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

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] German 10-year sovereign yields are down to 11 bps this morning.  Falling German yields are translating into low U.S. Treasury yields.

(Source: Bloomberg)

Since mid-2013, when Chairman Bernanke unveiled tapering, the two yields have been closely linked.  Interestingly enough, the spread between these rates has been rather closely linked to the EUR/USD exchange rate.

Based on the long-duration sovereign spread, the EUR/USD exchange rate is about in line with fundamentals.  For a weaker EUR, assuming all else remains constant, the long-duration spread would need to widen.  It is hard to see how much further German yields could fall as they are close to negative levels.  That isn’t to say German yields could not fall below zero, but falling much below zero probably isn’t likely.  Thus, a stronger EUR/USD will likely come with rising long-dated Treasury rates.  As long as inflation expectations remain anchored and the Fed policy rate moves slowly, a major rise in Treasury yields is unlikely.  Overall, we would expect a mostly steady EUR/USD into Q2.

An interesting NYT article caught our attention over the weekend reporting that there has been an upswing in intergenerational housing.[1]

(Source: Pew Research)

One of the effects of Social Security was to allow the elderly to stay in their own homes until they either required nursing care or passed away.  This was a major change from housing habits prior to the Great Depression.  However, we have seen a steady rise in the number of Americans living in multigenerational housing, particularly since 1990.  We suspect the insecurity of incomes for younger Americans and the need to attach to older Americans’ steadier income (due to regular Social Security) has led to this development.  In other words, economic factors are leading American families into arrangements where incomes are being pooled, a response to low income growth.  The NYT article noted that home builders have taken notice of this trend and are building new homes with accommodations for multiple generations.  This social development, coupled with older Americans remaining attached to the labor force, is part of the adaptations being made due to slower family income growth.

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[1] http://www.nytimes.com/2016/04/09/your-money/multigenerational-homes-that-fit-just-right.html

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The WTO released its global trade data for 2015 yesterday along with its forecasts for this year and next.  The sum of imports and exports rose 2.8% last year and is expected to rise at the same pace this year, rising to 3.6% in 2017.  The WTO noted that the past five years have been the slowest trade expansion in the postwar world.  Although trade volumes rose 2.8%, the value of trade plunged 13% due to the dollar’s strength.  Container shipping volumes were flat last year.

(Source: WTO)

This chart shows container traffic on a volume basis.  This indicator peaked in mid-2014 and recovered to its old highs at the end of last year.

(Source: WTO)

This table shows the world’s largest importers and exporters.  Note the growth declines seen across the board.  On the export side, only Vietnam showed positive growth and none of the 30 largest importers increased last year.  The world’s largest exporter remains China, with a 13.8% share of total exports; its exports fell 2.9% last year.  The U.S. is the second largest (a cautionary note for the political class, which is becoming increasingly protectionist), but U.S. exports fell over 7% last year.  Germany, the world’s third largest exporter, saw the value of its exports decline by 11.0%.  Also note that oil exporters suffered massive declines, with Saudi Arabia falling 41.1% and Russia off 31.6%.  On the import side, the U.S. remains the world’s largest importer, with a 13.8% share; the value of U.S. imports fell 4.3%.

The drop in trade is partially due to the strong dollar but that isn’t the whole story.  We suspect two factors are at work.  First, slow U.S. economic growth is dampening global trade.  Because of America’s reserve currency status, the U.S. is the global importer of last resort.  Deleveraging and weak economic activity is reducing America’s ability to fulfill that role, leading to weaker trade.  Second, without American leadership on trade, the world is slipping into mercantilism and “beggar thy neighbor” trade policies.  This development not only weakens global economic growth, but it makes the world a more dangerous place.  Nations that trade can still go to war with each other (the world was quite integrated before WWI), but trade does make the idea of conflict between trading powers more costly.  Falling trade leads to a scramble to capture aggregate demand from other nations and fosters protectionism.

In that light, the Japanese finance minister warned that the JPY is strengthening too quickly and fear of intervention has eased some of the currency’s strength today.  We are leaning toward the idea that Chairwoman Yellen is using the dollar as a policy indicator, which is really bad news for the ECB and BOJ.  This is a development we will be monitoring in the coming weeks (and which we discussed at length in yesterday’s comment).

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Yesterday’s FOMC minutes generally confirmed what we have been hearing from committee members over the past few weeks, namely, that international concerns are worrying members and keeping policy steady.  Of the 17 members on the committee, eight viewed the risks to be shifting toward slower growth, while six saw the risks as balanced between slower growth and inflation.  Eleven members expected inflation to trend lower.  These numbers suggest a dovish bias, so it seems unlikely that the Fed will move to raise rates this month.  This chart actually captures two of the risks mentioned by Fed members recently, international developments and the weakness in market inflation projections.

