by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] It was a very busy weekend for news.  Let’s take a look:

Terrorist attacks: There were a couple of bomb explosions over the weekend along with a number of unexploded devices found in the Greater New York area.  The story is evolving but security officials have named two suspects and are seeking three others for questioning.  Although police and FBI have stepped up their investigation, so far, the public and markets are taking this event in stride.  There is no evidence of problems in the financial markets.  Separately, a terrorist attacked and wounded nine people in a stabbing incident in a Minneapolis shopping mall.  This assailant was killed by an off-duty police officer.  IS did claim responsibility for the Minneapolis attack but has not made mention of the New York bombings.  We will have a WGR on terrorism out later today.

Central banks: The BOJ and Fed meet this week.  Perhaps the most important is the BOJ meeting as this bank is starting to grapple with the problem of the exhaustion of monetary policy.  Rumors continue to fly about what the BOJ will do.  In our opinion, the key is getting the JPY to weaken.  The most effective policy, QE with foreign bonds, probably won’t be implemented; we expect more QE.  This may not satisfy the financial markets but it is also likely that this outcome has been mostly discounted.  Meanwhile, the FOMC probably will not move this week but will likely signal a change by December.  The WSJ has a profile of Boston FRB President Rosengren who has moved into the hawkish camp due to worries about overvalued financial assets.  Although there is a case to be made for raising rates for this reason, it is hard for any Fed chair to go to Congress and explain that they raised rates because the stock market was too strong.

European elections: There were two elections over the weekend.  In what was no surprise, the United Russia Party, which is Putin’s affiliation, won Duma elections in a landslide.  The government had scripted the election, putting a virtual freeze on opposition media and thus making it nearly impossible for any opposition to campaign.  United Russia won 76% of the Duma, or 343 seats, up from 238 in the 2011 elections.  However, turnout was only 48% compared to 60% in 2011, suggesting that Russians are expressing their opposition by simply not voting.  In Germany, the CDU, Chancellor Merkel’s party, lost ground in Berlin local elections, its second straight defeat in a local election.  The populist AfD won 11.5% of the vote, which will give it proportional representation in the local government.  The CDU won 18% of the vote, down from 23% in the last election.

OPEC meeting: OPEC meets informally next week and, according to the cartel’s secretary general, if a consensus is reached at this meeting then an emergency formal meeting could be held.  According to Venezuelan officials, the group is “close” to an agreement.  We do not expect any move to cut production; at best, OPEC may freeze output at current levels.  However, Iran won’t agree to such a move and Saudi output is near record highs.  Thus, a freeze won’t do much to relieve the overhang.  Simply put, we look for more supportive talk but little supportive action.

An EU military: Saturday’s NYT reported that EU leaders are considering a consolidated military force, something that would have been impossible before Brexit.  The U.K. would not allow its soldiers to come under EU control but, now that the British are leaving, European leaders are considering a joint military force with its command in Brussels.  According to the article, the French are solidly behind the idea.  France has always tried to use the EU to leverage its influence.  Eastern European leaders were less enthusiastic about the plan for a couple of reasons.  First, they fear that the force won’t be strong enough to deter Russia but an EU army might tempt the U.S. to pull back from NATO.  Second, the French have never been keen on adding additional members in Eastern Europe and they worry a French-led EU military might be willing to offer them up to Russia in return for other favors.  Under a President Trump, the EU may have no other choice than to remilitarize, so preparing for that possibility is probably prudent.  However, given the EU’s inability to act in concert on most matters, it does seem like a long shot that they could coalesce around a plan to defend themselves.  In addition, the EU has long acted as a “free rider” to U.S. military power and it would be a shock for EU governments to actually take up their own defense.

The deplorable state of the U.K. military: The front page, below-the-fold article in the weekend FT was a telling of the woefully inadequate state of the British military.  According to the report, the U.K. has no plan to defend itself from a conventional attack, meaning a Russian attack might succeed.  It appears the defense plan is to call Washington.  The article also noted that Navy and RAF planes deploy without adequate munitions due to their growing dependence on the U.S.  Additionally, manpower has become depleted as it lacks adequate depth and the government has spent too much money on a few items of expensive military equipment.

