by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] We are seeing a continuation of yesterday’s market activity, with equities coming under pressure and sovereign bond yields falling around the world.  Commodity prices are falling with equities, and the dollar is strengthening along with the yen.  The weakness we are seeing in equities isn’t anything out of the ordinary, but the action in sovereign debt is truly extraordinary.  As we noted yesterday, over $10 trillion of sovereign debt is now trading with a negative yield.  Some of what is occurring in the sovereign debt area is due to continued QE in Europe and Japan.  It is possible that the BOJ will announce an increase in QE next week.  However, there does appear to be growing fear in the markets.  The U.S. employment data is raising concerns about the American economy, the political situation in the U.S. is unsettling as well, the ECB’s expansion into the buying of corporate bonds for its balance sheet is troubling (some of the bonds look less than stellar in terms of credit quality), and there are worries about Brexit and other geopolitical risks, as we note below.

Today’s NYT reports that, for the first time, China sent a warship into the disputed waters of the Senkaku Islands (Diaoyu Islands as named by China).  This group of small, uninhabited islands is near Taiwan and situated roughly in line with some of the small, southernmost islands that are part of Japan.  Both China and Japan claim the islands as part of their territory.  These islands are a “flashpoint” in that neither side wants to be seen as backing down on this issue of sovereignty.

China regularly sends civilian vessels (including China’s Coast Guard) around the islands where they are usually engaged by Japan’s Coast Guard.  Sending a naval vessel (specifically, a Jiangkai I frigate) is a clear escalation of tensions.  This action coincides with an increase in China’s aggressive air patrols, including threatening U.S. military aircraft flying in international areas in the South China Sea.   In another twist, two Russian naval vessels were spotted in the islands’ waters, the so-called “contiguous zone,” which is a 24 nautical mile area around the islands; it is not clear if they were working in concert with China or just happened to be in the area.

This action is an alarming development.  First, it’s becoming abundantly clear that China is escalating tensions in the region.  The key question is “why now?”  As we warned in mid-December in our 2016 Geopolitical Outlook, nations at odds with U.S. hegemony realize that there is a good chance that the next president will take a harder line with “miscreants” than the current occupant.  Thus, it makes sense to challenge America’s allies across the world to try to influence the allies’ behavior before the new president takes office.  Second, China is facing an increasingly unstable economic situation and it is not uncommon for nations dealing with economic issues to try to distract their citizens with nationalism.  China likely assumes that the U.S. will not support Japan in a conflict over uninhabited islands.  Third, Russia is clearly at odds with the U.S. and wants to solidify its relationship with China.  Supporting China by putting its warships in the same area will help make the U.S. look weak and, at the same time, enhance its relations with China.

It should be remembered that the contiguous zone around these islands are international waters.  Russian and Chinese ships can pass in these waters legally.  Still, Beijing knows these moves are provocative and are designed to send a message to both Tokyo and Washington.  Due to the media attention surrounding the presidential campaign, the situation in the waters around China is not getting much attention.  This is unfortunate because China and Russia’s actions should not go unchallenged, because if they are, it is highly probable that more aggressive moves will follow.

Yesterday, the Federal Reserve released the Financial Accounts of the U.S., formally known as the “flow of funds” report for Q1.  The report is packed with lots of interesting information.  Here are a few of the charts that we think are worth noting.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Signs of a growing rebellion against negative interest rate policies (NIRP) were evident this morning.  The front page story in today’s FT is “Negative Rates Stir Mutiny with Bank Threats to put Cash in Vaults.”  The report indicates that major banks in Europe and Japan are pushing back against NIRP.  Commerzbank (CRZBY, $8.31) is considering a plan to hold cash in vaults rather than pay a negative rate to the ECB.  With the phasing out of the €500 note, this process would be more difficult, but the threat does show the limits of NIRP.  The Bank of Tokyo-Mitsubishi UFJ, part of the Mitsubishi UFJ Financial Group (MTU, $5.01), is deliberating a plan to relinquish its primary dealer role for JGB.  If the bank leaves, it will be the first in Japan to walk away from this position.  For the most part, the move by Mitsubishi is symbolic; the BOJ is buying up most of the government’s new issuance of JGB anyway.  However, the action is a very public display of displeasure with BOJ policy.

NIRP acts as a tax on excess liquidity.  The idea is that by implementing negative rates, banks will be spurred to lend.  However, if the problem of excess reserves is due to the lack of loan demand, and not to the reluctance of bankers to lend, NIRP simply acts to reduce bank profitability.  Textbook economics suggests that a zero-bound exists; once interest rates turn negative, there is a nominal positive return from cash and the financial system will simply suffer disintermediation, meaning that households and businesses will simply hold cash.

That isn’t what we are actually seeing at present.  It is estimated that $10.4 trillion of sovereign debt around the world is now carrying a negative yield.  German sovereign yields are negative to almost a decade and it is expected that we could see a negative yield on the Bund soon.

