Author Archive for Marc Chandler

Refresher: CPI and the PCE Deflator

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

On Thursday, the US Department of Commerce will publish the May estimate of personal consumption expenditure deflator. Last week, investors learned that the consumer price index rose at its fastest rate in two years.

Since extraordinary monetary policy measures were taken, some observers have warned of inflation risks lurking around every corner. With CPI rising above 2%, could they finally be right?

Not so fast. The Federal Reserve’s 2% inflation target does not apply to the consumer price index. Since mid-2012, the Fed has identified the core PCE deflator as its preferred inflation measure. There is a significant difference. The PCE measure of inflation tends to be lower than the CPI measure.

In part, the two measure different things. The CPI is calculated by the Bureau of Labor Statistics of the Department of Labor. The PCE is calculated by the Bureau of Economic Analysis at the Commerce Department. An important methodological issue is the weights for the different components. The CPI uses the same weights for several years, while the PCE deflator uses current and preceding expenditures to calculate the weights. One implication of this is that the PCE measure also allows for substitution of goods with rising prices for similar goods with stable or falling prices.

pce cpi

When it comes to health care expenditures, which played a large role in the sharp downward revision to Q1 GDP, CPI and PCE measure somewhat different things. The CPI calculus includes only the expenses employees pay, while the PCE deflator also includes money that employers spend for their employee health care.

The CPI is calculated based on surveys of more than 14,000 families and 23,000 businesses they patronize. All told some 80,000 consumer items are included. Sales taxes are included.

The PCE deflator calculation is completely different, though both the PPI and CPI measures are used. Essentially, and at the risk of over-simplifying, the PCE deflator is derived from production, which is at the producer price level. The PCE methodology converts the producer priced goods/services into consumer prices, adding profit margins, taxes and transportation costs.

In addition, other data is incorporated. For example, it incorporates the monthly retail sales report, and the price of food grown and eaten on the farm comes from the US Department of Agriculture. The dealers’ margin on used vehicles is pulled from the National Auto Dealers Association.

The core measure strips out food and energy, mostly. Recent definitional changes, however, means that the core PCE measure includes restaurant meals. These have been redefined to be food services. Pet food is also included, seemingly as part of the pet expenditures rather than as part of the food budget.

Over the past 10 and 20 years, headline CPI has averaged 2.4%. The PCE deflator has averaged 2.1% and 1.9% for the 10 and 20 year periods respectively, or 0.3 percentage points and 0.5 percentage points respectively.

It is widely documented that for at least the past half century, headline inflation converges to core inflation (and not the other way around). This may help explain why the Federal Reserve prefers core measures.

The chart at the top shows the core CPI (white) and core PCE deflator (yellow) over the past 20 years. Over the past five years, the core PCE has undershot core CPI by 0.2% on average. Over the past ten and 20 years, the undershoot has been 0.2% and 0.4% respectively. The persistent lower estimates of the PCE deflator means that the Federal Reserve is likely to tolerate what may appear to be an overshoot of CPI.

There appears to be two elements that produce a more subdued rise in the PCE measure. One is the substitution effect that is not incorporated into the CPI measure. The other is the way that hospital expenses and airfares are calculated.

The consensus calls for the May core PCE deflator to rise to 1.6% in May from 1.4% in April. If accurate, it will keep this measure 0.4 percentage points lower the core CPI. It is consistent with the Fed’s assessment that the economy is evolving toward the Fed’s mandates. Some observers will make hay of the substantial contraction in Q1 GDP, but this too should not alter the outlook for Fed policy. The Fed’s economic mandates, as we have discussed, are on employment and prices and both did indeed move in the (Fed’s) desired direction in Q1 and appear to have done so further in Q2.

An OIl Update

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

West Texas crude oil prices are near their best levels of the year. The front month futures contract is near $104.50 a barrel. The high, thus far, this year was set in early March near $105.20 a barrel.

Declining US inventories appear to be a factor. The EIA reported that inventories at Cushing have fallen to five year lows. This has been a trend since January as the southern tranche of the Keystone XL pipeline has been shipping oil to the Gulf refineries.

There are several geopolitical considerations and these appear to be underpinning Brent more than WTI oil. First, a break away al-Qaeda group reportedly has taken control of Mosul, Iraq’s second largest city and are in a position to disrupt the country’s energy infrastructure. The critical 600k km pipeline has been closed for repairs since early March. Those repairs have reportedly been disrupted.

Second, reports suggest that China’s demand exceeds what is needed for immediate economic use. China is building a strategic reserve In the January-April period, China appears to have imported about 600k barrels of oil a day. Although the government data is scarce, industry watchers estimate a third to a half of the oil is for the strategic reserves.

Government figures suggest China’s strategic reserves were around 141 mln barrels at the end of last year. In comparison, the US strategic reserves were just below 700 mln barrels in late May. The US strategic reserves are sufficient to cover a little more than a month of consumption (~37 days). It can hold about 95 days of imports according to industry estimates. China aims at establishing strategic reserves to cover 100 days of net imports that are something on the magnitude of 600-700 mln barrels. Its coverage of current consumption is estimated to be around three weeks currently.

Third, OPEC decided to maintain the 30 mln barrel a day ceiling for the fifth consecutive meeting this week. There was some thought that it may have chosen to boost output to offset the shortfalls of Libyan and Iranian output. In the middle of May, the IEA called on OPEC significantly increase production. Libyan output is on the magnitude of 1/10 of its pre-conflict levels. If the Iranians does not reach agreement on its nuclear program by the end of next month, the sanctions that were lifted will be re-applied.

It is not a factor driving prices, but we note that apparently under pressure from the US and the EU, Bulgaria has halted construction of a pipeline that would have carried gas from Russia that would have circumvented Ukraine. The South Stream pipeline would go under Black Seat to Austria through Bulgaria. Bulgaria is an EU member and is thought to be among the most pro-Russian member.

