PrefBlog

The trouble with financial crises is that they’re boring. Originally, crises with global implications all came from the UK. Then they all came from the US. Nobody else had the size of capital and global connections to transmit mistakes to other countries. However, there is some hope that the next crisis will come from China:

China’s chief auditor discovered 94.4 billion yuan ($15.2 billion) of loans backed by falsified gold transactions, adding to signs of possible fraud in commodities financing deals.

Twenty-five bullion processors made a combined profit of more than 900 million yuan by using the loans to take advantage of the difference between onshore and offshore interest rates, and the appreciation of Chinese currency, according a report on the National Audit Office’s website. China is the biggest producer and consumer of gold.

Public security authorities are also probing alleged fraud at Qingdao Port where the same stockpiles of copper and aluminum may have been pledged multiple times as collateral for loans. As much as 1,000 tons of gold may be tied up in financing deals in China, in which commodities including metals and agricultural products are used to get credit amid restrictions on lending, according to World Gold Council estimates through 2013.

A recent lawsuit illustrates the total intellectual bankruptcy of the money management industry:

Schneiderman’s case is the boldest initiative and may open fissures in the decade-old defense of U.S. equity markets that has been championed by brokerages and traders. In their version of the story, dark pools serve as havens for institutional investors tired of seeing orders to buy and sell stocks front-run on public exchanges. According to Schneiderman, institutions may not have been much safer on Barclays’ platform.

“There’s going to be a significant amount more scrutiny on routing practices at dark pools, and I think you’re going to see more oversight,” said Larry Tabb, chief executive officer of Tabb Group LLC.
…
Barclays was so bent on lifting its private trading venue to the upper ranks of Wall Street dark pools that it falsified marketing materials to hide how much high-frequency traders were buying and selling, the complaint said.

Seeking to reassure customers that their stock orders wouldn’t be picked off by predatory counterparts, Barclays touted a system designed to keep that from happening called liquidity profiling, according to the complaint. Marketing material including charts purported to show that very little of the trading within the dark pool was “aggressive” and that operating there was safe for institutions.

“The representations were false,” according to the complaint. The chart and accompanying statements obscured the trading taking place in Barclays’ dark pool. Senior Barclays personnel de-emphasized the presence of high-frequency traders and left out reference to one of the largest and most toxic participants, it said.

Um … who cares? If your order is filled, it’s filled. If it ain’t, it ain’t. Only morons care about the identity of their counterparty. “Sorry, Mr. Smith, your portfolio underperformed the benchmark by 500bp, but on the positive side, we traded only with retired Sunday School teachers.”

You don’t choose a broker on the basis of its marketing materials, for God’s sake. You make a choice based on execution. But maybe I’m just old fashioned.

Here’s a good reason to pay cash – always:

You may soon get a call from your doctor if you’ve let your gym membership lapse, made a habit of picking up candy bars at the check-out counter or begin shopping at plus-sized stores.

That’s because some hospitals are starting to use detailed consumer data to create profiles on current and potential patients to identify those most likely to get sick, so the hospitals can intervene before they do.

Information compiled by data brokers from public records and credit card transactions can reveal where a person shops, the food they buy, and whether they smoke. The largest hospital chain in the Carolinas is plugging data for 2 million people into algorithms designed to identify high-risk patients, while Pennsylvania’s biggest system uses household and demographic data. Patients and their advocates, meanwhile, say they’re concerned that big data’s expansion into medical care will hurt the doctor-patient relationship and threaten privacy.

I told you guys this was coming! I told you! But does anybody ever listen to me? No.

Could it be that Putin’s policies are creating Soviet Union Redux:

State enterprises now account for more than half of the economy, up from 30 percent when Putin came to power at the end of 1999, according to BNP Paribas SA. (BNP) As the bureaucracy swelled during that period, Russia emerged as the world’s most corrupt major economy. It ranks alongside Pakistan and Nicaragua at 127th, out of 176 nations, by Transparency International, down from 82nd in 2000.

With Russia’s $2 trillion economy stagnating, fixed investment falling and the U.S. and the EU warning of a tougher round of sanctions over the pro-Russian revolt in eastern Ukraine, Putin’s solution is a list of proposals revealed in May that involve a greater role for the state. He ordered the central bank to set up long-term financing for manufacturers and called for rules to force “systemically important” companies to move their registrations inside Russia.

On the other hand, there are sufficient interconnections to keep things interesting:

Western companies are already wrestling with the thorny problem of complying with existing curbs on dealings with a limited number of wealthy Putin allies and their businesses, many of which have murky ownership structures and bases in tax havens. Now, the U.S. Chamber of Commerce and the National Association of Manufacturers have taken out full-page ads in The New York Times, Wall Street Journal and Washington Post to decry the prospect of unilateral sanctions that would only hurt U.S. companies in foreign markets, while benefiting their competitors.
…
Indeed, 83 per cent of economists polled by Bloomberg now think Washington will steer clear of stronger sanctions, compared with 66 per cent a month earlier. And 96 per cent expect no further action from the European Union.

“There is no sense in seeking sanctions which would harm the EU as much as Russia,” Czech State Secretary for European Affairs Tomas Prouza declared.

Bullard is sounding rather like a hawk:

Federal Reserve Bank of St. Louis President James Bullard predicted the central bank will raise interest rates starting in the first quarter of 2015, sooner than most of his colleagues think, as unemployment falls and inflation quickens.

Asked about his forecast for the timing of the first interest-rate increase since 2006, he said: “I’ve left mine at the end of the first quarter of next year.”

