Across the Curve

Forecast of Oil Demand for Reduced

September 13th, 2016 6:04 am

Via WSJ:
By Benoit Faucon
Sept. 13, 2016 4:00 a.m. ET
1 COMMENTS

The International Energy Agency on Tuesday sharply cut its forecast for global oil demand for this year and the next amid what it called “wobbling” Asian demand.

The fresh data is set to intensify the debate between oil producers later this month in Algiers about whether they should freeze their production.

In its closely watched monthly report, the IEA, which advises oil-consuming countries on their energy policies, downgraded its global oil demand predictions by about 100,000 barrels a day for this year—still growing by 1.3 million barrels a day. It also reduced the forecasts by about 200,000 barrels a day in 2017, with consumption increasing more slowly at 1.2 million barrels a day.

“Recent pillars of demand growth—China and India—are wobbling,” the agency said. “After more than a year with oil hovering around $50 a barrel, the stimulus from cheaper fuel is fading.”

The IEA said that in China, ongoing economic slowdown and reports of heavy flooding dented industrial oil use and transport fuel demand. But it also cited a decline of oil demand in Europe as a factor.

The news come as the Organization of the Petroleum Exporting Countries has been pumping at elevated levels, with Saudi Arabia now overtaking the U.S. as the world’s largest producer, according to the IEA.

The U.S. had held the top spot since April 2014 when the rapid rise of American shale production saw it vault past Saudi Arabia. Since May, however, the IEA estimates that the U.S. had shut in 460,000 barrels a day of high-cost production, while the low-cost oil fields of Saudi Arabia have pumped out an extra 400,000 barrels a day.

The Paris-based agency said Saudi Arabia’s output fell by 50,000 barrels a day in August to 10.6 million barrels a day. By contrast, it said U.S. crude production stood at 8.7 million barrels a day in June.

Overall, OPEC’s crude output edged up by about 20,000 barrels a day to 33.47 million barrels a day in August as Middle-East producers kept their taps open to near record rates, according to the IEA. By contrast, OPEC itself says its production fell slightly last month.

Kuwait kept its output stable at 2.91 million barrels a day in August while the United Arab Emirates increased it by 20,000 barrels a day to 3.09 million barrels a day—their highest output ever.

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FX

September 13th, 2016 6:01 am

Via Kit Juckes at SocGen:

<http://www.sgmarkets.com/r/?id=h11513852,1847e297,1847e298&p1=136122&p2=d1e3e3d0d913e0e042368a93c607811c>

The Fed’s Lael Brainard confounded expectations that she would set the scene for a rate hike next week, sounding more dovish then most expected. She emphasised asymmetrical risks in tightening vs easing policy from here, suggested the neutral real interest rate is now around zero and pointed out that the 20% USD rally from mid-2014 to early 2016 is the equivalent of a 2% rate hike. And no, I’m not sure about that but still, her dovish creedentials are reinforced.                                                                                                                                                Yet, for all that the dollar is slightly stronger across the board this morning. The improvement in risk sentiment is evident in equity markets but not in FX, despite better-than-expected August Chinese data in the form of industrial production (6.3% y/y), retail sales (10.6%) and non-rural fixed asset investment (8.1%). The net result is a market that’s ‘risk on’, with a strongish dollar – a rare combination of late. The key is that the Treasury market didn’t over-react to Ms Brainard either, and 10year Note yields are still about 11bp higher than they were a week ago.

I suspect that the Treasury market hols the key to the next move in FX from here: If the weight of longs, the sense that the BOJ and ECB are all but out of ammunition and concerns about valuations all weigh on the market and yields push higher, I’d look for the dollar to kick on. The reverse is also true of course and bond bears haven’t just had a few tough months – they’ve had years of pain. Still, the market’s mis-positioned and the QE-inspired collapse in yields, globally, is in its last stages even if it’s not completely over yet. So, we’ll watch Treasuries, and react, rather than pre-empt but I’m itching to get short both AUD/USD and NZD/USD as soon as I get any encouragement.

US yields holding onto gains, underpinning the dollar

[http://email.sgresearch.com/Content/PublicationPicture/232253/2]

The data calendar’s light. Swedish CPI at 8:30, SEK-friendly if it edges higher; UK CPI at 9:30, expected to show core CPI up to 1.4% from 1.3% which would be GBP-neutral; German ZEW where expectations probably improved to +2 from +0.5; and the US NFIB small business optimism index. None of these seems likely to answer any questions, leaving me a committed bond-watcher.

For now, we remain long EUR/GBP, and long AUD/NZD. Long-term shorts in AUD/MXN and ZAR/RUB remain open, but aren’t doing anything very helpful yet. A break of 0.7280 in USD/NZD would be a trigger to go short and as iron ore prices fall, the previously strong (for no good reason) between AUD/USD and copper prices is just another in a long list which says that AUD (and NZD) bears will eventually get third day in the sun.

