by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] There are three big stories today.

Leaning toward Bremain: In the wake of the assassination of MP Jo Cox, the first polls out suggest that the Bremain camp has halted the Brexit momentum.  Still, polls suggest a tight race, with 45% wanting to remain in the EU and 42% wanting to leave.  We prefer the betting pools and they are decidedly in the Bremain camp.

(Source: Bloomberg)

This chart shows the leave bets, which peaked around 45% but have fallen precipitously to the 28% 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.

Market reaction today is clearly a sign of relief.  The GBP is up strongly, equities around the world are higher and oil is up, while gold and sovereign debt prices are lower.  In fact, we may be preparing for another bout of “risk on” in the markets. The two factors hanging over the markets have been Brexit and the Fed.  We believe the former is tilting toward a market-calming outcome and the Fed may be friendly as well.  Think of it this way.  Since the summer of 2014, we have seen a steady tightening of monetary policy.  Tapering ended the expansion of the balance sheet, the dollar rallied and the Fed moved rates higher.  The combination had an adverse impact on financial markets and probably the economy.  Although we don’t expect the Fed to ease or resume QE, a weaker dollar will act as a policy stimulus.  The primary reason for dollar strength has been the divergence of monetary policy—the Fed was tightening while the rest of the world was easing.  If the Fed merely goes “steady” and expectations for tightening pull back, the dollar could weaken and, in a few months, lead to an improving economy and likely better earnings.  In other words, removing the likelihood of tightening policy and Brexit might give equity markets an upleg in the coming weeks.

At the last Fed meeting, we had a unanimous decision, with KC FRB President George voting with the group.  St. Louis FRB President Bullard’s bombshell last Friday suggests an entirely new regime for implementing monetary policy that, in the short run, will lead to at least one moderate hawk becoming a full dove.  We doubt Stanley Fisher will be swayed by Bullard’s new stance, but Bullard’s position is compelling for Chairwoman Yellen because it gives the FOMC an excuse to remain easy.

Of course, there will be other worries.  The elections will raise concerns and there are other issues in the world that could dampen sentiment.  Nevertheless, if the U.K. remains and the Fed isn’t going to raise rates more than one time, the dollar could weaken and boost the U.S. economy and equities.

Modi shoots an own goal: Raghuram Rajan, the current governor of the Reserve Bank of India, has indicated he will leave his post in September when his term ends.  Rajan is a well-respected financial figure and a solid central banker.  Under his watch, India’s inflation has eased and the economy appears to be on solid footing.  However, Modi and his political cronies are unhappy with Rajan, likely for two reasons.  First, he has kept policy tighter than they would like; there is no surprise here.  Politicians are rarely fans of prudent monetary policy.  Second, and perhaps more worrisome, the political class is reportedly uncomfortable with Rajan’s international status.  This status makes him independent and less easy to control.  According to reports, Modi wants a RBI governor that will be more sensitive to political pressure.  This is a bad time for India to be flirting with monetary populism.  Rajan has stabilized the Indian currency and fostered controlled inflation.  The next governor will, almost by design, lack the credibility of Rajan and so, expect more monetary stimulus and inflation in India.

China and Venezuela: As we have reported recently, the Venezuelan economy is in shambles due to lower oil prices and mismanagement.  China, the country’s largest creditor, is in talks with Venezuela over debt restructuring.  What is interesting is that Chinese negotiators are also talking to the opposition, wanting Madero’s opponents to agree to any debt deal to avoid repudiation if there is a change in government.  By forcing the opposition into the talks, China is also improving the status of the anti-Maduro factions which might undermine the current regime.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] There are three big stories today.

Jo Cox, martyr: MP Jo Cox was brutally assassinated yesterday while campaigning for the “remain” vote in Leeds, England yesterday.  A Labor MP and a rising star in the party, she was attacked while leaving a meeting with constituents.  According to British media, Thomas Mair has been accused of the murder and is in custody.  The Southern Poverty Law Center reports that Mair is a supporter of the National Alliance, a neo-Nazi organization based in the U.S.  Media reports suggest his support may not have extended beyond purchasing printed materials from the group.  Mair’s brother claims Thomas has a history of mental illness.

In the wake of this attack, both sides have suspended their campaigns.  There are no post-assassination polls.  However, markets never sleep and the betting pools show a decided drop in Brexit support.

(Source: Bloomberg)

The white line shows “Bremain” betting, which bounced to nearly 69% after falling to a low of 62.5%.  The orange line, the “Brexit” bet, has clearly declined, falling from nearly 45% to 36%.  Although we won’t know with certainty for a week, the tragedy clearly broke the Brexit momentum and we suspect this may shock U.K. voters into voting to stay in the EU simply because the Brexit campaign will probably not be able to rid itself from this assassination.  If we are correct, risk markets should get a relief rally after the vote; in fact, it may begin in anticipation of a Bremain victory.

