by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Looking for something to read?  In our travels we are often asked about books we recommend.  As a result, we have created The Reading List.  The list is a group of books, separated by category, that we believe are interesting and insightful.  Each book on the list has an associated review to help you decide if you want to read it.  We will be adding to the list over time.  Books marked with a “*” are ones we consider classics and come highly recommended.

We are seeing a sharp flip in financial markets following a higher than expected print in CPI (see below).  Here is what we are watching:

Is Netanyahu in trouble?  The Israeli police have recommended that Israel’s PM, Benjamin Netanyahu, be indicted for the crimes of bribery and fraud.  Although the PM says he will fight the charges, they do appear serious and may derail his political career.  From here, the attorney general must decide if the evidence supporting the recommendation is solid enough to proceed with the indictment.  We expect this process to take several months but, during that time, it will act as a cloud over Israeli politics.

Zuma faces a no-confidence vote: South African President Zuma is facing a showdown in the legislature in the form of a no-confidence vote.  Zuma has so far refused to leave office despite being ordered to do so by his party, the African National Congress.  Zuma has tried to negotiate an exit that would last several months but his party wants him out.  He faces serious corruption charges and could face years of costly litigation if he leaves the presidency.  Thus, we suspect he is trying to make a deal to leave office in return for some sort of amnesty.  The no-confidence vote could force him from office perhaps as soon as tomorrow.  Zuma’s departure is bullish for the ZAR and precious metals.

Mester for vice chair?  Cleveland FRB President Loretta Mester is apparently under consideration for the vice chair position on the Board of Governors.  We rate Mester as a hawk (we put her at a “2” on our 1 to 5 scale, with 1 being most hawkish).  Although the president promised to shake up the Fed, his selections thus far have been rather conventional and this one would also fit into that characterization.  The White House has indicated the president is not close to filling this position and it is clear more candidates are being considered.

Fed policy: With the release of the CPI data we can update the Mankiw models.  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 3.24%.  Using the employment/population ratio, the neutral rate is 0.97%.  Using involuntary part-time employment, the neutral rate is 2.64%.  Using wage growth for non-supervisory workers, the neutral rate is 1.25%.  The rise in core CPI has lifted the various neutral estimates higher but, as we have seen for several months, two of these measures of slack suggest the FOMC has achieved rate neutrality, while two suggest the FOMC is well behind the curve.  We still expect the FOMC to mostly split the difference and end up between 2.25% to 2.50% for the target at the end of this year.  However, the rise in inflation does increase the odds that the hawks on the FOMC will push for continued rate hikes into 2019; in other words, we may see a repeat of the 2004-06 tightening cycle with steady increases in the fed funds target, perhaps with hikes occurring at meetings lacking a press conference.

The CPI data is clearly bearish for equities, as shown by the quick and sharp reversal from higher to lower in this morning’s futures trade.  The usual impact of higher inflation is to lower the P/E multiple, which occurs as interest rates rise.  We are also seeing the dollar lift, although we doubt that can be sustained given the headwinds the fiscal deficit will cause…unless the FOMC finds its “inner Volcker.”  We wouldn’t count on that.  In fact, if monetary tightening worries begin to weigh on equities, expect the president to go “full Nixon” and tweet against Fed tightening.  Instead of Volcker, think Arthur Burns.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Looking for something to read?  In our travels we are often asked about books we recommend.  As a result, we have created The Reading List.  The list is a group of books, separated by category, that we believe are interesting and insightful.  Each book on the list has an associated review to help you decide if you want to read it.  We will be adding to the list over time.  Books marked with a “*” are ones we consider classics and come highly recommended.

Happy Valentine’s Day eve (a gentle reminder to our readers to not forget)!  Equity markets appear to be taking a breather this morning after two strong recovery days.  We expect another few days of “backing and filling” to build a base before a new uptrend develops.  Here is what we are watching this morning:

Was the VIX gamed?  Bloomberg[1] is reporting that the VIX futures were manipulated by a form of order “spoofing,” where an entity places S&P futures option orders that they do not intend to honor.  This activity could push the VIX higher.  It does appear that the VIX move was unusually high relative to the decline in equities; at the same time, we have our doubts that the entire turmoil was caused by manipulation.  It is rather obvious that there was a buildup in short volatility positions based on momentum alone and the short volatility positions were vulnerable to a squeeze when we saw a correction in equities.  However, it is possible that the spoofing, if true, exacerbated the squeeze and led to the panic reversal.

