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Here’s a chart for historical reference: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.

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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