by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The long anticipated Jackson Hole conference came and went.  Chair Yellen’s speech was initially taken as dovish, but comments from Vice Chair Fischer sent financial and commodity markets into a significant reversal when he indicated that two hikes may be possible this year.  We see the change in fed funds futures.  The market had the odds of a September rate hike at nearly zero after Brexit.  They are now at 44% with a 67% likelihood in December.  Yellen did note that the labor market is approaching the U.S. central bank’s target but also seemed to imply the Fed has time to wait before moving rates higher.  Fischer’s comments changed the tone of the meeting, turning it into a hawkish event.

In watching the market reaction, we note that there are clear worries about a near-term hike; however, expectations for the terminal rate remain low.

This chart shows the implied three-month LIBOR rate from the two-year deferred Eurodollars.  When Ben Bernanke opened the topic of tapering in May 2013, rates started a steady climb, reaching nearly 2% by H2 2014.  However, the projected LIBOR rate has steadily declined following last December’s rate hike.  We believe this indicates the markets are expecting a lower fed funds rate in the future.

Here’s another way of looking at the data.

This chart shows the weekly effective fed funds rate with the spread between the two-year deferred three-month Eurodollar futures and fed funds.  Note that the FOMC usually stops raising rates when the spread reaches zero.  The current spread has narrowed from nearly 190 bps in late 2014 to the current 68 bps.  That means if the implied LIBOR rate remains steady, we are probably looking at two to three hikes in total.

Tighter policy will have an impact on the financial and commodity markets.  We are already seeing an upward move in the Treasury curve, although it is also flattening.  Gold and other commodity prices, along with emerging markets, are weakening.  The dollar is strengthening.  Equities are holding up fairly well, but the short-term uptrend has stalled.

We note that BOJ Governor Kuroda was at Jackson Hole suggesting that more stimulus is coming.  Although there are grave doubts as to what the BOJ has left in terms of policy support, direct financing of fiscal spending is possible.  And, the BOJ could implement QE by purchasing U.S. Treasuries, although that would cause a firestorm of protests.

Canadian PM Trudeau is heading to China to talk trade with General Secretary Xi.  Saturday’s NYT discussed at length comments from Chinese nationals and Canadians of Chinese descent who face public criticism and worse for pointing out human rights problems in China.  According to reports, the Xi regime is putting pressure on Western governments to restrict criticism.  We also note that some activists have faced cyber-attacks and threats of physical harm.  Canada, like the U.S. and Australia, has been a prime destination for Chinese capital flight.  However, if Canada begins to muzzle Chinese political dissent in a bid to gain export markets, we would look for the Chinese (and their capital) to look for other places where their free speech will be protected.

The German economy minister, Sigmar Gabriel, said over the weekend that the Trans-Atlantic Trade and Investment Partnership, or TTIP, is dead.  Gabriel noted that after 14 rounds of talks, not one item of the 27 chapters of the proposed trade agreement was accepted by both sides.  TPP is barely viable; both U.S. presidential candidates have disavowed it and its only chance is to be passed in the lame duck session after the November elections but before inauguration.  Even then, the odds are long.  Retreating from these trade deals will have important geopolitical ramifications but, in the current political environment, free trade has lost its allure.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Market movement this morning is eerily quiet.  The change in currencies is small, energy is roughly unchanged as are Treasuries.  The lack of activity in front of Yellen’s remarks (which formally begin at 10:00 EDT) suggests that (a) the markets are mostly “squared” in front of the speech, meaning traders are not leaning in either direction, or (b) they have decided on a stance (dovish) and are vulnerable to a hawkish surprise.  We lean toward the latter.  On the other hand, we doubt her talk will be hawkish.  In fact, we doubt it will say much at all about the current situation.  We expect her speech to mostly focus on operating monetary policy in a low nominal interest rate environment.  In other words, when the economy does slip into recession, the FOMC probably won’t be able to cut rates significantly.  If this is the case, how will policymakers stimulate growth?  We expect the Yellen paper to offer ZIRP, forward guidance and QE.  NIRP will be mentioned but likely only as a last resort.

