[Posted: 9:30 AM EDT] The big news today is that the BOE cut rates 25 bps, to 0.25%, and clearly signaled a move to zero by year’s end. It also increased QE by £60 bn and will include corporate bonds in its purchases. This is the bank’s first rate cut in seven years. Although the initial rate cut was well discounted by the markets, the expansion of QE and the forward guidance was a surprise. The U.K. central bank cut its GDP forecast for 2017 to 0.8% from 2.2%; it seems to believe that its measures will either prevent a recession or make it mild enough that it won’t lead to a year’s worth of negative growth. The BOE also bumped up its inflation forecast, but still has inflation not reaching its 2% target until December 2017.
Because of the surprise, the GBP slumped.
(Source: Bloomberg)
We have also seen a strong rally in Treasuries on the news.
U.S. crude oil inventories rose 1.4 mb, the second week of a bearish surprise. Market expectations called for a 2.0 mb draw. Despite the build, prices jumped.
This chart shows current crude oil inventories, both over the long term and the last decade. We are starting to see inventories decline but normal levels would be below 400 mb, some 130 mb lower than now.
Inventories remain elevated. Inventory accumulation levels had been running below seasonal norms; this week, the divergence disappeared. We are in a period of the year when crude oil stockpiles tend to fall at a slowing pace; in fact, this month, declines slowed markedly. Oil prices rose due to a surprise 3.3 mb draw in gasoline stocks. Although clearly bullish for gasoline, the “clock” is running on this product as the summer driving season rapidly comes to a close. Still, for an oversold market, it was the catalyst for an impressive rally.
This week’s data closes out July.
Based on inventories alone, oil prices are profoundly overvalued at the fair value price of $35.45. Meanwhile, the EUR/WTI model generates a fair value of $45.83. Together (which is a more sound methodology), fair value is $40.07, meaning that current prices are generally fairly valued. Given that we don’t expect significant declines in inventory over the coming weeks, the key to oil prices probably rests with the dollar. It is worth noting that this decline we have seen from the highs merely puts us in the neighborhood of fair value, but oil isn’t undervalued by our measures. In about six weeks, oil inventories should make their seasonal lows and build about 7%, or put inventories around 530 mb by November. Although current prices are not unattractive, a dip into the mid-$30s for WTI is possible with a steady dollar.
[Posted: 9:30 AM EDT] In the wake of the BOJ and Abe disappointment yesterday, we have been observing a steady backup of long duration yields. So far, this isn’t anything too serious, but the market narrative behind it is important. There is a growing concern that BOJ monetary policy may have reached its limits. In terms of rate adjustment and QE, it probably has. Once a central bank becomes the dominant buyer of the entire yield curve, sovereign debt probably ceases to be a market and the central bank becomes the sole determinant of all rates, not just short-term ones. According to reports, BOJ Governor Kuroda is starting to receive pushback from some board members, suggesting that he will struggle to expand the balance sheet further.
However, it is probably a mistake to limit the possibility of policy to merely QE and rates. There are other policy tools available but the ones left are controversial. The first option, which we have discussed at great length, is helicopter money. However, this policy would require fiscal authorities to work directly with the central bank to accomplish anything. If the government is too timid with fiscal expansion, the impact of direct financing of fiscal spending is potentially minor. The second would be aggressive devaluation; imagine QE with foreign bonds. The goal here would be to drive down one’s exchange rate to boost exports and constrain imports. Such “beggar thy neighbor” policies, seen in the 1930s, are considered inappropriate now but, if conditions deteriorate enough, consideration of such actions cannot be discounted. The problem with this policy tool is that it is dependent on foreigners to acquiesce to the policy, which is unlikely. Trade retaliation and capital controls would be potential responses.
One common element to both of these controversial measures is that there will almost certainly be strong opposition from central bank policymakers. The possibility that a government could propose massive fiscal expansion only to see the central bank balk on funding it directly is a real possibility. This is why we took note of a Bloomberg article reporting that Kozo Yamamoto has joined Abe’s cabinet as Minister of Regional Revitalization. Yamamoto is a strong advocate of radical measures to combat Japan’s secular stagnation and one of his ideas is to strip the BOJ of its policy independence. Last year, Yamamoto was quoted as worrying that the BOJ was wavering on its commitment to monetary stimulus and Governor Kuroda might be contending with “a den of conspirators.”
