Daily Comment (February 15, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Looking for something to read?  In our travels we are often asked about books we recommend.  As a result, we have created The Reading List.  The list is a group of books, separated by category, that we believe are interesting and insightful.  Each book on the list has an associated review to help you decide if you want to read it.  We will be adding to the list over time.  Books marked with a “*” are ones we consider classics and come highly recommended.

It’s Chinese New Year’s Eve, the year of the dog!  The Chinese New Year is tomorrow so Chinese financial markets are closed today and will remain so until the 21st.  This will slow Asian trading for the next week.  Here is what we are watching this morning:

Cyprus trouble: Last week, on Feb. 9th, Turkish naval vessels blocked an Italian ship contracted by Italy’s oil firm Eni ($33.85) that was planning to explore for natural gas around the island nation.  In response, Italy has dispatched a naval frigate to the area, although the Italians have indicated their vessel is under orders not to engage with the Turkish military ships.

Cyprus’s population is roughly 25% Turkish and 75% Greek.  Both groups have vied for control of the island, which is geopolitically important in that the holder of that island could project naval power into the Levant and block shipping from the Black Sea.  The British held Cyprus as a colony until 1960.  During the colonial period, as was often the case, the British gave the minority Turks extensive rights.  This was a common ploy by European colonists—they would offer strong support to minority groups in a colony, making them dependent on the colonial power.  This practice made managing the colony easier since the minority group was dependent and usually didn’t have enough power to manage independence.  At independence, the British wrote a constitution that gave the Turkish Cypriots extensive minority rights.  It was a recipe for discord and, by 1963, the island was embroiled in a low-level civil war.  The Johnson administration was able to prevent the war from escalating but only by supporting a U.N. peacekeeping mission that essentially partitioned the island.  In 1974, a coup ousted the Greek Cypriot president and the junta planned to forcibly merge the island.  Turkey invaded the northern Turkish zone to prevent unification and declared (an almost universally unrecognized) Turkish Republic of Cyprus in the northern zone.  It has remained divided ever since.

What triggered the current dust-up was that the Greek Cyprus government, which is generally recognized as the legitimate government of the island, licensed blocs offshore for energy exploration as it appears there could be significant natural gas deposits around Cyprus.  However, most of these blocs sit in an area that Turkey has claimed as under its control, even though this area is on the southern end of the island.  However, no other nation in the world, save Turkey, recognizes the Turkish Republic of Cyprus and thus the exclusive zones claimed by this republic are also unrecognized.

At present, we don’t expect this situation to escalate.  Europe appears unable to conduct war without the U.S. and we don’t see the Trump administration getting involved.  In addition, Turkey has significant leverage over the EU; if sufficiently angered, Turkey would release a flood of refugees into Europe.  The last wave has had significant political ramifications and another would likely exacerbate those problems.  At the same time, Turkey has its hands full managing its southern border with what was once Syria and northern Iraq.  It can’t really deal with a full-scale naval battle in the Mediterranean.  We see this spat as jockeying for position in negotiations, with the prize being the control of natural gas reserves.  At the same time, the chances that this situation escalates, while remote, are higher than normal because the U.S. has created a global power vacuum by its steady withdrawal from the world.  Russia, for example, could tip the scales in either direction; supporting Italy might give Moscow an ally to attain EU sanctions relief, while cozying up to Turkey could help it project power in the Middle East.  We believe this event is an example of what we will see more of for the foreseeable future.

The JPY: Japan’s Finance Minister Aso indicated overnight that the recent strength of the JPY is not a major concern, opening the Japanese currency to further appreciation.  Reuters[1] is reporting that Governor Kuroda, who we recently noted is likely to get a rare second term as head of the BOJ, may face a less cooperative group of deputy governors at the central bank.  Overall, we expect the BOJ to allow for steady appreciation of the JPY as long as it doesn’t accelerate.  Openly calling for a weaker currency runs the risk of antagonizing the Trump administration, and Japan would prefer good relations with Washington while it is dealing with significant tensions on the Korean Peninsula and with China.

