by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The FOMC minutes did have some interesting information but no real surprises.  It confirmed what the dissents and the dots chart indicated—the FOMC is divided on policy.  The hawks are concerned that waiting too long to raise rates could lead to an overheating economy and force the central bank to ratchet up rates quickly, leading to a recession.  This group would recommend a modest hike now to prevent that overheating and extend the current business cycle.  The doves argue that slack remains in the labor market and, with rates this low, the FOMC has ample room to raise rates if the economy overheats but limited room to cut if the economy weakens.

It doesn’t appear to us that much has changed.  We expect the Fed to raise rates in December but make only one more move next year.  Fed funds futures put the odds of a December hike at 61%, unchanged from before the minutes.  Our position is that the FOMC will raise rates in December to placate the hawks.  To calm the doves, forward guidance will suggest that there will likely only be one hike in 2017, barring a surge in economic activity.

The king of Thailand, Bhumibol Adulyadej, died this morning at the age of 88.  He had been suffering from a myriad of age-related ailments for years.  The king had ruled for over 70 years.  He is expected to be succeeded by his son, Crown Prince Vajiralongkorn.  The king’s passing could raise political tensions in Thailand.  He was the key unifying figure in a country that has seen 19 coups (12 of which were successful) since the absolute monarchy was abolished in 1932.  This political instability has been managed mostly by the king intervening when tensions were close to boiling over.  His death raises the possibility that the rural-urban divide, the most potent in the country, will become unmanageable.  Currently, the country is governed by a military junta that replaced the previous democratically elected government that favored the rural faction.  Elections were expected by the end of next year; the king’s passing will likely delay the vote.

Thai financial markets have been under pressure from the king’s illness and his passing.

The chart above shows the Thai baht per dollar, so a rising reading is a weakening baht.  Note the rapid spike over the past two days, indicating currency depreciation in light of the political uncertainty.  Thai equities have suffered as well.

Finally, as we note below, China’s trade data came in weaker than expected.  Exports plunged 10%, much weaker than forecast, and imports were also soft, falling 1.9%.  This weakness might explain why the PBOC has been allowing the CNY to depreciate.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The big news overnight was that PM May will allow Parliament to debate on her plan to exit the EU.  The GBP rallied strongly on the reports.  However, there is nothing to suggest that she is planning to let the legislature vote on Brexit.  There is a constitutional dispute in the U.K. over this issue.  A number of legal scholars in Britain are arguing that the referendum on Brexit isn’t really binding and only an act of Parliament can authorize an Article 50 declaration.  An Article 50 declaration begins the process for the U.K. to exit the EU.  Thus, in order to declare Article 50, Parliament would need to vote on the measure and it is quite possible that an act to authorize Article 50 would fail given the current makeup of the U.K. legislature.

May seems to disagree with this legal position and is indicating that she has the authority to declare Article 50 without an act of Parliament.  The basis of this argument is the “Royal Prerogative,” which gives the state executive power to act without permission of the legislature.  There is some dispute over who actually now has this power; although historically reserved for the sovereign, in the modern era some have suggested it resides with the actual head of state, the prime minister.

It does not appear that May plans to request an act of Parliament to declare Article 50.  However, the legal situation isn’t all that clear and it is possible the courts will need to decide if PM May can actually move to declare Article 50 without an act of Parliament.  If this is the case, we could easily see a long process for Brexit, at a minimum.  It also isn’t out of the question that it still may not occur.  May’s action today doesn’t appear to be an impediment to her plans to declare Article 50 without an act of Parliament, but we do expect a legal challenge if she tries to start the Brexit process without one.

At 2:00 EDT, the Federal Reserve will release the minutes from the September meeting.  Although the heavily edited discussion is always closely scrutinized, this one will come under particular focus due to the growing divergence of views within the FOMC.  As noted before, we had three dissents to not raising rates at the September meeting, but the dots plot showed that three participants wanted to leave rates steady for the remainder of the year.  Fed fund futures are signaling a 68% chance of a rate hike at the December meeting.  The strength we are seeing in the dollar (which is, in our opinion, behind recent equity market weakness) is due, in part, to expected tightening.  However, the deferred Eurodollar futures are putting the terminal rate at 100 bps two years from now.  That suggests a hike this December and one next year.  Barring more aggressive easing by the other G-7 central banks, this strength in the dollar will be difficult to maintain.  In general, we look for dollar strength into year’s end but a retreat thereafter.  We will have more to say on this in the coming weeks in the Asset Allocation Weekly.

