by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EST] SUPER MARIO RETURNS!  ECB President Draghi, unlike in December, didn’t disappoint.  The central bank announced the following:

(1) The interest rate on the main refinancing operations of the Eurosystem will be decreased by 5 basis points to 0.00%, starting once the operation is settled on 16 March 2016.

(2) The interest rate on the marginal lending facility will be decreased by 5 basis points to 0.25%, effective 16 March 2016.

(3) The interest rate on the deposit facility will be decreased by 10 basis points to -0.40%, effective 16 March 2016.

(4) The monthly purchases under the asset purchase program (QE) will be expanded to €80 billion from €60 bn, starting in April.

(5) Investment grade euro-denominated bonds issued by non-bank corporations established in the euro area will be included in the list of assets that are eligible for regular purchases.  In other words, corporate bonds will now be eligible for the central bank’s asset purchase program.

(6) A new series of four targeted longer term refinancing operations (TLTRO II), each with a maturity of four years, will be launched starting in June 2016. Borrowing conditions in these operations can be as low as the interest rate on the deposit facility.  It appears that this is how banks will be supported in the face of negative interest rate policy (NIRP).  Banks will be effectively paid to lend money because the deposit rate is negative.  So, when a bank participates in the TLTRO, it borrows at -40 bps; obviously, if it just holds the cash, it earns a positive carry.  In the press conference, Draghi suggested that further cuts are not likely and noted that he doesn’t think NIRP can be extended without limit.  These comments dampen the impact of the announced policy measures by weakening the stimulative effect of the forward guidance part of policy. 

Draghi faced the problem of expectations going into this meeting.  After disappointing the market in December, there was great pressure on the ECB to positively surprise the market.  At least initially, market expectations were clearly exceeded and market reactions were consistent with these unexpected actions.  Equities and related futures rose sharply.  The dollar lifted across the board.  Commodity prices eased in the face of a stronger dollar.  The U.S. Treasury curve is flattening due to expectations that the Fed is probably leaning the other way (more on this below).  European bonds rallied, especially corporates.  European credit default swaps are narrowing as well.  However, the comments suggesting that today’s move is the last and that NIRP cannot be extended without limit have led to partial reversals in the initial market reactions.  In other words, in terms of forward guidance, the ECB is suggesting that there isn’t more to come, which dampens the market impact of the announcement.

Today’s WSJ “Heard on the Street” column introduces the notion of the “Yellen call” as a foil to the concept of the “Greenspan put.”  The analogy doesn’t really work but the idea is that as the financial markets stabilize, the Fed will probably lean toward tightening policy again.  Essentially, the Fed is acting as a cap on equity prices, using stability in the financial markets to move toward its preferred policy action, which is to lift rates.

Yesterday, the DOE released its weekly inventory data.  Oil prices have continued to rise, although inventory levels are very elevated.

Current stockpiles are 521.9 mb, the highest since August 1930.  The seasonal build in inventories is on track to reach around 560 mb by late April.

The crude oil inventory build season tends to run from early January into late April.  On this chart, we have indexed the five-year average for crude oil against the current year.  As the chart indicates, this rebuild season is closely tracking average; if that trend continues, commercial crude stocks will be near 560 mb by spring.

So, with this inventory overhang, why are prices so strong?  There are probably two explanations.  First, the market is beginning to look past the end of the rebuild season to the spring and summer driving season.  Thus, traders holding short positions are covering before the rebuild season ends.  Second, oil prices have become undervalued and have recovered to fair value.

This model uses oil stockpiles and the EUR exchange rate.  It is a monthly model that uses the average WTI price and the month-end inventory level.  The fair value level for March, so far, is near $36 per barrel.  On a nearby basis, we have moved above that level after being well below it a couple of weeks ago.  Current prices are no longer cheap and further rallies may become difficult to sustain in the short run.  However, we are becoming friendlier to oil after mid-year due to falling U.S. output, improving demand and a growing need for OPEC to boost prices (see below).