“The Fed (FDTR) is closer to its goal than many people appreciate,” Bullard said today in an interview with Fox Business Network. “We’re really pretty close to normal.”
…
Bullard predicted the jobless rate may fall below 6 percent and inflation rise near 2 percent by the end of this year.

If his forecasts bear out, “you’re basically going to be right at target on both dimensions possibly later this year,” Bullard said. “That’s shocking, and I don’t think markets, and I’m not sure policy makers, have really digested that that’s where we are.”

It was another positive day for the Canadian preferred share market, with PerpetualDiscounts winning 12bp, FixedResets up 8bp and DeemedRetractibles gaining 2bp. Volatility was average. Volume was above average.

The first quarter in the US was worse than we thought:

The U.S. economy contracted in the first quarter by the most since the depths of the last recession as consumer spending cooled.

Gross domestic product fell at a 2.9 percent annualized rate, more than forecast and the worst reading since the same three months in 2009, after a previously reported 1 percent drop, the Commerce Department said today in Washington. It marked the biggest downward revision from the agency’s second GDP estimate since records began in 1976. The revision reflected a slowdown in health care spending.
…
The revision reflected a drop in spending tied to health care services. The Bureau of Economic Analysis had estimated that major provisions of President Obama’s signature health care law would boost outlays. A quarterly services survey released this month showed the assumptions were too optimistic. Outlays for health spending actually slowed in the first quarter, subtracting 0.16 percentage point from GDP. The Commerce Department previously estimated those outlays added 1 percentage point to GDP.

Naturally, the US government wants Treasury debt to be unaffected by corporate-like inventory constraints:

• •The Volcker Rule bars banks from “proprietary trading” in credit.
• •But it allows proprietary trading in rates products such as Treasury and agency bonds.
• •So Citi set up a prop desk to trade agency bonds, managing over $1 billion of Citi’s money.
• •It’s run by a woman named Anna Raytcheva, who lost billions of dollars trading agency bonds during the financial crisis.

Obviously, some people are scandalized because people are scandalized by everything related to the Volcker Rule. And because the Volcker Rule is light on coherence. For instance, why does the Volcker Rule allow prop trading in rates? Well:

Lawmakers sought the flexibility to finance government spending and didn’t see the trading as particularly risky, said Barney Frank, who as a Massachusetts congressman helped draft the 2010 Dodd-Frank Act that mandated the Volcker Rule.

“To the extent the instruments being traded are completely secure, some of the rationale for the rule disappears,” Frank, a Democrat, said in a phone interview.

It was a good day for the Canadian preferred share market, with PerpetualDiscounts up 9bp, FixedResets winning 12bp and DeemedRetractibles gaining 6bp. Volatility was well above average and dominated by winning FixedResets. Volume was above average, with the highlights dominated by RY issues for some reason; the top two are both extremely likely to be called in August, for what that’s worth.

Looks like we’ve entered the Even Greater Moderation:

Expectations for price swings in the dollar-yen currency pair fell to a record as signs of an uneven U.S. economic recovery fueled bets the Federal Reserve will keep borrowing costs at unprecedented lows.
…
Three-month implied volatility in dollar-yen was at 5.795 percent at 6:46 a.m. in London after declining to 5.715 percent, the lowest level since Bloomberg began compiling the data in December 1995.

The SEC has demanded a test of small-stock tick-sizes to see whether a larger tick-size improves liquidity of these stocks:

The experiment was sought by exchange operators including Nasdaq OMX Group Inc. (NDAQ) and Intercontinental Exchange Inc. (ICE), which have seen their share of trading fall as private platforms such as dark pools have taken 37 percent of total share volume, according to data compiled by Bloomberg. The test will prevent trading outside the exchanges unless a competing venue or broker offers a significantly better price or size lot to investors, according to an order posted on the SEC’s website.

Other features of the program, which will last one year, will strictly test the impact of rolling back penny pricing in stocks of smaller-cap companies. Under that experiment, the shares of companies with market values under $5 billion will only be quoted in five-cent increments.

Supporters of the test say it will encourage market makers that facilitate trading to buy and sell more shares and create conditions that would persuade more companies to go public. The SEC has been considering the experiment for more than a year as some lawmakers in Congress have pushed legislation to force a change.

Regrettably, other tests have not been announced – repealing Sarbanes-Oxley for these companies, for instance, or reducing capital requirements for market-makers who are banks, or actually increasing maker-taker exchange pricing for these issues.

Manulife Financial, proud issuer of MFC.PR.A, MFC.PR.B, MFC.PR.C, MFC.PR.E, MFC.PR.F, MFC.PR.G, MFC.PR.H, MFC.PR.I, MFC.PR.J, MFC.PR.K and MFC.PR.L, has been confirmed at Pfd-2(high) by DBRS:

DBRS has today confirmed the ratings on Manulife Financial Corporation (Manulife or the Company) and its affiliates, including The Manufacturers Life Insurance Company, its primary operating company. The rating on the Senior Unsecured Notes issued by Manulife Finance Holdings Limited has been discontinued due to repayment. All trends are Stable.

The ratings reflect the Company’s strong position in a number of geographic and product markets, including Canada and the fast-growing Asian market through the Manulife brand, and in the United States through the John Hancock brand. The Company is also well diversified by customer, distribution channel and product line. Risk management policies and procedures are rigourous, giving rise to a high-quality asset portfolio, though legacy issues associated with the Company’s policy liabilities continue to be a potential source of adverse reserve development given the macroeconomic and regulatory environments. While DBRS regards Manulife’s reduction of market-related risks over the past few years as having been critical to maintaining the Company’s high rating, it also notes that with unexceptional financial risk metrics, under DBRS’s methodology it is the Company’s franchise strength and business that provide most of the rating strength.