The EU itself has expressed opposition to the pipeline on grounds of being counter-productive to diversifying suppliers away from Russia. The US is opposed, it appears on general grounds, but also because the company being used to build the pipeline is controlled by a person who is on the sanction list. The work stoppage ostensibly took place due to an investigation into how the project’s contracts were awarded.

There does not appear to be a stable correlation between the G7 currencies and oil prices. However, we do see for most of the year; the Canadian dollar (not the US dollar against the Canadian dollar) was inversely correlated with the price of oil (60-day percent change basis). However, since the start of the month the correlation has turned positive, but barely so (0.16). This correlation is just above sterling’s (0.15) and is the same for Brent. Looking at a somewhat broader array of major currencies finds that the Australian dollar’s correlation is also at the highest for the year, but still low (0.22). Ironically, the Norwegian krone’s correlation to Brent is inverse (-0.13).

Macro Perspective on the Investment Climate

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

One of the key issues hanging over the market since April when the policy signals pointed to a move by the ECB in early June was precisely what it would do. In recent days, it has become clearer that the ECB is more likely to cut rates than initiate an asset purchase program.

There are three interest rates the ECB could. The first is the lending rate, which stands at 75 bp and marks the top of its interest rate corridor. Usually in low or falling interest rate environment, the rate ceiling is of lesser importance. However, a lower lending rate, under current conditions, cold help reduce the volatility of overnight rates (EONIA).

The second rate it could cut is the re-finance. It is at 25 bp and under the current policy setting, the ECB is willing to provide as much funds at this rate as banks want, limited only by the acceptable collateral. A 10-15 bp cut seems to be the consensus view. The ECB also could extend the period for which is it willing to provide full allotment (unlimited funds). There have been some calls to reduce the refi rate to zero, but this seems to be an outside possibility. Even though EONIA has traded above the refi rate, a lower refi rate may still exert, albeit, limited downward pressure on overnight rates.

The third interest rate that the ECB could cut, and the most controversial is the deposit rate. It currently stands at zero, and there is much talk that the ECB could set it at -25 bp. This would, in effect, tax banks for leaving excess reserves at the ECB. The tax would hit banks with the most surplus funds that hardest and these of course are mostly from core countries, excluding France. Banks from peripheral Europe and France may account for 20% of the funds at the ECB. These banks typically are net borrowers and so lower rates would also likely benefit them the most.

There are secondary effects of a negative deposit rate that may overwhelm these primary effects. It is important to recognize that such a measure has not been implemented by a large economic area. Even at the worst of its deflationary phase, Japan never forced banks to pay for the privilege of leaving funds with it. Banks are likely to pass on the negative rates to customers, as some banks did when Denmark adopted a negative deposit rate. This may lead to a change in the way corporations and institutional investors manage their euro balances.

The prospects of a negative deposit rate may be a factor weighing on the euro. However, more importantly, the recognition that an asset purchase scheme is somewhat less likely, has helped encourage increasingly nervous investors in the peripheral European bond markets. As we have noted, IMF and EU officials have expressed concern about the sustainability of the peripheral bond rally and some institutional investors has been quoted by the press indicating some profit-taking had begun.

The flows leaving the periphery appear to be returning to core bonds. Last week, 10-year Treasury and bund yields fell 13-14 bp. Gilts, with the help of a dovish BOE’s Quarterly Inflation Report and soft earnings growth data, outperformed with 17 bp decline in 10-year yields. In contrast, Italy’s 10-year yield rose 9 bp, Portugal 16 and Greece 59 bp. Spain fared best, with only a 2 bp increase in the 10-year yield.

Funds also seemed to move into emerging markets. The MSCI Emerging Market Index (equity) rose 2.5% last week, easily outperforming the major indices. Emerging market bonds also rallied. Some investors are also moving into eastern and central Europe, including Poland and Hungary. HSCB will report its flash manufacturing PMI survey for China at midweek and some sign that the world’s second largest economy is not slow further may also provide some support for emerging markets as an asset class.

Global monetary conditions will remain extremely accommodative. Soft US industrial output and manufacturing data on the heels of a disappointing retail sales report continues to discourage investors from taking too seriously St Louis Fed’s call for a rate hike as early as Q1 15. Even now the Federal Reserve is buying more long-term assets than it was when it first announced QE3+ in September 2012. The rally in short-sterling futures suggests the BOE has been successful in pushing out interest rate hike expectations. The BOJ is the main exception. It is leaning against expectations that it will have to increase its $70 bln a month of asset purchases.

The economic data scheduled to be released in the coming days is unlikely to change the basic economic assessment and policy outlooks. The FOMC minutes will do nothing to change perceptions that those officials that are emphasizing the economic slack, particularly in the labor market, are in a majority over those who are emphasizing the risks of such extremely accommodative monetary policy. The stronger than expected housing starts reported last week, is likely the start of some more constructive housing data, including existing and new home sales reports this week.

We do not expect the minutes from the Reserve Bank of Australia or the Bank of England to be very revealing. The RBA is clearly on hold and prefers a weaker currency. The BOE’s minutes have been trumped by the Quarterly Inflation Report. Next month’s Financial Policy Committee meeting is more important in terms of macro-prudential efforts to address housing. This will reinforce the BOE’s signal that it is in no hurry to raise rates.

Separately, it appears that UK consumer prices are stabilizing while retail sales should accelerate from the nearly flat (0.1%) rise in March. They will be reported Tuesday and Wednesday respectively.

The flash euro zone PMI will be reported on Thursday. It should not be surprising to see the PMI begin to move broadly sideways after the strong advance in recent quarters. That said, the real economy has not performed much different than the ECB expected. There is no evidence that the risk of deflation is sparking a downward spiral in demand as consumers postpone purchases in anticipation of lower prices.

Politics, rather than economics, may be the key talking points in the coming days, ahead of the EU Parliament election in the second half of the week, with results announced on May 25. Polls suggest that the anti-EU parties may draw as much as a quarter of the vote, with France’s National Front and the UK’s Independent Party doing particularly well, with implications for national campaigns. It appears to be a very close race between the center-right EPP and the center-left S&P.

