by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Crude prices rebounded yesterday and are up again overnight.  Kuwait announced its plans to expand production back to normal levels despite the worker strike over public sector pay.  Kuwaiti officials indicated that some workers have returned to their positions and that the current inventory levels of petroleum derivatives can keep production at a normal level for a month.

Additionally, there’s speculation that Saudi Arabia may increase production in response to Iran’s refusal to agree to a production cut in Doha.  Saudi Arabia insisted that a production freeze is possible only if all OPEC producers, including Iran, participate.  Since the beginning of the year, Saudi Arabia has modestly cut its production, while Iran has increased more than 10%.  The risk of a market share war has increased as Saudi Arabian Prince Mohammed bin Salman indicated that the country currently has roughly another 1 million barrels per day of spare capacity (accounting for about 10% of current production), which the country is ready to use “if there is anyone that decides to raise their production.”  It is likely that this statement is a warning aimed at Iran, rather than a statement of current intent.

Last night, Boston FRB President Rosengren, a voter this year on the FOMC, indicated that he belives market expectations for rate hikes are too dovish and that the Fed is likely to tighten faster than the market expects.  Currently, the futures market is signaling expectations of a single quarter-point hike in rates over the next year.  This is the second time in two weeks that Rosengren has delivered a similar message and markets generally ignored the warning, with risk markets trending higher.  The FOMC is scheduled to meet next week, but this meeting does not have a press conference scheduled with it, thus market expectations for a rate hike are near zero.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] It was a news-heavy weekend with numerous major stories and cross currents.  Let’s dive in:

Doha was an epic bust: Expectations for the oil producers meeting were rather low going in.  Freezing already high production levels wasn’t going to lower the current supply overhang.  Nevertheless, the meeting offered two items of support for oil prices.  First, it suggested that OPEC+Russia could at least meet and talk, meaning that communication portals are being established.  Second, an agreement would imply that as non-OPEC production declines later this year and in 2017, Saudi Arabia and others would not try to fill that void but would allow the supply overhang to be reduced.  The failure to agree to a freeze was due to Saudi Arabia’s position that Iran needs to be party to any freeze, a clear non-starter for Tehran.  Iran had already signaled last week that it would not freeze output by refusing to send its oil minister to the meeting.  However, just before the meetings began, Iran said it would not send anyone to the meeting.  Saudi Arabia is clearly not going to cede market share to Iran as non-OPEC production declines and so the supply overhang will remain in place a while longer.

It should be remembered that most OPEC producers’ output is at full capacity and only the Saudis have significant excess capacity to tap.  If the Saudis keep production around the 10.0 mbpd level, another major decline in prices is unlikely.  In addition, we are nearing the U.S. summer driving season and the seasonal decline in oil inventories.  This factor will be bullish for oil almost regardless of what OPEC does.  The U.S. is nearing the long-awaited slowdown in production which should also buoy prices.  Finally, the FOMC’s dovish policy turn is dollar-bearish and commodity bullish (see below); if the Fed continues on this policy course, oil prices should continue to recover in the coming months.

We did see a strong opening drop in prices yesterday evening but prices recovered somewhat on reports of a Kuwaiti oil workers’ strike, which will take about 1.0 mbpd of production offline for the duration of the walkout.  We would not expect this strike to last long but it has helped this morning.  Overall, a decline in WTI to around $35 is probable but we would not expect to see much of a decline beyond that level.

Decaying U.S./Saudi relations: Since 1945, when Ibn Saud and President Roosevelt met on the U.S.S. Quincy in the Suez Canal, the two nations have been unusual allies.  One nation is the world’s leading democracy and the other a theocratic kingdom.  However, due to geopolitics and oil, the two parties have forged a relationship.  That relationship is fraying.  This week, President Obama is meeting King Salman in Riyadh to try to improve relations.  This meeting comes as Congress is debating a bill that will allow the survivors of 9/11 to sue the kingdom for its citizens’ roles in the attack.  The Saudis have indicated they might dump their $750 bn of Treasuries if the bill passes.