The devolution of the British Labour Party: Next weekend, the British Labour Party will hold its annual conference and is expected to re-elect Jeremy Corbyn as leader.  Corbyn is an unrepentant leftist who is taking the Labour Party back to its platforms of four decades ago.  Although the political class abhors Corbyn, the rank and file Labour Party members seem to like him a lot.  If the process continues as expected, the Tories would be fools not to call a snap election.  The Conservatives may not have a definable opposition if they do.  On the other hand, the fact that Corbyn can hold his current position after years in the political wilderness speaks volumes about changes in the Western electorate.

Good lives without good jobs: One of the more intriguing editorials in the Sunday NYT was about how to create good lives without good jobs.  It discussed an ever growing safety net designed to boost household income for those earning low wages.  This trend has been in place and growing for a while; we believe we are still in the early stages of this development.  Globalization, deregulation and the rapid introduction of technology are creating conditions that offer an ever narrowing road to the middle class.  For the bottom 50% of income brackets (and maybe up to the bottom 80%), jobs don’t pay well and have become increasingly uncertain.  At the same time, without enough income for the majority of households, spending will be restrained as will economic growth.  Social unrest will certainly rise.  This isn’t a new problem; we have been tracking this trend since the late 1970s.  However, the growth of household debt covered up this development and allowed this trend to continue.  The financial crisis ended this response to weakening income growth.  The article discusses how a patchwork of government programs, including disability, earned income tax credit, unemployment insurance, subsidies for health care, etc., have given households some support.  Essentially, society has two choices.  The first is a broader safety net that will provide some semblance of income for a workforce that is dealing with employment that is increasingly temporary and marginal, or a return to the 1950-60s model of essentially make-work programs where jobs were protected by regulation.  The former model will mean higher taxes, low inflation and the continued expansion of technological and global progress.  The second will lead to higher inflation, slower introduction of new technology, more regulation and less trade, but more people working.  We suspect we will end up with something that takes a bit from both, but the preponderance will be from the first model.

View the complete PDF

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] There isn’t a ton of news in the financial markets this morning.  The most discussed is the DOJ decision to levy a $14 bn fine against Deutsche Bank AG (DB, $14.76).  In European trading, shares were off over 8% overnight.  The bank was anticipating a fine but the size far exceeded expectations.  Other banks in Europe will likely also face fines, so how much Deutsche Bank actually pays is broadly important.  In addition, Deutsche Bank has other woes, so this fine came at an inopportune time.  This event raises fears that the Eurozone banking system may be suspect; the problems plaguing Italian banks have been known for a while, for example.  There is a solution—European banks will likely have to raise capital and consider international mergers.  So far, this outcome hasn’t been embraced.

EU leaders are holding informal meetings in Bratislava today to discuss Brexit.  In a speech today, Chancellor Merkel said that the EU is at a “critical point.”  We would tend to agree.  Brexit exposed real differences within the EU.  Southern Europe wants more financial support and an easing of debt and deficit rules.  Northern Europe, being the creditor, disagrees.  Central and Eastern Europe are seeing rising nationalism and oppose Brussel’s rules on immigration, refugees and other issues.  At the same time, the northern European nations are dealing with a rise of nationalist parties themselves.  How the EU manages Brexit is part of this debate; some nations want to pressure Britain with harsh conditions on the hope that the British will change their minds.  After all, several referendums on EU treaties have failed in other nations only to be eventually ratified.  The danger of going this route is that Britain’s position will harden even further, disrupting trade and investment flows.  On the other hand, going too easy on the U.K. may prompt others to follow suit and leave the EU.  It is these conditions that prompted Merkel’s aforementioned comment.

With the release of CPI data, we can update our versions of the Mankiw rule model.  This model attempts 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 by 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, Mankiw used the unemployment rate as a proxy for economic slack.  We have created three 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 and a third using involuntary part-time workers as a percentage of the total labor force.

