by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] At the time of this writing, ECB President Mario Draghi is holding his press conference.  The ECB did give the markets a modest surprise by announcing it will begin buying corporate bonds almost immediately.  Policy will remain easy.  The EUR has weakened during his comments.

At the Geneva OPEC meeting, Saudi Arabia has apparently offered a cartel-wide production target.  This proposal is seen as an attempt by the kingdom to improve relations with the rest of the cartel.  Iran has flatly rejected the offer, wanting individual quotas to return.  Iran’s plan is not going to happen; we expect that Saudi Arabia wants to fill any gaps that develop from civil disorder in various cartel nations.  Individual quotas would make grabbing this market share more difficult.  According to most recent comments, OPEC was unable to agree on an output target.  The other item on the cartel’s agenda is to appoint a new general secretary.  The odds-on favorite is Mohammed Barkindo, the former head of Nigeria’s state oil company.  If a general secretary isn’t appointed, it will be taken as further evidence that the OPEC cartel is dysfunctional and would be modestly bearish for crude oil prices.

Finally, we look for a fairly quiet trade today in front of tomorrow’s employment data.  The current Bloomberg consensus calls for a 160k rise in non-farm payrolls and a 4.9% unemployment rate, which would be down 0.1%.  Wage growth is expected to rise 2.5% over the past year.  One key uncertainty surrounding the data is the telecommunications strike, which probably reduced payrolls by 30k.  These workers have returned to work but were still on strike during mid-May when the surveys were conducted.  If we get a 160k number despite the strike, it would suggest that the June data will be significantly stronger.  Simply put, a weak number does not necessarily mean the FOMC won’t move in June, but a strong number will almost certainly dictate a rate hike.  The ADP data (see below) suggests a good number but it isn’t clear how ADP handled the strike.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Domestic and European equities are trading lower, following gains in May.  While investors are increasingly looking for the Fed to hike rates this summer, domestic equities traded higher over the past month even with a rate hike more likely.  Today’s market weakness is likely driven by profit-taking as investors look forward to Friday’s payroll data and Yellen’s speech next week.

(Source: Bloomberg)

The chart above shows the S&P 500 since the beginning of the year.  The index is up 14.7% from the February low.

Global manufacturing PMIs were mostly close to forecast.  Chinese manufacturing numbers hovered right around 50, with the official manufacturing PMI reading at 50.1, a bit better than the 50.0 level forecast (shown in the chart below), and the Caixin manufacturing PMI at 49.2, on forecast.

(Source: Bloomberg)

Eurozone manufacturing also came in on forecast at 51.5 (shown in the chart below).  Germany, Italy and the U.K. all had PMIs above the growth line of 50, while France’s manufacturing contracted with a reading below 50.

(Source: Bloomberg)

Japanese PM Abe announced that his government will delay the implementation of a planned tax hike.  Although the move was highly anticipated, the yen fell in response.

(Source: Bloomberg)

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Chinese equities rose sharply overnight as MSCI takes another look at adding this country’s equities to its emerging market indices.  In one sense, the exclusion of China’s equities in these key equity indices is hard to justify.  After all, China is an important country; its GDP is the second largest in the world and it has provided the bulk of global growth for most of this century.  However, index officials are concerned about the degree of government intervention in China’s securities markets.  China has put obstacles in the way of short selling.  Currently, companies can, nearly without notice, suspend trading of their shares.  According to media reports, MSCI is worried about this practice.  It should be noted that Bloomberg is reporting a surge in short selling against the FTSE China A50 index, which trades in Hong Kong and has fewer short selling restrictions.  We suspect the Xi government would like to see MSCI add Chinese equities to its indices as a sign the country is becoming developed.  At the same time, the Chinese government has become increasingly uncomfortable with allowing financial markets to set prices.  Although such sentiments are part of every Chinese policy plan, in practice, China seems to like market pricing until prices do something the government doesn’t like.  Then, it reverts back to intervention.  The recent behavior of the CNY is a clear example of China’s policy toward markets.  The PBOC supported letting the CNY float in a wider range until it looked like a weaker currency was triggering capital flight.  Since then, the PBOC has simply set the exchange rate.  We expect MSCI to add China to its indices; after all, the company makes money from licensing, and excluding China from its indices makes those products less attractive.  Unfortunately, if China is added, the indices will become affected by Chinese government’s actions.

