by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The IMF meetings are being held in Washington this weekend.  We would not expect anything too earthshattering out of these discussions.  However, the organization has calculated an interesting bit of data—the IMF estimates that the world has $152 trillion of debt, about twice the size of the global economy.  The IMF worries that this high level of debt will act as a constraint to growth.  That may be true.  However, a factor that seems to have been forgotten is that one party’s liability is another party’s asset, and one way the debt problem gets fixed is by forcing losses on creditors.  So far, the financial markets are treating the creditors as safe; for example, the Greek bailout seems to be designed, in part, to protect the German banks.  However, if growth becomes constrained enough, one way to end the constraint is to reduce the return on debt either through restructuring or repudiation.

One question we receive on occasion is, “What would the U.S. political situation look like if Trump had a normal personality?”  It is starting to look like the answer is coming from Britain.  PM May ripped the “international elite” (what we refer to as Davos Man) and laid out a plan for increased state intervention, workers’ rights and a “crackdown on corporate greed.”  May does have an advantage in that the Labour Party has essentially left the field wide open by moving so far to the left that the center-left has no one to occupy it.  So, May seems to be taking the position that the Tories are going to fill that gap.

U.S. crude oil inventories fell 3.0 mb compared to market expectations of a 1.5 mb build.

This chart shows current crude oil inventories, both over the long term and the last decade.  For the month of September, oil stocks unexpectedly dipped 25.2 mb.  As the chart below shows, seasonally, we should see inventories rise as refineries begin their maintenance period.  But, inventories have steadily declined even with the drop in refinery operations.  Falling imports are mostly to blame for the drop in imports; the fact that we are talking about “TS Nicole” shows that this has been a very active tropical season.  However, if we are going to see an influx of foreign oil to the U.S. then we will likely need to see a narrowing of the Brent/WTI spread to force world barrels to the U.S.  To date, the spread has remained stable.  If inventories continue to fall, it suggests rebalancing.  At the same time, media reports indicate gluts in other markets.  So, we will see if that oil eventually finds its way to the U.S.

Based on inventories alone, oil prices are overvalued with the fair value price of $45.29.  Meanwhile, the EUR/WTI model generates a fair value of $49.24.  Together (which is a more sound methodology), fair value is $46.18, meaning that current prices are a bit above fair value.  A stronger dollar is probably the biggest threat to oil prices at $50.  Finally, OPEC is planning informal meetings on October 8-13 to discuss production allocations before the formal meeting on November 30.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] It was a rather quiet night.  The VP debate came and went; polls suggest that Pence was better received but we doubt the interaction will change the election chances of either presidential candidate.  There are some interesting trends starting to develop that are worth mentioning:

Long-term yields are starting to rise.  The uptick in oil and expectations of a reduction in central bank accommodation are starting to have an adverse effect on long-duration bonds.  The FOMC seems poised to raise rates in December.  The BOJ has decided to set the yield on 10-year JGBs at 0%, which means tapering might occur.  Bloomberg reported yesterday that the ECB was considering tapering its QE, which sent long-duration Treasury yields even higher.  This morning, Reuters is reporting that the ECB isn’t considering such a move, although the formal QE program is set to expire in March.  There have been reports that ECB President Draghi is considering an extension of the program but perhaps at lower levels.

In general, there appears to be a shift in sentiment that suggests policymakers are going to move toward fiscal policy and away from monetary stimulus.  We believe this is probably justified, although it is remarkably easy to discuss fiscal policy in the abstract, but hard to implement.  Fiscal policy generally comes in two varieties, government investment and income enhancement.  The former is likely to have the most positive impact if administered correctly.  After all, the private sector continues to avoid investment and thus it makes sense for the public sector to fill any resulting gaps.  The problem is that the hardest action any society takes is investment because it requires some forecasting of the future.  There are monuments to poor investment everywhere; the shells of manufacturing plants that are no longer used are examples of private sector malinvestment, as are the “bridges to nowhere” on the public side.  Developing public investment that will actually foster efficient future growth is quite difficult.  Thus, the potential is high for building roads that don’t effectively move vehicles or dams no one wants.  The second variety of fiscal policy is income enhancement in the form of transfer payments, tax cuts, investment incentives, etc.  Giving households money during deleveraging likely turns out to be nothing more than a private to public sector debt swap.  In other words, if the government gives money to households that are deleveraging, they could simply use the cash to reduce their debt, improving household balance sheets but doing little for immediate growth.  As far as investment incentives go, if a project isn’t viable in the current interest rate environment then it probably won’t ever be feasible.  Still, the shift to fiscal policy, even if it disappoints, is probably bearish for long-duration debt.