Just another spurious and broken correlation

[http://email.sgresearch.com/Content/PublicationPicture/232253/4]

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Increased Capital Requirements

September 13th, 2016 5:55 am

Via Bloomberg:
Banks May Face 10% Basel Capital Requirement Increase, Heim Says
Cindy Roberts
crobertsCH
Fabio Benedetti Valentini

Societe Generale’s Heim commented on Basel revamp in New York
Basel debate focused on defining ‘significant’ increase

 

Banks may face an increase of about 10 percent in their capital requirements as a result of the overhaul of risk-assessment rules under way at the Basel Committee on Banking Supervision, according to Philippe Heim, chief financial officer of Societe Generale SA.

The Group of 20 nations and the Basel Committee’s oversight body “want to concretely deliver reform improving the comparability of risk-weighted assets, but with no significant capital increase,” Heim said on Sept. 12 at a conference in New York. “The whole debate is all about what does it mean: no significant capital increase. We begin to hear that it should be an inflation of around plus 10 percent.”

The Basel Committee’s oversight body, led by European Central Bank President Mario Draghi, met on Sept. 11 and reiterated its instruction to the regulator to “focus on not significantly increasing overall capital requirements” as it wraps up work on the framework known as Basel III. That promise, first made in January, left open the possibility that individual countries or banks could face a marked increase.

The Basel Committee is racing to finish work on the post-crisis capital framework by the end of the year. After the meeting of the oversight body, known as the Group of Central Bank Governors and Heads of Supervision, the committee will convene a two-day meeting on Sept. 14.

Banks warn that proposed changes in how they assess credit, market and operational risks would send capital requirements spiraling. Credit Agricole SA Chief Executive Officer Philippe Brassac said last week that the Basel Committee should freeze plans to overhaul capital rules for five years to avoid a “drastic” reduction in lending by European banks.

“What we understand is that all market participants will have full clarity on this, we hope, touch wood, beginning of Jan.,” Heim said. “The past months have been pretty intensive in terms of exchange with all the stakeholders.”

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Markets and the Rate Hikes

September 13th, 2016 5:51 am

This WSJ story argues that recent market tumult will make it more difficult for the Fed to raise rates. I think the FOMC should stop playing monetary Hamlet, grow a set of testicular appendages, and raise rates.

Via the WSJ:
By Justin Lahart
Updated Sept. 12, 2016 2:25 p.m. ET
10 COMMENTS

Calm returned to U.S. markets Monday, but Friday’s tumult has to leave the Federal Reserve less confident in the market’s ability to stomach a rate increase.

The dull summer in the markets probably made the Fed more likely to raise rates later in the year. Through last Thursday, the S&P 500 went 43 consecutive trading days without swinging more than 1%, and registered its lowest level of volatility since the 1960s.

It is ironic but not surprising that the Fed played a part in Friday’s selloff: A hawkish speech by Boston Fed President Eric Rosengren suggested the odds of a rate increase at next week’s policy-setting meeting were higher than investors had thought. A dovish speech on Monday by influential Fed Governor Lael Brainard served to ease those fears.

But the bigger cause of the selloff was likely a rise in European long-term bond yields on worries that European Central Bank may not buy as many assets next year as investors had expected.

That matters to U.S. markets and the Fed because the ECB’s buying of long-term bonds has been driving down yields and pushing global investors into long-term Treasurys, helping to keep their yields low. While that was the case, the Fed could be reasonably sure that it could raise its target on overnight rates without risking a sudden jump in long-term borrowing costs, which can weigh on the economy. Now it can’t be so certain.

The market action out of Europe may be just the first tremor, point out strategists at Evercore ISI. The Bank of Japan may be on the cusp of diverting more of its asset purchases toward short-term bonds, which could take away some of the downward pressure on long-term Japanese bond yields. Long-term yields have ticked up there recently. Plus, around the world there has been more talk about using fiscal, rather than monetary, stimulus to get moribund economies going. That would diminish central banks’ penchant for asset purchases while boosting the supply of long-term bonds.

 

Even before Friday, the Fed seemed more disposed toward keeping rates on hold this month than raising them. On the jobs front, for example, there has been plenty of progress, but not the wage gains and job hopping that would indicate the Fed’s goal of full employment has been reached. And inflation remains well below the 2% the Fed is targeting.

Further, as Ms. Brainard again pointed out, the Fed considers the risk of raising rates too quickly to be far more dangerous than moving too slowly. Throw in an aversion to disrupting markets before an unusual U.S. presidential election, and a rate increase next week, while not out of the question, seems unlikely. Anyone waiting for a rate rise will probably have to wait at least until the Fed’s December meeting—and may have to wait even longer than that.

