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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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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