The Ukraine presidential election will be held on May 25. That will likely begin a new phase in the crisis. Reports suggesting that non-uniformed combatants (Blackwater) maybe confronting non-uniformed Russian allied combatants in east Ukraine also appears to be mark a new phase. It continues to appear that the limited sanction regime is having a somewhat greater cooling off effect on Russia’s financial and trade ties than it may have initially appeared.

Perhaps it is Putin’s trip to China that may be the most suggestive of change. It might take Europe a few years to cut its dependency on Russian energy if it wanted. However, that is the direction that its strategic interest lie. Russia’s actions, especially the annexation of Crimea and its continued bully behavior towards Georgia and Moldova, has alienated it from the Europe. It must turn to Asia. Chinese officials are well aware of this. They hold the whip hand. It is an opportunity to secure low energy prices on a long-term contract. That this can turn into a strategic relationship is unlikely, but it may serve Russia and China’s interest independently to at least pretend this is possible.

For its part, China has adopted different tactics in Hong Kong, and Taiwan than Russia is on its borders. China would not accept Tibet, for example, of having a referendum on independence. It abstained in the UN Security Council vote to condemn Russia. To the extent the Russia’s actions in Europe frustrate the US effort to implement its Asian pivot, China is unlikely to undercut it.

China has its own problems in securing its territorial claims. The regional hostility toward Japan and the nationalistic impulse of Prime Minister Abe win little general support. The Philippines dispute with China may be dismissed as a client state of the US. However, the confrontation with Vietnam has escalated over the weekend, leading China to evacuate some of its citizens. Unlike Japan and the Philippines, Vietnam does not enjoy a security treaty with the US, leaving it more vulnerable to Chinese reprisals.

Lastly, the electoral victory in India of the BJP and its allies is encouraging investors and fanning the hopes of reform. In the five sessions, through May 15, foreign investors bought $1 bln of Indian shares, almost 20% of what was bought since the start of the year. Last week, Indian shares rallied 5% about 50% of what they had risen up until then. The rupee was the strongest of the Asian currencies last week appreciating 2% against the dollar. Before last week, it had gained about 3% since the start of the year. We expect Modi to enjoy a honeymoon that will be good for investors and recommend global investors embrace potential near-term profit-taking as a new opportunity to participate.

 

Chart of the Day: New DM-EM Equity Convergence

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

This Great Graphic, created on Bloomberg, depicts the MSCI equity index for the developed countries (orange line) and the emerging markets (white line).

dm em

The charts begins at the start of last year. In the first several months of 2013, DM outperformed EM. The big EM sell-off coincided with first hint from the FOMC about tapering. EM recovered and tracked the DM until October. A new phase of divergence, with DM outperforming again lasted into early March.

Since mid-March the performance is a study in contrasts. MSCI emerging market equity index is up about 8.4%. During the same time the developed markets index is up a little less than 1%.

In the foreign exchange market over this period, the dollar-bloc is the strongest. The Australian dollar is easily the best performer rising 3.3% against the dollar, followed by the Canadian dollar (1.7%) and the New Zealand dollar (1.5%). Sterling is a distant fourth, up 0.4%, and all this was recorded today. The other major currencies have lost ground against the dollar this period.

Among the emerging market currencies, the Brazilian real (5.8%), Colombian peso (5.5%) and Turkish lira (5.5%) have led the advance. Chilean peso (3.5%) and the Russian rouble (3.0%) round out the top five. As with the majors, the high yielding/high beta currencies has generally outperformed.

 

4 Macro Changes to the Current Investment Climate

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

There are four changes to the broad investment climate.

1. The ECB has stepped up its threat of unconventional action and may have purchased a two month grace period.
2. Confidence in the US economic rebound from sub-par growth in Q1 is strengthening.
3. After a strong start, the major developed countries’ equity markets appear poised to correct lower into the start of the US earnings season.
4. While geopolitical risks with Russia have stabilized albeit at elevated levels, the risks in Asia are rising.

How is this for coincidence? The German newspaper, Frankfurter Allgemeine Zeitung (FAZ), broke two stories before the weekend. In one story, the paper quoted BBK President Weidmann and EU Economics Commissioner Rehn arguing against the push from France for greater leeway on its fiscal targets.

In another article, reported, without citing a source, that the ECB has modeled a one trillion euro QE program that would boost inflation between 0.2% and 0.8%. When queried by other journalists at a different forum, ECB Vice President Constancio denied knowing about the report, though seemingly, by implication, not the research.

One cannot help but suspect it is purposeful leak that is meant to reinforce the Draghi’s effort to step up his attempt to hold the market at bay. At last week’s press conference, following the ECB meeting, Draghi escalated his verbal jousting increased calls for action, including by the head of the IMF.

To appreciate what is going on, consider the contrast: in recent years, the Federal Reserve has been dominated by a single individual–Volcker, Greenspan, Bernanke–. The ECB is much more of a collective. We suspect that Draghi is slowly shepherding the national central bank presidents onto the QE path. Because of the Easter quirk, there is reason to suspect that April will see an uptick in CPI (the flash reading is due on April 30)) from the flash 0.5% March pace.

Judging from economic surveys, many economists expect Q1 to be the low point in the inflation, i.e., the greatest risks of deflation. The creditors in the euro area, especially Germany, are wary of pursuing unconventionally inflationary policies just as inflation begins to rise on its own accord.

This analysis points to a new realistic window for ECB action seems not in May, which would be many observers tendency (just push out the expectation another month), but in June. This seems to be also along the line former ECB board member Bini-Smaghi suggested in a newswire interview, as well.

The possibility of QE will help support peripheral bond markets. Although some US credit spreads are back to levels seen since before the crisis, Spanish and Italian premiums over German remain substantially above pre-crisis levels. The premiums now are around 150 bp. For many years, into 2008, Spain and Italy a smaller premium than France pays now. Indeed, according to Bloomberg generic bond data, between 2003 and 2006, there were brief periods when the Spain would trade through Germany (lower interest rate).

