Financial Market Affects October 5, 2015

Economic news was rather light this past week with few reports available to assist traders in determining market direction.  Generally, the week’s economic data favored the notion the Federal Reserve will elect to leave interests rates unchanged for the remainder of the year.

Specifically, the Commerce Department reported the nation’s Balance of Trade showed a wider trade gap for the month of August of -$48.3 billion when the consensus forecast had been for a narrower deficit of -$44.5 billion.  This was an increase of 15.6% over July’s narrower than usual deficit of -$41.8 billion.

The imbalance stemmed from a three-year low in exports, largely due to a strong U.S. dollar, while imports increased with a hefty influx of consumer electronics including $2.1 billion worth of the latest Apple iPhones and Samsung Galaxy cellphones.  This report exemplifies the U.S. economy’s weaknesses to a strong dollar and weak demand in foreign markets and could influence Federal Reserve officials to delay the timing of an interest rate hike.

Further, the Labor Department reported overall Import Prices fell -0.1%, which was better than estimates of -0.5%.  Year-over-year, Import Prices are down -10.7%.  Export Prices fell -0.7%, which was lower than the 0.2% expected.  Year-over-year, Export Prices have fallen -7.4%.  These figures suggest inflation is not yet threatening the nation’s economic recovery.  A number of traders believe the absence of inflation will make it more difficult for the Federal Reserve to rationalize an interest rate hike, especially given ongoing global economic weakness.

In housing, CoreLogic released its latest Home Price Index (HPI) showing home prices increased 1.2% in August 2015 compared with July 2015.  On a year-over-year basis, home prices nationwide, including distressed sales, increased by +6.9% in August 2015 compared with August 2014.  CoreLogic is forecasting home prices to increase by 4.3% on a year-over-year basis from August 2015 to August 2016 and remain unchanged month-over-month from August 2015 to September 2015.

In mortgage news, the Mortgage Bankers Association released their Mortgage Application Data for the week ending October 2.  Overall the Index increased 25.5%.  The Refinance Index increased 24.0% from the prior week, while the seasonally adjusted Purchase Index soared by 27.0% from a week earlier.  Overall, the refinance portion of mortgage activity decreased to 57.4% from 58.0% of total applications the previous week.  The adjustable-rate mortgage segment of activity increased to 7.6% of total applications from 6.9% the prior week.  The average contract interest rate for 30-year fixed-rate mortgages with conforming loan balance fell to 3.99% from 4.08% the prior week.

For the week, the FNMA 3.5% coupon bond lost 28.1 basis points to end at $104.31 while the 10-year Treasury yield gained 9.9 basis points to end at 2.09%.  Stocks ended the week with the NASDAQ Composite gaining 122.69 points to close at 4,830.47.  The Dow Jones Industrial Average increased 612.12 points to end at 17,084.49, and the S&P 500 added 63.53 points to close at 2,014.89.

Year to date, and exclusive of any dividends, the NASDAQ Composite has gained 1.95%, the Dow Jones Industrial Average has declined 4.32%, and the S&P 500 has fallen 2.18%.  The national average 30-year mortgage rate increased to 3.89% from 3.77% while the 15-year mortgage rate increased to 3.16% from 3.06%.  The 5/1 ARM mortgage rate increased to 2.95% from 2.91%.  FHA 30-year rates increased to 3.50% from 3.40% while Jumbo 30-year rates increased to 3.68% from 3.55%.

 Mortgage Rate Forecast with Chart

For the week, the FNMA 30-year 3.5% coupon bond ($104.31, -28.1 bp) traded within a narrower 42 basis point range between a weekly intraday high of 104.59 and a weekly intraday low of $104.17 before closing at $104.31 on Friday.

The week’s trading demonstrated market indecision among traders.  The bond is slowly trending lower to test support at the 200-day moving average at $104.14.  The slide lower this week is also reflected in a gradually lower trending slow stochastic oscillator that remains “overbought.”

Technical signals continue to show weakness suggesting a test of key support.  Should a breach of this support level take place, we would see slightly higher mortgage rates.  However, a bounce higher off of this support level would likely lead to marginally improved mortgage rates.


Economic Calendar – for the Week of October 12

The economic calendar strengthens this coming week with a greater number of reports having a potential market impact.  Economic reports having the greatest potential impact on the financial markets this coming week are highlighted in bold.



Road Signs – Chip-enabled cards may curb fraud, but consumers will be picking up the tab

By Benjamin Dean, Fellow for Internet Governance and Cyber-security, School of International and Public Affairs, Columbia University

Most of us have by now received new credit cards in the mail embedded with “EMV” (Europay-MasterCard-Visa) chips.  Merchants across the country have been hastily investing large amounts of money in new EMV-compliant terminals.

This is because October 1 marks the moment that retailers become liable for fraud that occurs in their stores if they haven’t upgraded their old credit card readers to the new payments standard – an inducement intended to hurry along the transition.

This shift is commonly thought to be speeding us toward a more secure and less fraudulent future.  But who really benefits – and who bears the costs – of this step in the transition to a cashless society is not as clear cut as it seems.

 EMV comes to America, almost

EMV is a standard for payment cards and terminals in which the data are stored on integrated circuits (the chip) rather than on a magnetic stripe.  In most countries that have adopted EMV, a personal identification number (PIN) is used to verify payment rather than a signature.  For the time being, a less-secure signature will be used in the US.  With compatible terminals, they also allow contactless payments (through so-called near-field communication), which require no authentication up to a certain monetary limit.

The technology is not new.  France was one of the earliest adopters of the standard way back in 1992 and since then, over 200 countries have joined in.  The United States has been very late to the party, but it’s finally making the switch.