This chart shows the five-year forward inflation expectations from the TIPS spread and the JPM dollar index (on an inverted scale).  Since early 2008, the correlation between these two series is 77.8%; essentially, the dollar appears to be driving inflation expectations.  Although we would never expect the Fed to openly target the dollar for policy purposes, in fact, weakening the dollar is probably the best remaining tool in the Fed’s policy toolbox.  Unfortunately for the FOMC, there are two problems with this policy.  First, the exchange rate is not its policy mandate; the Treasury is in charge of exchange rate policy even though it has no tools to affect the exchange rate.  Thus, targeting the dollar is not part of the Fed’s Congressional mandate and could create legal trouble if it becomes an official policy goal.[1]  Second, an open policy to weaken the dollar could trigger a currency war reminiscent of the 1930s.  Still, if the Fed is successful in weakening the dollar (see below for more on this topic), it will reduce policy stimulus for the rest of the world, especially in Europe and developed Asia.

The JPY has strengthened considerably in recent weeks despite the BOJ’s foray into negative interest rates (NIRP).  The impotence of BOJ policy suggests that Fed policy is the primary driver of exchange rates in the current environment.  First, a look at the JPY/USD exchange rate:

(Source: Bloomberg)

This shows the exchange rate in JPY per USD on an inverted scale.  PM Abe took office in late 2012 and began Abenomics, which was a set of policies designed to boost Japanese economic growth and inflation.  One of the primary tools was currency weakness.  The JPY weakened in two phases, falling initially from 78 ¥/$ to over 100 ¥/$, and then, after additional stimulus, the currency took another leg down in 2014.  The latter drop was more likely due to a strengthening U.S. economy and expectations of the end of Fed monetary accommodation.  In January of this year, when the BOJ announced NIRP, the currency weakened (see arrow) but that drop failed to hold.  Since then, the JPY has steadily strengthened.  This is profoundly bad news for the Japanese economy.  The forex markets are going to force some sort of reaction from the Abe government but its most effective tool, intervention, will be very controversial given that we believe the FOMC is deliberately trying to weaken the dollar.  What makes it even worse is that such a move would become political fodder for the U.S. presidential primary candidates who are leaning against globalization.

Overall, the JPY could have a lot further to strengthen.

This chart shows a purchasing power parity valuation mode of the JPY/USD, which uses the ratio of inflation rates to value the exchange rate.  The theory suggests the economy with lower inflation should have a stronger exchange rate.  Because Japan is deflating, the parity rate is much stronger than the current exchange rate; in fact, at current rates, the JPY is a full standard error weaker than forecast.  Although we don’t expect the Abe government to allow the JPY to continue to strengthen without a fight, the general undervalued nature of the JPY may make it difficult to prevent the strengthening trend from continuing unless the Fed moves to tighten soon.

We had a surprise draw in crude oil stocks yesterday which was clearly bullish for crude oil.  A decline this time of year is unusual and may portend a lower seasonal peak.  However, Bloomberg is reporting that there are pipeline problems affecting Canadian exports to the U.S. which led to the unexpected draw in stockpiles.  If the problems are fixed this week, we will likely see a surge in imports next week to make up for this week’s draw.  This is probably why oil prices have not been able to follow through this morning.

China’s forex reserves rose $10 bn in March, rising to $3.213 bn.  Although this is a positive number on its face as it suggests that capital fight might be easing, the market reaction has been rather modest.  We will probably need to see a couple of months of reserve stability before we can declare that the PBOC has successfully contained the seeming panic of capital outflows.

Finally, the ripple effects from the Panama Wikileaks disclosures continue to mount.  Iceland’s government has been rocked by the revelations, with the PM resigning and the finance minister coming under fire.  Britain’s PM is catching flack for his family’s use of offshore accounts and the U.S. Treasury is apparently looking into whether the account violates sanctions against Russia.  President Putin apparently has it figured out—the leaks are a Western plot to undermine the Russian state.  On the topic of Russia, the FT is reporting that Putin is forming a National Guard that will be completely under his control.  The belief is that this body will be mostly for civil order, suggesting Putin is becoming worried about rising protests against his regime as the economy stumbles.

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[1] It should be noted that other central banks do have a forex mandate.  The ECB is given the task of currency stability (although to date that hasn’t been defined), and the Hong Kong monetary authority’s only real job is to maintain the USD/HKD peg.