by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Although global equity markets continue to rally, we are seeing a rather curious trade across financial and commodity markets.  Notably, gold and long-duration Treasuries remain strong.  Two charts highlight the impact.  First, we note that inflows into gold ETPs are steadily rising.

(Source: Bloomberg)

This chart shows the holdings of all gold ETPs in metric tons.  Since the beginning of the year, inflows have been rising steadily as investors appear to be using gold as a hedge against uncertainty.

Second, as long-duration Treasury yields fall, the yield curve continues to flatten.

(Source: Bloomberg)

The spread between two- and 10-year T-notes is down to 84 bps, the lowest since the recession began and clearly the lowest since the recovery began in mid-2009.  What is occuring is a classic “bull flattening,” where yields on the long end fall faster than yields on the short end.  A flattening curve is a warning sign for economic growth.  We note that Governor Powell’s remarks in Chicago yesterday were dovish.  He suggested the uncertainty coming from Brexit is enough to require a “more patient posture” for future rate changes.

Meanwhile, the political situation in the U.K. is becoming increasingly curious.  Jeremy Corybn, the leader of the Labour Party, suffered a devastating loss in a no-confidence vote, losing 172-40.  Corybn refused to step down, refuting the will of Labour MPs.  This measure taken by Labour MPs cannot force Corybn out of office.  Those opposing Corybn could force a leadership vote, which is sort of a primary by the Labour Party, but we doubt Corybn would lose given that he is wildly popular among Labour constituents.  If the Tories call for an election to settle their own internal party issues, Labour MPs fear that a Corybn-led party will lose badly in a general election.  Although there is much talk about cutting a deal with the EU that will allow the U.K. to operate in Europe much like it does today, Chancellor Merkel continues to signal that this outcome isn’t likely.  Although there is a clear path for negotiation, namely, that the U.K. be given more immigration control, EU leaders fear that if this concession is granted, all the states will clamor for a similar deal and the free movement of persons in the EU will end.

In the end, this may be a concession EU leaders will have to grant.  All accounts suggest that this whole issue turned on immigration.  Germany can live with allowing border crossings to return; however, the German economy can’t function if the free trade zone of the EU is lost.  After all, the Eurozone has become a de facto German colony where Germany effectively forces its exports on the rest of Europe, which cannot use currency depreciation to offset German policies.  Although the dream of EU elites is the free movement of people that allows Europe to mimic the U.S., in the end, that simply may not be possible.

We note that Sen. Sanders has an op-ed in today’s NYT warning his party that the Brexit vote, a vote in part against globalization, could happen in the U.S. as well.  In fact, his campaign, in terms of economics, is very similar to Donald Trump’s.  Sanders rejects the xenophobic rhetoric of both Brexit and Trump; however, what Sanders can’t prove or admit is that xenophobia is probably necessary to sell deglobalization.

Another factor boosting sentiment is that China continues to maintain control of the offshore yuan (CNH).

(Source: Bloomberg)

This chart shows the CNY/USD and CNH/USD exchange rates (top chart) and the spread (bottom chart).  The CNH is the offshore exchange rate that the PBOC has less control over; in fact, the only way it can control that rate is through direct intervention.  When the spread widens, we tend to see rising market volatility.  It is clear that the PBOC is determined to keep the spread under control since spiking early this year.  A weaker CNH is a proxy for capital flight.  A rising CNH (meaning it’s weakening against the dollar) suggests rising outflows.  The persistent intervention probably means that outflows are effectively being subsidized by the Chinese financial authorities, but, to the world, it looks like outflows are being controlled.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] We are seeing a rebound in risk markets this morning as there is growing speculation that the U.K. and the EU will be able to negotiate an acceptable deal.  This sentiment is rising despite comments from Chancellor Merkel indicating that there will be no “cherry picking” EU rules.  One tactic that appears to be developing is that the process of exit won’t start until an Article 50[1] request is formally made by the U.K.  Since the U.K. only has a temporary PM, nothing will formally begin until a new PM is selected.  There is growing sentiment to push Labour Party leader Corbyn out of his post to allow the party to select an establishment figure.  This new shadow PM would likely call for a vote of no confidence on the new Tory government and, if it wins, elections would be held.  Labour would likely run on a platform to reverse the Brexit referendum and it might win.  It is not clear if the establishment can reverse the outcome of last week’s vote, but it is beginning to look like it will be delayed for a while which gives markets some breathing room.

