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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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The first presidential debate was held last night and Sen. Clinton won by nearly all accounts.  She was, as expected, well prepared.  Potentially dangerous areas for her, such as the ongoing e-mail scandal and the Clinton Foundation, were not heavily covered.  Much time was spent on Trump’s tax returns; it does make one wonder what could possibly be in them that he does not want the world to see, because the cost of keeping them hidden appears to be very high.  As is typical of Mr. Trump, he suggested there was something “faulty” with his microphone that accounted for his problems.  In our research on his personality, he usually either wins or there is an exogenous reason for his apparent loss.  In reality, it appeared to us that Mrs. Clinton was successfully able to bait Trump into spending much time on his tax returns and his treatment of women.  And, most of Mr. Trump’s responses seemed to be a strange mix of word association, the kind of responses that one notices when teaching and a student answers a question with generalities, hoping that he says enough of the right words to get a pass at a right answer.

His response to the nuclear policy of “first use” was a good example.  He started his answer by seeming to suggest he would never use nuclear weapons first, which would be a monumental change in U.S. nuclear weapons policy.  First use allows NATO and the U.S. to respond with nuclear weapons if faced with a conventional attack.  Giving up first use would essentially restrict the use of nuclear weapons to only a response against a similar attack.  Later in his answer, he signaled that he would always want to keep his options open.  About the only conclusion we could draw was that he didn’t really understand the policy of first use and so he was “winging it.”  If our analysis is correct, he was simply unprepared for this debate.  The New Yorker recently quoted Trump as saying, “The day I realized it can be smart to be shallow was, for me, a deep experience.”  In the same piece, Trump is quoted as saying that others “…are surprised by how quickly I make big decisions, but I’ve learned to trust my instincts and not to overthink things.”[1]  These characteristics were evident last night.

The markets’ verdict was clear—Mrs. Clinton won.  The Mexican peso (MXN) has been very sensitive to the likelihood of a Trump win, weakening as he has been rising in the polls.   The currency’s performance last night was clear.

This is a three-day chart of the MXN/USD exchange rate on an inverted scale.  As Trump stumbled in the debate, the currency rallied strongly.

At the same time, it’s important not to read too much into this.  The Brexit vote showed that the establishment is a minority and even if the educated top 30% of the income scale saw Trump as unfit for office, that doesn’t mean he didn’t reach the lower 70%.

It should be noted, however, that the debate may not be decisive.  For voters who support Trump, he said all the right things about trade and the opportunity for political disruption.  Those who support Clinton heard what they needed to hear as well.  Among the potential undecideds, we have always suggested that the key voters are the disaffected Sanders voters.  We believe that there was nothing in yesterday’s debate that probably changed their minds.  Clinton came across as the status quo candidate; voting for her is simply a continuation of the last eight years.  Trump probably did nothing to make this group of voters feel comfortable about voting for him.  Thus, disillusioned Sanders supporters are still stuck with (a) voting for a third-party candidate, or (b) staying home.  We still contend the election rests with the Sanders voters and nothing about that changed last night.  We will be watching the polls in the coming days to see if anything decisive emerges but we would not expect such a change.  Trump would have liked to perform better and he will likely be better prepared for the next debate.

In other news, the OPEC meeting looks doomed to fail.  Iran came out today and said it has no plans to freeze its output.  This seemed to us to be a long shot all along, but the Saudi proposal will at least allow them to blame Iran for the failure of talks.  We note that Saudi Arabia has announced it will cut government worker pay by at least 20%, reduce perks and limit overtime as well.  Housing stipends were cut by 15% and vacations were capped at 30 days.  A hiring freeze was announced.  This news will be a shock for a protected class of worker that should have influence as more than two-thirds of all employed Saudis work in civil service.  This is a very dangerous announcement for the House of Saud.  The social contract in the kingdom is that the people have no say in how the government is run and the government provides a cushy life for its citizens.  Drastic cuts in pay could raise calls for greater participation in government.  We will be surprised if King Salman can push through these changes without civil unrest.

