by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The market-making news overnight was that the BOJ announced no new policy measures at its meeting.  Although this was mostly anticipated, there were hopes that Governor Kuroda would offer at least some support for the economy.  Instead, he suggested he is taking a “wait and see” approach to see if NIRP and other measures begin to bear fruit.  Clearly, the financial markets were disappointed.

First, the Nikkei:

(Source: Bloomberg)

This is a three-day, three-minute chart of the major Japanese stock index.  The market broke hard on the news.

The JPY soared:

(Source: Bloomberg)

The currency jumped 3% from Tuesday’s close.

There is much speculation on why Kuroda didn’t act.  Some are arguing that he is trying to press PM Abe into doing more with fiscal policy; by dragging his feet on more monetary stimulus, he is putting pressure on the government to act.  Although this may be the case, history shows that when monetary policy officials try to pressure elected officials, the latter usually win.  That’s because, even with central bank independence, a central banker gets his mandate from some elected official.  The other possibility is that Kuroda may be wondering if monetary policy is reaching its limit.  The impact of NIRP has been mixed at best.  Although rates have declined, the appreciation of the JPY has mitigated much of the positive bounce from falling rates.  The BOJ may be at a point where the last remaining policy tool is direct debt monetization (“helicopter money”), which probably can’t be implemented without government support.

The FOMC statement didn’t contain any serious surprises.  The committee noted that the labor market has shown improvement but the overall economy looks sluggish.  About the only serious surprise was that the comment about global economic and financial developments posing risks was dropped from the statement.  This may not mean much; later in the statement, it was noted that developments overseas will be “closely monitored.”  KC FRB President George dissented, as expected.

We have speculated that the Fed may be using a de facto currency target as part of its policy mix.  Although this would never be admitted in public (it’s outside the Fed’s policy mandate), it is impossible to argue for steady policy using virtually all the permutations of the Phillips Curve that we monitor.  Perhaps dropping the foreign risk statement is an indication that the Fed is comfortable with a 110ish JPY/USD and a 1.1300ish EUR/USD.  Or, this may be reading too much into a short statement.  Although pundits continue to suggest that the statement allows for a June hike, we doubt that will occur.

Oil prices continue to rally, exhibiting the characteristics of a bull market.  For the past two weeks, any bearish news has been met with buying, suggesting there is money on the sidelines looking to take advantage of pullbacks to establish long positions.  The market bounced back from a very bearish meeting in Doha and held gains after the API reported a stock draw that was contradicted by the official data from the DOE.

Inventory levels remain historically high.

However, inventories are clearly lagging the usual seasonal pattern.

On average, we are near the seasonal peak and should begin to see stock draws going forward as the summer vacation season gets underway.  Based on current inventory levels and the EUR, the average monthly price for WTI (which is currently $40.61) is a bit overvalued; our model puts the fair value price at $38.84.  However, the current price is rich.  Assuming a stable EUR, the current price of around $45.25 is consistent with inventory levels of 502 mb, implying a stock draw of nearly 40 mb, or about 7.0% from current levels.  Assuming the last data point represents the peak week, a normal seasonal storage decline puts the low at 500.5 mb by the third week of September, which calculates to a fair value price of $45.25 per barrel.  Essentially, the market has already discounted a lot of bullish news and further price strength could lead us into overvalued territory unless stock draws are much more than normal.  This isn’t to say we are bearish, but we wouldn’t be surprised to see a flat market develop in the coming weeks.