Going into 2016, we noted that there were four “known unknowns.”  The first on the list was monetary policy.  Brexit, along with sluggish growth, has mostly taken further policy tightening off the table.  As we note below in the Asset Allocation Weekly section, St. Louis FRB President Bullard’s recent changes will probably act to keep the Fed on the sidelines this year.  Our second unknown was the global economy.  Brexit highlighted the risk from this issue, although China remains a concern as well.  However, if Brexit is delayed significantly and global central banks remain accommodative (which seems to be the trend), the global economy will probably hold up.  The upcoming U.S. election was third on the list.  This remains a risk and may be the biggest risk we face this year.  Polls suggest Donald Trump won’t win, but polls have become remarkably unreliable due to a political science thesis known as “preference falsification,” which means that, under some circumstances, social pressure leads people to make public statements that are contrary to their private preferences.  Under conditions of preference falsification, unexpected events occur because voters hide their real intentions.  Surprises like Brexit or Sanders and Trump occur.  Under these conditions, it becomes nearly impossible to accurately determine the degree of discontent with the established order.  Thus, going into the Brexit vote, the financial markets had discounted a remain vote only to be caught on the wrong side of the position.  This risk exists in November as well.  The fourth unknown is geopolitics, which remains a wild card as it is unclear if U.S. enemies will act before a new president takes office.  If the world believes that Sen. Clinton will likely prevail, nations like Russia or China might become more belligerent on the idea that the current president is less likely to respond than the next one.  We monitor this risk closely but it is very difficult to predict with any accuracy what might happen and when.  About all we can say is that risks are elevated.

So, bottom line, removing the Fed from the situation is supportive for risk assets.  The world economy will probably be ok, too.  However, the elections and geopolitics remain a concern.  This probably means we won’t have a return to the earlier lows in equities, but the upside is probably limited also.

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[1] The article in the EU charter referring to a nation exiting the body.

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] British politics is in deep turmoil.  The Labour Party is in disarray after 17 members called for the ouster of party leader Jeremy Corbyn.  The Labour leader is deeply unpopular with the MPs but the party faithful adore him.  Labour Party officials partly blame Corbyn for Brexit as he refused to campaign with PM Cameron for the Bremain position.  So far, Corbyn has accepted the resignation of much of his shadow cabinet and will work on appointing new members in the coming days.  The Brexit issue should have been an opening for the opposition to push for a no confidence vote and oust the Conservatives.  Instead, the Brexit vote may signal the end of the Labour Party as we know it.

Meanwhile, the Tories are trying to figure out who will be the next PM.  Most likely, the former London mayor, Boris Johnson, will win the position.  EU officials are divided on how to deal with Brexit.  Chancellor Merkel is holding to a moderate line, while French officials and much of the EU bureaucracy clearly want to make the U.K. suffer greatly in order to make an example for others.

Most of the market effects are being seen in the currency markets.  The GBP has plunged to new depths on Brexit.  The chart below shows the GBP/USD exchange rate over the past three decades.  We have highlighted two major depreciations, the 1992 exit from the European Monetary System and the Great Financial Crisis.  Both events caused about a 30% decline in the currency.  So far, we are down about 10%; if history is any guide, this could get much worse.  Meanwhile, Japanese PM Abe has instructed his finance minister to “take needed FX steps” in the wake of Brexit.  We would not be surprised to see the BOJ aggressively intervene to halt the JPY’s strength.  We note Treasury Secretary Lew indicated today that the U.S. viewed recent forex moves as “orderly” and suggested that the U.S. is not considering direct intervention.  These comments will likely trigger more dollar strength.

(Source: Bloomberg)

Finally, China appears to be viewing the turmoil as an opportunity to depreciate its currency.