Write to Justin Lahart at [email protected]

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Curvology

September 13th, 2016 5:43 am

I just marked the Treasury complex and the overnight up trade has unwound some of the cheapness of the Long Bond. The Treasury will auction $12 billion crisp new bonds today via a reopening of the current Long Bond. The 5s 30s spread is at 117 versus 118.9 at the close yesterday. Similarly I marked 10s 30s a few minutes ago at 70.8 versus 72.3 at the close. The 5s 10s spread is also flatter but not as much as it has narrowed to 46.2 from 46.6.

The only customer trading I have heard of at this juncture is central banks selling the 3 year sector on an outright basis.

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Hilsenrath Article

September 12th, 2016 9:05 pm

Via Jon Hilsenrath at the WSJ:
By Jon Hilsenrath
Sept. 12, 2016 6:48 p.m. ET
36 COMMENTS

Federal Reserve officials, lacking a strong consensus for action a week before their next policy meeting, are leaning toward waiting until late in the year before raising short-term interest rates.

It is a close call. But with inflation holding below the Fed’s 2% target and the unemployment rate little changed in recent months, senior officials feel little sense of urgency about moving and an inclination toward delay, according to their public comments and recent interviews.

The Fed’s decision has become the subject of intense market speculation in recent days. Interest rates can affect stock valuations, the cost of financing a home and whether companies will take on big new projects, making the central bank the perpetual center of market attention. Wall Street is especially attuned to when the Fed will move after it has decided to hold rates steady so far this year.

For several weeks, investors saw a low probability of a rate increase in September, but they became more focused on the possibility of a move in recent days. Stocks tumbled on Friday, when traders interpreted comments from regional Fed bank officials as signals from the central bank that the likelihood of a rate move was rising.

 

Despite its hesitance, the Fed faces some external pressure to move. “Let’s just raise rates,” said J.P. Morgan Chase & Co. Chairman and Chief Executive Officer James Dimon at the Economic Club of Washington, D.C., on Monday. Bankers have been complaining more broadly that low rates hurt their profit margins because it holds down what they can charge customers for loans.

“You don’t want to be behind the eight ball on this one, and I think it’s time to raise rates,” he said, and a quarter-percentage-point increase would be a “drop in the bucket.”

Fed Chairwoman Janet Yellen will spend the week before the central bank’s Sept. 20-21 policy meeting conferring behind the scenes with 16 officials to listen to their views and plot out a plan for the meeting. She confronts a divided group of policy makers and the potential for more internal dissent than has been common during her tenure running the Fed since 2014.

With the jobless rate at 4.9%, some regional Fed bank presidents believe that the labor market has largely recovered from the financial crisis of 2007-2009, and that short-term interest rates just above zero are no longer warranted. This group notes that risks to the U.S. economy from overseas have dissipated in recent weeks, strengthening the case for a move now.

For others, the watchword is patience. This group largely expects to raise rates this year but doesn’t see a need to act now. These officials note the jobless rate hasn’t moved much this year. Slack in the labor market is thus diminishing at a slower pace than before. That has reduced the urgency to raise the cost of credit to prevent the economy from overheating.

Moreover, because the economy is growing so slowly, this group doesn’t believe rates need to move very high in the months and years ahead, thus the Fed can take its time.
Traders work on the floor of the New York Stock Exchange in New York on Monday. U.S. stocks rebounded after the biggest rout since June wiped about $500 billion from the value of equities.

“I don’t feel that we are incurring the costs of patience,” Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, told reporters after a speech on Monday.

Fed governor Lael Brainard—who has been an outspoken voice in the camp of those who want to wait—called for “prudence” in raising rates in a speech in Chicago on Monday.

The speech was closely watched in financial markets because some traders had speculated Ms. Brainard might reverse herself and throw her support behind a rate increase now. Instead, she laid out five arguments for why the Fed should stick to its strategy of moving rates up cautiously and slowly.

Among them, she noted, inflation hasn’t been responsive to the decline of unemployment from 10% after the financial crisis to below 5%. Inflation’s stickiness at low levels removes pressure on the Fed to act preemptively to head off a surge in consumer prices, she said.

The Fed’s cautious, go-slow approach, Ms. Brainard said, “has served us well” and warrants continuing. She didn’t directly address whether she would support or oppose a move in September.

A decision to delay would bring its own risks for Ms. Yellen. The Fed could be criticized for confusing market participants with mixed messages. Ms. Yellen herself argued in Jackson Hole, Wyo., last month that the case for a rate increase had strengthened. It was taken by some market participants as a sign that she was ready to move.

The Fed’s benchmark interest rate—an overnight bank lending rate called the federal funds rate—has been held in a range between 0.25% and 0.5% since December.

