[Posted: 9:30 AM EDT] It’s employment Friday! We cover the data in detail below, but the quick take is that it was a blowout report. Payrolls were well above forecast and the unemployment rate fell to its lowest level since December 1969. Here is what we are watching:
Moore out: Stephen Moore is no longer in the running for a Fed governor seat. The official line is that he withdrew.[1] Moore has made a number of controversial statements that ended up dooming his chances.[2] To some extent, the president is pressing the boundaries of who he can nominate for these positions. What lesson may have been learned? Try to meet your goal with candidates that are less divisive. We still think Larry Kudlow will be the next to be “run up the flagpole.” His views are similar to Moore’s but Larry has the reputation of being a genuinely nice guy.[3] The president could also appoint a committed dove to the FOMC, such as Minneapolis FRB President Kashkari or St. Louis FRB President Bullard, and get the same policy outcome without the controversy. If the president continues to seek out difficult candidates, it suggests he sees some value in the battle and is less concerned about getting doves for the last two open spots.
European inflation: Eurozone inflation rose more than forecast, up 1.7%, which was good news, although the data may have been distorted by the late Easter holiday. Core CPI also rose.[4]
Low inflation has weakened the ECB’s ability to stimulate the economy through rate cuts, so the central bank will welcome this rise.
U.K. local elections: As expected, the Tories took a beating in local council elections.[5] Interestingly enough, so did Labour. The Liberal-Democrats, a center-left party, had the best showing. These elections have the tenor of a protest vote, which probably means they don’t really tell us much about the path of national politics.
Politics and money: A couple of articles caught our attention. First, Silicon Valley is finding the flow of cash impeded a bit by the Treasury department, which is vetting inflows from China and Saudi Arabia.[6] Second, the Chamber of Commerce, a bastion of the GOP establishment, is finding itself on the outs with the White House.[7] As the GOP becomes more populist, establishment bodies, like the Chamber and the Koch brothers’ Americans for Prosperity, have seen their influence wane.
A German at the ECB? Jens Weidmann has been a controversial candidate for the ECB. His nationality is an issue; the rest of Europe, but especially the southern nations, are worried that a German at the helm will turn the ECB into the Bundesbank. In addition, Weidmann has been a critic of the extraordinary measures adopted by Draghi. Over the past couple of years his star has risen and fallen, but it appears the Merkel government is pushing for Weidmann to get the nod. Today, European Commission President Juncker, who is near the end of his term, has signaled he would support Weidmann.[8] We would expect a more hawkish bank if Weidmann does become ECB president, which would be bullish for the EUR.
Japan and consumption taxes:Japan used an investment-led development model after WWII. The model generated domestic saving by suppressing household consumption. Part of that effort was national consumption taxes. This method of taxation was appropriate for Japan’s development period, but that ended in 1990 and the inability to adapt to the post-development era has led to over three decades of economic stagnation. The Abe government has been proposing to increase the consumption tax to 10% from 8% to address a huge fiscal deficit. However, it has delayed the move twice due to economic conditions, once in 2014 and again in 2016. Policymakers are indicating they will raise rates this year.[9] In the past, such increases have undermined Japan’s growth; we would expect a negative reaction again if the country makes good on an increase this year.
[3] A couple of observations. First, (Bill speaking here) I have been interviewed by Larry Kudlow on CNBC. Although I don’t necessarily share his views on the economy, he was a fair questioner and allowed my viewpoints to be expressed. Second, he usually goes on Bloomberg with Jonathan Ferro after the labor or GDP data are released. While they do spar, it is done with respect and Kudlow goes to great lengths to make his point but in a fair manner.
[Posted: 9:30 AM EDT] Some markets, notably China and Japan, remain closed for May Day. Here is what we are watching:
The Fed: As expected, the FOMC left rates unchanged. The statement acknowledged the pickup in economic growth but tempered that positive comment by indicating that household spending and business investment had weakened. It also noted low inflation. The Fed did act to lower the IOER rate from 2.40% to 2.35%, as expected, leaving the policy range unchanged at 2.25% to 2.50%.[1] The fed funds rate had moved above 2.45% so the IOER rate was lowered. Initially, the lowering of the IOER rate was taken as dovish. However, Chair Powell specified that this action wasn’t a policy move and described it as “technical,” and financial markets reversed the dovish take. Essentially, not much happened but the financial markets misread the IOER cut as a precursor for easing; Chair Powell put that idea to rest and the dovish position reversed. A second factor weighed on sentiment when the chair characterized recent low inflation as “transitory.” Low inflation was mentioned and has been discussed among some members of the FOMC as a potential problem that may require easing. Powell’s characterization of low inflation as transitory seemed to contradict those concerns.