Using the unemployment rate, the neutral rate is now 3.85%, suggesting the FOMC is well behind the curve.  Using the employment/population ratio, the neutral rate is 1.41%, indicating that, even using the most dovish variation, the FOMC needs a rate hike of at least 100 bps to achieve neutral policy.  Finally, using involuntary part-time employment, the neutral rate is 2.98%.  Although we don’t expect the FOMC to raise rates next week, the pressure to raise rates is intensifying.  Of course, there is an ongoing debate as to the wisdom of the Taylor/Mankiw Rule framework.  Although there are clearly doubts about the model (the current wide deviation is clear evidence that the FOMC is deviating from these models), there is no obvious replacement.  Thus, we believe policymakers view the current deviation from the Taylor/Mankiw Rule models as temporary and policy rates will rise sharply at some future point.

View the complete PDF

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The big overnight news was the BOE’s decision to hold rates and bond-buying steady, which was expected.  The committee vote was 9-0 in favor of the current policy.  The bank did indicate, however, that it was still on course to lower rates later this year and this news caused a modest selloff in the GBP.  Although the British economy didn’t collapse as some feared it would after Brexit, we believe the longer term situation is still rather negative in the wake of the referendum.

In other news, Italy’s PM Renzi says he will announce the date for the upcoming referendum on government restructuring on September 26.  This restructuring is seen as a “make or break” moment for Italy.  The referendum would streamline the Italian government by reducing the power of the upper house and allowing policy to be more easily implemented.  Renzi, who was not elected to the PM post, says he will resign if the referendum fails.  The fear is that if the referendum does not pass, populist forces that may support Italy’s exit from the Eurozone could become ascendant.

We note that EU President Jean-Claude Juncker gave a talk yesterday in which he admitted that the EU is facing an “existential crisis,” suggesting there is little common ground between members and governments are facing nationalist and populist threats that undermine European unity.  From Brexit to the weakening of Chancellor Merkel’s party in recent elections, Europe is likely facing a crisis.

The U.S. pivot to Asia took a couple of hits this week.  First, the mercurial president of the Philippines, Rodrigo Duterte,[1] said today that “China is now in power, and they have military superiority in the region.”  Duterte announced the end of joint U.S./Philippine naval patrols in the South China Sea and expelled U.S. forces from Mindanao, an island region of the country.  U.S./Thai relations have become strained after the Obama administration criticized the current military leadership that has controlled Thailand since the 2014 coup.  In retaliation, Thailand announced it will buy three submarines from China.  Meanwhile, China is showing investment on Laos and is working to improve relations with the new Myanmar government.  Although one does not want to jump to conclusions, this information seems to be signaling that some of South Asia’s governments are seeing China as the new regional power and are beginning to accommodate the Middle Kingdom.  We suspect they would prefer U.S. hegemony but fear that America is giving up on its superpower role.  Thus, these nations are simply preparing for a new environment.

U.S. crude oil inventories fell 0.6 mb compared to market expectations of a 2.8 mb build.

This chart shows current crude oil inventories, both over the long term and the last decade.  We saw a huge 14.5 mb draw in crude stocks the previous week, which was mostly due to import disruptions caused by tropical storms.  About half of the oil imports returned to the market last week.  We would expect a rebound next week as imports normalize.

The unexpected drop in storage has put inventories below the normal seasonal trend.  Again, we would expect that drop to be reversed in the coming weeks.

Based on inventories alone, oil prices are overvalued with the fair value price of $41.07.  Meanwhile, the EUR/WTI model generates a fair value of $49.30.  Together (which is a more sound methodology), fair value is $44.67, meaning that current prices are a bit cheap.  Although the market has put great hope on an OPEC deal next month, the plan looks to be more like jawboning the market higher.  For now, oil prices are mostly marking time before OPEC meets on the 26^th.  We were somewhat surprised that oil prices fell off of yesterday’s unexpected draw, but expectations of rising inventories in the wake of the aforementioned drawdown are likely the reason.  In addition, reports yesterday that oil loadings will begin soon in two troubled areas, Libya and Nigeria, are also bearish factors.

View the complete PDF

______________________________

[1] Duterte recently referred to President Obama in crude and derogatory terms.

