by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] There is a lot of political news this morning, all of it from abroad.

Leadsom quits: The race to replace PM Cameron ended this morning when Energy Minister Andrea Leadsom quit the race, leaving Home Secretary Theresa May as the only remaining candidate.  Almost immediately, the GBP rallied as did U.K. equities.  In this week’s WGR, we discuss the post-Brexit situation.  One of the key points of our analysis is that the referendum was not the final word; Reuters reports today that over 1,000 prominent British lawyers have signed a letter, delivered to PM Cameron, stating that invoking Article 50 of the EU Charter can legally only come from an act of Parliament.  Simply put, it is quite possible that the U.K. never actually leaves the EU.  Although May has indicated that “Brexit is Brexit,” she supported the Bremain campaign and it would not be a surprise to see her press for a vote in Parliament to thwart the results of the referendum.  This may require an election to pull off, but the bottom line is that Brexit, if it does actually occur, may be months or years away.

Abe wins: In Sunday elections, PM Abe’s LDP won a clear majority in the upper house, gaining over two-thirds of the seats.  This power will allow Abe to press ahead with constitutional revisions.  Although there is great concern that Abe will try to end Japan’s pacifist constitution, we doubt he will make this move without a stronger economy.  There is talk of fiscal expansion; again, we doubt this will be the end of it.  According to reports, former Fed Chairman Bernanke is visiting Japan to meet with officials today.  As we noted in our WGR series on direct central bank financing of fiscal spending, or “helicopter money,” we argued that the first nation most likely to deploy this funding program would be Japan.  This vote brings that possibility closer.

Tribunal judgment tomorrow: The International Tribunal for the Law of the Sea at The Hague is set to announce its verdict on the Philippines’ claims that China has violated the law based on its “nine-dash line,” where China claims virtually all of the South China Sea.  It should be noted that the claim is not over competing sovereignty issues but over maritime rights attached to each claim.  It is expected that the tribunal will rule in favor of the Philippines.  China has already indicated that it will not abide by the tribunal’s ruling, arguing it lacks jurisdiction.  The U.S., which is not a signer of the Law of the Sea Treaty but generally abides by its rules, is the only power capable of enforcing the court’s claims if they are adverse to China’s goals.  The U.S. has increased its naval presence to signal to China not to react aggressively to the ruling, but escalating tensions cannot be ruled out.

The financial markets are reacting positively to the news out of the U.K. and Japan.  Risk assets, such as equities, commodities and foreign currencies, are rallying while safety assets, such as gold and Treasuries, are retreating this morning.  Although May’s “coronation” is initially positive for risk markets as it reduces the odds that Brexit is actually implemented, her mandate is less secure by not having a leadership vote.  Thus, she may need an election to actually secure a mandate.  Not only could she run to oppose Brexit, but elections would further delay an Article 50 declaration.  Anything that puts off Brexit is bullish for the GBP.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] We discuss the labor market data in more detail below but the initial response is that the Bureau of Labor Statistics (BLS) seems to have lost its way.  We saw a massive jump in June non-farm payrolls by 287k with a net revision of -6k, reversing the 11k rise (revised downward) in May.  The household survey indicated a significant recovery in the labor force, up 414k after seeing an over 800k drop in the labor force in April and May.  However, employment in the household survey only rose by 67k, leading to a 0.2% jump in the unemployment rate to 4.9%.  Wage growth came in below forecast, up 2.6% from last year.  Given the volatility of the monthly data, it would seem that one should be smoothing the numbers with three-month averages at a minimum.

Market reaction is reasonably predictable after the data—equities and the dollar rallied, while Treasuries and gold declined.  We doubt this data will change the policy stance of the FOMC.  The June data will quell any worries about an immediate recession, which is good news.  However, the inconsistencies between the surveys make it difficult to determine how strong the labor markets are at the moment.  On balance, though, we would call the report supportive for the economy.

U.S. crude oil inventories fell less than forecast, dipping 2.2 mb versus estimates of a 2.4 mb decline.

The above 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.

So, obviously, 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 the fair value price of $34.98.  Meanwhile, the EUR/WTI model generates a fair value of $47.07.  Together (which is a more sound methodology), fair value is $40.80, meaning that current prices are a bit rich.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Financial markets are attempting to stabilize in front of tomorrow’s employment data.  We did get the ADP data (see below), which came in above forecast and rather strong compared to last month.  Current expectations call for a 180k rise in payrolls and a 4.8% unemployment rate (+0.1%).  We tend to believe that the May data was an anomaly and non-farm payroll growth between 150k and 200k is the norm.  If the U.S. is unable to grow the labor force (or, to put it another way, raise the participation rate), then we are running up against labor market constraints and payroll growth should weaken.  But, we doubt that is the case.  The lack of labor force growth is complicated, a combination of skills mismatches, less mobile labor force and aging baby boomers.