Powell indicated that the Fed is on hold. He said the Fed could just as easily ease as tighten, which is a very good definition of neutral policy. Financial markets continue to signal that the next move should be a rate cut.
The chart on the left shows the implied three-month LIBOR rate from the Eurodollar futures for the contract two years in the future. Note that the rate has declined from over 3.30% last October to 2.16% now, a significant decline. The chart on the right compares this implied rate to the fed funds target. We have placed vertical lines when the two rates invert. When these two rates invert, it signals that the Fed needs to start easing to avoid a recession. With the rate inversion in February, which has persisted, these charts would argue for an “insurance” rate cut as recently discussed by Vice Chair Clarida. Thus, Powell’s description that policy is at neutral, meaning the FOMC could move rates in either direction, doesn’t fit the financial market’s position. Without a rate rise in the short end of the yield curve, the most likely next move is for lower rates, unless the Fed is determined to trigger a recession.
By the way, for those of you keeping score at home, here is the S&P on the dates of Chair Powell’s press conferences.
In seven meetings with press conferences, six had negative closes. We think the Fed’s policy transparency is a terrible mistake; policy functioned much better when little was said.
This chart shows the Chicago FRB National Financial Conditions Index, which is a reading of financial stress, and fed funds. From 1973 to mid-1998, the two series were highly correlated. Since then, they are virtually uncorrelated. The Fed began to slowly increase the level of transparency beginning in the mid-1990s. By mid-1998, we were getting statements and regular comments from FOMC members. During the period of relative opaqueness, financial stress was a force multiplier for the Fed, so raising or lowering rates had a dramatic impact on financial market behavior. Thus, tightening tended to reduce borrowing and raise the cost of risk, and lowering rates had the opposite effect. By increasing transparency, allowing market participants to accurately assess the direction of policy, the Fed’s ability to affect financial conditions has essentially been lost. So, when the Fed tightens it does little to inhibit risk activity, and easing does little to encourage risk-taking.
Powell’s decision to increase the number of press conferences is a good example of this problem. As the above table shows, the chair seems to have a remarkable ability to bring lower equity values. Now, if this is his goal, he should be commended. But, we doubt that is the case; instead, we suspect he is trying to sound “reasonable,” which gives a muddled picture and leads to selloffs. If the FOMC position on low inflation is transitory, then why have a meeting in June to discuss changing inflation targeting? On Friday, NY FRB President Williams and Vice Chair Clarida will give speeches. We will be watching to see if these two essentially walk back Powell’s comments. If they do, it would suggest the chair misspoke.
U.K. elections and other things: The U.K. is holding local elections today. The Tories are expected to take a drubbing, although the U.K. Independence Party isn’t competing which may limit the damage.[2] Turmoil continues within May’s government; she sacked her defense minister overnight, blaming him for the leak around Huawei (CNY 4.02, +0.17).[3] It appears PM May is leaning toward a customs union with the EU, the position supported by Labour, as a way of avoiding a hard Brexit. If she can gather enough supporters in the opposition, she might be able to close a deal soon.[4] However, there is a wild card in this idea. There is a sizeable number of hard Brexit supporters within Labour that may put Corbyn’s leadership at risk if he supports such an arrangement. The downside of a customs union is that it would prevent the U.K. from making its own free trade agreements, at least on goods trade, with other nations. The Bank of England (BoE), as expected, left policy unchanged. However, its comments struck a decidedly hawkish position, indicating that rate hikes will be needed in the future to offset stronger economic growth. Although the tone was hawkish, it is clear the BoE is in no hurry to tighten policy.[5]
Venezuela: It still isn’t exactly clear what happened this week. It does appear that Guaido thought he had splintered the security forces enough to unseat Maduro. It also seems that administration officials thought so, too.[6] Clearly, that plan didn’t work out. But, if the action failed (we would not call it a coup because there is a case to be made that Guaido is the legitimate leader of Venezuela), then why didn’t Maduro arrest Guaido? It is possible Maduro has concluded that he doesn’t have the power or the skill to return Venezuela to prior prosperity. Therefore, he wants to leave but the Russians[7] and Cubans have “convinced” him to stay.[8] There are reports of negotiations between the opposition and the regime.[9] Meanwhile, Guaido is trying to maintain momentum after what appears to be a significant disappointment.[10] Protests continue with no end in sight.[11] If Maduro were to exit, we would likely see a correction in oil prices. For now, Maduro is hanging on but we wonder whether he actually wants to stay. One possible outcome—Russia, Cuba and China could remove Maduro and replace him with another member of the regime, perhaps a military figure, that would protect their position in the country and defuse the protests and the opposition. Such an outcome would put the U.S. in a difficult position—would the administration support the new government or take steps to oust it? Although there are elements in the administration and GOP who would support a military intervention, we think President Trump would be very reluctant to commit troops to Venezuela.
