Update: Embarking on a New Career

Dear readers,

Financial markets is tough and even the best people are wrong many, many times. Yet, being able to witness, or anticipate, the world react to global developments is extremely fascinating. When I started out, I was thankful that I had a few seniors who were willing to mentor me. One of them is a credit trader in a local (SG) bank. I bombarded him questions regularly as I tried to:

• Explain often meaningless intra-day movements
• Understand the domino effect of major asset classes, and how they react to major news and data releases (GDP, CPI, Trade Balance, etc.)
• Get a sense of the speed and magnitude of these repricing across the different asset classes
• Shape a market view – This took me more than 6 months. I remembered I first took a view on USDSGD. But I would also add that most of the trade rationale were simply a regurgitation of others’ conviction.

Throughout this journey, I have probably only met 2-3 like-minded peers that share my passion. My point is, getting help wasn’t easy. I hardly have the opportunity to narrate my views to anyone. This is the main reason why I started this blog – to provide a platform for me to express my views, and in the process crystallising my thoughts.

I also appreciate the readers on this blog. This site received a total of 2,905 views in 2016, and 575 views a month at its peak. While it is certainly not a great achievement, I would have never expected such a huge readership base.

And now, I will be embarking on a new career in London. This career will provide me a platform to do what I love, and I am extremely grateful for it. Accordingly, I have decided to discontinue this blog.

However, if you are passionate about macro markets, specifically FX or Rates, I will be happy to pay it forward and guide you along. If you find that you are struggling to understand markets or position yourself favourably for an internship in Sales & Trading, you may reach out to me on LinkedIn on one condition: No formalities, please!

Once again, thank you for all your support.

Signing off,
P

Economic Revival is a Shared Responsibility

Since the Great Recession, central banks in developed nations have employed unconventional monetary policies in a desperate bid to boost inflation and growth. Today, around 35% of the world’s government debt has negative interest rates. In this essay, I’d like to discuss two negative effects of monetary policies.

A weaker banking system. As central banks started asset purchase programmes to buy longer term government debt, it led to a flatter sovereign yield curve. Banks’ profit margins, whose basic business models are to borrow short-term and lend long-term, naturally declined. This creates risks in two folds. First, this weakness in the banking sector may cause credit concerns which could freeze up the interbank market and lead to a self-fulfilling selloff that may spread to the wider economy. We have already seen this happening in 2007 when the insolvency of banks led to the biggest recession since the Great Depression; and more recently when concerns surrounding Deutsche Bank exacerbated an equity rout in February. Second, this weakness may discourage banks from providing credit for households and corporates. Ultimately, central banks rely primarily on the banks as intermediaries for an effective transmission of monetary policy.

Encouraging risk-taking behaviors. One of the main channel of reviving the economy through asset purchase programs is portfolio rebalancing, which creates incentives for economic agents to invest into riskier and higher yielding assets, and as a result affects relative prices, economic activity and eventually price levels. However, this broad asset price inflation can push price levels away from its fair value, which will prove catastrophic in an event of a correction. We have seen a familiar experience when global equity market entered a bear market earlier this year. While there was a case for concern due to an uncertain path of yuan devaluation, it seems to be a minor catalyst compared to prior equity market corrections.

While there are real concerns about these negative effects, one should also acknowledge the positive effects that monetary policies bring. The main role of central banks is to provide an automatic stabilizer to the economy, which may otherwise be in a worse shape if interest rates are not adjusted in respond to negative shocks. Ultimately, the onus is also shared with the government to employ counter-cyclical fiscal stimulus and structural reforms to inflate economies and promote growth.

Best,
P

Reassessing my Bearish Dollar View

Ever since Brexit happened, I had repeatedly stated that I do not believe a hike will materialise this year. Since then, more and more market participants are talking about a December hike – especially after most of the FOMC members have come forward to air their views. While I continue to believe Fed will hold off in September and October, I would like to reassess the possibility of a December hike in this piece.

Last week was all about Jackson Hole, an important event because it was Yellen’s first remarks since Brexit. While her comments were relatively neutral, the greenback managed to push through a delayed rally. As of today, the probability of a Fed hike in Dec stands at around 59%, compared to around 51 – 53% last week. The street’s view, on the other hand, lies somewhere closer to the Fed. Most banks expect a hike in Dec, with Goldman Sachs economists putting it at 80%.

Now that the ‘wild card’ is out, it would be timely to reassess my dollar view. Am I overly pessimistic as the markets have been? My conclusion is that considering the hawkish-tilting FOMC, the risk-reward profile for a bearish dollar view is unfavourable. Along with my previous argument of a risk-off catalyst, oil has recovered some of its losses and Trump hasn’t seem to have recovered since Khizr Khan’s incident. Together, these two risks have subsided and I am now less convicted about my bearish-equities view.

