by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Oil prices are surging this morning as short-term outages dominate the news.  Conflict in the Delta region of Nigeria has reduced production by 0.6 mbpd.  Although Canadian production does appear to be returning, the recent outages will likely lead to inventory declines in the U.S. for at least the next couple of weeks.  As we have noted, the seasonal withdrawal period for crude oil is about to start and we will likely see the supply situation improve over the summer.  At the same time, the current price has already discounted a drop of about 50 mb in U.S. commercial crude oil stockpiles, so the supply situation will have to improve even more to see prices continue to lift.

Unfortunately for oil, and for other markets as well, there is a lurking danger.  Despite numerous comments from regional FRB presidents suggesting that a rate hike could occur in June, fed funds futures put the odds of a hike at 4%.  At the same time, we are seeing the yield curve continue to flatten.

(Source: Bloomberg)

This chart shows the two-year to 10-year T-note spread, which hit its narrowest point since late 2007.  Although we have 95 bps to go to invert the curve (a near certain signal of recession), the narrowing is a worry.  Most of the narrowing is coming from the long end of the curve, which is likely benefitting from foreign inflows; with much of Europe and all of Japan sporting negative sovereign yields, the U.S. looks pretty attractive on a relative basis.

The implied two-year LIBOR rate has not moved significantly higher, which tends to indicate that the markets expect a low terminal policy rate.

Here is where our worry lies.  When five-star doves like Chicago FRB President Evans and Boston FRB President Rosengren argue that the financial markets are underestimating the odds of a rate hike, it suggests that support for stable policy is weakening.  In general, we assume that three dissenters among the voting members of the FOMC are akin to a no-confidence vote for the chair.  At this point, among the 10 voters, Bullard (St. Louis), George (KC) and Mester (Cleveland) would probably support a rate hike.  If Rosengren, usually a reliable dove, is leaning toward a hike, you could potentially have four dissenters.  Among the permanent voters, only Fischer would probably prefer to tighten, although we don’t see him voting against the chair.  Still, there is enough uncertainty to seriously question the 4% likelihood of a hike that is currently being discounted by fed funds futures.

The GDPNow data from the Atlanta FRB is suggesting a rather robust jump in Q2 growth, especially in relation to Q1.

Here are the component changes.

Of the 100 bps rise since the initial forecast, 61 bps are coming from consumption alone, which was reflected in the recent retail sales report.  Of the remaining 39 bps, residential investment, adding 11 bps, accounts for over a quarter of the rest.

The case for standing pat is strong.  International developments remain a worry (today’s China data is adding to worries) and U.S. industrial data is soft (see today’s Empire State report).  On the other hand, all our Mankiw model variations support a rate hike.  The dollar, which was much stronger, has retreated, giving the Fed room to hike.  The real worry is that a rate hike would be a complete surprise to the financial markets and unnecessarily raise market volatility.

This discussion brings us back to oil…if the Fed unexpectedly raises rates and the dollar rallies (which would be highly likely), oil prices are vulnerable to a pullback.  That doesn’t mean a collapse to the sub-$30s lows, but perhaps a drop into the low $40s or high $30s.  It also means the dollar would strengthen and emerging markets would be vulnerable to a pullback.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] As noted below, there was an interesting divergence between Q1 Eurozone GDP growth and German GDP growth.  The former was revised lower to 0.5% (2.0% annualized for the quarter), while German GDP was revised higher to 0.7% (2.8%) from 0.6% (2.4%).  Spain also grew strongly, up 0.8% (3.2%).  France (0.5%; 2.0%) and Italy (0.3%; 0.9%) were the laggards.  The pickup in German growth is particularly good news for the Eurozone economy.  Germany’s strong saving has led to large trade surpluses that have been offset by trade deficits in the rest of the Eurozone (at least with regard to internal Eurozone trade).  Rising German growth means that the rest of the Eurozone can export goods and services to Germany, which will tend to boost their economies and relieve some of the debt problems in the region.

The Obama administration announced another set of regulations on the fracking industry designed to reduce the amount of methane that escapes into the atmosphere during the drilling process.  These new regulations will undoubtedly raise the costs of drilling.  The government and industry dispute the actual amount, with the EPA arguing it will cost the industry $530 mm into 2025; the API suggests this number probably should be doubled.  In any case, the real takeaway is that the regulatory process usually works with a lag.  A new technology or process often can work without little regulatory oversight because the government hasn’t seen it long enough to determine whether it should face regulation and how it should be done.  However, the longer the new process is in place and the bigger it gets, the more likely it is to face regulatory scrutiny.  For the pioneers in the industry, the influx of regulation is jarring because they were able to initially operate with little interference.  The bottom line: the U.S. oil and gas industry will be facing increasing regulatory costs regardless of who wins in November.  This development may not be bullish for oil and gas companies but it is undoubtedly bullish for the price of the commodity—regulation will act to constrain supply.