(Source:  Bloomberg)

This chart shows the German sovereign yield curve for today and a month ago.  The German 10-year yield is currently at 4 bps and yields up to nearly a 10-year term are anchored below zero.  The combination of flight to safety, the lack of bonds for the ECB to conduct QE and the lack of an alternative are leading to negative rates.  Falling overseas yields have pushed longer duration Treasury rates lower in sympathy.

Finally, on the topic of central banks, the Bank of Korea surprised global financial markets with an unexpected 25 bps cut to 1.25% for its base lending rate.  The unanimous decision was based on slowing export growth, weak domestic growth and corporate restructuring.

In the aftermath of last Friday’s employment report, the JOLTS numbers, released yesterday at 10:00 EDT, became more closely watched than usual.  This isn’t to say this report isn’t considered important, but it has a limited history (it started in 2000) and there are a lot of numbers in the report that can be difficult to interpret.  The headline number showed job openings were higher than expected, coming in at 5.788 mm, up 118k from March, and above the survey level of 5.675 mm.   On the other hand, hires came in at 5.092 mm, down 198k.

Quit rates, which tend to show increasing worker confidence, held at pre-recession levels.

The relationship that caught our interest was between the hire/openings ratio and weekly wage growth.

This chart shows the ratio of hires to job openings.  The ratio is very low, which means that there are many more openings than hires.  In the 2000-10 period, the relationship between the yearly change in wage growth for non-supervisory workers was fairly tight, at -71.6%.  However, from 2011 to the present, the relationship has become virtually uncorrelated (and the sign reversed).  The green line on the chart shows the forecast from a regression where we use the hire/openings ratio to explain wage growth, based on the 2000-10 period.  If the relationship between these two variables had been maintained, wage growth would be approaching 5% instead of the 2.4% rise we are currently experiencing.

This divergence is a reflection of the changes we have seen in the labor market; the low level of the employment/population ratio and the participation rate coincide with this chart.  This chart does explain the fears of the FOMC; the members appear worried that, at some point, wage growth will “catch up” due to the tight labor markets.  If, on the other hand, the labor markets have permanently changed and we are not going back to the pre-2010 situation, wage growth will remain stagnant even with a plethora of job openings compared to hires.  And that will mean that inflation should remain under control and the need to raise rates will be less.

The U.S. crude oil inventories fell mostly in line with expectations; stockpiles fell 3.2 mb to 532.5 mb compared to estimates of a 3.3 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.  But, inventories are lagging the usual seasonal pattern and we are clearly 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 $31.01.  Meanwhile, the EUR/WTI model generates a fair value of $49.67, close to current values.  Together (which is a more sound methodology), fair value is $42.25, meaning that current prices are a bit rich.  For those interested in oil, the Fed is arguably more important than the DOE inventories for the future of oil prices, and the recent weak employment data was a bullish event for oil prices in that it put bearish pressure on the dollar.  The market is putting the odds of a July rate hike at 18%; if the employment data for June show that the May data was an anomaly, it could be bearish for oil prices.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] It was another quiet overnight session.  As we note above, equity markets are mixed while U.S. equities continue to slowly trend higher.  Commodity prices are continuing to show impressive strength.  Several factors are lifting prices.  The weak employment data has put downward pressure on the dollar which is helping lift the values.  Worries about a hot North American summer have boosted grain and natural gas prices.  And, a bout of policy stimulus from China has boosted demand.  In today’s trade data from China, there was some good news in the commodity flows, although the overall data was mostly neutral.  For the month of May, China crude oil import volumes rose 3% compared to a 7.3% decline in April, iron ore rose 6.5% compared to a -4.7% reading in the prior month and copper rose 6.2% compared to a 24.3% plunge in April.

The key unknown is how persistent these trends will be.  If the U.S. labor market continues to stay soft, it’s good news for keeping policy easy, but not so good for the economy.  A hot summer will boost demand for natural gas and could cut supplies of grain, but gas inventory levels remain high and grain stockpiles are high as well.  And, China has been engaging in a “start/stop” policy regime, where it stimulates if growth appears weak, only to withdraw the support as soon as the economy gathers momentum.  It’s hard for any trend to show much duration in the current market environment.

Speaking of duration, German 10-year sovereign yields continue to slide.