We will have more to say on the oil situation in tomorrow’s comment when we recap the DOE data, but the OPEC plan to reduce supply has, at a minimum, put a floor under oil prices.  We expect oil to remain in a trading range but even keeping prices steady will tend to reduce the deflationary impact of weak oil prices.

This chart shows the yearly difference in WTI.  Note that prices are now equal to last September, meaning that, on a yearly basis, oil is no longer acting as a damper for inflation.  It is important to remember that oil fell below $30 per barrel in February, so even if prices hold steady through Q1, it will raise the inflationary impact of energy prices.

Is Xi the new Mao?  The NYT is reporting that Chairman Xi is delaying the designation of his successor, perhaps laying the groundwork for staying beyond his two five-year terms.  If so, this would change the tradition of power transfers that were put in place by Deng.  Deng created a system in which the next leader is anointed during the second term of the current chairman.  This allowed for a smooth transfer of power as the new leader put his leadership team together.  If Xi doesn’t select his successor, this process of the next leader creating his power base won’t take place, allowing Xi more influence for the term that begins in 2022.  In fact, it very well could lead to Xi remaining in place, which would upset the transition process.  This change will likely raise internal tensions within the PRC leadership.  It is important to remember that Deng created this system to prevent another Mao from emerging.  If Xi does change this practice, it raises the potential for a new cult of personality and for internal party unrest.

Is Deutsche Bank becoming a nationalist issue?  We have noted the problems at Deutsche Bank (DB, $13.33, +0.35).  A Bloomberg article suggests that a narrative is evolving in Germany that suggests the problems at Deutsche Bank are really due to an attack on German values by foreigners.  The DOJ fine is being portrayed as retaliation for back taxes being levied against U.S. firms by the EU, and others are suggesting that the bank is the standard bearer for German firms and an attack on the bank is an attack on German business practices.  With elections due next year, this is a popular stance to take, especially with populist parties gaining ground.  At the same time, it would not be much of a stretch to see U.S. politicians taking up the cause of the DOJ against Deutsche Bank.  Unfortunately, political posturing will reduce policymakers’ ability to act if a crisis does develop.  Simply put, a global financial crisis will need international cooperation, not nationalism.  Although the problems at Deutsche Bank appear manageable, they could become a problem if the political class decides to “take a stand.”

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] BREAKING NEWS: The IMF has updated its economic forecasts.  Although world GDP growth remains steady, it has lowered Eurozone and U.S. GDP.  Overall, economic growth remains sluggish.

For the second straight day, the British pound (GBP) is taking a “pounding.”  The proximate cause is PM May’s decision to make an Article 50 declaration by the end of Q1 2017.  However, the GBP decline is being assisted by hawkish comments from Fed officials, the most recent of which from Cleveland FRB President Loretta Mester, who suggested that a hike is necessary and also indicated that she would be amenable to a November meeting hike.  Currently, fed funds futures put the odds of a November rate hike at 21.4% and rise to 61.2% for the December meeting.  The dollar is up across the board on growing expectations of a rate move.

The chart above shows a purchasing power parity model for the GBP/USD exchange rate.  Parity models use relative inflation rates to measure the value of currencies, with the idea that a nation with higher price levels equalizes global prices via a weaker currency.  The drop in the pound isn’t due to rising inflation (although one might argue that Brexit will lead to higher future inflation), but mostly due to worries about economic disruption and easier monetary policy due to Brexit.  This chart shows that this is the weakest the pound has been against the dollar since the mid-1980s when Volcker’s tight monetary policy triggered a massive dollar rally.  In fact, this is the second weakest pound since currencies began to float in 1971.