If our projection is correct, how will the markets react?  Since we have seen rate hike expectations creeping higher on the back of recent FOMC member comments, Yellen’s comments will be seen as neutral to dovish.  That outcome will be modestly bearish for the dollar, bullish for gold and commodities and supportive for equities and Treasuries.

In other news, the Saudi energy minister, Khalid al-Falih, indicated today that the talk of a production freeze isn’t a big deal and added that the market is moving toward balance without outside intervention.  This would seem to be a bid to temper expectations for next month’s meeting.  Iran told Reuters that it would be willing to help stabilize oil prices as long as OPEC members allow Iran to gain market share…which is, of course, silly.  Saudi oil policy, by design, is to gain and keep market share.  The only way Iran can gain market share while allowing Saudi Arabia to achieve its production goals is if the other OPEC members cut output.  That might occur but it won’t be due to policy—it would be due, most likely, to geopolitical events, e.g., a civil implosion in Venezuela.  Since that isn’t much of a policy, we suspect the OPEC meeting won’t be able to maintain prices on its own.  In fact, we note that the Saudis are planning to sell a dollar based bond soon.  It might be that the kingdom is trying to prop up oil prices in front of that bond sale, which will bear watching.

We are also continuing to monitor rising naval threats to shipping in the Persian Gulf.  Iranian vessels, operated by the Iranian Republican Guard Corp (as opposed to the tiny, official Iranian navy), have been playing “chicken” with U.S. warships.  Over the past few days, the U.S. has fired warning shots at these vessels that were making threatening passes at U.S. ships.  Iran appears to be increasing tensions in this area—the question is why?  Gillian Tett of the FT has an op-ed today where she notes how the lack of clarity surrounding the DOJ’s treatment of foreign banks operating in Iran has led most foreign banks to shun Iranian business.  Although the Obama administration has formally lifted the ban, there are other U.S. laws, such as counter-terrorism regulations, that might potentially snare foreign banks.  Thus, the lifting of sanctions after the nuclear deal has not led to massive investment in Iran.  It is not out of the question that Iran is expressing its frustration with U.S. policy through these naval acts.  We should note that U.S. banks continue to be prohibited from doing business in Iran.

Finally, the Brazilian Senate has begun its impeachment trial against President Dilma Rousseff.  To impeach the president, two-thirds of the 81 senators must vote to remove her from office.  If the vote passes, as expected, VP Temer will be elevated to president and hold office until Rousseff’s term ends in 2018.  Brazilian financial markets have rallied on expectations that Temer will be more business friendly than the leftist Rousseff, but we note that Temer is beset by low approval ratings and personal corruption.  If the impeachment vote fails, we would anticipate market disappointment.  However, even if it passes, as expected, the left will likely become obstructionist and Temer’s own shortcomings could weaken Brazilian financial markets.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] All eyes are focusing on the Grand Tetons as the KC FRB’s annual meetings start in Jackson Hole tomorrow.  Although the market’s focus is all about the timing of the next rate hike (fed funds futures indicate over 50% probability for the December meeting, 30% for September), the discussions at the meeting seem to be all about the Fed’s toolkit for managing future policy.  Specifically, the participants want to signal what they will do in the next downturn and the consensus is that QE, ZIRP and forward guidance will be the tools, while NIRP will probably be avoided.  Although there is much anticipation of Chair Yellen’s speech, we doubt she breaks new ground and so we would look for some disappointment at the lack of clarity that will emerge.

U.S. crude oil inventories rose 2.5 mb compared to market expectations that called for a 0.5 mb build.

This chart shows current crude oil inventories, both over the long term and the last decade.  The usual seasonal inventory draw, which is more evident in the chart below, is coming to a close.

Inventories remain elevated.  Inventory levels are now running above seasonal norms.  Although inventories usually don’t start rising again until mid-September, the recent behavior isn’t bullish and flies in the face of the recent rally.