It was a mixed day for the Canadian preferred share market, with PerpatualDiscounts down 19bp, FixedResets up 9bp and DeemedRetractibles gaining 1bp. Volatility was a little more than usual, heavily skewed towards winning FixedResets. Volume was very low.

Matt Levine of Bloomberg ran a thoughtful – if disjointed – piece on bond market structure philosophy titled SEC Wants to Give Everyone a Chance to Be a Bond Trader:

There are more fundamental structural worries about declining liquidity in the bond markets: What will happen if investors want to sell and there are no dealers to buy?7 How risky is it to have so many bonds held by ETFs? Should big bond managers such as BlackRock and Pimco be regulated as too-big-to-fail risks to financial stability?

These are tough questions, but one plausible way of addressing them might be to open up trading of bonds somewhat. The current model of investors calling dealers for quotes makes sense if dealers provide a lot of liquidity; but if the dealers are just working as well-paid, information-hoarding middlemen between investors, then maybe there are more efficient ways for investors to interact. And in fact there have been efforts to develop electronic, inter-institution trading platforms that would make the bond markets a bit more like the stock markets, by allowing investors and dealers to post quotes in the same place, and trade directly with each other.
…
But what’s gotten attention was [chairman of the Securities and Exchange Commission Mary Jo] White’s call for more transparency in bond markets. In particular, White wants more technology-supported pre-trade transparency: That is, she wants more publicly available, electronically distributed, quotes for bonds, so you can know before you trade what prices are being offered in the market for the bond you want to buy. This would be a move toward making the bond market more like the equity market, with publicly posted quotes and potentially electronic (and high-frequency! maybe) trading.
…
The SEC’s job is to regulate the financial markets. One way to approach that job would be to put a priority on optimizing market efficiency and stability. Another way to approach it would be to put a priority on protecting retail investors and preventing two-bit frauds. Obviously both are good but one is more important. If you think about bond market structure in terms of protecting the little guy, you will make one set of choices; if you think about it in terms of providing a stable liquid platform for massive flows of capital, you will make a second, probably somewhat different, set of choices.14 The second set of choices is probably right.

Quite right, and this is something I have reiterated in PrefBlog to the point of boredom. Increased price transparency will result in shallower, more brittle bond markets; there’s tons of evidence supporting this thesis. But the SEC is leaning in the other direction:

The main U.S. securities regulator is ramping up calls to democratize a $40 trillion bond market, proposing that smaller investors receive more price information to avoid getting fleeced when buying less-traded debt.

The Securities and Exchange Commission wants retail investors to have the same access to privately negotiated bond prices as big institutions, allowing them to make better decisions about how much to pay for the securities, Chair Mary Jo White said yesterday. Releasing such information on corporate and municipal transactions would promote competition and better execution, she said.
…
Finra is expanding its bond-price reporting into the $1.5 trillion market for private company debt, which is only sold to institutional buyers.

Another effect will be the continued acceleration of the current trend towards private placements. So retail will be able to get lots of pricing information on every publicly traded bond there is, but there won’t be too many. So we’ll see even more retail portfolios highly concentrated with big household names – the GMACs and GMs of this world, as worked out so well during the Credit Crunch. Another possibility, that I would like to see more of, would be institutional accounts trading directly with each other, bypassing the dealers completely. Naturally, you’ll get a few institutional houses running hedge-fund-like actively managed bond portfolios dominating the market – I see nothing wrong with that.

There are few inflation worries in the Treasury market:

In the past 13 months, the gap between yields of two- and five-year Treasuries has doubled to 1.22 percentage points, according to data compiled by Bloomberg. At the same time, the difference between those of five- and 30-year securities has narrowed to the least since 2009 as the long bond rallied.

Because yields on longer-dated debt usually rise more than shorter-term notes when investors see faster inflation spurring rate increases, the moves suggest a more sanguine outlook, according to Priya Misra, the New York-based head of U.S. rates strategy at Bank of America Corp., one of 22 primary dealers obligated to bid at U.S. debt auctions.

Taken together, the relationship now implies that while investors anticipate the Fed will eventually lift its benchmark rate after holding it close to zero for six years, they don’t foresee the central bank’s stimulus measures creating the kind of inflationary pressures that would force its hand, she said.

“The bond vigilantes have all been quieted,” Misra said by telephone on June 19. “The idea that just the act of printing money gets you inflation has been debunked.”

That view also indicates there’s little concern over a repeat of 1994, one of the worst years for bonds when Treasuries lost more than 4 percent in the first six months as the Fed began to double its benchmark rate to 6 percent, according to the Bank of America Merrill Lynch U.S. Treasury Index. In part because of the Fed’s success as an inflation fighter, Treasuries generated returns in 2004, 2005 and 2006 even though the bank boosted rates to 5.25 percent from 1 percent.

This year, Treasuries have advanced 2.58 percent in the biggest year-to-date gain since 2011, even as the Fed began to pare back its $85 billion-a-month bond buying program.

I’ll believe it’s not 1994 all over again when the Fed actually hikes its policy rate! But we’ll see.

There is some concern about the bond market’s vulnerability to mass ETF redemptions – particularly in odd sectors:

It’s never been easier for individuals to enter some of the most esoteric debt markets. Wall Street’s biggest firms are worried that it’ll be just as simple for them to leave.