Inflation tomorrow: We get the CPI data tomorrow.  Given recent inflation worries, the market will pay unusually close attention to this report.

Reciprocal trade tariffs?  In an apparent surprise to the White House staff, President Trump indicated he plans to announce a “reciprocal tax” on trade.  The tax seems to be that if they have higher tariffs than the U.S. does, an equalizing tax could be implemented.   This looks to us like throwing a “bone to the base” but, at this point, we don’t see the president or the White House using (or perhaps even having) political capital for passage.  First, current tariff practices are based on years of WTO and multilateral negotiations.  A reciprocal tariff would violate those measures.  Although the U.S. could leave the WTO, the global trade ramifications would be enormous.  It’s not clear if Congress would approve such a tax.  What it does show us is that even if the right-wing establishment that surrounds the president steers policy toward typical establishment GOP policy priorities (lower taxes, deregulation), the president still has a populist theme.  If the U.S. moves toward protectionism, we expect a series of inflation problems to develop and a more profound bond bear market to evolve.  We are not there yet…but we monitor the trade/protection issue very closely.  On a related note, Axios[2] reports that a survey of the majority of CEOs around the world show support for protectionism to restrict technology and intellectual capital.

U.S. attack kills Russian allies in Syria: Bloomberg[3] reports that a force of 200 mercenaries, mostly Russians fighting (volunteering?) for Syrian President Assad, attacked a base and refinery held by the U.S. and allied forces.  According to reports, some of the Russians were veterans of the Ukraine campaign, another area where Russia claimed that volunteers supported operations in a foreign nation.  It is possible that the attack was a rogue operation but it does highlight the level of confusion and uncertainty surrounding the conflict in Syria and western Iraq.

Zuma out?  The African National Congress (ANC) has ordered President Zuma to resign, which would end the scandal-ridden regime and allow for Cyril Ramaphosa, the party leader, to become the new president of South Africa.  Zuma has been trying to stall, asking for a three- to six-month period to exit, but the ANC has apparently had enough.  It is not clear if Zuma will step down.  He likely fears that he will face corruption charges once he is out of office and could end up in prison or face a clawback in illicit funds.  One way or another, we expect Zuma to go which would likely be bullish for the ZAR.  A stronger currency is usually associated with stronger precious metals prices, especially platinum as South Africa is one of two major world producers (the other being Russia).  South African mines pay their workers in ZAR but earn USD when they sell their metals on world markets.  A stronger currency means higher production prices which tends to reduce mining activity.

The chart below shows the relationship of platinum prices to the ZAR exchange rate.  We have inverted the scale; ZAR is quoted in currency per dollar so a smaller number means a stronger currency.  The correlation since 2000 isn’t all that strong, but the correlation since 2010 approaches 95%.  Thus, one of the outcomes from Zuma’s ouster could be stronger platinum prices.

Kuroda set for another term: Current BOJ Governor Kuroda appears on track to be reappointed for a second term.  This is a rare outcome; his term expires in April but if he is reappointed and serves his term he would be the longest serving BOJ governor in history.  Kuroda has been an avid supporter of Abenomics and so Kuroda will likely remain head of Japan’s central bank as long as PM Abe remains in office.

German tensions: Martin Schulz, the leader of the SDP, has made a series of mistakes that have reduced the odds that the SPD rank and file will approve the grand coalition government recently negotiated with Merkel’s CDU/CSU.  Prior to last September’s elections, Schulz indicated he would not join a coalition with the Merkel conservatives.  However, the SDP took a drubbing in the national polls, winning only 20% of the electorate.  When Merkel was unable to cobble together a coalition of Free Democrats and Greens into a government, she would have either had to (a) assemble another grand coalition with the SDP, (b) operate as a minority government, or (c) call for new elections.  The SDP feared that option (c) would lead to even greater losses and thus Schulz had to break his grand coalition promise.  That move angered the SPD membership.  Schulz did negotiate a good deal for his minority party, getting both the finance and foreign ministries, a much stronger outcome than the vote count would have indicated.  Then, he made another unforced error by personally accepting the foreign ministry portfolio, ousting the current SDP holder of that office, Sigmar Gabriel.  The uproar from party members was so intense that Schulz was forced to give up the foreign ministry and allow Gabriel to maintain the office.  Schulz remains party leader but he is deeply wounded politically and it isn’t a certainty that the rank and file vote, which will be completed by March 2, will confirm the grand coalition.  If the vote fails, elections will likely be held later this year and the EUR may face some weakness.