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] In the next AAW (published Friday), we will discuss the very important impact of foreign issues on U.S. Treasury yields.  This is one reason why the financial markets have become focused on the BOJ’s review of its monetary policy.  There are rumors swirling as to what the BOJ is likely to do.  According to the most recent reports, the bank looks set to dive deeper into NIRP.  When NIRP was deployed in February, market reaction was probably best described as “hostile.”  The JPY rallied and the economy showed no signs of improvement.  Going lower on NIRP is, in theory, a way to steepen the yield curve.  A steeper yield curve is designed to improve the stability of the financial system.  Commercial banks are essentially spread traders; they borrow from depositors and lend to debtors.  The bank earns money based on the spread.  The bank can gain spread in two ways—by taking credit risk or duration risk.  Lowering NIRP will widen the spread and support the banks.  However, the key concern is disintermediation (disintermediation is the process of taking cash out of the banking system).  No major central bank has created conditions where retail depositors have faced negative nominal rates.  Commercial depositors have in a few countries, mainly because these depositors have cash holdings that are so large that disintermediation isn’t a real option.  However, households just might.  If cash flees the banking system, it will make Japan’s economy less efficient.

It is also possible that the BOJ could reduce its QE of longer dated maturities in a bid to raise long-term rates and steepen the yield curve.  However, it isn’t clear whether raising long-term rates will hurt the economy by raising borrowing costs.  The BOJ might also expand QE but purchase more short-dated paper in a bid to drive down short-term rates and, again, steepen the yield curve.

If longer dated JGB yields continue to rise after the BOJ meets on the 21^st, it could have a negative effect on U.S. Treasuries.  Perhaps the best sign of success would be a dramatic decline in the JPY.  A weaker currency is probably the best policy stimulus Japan can generate.  Unfortunately, direct selling of the JPY is frowned upon by the G-7 and G-20 and could invite retaliation.  Clearly, QE with the BOJ buying U.S. Treasuries is probably the most effective tool the bank has to stimulate Japan’s economy—fully at the expense of the U.S. economy.  The other is probably direct financing of fiscal spending, otherwise known as “helicopter money.”

Finally, a word of caution about the BOJ is in order.  Governor Kuroda is a bit of an old school central banker.  In the early 1980s, when the economic theory of rational expectations was dominant, the idea was that central bankers could only affect the economy and markets by surprising them.  In other words, if a policy move was expected, its impact was mostly discounted by the time the move occurred.  The Bundesbank was notorious for “wrong-footing” financial markets with rate changes and currency interventions.  Kuroda seems to prefer surprises as well.  Thus, it is possible that none of the above discussion occurs and something totally unexpected is announced.  This uncertainty is probably a factor in recent market volatility.

Yesterday, the Census Bureau released its annual calculation of household and family income data.  The median showed a strong rise.

This chart shows median family and household incomes adjusted for inflation.  The official definition is, “Family income is income of households with two or more persons related through blood, marriage or adoption. Household income is income of family and non-family households.”  Both numbers rose sharply last year, with family income up 6.0% and household income up 5.2%.

This chart shows real median family income since 1947.  We have created two trend lines, the first showing the trend from 1947 into the mid-1970s, and a second from the mid-1970s forward.  Note that the slopes are significantly different.  Although the current improvement is notable, if real median family income had continued to track the first trend line, median inflation-adjusted family income would be $101,332.30, some $30,635.30 higher than the 2015 report.

A potential issue from this data is also the primary argument from the FOMC’s doves, which is that there is ample labor market slack.  Although inflation does remain tame, the rise in both family and household incomes will prompt the hawks to say there is now clear evidence that wages are rising faster and the FOMC needs to lift rates.  This is something we will be watching in the coming weeks.

