March 6. Commodity Resurgence
First, a quick overview of the state of the market. Most interest rate futures closed at their lowest levels since early February as stocks continue to rebound and the non-farm payroll report showed sturdy employment growth. Reuters pointed out that many gains were in lower wage occupations: “Retail payrolls increased 54,900 adding to the 62,100 positions created in January. Leisure and hospitality jobs rose 48,000, with employment at restaurants and bars increasing by 40,200.” I don’t quite understand how retail employment is doing so well, given relentless reports of store closings like Sports Authority, Staples, etc. But I guess I can grasp the need for more bartenders. In any case, the job picture is improving.
The larger overview has to take into account the turnaround in many commodity markets. For example, the Bloomberg Commodity Index closed essentially at the high of the year. Lumber, copper, gold, oil, coal…all have had powerful rallies. Mining shares have surged. Iron ore is up over 40% from the December low! Not only that, but there has been a significant change in the WTI curve. As an example, consider the spread between June 2016 and June 2017 Crude (CLM16 to CLM17). In mid-February, the near contract was at a discount of $7.22, as of Friday it had narrowed to $4.72, an indication that the market is coming more into balance. (More on this below).
Not surprisingly, the US curve is responding to these signals (to some degree). Near Eurodollar spreads rose to new highs Friday. For example, EDM16/EDM17 one-year calendar settled 29.5, fully 20 bps above the February 11 low of 9.5. In my morning note of March 2, I mentioned early signs of a turn, with high yield junk funds seeing strong closes on inflows, stabilization in crude oil, and a widening of the ten year treasury to tip (inflation indexed note) spread to a new recent high. This spread closed 153 on Friday, over 30 bps higher than the Feb 11 close. Treasury vol is near the lowest of the year, an indication that fears of a commodity/oil driven panic that spills over into stocks has significantly abated.
There is one LARGE caveat to this picture however, and that is weakness in financial shares. While the SPX has rallied just over the 0.618 retracement from the Nov high to Feb low (2116 to 1810; 0.618 ~2000), the major financials have badly lagged. JPM, WFC and USB are around the 50% retracement, but GS, C, BAC and AXP have recovered only to the 0.382 Fibonacci retracement or less. Large foreign banks look even worse. The Fed’s new proposals to limit counterparty exposure, not to mention Kashkari’s big bank break-up plans, will likely continue to weigh on the financial sector. Another related concern is that Moody’s “Oil and Gas Liquidity Stress Index” measuring companies facing credit problems, hit a new high of 27.2 compared to a peak of 24.5 in the last recession.
In any case, consider the chart below, which is the Bloomberg Commodity Index in red vs the 2/10 treasury spread in white:
The BCOM index is near the high of the year and through the high of early February, while 2/10 isn’t responding strongly…yet. This week brings auctions of 10’s and 30’s, which could support a steepening move.
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Outside of the US, the ECB meeting is this week, and the euro is starting to reflect concerns that the central bank won’t be nearly aggressive enough to destroy its value (expecting a 10 bp cut in the depo rate and €10 billion new QE). EUR closed just above 110, right around the midpoint of the past year’s range.
China’s parliament meeting started this weekend, with growth shaved down to 6.5%. From Reuters, “… the draft goal of running a fiscal deficit equivalent to 3 percent of GDP, while up from the previous year’s target of 2.3 percent, still disappointed some who had hoped for a number closer to 4. “The budget deficit of 3 percent is not enough and should be increased,” economist and former central bank advisor Yu Yongding told Reuters on the sidelines of the meeting.”