We note that there were some technical changes in the ECB’s collateral rules that went into effect last week. These changes will increase the haircut on Spanish and Italian T-bills used for collateral. It appears to be instrument specific and will not impact residual maturity of bonds. Reports suggest that this may not have much impact as Spanish and Italian banks use bills for managing liquidity more than collateral. On the hand, changes may also make more assets eligible for use in ECB operations.

We took the middle ground between those who suggested that the weakness of the US economy was only weather-induced and those who said the weakness showed that the economy was addicted to QE. We recognized that other influences, such as the build of inventories in H2 13 and the tax break on corporate investment brought forward some projects, also slowed the economy. We also recognized that some housing data had peaked in H2 13 and were already softening before the turn of the year.

However, weather also contributed to the sub-par performance and last week’s news, both the surge in auto sales and the constructive employment report, point to an economy regaining traction. In particular, we note that the participation rate rose to 63.2%, a six month high, without an uptick in the unemployment rate. We appeared to have been too cynical in our anticipation that the loss of emergency jobless benefits would generate further declines in the participation and unemployment rates. The workweek increased to 34.5 hours, the best since last November.

If the US economy expanded around 1.75% in Q1, then it appears that growth can return toward 3.0% here in Q2. This keeps the Federal Reserve’s path clear. Tapering continues apace. Indicative interest rates for the end of 2015 (look at both the Eurodollar and Fed funds futures strip) finished last week at their lowest levels since the FOMC meeting on March 19 and Yellen’s press conference. A rate hike in H2 2015 still seems like the most likely time frame, assuming no significant shocks, which would include renewed decline in core inflation.

The decline US interest rates before the weekend was more a function of the drop in equity market than the US economic news. The NASDAQ fell 2.5%, which is its third steepest drop since the start of 2012. It peaked a month ago. It finished last week below its 100-day moving average fore the first time since the end of 2012. The S&P 500 posted its record high before the weekend, but proceeded to sell-off and finished below last Thursday’s low. Technicians refer to this price action as a key reversal. There are also bearish divergences in some technical indicators like RSI and MACDs.

Given the magnitude of the sell-off in US equities and the appreciation of the yen, the Nikkei and other regional markets are at risk of steep losses at the start of the week. More interesting will be the European bourses reaction. On one hand, the risk of QE and lower interest rates would seem to encourage equity market flows.

On the other hand, consider the performances just since mid-March: the Italian and Spanish markets are up about 10.5%. The German DAX is up 9% and the French CAC up 7.5%. Spain and Italy’s markets are above the top of their Bollinger Bands, (two standard deviations above the 20-day moving average). France and Germany are flirting the top of their bands. Given that the UK’s FTSE has not fully participated in the latest leg up, gaining less than half of the CAC’s rise, it may hold up better, if a correction sets in. And it looks to us as if the risks of such a correction have increased. It is not uncommon, it seems, to see reversals at the start of new quarters or as the US earnings season begins.

The dispute over islands in the South China Sea appeared to pose the greatest geopolitical risks before Russia’s take-over of Crimea. While the tensions with Russia remain at high levels, they have stabilized. There is risk that the breakaway province of Moldova, on the east border of Ukraine, Transnistria, becomes a new flash point.

If Q1 was about Europe, Q2 might be about to Asia. Later this month, President Obama will visit South Korea, Malaysia, Japan and the Philippines. The Japan-China dispute had appeared the most pressing.

Unbeknownst to many, the dispute with between China and the Philippines has escalated and is, arguably, surpassing the dispute with Japan. There have been two developments that have escaped the notice of many observers.

First, China tried in vain to stop the Philippines from re-provisioning a garrison it created on the disputed Second Thomas Shoal in 1999. That China failed does not necessarily mean that it will give up, expressing it displeasure at the Philippines insistence of using force to resolve the dispute. It does not like fait accompli.

Second, the Philippines also pressed its legal case, filing a 4000-page opening argument with the International Permanent Court Arbitration at The Hague. China is not happy about this either. The sovereignty of the disputed islands is outside of the court’s jurisdiction, but it can decide whether it is really land or not, as they are often submerged. If it is not land, then the Philippines’ claim is stronger. But not just the Philippines’ but Vietnam, Malaysia, Brunei, Indonesia, and Taiwan’s claims may be stronger, as well.

At the end of last week, the US State Department’s point man on Asia, Assistant Secretary of State for East Asia, Daniel Russel warned China not to take inspiration from Russia’s annexation of Crimea (we anticipated this here). China took exception with the official remarks, Make no mistake about: although Russia’s threat in Europe is real and will not go away as long as Putin rules, the geopolitical problems in Asia are even more vexing. Yet, what Kissinger once purported to have asked about Europe (who do you call?) is more applicable to Asia now.

It is not just the US adversaries that ought to act in a restrained fashion, but so too should US allies. The nationalization of disputed islands by Japan prodded China with a stick. The Philippines are flaunting their security pact with the US to embarrass China. The US and China would have preferred to let sleeping dogs lie. But now that they have been awoken, they may come back to bite in the period ahead.

Chart of the Day: Estimating Wage Growth

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

This Great Graphic was tweeted by the Financial Times’ Cardiff Garcia, which he got from Goldman Sachs. It tries to assess the outlook for wage growth based on different measures of unemployment, including short-term unemployment rate.

wages

The problem is that wages do not seem to be tied to the measures of the unemployment rates. This is to say that wage growth is been considerably weaker than the improving labor market would suggest.

Wages are understood to be an economic function of supply and demand. Yet the relationship appears to have broken down. One response is that it is simply a question of time, Back in 1998-19900, wages grew faster than expected based different unemployment measures. This was a short run anomaly. An alternative hypothesis begins with the observation that since 2001, wage growth has typically under performed what the levels of unemployment would suggest. Could this be the implicit threat posed by China? It joined the WTO in late 2001. This hypothesis suggests that politics, as in power, is may be a better explanatory variable for how the social product is divided between profits and wages.