This chart shows the implied three-month LIBOR rate two-years from now, based off the Eurodollar futures.  Note that after Chair Bernanke introduced the idea of tapering in May 2013, the implied rate began to rise rapidly in anticipation of a withdrawal of monetary stimulus.  After the December 2015 rate hike, expectations began to fall rapidly and are currently suggesting the Fed will reach 1.00% for the fed funds target and hold that level.  Since the dollar’s rally was mostly precipitated by rates 80 bps higher, we would look for a moderation in the greenback next year.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Global equity markets are mixed this morning.  The EuroStoxx 50 is trading higher by 0.4% from the last close.  In Asia, the MSCI Asia Apex 50 closed lower by 1.7% from the prior close. Chinese markets were higher, with the Shanghai Composite moving up by 0.6% and the Shenzhen index moving up by 0.5%.  U.S. equity futures are signaling a lower opening.

Financial markets were mostly quiet overnight.  We are seeing some modest weakness in oil prices.  Oil rose yesterday, bolstered by comments from Russian President Putin who indicated that Russia would consider production cuts if OPEC reduced output.  This morning, the Russian Energy Minister, Alexander Novak, indicated that Russia was only considering a freeze on production, not a cutback.  The head of the state controlled Rosneft (MCX: ROSN, RUB 362.40), Igor Sechin, a key oligarch, indicated his company would not reduce output. Rosneft controls 40% of Russia’s output, which hit a new national record recently at 11.1 mbpd.  In fact, analysts project Russia will increase output next year by 1.6%.  Russia has a history of promising to cooperate with OPEC but failing to follow through.

The WSJ reports that Libya, Iran and Nigeria could add as much as 0.7 mbpd of production in the coming months.  The IEA indicated that OPEC output recently reached 33.6 mbpd, a new record.  Thus, even the advertised cut would only reduce output to 33.1 mbpd, and if the aforementioned nations hit their targets, OPEC output would actually rise to 33.8 mbpd.  We believe the talk about cutting output is driven by a form of Saudi “window dressing” as it prepares for a global bond issue and the Saudi Aramco IPO in 2018.  Given the run up in oil prices, any disappointment could lead to a sharp selloff in the near term.

On the topic of oil, there are two other side notes of interest.  The DOE, for some unknown reason, has decided to exclude a category of oil called “lease stocks” which is oil in the process of moving to pipelines, railcars or trucks on their way to refineries or tank farms.  In reality, it’s still oil and will eventually become part of the inventory number, but the change is material—lease stocks represent about 31 million barrels (mb) which will be cut from the inventory number this week.  Thus, on Wednesday, expect to see a massive draw in crude oil.  In reality, any number less than 31 mb will actually be a build in oil inventories.  Why did the government do this?  Strictly speaking, lease stocks are not available for current use and thus are not actually accessible.  On the other hand, the oil is available in short order and so excluding it now doesn’t necessarily make much sense.  The weekly data won’t contain it, although once we get past this week, the weekly changes should be consistent with the data that have the lease stocks included.  It appears that lease stocks generally run between 31 to 33 mb.  They probably should be considered like base gas in the natural gas inventory numbers; base gas pressurizes storage wells and remains mostly stable, although we have seen circumstances where storage operators tap base gas when supplies are unusually tight.  The bottom line…don’t be shocked to see a massive drop in stockpiles this week.

Second, we are seeing a steady rise in the dollar.  A strengthening dollar is generally bearish for commodities, including oil.  The longer this rally in the dollar extends, the greater the odds of an oil correction.  Based on a $1.1100 €/$ exchange rate, fair value for oil is $46.49.  Each penny drop in the exchange rate cuts the fair value for oil prices by $2.33.