Saudi Arabia has disapproved of the foreign policies of the last two presidents.  The kingdom viewed Saddam Hussein as a buffer against Iran.  Removing the dictator without a workable plan to replace that government has led to a Saudi nightmare, a Shiite and Iranian-dominated government in Baghdad and chaos in the Sunni regions of Iraq.  President Obama’s nuclear deal with Iran is seen as the first step toward normalizing relations with that country, which puts Saudi Arabia at risk.  Comments in Jeffery Goldberg’s long interview with the president put the states in the region in a harsh light, suggesting they are “free riding” on the U.S.  The problem is that if U.S./Saudi relations are completely ruptured we will not be able to control the kingdom and the odds of regional conflicts rise, which will put the security of oil supplies at risk.

Japan loses support: In an unusual turn, U.S. Treasury Secretary Lew indicated that Japan had no justification for intervening to weaken the JPY.  The Japanese currency has been weakening since it became clear that Abe was going to win the prime minister’s job in 2012.  It was generally believed the U.S. had given tacit approval for the weakness.  However, after nearly four years of weakness, the JPY has strengthened recently despite the BOJ’s foray into NIRP.  Japan came to this weekend’s F-20 finance ministers’ meeting with hopes of securing approval for currency weakening policies.  Instead, it was rebuffed.  We believe we are seeing a quiet currency war; as we note in the current Asset Allocation Weekly (see below, page 6), if the FOMC has any belief in the Phillips Curve then there is no justification for not raising rates.  As we discuss, there is a tight fit between the trade-weighted dollar and inflation expectations, and since the Fed seems to be using those expectations to defend steady policy, the Fed is engaging in a de facto currency signal for monetary policy.  The next step is up to Japan and the BOJ.  Will Japan move to further ease monetary policy with an eye toward weakening the JPY?  Will the U.S. and the Fed tolerate such action or will the Fed signal that “low for long” has become “low for longer”?  Up until recently, G-7 monetary authorities have been able to deny the currency war theory, but that position is becoming increasingly difficult to defend.

Rousseff is in trouble: Brazil’s President Rousseff lost her impeachment battle in the lower house 367-137, with seven abstaining.  The measure needed a two-thirds majority to pass, which was 342 votes.  The drama now moves to the upper house of the Chamber of Deputies.  The upper house has 81 members; if 54 vote to impeach, she is removed from office immediately.  If the majority but less than 54 approve impeachment, she steps down for 90 days while the Senate decides her fate.  The vote will occur sometime in the next month.  Despite the turmoil, Brazil’s equity markets have been on a tear, up 35.2% YTD for a USD based investor.  Even with the vote, the Ibovespa is up 1.6% today.  The hope is that impeachment will bring a market-friendly government to Brazil.  We suspect this is far too optimistic.  The left wing in Brazil is framing Rousseff’s impeachment as a coup, an unpleasant reminder of the country’s long history with military takeovers.  An impeachment could lead to widespread civil unrest.

So, what does this all mean?  The tight correlation between oil and U.S. equity markets is continuing, so a drop in oil prices due to the Doha disappointment makes sense.  Japan losing support will likely keep the JPY strong, which is bad news for Japan’s economy and equity markets.  Finally, the impeachment euphoria in Brazil may not have legs as the next leader of the country faces an economy in recession and a deeply divided electorate.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] It’s shaping up to be a very busy weekend.  In Brazil, the Chamber of Deputies will vote over the next couple of days to decide if the legislature should begin impeachment proceedings.  As we noted earlier this week, Brazilian financial markets have rallied on expectations that President Rousseff will be ousted at some point and the political turmoil will diminish.  We doubt that will be the case.  Although we suspect the legislature will vote for impeachment, Rousseff and her predecessor, Lula, still have widespread support and we would not be surprised to see a surge in civil unrest regardless of the outcome.  Therefore, we suspect the financial markets have gotten a bit ahead of themselves and a post-impeachment vote correction is likely.