The better than forecast retail sales data (see below) has led to a flattening of the yield curve.

(Source: Bloomberg)

The spread is approaching the lows set in late February.  The flattening of the curve is a form of monetary tightening and is bearish for equities.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] As expected, the Brazilian Senate voted 55-22[1] in favor of an impeachment trial against President Rousseff.  She will step down from power today and VP Michel Temer will take power.  A trial will be held over the next 180 days.  It ends with a Senate vote.  If less than two-thirds vote to impeach, Rousseff will be reinstated.  Given that 55 votes are enough to impeach, it appears likely that Rousseff will be removed from power.

The financial markets have turned higher in recent months on the prospect of impeachment.  The feeling is that Temer will be better for the economy than the left-leaning Rousseff.

(Source: Bloomberg)

This chart shows the MSCI Brazil index in USD terms.  Since early January, the index is up nearly 72% from low to high.  The market has already discounted much of the good news from impeachment.  Brazil has serious economic problems; GDP is exhibiting negative growth, paced by a plunge in investment spending.

Overall, we would not be surprised to see a bit of “buy rumor, sell fact” market action with Brazil in the next few weeks.

Oil prices are higher again this morning, supported by a bullish International Energy Agency (IEA) report (more on the IEA below).  The group cut its H1 oil surplus due to stronger Indian demand.  Its projected surplus is now 1.3 mbpd, down from 1.5 mbpd in the previous report.  The IEA is projecting demand of 95.9 mbpd this year, up 0.1 mbpd.  Non-OPEC production is forecast to fall 0.8 mbpd, mostly due to falling U.S. output.  OPEC output continues to rise, reaching its highest level since August 2008.  It appears that OPEC output will rise further as the group focuses on increasing market share.  In the short run, outages in Libya, Nigeria and Canada are boosting prices.

The U.S. inventory situation continues to improve as stockpiles declined last week.  Current stockpiles are 540 mb.  We expect that last week’s report, at 543.4 mb, will prove to be this year’s peak.

Historically, inventories remain elevated.  However, inventories are clearly lagging the usual seasonal pattern.

The current level is consistent with early July, improving the odds that we will see faster than normal stock draws.  We are currently about 2.1 mb below where the average would put us.  If that level is maintained, we will be at 498 mb by mid-September.

However, 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 $25.82.  Meanwhile, the EUR/WTI model generates a fair value of $54.61.  Combined correlation (which is a more sound methodology) fair value is $41.39, meaning that current prices are a bit rich.  Still, for those interested in oil, the Fed is arguably more important than the DOE inventories for the future of oil prices.  Simply put, a rate hike in June would likely lead to a much stronger dollar and weaker oil prices.  For example, a $1.100 EUR/ USD would generate a fair value for oil of $34.53, assuming current inventories.  We don’t expect the FOMC to move rates higher next month, but it is a risk to oil prices.

A couple of other news items affecting oil have emerged over the past two days.  First, the IEA, a body within the OECD that monitors the oil markets and OPEC, is considering breaking away from the OECD.  The IEA is currently an autonomous organization within the OECD.  The IEA dispute with the OECD appears to center around China.  The OECD has not accepted China as a member even though it is the world’s largest importer of crude oil.  The OECD is uncomfortable with the IEA’s drive for independent relations with China.  This news is more than just a bureaucratic spat.  Although it is not well known, the IEA is the world body that, in a global oil supply emergency, takes legal control of the OECD’s strategic petroleum reserves (SPR).[2]  If we end up in a situation where this action is required and the IEA isn’t part of the OECD, it may be difficult for the IEA to exercise control.  Thus, this isn’t a huge problem now but it could be in the future and, if it becomes a problem, it would be occurring at the worst possible moment.

The second item of note is that Belarus has delivered the Russian S-300 anti-aircraft, anti-missile defense system to Iran.  Given that Belarus is mostly a puppet of the Putin regime, having an ally sell the system offers a thin veil of plausible deniability.  This system is considered one of the world’s most potent anti-aircraft missile systems.  The fact that Iran has acquired this system will reduce Israel’s ability to bomb Iran’s alleged nuclear system; however, it won’t completely eliminate the threat.  It is thought that the F-35, which has stealth capabilities, may be able to elude the S-300.  The Israeli Air Force reportedly has 33 of these aircrafts on order.  Still, the presence of this system will increase the costs of attacking Iran’s potential nuclear facilities.