Although the consensus is that the pound will weaken further due to the uncertainty surrounding Brexit, this analysis suggests the currency is already quite weak and the current depreciation will act as a stimulus for the U.K. economy.  Interestingly enough, the FTSE is up strongly today (+1.6% at the time of this writing).  To see the impact of the weaker pound, the FTSE is up 13.7% YTD; in USD terms, it is down 1.6%.  In other words, despite a strong equity market, the British equity market has been a loser for dollar-based investors.

Our research suggests that the FOMC does pay attention to the dollar, something it didn’t always notice.  The dollar’s strength makes the path of policy “normalization” much flatter and slows the pace of tightening.  Thus, a December hike is still likely if the dollar continues to rally, but a “once-a-year” tightening cycle would also be likely as well.

Also of note is that gold prices are sharply lower on the rising rate/stronger dollar trend seen today.  We continue to hold a favorable view of gold but a significantly stronger dollar would be a drag on prices.

Finally, we want to note a Reuters report today suggesting that the BOJ’s primary policy indicator has become the JPY/USD exchange rate.  Simply put, the aggressiveness of monetary policy will mostly be triggered by yen strength.  Policymakers do not want to see a stronger JPY and are suggesting they will take steps to prevent the currency from appreciating.  Although some analysts suggest the BOJ is out of tools, we argue that accumulating U.S. Treasuries in place of JGBs for QE would be feasible (though politically controversial).  Additionally, the BOJ’s decision to peg the 10-year at zero yield could lead the way to negative rates and a steeper yield curve.  Another overlooked possibility is that the Abe government could aggressively expand fiscal policy with a pegged JGB 10-year, a form of helicopter money, similar to how the U.S. funded defense spending during WWII.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Politics mostly dominated the weekend news flow, although Deutsche Bank (DB, $13.09, +1.61) was in the news, too.  German markets are closed for a holiday (it’s Unification Day, the holiday that commemorates the official day when East and West Germany were reunited), so we haven’t seen a full overnight session for the bank.  Shares rallied on Friday following a report that the DOJ and the bank were nearing a settlement, with a fine well below the initial $14 bn indicated.  However, the WSJ has quashed these rumors in a weekend article suggesting that no deal is imminent; in fact, talks haven’t even reached the point where a proposal has been fashioned that could be presented to the U.S. government and bank officials.  Thus, the issues with Deutsche Bank will continue.  We are also hearing that Sen. Clinton will speak today about making it easier to bring private lawsuits against corporate “bad actors,” which may bring selling pressure against some large U.S. banks.

In Colombia, voters narrowly rejected a peace deal between the Revolutionary Armed Forces of Colombia (FARC) and the government.   The vote was 50.2% against, 49.8% for; turnout was only 37%, partly due to torrential rainfall.  President Santos has indicated that the ceasefire will remain in place.  Although the low turnout may have been critical, we note that pre-referendum polls showed the “yes” vote winning 2:1.  This is yet another example of polls failing to capture an adverse outcome; we saw something similar with Brexit polls.  It isn’t clear what Santos and FARC will do to move forward, but we don’t expect a return to war and would not be shocked to see another vote.

In other major political news, British PM May has set a deadline of no later than March 30, 2017 to invoke Article 50 of the EU charter, which will begin the process of Brexit.  We are still not sure if Britain can leave the EU without an act of Parliament (a vote in the House of Commons to leave the EU would probably fail to pass), but it does appear that PM May is set to leave.  It also appears that Britain won’t be able to hold informal talks in advance of the Article 50 declaration as May had wanted.  Ideally, the U.K. had wanted to hammer out an agreement before declaring Article 50 so that negotiations would be smooth.  However, because France and Germany are facing elections next year and it won’t be politically popular for either to make it easy on Britain, it looks like they are going to do this the hard way.  The GBP fell on the news; meanwhile, as we note below, U.K. PMI data came in much better than forecast, likely helped by the currency’s depreciation.