Finally, Venezuela is floating the idea of a debt swap; around $5.0 bn of PDVSA debt is coming due over the next two months and an additional $2.0 bn over the next year.  The state oil company is in discussions with bond holders to suggest a bond swap, trading current bonds for ones that mature in 2020.  We note that S&P is suggesting it will probably treat such a swap as a default.  There is some concern that the new bonds will pledge the Citgo assets as collateral and these have been promised on other bonds already.  Venezuela is skidding toward full default and this might be the opening salvo toward that end.

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[1] Osnos, E. (2016, September 26). Letter From Washington: President Trump. The New Yorker.

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] It was a quiet weekend.  The only major news of note was that Jeremy Corbyn was elected as the leader of the Labour Party by nearly 62% of party members.[1]  Most political pundits are predicting the Labour Party is doomed to the political wilderness until it gives up on this charge to the left.  Perhaps; however, like Brexit, the Trump/Sanders phenomenon, the AfD in Germany and the National Front in France, this news is a clear signal of the rise of populism.  Those left behind by globalization, deregulation and the rapid introduction of new technology have had enough.  Up until the financial crisis, rising debt and distraction from social issues kept populists on both the right and left pacified.  Deleveraging and weak growth have ended the populists’ tolerance.  As a result, populists across the West are trying to grow their influence, which could mean a reversal of the supply-side policies of the past 35 years.

It is with this background that the U.S. holds its first presidential debate this evening.  There has been much ink spilled on the ramifications of this debate.  Debates are always interesting because they are unscripted; unusual things can happen.  However, the impact is probably overstated as core supporters are rarely swayed by debates.  When a debate occurs between two establishment figures, likeability is probably the best trait to project.  Al Gore’s irritating sighing in response to George W. Bush’s answers did him serious harm.  This election is unusual because it is between a populist and an establishment candidate.  Essentially, Clinton offers continuity while Trump promises change.  Thus, much like the Reagan/Carter debates, this election may simply come down to how you fared over the past eight years.  If the years went well for you, Clinton is your candidate.  If they didn’t, either Trump or one of the other party candidates might be your preference.

So far, we don’t think the financial markets have discounted a Trump presidency.  If Trump even remotely projects a modicum of presidential aura, it will be a success.  If he doesn’t make a hash out of his performance tonight, we may see some weakness develop in equities.  On the other hand, Clinton needs to goad Trump into looking a bit crazy, or “non-presidential.”

Finally, OPEC is meeting over the next three days.  There is growing hope that the cartel will come to some sort of output agreement.  Although we doubt it will happen at this meeting, the outlines of a deal are starting to take shape.  Saudi Arabia will probably cut production to Q1 levels, around 10.2 mbpd, if Iran agrees to keep output at current levels, somewhere between 3.6 to 3.8 mbpd.  The other Gulf States will probably contribute an additional 0.4 mbpd.  This agreement likely isn’t enough to stimulate a recovery much above $50, but it will implement a floor around $40 per barrel.  As prices stabilize, we would expect U.S. production to stabilize and recover.  In addition, the Russians will not only keep production elevated, but they will try to grab market share.  So, the good news is that OPEC is probably creating a sustainable price floor but little else.  However, that may be enough to lift energy sentiment.

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[1] For background on Corbyn, see WGR, Meet Jeremy Corbyn, 9/21/2015.

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] This morning’s big news comes from OPEC, where Reuters is reporting that Saudi Arabia offered a production cut if Iran would freeze production.  We do not know how much the kingdom has offered to reduce its output, but Iran did tell Russian media that it would need Saudi Arabia to “slash” its production.  Current Saudi production is 10.6 mbpd, near record highs, while Iranian output is 3.6 mbpd.  Iran has indicated it wants to raise output to 4.0 mbpd; we believe that will probably be close to its sustainable output level.

Although we obviously don’t have all the details, we can develop a reasonable set of deal parameters.  We suspect Saudi Arabia wants to see Iran hold production at current levels and will not grant it the additional 0.4 mbpd of market share.  Iran would probably want Saudi Arabia to cut output by more than 0.4 mbpd.  We doubt the kingdom would meet this demand.  We note that about 0.8 mbpd has come to global markets due to production recoveries in Nigeria and Libya, and from new output by Russia.  A Saudi/Iranian agreement would force both to cede market share, something we doubt either would be comfortable doing.