Finally, it appears that Greece is becoming a problem yet again.  Greek PM Tsipras has been requesting a summit meeting with Eurozone officials, asking for an easing of terms to receive promised aid.  Donald Tusk, the current president of the European Council (which represents the 28 nations of the Eurozone), has only agreed to a meeting of finance ministers, who generally cannot change terms to an existing arrangement.  Greece faces a €3.5 bn loan payment in July and it doesn’t look like it will be able to make it.  In addition, Tsipras is struggling to make other reforms demanded by creditors.  Although this situation should be manageable, problems could escalate as we head into the Brexit vote in mid-June and new Spanish elections in late June, the outcomes of which could reduce the policy “bandwidth” available.  Thus, we may be heading into a series of Eurozone issues as summer nears.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] It’s FOMC Day!  As we noted earlier this week, we don’t expect any major news today.  The key focus will be on the idea of “balance of risks.”  The Fed often puts a note in the statement about the balance of risks.  In general, it leans toward inflation, recession or balanced.  If inflation is a concern, the committee is likely leaning toward rate hikes.  If recession is a concern, the Fed is likely moving to ease.  If it’s balanced, assuming the Fed is at the neutral rate, no change in policy would be expected.  However, the key to this issue is the neutral policy rate.  As we have demonstrated using the Mankiw Rule, if the Fed is relying on the Phillips Curve to determine the neutral rate then it is well behind the curve and needs to be raising rates.  Thus, if risks are said to be “balanced,” this would suggest rate hikes will be coming soon.  However, if the committee is looking at other factors for policy guidance, such as the dollar, then it may feel it is already at a neutral rate (the Fed’s behavior could arguably suggest this) and calling risks balanced should have little effect on the markets.  Overall, we suspect the financial markets would be spooked by the Fed describing the current risk environment as “balanced” and we would likely see selling develop in risk assets.

The BOJ meets tomorrow.  Again, nothing is expected here either, except that the JPY strength is hurting the bank’s attempts to boost the economy.  Although we don’t expect much at this meeting, we would not be surprised to see a good bit of “oral intervention” in a bid to weaken the JPY by promising to take more aggressive steps to boost the economy.

Oil prices, basis WTI, broke above $45 per barrel this morning after the American Petroleum Institute (API) said oil inventories fell last week.  The API data are not the official numbers; those will be released by the DOE at 10:30 EDT.  In general, the two data sets tend to track each other but have, on occasion, diverged, so the government data will need to confirm yesterday’s API data in order to hold current levels.  We will have more analysis on the oil data tomorrow.  However, it is interesting to note that the tight correlation between oil and the S&P 500 is breaking down somewhat.

Based on the regression line, the S&P 500’s fair value to the current level of oil prices is 2,132.  Although the current dispersion is within the normal range of the regression line, the values from the last few days, shown within the oval above, may be an early indication that oil and the equity market may be starting to delink.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The FOMC meeting starts today; although there are no expectations of a change in policy at this meeting, we will be closely watching the balance of risks statement.  For the past few meetings, the Fed has mostly refused to comment on the balance of risks, but the wording has suggested more concern about growth and less about inflation.  A hawkish tone would be a statement suggesting that risks are currently balanced.  We do not expect that outcome given that current projections for Q1 are pointing to nearly flat growth.  On the other hand, there are a couple of data points suggesting the economy is improving.  First, total vehicle miles driven have made a new high.

This chart shows total miles driven on a rolling 12-month basis.  Usually, we make a new high every month, although miles driven can hold for extended periods below the previous peak during recessions and periods of high gasoline prices.  We finally began making new highs in this measure at the end of 2014 and have seen robust growth since.  This data suggests the economy is on the mend and that the FOMC should not be overly dovish.

The other data point that will likely get close scrutiny is the labor force.

This chart shows the labor force, which includes all those working and looking for work.  Labor force growth has been rather lackluster during this recovery until recently.  In fact, this year the labor force is growing at a 1.5% rate (6-month rate of change) compared to a similar growth rate average of 0.7% from 2010 to 2015.  The surge in the labor force means that there is probably more slack in the labor market that will allow the Fed to remain easier for longer.  Simply put, the Fed doesn’t want to stomp on the labor market just when conditions are starting to improve.