Finally, Germany is poised to increase its troop numbers for the first time since the Cold War.  The reason given for this reversal of 25 years of force reduction is growing Islamic terrorism, instability in Africa and Russia’s new assertiveness.  However, we suspect underlying this decision is the growing realization that the U.S. will probably reduce its presence in Europe and force the EU to build its own defense.  Polls in Germany show that 45% of its citizens back the decision to increase troop strength, up from 15% seven years ago.  This decision, along with the proposal to boost defense spending, is both minor and major.  Even with proposed spending, Germany’s defense budget won’t reach 2% of GDP, the guideline for NATO nations.  On the other hand, the symbolism of Germany increasing its defense footprint is important and will likely raise concerns in Europe.  This decision probably doesn’t happen without the perceived change in U.S. policy.

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[1] There are 81 senators; 4 were absent.

[2] We have always had our doubts about this system.  It seems hard to imagine that taxpayer-funded oil supplies in Germany or the U.S. would be directed to Brazil or Portugal because of a global supply shortage.  Although this would be the most effective way to manage global oil prices as it would prevent hoarding, practically, we would not expect the IEA to be able to effectively control the national SPR.

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] As noted above, global equity markets are lower this morning in a quiet trade.  There wasn’t much news overnight and the trade looks like it is taking a breather today after a strong day in the U.S. yesterday.

One market that had a strong day yesterday was soybeans.

(Source: Bloomberg)

This chart shows the nearest soybean contract over the past three years.  Prices have been edging higher since mid-March.  A combination of factors has affected soybeans.  First, Brazil has been experiencing dry conditions.  Worries about the Brazilian crop, coupled with rising political turmoil (the Brazilian Senate votes today on impeachment proceedings—we expect them to vote to start an impeachment trial with the news coming out this evening), have raised worries about soybean supplies.  Then, flooding in Argentina has raised fears that some of the crop will be lost.  Although analysts always assume normal weather, there is an elevated chance of drought in the U.S. this summer if a La Niña develops.  Yesterday, the USDA estimated that global soybean inventories will decline 8.1% this year and end the season at 68.2 metric tons (mt), which is well below analyst estimates of 72.9 mt.  Corn inventories were also forecast lower than analyst estimates, at 1.8 billion bushels, but due to increased planted acreage the market expects a record U.S. harvest for corn this year.  Of course, if the weather fails to cooperate, that record crop won’t materialize.

Rising grain prices tend to eventually show up in rising food prices as corn and soybean meal are key inputs.  Although the relative importance of food to the U.S. household budget is relatively low, studies have shown that lower income households tend to spend more on food than their wealthier counterparts.  Thus, rising food, especially meat prices, could become an election issue by November.

First, this chart shows the relative importance of food and meat to the CPI.

Second, meat prices have declined after years of strong growth (see chart below).  Meat prices are also affected by drought; we have seen a sharp drop in the cattle herd in recent years, although reports indicate that the herd is building again.  A rise in corn and soybean meal prices should filter into higher meat and egg prices later this year.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Although we are seeing higher equity markets in many parts of the world, there is a palpable air of uncertainty.  Take yesterday’s market action in Brazil.  The leader of the lower house in the Brazilian legislature announced yesterday that last month’s impeachment vote should be annulled.  Then, in the dead of night, he revoked the call.  It isn’t clear what Waldir Maranhao was trying to accomplish.  According to reports, this little known member of the legislature is under investigation himself, dealing with corruption charges.  Market action yesterday was certainly interesting.

First, the Brazilian real (BRL) depreciated.

(Source: Bloomberg)

This is an intraday chart showing the BRL/USD exchange rate; it measures how many BRL are required to buy a dollar, so a rising price represents a weaker currency.  When the news broke, the currency plunged.

So did the Brazilian equity market.

(Source: Bloomberg)

This is a chart of the Brazilian MSCI index in USD terms.  Note the sharp drop.  When Maranhao reversed his position on impeachment, the market rallied but did not return to earlier highs.  This market action demonstrates the degree of sensitivity that Brazil’s financial markets have toward the impeachment process.  The markets have been betting that a new government will be more market friendly and Rousseff’s ouster will be bullish.  Although this may be true, we suspect that if impeachment occurs, Brazil’s financial markets will suffer a setback for two reasons.  First, the good news from impeachment will already be fully discounted.  Second, a new government will still face a difficult environment and any new government’s ability to improve conditions will be limited.  In fact, the best outcome for Brazil would be a debt-fueled boom in China, which probably isn’t likely.