Finally, there were three news items that deserve comment.  First, an update to this week’s WGR, Shavkat Mirziyoyev was named acting president of Uzbekistan.  Elections will be held on Dec. 4^th but will be a formality.  Elections are heavily manipulated in Uzbekistan and we are confident that Mirziyoyev will prevail.  We expect him to behave much like Karimov except that he may have closer relations with Moscow.  Second, a number of progressive groups have warned the Clinton campaign not to consider Lael Brainard for a cabinet post (perhaps Treasury) because of the “Wall Street revolving door.”  This strikes us as a bit odd; she seems amenable to left-wing populist causes and may be one of the few people standing in the way of tighter monetary policy.  If the standard from left-wing populists is that no one with financial industry experience can work for the president, about the only people who will qualify will be academics.  It almost seems that experience has become a disqualifier for populists on either wing.  Third, Bloomberg polls show Trump leading in Ohio by five points.  This is a rather big swing and shows that Sen. Clinton’s bad week has had an impact on the polls.  If Trump starts polling stronger, we may see a negative market reaction, especially in equities.

View the complete PDF

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Risk markets are lower to sideways as oil tumbled this morning after the International Energy Agency revised its global demand estimates lower and indicated that the global inventory glut will last longer than it had previously estimated.  Domestic oil inventories are expected to build this week following a week of inventory drawdowns as a result of tropical storm activity.  This will likely pressure prices lower in the short term.  We would expect OPEC members to jawbone about production freezes but, as recent OPEC talks have indicated, a production cut is unlikely.

The chart above shows domestic crude inventory levels.  The chart on the left shows data going back to 1920, while the chart on the right shows inventories for this year.  Stocks remain ample and inventories are expected to remain elevated given the expectations for falling demand.

Fed Governor Lael Brainard’s dovish speech yesterday afternoon fueled a rebound in equities.  Brainard’s comments are the last before the Fed enters a quiet period leading up to the FOMC meeting on September 20-21.  The speech was generally viewed as dovish, especially in contrast to Boston FRB President Rosengren’s speech last week, which was taken as hawkish and increased the likelihood of a rate hike to 60% for December.  Following Brainard’s speech, the December rate increase probability fell to 54% but remains higher than it has been all summer.

Brainard indicated that the economy is making gradual progress toward the central bank’s goals, although a preemptive hike is less compelling in an environment where labor markets have improved but inflation pressures remain mild.  Specifically, she pointed to five areas that should warrant caution.

1. Inflation has been less responsive to labor market improvements than in the past, making the Phillips Curve a less reliable indicator.  We have noted before that there is an ideological divide amongst the Fed board and FRB presidents over the importance of the unemployment/inflation relationship posited by the Phillips Curve.  Brainard belongs to the group that does not believe the Phillips Curve is as dependable of an indicator in the present environment as it was during the 1970s and 1980s.
2. Labor market slack has been greater than anticipated, with the unemployment rate improving but other labor market indicators only showing mild improvement.  She specifically pointed to the low participation rate, higher percentage of workers in part-time positions for economic reasons and lackluster wage growth.
3. There are risks presented by foreign market uncertainty.  Brainard discussed risks from today’s interrelated global markets, especially as the spread of disinflation is a worry in developed countries and weak international demand is likely to pressure domestic growth.
4. The neutral interest rate will likely remain low for an extended period of time and will be much lower than the pre-crisis neutral rate.  Brainard argues that the new normal economic growth environment also warrants a corresponding lower neutral rate.
5. Policy options remain asymmetrical as the low rate allows for the Fed to more easily respond to faster than expected growth, while options for responding to lower growth remain limited.  This is the argument that some Fed officials have made for hiking rates now as they would have the ability to loosen policy if growth slows.  The argument is somewhat controversial because a premature rate hike could add to conditions conducive for a recession in the current low-growth environment.

View the complete PDF

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Although Friday’s sell-off in equities was impressive, the financial chatter over the weekend was almost non-existent.  U.S. equity markets have been extended for some time and, so far, investors took Friday in stride.  The proximate cause for the drop was a renewed fear of Fed tightening.  Boston FRB President Rosengren, previously a reliable dove, said on Friday that a rate hike is “justified” due to the growing tightness of the labor market.  We have said much over the past few years on the issue of the labor market.  This chart, which should be familiar to our readers, is probably the best way to show the uncertainty.