In another heartwarming story about China, there’s this from Bloomberg: The Communist Party has directed one of the country’s largest state-run defense contractors, China Electronics Technology Group, to develop software to collate data on jobs, hobbies, consumption habits, and other behavior of ordinary citizens to predict terrorist acts before they occur. *link at bottom
I don’t typically include anything about politics, but one can’t escape the shifting global landscape. There were a couple of amusing posts on the Drudge Report. First, from the Washington Post, “Psychologists and massage therapists are reporting ‘Trump anxiety’ among clients, and are offering services to relieve this stress.” The second is from the Financial Times, noting that Jerry Springer is “stunned” by the republican race. Really? The man who has done more than anyone else in US history to find and celebrate the lowest common denominator is shocked? I’m sure there’s concern in DC. The median household income there is $69235. In similar sized metro areas, Atlanta’s is $46439 (67% of DC) and Denver’s is $51800 (75%). Well sure, if the money stops flowing because it can no longer buy influence, it can certainly provoke anxiety.
One more observation about oil and ETFs/ETNs. In mid-January, even as oil was rallying, the iPath ETN OIL was slammed lower, wiping out a premium to its net asset value.* On Friday, Blackrock suspended issuance of Gold Trust Shares (IAU) due to demand for gold (the fund has seen inflows every day in 2016, and trades at a premium to NAV). Gold soared to a new high. The world of ETFs can clearly distort markets. The USO (United States Oil Fund) owns anywhere from 20% to a third of the open interest in the front CL contract. (Currently has 112k CLJ6 vs 566k open). It wasn’t too long after the OIL debacle that the extreme contango in the oil curve started to abate. I am not recommending any sort of trade strategy here, just a reminder that ETFs are the tail wagging the commodity dog.
Two more quick notes: First, from the Daily Mail, “Auctions held by Sotheby’s and Christie’s last month sold a collective $210million worth of art, representing a huge 45 per cent drop from the $381million sold at similar events the year before… Among those to be hit by the slump has been Christie’s International, which reported a five per cent decline in annual sales after five years of growth.”
Second, and this could have a profound effect of student debt going forward, and therefore on the economy: Northwestern University announced that “students who qualify for financial aid will no longer have to borrow to pay for their education.” * Could be a game changer if others follow suit; there’s over $1 trillion outstanding in student debt.
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Trade thoughts
As alluded to above, I am inclined to buy the curve through options. The fact is, however, that spreads have already had a decent move, and if the Fed shifts back into a more hawkish demeanor, then the dollar will likely again rally and the commodity resurgence would fizzle. In other words, I view the commodity rally as being a bounce from deeply oversold territory (for now). Central bank manipulations of currencies can have a big impact on commodities priced in dollars.
Last week I mentioned this: With EDU6/EDZ6 at 4.5, I like buying EDU/EDZ 9900 put calendar at 6.0 (settled 6.25). I think the market should be more inclined to price hikes into the beginning of 2017 rather than just prior to the election. [Friday 3-March settles, EDU6 9900p 4.5 and EDZ6 9900p 12.25 so 7.25s, up 1 bp] I still favor this sort of trade.
