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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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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