Investors have piled more than $900 billion into taxable bond funds since the 2008 financial crisis, buying stock-like shares of mutual and exchange-traded funds to gain access to infrequently-traded markets. This flood of cash has helped cause prices to surge and yields to plunge.

Now, as the Federal Reserve discusses ending its easy-money policies, concern is mounting that the withdrawal of stimulus will lead to an exodus that’ll cause credit markets to freeze up. While new regulations have forced banks to reduce their balance-sheet risk, analysts at JPMorgan Chase & Co. (JPM) are focusing on the problems that individual investors could cause by yanking money from funds.
…
That concern is also revealed in BlackRock Inc.’s pitch in a paper published last month that regulators should consider redemption restrictions for some bond mutual funds, including extra fees for large redeemers.

A year ago, bond funds suffered record withdrawals amid hysteria about a sudden increase in benchmark yields. A 0.8 percentage point rise in the 10-year Treasury yield in May and June last year spurred a sell-off that caused $248 billion of market value losses on the Bank of America Merrill Lynch U.S. Corporate and High Yield Index.

Of course, yields on 10-year Treasuries (USGG10YR) have since fallen to 2.6 percent from 3 percent at the end of December and company bonds have resumed their rally. Analysts are worrying about what happens when the gift of easy money goes away for good.

US municipalities are a little gun-shy when it comes to infrastructure:

Across the U.S., localities are refraining from raising new funds in the $3.7 trillion municipal-bond market after the worst financial crisis since the Great Depression left them with unprecedented deficits. Rather than take advantage of Federal Reserve (FDTR) policy that’s held benchmark interest rates at historic lows since December 2008, they’re repaying obligations by the most on record.
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Issuance this year has tumbled to $123 billion nationwide through June 13, down 20 percent from the 2013 pace, according to data compiled by Bloomberg. It’s also 30 percent below levels seen in 2010, the final year of the federally subsidized Build America Bonds program, which was designed to spur infrastructure investment.

Since 2010, states and localities have lowered their bond load by $111 billion, the most since the Fed began keeping records in 1945. They’ve paid down the liabilities even as yields on 20-year general obligations have averaged 4.25 percent in the five years since the recession, the lowest since 1969, according to Bond Buyer data.
…
America’s governments would need to spend about $3.6 trillion through 2020 to put everything from roads and water to sewers and electricity networks into adequate shape, according to the American Society of Civil Engineers, based in Reston, Virginia. That’s about $1.6 trillion more than governments are expected to dispense.

Meanwhile, the Minister of Asset Allocation has market-timing advice:

Canada’s Finance Minister Joe Oliver warned on Monday that investors could be mispricing risk as they hunt for better investment returns, and said policymakers should keep the issue under close review.

Oliver is in London to promote trade and investment, and told Reuters in an interview that the global economy remained vulnerable to financial shocks.

“We’ve said again and again … that international financial markets are still fragile. Part of that is macroeconomic and monetary issues, but there is a geopolitical issue,” he said at the London residence of Canada’s envoy to London.

James Langton of Investment Executive highlights some interesting research in his piece Video better than text in boosting financial literacy:

New research finds that online video may be a particularly effective way of bolstering financial literacy.

According to a new paper (Visual Tools and Narratives: New Ways to Improve Financial Literacy) published by the U.S. National Bureau of Economic Research (NBER), video appears to be better at improving basic financial literacy than text-based approaches. The conclusion is based on an experiment financed by a grant from the U.S. Social Security Administration (SSA), and funded as part of the Financial Literacy Research Consortium.

Researchers developed four different online approaches to explaining the concept of risk diversification — a brochure, an interactive visual tool, a written narrative, and a video — and then tested them with a sample of 900 people. Overall, they found that video performed the best at both improving financial literacy scores and increasing people’s levels of confidence in their financial knowledge.

The actual paper is titled Visual Tools and Narratives: New Ways to Improve Financial Literacy:

We developed and experimentally evaluated four novel educational programs delivered online: an informational brochure, a visual interactive tool, a written narrative, and a video narrative. The programs were designed to inform people about risk diversification, an essential concept for financial decision- making. The effectiveness of these programs was evaluated using the RAND American Life Panel. Participants were exposed to one of the programs, and then asked to answer questions measuring financial literacy and self-efficacy. All of the programs were found to be effective at increasing self-efficacy, and several improved financial literacy, providing new evidence for the value of programs designed to help individuals make financial decisions. The video was more effective at improving financial literacy scores than the written narrative, highlighting the power of online media in financial education.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Well, I’m not paying for it.

Anyway, I had been hoping to read it to check what their actual conclusion regarding videos is. I suspect – although without reading the paper this is mere speculation, of course – that what they have measured is people’s ease of learning via different media, rather than anything specific to financial literacy. I hate videos and lectures. If I’m going to learn anything, I’ve got to read it. It’s entirely possible that all that has been discovered is that I am in the minority, which I knew already.

Nice to see such work being done, though. Here in Canada, potential funding for such research is instead splashed out to cronies with zero public benefit.

It was a modestly good day for the Canadian preferred share market, with PerpetualDiscounts gaining 7bp, FixedResets winning 9bp and DeemedRetractibles up 8bp. Volatility was average, skewed to winners. Volume was below average.

The hot news today was an unexpectedly high inflation number:

Inflation exceeded the Bank of Canada’s target last month for the first time in more than two years, an unexpected acceleration led by energy costs that sparked increases in the currency and bond yields.

The consumer price index rose 2.3 percent in May from a year ago following April’s 2 percent pace, Statistics Canada said today from Ottawa. The core rate, which excludes eight volatile products, increased 1.7 percent after a gain of 1.4 percent the prior month. Both increases were higher than all forecasts in Bloomberg economist surveys that called for total inflation of 2 percent and core prices to rise 1.5 percent.