EMV adoption has swept across much of the globe, except in the US.

A key milestone in this transition is occurring today: the liability shift.

From today onward, the liability for fraud committed at the point of sale (POS) on a non-EMV compliant terminal will no longer be borne by the card issuer but, instead, by the merchant.  One estimate puts the total cost for the EMV rollout at US$8.65 billion.  The very strong financial incentive of shifted liability is why merchants are willing to adopt the terminals at such great expense.

 An imperfect security upgrade

EMV-enabled payments are supposed to reduce fraud due to certain security features.  In some countries, they do away with the signature-based method of authentication in favor of a PIN code.  The merchants do not retain the PIN entered at the point of sale by the consumer.  They use cryptographic algorithms to authenticate the cardholder and transaction.

As with any security system, EMV is a long way from perfect.  A number of different ways to hack EMV have been known for some time.

Researchers at the University of Cambridge, for example, have shown that the card-reader terminals can be hacked to accept any PIN the criminal inputs.  In a practice called ATM-skimming, thieves can install a fake PIN pad on an ATM to trick consumers into providing card information, including their PIN, which can then be used to commit fraud.

The near-field communications (NFC) feature allows card users to pay by tapping their card against a reader.  The unencrypted card number and expiration date, which emit from the chip, can be intercepted with a remote RFID device and subsequently used to commit fraud.  It’s a bit like pickpocketing in the digital age.

Given the enormous cost of this transition, and the imperfect security of EMV, we need to ask: how large are the benefits from EMV in terms of curbing fraud?

 A race to the bottom

Evidence from other countries suggests that card-present fraud (face-to-face transactions) goes down following EMV adoption, as the charts below on the UK and the Single Euro Payments Area (SEPA) show.

However, the graphs also show a “race to the bottom” as fraudsters migrate to cross-border and “card-not-present” fraud (via the internet, phone or mail), considered much easier because EMV’s security measures, like entering a PIN, don’t work online.  For an idea of the scale, in the SEPA, 66% of all fraud resulted from card-not-present payments in 2013, compared with just 46% in 2008.



This broad pattern has been repeated in almost all developed EMV markets, including Australia and Canada.

So if EMV has proven to be an imperfect standard and merely migrates fraud from one category to another, why then push to adopt it at such an enormous cost?

 Who gains from EMV

Card issuers and banks will benefit from a likely drop in card-present fraud of 15% to 35% over the next three years if the pattern of declines in other countries following the switch holds.  Considering that such fraud was $2.2 billion in 2012, savings could be $342 million to $797 million a year.

This may be offset by the shift in fraud to card-not-present payments, which increased 40% to 100% in the three years following EMV implementation in Australia, Canada and the UK.  Such fraud in the US was $1.6 billion in 2012, so we could see anything from $624 million to $1.6 billion more in the next few years.  Given that the fraud is simply reallocated from card-present transactions though, a lower-bound estimate of $624 million is the more likely outcome.

Who will pay the price for this increased card-not-present fraud?  The onus is on the card issuer or bank to prove that the merchant did not take the necessary measures to secure the transaction.

But to meet this standard, merchants will have to implement an additional layer of security, at an indirect cost to sales, provided by the payment service providers, called a 3D Secure protocol program.  If a fraudulent card-not-present transaction gets through that, the issuer or bank carries the liability.

For all the billions of dollars in additional security investment, overall fraud levels will likely remain pretty stable.  So why are we doing it?

 The fraud sideshow

A deeper look reveals an interesting aspect to the card payments industry.  For all the attention paid to rising fraud losses borne by banks, it turns out we already cover the cost, as consumers, with or without EMV.

An “interchange fee” is imposed on every transaction that takes place with a card, typically 1% to 2%, and is used to cover fraud losses, reward programs and other processing costs.  Merchants pay the fee, but typically pass it on to consumers in the form of higher prices.

A rough estimate places total interchange fee revenue at $45 billion to $90 billion in the US in 2012 (based on the $4.5 trillion in debit, credit and prepaid card transactions that year).  For comparison, total fraud, across all categories, in the US was $6.4 billion – about a tenth of the fee revenue.

So why are merchants (in effect, consumers) paying billions of dollars to shift to a new card standard when they are already forking over tens of billions to issuers and banks to cover the costs of fraud?  Add to that, the total amount of fraud following EMV basically stays the same.

It’s particularly odd, given the operating margins of MasterCard and Visa hover around 54% and 65%, respectively, suggesting they have plenty of breathing room to make this hefty investment in fraud-prevention themselves.

In other countries, interchange fees were cut to encourage merchants to adopt EMV terminals.  But thus far, this doesn’t appear to be happening in the US.  And since two companies, Visa and MasterCard, control 75% of the market, there’s little incentive for them to cut this lucrative revenue stream.

 Questions for our brave new digital world

While the convenience of technological advances like electronic payments, and security from standards like EMV, cannot be denied, it’s important that we give thought to – and are properly informed of – the price that we pay.

The upgrade to EMV and its touted benefits, including reduced fraud, are not as compelling as we’re led to believe.  In the end, the cost for this upgrade is being footed by merchants and, ultimately, consumers, through opaque fees and higher prices, while the limited benefits accrue to the card issuers and banks.

The EMV transition costs – and the interchange fee – hint at the problem of information asymmetry – banks and card issuers know more than we do – which allows one party to take advantage of the other.  This information asymmetry is typical of the complex and bewildering technical changes that, ironically, characterize the “information age.”  So when you’re at the cash register, about to slip your chip-enabled card into the new reader, think about the costs and benefits of this new technology and ask yourself: is it worth it?