So, what is Saudi Arabia doing?  It is quite possible that it is trying to shift the blame for weak prices to Iran.  If the kingdom offers a token cut, less than 0.4 mbpd, Iran will almost certainly reject a freeze.  The Saudis will say that they did “try” to work out a deal with Iran but, due to Iranian intransigence, it failed.  If no deal emerges, oil prices will likely ease toward the $40 per barrel level.  However, we don’t expect prices to fall much below $40 in a worst case scenario.

The FOMC’s decision has been well discussed but we do want to offer a reflection on the growing dissention developing at the FOMC.  Three presidents dissented from the steady policy decision, while three “dots” suggest no rate hike this year.  There have only been five other instances in the past three decades when we had three dissents.  If a rate hike does occur, it is possible that we will have three dissents again; however, we suspect that at least two of those calling for no change this year are governors, probably Brainard and Tarullo.  The last time we have two governor dissents was in 1993.

Fed chairs try to maintain a consensus; large numbers of dissents raise fears in the financial markets of policy instability.  So far, the financial markets have taken the policy signals as supportive as the dots chart continues to show a steady slide in the terminal rate for the fed funds target.  Given the softening data recently, even a December hike isn’t certain.

Here is the latest Q3 GDP estimate from the Atlanta FRB.

From the September peak, the estimate has dropped 0.55%.

Looking at the data, since September 2, 39 bps of the 55 bps drop have come from lower consumption estimates, 11 bps have come from lower investment and 8 bps have come from lower government spending, while net exports have added 3 bps.  Overall, Q3 growth looks ok, but the momentum is slowing; election worries could make Q4 data soften further.  In this environment, if Yellen does want to raise rates with a divided Fed, she will likely be unable to sway the doves on the board.  Rising dissent will, at some point, become a risk factor for the financial markets.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] As expected, the Fed did not raise rates yesterday.  Risk markets rallied following the release and are higher again this morning as investors focus on the more dovish aspects of the release.  A key sentence was added to the FOMC statement, which read, “The Committee judges that the case for an increase in the federal funds rate has strengthened but decided, for the time being, to wait for further evidence of continued progress toward its objectives.”  Although it is hard to define what the Fed means by “for the time being,” the likelihood of a hike has increased for December, with market expectations for December at 61% last night and 59% this morning.  The Fed is signaling that the decision is still data-dependent and the committee is ready to raise rates if conditions improve further.

There were three items of note regarding the FOMC decision to maintain rates at the current level:

1. The prepared statement was hawkish, at least for the near term.  The language for growth was upgraded, and now states that “economic activity has picked up from the modest pace seen in the first half of this year.”  The Fed perceives that the labor market is healing and inflation levels are moving closer to the Fed’s target, and near-term risks to the economy appear “roughly balanced.”  In June, the committee indicated that the near-term risks to the economy had “diminished.”  Within the statement, business fixed investment was pointed out as an area that could use improvement and, during the Q&A, Yellen also said that the Fed is keeping an eye on international growth.  Additionally, the presidential election is adding another measure of uncertainty.  The prepared remarks basically said that although the Fed could have raised rates this time, it decided to wait to do so until it sees confirmation of a strengthening trend.
2. The dots chart was more dovish as members tapered their expectations for the path of rate increases.  Three participants look for no hikes this year compared to zero participants in June.  The chart below shows the dots.  Participant expectations for increases have moderated from prior data.  As a result, we have seen a modest flattening of the yield curve as short-term yields remained roughly unchanged, but the intermediate and longer term durations reacted to the more dovish dots.

   

3. The vote was 7-3, with George, Mester and Rosengren dissenting.  All three dissenters called for a September hike.  We note that for such a collegial FOMC, three dissenters is actually quite a lot.  All three dissenters were regional Fed presidents, rather than FOMC governors, as it is more common for regional presidents to have divergent views.  The past two FOMC chairs have generally aimed to maintain as much unity as possible, especially amongst the governors.  Divergent opinions are healthy in maintaining a well-rounded debate, but the increasing number of dissenters calling for an increase also means that it is more likely.

