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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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Given the large amount of news from the weekend, there were a couple of items that we wanted to mention but, for brevity, waited until today.  First, the Bank of International Settlements released its table of early warning indicators for banking system stress.

The key data is the credit-to-GDP gap.  The BIS measures the ratio against its long-term trend, and any reading over 10% has signaled trouble.  China is well above that level and the other columns suggest that the country is rather sensitive to rising rates.  The BIS admits that its indicator is “early” and countries can exceed safe levels for a long time before trouble develops. But, this data does show that the Chinese banking system is vulnerable to systemic risk.

Second, the Financial Accounts of the U.S., formerly known as the Flow of Funds data, was released by the Federal Reserve for Q2.  Although the report is a treasure trove of information, we would like to point out two charts, in particular.

This ratio peaked at just under 128% in Q4 2007.  It has declined to 100.1% but the pace of household deleveraging has clearly slowed.  Debt growth remains modest, with household liabilities growing at a modest 2.8%.  The slowdown in deleveraging will tend to support economic growth by boosting consumption.

The other chart of note is shown below.  It measures homeowners’ equity in real estate.  In general, we look for a positive wealth effect to boost spending once households have about 60% equity in their homes.  The latest shows a reading of 57.1%.

These two charts suggest that current improving consumption will likely continue and maintain positive economic growth.

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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.

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