Watching oil: The IEA reported today that OPEC has done a remarkable job in reducing the inventory overhang plaguing the oil market.  However, it warns that rising shale production in the U.S. could scuttle these efforts.  The EIA, the DOE’s data arm, is forecasting that shale output will rise to 6.8 mbpd by the end of March.  Another concern is that part of the recent budget agreement directs the DOE to sell 100 mb of oil out of the SPR, adding to the 189 mb that has been scheduled for sale since 2015.  The government is starting to use the SPR as an “oil piggybank.”  Although the need for SPR has been reduced due to shale production, there is a growing risk that oil prices could spike if a major Mideast oil disruption were to occur.  Finally, the Louisiana Offshore Oil Port (LOOP) is preparing to allow for exports.  The LOOP is the only offshore oil port that can handle supertanker oil directly.  Shifting the LOOP for exports is a major change.  Overall, we remain bullish on oil but these developments are bearish and warrant attention.

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[1] https://www.bloomberg.com/news/articles/2018-02-13/vix-manipulation-costs-investors-billions-whistle-blower-says

[2] https://www.axios.com/global-ceo-protectionism-ge-survey-06ab38ff-7c34-47a0-a647-4e2dcb58ec44.html

[3] https://www.bloomberg.com/news/articles/2018-02-13/u-s-strikes-said-to-kill-scores-of-russian-fighters-in-syria

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Looking for something to read?  In our travels we are often asked about books we recommend.  As a result, we have created The Reading List.  The list is a group of books, separated by category, that we believe are interesting and insightful.  Each book on the list has an associated review to help you decide if you want to read it.  We will be adding to the list over time.  Books marked with a “*” are ones we consider classics and come highly recommended.

Happy Monday!  Equity markets continue their recovery from Friday’s late surge.  Among candlestick chart aficionados, Friday’s formation was a “hammer.”  That means there was a large drop but the rally on the close led to a smaller body at the top, taking the form of a hammer.  A hammer is all about “hammering out” the bottom, so there is some technical evidence that this decline may be close to exhausting itself.  Meanwhile, there was lots of news over the weekend.  Here is what we are watching:

North Korea’s charm offensive: The Winter Olympics are in full swing, allowing us here in the Midwest to enjoy watching some of the less common sports.  Kim Jong-un has taken full advantage of the world’s spotlight to send a delegation led by his younger sister and a large contingent of cheerleaders to improve the Hermit Kingdom’s image.  So far, it has been a PR coup for Kim.  He has offered to open up leader talks with South Korea, a rather transparent bid to divide the U.S./South Korea alliance.  Although the talk out of South Korea is that the Moon government is cautious, center-left governments tend to be open to talks with Pyongyang.  The U.S. did itself no favors by suggesting that a conventional war on the peninsula, which would devastate South Korea, is preferable to the North Koreans having a deliverable nuclear weapon.[1]  We don’t think anything is happening here other than Kim wanting to divide the nations that are allied against him.  He is having some success but we doubt anything really changes.  The current South Korean government opposes any sort of military action against North Korea, and Kim is trying to build on that sentiment.

War in the Levant: Over the weekend, an Iranian drone moved into Israeli airspace.  The Israeli Defense forces (IDF) shot it down and made a retaliatory strike against the Iranian base where it originated.  Syrian anti-aircraft fire downed an IDF F-16 which led the Israelis to strike 12 targets in Syria, eight Syrian and four Iranian locations.  All this activity masks a broader issue—the region is up for grabs and Iran, Russia and Turkey are all jockeying for position as the U.S. steadily withdraws.  Iran wants to dominate Syria and form a clear arc from Tehran to Lebanon (which is essentially under Hezbollah’s control; Hezbollah is an Iranian proxy).  Turkey doesn’t want that to happen.  Russia wants Syria as its proxy state and Israel doesn’t want Iran on its doorstep.  Until recently, the U.S. would prevent all this from happening.  Since WWII, the U.S. managed to maintain stability through limited wars and its steady military presence.  However, the advent of shale oil has reduced American dependence on oil from the region and consequently the U.S. role in the region has changed.  During the Cold War, the U.S. was determined to prevent the Soviets from gaining control of the region’s oil; the U.S. wanted to keep that oil available for its free world allies.  Now, with ample North American supplies, the U.S. is questioning why it should pay for maintaining stability in the region while Europe gets cheap oil.  This isn’t just a recent development.  President Bush’s decision to oust Saddam Hussein without a clear plan on how to replace him removed the prime impediment to Iran’s regional aspirations.  The U.S. hasn’t been able to contain Iran since.  We see this conflict as “just warming up.”

