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)

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

[Posted: 9:30 AM EDT] The global political situation remains fluid.  In France, President Macron won an apparent smashing victory in the first round of parliamentary elections, winning nearly 32% of the vote and faring much better than the conservative parties, which captured around 20%.  The National Front picked up 14% of the vote and the Socialists polled in the single digits.  The second round of elections will be held on June 18 when the En Marche Party is expected to capture 400 to 440 seats out of 577 seats.  This is an impressive victory for a new party.  The vote will give this new party and Macron a dominating hold on the legislature.  Macron is promising to implement what can be best characterized as a neo-liberal policy, intending to lower taxes and end the 35-hour workweek.  France never really adopted neo-liberal policies during the Reagan-Thatcher period so it would be a major change if they are implemented.  On the other hand, Macron wants to create an EU fiscal mandate, which will surely be opposed by the Germans.  All in all, Macron will have domestic political support.

While France appears to be moving to the right, the U.K. seems to be leaning toward unreconstructed socialism.  Jeremy Corbyn pines to renationalize various industries that were privatized under Thatcher and initially nationalized by Labour after WWII.  Although the Tories did win the majority of seats in the last election, they will struggle to form a government and the odds of another election soon are rising.  After last week’s embarrassing loss, there is growing speculation that Theresa May will be forced to step down from her post as party leader while the Tories try to regather themselves.  David Davis, the minister overseeing Brexit, has stated that Brexit negotiations will not start on June 19 as planned but will likely take place sometime next week.

We are seeing a penchant for newness as there are high levels of discord across Western societies.  We have seen the rise of hard-left and hard-right parties, but what has been consistent across the West is a willingness by voters to try something new.  Corbyn and Trump are calling for different policies but are clearly outside the mainstream.  These persons become attractive because voters are desperate for something new, hence why France decided to go with a very young president and a new party promising neo-liberal, market-friendly policies.  So far, financial markets are handling these divergences without major problems, although one could argue that currency and fixed income markets have moved while equities continue to mostly ignore political discord.  We don’t know if this can last indefinitely, but it is clearly in place now.

In the Middle East, Qatar is still looking for a diplomatic solution to the blockade formed by Saudi Arabia.  Qatar has been accused of funding terrorism, a claim that it has vehemently denied.  SOS Tillerson has called for a de-escalation of the blockade, stating that it is hindering U.S. military operations within the region as well as being wrong on “humanitarian” grounds.  It is worth noting that Qatar hosts the largest U.S. military base in the Middle East.  As such, the Pentagon has also weighed in, stating that the blockade does not currently hinder its operations but rather its ability to plan for longer term military operations within the region.  Alongside SOS Tillerson’s calls for de-escalation, Trump has issued a statement praising the blockade as possibly leading to the end of terrorism.  Trump’s conflicting viewpoints from members of his administration have become somewhat routine.  That being said, the Trump administration’s inability to formulate a coherent foreign policy could lead to the U.S. losing clout around the world.

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

[Posted: 9:30 AM EDT] In Britain, Theresa May’s decision to call a snap election in order to win a larger mandate backfired last night.  The Tories, who were supposed to win more seats, lost their majority and barely squeaked out a plurality.  Final results show that the Tories lost 12 seats, falling to 318 in Parliament, and their rivals in the Labour Party won 31 seats, increasing their total to 261.  This outcome is seen as a stunning loss for the Tories who now need the help of a minority party in order to secure the additional eight seats needed to form a government.  As of right now, the Democratic Unionist Party (DUP), a party from Northern Ireland that won 10 seats, is likely to help the Tories form a government but will not form a coalition.  Despite the market’s negative reaction, there is growing sentiment that the election has possibly paved a way for a “soft” Brexit.  The voting results suggest that May’s insistence that “no deal is better than a bad deal” may have hurt the Tories in anti-Brexit strongholds such as London.  In the event that May fails to form a government, Jeremy Corbyn, leader of the Labour Party, will likely have to make concessions to the DUP (10 seats),  Liberal Democrats (12 seats) and the Sottish National Party (35 seats) in order to form a government, all of whom are strongly in favor of a “soft” Brexit.  That being said, May is expected to retain her role as prime minister as Brexit negotiations begin in 10 days, but it is unclear whether she will be able to retain her role as party leader in the long term.  The GBP is currently down 147 bps relative to the dollar from the prior close.