Chinese pork imports and ASF: As African Swine Fever (ASF) decimates the Chinese pork industry, Beijing has taken two actions that perhaps offset each other. Due to continued tensions between Ottawa and Beijing over the arrest of Meng Wanzhou of Huawei, China has been taking steps to punish Canada, including arresting Canadian nationals in China. Today, China announced it was suspending pork imports from two Canadian pork producers,[12] likely another step in its attempts to pressure Canada to release Meng. However, this action by China risks driving up pork prices further, so why target this industry? Perhaps because China has found alternative sources for pork in Argentina.[13]
Capital flight: One position we have held for some time is that if the U.S. does back away from its hegemonic role, world stability would suffer and the wealthy worldwide would be looking for an “escape portal” to protect their wealth and person. We have contended that the U.S. would be a prime destination for this capital flight. The U.S. has deep financial markets and a stable legal system, making it a good place to land if one’s homeland turns hostile. Recent data suggest an increase in “wealth migration” last year, with the U.S. seeing some of that flow.[14]
Europe and LNG: U.S. LNG exports to Europe are surging, up 272% over the past year.[15] The exports began to rise in the wake of meetings between President Trump and President Juncker last summer. The chart below shows how shipments have jumped after the meeting. It appears the EU may be using LNG as a potential bargaining chip in upcoming trade talks.[16]
U.S. natural gas prices have been depressed due to the high associated gas production tied to surging U.S. oil output. But, expanding LNG exports could reduce this supply overhang and eventually lift prices.
Energy update: Crude oil inventories rose 9.9 mb last week compared to the forecast rise of 1.8 mb.
In the details, refining activity expectedly fell 0.9% compared to the 0.5% increase forecast. Estimated U.S. production rose slightly by 0.1 mbpd to 12.3 mbpd, a new record. Crude oil imports rose 0.2 mbpd, while exports fell 0.1 mbpd.
(Sources: DOE, CIM)
This is the seasonal pattern chart for commercial crude oil inventories. We are entering the spring/summer withdrawal season next week, so if inventories continue their rise it will become a significant bearish factor for prices. The recent upswing in inventories is remarkable; stockpiles have increased 30 mb over the past six weeks. Although we did not achieve seasonal parity with regard to inventories, the gap clearly narrowed.
Based on oil inventories alone, fair value for crude oil is $50.83. Based on the EUR, fair value is $51.96. Using both independent variables, a more complete way of looking at the data, fair value is $50.55. This is one of those circumstances when the combined model fair value does not lie between the two single-variable models. Current prices are running well above fair value. Geopolitical risks, including the turmoil in Libya, continued problems in Iraq, unrest in Venezuela and the end of Iranian oil export waivers, are all lifting prices. However, our data does suggest that the markets are getting a bit rich so any evidence that these situations are improving will likely lead to at least a period of consolidation, if not a pullback, in prices.
[Posted: 9:30 AM EDT] Happy May Day, the international Labor Day! It’s also Fed day. Here is what we are watching:
The Fed: The president continues to press the FOMC to cut rates.[1] So far, his demands have not had much effect, although we can make a cogent case that the financial markets are clearly signaling that a rate cut would be justified. It appears support for Stephen Moore is deteriorating in the Senate.[2] Although Moore is well-connected in the GOP, he has apparently made some enemies along the way and his comments about women are turning out to be rather damning to his support. Moore may fail to get nominated, but we still expect Trump to put doves in the two remaining governor positions. We still would not be surprised to see Larry Kudlow get the nod.
As far as today’s meeting goes, there is little chance of a rate move but we might see some technical adjustments to free up reserves in the banking system. We expect Powell to deal with questions about falling inflation in the press conference, but he should be able to deflect these to the early June meeting when policymakers are going to discuss changing the inflation target.
The mess in Venezuela: Yesterday, Juan Guaido called on the military to revolt against the Maduro regime.[3] It had the look of a staged event;[4] in other words, Guaido seemed to have gotten some assurances that there was support for an overthrow,[5] otherwise his actions bordered on treason. There are lots of reports in the media, which are difficult to substantiate, saying that a coup was indeed in place but Guaido may have moved prematurely.[6] In any case, as the dust clears, Maduro is still in office and Guaido’s position appears even shakier. Maduro supporters have violently pushed back against the opposition.[7] Although Guaido continues to call for protests, it looks like the bulk of the military are remaining loyal to the regime.[8] The situation remains fluid but Maduro seems to have more staying power than Washington expected. As long as turmoil continues, it will be a supportive factor for oil prices.