This chart shows the cyclical expansion of the labor force or the past eight business cycles, indexed to the end of each recession.  As the chart shows, this is the slowest expansion of the labor force over these eight business cycles.

In Europe, starting with the U.K., the Conservatives have narrowed their choices for David Cameron’s successor to Home Secretary Theresa May and Energy Minister Andrea Leadsom.  Michael Gove was eliminated after this cycle of voting.  Of the two, Leadsom is the most supportive of Brexit.  Current betting pools indicate that May will be the most likely winner, although the actual vote among Tories won’t be held until September.  If May remains the frontrunner, it increases the likelihood that the U.K. exit will be amicable and, in fact, might not occur.  Meanwhile, in Italy, talks between the EU and Italian authorities over the banking situation have stalled over government involvement in the bailout.  The EU wants creditors to be the first line of defense for bank recapitalization rather than governments.  The problem is that, in Italy, the banks have sold bonds to households that appear to be viewed as forms of deposits.  It is estimated that households own about a third of Italian bank debt securities.  The EU rules are designed to protect taxpayers from bank bailouts and force creditors to carry the bulk of the risk.  However, in Italy, this isn’t much different than having depositors bear the risk of a bank failure.  If the bonds take a hit it could easily create conditions for a bank run.  The FT is reporting that the populist Five Star party is surging in the polls.  The latest polls show support for Five Star at 30.6%, exceeding the governing PD party support of 29.8%.  In January, the PD led by six points.  PM Renzi is holding a referendum on streamlining the structure of government in October.  If the vote fails, we expect the Renzi government to fall.  At present, the odds of such a rupture are rising.  Finally, Reuters is reporting that about a third of Eurozone sovereign bonds are ineligible for QE because they yield less than the -0.4% deposit rate set by the ECB.  Brexit has exacerbated this problem; before the vote, about 22% were ineligible.  The WSJ reports that QE has reduced the availability of sovereign bonds to the financial system.  Without risk-free bonds for collateral, QE inadvertently undermines the operations of the shadow banking system, reducing the availability of credit.

The FOMC minutes didn’t tell us much other than the members were dealing with such uncertainty that they all agreed not to make any changes.  If we get a rebound in the employment data tomorrow, expect to see the markets rebuild at least some possibility of rate hikes.  That result would be dollar bullish and Treasury bearish.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] It’s more of the same this morning.  The GBP has declined under $1.30, worries are present about Italian banks becoming a systemic risk and we continue to see the relentless decline in sovereign yields.  China is continuing its “stealth” depreciation.  Here are a few charts of note:

First, Italian bank shares continue to tumble.

(Source: Bloomberg)

This chart shows an index of Italian banks.  Shares are testing the lows seen during the 2012 Eurozone crisis.  The key conflict is that Italian banks are sitting on €360 bn of non-performing loans (NPLs).  Under normal circumstances, in a nation that prints its own currency, the banking crisis could be averted by the government borrowing money to either create a functioning “bad bank” to buy the NPLs or directly recapitalize the banking system.  If the lira still existed, the exchange value would be tumbling but the banking system would be safe.  However, the Bank of Italy can’t produce euros.  This doesn’t necessarily mean that the Italian government can’t issue euro debt to address its banks, but it will run afoul of EU rules regarding government debt issuance if it does.  It would not be a huge surprise to see yields on Italian sovereigns rise, although that hasn’t been the case recently.  Since Brexit, Italian 10-year yields have fallen from 1.50% to near 1.20%.  The odds of a conflict between the EU (read: Germany) and Italy over a bank bailout are rising and that risk is clearly weighing on Eurozone sentiment and Italian banks.

Here’s a chart for historical reference:

(Source: Bloomberg)

This chart shows the Swiss sovereign yield curve.  We have placed a solid red line at zero (noted with an arrow).  The entire Swiss yield curve is now below zero.  There isn’t much more to say on this issue, other than this must reflect deflation threats and weak global growth.

The GBP remains under pressure.

(Source: Bloomberg)

This shows the pound has dipped under $1.30 (although chartists will note that this candlestick chart’s entry for today may be signaling a “hammer,” which occurs with a short body at the upper end of the bar with a long “stalk,” mimicking a hammer, supposedly to hammer out a bottom).

Perhaps of greater interest is the continued softening of the CNY.

