by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Happy employment day!  We will go into much more detail below, but we are seeing solid improvement in the labor market.  Most importantly, the labor force is finally starting to expand; in fact, the unemployment rate rose this month in a good way as the labor force expanded faster than employment.  We have also seen a rise in wage growth, although it still remains soft.  The market is taking the data as hawkish, leading to higher interest rates today and a stronger dollar.

There were two overseas developments of note overnight.  First, China’s PMI data (see below) came in better than forecast, with the Caixin PMI number reaching 49.7, the highest report in 13 months.  The official report hit 50.2, above the 50 expansion line and a nine-month high.  Although some of this may be due to the timing of the New Year’s holiday, it does appear that stimulus measures are starting to have an impact, which is a good sign.  Second, Saudi Arabia’s Deputy Crown Prince Salman conducted a long interview with Bloomberg overnight.  The primary short run news is that the kingdom does not intend to freeze oil output unless Iran does as well.  This scotches hopes that OPEC + Russia were on the brink of a production deal; oil prices have fallen as a result.  Salman also suggested that the kingdom would only sell 5% or less of Saudi Aramco and would create a massive $2.0 trillion sovereign wealth fund to support the kingdom’s efforts.  Although the value of the wealth fund appears massive, in fact, it looks like Saudi Arabia will simply put Saudi Aramco in the fund which will become the bulk of its assets.  The most important takeaway from the interview is that Saudi Arabia is in no hurry to support an oil price recovery.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Standard & Poor’s lowered China’s credit rating outlook from stable to negative, citing a slower than expected economic rebalancing.  Although Chinese risk markets dropped initially, they have recovered since, indicating that the rating outlook cut is not likely to have a long-term effect.  We saw similar temporary weakness when Moody’s cut the nation’s rating outlook in the beginning of March, but equities were seemingly unaffected after the initial drop.  After all, it was already known that the rebalancing would be slower as the government attempts to maintain higher rates of growth through continued investment support.

Domestic wage growth, in general, has remained lackluster, with economists forecasting a 2.2% annual increase in hourly earnings for tomorrow’s employment report.  Yellen has cited disappointing wage growth as one of the reasons why she supports a cautious pace of monetary tightening.  The chart below shows a long-term history of growth in average hourly earnings.  Historically, and especially during the time that most of the Fed governors were completing their graduate degrees, the Phillips Curve was applicable, meaning that tighter labor markets led to higher wages which led to higher prices.  We note that this process is slow, with average inflation rising gradually as the labor market improves, but the closer we move to full employment the more likely it is that wage growth and inflation will accelerate.

The question of whether the Phillips Curve is still relevant is significant.  Although the unemployment rate has improved since the end of the recession, structural changes in the labor market mean that the participation rate has hardly moved from its recessionary lows and wages have remained stagnant.  We are seeing wage growth pick up in certain areas of the country as Minneapolis-St. Paul, Dallas and Seattle are all seeing strong yearly wage growth.  These “hot” wage growth regions could be the first signs of future general improvement in wages for the country.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Risk markets surged globally yesterday as Fed Chair Yellen re-confirmed the central bank’s intention to move rates up slowly, citing weak global growth.  This was exactly the kind of reconciliatory signal that the markets were looking for after several FRB presidents had voiced their support for moving rates higher, possibly as soon as next month’s meeting.  Clearly, the market likes a unified and clear message from the Fed’s leadership.

Risk markets jumped following her presentation, with the S&P 500 swinging to a positive change for the year.

(Source: Bloomberg)

Additionally, the dollar plunged almost the moment she started speaking.

(Source: Bloomberg)

Market expectations for a rate hike were dampened, with futures now showing a zero percent chance of a rate hike next month, a 28% chance of a hike by June, and a 54% likelihood of an increase by November.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] European markets opened strongly higher after the long Easter holiday, but have given back some of the gains in early morning trading.  Asian equities were mixed, with Chinese markets trading lower.

All eyes will be turned to Fed Chairman Yellen’s address to the Economic Club of NY today.  Given the relatively sanguine tone from recent Fed speakers compared to the dovish tone of the most recent FOMC press conference, investors will be watching for indications of divergences within the FOMC.

