by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The FOMC meeting begins today and concludes tomorrow.  As we noted yesterday, we expect the Fed to try to inject expectations of potential tightening.  We also expect the FOMC to fail on this goal.  The financial markets are quite sure the Fed won’t move until next year.  We note that the NYT has a feature article on Governor Brainard, one of the most dovish members of the FOMC.  The article discusses her Democratic Party leanings (she has donated $2,700 to the Clinton campaign, the largest donation an individual can make) and her focus on global economic conditions in setting U.S. monetary policy.  The Fed’s mandate from Congress is to focus on the U.S. economy.  However, given the U.S. superpower role, the singular focus on the domestic economy is probably inappropriate.  For better or worse, the U.S. is the world’s central bank.  Given global conditions, the Fed should remain on the sidelines.

We are seeing the JPY much stronger this morning after the Japanese media reported that PM Abe is likely to propose a ¥6 trillion fiscal package, well below the ¥20 trillion suggested earlier this week.  However, it should be noted that the higher numbers were somewhat overstated in that many were simply loan guarantees.  Since Japan has negative sovereign rates, loan guarantees are rather silly.  The proposal being discussed today appears to be real spending over a two-year time frame.  Although this spending is not small, the reaction from financial markets is a clear signal that more is required to “move the needle.”

On Friday, the first look at Q2 GDP will be released.  We do note that there will be benchmark revisions to the data which could affect how the numbers come in relative to expectations.  The latest data from the Atlanta FRB showed the following:

This GDP tracker puts growth at +2.4%.

The above table shows contributions to the overall growth number.  The data suggest that household consumption is the source of nearly all growth in the economy, adding just over 3%.  The biggest drag on growth is inventory reduction, which is peeling nearly 60 bps off of growth (CIPI on the above table).  That is something of a “bad news/good news” situation as inventory rebuilding will tend to support growth in future quarters.  Net exports added modestly, although if one observes the trends in the data, the contribution from net exports fell as consumption improved over the quarter.  This is consistent with theory; as consumption rises, some growth is lost to foreigners.  It is also disconcerting that the government sector remains a drag on the economy, a persistent problem in this recovery and expansion.

This chart shows the three-year average of the contribution to GDP growth coming from government.  Since 1950, the trend contribution from government tends to run between 50 to 100 bps.  There were three periods prior to the current one when the government contribution was negative.  All three of these periods occurred during post-war demobilizations.  The current weakness, occurring during wars in Iraq and Afghanistan, suggests that other spending on infrastructure, education, etc. has been severely constrained.  It is important to note that only spending on goods and services by the government affects GDP directly in the GDP data.  Transfer payments, such as Social Security, Medicare, etc., are not counted as government consumption.  That spending shows up in consumption as households spend these transfers.

Both candidates for president are promising higher fiscal spending.  Although we have serious concerns about the potential return on investment (nicer airports and more roads probably won’t boost productivity), at least the spending will lift GDP growth.  Overall, we would expect the proposed fiscal policy boosts to lift growth by 50 to 100 bps most quarters.

So, overall, we are looking for a recovery in the data on Friday.  The revisions do add an element of uncertainty to the data.  However, we feel safe in saying that the data will be an improvement over Q1.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] It was another mostly quiet night.  We did see European equities lift on better economic sentiment data (see below).  The G-20 meeting ended with a mostly banal communiqué.  There was some discussion of fiscal policy by the group.  However, the G-20 structure is so unwieldy that any real group-wide adjustments only occur during crises.

For summer, this could be a momentous week.  First, the FOMC meets tomorrow and Wednesday.  No change in policy is expected.  This meeting will not produce dots or changes in forecasts, so the statement will be the most important item to emerge from the meeting.  The fed funds futures put the odds of a hike at this week’s meeting at a mere 10% and don’t record a greater than 50% reading until next March.  Thus, the financial markets could be vulnerable to comments that suggest a rate hike may be back on the agenda.  We would not be surprised to see some leaning in a hawkish direction but would not expect the FOMC to make a clear case for higher rates.  Still, one important risk to the “goldilocks” conditions we are experiencing would be a change in policy perceptions.

