by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] It’s employment data Friday!  We will update all the numbers below but the short summary is that the data was a bit soft.  Non-farm payrolls disappointed, and the unemployment rate fell only because the labor force contracted less than employment did in the household survey.

Global equity markets are weaker and consequently we are seeing a drop in sovereign yields.  German 10-year sovereign yields are moving to test their historic lows.

(Source: Bloomberg)

This chart shows the yield on the German 10-year sovereign.  The yield is down to 0.145 bps and clearly in a downtrend.  Although Eurozone economic growth has picked up a bit, fears of falling inflation and concerns about the banking system are continuing to weigh on interest rates in Europe.  As European rates decline, U.S. Treasuries are starting to rally as well.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Oil prices moved higher overnight on the Canadian oil sands wildfire and escalation of fighting in Libya, both leading to speculation of supply contraction.  The Fort McMurray oil sands wildfire has spread to five times its initial size, leading to the evacuation of the entire town of more than 80,000 residents.  Fort McMurray is the main city in Canada’s oil sands region.  Separately, escalating tensions in Libya could cause short-term disruptions in production.  While the market is generally over-supplied, prices are becoming more sensitive to supply disturbances.  The chart below shows the year-to-date Brent crude price chart.

(Source: Bloomberg)

Yesterday, the March factory orders report was released, which came in stronger than forecast, rising 1.1% monthly compared to the 0.6% increase expected.  Durable goods orders came in on forecast, rising 0.8% from the month before.  Despite the monthly increases, the annual data revealed some weakness in both durable and non-durable production.  Total new factory orders fell 2.8% annually.  New orders for non-durables fell 5.8%, while durables fell 2.6%.  As the chart below shows, new orders have not been able to recover recently.  Weak global demand and the stronger dollar are the two main reasons for the weakness.

At the same time, non-defense capital goods excluding aircraft shipments rose 0.5% in March.  This measure is called core shipments and is a good proxy for capital spending in the business investment component of the GDP report.  However, the March increase follows a decline of 1.4% in January and a decline of 1.8% in February, which will likely lead to a decline for the quarter.  Additionally, weak demand maintained the inventory/shipments ratio at the highest level since 2009.

The dollar remains strong but, as the chart below indicates, has actually weakened since the beginning of the year.  This may ease some of the pressures felt by the manufacturing sector.

(Source: Bloomberg)

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] We will keep our opening comments short as quite a few economic indicators were released this morning.  Risk markets are trading lower this morning, with equities lower globally and Treasuries trading higher.  As the earnings season continues, equity fundamentals have not changed much, thus the pullback in equities is more a function of profit taking and the fact that positive factors that could drive the market higher have already been discounted.

(Source: Bloomberg)

As the chart above indicates, the dollar rebounded yesterday afternoon and maintained its strength overnight.  This is likely due to weak Chinese manufacturing data released earlier in the week as well as indications from Fed speakers that the June FOMC meeting should be considered “live,” meaning that we could see a hike from that meeting.  Currently, the markets peg the likelihood of a June hike essentially at zero.

Trump became the presumptive Republican presidential nominee yesterday as Cruz quit the race after Trump won a resounding victory in Indiana.  Yesterday’s win is almost certain to allow Trump to gather the 1,237 delegates needed for an outright nomination victory.  On the Democratic side, Sanders won Indiana with 52.5% of the votes.  Despite the unexpected loss in Indiana, Clinton is likely to receive the delegates needed for an outright nomination win.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] After a rally in risk assets yesterday, we are seeing a reversal this morning.  Although China’s official PMI data came in a bit soft (see below), we suspect the real story continues to come from the forex markets.  Overnight, the Reserve Bank of Australia (RBA), the country’s central bank, surprised the markets by cutting its policy rate to a record low of 1.75%.  A Bloomberg survey showed that 12 economists out of the 27 polled had forecast a cut in rates.  The bank cited low inflation as the reason.  We have our doubts.

This chart shows the market’s reaction to the rate cut.  The AUD is quoted in USD per AUD, meaning the higher the reading the stronger the AUD.  Note the sharp decline in light of the unexpected rate action by the RBA.

(Source: Bloomberg)

Here is a longer term look at the data.

(Source: Bloomberg)

This is a five-year chart of the USD/AUD exchange rate.  The AUD fell sharply as commodity prices began to decline in 2014.  During China’s stronger growth period into mid-2013, the AUD traded above $1.00.  It slipped under 70 cents in Q3 2015 and has been bouncing around 70 cents until recently, when the currency began to appreciate.