Jon Hilsenrath, the “Fed whisperer” at the WSJ, recently penned an article suggesting that dissent has declined at the Fed.  He suggested that Dallas FRB President Kaplan, Philadelphia FRB President Harker and Minneapolis FRB President Kashkari are more moderate than their predecessors and we would concur with that assessment.  Kaplan and Harker replaced two very hawkish presidents, Fisher and Plosser, while Kashkari replaced Kocherlakota, who was very dovish.  On our 1-5 scale, which runs most hawkish to most dovish, the previous committee averaged 3.06 with a standard deviation of 1.5.  The current full committee averages 3.18 with a standard deviation of 1.2.  The good news is that the odds of dissent are lower, which means that Chairman Yellen will likely get her way.  At the same time, there is a lack of diversity of views, meaning that there are fewer members who would be likely to oppose the chairman if the FOMC goes in a bad direction.  If the two governor positions are filled this year, the board will likely become even more centrist.

In the wake of relatively soft Q4 GDP, the outlook for Q1 GDP is rapidly deteriorating.

This chart shows the latest data from the Atlanta’s FRB GDPNow model, which projects the current quarter’s GDP based on the flow of economic data.  With the downward revision to January personal consumption expenditures and the weak trade data, the current forecast is now 0.6%.  Although the employment data on Friday might give these numbers a boost, this data should scotch talk of Fed tightening in April.

This data shows the contributions to GDP based on the Atlanta FRB’s model.  Note that yesterday’s report cut growth by 80 bps and, since March 11, the GDP forecast has been cut by 170 bps.  All categories are down, which is a disturbing sign.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Trading was quiet overnight.  Hong Kong and European markets are closed for Easter Monday, which limited market activity.  On Good Friday, the Commerce Department issued the GDP report for Q4 (see below).  In addition to our usual coverage, we want to highlight a couple of important charts from this report.

This chart shows the 12-quarter moving average of the contribution from consumption.  As the chart shows, consumption collapsed during the Great Financial Crisis but has since rebounded sharply.  Note that no recession has ever occurred with the measure rising.  Improving consumption is probably the most favorable data on the economy.

Perhaps the second most positive development for the economy is that government is almost no longer a drag on the economy.  Now, in an age of deficits and fights over the fiscal budget, suggesting that the lack of government spending is acting as a drag on the economy seems illogical.  However, we note that in the GDP calculation, government’s contribution to the economy is what government spends on “stuff”—bridges, tanks, roads, etc.  That discretionary part of the budget has been dramatically squeezed in this business cycle, meaning the government has subtracted from growth at its fastest pace since the demobilization from the Korean War.  However, as state and local government budgets improve, spending is also improving, adding to GDP.

We have been getting a number of questions about our coverage of oil inventories.  Due to the attention on oil prices and their tight correlation to equities, we have been regularly updating the oil inventory data in this report; we have been mostly focusing on the seasonal pattern in oil stockpiles.  However, a number of readers have correctly noted that because demand is higher today, current inventory levels nearing the highs set in the 1930s is really not a fair comparison.  This is true.  So, to address these comments, we have created the two charts shown below.

To measure the level of inventory to demand, we divide oil inventories by the amount of crude oil that is used by refineries.  That measure tells us how many days of inventory exist at the current refinery run rate.  The chart on the left looks at commercial crude oil inventories only.  Unfortunately, the DOE data only goes back to 1949, so we can’t capture the days to cover from the 1930s, but it is fairly clear that current inventory levels are not excessively high by this measure.  In fact, inventories are only approaching the levels seen during the early 1980s when oil companies were hoarding oil due to the Iran-Iraq War.

However, there is another element to the story.  In 1977, President Carter began filling the Strategic Petroleum Reserve (SPR) as part of an international effort to create an emergency supply buffer to counteract future supply disruptions from the Middle East or elsewhere.  The actual availability of the SPR is always an issue—defining what constitutes a real emergency is difficult.  On the other hand, the existence of the SPR probably does have some impact on storage management; before the SPR, commercial firms had to have large enough supply buffers to counteract events that might reduce supply.  Once the government took over this role, firms were no longer required to keep storage on hand for emergencies.  Thus, the right-hand chart is probably a more accurate snapshot of how much oil is available.  Interestingly enough, the right hand chart tells us that the current level of stockpiles, relative to refinery operations, isn’t all that unusual.

Our analysis suggests that commercial crude oil stocks are more critical to oil prices than the SPR, although we have done work that suggests adjustments to the Strategic Reserve have an impact on prices.  For example, in the fall of 1990, President George H.W. Bush ordered a test withdrawal from the SPR to see if it could be used in the case of war in Iraq.  The very announcement coincided with the peak in prices (although we did see a new panic high on the day the air war started that was very short lived).  In addition, his son’s policy of filling the reserve during his term likely boosted oil prices as well.

