by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] There wasn’t too much news over the weekend.  Perhaps the most interesting news came from the NYT, which carried a report that establishment Republicans are considering a third-party candidate if Donald Trump wins the nomination.  Although such actions are not seen often in the U.S., they are quite common in Europe.  In fact, this is how the European establishment has kept the populist parties from gaining power in the major Western European nations.  For example, in recent regional elections in France, the National Front did very well in the first round of elections.  In response, the Socialists, who represent the center-left establishment, pulled their candidates for the second round of voting, ensuring the center-right conservatives would carry the election.  Essentially, the establishment, which includes the center-left and center-right, will engage in a form of political suicide to ensure that a populist party fails to gain control.  By running a third-party conservative candidate, the GOP coalition would be split and guarantee that the presumptive Democratic Party nominee, Sen. Clinton, will be the next president.  Of course, this assumes that Sen. Sanders doesn’t make the same play by running as an extra-party candidate himself.  The fact that the GOP establishment is willing to consider a third-party candidate confirms our position that the establishment prefers a leader from the opposite party rather than a populist.

Meanwhile, in the U.K., PM Cameron’s position is becoming increasingly difficult.  Over the weekend, Pension Minister Iain Duncan Smith resigned after the Tory budget included cuts to the disabled.  Cameron is trying to prevent the U.K. from leaving the EU and budget turmoil is the last thing he needs; this will undermine the popularity of his administration and give Brexit supporters a chance to build support for their position.  As a side note, recent polls show that Labour leader Jeremy Corbyn is now as popular as the prime minister, suggesting that if Cameron faces a no-confidence vote, the British equivalent of Bernie Sanders will be running the country.[1]

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[1] See WGR, 9/21/2015, Meet Jeremy Corbyn.

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] As noted below, we have a large number of Fed speakers today.  Perhaps we will get further insight into the FOMC’s thinking on policy.  It is becoming increasingly evident that the Taylor Rule models, which incorporate the Phillips Curve, are either out or being temporarily superseded.  As we noted yesterday, the steady decline in inflation expectations is likely playing a role in tightening delays.  However, the forex situation may be even more important.  Bloomberg[1] is reporting today on speculation that the G-20 has engineered a dollar decline.  We find this discussion incredulous.  If the major central banks were trying to weaken the dollar, why would several European banks, including the ECB, ease policy?  Yes, the BOJ didn’t take any steps to ease further, but PM Abe appears to be increasing pressure on the BOJ to lower rates more.  Instead, we think the WSJ has it right.[2]  It has an article today with the headline, “Global Currencies Soar, Defying Central Bankers.”

We are starting to think that this is more like a quiet currency war.

The chart above shows the JPM real effective dollar index, which adjusts for trade flows and inflation.  We are in the third major bull market in the dollar; as the chart below shows, it began in mid-2014.

Note last month’s decline.  We can assume further weakness this month, too (although we won’t know for sure until all the inflation data is recorded).  In terms of policy, the dollar’s strength acted as a form of tightening.  However, for the FOMC, this is a rather difficult problem because the Fed does not have the mandate for managing the currency; that mandate rests with the Treasury.  Nevertheless, these constant comments about “global risks” may simply be a thinly veiled signal that the Fed won’t raise rates until the dollar weakens.

This scenario pits central bank leaders against each other, much like what history recorded during the Great Depression.  When there is a dearth of global aggregate demand, capturing that demand becomes a zero sum game.  The transmission mechanism for capturing that demand is the exchange rate.

The chart above shows the ratio of U.S. to Eurozone industrial production and the JPM dollar index.  Note that when the dollar was weak, U.S. production outpaced Europe.  However, the relative performance reversed shortly after the dollar began to appreciate.  This occurred despite the fact that the Eurozone has been hit with numerous crises that have tended to dampen the region’s economic performance.