Some other news items of note:

• Chinese CPI came in stronger than expected, up +2.3% year-over-year in February. Although inflation does remain below the PBOC’s 3% target, China has a long, unpleasant history with high inflation and so, when it rises quickly, it does get the attention of the CPC’s leadership.  Food prices were up 7.3% from last year, which is a major concern because higher food prices affect a large number of people and could cause civil unrest.  However, it is important to remember that seasonal factors affected the data as the New Year holiday fell in February.  Thus, the inflation rate may ease in the coming months.
• The Reserve Bank of New Zealand (RBNZ) surprised the markets by cutting its policy rate by 25 bps to 2.25%. The RBNZ cited weaker global growth as the reason for the rate cut.
• The WSJ reports that Saudi Arabia is looking to borrow up to $8 bn from international banks and may issue foreign bonds in an attempt to plug its widening fiscal deficit due to rising spending from wars and weak oil prices. There are also reports suggesting the kingdom is moving forward on a partial IPO of Saudi Aramco.  All this suggests that Riyadh’s finances are deteriorating, which increases the odds that some action to support oil prices may become attractive in the coming months.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EST] It was a mostly quiet night in front of the ECB decision tomorrow.  Market expectations are optimistic that Draghi will come through with some sort of stimulus.  If the EUR fails to weaken after tomorrow’s meeting, it may signal that the ECB is mostly out of policy tools to address the lack of Eurozone inflation.  We look for a deeper dive into negative territory for policy rates, and either a lengthening of QE or a boost to the levels of buying, or both.

Meanwhile, in Japan, reports suggest that the BOJ will likely hold policy steady next week when it meets.  Its surprise move to take rates into negative territory has not had the desired impact; the JPY has continued to strengthen and the FT reports that trade unions in Japan’s financial sector are giving up demands for higher wages this year.  According to the report, the adverse impact of negative rates on banks has led the unions to abandon any efforts to boost wages on the assumption that banks won’t be able to afford a wage hike.  Negative policy rates continue to be a controversial issue.  Japan’s experience thus far has been mostly disappointing.

On the topic of central banks, the WSJ’s Jon Hilsenrath has a column today discussing next week’s FOMC meeting.  Although it is widely assumed that there will be no policy action taken, Yellen will probably try to signal that a potential hike is on the table for April or June.  Since there is little chance that they will move at a meeting without a press conference, June is the most likely time to take rates higher.  Probably the closest watched factor will be the dots chart.  In looking at the voting roster, based on recent comments, we would expect steady policy at next week’s meeting with one likely dissenter (KC FRB President George) and an outside chance of another (Cleveland FRB President Mester).  We expect all the governors to vote for steady policy.  Two dissents would probably not be taken well by the markets as it increases the odds of further rate hikes; one dissent will likely be ignored.

Finally, in Yemen, there is some movement on the war front.  Reuters is reporting that the Saudis and Houthis, the primary combatants in the Yemen conflict, have begun talks to end the war.  A delegation representing the Houthis has traveled to neighboring Saudi Arabia to begin discussions.  Iran, who backs the Houthis, has made a veiled offer to send military advisors to the group, which will raise concerns in Riyadh.  If a peace deal can be reached it will reduce tensions in the region and reduce some of Saudi Arabia’s expenses.  We would expect Iran to try to undermine the talks to keep the conflict alive.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EST] Global equity markets are taking a breather today after an impressive rally.  Commodity prices have been rallying as well.  As noted below, China’s trade data came in a bit sloppy, with exports down 25.4% from last year.  However, all Chinese data is difficult to read in the first two months of the year due to variations in when the Chinese New Year holiday begins.  For example, last year the holiday came late and firms tended to increase exports before the holiday, making this year’s comparison difficult.  If this is the reason, March exports should show a strong yearly rebound.  Imports were down 13.8% from last year.  Commodity import volumes did show some improvement, which likely reflects the Chinese position that raw material prices are attractive.  That sentiment partly accounts for the recent rebound in commodity prices.

As we warned yesterday, the Fed hawks are surfacing.  Vice Chairman Fischer suggested the U.S. is starting to see the “first stirrings” of inflation.  He also made a spirited defense of the Phillips Curve, suggesting that it isn’t dead, just flat.  In other words, the relationship between inflation and employment still stands but has become less sensitive over time.

The following is another interesting labor market chart.

This chart shows the ratio of workers who used to be outside the labor force but are now employed divided by the sum of these same workers plus workers who were already in the labor force and are now employed.  When the ratio rises, more workers are being employed from outside the labor force.  To be in the labor force, one must either be working or looking for work; the latter are the officially “unemployed.”  Once someone stops working and looking for work, they officially leave the labor force.  The above data shows an unusually high degree of workers who were not in the labor force entering employment.  In the past, when this ratio hit about 0.68, wage growth was averaging about 4% per year.  So far, despite these flows from discouraged workers to employment, wage growth has remained soft.  In other words, firms have been able to draw workers from the pool of discouraged workers without lifting wages.  There is a plethora of explanations why wage growth has been sluggish.  In fact, the San Francisco FRB recently published a study[1] suggesting that retiring baby boomers may be to blame.  As older workers retire, presumably at near-peak wage levels, they are replaced with new workers making less money.  The paper argues that the sluggishness of wage growth may not be due to slack but due to a generational shift, and so the labor market is actually rather tight.  Although we suspect there are other explanations as well, this one does solve a couple of mysteries.  First, if depressed wage growth is due to this generational shift, it would also explain why productivity is so weak.  The newer workers are less trained than the retiring baby boomers they are replacing, thus dragging down productivity.  Second, it would explain Fischer’s “flat” Phillips Curve theory in that wage growth is weak because this generational shift is to blame.

