Saturday, May 28, 2016

US Yield Curve: Global Yellow Light?

The spread between the 10-year US Treasury bond yield and the federal funds rate is one of the 10 components of the Index of Leading Economic Indicators compiled monthly by the Conference Board. There is no trend in this series, which tends to cycle around zero. It is widely deemed to be one of the more accurate business-cycle indicators, predicting economic growth when it is positive and a recession when it is negative. The spread does tend to lead the y/y growth cycle in the Index of Coincident Economic Indicators.

Of course, the spread is also available on a daily basis. A more sensitive version of this leading indicator is the spread between the 10-year Treasury yield and the 2-year Treasury yield. That’s because the latter tends to anticipate moves in the federal funds rate, which is managed by the Fed. Currently, the spread is still positive but narrowing. It was 96bps on Friday, May 20, down from the most recent cyclical high of 266bps during December 31, 2013.

Interestingly, the spread has been narrowing as the Fed has been moving toward normalizing monetary policy. When QE was terminated at the end of October 2014, the spread was 185bps. It was down to 128bps on December 16, 2015, when the Fed hiked the federal funds rate by 25bps. It was down to 93bps following the release on Wednesday, May 18, of April’s FOMC minutes, which heightened expectations of a rate hike at the June 14-15 meeting of the FOMC.

The FOMC is tightening monetary policy because Fed officials believe that the US economy is showing more signs of sustainable growth with inflation rising back near their 2% target. Yet the yield curve is warning that the Fed’s moves could slow the US economy and halt the desired upturn in the inflation rate. Another possibility is that while the US economy might be strong enough to tolerate the normalization of US monetary policy, the global economy is much more vulnerable to Fed tightening moves.

It’s a small world after all, and it seems that national economies and financial markets have become more interdependent than ever as a result of globalization. Fed officials are still operating as though the US economy is relatively independent of the rest of the world. Until recent FOMC minutes, overseas economic and financial developments were almost never mentioned in the minutes. Nor was the foreign-exchange value of the dollar. The US economy may still be relatively independent, but that’s not to say that other national economies and their financial markets aren’t more dependent on the US and on Fed policy than ever before. Consider the following:

(1) World business-cycle indicators. The yield curve spread is often shown on a chart as a leading indicator for the y/y growth in US industrial production, which is one of the four components of the US Index of Coincident Economic Indicators. Given the size and importance of the US economy, it isn’t surprising to see that the US yield spread sometimes has been a good leading indicator of the growth rates of both global industrial production and the volume of world exports. It may be increasingly so now thanks to the ongoing globalization of national economies and financial markets.

(2) S&P 500 revenues & earnings. It also isn’t surprising to see that the growth rate of S&P 500 revenues per share is highly correlated with the growth rates of world industrial production and the volume of global exports. Roughly half of S&P 500 revenues comes from abroad. The global economic slowdown over the past couple of years certainly has weighed on US company revenues, which have weakened further due to the strong dollar since late 2014. In turn, the weakness in revenues and earnings has undoubtedly weighed on US companies’ spending in the US and overseas.

The yield curve spread on a weekly basis has been highly correlated with the y/y growth rates in both the forward revenues and forward earnings of the S&P 500. The recent narrowing of the spread isn’t a good omen for either of them.

(3) Central banks’ policy divergence. All of the above suggests that the US yield curve may be a good leading indicator not only for the US economy but also increasingly the world economy. The Fed’s monetary normalization has pushed up the 2-year Treasury yield from a 2014 low of 0.34% on October 15 to 0.91% on May 23. This reflects the relative strength of the US economy, particularly compared to the weakness in the Eurozone and Japan, which has forced both the ECB and BOJ to double down on their ultra-easy monetary policies, with more QE and negative interest rates.

The result has been that global fixed-income investors have been buying more US bonds because their yields exceed those available in the Eurozone and Japan. In other words, the short end of the yield curve may reflect the relative strength of the US economy and Fed tightening, while the longer end reflects weak global economic activity and easing by the other major central banks.