China trade deal:There are reports that the U.S. has watered down its demands for preventing Chinese cybertheft in order to get a deal finished.[9] We continue to closely watch USTR Lighthizer. His longstanding goal was to address China’s trade practices but we would expect him to resign if he is forced to negotiate a deal that he opposes. If he does, it might reduce the otherwise positive impact that an agreement would bring.
[Posted: 9:30 AM EDT] As we bid goodbye to April, there’s a new emperor in Japan and the IS leader re-emerges. China’s PMI data (see below) came in a bit light.[1] On the other hand, Europe’s GDP came in better than expected.[2] Here is what we are watching:
Spanish elections, some thoughts: The center-left has struggled in Europe recently, so the improved fortunes in Spain have raised some hopes of a recovery. Here is what we noticed. First, a key factor in the Socialists’ resurgence was a fracture on the right. The center-right lost votes to Vox, the hard-right anti-immigrant party.[3] Centrist parties have struggled with the rise of populism in recent years; for example, in Germany, the AfD has made strides against the CDU and has been pulling the CDU in a rightward direction. The Popular Party in Spain tried to hold on by moving to the right but the gambit failed. The Socialists were better able to maintain solidarity, mostly by suggesting that not voting for the center-left was implicit support for Vox.[4] The problem is that this outcome was probably unique to Spain and may have been an accident of timing and may not be repeatable. In other words, there doesn’t appear to be anything magical about what Sanchez did to win; he may have simply gotten lucky. Second, Sanchez did offer a more leftist platform, calling for a reversal of austerity and a higher minimum wage. So, in essence, his win was due to the right fracturing and a shift to more populist positions. Without the first, the second probably wouldn’t have mattered.
The return of Baghdadi: The leader of Islamic State (which, in reality, no longer exists) was seen in a video released by the group yesterday. This is the first time in five years that he has been seen in this format. Although there have been rumors of his demise, he appears to be on this side of the earthly pale.[5] IS has lost its caliphate, but it is rapidly becoming a global terrorist organization, similar to al Qaeda.[6] This will require different tactics compared to attacking a specific land target; look for the same strategies that were used against al Qaeda to be applied here, such as tracking money flows and counterterrorist activities.
Infrastructure? Senate Minority Leader Schumer and Speaker Pelosi are scheduled to meet with President Trump to discuss infrastructure.[7] Although infrastructure spending is attractive in the abstract, we haven’t seen much action on this issue because the two parties are divided on their methods of achieving public investment. Initially, the administration wanted public/private partnerships to fund infrastructure spending. Unfortunately, opportunities for large projects with such mechanisms are limited because a steady stream of revenue must be generated in order for them to work. Much of public investment does not generate direct cash flows. President Trump is said to favor direct public investment as do Pelosi and Schumer.[8] However, the latter want to force the president to raise taxes to fund the project, which is a non-starter as 2020 looms. In addition, Trump’s position is at odds with GOP legislators, who want to spend less, not more, especially with the debt ceiling looming in the fall.[9] So, we expect a lot of media coverage but see little chance of progress.
Oil bounce: Oil prices are lifting today on reports that Saudi Arabia wants to extend production cuts into year-end.[10] Meanwhile, Iran has indicated it will ignore U.S. sanctions and continue to export oil by evading such measures.[11]
A peace accord between Kosovo and Serbia: Two decades after a conflict that led to the separation of Kosovo from Serbia, the two sides are nearing an accord in which the latter will formally recognize the existence of the former.[12] If a deal can be reached, it would create conditions where Serbia could potentially join the EU. It would also mean Serbia no longer blocks Kosovo from joining the UN. Still, a deal isn’t certain. To make it work, there may need to be a swap of land, which is fraught with risk.[13] And, Russia would not be keen on Serbia joining the EU and perhaps being pulled from its orbit.
Equities and flows: Although equity markets continue to grind higher, flows from investors continue to move in the opposite direction. Lipper reports that both equity ETFs and mutual funds reported outflows last week, while fixed income enjoyed new flows.[14]
Reflections on serial defaulters:There are some nations that engage in sovereign defaults on a seemingly regular basis. Argentina is the most notable but isn’t alone. Early in my career,[15] I worked as a country risk analyst and had a front row seat to the latter stages of the Latin American debt workout. I was part of a massive debt/equity swap program that saw my commercial bank shed hundreds of millions of non-performing sovereign loans. As the process wound down, I remember thinking that these defaulters would be denied access to the credit markets for decades. Yet, in less than five years, most of them were borrowing again. Although I had chalked up that development to P.T. Barnum’s observation that “a sucker is born every minute,” it turns out there is good reason to invest in the “borrow, default, return” cycle. A recent paper by Josefin Meyer, Carmen Reinhart and Christoph Trebesch supports the idea that it is profitable to lend to serial defaulters.[16] However, as one would expect, such lending carries much higher risk.[17] The trick is to get a return commensurate with the risk, which usually means putting money in the country when it is in its most dire state.
