by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] There were five news items worth noting overnight:

Carney goes dovish: Last week, the BOE voted to keep policy steady but had three dissenters.  In a speech today, BOE Governor Carney focused on the economic problems that could be triggered by Brexit and suggested it wasn’t time to raise rates.  The GBP fell on his comments.  Britain is rapidly heading to a point where it will be forced to decide which policy problem it will address—inflation or weak growth?  A Dutch economist, Jan Tinbergen, suggested that policymakers need to have an equal number of tools for an equal number of problems.  In other words, if a nation faces weak growth and rising inflation, it needs to address each problem with separate policies.  Usually, in this case, the ideal policy mix would be to use fiscal policy to address weak growth and tighter monetary policy to deal with inflation.  Given the political turmoil in the U.K., the BOE is likely on its own.  Thus, it must decide if it will raise rates to deal with inflation or keep rates low to support the economy.  Carney indicated his choice would be the latter and so the GBP is falling this morning.  It isn’t clear whether the rest of the Monetary Policy Committee will go along with this sentiment.

More Fed hawks than doves: Boston FRB President Rosengren, who has been a reliable dove over the years, gave a fairly hawkish speech in Europe this morning.  He is suggesting that easy monetary policy could be leading to inflated asset markets and, if so, the Fed should raise rates to prevent excessive valuations and the potential market risk such valuations might bring.  Although other FOMC members have made such statements in the past (Jeremy Stein, most notably), such views are not predominant among members because it smacks of setting policy based on asset markets.  Although theoretically defensible, such positions are fraught with political risk.  Alan Greenspan briefly touched this “third rail” once, with his famous speech in 1996 when he coined the phrase “irrational exuberance.”  He faced severe criticism on the idea that the Fed would raise rates because equity valuations were “too high.”  Although we don’t expect Rosengren’s views to sway policy, he is joining others on the FOMC who hold more hawkish views on expectations of higher inflation.  In the end, regardless of viewpoint, the outcome is tighter policy.  We note that NY FRB President Dudley made hawkish comments yesterday as well.  By the way, the WSJ has an article today about the FOMC’s poor record on soft landings.[1]

Special election in Georgia: The state of Georgia is holding a special election to fill the Congressional seat of Tom Price.  This is usually a safe GOP seat (the party has held it for nearly four decades), but the race between Democrat Jon Ossoff and Republican Karen Handel is close.  The Democrats have poured money into this race, suggesting it is a referendum on the Trump administration.  In fact, this has become the most expensive Congressional race in U.S. history.[2]  Ossoff has eschewed the Sanders platform, running as a centrist; it should be noted that Trump narrowly won what is usually a reliable GOP state.  If Ossoff wins, the establishment Democrats will use it to argue that the Sanders/Warren wing doesn’t win elections.  If Handel wins, the hard left will argue that the Democratic centrists can’t win.  Our view is that there will probably be few takeaways regardless of the outcome, although the pundits will try to use the election as a harbinger for 2018.

Otto Warmbier dies: The UVA student who was recently incarcerated by North Korea died yesterday.  Our condolences and prayers go out to his family.  We are in the middle of a two-part examination of the possibilities for war with North Korea.  His passing won’t necessarily increase the odds for war but it does reduce the chances of any sort of negotiated settlement and that, by itself, could lead us into a conflict.

Saudi Navy captures three Iranian Republican Guard Corp troops: The Saudi Navy captured three IRGC members in the Persian Gulf Friday.  The Saudis claim the three were manning a vessel loaded with explosives and headed toward a Saudi offshore oil rig.  The Iranians claim they were civilian fishermen and claim that the Saudis killed one of the Iranians.  We don’t know who is telling the truth here but it is part of a broader trend of rising tensions in the region.  So far, oil prices are clearly unconcerned about these tensions but that position is probably underestimating the potential for supply disruption.

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[1] https://www.wsj.com/articles/the-feds-poor-record-on-soft-landings-1497890842 (paywall)

[2] http://www.politico.com/story/2017/05/06/georgia-special-election-spending-record-238054

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] Global equity markets are rising this morning, although the weekend news was mixed.  Here’s a recap:

Macron dominates in France: Emmanuel Macron, the recently elected president of France, solidified his new government with a solid win, capturing 350 of the 577 seats in the National Assembly.  For a party that didn’t exist before the election, this was a remarkable achievement.  The center-right held 135 seats, representing the opposition.  The Socialists, who had a majority in the previous government, were reduced to a mere 45 seats.  The National Front, led by Le Pen, won only eight seats while the far-left won 17 seats.  It should be noted that the turnout was very low; it isn’t clear if the turnout dropped because voters saw Macron’s win as inevitable and decided to stay away from the polls, or if they were in despair that a good outcome was not possible.  Macron describes his policies as “muscular centrism,” but they look to us like neo-conservative.  He is pushing deregulation and lower taxes.  Although such policies are on shaky ground around the world, France never really had a Thatcher-Reagan revolution and so having one now would not be unusual for France.  Still, we suspect the low turnout reflects more of a rejection of politics in general and, if that is the case, Macron may face more opposition than this vote would indicate.