I also mentioned the following ideas: All euro$ calendar spreads are “cheap”. The question is, how do you hedge if you’re wrong? For example, last Thursday EDU’16/EDU’17 settled at just 13 bps (and settled 16 on Friday). One way is to buy calls in Greens. For example, pay 16 or less in EDU’16/EDU’17 and pay 3.0 for Green April 9925 calls (settled 3.25, 16 delta), ref 9886.5. The thought is that the green calls will provide at least some offset if spreads don’t widen. [EDU’16/17 settled 28.5 and 2EJ 9925c settled 1.0, so up 10.5]
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| 2/26/2016 | 3/4/2016 | chg | |
| UST 2Y | 79.7 | 87.0 | 7.3 |
| UST 5Y | 124.0 | 138.1 | 14.1 |
| UST 10Y | 176.4 | 187.9 | 11.5 |
| UST 30Y | 263.5 | 270.3 | 6.8 |
| GERM 2Y | -54.7 | -54.0 | 0.7 |
| GERM 10Y | 14.7 | 23.8 | 9.1 |
| EURO$ M6/M7 | 15.5 | 29.5 | 14.0 |
| EURO$ M7/M8 | 23.5 | 29.0 | 5.5 |
| EUR | 109.33 | 110.06 | 0.73 |
| CRUDE (1st cont) | 32.78 | 35.92 | 3.14 |
| SPX | 1948.05 | 1999.99 | 51.94 |
| VIX | 19.81 | 16.86 | -2.95 |
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Below are supporting links and other interesting snippets:
http://www.bloomberg.com/news/articles/2016-03-03/china-tries-its-hand-at-pre-crime
http://www.zerohedge.com/news/2016-01-22/barclays-rigged-its-oil-etn-limiting-new-creation-units
http://www.unitedstatescommodityfunds.com/holdings.php?fund=uso&page=holdings
March 4. Employment data and policy divergence
–Employment today with NFP expected 190k and avg hourly earnings +0.2%. Treasuries appear vulnerable going into the data, but implied vol has been under consistent pressure and is going into the data at the low of the week, not exactly suggestive of downside fear. Additionally, open interest shows modest declines in treasuries yesterday, another indication that hedges aren’t deemed essential at this level. There were, however, 10k purchases of TYM 124 and 124.5 puts which settled 7 and 8. At about 12 bps per strike, the top strike is around 60 bps away. As mentioned yesterday, blue or gold midcurve puts are likely the better buy.
–Yesterday German Schatz hit a new low yield of -58 bps. I have attached two charts, one of the US two year vs German and the other of red sept euro$ vs euribor. Two year spread is right at the extreme, 142 bps. ED/ER spread is about halfway back. Makes it appear as if one should sell schatz and buy US, even in front of the upcoming ECB meeting. Brainard’s thesis in last Friday’s speech that Central Bank policy divergences are likely to be muted is under going its own ‘stress test’.
March 3. Buying at the zero-bound
–Modest follow-through selling yesterday in treasuries yesterday as ISM was a bit better than expected at 49.5. Five year rose 3 bps to 1.346, tens were up 1.2 to 1.846 and bonds declined 1.4 bp to 2.69, causing a new low in the 5/30 spread at 134.4. Beige book was non-committal.
–Interesting feature of yesterday’s trade was buying in 100 calls, and there was even a small trade in the red pack 100.25 call strip. (All as SF Fed Williams poured cold water on the idea of negative rates in the US). The red pack 100 c strip settled 9.75, the largest volume was in EDH7 100c which traded 1.0 about 7k. The red 100.25 c strip traded 5.5 300x, settled 3.75. Green pack 100c strip traded 35 and settled there. Also small buying in the long blue 100c strip for 56.0. With euribor deeply negative it’s not surprising to see headlines like this in the FT: Life Insurers shaken by rock bottom rates. –There was also additional large buying of EDZ6 9950/9975/100c fly yesterday, settled 2.25. In the opposite direction, both the April and May (EDM6 underlying 99.26s) 9912/9937 combos were bought…paying for puts. May traded 1.0 about 60k, but settled flat.
–Interesting to note that gold had a strong day with GCJ closing +11.00 at 1241.80, nearing the high put in on the Feb 11 panic trade, when the SPX re-tested 1800 and treasuries soared higher, boosting interest rate implied vol to the highs. As a comparison I marked ten year vol above 6.6 on Feb 11, vs 5.4 currently. Also worth mentioning that the Japanese Yen has been strengthening, in spite of the late Jan move to negative rates by the BoJ. The yen weakened temporarily on the ease, and then completely rejected that move. Feels like a major painful squeeze coming (a much lower $/yen; test of 100).
–Today’s news includes Jobless Claims expected 270k. Q4 Productivity -3.2%. Factory Orders +2.0 and non-mfg ISM expected 53.1.
March 2. Signs of a turn?