I have compiled comments from each of the voting members at the end of the article. Note that my dove-hawk scale is predicated upon whether governors would vote for a December hike. 

Here’s the brief summary:

Here are my observations:

• Overall, there are 5 hawks against 4 doves.
• Among the top 3, it’s 2 semi-hawks against 1 semi-dove.
• For the others, it’s 3 strong hawks against only 1 strong dove.

Having said that, one has to bear in mind that an extremely intelligent discussion first takes place before the vote. This explains why we usually see unanimous voting patterns, as lengthy discussions have turned into consensus. Needless to say, some governors will be more vocal or influential than others. Therefore, the above table only serves as a guide. Non-voting members take part in these discussions as well.

On Fed’s ‘need’ to restock its monetary toolkit…

The rather common view that Fed needs to raise rates to prepare for the next recession has officially been shot down by Fed Chair Yellen herself, who described the argument as “exaggerated”, with other tools such as bond purchases and forward guidance available.

“In addition to taking the federal-funds rate back down to nearly zero, (FOMC) could resume asset purchases and announce its intention to keep the federal-funds rate at this level until conditions had improved markedly.”

Final thoughts…

Market participants will again be gluing their eyes on payroll number (cons: 180K) this Friday. I reiterate that labor market is largely a checked box for Fed’s dual mandate. However, given the market’s stubborn pessimism of a no-hike, we may see a price action similar (but in smaller magnitude) to NFP last month, with bonds selling off sharply (treasuries sold off 8-11bps between 2 and 10 year tenors) last month on the back of strong payrolls.

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Janet Yellen

Jackson Hole: In light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months. U.S. economy was nearing the Federal Reserve’s statutory goals of maximum employment and price stability.

Stanley Fischer

Jackson Hole: I think what (Yellen) said today was consistent with answering yes to both your questions, but these are not things we know until we see the data. Core PCE inflation, at 1.6%, is within hailing distance of 2 percent–and the core consumer price index inflation rate is currently above 2%… We are close to our targets. Not only that, the behavior of employment has been remarkably resilient.

William Dudley

16 August: Market is complacent about the need for gradually snugging up short-term interest rates over the next year or so. We’re edging closer towards the point in time where it’ll be appropriate to raise interest rates further. I think it’s possible. We’re getting closer in the sense that headline inflation is drifting up a little bit… because the earlier declines from energy prices are dropping out of it year over year calculations. We’re looking for growth in the second half of the year that’ll be stronger than the first half — so some acceleration in the growth outlook.

Jerome Powell

8 August: With inflation below target, I think we can be patient… (Hard to raise rates) in a world where everyone else is cutting and demand is weak around the world. I wouldn’t be pounding the table saying we really need to raise rates.

Jackson Hole: My view is, and has been, we should be on a program of gradual rate increases — we can afford to be patient… When we see progress toward 2% inflation and a tightening labor market and growth strong enough to support (a rate hike), we should take the opportunity to do so.

Daniel Tarullo

6 July: Inflation is not at our stated target, not near our stated target, and hasn’t been so in quite some time. This is not an economy that is running hot. For some time now I thought it was the better course to wait to see more convincing evidence that inflation is moving toward and would remain around the 2% target… To this point, I have not seen that type of evidence.

Lael Brainard

3 June (Pre-Brexit): There would appear to be an advantage to waiting until developments provide greater confidence.

James Bullard

Jackson Hole: If we got to a meeting and we felt things were looking stronger, that might be a good time (to hike rates) … We had a couple of good jobs reports here. But year over year, the GDP growth rate is very low, below trend really.

Esther George

Voted for rate hike in July; no reasons to think she will change course for now

Loretta Mester

Jackson Hole: I see a gradual upward pace in interest rates as being appropriate. Now, that doesn’t mean we’re behind the curve now. But I do think that it makes sense to be starting to move interest rates up on that gradual path. I think the economy is on a good track. I think the employment numbers show that; I think the inflation’s numbers are coming up slowly; they’re below our target still but they’re moving in the right direction.

Eric Rosengren

6 June: It is my expectation that economic conditions will continue to gradually improve, which in turn would justify further actions to normalize policy, continuing a gradual return to a more normal rate environment. (Inflation has been) edging closer, (Fed’s dual mandate) likely to be achieved relatively soon. Policymakers must weigh the benefits of low interest rates now against the potential costs in the future of possibly spurring financial instability that will ultimately have downstream adverse effects on firms and households. (Commercial real estate prices) have risen quite dramatically. A somewhat faster move to rate normalization may defer somewhat how quickly we achieve the dual mandate goals of full employment and price stability, but could reduce the risk of a larger divergence from the dual mandate in the next downturn… (This) could make a recession worse than it would have been had policymakers normalized interest rates more rapidly.