The other major event is the Doha oil producers meeting, bringing together OPEC members and Russia to decide on an output freeze.  Oil markets have recovered strongly in anticipation that the freeze will be the first step in an agreement to reduce production.  However, those hopes were dealt a blow this morning when Iran announced it would not send its oil minister but a second level representative instead; the news has oil prices falling this morning.  Iran has made it abundantly clear that it is not planning to freeze output until its production reaches pre-sanctions levels.  Saudi Arabia has sent mixed signals with regards to its plans; initially, there were reports that the Saudis would not promise to freeze without Iran doing the same.  However, later comments suggested that the Saudis would probably go along with a freeze even without Iran.  By downgrading its representation, Iran is signaling that there is no chance of a surprise freeze agreement.  There was almost no chance even if its oil minister did attend, but a lower level functionary likely guarantees no change in Iran’s position.

In general, we view a freeze as having a modestly positive impact at best.  Most oil producers have been boosting output in front of the freeze meeting to ensure that they won’t have to reduce output as part of any agreement.  It is positive for oil prices that major producers are in discussions.  However, we don’t expect a freeze to have a material impact on the current supply situation.  We agree with the IEA, who noted yesterday that the oil markets will achieve supply/demand balance by the end of this year, mostly due to declines in non-OPEC output, which will be sizeable in North America.  Nevertheless, balance doesn’t address the inventory overhang which will take some time to reduce.  We would not be surprised to see oil prices fall after this meeting, if for no other reason than the oil markets appear to have already discounted the most likely outcome, which is a promise to freeze output and a meeting environment that suggests cooperation, at least on the surface.  Anything less than that could be much more bearish for oil prices.

China’s GDP came in at 6.7% in Q1, within the new 6.5% to 7.0% range.  As usual with China, it was a “good news/bad news” situation.  The good news is that growth remains elevated.  The bad news is that growth is coming the old fashioned way, from debt and investment.  In Q1, total credit rose to CNY 7.5 trillion, a 58% increase over last year’s level and 46.5% of nominal Q1 GDP.  For March, new loans rose CNY 1.37 trillion, well above expectations.  New net corporate bond issuance rose CNY 695 bn.  Yearly cement production rose nearly 25% for the first two months of the year.  Total fixed investment, on a rolling quarterly basis, increased 10% but state sector investment rose 23%.  Floor space jumped 40% from last year.  Essentially, as China’s growth has slowed, it has returned to its old practices of boosting investment in the State Owned Enterprises (SOEs) and housing, using massive amounts of debt to bring economic recovery.  This has boosted commodity demand and emerging markets.  There are two key unknowns.  First, how long will this “goosing” last, and second, when does China run out of debt capacity?  The goosing probably lasts into Q4 at the least but we would expect a return to rebalancing.  The second question is a clear unknown.  At some point, just as Japan discovered in the late 1980s, China will run out of borrowing capacity.  Because it delayed restructuring, it will likely face years of sluggish growth.  However, for now, China’s policy actions will be bullish for commodities and emerging markets.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Oil prices are modestly higher after a small decline yesterday due to a higher than forecast weekly oil inventory report, which we cover below.  Prices were down until IEA headlines emerged indicating that the OECD’s oil monitoring body is expecting the oil market to balance later this year.  We would tend to agree with this position, although balancing the market doesn’t address the massive inventory overhang that will need to be worked off.  Still, balance means that the cyclical low in oil prices is probably in place.

Yesterday’s oil inventory data was a bit bearish, although it was somewhat offset by falling gasoline stockpiles.

Inventories have started to lag the usual seasonal pattern.  This is supportive for oil prices.

We would expect inventories to peak at 547.8 mb over the next three weeks from 536.5.  Assuming a stable EUR of around 1.1375, fair value for oil is just under $38 per barrel.  Thus, prices are a bit overvalued, mostly due to expectations of positive OPEC news on Sunday.  We wouldn’t be surprised to see choppy markets over the next week or so as the OPEC news is likely discounted.  However, as noted above, the lows are likely in place and we should see better oil prices as we move into summer.