Yesterday’s testimony by former FBI Director Comey is being spun furiously by both sides.  Our take is that it’s damaging but not fatal.  It doesn’t appear that there is a clear case of obstruction.  Comey’s decision to leak is normal for Washington but it does taint his image.  Former AG Lynch came off badly.  For the financial markets, probably the best model to think about this issue is not Watergate, but Whitewater.  There may not be much here, but the administration’s handling of the issue keeps leading to concern that “something” is being covered up.  That means the special investigation will continue for months, if not years, and will be a distraction for the administration.  If they are going to have any legislative success, they need to figure out how to manage this distraction.

Yesterday, the Federal Reserve issued its Financial Accounts of the U.S. for Q1, otherwise known as the “Flow of Funds” report.  It offers a plethora of useful and interesting data about the economy and the health of important sectors of the economy.  The charts below show a few of our favorites.

The chart below shows net worth as a percentage of after-tax income.  It has reached a new record high as financial assets rise and housing prices recover.

Deleveraging has slowed, but we are still seeing households lower their debt levels relative to after-tax income.

We are seeing a steady healing of the real estate sector.  Owners’ equity in real estate continues to approach 60%, which history would suggest is “normal.”  In other words, as we approach this level, we could see homeowners and potential buyers view home buying as a less risky activity.  If so, we could see a boost in homebuilding that would help the economy.

 

The Flow of Funds report also publishes national income data.  Labor picked up modestly in Q1 but its share remains depressed.  The steady loss of share is likely a factor in the rise of political populism.

Rental income reached a new high, one of the factors that has made real estate investments attractive.

Our last chart examines the income from interest and dividends.

Dividends are currently about 6% of national income, with interest income under 3%.  The last time we had dividends consistently exceeding interest income was in the 1950s and early 1960s, a period of financial repression.  This chart portrays investor preference of income-producing equities.

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

[Posted: 9:30 AM EDT] In Iran, a gunman and suicide bomber attacked the Iranian parliament and the Ayatollah Rullah Khomeini shrine.  The Sunni-led group ISIS has claimed responsibility for both attacks, its first significant attack in Iran, which is majority Shiite.  According to the Iranian news media, previous attempts have been thwarted over the past three years.  These attacks have raised fears that the ongoing sectarian violence may spread throughout the Middle East.  If conflict persists, we expect oil prices to rise as conflicts in the region typically disrupt oil production.  As of this morning, oil has been trading lower than the previous day’s close as the U.S. has increased oil exports.

In a morning tweet, Trump announced that he has nominated Attorney General Christopher Wary for FBI director.  Wary had previously worked as the assistant attorney general under the Bush administration.  This announcement comes a day before former FBI Director Comey’s testimony, and amidst a number of headlines regarding Trump’s contentious relationship with AG Sessions.  It would seem prudent to simply wait for Comey to testify but the comments will be the focus of the media come Thursday.  So far, equity markets are mostly shrugging off the news as it is widely believed that Comey will stop short of saying that Trump tried to obstruct justice.  It is worth noting that the dollar has been weakening and Treasuries have been showing price strength; gold has also been stronger.  There are some concerns in the financial markets but the attention has been outside the equity space.

Bloomberg reports that the ECB is considering downgrading its inflation outlook through 2019 and slightly revising its GDP forecast higher.  The downgrade is due to pessimism as to whether energy prices will rise in the future.  Despite Eurozone strength, the ECB is likely to remain dovish for the foreseeable future.  This report comes a day before the ECB is due to hold its policy meeting.  Currently, the euro has fallen 54 bps relative to the USD.

Yesterday, the JOLTS report showed a surge in job openings and only modest hiring.  The chart below illustrates the odd behavior of the labor markets.

The blue line on the chart shows the ratio of hires to openings; when the ratio is below one, it means there are more openings than hires and would suggest a tight labor market.  The JOLTS report doesn’t have a long history but the ratio has never been this low.  Note that the previous business cycle low, in 2006, led to wage growth of 4%.  It is shocking that labor markets can seem to be this tight and wage growth remain subdued.  It may be that labor fears of being substituted for machines or the huge pool of discouraged workers are keeping wage growth low, but, clearly, firms are looking for workers and struggling to fill positions.  Basic economic theory would suggest that if demand is this strong, the price of labor should rise unless the supply curve is perfectly flat; if that were the case, the openings would be filled.  This gap will likely encourage the FOMC that the proper course for monetary policy is to tighten further.

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