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[1] https://www.reuters.com/article/us-japan-economy-boj/choice-of-deputies-may-complicate-kurodas-job-at-the-boj-helm-idUSKCN1FZ0WT

Daily Comment (October 20, 2017)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Risk-on returned to the financial markets this morning, with the dollar and equities higher and Treasuries and gold lower.  The possibility that John Taylor could be the next Fed chair along with hopes of tax reform are boosting risk assets this morning.

Chair talk: There are a series of dueling stories in the media this morning on who the president will select for the Fed chair position.  The current conventional wisdom suggests that Powell is the front-runner, while John Taylor is running second.  Below is the latest on the topic from PredictIt, the decision-betting site.

(Source: Predictit.org)

Warsh was the front-runner until about two weeks ago; since then, his star has fallen rather quickly.  Powell makes sense as a chair.  He favors deregulation and is considered a moderate on policy.  However, he does not fit the “shake things up” framework of the president, so a surprise is possible.

Here is the history of the target and the Taylor Rule, calculated using core PCE:

There has been an interesting trend in the relationship of the rule to the policy rate.  From 1983 to 2000, the policy rate target exceeded the Taylor Rule by an average of 178 bps.  Since 2000, it has averaged -136 bps. The current Taylor Rule rate would be 3.25%, roughly the level of the Mankiw Rule using involuntary part-time employment.  Greenspan mostly exceeded the Taylor Rule rate until the 2000 tech crash.  He and Bernanke clearly lagged the rule rate during the last tightening cycle.  Note that the FOMC moved much more quickly to lower rates during the last recession than did the Taylor Rule.  In fact, it’s rather clear the FOMC performed better than the Taylor Rule during the downturn by acting faster to cut rates, recognizing the gravity of the situation.  If one reads the meeting transcripts from 2008, there was a growing call to raise rates in August 2008.  We suspect the Taylor Rule was one of the reasons why some hawks were leaning in that direction.  In hindsight, that increase would have been toxic.

We are leaning toward Powell but it should be noted that the other open governor spots are important, too.  If Taylor and Warsh are offered governor positions as a consolation prize, Powell’s ability to manage to a consensus will be significantly undermined.

A budget deal: By a 51-49 vote, the Senate passed a fiscal 2018 budget resolution and the House has agreed to accept.  The vote was nearly by party line, with Rand Paul (R-KY) the only Republican voting against the measure.  The resolution is important because now that one is in place Congress can consider tax law changes without fear of filibuster in the Senate.  Although this is a first step toward tax reform, it is a rather small one; tax reform remains a difficult task.

More non-centrist political developments: If polls are accurate, the next PM of the Czech Republic will be Andrej Babis, a right-wing populist businessman.  Although the overall economic data from the country is rather good, rising inequality and political corruption is lending support to Babis.  He has run on an anti-corruption, anti-EU and anti-immigrant platform.  If elections pan out as expected, another EU government will have moved to the political fringe.  Meanwhile, in New Zealand, Jacinda Ardern, aged 37, will be the next PM; she is the leader of the hard-left Labour Party and another young figure at the helm of an important Western government.  She was able to gain power after the New Zealand Party, a party dedicated to providing government funding to the elderly, joined Arden to form a majority coalition.  Arden’s platform calls for social spending but is also anti-immigrant and wants to ban foreigners from buying property.[1]  Like many nations in the region, New Zealand has been favored by foreign capital flight.  In the election, the center-right (and former government leader) National Party received 56 seats, Labour won 46, the New Zealand Party won nine and the Greens eight.  The Greens didn’t join the coalition but agreed to caucus with it, giving it a majority.  The NZD dropped 2% yesterday on the news.

