principles,” he says.

The final paragraph quoted above bothers me, because it’s not supported in the actual paper, titled The Effects of Scientists and Engineers on Productivity and Earnings at the Establishment Where They Work. After all, if you know you’ve got to fix the airflow, you don’t get Joe from accounting to fix it because he’s got a Chemistry degree! You hire a firm of airflow engineers, and any establishment can do that. The paper itself concludes in part:

A plausible interpretation of the results is that production establishment-based scientists and engineers help implement the adoption of new technologies and products at workplaces.

It is my view that STEM training promotes the view that there is exactly one right answer to any question and that while we might never actually know that answer, we can always get a little closer; and that people who have this type of world-view at an early age are more likely than others to pursue STEM training in the first place. On the other hand, an archetypal arts graduate will be more inclined to believe there are multiple answers to any question, with a good argument to be made for each.

And it is the archetypal STEM outlook that leads to dissatisfaction with extant processes, with stream of suggested and implemented improvements that eventually result in a measurable increase in productivity.

Obviously, this is a very broad generalization and perhaps not very well put; if I were an arts graduate I would doubtless be able to articulate my idea more clearly!

And Poloz reiterated his hawkish bent:

The Canadian dollar extended gains and investors ramped up bets of a rate increase as early as next month after Bank of Canada Governor Stephen Poloz reiterated the central bank may be considering higher interest rates.

The nation’s currency jumped 0.7 percent to C$1.3103 per U.S. dollar at 8:57 a.m. in Toronto. The loonie traded at 76.3 U.S. cents. Swaps trading suggests investors are placing a 65 percent chance of a rate hike at the bank’s July 12 rate decision, up from 39 percent Tuesday.
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Poloz used similar language in an interview with CNBC.

“Rates are of course extraordinarily low,” Poloz said, adding the bank cut rates by 50 basis points in 2015 to counteract the effects of the oil price shock. “It does look as though those cuts have done their job,” he said, according to a transcript of the interview. “But we’re just approaching a new interest rate decision so I don’t want to prejudge. But certainly we need to be at least considering that whole situation now that the excess capacity is being used up steadily.”

The comments also pushed bond yields higher. The government of Canada two-year note fell for a third day, with the yield rising to 1.01 percent, the highest since January 2015.

The Canada five-year yield was up big-time today, but I’m not convinced that This Is It. Inflation is still quiescent as discussed on June 23 and oil isn’t doing anything special ( BOC Deputy Governor Lynn Patterson says the oil shock that hit Canada in 2014 is no longer acting as a drag on the economy ). However, the volatility in the five-year this month does have me leaning towards the view that when the bond market does normalize, it will do so in a disorderly, abrupt manner, whether it happens next week or in ten years.

This view is bolstered by market reaction to Draghi’s statement in Europe:

Mario Draghi just got evidence that his call for “prudence” in withdrawing European Central Bank stimulus applies to his words too.

The euro and bond yields surged on Tuesday after the ECB president said the reflation of the euro-area economy creates room to pull back unconventional measures without tightening the stance. Policy makers noted the jolt that showed how hypersensitive investors are to statements that can be read as even mildly hawkish, according to three Eurosystem officials familiar with their thinking.
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A key concern for the central bank is that too-hasty communication that stimulus is on the way out may have an outsized impact on bond yields and bring about an “unwarranted tightening of financial conditions” that would jeopardize the economy’s progress so far. Draghi stressed exactly this point in his Tuesday speech.

>“We need prudence. As the economy picks up we will need to be gradual when adjusting our policy parameters, so as to ensure that our stimulus accompanies the recovery amid the lingering uncertainties.”

Yet by avoiding formal discussion of any tapering of quantitative easing until late in the year, the ECB raises the risk of more market volatility when speeches such as Draghi’s hit, especially over the summer months when liquidity is typically thinner. The ECB chief also stressed the need for persistence in maintaining monetary accommodation, but investors focused on his line about the scope for policy tweaks.

“As the economy continues to recover, a constant policy stance will become more accommodative, and the central bank can accompany the recovery by adjusting the parameters of its policy instruments — not in order to tighten the policy stance, but to keep it broadly unchanged.”

There was a nice article on the New York Fed’s blog today titled Low Productivity Growth: The Capital Formation Link, which I don’t find entirely convincing:

Growth of pure technological and managerial knowledge is much harder to observe (in fact, it’s typically interpreted as the portion of productivity growth that can’t be directly credited to improved worker skills or capital formation). It’s difficult to infer what this factor is likely to do: some observers claim that, say, increased application of artificial intelligence will lead to a marked acceleration of productivity, while others assert that there’s little reason to believe that such factors will add as much to productivity as seemingly humbler innovations of the past (such as, say, the adoption of containerization by the transportation sector in the 1960s).