Best,
P

US Consumer Spending & Labour Market

Markets have been range-bound for some time and here’s the time where I get some capacity to deep dive into some of the more fundamental side of macro markets. In this piece, I explore the marked increase in consumer spending and also the often lamented low-quality jobs in the US.

1. Consumer Spending

Consumer spending has been great, supported by (i) wage growth, (ii) fall in savings rate and (iii) increase in household wealth.

So what are they spending on? Household consumption services ranks highly on the list, accounting for a total of 83.2% of increased nominal spending and hoards 5 out of the top 6 of increased spending list. This is in line with goods vs services within Core CPI, as we are seeing Core services leading the way.

2. Labour Market

I’d consider 37% of the 255,000 NFP print comparatively ‘less-prospective’

• 48,800 were Healthcare/Social Assistance (aka Obamacare administrators)
• 45,000 were Leisure/Hospitality (includes food services and drinking places)
• 1,700 were temporary jobs Other less-prospective shops

In May, Walmart announced that it is increasing the number of greeters. These greeters will welcome arriving customers and answer questions. However, the disclosure was that these new Walmart greeters will also be checking the receipts of departing shoppers to cut down on shoplifting.

Last of all, GoBankingRates, a national website that tracks interest rates, reported in Oct 2015 that 28% of Americans have ZERO money in their savings account, 13% had less than $1,000, and 21% don’t even have a savings account.

Best,
P

Impact of Oil on EM Asia

Some weeks ago, Brent oil sold off 21% to a 4-month low of 41.5 and broke off the 20/100/200 moving averages. I did some work on the impact of oil and EM Asia but clearly it has all reversed now and I was proven wrong. Nevertheless, this note may help in understanding the impact of oil on EM Asia in terms of (1) inflation; (2) trade balance/BOP, (3) consumption, (4) investment, (5) policy rates and FX NEER (6) looking at EM Asia as a risk asset and (7) considering the recent DD/SS dynamics in oil prices.

Starting point: The recent divergence in oil and EM Asia (ADXY Index) has led me to mistakenly believe that further decline in oil prices is a negative for EM Asia.

1. Oil on EM Asia inflation

While crude oil prices have fallen around 44% in US dollar terms between May and Oct 2015, the impact on Asian retail gasoline prices has been more modest. This is primarily attributed to ‘shields’ such as direct and indirect subsidies or taxes for energy across much of EM Asia. Crude oil prices fell 44% during the period; gasoline prices in countries like Indonesia are unaffected. EM Asia’s coefficients of pass-through from crude oil prices in local currency terms to retail pump prices are much smaller in EMs than DMs. More interestingly, this ‘beta’ can be lower during periods when crude prices decline than when they rise. My suspicion is that energy companies/government is slow to pass on these cost savings, while quick to raise prices in the face of higher costs. Given the upwards trajectory of oil prices, it seems that there are more upside risk on CPI on EM Asia. This may give central banks in EM Asia a reason to slow down their rate cuts.

2. Oil prices on current account balance and GDP

Given the relatively high import shares of oil and oil-related products in most of ASEAN and Northeast Asia, the fall in oil prices, if sustained, points to an improvement in regional trade balances, albeit to varying degrees. Research from JPM suggests that Taiwan and Thailand will benefit most in terms of current account balance. Another potential linkage is that when oil prices fall, it tends to drag other commodities’ prices down as well, which may adversely affect EM Asia as they are usually large exporters of agriculture goods.

3. Consumption: 30% fall in oil prices will increase HH income by 0.5% and consumption by 0.35%

While the pass-through from savings in oil prices to households are less pronounced compared to DMs, the higher MPC (marginal propensities to consume) of around 0.7 should counter some of these effects. JPM models suggest that a 30% drop in crude oil price should increase real household income 0.5%-pts. This assumes that all fuel components in the CPI adjust by the past through coefficient but this is often not the case given offsetting tariffs and taxes. This should increase consumption growth 0.35%-pts.

4. Investment: Uncertain as corporate savings from oil prices are a small factor relative to other factors affecting investment

While lower margins over the past few years and relatively tight domestic credit conditions played a role, JPMM research found that weak export growth has been a much bigger driver in slowing down investment growth. Only during brief episodes when governments embarked on large public investment projects to support growth did overall investment pick up without a lift from exports. Indeed, the impact of export growth is significantly bigger than even that of funding costs/real lending rates, let alone oil savings from corporates.

