Reminder: the first Clinton/Trump presidential election debate takes place tonight, Monday 26th September.
It’s fair to say that last week’s meeting of the US Federal Reserve was keenly-awaited, yet destined to be a massive anti-climax. There really were very few commentators out there who predicted that the Fed would actually bite the bullet and hike its funds rate at this meeting. And of those that did, it felt that deep-down they knew it wouldn’t happen either.
Just to recap: the Fed kept its key policy rate unchanged in a band of 0.25%-0.5%. Three members dissented - Esther George, Loretta Mester and Eric Rosengren - and called for an immediate hike. The Fed also released its latest Summary of Economic Projections and there were some interesting takeaways and observations. Firstly, and offsetting the dissenters to some degree, three FOMC members expect no more rate hikes in 2016. As far as the FOMC’s economic forecasts were concerned: it raised its prediction for the 2016 unemployment rate to 4.8% from the 4.7% it expected back in June. It now expects Real GDP to come in at +1.8% for 2016, down from its +2.0% estimate in June. As far as inflation is concerned, the FOMC expects Core PCE to come in at 1.7% for 2016. This prediction was unchanged from June’s. Bear in mind that the Fed’s target is 2% per annum and currently stands at 1.6%. We get an update this Friday. As far as rates are concerned, the FOMC expects to raise fed funds two times in the next 12 months. That’s down from the three predicted in June. Finally, the median expectation is for no more than 0.75% tightening between now and end of 2017.
So, the FOMC expects unemployment to tick higher, inflation to remain below target and growth to slow. It has dialled back on its rate hike predictions. During her press conference Janet Yellen said that the Fed's decision shouldn't be interpreted as a lack of confidence in the economy. She also gave a fairly strong indication that a hike will happen before 2016 is over (and rejected the suggestion that the central bank bases its decisions on partisan politics. In other words, the Fed didn’t hold off from hiking rates because such a move may have boosted Trump’s chances).
Now let’s consider the key sentence from the FOMC statement:
"The committee judges that the case for an increase in the federal funds rate has strengthened but decided, for the time being, to wait for further evidence of continued progress toward its objectives”.
Yet just a few weeks ago, Janet Yellen and her Vice-Chair Stanley Fischer said the coast was clear for two rate hikes before the year-end. But since then just about every important US economic data release has disappointed. And this is the problem. The Fed needs to “normalise” rates to prepare for an economic downturn. Yet it doesn’t dare move as it risks cratering the equity and bond markets. At the same time it is desperate to “talk up” the US economy even though the evidence points to a slow-down. The committee needs to see a string of stronger data points between now and the year-end. The trouble is that the trend in recent economic releases has been negative, suggesting that the FOMC may have even more of an excuse to hold back from hiking rates in December than it did on Wednesday. Once again, the Fed is stuck in a bind of its own making. The danger now is that investors wake up to the fact and lose confidence in central bankers. When that happens, the dodgy supports currently propping up asset markets will crumble.
Meanwhile, the Bank of Japan (BOJ) kept its key Policy Rate unchanged at minus 0.1%, abandoned its 80 trillion yen per annum target for asset purchases and introduced a target yield for the 10-year Japanese government bond (JGB) of zero. By anchoring this yield it looks as if the BOJ is switching the focus away from its asset purchase programme. That’s just as well given how it is running out of eligible stuff to buy and has found it impossible to boost inflation to anywhere near its 2%-plus inflation target. The BOJ’s balance sheet is around three times the size of the next closest G4 counterpart when adjusted for the size of the respective economies. Meanwhile, it is the biggest holder of Japanese government debt holding just under 40% of the total.
Back in July BOJ Governor Haruhiko Kuroda said that the central bank would release details of a comprehensive assessment of its policies at this week’s meeting. We’re still waiting.
This week’s major economic releases include:
EUR German Ifo Business Climate, Italian Retail Sales; GBP BBA Mortgage Approvals; USD New Home Sales, First US Presidential Debate
JPY Monetary Policy Meeting Minutes; EUR M3 Money Supply; GBP CBI Realized Sales; USD S&P/CS Composite-20 HPI, Flash Services PMI, CB Consumer Confidence, Richmond Manufacturing Index
AUD Mid-Year Economic and Fiscal Outlook; CHF UBS Consumption Indicator, KOF Economic Barometer; EUR GfK German Consumer Climate; USD Durable Goods Orders, Crude Oil Inventories
JPY Retail Sales; EUR German Prelim CPI, Spanish Flash CPI, German Unemployment Change; GBP Net Lending to Individuals, M4 Money Supply, Mortgage Approvals; USD Final GDP, Unemployment Claims, Pending Home Sales
JPY Household Spending, Tokyo Core CPI, National Core CPI, Unemployment Rate, BOJ Summary of Opinions, Prelim Industrial Production; CNY Caixin Manufacturing PMI, Caixin Services PMI; EUR German Retail Sales; GBP Current Account, Final GDP, Index of Services; EUR CPI Flash Estimate; CAD GDP; USD Core PCE Price Index, Personal Spending, Personal Income, Chicago PMI, Consumer Sentiment, Inflation Expectations
CNY Manufacturing PMI, Non-Manufacturing PMI
During her press conference Janet Yellen suggested that the FOMC was concerned that the US economy could overheat:
“Nevertheless, we don’t want the economy to overheat, and if things continue on the current course, I think some gradual increase will be appropriate.”
There’s no sign of the US economy overheating but plenty of evidence that the equity, bond and property markets are. US stock indices trading at or near all-time highs, and global bond yields at or near all-time lows. Since the March 2009 low, the S&P 500 has surged around 225%. Meanwhile the yield on the US 10-year Treasury is currently 1.6%. To put this into perspective, from 1962 to 2007 the average yield came in around 7.0% per annum.