We are coming to the position that no central bank or financial authority on planet Earth wants a stronger currency.  Every nation is trying to engage in some sort of accommodative policy and an appreciating currency tends to undermine those efforts.  The AUD has bounced, in part, due to Chinese stimulus.  In fact, there is a positive relationship (r=76.7%) between gold and the AUD (with gold leading the currency by about eight months), and so this may be a move by the RBA to preempt further appreciation.

Although deviations this wide are not unprecedented, history suggests that such deviations tend to get corrected by an appreciating AUD.  The recent rally in gold (seen by the late rise in the red line) makes the bullish case for the AUD even stronger.  We suspect that Australian authorities do not want a stronger currency and thus are taking steps to weaken it by cutting rates.

If our thesis is correct, we should see the Eurozone and Japan take steps to address the recent strength in the EUR and JPY.  Reuters reported yesterday that BOJ Governor Kuroda expressed concern about JPY strength, which was given as a reason for yesterday’s strength.  We note today that comments out of Japan suggest that NIRP is very unpopular, meaning the BOJ may be forced into other stimulus measures, which might include even bigger QE, currency intervention (very controversial) or considerations of “monetary financing of fiscal spending,” or “helicopter money” in the vernacular.[1]  We look for ECB President Draghi to react to recent EUR strength as well.  Additionally, it appears to us that the Fed won’t really move rates higher without assurances that tightening policy won’t lead to a much stronger dollar…which it undoubtedly will.  All of this means that easy policies will remain in place everywhere and currency depreciation may be the only tool left that will measurably lead to stronger growth.  However, as the 1930s showed, everyone cannot have a weaker currency.

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[1] See this week’s WGR and the following two weeks’ WGRs.

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] May Day is being celebrated in much of the world today.  This holiday is “Labor Day” for most of the rest of the world.  Most notably, British markets are closed today.

The global PMI data is out (see below).  The numbers today are the official ones that follow the “flash” estimates that came out a couple weeks earlier.  In general, they show that most of the developed world is holding above the 50 expansion line.  In China, we note that new orders are rising, suggesting that the borrowing binge undertaken in Q1 has worked to boost the economy.  However, Chinese officials are already talking about scaling back the lending on fears that China is creating a new bubble.  For example, today’s NYT is reporting that Dalian egg futures are up nearly 33% this year, despite no evidence of supply problems or rising demand.  Instead, as bank lending has increased, speculators appear to be using the funds to make bets across numerous markets.  Another quip we saw over the weekend was that Dalian iron ore futures are “the new casino.”  The problem in China is that as the PBOC spurs money creation, there are not a lot of places for the liquidity to go.  Overseas investment faces growing restrictions, and property prices are already elevated and evidence of overbuilding is widespread.  Thus, there are reports that the PBOC is looking to rein in money growth, which will likely lead to retracement in various commodity markets.

Oil prices are roughly flat this morning but have been very strong recently.  It appears that this rally has mostly been fueled by short covering.

(Source: Bloomberg)

The lower panel of the chart tells the story.  It measures cumulative open interest, the number of accounts that remain open.  A futures market is evenly divided by longs and shorts (because the futures market is, at heart, a “zero sum” market).  Note that open interest peaked when oil prices made their lows in mid-February.  Since then, we have seen a steady decline in open interest accompanied by a strong rise in prices.  Anytime there is a divergence between the trend in prices and open interest, it suggests covering activity.  In other words, a rising market with falling open interest indicates short covering; a falling price market with falling open interest suggests long liquidation.  On the other hand, rising open interest with rising prices suggests new long positions are being added, and falling prices with rising open interest indicates increased shorting activity.

The key short-term questions for oil are when will the short covering end and how will the market do once this buying stops?  We suspect the short covering began, in part, on the belief that prices probably weren’t going much lower and that inventory accumulation would have ended by now.  However, as we noted last week, current prices have already built in almost all the seasonal decline in inventories, meaning that further strength is probably dependent on dollar weakness.

On that front, the dollar is continuing to depreciate.

(Source: Bloomberg)

The dollar broke through support established in Q4 2014.  Technically, a trip to around 89 wouldn’t be out of the question (which would be a EUR of around $1.20).  With a September seasonal inventory trough of around 500 mb of crude and a $1.200 reading on the EUR, WTI’s fair value would be around $56 per barrel.  Thus, this dollar drop is important.