Syrian warplane shot down: A U.S. F-18 shot down a Syrian military jet that was bombing rebel positions.  These rebels have U.S. support.  Russia indicated this morning that it would now treat U.S. aircraft in the region as hostile.  There has been a concerted effort by the U.S. and Russia to avoid air confrontation but, as IS continues to wither, the war is now shifting away from IS onto the ultimate fate of the Syrian regime.  We note that Iran fired missiles into Syria over the weekend to attack IS in retaliation for the recent terror attack.  We are seeing a clear escalation in this region which is a concern and points to the rising likelihood of a broader conflict.

Apparent terrorism in London: Yesterday, what appeared to be a terror attack occurred in London, this time directed against Muslims.  A vehicle drove into a crowd leaving a mosque.  These attacks serve to further undermine the PM just as talks begin with the EU over Brexit.

Chinese regulators tout commodities: The China Securities Regulatory Commission indicated it will loosen limits on how much commodity exposure commercial banks, insurance companies and pension funds can have.  It isn’t completely obvious why this policy is being proposed but it may be as simple as trying to distract investors from Chinese property markets.  The commission did indicate it wants to see deeper futures markets; perhaps the increased investment exposure would develop those markets but we doubt investment firms would offer a two-way trade.  We will continue to closely monitor commodity markets to see if Chinese flows show up in any meaningful way.

Vancouver real estate woes: Canadian financial regulators are taking a much closer look at residential lending practices as it appears loose collateral rules may be part of the lending boom.  There are reports that some loans may have been made against collateral in China, which would be rather problematic to seize in case of default.  Canada avoided a real estate crisis in 2008 but it may be facing one now.[1]

Where millionaires flee: New World Wealth, a market research firm, has published its most recent report which offers some insight into capital flight.  In 2016, the top five nations with the most fleeing millionaires were France, China, Brazil, India and Turkey.  The favorite destinations for this capital flight were Australia, the U.S., Canada, the UAE and New Zealand.[2]  As global tensions rise, we could see more capital flight in the future.

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[1] http://vancouversun.com/news/local-news/vancouver-real-estate-in-the-red?cn=bWVudGlvbg%3D%3D&cn=cmV0d2VldA%3D%3D

[2] http://www.marketwatch.com/story/this-country-is-no-1-for-millionaire-migrants-and-its-not-the-us-2017-02-27?link=sfmw_tw

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] After a choppy week, financial and commodity markets are rather quiet this morning.  There were a couple of news items of note.  The BOJ, as anticipated, left policy unchanged.  The vote was 7-2, with the two dissenters calling for tighter policy.  However, the two outliers, Takahide Kiuchi and Takehiro Sato, will be leaving the BOJ board after this meeting and will be replaced by allies of Governor Kuroda.  Thus, the governor will face less internal pressure to begin withdrawing stimulus.  The news is modestly bearish for the JPY.

Greece has avoided default by reaching an agreement with its international creditors.  The country will receive €8.5 bn in bailout aid, allowing it to make €7.0 bn in debt repayments.  The primary sticking point was the IMF.  The international lender wants European creditors to give Greece debt relief.  German leaders are loath to do this, especially with elections looming in the fall.  The IMF formally joined the agreement and will contribute €2.0 bn in new loans.  However, the IMF won’t actually disburse the funds until the EU develops a plan for debt relief.  Germany wants IMF participation for two reasons.  First, the Merkel government fears that the EU won’t hold Greece to austerity, and second, the IMF gives the bailout/austerity package an international imprimatur.

In the wake of the FOMC meeting, the deferred Eurodollar futures market was essentially unchanged.  This chart below shows the current pricing for three-month LIBOR in two years.  After the election, the implied rate jumped to levels not seen since 2011 on expectations of fiscal expansion.  However, as those expectations erode, we are seeing expected yields decline.  The fed funds rate implied from the Eurodollar futures suggests only one more rate hike.  The dots plot clearly suggests that policymakers expect to raise rates more than the market expects so there is a danger that policy may become too tight and trigger a recession.