The bottom line is that when the SPR is included, oil stocks are ample and the rise in commercial inventories, which are unencumbered by policy, has an even greater impact.  Simply put, a major recovery in oil prices, barring a geopolitical event, needs a reduction in the inventory overhang.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] As noted below, St. Louis FRB President Bullard has joined a chorus of other regional presidents pushing back against the dovish tone from the last Fed meeting.  The change in Fed behavior is discussed in this week’s Asset Allocation Comment, published below on page 7.  As these comments ripple through the market, we are seeing the recent rally fade in commodities, foreign currencies and equities.

What is becoming evident is that the paths of several markets are increasingly dependent on U.S. monetary policy.  The tone out of the March meeting was clearly bullish.  However, subsequent speeches have also made it known that this dovish position isn’t universally shared.  We do believe that Yellen is probably fending off the Phillips Curve adherents on the committee by using inflation expectations and dollar strength to argue against further tightening.  The dots plot suggesting two rate hikes this year is probably about right, but the financial and commodity markets are taking the position that monetary policy will be consistently accommodative.  For that to happen, Chairman Yellen is going to need to keep control of the committee against rising opposition to policy accommodation.  If she loses the battle, equities and commodities are at risk, whereas the dollar and Treasuries should benefit.  In general, it is usually safe to side with the chairman; however, it should also be noted that she probably can’t hold her position with three dissents on any policy decision.

At present, it would not be a stretch to see Bullard, George, Williams and Mester press for a rate hike in April.  If they hold off, that concession probably only comes with a promise to raise rates in June.  Only George has shown she will consistently dissent.  Growing opposition to dovish policy could make Yellen’s job much tougher in the coming months and create choppier markets.

Oil prices fell yesterday as inventories rose well above expectations.

Current stockpiles are 532.5 mb, only about 12 mb below the all-time high set in October 1929.  Based on seasonal patterns, we would expect that oil record to be broken before the end of next month.

This chart indexes current storage levels compared to the past five-year average.  By the middle of next month, the injection season will come to a close.  If we assume that the EUR/USD exchange rate remains in the $1.11 neighborhood, a return to the low $30s on crude oil is possible.  However, by late summer, a return to the low $40s would be expected.  To some extent, we view the crude oil market as a bit ahead of itself, but the bearish seasonal situation is almost over.

The relationship between oil prices and equities remains very tight.

The current pair of oil prices and the S&P 500 are noted with an arrow.  The current level of the equity index is a bit below the linear regression line, suggesting the market is a bit cheap.  If this relationship holds, a trip to the low $30s in crude oil will likely result in an S&P between 1,900 and 1,950.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] In the aftermath of the terrorist bombings in Belgium, security officials in Europe have been working feverishly to track down the identities of the bombers and search for other terrorist cells.  It is widely thought that this cell was already in place and may have decided to activate after the recent arrests of other suspects.

A couple of observations are in order.  First, it appears that financial markets are becoming increasingly inured to terrorist events.  The reaction in equities was quite modest and the rally in gold is partially reversing today.  Second, attacking Brussels, the seat of the EU, looks like a big deal.  However, true sovereignty rests at the national level, not at the continental level.  The EU has no military.  It has a continental investigation unit but it cannot issue arrest warrants.  IS won’t face calls for military intervention like those that followed the Paris bombings.  The reason is that France has a military; the EU does not.  Thus, the attacks in Brussels are more symbolic than the Paris attacks but probably won’t lead to stepped up attacks on IS.

Is Yellen facing a rebellion?  The last FOMC meeting was decidedly dovish but three presidents, Dallas FRB President Harker, San Francisco FRB President Williams and Atlanta FRB President Lockhart, all made statements this week suggesting that they disagree with the pause in rate hikes and want the Fed to start raising rates.  It should be noted that none of these presidents are voting this year.  Thus, their statements, though important, don’t necessarily mean that policy is going to reverse.  However, it does suggest that Yellen may be facing more opposition to a dovish stance.  At the last meeting, KC Fed President George dissented.  At the time of this writing, St. Louis FRB President Bullard is talking on Bloomberg and is leaning toward tightening, although he seems quite comfortable with an inflation overshoot.  Bullard is a voter and he said he wants to see April as a “live meeting,” but the real thrust of his comment is that he thinks the Fed is giving out too much information and should stop offering “balance of risk” statements and dump the “dots” chart.  We agree this is exactly what the Fed should do.  The real issue is that the markets have adjusted to a dovish central bank and these statements suggest that the robustness of this dovish stance may be rather low.