Two weeks ago, we introduced this report with a review of the basics of the reserve currency and the savings identity. This week, we will examine two important historical analogs, the Nixon and Reagan administrations.
#1: The Nixon Analog
As President Nixon prepared for the 1972 presidential campaign, he faced a number of serious problems. First, inflation was increasing.
In 1967, inflation was 2.5%; by mid-1969, it was more than 5.0%. The Federal Reserve acted to quell inflation by raising the fed funds rate to nearly 9.2% by August 1969.
As the chart below shows, the increase in interest rates led to a recession, ending the long economic expansion that began in March 1961. The recession, which ran from December 1969 to November 1970, was not an especially harsh one, but Nixon knew that if he didn’t boost the economy in 1971 his reelection chances would be significantly diminished.
[Posted: 9:30 AM EDT] Happy Monday! It was a cold weekend in the Midwest, with a late April snow for the upper parts of the nation’s midsection. It’s going to be a busy week, with the FOMC meeting and Japan’s Emperor Akihito taking the rare step of abdication tomorrow.[1] Here is what we are watching:
Spanish elections: Pedro Sanchez’s Socialist Party had a good election, a rarity for center-left parties in the West. Although the Socialists will still need to build a coalition government, the party did take 123 of the 350 seats in the Spanish Parliament; that was up from 85 seats in the last government. The center-right opposition Popular Party took 66 seats. The centrist Ciudadanos won 57 seats, and the hard-left Podemos won 42 seats.[2] Vox, the right-wing populist party, took a surprising 24 seats, the best performance for a hard-right party in Spain since 1982.[3] It will still take weeks for Sanchez to form a government, but there isn’t another alternative to a return of his government. The election is supportive for the Eurozone and the EU as it shows that a centrist party can still win elections in the region.
Fed: The FOMC meets this week. There will be talk of an “insurance cut,” a rate reduction to “ensure” the expansion continues. This won’t happen on Wednesday but expect the chair to be noncommittal on this issue in the press conference. There are no dots or new forecasts at this meeting but, consistent with the Fed’s new policy, there will be a press conference. The key issue for the FOMC is falling inflation.[4] Chicago FRB President Evans suggested that inflation around 1.5% could trigger a rate cut.[5] Although the insurance cut and rate reductions due to inflation will likely dominate the discussion, we would not expect a move this week. In fact, with the early June summit on the inflation mandate, we probably won’t see a rate move before that meeting unless the economic data turns decidedly bad or a financial accident occurs.
China trade talks: Talks resume this week in Beijing as negotiators near an agreement.[6] Still, there are difficult issues that remain to be worked out,[7] with enforcement of the agreement one of the areas that remains unresolved.[8] It does appear President Trump and General Secretary Xi are planning a June signing ceremony in the U.S.[9] The financial markets have mostly discounted an agreement with China, although we would not be surprised to see further gains if a deal is completed.
Japan trade talks: Although President Trump has expressed some optimism that a Japan/U.S. trade deal may be coming soon, PM Abe has refused a key component of U.S. demands, an end to agricultural tariffs.[10] Abe faces local elections later this year and giving in on agriculture would put Abe’s party at risk. Paradoxically, Abe did consume a significant amount of political capital to reduce agricultural tariffs as part of TPP. Thus, the other nations in the agreement now have better access to Japan’s agricultural markets compared to the U.S., which refused to join the agreement.[11]
Growing tensions in the South China Sea: The U.S. has put China on notice that it will no longer tolerate aggressive actions at sea by China’s fishing fleet and its coast guard.[12] China has been expanding its power in the region by using these two factors to expand its influence. Traditionally, navies have less aggressive terms of engagement with non-military vessels. China has used this practice to its advantage, using the coast guard and fishing fleet to project power. By putting out this notice, the U.S. Navy is signaling to China that the U.S. will treat fishing vessels and coast guard ships with the same protocol as official Chinese naval vessels. We also note that the U.S. sent two warships through the Taiwan Strait yesterday as a show of force.[13]
Iran oil sanctions: The Trump administration is holding fast to its position on Iranian oil waivers, indicating that a hard stop will be enforced on May 1. In other words, there will be no grace period for winding down transactions with Iran.[14] Meanwhile, President Trump has renewed his call for OPEC to boost production to offset the loss of Iranian crude.[15]
African Swine Fever: There are reports that the deadly African Swine Fever[16] has moved into North Korea.[17] The virus, which does not directly affect humans, is deadly for pigs, with a very high fatality rate. It has already adversely affected China’s massive pork industry and reports indicate it may be in Eastern Europe as well.[18] It hasn’t been reported in the U.S. yet, but agriculture security officials are very concerned about the virus entering North America at some point. The virus is a bearish factor for grains but has sent pork prices soaring.