Also this week, the ECB will be releasing the results of its bank stress tests on Friday.  All eyes will be on Italy’s results.  Italian officials continue to claim that any problems are under control.  EU officials also claim that measures already taken have made the system safer.  We would be surprised to see any major banks fail the tests.  After all, they are political in nature.  We will be watching the market’s reaction to an expected good result.  If bank equities rally, it would suggest that investors view the tests as credible.  Today’s FT reports that Portuguese banks are bracing for massive losses from the government’s inability to find buyers for Novo Banco, the lender that emerged from the resolution of Banco Espirito Santo, which failed nearly two years ago.  Novo Banco was the “good bank” that came from the failed bank, and the government’s inability to privatize the good bank is not a good sign for financial markets in the EU.

Also on Friday, the BOJ will hold its policy meeting.  There are high expectations that the BOJ will “do something” to support the economy.  There is growing speculation that the Abe government will try to coordinate stimulus policy with the BOJ, although that may not happen at this meeting.  We would not be surprised to see the BOJ increase its buying of non-traditional assets, such as equity ETFs, but the hope for “helicopter money” is likely to be dashed, at least at this meeting.

In other news, the Guardian is reporting that the EU may be willing to offer Britain a seven-year exemption to freedom of movement rules while allowing the U.K. to remain in the single market.  France is strongly opposed to the concession but we suspect Germany does not want to see a major trading partner’s economy hurt by a hard Brexit.  Britain would still need to pay into the EU budget and would give up its seat at the negotiating table, but unchecked immigration seemed to be the biggest issue triggering the Brexit vote.  The risks for the EU are that such restrictions on movement inside the EU would be popular with other states but, if widely implemented, it would represent a major retreat from a unified Europe.  On the other hand, this might be the best solution available.  If this rule does come to pass, it would be supportive for U.K. financial assets.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The GOP convention wrapped up last night; the Democrats hold theirs next week.  Financial markets are very quiet this morning, typical of the “dog days” of summer.  There were two items of note.  First, the flash PMI data from the U.K. was quite weak, with the July composite index tumbling to 47.7 from 52.4 in June.  This is the first major economic report since Brexit and it paints a weak picture.  In fact, the data suggest a recession could be underway.  The GBP dipped on the news as the weak data will tend to prompt the BOE to ease credit.

The second item of interest comes from the WSJ, which reports growing discord between General Secretary Xi and Premier Li over reforms to the Chinese State-Owned Enterprises (SOE).  On July 4^th, Xi called for “stronger, bigger, better” SOEs with the CPC playing a central role in their management.  Li’s comments, issued about the same time, called on the SOEs to “slim down” and “follow market rules” in their restructuring.  Although we have been hearing reports of rising discord between the two leaders, these conflicting comments are perhaps the clearest evidence that Li and Xi are not on the same page.

Xi has systematically undermined Li’s authority and influence.  Xi is the president of China, the General Secretary of the CPC and commander in chief.  Li, as Premier, heads the cabinet within the Politburo and, at least traditionally, was in charge of economic policy.  However, Xi has created a set of ad hoc committees that answer only to him that have taken over many of the cabinet’s roles.  Xi’s supporters argue that corruption is so endemic that the president must take direct control.  Xi’s detractors suggest he is power-hungry and has taken on more tasks than he can effectively manage.

The tensions between Xi and Li are part of a deeper divide within the CPC. Xi is a “princeling” whose family lineage includes important founding revolutionaries.  Li comes from a more humble background, rising from the other source of power, the Communist Youth League (CYL).  The CYL is how those from the countryside rise to levels of influence.  Princelings tend to support economic growth at the expense of equality; CYL leaders tend to focus on growth in the interior of the country and equality.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The JPY rose strongly overnight after media reports quoted BOJ Governor Kuroda as saying that helicopter money was not being considered and would never be implemented.  This comment came as a surprise as the financial markets have been steadily discounting some sort of action from the Japanese central bank.  We have seen the JPY retreat after it was discovered that the comments are about a month old.  Still, there are reports carried by both Reuters and Bloomberg raising concerns from BOJ officials that the BOJ may be reaching the point where its unconventional policies are no longer able to boost growth.  The BOJ holds its official meeting on July 29.

On the fiscal side, Japan’s PM Abe is hinting at a ¥20 trillion ($108 bn) package, which is massive.  However, the actual fiscal thrust could be much less, closer to ¥3 trillion ($28 bn).  How does this work?  Much of the package isn’t direct spending but special loans offered to the private sector for special projects.  Given that the Japanese financial system has ample liquidity, it isn’t obvious that these loans are even necessary.  It should be noted that many of these projects are multi-year in nature, which dilutes the impact in the short run.