Given that the forward guidance of the Federal Reserve is evolving and, most recently, it dropped the reference to a 6.5% unemployment rate, and the comments by Yellen, investors will be watching earnings very closely. Recall that in February, the weather prevented many from going to work, but their salaries were not impacted. This helped generate a statistical quirk of a larger than expected increase in hourly earnings. They rose 0.4% for a 2.2% year-over-year rate, which is the upper end of the range for the past three years.

 

Chart of the Day: Rate Differential Gaining Traction

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

This Great Graphic is the bane of our euro bearishness, at least until last week’s FOMC meeting. This Bloomberg chart shows the US premium over Germany on 2-year money (white line) and the inverted euro (yellow line).

rates and fx

We have often found the spread helpful thinking about the euro’s movement. You can see how well the differential tracked the euro-dollar exchange rate until more recently and especially since February.

However, the divergence of monetary policy is reaching a point now that indeed seems to be re-coupling the two time series. Although most Fed watchers still expected the first hike in H2 15, there is clearly risk that it comes earlier.

At the same time, many do not think the ECB will move next week, but recognize the risks have increased by the low CPI readings in Germany, Spain and Belgium. Money supply growth remains lackluster and private sector (non-financial) lending continues to contract. Excess liquidity in the euro system is threatening to fall below 100 bln. EONIA has not spiked (yet) into month and quarter end, but around 17 bp, it is twice the US equivalent (effective Fed funds).

Chart of the Day: the CRB and Oil Prices

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

Commodities are very much the center of attention in the financial markets. The first Great Graphic, created on Bloomberg, is the CRB index. Through last Friday (March 7) it had rallied 13.5% since January 9.

It gapped higher on March 3and gapped lower earlier today, leaving a bearish island top in it wake. Technical indicators like the RSI and MACDs have turned lower. The gap extends from yesterday’s low (304.75) to today’s high (303.72). Completing the gap and moving above it would negate this bearish views. In late morning activity, there was an attempt to close the gap but it was rebuffed and the CRB returned to the middle of its range. We suspect is break away gap, meaning that it is unlikely to be filled in the near-term.

crb

The CRB index also gapped higher on February 19. This gap has not been completed. In can be found between 298.55 and 299.29. A move to this area will be the first bearish objective. The next one is 294.50 We suspect there may be potential toward 290.

The lower chart, also from Bloomberg is a chart of the May US crude oil futures contract. The rally was not as impressive as the one in the CRB. It did not gap lower and there is not island gap, but the technical condition appears almost as bearish. The RSI and MACDs are trending lower.

It closed yesterday at the psychologically and technically important $100 a barrel level, but follow through selling today has seen it loss another 2%. It has moved toward the 61.8% of the rally off the the early-January though early March high (found near $96.60). That rally has carried oil up a little more than 15%.

oil

Today’s sell-off may have been aggravated by conspiracy theories sparked by the unexpected announcement by the US Department of Energy. It said it would sell up to 5 mln barrels of crude oil from its strategic reserves as a test of its systems. It is the first sale since 1990 specifically for test purposes. It will off sour crude and bids are due March 14.

The test apparently has been subject of internal discussion for some time and was timed to be the most helpful for refineries in term of their maintenance schedule. The 5 mln barrels is roughly equivalent to the US daily import of crude oil and about 25% of the US daily consumption.

Many observers initially linked the release of the strategic reserves to confrontation with Russia over Ukraine and Crimea. Yet, 5 mln barrels is a drop in the bucket, so to speak and it is not clear, in any event, how much the announcement weighed on prices, which were already moving lower before announcement. If the US were really trying to depress oil prices, the amount would have been bigger and, more than likely, it would have tried coordinating with Europe as was the case when the last time the reserves were tapped. In 2011, in response to the civil war in Libya, in coordination with Europe, the US sold 30 mln barrels of oil from its reserves.

At the present, none of the major currencies, including some crosses, are particularly closely tied to the CRB in general or oil prices in particular. Sterling against the yen may be about the best (highest correlation with oil) and that is only about 0.28 correlated ( 60 day percentage change basis) We have looked at a number of emerging market currencies and the results were similar results.

 

Seven Event Risks in the Week Ahead

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

The week ahead could very well be the most important week of the month. Four central banks from the high income countries meet, the latest purchasing managers surveys will be released and the latest reading on the US labor market will be announced.

At the same time, Russia’s move on Crimea and the US and European response may eclipse, at least partially, the economic focus of investors. Lithuania and Latvia have invoked Article 4, which requires consultation over Russia’s actions when a member feels its security or independence is threatened. It is only the fourth such action in NATO history.

1. Ukraine (Moderate risk): Neither the US nor Europe are inclined to try to use military force to push Russia out of Crimea. There may be a short-lived wobble to the detriment of risk assets and beneficial for the dollar, yen and Swiss franc. Yet, the impact of geopolitics tends to be transitory. The early July G8 Summit in Sochi may be in jeopardy, but the G7/G8 had already been reduced to a caucus within the G20 and Russia’s special role had already been diluted. Dis-inviting Russia from the G8 on grounds of not going to the UN for authority is laughable, given what happened in Iraq, but it does not mean it can’t happen.

After Ukraine, Germany may have the most to lose from Russian actions. Its energy program and efforts to de-nuclearize seems to force greater reliance on Russian energy. The Soviet invasion of Afghanistan spurred an increase in military spending (which in the US began under Carter, not Reagan as often suggested). Many countries in the West are reducing military spending presently. There is some risk that China will use the West’s distraction to press is case in the South or East China Sea. There may also be knock-on effect in the EU parliamentary election in May, where the anti-EU parties seemed to have moved into ascendancy.

2. China (Low risk): China reported its official manufacturing PMI eased to 50.2 from 50.5 in January. The Bloomberg consensus was for 50.1. Output and orders slipped, while exports remained below the 50 boom/bust level for the third consecutive month. The PMI for large businesses eased to 50.7 from 51.4, while the reading for small businesses is contracting, as the HSBC flash PMI showed. The final manufacturing read and its service PMI, along with the official one, will be released first thing Monday in Beijing. In part, what is happening is a decline in investment, especially in the credit sensitive sectors, like infrastructure and real estate where investment has been excessive.