Central bank independence has not always been considered best practice. The Federal Reserve didn’t become independent until the 1951 Treasury Accord. The BOJ didn’t become independent until 1998. On the one hand, there is an argument to be made that it makes sense for a central bank to coordinate policy with the fiscal arm of the government to make it more effective. If fiscal spending and monetary policy work at cross purposes, it can make fiscal stimulus less effective or lead to ineffective inflation control. On the other hand, since fiscal policy is affected by politics, central bank independence is put in place to act as a bulwark against inflation. Simply put, if the goal is inflation control, central bank independence is a key component. If the goal is reflation and the escape of secular stagnation, central bank independence is a hindrance.
Giving Yamamoto a stronger voice could lead the BOJ to simply become the funding arm of fiscal spending. Another news item we noted last night was that North Korea launched a ballistic missile that landed near Japan. It isn’t hard to imagine a massive defense spending expansion, funded directly by the BOJ, which is under the supervision of the Ministry of Finance. So, we would caution that the idea that central bankers are out of tools may not be true. Yes, further measures would require fiscal coordination but that could be accomplished. The key issue is that we have, over the past 36 years, built a policy consensus that is designed to keep inflation under control. Brexit, Trump, Sanders and perhaps Yamamoto all suggest that this policy consensus may be coming to a close. If that is the case, rising inflation somewhere in the medium term is increasingly likely.
[Posted: 9:30 AM EDT] The big news overnight came from Japan as PM Abe’s cabinet approved the ¥28 trillion stimulus package. Actual new spending is only about a quarter of the headline number. The JPY appreciated on the news and the JGB saw a modest uptick in yields. Overall, the package disappointed investors. Some of this disappointment is being attributed to the lack of new bond issuance and the decision not to issue 50-year JGB. It should be noted that the BOJ held an “emergency” meeting today. All that emerged from the meeting was Governor Kuroda’s promise that the upcoming stimulus report “would not disappoint.”
However, it appears to us that all the packages (this is reportedly the 28th fiscal stimulus package since 1990) will fail without one critical element—Japan needs a weaker JPY. So far, Japanese policymakers are allowing themselves to be boxed in by the G-7’s promise not to use competitive devaluations to support economic growth. We suspect that, at some point, these promises will be jettisoned and open currency warfare will emerge. Eisuke Sakakibara, the former finance minister who engineered the weaker JPY and the Halifax Accord in the mid-1990s, said today that he believes the government’s trigger point would be a 90 ¥/$ rate.
How would Japan force the JPY lower? Think of Japan conducting QE by purchasing U.S. Treasuries. There would be much howling by other nations but the bottom line is that foreigners don’t vote in other countries’ elections. Competitive devaluations and subsequent retaliations were the bane of the 1930s; the rise in populism increases the likelihood of a return to such policies.
The Reserve Bank of Australia cut its main lending rate to 1.50%, a 25 bps cut, the lowest policy rate on record. The move was generally expected by the financial markets but the fact that the rates have hit a new record low is newsworthy. Interestingly enough, the AUD rallied on the news. This may have occurred, in part, because the RBA didn’t signal further easing. However, the biggest factor in exchange rates right now is probably U.S. monetary policy. If the money markets have this right, and the FOMC stays on hold, the dollar will probably weaken in the coming months.
Last week, we began a three-part series on the attempted Turkish coup that started on Friday, July 15. In Part I, we examined Turkey’s history to frame the historical conditions that affected the failed coup. As promised, this week’s report will discuss the actual coup.
The Coup
Around 7:30 p.m. Eastern European Standard Time (EEST), there were reports that key bridges that cross the Bosporus had been closed by soldiers. About 20 minutes later, military jets and helicopters were flying over Ankara and Istanbul. Gunshots were also reported in the capital. At 8:00 p.m., Prime Minister Binali Yildirim announced a coup was underway and called for calm. He indicated that a group within the military was behind the coup and noted that loyal security forces were being mobilized. At 8:25 p.m., the rebels issued a statement indicating that the military was taking over to “protect the democratic order.” The same statement indicated that Turkey’s existing foreign relations would be maintained.
[Posted: 9:30 AM EDT] It’s global PMI day today. As we note below, most of the data came in around expectations. Australia was unusually robust while the U.K. was rather weak. Overall, the data suggests a global economy that is mostly steady.
We had two fed officials speak over the weekend, Dallas FRB President Kaplan and NY FRB President Dudley. Kaplan was mostly hawkish, suggesting that September was a live meeting, but also expressed the need for “patience.” Dudley, on the other hand, spent most of his time talking about the problems the economy faces. Despite these comments, financial markets continue to project a slow path for tightening; for now, the market doesn’t have the probability of an increase greater than 50% until the June 2017 meeting (based on the fed funds futures).
One item we neglected to mention with last week’s GDP benchmark revisions is that corporate profits, after inventory adjustments and depreciation, were revised higher. As the chart below shows, profits were stronger than originally reported, which is supportive for the equity markets.
