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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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The G-7 meeting ended with a reaffirmed pledge not to weaken currencies.  Japanese Finance Minister Aso said that the country will not be delaying a planned sales tax hike.  Additionally, BOJ Governor Kuroda indicated that the central bank is ready to use additional monetary stimulus as soon as this summer if conditions warrant.

Japanese and European PMI were generally soft, although the reasons seem to be temporary rather than indications of longer term trends.  Japanese manufacturing PMI remained below the expansionary line and also weakened from the month before.  Eurozone aggregate manufacturing disappointed, but remained above the expansionary line.  France’s manufacturing remained in contractionary territory, while Germany’s manufacturing was stronger than forecast (see table below in Foreign Economic News).

Expectations for a rate hike this summer are rising as Fed speakers indicate willingness to hike either at the June or July meeting.  Yellen’s speech on Friday was instrumental in shaping market expectations.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Markets were quiet overnight.  The G-7 meeting, being held in Japan, is probably the most important event going on at the moment.  So far, Japan has been politely discouraged from using tools to weaken the JPY.  We suspect that after this meeting ends, Japan will take steps to weaken the currency regardless of G-7 opposition.  We believe we are in a world where every nation wants a weaker currency.  Since that is mathematically impossible, those nations with the potential for currency strength, such as the U.S., are trying to use moral suasion to discourage other nations from using policy to create currency depreciation.  Since the Fed appears ready to lift rates, don’t be surprised to see the dollar strengthen over the next few weeks.  A stronger dollar would weigh on commodity prices and emerging markets.  In fact, a rising currency tends to act as a form of monetary policy tightening, so if we are right about a recovery in the greenback, it would act as a force multiplier to any Fed action to lift rates.  We don’t expect anything of substance to emerge out of the communiqué at the end of the G-7 meeting tomorrow.  However, we will be watching Japan closely after the meeting ends and expect some moves to weaken the JPY.

It appears that the EU will extend Russian sanctions.  We expected Putin to work harder to get sanctions lifted, but he may be facing a bandwidth problem.  Because he doesn’t seem to delegate well, he probably was so consumed with the Syrian operation that he was unable to take the time to woo EU governments to change their stance on sanctions.  At the same time, the EU is usually plagued with inertia.  It was difficult to get sanctions in place to begin with and, once in place, it takes almost the same effort to end them.  Continued sanctions will keep pressure on the Russian economy and leave it at the mercy of oil prices.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The FOMC minutes were more hawkish than the market expected.  In fact, in the minutes, the members expressed concern that the financial markets are underestimating the likelihood of a rate move.  The committee felt that foreign risks have lessened and several suggested that the balance of risks between inflation and recession are “balanced,” although this sentiment did not make it into the statement.  This signals that the balance of risks sentiment was not universal.  The minutes now indicate that June is a live meeting.

This morning, we are seeing markets move to discount a hike this summer.  Fed funds futures now put the odds of a June meeting hike at 30%, which are up from 4% last week.  The odds for July are up to nearly 48%.  Short-term interest rates are reflecting this change in sentiment as well.

(Source: Bloomberg)

This chart shows the two -year Treasury yield.  This yield, which is very sensitive to the policy rate, is moving rapidly higher and rose further in light of the minutes.

There were other interesting tidbits in the report.  The staff presented papers about using “macroprudential measures” to deal with financial market distortions and generally came down on the side that regulation will tend to not work as well as needed.  This is the position of Vice Chair Fischer.  This means that if markets become askew and overvalued, tightening might be necessary and cuts might be in order if they get panicky.  Chair Yellen’s public comments suggest she believes macroprudential measures can be deployed successfully to deflate bubbles; she may be a minority on this issue.

We have noted our worries recently about how one-sided the financial markets have become on monetary policy, essentially almost ruling out any rate hikes this year.  That position may end up being accurate, given the uncertainty this election cycle could engender.  Nevertheless, it is clear from the minutes that the Fed is leaning toward raising rates at some point this year.  We see yesterday’s comments as a bit negative for equities and bonds.  The market with the most potential to move is probably the dollar.

The U.S. inventory situation unexpectedly worsened last week as inventories rose by 1.3 mb when a decline was forecast.  Current stockpiles are 541.3 mb.  We expect that the April high of 543.4 mb will prove to be this year’s peak.

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

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 a fair value price of $25.36.  Meanwhile, the EUR/WTI model generates a fair value of $53.49.  Together (which is a more sound methodology), fair value is $40.59, meaning that current prices are a bit rich.  Still, for those interested in oil, the Fed is arguably more important for the future of oil prices than the DOE inventories, and the Fed minutes are bearish for 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 at $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.

In other news, we are monitoring news on EgyptAir Flight 804, which apparently crashed this morning.  If it turns out to be a terrorist event, it will tend to boost nationalist fervor and likely help Candidate Trump.  On that topic, today’s FT reports that business lobbying groups prefer Senator Clinton to Donald Trump by a ratio of 2:1.  Although this position is different from what we have seen in the past, as the GOP has been considered the party of capital, Trump is running as a nationalist-leaning populist.  Given the choice between the establishment and populism, business will tend to lean toward the former.

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