Which had an effect on policy expectations which had an effect on the dollar:

The loonie, nicknamed for the image of the aquatic bird on the C$1 coin, appreciated 0.6 percent to C$1.0758 per U.S. dollar at 5 p.m. in Toronto. It touched C$1.0752, the strongest since Jan. 7, after weakening on March 20 to C$1.1279. One loonie buys 92.95 U.S. cents. The Canadian dollar gained 0.9 percent this week in its second five-day advance.

The currency is the top performer for the past three months in a basket of 10 developed-market currencies tracked by the Bloomberg Correlation Weighted Index, strengthening 4.5 percent. It has lost 2 percent this year.
…
The Canadian government’s two-year note dropped, pushing the yield to as high as 1.15 percent, the most since Jan. 6. Benchmark 10-year bond yields rose as much as seven basis points, or 0.07 percentage point, the most since March 19, to 2.33 percent before trading at 2.29 percent. The 2.5 percent security maturing in June 2024 lost 29 cents to C$101.84.
…
The yield on June 2015 bankers’ acceptance contracts reached 1.46 percent today, the highest since April 4, suggesting investors are moving up their expected date for the Bank of Canada to begin raising interest rates.

David Parkinson of the Globe dismisses Exchange Rate Pass Through (ERPT) as the rationale:

Meanwhile, one has to wonder how long “exchange-rate pass-through” should be expected to distort the inflation trend. The Canadian dollar did fall more than 10 cents against its U.S. counterpart in the span of a year – but for the past five months the currency has actually been stable, in the 90 to 92 cents (U.S.) range. Certainly it would take a while for last year’s decline in the loonie to work its way fully through pricing for imported goods (and goods dependent on imported inputs), but presumably the impact should already be softening in the month-to-month numbers as the currency continues to hold its footing. Yet on a month-to-month basis, core CPI was up 0.5 per cent (unadjusted for seasonal effects) in May, in a month when the dollar actually rose.

The BoC has lots of research that suggests ERPT is not really all that important. F’rinstance, a 2004 review by Jeannine Bailliu and Hafedh Bouakez titled Exchange Rate Pass-Through in Industrialized Countries:

• Although estimates of exchange rate passthrough vary both by industry and by country, it appears that the full effect of a depreciation or appreciation of the domestic currency is not passed through to local currency import prices across industrialized countries.
• • Many industrialized countries seem to have experienced a decline in exchange rate passthrough to consumer prices in the 1990s, despite large exchange rate depreciations in many of them.
• • The fact that this documented decline in exchange rate pass-through has coincided with the low-inflation period that most industrialized countries entered a decade or so ago has popularized the view that these two phenomena could be linked.
• • Assessing the extent of exchange rate passthrough, and whether it has indeed declined, has important implications for the conduct and design of monetary policy.
  …
  Assuming for a moment that the prices of domestically produced goods do not respond to exchange rate changes, there are at least two reasons why passthrough to consumer prices might not equal the share of imports in the consumption basket even if passthrough to import prices is complete. First, local distribution costs, such as transportation costs, marketing, and services, will cause import and consumer prices to diverge, and the wedge between the two prices will fluctuate if distributors adjust their profit margins in response to movements in the exchange rate. Second, as discussed in Bacchetta and vanWincoop (2002), differences in the optimal pricing strategies of foreign wholesalers and domestic retailers can explain why pass-through to consumer prices is lower than the share of imports in the CPI even when pass-through to import prices is complete. Indeed, this discrepancy can occur if foreign exporting firms price their goods in the exporter’s currency, while domestic retailers resell these goods priced in domestic currency

… and Stephen Murchison’s October 2009 paper Exchange Rate Pass-through and Monetary Policy: How Strong is the Link?:

Several authors have presented reduced-form evidence suggesting that the degree of exchange rate pass-through to the consumer price index has declined in Canada since the early 1980s and is currently close to zero. Taylor (2000) suggests that this phenomenon, which has been observed for several other countries, may be due to a change in the behaviour of inflation. Specifically, moving from a high to a low-inflation environment has reduced the expected persistence of cost changes and, by consequence, the degree of pass-through to prices. This paper extends his argument, suggesting that this change in persistence is due to a change in the parameters of the central bank’s policy rule. Evidence is presented for Canada indicating that policy has responded more aggressively to inflation deviations over the low pass-through period relative to the high pass-through period. We test the quantitative importance of this change in policy for exchange rate pass-through by varying the parameters of a simple monetary policy rule embedded in an open economy, dynamic stochastic general equilibrium model. Results suggest that increases in the aggressiveness of policy consistent with that observed for Canada are sufficient to effectively eliminate measured pass-through. However, this conclusion depends critically on the inclusion of price-mark-up shocks in the model. When these are excluded, a more modest decline to pass-through is predicted.

… and a review by Jeannine Bailliu, Wei Dong and John Murray titled Has Exchange Rate Pass-Through Really Declined? Some Recent Insights from the Literature:

• • A substantial empirical literature has shown that the correlation between changes in consumer prices and changes in the nominal exchange rate has been quite low and declining over the past two decades for a broad group of countries.
• • The issue of exchange rate pass-through (ERPT) has recently been explored more fully in the context of sticky-price, open-economy, dynamic stochastic general-equilibrium (DSGE) models. The findings of these studies put into question results from previous work based on reduced-form equations. In particular, ERPT to import prices may remain larger than the estimated parameters from
  reduced-form regressions would indicate, owing to an econometric bias related to the endogeneity of the exchange rate.