Officials began the year thinking they would nudge it up in four quarter-percentage-point increments this year, but have routinely deferred action amid uncertainty about a range of issues—including market volatility early in the year, soft jobs data in the spring and worries about the U.K.’s June vote to exit from the European Union.

Traders in futures markets place a 15% probability on a Fed rate increase in September and a 57% probability on a move by its Dec. 13-14 meeting. Fed officials are usually reluctant to surprise investors, another factor that tilts them toward delay.

Officials also meet Nov. 1-2, but a move seems unlikely then, just a week before Election Day.

“I would like to find a way for us to remove some amount of accommodation, but you can’t force it,” said Robert Kaplan, president of the Federal Reserve Bank of Dallas, in an interview. “You have to remind yourself it makes sense to be patient, because I don’t think the economy is overheating.”

The Fed might sound like it is waffling, but Mr. Kaplan said it is simply reacting to a mixed economic backdrop. “For the public hearing this, it sounds like, ‘Boy, this is on-the-one-hand, on-the-other-hand,’ ” he said. “That’s true. It is not that the Fed is being so agonizingly judicious. It is that the economy is expanding at a very moderate pace, and inflation has been very slow to get to our target, and we’re reacting to that, and that’s what people are seeing.”

The central bank could have other market-soothing words on the longer-run outlook for rates at its September meeting. Officials in June had penciled in two quarter-percentage-point interest-rate increases in 2016, three in 2017 and three more in 2018, a path that would bring the federal funds rate to 2.375% by late 2018.

Officials release updated projections next week, and those could come down as officials coalesce around a view that rates will rise at an exceptionally gradual pace in the months ahead. Two rate increases in 2016 look especially unlikely.

At the same time, the Fed could present a more optimistic view about risks to the economic outlook. Early in the year, officials worried that a range of issues could derail growth and hiring. That included market turbulence tied to worries about China’s economy and to Britain’s decision to leave the European Union. Those worries have dissipated.

After flagging their worries for several months about risks to the economic outlook, officials could revert to calling these risks “balanced,” meaning the central bankers have become more open to raising rates later this year, as long as the economy doesn’t stumble in the weeks ahead.

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Goldman on Why the Bond Rout is Likely to Continue

September 12th, 2016 5:18 pm

Via Bloomberg:

Why the Bond Rout Is Going to Get Worse
Stretched bond valuations, waning impact from quantitative easing, and rising importance of fiscal policy. Oh my.
Tracy Alloway
tracyalloway
Luke Kawa
LJKawa
September 12, 2016 — 8:41 AM EDT

Yields on 10-year U.S. Treasuries have been doing their best impression of a soaring eagle in recent days, following examples set by Japanese and German government debt.

The rout in global bonds, which has seen yields on the U.S. 10-year rise 15 basis points in two days as investors backed away from buying the debt, has coincided with a sell-off in other assets and prompted a flurry of comparisons to the 2013 “taper tantrum” that erupted as investors fretted over potentially rising U.S. interest rates.

The bond rout is only set to continue according to Francesco Garzarelli, London-based co-head of global macro and markets research at Goldman Sachs Group Inc, who cites three key reasons for higher U.S. Treasury yields to come. The bank is now predicting that yields on the 10-year note will reach 2 percent towards the beginning of 2017 — or about 32 basis points higher than the current yield level on the debt.

“The resultant drop in stock market indices may slow the move up in yields but not reverse it, in our view,” Garzarelli said. “Importantly, we do not see a normalization of the bond premium from such low levels as detrimental for the economic recovery.”

While Goldman has been forecasting higher U.S. yields for a while, their call stands in contrast to the analyst consensus prior to the recent tumult in bonds, which saw strategists’ forecasts for where the 10-year Treasury yield will go sink to ever-new lows. Analysts had been converging with the forward market-implied for bond yields, effectively moving closer to pricing in secular stagnation — or the notion that economies will be marked by little or no growth for the foreseeable future.

On Sept. 8, Brean Capital LLC Head of Macro Strategy Peter Tchir noted that the spread between the forward and the estimated yield shrank to its lowest level on record, for instance, with the median forecast nosediving in July. “Capitulation?” he wondered. “The last time analysts let their forecasts chase yields down (in February) we saw a bump in yields (one of the only times all year).”

Here are Goldman’s reasons why the bump-up in yields is set to turn into a punch higher.
1. Bond valuations have been stretched for a while now

The sharp drop in bond yields following the U.K. referendum to leave the European Union has not been justified by a slowdown in economic growth that would normally send investors scurrying into the relative safety of government debt, Garzarelli argues. With Goldman expecting economic activity to pick-up in developed markets, the crowding of investors into government bonds looks odd.