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by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] There were three items dominating the overnight news.  First, the shooting at the GOP baseball practice yesterday continues to reverberate.  We will have more to say about this event in the future but it is further evidence of deep divisions within American society that show no signs of improving.  Second, the BOE followed script and held policy steady.  However, the vote was 5-3, with the dissenters calling for rate hikes.  The strength of dissent caught the markets by surprise; the GBP rallied off its lows (the dollar has been stronger today) and Gilt yields jumped.  Financial markets in Britain have been leaning toward rate cuts.  The high level of dissent suggests that cuts will be difficult.  Third, we are seeing further fallout from yesterday’s FOMC meeting; the dollar is up, gold and equities are lower and Treasury yields, which fell yesterday, are recovering a bit this morning.

The FOMC did as expected, raising rates by 25 bps.  The comments about the economy remain upbeat but the lack of inflation was noted.  The big news was that the balance sheet reduction is expected to start later this year, perhaps as soon as September.  At some point this year, which remains unspecified, the Fed will begin allowing the balance sheet to decline by $10 bn per month, increasing by the same amount every three months until it reaches a maximum decline rate of $50 bn per month within five quarters.  There will be a 60/40 split on Treasury and mortgages, respectively.  We do have concerns about the balance sheet; in theory, since most of QE has been sitting innocuously on commercial bank balance sheets, removing it shouldn’t be a big deal.  In reality, we simply don’t know how the market will react.  If the behavior is symmetrical, it should “double down” on the idea that the Fed is tightening policy.  There was one dissenter, Minneapolis FRB President Kashkari, who wanted to maintain the current rate.

Here are some relevant charts:

This shows the dispersion of the dots chart.  The green line plots the median from yesterday’s meeting, while the gray shows the previous meeting.  There wasn’t any change for the next two years but a modest decline in 2019.  The median does suggest a 2.25% peak rate for next year, with only one more hike forecast this year and at least three hikes would be scheduled for next year.  The market doesn’t expect this pace of hikes.

Here is our average dots chart:

The most recent dot is in red.  The average suggests very little change in projections from the FOMC.  The history of the dots chart is one of a steady decline in projections.  However, for the past several quarters, there has been a stabilization of expectations, suggesting the FOMC is becoming comfortable with its policy path.

With the release of the CPI data and yesterday’s FOMC action, we can upgrade the Mankiw Rule models.  The dip in the core CPI rate (see below) did affect the Mankiw Rule model results.

The Mankiw Rule models attempt to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative.  Mankiw’s model is a variation of the Taylor Rule.  The latter measures the neutral rate using core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy.  Potential GDP cannot be directly observed, only estimated.  To overcome this problem with potential GDP, Mankiw used the unemployment rate as a proxy for economic slack.  We have created four versions of the rule, one that follows the original construction by using the unemployment rate as a measure of slack, a second that uses the employment/population ratio, a third using involuntary part-time workers as a percentage of the total labor force and a fourth using yearly wage growth for non-supervisory workers.

Using the unemployment rate, the neutral rate is now 3.08%.  Using the employment/population ratio, the neutral rate is 0.75%.  Using involuntary part-time employment, the neutral rate is 2.31%.  Using wage growth for non-supervisory workers, the neutral rate is 1.08%.  The labor data is mixed, with the employment/population ratio falling and wage growth stagnant, while the unemployment rate fell and involuntary part-time employment was steady.  The drop in core CPI has led to lower Mankiw neutral rate estimates across the board.

To a great extent, the issue for policymakers remains the proper measure of slack.  The danger for the financial markets is if the proper measure is wage growth or the employment/population ratio but policymakers believe slack is best measured by involuntary part-time employment or the unemployment rate.  If that is their measure, policymakers will likely overtighten and prompt a recession.  For the past couple of years, this issue has been mostly academic.  Regardless of the measurement of slack, policy was generally accommodative.  Now, using either wage growth or the employment/population ratio, monetary policy has achieved neutrality.  If rates are raised as projected by the dots chart, assuming no change in inflation, the policy rate will reach a level consistent with tight policy with another two rate increases.  Thus, we are now entering a more dangerous period for the economy where a policy mistake will matter.

U.S. crude oil inventories fell 1.7 mb compared to market expectations of a 2.3 mb draw.

This chart shows current crude oil inventories, both over the long term and the last decade.  We have added the estimated level of lease stocks to maintain the consistency of the data.  As the chart shows, inventories remain historically high but they are declining.  We also note that, as part of an Obama era agreement, there was a 0.4 mb sale of oil out of the Strategic Petroleum Reserve.  This is part of a $375.4 mm sale (or 8.0 mb) done, in part, to pay for modernization of the SPR facilities.  International agreements require that OECD nations hold 90 days of imports in storage.  Due to falling imports, the current coverage is near 140 days.  Taking that into account, the draw would have been 2.1 mb, which is near forecast.

