As he points out in today’s Breakfast with Dave: Market Musings & Data Deciphering, Australia has a great deal more exposure to accelerating growth in China. Only 3% of Canadian exports go to China while 24% of Australian exports go there. Furthermore, Canada has much greater exposure to the moribund U.S. consumer: 75% of its exports go to the U.S versus 6% for Australia.

Yet, interestingly, the Aussie dollar lost ground after the central bank’s latest rate hike in a “sell-the-news-buy-the-rumor” kind of move. Bank of Canada Governor Carney no doubt noticed that response and might accordingly be less fearful a rate hike would strengthen the loonie (as happens most of the time due to capital inflows). And no doubt he would love to raise rates to head off the bubble-like conditions fermenting in the housing market – especially if the loonie remains well behaved and doesn’t inflict any more pain on the already hard-hit export sector.

The 2.1% yield to maturity is what an “investor holding the underlying bonds within the fund would earn per year if they could hold them until they mature,” said Oliver McMahon, Director of Product Management for iShares Canada. 

“Some of the 2.1% annual return is due to the coupon payments, but some is due to the price of the bonds moving towards par.” In other words, the prices of the bonds in the ETF’s portfolio have been bid up past their par values; as time passes and maturity dates are approached, prices edge back down to par. This decline in prices offsets the coupon yield and pushes it toward 2.1%.

The unit price of the ETF will edge down over time due to this factor but it will be hidden in the fluctuations in market rates;  “…while we can be reasonably comfortable assuming the underlying portfolio will produce a yield equivalent to 2.1% per annum over the life of the portfolio, it should not be assumed that this will be a constant return over each year. It may be that the return is higher one year and lower the next.” 

The stream of interest payments will also edge down said Aubrey Basdeo, Head of Fixed Income, Barclays Global Investors. One can see the decline already in the past three or four quarters of distribution payments. I didn’t quite catch the reason for this and Mr. Basdeo has so far not responded to a request for clarification. My guess is that it may come about from the portfolio rolling over into new bonds at lower interest rates.

Yet another complication: “the portfolio of XSB does not hold bonds until maturity. The product has been created to be representative of the short end of the bond market, which is generally understood to be 1 to 5 years. Thus, as a bond’s life is reduced to less than 1 year it is removed from the index (thus sold from the portfolio) and the proceeds are reinvested across other index holdings. This means that the yield to maturity, while being a useful measure of the return in the market, is not a rate of return the fund can be assured of achieving,” noted Mr. McMahon.

And here, we thought ETFs would simply the construction of portfolios!

Update: Aubrey Basdeo did subsequently confirm that the cause for a decline in the steam of interest payments was the rolling over of the portfolio into new bonds with lower coupon rates. If presently low rates of interest were to rise, this would become less of a factor.

UpdateII: As a reader has noted, it might be useful to explain how Yahoo Finance calculates the 4% yield. Yahoo Finance adds up the XSB distributions over the last 4 quarters and expresses that amount as a percentage of the current price.

This rising bearish sentiment is at odds with a suggestion I made several days ago that “the U.S. dollar could rise as the fiscal deficit widens and pushes up interest rates.” Perhaps I should explain some of the reasoning behind this statement.

While the huge government deficits planned for the next few years will put pressure on the Fed to print a great deal of money to buy government debt and contribute to further debasement of the currency, it will also put upward pressure on U.S. long-term interest rates. And this rise in interest rates will attract inflows of foreign capital that should put upward pressures on the U.S. dollar.

The precedent is the period from the early 1980s when President Reagan and Congress ran an enormous deficit that resulted in a flood of government treasuries being issued. Successively higher yields had to be offered in order to get investors to take up the Treasuries. Those higher interest rates attracted large inflows of foreign capital, which bid up the value of the U.S. dollar — until the Plaza Accord of 1985 reversed the uptrend.

At the moment, the currency market seems to be betting that the Fed will choose to finance a big chunk of the deficit by printing money rather than letting treasury yields rise. That might be a reasonable assumption this early in the recovery, which is still in the “green shoots” stage. Moreover, the Fed likely feels it can run the printing presses without trigging inflation as long as amount of slack in the economy is as huge as it is presently.

However, as the recovery becomes more firmly rooted, I believe the Fed will step back and let treasury yields rise, shifting more of the burden of deficit financing to domestic and foreign savings. In fact, this will be necessary to cut the risk of igniting galloping inflation. In any event, rising bond yields should draw in foreign capital and boost the U.S. dollar.

If this scenario is the one that unfolds, it may be worthwhile over the next few months to pick up some units in currency ETFs on any further dips in the U.S. dollar. Canadian investors not fearful of double-leveraged ETFs could consider the Horizons BetaPro U.S. Dollar Bull Plus ETF (HDU). In the U.S., there are a lot of choices, including PowerShares DB US Dollar Index Bullish Fund (UUP).

