by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] Markets are very quiet this morning.  We are seeing the dollar lift in part due to hawkish comments from Fed officials yesterday.  For example, Boston FRB President Rosengren called for three more hikes this year; we rate Rosengren as a moderate so his hawkish stance is notable.  However, he isn’t a voter this year and we don’t expect the committee to lean against Chair Yellen, who seems content with two more increases.  Still, this hawkish talk coupled with soft German inflation data is helping the dollar this morning.

A WSJ editorial is critical of President Trump’s immigration policy, suggesting it is causing shortages of labor and lifting wages.  Given that this is one of his goals, we doubt the president will be too concerned with the WSJ’s worry.  Still, if labor shortages are developing, we should be seeing it in the data.  Since the editorial specifically mentioned construction, we decided to take a look at the numbers.

Residential construction jobs represent 766.9k jobs in the U.S., about 0.6% of total private sector jobs.  That number is up 37.7% from the trough in January 2011.  Jobs in this category grew 6.5% in February from the previous year.  Wage growth is up 3.4% compared to 2.5% for private sector jobs in general.

What is interesting in the data is that there appears to be about a three-year lag between construction wage growth relative to overall private sector wage growth and housing starts.

When wages paid to construction workers decline relative to other workers, housing starts decline with a three-year lag.  We can’t determine the direction of causality; do starts fall because firms can’t find workers because they are finding better jobs elsewhere, or are relative wages falling because construction activity is soft?  Because the relative wage data seems to lead starts, it suggests that relative wage growth drives starts.  The current lack of workers that construction firms are anecdotally confirming is probably because three years ago construction wages lagged relative to other professions.  The current rise is necessary to lure these workers out of those industries (or across the border, which is more difficult now).  The data suggests that the process takes about three years, which makes some sense.  If a worker had been in construction, lost his job in the downturn and has found other employment, luring him back to construction will take money and time.  In other words, construction firms will need to offer higher wages for a period of time before workers will be willing to return.  The data suggests that there could be some weakness in starts before picking up in late 2018 or early 2019.  We do want to caution that the wage spread is not a strong determinant of starts—it is only a supply variable and demand variables, like housing affordability and the availability of mortgages, matter more.  The bottom line is that we would expect tight labor conditions to persist in construction into next year as long as a recession is avoided.

U.S. crude oil inventories rose 0.9 mb compared to market expectations of a 1.4 mb build.

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 below shows, inventories remain elevated.

As the seasonal chart below shows, inventories usually increase into April before rising refinery operations for the summer driving season lower stockpiles.  This week’s rise puts us further below normal.  If we begin to see inventory accumulation slow below normal it would be supportive for prices.  Although our models are still quite bearish, slowing inventory builds could portend faster withdrawals later this year and support oil prices.

Based on inventories alone, oil prices are overvalued with the fair value price of $27.32.  Meanwhile, the EUR/WTI model generates a fair value of $40.14.  Together (which is a more sound methodology), fair value is $35.14, meaning that current prices are well above fair value.  The data does show that the bullish case for oil mostly rests on a weaker dollar.  If the dollar continues to soften, oil may be able to overcome the inventory overhang which should be approaching its seasonal peak.

One of the bullish factors we are seeing is a pickup in refinery utilization.  History suggests that we will see this number flatten into early May.  If that fails to occur, the fundamentals for oil will improve.

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by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] Yesterday, there was a terrorist attack near Parliament in the U.K.  Five people were killed (including the terrorist) and around 40 injured.  Although reports suggest the attacker, who hasn’t been named yet, acted alone, eight others have been arrested.  This attack followed the pattern where the terrorist uses a vehicle to attack pedestrians in a busy area and then uses a weapon in an attempt to escape or expand the attack.  This mode was recently used in France and Germany.  We suspect this method is being used because security in Europe has been tightened.  For example, it may be more difficult to gather materials commonly used in bomb making because they are being tracked more closely.  However, cars and trucks are ubiquitous and it’s hard to see how security forces can stop their use.  It is noteworthy that many important public venues have been hardened; for instance, the number of barriers around Washington would tend to thwart vehicle attacks.  But, hardening all areas would be almost impossible.