Bullard outs himself: Yesterday, we noted that there was a stray dot on the Fed’s dot chart that was clearly an outlier.  We assumed it was one of the well-known doves.  We were wrong.  To recap, here is the chart:

The red oval contains two dots that show no further rate increases after this year.  In a paper released today, STL FRB President Bullard revealed his dots were the ones in the oval and his paper explained his position.  The summary of his thoughts are simple, but profound.  Instead of viewing the economy as having a long-term structural equilibrium, Bullard argues that there are a series of medium- to long-term “regimes.”  These regimes, although not necessarily permanent, are persistent and thus policy should be shaped to the regime and not some theoretical equilibrium.  The other important point is that regimes themselves are not forecastable.  In other words, Bullard will assume a regime in place will stay in place until there is clear evidence of change.  The current regime is characterized by real GDP growth of about 2%, unemployment around the current level of 4.7% and inflation in the area of 2% (using the Dallas FRB trimmed mean CPI).  This implies that productivity will likely remain low and, due primarily to abnormally large liquidity premium on safe assets, fixed income returns will be low, as will interest rates.  He also assumes no recession on the horizon.

What does this mean?  Assuming this regime stays in place, Bullard believes that the proper fed funds rate is 63 bps, suggesting a target range of 50-75 bps for fed funds.  By design, if policymakers adopt the Bullard model, monetary policy will no longer be anticipatory, but will always lag its goals.  This is probably a more honest approach to policy but one we suspect will be rejected by the other 16 members of the FOMC or any future governors (there are two unfilled seats on the FOMC).  Why?  Because adopting this policy will undermine the “oracle” image that the Fed tries to project.  In other words, there will be no more “maestros.”  The problem for Bullard’s policy model will be at the point of regime change—when regimes change, the Fed will be playing “catch up” to the new regime which will probably require aggressive moves.  Understanding the new regime when an old one is going away will take time.  On the other hand, Bullard’s program will end much of the speculation on policy; note that Bullard’s dots mostly follow the Eurodollar futures market.  In effect, the financial markets will likely set rates (which they really do anyway).

Expect a heated debate on Bullard’s paper.  Although the Fed may press against his model, in practice, his scheme is really how it tends to behave.  If adopted, it will tend to change the narratives around monetary policy and make them less confusing.

Japan’s cries for help: Japanese policymakers are calling for G-7 assistance in halting the JPY’s strength.  FM Taro Aso remarked today that he was deeply concerned about the “one-sided, rapid and speculative” currency moves and hinted at intervention.  We doubt Japan will get much sympathy from the rest of the group but that may not stop Japan from intervention.  Unfortunately, in the absence of joint intervention, simply buying currency to weaken the JPY won’t have a lasting impact unless it is tied to other policies, e.g., “helicopter money.”  Still, Japan is warning the financial markets that it is ready to act.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The last eight years have been full of unusual events.  We have seen ZIRP, NIRP, QE of all stripes, massive increases in central bank balance sheets, collapses in monetary multipliers, low inflation, consistently wrong forecasts of higher interest rates, massive borrowing in China, flash crashes, commodity volatility and so on.  Through it all, there has been an underlying expectation that, someday, conditions will return to normal.  Instead, oddities persist.

Today’s new “never thought I would ever see that” is the Swiss 30-year sovereign reaching a negative yield.  Although it has popped back up above zero, it is amazing that nearly all of a nation’s yield curve is under zero.

(Source:  Bloomberg)

The blue line is the German sovereign yield curve and the green line is the Swiss sovereign yield curve.  Germany can borrow at a negative rate for 10 years; as noted, the Swiss can now do this for three decades.  Clearly, Brexit worries are part of this trend.

The BOJ also met this morning and as expected, did nothing, although it did warn against Brexit. We are seeing massive flight-to-safety activity with the JPY soaring this morning.  Of course, part of the Japanese currency strength is due to the BOJ standing pat at today’s policy meeting.  Although most economists didn’t expect anything, it is hard to imagine that Japanese officials will continue to allow the JPY to strengthen without reacting at some point.

Although worries are high, we note that the betting pools are still signaling that the U.K. will stay in the EU.

(Source:  Bloomberg)

This chart shows the average from the wagering sites, with the white line representing the “remain” bet, the orange line the “exit” bet.  The white line is read off the right scale, the orange on the left scale.  The remain bet stands at nearly 62% a week before the vote, but clearly, the trend is worrisome.

The June Fed meeting occurred yesterday and although expectations for a change in policy were virtually nil, the FOMC managed to give the meeting a dovish tone.  The statement was mixed; the committee acknowledged that the labor markets have softened but did note the overall economy is doing fairly well, citing the housing market and net exports as improving, but showing concern about business investment.  About the most important note was that KC FRB President George, a constant dissenter, agreed with the majority this time.  It really isn’t clear why she decided not to call for higher rates; perhaps international issues played a role, or the weak labor market data.