(Source: Bloomberg)

It is becoming increasingly clear that the PBOC is using global turmoil to reduce the value of the CNY.  This drop will make Chinese exports more competitive and put greater deflationary pressures into the global economy.

All in all, today is more of the same.  However, the trends in place are not giving positive signals for global growth.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] After an impressive recovery in equities last week, markets are weakening to start this week.  There are a number of factors weighing on sentiment.  Here are the key ones:

The Italian banking mess: Today’s lead headline in the FT discusses how Monte dei Paschi (BMPS: IM, €0.30. -0.03), the world’s oldest bank, may need a capital injection from the Italian government.  The ECB has told the bank it needs to shed €10 bn of bad loans to meet regulatory requirements.  Shares of the bank tumbled 13% at one point overnight and other Italian bank shares are down as well.  There is growing concern that the Renzi government (which is facing an October referendum on government restructuring) may bypass EU banking rules and use public funds to bail out the banks.  EU rules severely restrict government’s ability to recapitalize banks; instead, the EU wants bank creditors to bear the risk of a bank failure.  The primary creditors are bondholders, and bank bonds in Italy are mostly held by households as a form of saving.  If Italy follows EU rules, it could trigger conditions similar to bank runs.  Although Brexit is the focus of media concern, Italy’s banks are probably a much greater risk to European stability.

U.K. financial troubles: Standard Life Investments announced it is suspending trading in a £2.9 bn commercial property fund which was facing massive redemption requests.  The BOE announced that it is easing bank capital requirements to support liquidity, but Governor Carney admitted that the problem with lending would not be from the lack of loanable funds but from demand for those funds.  We would not be surprised to see rate cuts in the near term.  The GBP plunged overnight, hitting $1.31 briefly.

China concerns: China is holding military exercises in disputed areas in front of an international tribunal’s decision that is expected to challenge China’s claims on the region.  China has already indicated it will ignore any ruling that it disagrees with.  Meanwhile, the PBOC is using the Brexit turmoil to allow the CNY to steadily depreciate.

(Source: Bloomberg)

This weakening of the CNY isn’t catching much attention because the PBOC has managed to keep the offshore exchange rate (the CNH) mostly in line with the CNY.  When the two rates diverge (mostly due to the CNH weakening faster), it suggests capital flight and raises fears about global financial stability.  Still, the weakening of the CNY increases the likelihood that China is trying to export its way out of its growth issues.

A hung Australian election: Elections in Australia have not given a clear-cut result quite yet.  The ruling party is about five seats short of gaining unilateral control of the government.  It is quite possible we may not have a government in Australia for at least a week.  If a coalition government is necessary, it may take up to a month.  Under normal circumstances, this outcome would not be so bad but, given the current global political upheaval, another Western government in turmoil simply adds to global uncertainty.

The continued fall in long-duration Treasuries: The 10-year T-note yield fell below 1.40% this morning as all the aforementioned issues weigh on investor confidence and trigger further flight to safety demand.  We are seeing similar strength in gold prices.  The major worry from falling Treasury yields is that we are seeing further flattening of the yield curve.

(Source: Bloomberg)

The good news is that the curve hasn’t inverted; an inverted curve is probably the most reliable signal of recession available.  The bad news is that the yield curve is rapidly flattening, suggesting sluggish economic growth.

Overall, fear has returned to global financial markets.  The trading pattern lately has been that opening equity weakness from overseas issues has tended to dissipate as the trading day wears on and often a rally develops into the close.  We will be watching to see if that pattern resumes today.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] It’s global PMI day!  We have recorded the overseas numbers below.  Overall, Europe came in strong, while Asia was mostly neutral to negative.  Although the European numbers were positive, they may be dampened post-Brexit.

After BOE Governor Carney promised further monetary accommodation yesterday, financial markets rose strongly, showing that, even after eight years of easy global monetary policy, central bankers talking about policy support still has an impact.  We note that the U.S. 10-year T-note is challenging 1.40% this morning.  In fact, we are seeing the most curious of trading patterns—gold and Treasuries are rallying with equities.  It’s almost as if investors are engaging in a barbell approach, simultaneously acquiring equities and safety instruments.  We maintain that the key indicator will remain in the forex markets.  Currency depreciation will likely be the unspoken tool of choice to stimulate economic growth, which means, of course, that the best way to grow is by absorbing the aggregate demand of other nations.  So far, the currency markets are mostly steady as all the central banks continue to maintain policy accommodation.  We have achieved a balance of sorts, although the GBP’s weakness could eventually trigger instability.