In the most recent rebalance of our Asset Allocation portfolios, we maintained an allocation to emerging market equities in the Aggressive Growth portfolio. As we have noted in the past, there is a positive relationship between the dollar’s exchange rate and the relative performance of developed market equities and emerging market equities.
This chart shows the relative performance of the S&P 500 and the MSCI emerging market index (denominated in dollars). A rising blue line on the chart signals stronger S&P performance relative to emerging markets and vice versa. Using the JPM dollar index, we note the dollar bottomed in late 2011. As the dollar appreciated, the S&P began to consistently outperform emerging markets.
The most important factor boosting the dollar was monetary policy divergence. The Federal Reserve ended its balance sheet expansion in December 2014. It raised its policy rate in December 2015. This tightening occurred while the European Central Bank (ECB) and the Bank of Japan (BOJ) both continued to implement aggressively accommodative policies. The dollar’s strength clearly accelerated in the 2014-15 period, although the rally has stalled this year. We believe the stall has occurred because of uncertainty surrounding U.S. monetary policy. Initially, the FOMC signaled four rate hikes this year. Currently, fed funds futures are suggesting no rate hikes this year and perhaps only one hike next year. If this does become the path of policy, the dollar bull market may be coming to a close unless the ECB and BOJ become even more aggressive in policy easing. If we are reaching the point where further accommodation isn’t possible, a stronger dollar is less likely and thus, emerging market equities become attractive given their recent relative weakness.
However, due to the uncertainty over the direction of policy, as noted above, the asset allocation committee has judged emerging market equities as only appropriate for aggressive investors. If the FOMC tightens policy sooner or to a greater degree than expected, developed markets could begin to sharply outperform emerging markets again. Given that market expectations are leaning heavily toward steady Fed policy, there is the potential for a bearish surprise for the emerging equity sector. Thus, in our judgement, only the most risk tolerant investors should be considering emerging market equities at this time.
[Posted: 9:30 AM EDT] The BOJ disappointed the financial markets. Expectations for a larger stimulus package, maybe even helicopter money, was hoped for. Instead, the BOJ offered to boost ETF purchases and indicated it will perform a study of its stimulus programs, hinting perhaps that more could come later this year. But, there is a growing fear that the BOJ may have exhausted all of its options. After all, NIRP hasn’t worked very well and given the absorption of bonds that QE is already doing, some portion of fiscal spending will be bought by the BOJ anyway. As expected, the JPY rallied but, surprisingly, Japanese equities rallied too. This unexpected improvement in stocks might be due to the expansion of ETF buying. Still, one day doesn’t make a trend and we will be watching to see if Japan’s equities hold up.
The U.S. presidential season is officially underway now that the two conventions are over, although many political analysts argue that most voters don’t really think about elections until after Labor Day. We have discussed this issue at length over the past few months and will be analyzing it in the coming months as well. Our take on this election hasn’t changed. We believe there have only been a handful of important presidential elections since 1792; this one could be one of those inflection point events. Hillary Clinton, despite her historical breaking of the gender barrier, is the continuity candidate. She ran her primary campaign using the playbook of a sitting vice-president and is leaning heavily on President Obama’s legacy. Donald Trump is running as a candidate of change. The most important change he is signaling is either an end to, or a massive adjustment of, America’s superpower role. There is a growing segment of the American public that is tiring of the costs of this role. They are unhappy with the constant wars and the unending foreign competition from globalization. Sanders represents this trend as well. To a great extent, this election is shaping up to be a referendum on the superpower role. If Trump were to win, the global impact would be massive. Our current expectation is that Clinton will win. Trump is a mercurial candidate that is capable of unforced errors and thus could make a fatal error at any time. Clinton may not be flashy, but she is disciplined and won’t go off message. Any mistakes she makes will be ones where she is blinded by her membership in the political establishment. Her VP selection and her giving Mayor Bloomberg a prime time speaking slot shows this tone deafness. Kaine, while giving us no doubt he is a solid citizen, does nothing to sway the Sanders voters and Bloomberg, although able to attract GOP establishment voters, is a paragon of Wall Street, an anathema to the Sanders and Warren supporters. The uncertainty surrounding this election should act as a damper for risk assets in the coming months.
The GDP data, as shown below, was less than impressive. Another number that worries us as well is the drop in home ownership.
This chart shows the most recent data on the percentage of households that own or have a mortgage on their homes. It is at its lowest level since the mid-1960s. Our position has been that housing would not heal until home ownership fell to sustainable levels, which we assumed would be between 64% and 65%. We did not expect a decline to 63% and with few signs of stabilizing. If this doesn’t turn soon, it suggests that, at best, growth remains sluggish.