–Early yesterday Treasury Sec’y Jack Lew said the Chinese assured him they had no plans or need to devlaue the yuan. Today, (RTRS) “Moody’s downgraded its outlook on Chinese government debt to “negative” from “stable” on Wednesday, citing uncertainty over authorities’ capacity to implement economic reforms, rising government debt and falling reserves.” Also an advisor to Abe said the G20 statement, “…does not place any restrictions on the Bank of Japan’s ability to expand its negative interest rate policy.”
–Clearly the ratings agencies are typically late to the party, but the prospect of competitive devaluations putting more pressure on China (and the entire globe) is palpable.
–While stocks soared and treasury yields surged with US tens up 9.6 to 183.4, the Atlanta Fed revised their GDP Now forecast to just 1.9% for Q1, down from 2.1. However, the market appears to be buoyed by ideas of monetary largesse forthcoming from the ECB, and lack of immediate action from the Fed in the opposite direction. As mentioned yesterday, hi yield etfs HYG and JNK have turned the corner and both had very strong closes, an indication that the worst of financial stress may be over. While oil didn’t take out early Feb highs, it still appears to be stabilizing (though trading lower this morning), another positive sign. One other note, earlier this month ten year treasury to inflation-indexed note spread made a new low at 120 bps (one of the “market measures of inflation expectations”. Yesterday, this spread closed at a new monthly high of 150. Another sign of a general turn in sentiment? However, eurodollar calendar spreads, while generally firmer, haven’t seen the same type of surge.
–Today’s news includes ADP expected 190k and Beige Book, prepared for the March 16 FOMC.
March 1. Dudley: “Hey have you guys noticed the euro$ curve?”
–(Reuters) “At this moment, I judge that the balance of risks to my growth and inflation outlooks may be starting to tilt slightly to the downside,” New York Federal Reserve President William Dudley said.
–Dudley’s reassessment combined with other factors has the market trading in an ambien induced sleepwalk of reinstated QE. (Buy risk assets, sell treasuries). China Mfg PMI and Caixin both below expectations at 49.0 and 48.0…must mean more stimulus on the way. Japan sells ten year notes at negative yield, yet EURJPY near new lows. Chicago PMI yesterday takes a new dive to 47.6. Weak Europe PMIs put more pressure on the ECB to increase stimulus next week. All of which take ESH from a deficit in early evening trade to a strong positive this morning (currently +15.00). I would also note that both HYG and JNK had strong rallies yesterday and were able to close above the early Feb highs. Spread compression is another sign of QE. Central banks riding to the rescue…but we better allocate a bit more to gold, just in case (gold is up around 17% this year). However, as BoE’s Carney reminded last Friday, “It is a reminder that demand stimulus on its own can do little to counteract longer-term forces of demographic change and productivity growth.” http://www.businessinsider.com/bank-of-england-mark-carney-downside-of-negative-interest-rates-2016-2
–Curve closed at new lows yesterday with 2/10 just above 95 bps and red/gold pack spread edging another 1.125 bps low to just under 75 bps (and was actually about 3.5 bps lower during the day). Red/green closed at a new low of just 22.75 bps! At least Dudley is getting the message….
–Today’s news includes ISM expected 48.5, was last at 48.2.
Feb 28. International Linkages
Themes:
- G20…ineffectual
- Brainard…respectful of the markets and internat’l linkages
- Core PCE was 1.7…inflation coming back?
- Technicals don’t yet confirm an equity mkt bottom
Let’s start with a couple of snippets from the G20: (Rtrs) “Downside risks and vulnerabilities have risen,” [the communique] said, citing a backdrop of volatile capital flows, a drop in commodity prices, the “shock” of a potential British exit from the European Union and increasing refugee flows.
Again from Reuters, “The world’s top economies declared on Saturday that they need to look beyond ultra-low interest rates and printing money to shake the global economy out of its torpor, while renewing their focus on structural reform to spark activity.” But, they “…were unable to agree on a joint push for new stimulus measures.” A Bloomberg article said the G20 is worried about competitive devaluations, notably Japan.