The seasonal pattern is due to the refining cycle.  This reporting week, on a five-year average basis, is the last week before operations begin to slow.  This means that oil demand is set to decline.

Based on inventories alone, oil prices are profoundly overvalued with the fair value price of $35.72.  Meanwhile, the EUR/WTI model generates a fair value of $49.16.  Together (which is a more sound methodology), fair value is $42.53, meaning that current prices are a bit rich.  Although the market has put great hope on an OPEC deal next month, the plan looks to be more like jawboning the market higher.  We note that Iran has confirmed it will send its oil minister to the September meeting in Algiers, which may keep prices elevated into the meeting.  On the other hand, oil markets tend to trade in ranges, and the oral intervention by OPEC members did put a $40 floor in place.  That floor could be tested in the coming weeks as crude oil inventories rise; without a weaker dollar, oil prices will likely ease toward the $40 floor.

Bloomberg is reporting that Saudi Arabia is planning to raise $10 bn in bonds denominated in USD, its first dollar bond.  The kingdom is planning to make the offer after the September FOMC meeting.  In other Middle East news, Turkish armored troops, supported by U.S. air support, have successfully ousted IS forces from Jarablus.  Turkey has been concerned about Kurdish expansion and informed Kurdish forces that they need to remain east of the Euphrates River.  Jarablus is on the river.  Although the Obama administration welcomed the Turkish incursion, it probably had more to do with containing the Kurds than ousting IS.  Pentagon officials have indicated that four Iranian patrol boats approached the U.S.S. Nitze, a guided missile destroyer, in the Strait of Hormuz.  The Iranian vessels reportedly approached the U.S. ship at a high rate of speed.  Iran is claiming the U.S. ship was in Iranian waters; the U.S. contends it was in international waters.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Late summer doldrums are upon us.  Financial markets are quiet; the VIX is falling as investor fears dissipate.  About the only concern out there is Fed policy.  As we noted yesterday, Chair Yellen speaks on Friday.  She is not taking questions and her topic is on the toolbox the central bank has to operate policy.  Although there is ample room to become restrictive by raising rates, the concern is what will the Fed do if the economy rolls over?  With the policy rate just off zero, the Fed would hit ZIRP in short order.  A recent paper from the FOMC’s staff economists suggests that the U.S. central bank will resume QE and forward guidance if it needs to stimulate but will likely avoid negative interest rates.  We doubt Chair Yellen will deviate much from this script.  Broader questions about long-term growth and inflation prospects will probably be dealt with in only the broadest of terms.  The Fed could consider changing its inflation target, as San Francisco FRB President Williams suggested last week, but we would expect Yellen to intimate that although this is a possible response, it carries risk and would only be done after ample consideration.

There was some interesting news on the FOMC front in the minutes that we missed in earlier comments.  Eight of the 12 regional banks requested a discount rate hike.  It should be noted that the nature of the discount rate changed in 2002.  Prior to the regulatory change, the discount rate was lower than fed funds.  The former was designed as an emergency rate for a bank in trouble; banks that were OK simply used fed funds.  There was a stigma attached to borrowing at the discount window as it signaled the bank was in trouble.  Thus, it was decided that the discount rate would be used as a penalty rate to give banks incentives to use fed funds.  With the banking system drowning in excess reserves, the need to borrow at the discount window is low.  However, the fact that eight regional banks voted to lift the rate does suggest growing sentiment among the presidents to lift the fed funds target.  Yellen may be forced to allow a hike sooner than we (and the market) have been anticipating.  We note that there were nine votes to raise the discount rate at the November FOMC meeting last year, and the rate hike occurred at the next meeting.

Finally, on a geopolitical note, Turkish armored units have crossed the border into Syria, supported by Turkish and U.S. air assets.  Ostensibly, the attack is on IS but it does appear that the operation is also designed to push Kurdish elements out of the area.  At the same time, the area around al-Hasakah has been ceded to the Kurds.  According to the NYT, the Assad government has declared a ceasefire with the Kurds in this northeastern region of Syria.  The regions are indicated by the boxes below.