That leaves capital formation as the remaining factor affecting productivity. Workers need tools to do their jobs; the more tools per worker, the more the workers can produce (at least to a point!). As a result, one important factor to examine in assessing productivity trends is the growth of capital per hour worked.
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Indeed, the chart below shows that relative to depreciation, investment has been weak in this expansion. (Note, a value of one in the following chart means that gross investment equals depreciation, so the net capital stock would be unchanged over time. A value greater than one indicates that gross investment exceeds depreciation and so the net capital stock would grow. Conversely, a value below one indicates that gross investment is less than depreciation and so the capital stock would shrink.)

Click for Big

Far be it from me to claim that all the productivity gains that can be made have been made. However, given the increasing role of services there are limits to the overall impact of manufacturing improvements in the economy. In order to make productivity improvements in manufacturing worthwhile, there must be demand for the goods produced and I’m not convinced that the same opportunities exist today as they did in, say, 1955, when new capital to build a new steel mill was enthusiastically received.

Note that this does not contradict my other views on productivity, as expressed in my periodic rants about the minimum wage. I suggest that while productivity improvements in manufacturing are largely capital-intensive, such improvements in services are process-intensive. It doesn’t cost much money, in the great scheme of things, to develop a new process and write software to implement it; it takes intellectual capital.

Bonds got hammered today, with the Canada five-year up 8bp to 1.28%. We are told that the causes may include spread speculation vs. Treasuries:

An unusual trade across America’s northern border is starting to become a more prominent fixture in the market for sovereign debt.

It’s a straightforward play: simultaneously purchase Ultra 10-year Treasury futures and sell contracts for similar-maturity Canadian debt. It’s a bet that U.S. bonds will outperform as the Federal Reserve slows down its pace of interest-rate increases, while the Bank of Canada appears to be considering a hike as soon as next month.

What’s striking to traders is the size of the wagers. Each leg of Wednesday’s transaction, which sent Canadian bond futures tumbling, represented about $820,000 of risk per basis point. The 9,098-contract Canadian block is the second-largest ever, trailing only a trade in March 2008, according to Shane Quinn, a spokesman for TMX Group.

It’s a poorly written article, but the gist is reasonably clear. The contract size on the Canada 10-year is $100,000 nominal (of a 6% (!) bond, closed today at 142.48). Therefore the Canadian leg of 9,098 contracts had a notional value of about $910-million p.v., $1.3-billion value. The US “Ultra” contract is a relatively new contract:

A main difference between the ultra and regular 10-year T-note is range of maturities of Treasuries buyers would accept.

Regular 10-year T-note holders could take delivery of cash government debt that mature in 6-1/2 years to 10 years. This compare with ultra 10-year owners who could take delivery of cash Treasuries that come in 9 years and five months to 10 years.

I guess people were getting tired of the enormous negative convexity with the ‘regular’ contract!

Anyway … the hit to the bond market was probably behind a good chunk of today’s excellent preferred share market! Assiduous Readers with a fine appreciation of the more awkward things in life will remember that June 13 was also a big day for performance, and had 51/377 issues going ex-dividend. Today, 39/377 issues went ex … so there will be more sad stories!

PerpetualDiscounts now yield 5.08%, equivalent to 6.60% interest at the standard equivalency factor of 1.3x. Long corporates now yield about 3.65%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 295bp, a slight (and perhaps spurious) narrowing from the 300bp reported June 21.

I thought this was an excellent article on index funds and corporate governance:

No passive investor cares much about governance of a particular company. The impact on an index when a single company underperforms is usually either slight or offset by gains from its competitors. It may be rational for index funds to ignore governance, since the money they spend on improving it benefits not just them but also rival funds that invest in the same stocks.

So it’s a problem when these investors control voting outcomes for the companies that they invest in. This is often the case, since 88% of public companies count one of three large institutional investors— State Street Global Advisors, Vanguard, and BlackRock—as their largest investor. All investors have a stake in companies being well-run, but they aren’t always willing to pay higher fees for monitoring or governance. And because there is no such thing as universally good governance, the blind application of one-size-fits-all governance solutions across vastly different companies often has negative effects.

Blackrock touts its Investment Stewardship team:

The BlackRock Investment Stewardship team is a centralized resource for portfolio managers. In our stewardship work we aim to:
1 Protect and enhance the value of clients’ assets through engagement with companies
2 Encourage business and management practices that support sustainable financial performance over the long-term
3 Provide specialist insight on environmental, social and governance (ESG) considerations to all investment strategies, whether indexed or actively managed.