(Source:  Bloomberg)

This chart shows the yield on the aforementioned debt instrument.  The ECB announced it was buying high grade corporate bonds as part of its QE program.  Essentially, the ECB is finding it difficult to acquire acceptable sovereigns in the quantities needed and this is being reflected in the German yields.  We include German yields when calculating the fair value for U.S. 10-year T-note yields.  Holding the other variables constant (which include inflation trends, fed funds, the JPY/USD exchange rate and oil prices), a 100 bps change in German yields will, with a positive correlation, change U.S. yields by 23 bps.  So, the drop in German yields is bullish for U.S. long-duration Treasuries, but not a decisive factor.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Chair Yellen’s speech yesterday was about as we expected; she didn’t say too much and did work hard to give her and the FOMC ample space to raise or not raise rates.  She did paint a view of the economy that was reasonably upbeat but also noted a series of concerns that she was watching.  Overall, the tone really hasn’t changed—the Fed wants to move rates higher but is being very cautious.   The good news is that the financial markets took the comments in stride and we are seeing stronger equity markets again this morning.

Of course, part of the reason the financial markets are better this morning is that we have seen a dovish shift in the fed funds futures.  There is now a 0% chance of a rate hike later this month and the markets don’t have the odds of a hike exceeding 50% until the December meeting.  We are not sure this degree of dovishness is reasonable in light of yesterday’s talk.  On the other hand, given how volatile this year’s election season could be, it is really hard to fathom the Fed injecting itself into that mess by changing policy in autumn.  Thus, we tend to agree that, barring some inflation shock, July is probably the last chance to change policy before the election cycle goes into full swing.  And, we doubt the data will improve that much in such a short amount of time to trigger a rate change.

China’s foreign reserves dipped by $28 bn to $3.19 trillion last month.  That was near expectations.  The stronger dollar weighed on China’s reserves, in that any reserves held in JPY or EUR reduced the dollar level of reserves.  The key takeaway is that China has managed to stabilize its currency without spending a lot out of reserves to stabilize it.  Thus, this is good news for China.

The U.S. and China are holding semiannual talks at the U.S.-China Strategic and Economic Dialogue meetings this week.  Treasury Secretary Lew suggested yesterday that China needed to reduce its industrial capacity because its production of industrial metals was overwhelming global markets.  China pushed back today, suggesting that the U.S. and the world cheered China’s expansion of capacity after the 2008 downturn as a way to boost global growth.  We suspect that the leaders of both nations are posturing.  China knows it needs to reduce its capacity; it doesn’t know how do to that without causing unemployment.  One trip through the U.S. rust belt makes it evident just how painful reducing capacity is in real life.  Chinese officials are grappling with the political and social fallout from cutting capacity and certainly don’t want it to look like the U.S. is pressing China to make such painful moves.  On the other hand, China’s pattern has been to talk about doing the right things but avoiding the pain once the policy change starts.  The U.S.  fear is that China is more likely to maintain the capacity and keep dumping goods on global markets, leading to global deflation.  We tend to expect that dumping is the more likely outcome and trade barriers are the most likely response.

With last week’s employment data, we can tentatively update our versions of the Mankiw rule model.  This model attempts to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative.  Mankiw’s model is a variation of the Taylor Rule.  The latter measures the neutral rate by core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy.  The latter number cannot be directly observed, only estimated.  To overcome the problem of potential GDP, Mankiw used the unemployment rate as a proxy for economic slack.  We have created three versions of the rule, one that follows the original construction by using the unemployment rate, a second that uses the employment/population ratio and a third using involuntary part-time workers as a percent of the total labor force as a measure of slack.

Using the unemployment rate, the neutral rate is now up to 3.75%, suggesting the FOMC is well behind the curve.  Using the employment/population ratio, the neutral rate is 1.16%, indicating that, even using the most dovish variation, the FOMC needs at least a 75 to 100 bps rate hike to achieve neutral policy. And finally, using involuntary part-time employment, the neutral rate is 2.34%.   Although these neutral rate estimates are well above the current target, it is important to note that two of the three have declined in this most recent calculation.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The big news for today is Chair Yellen’s speech at 12:30 EDT today in Philadelphia.  This talk has been widely anticipated but will get even more attention following the much weaker than expected employment report for May, which was released last Friday.  Jon Hilsenrath of the WSJ is reporting that officials will likely not move rates this month but that July is still likely.  We expect Yellen to downplay a hike this month as well, but don’t be surprised if she tries to argue that July is still a possibility.  A good central banker always wants to keep her options open and this usually means being as non-committal as possible.  Thus, we would be very surprised if Yellen is clear on anything.

In Friday’s market action, the initial shock of the data led to a major drop in interest rates and weaker equities.  However, the latter rallied as the day wore on.  The most pronounced move though was in the dollar, which weakened considerably.  The weaker dollar led to a smart rally in commodities which continues this morning although weather is helping.  Summer is clearly coming to the Midwest, with rising temperatures forecast; this is boosting grain prices this morning.  And, TS Colin is making its way through the Gulf of Mexico, which could disrupt oil imports and offshore oil and gas production.