Quick summary: Identify problems and do nothing about them. Talk about the need to avoid competitive devaluations, but tacitly accept negative rates which have currency depreciation as a goal.
Regarding Japan, there’s this note from The Guardian: “Japan’s population has fallen by nearly one million…the first decline since official census records began in the 1920’s. The country lost 947,345 people – more than the population of San Francisco – between 2010 and 2015.”
What else can Japan do besides devalue? It’s the developed economy conundrum, aging populations and heavy debt. It was Japan’s huge QE program which started in 2012 that had the desired effect of weakening the yen, followed by the mid-2013 US taper tantrum, and then the actual taper, which put increasing pressure on China’s peg and led to the August devaluation.
In a thoughtful and nuanced speech Friday, Lael Brainard touched upon policy divergences across the globe, and suggested they might be suppressed in current circumstances. “Such limits [on policy divergence] might reflect common forces buffeting economies around the world or the powerful transmission of shocks across borders through exchange rate and other financial channels that may have the effect of front-running monetary policy adjustments in the vicinity of the zero lower bound.”
A couple of other excerpts…
…if core inflation remains below target in all major advanced economies and inflation expectations remain under pressure in many, I might expect policy divergence to remain more limited than previously predicted.
The global economy is also experiencing a downshift in emerging market growth momentum led by China, which may prove somewhat persistent. … China’s investment has slowed sharply recently after accounting for nearly one-third of global investment over the past three years and about one-half of global consumption in certain metals such as iron ore, aluminum, copper, and nickel. Commodity exporters and close trading partners in Asia will be most affected, but the changes in the composition and rate of growth in a country that has accounted for about one-third of the growth in world output and trade will likely ripple through the global economy much more generally.
In this regard, although China’s direct imports from the United States are modest, uncertainty about changes to its exchange rate system and financial imbalances, together with changes in the composition of its growth, have had broader global spillovers that may pose risks to the U.S. outlook.
In some circumstances, however, cooperation can be quite helpful. If, for example, economies face a common challenge, coordination can communicate to markets that policymakers recognize the challenge and will work to address it.
Unlike Mester, Brainard recognizes the spillover risks of China’s slowdown, essentially concluding that the market has front-run policy makers, though saying that cooperation is important. While I have always thought of the Fed as having only three important players, Yellen, Fischer, and Dudley, I now have to round out the field with Brainard.
How have the markets been front-running? First, as noted last week, the curve is flattening to lows not seen since 2007, with 2/10 closing Friday just under 97 bps and red/gold euro$ pack spread at just 76 bps. Core PCE was higher than expected Friday at 1.7 yoy, much closer to the Fed’s goal but likely heavily influenced by medical care services, just as CPI was. However, Eurodollar calendar spreads suggest extremely limited odds for rates hikes, with NO one-year calendar exceeding 27 bps. German gov’t yields are at new lows, with the ten year bund below 15 (nearing last year’s low of 7 bps).
In terms of financial market risks, there are many cross-currents. For example, the gold/silver ratio is just above 83, at a level previously associated with stress, like 2008 and 2002. However, VIX has come down and is now below 20 (19.81). A rolling spread of the 2nd to 4th VIX future is another stress indicator. Throughout much of January and the middle of February, the second contract traded at a premium to the fourth, reflecting market turmoil, but in the latter half of the month the curve has again gone contango, with nearer contracts trading at a discount. Similarly treasury vol has come well off the highs, with TYM implied now running 5.5.
The bounce in many markets in late Jan/ early February set important technical resistance levels. This week, the S&P 500 exceeded that high, but had a soft close Friday. Nasdaq futures also took out the early Feb high, but the cash index didn’t, and again, Friday’s close was weak. Russell 2000, HYG, JNK, EEM are all testing this same area but without solid closes above, it’s premature to consider a bottom formation. As can be seen on the attached chart, the WSJ major internat’l bank index is sorely lagging the SPX. By the way, even with the recent rally in crude, it remains well below the late Jan high, and NatGas has of course, imploded to new lows as I look out at the bright morning sunshine and mid-50 degree weather in Chicago in February.