Another trend we are noting is that the bitcoin exchange rate is steadily rising and the uptrend is accelerating.

(Source: Bloomberg)

This chart shows the level of bitcoin in USD.  After the 2013 spike, the cryptocurrency’s value steadily dropped into early 2015 and was mostly range bound until last autumn when prices began to rise.  Over the past couple of days, we have seen a surge in value.  Bloomberg, quoting the website bitcoincharts.com, notes that 90% of bitcoin trading is coming from China.  We suspect Chinese investors are using the currency as one avenue for capital flight.  Given the cryptocurrency’s anonymous structure, it is attractive to investors and others trying to keep their assets invisible to governments.  The recent spike in bitcoin may be a signal of growing financial system problems in China.

Yesterday, the JPY weakened considerably and it is steady this morning.  Now that the G-7 meeting is out of the way, we look for Japan to take steps to strengthen its economy via fiscal and monetary expansion.  We expect a fiscal stimulus package of at least 1% of GDP.  It will likely include actual spending and a delay of a VAT increase.  On monetary policy, about the only avenue left would be to expand QE as NIRP hasn’t worked as expected.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] As noted below, Chair Yellen speaks later this morning.  This talk has been long awaited; however, we don’t expect too much.  In our opinion, Yellen remains dovish and would likely prefer not to move rates this year.  However, she does need to maintain control of the FOMC and so she occasionally has to acquiesce to rate hikes.  We look for a move of 25 bps in either June or July, which will probably be the last one for the year.  The market’s reaction to the anticipated hike has been quite controlled so far.  There has been an uptick in the two-year T-note yield, but not as high as we saw in December, and the dollar has rallied, but we haven’t revisited the recent highs.  Those reactions suggest that the markets are not projecting a summer move to trigger a series of future rate hikes.  To some extent, this is what the Fed has been trying to communicate; policy would only tighten gradually.  While this is good news in the short term, the policy seems strikingly similar to what the Fed tried to accomplish with its tightening cycle that ran from 2004 to 2006.  That cycle, on its face, didn’t cause the major market disruption that it needed to cause.  By not causing significant pain, risky leveraging behavior continued which culminated in the 2008 Great Financial Crisis.  So, bottom line, we don’t expect Yellen to say much and she will likely not dispel rate hike expectations for this summer.  Since this outcome is probably discounted, if we are correct, market action should be minor (especially in front of a long holiday weekend in the U.S.).

The G-7 communiqué probably disappointed the host nation, Japan.  PM Abe was trying to suggest that the world economy faces similar risk issues as seen in 2008.  The other six members of the group clearly disagreed.  We suspect Abe will use his outlook expressed at this meeting to deploy fiscal stimulation with the hope that the action will depreciate the JPY.  He would have likely preferred G-7 support but we expect him to move without it.

For those calling for a rate hike, the Atlanta FRB GDPNow forecast suggests strong support.

The current forecast is up to 2.9% compared to the consensus forecast of 2.4% and the initial forecast of 1.8%.  The contributions to GDP are clearly coming from consumption, which accounts for 2.46% of the 2.90%.  Residential investment is adding 28 bps (up from 8 bps in late April) and net exports is actually a positive contributor.  The primary drags on growth are inventory liquidation and commercial building.

Overall, this forecast will increase the odds of a summer rate increase by the FOMC.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Last week, the finance ministers of the G-7 met; now the leaders are meeting.  There is no lack of topics for discussion.  Although China isn’t a member, there has been some discussion of China’s activity in the South China Sea.  China, of course, suggests that this isn’t a proper issue for G-7 discussion.  The G-7 apparently disagrees and says it will send a “strong message” on this issue.  Much of the discussion centered on the global economy.  President Obama took some time out of his schedule to make disparaging remarks about Donald Trump.  Probably the most important post-meeting issue will be Japan’s handling of the JPY.  We would not be surprised to see Japan take steps to weaken its currency in the wake of this meeting.

The FT reported on a Conference Board study that focused on weak productivity in the U.S.