Is a sacred cow on the block? A decade ago, Germany implemented a fiscal rule that makes it nearly impossible for the country to run fiscal deficits. This decision, coupled with high private sector net saving, has led to Germany running a massive trade surplus. At long last, it appears there may be some cracks developing in support of the fiscal rule.[19] The rule has curtailed public investment and Germany’s infrastructure has suffered over the 10 years it has been in place. Germany needs to bend on this issue. Its economy has become very dependent on exports.
On the above chart, we have put a vertical line representing the onset of the fiscal law. Since implemented, the trade surplus has continued to increase.[20] Germany’s current account surplus represents about 7.5% of its GDP, one of the highest in the world. Expanding its fiscal deficit should reduce that surplus and boost growth for the rest of the Eurozone.
S&P on Italy:Standard and Poor’s left everything unchanged by maintaining the BBB rating on Italy’s sovereign debt along with the negative outlook. So, the good news is that a crisis was averted; the bad news is that nothing has been resolved.
One of the age-old problems of analysis is the problem of correlation versus causality. Correlations simply show the degree of relation; the range runs from -1 (perfectly negative) to +1 (perfectly positive). In any introductory statistics class, the instructor will discuss the difference between relation and causality. Here is an example:
Although it might be possible to concoct a reason why chicken consumption would be related to crude oil imports, in reality, the relationship is spurious.
The advent of cheap computing power has given rise to data mining that allows researchers to scan massive amounts of data and find relations. In fact, some in the tech industry tend to believe that theory is unnecessary—simply find the relationships and assume they will continue. However, without theory, if the relationship breaks down then there is no way of knowing why it fell apart.
This chart has started making the rounds in reports:
This chart shows the 10-year Chinese sovereign yield with the yearly change in the S&P 500 and the MSCI World Index. Casual observation would suggest they are closely related; in fact, the correlation between the Chinese bond yield and the MSCI is 66.7% and 72.1%with the S&P 500. What’s implied is that developed world stock markets are dependent on Chinese yields. One would expect Chinese yields to rise with better growth in China, and this would suggest that foreign economies, and thus their markets, depend on Chinese growth.[1]
Perhaps. But it is also possible that Chinese interest rates are sensitive to world growth; therefore, when the developed world economy does better so does the Chinese economy, and the improvement leads to higher yields in China. In other words, the direction of causality is difficult to ascertain.
Often, relationships such as this occur because of some other, unnamed variable. Consequently, in the above case, all three are related to a fourth variable. Since 2014, for example, Chinese bond yields have been closely correlated to the dollar.
On this chart, the JPM Dollar Index is shown on an inverted scale. When the dollar strengthens, Chinese yields tend to fall; during periods of dollar weakness, the CNY yields rise. Since China tends to manage the CNY/USD rate, it’s plausible that when the dollar weakens China enjoys the benefits of that weakness by allowing the CNY to weaken as well. A weaker currency boosts China’s exports and leads to higher interest rates. And, a weaker dollar tends to support both the above stock indices. Therefore, the dollar’s impact probably explains the relationship between Chinese bond yields and developed market equities.
Finally, one last word of caution. In regression analysis, the dependent variable = intercept + independent variable + error term. The error term, in theory, contains a myriad of variables that we assume, under the majority of circumstances, balance each other out and thus allow for the model to be stable. In reality, the variables not specifically delineated in the error term can emerge and affect the dependent variable; sometimes this occurs only for a short time but can make forecasting a challenge. Given the short history of the above, it is possible that conditions could change and the relationship completely breaks down. Thus, the moral of the story is that conditions do change and investors need to be cognizant of that fact and try to adjust accordingly. And, one needs to be careful of seemingly clear charts.
[1] Granger causality testing tends to support the idea that Chinese yields drive equity market performance. Although statistically sound, Granger causality testing is atheoretical and thus not necessarily causal.
[Posted: 9:30 AM EDT] It’s GDP day! We cover the numbers in detail below, but our quick take is that the data was much stronger than expected, coming in at 3.2%, well above the +2.3% forecast. Here is what we are watching:
Disappointing Japan: Although inflation was modestly higher than expected, the decline in industrial production was unsettling.
This chart shows the yearly change in industrial production. The gray bars indicate recessions in Japan. Although March’s decline of -4.6% isn’t necessarily a clear signal of an impending downturn in Japan, any further weakness increases the odds that the country is entering a downturn.