This week brings Friday’s employment report, along with ISM data. Consensus for the wage component of Friday’s report is +0.2%, after the strong +0.5 gain last time.
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| 2/19/2016 | 2/26/2016 | chg | |
| UST 2Y | 75.5 | 79.7 | 4.2 |
| UST 5Y | 122.3 | 124.0 | 1.7 |
| UST 10Y | 174.8 | 176.4 | 1.6 |
| UST 30Y | 260.7 | 263.5 | 2.8 |
| GERM 2Y | -53.2 | -54.7 | -1.5 |
| GERM 10Y | 20.2 | 14.7 | -5.5 |
| EURO$ M6/M7 | 18.0 | 15.5 | -2.5 |
| EURO$ M7/M8 | 25.0 | 23.5 | -1.5 |
| EUR | 111.31 | 109.33 | -1.98 |
| CRUDE (1st cont) | 31.75 | 32.78 | 1.03 |
| SPX | 1917.78 | 1948.05 | 30.27 |
| VIX | 20.53 | 19.81 | -0.72 |
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Feb 24. Fed’s on hold
–Stanley Fischer spoke last night and in my opinion the speech tilted somewhat dovish. He noted that while Core CPI rose above 2%, that “…further declines in oil prices suggest that total inflation will likely remain low for somewhat longer than had been previously expected before moving back to 2 percent.” He also mentioned risks from asset price declines and tightening of financial conditions. With regard to employment, he allowed that a modest “overshoot” could be helpful. And finally, he addressed the size of the balance sheet, maintaining that there’s “…some benefit to maintaining a larger balance sheet for a time.”
–This morning interest rate futures are rallying with the ten year yield below 170, from yesterday’s close of 174.5. Stocks are weaker after a relatively soft close yesterday. Gold is rallying and the pound is making new lows near 1.39, with Brexit looming as another uncertainty.
–Yesterday, KC Fed chief Esther George spoke as well. Much more hawkish, insisting that March is a live meeting. It isn’t. Today we have Lacker and Kaplan comments, with Bullard after the close. Five year notes will be auctioned, and New Home Sales are released this morning, expected 520k rate.
–As a clear example of Fischer’s concern about international volatility spilling over into the US economy, JPM said yesterday that Q1 revenue from investment banking is down 25% and trading revenue is down 20% from a year ago. The bank is also setting aside $600 million for possible loan losses relating to energy and mining. As the banker on South Park says, “Annnnnnd…it’s gone. Next customer please.”
–Even though there were relatively small net changes in US rate futures, it’s worth noting that the curve flattened further. Red/green euro$ pack spread (2nd to 3rd year) made a new low of 25.625 bps. Red/gold was down another 0.5 to close at a new low of 81.25.
Feb 23. Fischer speaks this evening
–Slow trading day yesterday. Chgo Fed Nat’l Activity Index was positive for only the third time in the past thirteen months, though the 3-month moving average remains negative. There were a few protective buys of midcurve puts, for example 0EH 9887/9900 put spread bought for 1.5, and 2EH 9862 puts bought for 1.5 as well, settled 1.25 ref EDH’19 9893.0. Crude oil was well bid (though lower this morning), as were stocks. The ten year yield edged up 1.6 bps to 176.4. Curve continues to flatten with the front end down slightly but all contracts from golds back (EDH’20 and beyond) were either unch’d or 0.5 higher. New low once again in red/gold pack spread at 82 bps.
–Existing Home Sales out today expected 5.32 million annual rate. Stanley Fischer speaks this evening at 8:30 EST on Developments in Monetary Policy.
–A couple of other quick points:
Nice rebound yesterday in Brazil Bovespa index, up over 4% on stability/rally in commodities.