If the Fed is shifting to a de facto exchange rate policy, it means that our historical models won’t be all that informative as long as that policy is in place.  The other key to watch is the reaction of the other central banks.  If they hold policy steady, the aforementioned Bloomberg report may be correct.  In other words, G-20 monetary authorities are working in concert to boost the dollar.  We don’t believe it.  We think the BOJ and ECB, along with the remaining independent European central banks, will “do whatever it takes” to weaken their exchange rates.  We will have more on this topic in the coming weeks.

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[1] http://www.bloomberg.com/news/articles/2016-03-17/shades-of-plaza-accord-seen-in-barrage-of-stimulus-after-g-20

[2] http://www.wsj.com/articles/global-currencies-soar-defying-central-bankers-1458258134 (paywall)

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Before we dive into the Fed and oil prices this morning, there are a couple of geopolitical items worth noting.  First, Brazil is facing massive civil unrest this morning after wiretaps revealed that President Rousseff offered to appoint former President Luiz Inacio Lula de Silva as Chief of Staff in a bid to avoid his prosecution.  A minister is immune from prosecution.  Second, there was an outbreak of violence on the Sinai Peninsula today as insurgents attacked an Egyptian military base in Rafah and there were reports of other smaller attacks as well.  Egypt faces numerous insurgent groups in Sinai, including IS.

The FOMC came out with a dovish report.  As expected, the Fed left rates unchanged and KC FRB President George dissented from the decision.  From there, however, the FOMC changed its stance on policy as shown by the dovish dots chart projections.

(Source: Federal Reserve)

The bulk of the votes are around 0.875% for this year.  One voter is actually at 0.625%, putting only one hike on the agenda.  The average is 1.02%, meaning that two tightening moves are forecast.

This chart shows the progression of the dots average compared to the market’s projection for policy, derived from the Eurodollar futures market.  The progression shows that the FOMC is steadily reducing its expectations for the terminal rate.  In fact, the average dot for this meeting is dead on expectations of the Eurodollar futures market, meaning the FOMC has moved its forecast year-end rate to what has already been discounted by the financial markets.  The Fed is still looking to move rates higher in the more distant years but, as the dots progression shows, it is highly likely that these expectations will probably fall as well…at least, that’s been the trend over the past several years.

We were surprised by the dovish stance of the Fed.  As we noted yesterday, inflation is clearly picking up and any Phillips Curve-based model suggests that monetary policy is getting behind the curve.  As we discussed yesterday, we were worried that Yellen would “tee up” a tightening for June.  Not only did that not happen, but the Fed actually uncorked a dovish statement. What led to this decision?  We believe it is one of three factors:

The FOMC has decided the Phillips Curve is no longer relevant.  This has been the position of Governor Brainard and Chicago FRB President Evans.  Although this is possible, recent comments from Vice Chairman Fischer suggest that he has not been swayed by this argument.

The FOMC still believes in the Phillips Curve, but is worried about inflation expectations.  Expectations have been falling for some time, and lifting the policy rate into declining inflation expectations means that policy is being tightened even more than simply an increase in rates.

This chart shows the five-year forward implied inflation rate using the Treasury TIPS.  From 2003 through 2014, the average expected inflation rate was 2.42%.  Over the past two years, it has declined to an average of 1.94% and, as the chart shows, it is falling rapidly.  One implied goal of Fed policy is to “anchor” inflation expectations.  In the 1970s, as expectations ratcheted higher, it became harder to control inflation because the very act of expecting higher inflation induced behaviors that exacerbated it.  Thus, consumers would buy today fearing prices would be higher tomorrow, and businesses held more inventory because it rose in value with inflation and inventory accumulation acted to boost demand.  The Fed’s worry is that in an environment of falling expectations, you get the opposite behavior.  Households delay purchases because prices are not expected to rise appreciably or, perhaps, may even decline.  Businesses do everything they can to not hold stockpiles.  It appears that the FOMC will be reluctant to lift rates as long as inflation expectations are weakening.