It also seems worthwhile to continue holding the inverse bond ETFs suggested in the April 22 post, such as the ProShares Ultra-Short 20+ year Treasury (TBT). One ETF I didn’t mention, but perhaps could have for Canadian investors, is the Horizons BetaPro U.S. 30-year Bear Plus ETF (HTD).  The ETFs are up 10% to 20% since the post appeared. They might suffer a setback near term if the Fed moves to buy down treasury yields, but I would see such a reversal as more as a chance to add to (or start) positions.

At 18.7%, that card’s interest rate wasn’t great, and new debt piled. So when Capital One offered Lokanandi a new credit card with what looked like fabulous terms — zero percent interest for the first six months — he bit. He took the card, and transferred much of the debt he owed on the first card to the second.

What Lokanandi didn’t see was the fine print. Should he be late on a payment, or God forbid, miss a payment, Capital One reserved the right to hike the interest rate — to a whopping 23%. Sure enough, there came a day this past winter when Lokanandi missed a payment. Next thing he knew, he was paying interest charges of up to $90 a month on his fall debt.

Such personal indebtedness is rife on both sides of the border. One couple featured on Oprah on September 23rd of this year owned a home that was worth less than they had paid; had recently endured a layoff; had no health insurance; and were living off of 29 credit cards. Lokanandi’s case is mild in comparison. But all that debt adds up. At the end of 2008, Americans’ credit card debt reached $972.73 billion, up 1.12% from 2007. (That number, sourced from sector watchdog www.creditcards.com, includes both general purpose credit cards and private label credit cards that aren’t owned by a bank).

To mitigate against such a teetering mountain of personal indebtedness, today the Obama administration announced the passage of the Credit Card Accountability, Responsibility and Disclosure Act. The law is designed to prevent what’s described as “unfair” rate increases, put a stop to unfair rate traps and late fees, and ensure the terms of contracts that are disclosed in plain language, in plain sight. Credit card issuers have nine months with which to adapt to the new regulations. Hence Lokanandi’s and many other American consumers’ difficulties, as banks hereabouts tighten their terms of credit and jack up rates.

Of course, a law that is designed to protect consumers will also have a real and measurable impact on banks’ willingness to issue credit to consumers in the first place.

“This law signals we are moving back to an era of real underwriting and real pricing,” explained Ellen Seidman, financial services policy director for the New America Foundation in Washington, D.C. “We’ve all been free-riding for years on cheap credit; this law ensures people will have to pay for that credit in a timely and appropriate manner.”

In Seidman’s view, it’s the rules around how banks alter the interest rates they charge are likely to have the most immediate impact. “This legislation basically puts an end to the cheap-credit model,” she says. “In the past, any time an issuer became concerned about the ability of a customer to pay their past debts, they simply raised the rate they would charge. That is what they will not be able to do anymore.” That means fewer people will have access to credit. “But those who receive credit, will get it on terms that are priced more fairly, thus ensuring that credit will be repaid,” she said.

The new laws also imply a change to the way American workers get paid. People will no longer be able to use their credit cards as a form of bridge financing to supplement inadequate paychecks, Seidman said. To sustain demand, the wages of average workers may finally start to increase in step with inflation, after several years of remaining stagnant.

Similar legislation is in the works in Canada. This week, Finance Minister Jim Flaherty proposed nine new regulations that would rein in the use of credit cards. The highlights of those proposals include a 21-day grace period on new purchases, provided the outstanding balance is paid in full; card issuers must also supply consumers with notice before making a change to their interest rate on an existing balance. The Canadian proposals differ in that Flaherty is not pushing for legislation that limits a card issuer’s ability to increase rates “unfairly” on existing balances, or introduce most new fees. Issuers can still raise rates but they must provide the consumer with “adequate” notice before doing so.

It’s difficult to tell what impact this legislation is likely to have on the U.S. economic recovery—and by extension, that of Canada. But in the meantime, think it through: what do the Canadian proposals imply for your use of credit cards, and what is the new legislation’s likely impact on the U.S. economy, as it struggles towards recovery? Have your say at www.canadianbusiness.com.

]]> http://blog.canadianbusiness.com/cheap-credit-rip/feed/ 1 http://blog.canadianbusiness.com/qa-with-a-wall-street-economist/ http://blog.canadianbusiness.com/qa-with-a-wall-street-economist/#comments Thu, 14 May 2009 16:20:29 +0000 Larry MacDonald http://blog.canadianbusiness.com/?p=2030 How might markets and economies unfold from here? Probably one of the better persons to ask this question is Robert Barbera, a noted Wall Street economist who has been following economic trends for over 25 years. He is also a professor at Johns Hopkins University and author of a recent book, “The Cost of Capitalism: Understanding Market Mayhem and Stabilizing Our Economic Future” (McGraw-Hill Publishers, February, 2009). I will be reviewing that book shortly but first, Mr. Barbera’s (paraphrased) answers to some questions I recently asked him.