(Source: Bloomberg)

This chart shows the CNY/USD exchange rate on an inverted scale.  The Chinese currency is also making new lows.  China greatly fears a stronger dollar and so, as the greenback rises, it is allowing its currency to weaken in order to remain competitive.  Of course, this action risks increased capital flight.

Two other points: Spanish elections actually favored the establishment parties over the populist insurgents, which is good news.  The bad news is that the results probably won’t allow for a government to be formed.  Thus, political turmoil in Europe continues.  Second, we are seeing a remarkable adjustment to expectations for U.S. monetary policy.  Fed funds futures put the odds of a rate hike for February 2017 at 8.1% but have a 17.1% likelihood of a rate cut in the same time frame.

Until the currency markets stabilize, overall financial market turmoil will remain elevated.  Perhaps the most disconcerting factor we are seeing in world markets is the lack of leadership.  There isn’t a “committee to save the world” on the horizon as we saw during the Asian Economic Crisis.  Thus, the potential for fallout in global markets is elevated.  On the other hand, when global capital is frightened it tends to flee to safety, which would be the U.S.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] In a major shock, U.K. voters chose to exit the EU in yesterday’s referendum.  The vote, which ran roughly 52/48 in favor of Brexit, defied polls and, for the first time in our experience, the betting pools as well.  In the U.K., this is the second straight polling miss; pollsters also missed the Labour loss in the last elections.  As expected, PM Cameron, who promised a referendum to quell a backbencher revolt, resigned.  His political ploy clearly backfired.  One half of our macro team, Kaisa, is in London this week.  The mood on the ground there is calm, but confused.  Many voters felt that they did not have enough details to make an informed decision.  The turnout for the referendum was the highest in any U.K. election since 1992.  England and Wales voted strongly in favor of leaving, while Scotland and Northern Ireland voted for remaining in the EU.

It will take some months to completely determine what this historic vote means, but here are our initial thoughts:

Financial and commodity markets: As one would expect, market volatility is historic.  Part of the reason for the massive volatility is that the markets were surprised by the outcome.  With polls mostly leaning toward remain going into the vote, we had seen a rather impressive rally in the GBP and global equities over the past few days.  So, with the unexpected outcome, reverse market action is accentuated.  Flight to safety instruments have all rallied strongly.  Treasury yields plunged across the board, with the 10-year T-note dipping under 1.50%.  Perhaps even more shocking, the two-year T-note fell over 20 bps, approaching the 56 bps level.  This T-note is very sensitive to Fed policy and the plunge in yield suggests that no tightening will occur for the rest of the year and perhaps longer.  The JPY penetrated the 100 ¥/$ rate and it appears the BOJ did intervene to prevent further strength.  Gold prices have soared, with the nearby futures price hitting $1,362.60, a rise of nearly $100 per ounce.  The rise in gold occurred despite a strong dollar.  On the flip side, global equities are all lower, with most major markets off around 7%.  Bank stocks were especially vulnerable, with most dropping double digits.  Outside of gold, most commodity prices are lower, with oil down over $3.00 per barrel at the lows.  The GBP fell below $1.3300.

In the ensuing hours, we have seen markets stabilize and, in most cases, they have lifted off their worst levels of the overnight session.  However, thus far, we haven’t seen anything that would suggest a recovery is in the offing.  Going into 2016, there were two major concerns, Fed tightening and Brexit.  The first concern is now off the board, but the second, unfortunately, has occurred.  The BOE has already indicated it will take steps to stabilize markets but there will be limits to what it can do.  Usually, major market dislocations such as this one tend to create buying opportunities; we suspect this one will as well, but it will take a few days to sort out where we go forward.

The question of Europe: The EU and the U.K. will begin the process of splitting up.  The official process creates a two-year period where negotiations take place for exit.  Thus, nothing happens immediately.  We suspect EU officials have two goals; first, they want to quell panic, and second, they want to greatly punish the U.K. for its actions to make it abundantly clear to the remaining members of the EU that exiting isn’t a viable option.  Already, EU officials have indicated that there will be no further concessions made to the U.K.  Unfortunately for the EU, the populist trend appears to be gaining strength and other nations in the EU are going to consider an exit.  Already, Geert Wilders, a right-wing populist political leader in the Netherlands, applauded the British outcome and suggested his nation should consider a referendum as well.  Scottish leaders have indicated that Scotland will be exploring its options, which may include devolution.