We expect the RMB to stabilize in the week ahead, though last week’s decline did not prevent the Shanghai Composite from finishing the week with a three-day rally or the MSCI Emerging Market equity index from ending February at its highest level since January 23. The depreciation of the RMB is too small, given the relatively low-value added being done by Chinese workers, too boost exports and therefore the direct impact on trade is likely minimal at best. The National People’s Congress begins at midweek and a solidification of the reform agenda should expected.

3. The Reserve Bank of Australia (Low risk): The RBA meets and the result will be announced Tuesday morning in Sydney. At its last meeting, it indicated that a period of rate stability is best and although the labor market continues to deteriorate and activity outside mining is not picking up sufficiently quickly, it is too soon to expect much of a change in the RBA’s stance. The market may decide to ease for it, by taking the currency lower. Technically, the February rally looks over and a new push lower appears to have begun. Its failure to resurface above $0.9000 signals initial downside risk back into the $0.8840-80 range.

4. Bank of Canada (Low risk): The Bank of Canada meets Wednesday March 5. There is little to no chance of a rate cut and the BoC has already shifted its rhetoric to a more dovish/neutral tone since Carney went to the Bank of England. As in the US, the extent of the weather-induced economic disruption is not immediately clear and reasonable people can and do disagree. The February IVEY (Thursday) and jobs data (Friday), the latter to overshadow the January trade figures due out at the same time, may be more important for the Canadian dollar direction.

5. Bank of England (Low risk): Under Carney, the emphasis at the BOE is on using forward guidance to push against market fears of a rate hike sooner than the first part of next year. There is practically no chance of a change in rate. And because the BOE does not say anything when it does not do anything, there is no statement-risk a there is with the other central banks. The three PMIs (construction, manufacturing and service) are expected to show that UK economic activity has leveled off a bit at a reasonably robust pace.

6. European Central Bank (High risk): Of the central bank meetings this week, the ECB’s is the only live one in the sense of a realistic possibility of a change. The failure to act in a substantive way could see the euro appreciate. Many, if not most, have focused on what we would regard as a symbolic 10-15 bp cut in the main repo rate. We suspect the euro could rally on this, as it is not the significant rate. It would unlikely even impact forward pricing. With the PMI likely showing continued expansion for the region and the preliminary CPI reading unchanged, officials will not feel compelled to take drastic measures such as adopting a negative deposit rate or launching a sovereign bond purchase program.

There has been some speculation that to boost the excess liquidity to keep EONIA (the key rate) stable and low, the ECB could formally stop sterilizing the SMP purchases. We suspect this would be a very controversial decision. Recall two German ECB member, Weber and Stark resigned over the program. In the absence of sterilization, this would leave the SMP too close to QE, given the treaty prohibitions. We have advocated cutting the lending rate, which is the top of the official rate corridor and now sits at 75 bp. It is true the cap on EONIA, The ECB is also expected to use the new staff forecasts, that will project out to 2016 for the first time, to point to its belief that the low inflation may persist but the risk of outright deflation for the monetary union is slim. The euro could rally on this because it would strengthen the view that there is no appetite for those drastic measures.

7. US data (High risk): The US jobs data, with the February assessment due on Friday March 7, tends to be among the most important economic reports of the monthly cycle. Yet, almost regardless of the report, whose thunder is partly stolen by the ADP estimate a couple days earlier, or the week’s other data, which includes auto sales, purchasing managers surveys, the Fed’s measured tapering pace is unlikely to be disrupted.

The Fed’s tapering has not pushed up US 10-year yields this year, which have fallen by 38 bp through the end of February. Nor has it lent the dollar support, which has fallen against all the major currencies and many emerging market currencies (including Indonesian rupiah, Polish zloty, Hungarian forint, South African rand, Mexican peso, Brazilian real and Turkish lira).

Most of the US economic data in recent weeks have been reported below expectations. It means that the market has not fully grasped the magnitude of the slowdown being experienced here in Q1. Few really claim that it is only due to the weather, which has become a bit of a straw man in the blogosphere. We highlight three other forces at work: a) the inventory cycle, b) the end of the tax break for capex and c) the loss of income for 1.7 mln Americans who had been collecting emergency jobless benefits. At the end of last week, there were a few secondary economic reports, notably new home sales, durable goods orders and Chicago PMI, were stronger than expected. With more important economic data out this week, it will be important to monitor this pattern, and if, better than expected data lends the dollar support. We suspect it may with a lag.

For the record, the Bloomberg consensus is for a 150k rise in February nonfarm payrolls. This is in line with the 3-month average of 154k, but below the 6-month average (177.5k), which is nearly identical with the 2-year average (179.6k). Although the consensus does not expect a decline in the 6.6% unemployment rate, we see the risk to the downside in response to the loss of the emergency jobless benefits. This is turn would reinforce expectations for a modification/evolution in the FOMC forward guidance at its March 18-19 meeting. Judging from the Fed funds and Eurodollar futures strips, the market is not pricing in the first rate hike until the second half of 2015.

Obama is expected to present the FY15 budget proposals on March 4. This tends not to be a market mover. Moreover, in recent years, due to the political paralysis, the Federal government has operated on the basis of continuing resolutions. Yet the budget proposal will help shape the coming debate. It takes place on the heels of news that FY13 budget deficit was only $680 bln from $1.1 trillion the previous year. The budget deficit fell to 4.1% of GDP from 6.8%. It is projected to continue trending lower over the next few years. Obama is expected to avoid further cuts in spending, drop efforts to use chain-weighted CPI measures to slow Social Security payouts and promote public investment.

 

Chart of the day: Rewarding US Shareholders

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

Those who draw their income primarily from wages have been squeezed. However, those that draw more income from their savings and investments have fared better. This is the story behind the growing disparity of income in the United States.