[Posted: 9:30 AM EDT] The FOMC statement was generally as expected. The committee acknowledged the economy improved from their last meeting. Labor markets are better and household spending is robust. On the other hand, business investment remains sluggish. Overall, the FOMC indicates that “near-term risks to the economic outlook have diminished.” Yet, the language suggesting that policymakers are in no rush to raise rates remains in place. The statement, for example, did not signal that risks to the economy were “nearly balanced” as some feared. KC Fed President George dissented, resuming her lonely assault on policy stability. But, overall, there were few surprises. We would view the statement as consistent with an outside chance of one hike this year, and more likely, no rate adjustments until 2017. Simply put, if the Fed wanted to prepare the markets for a rate hike, this statement failed in the goal, leading us to conclude that was not their aim.
Market action would suggest that the financial markets were primed for a more hawkish stance from the FOMC. In the hours after the statement, the dollar has weakened significantly and long-duration Treasuries rallied. Although STL Fed President Bullard has been roundly criticized for his regime model of monetary policy, the actual behavior of the Fed is very consistent with his model. He has faced criticism because his theory implies that policymakers are anticipatory except when regimes change; at that point, monetary policy would shift to a new focus (e.g., from controlling inflation to stabilizing the financial system) which would require a period of adjustment where the Fed would be behind the curve until the new regime is implemented. This is an unpopular view of policy; the preferred view is one where the focus of policy never changes. However, if one actually looks at how policy is conducted, it does pass through periods of goal adjustments, or regimes. The reason this is unpopular is that it adds another layer of risk to the financial markets. If, for example, the Fed switched to a regime of getting to 8% annual M2 growth instead of targeting inflation, interest rate volatility could soar. And yet, this was exactly Volcker’s monetary policy regime.
The BOJ decision is expected tomorrow. As we noted yesterday, PM Abe unveiled a ¥28 trillion fiscal package that included new spending and loan guarantees. The latter isn’t all that important because money is nearly free in Japan and so a project that needs a guarantee might be difficult to do anyway. The focus, then, is on how much new spending is included. Bloomberg reports today that it’s about a quarter of the total package, or ¥7 trillion. The unknown is the time frame for that spending. If it is spread out over several years, the immediate impact is less. From the BOJ tomorrow, we would not expect an announcement of helicopter money but would expect an expansion of QE.
Meanwhile, in Europe, EU Commission President Juncker appointed Michel Barnier to negotiate Britain’s exit from the EU. This appointment raised alarm in London; Barnier is considered anti-finance. He has supported regulatory measure, which has been unpopular in London, including broker bonus caps. Quotes surrounding his appointment include “I can’t see how it could be worse” and “It’s incredibly provocative. This is Juncker’s revenge on Britain”. We still believe that Chancellor Merkel is the ultimate decision maker on Brexit and initial meetings between the German leader and PM May appeared cordial. But the French are taking a hard line, in part to scare off the Le Pen’s National Front party, and are likely behind Barnier’s appointment. This decision could make things worse in terms of Brexit.
The U.S. crude oil inventories rose 1.6 mb, a bearish surprise. Market expectations called for a 2.0 mb draw.
This chart shows current crude oil inventories, both over the long term and the last decade. We are starting to see inventories decline but normal levels would be below 400 mb, some 130 mb lower than now.
Inventory levels have been running below seasonal norms although the divergence has been narrowing. It narrowed significantly this week. We are in a period of the year where crude oil stockpiles tend fall at an increasing pace; in fact, in August, declines slow markedly. We note this week that refinery utilization fell 0.8%. Given the overhang in gasoline inventories, which rose 0.5 mb compared to expectations of a 0.2 mb rise, further declines in refinery utilization could lead to additional increases in oil stockpiles.
It is important to remember that the dollar is playing a bigger role in determining oil prices.
Based on inventories alone, oil prices are profoundly overvalued with the fair value price of $35.99. Meanwhile, the EUR/WTI model generates a fair value of $45.92. Together (which is a more sound methodology), fair value is $40.34, meaning that current prices are a bit rich although valuations are improving.
[Posted: 9:30 AM EDT] The FOMC meeting concludes today. Expectations are very low for this meeting although we would not be surprised to see the statement take on a more hawkish tone. Markets are not expecting the FOMC to move higher this year; in fact, the fed funds futures don’t signal a greater than 50% probability until February of next year. It should be noted that this projection has been creeping in recently. Just a few days ago, we didn’t get the first greater than 50% month until June. Still, the markets are consistently not expecting a rate hike this year. We would not be surprised to see the Fed try to inject some degree of uncertainty into this calculation but we doubt they will have much success.