The FOMC is reacting to foreign developments, especially actions recently taken over the past few weeks by the ECB and BOJ to engage in additional stimulus.  We were most struck by the market reaction in the dollar and gold, with the former plunging and the latter rising sharply.  Although there isn’t much history of the FOMC paying close attention to the dollar and international events except in extreme cases, it is starting to look like the Fed is viewing the behavior of foreign central banks as a form of easing.  Of course, that only occurs if the dollar strengthens, which it didn’t do yesterday.

There are some commentators arguing that some sort of deal to support the dollar came out of the last G-20 meeting.  We strongly doubt this was the case.  Instead, we believe both the BOJ and ECB eased policy with the aim of weakening their currencies.  The lack of reactions in the JPY and EUR and failures to weaken after they eased, and the reaction to the Fed, suggests to us that something more like a “currency war” is underway.  Negative interest rate policy’s (NIRP) primary stimulative effect comes from a weaker currency.  If the dollar continues to depreciate, it will be interesting to see how the BOJ and ECB will react.  If our narrative is correct, we can expect to see further aggressive easing by these central banks.

We note the Fed didn’t offer a “balance of risks” assessment, which avoided exposing the divisions on the committee.  Thus, we expect that the second and third points are probably the keys.  Inflation expectations are a concern.  Although labor markets are clearly improving, the lack of wage growth suggests something isn’t working right.  The annual wage-setting season in Japan has been very disappointing for PM Abe in that wage increases are almost non-existent and NIRP is being blamed for the lack of labor bargaining power.  There is probably some legitimate fear among the committee members that perhaps the lack of inflation expectations (see above) is bleeding into the wage-setting process in the U.S.  Foreign developments could be weighing on the committee as well.  The expected divergence in policy led to a much stronger dollar that clearly dampened Q4 economic growth.  By not raising rates and by lowering the trajectory of tightening, the retreat of the dollar is good news for the U.S. economy.  However, as we discussed above, the negative reaction of developed market equities to the Fed’s decision shows how sensitive these markets have become to currency values.

So, the big winners from yesterday are commodities, emerging markets, foreign currencies, domestic equities and U.S. fixed income.  Losers look like the dollar and developed market equities.

This discussion takes us to the oil market.  Oil prices jumped yesterday, in part due to a lower than expected build in crude oil inventories but also due to the aforementioned dovish Fed statement.

Inventories remain historically high.  Assuming the usual seasonal pattern continues, we should end up with stockpiles of around 555 mb by the end of next month.

As this chart shows, we have about another six weeks before inventories peak.  Based on current oil inventories and the euro, fair value for crude oil is $36.70 per barrel.  Thus, current prices are a bit overvalued.  Assuming we continue to see normal seasonal builds, fair value by the end of April will be $31.02.  To justify current oil prices with the expected peak in stockpiles, the euro will need to strengthen to $1.155, which isn’t out of the question in light of the Fed’s behavior.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] It’s FOMC Day!  Although no change in rates is expected, we will be paying close attention to the data forecasts and the dots chart forecast of future policy rates.  As we note in the Mankiw model discussion below, unless one has concluded that the Phillips Curve is completely irrelevant, the Fed is getting behind the curve and current expectations of steady policy are becoming very difficult to justify.  There are two key issues to watch for today:

1. Will Yellen lay the groundwork for a rate hike in June?

2. How many policy dissenters will emerge today?

On question #1, we think the inflation data will give a hawkish tone to the press conference and maybe even the data.  On the second question, a single dissenter (KC FRB President George) would, interestingly enough, be a good sign as it would suggest she didn’t come away from the discussion believing the Fed will certainly lift rates in April or June.  If there are no dissents, it probably means that a rate hike is being teed up and George was satisfied to wait in anticipation that rates will rise soon enough.