Q) In your book, you say the big monetary ease in 2001-2003 played a role in the formation of the housing bubble. Will the big easing in monetary policy in 2009 lead to another bubble?

A) First, we have to get through a difficult period and produce a recovery in the economy. After that happens, the Federal Reserve will need to rein in liquidity to keep inflation from becoming a problem. Then the risk remains of creating another bubble like the ones seen over the past ten years. This time, though, I don’t see it happening because I believe central bankers have learned from the financial crisis that they need to conduct monetary policy with an eye on more than just wage and price changes. They’ll also be looking at leaning against excessive risk taking and rising asset prices before they get too far out of line.

Q) In your book, you say the Savings and Loan crisis of the late 1980s and the recession of 1990-91 coincided with the beginning of Japan’s descent. Is China’s investment boom and “heady rates of growth” similarly at risk now that they can’t rely as much on exporting to U.S. and other developed countries?

A) China is definitely feeling the pinch. I was in Hong Kong recently and people there were remarking on how the air was so clean these days. It appears that the factories nearby in China had curtailed production substantially. But the drop-off in exports has led to the Chinese authorities launching a huge fiscal stimulus to build infrastructure and keep the economy running. They appear to be in the midst of replacing export-led growth with consumer-driven growth.

Q) If China is replacing export-led growth with domestic-sourced growth, could this mean U.S. interest rates might ratchet upwards since China won’t have as great a need to peg its currency and thus won’t be buying U.S. dollars as much as before and parking them in U.S. treasuries?

A) I see domestic stimulus by China and other emerging countries as a good thing. For thirty years, the U.S bailed out the world economy by easing its fiscal and monetary policies in response to downturns, which stimulated exports from Asia and elsewhere. We can’t do this again because it will worsen already tenuous structural imbalances. Asia and other emerging countries have to engineer their own growth. China’s fiscal stimulus will help the global economy recover in a way that should reduce structural imbalances such as chronic trade deficits and surpluses. China may buy fewer U.S. treasuries but other buyers will emerge – just the mix of owners will change.

That’s not especially good news. Yields on long-term Treasuries affect a wide range of interest rates in the economy, from mortgages to auto loans. When they go up, so does the cost of buying a house or car – not exactly the right medicine for getting out of recession.

But the more the economy picks up, the more the flight to safety unwinds and inflation fears revive. Let’s hope that the economic turnaround doesn’t ramp up too quickly and intensify selling of government bonds on these two fronts.

For the rise could potentially get out of hand considering other upward pressures on yields. One is the tsunami of new government bonds being issued as a result of the U.S. government’s massive spending plans on guns, butter, bailouts, and gargantuan stimulus packages. These plans are epic: they are projected to raise the 2009 fiscal deficit to a 60 year high of 12.5% of GDP.

Yet another source of upward pressure may be the huge domestic stimulus program in China. It’s even more massive the one in the U.S. and seems likely to lessen the importance of exporting to the U.S. as a means of promoting industrialization in China. That could lower China’s need to hold its exchange rate down against the U.S. dollar, and, in turn, it’s buying of U.S. dollars and parking them in U.S. government bonds.

If U.S. government bond yields do get too far out in front, they risk choking off the recovery. If this eventuality becomes apparent while the economy is still trying to find its feet, the Fed would likely print even more money and buy up Treasuries in greater quantities to keep yields low. So there could still be an upswing in the economy but it probably will be more violent and short-lived since inflation is likely to begin galloping sooner and compel the Fed to take liquidity out of the system.

So the aftershocks of the financial earthquake of 2008 may be felt for years to come in the form of more extreme fluctuations in economic activity. Maybe it’s back to the 1970s?

Conducting monetary policy will certainly be a challenge to say the least. It would appear we are threading the needle on this one. As I said before, it reminds of a scene in the computer-animated movie, Polar Express, my 6-year-old used to watch. In it, a train full of children runs off the tracks onto a frozen lake. With the ice breaking up behind it, the engineer guns the swerving locomotive toward the railway tracks on the other side and, just as the water is about to engulf the passenger cars, hits the rails square on and speeds to safety across the Arctic tundra.

Hopefully central bankers of the world will be able to pull off a similar feat. In any event, holding government bond yields down by printing money does not seem to be a sustainable policy.  As mentioned previously, it may be a good time to start, or add to, a short position on government bonds – especially if the Fed does step up its monetarizing of Treasuries and succeeds in pushing rates back down for a time.