Oil prices have enjoyed a nice lift (we get the DOE data later this morning), but the IEA is on the tape today suggesting that the OPEC freeze may be “meaningless” because Saudi Arabia is the only nation that can boost production anyway.  It is our position that this rally was a correction from oversold levels that were caused by uncertainty surrounding the availability of storage.  It appears that the industry has managed to find space for inventory and this, along with a drop in the dollar (partly caused by the unexpectedly easy Fed, noted above), has led to a strong rally in oil prices.  We believe this rally has eliminated the oversold rally and more, and a modest correction (prices between $30 and $35 per barrel) is likely in the coming weeks.  We think the recent lows will likely be the lows for this cycle but we don’t expect a major recovery unless the Saudis change their oil production policy.  In other words, without a cut in Saudi production, the oil price recovery will be “L” shaped, like what we saw after the oil market stabilized in 1986.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The big overnight news was a series of apparent terrorist bombings in Belgium.  At the time of this writing, 34 are confirmed dead after two bombing attacks, one at the Brussels airport and the other at a metro station near EU headquarters.  There have been reports of evacuations of a park near the royal palace and the palace itself.  At this time, it isn’t clear if more attacks are in the offing.  It is presumed that these were conducted by Islamic extremists; according to Belgian authorities, one attack was carried out by a suicide bomber, which is consistent with the operational tactics of Islamic terrorists.

Financial markets are reacting in a manner consistent with other such events.  The dollar, yen, Treasuries and gold are higher, while equities in Europe and the U.S. are lower.  Usually, such attacks don’t have an extended impact on the markets unless they are followed by additional events in short order.  It is highly probable that these attacks are in retaliation for the recent arrest of Salah Abdeslam, who is thought to be a key figure in the Paris terrorist attacks.

In other news, as we show below, the flash PMI data is out.  The European data was stronger than expected, led by robust German growth, while Japan was weaker than forecast.  The U.S. data is out later today.

Both Bloomberg and the WSJ are reporting comments about introducing “helicopter money.”  It is becoming apparent that monetary policy is reaching the point of diminishing returns.  With interest rates already low, QE is now at the point where central banks are simply accumulating assets.  The recent decision by the ECB to buy corporate debt dovetails with the BOJ’s purchases of equities.  At some point, it will become apparent that these measures merely prop up the financial markets but do little to actually boost economic activity.  Globally, investment remains depressed and the wealth effect hasn’t helped boost consumption.  For the most part, monetary policy works through the financial system but it does have the problem of “pushing on a string.”  In other words, just because one can create conditions that foster borrowing doesn’t mean that borrowing will actually occur.  Creditors may be spooked by the inability of debtors to service debt even at low rates, and debtors may not want to borrow.  Going to NIRP is probably the Almighty’s way of suggesting that monetary policy is exhausted; after all, the distortions caused by negative interest rates may far exceed the benefits.

Helicopter money means that the central bank directly funnels money to consumers, either by direct injections of liquidity to households (thus the metaphor of “helicopter”) or by direct monetization of fiscal spending.  We have seen others talk about this as well; Jeremy Corbyn has proposed “QE for people” by directing funds to the public rather than through the financial system.  If there is a dearth of public investment, monetization of fiscal spending on roads, bridges, etc. is probably a better way to inject funds into the economy.  In a developed economy, the direct support of household spending might work better.  It should be noted that such activity does occasionally occur during periods of war; during WWII, the Fed capped interest rates despite massive government borrowing, which was a form of debt monetization.

Although helicopter money has the tone of something from Marx, it was actually proposed by one of the titans of conservative economics, Milton Friedman.  Would it be inflationary?  Eventually, although in a world awash in excess capacity it might take longer to create inflation than one would think.  If trade remained open, one would expect to see a flood of imports and a weaker currency result.  Although we are not at the point where such policy moves are imminent, we would not be surprised to see this policy deployed if rates are very low going into the next recession.

Finally, former President Bill Clinton got a bit off message yesterday with this quote:

If you believe we can all rise together, if you believe we’ve finally come to the point where we can put the awful legacy of the last eight years behind us and the seven years before that when we were practicing trickle-down economics…then you should vote for her.

This comment flies in the face of his wife’s campaign, who has been running on a platform similar to that of a sitting vice president, namely, honoring the legacy of the last president.  After all, George H.W. Bush didn’t run as a change candidate when he succeeded President Reagan.  Although the former president tried to walk back the quote, suggesting he was talking about obstructionism, it is hard to argue that Obama faced much obstruction in the first two years of his term when his party controlled both houses of Congress.  Either Mr. Clinton “has lost something off his fast ball” or he may have revealed his true feelings.

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