“Over coming quarters, we expect economic activity in the advanced economies to expand at around trend levels, headline CPI inflation to receive a boost from base effects in energy prices, and the Fed[eral Reserve] to raise policy rates – an outcome we believe the market under-prices even for the remainder of this year,” Garzarelli said.

On that basis, 10-year U.S. Treasuries should be trading closer to 2 to 2.25 percent.
2. Quantitative easing is losing influence

 

Bond purchase programs by central banks have helped compress yields on government debt but that effect may now be waning, Garzarelli argues, with growing realization of the technical restrictions and downsides to unconventional monetary policy now emerging. He cites the example of recent discussions by the Bank of Japan and the European Central Bank as to the limits of unconventional monetary policy.

“There are various reasons why such an assessment is necessary at this juncture. One of them is that the sharp fall in ultra-long dated yields has resulted in costs and distortions counterbalancing the economic benefits of lower real rates,” he said. “Consider that pension and life insurance companies in Europe and Japan have large stocks of defined liabilities and asset allocations skewed towards fixed income products. When long-term rates decline, these financial institutions tend to manage down their risk exposure, rather than increase it.”
3. Everyone’s hoping for fiscal policy now

With ever-increasing questions over the willingness and ability of central banks to keep on ‘QEasing’, more investors are looking to government-led measures to help spur economic growth. Expectations of such fiscal measures have been rising in Europe and Japan, despite increasing budget deficits, as well as in the U.S., Garzarelli argues.

“In the U.S., discussions on the possibility of an easier fiscal policy are linked to the outcome of the Presidential election,” he says. “But the market appears increasingly responsive to such moves, as it considers them more effective in supporting final domestic demand when interest rates are close to their effective lower nominal bound.

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Skewering Brainard

September 12th, 2016 3:22 pm

Via Stephen Stanley at Amherst Pierpont Securities:

For some strange reason, there were a number of commentators who argued that Fed Governor Brainard, an arch-dove, had scheduled a speech for today so that she could do a dramatic heel-turn (a la pro wrestling) and signal that a rate hike was coming next week.  This hypothesis always struck me as preposterous.  My thinking coming into today was that Brainard is more likely to go down with the dovish ship than to switch camps.  In fact, while I doubt she would dissent, it is hard for me to imagine her EVER supporting a rate increase with a smile on her face.  Much as she did in March and in June, I expected today’s speech to be an aggressive case-building exercise for the dove camp, attempting to counterbalance the often-vocal hawks who periodically dare to advocate for a rate hike.

In any case, Brainard’s speech today fit quite well with my suppositions.  She is over the top dovish.  She sees weakness where others see weakness and she sees weakness where others see strength.  In fact (and to be fair, as you know, I have fairly strong hawkish predilections), her speech strikes me in much the same way that Chair Yellen’s March 2016 speech did: an excessively negative assessment of the current state of play, out of line with reality.  Based on her speech today, Brainard will certainly not be arguing for or voting for a rate hike next week.

Brainard spends the bulk of her speech laying out the attributes of a new normal that defines the state of the art in the sort of flawed analysis that I addressed at length in my piece “House of Cards” recently.  She spins any fact, positive or negative, as a reason to stay easy.  Her first point is that the Phillips Curve doesn’t seem to be working, to which she concludes not that we might want to search for a new model but that inflation will definitely not pick up significantly, so that the Fed ought not to tighten preemptively (this is an especially rich line that the doves have begun to use more lately – note: when the policy rate is 200 BPs below what the various forms of the Taylor Rule recommend, it is probably too late to be preemptive!).  Her second point is that the flattening of the unemployment rate and the rise in the labor force participation rate this year is a compelling argument that there is more slack in the labor market than we thought, not less.  She is ready to conclude that the natural rate of unemployment is probably substantially lower than everyone else thinks.  And she thinks that wage growth is still disturbingly low, apparently not making the necessary adjustment for the drop in productivity growth.  Her third point is that international developments are really, really important for the U.S. economy and she sees nothing but downside risks everywhere she looks around the world.  Her fourth point is the “real neutral rate is zero” story that I addressed in House of Cards.  Finally, she ends with the argument that the Fed needs to stay easy because the risks are asymmetric when you are close to the zero bound.  I have not heard anyone making this argument (including Yellen up until early this year) explain where the statute of limitations ends.  Of course, it is correct that the risks are asymmetric when you are close to zero, which is why the Fed has already allowed itself to fall about 200 BPs behind what traditional policy benchmarks would recommend.  Why is this an argument for falling even further behind at the margin?  Surely, there has to be some limit to the application of this argument, but we apparently have not reached it yet in Brainard’s view.