Merkel gives May a lifeline: Chancellor Merkel welcomed PM May’s initial offer of £20 bn and a transition deal on the EU’s terms to facilitate a smooth Brexit.  Although the hardliners in the EU want something closer to £60 bn or more, Merkel’s reaction probably means that a less onerous package can be negotiated.  The GBP rose on the news.

Retail MMK update: Yesterday’s market action in equities was consistent with recent patterns, which is that each pullback has been shallow and met with almost immediate buying.  Thus, pullbacks have been consistently unsustainable.  We attribute that characteristic to high levels of cash among investors waiting for the opportunity to invest.  As a result, small market declines are seen as rare opportunities for purchasing.  We have noted that the level of retail money market holdings has been a fairly good indicator of buying power.

This chart shows the weekly Friday close for the S&P 500 along with the level of retail money market funds.  We have applied areas to the chart in orange—these represent periods when money market levels fell below $920 bn.  In general, when money market funds held by retail fall to “low” levels, which we define as $920 bn, equity markets tend to decline or stall.  We believe this occurs due to the lack of “fuel” for new buying.  Current levels are near $985 bn, meaning there is ample cash for buying and thus, barring a geopolitical event, elevated levels of liquidity would be consistent with shallow pullbacks and a “buy the dip” mentality, exhibited yesterday.

Energy recap: U.S. crude oil inventories fell 5.7 mb compared to market expectations of a 3.0 mb decline.

This chart shows current crude oil inventories, both over the long term and the last decade.  We have added the estimated level of lease stocks to maintain the consistency of the data.  As the chart shows, inventories remain historically high but have declined.  The impact of Hurricane Harvey is diminishing as refinery operations recover.  We also note the SPR fell by 0.7 mb, meaning the total draw was 6.4 mb.

As the seasonal chart below shows, inventories fell this week.  It appears we have started the inventory rebuild period sooner than normal this year due to the hurricanes.  However, inventories have declined over the past three weeks, which is a surprise based on the seasonal pattern.  Crude oil inventories usually rise into mid-November, so if this decline phase continues it should be supportive for crude oil prices.

(Source: DOE, CIM)
(Source: DOE, CIM)

Refinery operations fell sharply last week in line with seasonal norms.  This week usually represents the low in seasonal refinery activity, meaning that demand should rise on a seasonal basis going forward.  What was interesting this week was that U.S. production appears to have declined by 1.1 mbpd.  It isn’t obvious why this would have occurred and so we will be watching to see if this is a one-week event or part of a larger drop in oil production.  If production remains low, it is also a bullish factor for prices.

Based on inventories alone, oil prices are undervalued with the fair value price of $54.33.  Meanwhile, the EUR/WTI model generates a fair value of $63.44.  Together (which is a more sound methodology), fair value is $60.01, meaning that current prices remain below fair value.  For the past few months, the oil market has not fully accounted for dollar weakness.  However, now the markets are not even taking tightening inventories into account.  In general, without the expected seasonal lift in crude oil inventories, oil prices at current levels are attractive.

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[1] We suspect terror has just erupted in Silicon Valley!

Daily Comment (October 13, 2017)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Markets are quiet again this morning; we are seeing the dollar weaken a bit and bonds rally on the weaker than forecast CPI data.  On the other hand, retail sales were strong, although some of that is coming from hurricane distortion.  Here is what we are following this morning:

ECB—less but longer: Reuters[1] is reporting that ECB policymakers have agreed on a plan to begin tapering.  According to reports, the bank will extend the stimulus program by nine months but bond buying will be reduced to a range of €25 bn to €40 bn, down from the current €60 bn.  The EUR eased modestly on the news.  One of the problems is that the ECB is running out of eligible bonds to purchase so it needed to reduce its buying levels.  At the same time, if this action is taken, the ECB is signaling its desire to remain accommodative.  We view this action as modestly bearish for the EUR.