Overall, the FOMC is navigating an environment of rather difficult structural divergences.  For the most part, the committee does seem aware of how treacherous it is and so we expect the Fed to maintain a bias toward tightening but move very cautiously in an attempt to avoid a policy mistake.

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[1] http://www.frbsf.org/economic-research/publications/economic-letter/2016/march/slow-wage-growth-and-the-labor-market/?utm_source=frbsf-home-economic-letter-title&utm_medium=frbsf&utm_campaign=economic-letter

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EST] There are two issues we want to discuss this morning, China and monetary policy as it relates to Friday’s employment report.

China: The National People’s Congress meetings began on Saturday and a clear signal is being sent—restructuring is being put on the back burner and the country is going for growth.  The GDP target is being set at a range of 6.5% to 7.0%, which is overstating growth (most analysts put Chinese growth around 4.5%), but suggests that the Xi government continues to believe that its legitimacy (and the CPC’s) rests on delivering strong growth.  Both fiscal and monetary levers are being deployed, with a bigger focus on the former.  The official deficit is forecast to rise to 3.0% of GDP from 2.3%; including off-balance sheet items, the actual deficit will likely rise to 4.5% from 3.9%.  Tax cuts and deductions are being adjusted to support household consumption.  Monetary policy will remain accommodative.  Overall, it appears that China is using policy to boost growth.  Ultimately, this will almost certainly mean higher levels of debt accumulation.  This isn’t a long-term solution and it suggests that Chairman Xi doesn’t feel comfortable enough to lower growth to sustainable levels to curb debt expansion and shift the economy toward consumption and away from investment and exports.

China’s focus on growth may be placing a floor under commodity prices.  Although the broad indices are not showing a major recovery, the CRB commodity index data suggests that prices are trying to bottom.

(Source: Bloomberg)

Over the past month, there has been a rebound in commodity prices.  It’s hard to make a case for returning to mid-2014 levels, which would likely take an OPEC agreement and a doubling of oil prices.  However, if China is going to boost growth, investors may be willing to shift funds to commodities which, as the chart above shows, have been hit hard over the past 18 months.

China’s foreign reserves fell further, to $3.202 trillion, a bit better than expected.  Forecasts were calling for $3.19 trillion.  Net capital outflows (gross outflows net of the trade surplus and currency adjustments) were probably around $65 bn in February.

(Source: Bloomberg)

Since peaking in mid-2014, reserves are down 19.8%.  The BIS reports that most of the outflows appear to be Chinese firms paying back dollar loans.  If so, that is much less of a problem than capital flight.  However, the real estate markets in British Columbia, California, New York and Australia do suggest that there is some degree of capital fight.

The bottom line is that if China is determined to grow by further debt expansion, it could be bullish in the short run for global growth, commodity prices and emerging markets.  We don’t think that this is a long-term solution.  Eventually, China will run out of debt capacity, but that probably isn’t an immediate concern and so we may see some growth acceleration as the year continues.

Employment: Friday’s employment data was unusually strong as the labor force is showing signs of expanding.

Note how the gap between the employment/population ratio and the unemployment rate has narrowed.  This trend suggests that formerly discouraged workers may be finding an attractive enough labor market to rejoin the workforce.

That improvement will likely spur the FOMC to return to tightening.  Using the employment data and assuming that February core CPI will be in line with January, we can make a tentative update to 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 3.76%, suggesting the FOMC is well behind the curve.  Using the employment/population ratio, the neutral rate is 1.35%, indicating that, even using the most dovish variation, the FOMC needs a rate hike of nearly 100 bps to achieve neutral policy.  Finally, using involuntary part-time employment, the neutral rate is 2.47%.  The lift in the employment/population ratio suggests the economy is heating up and that the Fed could move rates higher.  Although wage growth was modest, that may be a quirk in the calculation.  The reporting period fell before the 15th of February, which tends to underestimate growth; thus, don’t be shocked by a reading of 2.6% or a bit higher in March.