A second referendum?  The Sunday NYT[2] reported there is growing support for a second referendum on Brexit.  The article noted regions that previously supported leaving the EU are having second thoughts and even hardline anti-EU political figures, such as Nigel Farage, the former leader of the U.K. Independence Party, would like a second vote to prove that the majority still want to leave the EU.  Would another vote bring a different outcome?  Latest polling show 46% would vote to remain in the EU, 42% to leave.  That is close enough to probably declare it a toss-up.  However, we note that the percentage of voters who were undecided in May 2016 was 14%, and it appeared most of those votes broke for leave.  The undecided vote is now down to 7%.  It is quite possible that a second vote would generate a reversal.  What would the EU do?  Although the rules suggest the U.K. would still need to depart because it said it would, we suspect Chancellor Merkel would allow the U.K. to stay with open arms.  In fact, the British may be able to use the Brexit scare as a way to negotiate more favorable treatment from the EU.  After all, it should be noted that the EU faces a growing authoritarian threat from central Europe (Hungary, Poland) and a contentious vote in Italy in March.  Having Britain stay would lessen tensions.  If a second referendum is called and the decision reverses, we would expect a significant rally in the GBP.

The fiscal debt and Treasuries: OMB Director Mulvaney was quoted over the weekend warning of a yield spike due to the rapidly widening deficit.  In reality, the impact of fiscal spending and the deficit is rather complicated.  Over the long run, the relationship between the deficit and bond yields is essentially nil.  The chart below shows the 10-year T-note yield and the deficit as a percentage of GDP (with the CBO’s forecast, which hasn’t been updated for recent developments).  Note the long-term correlation is -0.06%, or virtually uncorrelated.  Conversely, from 1956 to 1995, the correlation was rather significant at -0.65%.  In other words, as the deficit rose (became more negative on the chart), so did bond yields.  Then again, the correlation’s sign flips to positive since 1995, with a reading of 0.64%, meaning yields follow the deficit lower.

It should be noted that many of the deficit hawks, such as Martin Feldstein, came of age during the 1970s and 1980s when deficits seemed to matter.  They apparently believe this period was the norm but have failed to address the fact that the correlation has reversed.  The key issue is how the deficit is funded.  Until the mid-1980s, the deficit was mostly funded domestically, which meant that higher government borrowing “crowded out” domestic investment and, unless the fiscal spending was on something that was critical to growth, the deficits tended to boost interest rates.  However, after the mid-1980s, massive overseas dollar balances, a product of the larger trade deficit, created a source of foreign funding.  Since this foreign funding was a product of foreign nations using the U.S. consumer for growth and development, the U.S. didn’t really face serious constraints on the size of the deficit.  Thus, the correlation reversed.  Our expectation is that the fiscal deficits will result in a much larger trade deficit and a weaker dollar, which is why we are so concerned with protectionist trade measures.  If they are successful, it will lead us to conditions similar to the 1970s and early 1980s, meaning higher inflation and much higher bond yields.  So far, the president hasn’t acted as aggressively on trade as his campaign rhetoric suggested.  Our recent WGR discussion[3] suggests the real goal of the president’s policy is to attract foreign investment.  If we are correct, the scare talk from the deficit is just that—scary, but with no lasting impact.

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[1] https://www.theatlantic.com/international/archive/2017/08/lindsey-graham-north-korea/535578/

[2] https://www.nytimes.com/2018/02/10/world/europe/uk-brexit-second-referendum.html

[3] See WGR, 2/5/18, Trump & Trade: The First Year.

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Looking for something to read?  In our travels we are often asked about books we recommend.  As a result, we have created The Reading List.  The list is a group of books, separated by category, that we believe are interesting and insightful.  Each book on the list has an associated review to help you decide if you want to read it.  We will be adding to the list over time.  Books marked with a “*” are ones we consider classics and come highly recommended.

It’s official!  We are in a correction.  The S&P 500 has now declined just over 10% on an intraday high-to-low basis.

Do we have more downside from here?  Probably not materially, although we expect more grinding around current levels before we head back higher.  Next week’s CPI data will be important.  If inflation does appear to be accelerating, it may trigger another downleg.  Overall, the economy is still doing fine; the drop in equities might affect sentiment but it’s important to remember that nearly 85% of equities are held by households in the top 10% of income brackets.  In other words, the real losses are concentrated at the top end of the income scale so, for most Americans, the gyrations in equities are not a materially negative factor.