• • Nevertheless, there is fairly convincing evidence to suggest that measured short-term ERPT to consumer prices has declined because of a shift to more credible monetary policy regimes, and, in this case, the findings from DSGE models confirm the results of reduced-form models.
• • Studies using microdata are a promising area of research, since they provide additional insights that help us to better understand the phenomenon of ERPT by providing evidence of some of its drivers at the micro level.

…
If the price of an imported good rises because of a depreciation, domestic importers may simply switch suppliers. This would be measured as low pass-through, even though pass-through may be complete.
…
As discussed by Bacchetta and van Wincoop (2003), the insensitivity of consumer prices to changes in the exchange rate may be the outcome of an optimal strategy from the retailer’s perspective. Indeed, when there is rising competition in the local market, it may be optimal for retailers to absorb some of the fluctuations in the exchange rate into their margins, regardless of the sensitivity of border prices to exchange rates. Moreover, when there is limited substitution between non-tradable goods and imported goods, the prices of non-tradable goods can be very sticky, even after large exchange rate movements, leading to very little response in aggregate consumer prices.

… and a paper by Abdul ALEEM and Amine LAHIANI from 2010, Monetary Policy Credibility and Exchange Rate Pass-Through: Some evidence from Emerging Countries:

Considering external constraints on monetary policy in emerging countries, we propose a vector autoregressive model with exogenous variables (VARX) to examine the exchange rate pass-through to domestic prices. We demonstrate that a lower exchange rate pass-through is associated with a credible monetary policy aiming at price stability. The empirical results suggest that the exchange rate pass-through is higher in Latin American countries than in East Asian countries. The exchange rate pass-through has declined after the adoption of inflation targeting monetary policy.

All this talk of distributors and retailers absorbing exchange rate fluctuations is fascinating in view of the federal government’s musing on price controls:

Minister Flaherty has once again proven that the Competition Act is vulnerable to politically expedient amendments developed to respond to perceived exploitative conduct. Following on statements in the 2013 Throne Speech, Minister Flaherty indicated in the 2014 Budget that the government will introduce legislation to address geographic price discrimination “that is not justified by higher operating costs in Canada, and to empower the Commissioner of Competition to enforce the new framework.” While Canadians will not know what this really means until the proposed legislation is disclosed, the language in the 2014 Economic Action Plan suggests the Commissioner of Competition may become a price regulator in addition to its role as enforcer of Canada’s competition law.

The 2014 Budget tabled in Parliament on February 11 states that the Harper government

“proposes to address another source of the price gap identified by the Senate Committee: country pricing strategies—that is, when companies use their market power to charge higher prices in Canada that are not reflective of legitimate higher costs. Evidence suggests that some companies charge higher prices in Canada than in the U.S. for the same goods, beyond what could be justified by higher operating costs. Higher prices brought on by excessive market power hurt Canadian consumers.

The Government intends to introduce legislation to address price discrimination that is not justified by higher operating costs in Canada, and to empower the Commissioner of Competition to enforce the new framework. Details will be announced in the coming months.”

Not surprisingly, there was no mention of this mechanism in the Pack of Useless Hacks, Has-Beens and Bag-Men’s report The Canada-USA Price Gap, although it seems to me that if distribution/retail margins are reduced when purchasing power goes down, then distribution/retail margins should be _____________ when purchasing power goes up. [Fill in the blank: Three Marks]

The government’s plan was attacked by my old school buddy Andrew Coyne:

You might have wondered quite how this mad scheme could have been produced by a government that occasionally proclaims its belief in a free market economy, but only if you had not been paying attention: This was simply the latest expression of how far populism has displaced market liberalism in the Conservatives’ thinking. Still, this was taking things, as they say, to another level: an expensive, bureaucratic muddle that, on its own, would undo much of whatever good the late Jim Flaherty might have achieved in his time at Finance.

But don’t take my word on it. The C.D. Howe Institute has just released a report, drawing on the advice of a panel of the country’s foremost competition policy experts. They include three former directors of investigation at the Competition Bureau, a former Commissioner of Competition, as well as leading economists and practitioners in competition law. Their conclusion: the plan is “profoundly wrong-headed,” “wholly impractical,” “misguided” and “unenforceable” and probably illegal under international trade law. In sum, they said, it was “destined for costly failure” and “should be abandoned forthwith.”
…
It is, in sum, a thoroughgoing policy debacle in the making; the government would do well to heed to the panel’s advice, and deep-six it. Will it? Or will it once again treat overwhelming expert opposition to one of its policies as evidence, not that the policy is wrong, but that the experts are biased against it?

In other news, retail sales increased:

This came as a separate reading by the agency showed Canadian shoppers out in force in April, as retail sales climbed 1.1 per cent, driven by cars and car parts.

Still, the gains across Canada were exceptionally broad-based, with sales up in 10 of 11 sectors measured, or 98 per cent.

“The advance in retail volumes is welcome news, and suggest Canadian consumers are bouncing back after a tepid first quarter,” said senior economist Krishen Rangasamy of National Bank.

“The overall picture for April is good, with a trifecta of volume gains in retailing, wholesaling and manufacturing, enough in our view to prop up GDP by around 0.2 per cent in the month.”

Bloomberg carries an interesting exchange of views on High-Frequency Trading. In his piece Slow Your Judgments on Fast Trading, Noah Smith conflates slippage and market impact, claiming that:

Slippage, also called implementation shortfall, is the difference between the price that triggers the decision to trade and the actual execution price. It matters for people who use market orders, or the best immediate price. Price impact matters to people who split their trades into pieces.