PM May did say the unnamed attacker had been known to MI-5, Britain’s internal security service (roughly equivalent to the FBI).  However, being known and being stopped are clearly two different things.  So far, all indications suggest this attacker was inspired, but probably not directed, by foreign jihadists.

What we found interesting about the attack was the market reaction, which was quite mild.  Financial markets tend to follow a pattern where the first time an event occurs, it’s a huge deal, while each successive event becomes less significant.  Although one could argue that the scale wasn’t all that big in this attack (relative to 9/11, for example), the act was still designed to terrorize.  That part probably worked.  But, financial markets are viewing these events in the proper context—they are something that one hopes shouldn’t happen but the single event doesn’t threaten the stability of the Western world.

There are reports that the American Health Care Act (AHCA) has been changed enough for the majority of the Freedom Caucus to vote for the bill.  According to reports, senior members of this caucus will meet with the president at 11:00 EDT today.  We believe that these changes make it almost certain to have no hope of getting through the Senate.  If the bill fails in the House, we will likely see a knee-jerk decline in equities on fears that this loss will scotch tax reform.  We tend to disagree with this assessment; instead, the president and Congress can simply move on to taxes.  Health care is a quagmire; it would have made more sense to focus on tax reform first.  We realize that there were hopes that some of the savings from health care reform could have been used to fund tax cuts, but that was always a long shot.  If Ryan and Trump pivot to taxes after the AHCA passes the House but dies in the Senate, or simply dies, the drop in equities will probably be more of a welcome correction.[1]

U.S. crude oil inventories rose 5.0 mb compared to market expectations of a 3.0 mb build.

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 elevated.

As the seasonal chart below shows, inventories usually increase into April before rising refinery operations for the summer driving season lower stockpiles.  We did see refinery activity rise this week, which is a welcome sign.  This week’s rise puts us just below normal.  We saw a sharp rebound in crude oil imports that boosted inventories, reversing last week’s import weakness.  So far, the numbers continue to indicate that we have about another month of inventory accumulation before oil inventories start their seasonal decline.

Based on inventories alone, oil prices are overvalued with the fair value price of $27.59.  Meanwhile, the EUR/WTI model generates a fair value of $39.81.  Together (which is a more sound methodology), fair value is $34.96, meaning that current prices are well above fair value.  The data does show that the bullish case for oil mostly rests on a weaker dollar.  If the dollar continues to soften, oil may be able to overcome the inventory overhang which should be approaching its seasonal peak.

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[1] Or, to use the parlance of a former colleague, a “pause to refresh.”

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] The Dutch elections reflected recent polling that showed declining support for Geert Wilders.  However, despite media commentary suggesting that populism has been halted on the continent, a second look suggests that it’s not quite that simple.  To recap, Wilders’s PVV party gained five seats, winning 20 out of the 150 seats in the lower house.  Mark Rutte’s VVD is the largest party, at 33 seats; however, he lost eight seats compared to the last election.  The right-wing CDA party, a traditional Christian-Democratic party, gained six seats and now has 19 seats.  The D66 party also won 19 seats, gaining seven.  It is mostly a centrist party that has one primary goal, a more direct democracy.  The Greens also did well, gaining 10 seats for a total of 14.  The Socialists, a hard-left party, lost one seat, holding 14 in the new parliament.  The big loser was Labor, which lost 29 seats for a total of nine.