An EU without the U.K. will become more German-centric.  France will struggle to dilute German dominance.  As we noted in last week’s WGR, the entire EU project is now in question.  The goal of the EU was to offer peace and prosperity as an alternative to nationalism.  When the Soviet Union was a threat and the U.S. was willing to fund European security, the EU worked reasonably well.  But, absent the communist peril, with the U.S. less interested in Europe and with prosperity lagging for the masses, nationalism is gaining strength.  Although we don’t expect Europe to become a threat to global security for the foreseeable future, one cannot fully discount history.  Simply put, we have seen two world wars spawned by European nationalism.  If it returns, it is reasonable to expect that this threat will return.  Again, this isn’t an immediate concern but the risks will rise over the next two decades.

The growing threat of populism: We have been discussing this issue for some time.  Sluggish economic growth and widening income inequality has led to a growing backlash against globalization and deregulation.  Numerous right- and left-wing populist movements have been rising in Europe and the remarkable primary campaigns of Donald Trump and Bernie Sanders show that similar sentiment is occurring here as well.  At heart, populism is anti-globalization and, at some point, will also push for protective regulation.  Such policies threaten price stability and, if implemented, will lead to inflation.

The fact that the polls and betting pools in the U.K. completely missed this outcome suggests that populism is growing.  Think of it this way: although there were no official exit polls in the referendum, there were a couple private ones that were calling for remain to win 52/48.  So, how does this happen?  Assuming that there was a random sample, the only explanation is that responders probably lied to poll takers.  In other words, people may say they deplore populist positions, but in the voting booth they are voting for populism.  If we are correct, it means that pollsters and the elites are greatly underestimating the strength of populism.  The European establishment has been left looking very much like the Republican establishment in the wake of Trump’s primary campaign: befuddled and completely wrong about the public’s passions.  It also means that the polls here may be underestimating the impact of the Trump general election campaign.  Historians may pinpoint yesterday’s referendum as the turning point where globalization began its retreat.

We will have more on this issue in the coming weeks.  For now, expect markets to remain under pressure.  We would not expect this event to trigger a recession in the U.S., but we are confident that U.S. monetary policy will not tighten further this year.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Voters in the U.K. go to the polls today to decide whether or not they are staying in the EU.  The markets, however, appear to have already voted as we are seeing full “risk-on” activity, with the dollar and yen lower and Treasury yields higher.  In fact, the GBP is on a tear.

(Source: Bloomberg)

This chart shows the closes for the GBP; we are breaking out to new highs for this year and up over 5.5% since June 14.

Simply put, the markets are shifting rapidly to discount a remain vote.  If the voters decide to stay, we probably won’t see markets rise too much more.  On the other hand, if Brexit is the outcome, markets will likely look much weaker tomorrow.  We tend to think that remain will win but the preemptive market action is a concern in that we may be setting ourselves up for a nasty reversal tomorrow.

It’s PMI data day—flash readings for the U.S., Japan and much of the Eurozone are out today (see below).  In general, the PMIs show slow growth.  Although Germany is doing quite well, France and the Eurozone are lagging.  U.S. data comes out later this morning (again, see below).

Our recap of yesterday’s energy data shows that oil inventories are declining but the pace of withdrawals is slowing.  U.S. crude oil inventories fell less than expected; stockpiles fell 0.9 mb to 530.6 mb compared to estimates of a 2.6 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.  Over the past three weeks, the pace of declines has slowed and it will be somewhat bearish for oil prices if this trend continues.

This chart shows oil imports on a four-week average basis.  Oil imports have been running below average recently, in part due to the fires in Western Canada.  As those disruptions ended, we expected a pickup in imports and the data does confirm this expectation.  If imports continue to rise, the drop in oil inventories should slow and pressure prices.