As the seasonal chart below shows, inventories are usually well into the seasonal withdrawal period.  This year, that process began early.  Although the actual level of stockpiles remains quite high, we have seen rather sharp stock declines until the past two weeks.  We would expect the draws to increase as the recent rise in imports should fade.

Based on inventories alone, oil prices are overvalued with the fair value price of $37.65.  Meanwhile, the EUR/WTI model generates a fair value of $52.56.  Together (which is a more sound methodology), fair value is $48.00, meaning that current prices are well below fair value.  Currently, prices are below our expected trading range; we view oil prices as attractive on a short-term trading basis.

This chart shows the nearest WTI futures price.  We have drawn a box between $45 and $55 per barrel.  Note that since early October, nearly all prices fall within this range.  This range has developed because OPEC’s cuts are being offset by rising U.S., Canadian and Brazilian output, leaving a mostly balanced market.  As the chart shows, prices at this level have been attractive entry points.  Of course, the risk is that we are seeing a downside breakout but we view further weakness as unlikely without strong evidence of OPEC cheating.  Thus, a recovery should develop in the coming weeks.

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by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] There is breaking news at the time of this writing.  A gunman shot at Congressional members and staffers at a baseball practice in suburban Virginia.  The Congressional baseball game is one of the few bipartisan social events in Washington.  Although the situation is evolving, early reports indicate at least five people were shot.  The most notable is Steve Scalise (R-LA), the GOP House Whip, who was reportedly shot in the hip.  Scalise is the third-highest ranking member of the House GOP leadership.  His injuries are not considered life threatening.  Although not confirmed at this time, there are reports the shooter was also shot and has been “neutralized” and is in custody. 

Today is FOMC day.  The Fed concludes its policy meeting with near certainty that the central bank will raise rates.  This is a meeting with a press conference, new economic forecasts and a new dots plot.  We don’t expect the Fed to change the dots plot too much; if so, the last plot implied one more hike this year, assuming a 25 bps hike today.  Although we don’t expect details on shrinking the balance sheet today, we may hear more about that in the press conference.  The FOMC is striving for transparency to preclude adverse market effects.  Fed funds futures put the odds of a hike today at 92.7%.  The odds of an additional hike in September are only 21.7% and, assuming no change until year’s end, a December move is currently priced at 34.3%.  In fact, we don’t get a greater than 50% likelihood of a rate increase until the June 2018 meeting.  Thus, anything suggesting a higher probability of a rate hike this year might be taken as hawkish.

CPI and retail sales for the U.S. came in soft (see below for details); the dollar rolled over on the news and interest rates declined.  Gold prices also rose, but the yellow metal may also be reacting to the aforementioned shooting.

Oil prices are coming under pressure again this morning.  The proximate cause was a report from the American Petroleum Institute (API) that crude oil inventories rose last week.  The API report, based on a non-compulsory survey, comes out the evening before the official data from the DOE.  The two series can disagree but inventory increases this time of year are unusual and thus bearish.  However, on a longer term basis, the International Energy Agency (IEA), a division of the OECD, indicated today that the current inventory overhang will persist this year despite OPEC efforts to cut output.  Rising production from Brazil, the U.S. and Canada are partially offsetting OPEC cuts.  The IEA indicated that OECD stocks of oil rose 18.6 mb in April and are 292 mb above the five-year average.  The IEA estimates that oil stocks won’t fall to their five-year average until March 2018 and this only occurs if OPEC maintains its production constraint.  Industry reports suggest that U.S. production growth will stall the closer oil prices get to $40; although such a drop is possible, we expect a weaker dollar to mitigate downside risk in oil prices.  We will have our usual recap of the oil data in tomorrow’s Daily Comment.

The debt ceiling is a looming threat; as we have noted in earlier reports, the Treasury is suggesting that the government will enter a partial shutdown by the first half of September without action taken to raise the debt ceiling.  This issue has become an inter-party conflict within the GOP as the Freedom Caucus is proposing a $1.5 trillion increase in the ceiling, $1 trillion less than what the White House is requesting.  The lower ceiling would lead to the exhaustion of borrowing capacity soon after the mid-terms.  The White House would like to avoid further drama with a higher ceiling.  We would expect a compromise, although the more entrenched positions become the longer we may go before a deal is reached.  What is significant in this problem is that the battle is occurring within the GOP and highlights divisions within the party.  The debt ceiling could be a further distraction from the president’s agenda and consume precious political capital.

