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.”

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.)

The Shanghai Conspiracy

I love conspiracy theories. They help to explain puzzling developments that don't make much sense unless there is a conspiracy behind them. The conspiracy theory du jour is that at the February 26-27 meeting of the G20 finance ministers in Shanghai, the Chinese threatened to devalue their currency by 15%-20% unless the Fed agreed to postpone normalizing monetary policy. A 4/8 Reuters article titled "Markets happy to play, if not believe, idea of G20 dollar accord," reviewed the possible scenario. It observed:

Even if there was no secret deal to weaken the dollar and stabilize world markets at a meeting of Group of 20 finance chiefs in Shanghai six weeks ago, currency and stock markets seem happy to play as if there was. ... In the weeks since, the three big headaches of the past year--China's yuan, falling oil prices and the threat of a stronger dollar and higher U.S. interest rates--have eased. In response, emerging markets have steadied, stocks and oil are not falling as fast and China's currency reserves, the cause of a huge global sell-off in early January, are rising again. It looks almost as if someone planned it.

The article proceeded to report why such a secret agreement was unlikely to have occurred: "China's vice finance minister last month also denied the existence of a secret agreement with Washington. 'The more conspiracy oriented sides of this are fairly unlikely,' former U.S. Treasury chief Larry Summers told an event in Washington this week. 'It is just not the way that they (central banks) work.'"

Maybe so, but in the 1/26-27 FOMC minutes, China's troubles were mentioned six times. In the 3/15-16 minutes released last Wednesday, China was still mentioned three times, though financial conditions over there had improved. On the other hand, Fed Chair Janet Yellen mentioned China only once in her 3/16 press conference. However, in her 3/29 speech before the Economic Club of New York, Yellen singled out China and the country’s currency as a major source of global uncertainty as follows:

One concern pertains to the pace of global growth, which is importantly influenced by developments in China. There is a consensus that China's economy will slow in the coming years as it transitions away from investment toward consumption and from exports toward domestic sources of growth. There is much uncertainty, however, about how smoothly this transition will proceed and about the policy framework in place to manage any financial disruptions that might accompany it. These uncertainties were heightened by market confusion earlier this year over China's exchange rate policy.

Interestingly, in a 4/5 speech on the global economic situation, IMF Chief Christine Lagarde mentioned China five times, noting that its economy was slowing. She also observed: "Following turbulence at the beginning of this year, economic sentiment has improved--driven by further easing from the ECB, an apparent shift to a slower pace of rate increases by the U.S. Fed, a relative firming of oil prices, and lower capital outflows from China." That certainly sounds like the G20 finance ministers' ideal outcome following their meeting. You decide whether it was a lucky coincidence or a conspiracy.

In any event, the downward pressure on the Chinese yuan started around mid-2014, about the same time as the dollar started to soar on mounting expectations that the Fed would soon start raising interest rates while the ECB and BOJ were going the other way. The situation might have been exacerbated by Chinese companies that had borrowed in dollars and were scrambling to get dollars to pay off those debts in order to borrow at home instead.

Gillian Tett, the widely respected FT reporter, hobnobbed in Davos in late January and recapped the intelligence she gathered in a 1/21 article titled “The tiny shifts that can signal huge changes.” She raised the possibility of lots of trouble among emerging markets that had borrowed in dollars:

In recent years emerging markets companies in general--and Chinese groups in particular--have dramatically increased their dollar debts. The Bank for International Settlements calculates this now stands at $4,000bn for emerging markets as a whole, four times higher than in 2008. A quarter of this debt has emanated from China. Until lately, using dollar-based markets to issue bonds or take loans seemed a smart strategy for Chinese groups. After all, the US Federal Reserve has kept dollar rates at rock bottom lows and the renminbi has strengthened against the dollar in the past decade. But now the US interest rate cycle has turned and the renminbi has weakened. Moreover, contrary to assurances made in Davos by China’s most senior regulator that Beijing is committed to maintaining a stable currency, most delegates I have spoken to expect the renminbi to fall 10-15 per cent against the dollar in the next year.

From the perspective of Chinese officials, the Shanghai conspiracy makes sense. They wanted the US dollar to stop soaring, and figured that would happen only if the Fed backed off hiking rates. Their off-the-record Davos chatter confirms that they were threatening to devalue their currency if the Fed persisted. Meanwhile, Fed officials finally seem to have realized that a soaring dollar is not good for the US economy. So the Shanghai “deal” (whether it was a coincidence or a conspiracy) made sense for both the US and China.