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 at a fair value price of $31.64.  Meanwhile, the EUR/WTI model generates a fair value of $51.09.  Together (which is a more sound methodology), fair value is $42.11, meaning that current prices are a bit rich.  The dovish Fed should be considered bullish for the EUR and thus supportive for oil prices, which may offset the slowing decline of oil inventories.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] On the eve of the vote in the U.K., polling suggests that the Brexit vote will be close.  However, the message coming from the betting pools maintains the leave camp at roughly 25%.

(Source: Bloomberg)

This chart shows the leave bets, which peaked around 45% but have fallen precipitously to the 25% level.  Our experience has been that betting pools are more reliable than polling.  We believe this has been the case for three reasons.  First, polling questions can vary slightly from poll to poll; a bet is the same throughout the run-up to the event.  Second, money is involved.  It’s easy to offer an opinion, but once cash is in play participants tend to take it more seriously.  Third, betting is anonymous whereas most polls require giving an opinion to someone and, in the case where a candidate or position may be seen as being favored by a “lesser” class, there can be an incentive for the questioned person to lie.  Being able to make a wage in private eliminates that issue.  It is possible to manipulate a betting pool; amounts are not usually that large and a few well-heeled bettors can swamp a pool.  But, like in a horse betting situation, driving down the odds on a horse only works if one can distort the bet to the point where an arbitrage can be made.  It isn’t obvious how one could do this in a binary bet.  However, that being said, Bloomberg has reported that the odds makers are noting a large number of small bets being placed for exit while fewer, but larger, bets are being made for remain.  Thus, the pools could be getting distorted, although it is hard to see how this benefits a remain voter because it lowers the payout even if one is correct and raises the risk of being wrong if these bets have distorted the markets.  In any case, somewhere around midnight to one o’clock on Friday we will know how the vote played out.

In general, it does appear that the markets have mostly discounted remain and we suspect that will be the outcome.  If the U.K. does remain, look for a strong risk-on trade that fades as the day wears on.

Chairwoman Yellen will face the second round of her semi-annual “grilling” from Congress today.  Nothing new was revealed yesterday and we expect the Fed to remain dovish.  We note that the fed funds futures have only a 10% chance of a hike in July and don’t even crack 50% by the meeting on February 2, 2017.  Simply put, the Fed is probably on hold for the rest of the year.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Polling suggests that the Brexit vote will be close.  However, that isn’t the message coming from the betting pools, where the leave camp lost another four points.

(Source: Bloomberg)

This chart shows the leave bets, which peaked around 45% but have fallen precipitously to the 24% level.  We suspect that Britain will vote to stay in the EU.  That outcome won’t completely eliminate the drama as a close vote could lead to a backbench revolt against PM Cameron.  However, for the markets, the “inside baseball” of U.K. politics won’t be a big deal.

Yesterday’s market reaction was a sign of relief.  Today we are seeing more of a careful tone, a market that wants the certainty that all will be OK with the U.K.  Still, the combination of a remain vote and an ever more dovish Fed (see below) should support risk assets into the second part of the summer.

That doesn’t mean there aren’t other concerns.  Southern Europe has not attracted much media attention but problems there remain.  The populist Five-Star movement in Italy won a major victory as its candidate won the mayoral contest in Rome.  A similar victory was recorded in Turin.  Although the ruling coalition remains in place, populism is a growing threat.  We expect the Renzi government to expand spending in front of a constitutional referendum in October.  This vote will concentrate more power in the lower house and make it easier to pass reform legislation.  PM Renzi has indicated he will resign if the referendum fails.  In Spain, elections will be held on Sunday.  The leftist Podemos party is gaining momentum in the polls and the most likely outcome will be another inconclusive vote where no alliance can form a government.  Although Spain and Italy are not offering the same degree of drama that we have seen from the U.K., the key point is that pressure will remain in Europe.

Chairwoman Yellen will face her semi-annual “grilling” from Congress today.  Expect much grandstanding and snarky questioning from our legislatures but, beyond that, we don’t expect any startling revelations.  We expect that the Fed will remain data-dependent, the economy will be described as improving but not perfect, and the Fed will continue to offer support where necessary.  The most pointed questioning will focus on bank regulation.  Concerns over “too big to fail” and desires to support the popular community banks will be front and center.  However, in the end, we expect that nothing much of substance will be revealed and little will change.

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