The other big political news was Mr. Trump’s 1995 tax returns that were apparently leaked to the NYT.  This story is quite interesting on a number of levels.  First, it does appear to be a leak—according to reports, three photocopied pages arrived in NYT reporter Susan Craig’s mailbox a few days ago.  The letter’s return address was “The Trump Organization” and the postmark was from New York City.  The source appears to be unknown and could be a hoax, although his tax attorney from 1995 did confirm the paperwork as legitimate and noted that the first two digits of the eye-watering $916 mm loss had to be hand-typed because the tax preparation software of that era couldn’t handle a number that large.  Second, the loss is substantial, but not implausible.  The Trump Empire was under great strain during that time period as there were serious problems with the Atlantic City casinos.  Third, and perhaps the most critical unknown part of the story, is what happened with the losses?  When a household renegotiates a loan, if any part is forgiven then the amount forgiven becomes income and is subject to tax.  So, speculation that Trump has these massive tax losses that could shield his income for years may not be true.  At the same time, there are ways to avoid this issue.  A practice called “debt parking” can hold the discounted debt and Trump gets to keep the tax losses to offset future income as long as it never requires Trump to service the debt.  It could be illegal if Trump has any ties to whatever body is holding the parked debt.  We are not sure that this occurred, but the steadfast refusal to release his tax returns could be to protect the entity—a family member or a shell corporation—that may have bought the deeply discounted debt from the original debt holders.  Suddenly becoming liable for the income from the original debt forgiveness could be very costly for Trump.  Again, we are not tax accountants but the way the documents were leaked suggests a disgruntled employee or something of the like.

How serious is this news to the Trump campaign?  We doubt it will sway his hard core supporters.  This is the part that pundits seem to miss.  Trump’s policies on trade and immigration offer hope to a band of the electorate that sees these two issues as the primary reasons for their woes and thus Trump’s personal behavior is immaterial.  That group, by itself, won’t win Trump the election, but it probably means that he has a solid 35% to 40% of the electorate that is almost unshakable.  Taxes, ill-advised tweets and personal behavior will sway the undecided away from Trump and so they do matter.  However, unless Sen. Clinton can offer the undecided a reason to vote for her, they may simply stay home or vote for a third party.  Brexit and the Colombia vote showed the unreliability of polls.  The tax issue does matter but probably not as much as the pundit class is suggesting.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The market’s focus continues to center on the banking system, with Deutsche Bank (DB, $11.48, -0.82) being the most market relevant, although the travails of bankers testifying before Congress hasn’t helped the sector.  Deutsche Bank is the bigger issue because it raises fears of systemic problems.  The heart of the matter is that no bank can really absorb a bank run.  The whole premise of banking is term conversion—they take our deposits, which are short term in nature, and turn them into long-term assets in the form of loans.  The famous scene in It’s a Wonderful Life when the hero, George Bailey, is faced with a bank run is a good portrayal of the problem.  When confronted with frightened depositors, he explains, “Your money isn’t here, it’s in the homes of your friends and neighbors.”  When a handful of hedge funds announced they were pulling their business from Deutsche Bank, it raised fears of a broader run against the bank.

The reality is that all banks are potentially subject to runs.  What prevents them from occurring?  In a word, confidence.  If depositors (which are lenders to the bank) are confident the bank is well run and that their deposits (which are really loans to the bank) are safe, then they don’t run to the bank to redeem their deposits and claim their cash.  So, is Deutsche Bank at risk?  Yes, but not in an extraordinary manner.  All banks are at risk.

Thus, all banks are potentially at risk for a run and, once a run starts, idiosyncratic risk can become systemic risk.  Governments are aware of this issue and therefore create backstops to lessen the perception of risk and support financial system confidence.  This is what regulation and deposit insurance provide.  The goal isn’t to necessarily protect all banks but to ensure that a single bank problem doesn’t trigger system-wide problems, which is the entire issue behind “too big to fail.”  If a bank becomes a systemic risk by itself due to its size, it creates conditions of moral hazard, where the too big to fail bank takes large risks, knowing that the government can’t let it collapse or it would face a systemic meltdown.