The dots chart was decidedly dovish.

The newest parlor game among strategists is “who thinks rates should stay at 0.875% for the next two years?”  The most common guess is Governor Lael Brainard, although it could be Boston FRB president Rosengren or Chicago FRB President Evans.  In any case, those outliers are clearly catching everyone’s attention.  It is also worth noting that six members are projecting a single rate hike this year and only two expect more than two hikes.  In March, only one member called for one hike, nine voted for two hikes, and seven wanted three or more.

The dots average continues to decline toward the Eurodollar futures market projections.  Inflation projections remain steady, so it does appear that the FOMC will tolerate a bit higher than target inflation at some point.

There are two takeaways from the Fed meeting.  First, the dollar weakened after the statement and this will put pressure on other central bankers to ease further and prevent their currencies from strengthening.  Second, it looks like the Fed may only raise rates once this year, if at all.   There were no measures taken to signal a July hike meaning that if the employment data for June, released in early July, show that the May data was a fluke, the FOMC has not prepared the market for a move.  This would suggest they FOMC does not expect the data to be revised or reversed.  Overall, the statement was clearly bearish for the dollar, bullish for Treasuries while equities failed to respond positively to the decision.  Overall, we do view a steady Fed as supportive for equities but it’s likely that stocks have already discounted that outcome.

The U.S. crude oil inventories fell mostly in line with expectations; stockpiles fell 0.9 mb to 531.5 mb compared to estimates of a 2.6 mb decline.

This chart shows current crude oil inventories over the long-term and over 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.  But, inventories are clearly lagging the usual seasonal pattern and we are on a declining path.  We are running about a month ahead of the normal seasonal decline.

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 $31.32.  Meanwhile, the EUR/WTI model generates a fair value of $51.21.  Together (which is a more sound methodology) fair value is $42.08, meaning that current prices are a bit rich.  The dovish Fed meeting, discussed above, should be considered bullish for the EUR and thus supportive for oil prices.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] BREAKING NEWS: Nigeria announced it is moving toward a market driven exchange rate policy, likely taking steps toward allowing its currency, the naira, to float.  Although the Central Bank of Nigeria has allowed more flexible exchange rates recently, allowing a full float will likely lead to a much weaker currency.  This action will boost inflation and import prices but will make the domestic oil industry more competitive as it pays its workers in a depreciating currency but sells oil in dollars.  To a great extent, this news reflects the tensions caused by lower oil prices.

It’s Fed Day!  After six weeks of waiting and a swing in the employment data, the current fed funds futures expectations put the odds of a rate hike today at virtually zero and only 17.6% for July.  This outcome is probably too low for the Fed’s liking.  Although we believe Chairwoman Yellen is generally dovish, she will likely be uncomfortable with this degree of certainty in the markets and will try to inject a bit of worry.  Thus, we expect a more hawkish tone to the statement, data expectations and “dots” from the FOMC.  At the same time, with Brexit and what will likely be a political circus through autumn, we believe that if the Fed doesn’t hike in July, it probably won’t move again until December.

Nevertheless, the Fed has hiked rates during election years despite general market beliefs that the central bank would stay neutral.  This chart shows that since 1984, or nine election cycles, the Fed has raised rates in five, cut rates in two and stayed neutral in two.  On the other hand, these were fairly standard elections between two establishment candidates.  It isn’t farfetched to expect Democrats to complain that rate hikes could toss the election to Donald Trump.  Of course, it could work the other way as well, that not cutting rates is a boost to the Democrats if the economy needs it.  Given the degree of vitriol, it would take a very compelling reason for the Fed to raise rates once campaigning escalates later this summer.

Another potential reason for today’s Fed meeting to have a hawkish tilt is that Q2, despite the employment data, looks like it will be rather strong.

The Atlanta FRB’s GDPNow report is projecting a 2.8% Q2 GDP number.  This report is above the Blue Chip Consensus and approaching the upper bound of that forecasting groups expectations.  In looking at the contributions to growth, virtually all the expansion is coming from personal consumption.

Of the 2.8% projection, 2.7% is coming from consumption.  Investment spending is negative, mostly due to a drop in inventories.  Net exports are showing an impressive recovery while government continues to disappoint.  The bottom line: the market’s expectations are too dovish at this point and even if the FOMC doesn’t want to raise rates until December, it will try to inject a degree of uncertainty into the markets.