Another somewhat overlooked factor for oil that we are starting to take note of is that the regulatory burden on energy production is starting to increase.  The Obama administration released its offshore drilling regulations and the response from industry is that the new rules will kill numerous projects.  Exxon-Mobil (XOM, 84.83) told Bloomberg that the rule will cost $25 bn over 10 years, which is 25x the government’s estimate.  We also note that there are increasing regulations on onshore drilling as well.  One of the fears in the marketplace is that if oil prices recover, oil companies in the U.S. can quickly bring new production to market and kill off any rallies.  That scenario becomes less likely if the regulatory environment increases the costs of new projects.  In other words, regulation affects breakeven costs and projects will face higher hurdles and supply will contract as regulations rise.

With today’s inflation data, we can update our versions of the Mankiw rule model.  This model attempts to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative.  Mankiw’s model is a variation of the Taylor Rule.  The latter measures the neutral rate by core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy.  Potential GDP cannot be directly observed, only estimated.  To overcome this problem with potential GDP, Mankiw used the unemployment rate as a proxy for economic slack.  We have created three versions of the rule, one that follows the original construction by using the unemployment rate as a measure of slack, a second that uses the employment/population ratio and a third using involuntary part-time workers as a percentage of the total labor force.

Using the unemployment rate, the neutral rate is now up to 3.64%, suggesting the FOMC is well behind the curve.  Using the employment/population ratio, the neutral rate is 1.41%, indicating that, even using the most dovish variation, the FOMC needs a rate hike of at least 100 bps to achieve neutral policy.  Finally, using involuntary part-time employment, the neutral rate is 2.71%.  Although these neutral rate estimates are well above the current target, it is important to note they have all declined by 20 to 30 bps over recent estimates.  First, core CPI declined to 2.19% from 2.30% and improving labor markets are boosting the labor force, leading to a higher unemployment rate and fewer involuntary part-time workers.  The drop in the estimate using the employment/population ratio is fully due to the drop in inflation as the ratio is showing strong improvement.  However, we can safely argue that if the FOMC believes in the Phillips Curve then, according to any measure, it should be lifting rates.  We suspect that the dollar may have, at least for now, become a better indicator of monetary policy.  With the dollar still relatively strong, we expect Fed policy to remain stable.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Financial markets are stronger this morning on better than expected trade data out of China.  March exports rose 11.5% from last year.  Last month the same measure fell 25.4%.  However, the data does fluctuate due to the variance in dates of when the Chinese New Year is celebrated.  On a rolling three-month basis, both exports and imports are down around 10%.  Overall, the data is good news for China, but somewhat less so for the world economy.  After all, if China is running a trade surplus, it is essentially acquiring aggregate demand from the rest of the world.  These conditions would be appropriate if the world was dealing with inflation, but that is not the case and so China running trade surpluses will become a bigger issue for the developed world.  It is already an issue in the U.S. presidential primary season.

Two interesting articles in the FT and NYT are focusing on the problem of IS.  Although IS remains in control of significant territory in Syria and Iraq, airstrikes and ground attacks are taking their toll on the group.  Targeting its oil flows and the drop in oil prices have cut its funding.  Attacks from Kurdish troops and Iraqi forces are reducing the area controlled by the group.  Although this is good news, like most things in life, even good outcomes carry unexpectedly negative consequences.  As IS has been losing territory in the Middle East, it has been stepping up terrorist attacks in Europe.  It is unclear if the group can maintain operational tempo as it loses territory; we suspect it may not as it will lose its training ground and funding for operations.  Another problematic development is that as IS has been losing territory in the Levant, it has been gaining territory in what is left of Libya.  History has shown that terrorist groups tend to thrive in failed states and Libya may be the most significant failed state in the world today.