Finally, the FT is reporting that Russian President Putin is shuffling his security officials, firing eight high-ranking members and adding 12 new ones.  He has also brought Alexei Kudrin back into his government with the position of Deputy Head of the Economic Council.  Kudrin is an orthodox government finance official who has opposed the security official’s takeover of the government.  We note that this news comes a couple weeks after Putin created his personal guard.  The creation of his guard along with bringing Kudrin back to government might mean that Putin is about to engage in some sort of shock therapy for the economy; Kudrin would likely support austerity to deal with the drop in oil and the personal guard might be there to protect Putin from public opposition to austerity.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The primary feature of today’s financial markets is dollar weakness.

(Source:  Bloomberg)

This chart shows the CME dollar index, which is comprised of about 56% EUR and correlates at nearly +80% with the EUR/USD exchange rate.  The dollar began to rally in mid-2014 as the U.S. economy began to improve and Fed policy stimulus began to wane.  At the same time, weaker Japanese and Eurozone inflation led to increased policy stimulus by the BOJ and ECB, leading to a dollar bull market.  The dollar has been consolidating after peaking in March of last year.  Recent weakness is putting the index at the support line experienced over the past year and a break below this support line would likely prompt technical selling.

Although it is difficult to prove, we have been suggesting the Fed is using the dollar as a policy target.  After all, by any measure of the Phillips Curve, the FOMC should be raising rates at least twice this year if one believes the employment/population ratio is the best reflection of the labor markets, and should be moving aggressively if the unemployment rate is the best reflection.  Since the Fed doesn’t seem to be using the Phillips Curve, it has to be focusing on something and the dollar is a plausible alternative.  We note today’s WSJ has an op-ed from Kevin Warsh, former Fed governor, speculating as we are that the FOMC is targeting the dollar for policy purposes.  Of course, the key unknown is what exchange rates the Chair has in mind for raising rates but if we break support, we might find out in rapid fashion.

The editorial pages in most major news outlets are reacting to the growing likelihood that Donald Trump will be the GOP candidate for president.  There is much discussion about his recent foreign policy address, which we would view as mostly Jacksonian in nature.  In other words, isolationist with a very strong military.  The key campaign slogan is “America First,” likely an inadvertent reference to an earlier America First movement that was dead set against participating in WWII.  Many pundits are treating the earlier version with derision, tying it to its now discredited chief spokesman Charles Lindbergh.  However, it should be noted that, at its peak, it had 880k paying members, including future presidents John Kennedy and Gerald Ford, future Supreme Court Justice Potter Stewart, Sargent Shriver, General Wood of Sears-Roebuck, the publisher of the Daily News, Joe Patterson and the publisher of the Chicago Tribune, Robert McCormick.   Walt Disney and Frank Lloyd Wright were also members.  Simply put, the America First movement wasn’t a den of kooks…it has a rich history that was only discredited after the U.S. abandoned isolationism and accepted the burden of global hegemony.

We believe that the wave is turning.  Due to intergenerational forgetfulness, today’s Americans are keenly aware of the costs of hegemony but have taken the benefits for granted.  It isn’t just Trump who is touting a return to isolationism.  Rand Paul represents a similar strain and Sen. Sanders’s foreign policy wouldn’t be much different.  Sen. Clinton represents the neo-conservative Wilsonian vision of America keeping the world safe, which is probably a fading position.

What is interesting to us is while the American media is fixated on Trump, it is failing to notice a growing degree of anti-Americanism in Europe.  This is most evident in the strong opposition to the Trans-Atlantic Trade and Investment Partnership (TTIP) in Germany.  The TTIP is the European version of the Trans-Pacific Partnership, which has been tentatively approved.  Essentially, these are free trade zones that would become the new trade framework for the world.  In Germany, support for TTIP is down to 17%, compared to 55% just two years ago.  Given that Germany is an exporting power, it seems rather odd it would oppose an expansion of trade.  However, in today’s FT, Stefan Wagstyl argues that Germany’s opposition is rooted in growing anti-Americanism and anti-globalism.  Perhaps the Germans and other Europeans are also suffering from intergenerational forgetfulness, concluding that they can handle a resurgent and belligerent Russia without U.S. support.

Finally, the NYT reports that there are growing voices calling for a partition of Iraq.  We have suspected this would be the eventual outcome from the minute U.S. troops entered the country in 2003.  Iraq was never a natural nation.  Instead, it was an artificial construct created by British and French diplomats primarily for the purpose of colonial control.  The only way such a nation could be held together was either by outside force or internal authoritarianism.  In the absence of either, there seems little reason for current borders to be maintained.  The problem is that a three-part Iraq will be difficult to defend from outside powers, and so partitioning will likely lead to a battle for territory between Iran, Saudi Arabia and Turkey.

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