Reuters reports that Illinois Governor Rauner may block the Chicago Public Schools from issuing more debt
EURGBP marching higher due to Brexit fears, another problem for Draghi.
Feb 22. Official stats vs market perception
–The curve flattened to new lows on stronger than expected CPI, with yoy Core +2.2% a 4 1/2 year high. Whenever it seems plausible that the Fed might tighten at a somewhat faster pace (even though ‘faster’ has now been demoted to perhaps two or three times in a year), the curve flattens as the tinge of slightly more restrictive monetary policy is seen as putting a stranglehold on the economy. Red/gold pack spread fell 5 bps to a new low just over 83 bps. Two/ten treasury spread is just over 100 bps, having ended the year at 122. As mentioned earlier, strong gains were seen in the prices of medical care services and shelter. Interesting that official stats on inflation have generally been firming while market based measures have been declining. For example, (and no, I don’t think this is the BEST measure, just instructive) the spread between the ten year inflation indexed note and ten year treasury averaged 156 bps in November through December. It’s now just 127 bps, having hit a low of 120 two weeks ago. And actually, in terms of the pace of tightening, there are no near one-year euro$ calendar spreads above 30 bps. The ED curve reflects odds of 1 or maybe 2 hikes. In fact, the whites (front four) as a pack spread to the reds is 19 bps and reds/greens is 25.75.
–This morning ESH is up 22, and gold down 25. The British pound is getting clobbered as Brexit edges closer to reality, now 141.50 having been as high as 155 at the start of November. Light news day includes Chicago Fed National Activity Index, which was a soft -0.22 last.
–Saw this interesting snippet today: Mexico is changing the way it will intervene in FX markets…from the Foreign Exchange Commission there: “As we have long been stating, the FX intervention pattern adopted by Banxico was easily absorbed by market players and resulted in significant losses in internat’l reserves without any measurable impact on MXN dynamics.” I’m not saying that China doesn’t have far greater firepower than Mexico, but it’s still a cautionary tale for FX intervention.
Feb 21. Inflation/stagflation
Themes:
- Inflation / deflation
- Financial market stress (Cleveland Fed)
- Curve flattening
- Tax withholding slowdown
Looking at a chart of CPI as published by the BLS, it has clearly been on an uptrend for the past year. As Friday’s release said: “CPI for all items unchanged in Jan as energy declines offset array of increases.” Friday’s Core CPI was 2.2%, the highest in 4 ½ years. The data breakdown confirms that energy is the culprit holding inflation down. The Fed’s latest mantra, repeated by Mester Friday, is that “Oil prices cannot continue to decline indefinitely, nor can the dollar continue to appreciate forever.” Quite true. Ian Shepherdson of Pantheon Macro said, “…the dollar is not pushing down goods prices to the extent signaled by past experience, and that is allowing the clear upward trend in services inflation to drive up the aggregate.” So what are the services? Unadjusted 12 months ending January, Shelter +3.2% and Medical Care Services +3.3%.* As we know, prior to the housing bust, home prices relative to income had gotten to record levels. Now of course, rents are growing faster than income, another situation that ‘cannot continue indefinitely’. And the increase in medical care is not exactly reflective of economic strength.
My personal view of inflation/deflation is that deflation risk grows when firms/households cannot service their debts, leading to asset sales and product price cuts, even below costs. The risk of inflation is driven by a spiral of strongly rising wages absent increased productivity, which courses through the entire system. The fact that major retailers are involved in huge cutbacks while shelter and medical care increase in price, makes me lean towards the former scenario. The price action of equities only reinforces this view, as does the decline in market based measures of inflation expectations.
What many analysts do (another echo of the subprime crisis) is measure the percentage of a given problem to determine its impact going forward. For example, Mester went into some detail about China: “Exports to China represent 7 to 8 pct of total US exports and total US exports are about 12 to 13 pct of US GDP. So the direct effect of trade with China on US output is small.” Perhaps the static previous measurements are correct, but the dynamic forward impact is much harder to predict, and that’s where the Fed seems to get things consistently wrong.