According to Brusca, optimism is still optional, but with inflation (CPI and PCE core) returning to pre-Lehman trends, Fed policy could get “real different, real fast.” Simply put, if deflation stops looking like a threat, the Fed will start back-tracking, maybe even at WARP speed.

Brusca has his own blog called GPS for Investors at http://robertbrusca.blogspot.com/

If you don’t think I am a total twit, follow my DOUBLE TAKE posts via my NotSOCRATES Twitter site at http://twitter.com/NotSocrates

DOUBLE TAKE: Aside from trying to promote myself while generating Web traffic that helps put bread and butter on my table, this blog aims to stir debate by taking a harder look at current news and events. I obviously enjoy voicing my own opinions, but I am a big boy and I welcome all comments that don’t require R ratings. So let me have it via this blog or send me an email at tom.watson@canadianbusiness.rogers.com. I reserve the right to post email comments without disclosing the sender’s name.

THOMAS WATSON is a Senior Writer and editorial board member at Canadian Business magazine. Since winning a community journalism award as a cub reporter with the Hamilton Spectator in the early ’90s, he has covered business, finance, politics and technology for various news outlets. Prior to joining CB in 2001, he reported on the steel and automotive sectors for the Financial Post. Watson received his first magazine award nomination for exposing a stock manipulation plot aimed at Waterloo, Ont.-based Open Text in 2000, when he was head of investor relations for an international venture capital outfit in the City of London. Watson holds graduate degrees in journalism, international relations and public finance and undergraduate degrees in history and politics.

It could be a warning not to expect a sustained rally in stocks if and when policymakers stabilize the financial crisis. There may be no need to rush back into equities, just yet.

The silver lining might be that a weaker world economy could considerably reduce the odds of the tumble in the U.S. dollar, upward spike in interest rates, and/or galloping inflation that many fear will be the consequence of the U.S. government taking on an estimated $1 trillion (U.S.) in debt to rescue the U.S. financial sector.

As the Chinese economy ratchets down, the authorities will likely want to keep the yuan from rising even more so than before — so they should remain willing buyers of U.S. dollars and treasuries. They won’t want to flee U.S. assets when it will cause the U.S. dollar to fall against the yuan and undermine their export-led, industrial development strategy. A preliminary signal of their willingness to continue supporting the U.S. dollar was the recent decision to cut interest rates.

Commodity-based economies like Canada and Australia will see weakness in their currencies against the U.S. dollar as the commodity boom fades further. And Europe’s regional differences are likely to be exacerbated, raising political conflicts that could undermine the euro – on top of the region’s more restrictive monetary policy that seems destined to produce a greater and/or longer lasting economic slump in the region.

And don’t forget, the U.S. dollar’s status is not just about economics. For many countries, political considerations are paramount. Countries like Japan, South Korea, Taiwan and Saudi Arabia would not want to dump the U.S dollar and assets because of their security relationships with the U.S.

During recessions, lower risk appetite and flight to safety favors government bonds. Although the supply of treasuries will be rising in the U.S., so will portfolio demand – especially considering how underweight many investors are. A Merrill Lynch study noted households currently have less than 0.7% of their financial assets in government bonds, about $1 trillion (U.S.) less than the peak of 4% in 1993. Public pension bond holdings are close to two-decade lows. Bond yields are low right now, even negative after adjusting for inflation, but as the economy winds down, inflation should be subsiding.

Admittedly, the debt obligations arising from the financial crisis — along with ongoing debt requirements for other government programs — are substantial and there should be upward pressures on interest rates. However, like in the 1980s, higher rates should be bullish for the U.S. dollar as foreign capital flows in, attracted by the higher yields. And slack in the U.S. economy may also allow the Federal Reserve to buy some of the debt without inflationary consequences, which offers some assurance the rise in bond rates should not be extensive.

History is an imperfect guide, but when the Resolution Trust Corporation began to buy bad assets during the savings and loan crisis in 1989, U.S. economic growth, house prices and equity markets did not bottom out for another 12 to 18 months. The dollar, however, traded sideways during the period

But the Federal Reserve is not running the “printing presses” any faster and Bernanke’s helicopter is gathering cobwebs in the hangar. True, the Fed’s efforts to stabilize the financial crisis through the Term Auction Facility (TAF) and the Primary Dealer Credit Facility (PCCF) is expanding liquidity. But as the economists at Northern Trust indicate, the Fed has also sold $230 billion (U.S.) of its U.S. Treasury bond holdings to private-sector banks over the four months to April 23. This has drawn liquidity out the financial system, roughly offsetting or “sterilizing” the expansion in liquidity arising from the TAF and PDCF.