What are we paying attention to?  It is clear in the data that the last major equity market decline in the absence of recession occurred in 1987.  This begs the question, “Is this another 1987 event?”  At present, we don’t think so but, if it is going to be that kind of event, the trigger would probably be the use of volatility products.  In 1987, portfolio insurance led to a selling effect that exacerbated the downdraft.  Volatility trading won’t necessarily involve the same methods, but it could lead to similar results.

We have been getting questions on the volatility trade and note there is some confusion on how it works.  It’s important to note that betting on volatility is just that—it’s essentially trying to predict when the “freight train” is coming while others pick up nickels from the tracks.  To get an idea of this, we refer to the prospectus for the VXX (55.24), which says (on pages 13-14):

The long-term expected value of your ETN is zero.  If you hold your ETN as a long-term investment, it is likely you will lose all or a substantial portion of your investment.

The reason is the roll yield.  The long volatility products are long the front contract of the VIX futures when the term structure of the VIX futures are normally in contango, meaning the deferred futures price is above the nearest price.  When the nearest contract expires, the VXX manager buys the next nearest contract at a higher price.  If nothing happens, that contract will decline to where the previous contract expired, meaning the value of the positon will decline.  Over the long term, that means steady losses for the holder of long volatility.  So, the inverse position in volatility is in the opposite position.  Their position gains over time.  The anti-vol trade is really more of a roll yield position and less of a position on volatility.  Now, when policymakers are dampening volatility with accommodative and transparent monetary policy, the periods lengthen between volatility spikes (when the VXX pays off, or, when the “freight train” arrives), making the anti-vol positions quite profitable.

What led to the collapse of the anti-vol ETP was not just the jump in volatility but the fact that the volatility futures term structure flipped from contango to backward.  In other words, the nearest futures contract rose relative to the deferred contracts.  This means that losses were being accumulated on the roll yield and on the outright short position against volatility, which pushed prices down to points where some (but not all) ETN managers, to protect losses, exercised the call provision of the note and closed their products.

The unknown is how widespread was anti-vol positioning, who was in it and how much leverage was being deployed?  A casual look at the holders of XIV (0.00), the primary inverse ETN, shows a number of banks and broker dealers that were probably holding these for customers.  But, a large number of hedge funds are also represented and that is where the concern lies.  The fact that we are seeing selloffs in the last hour of trading may be a signal that these entities are still trying to build liquidity.  We don’t think the current event is going to be another 1987 situation, but we are watching the volatility issue closely because that is the most likely source if this does turn out to be a similar occurrence.

Is there a Powell put?  At present, if there is one, we are far from its strike price.  Various Fed speakers have been out in recent days and none seem overly concerned about the decline in equities, and fed fund futures are still projecting the odds of a March rate hike at around 85%.

A budget: The president signed the Senate budget deal that was passed early this morning by the House and Senate.  We did have a filibuster in the Senate that delayed the passage but we felt confident it would pass.  The good news is that we have now removed the budget drama from the markets for a couple of years.  What we have to deal with is the additional fiscal stimulus coming from the tax bill and this new spending.  We expect much of the expansion to boost imports, meaning the national growth effect will not be all that impressive but it is quite good for the global economy.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Looking for something to read?  In our travels we are often asked about books we recommend.  As a result, we have created The Reading List.  The list is a group of books, separated by category, that we believe are interesting and insightful.  Each book on the list has an associated review to help you decide if you want to read it.  We will be adding to the list over time.  Books marked with a “*” are ones we consider classics and come highly recommended.

BOE monetary tightening: Today, the Bank of England voted unanimously to leave interest rates unchanged but warned that earlier and larger interest rates increases are on the horizon in order to dampen the effects of a faster growing global economy on U.K. inflation.  In the BOE’s quarterly inflation report, each of the members of the BOE Monetary Policy Committee agreed that they are unwilling to tolerate inflation exceeding the 2% target for the next three years.  At a press conference, BOE Governor Mark Carney stressed that tighter monetary policy is needed due to expectations of faster demand growth and diminishing supply.  There has been speculation that the next rate increase could come as early as May.  The pound rallied following the news.

The chart above shows the year-over-year change in CPI for the U.K.  Following the Brexit vote in June 2016, the BOE stated that it would tolerate higher inflation to support domestic growth; as a result, the BOE has been slow to respond to rising inflation even though CPI has persistently remained above the 2% target since January of last year.  The Monetary Policy Committee’s decision to reverse course was largely due to concerns of possible overheating as previous concerns of rising instability following the Brexit decision proved to be unsubstantiated.