5. Policy rates and FX NEER

Although initially policy rates ease modestly (and not in a statistically significant way) in response to the lower domestic inflation, the subsequent rise in growth and inflation prompts central banks to tighten in later quarters. Indeed, three quarters after the shock, policy rates begin to be hiked and by the end of 6 quarters and when base effects of oil price fall wears off, rates are up nearly 25bps! The impact on exchange rate is straightforward. As the current account balance improves because of the lower oil price, the exchange rate appreciates nearly 100bps over two quarters. This appreciation seems small relative to the large size of the oil price shock, but one needs to keep in mind that the current accounts of EM Asia’s main trading partners, i.e., DM economies, also improve, being net importers of oil, strengthening the latter’s currencies too.

6. EM Asia as a risk asset

The connection between crude oil price plunge and a risk-off sentiment starts when markets start worrying that energy companies will default on their debt obligations. Recall when macro markets were trading oil last summer, and empirically insignificant data points like rig counts were actually ’moving markets’. Why are markets ignoring it now? I attribute it to three possibilities: (1) Brent is trading sufficiently far away from its lows; and markets may see this as a retracement of its gains; (2) Brent is trading closer to breakevens, which has come off significantly due to increase efficiency (see chart below) and (3) speculative positions from funds are not sizable. According to Wood Mackenzie, the average break-even point has fallen $19 a barrel since the 2014 peak to $51.

7. Story of demand or supply?

If the recent fall in oil prices is caused by a fall in aggregate demand across the world, then this will raise concerns about global growth and subsequently cause spillover effects on export-orientated EM Asia. A look at crack spreads (price difference between crude oil and refined oil), an indicator of oil demand, has seen a fall in both gas oil and RBOB spreads. Of course, there is also the supply side of the story. Saudi Arabia, the world’s largest crude exporter, was reported to have boosted oil output to a record 10.67 million barrels a day in July. Iran’s output, on the other hand, is up to 3.85 million barrels a day, highest since 2008. Whether this is a demand-driven sell-off, or a supply-side narrative is a tough judgment. But if one were to attribute it to oil price plunge, then there is a case for concern for a market sell-off brewing in the background.

Best,
P

Curious Case of Fed Funds Rate

A question popped up on my mind as to why there is a plunge in Effective Fed Funds rate and also why it broke the RRP floor on Dec 2015.

Short answer

Month-end Plunge: GSEs (notably FHLBs like Fannie Mae) do not have access to IOERs and earn zero interest on their cash. Hence, they lend it out in the Fed Funds market to earn interest. Near month-end, banks face higher balance sheet usage as borrowings cause stress on their leverage ratio. Hence, they need to be enticed to borrow at a lower rate. This explains why we see a plunge near month-end.

RRP Floor: On why the floor broke on 31 Dec 2015, it is worth noting that it has only broken once since RRP’s inception, on the last day of the year with thin liquidity. I won’t read too much into it. Theoretically the floor should always hold since GSEs have access to ON RRP, unlike IOER.

Background information

Dynamics of GSEs and banks in the Fed Funds market: GSEs, having no access to IOER, often lend their reserve balances overnight on the fed funds market to commercial banks. These commercial banks could then hold the funds as reserves overnight, earning 0.25%, while paying the GSEs x%, where 0 x 0.25, to make a profit (Under PC market, x = 0.25, since there are limited number of GSEs). Indeed, ~75% of lending on the fed funds market was accounted for by FHLBs (2012).

However, financial institutions that receive IOER also face balance sheet costs associated with borrowing on the fed funds market. This includes FDIC cost, which since Dodd Frank has become dependent on total balance sheet assets as well (only for US banks). This gives foreign banks a cost advantage, which means they will be the main agent to borrow from FHLBs to arbitrage the IOER-FFR spread. This explains why ~60% of borrowing on the fed funds market was being done by foreign-owned banks.

Best,
P

Disclaimer: Perry is a summer analyst at JP Morgan. This is his personal view.

BOJ Review: Kuroda concedes that Japan’s monetary policies have been exhausted

Friday came and went, with Kuroda stating that “ETF was the most appropriate” policy response to Japan’s bad economic shape. While I had underestimated the resistance from banks’ against NIRP, I am glad that my interpretation of BOJ’s narrative was not too far off. Now, what’s next?

Kuroda has ordered a policy review to be assessed during the next MPM on the 21 Sept ‘because it has been more than 3 years since it started’. Coincidentally, it is also when market participants have wagered on their inability to ease further. I struggle to imagine how much more magic they can create. As some media reports have speculated over the weekend, perhaps they will stop having a calendar target of 2% inflation – since it cannot account for unforeseen factors. Perhaps they will continue to employ creative measures that has very little effect of boosting the real economy, such as doubling the loans from 12bn to 24bn to ‘boost the foundation for economic growth’. I would think the underlying intention was to fill up half of the monetary policy statement so as to look like BOJ is willing and able to act. I continue to be bearish USDJPY in the near term. On the USD side, Friday weak GDP print has become the first catalyst for a sharp sell-off.