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by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] After a two-day correction in tech stocks, equities are stabilizing this morning.  Although the drop in the popular sector seemed to come out of nowhere, it looks to us like a fairly normal market correction, merely some profit taking.  In a world of ultra-low volatility, such pullbacks are less common and thus receive a lot of media coverage.  However, in the broader context, we haven’t seen anything so far in the decline that looks like it will have “legs.”  That isn’t to say the group isn’t richly priced or a “good buy,” but it also doesn’t mean the recent pullback is the start of a larger market correction.

Bloomberg[1] is reporting that there is evidence of broad election interference by Russia in the 2016 presidential campaign.  There have been scattered reports for weeks of Russian actions but this is the first time we have seen a reputable source indicating that there were Russian cyberattacks on election software in at least 39 states.  Our view on this issue, which the article confirms, is that Russia’s goal wasn’t necessarily to sway the election in either direction but to undermine confidence in the electoral process.  There were worries that these cyberattacks might corrupt voter rolls and lead to spoiled ballots or slow the counting process.  What is particularly worrisome is that there is no unified electoral process in the U.S.  Voting procedures are set at the state and local government levels and the degree of technical sophistication varies widely.  On the other hand, having to attack some 7,000 county voting registration rolls would be a massive task and may not yield the desired results.

Partisan divisions have tended to undermine the legitimacy of presidents since the 2000 election.  From hanging chads to controversies surrounding birth certificates, constant rumors of irregular voting and legislative attempts to increase the legal hurdles for voting, the voting process has become another battleground area in American politics.  Now we can add Russian hacking to the list.

From Russia’s perspective, the goal is to support candidates who want to end the hegemonic role that America has played since WWII.  In the last election, Hillary Clinton represented the establishment policies that would have maintained this role.  President Trump’s campaign slogan made it clear he did not support this policy any longer.  Thus, it would make sense that the Putin regime would support measures to help Trump.  It is probably worth noting that Putin would have likely supported Bernie Sanders as well because his foreign policy positions were similar to Trump’s; neither candidate supported the two major trade deals and Sanders voted against the Iraq War.  Thus, if the race would have been Sanders v. Rubio, for example, Russia would have probably tried to undermine the latter’s campaign.

Meanwhile, Putin is facing his own unrest as protests were held across Russia yesterday.  Reports indicate that events were held in 145 cities across the country.  Security forces in Russia moved quickly to quash the unrest.  It has to be unsettling for the regime that it is mostly young Russians involved in the protests.  We don’t think the regime is in any sort of immediate trouble as these events are not going to drive the Russian president from office.  However, faith in the Russian government rests on the person of Putin; polls show that his approval ratings, which run around 80%, are well above the government’s approval ratings in the low 60%.  To ensure the protests don’t gain momentum, the Kremlin is planning to tap one of its sovereign funds and there are rumors that Putin may sack his long time protégé Dmitry Medvedev, the current PM and former president.  The government is also trying to revive its old patriotic youth movements in an attempt to control the uprising.  Clearly, the regime is concerned about these protests.  We note that the U.S. Senate is considering new sanctions on Russia.

Qatar is apparently running the blockade through Oman.  The current blockade, which shows no signs of easing, continues to divide the region, with Iran and Turkey using the opportunity to support divisions within the Gulf Cooperation Council.  In other Middle East news, the Saudi defense purchase deal is facing opposition in Congress.

The FOMC begins its meeting today, concluding tomorrow.  This is a “presser” meeting so we will get a press conference, new economic forecasts and “dots.”  It is a near certainty that the Fed will raise rates tomorrow.  We will be watching for hints of future policy rates.

The Bank of Canada surprised the markets by signaling a rate hike is in the offing.  The CAD rallied on the news.

Finally, the WSJ[2] is reporting the mortgage issuance industry is “re-learning” how to sell subprime mortgages.  Early in my career (clearly, this is Bill writing), I was part of the process of winding down Latin America’s debt crisis, which ended by debt/equity swaps in the late 1980s.  I remember at the time thinking, “It will be another generation before anyone lends to South America again.”  It took about five years.  The reason is that the previous lenders are usually swept away and find other jobs, and a new group enters without any experience of the pain suffered by the previous generation of lenders.  This WSJ article describes well how this process works.

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[1] https://www.bloomberg.com/politics/articles/2017-06-13/russian-breach-of-39-states-threatens-future-u-s-elections?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top-stories

[2] https://www.wsj.com/articles/does-anyone-remember-how-to-make-a-subprime-mortgage-1497259803?mod=nwsrl_today_s_markets (paywall)