The other concern this morning is that the most recent polls suggest that the “leave” voters are gaining momentum in the U.K.  The GBP declined on the news.  We are viewing the Brexit vote as a potential reflection of the November presidential elections.  It is likely that the same voting sentiment that would prompt the exit from the EU would also support the policy stance of Donald Trump.  Although Trump has been sliding in the polls recently, we still expect this to be a tight race and that other surprises may be in the offing this year.

Because Friday’s employment report was such a shocker, we wanted to offer a few reflections on the data.  First, the decline in the non-farm payroll number and the labor force was probably exaggerated by seasonal factors.  The chart below shows the monthly change in the non-farm payroll numbers, with the series in red showing the seasonally adjusted change and the lower dots showing the raw data without seasonal adjustments.  Note that the seasonally adjusted data show a mere rise of 38k; however the non-seasonally adjusted data is up 651k.  This recent non-seasonally adjusted number is well below the past four years, which have averaged 891k.  So, this year’s change is well below previous years.

Some of the drop in May could be due to a rather strong March.

Over the past four years, March non-seasonally adjusted payrolls rose 854k; this year they rose 903k, most likely due to mild weather.

Something similar occurred with the labor force.

The actual data showed a 312k rise in the labor force; however, for the past four years, the labor force has increased by 1.062 mm, leading the seasonal adjustment process to signal a major contraction in the labor force.  It is worth noting, though, that the data in the last decade tended to see smaller increases in the labor force than seen post-recession.

Some observations…the weakness seen in May is real; it isn’t solely due to seasonal factors.  But seasonal factors did contribute to the weakness.  It is also important to note that the raw data show long term shifts over time.  For example, the May and March non-farm payroll data show a steady increase over time.  Some of this may be due to population expansion but it may also signal less seasonality overall.  The May labor force data, unadjusted, is remarkably volatile and thus the real question may be whether the past four years reflect a “normal” increase in the labor force in May or if the data in the last decade are more “normal” and the last four years are unusual.  If the latter is the case, the Bureau of Labor Statistics probably overstated the degree of contraction in the labor force.  What can we expect for June?  For the past four years, the non-seasonally adjusted change averaged 455k, meaning that for June we have a somewhat smaller hurdle to overcome.

We want to close the discussion with this chart.

It shows the rolling 12-month sum of the changes in non-farm payrolls along with the effective fed funds rate.  Since the early 1980s, most tightening cycles occur when the 12-month payrolls are rising by 2.5 mm.  About the only exception was the 2004-06 tightening cycle, which began with yearly payrolls growing below this level but on their way to the 2.5 mm growth area.  The fact that this cycle rose “early” suggests that Greenspan probably believed that the 1% fed funds target of that era was artificially low.  To a great extent, this relationship suggests the Fed waited too long to raise rates and missed its opportunity.  On the other hand, if tightening began in December 2014 as tapering began (which we would argue is probably the case), then the tightening occurred in line with historical patterns.  At the same time, this pattern would suggest the tightening cycle should probably be ending, not beginning.  Finally, on a side note, a drop below 1.5 mm usually signals recession.  We are above that level.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The employment data came in with a very negative surprise (see charts below for details).  Here are some of the highlights.  Non-farm payrolls rose by a mere 38k compared to estimates calling for a 160k rise.  The previous month’s numbers were also revised down by 59k; thus, taking the revisions into account, the payroll numbers were negative in May.  The telecommunication workers’ strike may have cut payrolls by around 35k, but the weak employment data cannot be blamed solely on the strike.  Services jobs rose 61k, while goods-producing jobs dropped 36k, with the total private jobs rising a mere 25k.

In the household survey, a 458k drop in the labor force, coupled with a 26k rise in employment, led to a drop in the unemployment rate of 0.3% to 4.7%.  Obviously, this isn’t the way one wants to see the unemployment rate decline.  The participation rate fell to 62.6% from 62.8%.  Those Americans not in the labor force rose by 664k, to 94.708 mm.  Over the past two months, the “not in the labor force” number is up 1.226 mm.  And, with all this, wage growth held steady at 2.5%, on forecast, and hours worked was unchanged at 34.4 hours, a bit below the 34.5 hours forecast.

Market action is fairly predictable.  The dollar is plunging, the EUR and JPY are appreciating, gold is up over $20 per ounce, equities are weakening and interest rates are falling.  The yield curve is steepening.  This data almost certainly takes June off the table for a rate hike and, barring some sort of major revision in the June report, July is probably not likely either.  Fed funds futures for a June hike were around 35% before the data; it has fallen to 6%.  For July, the same data is similar, from 45% to 30%.  In fact, you don’t get to a 50% odds of a hike now until November.

There is always an element of caution with the employment report.  Revisions do occur and other indicators of labor markets, like the ADP report and initial claims, gave no warning that a number this bad was in the offing.  Thus, it’s important not to over-react to the clearly negative tone of this report.  However, if the data doesn’t improve quickly, this is a very worrisome factor which will raise concerns about a downturn in the economy.

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