… but the opinion piece points out:

But there is reason to believe that these teams are not up to the task. As of October 2016, Vanguard’s governance team employed 15 people to cover some 13,000 companies; BlackRock employed about 20 for its 14,000 companies; and State Street employed fewer than 10 for about 9,000 companies.

The Globe had an excellent article on productivity in Ontario which well illustrates my view on the minimum wage controversy:

Don’t lecture Jocelyn Bamford about lack of ambition. She helps run Automatic Coating Ltd., a company founded by her husband’s family in the 1950s.
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“We are absolutely losing our competitiveness,” Ms. Bamford said.

The culprit, she said, is a provincial government that has rained blows on small and mid-sized businesses over the past two years. The unwelcome changes include unpredictable energy costs, a complicated cap-and-trade system for greenhouse-gas emitters, the planned hike in the minimum wage and new rules that will make it far easier for organizers to unionize workplaces.
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Right now, she says, the only factor that allows many of the province’s manufacturers to compete against U.S. rivals is the low Canadian dollar. But she worries about the impact of the new workplace legislation, especially the radical hike to the minimum wage.

The problem, she says, is that a higher minimum wage forces up wages across the entire pay scale. Experienced workers who are already making $15 an hour will demand a few dollars more, and the ripple effect will result in dramatically higher labour costs over all.

What are her alternatives? She and her husband have debated whether it makes sense to cut jobs and automate more of their factory operations. Even simpler, though, would be a move to Mississippi, where the state is dangling a tempting package of relocation benefits.

Well, I’m not impressed by business owners who seek success through cheap labour and government handouts. Fortunately, the Globe also interviewed a man after my own heart:

“But all that being said, I don’t think the $15 minimum is likely to be a game changer in the long run,” says Craig Alexander, chief economist of the Conference Board of Canada, a not-for-profit research organization.

He notes that several U.S. states have announced their own plans to move to similar wage levels over the next few years. Rather than relocating operations, many employers in Ontario are likely to respond to higher wages by reducing jobs and installing more automation.

“You already see the trend at some fast-food restaurants, where you order at a screen instead of talking to a human,” Mr. Alexander says.

His analysis demonstrates the complexity of any policy change: By encouraging automation, higher minimum wages could boost productivity over the long run, which the province badly needs.

… and at least one of the interviewed business owners gets it:

Mr. Josephs, the freezie maker, acknowledges the many conflicting factors. It’s difficult to find anyone who will work for minimum wage these days, he says. His big worry is not so much the hike itself but the knock-on effect it will have on workers who may be making slightly more than the $15-an-hour level and will want raises of their own.

If he decides to stay in Ontario, he’s looking at automating his plant to drastically reduce his use of seasonal workers, slashing the number of hires from 100 to about 40. “And we’ll be looking to reduce even further,” he says.

Meanwhile CRM2 is having its intended effect:

Financial advisors who work at three of the Big Six banks had much to complain about concerning their pay as a result of recent changes to their compensation packages.

Notably, advisors who work at Toronto-based Bank of Nova Scotia, Montreal-based National Bank of Canada and Toronto-based Canadian Imperial Bank of Commerce (CIBC) either gave their firms the lowest or much lower ratings in the “firm’s total compensation” category in this year’s Report Card on Banks because of changes that led to drastic reductions in their take-home pay.

Scotiabank received the lowest rating in the category (6.9) – a tie with National Bank – because advisors are dissatisfied that Scotiabank eliminated the investment bonus from advisors’ pay packages.

“[The bank] took away about $16,000 to $18,000 – or 20% of my salary,” says a Scotiabank advisor in British Columbia.
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Similarly, advisors with National Bank took issue with several recent tweaks to the firm’s compensation regime. For starters, the bank announced a new compensation structure this past January, through which advisors will take an 8% cut in their salary as of July 1; this did not sit well with many advisors surveyed.
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The new payout structure for National Bank advisors is 70% base salary and 30% variable compensation, says Nancy Paquet, vice president, partnerships, with National Bank. The changes include an 8% reduction to advisors’ salary, as well as changes to how the variable portion is calculated; specifically, the latter now is paid quarterly instead of annually.

Isn’t it great? Trailer fee disclosure will drive a lot of business away from independents to the banks, where the nice man at the bank will put investors into the bank’s funds and GICs (because GICs are safe!) – with no fee! Well, sure, there’s a MER, but all funds have MERs … advice will be free, free, free!

I am sure we all look forward to the day when trailer fees are banned completely; then all those expensive bank advisors can be replaced with high school students working part time. The banks were successful in implementing such a change (as far as I was ever able to tell) with respect to institutional salesmen in the first decade of this century and we can all look forward to universality.