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, 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 3.97%, suggesting the FOMC is well behind the curve.  Using the employment/population ratio, the neutral rate is 1.54%, 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 3.07%.  The rise in the core CPI rate to 2.30% and the improving labor market are lifting all the variations’ target rates and support policy tightening.   Although we don’t expect the FOMC to move today, the rise in core CPI will raise concerns among the hawks on the board that the central bank needs to adjust rates higher.

The inflation data is leading to a rebound in short-term interest rates, which is flattening the yield curve.  We note the implied three-month LIBOR rate, two-years deferred, has jumped recently, rising back into the earlier range of interest rates.

This rate, which had declined to 86 bps in February, is up just under 60 bps in five weeks.  Simply put, fears of tightening monetary policy, which had recently evaporated, are starting to return.  If this continues, a stronger dollar is likely along with weaker commodity prices and overall equities.

The National People’s Congress meetings ended today in China.  The key points are that the Xi government is planning to expand fiscal stimulation and it will be “front loaded,” meaning that most of the spending will occur in the short run.  Monetary policy will also remain accommodative.  Officials downplayed the need for CNY devaluation and seemed unconcerned about capital flight.  The bottom line is that this news is bullish for emerging market stocks and commodities in the short run, but this policy mix will most likely lead to an increase in debt in the long run.  We think China has the capacity to expand its debt load for now, but we expect the bad debt problem to increase over time and become a much bigger problem in a few years.  So, good news now, bad news later.

Oil prices are higher this morning, supported by a smaller than expected build in the API data.  We get the official data at 10:30 EDT today.  In general, the API data tends to be less reliable than the government report, so until we see the DOE data confirm the lower than expected build, the price recovery from this morning could be at risk.  However, we note that OPEC producers, along with Russia, will meet next month in a bid to freeze output and support prices.  The group has set April 17 as its meeting date.  This news may offer price support as the seasonal build season concludes later next month.  We have our doubts that Iran will agree to a production freeze and it isn’t clear whether this step will be enough to rebalance markets.  Nevertheless, we expect that the recent lows will hold and that we are likely creating a price range that should hold for the foreseeable future.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Overnight, the BOJ did as expected, leaving policy unchanged.  Governor Kuroda’s outlook for the economy was rather bleak, suggesting that there may be more policy measures coming.  Unfortunately, there is growing doubt over the efficacy of further policy easing.  The reaction to negative rates hasn’t been good; the JPY continues to appreciate.  It also isn’t clear if additional QE will really matter.  The vote to keep policy unchanged was 7-2 to maintain negative rates and 8-1 for QE.

In a bid to dampen currency speculation, China announced it is considering a transaction tax on foreign exchange.  Dubbed a “Tobin tax” after Nobel Laureate James Tobin suggested it in 1972, it is designed to increase the cost of short-term trading in the currency markets.  Sweden taxed equity and bond trading in the mid-1980s and it did act as a short-term bearish factor.  Britain had a Stamp Tax on financial transactions starting in 1808.  Changing the rate had the expected impact—higher rates lowered volume and cuts increased it.  Although their use isn’t widespread, we would not be shocked to see China implement such measures.  However, if the country’s goal is to make the CNY a global reserve currency, a tax will tend to undermine that aim.

In what has been a historic primary season, voters in Ohio, Florida, Illinois, Missouri and North Carolina go to the polls today.  Predictit, the betting site, has Trump winning Florida (92 cents to win $1), Illinois (67 cents/$1), North Carolina (87 cents/$1) and Missouri (53 cents/$1).  Kasich looks to win Ohio (74 cents/$1).  On the Democratic Party side, Clinton is expected to win Ohio (64 cents/$1), Illinois (53 cents/$1) and Florida (94 cents/$1), while Sanders is expected to win Missouri (69 cents/$1).  Ohio will be key; if Kasich wins, the likelihood of a contested convention will increase.

Tomorrow, the FOMC announces its decision.  As we noted yesterday, we get a press conference, new economic forecasts and new rate expectations tomorrow.  Our expectation is that the dots chart will show a slower pace of tightening compared to December but will still be higher than market expectations for 2017-18.  We would expect one dissent for tightening (KC FRB President George).

