by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Financial markets are quiet again this morning, with the focus mostly on policy.  The ECB meets on Thursday.  Although there is a need for the bank to have a wider range of bonds to buy to maintain QE, the Germans are uncomfortable with easing the rules that would allow the ECB to buy lesser credits.  We suspect the ECB will need to adjust its rules at some point but probably doesn’t have the consensus for this week’s meeting.  Both the Fed and the BOJ meet on September 21.  San Francisco FRB President Williams gave a speech in Reno yesterday, offering mixed messages.  On the one hand, he suggested that rates should rise.  On the other, he called for the consideration of a higher inflation target and a slower pace of rate hikes.  The Fed seems to be leaning toward a rate hike but is also trying to keep the terminal rate, the rate where the rate hike strategy would cease, at lower levels.  We suspect some of this may be about raising rates to give the bank room to ease in a recession, a rather odd policy (raising rates increases the odds of a recession).  At the same time, calling for a lower terminal rate would probably prevent the dollar from rising sharply, which is also a policy goal.

Meanwhile, mixed messages abound from the BOJ as well.  Reuters is reporting that there is a three-way split among the BOJ board members.   According to the report, about one-third of the nine-member board wants to stand pat, one-third wants to lower rates further into negative territory and one-third wants to expand QE.  Governor Kuroda is said to support the negative rate option.  According to The Nikkei newspaper, PM Abe supports expanding QE by purchasing foreign bonds.  It seems Abe believes that it would be permissible as long as the goal of foreign bond purchasing is to support economic growth and not specifically to weaken the JPY.  We suspect Japan’s G-7 partners would disagree with this characterization.  In fact, foreign bond purchases would have the same impact as currency intervention even if the goal is something else.  Still, foreign bond buying would likely be effective in boosting Japanese asset markets and would weaken the JPY, which is, by itself, a form of monetary stimulus.

China’s foreign reserves fell $15.9 bn in August to $3.19 trillion, the lowest level since 2011.  Although China has been trying to clamp down on capital flight, there is a steady drop in reserves that mostly tracks the continued weakness in the CNY.  Chinese authorities seem to be willing to tolerate the outflow as long as it remains contained.

Finally, the WSJ is reporting that OPEC is interested in raising prices (although we haven’t seen anything yet that would suggest production cuts), but there is concern about allowing prices to rise near $70 per barrel because that might trigger a resurgence in shale oil production in the U.S.  Instead, the cartel is signaling it is more comfortable with oil holding in a $50 to $60 range.  Although we are comfortable with this range, we expect prices to test the low $40s or high $30s in the short run due to seasonal factors.  The WSJ reports that the end of the summer driving season finds the U.S. market still oversupplied, which probably means prices will remain soft until winter sets in.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Well, it’s time to say goodbye to the summer.  Our reflections on the long weekend’s news:

The lead article in Sunday’s NYT was all about climate change and coastal flooding.  The report documented rising sea waters affecting numerous communities along the Atlantic Seaboard, although there were references to problems developing on the Pacific side as well.  Climate change is a controversial topic.  We believe it is happening but the causal factors are complicated.  Human activity likely plays a role; so does sunspot activity.  It is clear that there have been wide swings in temperature in the history of Earth that also occurred prior to the time of mankind.  Our view on this topic is the same as our position on politics.  We don’t take positions—we react to what policymakers are likely to do and how their actions will affect financial and commodity markets.

The article makes clear that the GOP leadership in Congress is not going to bend on this issue as it views climate change as either a hoax or unrelated to human activity.  If the GOP is ever going to change on this issue, it won’t come from the leadership; it will come from the sub-Federal level.  Governors and major city mayors dealing with the effects of climate change will call on Washington for help.  Eventually, we expect legislation to have an impact on markets.

Economically, this is a straightforward fix—you simply tax carbon emissions.  Markets will adjust quickly.  The problem, of course, is the incidence of the tax (economist jargon for “who pays?”).  Many opponents of climate change legislation fear that forces outside their influence will allocate most of the costs to them while allowing others to go about their lives with little impact.  This is partly why they vehemently oppose climate change legislation.  The impact of environmental legislation on coal workers is a case in point.  One blogger we read remarked that if climate change legislation made air travel prohibitively expensive (especially private air travel), then it might be easier to get the majority of citizens on board.

The NYT also reported that the U.S. and China agreed to the Paris climate agreement while the president was in China.  However, buried in the report were details that China has only agreed to have its carbon emissions “peak or plateau” by 2030.  The U.S. has committed to reduce emissions by 25%, based on levels in 2005.  Thus, China’s agreement is far less momentous.

President Obama’s visit to China for the G-20 meeting was described as “bumpy.”  Chinese security officials did not allow the president to deplane by the side steps but forced him to exit through the underbelly of Air Force One.  Usually, this exit is only utilized when an area is insecure, such as in Afghanistan.  According to reports, there were several incidents of friction between Chinese and American officials regarding who could be in the president’s entourage.  We suspect this was designed to put the president on the defensive and help Chinese negotiators.