Her assessment of current conditions is filtered through this House of Mirrors.  Every negative aspect of the economy becomes a fearsome problem and every reason for optimism is actually just another reason to stay easy (e.g. her spin on the labor market).  Basically, she concludes that since there is actually a lot of slack in labor markets and the Phillips Curve is much flatter (i.e. inflation is less responsive to movements in labor market slack) than in the past, inflation will be very slow to pick up and will do so only gradually when it finally does.  Thus, the Fed can stay super-easy for quite some time.  She’s even got the loaded language down from her years in the political sphere (she came to the Fed Board from the Treasury Department), defining her approach as “prudence.”  Well then, I guess I could say that I expect the Fed to remain prudent in September, though I am projecting them to lapse into imprudence in December.

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Ten Year Auction Preview

September 12th, 2016 10:51 am

Via Ian Lyngen :

We are apprehensive about this afternoon’s 10-year auction and expect non-dealer interest to be a significant test of overseas demand for the sector in the current bearish move. We see the risks skewed toward a tail even though we’ve arguably seen a meaningful pre-auction concession. Foreign awards at the last four Reopenings have decreased moderately to 22.1% from 26.5%, leaving overseas bidders as a key wildcard and one we suspect will ultimately be sidelined given the double-auction schedule and this afternoon’s Brainard speech. On the other hand, 10s are relatively cheap for an auction day vs. 5s and 30s and recent history shows that four of the last five 10-year auctions have stopped-through an average of 1.1 bp.    That said, if sponsorship is light and the auction tails, it will be a more meaningful commentary on the broader Treasury market and its direction – especially given the backdrop of the recent selloff.

• Recent 10-year auctions have met strong receptions with four of the last five stopping-through an average of 1.1 bp.

• Foreign awards at 10-year Reopenings have been decreasing over the last four auctions, taking 22.1% or $4.4 bn vs. 26.5% or $5.6 bn at the prior four. In contrast, investment fund interest has been gaining over the same period, taking 47% or $9.5 bn vs. 46% in the prior four.

• Indirect awards have decreased, taking 61% at the last four Reopening auctions vs. 63% at the prior four.  Over a comparable period, direct bidding has fallen to 10% vs. 11% prior.

• The technicals are increasingly bearish. We’ve got initial support at an upward-sloping trendline at 1.694% before the key opening-gap from Brexit-day (still unfilled) at 1.701% to 1.746%.  Beyond there we’re back into the range that held before this dismal June NFP release (May’s data) that comes in at 1.794% to 1.888%. For resistance, we like the 9-day moving-average at 1.585% and then the 40-day at 1.558%.  Through there is last week’s low yield-close at 1.534% before the bottom of the yield-range at 1.517%.

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FX

September 12th, 2016 6:22 am

Via Marc Chandler at Brown Brothers Harriman:

Drivers for the Week Ahead

• The week ahead will likely be shaped by a combination of what happened last week and what will happen next week
• Three UK economic reports that will be the focus for investors:  Inflation, employment, and retail sales
• The US will also report August retail sales
• Ahead of the blackout period around the FOMC meeting, three Fed officials will speak on Monday
• We are skeptical of the merits of either of the two considerations that lifted oil prices
• EM ended last week on a soft note, and that weakness continues this week

The dollar is broadly firmer against the majors as risk off trading picks up.  The yen is the exception and is outperforming while the dollar bloc and Scandies are underperforming.  EM currencies are mostly weaker.  CNY is outperforming while ZAR, KRW, and MXN are underperforming.  MSCI Asia Pacific was down 2.1%, with the Nikkei falling 1.7%.  MSCI EM is down 2.6%, with Chinese markets falling 1.7%.  All are seeing the biggest drops since the Brexit vote.  Euro Stoxx 600 is down 1.7% near midday, while S&P futures are pointing to a lower open.  The 10-year UST yield is up 1 bp at 1.69%.  Commodity prices are mostly lower, with oil down 2%, copper down 1.3%, and gold flat.  

The week ahead will likely be shaped by a combination of what happened last week and what will happen next week.  The end of last week saw a sell-off in equities and bonds and a recovery in the US dollar.  The week after this, the FOMC and BOJ meet in apparently live meetings, meaning that policies may be adjusted.  

The S&P 500 suffered its biggest decline in two months, falling 2.5% ahead of the weekend.  It gapped lower and sold-off sharply and closed on its lows.  It is a particularly poor sign.  Our initial expectation is that this is not a normal gap that is quickly closed.  On Saturday (September 10) the Taiwan equity market sold off 1.2%, its biggest decline in two months as well.  This may be a hint of what is going to happen when Asian equity markets on September 12.