Going forward, I expect markets to completely price off the 35% of rate hike going into Dec.

1. Libor has already done a de-facto tightening, rising by almost a full hike (+22.5bps) since 27 June. Moreover, it appears that the rise is not halting anytime soon.
2. No one has started to think about Trump-risk. I assign a high probability that October will resume its role as the month of market crashes, as markets start to rethink about the possibility of a Trump presidency. Polls are already suggesting that Trump will put up a close fight. Here’s a fun fact: Trump currently polls 49.7% in Florida, and no presidents have ever won the US presidential elections without winning the sunshine state. When market participants will start pricing in a Trump presidency is the real question.
3. Even without Trump risk, any other risk-off catalyst or stock market correction may morph into a full-fledged sell-off, again prompting investors to price off hikes and sell the dollar. S&P 500 continues to trade near record-highs, definitely not a good sign if we observe how it has traded over the past two years.
4. Other central banks will help Fed do the leg work: While BOJ hasn’t exactly met up to market expectations, BOE is slated to ease next week, while ECB contemplates a comprehensive easing package in Sept. In EM Asia, many are also in the midst of an easing cycle, such as Korea and Thailand.
5. Just when the street is talking about a rebound in inflation from an impressive oil price rebound, oil dampened investors’ hopes by its recent decline. The whole argument of ‘oil-just-needs-to-stabilize-and-inflation-will-surprise’ has once again (recall Dec 2015) gone down the drain. Watch out for oil/Commodity FX – could it be the next risk-off catalyst?
6. My old argument of ‘appreciation-per-bp-hike’: BOE left the hiking club, so any additional hike will bring a more pronounced appreciation to the dollar. Yes, 25 bps may not bring down the skies, but Fed’s hiking playbook seems to be in play only when all the stars are aligned.

Recall in March/April when Yellen was unexpectedly and intentionally dovish during FOMC and Congress testimonial. At that point, markets have largely recovered from the February sell-off, and inflation data was largely positive. Why did Fed play the dovish card at the stake of its own credibility? I have not heard a convincing argument…

And here we are, thinking about a December hike even as Yellen has not voiced her opinion about Fed’s hiking cycle (next public appearance at August Jackson Hole). If there is one lesson we can all learn, the risk for a dovish Yellen outweighs a hawkish one.

All these suggests me to sell the dollar and long duration. Long duration makes a great trade since the run-up in treasuries’ yields has outpaced the appreciation in the dollar. Else, short USD against JPY and CHF to position for the next risk off. Both trades are favorable in terms of technical analysis and fundamental backdrop.

Best,
Perry

Disclaimer: Perry is a summer analyst at JP Morgan. This is his personal view.

Will BOJ decision to make borrowing JGBs easier affect banks’ behavior to employ Fed swap lines?

Federal Reserve Building, Washington DC, USA

Over the past few months, we have seen LIBOR rising across all tenors (+22.5bps since 27 June) and JPY and EUR XCCS widening due to MMF reforms.

The main reason is because US prime funds’ holdings of securities by non-US issuers have been reduced while holdings of US issuers have been broadly unchanged. This is most pronounced in French banks, and also observed in Japanese banks.

Yesterday, BOJ announced two key measures support growth and maintaining smooth functioning of money markets. This has created some discussions as to whether this will fade the rising LIBOR and cause 3s6s LIBOR to flatten (It has continued to steepen on Friday evening).

My research conclusion is no, it has no impact as the widening in JPY XCCS is an effect and not a cause. I have also attempted to look at the behaviors of Japanese banks relative to the cost of tapping on BOJ-Fed swap lines. However, data published on BOJ website suggests that the swap lines, though unlimited, are hardly used. As such, it is difficult to study the behavior of Japanese banks against the relative price to obtain USD funding. A similar analysis was done by Deutsche Bank on EUR XCCY. It concluded that while the widening in EUR XCCY basis should, in theory, find a floor once ECB-Fed swap lines become equivalent, in reality, there are other considerations in play that are hard to quantify.

Firstly, what are the two special measures announced?

