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.

View the complete PDF

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.

View the complete PDF

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.

View the complete PDF

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.

View the complete PDF

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.

View the complete PDF

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.

View the complete PDF