Deputy Crown Prince Salman of Saudi Arabia unveiled the broad outlines of an economic restructuring plan that, if implemented, would fundamentally change the nature of the kingdom.  The plan is to reduce Saudi Arabia’s dependence on oil by partially privatizing Saudi Aramco and working to boost investment to create new industries in the country.  There is also talk about easing social and religious restrictions to employ women in the workforce and increase “entertainment.”  The plan is extraordinarily ambitious and fraught with risk.  The partial privatization of Saudi Aramco will require financial transparency that will make it difficult to divert profits to support fiscal spending and the lifestyles of the royals.  The reforms, if implemented successfully, would put the kingdom on a more sustainable path to development.  However, powerful parts of the political system will be hurt by these changes and so it remains to be seen if the young prince can bring these plans to fruition.  If he cannot, and civil strife develops, it may be a bullish event for crude oil.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] It was a remarkably quiet weekend and that pattern has continued into this morning.  Risk markets are easing this morning in what looks more like tactical profit taking.  The BOJ and Fed both meet this week, with the former finishing its meeting on Thursday and the latter on Wednesday.  Neither is expected to do very much; the BOJ is expected to keep all its measures on hold, although it may ease its bank lending facilities to copy the ECB, which allows banks to borrow from the central bank at a negative rate.  Meanwhile, we don’t expect much at all from the FOMC.  The focus will be on the June meeting, which could yield a rate hike except that the meeting will coincide with the Brexit vote which may keep the Fed on hold.

One interesting note came from a Bloomberg report that the BOJ now holds 52% of Japan’s equity ETF.  Part of the BOJ’s QE allows it to buy equities in the form of ETF.  In the short run, for investors, this direct support for equities is clearly bullish.  On the other hand, it does create two risks.  First, the central bank’s capital could be at risk if equities turn lower, and second, there is always the fear that the BOJ will, at some point, sell the ETF positions.  What makes the second point tricky is that the selling probably won’t occur for the usual reasons an investor liquidates a position, e.g., valuation, but will occur for other reasons, which could include political considerations.  In fact, once purchased, it is hard to see how the BOJ will ever be able to liquidate its equity holdings.

As we head into the FOMC meeting this week, it is worth noting that market expectations remain very low.

This chart shows the implied three-month LIBOR yield two years deferred.  Although the rate has lifted off its recent lows, it remains below the range set from mid-2014 into Q3 2015.  Essentially, the markets believe that the terminal rate for the policy rate will be lower than previously expected.

Finally, a few geopolitical comments are in order.  President Obama indicated that he will add 250 Special Operations troops to combat IS.  The president is in Europe, currently visiting Germany.  His tour through Britain was divisive, infuriating those who support Brexit and heartening those who want to remain in the EU.  The president also met with Chancellor Merkel; it appears those meetings were more cordial, although we do note that the president suggested the chancellor is “on the right side of history” in the immigration and refugee debate, a point that many Germans would dispute.

In Saudi Arabia, King Salman has approved the economic restructuring proposed by his son, the deputy crown prince.  The program will include the partial sale of the state oil company, Saudi Aramco, but more importantly it calls for austerity that will reduce the fiscal breakeven oil price to $66.70 from $94.80 last year (both numbers calculated by the IMF).  The fiscal austerity suggests the kingdom is digging in for oil prices to stay low for a longer period of time.  We also note that Bloomberg is reporting Saudi Aramco has increased the capacity of its Shaybah field by 0.25 mbpd to 1.0 mbpd, keeping the nation’s productive capacity at 12.0 mbpd.  There have been hints that the Saudis may lift output as U.S. production declines in a bid to capture market share.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Japanese risk markets traded higher on reports that the BOJ may consider negative rate loan programs for banks, making the lending facility more attractive.  Under the program, the BOJ would pay banks to borrow under certain conditions.  The BOJ is scheduled to meet next week and market expectations call for some sort of stimulative measure, either the negative rate bank lending or an expansion of QE.  The chart below shows the weekly move in the Nikkei, which is up 7.5% for the week.

(Source: Bloomberg)

Additionally, the yen weakened on the news and bond yields fell.  The chart below shows the weekly move in the yen (this shows yen per dollar, so a higher level means a weaker yen).