1. Increasing size of the bank’s lending program to support growth

• Launched June 2010, the program seeks to promote ‘pro-economic growth’ projects by lending to Corporations
• Duration of loans up to 1 year
• Total program size: Not more than USD$24 (up from 12) billion at any one point of time
• Size per firm: Up to USD$2 (up from 1) billion
• Interest rates: Libor 6m

2. Lending JGBs to FIs via US Dollar funds-supplying operations

• Launched May 2010, the program seeks to facilitate money market operations and ensure smooth functioning by lending to Financial Institutions
• Duration of loans up to 3 months, but has empirically only lasted 1 week
• Interest rates: Fed Funds rate + 50bps
• Comes with a stigma/ reputational costs
• The only change is that banks, to the extent they were struggling with a lack of JGB collateral, can now get those JGB’s from the BOJ, posting their CA balances. Those JGB’s are then reposted to the BOJ in return for USD

This caused 1Y JPY basis swap to tighten both in the short end and long end, with 1Y and 5Y tightening by 7.25 and 5.8 bps respectively. Directionally, they make sense because of prior baked-in expectations of aggressive easing by BOJ. However, whether the second measure will affect FIs’ behavior to tap on USD-funding via the swap lines is unknown.

This is important because it may produce a more structurally shift the XCCS basis (rather than just a re-pricing on Friday). I will attempt to answer this question by analyzing the factors that affect banks’ borrowing via the swap lines. Three questions in my mind:

1. Were banks previously constrained by lack of JGB collaterals?
2. Does swap-line borrowing correlates with relative cost differentials with market-based borrowing via XCCS?
3. Are there stigma/reputational costs faced by banks to borrow from BOJ?

On (i), if there were a lack of JGB collaterals, we should see an increasing usage of the JGS repurchase agreements that the BOJ hold every day. Yet, we are not able to see any notable trend and as such it is not conclusive.

On (ii), running a correlation between (1) relative cost differentials between OIS + XCCY and (2) usage of USD funding facility may provide some insights. The idea is simple. If it is more economical to employ the swap lines to obtain USD funding, then the usage in USD funding should increase accordingly. However, after plotting the usage of swap lines, there are no visible trends and as such inconclusive (sorry for disappointment).

Here’s more research regarding MMF Reforms

• Dynamics of 14 Oct milestone

As we move towards the compliance date, prime funds are shortening their weighted average maturity (WAMs) so they can get as much yield out of SSAs as possible before converting to govt-only funds. For example, on 14 July, the date of which it is exactly 3 months before the 14 October date, money market managers should shorten their funding term to buy prime funds. While it is less clear for 6v12, both 1v3 and 3v6 Libor have faced a steepening in the curve when they ‘move within’ the compliance date.

• EUR XCCY has become more expensive to fund than ECB-Fed swap lines (Db):

Db did an analysis and found that EUR XCCY has become more expensive to fund. They concluded that while in theory the widening in EUR XCCY basis should find a floor once ECB-Fed swap lines become equivalent, in practice, there are three other considerations in play:

1. Stigma in accessing the ECB’s dollar swap lines
2. Potential differences in balance sheet and/or capital costs of these transactions
3. Other potential regulatory pressures including impact on LCR and/or NSFR

• Looking into June outflows of $118 bn in Prime funds

1. Brexit safe haven demand (lost 57bn in the days surrounding Brexit)
2. Seasonality for quarter-end flows (observed in past 4 years – avg of 18bn outflows in June)
3. Fund conversions accounted for ~8bn… this means potential MMF related flows (including Brexit flows) could be up to 92bn!

• Prime-Govies Transition Statistics

U.S. mutual funds, including Fidelity and Franklin Templeton, have already shifted more than $250bn of short-term bank corporate debt into government debt in 2015. The street estimates that between 150-700bn of flows will move from prime funds to govies. $250bn of this has already been announced by various mutual funds by the end of 2015. This also prompted the US government to ramp-up its Treasury bill sizes and Treasury’s deliberation of introducing a new 2m bill maturity.

Fitch (Jan 16): Money fund managers’ transition of U.S. prime funds into government funds is almost complete. Fund managers have transitioned $152 billion of their assets from prime to government, with approximately $41 billion remaining to shift. 14 funds have now completely transitioned from prime to government, including some of the largest funds (Fidelity, Franklin Templeton etc.) that intended to convert to government.

• As more funds shift from Prime to govt-only funds, where will all this cash go? (Barclays)