Shareholders have been rewarded. The top Great Graphic was posted by Matt Phillips on Quartz. It was taken from Goldman Sachs Research. It shows both the authorized and executed share buyback schemes among the S&P 500 through Q3 13. The authorized programs area approached record size.

buy back activity

There are a number of ETFs that try to capitalize on share buyback programs or favorable insider activity or strong hand buying. The Bloomberg chart here shows a the S&P 500s performance since the beginning of last year (purple line), with three ETFs in this space. The white line is PowerShares Buyback Achievers Portfolio (PKW). The yellow line is the Guggenheim Insider Sentiment (NFO), which looks at trends in insider buying and analysts’ opinions. The green line is TrimTabs Float Shrink (TTFS). It uses a screen for to assess the quality of the reduction in the free float. This summary of ETFs in this space should not be confused with a trade recommendation or investment advice.

buyback etf

We are skeptical, though of Phillips effort to draw a connection between the cash holdings of almost $2 trillion to the share buyback efforts. Yet, it seems as if many corporations are borrowing to fund the repurchase programs.

Separately, Phillips points to another way shareholders are being rewarded: dividends. He notes that as of the end of January 420 of the S&P 500 were paying dividends, which is the most since 1998. S&P 500 companies will pay out an estimated $330 bln in dividends this year, which represents a new record.

 

Debt Ceiling Update

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

The US debt ceiling looms. The House Republicans are still formulating their strategy. Treasury Secretary Lew has said his ability to maneuver will be exhausted by February 27. While this sounds like ample time to avoid a delayed payment or default, the problem is that Congress recesses this Wednesday and will not return for a full day session until February 26. Time is really of the essence. Moreover, officials seems vaguely unaware of how it undermines US prestige after the government shutdown in Q4 last year.

The word from Washington is that the House Republicans are looking for a face saving way to avoid a confrontation. To this end, efforts to repeal or delay parts of the Affordable Care Act (Obamacare) have been jettisoned. The two demands that have received the most press attention do not seem particularly controversial. They include reversing recent changes to the cost of living for the military personnel and updating the rate at which doctors that treat Medicare patients are reimbursed (Sustainable Growth Rate).

However, there does seem to be a technical glitch of sorts with the Sustainable Growth Rate. A bipartisan group in Congress submitted a bill last week that eliminated it completely. The temporary fix suggested as part of a deal to lift the debt ceiling is seen as threatening the effort for a longer term solution and is opposed by powerful industry interests like the American Medical Association.

The Democrats in both chambers and the White House want a clean bill; that is one without any policy strings attached. A bill in the House of Representatives will require support from the Democrats because there are around 30 Republicans that are unlikely to support an increase in the debt ceiling no matter what.

We have likened the debt ceiling debate to going to a restaurant, eating the meal and debating about whether to pay the bill when it arrives. The government’s spending was authorized. The fact that the government may not be authorized to make good on its debt makes little sense to many inside as well as outside the US.

A deal, which will eventually take place, is expected to raise the debt ceiling until after the November mid-term elections. There was talk before the weekend of a full year extension. Part of the problem is that this time of year, heavily laden with tax refunds, the federal government has relatively high needs for cash. This is reflected in the increase size of US bill auctions.

Owing to the unresolved debt ceiling, the Treasury Department seems more reluctant to expand its issuance of 4-week bills, but has increased the supply of 3- and 6-month bills and cash management bills. Some dealers warn of an increase in general collateral rates of 3-5 bp, but potentially more tomorrow and Thursday due to the settlement of bills.

While we have not talked with any one that actually expects the US to default on its debt, the risk of disruption does weigh on some investors. Investors, for example, appear to be avoiding T-bills maturing over the next several weeks.

Nine Event Risks in the Week Ahead

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

The investment climate has proven extremely difficult for investors to navigate. Fed tapering and better world growth was to lead to higher interest rates. Yet interest rates for the developed world have fallen sharply in recent weeks. Aggressive quantitative easing by the Bank of Japan was widely understood to be yen negative, yet the yen is the only currency to have been stronger than the dollar in January. Toward the emerging markets, investors were to take a more differentiated approach. Countries with large current account deficit were particularly vulnerable, yet it appears that the entire asset class was tarred with the same brush. Reports suggest that ETF for Mexican equities (EWW) showed the largest outflow, which seems counter-intuitive, especially since the higher wages and economic slowdown in China appear to work to its benefit.

We identify, discuss and assess nine event risks of global investors in the week ahead.

Emerging Markets (High Risk): The MSCI Emerging Market equity index peaked in 2011 and is off a little more than 20% since then. Last month, it fell 6%. Investors’ post-2009 love affair with emerging markets is over. The fact of the matter is that most were emerging markets 20 years ago and are likely to be emerging markets 20 years from now. There were two attractors—liquidity and structural reforms and we suspect, as is their wont, investors have tended to emphasis the latter and under appreciate the former. One clear implication is that real interest rates will have to rise through most of the emerging market universe. And this will have negative knock-on effects for growth.

However, due to some structural reforms, including more flexible currency regimes, somewhat deeper capital markets, and the accumulation of reserves, which can be understood as a type of self-insurance, many emerging market countries are better able to cope with a capital outflows. The key to whether investor panic leads to a crisis seems to be largely a function of the response by policy makers. The IMF/World Bank and the US Treasury have urged developing countries to take advantage of the signals to strengthen their own policy reaction. They might as well be shouting in the wind.

Portfolio Allocation (High Risk): In addition to sizeable outflows from emerging market funds that have been widely reported, there have been three other notable portfolio adjustments. First, anecdotal reports indicate that in recent weeks, several large asset managers have shifted from stocks to bonds. In this context, we note that US Treasuries had their single best month in January since the middle of 2012. To the extent there is foreign investment component, we note that due to relative volatilities, foreign fixed income investment tends to carry a higher hedge ratio than foreign equity investments. Second, after strong foreign interests in recent months that has helped drive Spain and Italian rates to record lows, some large asset managers have reportedly begun adjusting positions on valuation grounds. Third, Japanese investor appetite for foreign bonds that was evident in the second half of 2013 appears to have waned in January, as they turned net sellers again. For their part, foreign investors have slowed their purchases of Japanese shares.