Essentially, as we have seen in the U.S. and U.K., the center-left is struggling.  On the left side of the political spectrum, there is more support for harder left policies and so there was more support for the Greens and other fringe leftist parties.  The more traditional rightist parties won, to some extent, by moving to the populist right to stunt the appeal of the PVV.  This is the usual pattern; the established parties have a tendency to co-opt the ideas of emerging parties to blunt their influence.  Thus, what we see from this election is that the populist movement is being slowed as the established parties learn to incorporate the goals of the populists into the mainstream.  This may mean moderate immigration controls in the case of the Netherlands.  The likely PM Mark Rutte noted after his win that Dutch voters said “no to the wrong sort of populism,” but it’s worth noting that he didn’t see his victory as a defeat of populism.  It is quite likely that the row the Netherlands had with Turkey ended up making Rutte appear more populist as it may have helped him seem more anti-Muslim.

To have a majority government, Rutte will need to cobble together a coalition of 76 seats.  Since the PVV won’t be part of any government, the more right-wing parties, the CDA and D66, will only get him to 71 seats.  He may add the CU party, a Calvinist, socially conservative party which has five seats, but currently this party is in the official opposition.  We expect it to take several months before a government is formed.

Overall, this election likely tells us that populism is still a force in Europe but is being managed by the established parties.  That may mean some retreat on open borders and globalization but may preclude a wholesale rejection of these factors.

Although the BOJ and SNB made no changes to policy, as expected, we did get a surprise of sorts from the BOE.  Policy was left unchanged, but there was one dissent on interest rates.  One of the members called for a rate hike of 25 bps due to continued strength in the economy.  After Brexit, there was a general consensus that the economy would weaken and the British central bank would need to lower rates.  However, at least so far, it appears that Brexit hasn’t been all that negative for the U.K. and that the GBP’s decline was probably more stimulative than expected.  If the BOE is moving to raise rates, the bearish forecasts for the GBP are probably wrong and the currency could recover.

The FOMC, as expected, raised rates 25 bps.  Despite the rate hike, the wording of the statement was not materially different than the February statement.  Minneapolis FRB President Kashkari dissented, calling for no change in rates.  Finally, the worry that we may see four rate hikes this year was put to rest—the dots chart signals that the central bank is only projecting two more hikes for the year.

This is Bloomberg’s dots chart along with the median of the dots (the green line) and the Eurodollar’s expectation for fed funds.  Although the FOMC is clearly looking for more rate increases than the market in 2018 and beyond, they are quite close for this year.  The median is looking for 1.375% by year’s end, which would be the midpoint between 1.25% and 1.50%, a clear signal that only two more hikes are expected for this year.

To get a flavor for the Fed’s projections, here is the average dots projected by meeting.

The lime green dot reflects yesterday’s data.  For this year, there is clear agreement on two more hikes.  This meeting suggests a modest increase in expectations but nothing significant.  Both this chart and the Bloomberg chart above are clearly suggesting that the terminal rate for the fed funds target is 3.00%.

If that is the terminal rate and core inflation holds around 2.00%, a case can be made that the expansion will continue.

This chart shows the effective fed funds rate less core PCE.  The data is for January since the PCE hasn’t been released, but assuming core inflation remains around 1.75%, even with the 25 bps increase, the real rate is only -0.83%.  The last three business cycles ended with positive real fed funds.  Granted, we are seeing a steady cascade lower with each business cycle but, even assuming a modest decline in the “danger” rate, let’s say 2.00%, if the Fed has a core PCE of 2.00% a recession would be triggered with a fed funds target of 4.00%.  According to the dots chart, that simply may not occur.  Of course, figuring out the level of tolerance for real rates and the economy isn’t an exact science, but the U.S. economy is in deep structural trouble if a mere 1.00% real fed funds rate ends this expansion.

Clearly, the financial and commodity markets liked the news; a rally in both bonds and stocks suggests the markets feared a more hawkish central bank.  In addition to the strength in equity and debt, gold rose and the dollar dipped.  Fears that the FOMC was preparing to raise rates rapidly have been mostly quelled.  A terminal rate of 3.00% means roughly three hikes each year for 2018 and 2019.  As the dots chart suggests, the financial markets really don’t expect that to occur but the remaining two hikes for this year are fully expected.

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