Is Goodfriend out?  Bloomberg[1] is reporting that Marvin Goodfriend, the White House’s nominee for one of the vacant Fed governor positions, may not get confirmed by the Senate.  The vote is expected today and he is expected to make it through the Banking Committee but the full Senate may be a problem.  Goodfriend has a controversial record.  He warned against an inflation problem after QE; although he was part of a broader chorus, the call was simply wrong.  He has not backed down from that position and was criticized for it.  He has also made disparaging comments about the dual mandate (a reasonable position from a theoretical standpoint, but Congress mostly likes the dual mandate as it acts as something of a brake on overly tight monetary policy), has shown support for negative interest rates and called for a magnetic strip to be added to paper currency, perhaps to give it a “stale date” in order to prevent currency hoarding under periods of negative nominal interest rates.  That sort of thing is vehemently opposed by Libertarians.  The left-wing populist group “Fed Up” is urging Democrats to reject the candidate.  Rejecting a Fed nominee would be a blow to the administration; it isn’t obvious who they would tap as a replacement.

A budget deal: The Senate leadership has agreed to a two-year funding deal, as we touched on yesterday.  The agreement lifts the sequestration caps and will increase discretionary spending by $300 bn over two years.  Defense spending will rise by about $131 bn and be matched with non-defense spending.  The agreement was not met with open arms by deficit hawks but, given that they are a minority in both houses, we expect this deal to pass.  It’s important to remember that Jacksonians, of which the president is one, are not opposed to government spending.  In fact, they like it, but only on their priorities.  In other words, foreigners and the undeserving should not get help from the government.  It is rare to see the deficit widen during expansions but the CBO is projecting just that outcome after this year and it hasn’t taken into account this new budget agreement in the below chart.

What does the deficit cause?  Although the textbook answer to this question is inflation, in fact, the impact is very complicated.  Our expectation is that budget deficits will most likely bring higher trade deficits and a weaker dollar, but probably have a modest impact on inflation.

Energy recap: U.S. crude oil inventories rose 1.9 mb compared to market expectations of a 3.0 mb build.

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 have declined significantly since last March.  We would consider the overhang closed if stocks fall under 400 mb.

As the seasonal chart below shows, inventories are usually rising this time of year.  We are seeing increasing inventories but they are running below the usual seasonal levels.

The rise in stocks is normal but the surprise this week was that the increase occurred with a sharp rise in refining activity.  If this jump indicates that maintenance is over, oil demand will rise.

Based on inventories alone, oil prices are undervalued with the fair value price of $67.44.  Meanwhile, the EUR/WTI model generates a fair value of $76.56.  Together (which is a more sound methodology), fair value is $73.79, meaning that current prices are below fair value.  We did see oil prices sell off yesterday despite the lower than expected rise in inventories.  That’s because weekly lower 48 production jumped 0.3 mbpd to 9.727 mbpd; coupled with Alaskan output, U.S. output hit 10.3 mbpd.  The market fears that rising U.S. output will cap prices.  Perhaps the largest risk is that Russia and Saudi Arabia decide to stop ceding market share to the U.S.; although we do expect that to occur at some point, it probably won’t happen until the Saudi Aramco IPO price sometime later this year or early next year.

As noted above, refining activity rose.

Although refiners had been cutting output since late last year, we usually see about two months of reduced activity before production returns.  One week doesn’t make a trend, but this reversal is rather shocking and does suggest that refiners see demand for their product (perhaps exports?).  While the rise in U.S. production is a concern, we would need to see a surge in inventories to become worried about prices.

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[1] https://www.bloomberg.com/amp/news/articles/2018-02-07/goodfriend-faces-close-vote-for-fed-after-rough-senate-grilling?__twitter_impression=true

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Looking for something to read?  In our travels we are often asked about books we recommend.  As a result, we have created The Reading List.  The list is a group of books, separated by category, that we believe are interesting and insightful.  Each book on the list has an associated review to help you decide if you want to read it.  We will be adding to the list over time.  Books marked with a “*” are ones we consider classics and come highly recommended.

