Month: May 2018

The news of the day is the FOMC release:

Information received since the Federal Open Market Committee met in March indicates that the labor market has continued to strengthen and that economic activity has been rising at a moderate rate. Job gains have been strong, on average, in recent months, and the unemployment rate has stayed low. Recent data suggest that growth of household spending moderated from its strong fourth-quarter pace, while business fixed investment continued to grow strongly. On a 12-month basis, both overall inflation and inflation for items other than food and energy have moved close to 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with further gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace in the medium term and labor market conditions will remain strong. Inflation on a 12-month basis is expected to run near the Committee’s symmetric 2 percent objective over the medium term. Risks to the economic outlook appear roughly balanced.

In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1-1/2 to 1-3/4 percent. The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation.

The release was considered dovish:

U.S. stocks fell to their lowest in a week and the dollar jumped as investors assessed the Federal Reserve’s signal that it’s in no rush to raise rates even as inflation rises to its target.

The S&P 500 ended near session lows after briefly pushing higher following the central bank’s decision to hold rates steady. Equities tumbled in the final hour of trading as concern mounted that the Fed may let inflation run hot as it gradually tightens. Treasury yields resumed a march to 3 percent and the dollar strengthened versus major peers, adding to equity headwinds.

Central bank officials may have signaled their willingness to allow inflation to exceed their 2 percent goal somewhat by adding a reference to the “symmetric” nature of their target.

“This week’s government data showed inflation moving closer to its 2 percent target. This adjustment is simply an acknowledgment by the Fed that its inflation forecast is, in fact, playing out as predicted,” Robin Anderson, a senior economist at Principal Global Investors, said in an email. “Since inflation was running below 2 percent, this language indicates that the Fed might be willing to let it run a little above 2 percent for a little while.”

The BoC published a Staff Analytical Note by Corey Garriott and Jesse Johal titled Customer Liquidity Provision in Canadian Bond Markets:

This note assesses the provision of bond market liquidity by institutional customers (i.e., pension funds, hedge funds, mutual funds and insurance companies) in Canada. Customer liquidity provision occurs when a dealer, after filling an order from a customer, quickly makes an offsetting trade with an institutional investor.

Customer liquidity on a large scale could have positive and negative effects on bond markets. It can diversify the supply of liquidity beyond a small group of dealers and brokers, thus making bond markets more competitive and robust. However, customer liquidity may be more sensitive to a deterioration in market conditions and thus a less reliable source of liquidity. For example, sudden redemptions at a mutual fund can force the fund to switch from supplying liquidity to demanding it (Arora 2018). In contrast, dealers have a broad set of funding sources and may be more able to provide liquidity for their clients through a range of market conditions.

I don’t quite understand the reasoning behind the assertion “sudden redemptions at a mutual fund can force the fund to switch from supplying liquidity to demanding it”. According to their definition in paragraph 1, liquidity provision is bidirectional, so to a first approximation the opportunities for provision will not be affected – they might even be increased if everybody else is buying! However, it’s reasonable to assume that if one fund is suffering sudden redemptions and selling its holdings then similar conditions and similar effects prevail elsewhere.

Customer-supplied liquidity is uncommon in Canada, averaging between 4 and 9 per cent, depending on the type of bond, and is significantly less common than in the United States (Choi and Huh 2017). Customer liquidity provision is more frequent for less liquid securities such as corporate debt and the debt of provinces with low quantities of debt outstanding (i.e., provinces other than Ontario and Quebec). This is consistent with dealers seeking client liquidity to reduce inventory risk.

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Chart 2 shows the average spreads for trades where liquidity was provided by customers and by dealers. Trades drawing on customer liquidity have higher average spreads than trades that draw solely on dealer liquidity. This contrasts with the US results seen in Choi and Huh (2017), in which trades using customer liquidity have lower average spreads. Our result is surprising because, as Choi and Huh point out, the effective spread for trades with some customer-liquidity supply should be biased downward by the prices of the offsetting trades. Yet, despite the potential bias, we still measure a larger spread for these trades.

Our explanation for this difference is that, in Canada, institutional investors are a discretionary source of liquidity for dealers, who use their customers selectively because customers demand a price concession to supply liquidity. If our explanation is correct, we should observe that the use of customer liquidity eats into dealer revenues and that dealers use customers mainly on days when liquidity is scarce or when volume is high (i.e., days when they are more likely to run into risk constraints).

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It’s not clear to me whether the trades populating “Dealer Supplied” and “Client supplied” are directly comparable. It might be, for instance, that customer-supplied liquidity is tapped only when a highly motivated client desperately needs to execute a trade in something obscure … and only then do the dealers take out their rolodex, because they don’t want a position in that obscure stuff either!

We find the share of customer liquidity is small in Canada. However, data are only available from June 2016 on. Survey evidence suggests that the share of customer liquidity may be rising. Responses to the Survey on Market Liquidity, Transparency, and Market Access (Canadian Fixed-Income Forum 2016) indicate that a sizable minority of customers are supplying liquidity to markets: 30 per cent of buy-side respondents said they have increased their short-term trading to take advantage of short-term price dislocations. An equal number said they use their portfolio to provide liquidity.