Yesterday, an unnamed Chinese official criticized the extended use of debt in fueling China’s growth.  Although this is a legitimate criticism, reducing debt growth will almost certainly lead to a dramatic drop in growth.  There is growing speculation that when the 19^th party congress meets in 2017 that Li Keqiang, the current premier, may be replaced by Wang Qishan.  In China, the premier (second in command) has the economy mandate, although Chairman Xi has been unusually active in economic policy for a Chinese head of state and leader of the CPC.  Wang is currently head of the Commission on Discipline Inspection, the body that has been conducting the purges.  Wang is an accomplished financier, with experience in banking.  He is also one of Chairman Xi’s most trusted advisors.  It may be that Li will take the blame for weaker growth and market turmoil, allowing Xi to put a loyalist in charge of the economy.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] There were five major news items over the weekend:

Saudi Oil Minister al-Naimi sacked: Al-Naimi, who has been oil minister since 1995, was unceremoniously fired over the weekend, replaced with another Saudi Aramco official, Khalid al-Falih.  Al-Naimi was considered a good administrator and was the de facto head of OPEC.  At 80 years old, he has hinted at stepping down for some time but the fact that he was fired, and not allowed to resign, sends a signal that the new king and his effective regent, DCP Salman, are putting their own stamp on the country.  At the Doha meeting, al-Naimi appeared prepared to agree to a production freeze, only to be overruled at the last minute by the DCP, who insisted that Iran also freeze output, which was sure to kill any deals.  Although the official stance of the kingdom is that this move will not lead to new policies, we suspect that al-Naimi was willing to engage in jawboning to lift oil prices.  Our position is that the Saudi policy of gaining market share was not necessarily targeted at the U.S. but at Russia and Iran, which pose geopolitical threats to the kingdom.  By firing al-Naimi, the DCP is making it clear that the goal of Saudi oil policy is to undermine the Iranian and Russian economies.  After all, a freeze would have likely led to higher oil prices even in the absence of real change because it held the promise of future cooperation.  We strongly suspect that the new minister has heard loud and clear that the kingdom’s policy is to hurt Iran and, to a lesser extent, Russia.  Thus, we view the change as potentially bearish for oil prices.

Fed officials talking about hikes: NY FRB President Dudley suggested after the employment report that the FOMC is on path for two hikes this year.  St. Louis FRB President Bullard says he is “open” to a June hike and Boston FRB President Rosengren (an avowed dove) has been saying that the financial markets are underestimating the Fed’s likelihood of raising rates.  Atlanta FRB President Lockhart says he is “on the fence” for June.  Meanwhile, the fed funds futures put the odds of a June hike at 4.0% and don’t get to 50% odds until February 2017.  As we have noted before, based on the Phillips Curve relationship, the FOMC is well behind the curve in any iteration.  We have noted that there is a chance that Chair Yellen is using the dollar as her policy target.  Waiting for dollar weakness before raising rates would make sense.  However, given the comments coming out of the rest of the FOMC, there is little evidence anyone else is buying into this policy.  We doubt the Fed moves in June; the WSJ’s Jon Hilsenrath also suggested this idea today.  But the noise surrounding a hike may be there to build some degree of uncertainty into the financial markets.

Greece is becoming dicey: Despite demonstrations against the measures, PM Tsipras did get the Greek parliament to agree to reform pensions and raise taxes yesterday, but the IMF is making more comments indicating that the body may not agree to further bailout measures without debt relief.  Debt relief is an anathema to Germany, which fears that others may ask for similar support.  Meanwhile, surveys across Europe indicate that the Brexit vote may trigger similar referendums in other nations as well.  Another Greek debt crisis could trigger even more problems in the EU and Eurozone and could put pressure on the EUR, which would not be welcome in the U.S.

Alberta fires: Forest fires in Alberta have reportedly cut tar sands oil production by 1.0 mbpd, although it does appear the fires will mostly miss the oil-producing regions.  However, the workers tend to live in Fort McMurray, so it isn’t clear how the oil companies will function even after there is no fire danger.  Oil markets were initially higher on the news but have given back some of their gains.

Chinese trade data: Exports in April fell 1.8% and imports fell more than forecast (down 10.9%).  Key commodity imports declined; oil imports were down 7.2% (in volume terms), iron ore fell 4.7% and copper imports dropped 23.8%.  Meanwhile, a major Chinese newspaper carried a full page ad warning about growing debt and non-performing loans.

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