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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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