The WP reports that the Philippines’ Air Force noted that at least eight Chinese vessels were spotted near the Scarborough Shoal, an area of tension between the two nations.  The fact that China would take such provocative action during the G-20 and the ASEAN meetings that followed suggests the Xi regime is testing American resolve as U.S. elections loom.

We have been concerned for some time[1] that Iran, Russia and China would use Obama’s lame duck period to press their claims, assuming that the administration would be reluctant to use force in front of the elections.  Russia’s recent behavior in Syria and Ukraine along with China’s continued belligerence both suggest these fears are being realized.

Populism is a growing trend in the Western world.  Chancellor Merkel’s party, for the first time, gathered a smaller share of votes in a state election compared to the populist and anti-Eurozone AfD (Alternative for Germany) party.  The AfD won 22% of the vote in the Mecklenburg-Western Pomerania, a state on the Baltic coast, compared to 19% for Merkel’s Christian Democrats.  The Social Democrats won control with 30% of the vote; this party has held power in the state since 1998.  This is Merkel’s political homeland, so losing to the AfD is a severe rebuke to her open immigration policy.

In other European news, acting Spanish PM Rajoy lost another confidence vote, signaling that Spain will likely need to hold another round of elections.  If a government isn’t formed by Halloween, the third election in less than a year will be necessary.

The ECB meets on Thursday and the WSJ asks an important question—will the European Central Bank adopt the policy of the Bank of Japan and start buying equities?  Based on ECB rules, the bank is starting to run out of bonds to buy.  This isn’t unprecedented in Europe.  The Swiss National Bank, facing the same problem, accumulated $100 bn of equities when it was pegging the CHF/EUR exchange rate.  The BOJ has been buying equity index ETFs in Japan.  To some extent, owning stocks may be safer than owning lower rated bonds as equities won’t default.  On the other hand, companies do go bankrupt and equity holders are usually left with nothing.  Still, if the goal is to use asset markets to lift economic activity then equities are a logical extension.

Although there is a persistent anti-Trump tone in the media,[2] we note that the NYT ran two articles on Sen. Clinton over the weekend that put her in an unpleasant light.  The first discussed her email woes and new revelations that suggest she was less than truthful in her depiction of them.  The second revels in her fundraising with the super wealthy.  Although raising money from the rich is a time-honored political practice in U.S. politics, she faces persistent charges that she is beholden to the moneyed class.  This was Sen. Sanders’s argument against her candidacy.  The fact that the NYT prominently reported on this may be taken, at least in part, as a signal of disapproval.

Several sources report that Saudi Arabia and Russia are considering a plan to “stabilize” oil prices.  We suspect both are trying to talk the market up; the former wants stronger oil prices before its debt deal, the latter because that is the basis of its economy.  We doubt anything real will come from the oil meetings later this month, but oil prices will likely be underpinned in front of them.  Until the inventory overhang is reduced, it will be difficult for oil prices to rise.  Seasonally, this is a weak period for oil and prices would likely be lower without the jawboning.

However, there is one factor that could make a real difference.  The Venezuelan state oil company, PDVSA, has a $3.0 bn loan payment due in October and November.  An additional $2.0 bn of general sovereign payments are due in November.  Although the Maduro government continues to insist it will meet all its debt obligations, simple math suggests it is running out of money.  If Venezuela defaults, bondholders may try to seize Venezuelan oil in the U.S.  We note that Citibank (C, 47.53) has ended its role as payment processor for bondholders.  Citibank has apparently become concerned that it might face legal liability as the DOJ and Treasury have been investigating PDVSA’s criminal activity; money laundering was one focus of the investigation.  Venezuela will be forced to find another bank to take on that role, and it will likely default if it can’t find one.

American refineries are capable of refining the heavy, sour Venezuelan crude.  Other non-U.S. refineries would be forced to mix the oil with lighter crudes to process them.  If any of those other oils are touched by the U.S. oil industry or the American financial system, then seizure is possible.  Thus, Venezuela would be forced to sell oil to a nation outside U.S. financial jurisdiction.  China is pretty much the only nation that fits the bill.  However, Venezuela is already deeply indebted to China, with 0.5 mbpd of oil already going there for debt service.  We doubt China would want more of Venezuela’s oil, at least at market prices.  The bottom line is that if Venezuela defaults, 1.5 mbpd of global oil production may come off the market.  This would help rebalance the global oil market.  We also note that Venezuela sells about 0.7 mbpd to the U.S.  If it defaults, these oil exports will likely end; this may narrow the Brent-WTI spread in favor of the latter.

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[1] See WGR, 6/27/2016, The Mid-Year Geopolitical Outlook.

[2] For a good analysis of this, see http://www.rollingstone.com/politics/matt-taibbi-on-the-summer-of-the-media-shill-w434484.