In Europe, we continue to monitor the situation in Britain; today, there is nothing significant to report but there was a surprising development in Austria.  In May, the Green Party presidential candidate fended off a challenge from the far-right Freedom Party, winning by a narrow vote.  For the first time since 1945, Austrian courts have ruled that there were enough voting irregularities to require another runoff election.  Thus, in September or October, another round of elections will be held.  According to reports, Norbert Hofer, the Freedom Party candidate, was winning by a small margin before postal ballots were counted.  The postal votes swung the election but the Freedom Party charged that there were questionable practices in certifying these ballots.  The courts agreed.  Under normal circumstances, this news wouldn’t be that important.  However, in the currently charged atmosphere in Europe, the possibility of a far-right government in a significant European nation raises concerns.  The fact that a re-vote is necessary in a modern economy raises serious questions.  This vote may occur nearly simultaneous to the Italian government restructuring referendum, which may turn out to be a proxy vote on EU and Eurozone membership.

Finally, we are watching with great interest comments from Sen. Warren (D-MA), who seems to be turning her populist aim toward the tech giants.  In a recent speech, she raised the question about industry concentration in the tech sector, arguing that the tech giants seem to be preventing small firms from threatening the large ones with creative destruction.  This condition has been noted by others; a recent book[1] discussed how the technology industry’s business model is based on monopoly and market domination.  The so-called “unicorns” have little value to investors unless they can completely dominate their industries and thus have the potential to earn monopoly profits.

In some respects, it’s remarkable to us that this hasn’t attracted attention sooner.  The technology giants have sometimes acted in manners that would make a trust operator of the late 19^th century blush.  However, unlike the monopolists of old, these tech dominators do not use their vast market power to raise prices, for the most part.  Instead, they seem to use their market power to depress wages.  The usual way that monopoly power catches the attention of regulators is by high and steadily rising prices; these new monopolies maintain profit margins by keeping labor power depressed.

The fact that Warren is turning her sights on this industry is something that we will be watching in the coming months.  If this trend continues, it will suggest a significant new turn in populism, away from the relatively easy target of banks to a more complicated target of technology.

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[1] Rushkoff, D. (2016). Throwing Rocks at the Google Bus. New York, NY: Random House.

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The big shock overnight came from a surpise announcement by former London Mayor Boris Johnson, who withdrew from the race for the PM job in the U.K. after a withering attack from an (now probably former) ally, Michael Gove.  This withdrawal adds to uncertainty surrounding the U.K. government.  Although Mr. Gove is running for PM, the leading candidate is Theresa May, the Home Secretary.[1]  May supported the remain campaign, but did say today that “Brexit means Brexit.”  She opposes another referendum.  Meanwhile, the Labour Party continues to self-destruct as the Shadow PM, Corbyn, refuses to step down despite a no-confidence vote.  Today’s FT is full of stories suggesting the EU is going to make it difficult for the U.K. in order to set an example for others.  George Soros, speaking to the EU Parliament, offered a dire warning about the impact of Brexit, suggesting it has unleashed a financial crisis similar to 2008.

The other big news came from mixed messages out of China regarding the CNY.  Reuters is reporting that, according to unnamed sources, the PBOC is willing to allow the currency to depreciate 6.8% (the degree of precision is worth noting).  The report suggested that as long as the decline in the currency is within expectations and managable, its preferred policy is a weaker currency.  The primary risk to China is that fears of depreciation could turn into a rout as it fosters capital flight.  It appears that the PBOC is trying to create a situation where the CNY can weaken without repercussions.  After the story was published, the PBOC tried to quash it, saying it has no intention to promote trade competitiveness through currency depreciation.  We suspect the PBOC wants to quietly weaken the CNY, but stories that offer targets are dangerous because financial markets have a tendency to immediately move toward the target level quickly which can become difficult to control.

With yesterday’s DOE report, we can update the oil situation.  U.S. crude oil inventories fell more than forecast, dipping 4.0 mb versus estimates of a 2.5 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.

So, obviously, 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 after Independence Day but we should have at least a couple of weeks with large draws in stocks.

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 $32.99.  Meanwhile, the EUR/WTI model generates a fair value of $50.32.  Together (which is a more sound methodology), fair value is $42.06, meaning that current prices are a bit rich.  The recent turmoil with Brexit did put downward pressure on oil prices, but the improvement in sentiment has allowed oil prices to recover some of their losses.

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[1] In the U.K, the Home Secretary has the mandate of internal affairs for the country.  This role includes overseeing MI-5, roughly the U.S. equivalent of the FBI.