This, not to put too fine a point on it, is bullshit. From the links:

slippage is the difference between where the computer signaled the entry and exit for a trade and where actual clients, with actual money, entered and exited the market using the computer’s signals.[1] Market-impacted, liquidity, and frictional costs may also contribute.

and

market impact is the effect that a market participant has when it buys or sells an asset. It is the extent to which the buying or selling moves the price against the buyer or seller, i.e. upward when buying and downward when selling. It is closely related to market liquidity; in many cases “liquidity” and “market impact” are synonymous.

So it should be clear that “slippage” is almost always merely bafflegab spouted by useless pseudo-quants of the ‘Look mummy, I gotta spreadsheet’ school of investing. Any trading decision is binary: you either do it or you don’t do it, given the market prices. If a properly written quantitative investment programme tells you it would be a good thing if you sold A and bought B at a take-out of $1.00 and no less, you can’t do the trade at $0.95 and then whimper to your gullible clients about “slippage”. If you can do some of the desired trade at a take-out of $1.00 or better, great! If the market impact of the first part of your trade moves the take-out to $0.95, YOU DON’T FUCKEN DO THE SECOND PART OF THE TRADE!

There is only sequence of events for which I can imagine “slippage” being a legitimate concept. Exchange trades are independent; you can’t make one contingent on another – you can do this with a dealer, but then he’s going to be building in a margin. So it is possible that you see your take-out of $1.00, execute your sale of A, and then be chagrined to learn that the offer of B you were counting on doesn’t exist any more, leaving you with the grim choice of buying back your A (almost certainly at a loss), or gritting your teeth and executing the purchase of B at the higher price anyway. This can be minimized by algorithmic trading, with which you can execute the two sides of the trade with as little time separation as possible, and by reducing your trade sizes to minimize the harmful impact of such a disappearance … and note that the latter strategy might give HFT the signals it needs to scoop things up, so be careful!

So “slippage” is not another word for “implementation shortfall”. “Slippage” is, in fact, another word for “gross incompetence”. And, in fact, the cited paper by Jones defines:

These price impacts can be measured by looking at the response of share prices to a particular trade. However, the preferred trading cost measure for institutions is known as implementation shortfall. It is calculated as the average execution price for the large order compared to the price of the stock prior to the start of execution. As with spreads, implementation shortfalls are usually calculated on a proportional basis relative to the amount traded, and implementation shortfall is usually reported in basis points.

This definition is OK, but brings with it the potential for more incompetent bafflegab. Let us say we are competent investment managers running assets as well as we can. “A” can be swapped into “B” on favourable terms with a take-out of $1.05, but we don’t do it, because we’re looking for $1.10. Suddenly there’s a discontinuity in the market – a policy announcement, or a large trade or new issue somewhere changes the overall pricing in an entire sector, could be anything – and our desired take-out changes to $1.00, even though the relative prices of A and B haven’t changed. Hurray! We’re generating a trade signal, so let’s get to work … we do half the desired trade size at $1.05, but then our price impact moves the price to takeout of $0.95. So what do you do?

If you are a moron, you do the other half at $0.95, and then ring up your mummy and tell her you just did a gigantic trade at an average take-out of your desired $1.00. If you are a reasonably rational person (not employed by a bank, obviously), you stop trading, satisfied that you did half the trade at better than necessary prices, and recommence running your programme, hoping for another opportunity. You don’t do a trade on unfavourable terms just because the price ten minutes ago, with your portfolio as of ten minutes ago, was favourable. That’s just stupid.

So the moral of the story is: let’s ignore Noah Smith’s use of the word slippage and see if his essay makes any sense with proper terminology.

As it turns out, it doesn’t really matter: one of the major assertions in his essay Slow Your Judgments on Fast Trading is:

If HFTs have big speed advantages and very good guesses about the decisions of non-HFT investors, they might theoretically be able to increase slippage and price impact for non-HFTs. That would increase total trading costs for non-HFTs, thus discouraging them from trading. If non-HFTs are bringing important information to the market by their trading, then the net effect of HFT could reduce the informational efficiency of markets.
…
But a word of caution — the decrease in slippage and price impact might be happening because informed traders are now staying out of the market in response to HFT itself. If that’s happening, it isn’t a reason for celebration — it’s like saying the Spanish flu decreased the death rate from heart disease. The problem is that it’s very hard, if not impossible, to tell how much information is getting pumped into market prices via trading. The increase in the use of dark pools might be the result of informed traders fleeing the public exchanges in an effort to escape HFTs.

OK, so yes, it is possible for an HFT to increase the price impact of the first moiety of my trade at $1.05; I could do a portion at $1.05, but before I can do my second portion at $1.04, HFT swoops in and the take-out is suddenly $0.95, even though I’ve traded a quarter of my desired size when in the absence of HFT I could have done half. The problem with his reasoning is the next sentence:

That would increase total trading costs for non-HFTs, thus discouraging them from trading.

No, it doesn’t increase total trading costs for all non-HFTs; it only increases the trading costs for morons, who insist on doing all their trade, even at prices that don’t make sense any more. It certainly doesn’t increase my trading costs; it might even be said to decrease them, since I did one-quarter of my desired trade at 1.05, instead of half at an average take-out of $1.045.