Russian President Putin surprised the world by announcing he will begin withdrawing troops and aircraft from Syria.  This issue deserves wider treatment than we can offer here, so we will discuss it in next week’s WGR.  Our initial reaction is that Putin, like so many before him, has discovered the leadership of Syria is difficult to manage and, driven by frustration, has decided to move on.  We believe Putin wanted Assad to step down to stabilize the region.  Assad refused and so Putin has decided to let him face IS without Russian support.  There are likely more twists and turns to this story, which we will examine in next week’s report.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Markets are trending higher leading into a busy week.  Here are a few highlights as most of the U.S. shifts to the dreaded Daylight Savings Time:

Three central banks meet this week: The FOMC meets this week.  This meeting is one of the four that includes a press conference and an updated dots chart.  No change in policy is expected, although the recent lift in equities and the weaker dollar have started to shift the market narrative back to tightening.  We expect the following from the meeting, which will conclude tomorrow:

1. No change in rates.

2. One dissent, coming from KC FRB President George.

3. A downward revision in the dots chart but rates still higher than market expectations.

4. A narrative that is reasonably upbeat on the economy.

The BOJ and BOE also meet this week.  The former is not expected to make any changes in policy despite the disappointing reaction after the bank introduced its negative interest rate policy (NIRP).  It appears that some dissention between the Abe government and the BOJ is brewing.  The government wants the central bank to be more aggressive while the BOJ seems worried that NIRP could backfire and policymakers appear somewhat stumped on what to do next.  Meanwhile, the BOE isn’t expected to do anything as Britain is in the throes of Brexit, which might require the BOE to aggressively support the economy if the U.K. leaves the EU.

Egypt devalues: Although the move wasn’t a huge surprise, it will lift inflation in Egypt and could add instability to an already volatile region.

(Source: Bloomberg)

This chart shows the EGP (Egyptian pound) per dollar.  We have inverted the scale such that a decline in the chart (a higher number) actually indicates a weaker EGP.  This is a big drop and may trigger other nations in the region to consider devaluations of their own.  At the same time, the move was well anticipated.  The black market rate is reportedly around 9.6 so we cannot rule out another devaluation.

China’s economy and financial markets: Although the headline data was disappointing (see below), the actual numbers are probably a bit better than the reports would suggest.  Industrial production came in weaker than expected; however, the entire drop in growth was due to a slide in tobacco output, which may be due to adverse weather.  Electricity production rose, which is a good proxy for economic growth.  Meanwhile, the new head of financial market supervision hinted at equity market support.  As we noted last week, China may create a loan/equity swap facility that would allow banks to swap deteriorating debt for equity.  This is potentially a good move depending on how the deals are priced.  Overall, a better Chinese economy would be bullish for emerging markets and commodities.

Politics: There are crucial primaries in the U.S. tomorrow.  Donald Trump is currently expected to win Illinois, Florida and Missouri, but lose to Kasich in Ohio, based on betting data from Predictit.  If this is the outcome, it will most likely mean that Trump will have the largest number of delegates at the Cleveland convention but not a majority.  Then, we will see if the GOP establishment can maintain control over the political system or not.  Over the weekend, violence erupted at Trump rallies and there is concern that this could spread to other candidates as well.  Meanwhile, in Germany, Chancellor Merkel’s coalition lost two out of three state elections yesterday.  Most concerning, the Alternative for Germany (AfD) made gains in all three states, building its base as a leading opposition party.  The AfD is a right-wing, anti-immigration party and has been making gains due to the refugee turmoil.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EST] After yesterday’s wild ride, risk-on has returned this morning.  Equities and the dollar are higher, while Treasuries and gold are lower.  Yesterday, the ECB far exceeded expectations with its stimulus package.  All was going according to plan after the announcement—the dollar rose, equities were higher—and then ECB President Draghi took the air out of the room by offering forward guidance that suggested yesterday’s move would be the last of the stimulus.  Within minutes, the favorable trends reversed.  However, this morning, we are seeing a return to positive sentiment.  We suspect Draghi really meant to infer that he believes the plan unveiled yesterday will be enough to reach the bank’s inflation target and additional stimulus won’t be necessary.  However, Draghi has shown he will continue to do “whatever it takes” and we suspect that he will do more if inflation fails to rise.