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Happy labor data day…just before Labor Day weekend!  We will spend much of this report going over the data but we want to make a couple of comments about yesterday’s ISM manufacturing data.  The report came in unusually weak, at 49.4 compared to expectations of 52.0.  It also contradicted the Markit number (a data provider that offers a similar survey), which came in at 52.0, near the 52.1 forecast.  New orders, a key sub-component of the report, came in at 49.1, down from 56.9 in July.

Although there are concerns about this data, it should be noted that it is one data point and a bit of an outlier.  We would need to see a couple more like this before we would get really worried.  Although a reading under 50 means that the majority of survey participants saw weakness, it is a slim majority.  Looking at the data on a six-month average basis shows nothing out of the ordinary.

A simple GDP/ISM manufacturing model suggests that a reading of 49.4 would generate a GDP for Q3 of 2.1%.  We would expect the Atlanta FRB’s Q3 forecast for GDP to dip off this report, but the data, by itself, is not signaling recession.  It is confirming continued slow growth.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] It’s global manufacturing PMI day (see Foreign Economic News section for full data table).  China’s official PMI came in better than expected, crossing into expansionary territory with a reading above 50.  At the same time, China’s Caixin PMI reading came in slightly below expectations but remained right at 50, indicating expectations of neutral growth (no expansion or contraction).  Below is the historical chart for the two Chinese PMIs.  In general, the official PMI tends to be more stable, while the Caixin has produced lower readings for the country’s manufacturing.  The good news is that although the Caixin reading showed a generally contracting manufacturing sector for most of last year, both gauges show a manufacturing rebound over the past two months.

The yuan advanced for the fifth day on relatively strong PMI data, but also on speculation that the PBOC has been supporting the currency ahead of the G-20 meeting.  The chart below shows the one-year move in the yuan.  Although the currency has weakened since the end of last year, speculation is that the central bank does not want the currency to weaken further from its current level ahead of the G-20 meeting.  However, the policy is likely to change later in September.

The U.K. also saw a strong rebound in its manufacturing PMI in August following a relatively weak reading in July.  The stronger than expected PMI reading helps dissipate post-Brexit worries and indicates that the country can grow even amidst the prospect of leaving the EU.  We have drawn a vertical line on the chart below at the Brexit vote date.  The subsequent PMI reading in July had plunged to a contractionary level of 48.3, but rebounded strongly to 53.3 in August.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Talks of a Fed hike in September are intensifying as we approach the FOMC meeting on September 20-21 and markets look to the release of the employment report as an important indication of the possible policy rate path.  Treasuries have sold off in August; the 10-year Treasury yield is up 13 bps for the month, as the chart below shows.

Additionally, we have seen the curve flatten, with the spread between 30-year and two-year Treasury yields at its narrowest since January 2008.  The spread is shown in the chart below.  The yield curve has historically flattened during Fed rate hike cycles, thus further flattening is likely as the Fed continues to tighten.

Despite BOJ Governor Kuroda’s indication that the country will not use helicopter money, speculation of the controversial policy is intensifying.  Helicopter money is not currently allowed under the Japanese legal framework and the BOJ has indicated that “ample space for additional easing” remains, but growth and inflation remain low even after the central bank’s implementation of QE and NIRP.  Additionally, an aide to PM Abe said that the central bank could consider foreign bond purchases as part of its asset purchase program in an attempt to weaken the yen.  This would be a way to get around the accusations of direct currency manipulation, but would be implemented for the same purpose of weakening the yen.

The Brazilian Senate is scheduled to vote on Rousseff’s impeachment later today and it looks very likely that she will be ousted and VP Michel Temer will be sworn in to serve for the rest of this presidential term, which ends in 2018.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Fed Vice Chairman Stanley Fischer gave an interview on Bloomberg TV this morning indicating that although a September rate hike is data-dependent, the likelihood of a move has increased.  This comes after Fischer’s interview last week, which was also generally considered hawkish.  Following the two Fischer interviews over the past week, the market is now pegging a September hike at 36% likelihood, up from 24% a week ago.

Fischer pointed to this Friday’s employment report as one of the main data points that the Fed uses to measure economic health.  He said that the U.S. economy is close to full employment, despite the slowing pace of the expansion, as the “problem is largely about productivity growth, something which is very hard to control by policymakers.  It depends enormously on what private individuals are doing at their companies, and it’s very slow at the moment.”  Still, he expects technology to boost productivity growth in the future.

Expectations for Friday’s employment report are calling for an improvement in the unemployment rate, which is forecast to improve to 4.8% from 4.9% in July.  The chart below shows the unemployment rate, which has improved steadily since the end of the recession.

At the same time, earnings growth is forecast to remain slow, rising 0.2% in August.  Additionally, the rate of part-time workers for economic reasons (shown in the chart below), one of Yellen’s favorite measures of labor market health, has seen some deterioration this year.

Thus, although a September hike remains a one-in-three possibility, it is looking more likely than previously perceived by the market.  Still, a September hike would be risky ahead of the elections and Chair Yellen’s Jackson Hole interview was considered mildly dovish, so it is not clear whether she would support a hike this fall.

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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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