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David Tab
David Tan
Head of Global Rates

Just when you think it is almost over…

Posted on April 17, 2014

US economic data since March have picked up following a weather related dip during the start of the year.  Market participants believe with an increasing degree of confidence that with tapering well in motion, the Fed will end quantitative easing (QE) in October.  But just as we think that major central banks’ QE programs are almost over, recent ECB rhetoric have fanned speculation that they have overcome internal opposition and are ready to use all monetary tools at their disposal to achieve their inflation target of close to, but below 2%.  These measures include “conventional” rate cuts and “unconventional” measures, such as QE.

Inflation in the Eurozone is currently running at only 0.5% but the ECB projects a rise to 1.7% by the end of 2016.  However the strength of the Euro may make the ECB’s task more difficult to achieve, and President Draghi has said that the exchange rate will be an important input in their reaction function.  To be clear, the ECB does not have an explicit exchange rate target but, if a stronger exchange rate feeds through into lower inflation, the ECB will not hesitate to act.  Draghi provided a rough rule of thumb and suggested that a sustained 10% appreciation in the trade-weighted exchange rate is associated with a 0.5% point decline in the rate of inflation.

Such comments from Draghi and other ECB board members have given markets some hints on when they may act. Unlike the OMT program, which remains an as yet untested promise that the ECB will “do whatever it takes” to defend attacks on the irrevocability of Eurozone membership, the recent promise to deliver more monetary easing may be put to test should the currency strengthen further,  or should inflation and expected inflation move further away from target.

In judging how close the ECB may be to easing, we will look at four indicators:

  1. Continued strength of the Euro (and the inference for inflation described above)
  2. Inflation and long term inflation expectations, in particular the latter which have so far remained well anchored to the ECB’s inflation target
  3. Activity indicators such as the Eurozone’s Composite PMI which has traditionally been a good leading indicator of gdp growth.  If growth remains positive or picks up further, the ECB may be willing to tolerate low inflation for longer
  4. Lending rates to the real economy as a measure of the effectiveness of the monetary policy transmission mechanism

If the above indicators collectively point to renewed monetary ease, we believe the ECB will deliver incremental easing in the following sequence:

  1. A cut in the Refi Rate from 0.25% to, say, 0.10%
  2. Some form of Credit Easing.  The ECB have previously bought covered bonds and a new purchase program including asset backed securities formed from repackaged SME loans may help to channel credit into the real economy (some regulatory changes may also be required)
  3. A cut in the ECB’s deposit rate from 0% to negative in order to penalize holders of Euros who make deposits at the ECB
  4. A Large Scale Asset Purchase Program.  The ECB may rank the purchase of private sector assets ahead of purchases of government bonds (QE) to avoid  “monetary financing” of governments

What are the global macroeconomic implications of ECB easing later this year even as the Fed steps away?  Global liquidity will remain ample and global monetary policy will remain loose well into next  year.  Risk assets will continue to be supported by central bank actions, and those waiting for the long predicted bear market in bonds may have to wait a little longer.

Priscilla Hancock
Global Fixed Income Strategist
Byrne Margaret_200dpi
Margaret Byrne
Senior CPM, Municipal Strategist

Detroit motors toward the finish (starting?) line

Posted on April 17, 2014

As everyone who follows the news knows, Detroit is in the throes of bankruptcy resolution. The City’s economy declined along with the decline in domestic auto production.  The City’s budget, however, did not contract proportionate to the economy (the tax base fell from $12 billion in FY’03 to $9.4 billion in FY’12; revenues fell from $1.8 billion to $1.3 billion), and the levels of poverty, the demand for social services, and the more generous pension benefits for City employees outstripped the City’s ability to raise revenues.  In December 2013, Detroit was officially declared bankrupt. Since then, the City has made various proposals that included significant cuts to creditors, including bondholders and pensioners.