If Fed tightening talk begins to surface, we would expect the dollar to rise and risk assets to suffer.  That won’t be a problem for the March meeting, but could become an issue later this spring.  Currently, the financial markets are not prepared for a hike; fed funds futures estimate only a 44% likelihood of an increase at the June meeting and that is probably too low given the employment data.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EST] BREAKING NEWS: Former Brazilian President Lula has been detained for questioning in an investigation of corruption. So far, he has not been arrested. Interestingly enough, it’s “risk on” with Brazilian assets, the BRL is advancing and Brazilian equities are rallying. This reaction may be due to relief that the probe could be coming to an end, or the news may have led to massive short covering. If Brazilian risk assets hold their gains in the coming days, it would suggest that the worst may be over for Brazil.

Due to our coverage of the employment data, we will keep our opening comments short. There wasn’t a lot of other news overnight. Chinese officials are gathering to set economic policy for the next five years. We expect a modestly lower forecast for GDP and officials are signaling a slowdown in defense spending. We do note the government intervened in equity markets today before the meeting officially starts tomorrow.

Although BOJ head Kuroda indicated that the Japanese central bank is not planning additional dips into negative rate territory, PM Abe has bolstered the case for further monetary stimulus by replacing Sayuri Sharai, a member of the BOJ policy board whose term ends this month, with Makoto Sakurai, described as “an obscure 70-year-old economist.” Ms. Sharai voted against last month’s surprise stimulus whereas Mr. Sakurai has a reputation for being dovish. Essentially, Abe is packing the BOJ with doves and sending a clear signal that the government wants the BOJ to do more. Abe has picked three doves with his selections and assuming Deputy Governor Hiroshi Nakaso continues to vote in line with Governor Kuroda, the head of the BOJ can act with virtual impunity to implement any policy he chooses. Probably the only restraint on policy is Kuroda himself. We look for the BOJ to lean against the recent strength of the JPY, but we have doubts it will have much success in stemming the rally.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EST] U.S. commercial crude oil inventories jumped 10.4 mb for the week ending 2/26, well above forecast.  Current stockpiles remain at 80+ year highs.  We are only 21 mb below the all-time high and there is a very good chance we will make a new high in the coming weeks.

The below chart shows the current build compared to the five-year average on an indexed basis.  As the chart indicates, the current build is running close to normal.  If we continue to track the average, we will see stockpiles peak at 555.8 mb, a new high.

Oil prices rose yesterday despite the massive inventory overhang.  This is probably because current prices are below where the combination of the dollar and inventories suggest they should be.

Our oil price model, which uses commercial crude oil inventories and the EUR exchange rate, puts fair value at $38.53.  Thus, the market is a bit cheap here.  Assuming we do reach the expected seasonal peak, fair value would be $31.62, so we are not necessarily out of the woods yet on oil.  If the European Central Bank presses the EUR lower at next week’s meeting, oil could come under further pressure.

Market action is clearly supportive; rallying in the face of such bearish data is at least a short-term signal that oil has bottomed.  Nevertheless, we still have to make it through the rest of the injection season.  The good news is that we probably have seen the lows in oil.

The relationship between oil and U.S. equities has been rather tight.  Looking at the relationship since the last OPEC meeting, the two series are correlated at the 93.9% level.

Although one cannot necessarily derive causality from correlation, market behavior seems to suggest that oil prices drive equity values.  The relationship is currently quite strong; the regression suggests that every dollar change in oil prices leads to a change in the S&P 500 of 18.75 points.  Thus, if we get to our current fair value price, the S&P 500 would be 2,057, assuming the above relationship holds.  Of course, as noted above, we still have eight weeks of storage accumulation in front of us, which will likely pressure oil prices.  The fact that we are currently below fair value is likely due to expectations of rising storage.  If we reach the expected level of storage, the fair value level for the S&P 500 would be 1,928, based on the oil price/equity relationship.

The wild card in all this rests with the ECB.  If the ECB expands monetary stimulus and leads the EUR lower, the fair value for oil will decline as well.  The other critically important caveat is that short-term relationships in markets come and go; this one will as well.  If the FOMC returns to hawkishness (as intimated yesterday by San Francisco FRB President Williams) the oil/equity relationship could break down.  However, for now, it appears that any equity rallies depend on rising oil prices.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EST] Super Tuesday didn’t bring too many surprises.  Donald Trump and Sen. Clinton both won the majority of states but, with proportional delegate distribution, all the candidates still running gathered at least a few delegates.  Soon we will shift to winner-takes-all voting, which should accelerate the process of nominating a candidate.

Yesterday’s equity market recovery was quite impressive, built on the back of improving U.S. economic data, at least relative to expectations, and dovish Fed comments.