We are watching the USD against the JPY and EUR.  Given the drop into negative rates, one would have expected further weakness in the latter two, but so far both have held up rather well.  Although the emerging market currencies may have further to decline, we may have seen the bottom on the EUR and JPY.  If so, further stimulus from the BOJ and ECB will likely fail to generate an uptick in growth.

There were a couple of news items of note out of China.  First, February bank loans came in weaker than forecast, at CNY 727 billion, well below the CNY 1.2 trillion forecast.  Given that January loans were CNY 2.5 trillion, some pullback was expected, but the drop was larger than forecast.  With the recent cut in reserve requirements, we would expect loan growth to remain elevated.  The second item is that financial authorities are considering a policy to allow banks to swap deteriorating loans for equity.  There has been no official confirmation of the report and few details (a trial balloon, most likely).  However, media reports suggest that state-owned enterprises (SOEs) in overbuilt industries would be the likely targets.  On its face, this won’t do much.  Banks have to assign a 100% risk/capital weighting to loans, which rises to 250% once a loan begins to deteriorate.  Publicly traded equities require a weighting of 290% and unlisted equities require 370%.  The only way this makes sense is if the banks take the equity and then are allowed to sell it to new buyers (likely at a much lower price).  This may be a way for the government to shift ownership of these firms to the public, but it would also require giving up control of these entities.  We expect to see some hopeful comments in the media supporting the swap, but most likely it won’t be a big deal.

Oil prices are lifting this morning on reports from the IEA that suggest oil prices may have bottomed.  The OECD group says that falling output from both OPEC and non-OPEC producers will lead to lower supplies.  However, the IEA does not expect much relief on inventories, meaning that prices may have bottomed but a big rally might not be on tap.  We note that meetings with Russia and OPEC leaders to freeze output have not been held; in fact, they cannot agree on a place or time.  Additionally, Iran has indicated it won’t freeze production until it regains its lost market share.  We doubt OPEC will make any significant reductions in output until the Saudis decide they want to boost prices.  Although the Saudis’ financial position is deteriorating, they still have the wherewithal to deal with weaker oil prices compared to their competitors.

Yesterday, the Fed released its Financial Accounts for the United States for Q4.  Formerly known as the “Flow of Funds” report, it offers deep insight into U.S. financial conditions for government, businesses and households.  Here are a few highlights:

Deleveraging has pretty much stopped.  Household debt is now 101.14% of after-tax income, up modestly from 101.09% in Q3.  Households are not adding debt much faster than income, but it does appear that debt reduction is clearly ending.  In the near term, this is bullish for the economy as rising consumption is key to stronger growth.

As this chart shows, debt growth is rising modestly but remains well below historical growth levels.  The lack of deleveraging is due, in part, to sluggish income growth.

Homeowners equity in real estate creeped higher, to 56.9%in Q4 from 56.3% in Q3.   We believe that when this percentage reaches 60%, homeowners will feel that they are back to a comfortable level of equity and spending will likely rise.

Finally, net saving by sector continues to slowly move in a favorable direction.  Businesses continue to dissave, which is good for the economy.  Business saving has two detrimental effects.  First, if businesses are net savers, they are not investing their excess which usually means the economy is soft.  Second, a business sector with excess saving can invest without using the financial markets to vet the investment decision.  Thus, in a healthy economy, the business sector should be a net borrower most of the time.  Household saving rose modestly by 5 bps, government reduced its dissaving by 86 bps and the foreign sector (the mirror image of the current account deficit) reduced its saving by 7 bps.

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