Tensions rise in Iraq: Iraqi forces are moving into the Kirkuk region, an area claimed by the Kurds.  According to reports, Kurdish forces are withdrawing in front of the Iraqi deployment.  Kirkuk is a key city in northern Iraq; both Kurds and Arabs see it as theirs (and both have controlled the town during various periods in history).  It is also an important oil city.  If open fighting develops, we would expect a disruption in oil flows and potentially higher prices.

Saudis buying Russian arms: Reuters[2] is reporting that Russia and Saudi Arabia are nearing a deal in which the latter will purchase the S-400 air defense system from Russia.  This is a sophisticated air defense system, considered one of the best in the world.  In fact, it seems odd the Saudis would need such a sophisticated air defense system because it isn’t obvious they face that sort of threat.  We suspect this is a gesture of goodwill and a signal of deepening cooperation between Russia and the kingdom.  Although the Trump administration has been working to improve relations with Saudi Arabia, it’s no secret that U.S. geopolitical interest in the region has lessened with the end of the Cold War and the advent of shale oil.  We would expect continued cooperation between the two states as Saudi Arabia adjusts policy to emerging U.S. actions.

Fed policy:  With the release of the CPI data we can update the Mankiw models.  The Mankiw rule models attempt 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 using 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 four 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, a third using involuntary part-time workers as a percentage of the total labor force and a fourth using yearly wage growth for non-supervisory workers.

Using the unemployment rate, the neutral rate is now 3.01%.  Using the employment/population ratio, the neutral rate is 1.01%.  Using involuntary part-time employment, the neutral rate is 2.31%.  Using wage growth for non-supervisory workers, the neutral rate is 1.23%.  The improved labor market data has lifted each model’s neutral rate calculation by 15 bps to 25 bps, putting all but the employment/population ratio variant below the current target.

Although the core rate rose less than forecast, we suspect there is enough support for a December hike to keep the likelihood of a move high.  Fed funds futures still put the odds at 78% for an increase.

Energy recap: U.S. crude oil inventories fell 2.8 mb compared to market expectations of a 2.0 mb increase.

This chart shows current crude oil inventories, both over the long term and the last decade.  We have added the estimated level of lease stocks to maintain the consistency of the data.  As the chart shows, inventories remain historically high but have declined.  The impact of Hurricane Harvey is diminishing as refinery operations recover.  We also note the SPR fell by 1.8 mb, meaning the total draw was 4.6 mb.

As the seasonal chart below shows, inventories fell this week.  It appears we have started the inventory rebuild period sooner than normal this year due to the hurricanes.  However, over the past two weeks, inventories have declined, which is a modest surprise based on the seasonal pattern.

(Source: DOE, CIM)
(Source: DOE, CIM)

Refinery operations unexpectedly rose last week, which is a divergence from seasonal norms.  Strong product demand and attractive refining margins are supporting strong utilization.  The seasonal trough usually occurs next week; this week’s activity suggests that the maintenance season may be concluding early, which is bullish for oil prices.

Based on inventories alone, oil prices are undervalued with the fair value price of $52.79.  Meanwhile, the EUR/WTI model generates a fair value of $63.15.  Together (which is a more sound methodology), fair value is $59.27, meaning that current prices are well below fair value.  For the past few months, the oil market has not fully accounted for dollar weakness.  If the oil market begins to recognize the dollar’s weakness, a broader rally in oil is possible.

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[1] https://www.reuters.com/article/ecb-policy/update-2-ecb-homes-in-on-9-more-months-of-bond-buying-at-lower-volumes-idUSL8N1MO0YM

[2] http://www.reuters.com/article/us-russia-saudiarabia-missiles/russia-saudi-arabia-close-to-sign-s-400-missile-deal-ifax-cites-putin-aide-idUSKBN1CI0NU?utm_source=Sailthru&utm_medium=email&utm_campaign=New%20Campaign&utm_term=%2ASituation%20Report