The FT article notes that something of a power vacuum is developing as IS loses territory.  In most cases, IS leaves behind a shattered infrastructure that neither Iraq nor Syria can afford to rebuild, and no outside power will be comfortable providing funding for rebuilding without a working government in place.  Defeating IS is a worthwhile goal but there does not appear to be a plan for the aftermath.  Given that the government in Baghdad is Shiite-dominated, we doubt the Sunnis who live in what was western Iraq will be comfortable with a return of Iraqi dominance.  Western Iraq and eastern Syria are ripe for an outside Sunni power to move in and take control.  We will be watching to see whether Saudi Arabia and/or Turkey decide to fill the void created by defeating IS.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] BREAKING: IMF CUTS 2016 GLOBAL GROWTH FORECAST TO 3.2% FROM 3.4%. 

President Rousseff of Brazil came another step closer to impeachment yesterday as a congressional impeachment committee voted to recommend a Senate trial.  The next step is a vote by the full Chamber of Deputies on Sunday.  If two-thirds of the Deputies vote to impeach (342/513), the case will go to the Senate for trial.  During the trial, which must be completed in 180 days, Vice President Michel Temer will be in power.  According to Brazilian media reports, Temer was caught practicing his speech for when he is in control.

Brazilian equities have been rising in anticipation of impeachment.

(Source: Bloomberg)

The Brazilian real has been appreciating as well.

(Source: Bloomberg)

Two notes of caution.  First, it isn’t clear whether the Brazilian legislature will take steps to remove Rousseff.  Although it appears that Rousseff and her predecessor, Lula, took enormous amounts of money from the oil boom, the level of corruption in Brazil is rather high, in general.  Transparency International, the corruption monitoring NGO, gives Brazil a ranking of 38/100, with 100 indicating almost no corruption.  Globally, Brazil ranks 76^th out of 167 countries, putting it in line with Bosnia, India, Thailand, Tunisia and Zambia.  The OECD has designated Brazil’s corruption enforcement level as “little” (the second lowest level possible).  This may be a situation similar to the Biblical narrative of Jesus and the woman taken in adultery.[1] There is no guarantee that Rousseff will be removed from office even if impeachment proceedings begin.  Second, removing Rousseff doesn’t necessarily fix the problems facing Brazil; its economy remains heavily dependent on global commodity demand and the political upheaval that impeachment will likely bring could undermine risk assets.  Thus, the financial markets may have gotten a bit ahead of themselves if the Rousseff impeachment is driving equities higher and leading to BRL appreciation.

Bloomberg is reporting that the Bank of Japan (BOJ) is easing the level of deposits affected by NIRP.  This news lifted Japanese bank shares, although we wonder if this action really says that NIRP is a mistake.  After all, reducing the level of deposits affected will also tend to reduce the incentive to lend these deposits into the economy.  On the topic of banks, we note that Italy appears to be making progress on creating a “bad bank” for non-performing loans (NPLs) in a bid to recapitalize the banking system.  After this new bank buys NPLs from an Italian bank, the latter should be able to issue new equity to recapitalize itself…if investors are willing to buy the new equity.  The bad bank will be capitalized from the banks itself, although we would expect government support.

The NY FRB has released its survey of consumer inflation expectations; overall, for March 2016, inflation expectations for the year ahead have fallen to 2.5% from 2.7% in February.

As the chart indicates, inflation expectations have been falling in general.  What we find most interesting is the impact of age on inflation expectations.

Note how much lower inflation expectations are for younger Americans.  The oldest of the youngest cohort was born in 1976 and probably developed “inflation consciousness” at age 10 in 1986.  For the most part, they have seen mostly low inflation and that experience anchors their inflation expectations.  Compare that to the oldest cohort—their expectations, born of the high inflation problems of 1965-80, remain stubbornly high.

Finally, income clearly affects inflation expectations.

Note that higher income households tend to have persistently lower inflation expectations.  This is probably because they spend less of their income proportionally on necessities and thus rising oil or food prices affect their inflation perceptions less.  Expectations for the lowest bracket are falling coincident with the decline in oil prices.

Overall, these data do suggest that inflation expectations remain low, which gives the FOMC room to wait if it so desires.

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[1] John 7:53-8:11