Equity markets are attempting to stabilize this morning.  As noted above, Asia was mostly lower while Europe is in the green.  Here is what we are looking at this morning:

Is this it?  By our calculation, the current decline from the recent high (basis the S&P 500) was just under 10%, but would round up to that level, which is generally considered a full correction.  Despite the sudden drop after months of calm, investors have been relatively sanguine.  We do note the Ned Davis Crowd Sentiment Poll fell from around 75 to just under 67.  Usually, this index would need to decline to around 61 to signal that excessive optimism has “washed out.”  We note some of the major wirehouses have given “all clear” signals and are suggesting we should move higher from here.  We don’t necessarily disagree, but would note that in our personal experience equity corrections don’t usually end without a greater degree of fear.  It is possible that some of the usual panic has been transferred to other markets, perhaps cryptocurrencies or the volatility products, but we would not be surprised to see at least a retest of recent lows before a recovery develops.  In other words, this probably isn’t a “V” bottom in equities.

At the same time, there is no strong evidence of recession, which is the usual trigger for a major bear market.  Recent market action is rather normal behavior; in recent years, persistently supportive monetary policy has dampened market volatility and thus made corrections less common.  As monetary policy normalizes, choppy equity markets are a likely outcome.

No change in policy expectations: Fed funds futures are still indicating about an 83% chance of tightening at the March 21^st FOMC meeting.

This chart shows the probability of a rate hike for the March meeting.  At the end of January, the fed funds futures indicated near certainty of a rate hike.  Recent equity market action did add a degree of doubt but odds still strongly favor a rate hike.

The budget process: The House has passed a stopgap measure while Senate leaders are indicating they are nearing a two-year budget deal that would not only address the upcoming spending limit issue but also address the debt ceiling that is looming next month.  The keys to the emerging Senate deal are (a) immigration is to be dealt with outside the budget process, and (b) spending will rise to bring enough members on board for passage.  The Senate version will not be popular with the Freedom Caucus in the House, which means passage will rely mostly on Democrats and enough moderate Republicans to vote for the measure.  We may see another shutdown later this week, but would not expect much market impact.

Merkel has a deal: Chancellor Merkel will give the SPD the finance and foreign ministries in a new grand coalition government, which was apparently enough to get the SDP leadership to agree to form a government.  Although the SDP rank and file still need to vote on the measure, getting these two key ministries should be enough to sway most members.  Merkel’s CDU/CSU party is not pleased, according to reports.  The general expectation was that the SDP would get one of these two ministries, but not both.  Assuming the SDP approves the deal (and they would be making a huge mistake if they didn’t), Germany’s stance on the EU could soften dramatically, which could mean a more French vision is in the offing.  A more French vision would include more fiscal unity and relaxed rules of fiscal spending by individual states.  Although a new government is likely, it may not last very long; most Germans are fearful of providing a “credit card” to the rest of Europe and the SDP’s version of the EU won’t be popular with the CDU/CSU or the AfD.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Equities remain under pressure around the world.  We are seeing lots of swings in other markets, with Treasuries flipping from higher to lower prices and the dollar is volatile as well.  Here is what we are watching:

Algos and risk parity: Innovation is always a factor in markets, including financial ones.  Most of the time, new things are an improvement.  Sometimes this isn’t the case and, even with good things, overdoing it or becoming overly reliant upon a new, untested product can cause problems.  Early in my career, portfolio insurance was the rage; buying equities and offsetting part of the risk by being short futures (or having stops under the market in futures) gave investors the impression they were protected from market declines.  In 1987, that proved to be a false assumption.  In our times, risk parity has the potential to be the new version of portfolio insurance.  At its most basic level, both portfolio insurance and risk parity are nothing more than portfolio diversification.  In other words, holding an asset in a portfolio that moves in the opposite direction to other parts of the portfolio is basic modern portfolio theory.  Finding that diversification asset is the trick; it must (a) not be overly costly, and (b) work consistently.  Finding instruments that always move opposite to stocks is easy; finding ones that don’t offset most of one’s equity gains is hard.

Simple risk parity models usually use bonds to offset portfolio risk.  Although that hasn’t always worked, it has been effective in this century.

This chart shows the rolling five-year correlation between returns for 10-year T-notes and the S&P 500.  Until around 2000, returns for these two asset classes were positively, or directly, correlated.  They are now negatively, or inversely, correlated.  There are probably a myriad of reasons for this flip, including confidence that inflation would remain controlled.  Declines in long-term interest rates seem to have an impact as well (when the 10-year yield fell under 6%, the correlation switched), and consistent and transparent Fed policy also likely played a role.  Recently, we have seen both Treasuries and equities come under pressure.  Heightened inflation fears seem to be behind this market action.  This is an issue we are monitoring closely because asset allocation would become much more challenging if this relationship between bonds and stocks were to change to the pre-2000 relationship.