The trouble is that nobody ever asks, considers or resolves the question: ‘what are the capital markets for? How can the capital markets accomplish their purpose more efficiently?’. Nobody’s paid to do it. In an ideal world the regulators would have these questions front and centre of every proposal, but in this world regulators are mandated to make sure there are no scandals that might embarrass their political masters. And so public markets get more inefficient, investment outcomes become more of a one-size-fits-all plain-vanilla whitewash and – most importantly – big banks get bigger and find they need more ex-regulators on staff.

A rate hike in Canada won’t come as soon as some people think, according to recent inflation numbers:

The Bank of Canada’s efforts to set the stage for a rate increase were set back Friday after data showed inflation pressures continuing to ease.

Canada’s consumer price index rose 1.3 percent in May from a year ago, the slowest pace this year, down from an annual pace of 1.6 percent in April, Statistics Canada said Friday from Ottawa. Another key gauge of price pressures that excludes gasoline and some other more volatile items fell to the lowest since 1999.

The inflation report undermines the case for a quick rate hike by the Bank of Canada even as the nation’s economy has been growing at a pace that is among the fastest in the developed world.

I remain convinced that it will come eventually – but trying to time it is a mug’s game. But there are doubts about US inflation:

Barely a week after raising short-term interest rates for the second time this year, Federal Reserve officials are increasingly divided on the timing of their next move, with some saying they won’t support another increase until they see a pickup in inflation.

Inflation, as measured by the Fed’s preferred gauge, breached its annual 2% goal in February for the first time in nearly five years but has since retreated, sinking to 1.7% in April.

Fed officials in their public remarks since their policy meeting last week have disagreed on whether the recent weakening of price pressures is likely transitory or perhaps more persistent.

Fed Chairwoman Janet Yellen, New York Fed President William Dudley and Cleveland Fed chief Loretta Mester view the recent sluggishness as probably temporary, driven by some one-time factors such as new, more generous cellphone plans and slower growth in prescription drug prices.

Others such as regional Fed bank presidents Charles Evans of Chicago, Neel Kashkari of Minneapolis, Robert Kaplan of Dallas and James Bullard of St. Louis have expressed more concern about slower inflation.

Change and confusion all ’round! Last Friday, Quebec was upgraded. Today Saskatchewan is downgraded:

• •Weaker commodity prices and elevated capital spending are negatively affecting the Province of Saskatchewan’s budgetary performance and debt burden.
• •As a result, we are lowering our long-term issuer credit and senior unsecured debt ratings on Saskatchewan to ‘AA’ from ‘AA+’ and affirming our ‘A-1+’ global scale and ‘A-1(High)’ Canada scale short-term ratings.
• •The stable outlook reflects our expectation that, in the next two years, as Saskatchewan realizes positive results from its revenue measures and cost efficiencies, its budgetary performance will continue to stabilize, leading to near-balanced operating balances and declining after-capital deficits of less than 10% of total revenues

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The downgrade reflects the province’s weakened budget performance and growing debt burden, which are symptoms of low commodity prices in two of
Saskatchewan’s key economic sectors: oil and gas, and potash. Low commodity prices have prompted the province to implement tax reforms and cost control targets, which are expected to support an improvement in budget outcomes. However, despite these efforts, Saskatchewan’s budget trajectory is now weaker than it was last year, due to slower economic growth and higher near-term capital spending intentions under its Saskatchewan Builds Capital Program. We now expect Saskatchewan’s after-capital balances to remain negative over the next two years. We also expect new borrowing requirements tied to SaskBuilds and government-related entities (GREs) to cause its tax-supported debt burden to approach 150% of consolidated operating revenues, which is high compared with similarly rated international peers’.

We expect Saskatchewan will record, on average, a modest operating deficit of about 2% of operating revenues and an after-capital deficit of 10% of total revenues for fiscal years 2016-2020. We expect that new revenue measures, such as eliminating certain exemptions and increasing the provincial sales tax, will help to mitigate the negative influence of weak commodity prices, leading to a steady improvement in budget outcomes over the next two years. Saskatchewan is forecasting operating revenue growth of 3.7% per year, on average, between fiscal years 2018 and 2020. On the expense side, considering continued spending control and a projected return to more moderate levels of capital spending in the outer years of our forecast, we expect that the province’s after-capital budgetary performance will moderately improve. Saskatchewan is projecting an operating expenditure decline of 1.2% in fiscal 2018, followed by expenditure growth of 1.2% per year, on average, between fiscal years 2019 and 2020.

PerpetualDiscounts now yield 5.08%, equivalent to 6.60% interest at the standard equivalency factor of 1.3x. Long corporates now yield about 3.60% (maybe a little over) and so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 300bp, a widening from the 290bp reported June 14.