S&P on Italy: Standard and Poor’s is expected to issue an update on its BBB rating on Italy’s sovereign debt. In October, the rating agency maintained this rating, just above “junk,” but also indicated it had a negative outlook for the country. Although we would be surprised to see S&P cut Italy below investment grade, such an action isn’t out of the question and would lead to significant market turmoil.[1]
Weaker global trade: Global trade volumes fell at their fastest pace since May 2009, when the world economy was still reeling from the global financial crisis. The current downturn reflects weak global growth but also rising trade tensions.[2]
Spanish elections: Spain’s voters go to the polls on Sunday for what will likely be an inconclusive election.[3] Although the current PM, Pedro Sanchez, is expected to remain in power, it may take weeks of coalition-building before a government will form. Until recently, Spain was a stable two-party system, with a center-left and center-right party holding court. But, this stability has fractured over separatism (Catalonia, Basque) and economic issues.[4] All eyes will be on a newly emerged hard-right party, Vox, which has been rising in the polls. Vox is expected to receive around 10% of the vote.[5]
China trade talks: There are numerous reports that President Trump and Chairman Xi are planning to meet soon to finalize a trade agreement.[6] Chairman Xi is expected to travel to the U.S. for the signing ceremony. China has been worried about last-minute changes to the agreement at the time the leaders meet, so we expect the meeting won’t take place without solid guarantees that such changes won’t occur.
OBR: Chairman Xi promised that “one belt, one road” financing will be less onerous in the future and that corruption concerns will be addressed.[7] The plan is also looking for financing from third parties, suggesting that China may be having second thoughts about the credit risk it is undertaking.
Brexit: Talks with Labour are apparently going nowhere and PM May has pulled her exit program from a vote.[8] It looks like the U.K. will still be part of the EU for the upcoming European Parliament elections next month, much to the chagrin of all involved. Although we don’t expect anything to happen in the near term, it is looking increasingly as if all parties will drift into October without a deal and a hard break is becoming more likely.
Japan and monetary policy: Treasury Secretary Mnuchin has made it a point during trade negotiations to include restrictions on currency depreciation. His concerns are well founded—one of the reasons that tariffs became less common was that in a floating currency environment countries could easily offset the impact of tariffs through currency depreciation. Comments about a return to the gold standard by some Fed governor candidates is, in part, tied to this issue. Therefore, we noticed with interest that Japan’s Finance Minister, Taro Aso, indicated Japan would not consider tying monetary policy to current trade discussions.
There was a seemingly unspoken arrangement among central bankers that unorthodox monetary policy, e.g., negative rates, zero rates, quantitative easing, would only be tolerated if the express purpose was for domestic economic support but not for competitive depreciation. In reality, those practices tended to bring currency weakness.
Since 2010, the dollar was tightly correlated with the yearly change in the Fed’s balance sheet. During QE, there was widespread criticism of the practice, especially by emerging economy central bankers, fearing the U.S. was forcing adjustment on their economies through the weaker dollar.
Taro’s comment is important; if the U.S. begins to press foreign nations to abandon unconventional monetary practices due to their effects on foreign exchange, it will severely restrict these nations’ abilities to conduct independent monetary policy. Of course, the whole point of the gold standard was to place some degree of restriction on the actions of central bankers and governments. That’s why we don’t expect a return to such a program, and it should be noted that returning to a gold standard would, at some point, lead to deflation.
We expect the Trump administration to eventually realize that the most important tool it has available is a weaker dollar. Such a deliberate policy would likely need some degree of Fed cooperation but, given how aggressive the president has been with the Fed, cooperation could likely be delivered. Like Reagan in his first term, there was a seeming problem with the idea of “weakness” in any policy; however, as we saw with the Plaza Accord in the second term, policy can change. If the goal is reflation, a weaker dollar is a useful tool.
Crypto in trouble: The NY attorney general has made allegations against two firms, Tether and Bitfinex, alleging they participated in a cover-up to hide losses up to $850 mm. Both firms have been under scrutiny for some time but if the legal process moves forward then it will likely undermine the entire cryptocurrency complex.[9]
[Posted: 9:30 AM EDT] It’s another mostly quiet morning as a plethora of earnings are released. Here is what we are watching:
South Korea goes negative: Real GDP slipped into negative territory in Q1.
Weak investment spending led to the unexpected slowdown. Although exports were weak, on a net basis, they were offset by soft imports as well. The decline in South Korean growth is further evidence of a global slowdown.