(Source: Bloomberg)

On the domestic front, we have heard some concerns over pockets of weakness in the labor market.  Namely, temporary help payrolls have been weak since the beginning of the year.  Temp help is a leading indicator of the overall health of the labor market and the economy, in general, as temp payrolls typically peak up to a year ahead of a recession.  The chart below shows the level of temp help payrolls, which has fallen in two out of the last three months.  Temp help levels turned 11 months ahead of the 2001 recession and 16 months ahead of the 2008 recession, leading some analysts to call for an increased likelihood of a recession over the next three years.  We do not see a recession in the offing, and (absent an outside shock) the probability of one has remained low.  The tapering of temp hiring, viewed within the context of the overall improving labor market, could be a function of employers hiring directly into permanent positions.  Temp hiring is one of the labor market indicators that we follow closely, but at this time we do not believe that a slowing level signals an imminent recession.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The ECB maintained its interest rates at historic lows and did not change the size of its QE program.  The Eurozone central bank left its benchmark rate at 0.00%, the deposit rate at -0.40%, the marginal lending facility at 0.25% and its QE amount at €80 bn ($90 bn) per month, all on forecast.  ECB President Mario Draghi is giving a press conference as we write and, thus far, Draghi has very much maintained the tone that the markets expected.  The central bank will keep rates at “present or lower levels for an extended time,” in addition to the bond-buying program, and rates are to remain low well past the currently announced QE timeframe.  Draghi said the ECB is waiting to see how current measures, announced last month, will affect the economy before utilizing further measures.  One of the main indicators Draghi is watching is the inflation level, which has remained below the ECB target rate of 2.0% for three years.

The chart above shows the annual change in the Eurozone CPI, which currently stands at 0.0%.  Draghi indicated easy policy will continue until the rate has reached the target.  The ECB says inflation rates could move back into negative territory over the coming months, before picking up again in the second half of the year.  We note that market inflation expectations are much more modest, which would keep rates lower longer and could push Draghi to introduce further unconventional stimulus, something that the central bank has expressed an openness to.

At the same time, the Eurozone unemployment rate has improved but has not reached pre-recessionary levels.  Draghi said fiscal stimulus and structural reform are needed to help the labor markets, and that the ECB will boost employment via monetary stimulus only.

The central bank’s low rates have been publicly criticized by its largest stakeholder, Germany.  Most recently, German Finance Minister Wolfgang Schaeuble stated that the general perception is that “excessive liquidity has become more a cause than a solution.”  In addition, critics of the low rates voice concerns that the central bank has reached its limit of monetary policy and that low rates are adding to political uncertainty, including the rise of populism.  Draghi’s response to the criticism was that the central bank’s board is in unanimous agreement that the ECB needs to maintain its independence from political goals.  This unanimous agreement includes the president of the German Bunderbank, Jens Weidman.  The ECB is also being criticized by other Eurozone countries for failing to do enough to lift economic growth.  Thus, Draghi is in the difficult position of trying to placate both sides, and his lean toward data-dependent policy could take some pressure off the central bank.

The possibility of “helicopter money,” a program under which money is injected directly into the economy by transferring funds to consumers, has sparked public debate recently.  However, Draghi emphasized the ECB has “never discussed” the possibility and is actually surprised that the market has been so interested in the program.

U.S. equities have moved sideways on the news, while European risk markets have moved modestly lower. The euro stayed higher leading into the press conference, but has now given back its gains during the Draghi press conference.  The chart below shows the euro’s move this morning.

(Source: Bloomberg)

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Chinese risk markets traded lower overnight as Chinese officials indicated that the People’s Bank of China (PBOC) is likely to reduce stimulus over the coming year due to improving economic data.  While the PBOC has not released an official statement, at least two government sources have hinted at the stimulus deceleration.  Late last night, a PBOC official said that the central bank will balance the need for continued economic growth support with the risks that additional stimulus could pose—especially the over-leveraging of the corporate sector.  At the same time, the PBOC injected the most funds into the economy in two months in anticipation of a seasonal cash squeeze, auctioning $38.7 bn of seven-day reverse-repo agreements.  The chart below shows the volume of seven-day reverse repos auctioned since the beginning of the year.  Even though liquidity should improve as a result of the cash injections, the impending maturation of medium-term lending facility loans, tax bills and payments of required reserves will drain more than the injected amount from the economy.

(Source: Bloomberg)

In other news, crude fell overnight as the Kuwaiti workers’ strike came to an end.  This should boost production, adding to ample global supplies.  On the political front, Trump and Clinton won the New York state primaries, leading the two front-runners to re-assert their positions as their parties’ possible nominees.

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