Daily Comment (October 5, 2017)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Financial markets are very quiet again this morning in front of the employment data on Friday.  Here is what we are watching:

PM May’s no good, very bad day: With compliments to Judith Viorst,[1] the Tory PM has had a really rough run recently.  She was attempting to give a speech that the FT has characterized as a “relaunch,”[2] in which she would discuss Tory plans for energy and housing, when she was struck by a coughing fit and was barely able to deliver her comments.  Just before her speech a prankster had delivered a phony pink slip, telling her she had been fired.  And, earlier in the week, her foreign secretary, Boris Johnson, undermined May’s positions on Brexit.  The Tories are really struggling; recent polling shows that voters under the age of 34 are rapidly abandoning the conservative party.  A think tank estimates that the average age of a Tory voter is 72.[3]  If the Tories continue to flounder, it just might open up a window for the Corbyn-led Labour Party to gain control of the government.  He represents left-wing populism in a nearly pure form.  If Labour wins, we would expect the GBP to suffer severe losses.  The U.K. currency is weaker this morning due to the political disarray.

Did he say that out loud?!  Former Fed Governor Dan Tarullo told the FT something that many of us have speculated about for a while.  He admitted the Fed does not have a reliable theory of inflation.[4]  For the most part, the FOMC tends to rely on the Phillips Curve, which postulates that there is a relationship between labor slack and inflation.  Tight labor markets tend to bring higher inflation and vice versa.  Although there is some evidence to support this idea through the 1970s, the relationship is now spotty at best as the economy has become increasingly globalized and deregulated.  If Tarullo is right, and we side with his position, the Fed should wait until inflation actually presents itself before acting to raise rates.  That isn’t the majority thinking at the Fed, although Governor Brainard, along with Presidents Kashkari and Bullard, would fall into the minority of Phillips Curve heretics.

Saudi King to Moscow: For the first time ever, a Saudi king is visiting Russia.  King Salman and President Putin are meeting today, further evidence of a warming relationship.  We see two factors driving this growing friendship.  First, OPEC’s power has been diminishing because it doesn’t control enough supply to easily adjust prices.  In the 1970s, there were periods when OPEC oil was half of consumption.  It is now around a third.  Getting cooperation from Russia puts it over 45% of supply, meaning supply measures are much more effective.  Second, we suspect the Saudis realize the U.S. is gradually withdrawing from the region.  Since WWII, the U.S. and Saudi Arabia have had a strong security relationship.  This was bolstered by the First Gulf War where the U.S. based Allied troops in the Kingdom to enforce existing borders.  However, the Saudis opposed the U.S. invasion of Iraq (the Second Gulf War), fearing it would leave Iraq too weak and fractured to act as a counterweight to Iran.  Those fears turned out to be justified.  President Obama’s fumbling of the Syrian “red line” added to concerns about U.S. commitment and competency in stabilizing the region.  Saudi Arabia appears to be looking at alternatives to the U.S.  Russia is far from perfect—it has somewhat close relations with Iran and has, in the past, acted as a free-rider on OPEC supply cuts.  But, a visit by a Saudi king to Russia indicates that relationships in the Middle East are becoming fluid.

Puerto Rico bonds continue to slide: Yesterday, we noted that the price of Puerto Rico’s bonds fell sharply after the president’s comments suggesting debt forgiveness for the island commonwealth.  That trend continues.

(Source: Bloomberg)

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[1] https://www.amazon.com/Alexander-Terrible-Horrible-Classic-Board/dp/1442498161. Most parents have probably read this book to their children at some point.

[2] https://www.ft.com/content/e5cf6b1c-a8d6-11e7-93c5-648314d2c72c?emailId=59d5b9918df16b0004214a71&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22 (paywall)

[3] https://www.ft.com/content/b97e04d8-a854-11e7-ab55-27219df83c97 (paywall)

[4] https://www.ft.com/content/a5438cce-a933-11e7-ab55-27219df83c97?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56 (paywall)