PM Abe unveiled a massive fiscal stimulus plan, which came in at ¥28 trillion ($265.3 bn). Early estimates were around ¥20 trillion, so this is a big deal, representing about 6% of GDP. Of the ¥28 trillion, it appears that ¥13 trillion is new spending and the rest is loan guarantees. The details of the package will be released sometime next week but it does appear that this spending will be spread out over several years, which will dampen the impact of the fiscal package. We do note that the JPY weakened overnight and the Nikkei rose on the news. The headline data is quite bullish but the overall impact will probably be less than meets the eye. Still, it is a positive step for policy in Japan as monetary policy is clearly near the end of its usefulness. On this topic, the WSJ is reporting that Japan is considering issuing 50-year bonds. It is possible that a 50-year bond can be a tool in “stealth” helicopter money. The Abe government is probably reluctant to openly implement Monetary Funded Fiscal Spending (MFFS) because of its bearish effects on the JPY—it doesn’t want to trigger a currency war. In MFFS, the fiscal authority spends money and issues bonds that the central bank buys and effectively extinguishes by holding them to maturity. Given the usual adult lifespan, a 50-year bond is essentially a lifetime, thus allowing the fiction that MFFS isn’t being done when, essentially, it is. It should be noted that France and Spain have issued 50-year bonds and Ireland and Belgium have issued century bonds.
There has been some curious behavior in the LIBOR markets recently. Although expectations of Fed tightening are benign, LIBOR rates have been ticking up.
(Source: Bloomberg)
This chart shows 3-month USD LIBOR. Note that over the past month, the rate has moved up around 10 bps. Usually, such moves occur for one of the following reasons: (a) the Fed is raising rates or (b) there is a systematic financial system problem developing, leading investors to flee the LIBOR market for sovereigns. The second case is one of the reasons for monitoring the TED (T-bills vs. Eurodollar) spreads.
The TED spread has ticked up modestly, but isn’t signaling a problem.
(Source: Bloomberg)
Just compare the above chart to the long-term TED.
(Source: Bloomberg)
Note how LIBOR rates spiked in 2008 and was “spikey” from mid-2007 through 2008. That is a more classic example of the flight to safety element of the TED spread. We are not seeing that now.
So, why the rise in rates? It’s entirely due to regulation. On October 14, prime money market funds (MMF) will see their statutory maximum weighted average maturity fall from 90 to 60 days. In addition, institutional MMFs will be forced to institute a floating NAV and can put up “gates” to slow withdrawals during crises. We are already seeing the impact.
Total Prime MMFs have declined about $500 bn and government funds have risen by about the same amount. Prime MMFs now represent 37% of total MMFs, down from 53% last October. The total assets in MMFs are about the same but the allocation has shifted from Prime to government MMF, which don’t face the same restrictions. We expect further shifts as investors begin to realize that a Prime MMF isn’t “cash.”
Here are some potential market effects:
The dollar could rise. The rise in USD LIBOR hasn’t been matched by a similar rise in EUR LIBOR. All else held equal, the higher yield should support dollar buying.
(Source: Bloomberg)
This chart shows USD and EUR 3-month LIBOR, with the spread on the lower chart. Note how the spread has widened recently.
Commercial paper markets will be adversely affected. Prime MMFs buy commercial paper. As funds shift to government funds, the money available to buy commercial paper will decline, boosting funding costs to commercial paper issuers.
A secular change in the TED spread is likely. In general, investors discount the odds of a problem in the financial markets when they buy LIBOR-based paper. With the rules on Prime MMFs changing, the risk calculation will change which should permanently shift the spread wider. It is important for investors to realize that the TED isn’t necessarily signaling a financial system problem during this reset.
The rise in LIBOR and the dollar could be a bearish factor for commodities. If the regulatory change acts as a de facto monetary policy tightening and isn’t offset by the Fed, we may see some weakness develop in commodities. The primary driver of this will be the dollar.
Overall, investors will need to consult with their MMF providers to determine if they are willing to stay with Prime MMFs or shift to government MMFs. The issue really is what the function of the MMF is in the portfolio; if it is truly cash, then the government funds are more appropriate. If it is for yield, then one needs to realize that a Prime MMF will likely lose its cash-like characteristics during financial crises and one could find that there will be a delay in tapping a Prime MMF if financial conditions deteriorate. In addition, the floating NAV could mean that “a dollar isn’t a dollar” under some conditions. In other words, the new regulations force the Prime MMFs to “break the buck” if asset values decline.
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