Markets have reached a calm following the Fed’s decision.  Most risk markets are trading higher as the Fed and other central bank decisions are in the rear-view mirror, thus removing short-term uncertainty.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Equity markets are generally higher following the BOJ release.  The BOJ did not do anything too radical—no helicopter money or foreign bond purchases.  But, there were some changes.  The focus of policy will shift to the yield curve as the 10-year JGB will be pegged at zero; the rate had been negative.  This move appears designed to steepen the yield curve.  Asset purchases will continue but will depend on rates as opposed to a specific target amount for QE.  Thus, in theory, QE could exceed the ¥80 bn per month but could also fall from that level, introducing tapering, depending on the rate path of the long end of the curve.  There will probably be no changes in purchases in the short run, but we would look for a modest decline in purchases over time.  Finally, there was some degree of forward guidance as the bank promised to exceed its 2% inflation target.  This move isn’t really significant as it has been missing its 2% inflation target for over a year.

Although global equity markets seem to like the BOJ’s moves, we think a key insight can be derived from the forex market.  The JPY initially weakened but has subsequently rallied.

If BOJ policy had been seen as stimulative, the JPY would have continued to weaken.  We suspect that, eventually, markets will conclude the BOJ is running out of policy tools and deflation will remain in place indefinitely.  It would not be unusual for markets to take 24-48 hours to digest the ramifications of the central bank’s moves.  Investors’ attention is now turned to the Fed and market reaction to the BOJ decision could change following the FOMC release.  Nevertheless, today’s market reaction to the BOJ was not negative.  The chart below shows the overnight move in the Nikkei index, which rose following the BOJ release.

The consensus is that the FOMC will stand pat, with market expectations calling for a 22% likelihood of a rate increase.  We recently read a provocative analysis from Ben Hunt, the chief risk officer at Salient Partners.  In his report, “Epsilon Theory,” he makes the case that the Fed’s culture is much like a large research university.  If this is true, the Fed’s decision making isn’t about keeping the markets calm or supporting the banking system.  Instead, it’s all about reputation.  A college professor usually isn’t in it for the money (although most are not opposed to getting a bit of cash along the way); the goal is to be perceived as smart.  Hunt’s argument is that if a decision is between hurting the market but sustaining the Fed’s reputation or supporting the market but making the Fed look incompetent, then the former will win.  Thus, the idea that the Fed follows the market is nothing more than a coincidence, a spurious correlation.

The Fed’s reputation has been taking a beating recently.  Negative interest rates are feared by the public and seen as a potential mistake.  Low interest rates are quite unpopular with the retiring baby boom generation.  What does the Fed need to do, at least according to Hunt?  Raise rates and declare victory.  Does the economy need a rate hike?  Probably not.  However, if negative rates are not a possibility, then the Fed has little room to act when the next recession hits.  Lifting rates to give itself room to cut doesn’t make a lot of sense—policy should be in response to current circumstances.  But, from a reputational perspective, having room to cut will give the illusion that the central bank can act, even if the rate hike itself potentially contributed to the recession.

In addition, if the Fed is really nothing more than a high-powered university economics department, then the goal also seems to be about creating a consensus among the really smart people.  There does appear to be a growing consensus about a rate hike.  Declaring victory by saying the FOMC has met its institutional goals (full employment and low inflation), raising rates today and signaling that it will be a long time before the next move would likely be a good outcome.  Although financial markets would not react well initially, the signal of no more moves this year would be welcomed.  Financial markets would likely rebound and the dollar would probably remain mostly steady.  By declaring victory, the Fed would then put the onus of the next recession on fiscal policy.

An alternative scenario is no hike today but certain hike in December.  In fact, market expectations call for a 60% likelihood of a December increase.  No hike in September with a hike in December would tend to damper equities and boost the dollar.  A better outcome would probably be “a hike today and go away,” stating the terminal rate is in place for the foreseeable future.  Of course, the worst outcome would be a hike today that the market doesn’t expect with no declaration of victory.

The bottom line: although odds still favor a December rate increase, the odds of a move today are probably higher than the market thinks.  We will find out at 2:00 pm EDT when the Fed releases its policy decision, economic projections and dots chart, followed by a press conference.

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