This chart shows the annual change in real output per hour worked with the postwar average.  Clearly, since 2011, real output per hour work has slumped; it isn’t completely clear why.  Some of this could simply be that there is excessive productive capacity in the economy compared to demand, and so the economy may not be able to efficiently produce what we need.  A more likely reason is that workers are flooding the low productivity parts of the economy which pay little but are mostly protected from technology and globalization.  That would explain a good bit of the wage disparity.  Raising wages in these sectors will simply force these industries to deploy automation (in fact, a former CEO of a fast food firm warned today about lifting the minimum wage due to this threat).

Oil prices moved above $50 this morning.  Yesterday, the DOE reported that oil inventories fell 4.2 mb last week, more than the 1.6 mb decline expected.  It does appear that the Alberta fires probably cut imports and led to the bigger than expected decline (we participate in the various media surveys and were projecting a 3.0 mb draw).  Crude oil inventories remain elevated but are clearly in the seasonal liquidation period.

This chart shows the current level of stockpiles, along with last year’s storage level and the five-year average.

This year’s seasonal pattern is showing faster than normal withdrawals because of the unexpected drop in inventories recorded in early April.  Since then, stocks have been reacting fairly close to normal but have failed to narrow the gap.

Based on the average EUR exchange rate and current oil inventories, fair value for crude oil is $40.72.  Assuming a €/$ exchange rate of 1.133 (the current closing average, month to date), the current price has discounted oil inventories of approximately 480 mb, or 57 mb below current levels.  That would be a much faster decline in the inventory overhang than the current pattern would generate.  Although we are friendly to oil longer term, the oil market has already discounted a significant storage withdrawal that is probably not going to happen.  In other words, the current price is a bit rich based on the dollar and inventories.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] It was another quiet night for news.  EU officials hailed a “breakthrough” in debt talks with Greece.  Officials met “into the wee, small hours of the morning”[1] and agreed to release €10.3 bn of new funds to Greece in recognition of the fiscal reforms already made by the country.  The EU did agree to offer debt relief in 2018, if necessary, to meet agreed upon criteria on its payment burden.  This deal is nothing more than political expediency and the continued process of extending and pretending.  The IMF was threatening to walk away from further involvement in the Greek situation.  For Eurozone leaders, IMF participation gives the negotiations an air of global involvement; without the IMF, the Eurozone/Greek problems are simply a European situation that requires a European solution.  The German translation of “European solution” is “Germany pays.”  Thus, the Germans are desperate to keep the IMF on board, and to do so Germany has to offer some promise of debt relief.  German Finance Minister Wolfgang Schäuble wants to avoid any sort of debt relief to Greece before the 2018 German national elections.  Thus, he made vague promises of future debt relief after said elections and the IMF agreed to the deal.  Essentially, all that has occurred is that Greece will receive much-needed bailout funds and the Germans have delayed the likely necessary debt relief by two years.  When 2018 rolls around, we doubt Germany will be any more open to writing off the debt, which is deeply unpopular in Germany.  Still, this agreement will forestall any immediate crisis in Europe.

China and the U.S. are holding talks on June 6-7, known as the “U.S.-China Strategic & Economic Dialogue.”  According to Bloomberg, Chinese officials are going to ask U.S. officials when the Fed is going to raise rates and by how much.  According to reports, Chinese officials are quite concerned about the Fed’s decision to raise rates because it will make managing the exchange rate more difficult.  Yesterday, we discussed a WSJ report that indicated the PBOC has abandoned the practice of allowing market forces to adjust the exchange rate.  Essentially, Chinese officials seem to back the idea of the market setting prices until the market does something these same officials don’t like.  Then, they intervene to get the outcome they want.  China does not want to see a weaker CNY because it fears that a rapidly weakening currency will trigger capital flight.  It appears that the PBOC is allowing the CNY to gradually weaken in anticipation of a rate move.