We still believe that direct financing of fiscal spending will eventually occur and will most likely occur in Japan first.  However, it may not happen this summer.  If Abe and Kuroda disappoint, the recent rally seen in Japanese equities and the weakness in the JPY may not be sustained.

ECB President Mario Draghi is holding his press conference after the bank made no changes to policy.  The markets initially took the bank’s action as modestly hawkish as the EUR rallied before and early on Draghi’s comments.  Draghi has hinted that a stimulus boost might be considered in September.  This comment reversed gains in the EUR, leaving it unchanged as the U.S. equity markets open.

The GOP is holding its convention.  Unlike conventions in recent years, this one is clearly not tightly managed.  Although the chattering classes are uncomfortable with the surprises and the lack of control, we suspect this issue isn’t a big deal for the public.  In fact, the lack of a followed script makes it more interesting to watch and may be boosting ratings.  After all, we don’t expect any surprises when the other party meets so there is little reason to watch.  In today’s NYT, Donald Trump suggested that, under his administration, the U.S. may not move automatically on an Article 5 event, the part that says that an attack on one member is considered an attack on all.  It is known as the “collective security” article.  In NATO’s own documents, it is considered a “cornerstone of the Alliance.”[1]  Instead, Trump suggested that U.S. support may be contingent on how much a member contributes to NATO defense.  In other words, he is offering a warning that “free riding” the U.S. may be very costly.

If this stance were to become the policy of the next government, it would raise significant fears among NATO members.  After all, an important part of Europe’s recovery from WWII was the ability to steer away from defense spending toward social spending because the former became less important due to U.S. defense spending.  Trump is signaling that the behavior of the superpower will change significantly if he becomes president.  We would note that this position would probably be endorsed by Sen. Sanders if he did not know the author of the statement.

The U.S. crude oil inventories fell a bit more than forecast, dipping 2.3 mb versus estimates of a 1.3 mb decline.

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.  Inventories have been lagging the usual seasonal pattern.  We are in a period of the year when crude oil stockpiles tend to fall at an increasing pace.  The pace of declines will slow in the coming weeks as we are halfway through the summer driving season.

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 a fair value price of $36.62.  Meanwhile, the EUR/WTI model generates a fair value of $46.33.  Together (which is a more sound methodology), fair value is $40.85, meaning that current prices are a bit rich.

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[1] http://www.nato.int/cps/en/natohq/topics_110496.htm

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Market commentary is starting to suggest that the FOMC may be heading toward a rate hike later this year.  Since the Brexit event is now behind us and the U.S. economy has stabilized, if the Fed wants to return to a tightening mode, it could.  However, the markets themselves don’t believe it is going to occur.  The fed funds futures market doesn’t signal a greater than 50% probability of a rate increase until the March 2017 meeting and, even then, the odds are only 53.1%.  By next June, the odds reach 64.3%.  If the FOMC moves more quickly, this would come as a surprise to the financial markets.  If sentiment toward tightening increases, we would expect some weakness to emerge in equities.  Fixed income would likely experience a flattening yield curve and the dollar would probably rally, which would be bearish for commodities.  We doubt the FOMC moves rates this year.  The level of political turmoil is high, the economy isn’t robust and inflation remains contained.  However, the lack of policy consensus on the FOMC does suggest that a return to a more hawkish rhetoric from the U.S. central bank would not be a shock.

Reuters is reporting that a survey of Chinese sales managers confirms the economy is growing but suggests the growth rate is only about 50% of the official rate.  The Sales Manager Index for July came in at 51.7, up from 51.6; the group that conducts the survey, World Economics, suggests that China is growing around 3.3% based on its data.

The WSJ is reporting that Saudi Arabia is drawing down inventories in order to meet domestic demand.  The kingdom estimates its maximum production capacity at 12.5 mbpd and current production is pegged at 10.3 mbpd.  There is some controversy surrounding the capacity number.  This level is not verified by outside sources so there is some doubt the kingdom can actually achieve this level of production.  In addition, there is some question as to why Saudi Arabia doesn’t just raise output to meet domestic demand and maintain export levels.  Reports suggest it would need to raise output by 0.3 mbpd to meet domestic demand, but it is possible the kingdom fears that an increase of that magnitude would signal a renewed market share war and send prices lower.  Another possibility is that the marginal production is more expensive than the cost of the oil in storage, thus it’s a decision based on relative costs.  It should be noted that Saudi Arabian oil inventories are 289 mb, down from 324 mb from last October.  There is still ample oil in storage, so there is little chance that the Saudis will allow global supplies to tighten due to the lack of storage.  Overall, we still believe the guiding principle of Saudi oil policy is market share and the decision to boost output or use inventories is probably more a function of relative cost.  On the other hand, the behavior suggests the kingdom is comfortable with current prices.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Financial and commodity markets are very quiet this morning as the summer doldrums are starting to become evident.  However, three news items did catch our attention and are worthy of comment:

GOP Platform calls for a return to Glass-Steagall: The Glass-Steagall Act separated commercial from investment banking, preventing the creation of universal banks that can perform both services.[1]  Although political platforms have become rather inconsequential in recent years, this addition is something of a shocker.  Breaking up the banks’ commercial and investment banking operations would significantly change the landscape of the current industry.  Acquisitions of broker-dealers would become more difficult without the large balance sheets of the commercial banks.  Although most universal banks have struggled with the cross-selling concept, it remains a significant goal and potentially lucrative source of revenue.  We suspect this is a ploy by the GOP to capture the Sanders voters, who tend to believe that Clinton supports the large banks in their current form.  Simply put, if the GOP is on the side of attacking the large banks, it’s hard to see where they will find support.

The Bundesbank drops a bombshell: The Bundesbank, usually the stanch supporter of creditor interests, recently proposed reforms to improve Europe’s response to future fiscal crises.  First, the German central bank wants to broaden the European Stability Mechanism’s (ESM) mandate to a Eurozone fiscal authority, a role currently being met by the European Commission, the IMF and the ECB (otherwise known as the “troika”).  Currently, the ESM acts as a Eurozone IMF, helping countries with fiscal problems with liquidity.  The Bundesbank wants the ESM to become this fiscal monitoring body which would assess economic prospects, debt sustainability and the financial needs of nations with fiscal problems.  The ESM would also oversee aid programs, replacing the troika.  The second part is the surprise.  The Bundesbank wants newly issued sovereigns to contain clauses that would automatically extend maturities once a nation accepts ESM assistance without triggering a credit event.  This proposal has serious ramifications if adopted.  First, it renders credit default swaps (CDS) worthless, as extending maturities is a remedy for default.  By allowing that to occur without a credit event, which is the trigger for a CDS, investors would have no protection from a credit event.  Second, this action would be a forced “bail-in” by a nation’s creditors.  Third, the risk profile of Eurozone government debt would change dramatically; suddenly, a two-year note could become a 10-year one by a keystroke.  Investors would, assuming rationality, start shunning sovereigns issued by weaker nations, driving up their yields.  It is also quite possible that the ECB might avoid buying them in QE operations…or, it might not avoid them, which would support the bailout.  The creditworthiness of the G-7, or perhaps most of the G-20, sovereign debt is generally not called into question; the Bundesbank’s proposal may be the slippery slope to a form of built-in debt repudiation.  The fact that this is even being considered shows how strange conditions have become.

China’s newest export: One of the concerns we have about China is its debt capacity, which is broadly defined as the ability of an entity to issue debt relative to the growth the new debt generates.  There is ample evidence to suggest that the effectiveness of Chinese debt is waning; it appears that ever higher levels of new debt are necessary to bring smaller increments of growth.  That situation is a concern.  The other concern is that, with debt effectiveness waning, how will China be able to sell new debt without resorting to steadily higher interest rates?  The answer appears to be by selling debt to overseas buyers.  Bloomberg reports that debt from Special Purpose Vehicles, which are bonds used to fund municipal and provincial building projects, is finding its way into overseas portfolios.  It is unclear what currency this paper is denominated in; we suspect CNY, although we can’t always be sure.  In a yield-starved world, this paper is yielding 4.9%; one can imagine the sales pitch, “muni paper from China…they won’t default…stable currency, see the long-term chart…nice yield!”  If China decides to tap the international markets, it can likely expand its debt even further, even if the economic effects are small.  After all, if the economic impact is modestly positive and the default risk resides with foreigners, the political risks are small.  Caveat emptor!

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[1] The Glass-Steagall Act did not necessarily restrict interstate branch banking.  These laws were covered by the 1927 McFadden Act and the 1956 Bank Holding Company Act.  Restrictions on branch and interstate banking were completely repealed by the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994.  Interstate banking dramatically increases the ability of banks to grow, and limiting geographic scope would be the next step toward reducing bank power.