The divergence between the tightening of the Fed’s monetary policy and the ultra-easy policies of the ECB and BOJ has certainly contributed to the strength in the dollar and weakness in both the euro and yen since mid-2014. However, so far, the latter have failed to boost exports in the Eurozone and Japan, while the strong dollar has weighed on US exports.

Could it be that while the US economy can handle a gradual normalization of monetary policy in the US, the rest of the world cannot do so? That may be the message conveyed by the US yield curve.

(4) Kuroda’s kabuki. Japan’s economy certainly remains fragile. The BOJ adopted negative interest-rate policy (NIRP) at the end of January. The Japanese 10-year government bond yield was -0.10% on May 23. Yet the yen is 15% above last year’s low on June 5. On May 23, we learned that Japan’s flash M-PMI fell for the fifth consecutive month in May to 47.6, the lowest since December 2012. We also learned that Japan’s exports (in yen) fell 9.5% y/y during April to the lowest since January 2014. Imports plummeted 20.0% to the lowest since December 2010!

(5) Draghi’s drag. The ECB first introduced NIRP on June 5, 2014. The German 10-year government bond yield was only 0.18% on May 23. Yet the Eurozone’s industrial production rose just 0.2% over the 12 months through March. Just as frustrating for the ECB is that the CPI inflation rate remains just below zero. It was just -0.2% y/y during April, according to the flash estimate, while the core rate was 0.7%.

Saturday, May 21, 2016

US Entitlements: In Government We Trust

In addition to earned income, another important source of purchasing power for consumers is government benefits. We can see this by subtracting US federal government spending on goods and services as reported in nominal GDP from total federal government spending as reported by the US Treasury. The difference is federal government spending on income redistribution through the various entitlement programs. Here are some observations:

(1) GDP vs. benefits spending. Federal government spending on goods and services as measured in the nominal GDP accounts has been essentially flat around $1.25 trillion (at an annualized rate) since 2010. Government spending on benefits to persons was relatively flat at a record high of about $2.25 trillion from 2009-2013. Over the past two years, it has risen 11.9% to a record $2.50 trillion.

(2) Benefits prevailing. Federal government spending on income redistribution has soared from just 10% of total federal spending right before President Johnson’s Great Society programs were passed (1964-1965) to 67% currently. This percentage includes so-called tax expenditures like the Earned Income Tax Credit (EITC), which is a refundable tax credit for low- to moderate-income working individuals and couples, particularly those with children.

The EITC is included in an outlays category called “Income Security” along with the Supplemental Nutrition Assistance Program, Supplemental Security Income, unemployment compensation, family support and foster care, and child nutrition.

(3) Impact on shopping. Of course, not all of the government benefits are paid in cash to beneficiaries. Medicaid and Medicare expenses are paid directly by the government to health care providers. However, this frees up income received by beneficiaries either from earnings or from cash benefits such as Social Security to spend on goods and services other than health care.

The sum of federal government outlays on income redistribution and labor compensation (wages, salaries, and supplements) rose to a record $12.4 trillion (at an annual rate) during Q1. That’s up 4.5% y/y.

The sum of the cash (or near-cash) benefits paid by Social Security and Income Security programs plus labor compensation rose to a record $11.3 trillion during Q1, up 4.1% y/y.

In other words, consumers have lots of purchasing power provided by earned income and by federal government income redistribution programs.

Sunday, May 15, 2016


In the eternal battle between the forces of light and the forces of darkness, I prefer the light side. I tend to be an optimist. However, in recent years, my optimism has been focused on the outlook for the US. I’m less enthusiastic about the Eurozone and Japan. In general, I’m not a big fan of emerging economies, particularly China. As a result, I have recommended a “Stay Home” investment strategy as opposed to the “Go Global” alternative.

On the dark side, I’ve written often about the credit excesses that have fueled excess capacity in China, which has to be the world’s biggest bubble ever. I was early in detecting the country’s capital outflows problem. I would like the Chinese authorities to know that no one else at Yardeni Research has contributed to my critical analyses of the country. But I will continue to write the truth, the whole truth, and nothing but the truth, though it is becoming increasingly dangerous to do so, especially for economists in China. The 5/3 WSJ included an article titled “China Presses Economists to Brighten Their Outlooks.” It ominously reported the following:
Chinese authorities are training their sights on a new set of targets: economists, analysts and business reporters with gloomy views on the country’s economy. Securities regulators, media censors and other government officials have issued verbal warnings to commentators whose public remarks on the economy are out of step with the government’s upbeat statements, according to government officials and commentators with knowledge of the matter.