Central bank news: The BOJ left policy unchanged[1] despite lowering growth and inflation forecasts for 2020. Its primary response to the downgrade was forward guidance, indicating it would not consider raising rates until next year. At the same time, Governor Kuroda signaled that no new stimulus measures would be considered. The PBOC indicated that policy is on hold, responding to speculation that additional easing is coming.[2] The BOE is beginning the process of selecting a new governor.[3] Carney will be leaving his post next February. Carney has been controversial, angering Brexit supporters by forecasting an economic downturn if the U.K. leaves the EU without a trade arrangement. Although not in today’s news, ECB President Draghi will leave office in the fall and we expect that EU leaders will announce his successor in June. From a market perspective, the key is “anyone other than Jens Weidmann” of the Bundesbank. Weidmann is considered an extreme hawk and would be less likely to support unconventional policy if the Eurozone runs into debt issues.[4] If he gets the nod (and Berlin is thought to be supporting him in this role) we would expect at least a temporary jump in the EUR.
OBR: The “one belt, one road” foreign investment program (or, as we like to refer to it, “the Chinese imperial project”) is holding meetings in Beijing at the Belt and Road Forum. Dozens of nations have sent representatives to the meeting, indicating the interest in gaining access to Chinese infrastructure funding. China is taking steps at this meeting to address criticism that the projects saddle countries with high debt.[5] The U.S. has not moved strongly against the project yet, but it clearly has the attention of Washington.
Turkey: The central bank dropped references to further policy tightening and admitted that currency reserves fell $1.8 bn last week. Although official foreign reserves are $26.9 bn, if drawn swap lines are removed, reserves are closer to $14.9 bn. In February, Turkey’s goods and services imports were around $16 bn, so Turkey is in a precarious position without swaps. At the same time, it’s important to note that Turkey sits in a geopolitically sensitive area. It can likely “encourage” EU support by “discussing” the flow of refugees, and can play the West off Russian or Iranian influence. We are always worried that Erdogan will overplay his leverage but that doesn’t mean the leverage doesn’t exist.
Argentina: Unlike Turkey, Argentina sits at the end of the world. It isn’t geopolitically important and thus has to fend for itself. Borrowing costs have jumped and credit default swaps have reached 1200 bps, making it the world’s second most risky sovereign borrower (with Venezuela in the top spot). Remember that century bond issued in 2017?[6] It’s trading at 70 cents to the dollar.[7] The Macri government announced a price freeze on 60 items in a bid to bring inflation under control. Spooking investors are the looming elections on October 27 and the increasing likelihood that the infamous Kirchners will return to power. The latest polls indicate that Cristina Kirchner holds a four-point lead over the incumbent. The Argentine peso has been under pressure.
Brexit: The leadership challenge against PM May failed.[8] There is no evidence of progress on talks with Labour. However, a major looming threat did emerge to the U.K. as Scotland’s First Minister Sturgeon indicated she will take steps to hold another referendum on leaving the U.K. if Brexit occurs.[9] We suspect this one might pass.
Putin’s trash problem: The late congressional leader Tip O’Neill was credited with the quote that “all politics is local.” No matter how powerful the office, basic public goods must be provided by officeholders. Mayors in major U.S. cities have lost elections over potholes and snow removal. In Russia, protests have broken out against the creation and expansion of open-air landfills, which are estimated to be four times the size of the island of Cyprus.[10] Although we doubt this will bring down the government, as noted above, other politicians have fallen from power for less.
GDP: The first report of Q1 GDP will be released tomorrow. Here is the Atlanta Fed estimate.
The current forecast is for 2.8% growth. The Bloomberg consensus is for 2.2% growth. Here are the Atlanta FRB’s contributions to growth estimates. Inventory rebuilding and improved net exports have lifted their growth estimates over the quarter.
Energy update: Crude oil inventories rose 5.5 mb last week compared to the forecast rise of 0.5 mb.
In the details, refining activity jumped 2.4%, well above the 0.9% increase that was forecast. Estimated U.S. production rose slightly by 0.1 mbpd to 12.2 mbpd. Crude oil imports surged 1.2 mbpd, while exports rose 0.3 mbpd.
(Sources: DOE, CIM)
This is the seasonal pattern chart for commercial crude oil inventories. We are nearing the end of the spring build season and will probably not achieve average, although the gap has narrowed significantly in recent weeks.
Refinery activity recovered strongly this week.
(Sources: DOE, CIM)
Had it not been for the rise in imports, we would have likely seen a decline in inventory levels.
Based on oil inventories alone, fair value for crude oil is $53.98. Based on the EUR, fair value is $52.22. Using both independent variables, a more complete way of looking at the data, fair value is $51.91. This is one of those rare circumstances when the combined model fair value does not lie between the estimates from the two single-variable models.
Current prices are running well above fair value. Geopolitical risks, including the unrest in Libya, continued problems in Iraq and the end of Iranian oil export waivers, are lifting prices. However, our data does suggest that the markets are getting a bit rich and evidence that any of these situations are improving will likely lead to at least a period of consolidation, if not a pullback, in prices. We note that some Russian crude oil has been rejected by refineries due to contamination.[11] Given tight supply conditions, such news is important and has lifted prices this morning.
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