1. Treasuries: Effects from more bill issuance have been delayed due to tax collection seasonal effects. However, this is expected to pick up in Q3 and Q4. Barclays estimate bill issuance to increase by 235bn through Dec (60 in Q3, 175 bn in Q4). This effectively increases outstanding bills by 15.6% over the Dec 2015 level. Assuming govt-only funds maintain current asset allocations at 33%, their anticipated inflows could boost demand for bills by 87bn, compared to 235bn increase in supply. In other words, there should have no problems filling this demand surge. In fact, yields may go higher…
2. Repo – More supply: While there will be more cash, the question is whether there be enough collaterals to accommodate the increased demand. Most collaterals are coming in from traditional, large banks and dealers: these are the players who face the biggest regulatory hurdles from the leverage ratio – and they come namely from French, Japanese and even Canadian banks. Outside of private-sector repo, the RRP program has continued to remain very light in terms of usage (even as it surged during quarter end). This is due to the fact that govies funds have a preference of treasury tri-party repo (generally 3m bills cleared by BNYM), who yields about 5bp over the RRP rate. Whether the banks will continue providing collaterals is an unknown, but RRP will remain available and thus always provide a yield floor for cash to continue coming in.
3. Agency discount notes: This will be the main bulk of increased asset allocation in govt-only funds, as seen from 35% from 27% since May 2015. In dollar terms, funds have doubled the agency holdings during the past year to 461bn. Where did the extra supply of agency discount notes come from? Most are coming out from the 11 Federal Home Loan Banks (FHLB). While I haven’t got the chance to speak to Gaku/Andy, it seems that banks have been asking for advances in cash. Specifically, these advances in cash have increased by 50% since early 2013 (banks pledging their mortgage loans to FHLBs in return for cash.) Their motivation? The need to satisfy LCR/NSFR requirements for HQLA by monetizing their mortgages into cash to buy treasuries! Barclays expects this to cool off, but to what extent is difficult to gauge. Another source of demand comes from banks, which traditionally raise funding from prime funds. Now that the shift from prime to govies, they may be required to replace this funding with govies funds. Note that the largest banks raise approximately the same amount of funding from prime funds as advances from FHLBs.

Best,
Perry

Disclaimer: Perry is a summer analyst at JP Morgan. This is his personal view.

BOJ Preview: I expect USDJPY to end the day lower

• Having exhausted his monetary toolkit, Kuroda knows there is a chance that USD/JPY will sell-off regardless of what measures he employ within his authority; and as such will do just enough to show market participants that he will continue to ease monetary policy to support growth and inflation.
• I expect USDJPY to end the day lower. When will this ‘appreciation-regardless-of-easing’ regime ends? I am usually skeptical of such ‘sell-off-no-matter-what’ mentality, but this may be an exception because BOJ has lost all its credibility and exhausted all its monetary ammunition.
• While scope of easing is large and therefore uncertain, I expect 10 bps cut in policy rate and ¥3-5 trn increase in ETFs purchases. There is also a possibility that BOJ purchases FILP.

The narrative, in my opinion, comes down to three options (I may be over-simplifying it here):

Market Pricing

Market pricing in ~15 bps cut by in the next 6 months (1 year swap); but dependent on LIBOR JPY fixing movements (WIRP is not reliable because of thin liquidity in OIS market)

Why expectations are sky high tomorrow

BOJ expected to revise down FY2016 CPI and GDP materially (GDP currently 1.2% and core CPI from 0.5%). Note that this revision will be BOJ’s implicit admission that the target cannot be achieved during the Kurodas 5 year term.

JGBs market unable to support any increase in purchases…

50Y bonds will be an exception JGBs’ liquidity has been declining rapidly. In Sept 2015, IMF estimated that BOJ will hold ~40% of the JGBs market by 2016 and ~60% by end-2018. JCER (Japan Center of Economic Research) has also released estimated results indicating that BOJ will find it difficult to continue purchases around mid-2017. As of Jun 2016, BOJ already owns 37.4% of JGB market. This is perhaps why they decided to go negative in January, as interest rate targeting may be arguably more sustainable than monetary base targeting. As such, unless MOF starts to issue 50Y bonds, I do not expect JGB purchases to be increased.

Negative rate floor is theoretically at the storage cost of cash

At a tiered rate of -10bps, the BOJ is unlikely to be anywhere close to the floor (considering Switzerland is at -75bps – forgive my loose comparison). Also, Kuroda has emphasized that effects in NIRP were being felt in the economy, and that the economy would be worse-off without NIRP (no one knows). He even went as far to give NIRP credit for a pick-up in housing investment and sharp rise in rental housing. On the other hand, it is hard to imagine any central banker that would dismiss the effectiveness of their own policies.

On banks’ strong resistance…

BOJ Deputy Governor Hiroshi Nakaso also said in March argued that:

1. Banks are slow to restructure business model
2. Banks can achieve substantial margins by leveraging their intangible assets such as using them as collaterals

What about adverse effects on banks’ profitability?

On 20th July, BOJ released the Senior Loan Officer Opinion Survey, which showed that banks’ interest rate margin has shrunk again. Similar to other NIRP countries, banks have been slow to pass on the negative rates to their customers, especially in Japan where corporates have high ‘pricing power’. With exception to deposits at investment trust going negative, most institutional clients have not yet felt the effects of negative rates.