(Source: Bloomberg)

This chart shows a 10-year chart of the CNY/USD exchange rate on an inverted scale.  Note that the Chinese currency did appreciate earlier this year but has started to weaken again.  We suspect that if Chinese officials hear from U.S. officials that a hike will occur this summer, the PBOC will try to get in front of the move by gradually allowing the CNY to weaken further.  The hope is that when the rate hike occurs in the U.S. it won’t lead to a sudden weakening of the exchange rate, which would lead to panicky capital flight out of China.  Most likely, Chinese officials would prefer the Fed to keep rates steady; an appreciating dollar means that China must either maintain its loose peg, meaning its currency strengthens and undermines exports and growth, or allow the CNY to depreciate and risk capital flight.

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[1] https://www.youtube.com/watch?v=sqCLsp5owY8

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] It’s another quiet morning in front of Chair Yellen’s speech on Friday.  Yesterday, Dallas FRB President Harker added to voices calling for a rate hike this summer.  Fed funds futures are putting the odds of a June hike at about 32%, but the odds are over 50% for July.

One of the comments we hear frequently is, “how can a mere 25 bps rate hike matter all that much?”  By itself, the small rate hike really doesn’t matter.  The greater issue is the projection of future policy.

This chart shows the implied three-month LIBOR rate from the Eurodollar futures market.  It is a reasonably good gauge of market expectations toward future short-term interest rates.  Note how the implied rate was running around 40 bps when then-Fed Chair Bernanke began to talk about “tapering” the pace of the Fed’s balance sheet expansion in Q2 2013.  This decision marked, in our opinion, the beginning of the FOMC’s tightening cycle.  Implied rates rose nearly 160 bps.  A 200 bps reading on three-month LIBOR is consistent with a fed funds target of 175 bps.  As the FOMC raised the policy rate to a range of 25-50 bps last December, the implied LIBOR rate jumped about 50 bps.  It is interesting now that, even with rate hike expectations rising, the implied LIBOR rate has not increased by a lot.  The current reading discounts a fed funds target of roughly 100 bps two years from now.

If the implied LIBOR rate remains low, it would suggest that the market doesn’t expect the Fed to raise rates very much and thus, the financial market impact from a summer rate hike probably won’t be as bearish of an event as we saw in Q1.  Of course, the tenor of the Eurodollar market could change over time.  Nevertheless, based on what we know right now, the effect of a summer tightening probably won’t be all that extreme.  We will continue to closely monitor the deferred Eurodollar futures for clues about market expectations toward monetary policy.

The GBP is higher this morning after recent polls in the U.K. showed that the vote in favor of remaining in the EU holds a 13-point lead over those who support leaving.  We generally expect the U.K. to remain in the EU.  The economic benefits are high.  However, one issue we are watching closely has to do with the reliability of polling.  It is quite possible that voters polled may be lying about saying they will vote to remain.  Why?  Because establishment opinion clearly supports the campaign to stay and is painting those who want to leave as economically illiterate xenophobes.  Admitting to a pollster that one is such a person might be hard.  If the actual vote turns out to be much closer than these polls signal, it will offer us some insight into U.S. polling.  More specifically, it may be difficult for voters to admit they support Donald Trump and thus polls may be underestimating his popularity.  If the Brexit polling turns out to overestimate the support for remaining in the EU, then it may also be a harbinger of similar circumstances for Donald Trump.

The WSJ grabbed a major scoop yesterday when it ran a story suggesting that the Xi government is only giving lip service to the idea that financial markets are allowed to set exchange rates, and that stability is the primary goal of the regime, not clearing markets.  According to the report, in early January, the PBOC jettisoned the market-based mechanism; this change was unannounced.  Instead, the central bank now adjusts the CNY’s daily value based on directives from Beijing.  There is an old adage in economics that fixing one price forces other markets to experience higher volatility.  Fixing the exchange rate gives the illusion of stability that should ease the incentive for capital flight.  On the other hand, it makes China’s export sector more vulnerable to Fed tightening; if the dollar rallies, the CNY will appreciate as well.  It will also slow the drive to make the CNY a widely used reserve currency as history shows that fixed exchange rates eventually become unpegged, and the shifts tend to be violent when they lose their anchor.  The fact that the WSJ nabbed this report is, in itself, an interesting part of the story too.  It suggests the Xi government wants to signal to the world that it is re-pegging its currency and wants this information to be distributed by an unimpeachable source.

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