The stepped-up censorship, many inside and outside the ruling Communist Party say, represents an effort by China’s leadership to quell growing concerns about the country’s economic prospects as it experiences a prolonged slowdown in growth. As more citizens try to take money out of the country, officials say, regulators and censors are trying to foster an environment of what party officials have dubbed "zhengnengliang," or "positive energy."
China’s President Xi Jinping seems to long for the glory days of Chairman Mao. He launched an anti-corruption campaign in 2012. It increasingly seems aimed at vanquishing his foes and at consolidating his power. His latest campaign aims to galvanize China around threats to national security. In recent weeks, the government has called for vigilance against spies. Even in the schools, children are playing games such as “Spot the Spy.” In mid-April, there was the first-ever National Security Education Day. Volunteers in Beijing handed out thousands of umbrellas imprinted with a hotline for reporting any perceived risks.

The accuracy and credibility of Chinese economic data have never been very good. Now they could get much worse. The official M-PMI may be sent to the countryside for a reeducation campaign. It edged down from 50.2 during March to 50.1 during April. It may have to be shot, or at least disappear, if it drops below 50.0 this month. Another candidate for summary execution is China’s monthly series on railways freight traffic. The series, which isn’t adjusted for seasonality, rebounded in March, offsetting most of February’s drop; but its 12-month average is down 17% from its record high on January 2014 and the lowest since November 2009.

By the way, FRB-Dallas Fed President Kaplan should probably watch his back too. In a recent speech, he warned:
[W]e are closely watching China, given its size and importance to world GDP growth … We estimate that [China’s GDP] growth rate will slow to 6.5 percent in 2016 and likely trend lower in subsequent years. China is dealing with high levels of overcapacity (particularly in state-owned enterprises), high levels of debt and an aging workforce. In addition, it has embarked on [what is] likely to be a very difficult [economic] transition.
I have instructed my colleagues that in the event of my disappearance, they should carry on without me and write only upbeat stories about China.

Thursday, April 28, 2016

Central Banks: Buying Into Risk-On

The major central banks are no longer just the Banks of Last Resort. They are turning into Investors of First Resort. In the long run, it’s hard to imagine that having the central monetary planners buy corporate bonds and stocks with the money they print can end well. In effect, the central banks are turning into the world’s biggest hedge funds, financed by their own internal primary (money-printing) dealers and backstopped by the government--which can always borrow more from the central bank or force taxpayers to make good on this Ponzi scheme. Nevertheless, in the short run, it should be bullish for bonds and stocks. Consider the following:

(1) ECB. The ECB plans to start buying corporate bonds in June. When ECB President Mario Draghi was asked at his press conference on Thursday, April 21, whether the ECB is considering buying corporate shares too, he said there are no plans to do so. Of course, by buying corporate bonds, the ECB is benefitting share prices by providing companies with a more liquid market for their bond issues, with yields likely to be lower than before the ECB entered the market.

In fact, while the ECB can buy government bonds issued by the members of the Eurozone only in the secondary market, and not in the primary market for new issues, there is no such restriction for the ECB’s corporate bond purchases, with the central bank buying as much as 70% of individual issues. So the ECB can be an extremely important financier for Eurozone corporations.

(2) BOJ. On January 29, the BOJ shocked and awed financial markets by introducing negative interest-rate policy (NIRP). Recently, there were rumors that the central bank is considering helping banks to offer negative interest-rate loans (NIRLs). More shocking and awesome has been the BOJ’s low-key purchases of stocks.

On 4/24, Bloomberg reported: “While the Bank of Japan’s name is nowhere to be found in regulatory filings on major stock investors, the monetary authority’s exchange-traded fund purchases have made it a top 10 shareholder in about 90 percent of the Nikkei 225 Stock Average, according to estimates compiled by Bloomberg from public data. It’s now a major owner of more Japanese blue-chips than both BlackRock Inc., the world’s largest money manager, and Vanguard Group, which oversees more than $3 trillion.”