So, the real question isn’t about the financial conditions of Deutsche Bank, but rather market confidence in the German government’s support for the bank.  At first glance, this appears to be a no-brainer; the Merkel government would be profoundly inept if it failed to bail out Deutsche Bank if it faces a run.  That’s economics…unfortunately, there is a political element to this issue as well.  First, the rapidly rising right-wing AfD party would use a bailout of Deutsche Bank as a cudgel against the Merkel coalition, portraying the move as either incompetence or cronyism.  According to EU rules, bank creditors would be first in line to take losses (the “bail-in” clause), followed by state support.  However, it would not go over well to have the largest bank in your nation converting bank bonds to equity and, if the run became fully developed, creditor bail-in would probably be inadequate.  The need to inject state money would be difficult to avoid and very unpopular.  Second, if Germany uses state money to bail out its banks, it will be hard to tell Italy that it can’t do the same.[1]  Once governments begin bailing out banks, fiscal profligacy could easily follow and that notion worries Germany, fearing that excessive fiscal spending will weaken the EUR and bring inflation.

Thus, the risk is that the Merkel government, already prone to deliberate actions, may wait too long to step into a deteriorating situation with Deutsche Bank due to high political costs and cause more market turmoil than necessary.  It is important to remember that the Bush administration’s decision not to support Lehman Brothers was ultimately a political calculation.  The concern among policymakers was that continuing to bail out banks created a moral hazard and led the banks to increase their risky behavior, confident in ultimate government support.  The decision to try to stop that process was defensible, but it’s hard to fully account for all the risks.  The same is true with the Deutsche Bank situation.  It is no doubt true that the bank has significant resources to weather the storm (assuming the storm remains manageable), but concerns that a government backstop may not be as solid as one would expect given the bank’s size and position in the German economy remains the key issue.  Therein lies the risk.

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[1] http://www.reuters.com/article/us-eurozone-banks-italy-boi-idUSKCN1200KD?il=0

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Oil prices jumped yesterday on an announcement that OPEC had arrived at a deal to cut production.  This was mostly unexpected (we didn’t expect it).  According to early reports, the cartel agreed to cut output by 0.7 mbpd, which included a 0.4 mbpd cut by Saudi Arabia and a cap on Iranian production at 3.7 mbpd.  That agreement would put cartel output at 32.5 mbpd.  As the day wore on, however, the deal was clearly less than advertised.  First, there isn’t really an agreement.  OPEC won’t actually detail production quotas until the November 30^th meeting.  The latter commentary suggested that cuts could be in a range between 0.7 mbpd and 0.2 mbpd.  The former is impressive; the latter is mostly a rounding error.  Later comments from the Iranians indicated they will not “have” to freeze output, which we read as “won’t.”

There are other questions.  Why would the Saudis raise the risk of social unrest by announcing a 20% salary cut for government workers, along with subsidy cuts of up to 15% for housing, if they knew they were going to work out a deal with OPEC to lift prices?  Will Saudi civil servants, who represent about 66% of all employed Saudis, go along with less income when they know that the kingdom has a deal to lift oil prices?  What prompted the kingdom to cave into Iran’s demands?  Given recent history, giving in to Iran would suggest that conditions have deteriorated more than the financial data would suggest, or the Saudi princes have rebelled against Deputy Crown Prince Salman and demanded higher oil prices and more revenue.  This seems like a major policy reversal that has come without comment from the DCP.  Finally, the Russians got off without cutting output!

The sharp rise in prices yesterday had all the look of short covering.  OPEC did buy itself some time before it has to make a deal, but a meaningful agreement still looks like a long shot.  Thus, we would be surprised to see much follow through from yesterday.  At the same time, the potential for an agreement will put a floor under prices, meaning that the $40 to $42 price zone (WTI) will probably become a base for the market.  Why?  Because OPEC appears to be working to resume its market-balancing role.  It still isn’t clear whether the cartel is fully behind this resumption and it doesn’t answer the long-term question for oil producers, which is the value of future reserves.  If regulation turns oil into coal in 20 years, why would anyone wait to produce instead of doing so now?