Trade Promotion Authority (Low Risk): Within 24-hours of President Obama’s State of the Union Speech in which he called on Congress to grant him Trade Promotion Authority to complete the negotiations for Trans-Pacific Partnership and the Trans-Atlantic Trade and Investment Partnership, Senate Majority Leader Reid underscored his opposition. Even though the risk that TPP, which was initially to be completed last year, is further delayed is high, the risk to investors appears minimal. Yet, it speaks volumes about the outlook for fresh initiatives ahead of the November election and the consequence of the erosion of support for President Obama. Note that this follows the recent refusal by Congress to ratify the long planned increase in the IMF’s quota. Some observers talk about a new wave of isolationism in the US, but sometimes in the past, isolationism was a shroud to cover unilateralism.

China (Near-term Low Risk): The Lunar New Year celebration will keep China out of the spotlight in the coming week. It will report the service sector PMI reading first thing Monday in Beijing, but other than that, it will likely be out of the news in the coming days. The official manufacturing PMI was reported at 50.5, which was in line with expectations, but is the lowest reading since last July. Output hit a four month low and new orders slipped to six month lows, though both are still above the 50 boom/bust level. Employment and export orders were below 50.

Reserve Bank of Australia (Medium Risk): The RBA is the first of the three central bank meetings from the high income countries. There is little doubt that policy is on hold with the cash rate at a record low 2.5%. The credit expansion, the somewhat higher than expected CPI inflation figures, and the roughly 8% decline in a trade-weighted measure of the Australian dollar over the last four months remove the sense of urgency to cut rate further. At the same time, the weakness of the labor market, the softness in producer prices (pipeline inflation?) and the erosion of the terms of trade, means the RBA is unlikely to close the door completely on another rate cut, which now seems more likely in Q2 than Q1. We attribute a medium risk to the prospect of a more neutral sounding RBA statement. We note that central bank officials have cited $0.8500 and $0.8000 as targets for the exchange rate.

Bank of England (Low Risk): The Bank of England is securely on the sidelines. BOE Governor Carney has already indicated that the next step in the evolution of forward guidance will be announced with the quarterly inflation report on February 12. Contrary to claims that Carney is jettisoning the forward guidance, we expect the BOE to drive home the point that the 7.0% unemployment rate was a threshold not a trigger for tighter policy. In effect, the BOE will say, we re-examined the economic conditions in light of the threshold being approached and we continue to judge the economy as recovering but still in need to very low interest rates. The September short sterling futures contract rallied in January and the implied yield is 16 bp lower than it was in late-December at an implied yield of about 64 bp. It can fall toward 50 bp bank rate on dovish comments and data that suggest the economic activity is leveling off, which is expected to be seen in the PMI reports in the coming days.

Euro Area PMI (Low Risk): The flash readings steal much of the thunder from the final reports that are out in week ahead. The focus will be on Spain and Italy for signs of continued recovery. The manufacturing PMI for the euro area is at its best level since 2011, which has lifted the composite as well. The service sector has lagged, though the flash reading put it at four month highs. We note that the criticism of the lack of progress reform in the German service sector appears to be on the rise.

ECB Meeting (High Risk): The two pillars of ECB monetary policy, money supply and inflation, disappointed on the downside. This has spurred speculation that the ECB will take action at its meeting on February 6. A large German bank has forecast a small cut in the 25 bp repo rate and, more important, a move to a negative deposit rate. Others have predicted an end to the efforts to sterilize the SMP purchases. Since EONIA has traded above the repo rate, we think a repo rate cut is largely immaterial. Cutting the 75 bp lending rate would be more significant in capping the increase in EONIA. A negative deposit rate could be potentially very disruptive as it puts the ECB in unprecedented territory. Even Japan through its deflationary years never adopted a negative deposit rate.

The ECB does not need to open the can of worms by formally ending its sterilization of the SMP sovereign bond purchases. It would likely be highly controversial as some (read Germany and its creditor allies) may see it is an illegal monetization of sovereign debt. It can take a stay with its more passive of failing to attract enough interest in its sterilization operations. This would be less controversial but effective in providing more liquidity on a weekly basis. We see ECB officials more concerned about lending to the SME sector. In one of the more important discussions at Davos, Draghi indicated a willingness to consider buying bank bonds, backed by loans to households and SMEs. Though it does not appear imminent, development along these lines seem more promising.

US Jobs Data (High Risk): The market generally anticipates a dramatic recovery in non-farm payrolls in January after the disappointing 74k increase in December. However, there is substantial risk that the frigid temperatures in the Midwest, South and Northeast will make for another disappointing report. Last month, we noted how well the ADP estimates had anticipated the official data, just in time for the large miss (ADP Jan estimates was 238k, while the private sector NFP grew by only 87k). Having been burned last month, investors will likely put less weight on it this time. The market will quickly look at the weather distortions and make adjustment accordingly. Before the Fed meets again (mid-March), it will see another jobs report, so the policy implications of a disappointing report may not be that great. Most investors and observers see the bar relatively high against the Fed deviating from the tapering strategy outlined by the FOMC in December. There is also substantial risk that without emergency unemployment benefits being extended there may be an unusually large decline in the unemployment rate as more people leave the labor market. Arguably the Fed’s forward guidance anticipates this possibility by saying rates will remain low even after unemployment falls through the 6.5% threshold.

While the employment report is the last major event of the week, at the start of the week, the US reports January auto sales. The consensus calls for a 15.7 mln unit selling pace after the disappointing 15.3 mln unit pace in December. If true, this would put the January sales above the average in H2 13. However, there is risk of disappointment due to weather disruptions and this would weigh on the retail sales report (January 13), which already are looking soft even excluding auto sales. Lastly, the debt ceiling debt poses headline risk, though distortions to the short-dated T-bills appears to have eased somewhat.