by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] It was another quiet overnight session.  Chinese inflation data (see below) was roughly in line with expectations.  U.S. equity futures are modestly higher this morning, and Treasuries are rallying a bit as well.  If anything, market action is consistent with late summer.

However, there are a couple of news items that are interesting.  At the end of July, Ylan Mui of the Washington Post wrote a piece for Wonkblog noting that FOMC members are slowly coming to grips with a world in which growth is persistently slow and inflation remains soft.  Former Fed Chair Bernanke has picked up this theme and noted that FOMC member forecasts have been steadily edging lower.

(Source: Brookings Institute, Bernanke)

This chart shows the FOMC’s long-run projections for growth, unemployment and fed funds since 2012.  Note that growth rate expectations have declined about 0.5%; there has been a similar decline for the “natural” rate of unemployment.  The drop in growth and the lack of inflation has led to a long-run drop in the terminal fed funds rate.  Why has this occurred?  In one sense, it’s because earlier expectations continue to disappoint and so the committee is merely accepting reality.  However, underlying these changes are, according to Bernanke, a change in the economy’s output potential.  As productivity has declined, it takes more workers to generate the same level of growth, which would normally lead to higher wages and, eventually, higher inflation.  But, if growth remains soft, the inflation lift never comes.

In our opinion, the missing part of Bernanke’s analysis is the dearth of discussion over slow wage growth.  We suspect it is coming from three factors.  First, technology is increasingly intruding into new areas of the labor market, reducing the number of people needed to operate the economy.  For those areas not yet affected by technology, the threat tends to keep wages down.  Second, globalization means that firms can search the globe for cheaper alternatives, which depresses wages.  The third component is industry concentration.  As firms merge, there are fewer staff positions available and firms develop market power over labor.

The bottom line is that the FOMC has become increasingly cautious about the economy’s future and thus doesn’t want to make a mistake by raising rates too soon or too much.  Accordingly, the FOMC is likely to be hesitant to raise rates mostly because the economy isn’t behaving as it did prior to the 2008 Financial Crisis.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Equity markets continue to move higher across the globe as the dollar rises in the wake of Friday’s employment data.  We have seen two consecutive strong employment reports and this has raised expectations of tighter monetary policy.  As tightening expectations ramp up, the dollar is steadily appreciating.  The higher greenback is weighing on gold and the risk-on trend is putting mild pressure on Treasuries, although most of the pressure this morning is coming from a flattening yield curve.

The Chinese trade surplus came in better than expected (see below); however, imports fell significantly, while exports were also weaker than expected.  Falling imports improved the overall trade surplus, but the trend also signals weakening underlying growth.  In general, imports are one of the better signals of economic growth and slowing imports add to evidence that the Chinese economy is sluggish.  This week, CPC leaders are meeting at the seaside resort at Beidaihe, a traditional gathering spot.  The meetings at Beidaihe are informal in nature and no press conferences or communiqués are released, but this meeting will set the groundwork for important leadership changes looming next year.  2017 marks the end of Chairman Xi’s first term.  Five of the seven members of the Standing Committee of the Politburo reach retirement age by next year, meaning major turnover is likely.  It has been reported that relations between Premier Li and Chairman Xi have deteriorated; since Li has the formal mandate for economic policy, we will be watching to see if Xi tries to lift growth in the last year of his term, which would likely offer some support to Li, or if he allows the economy to flounder, blaming Li and using it as an excuse to fire him.  There is rising potential for unrest at the top of China’s power structure, which we will be monitoring as the next 18 months unfold.

We saw something rather odd from Australia in the wake of recent rate cuts.  The major banks cut lending rates in the aftermath of the RBA’s rate decision but raised deposit rates.  This move will, by design, cut margins.  It isn’t that such behavior is unprecedented; unfortunately, it tends to occur when a financial firm is in need of deposits and raises the price it will pay for them by raising the yield.  This situation may simply be a blip, but it bears watching.  In an interconnected world, a banking crisis in a large country could lead to unexpected outcomes.

Here’s a chart from Friday’s employment data that caught our attention.  This chart overlays the unemployment rate for those over 25 years old without a high school diploma or equivalent along with the core CPI.  Since 1997, the particular unemployment rate, with a six-month lag, does a reasonably good job of signaling changes to core CPI.  We suspect this category is the most difficult to employ in the current economy and thus is a measure of the relative tightness of the labor market.  History shows that when this unemployment rate approaches 6%, price levels tend to rise toward 2.5% to 3.0%.  We are already seeing some lift; the employment data suggests that a tighter labor market will probably support tighter monetary policy from the FOMC. 

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The big news today is the employment report, which we will cover in detail below.  We do want to note that economic data from Germany and the U.K. were unusually weak and natural gas inventories recorded a rare August draw in stockpiles.

There has been some interesting news emerging from China over the past couple of days.  First, the CPC announced a delay to the National Financial Work Conference, saying it will be held “no earlier than late September.”  This conference, which occurs every five years and has, on occasion, produced important economic changes, is usually held before this date.  Speculation is that the leadership is divided and needs more time to create a consensus.

The other news of note is that the CPC announced a major overhaul to the Communist Youth League (CYL).  The CYL has been one of two paths to power in the CPC, the other being born into fortunate circumstances.  The latter, called “princelings,” are men who are the sons of prominent revolutionary leaders.  General Secretary Xi is a princeling; Premier Li is a CYL man.  It appears that Xi is consolidating power by taking control of the CYL and undermining this path to power, meaning that only princelings will be able to reach the pinnacles of the CPC in future years.  The fact that these two events have occurred so closely together probably means that Xi is concentrating power before he begins his second term next year.  Reducing the influence of the CYL will eliminate a competing power center, and it is likely that Xi is also trying to complete his takeover of economic policy, usually the mandate of the premier.

Finally, the WSJ is breaking news that OPEC may consider an output freeze at an emergency meeting in September.  Russia has noted it has not been contacted about any such meetings.  We suspect this is “oral intervention” by OPEC in response to recent price weakness. We cannot see how Iran would agree to an output freeze as it ramps up output.

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by Bill O’Grady and Kaisa Stucke

[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.

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.

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by Bill O’Grady and Kaisa Stucke

[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.

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by Bill O’Grady and Kaisa Stucke

[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 28^th 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.

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