MSCI denied the inclusion of China’s A shares into its indices, which was something of a surprise.  MSCI rightly pointed out that the Chinese government still has an excessive degree of involvement in the markets and capital controls make it difficult for foreign investors to pull their investments quickly.  The group did say China will be considered for inclusion in 2017.  This decision is a blow of sorts to the Xi regime as it seems to like international recognition for its development.

Although this development hasn’t been noted widely in the news, the U.S. Navy announced it is moving vessels from the Third Fleet, based in San Diego, to the waters in the East and South China seas.  As the map below shows, the Third Fleet’s normal area of operations is mostly around the U.S.  Apparently, the Obama administration wants to beef up U.S. presence in the Seventh Fleet’s area of operation to counter increasing Chinese belligerence.  This shift suggests growing tensions with China.

(Source: Google)

This map shows the areas of operation for six of the seven U.S. Navy Fleets.  The First Fleet, which has no designation on this map, was designated as the Third Fleet in 1973.  There is also a Tenth Fleet, which is in charge of Cyber Command.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Risk markets remain soft this morning in the wake of the German 10-year yield dipping under zero.

(Source: Bloomberg)

It is historic enough that we now have the German yield curve below zero going out 10 years.  A total of 75% of German bonds now carry a negative yield and 50% yield below -40 bps.  The -40 bps level is important because the ECB can’t legally buy bonds with a yield below that level.  Thus the continued decline in German yields is making QE in Europe increasingly difficult, forcing the ECB to purchase riskier credits.  Perhaps just as important is that U.S. 10-year T-note yields have dipped under 1.60% this morning, reaching a low yield of 1.57%.

The other big news is Brexit.  The Sun newspaper, with the highest circulation in the U.K., has come out in favor of leaving the EU.  Although the actual impact of this news is probably less than it would have been a decade ago, it does add to evidence of a surge toward leaving the EU.

(Source: Bloomberg)

This chart shows a Bloomberg calculation of the average of betting sites on the question of staying in the EU.  At the beginning of the month, odds makers’ betting pools showed a clear bias toward Bremain as the betting flows suggested the U.K. would not vote to leave the EU.  Although the odds still favor that position, there has been a definitive shift since early June.  Next week’s WGR will examine the Brexit issue from the context of the viability of the EU project.

Finally, the FT is reporting that, since last August, China has spent $470 bn supporting the CNY.  The onshore rate has been inching down recently despite persistent central bank support.  Recent comments suggest China will not allow a free float of the CNY; usually, that means depreciation, but due to fears of capital flight, the most likely outcome is a gradual slide in the exchange rate.  On a related note, the MSCI is nearing a decision to allow onshore (A shares) equities into its emerging market basket.  Based on the lack of openness in the Chinese financial markets, it is hard to justify adding additional Chinese exposure to the emerging indices.  On the other hand, given China’s size, it will be difficult to keep the onshore shares out indefinitely.  We suspect they will get added in a measured fashion starting later this year.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Week of meetings: the Federal Reserve, BOJ, BOE and SNB all meet this week.  None are expected to change policy, although if one might, the BOJ would be the most likely.  The JPY has been on a tear and the Abe government would like to reverse that trend.  About the only tool available to the BOJ would be to increase the amount of QE, which might happen.  Although the best tool for the BOJ would be the expansion of its balance sheet by purchasing U.S. Treasuries, this would be seen as a hostile currency event, making it unlikely, at least for now.

Of course, the big issue is the Brexit vote, which will be held on June 23.  Polls are all over the place, but we note that the PredictIt betting market puts the odds of leaving at 42%.  Although the leave odds have been rising, they are still comfortably under 50%.  We suspect that the race may tighten a bit from here but, in general, most separation votes (Scotland, Quebec) end up failing and we suspect this one will as well.  For us, the Brexit vote is very useful because it reflects the nationalism fueling the Trump campaign.  If the U.K. votes to exit, it may show that the cosmopolitan position of the political elites in Europe and the U.S. is eroding.  If the betting line is correct, we may be setting up for a decent rally in the GBP and risk assets in general.

On the topic of the Fed, we don’t expect any rate movement this week.  To trigger a July hike, the June employment data will have to show that the May numbers were an anomaly and labor market conditions aren’t deteriorating.  If the July data are not all that robust, the next hike will be pushed into year’s end.  Yes, the Fed can raise rates in an election year but it raises political heat on the committee when it does so and this election cycle will be so divisive that we doubt the Fed will have any desire to inject itself into that turmoil.

China released a series of data over the weekend.  In general, most of the numbers came in either near or a bit below forecast, suggesting a degree of stabilization in China.  However, one number did come in surprisingly weak—foreign direct investment.  Foreign direct investment is when a foreigner either buys or builds something in a nation, as compared to portfolio investment, which is the purchase of securities by a foreigner.  The drop may be simply one month’s issue but losing foreign direct investment may be a sign that foreigners are becoming less comfortable with the social and political stability of China.

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