In terms of tightening it’s instructive to look at the Cleveland Fed’s Financial Stress Index [chart] which is nearing the peak in 2012. The market is very clearly tightening for the Fed, and I would personally submit that price increases in medical care/insurance only add to that stress.
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Below is a chart of 2/10 treasury spread with the red/gold euro$ pack spread (2nd to 5th year), and the Fed Fund target rate. With Friday’s release of CPI, these curve measures made new lows (100 bps and 83 bps respectively), well below the lows of 2012. While equities rebounded this week, these charts are not meant to give a warm and fuzzy feeling. The flattening is indicative of 1) absolutely no inflation premium and 2) a global economy in a dubious state of disrepair. Or despair.
2/10 is the white line, red/gold pack spread is red, Fed Fund target in blue.
Just a couple of other things to mention about the chart. The circled areas on the far left show inverted curves, or negative levels. That’s when the Fed had just wrapped up its tightening campaign from 2004 to 2006 and the FF target hit 5.25%. We know what happened next. Of course, we are nowhere near negative now but the direction is disconcerting, especially with funds hugging zero. The second thing is that the charts aren’t on the same axis, the highs in both 2/10 and red/gold are both around 300 bps. Another thing to note is that the 2/10 spread is right at the 0.618 retracement of the 2006 low of -19 bps to the Feb 2010 high of 291 bps. This is an area to try to hold.
In short, who are you going to believe? The Fed and other government agencies or the messages from the markets?
One other indicator I would like to highlight is one that I don’t often see information about, federal income and employment tax withholdings. http://www.investors.com/news/economy/tax-withholdings-cast-doubt-on-rosy-fed-jobs-view/
“The broadest and most timely read on the health of the job market has been sinking at an alarming rate”. From the source material website dailyjobsupdate.com : “The data is a simple bean-counting of how much money was collected. It is not estimated, adjusted, or massaged in any way. You are looking at the most precise depiction of the economic cycle ever invented.”
“…for most of 2015 tax withholding rose at a rate of 5% or more from a year ago…revenue inflows to Treasury steadily slowed through the fall, bringing the annual growth rate down to just 4% by the start of 2016. That’s when growth seemingly collapsed – to just 1.8% over the past five-plus weeks, from Jan 11 through Feb 16.” Maybe it’s just a rough patch. But the fact that stocks and the curve are sending warning signals at the same time seems more than coincidental.
Coming up this week:
Stanley Fischer speaks Feb 23 at 8:30 pm EST, Developments in Monetary Policy
Lael Brainard on Feb 26 1:30 pm EST, International Monetary Policy Synchronization
G20 meeting in Shanghai Feb 26/27. Note a new rule from China: Will “…ban all foreign publishers – even those in a local joint venture – from putting content online in the country directly or without prior approval.” (Forbes). So things must be pretty good over there…
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| 2/12/2016 | 2/19/2016 | chg | |
| UST 2Y | 69.4 | 74.2 | 4.8 |
| UST 5Y | 119.9 | 122.6 | 2.7 |
| UST 10Y | 174.5 | 174.8 | 0.3 |
| UST 30Y | 260.2 | 260.7 | 0.5 |
| GERM 2Y | -50.8 | -53.2 | -2.4 |
| GERM 10Y | 26.1 | 20.2 | -5.9 |
| EURO$ M6/M7 | 16.5 | 18.0 | 1.5 |
| EURO$ M7/M8 | 28.0 | 25.0 | -3.0 |
| EUR | 112.56 | 111.31 | -1.25 |
| CRUDE (1st cont) | 31.91 | 31.75 | -0.16 |
| SPX | 1864.78 | 1917.78 | 53.00 |
| VIX | 25.40 | 20.53 | -4.87 |
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