The MSCI Asia Pacific Index fell last Thursday and Friday, the first two-day loss in a month.  Friday’s 1.2% decline had been the largest since early August until today’s 2.1% drop eclipsed it.  This much-watched index enjoyed a 15% rally since the end of June, and at the very least, a technical correction of this advance is likely unfolding.  The first target was met at the late-August low near 137.20, but the 38.2% retracement objective is found at 135.35.  That suggests scope for a 3.6% decline.  Ahead of the quarter-end asset managers may be tempted to protect profits.  

The MSCI Emerging Market equity index snapped a five-day advance before the weekend.  The nearly 2% drop gave back nearly half of that five-day rally, and then lopped of another 2.6% today.  This was the biggest decline since the UK referendum.  This benchmark rallied more than 17.5% since the UK referendum.  The prospect is for a decline on the magnitude as we have noted for the Asian-Pacific Index (2.3-3.6%).  Here too weakness of US shares, the backing up of US interest rates, and the prospects that the Fed hikes rates, may encourage position adjusting ahead of the end of the quarter.  

The Dow Jones Stoxx 600 rallied a little less than 14.5% since the UK referendum.  It finished last week on a soft note, dropping 1.1% ahead of the weekend, its largest loss since August 2 until today’s (so far) 1.7% drop.  The index appears to have stalled in the same area that stopped rallies in April and May (~351).   A minimal technical correction gives scope for 2-3% near-term declines.  

Before the weekend there was also a sharp increase in benchmark bond yields.  It is likely overdetermined, meaning that there are many causes.  There had been a significant rise in long-term Japanese yields amid speculation that the BOJ may adjust its asset purchases to facilitate a steepening of the yield curve.  For example, the 40-year JGB yield has risen more than 50 bp since the end of June.  The 10-year bond yield bottomed in late-July near minus 30 bp.  It has flirted with zero in recent sessions.

Many investors were disappointed that the ECB did not announce an extension of its asset purchases last week.  Ahead of the weekend, the EMU core bond yields rose around 7 bp, and peripheral bond yields rose 9 bp.  The generic 10-year German bund yield rose from minus 12.5 bp before the ECB meeting and finished the week at positive one basis point, the highest yield in nearly two months.  

After an initial hit to sentiment, the UK referendum does not appear to have triggered an economic contraction.  Economic data are generally coming in better than expected.  The Bank of England acted preemptively, providing low rate loans to banks, cutting interest rates and re-launching an asset purchase plan than includes corporate bonds.  Critics of Bank of England Governor Carney argue he was too partisan before the referendum and led a panicked response afterward.  

Some of the criticism is unfair.  We do want policymakers to act to minimize the biggest regret.  The biggest regret would have been if officials did nothing and the economy took a hit.  Part of the reason the economy did not take a harder hit was that sterling and interest rates fell sharply, and this was facilitated by the signal and real response by the BOE.  

Nor can medium and long-term investors forget that despite all the talk, Brexit has not yet taken place.  Business decisions on location and hiring take some time to formulate and implement. The full impact of the referendum is still to come.  The week ahead will provide more fodder. Ironically, the BOE meeting may not be the highlight for investors.  

In the past, when the BOE would not do anything, they did not say anything.  Times are different now.  The minutes, for example, are released simultaneously with the decision.  The market is interested in how the Monetary Policy Committee understands the context of its decision, and, in particular, the prospects for a further cut in interest rates, which seemed to have been previously implied.  

Three UK economic reports that will be the focus for investors:  Inflation, employment, and retail sales.  The structure of the UK economy means that the decline in sterling will boost consumer prices, which had already begun recovering from the deflation scare.  UK consumer prices were flat in 2015 (December CPI was zero year-over-year).  It stood at 0.5% in June and rose to 0.6% in July.  It is expected to rise to 0.7% in August.  The core rate is essentially flat.  It was 1.4% at the end of last year, and in August, it is expected to have edged to it from 1.3% in July.

Separately, the drop in sterling will also lift producer prices.  This may also spur some businesses to lift selling prices or face margin compression.  It may take some time for sterling’s impact to work its way through.  Although it appears to be consolidating its decline in the $1.30-1.35 range, the duration of some business contracts argues in favor of a prolonged process.  

UK consumer prices are rising while wage growth is slowing.  The August jobs report is unlikely to show a major change in conditions.  However, average weekly earnings are expected to be up 2.1% in the three-month period through July from a year ago.  This is down from 2.4% in June, after having peaked last August at 3.2%.  

Real wage growth will slow in the UK and this may impact consumption.  Retail sales leaped 1.4% in July, defying conventional wisdom.  This pace cannot be sustained.  The median forecast is for a 0.4% decline in August (0.7% excluding petrol).  The risk may be on the upside as anecdotal reports suggest elevated tourism, drawn, yes, to the weak pound.  

Tourists from EMU and Japan have not seen sterling this soft for three or four years.  Chinese shoppers see the most favorable exchange rate in around a quarter of a century.  Americans see the lowest exchange rate for sterling in more than 30 years.  