U.S. crude oil inventories fell 1.9 mb compared to market expectations of a 2.4 mb build.

This chart shows current crude oil inventories, both over the long term and the last decade.  For the past three weeks we have seen a steady decline in stockpiles.  As the chart below shows, seasonally, we should see inventories rise as refineries begin their maintenance period.  However, we have seen a sharp drop in oil imports which have exceeded seasonal norms.  Some of that decline was due to tropical disruptions but the drop is clearly noticeable.

If this trend continues, it would be bullish for WTI.  The seasonal pattern suggests at least a leveling off of import flows and a build in stockpiles.

Based on inventories alone, oil prices are overvalued with the fair value price of $45.66.  Meanwhile, the EUR/WTI model generates a fair value of $49.07.  Together (which is a more sound methodology), fair value is $44.17, meaning that current prices are close to fair value.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Overall, there wasn’t much news overnight.  We haven’t had much to say about Deutsche Bank (DB, $11.92, +0.07), although there have been legitimate fears that Germany’s largest bank could need a bailout despite protests to the contrary.  Shares did lift this morning on news that the bank sold off some insurance assets and continues to promise it won’t raise new capital.  Probably the most supportive news came from Reuters, which reported that the German government is quietly preparing a rescue plan.  According to the report, the German government is prepared to acquire up to a 25% stake in the lender.  Usually, the bearish trend begins to dissipate once the markets know a backstop is in place.  For the broader markets, this step will be welcomed in the hope that it will reduce the odds of a financial breakdown.

The other important news is that oil prices ticked higher overnight despite the almost certain likelihood that OPEC won’t be able to negotiate a deal.  We have been under the impression that the Saudis are trying to shift the blame to Iran by offering a cut only if Iran freezes its output, fully aware that the Iranians won’t accept the deal.  However, reports from Bloomberg build the case that the kingdom is working toward a deal with Iran and hopes to come to an agreement at the regular meeting in November.  Roughly speaking, there is a 0.6 mbpd production cut gap between Iran and Saudi Arabia that will have to be negotiated.  It should be noted that even if Iran and Saudi Arabia come to an agreement, Russian oil output continues to rise, reading a new post-Soviet record of 11.1 mbpd of crude oil and condensate, exceeding the old record by 0.2 mbpd.  U.S. production also appears to have stabilized.  Thus, a Saudi-Iran deal within OPEC may put a floor in the market but may not lead to a major recovery.

If there is an evolving change in Saudi Arabia’s production policy, suggesting the kingdom needs price relief, we suspect its coming from continued deterioration in its financial position.  Earlier this week we discussed the kingdom’s plan to slash government workers’ wages and benefits.  As we noted, this move undermines the Royal Family’s social contract with its people, where the people forfeit any say in running the government in return for a posh lifestyle.  Here are a couple of charts that show the problems the kingdom is facing.

The chart above shows Saudi Arabia’s foreign reserves.  They have declined over 23% from the peak set in September 2014, and the pace of the decline is unmistakable.  In addition, the country is facing growing financial pressure.

This chart shows Saudi three-month LIBOR.  Since the summer of 2015, interbank lending rates in Saudi Arabia have been rising quickly.  These rates can often reflect stresses in a nation’s banking system.  The steady rise in yields suggests problems in the Saudi financial system.

The short-term cure to falling Saudi foreign reserves and rising financial stress is higher oil prices.  The more conciliatory position may be a signal that the kingdom is “tapping out” to some extent and is preparing to abandon its singular focus on market share.  We don’t know for sure whether Deputy Crown Prince Salman is the architect of this potential policy shift, or if he will step in at the last minute as he did in the spring and signal that the kingdom will maintain its goal of gaining market share.  This unknown will likely be addressed in November.  Nevertheless, if OPEC can signal that there is hope for a deal in two months, it would probably put a floor in prices and prevent a drop under $40 per barrel.

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