(Source: Bloomberg)

This chart shows the Citi Economic Surprise Index since inception.  The index measures the performance of a basket of economic indicators, weighted by the bank’s economic team for importance, relative to expectations.  In other words, it isn’t necessarily a look at how the economy is doing per se, but relative to the economists’ forecasts.  We have noted over the years that economist forecasts tend to track the data like a moving average; thus, when the economy starts to improve, it takes a few weeks for the estimates to catch up.  Over the past two weeks, we have seen a rather sharp improvement in sentiment.  This does, in part, reflect a better economy but mostly shows that the forecasts have been lagging the improvement in the economy.  In any case, good news on the economy is partly a reason for the equity market rally.

Striking a more cautionary tone, the Atlanta FRB’s GDPNow tracker has slipped recently.

Q1 GDP is now on track for a +1.9% rise, down from 2.7% in early February.  Since the peak, the bank projects that inventories have shaved 50 bps from growth and residential investment has dropped 22 bps.  Government spending has added 16 bps.  Overall, the path of the data suggests that Q1 growth isn’t going to be much better than Q4 2015.  However, it should be noted that growth remains positive, in line with our forecast of slow growth but no recession.

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by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EST] It’s “Super Tuesday,” perhaps the most important date on the primary calendar.  By tomorrow morning, we should have a fairly good idea of who will be the candidates from both parties.  Polls suggest that it will be Trump versus Clinton for November.  It probably won’t be the de facto end of the primary season, but it will likely be the de jure.  If that is the outcome, both parties will have to start calibrating for the future.  For the Democrats, the left-wing rebellion started by Sen. Sanders won’t end even if he is defeated.  Sen. Clinton will struggle to convince Sanders supporters that she is anything more than the establishment standard bearer.  If she cannot bridge that gap, she will need to win with a coalition of minority voters and the establishment.  Of course, that assumes the DOJ doesn’t derail her candidacy with an indictment.  On the other hand, the GOP is facing disarray with a Trump candidacy.  The establishment of the GOP is recoiling from the choice but hasn’t been able to select a single candidate to challenge him.  It’s probably too late to stop Trump.  However, it isn’t clear if he can carry the GOP establishment and so he may try to win the presidency with a narrow Jacksonian coalition.  For the financial markets, the elections may simply be a huuge uncertainty that weighs on sentiment.

In looking at the election year cycles, we don’t have a lot of data for the current cycle (we index S&P 500 weekly closes for the first week of the election year through the four-year presidential term), but the two highest correlating years so far are 1948 and 2000.  The 1948 election was quite interesting as Harry Truman won a huge upset against Thomas Dewey.  The 2000 election was, for the most part, a fairly typical campaign, with a sitting vice president running for the Democrats against an establishment-selected former governor from a political family for the GOP.  The real fireworks in that election came after the vote when the Supreme Court effectively ended the recount in Florida and gave the victory to George W. Bush.

The data from these two elections doesn’t necessarily tell us much except that one outcome would clearly be welcomed and the other not.  Note that in both 1948 and 2000, equities rallied into the summer before the election (the x-axis shows weeks) but values weakened as the election approached.  In both cases, the second year of the election cycle featured weak equity markets, and recessions followed the election.  If a recession is in our 2017 future, these two years might be useful in suggesting that we are looking at mostly lackluster markets for the next 12 to 18 months. 

We are seeing stronger equities this morning despite rather lackluster Chinese data (see below).  China is clearly working to support its economy and we may be moving into a situation where “bad news is good news.”  Dovish comments from NY FRB President Dudley did bolster the market this morning.

We are getting a bit concerned about the market’s shift away from tighter monetary policy.

First, the deferred Eurodollar futures market continues to suggest the Fed won’t lift rates much over the next two years.  The chart below shows the implied interest rate from the two-year deferred Eurodollar futures contract.  Although the implied rate has moved modestly higher, it still stands just over 1%.  That suggests a policy rate of 74 bps two years from now, which is only one to two increases of 25 bps (since the FOMC uses a range, getting to 74 bps midpoint might take two changes).

At the same time, the yield curve is flattening, which is a concern.

(Source: Bloomberg)

The 10-year/two-year T-note spread has dropped under 100 bps, the lowest since late 2007 when the last recession began.  An inversion of this relationship would strongly suggest a recession is in the offing.

At the same time, inflation is creeping higher.  The chart below shows the yearly change in the core PCE, the Fed’s favorite inflation indicator.  Although the rate remains below the 2% target, it is approaching that level.  We don’t expect a rate hike in March but would not be surprised by increasing rate hike rhetoric as we approach the June meeting.

Overall, between the unsettling political situation and the potential for policy uncertainty, it is hard to foresee anything but a rangebound equity market into late summer.

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