Thursday, April 21, 2016

Crude Oil: No April Freeze

One of our savvy accounts sent me an email early Monday morning with a terse message: “Doha: Ha, Ha!” He correctly predicted that there wouldn’t be a deal over the weekend to freeze oil production. Apparently, he wasn’t alone. Lots of traders must have shorted the oil market last week expecting no deal. The nimble ones must have covered their positions quickly Monday morning on the initial swoon in the oil price; after the low made on the open of the regular session, a rally swept the price north to close down only 0.4%.

Giving the market a boost on Monday was news that Kuwait’s oil workers went on strike to demand more pay. On Wednesday, oil prices fell in the morning as oversupply worries returned after Kuwaiti oil workers ended their three-day strike and American Petroleum Institute data indicated a larger-than-expected build in US crude inventories last week. By Wednesday afternoon, prices hit new 2016 highs after the US Energy Department (DOE) reported a smaller-than-expected US crude build, which more than offset glut worries stirred by the end of a Kuwaiti strike.

In addition, as CNBC reported on Wednesday, “Markets also got lift from reports that OPEC members and other crude-producing nations could meet in Russia in May following a failed attempt to freeze output at a gathering in Doha this week. But Russian Energy Minister Alexander Novak on Wednesday denied media reports of the potential meeting, RIA news agency reported. ‘There is no such agreement,’ RIA quoted him as saying.”

I also didn’t expect a Doha deal. On March 31, I wrote that it’s “[h]ard to see a freeze in April.” I wasn’t predicting the weather, but rather the likelihood that the Iranians would balk at the Saudis’ insistence that they freeze their production at pre-sanction levels. Sure enough, the Saudis continued to press their demand prior to the meeting, so the Iranians simply didn’t show up. What now? Consider the following:

(1) Production. The Saudis are threatening to increase their production. So are the Russians. On the other hand, everyone is waiting for US oil production to decline in reaction to the plunge in oil prices. However, the rebound in prices since the start of the year might allow many US producers to keep pumping.

The bulls are taking comfort from a chart showing that the US oil rig count leads oil field production by roughly 18 months. This relationship suggests an imminent plunge in US output. So does the relationship between US oil field production and railcar loadings of chemicals and petroleum products.

On the other hand, US frackers have DUCs, or “drilled but uncompleted” wells. “When oil prices started their long slide in mid-2014, many producers kept drilling wells, but halted expensive fracking work that brings them online, waiting for prices to bounce back,” Reuters explained on 3/21. As the price of oil increases, drillers can easily bring those uncompleted wells online. “Wood Mackenzie reckons that the backlog of excess DUCs will decline over the next two years, and return to normal levels by the end of 2017,” the article states. This ready-and-waiting supply in the wings is likely to keep crude oil prices closer to today’s levels than north of $100 per barrel. I agree with this conclusion.

Meanwhile, data compiled by Oil Market Intelligence (OMI) show that during March, crude oil output in the US and Canada combined rose to a record 13.6 million barrels per day (mbd). Russian and Saudi production remained in record-high territory at 11.4mbd and 10.2mbd. The same can be said of Iraq’s output at 4.3mbd. Iran’s production was up 0.7mbd y/y to 3.3mbd during March, with the country aiming to increase it to 4.0mbd before considering joining other suppliers in “re-balancing” the market.

(2) Inventories. Notwithstanding the positive reaction to yesterday’s DOE crude oil report, US crude oil stocks rose to yet another record high and are up 10.1% y/y. Total petroleum inventories were flat during the latest week at a record high and remain 10.3% above last year. (See our US Petroleum Weekly.)

(3) Demand/supply. Global oil demand rose to a record high during March. However, over the latest three-month period it rose just 1.4% y/y, while oil supply on a comparable basis increased 2.3%. The demand/supply ratio, which we calculate using OMI data, turned bearish in early 2014. It remains bearish, but ticked up during March. (See our Global Oil Demand & Supply.)