We suspect the Obama administration is coordinating with Turkey against some Kurdish elements as a way to maintain relations with Erdogan.  Also of note, Stars and Stripes is reporting that Turkey is “open” to allowing Russian warplanes to operate from Incirlik air base, the same base the U.S. has used for years for Middle East operations.  It should be noted that some 50 U.S. nuclear warheads are on this airbase.  Although it isn’t getting much press, Russian influence in the Middle East is growing and Turkey is becoming a less reliable U.S. ally.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] It was another quiet overnight session, typical of late summer.  The flash PMI data came in fairly strong (details below), easing some concerns about the economy post-Brexit.  However, until Britain actually leaves the EU, it is almost impossible to determine what the actual impact will be, simply because we don’t know the terms of the exit.

The real story this week is Fed Chair Yellen’s Jackson Hole speech on Friday.  As best we can tell, the Fed and the world’s other industrialized central banks are starting to realize that the economy isn’t normalizing as they had projected it would since 2009.  El-Erian’s “new normal” has come to pass, meaning that we live in a world of low growth and low inflation.  We believe there are multiple reasons for low inflation and persistently slow growth.  The primary culprit is the level of household debt; we are in a period of deleveraging, which tends to foster slow economic growth as household are less likely to borrow.

The key to a debt problem is resolution; society has to decide how to assign the bad debt losses.  There are essentially three ways to address a bad debt problem.  The debtors can shoulder the burden and are forced to cut their spending and increase their savings to service the debt.  The creditors can carry the burden through repudiation or restructuring.  Lastly, a third party can settle the debt and favor either side; in other words, if the outside party buys the debt at full face value, then the creditors are saved (of course, the debtors are too) and the third party bears the burden.  Or, the outside party can buy the debt at a discount and force the creditor to bear some of the losses.

Such negotiations are political in nature.  In Europe, for example, the debtors have carried nearly all the burden, which is why the economies of Greece, Spain, et al. have been so weak.  In the U.S., the debtors have shouldered most of the burden.  We note that during the Dodd-Frank negotiations, Senator Frank toyed with mortgage “cram downs” which would have forced principal losses on creditors.  That didn’t happen.  However, the creditors have not gotten away without pain.  The Federal Reserve is allocating some of the cost of restructuring to creditors in the form of financial repression.  By holding interest rates at very low levels, debtors can more easily refinance their debt, which is a form of credit restructuring.  Creditors are also being forced to fund lesser quality debt in the desperate search for yield.

The missing element of financial repression has been the lack of inflation.  Central banks seem to remain under the sway of monetarism, which postulates that the central bank can create any inflation it wants by expanding its balance sheet.  This has proven to be untrue.  In our opinion, inflation comes from the intersection of aggregate supply and aggregate demand and the aggregate supply curve is nearly horizontal in a globalized and deregulated world, meaning that rising demand won’t necessarily lead to higher price levels.  Without rising inflation, it is hard to enforce financial repression in a manner that would rapidly address the debt overhang.  Think of the above chart, which is a ratio of debt and GDP; rising inflation would lift nominal GDP (the denominator) and consequently lower the ratio, if debt merely stays the same.  The fastest way to lift nominal GDP is with higher price levels.

Needless to say, this solution isn’t making either side very happy.  It is worth noting that when we had this problem in the 1930s the solution was WWII.  The government acted as the third party, taking on massive debt via war spending which allowed the private sector (households and businesses) to effect a debt swap, shifting their debt to the government.  The chart below shows how that worked.

In the most recent debt cycle, we have seen a smaller version of the post-1930 debt swap but, frankly, the government didn’t increase debt enough.  Political constraints prevented that from occurring.  Consequently, the swap was never fully executed and now, with increased business borrowing, progress on deleveraging has stalled prematurely.