We did see a rather sharp selloff in the South African rand after news broke that the well-respected Finance Minister Pravin Gordhan was summoned to appear in court over fraud allegations.  According to reports, the fraud stems from his role as head of South Africa’s tax authority a decade ago.  Gordhan and President Zuma have been at odds for some time over control of the country’s state finances.  Zuma tried to fire him in the past but was forced to relent due to financial market volatility.  We suspect these charges are a power grab by the president.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Global equity markets are mixed this morning.  The EuroStoxx 50 is trading higher by 0.7% from the last close.  In Asia, the MSCI Asia Apex 50 closed lower by 0.05% from the prior close. Chinese markets were higher, with the Shanghai Composite moving up by 1.5% and the Shenzhen index moving up by 1.9%.  U.S. equity futures are signaling a higher opening.

Trading is a bit thin this morning.  In Asia, markets in Japan, Hong Kong and Taiwan were closed last week and U.S. fixed income markets are not open for the Columbus Day holiday.  Most of the weekend news was political although there was some other news as well.

The political backdrop:  Four weeks from tomorrow most Americans will go to the polls to elect electors for president and to vote on Congressional candidates.  There were three big items over the weekend.  First, a 2005 “hot mic” on Donald Trump revealed a series of comments that put the candidate in a very bad light.  As the weekend passed, a large number of GOP candidates pulled their endorsements and the GOP leadership appears to be withdrawing its support for Trump and instead is trying to salvage the down ballot candidates.  There was talk that Trump would be forced out as the party’s candidate, and rumors continue to circulate that Sen. Pence may leave the campaign as well.

We view this from the prism of establishment v. populist.  Trump has been the candidate of the latter; the center-right was never comfortable with his candidacy.  We find it a bit odd that the tapes were taken as a surprise—how many times has Trump said something that would have ended the candidacy of an establishment candidate, but seemingly had little impact on the Trump campaign.  We doubt these revelations will change the minds of committed Trump voters who are attracted to him for his positions on trade and immigration.  However, that group isn’t large enough to win the election and without the support of the center-right, the hurdle to win is quite high.

Second, a series of Wikileaks were released, detailing comments following Sen. Clinton’s speeches to financial services firms (for which she was well compensated).  They suggested that her positions on financial services regulation, trade and the like were solidly establishment.  It came up in the debate where she was asked about her comments about having public and private positions.  She responded with a rather unconvincing story about how the comments were part of a critique of a movie about President Lincoln.  Had this come out during the primaries (in other words, if the transcripts of her talks to financial services firms had been released), she might not have been able to defeat Sen. Sanders.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Global equity markets are mixed this morning.  The EuroStoxx 50 is trading lower by 0.5% from the last close.  In Asia, the MSCI Asia Apex 50 closed lower by 0.3% from the prior close.  Chinese markets are closed for the Golden Week holiday.  U.S. equity futures are signaling a lower opening.

Happy employment day Friday!  We cover all the information below, but the quick overview is that the data was fairly close to expectations.  Non-farm payrolls rose 156k, a bit weaker than the 175k forecast.  Revisions subtracted 7k from the current number.  The unemployment rate ticked higher, to 5.0% from 4.9%, and was higher than expected.  However, this was a “good” rise in the unemployment rate because it came from a 444k rise in the labor force along with a 354k rise in employment as measured by the household survey.  Simply put, more Americans returned to the labor force, most likely because economic conditions have improved enough to encourage a return to work.  Wages grew by 2.6%, in line with estimates.

Overall, the data is such that one could make a good argument for holding monetary policy steady.  In fact, it’s almost a “goldilocks” report.  The payroll number was strong enough to show no danger of recession but weak enough to reduce the threat of overheating.  The worry is that low unemployment will eventually push wages higher and cause inflation.  The great unknown is whether the low level of employment participation represents people who are permanently out of the labor force or more of a “reserve army of the unemployed.”  If the former is true, the Fed should move rates higher now.  If the latter is true, there is still slack in the economy and moving rates too quickly will snuff out the expansion just when it is encouraging labor market participation.  Given the divisions on the FOMC, we expect a modest “one and done” tightening in December.

But, before we jump into the employment report, we have to take some time to discuss one of the more bizarre events overnight when the British pound plunged.

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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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