The US will also report August retail sales.  The headline will be kept in check by autos and gasoline.  The median forecast is of a 0.1% decline.  However, the underlying news should be better than the headline.  Excluding autos, gasoline, and building materials, the component used for GDP calculations is expected to rise 0.4%.

US policymakers may be encouraged by such a report.  Over the past 12 months, the average monthly increase as been 0.3%.   Despite the disappointing PMI, the US economy is likely to post its strongest growth since Q2 2015 (NY Fed GDP tracker) or mid-2014 (Atlanta Fed GDP tracker).

Ahead of the blackout period around the FOMC meeting, three Fed officials will speak on Monday.  Atlanta and Minneapolis Fed presidents will be overshadowed by Governor Brainard.  Brainard has been consistently a voice of caution, and has tended to emphasize the international context in which the Federal Reserve operates.  Her speech in Chicago, on the outlook for the economy, will be closely followed.  No change in her stance or tone, could encourage softer yields, a softer dollar and lend support to equities.  On the other hand, any hint that the Fed has been sufficiently cautious, and recognition that the Fed’s objective are near would likely see a more dramatic reaction the other way.  

Some observers argue that the Fed has become so politicized that it will not hike rates before the election.  This is not a strong argument on a number of counts.  First, the US Senate has left the Board of Governors understaffed.  It has refused to confirm Obama nominee to fill two vacant seats.  Second, the structure of the Federal Reserve includes staggered terms, with the chair’s not concurring with the President’s.  This allows for a great degree of independence, especially after the 1951 agreement with the US Treasury.  

Third, and most importantly, a rate hike in the current context is a vote of confidence in the US economy.  It is not clear what monetary policy the Obama Administration or Clinton (or Trump for that matter) desire.  Increasing the Fed’s target range for Fed funds from 25-50 bp to 50-75 bp will likely have little impact on most Americans.  Last December’s rate hike, similarly had little perceptible impact.  It did not stop mortgage rates from easing.  It did not lead to higher unemployment.  It did not sap consumption.  

Lastly, we note that the backing up in interest rates and market-based measures of inflation expectations were in part driven by the rally in oil prices.  A two-week drop was ended by two considerations.  First, there is some defensive positioning taking place amid a steady, although not contradictory, news stream playing up the possibility of an agreement to limit future oil output.  

Some saw the reports that OPEC output may have slipped in August as some kind of sign that an agreement is looming.  We see it differently.  The minor 45k barrel decline in Saudi output is noise.  It may be a result of less production for domestic demand.  Saudi Arabia is one of the few countries that burn oil for electricity, and demand for cooling often sees this kind of seasonal pattern.

Moreover, insight from game theory, assuming rational actors, output is not cut ahead of an anticipated freeze.  It is boost instead to lock in a superior position for the freeze and possible future agreements for a cut in output.  In addition, we had previously anticipated that the Iranian output would be back at pre-embargo levels by the end of this year, creating the conditions for a future agreement.  However, the latest indications suggest its output may have stalled recently.  

In any event, the second boost to oil prices came from large drop in US oil and gas inventories. The market overreacted.  The dramatic fall stemmed from weather conditions (hurricane) rather than a sudden restoration of equilibrium.  After the large run-up, oil prices fell ahead of the weekend.  Brent managed to finish the week 2.5% higher at $48 (front-month November futures contract) after dropping 4% at the end of last week.  WTI fell 3.7% on Friday, leaving it up 3.2% on the week, a little below $46 (front-month October futures contract).  Both are down nearly 2% today.  

We are skeptical of the merits of either of the two considerations that lifted oil prices.  However, the real takeaway is that the price of oil has largely been in a $40-$50 range for six months (with Brent a little higher).  From neither a fundamental nor technical point of view does a breakout appear to be at hand.  

More broadly, commodity prices are trading heavily.  Even though the CRB Index closed higher (1.4%), it lost its momentum ahead of the weekend and fell 1.7%.  It held below its 100-day moving average and is 7% below its May highs.  The combination of falling oil and commodity prices, coupled with rising core yields, saw the Australian and Canadian dollar sell-off in the last three sessions.  Technically, they look vulnerable as well.

EM ended last week on a soft note, and that weakness continues this week.  Perhaps it was the North Korean nuclear test.  Perhaps it was disappointment in the ECB or rising Fed tightening odds.  Whatever the trigger was, EM FX weakness persisted and appears likely to carry over into this week.  Indeed, as the September 21 FOMC meeting approaches, markets are likely to get even more jittery and choppy.  Just to keep things in perspective, after Friday’s drop, MSCI EM has retraced less than 38% of the big post-Brexit bounce and so this correction in “risk” could go on for a bit longer.  

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