By the way, another coincidence is that the yuan stopped falling as Chinese capital outflows slowed. The yuan fell to this year's low on January 7, and is up slightly since then. China's non-gold international reserves edged up by $11 billion during March after dropping $788 billion from the record high of $4.0 trillion during June 2014. Over the 12 months through February, China's reserves fell $594 billion while the country's trade surplus totaled $591 billion, implying capital outflows of nearly $1.2 trillion. It's not obvious what caused the outflows to suddenly stop in March. Maybe it was a conspiracy.

‘The New Mediocre’ (excerpt)

Global Economy I: The IMF Director’s Speech. It’s official: The New Normal is now the New Mediocre! Christine Lagarde, the managing director of the IMF, isn’t ringing the alarm bell, but she is on full alert about the sorry state of the global economy. She said so in a 4/5 speech titled “Decisive Action to Secure Durable Growth.” More specifically, she warned:

The good news is that the recovery continues; we have growth; we are not in a crisis. The not-so-good news is that the recovery remains too slow, too fragile, and risks to its durability are increasing. Certainly, we have made much progress since the great financial crisis. But because growth has been too low for too long, too many people are simply not feeling it. This persistent low growth can be self-reinforcing through negative effects on potential output that can be hard to reverse. The risk of becoming trapped in what I have called a ‘new mediocre’ has increased.

Lagarde is good friends with Fed Chair Janet Yellen. They must have had dinner together recently because the IMF chief’s speech sounded a bit like Yellen’s latest one, at the end of March. They both said we are in a time of uncertainty about the global economic outlook. They both mentioned the slowdown in China. Lagarde said:

China’s transition to a more sustainable economic model--which is good for China and the world--means that its growth rate, while still strong, is lower.

In her speech, Yellen said:

There is a consensus that China’s economy will slow in the coming years as it transitions away from investment toward consumption and from exports toward domestic sources of growth. There is much uncertainty, however, about how smoothly this transition will proceed and about the policy framework in place to manage any financial disruptions that might accompany it.

While on the subject of emerging economies, the IMF chief added:

Downturns in Brazil and Russia are larger than expected. The same is true for the Middle East--hit hard by the oil price decline. Many African and low-income nations also face diminished prospects.

As for advanced economies, they have lots of challenges as well, including “high debt, low inflation, low investment, low productivity, and, for some, high unemployment. In some countries, balance sheets of banks, and increasingly non-bank financial institutions, are strained by non-performing assets and low operating profit margins.”

As her speech progressed, Lagarde’s alarm escalated--over the slowdown in global trade, the increase in financial instability, frequent acts of terrorism, global epidemics, more refugees, and worsening income inequality. She noted that while income inequality “on a global, cross-country scale has been declining,” the widespread perception is that it is getting worse. She mentioned Oxfam’s recent report, which claims that the world’s richest 62 individuals own the same amount of wealth as the poorest 3.6 billion. She warned:

These frustrations are leading people to question established institutions and international norms. To some, the answer is to look inward, to somehow unwind these linkages, to close borders and retreat into protectionism.

Her solution is mostly more government. In the US, she wants to see the Earned Income Tax Credit expanded, the federal minimum wage increased, and “family-friendly benefits” strengthened. In the Eurozone, she advocated “better training and employment-matching policies to help more people find jobs, especially young people.” Her recommendation for emerging economies is “increased diversification.”

In addition to these “supply-side measures,” she wants to see more fiscal spending on infrastructure everywhere, and she is all for a continuation of ultra-easy monetary policies, including negative interest rates. There was no mention in her speech of true supply-side measures like cutting taxes and reducing government regulations.

I have been monitoring the subpar pace of global economic growth for the past few years. I’ve characterized it as “secular stagnation.” The IMF chief prefers to call it the “new mediocre.” She thinks that more government can end the mediocrity. I think that it is too much government that got us into this mess in the first place.

Global Economy II: More Mediocrity. The latest batch of global economic indicators are mediocre. Consider the following:

(1) US. The Atlanta Fed’s GDPNow model forecast for real GDP growth (saar) in Q1-2016 was lowered to 0.4% from 0.7% on April 1 following the release of relatively weak auto sales data for March. The forecast remained at 0.4% after April 6's merchandise trade report. Real imports rose more than real exports during February, with the former up 6.8% y/y, while the latter was up just 0.5%.

February’s nondefense capital goods orders excluding aircraft fell 2.5% m/m and 0.7% y/y. Among machinery orders, the strength in demand for industrial, metalworking, and material-handling equipment continues to be offset by weakness for construction, farm, and mining gear.