In addition, forthcoming regulations may lead to a greater share of client liquidity in Canada. The implementation of the Net Stable Funding Ratio and the Fundamental Review of the Trading Book will likely increase the cost to bank-owned dealers of carrying large inventories of bonds. After other capital and liquidity standards were implemented (e.g., Liquidity Coverage Ratio, Leverage Ratio), banks generally reduced their capital commitment to market-making in the United States (Adrian, Boyarchenko and Shachar 2017; Bessembinder et al. 2017; Schultz 2017; Bao, O’Hara and Zhou 2016), while the volume share of non-bank dealers grew in the same period (Bao, O’Hara and Zhou 2016). Finally, further proliferation of electronic bond trading platforms, together with a broader array of trading protocols, could make it possible for customers to supply liquidity at lower costs.

At times I wish I was back in the bond business. I would dearly love to see whether an asset manager could outperform by aggressively competing with the dealers.

This year’s Projection assumption guidelines have been published:

Among the changes to this year’s projections, projected fixed-income returns have been reduced “to account for the appreciation in historical bond prices that cannot be explained by changes in interest rates,” FPSC and IQPF say in a news release.

The projected guidelines for Canadian equities are 6.4%, below the 6.7% returns projected for other developed market equities and the 7.4% for emerging market equities. The return projection for fixed-income is 3.9%, with short-term returns projected at 2.9%.

Unusually, the report itself mentions our favourite asset class:

The projected fixed-income rate of return can also be applied to preferred share holdings. Please note that this is not an opinion regarding the volatility of preferred shares vs. fixed-income securities and that preferred shares can have different characteristics that can impact their pricing.

Their ballyhooed fixed income return adjustment is explained as:

“Fixed-income investments have experienced significant appreciation in value over the last 50 years. Given the current low rate interest environment, similar appreciation in value is not expected. The 50-year history of fixed-income investments can be adjusted to remove the price appreciation that cannot be reproduced in the future given the current low interest rate environment. Using 10-year bonds as a proxy for the price change of fixed-income investments, one can estimate the price appreciation that fixed-income investments have experienced over the past 50 years.

Interest rates available on 10-year bonds in 2018 are 3.45% lower than those that were available on a 10-year bond in 1968 (2.15% versus 5.60%). Going forward, because the potential magnitude of interest rate decreases on 10-year bonds are less than the decrease that was experienced on similar bonds between 1968 and 2018, the same annual price appreciation (0.289%) that those bonds have experienced over the past 50 years cannot be reproduced over the next 50 years. Similar results are expected for fixed-income investments. As such, the historical average return portion of the calculation used to develop the guideline for fixed-income investments can be reduced by 0.289% per year.”

Well, it’s about time they did something about that!

PerpetualDiscounts now yield 5.43%, equivalent to 7.06% interest at the standard equivalency factor of 1.3x. Long corporates now yield about 4.00%, so the pre-tax interest equivalent spread (in this context, the “Seniority Spread”) is now about 305bp, unchanged from the 305bp reported April 25.

Bank of Canada Governor Stephen Poloz gave a speech today titled Canada’s Economy and Household Debt: How Big Is the Problem?:

But the Bank is also focused on the vulnerability of our economy to rising interest rates, given high household debt. There is little doubt that the economy is more sensitive to higher interest rates today than it was in the past, and that global and domestic interest rates are on the rise.

So, today I want to talk about household debt in Canada—the dynamics that led to its buildup, how big a problem it is for Canadians now, and how we can manage the risks in the years ahead.
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In other words, the average Canadian owes about $1.70 for every dollar of income he or she earns per year, after taxes.

That ratio is a Canadian record, and up from about 100 per cent 20 years ago. Although this ratio is on the high side, other economies such as Sweden, Norway and Australia have even more household debt relative to disposable income.
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If fiscal policy takes the lead in stimulating the economy, this can result in a buildup of government debt. If monetary policy takes the lead, this brings about a buildup in household debt. In both cases, stimulus leads to a buildup of debt over time, whether public or private. And excessive debt levels create a vulnerability, making the economy less resilient to future shocks.
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Canadians, regardless of their age group, are increasingly relying on mortgages. Among people under 35 years old, the percentage of homeowners with a mortgage has edged higher from about 85 per cent in 1999 to 90 per cent in 2016. For people in the 55 to 64 age bracket, the increase was more dramatic—from 34 per cent to 46 per cent. This casts a new light on that 170 per cent debt-to-income ratio I cited before.
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about 8 per cent of indebted households owe 350 per cent or more of their gross income, representing a bit more than 20 per cent of total household debt. These are the people who would be most affected by an increase in interest rates. We are closely watching the vulnerability represented by this group and the debt they carry, and how it poses a risk to both the financial system and the economy.
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In our Monetary Policy Report (MPR) last month, we published our latest estimate of Canada’s neutral rate, saying it falls in a range between 2.50 and 3.50 per cent, assuming that all shocks affecting the economy have dissipated. At 1.25 per cent, our current policy rate is still well below our estimate of the neutral rate.
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At the Bank of Canada, we have been watching these debt levels closely because of the growing risks they pose to financial stability and the economy. We know that a portion of Canadian households are carrying large debts, and the concern will become larger for them as interest rates rise. Of course, higher interest rates would likely reflect an economy that is on even more solid ground and less prone to a major economic setback. Furthermore, our financial system is resilient, and the new mortgage rules mean that it is becoming progressively more so. Even so, our economy is at risk should there be an unexpected increase in bond yields or a global slowdown, because both effects would be magnified by their interaction with high household debt.