PrefBlog

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.

The Great White Short?:

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

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

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

Just in time for Christmas:

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

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

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

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

The key heightened policyholder protections to which Apollo agreed include:

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

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

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

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

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

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

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

Bonds got hit today:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Everything is Morgan Stanley’s fault!

Institutional investors’ allocations to dollar-denominated bonds have dropped to the lowest level since 2007 as strategists at Morgan Stanley and JPMorgan Chase & Co. see a shift away from the debt that may fuel higher borrowing costs.

Holdings by investors from pensions to endowments fell to 26.2 percent of assets in the second quarter, from 30.1 percent in the corresponding period of 2012, according to the Wilshire Trust Universe Comparison Service, which tracks plans that oversee $3.46 trillion. Morgan Stanley’s $1.8 trillion wealth management unit has been advising clients to cut bond allocations to the lowest in more than five years, Chief Investment Strategist David Darst said.
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Institutional investors such as corporate and public pensions have reduced their median allocation to U.S. bonds from 32 percent of their assets in the last three months of 2011, according to data compiled by Wilshire Associates Inc., whose Trust Universe Comparison Service tracks more than 1,700 plans.
The current proportion of dollar-denominated debt holdings is the least since the fourth quarter of 2007, Kim Shepherd, a spokeswoman for the firm, said in an e-mail.

“There is movement by institutional investors out of investment-grade bonds,” said Eileen Neill, a managing director in the consulting division of Wilshire, a Santa Monica, California-based financial advisory firm. “It’s not out of fear of bonds, it’s out of necessity because of the low yields. They’re moving to higher yielding bonds and emerging markets debt.”

Individual investors have been shifting to stocks from bonds as well. The gap between flows into bond mutual funds and exchange-traded funds and those focused on equities widened to $70 billion in June, the most ever, according to JPMorgan analysts led by Nikolaos Panigirtzoglou in London.

The bank-owned Toronto Stock Exchange is up to its usual tricks today. It sold me very expensive data indicating that the “last” quote for CIU.PR.C was 6.83-23.99. When I went to their website to check the last few trades, I was informed that the “last” quote was 24.41-23.99 … bid bigger than the ask. Not even the most cursory editor … so in despair, I have put it into HIMIPref™ as 22.99-23.99.

Wonder of wonders, it was mixed day for the Canadian preferred share market, with PerpetualDiscounts off 12bp, FixedResets down 16bp and DeemedRetractibles gaining 9bp. Lots of volatility, with FixedResets prominent on the down side. Volume was high.