This chart shows the difference between the unemployment rate and the employment/population ratio.  The two series tracked each other closely from 1980 into the financial crisis.  Since then, they have diverged significantly.  Some of the weakness in the employment/population ratio is due to demographics; as the baby boom generation heads to retirement, the ratio should ease.

However, there are two problems with this explanation.  First, the millennial generation, which is also large, is entering its working years and should offset some of the retirements.  Second, the baby boomers are working longer.

The markets correctly worry that the Fed might tighten into an economy with ample slack and clearly low inflation.  Thus a hike may be a mistake.

There may be a bigger issue, however.  This most recent weakness has hit both long-duration bonds and stocks and seemed to follow after the ECB made no policy adjustments.  There is a worry that central banks may be concluding that there isn’t much more they can do to boost economic growth without participation from fiscal policy.  And, since the odds of expanding fiscal policy are remote, we may be moving to a market situation where further monetary stimulus isn’t coming.  A case can be made that monetary policy has been majorly supportive for equity markets.

The good news is that it’s doubtful the Fed will be contracting its balance sheet anytime soon.  The bad news is that we may be moving back to mid-range, which, from this point, will be a notable pullback in equity values.  The chart below shows an S&P index model, using the Fed’s balance sheet as the explanatory variable.  The last time we had a market this expensive to the model was in 2012 when the market was anticipating QE.  Fair value for this model is 2030 on the S&P.  Although a drop to that level would not be catastrophic, it would represent about an 8% decline from current levels.

Governor Brainard, a reliable dove, is expected to speak early this afternoon.  She may ease fears of policy tightening.  Currently, the fed funds futures market places only about a 15% chance of a rate hike on the 21^st of this month but the odds are around 60% for December.

There were three other news items from the weekend that caught our attention.

What is the state of Sen. Clinton’s health?  For the most part, these discussions have been only held among right-wing pundits and bloggers.  The mainstream media has either ignored the controversy or ridiculed it.  That stance may have changed after Sen. Clinton was removed from a 9/11 ceremony complaining of light-headedness.  The video of her entourage taking her away did not look good.  Later in the day, the campaign admitted the senator had pneumonia but mainstream commentators were sounding concern.  This election season has been one of the oddest in our memory.  The weekend events simply added to the controversy.  So far, financial markets have not been affected but we would not be surprised to see some volatility tied to the election as we get closer to November.

Is Kim Jong-un crazy?  The general consensus is no.  If one looks at it from the viewpoint of the dynasty, acquiring nuclear weapons is completely rational.  For most of the Cold War, North Korea was protected by the Soviet Union and its economy was mostly on par with the South.  But, its economy lost its funding from the U.S.S.R. with the fall of the Soviet Union, and South Korea’s economy was booming during the late Cold War years, clearly overtaking the North.  The Kims found themselves isolated.  They also could not help but notice that the U.S. had overturned various regimes in nations such as Libya, Iraq and Afghanistan, and President Bush had included North Korea in his “axis of evil.”  So, how does a state keep from getting invaded?  Get a nuclear weapon.  Dictators around the world believe that Muammar Gaddafi made a strategic error by ending Libya’s nuclear program.  It should be noted that getting a nuke won’t improve North Korea’s economy or allow it to take over the South.  All nuclear powers realize that the bomb is only a defensive weapon; even if North Korea attacked the U.S., it would face certain annihilation.  It doesn’t appear that is what the Kims have in mind.  Thus, we suspect North Korea will become a nuclear power that can deliver a warhead.  The U.S. won’t like it but there isn’t much we can do about it.  In fact, only one power on Earth can, and that’s China.  Until China decides North Korea is too big of a liability it will refrain from acting against the regime.  This morning, Chinese officials criticized the U.S. for “creating” the situation on the Korean peninsula.  After all, the U.S. is the global hegemon.  It has a duty to fix such things.  The only way China may conclude it has to curb the Kim regime is if South Korea and Japan decide to build their own nuclear deterrents.  The U.S. has worked to prevent that from occurring, but that doesn’t mean we can continue to prevent it.

View the complete PDF