Risk parity can be much more than the simple addition of bonds to a portfolio.  One of the more popular strategies in recent years has been to use volatility instruments to diversify portfolios.  And, for every buyer of insurance, someone has to be a provider.  Selling volatility has been a very profitable strategy in recent years.  With every popular strategy, the financial services industry will create a product to facilitate demand.  Inverse volatility ETPs, which are usually ETNs,^[1] have done quite well in recent years.  Volatility has steadily declined, in part due to easy and transparent monetary policy, slow economic growth and low inflation.

This is a two-year chart of the XIV (CS VELOCITYSHRS DLY INV VIX SHRT ETN, 99.00).  Two years ago, this ETN was trading at 20; it peaked last month at 140.  The current after-hours indication is 15.43 (see below for more on this issue).

To some extent, what we are seeing in the financial markets is a normal late-cycle environment where the economy expands to capacity constraints, inflation begins to rise, interest rates move up and monetary policy tightens.  There is nothing too unusual in what we are seeing.  Now, we can quibble about all of these elements.  First, we are not convinced that hitting capacity constraints is relevant in a globalized world.  As long as excess capacity exists in the global economy, inflation can be contained by a wider trade deficit.  Second, the rise in inflation we are contemplating, to maybe 2.5% for core CPI in the coming 12 to 18 months, isn’t so earth-shattering as to force the Fed to slam on the money brakes.  Third, we are not convinced that the recent rise in wages is material; although overall wages rose by 2.9%, wages for the majority of workers, shown by non-supervisory and production workers, remain stagnant at 2.4%.  Still, there is little doubt the FOMC will continue to lift rates unless the recent break in equity markets destroys enough wealth that it affects the economy.  That isn’t likely, simply because significant equity ownership isn’t broad enough to have that effect.

What is causing the market turmoil is a repricing of the outlook coupled with vulnerabilities caused by volatility products and algorithms.  As holders of short volatility products take losses and try to exit products, they are likely selling other parts of their portfolio to gain liquidity.  It should be noted that trading was halted yesterday on several of these ETNs and they remain halted at the time of this writing.  As the chart below shows, the NAV on XIV has plunged to 4.22.

According to reports, some of these ETNs may be liquidated due to their price action.^[2]  If that occurs, it may end this product’s availability to average investors.

Algorithms are the other innovation that affects the financial markets.  These pre-programmed trading strategies are designed to use speed to succeed.  Thus, when various conditions are met, these programs begin rapid trading.  The sharp drop seen in the last hours of trading yesterday were likely triggered by such programs.^[3]  These programs can make financial markets temporarily unstable but really don’t affect long-term investors…as long as they don’t pay close attention to such swings.  To some extent, algorithms are not doing anything humans don’t usually do, but they do them faster and they seem impossible to stop once triggered.  That feature is what makes them a bit worrisome.

So, where does all this leave us?  We view this pullback as a buying opportunity.  The real worry is a recession that brings a broader bear market, and the economy is doing ok.  Insofar as this correction rids the market of some of these activities that rely on conditions that are probably unsustainable, it will make equities less vulnerable to shocks.  The bigger picture is the repricing of stocks that we are seeing; in other words, are we going to see a broader downward shift in market multiples that will lead to lower prices this year?  It’s possible, but if inflation doesn’t begin to accelerate significantly and the FOMC remains on a steady path, a dramatic repricing isn’t likely.  At the same time, we think there is probably more market turmoil in the short run.  We haven’t seen a real panic yet and usually these sort of events don’t end without fear returning to the markets.

Bitcoin hit again: While bitcoin continues to come under pressure, another voice calling for regulation has emerged.  The Bank of International Settlements (BIS), the “central banker’s central banker,” is calling on central banks to “clamp down” on these instruments, calling them a “threat to financial stability.”^[4]

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[1] Exchange Traded Products (ETPs) is the broad definition; Exchange Traded Notes (ETNs) are subsets of ETPs (the broader cousins of ETFs, or Exchange Traded Funds) which are bank notes issued to replicate an index.

[2] https://www.bloomberg.com/news/articles/2018-02-06/volatility-jump-has-traders-asking-about-poison-pill-in-vix-note

[3] https://www.bloomberg.com/news/articles/2018-02-05/machines-had-their-fingerprints-all-over-a-dow-rout-for-the-ages

[4] https://www.ft.com/content/78bf5612-0b1a-11e8-839d-41ca06376bf2