There are also some speculations about municipal bond-buying and Fiscal Investment and Loan Program (FILP)

Municipals: Low liquidity market; may act more as a regional government subsidy than economic stimulus; transmission is unclear
FILP: May be seen as proxy for helicopter-money since signal closer co-operation w fiscal authorities. (In the case of FILP bonds, funds supply resources to the Fiscal Loan Fund and their principal and interest repayment is covered by returns from these loans). Outstanding 90trn bond market may loosen constraints of JGBs limited supply.
ETF/REITs: Argument against it is market dominance and potential losses; both pretty insignificant hurdles compared to the other easing measures.

Best,
Perry

Disclaimer: Perry is a summer analyst at JP Morgan. This is his personal view.

Brief Note: What’s in PBoC playbook?

The PBoC could’ve easily set their fixing above 6.7 last week on the back of a stronger dollar. This is the perfect excuse to go beyond the psychological barrier of 6.7 – to protect the credibility of the market-based fixing methodology without a depreciative bias.

Setting the fixing lower will only reduce the credibility they have painstakingly built since February. Moreover, markets have been calm and obedient despite the PBoC engineering a staggering 8.31% depreciation in the CFETS Index since Nov 2015. This calmness has largely been attributed to (1) better communications from officials; (2) increased transparency in fixing methodology; (3) pause in monetary policy since Oct 2015 and (4) the government increased clampdown on outflows.

Yet, they set the fixing lower on Tue and Wed last week (see table below) when estimated fixing was above 6.70. Even on Friday, they continued to set the fixing lower, prompting FM community to sell USDCNH on rally as an interpretation of PBoC’s firm commitment to draw a line in the 6.7 sand. I am baffled by why they would do that, and will explore PBoC’s possible rationale in this piece.

In short, I am inclined to believe they set the fixing lower because of the G20 Meeting hosted in Chengdu, China. If that is the case, they are likely to breach the 6.7 level in the coming weeks (possibly this week).

Stability ahead of SDR inclusion

Last Wednesday, the Federal Reserve Bank of Dallas published a report questioning the suitability of yuan as a safe haven currency.

“Overall our findings do not support the suggestion that the renminbi is currently a safe haven currency and in that sense question the notion that the renminbi is progressing towards safe haven currency status. We find that the relative value of the renminbi vis-à-vis all traditional safe haven currency candidates decreases as market uncertainty increases.”

Could this have prompted the PBoC to stabilize the fixing? Maybe, but even so, I find little persuasion that PBoC will decide to take a pause for the next 3 months for something that has already been officiated. The report may prompt PBoC to stabilize the fixing for a few weeks, before resuming a depreciative trajectory of the USDCNY.

EM Contagion from Turkey

Another argument is that the PBoC wanted to stabilize the fixing before the crisis in Turkey spread to EM Asia. But even as markets shrugged off the crisis during the week, PBoC still set the fixing 54 pips lower on Friday. If this is true, then we will also see PBoC set the fixing higher in the coming days.

PBoC’s Standard Playbook…?

One other possible reasoning is that PBoC has a standard way of depreciating its currency – in predictable cycles. If we look at how the USDCNY has moved since Jan 2014, one can easily see certain characteristics in each cycle. Each depreciation cycle brought USDCNY around 3-4% higher, while stabilization retraced it by around 2%. Even though it takes a conspiracy theorist to believe this, I find myself rethinking about this possibility more than I should. Will the PBoC really take such a systematic approach to depreciate its currency? From a policy-setting standpoint, it would be arguably foolish thing to do. Further, if you look at each of the cycle, there has always been good reasons why PBoC stabilized the fixing – be it SDR’s political reasons, intensified capital outflows or market panic. I leave you to make a judgement on this.

G20 Meeting in Chengdu

Or perhaps PBoC simply does not want to breach the 6.7 level just yet before heading into the G20 meeting. After all, the 6.7 level holds dearly to many investors and speculators and breaching it a week before the meeting may attract unnecessary attention. Governor Zhou Xiaochuan knows this, and he wants to avoid any uncomfortable confrontation from IMF or Japan. Logically speaking, I find this the most convincing, and if that is the case, the PBoC may continue to set its fixing higher in the coming weeks.

No Trade: What’s the rush, really?

While I thought long and hard about putting on a long USDCNH trade, the risk-reward ratio isn’t favorable, in my opinion. Given recent good data (GDP, retail sales and industrial output all beat expectations 2 weeks ago), there is really no hurry for PBoC to continue bringing the CFETS Index down, especially after a relatively sharp depreciation since 23 June. PBoC can afford to be in a wait-and-see mode. As such, I’d stay away from the trade for now, but will continue monitoring the fixing closely for any faltering signs of this 6.7 commitment.

Best,
Perry

Disclaimer: Perry is a summer analyst at JP Morgan. This is his personal view.