Over the last week, the City and some of its creditors have reached a series of settlements, several of which may have a lasting impact on the bond markets:

Unlimited Tax General Obligation Bonds   On the 9th, in what the markets hoped was a landmark agreement, Detroit reached a tentative settlement with the guarantors of its unlimited tax general obligation bonds (ULTGOs).  The agreement would result in a recovery rate equal to 74% of the $388 million that they are owed, a dramatic increase over the 15% they were offered just weeks ago.  The remainder of the existing property tax stream will be diverted to the City’s lowest-income pensioners, and the bond insurers will cover the remainder of the payments to the bondholders. The agreement resulted from the City’s recognition that those bonds are secured by a dedicated revenue stream. According to Emergency Manager Kevin Orr, “Their revenue stream is unlimited tax GO.  That’s a dedicated revenue stream.” According to the agreement, the unlimited tax general obligation debt may be converted into two new bonds, one issued by the Michigan Finance Authority (MFA), representing the City’s future obligation, and one backed solely by the bond insurers, representing the remainder. In addition to the pledge of property taxes, the MFA bonds will have a lien on state aid, adding additional bondholder security and ensuring that the bonds would be considered secured in the future. 

Pension Benefits   Subsequently, the City reached additional tentative agreements with several groups representing the City’s pension funds and police and fire retirees.  Reportedly, the City agreed that police and fire retirees would see no pension cuts, but would accept an approximately 50% cut to their cost of living increases (COLA).  The City’s two pension funds are reported to have accepted a 4.5% pension cut, and an elimination of COLA.  As with the GO bond agreement, these settlements are a significant improvement over the City’s most recent offers. These agreements stem in part from the City’s agreement to increase the assumed investment rate on its pension assets; in part from a package of state and private funds that have been offered in exchange for protection of the Detroit Art Institute’s assets; in part from recognition that the average pension for municipal workers is a mere $19,000 a year; and in part from the fact that the City’s public safety workers do not qualify for social security payments. 

Swaps   Separately, the City reached an agreement to pay its interest rate swap counterparties, UBS and Merrill Lynch, $85 million.  Syncora Guarantee, which insured the swaps, may now be forced to cover incremental costs of the termination.  Separately, Syncora also insures a portion of the City’s pension certificates, for which a settlement has not been reached.  Syncora has promised to fight any adverse agreement in court.

Implications The seniority and security of unlimited tax general obligation bonds has long been considered sacrosanct by municipal market participants.  And market participants have argued that unlimited tax general obligation bonds are, at a minimum, on par with pension claims.  Recent bankruptcy cases have heightened the market’s focus on this issue, although Detroit is the first example of unlimited tax general obligation bondholders receiving less than pensioners. In previous cases, the two were treated equally or, in the case of Central Falls, Rhode Island, bondholders were paid in full, while pensioners received significant cuts.

Nevertheless, while the ULTGO settlement does not establish legal precedent, the agreement did help reassure municipal bond market participants that the approximately $900 billion of outstanding municipal bonds backed by taxes are, in fact, among the most secure, and that unlimited tax bonds do have a lien on property taxes. 

It remains to be seen if there will be lasting impacts on bond spreads or if future bond covenants will be needed to more clearly define the secured nature of tax-backed bonds. 

A further unknown regarding the ULTGO agreement is the exact mechanics of the bond exchange. Splitting a single security into more than one obligor raises a number of questions, among which are i) whether new bonds will be issued; ii) whether the bonds backed solely by the bond insurers will be subject to taxation; and iii) if odd lots will be created.  The variety of outcomes could provide an interesting case study into bond spreads and liquidity premiums, and could provide credit arbitrage opportunities.


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Yield Hogs Unite

Norelli_Andrew 72dpi
Andrew Norelli
PM, US Macro Strategies
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China: Still running like a tremendous machine?

Stephen Change
Stephen Chang
Head of Asian FI
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Ai Ling Ngiam
PM, Asia Macro Strategist
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“Breaking up is hard to do*”

Edward_Fitzpatrick 72dpi
Ed Fitzpatrick
Head of US Rates
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