So, what is the answer?  There are really two paths to take.  The first is to take another swing at expanding government debt through fiscal spending.  Although there is a rising drumbeat for such policies, they are only attractive in the abstract.  Politically, you have to pick winners and losers if fiscal spending is going to expand.  Given the degree of political gridlock, it has been virtually impossible to come up with mutually agreeable spending.  The other path would be to bring inflation by reversing globalization and deregulation, the policies of Donald Trump and Bernie Sanders.  In the end, neither choice is particularly attractive, so we continue to muddle through with slow growth and low inflation.  Until there is some political resolution of this issue, we expect more of the same.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] There are two items of note this morning.  First, talk coming from the FOMC is that of two minds.  On the one hand, several members are taking great pains to suggest that all meetings are “live.”  Today’s weakness in equities and dollar strength is being attributed to comments from Vice Chair Fischer who said the economy is “…close to our targets” for raising rates further.  Fischer appears to be in the camp that believes recent economic sluggishness is not a permanent feature but a series of temporary headwinds.  This position is different than what we have heard from the San Francisco and St. Louis FRB presidents, who have suggested that sluggish growth may be more persistent and that the FOMC may need to have a much lower terminal rate target or tolerate higher than 2% inflation.

Chair Yellen will speak later this week at Jackson Hole, WY, at the annual gathering sponsored by the KC FRB.  The markets do not expect Fischer and Yellen to contradict each other; if Fischer’s comments are hawkish, the fear is that Yellen will reflect similar sentiments on Friday.

We do note that WSJ Fed whisperer Jon Hilsenrath has an article today in which he admits his earlier opposition to raising the inflation target was probably wrong.  Raising the inflation target solidifies the “lower for longer” position but it also assumes that central banks can control inflation, which we think is incorrect.  The intersection of aggregate supply and demand sets inflation.  Monetary policy tends to affect aggregate demand but only if banks circulate the reserves (which they have not done).  In a globalized and deregulated world, aggregate supply is ample, leading to a mostly flat supply curve, meaning that the economy can take lots of stimulus before price levels start to rise.  That is why we have been watching the populist uprising in the West; if anything could upend the current regime of globalization and deregulation, it would be nationalism and populism.  But, as long as centrists continue to control government, the current regime will probably stay in place.

To some extent, the FOMC probably wants to inject a bit of uncertainty into the financial markets.  This is a fool’s errand—financial markets are calling the Fed’s bluff and we doubt the FOMC will raise rates because of an elevated P/E.  Thus, even if they do raise rates, we would expect a parade of Fed speakers to make it clear that a hike at one meeting doesn’t necessarily signal a series of hikes.  This gets us to the “two minds” problem.  On the one hand, the Fed would like to raise rates a bit; on the other hand, it’s becoming clear that more members are buying into the secular stagnation idea, which means the terminal rate will be lower.

In foreign central bank news, the Reserve Bank of India announced its new governor.  He is Urjit Patel, a former Yale economist who spent time at the IMF in the early 1990s.  He replaces Raghuram Rajan, who had fallen out of favor with the Modi regime.  Patel is said to be an inflation hawk, so we don’t expect much change in policy.  We also note that BOJ Governor Kuroda said over the weekend that there is “sufficient chance” of further easing at the next policy meeting.  It is unclear how much more could be done, absent of direct fiscal financing.

Second, we are seeing lower oil prices this morning.  The latest commitment of traders’ data confirms that the rally over the past two weeks has been nothing more than massive short covering.  In Nigeria, the rebel group that has cut the nation’s output by about a third has agreed to a ceasefire and is “ready for dialogue.”  We suspect that the government will have to pay off these rebels in order to lift output; that was the strategy of the former government.  In addition, Iraq has announced a deal with the Kurds to lift Iraqi oil exports by 5% in the next few days.  The Northern Iraqi Oil Company owns the oil but uses pipelines that move through Kurdish territory.  There was a payment dispute but that has apparently been resolved.  Finally, Reuters is reporting that Chinese refiners are boosting exports to record levels.  Diesel exports are up 182% from last year and gasoline shipments are up 145%.  We expect to see oil prices ease back toward recent lows in the coming weeks as the summer driving season in the U.S. comes to a close.

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