It would have been nicer, of course, to have scooped up all the available trade, but that’s my fault. If I had been a little quicker, a little smarter, then I actually would have scooped up everything available; but as it was, my sluggishness and stupidity gave HFT the opportunity the chance to (i) read my signal, (ii) interpret my signal and (iii) get his own trade in. So my clients are less happy than they might otherwise be and his clients are happier than they might otherwise be, and this has come about because he was smarter than me (this time!). And that’s exactly the way it should be. I see no problems here. I’ll just have to get better at what I do.

In his counterpoint Why I Love High-Speed Trading, Clifford S. Asness makes some very good points:

Smith’s lead point is that I claim HFTs don’t front-run because I used an outdated definition of the term. That is, I take “front-running” to mean using information you’ve been entrusted with and promised not to use to the disadvantage of whoever entrusted that information to you (usually a paying client). Smith says the definition must be broadened to encompass “order anticipation with speed advantages.” Therefore, he says, it is legitimate to say that HFTs engage in front-running.

He’s wrong. First, you can’t just change the definition of a word used to describe a crime and apply it to something that’s both legal and ethical. Perhaps all of us should have used the more straightforward term “guessing,” because that is all “order anticipation” means. Traders have always made educated guesses about who is going to buy and sell what, and they’ve always tried to do it faster than the other guy. They did this long before HFT. In fact, what are traders doing if not trying to make educated guesses about who plans to buy and sell what and then act before other traders? If these traders — HFT or not — are using legal, public information, this is exactly what they’re supposed to be doing. To say “we’ll call that front-running as we’ve broadened the term” is ridiculous.

Yes, very good. It’s much like the Peter ‘My Word Is My Bond, Sometimes’ MacKay’s attempt to reclassify prostitutes’ clients as “perverts”.

Asness’ other good point is:

But Smith is creative! He advances the untestable hypothesis that perhaps fewer people are bothering to become informed traders because HFTs will just take their profits, and as a result markets are less efficient. As we have pointed out, HFTs shouldn’t be judged against an unattainable nirvana of zero bid-ask spreads and infinite liquidity, but against the system that preceded it. Before the advent of HFTs, human market-makers engaged in order anticipation and moved prices away from large traders all while earning much fatter profits.1 Any informed trader discouraged because potential profits are syphoned away by HFTs would have been even more discouraged under the old trading regime.

Yes, yes and yes again! As I have often pointed out, much of the controversy regarding HFT is fuelled by the pique and despair of the old-money smiley-boy crowd, dismayed that some parvenus are eating their lunch. Since they don’t have the talent to do their jobs properly, they prefer to whine to teacher.

The paper on implementation costs was by Charles M. Jones, by the way, and titled What Do We Know About High-Frequency Trading?:

This paper reviews recent theoretical and empirical research on high-frequency trading (HFT). Economic theory identifies several ways that HFT could affect liquidity. The main positive is that HFT can intermediate trades at lower cost. However, HFT speed could disadvantage other investors, and the resulting adverse selection could reduce market quality.

Over the past decade, HFT has increased sharply, and liquidity has steadily improved. But correlation is not necessarily causation. Empirically, the challenge is to measure the incremental effect of HFT beyond other changes in equity markets. The best papers for this purpose isolate market structure changes that facilitate HFT. Virtually every time a market structure change results in more HFT, liquidity and market quality have improved because liquidity suppliers are better able to adjust their quotes in response to new information.

Does HFT make markets more fragile? In the May 6, 2010 Flash Crash, for example, HFT initially stabilized prices but were eventually overwhelmed, and in liquidating their positions, HFT exacerbated the downturn. This appears to be a generic feature of equity markets: similar events have occurred in manual markets, even with affirmative market-maker obligations. Well-crafted individual stock price limits and trading halts have been introduced since. Similarly, kill switches are a sensible response to the Knight trading episode.

Many of the regulatory issues associated with HFT are the same issues that arose in more manual markets. Now regulators in the US are appropriately relying on competition to minimize abuses. Other regulation is appropriate if there are market failures. For instance, consolidated order-level audit trails are key to robust enforcement. If excessive messages impose negative externalities on others, fees are appropriate. But a message tax may act like a transaction tax, reducing share prices, increasing volatility, and worsening liquidity. Minimum order exposure times would also severely discourage liquidity provision.

And in other, other news, Jed Kolko of Trulia addresses fears that boomer downsizing will devastate house prices in his piece Baby-Boomer Downsizing? Perhaps Not So Fast:

Let’s start by looking at the age when older households move from single-family homes to multi-unit buildings. Based on the 2013 Current Population Survey’s Annual Social and Economic Supplement (CPS ASEC) – the most recent detailed demographic data available – baby boomers (born between 1946 and 1964, which means 50-68 years old in 2014) are less likely than almost any other age group to live in multi-unit buildings as opposed to single-family homes. The only age group less likely to live in multi-unit buildings is 70-74 year-olds, which is the age group that baby boomers will start to enter in the coming years.

In later years, the share of households in multi-unit buildings rises, but by less than you might guess. Just 25% of households headed by 80-84 year-olds live in multi-unit buildings – which is a lower share than 40-44 year-olds. Even among households headed by adults aged 85 and older, only one-third live in multi-unit buildings – and that’s only counting those who head their own household are not living with adult children or in institutions.

Therefore, as today’s baby boomers age, they’ll grow into age groups first with a lower likelihood of living in multi-unit buildings (70-74 year-olds). Multi-unit living starts rising slightly at age 75-79, and rises more notably only when heads of household reach their 80s.

It was a mixed day for the Canadian preferred share market, with PerpetualDiscounts down 6bp, FixedResets gaining 3bp and DeemedRetractibles off 1bp. Volatility wasn’t much – boosted by Floaters reversing yesterday’s jump. Volume was very low.