On the other hand, there is more good news in the US labor market, as new hires jumped to a cyclical high of 5.42 million in February. The total number of job openings, at 5.45 million, remained near its recent record high. Furthermore, the ISM nonmanufacturing PMI rose to 54.5 last month, the best reading since December. (See our US Business Surveys.)

(2) Eurozone. There have also been a few strong and weak economic indicators in the Eurozone lately that add up to a mediocre mix. The volume of retail sales excluding motor vehicles rose 2.4% y/y to a cyclical high that matches the previous record high during February 2008. However, German factory orders fell 1.2% m/m and were basically flat with last February’s level. German manufacturing output also fell during February by 0.5% m/m but is up 1.2% y/y.

The Fed: Thanks Again, Fairy Godmother!

Snow White didn’t have a fairy godmother. However, we do: Fed Chair Janet Yellen. In her speech this past Tuesday, she strongly suggested that she is in no rush to raise the federal funds rate again anytime soon. Apparently, she wants to see the snow whites of inflation’s eyes before doing so. Her speech before the Economic Club of New York was titled “The Outlook, Uncertainty, and Monetary Policy.”

By emphasizing uncertainty, she basically said that she (and her dovish allies on the FOMC) don’t have much confidence in their relatively upbeat outlook for the US economy. So it might be best to do nothing for a while. They clearly had more confidence when they hiked the federal funds rate at the end of last year. But then global financial markets tumbled at the start of this year after a couple of Fed officials said that four more rate hikes were likely by yearend. Apparently, the doves were traumatized by that and have decided to stay in their coop until there is more certainty. Consider the following:

(1) Volatile markets. At the start of her speech, Yellen said that “global economic and financial developments since December…“at times have included significant changes in oil prices, interest rates, and stock values.” She reiterated that “global developments have increased the risks associated with” the Fed’s outlook.

She continued to stress the market risks and uncertainties as follows: “Looking forward however, we have to take into account the potential fallout from recent global economic and financial developments, which have been marked by bouts of turbulence since the turn of the year. For a time, equity prices were down sharply, oil traded at less than $30 per barrel, and many currencies were depreciating against the dollar. Although prices in these markets have since largely returned to where they stood at the start of the year, in other respects economic and financial conditions remain less favorable than they did back at the time of the December FOMC meeting.”

(2) Risks to growth. Yellen is clearly concerned that by raising rates again, the Fed could destabilize the global economy and financial markets, which certainly would have an adverse impact on the US. She mentioned that while China is certainly slowing, there is much uncertainty about the pace of the slowdown. She didn’t say so directly, but she implied that Fed actions could destabilize China’s financial markets and exchange rate.

Rather than focus on the recent rebound in oil prices, Yellen chose to say that if they start falling again, that could renew the risk of an adverse “financial tipping point” for some oil-producing countries and companies.

(3) Risks of disinflation. Yellen also was extremely dovish about the inflation situation. She noted that the PCED inflation rate was 1.0% y/y through February and that the core rate was 1.7%, up from a recent low of 1.3% during October. In other words, the core rate is getting close to the Fed’s 2.0% target. Yet she chose to minimize this development as follows: “But it is too early to tell if this recent faster pace will prove durable. Even when measured on a 12-month basis, core inflation can vary substantially from quarter to quarter and earlier dollar appreciation is still expected to weigh on consumer prices in the coming months.”

Consequently, she expects inflation will remain below 2.0% this year, though it should be up there in 2017 and 2018. She continued to accentuate the risks of lower inflation, saying: “The inflation outlook has also become somewhat more uncertain since the turn of the year, in part for reasons related to risks to the outlook for economic growth. To the extent that recent financial market turbulence signals an increased chance of a further slowing of growth abroad, oil prices could resume falling, and the dollar could start rising again.”

(4) Uncertainty begets caution. The conclusion was obvious: The Fed should do no more harm as it had at the start of the year. Yellen put it this way: “Given the risks to the outlook, I consider it appropriate for the Committee to proceed cautiously in adjusting policy. This caution is especially warranted because, with the federal funds rate so low, the FOMC’s ability to use conventional monetary policy to respond to economic disturbances is asymmetric. If economic conditions were to strengthen considerably more than currently expected, the FOMC could readily raise its target range for the federal funds rate to stabilize the economy. By contrast, if the expansion was to falter or if inflation was to remain stubbornly low, the FOMC would be able to provide only a modest degree of additional stimulus by cutting the federal funds rate back to near zero.”

I think this all adds up to another year like last year of either none-and-done or one-and-done for Fed rate hikes. I am leaning toward the first choice. There could be more global uncertainty this summer if Brexit happens. In early November, there could be more domestic uncertainty if Donald Trump happens.