But while US stock indices trade near record highs, earnings for companies in the S&P 500 have declined year-on-year for five consecutive quarters, making stocks in the S&P500 the most expensive they have been in 14 years. Money has moved into equities as low bond yields have forced investors to take greater risks in a search for returns. However, low interest rates have also spurred corporations to issue debt. But rather than using the borrowed money to fund capital expenditure and investment spending, companies have used the funds for stock buy-backs and dividends. Why? Because dividends help to attract fresh yield-hungry investors, while buybacks boost the share price, which is very handy if you’re an executive whose bonus is linked to your company’s stock price.
But now there’s evidence that buyback activity is slowing down. As data and analytics company FactSet reports: “Aggregate buybacks in Q2 represented a 6.8% decline from the year-ago quarter, which was the largest year-over-year decrease since Q1 2015. This Q2 decline came during a quarter that saw the S&P 500 index hit record-high price levels.”
If this continues as companies struggle to raise earnings and revenues, then another equity market support could get kicked away.
Commodity/ FX Outlook
There was a strong rally in crude oil last week and once again the move was sparked by US inventory data. On Tuesday evening the American Petroleum Institute (API) reported a drawdown of 7.5 million barrels of crude for the prior week. Then on Wednesday the Energy Information Administration (EIA) confirmed this decline, reporting a 6.2 million barrel fall in crude on expectations of a 3.3 million build.
It’s worth remembering that just over a week ago WTI fell to its lowest level in over a month as a succession of bearish news items battered prices. Chief amongst these was a report from the International Energy Agency (IEA) which downgraded its forecasts for future global demand growth. The IEA downgraded its forecast for demand growth for this year by 100,000 barrels to 1.3 million barrels per day (bpd). It said that growth momentum was set to ease further in 2017 to 1.2 million barrels per day. It also said that the decline in non-OPEC production had been offset by increased OPEC output – specifically from Saudi Arabia, Iraq and Iran. The IEA said that demand growth from China and India was “wobbling” while there were no gains from Europe and US momentum had “slowed dramatically." The agency said it expected supply to “continue to outpace demand at least through the first half of next year”. Bear in mind also that the US rig count has continued to rise along with the price of crude.
Now here’s the question: ultimately, what is the biggest driver for the oil price over the medium to long term? Is it unexpected builds/drawdowns in the notoriously volatile US inventory data? Or is it evidence-based forecasts which suggest that global supply will continue to significantly outstrip demand for some time to come? In fact, not just “some time to come,” but crucially for much longer than previously estimated. The weekly inventory data no doubt offers up some great opportunities for short-term traders. But ultimately it is just noise – unless one considers the longer term trend. And as far as that is concerned, there has been a definite downturn since the beginning of summer. However, US inventories are still much higher than this time last year. Last week’s EIA update noted that: “US crude oil inventories are at historically high levels for this time of year” while total products supplied were up 3.0% from the same period last year, motor gasoline product were up 4.1% and jet fuel product up 8.1%. Only distillate fuel inventory declined, falling 5.9% from the same period last year.
Also, bear in mind the technical aspect to price movements. Last week both WTI and Brent bounced off the 61.8% Fibonacci Retracement of the rally in the first few weeks of August. Now we’ll see if Brent and WTI will continue to find enough buyers for them to retest resistance which comes in (very roughly) around $49 and $47 respectively. For the moment both contracts are getting a boost from dollar weakness following the Fed’s decision to hold back from hiking rates. There’s also the added complication of this week’s meeting of the world’s major oil producers (except the US) in Algeria. A side meeting is planned to discuss a production freeze. Very few analysts believe that an agreement can be reached, let alone honoured. However, on Friday afternoon Reuters reported that Saudi Arabia had offered to cut production if Iran would agree to cap output this year. We’ll soon see if this is a genuine proposal or a political move to paint Iran into a corner.
PS: More like the latter it appears. Saudi subsequently warned the market not to expect any agreement to freeze production. Crude slumped 3% on the news.
Both precious metals put in solid performances last week, helped along by ongoing loose monetary policy from the developed world’s major central banks. On Wednesday the Bank of Japan (BOJ) kept its key interest rate unchanged at -0.1%, abandoned its monetary base target (and said this could expand until CPI inflation exceeds 2%) and introduced a target yield for the 10-year Japanese government bond (JGB) of zero, effectively taking control of the first 10 years of the bond market and yield curve. Interestingly, the promised “comprehensive assessment of the BOJ’s current quantitative and qualitative easing (QQE) and negative interest rate policies” never materialised. But then what could it honestly conclude, other than these policies haven’t worked.
Later that day the Fed kept interest rates on hold saying that while the case for an increase in the federal funds rate had strengthened, it wanted to “wait for further evidence of continued progress toward its objectives”. At the same time the Fed indicated that there could be a rise in December, but that threat wasn’t taken seriously by precious metals investors. And why should it? The Fed has repeatedly ducked hiking rates even as it assured investors that the case for tightening monetary policy had strengthened. On top of this, even if the Fed does tighten this year, or next, the evidence shows that gold can rally even in a rate hiking cycle. The fed funds rate rose from 1% in May 2004 to 5% two years later. Over the same period gold went from $375 to $730 per ounce – an increase of over 90%. Granted, it had dropped back to $560 six weeks later. But 18 months later it hit $1,000 for the first time ever as interest rates plateaued at 5.25% and then declined down to 2% over the same period. The lesson from all this is that, under the right conditions, gold (and silver) can go up regardless of the trend in the US fed funds rates, or the US dollar for that matter.
At the end of last week the latest Flash Manufacturing and Services PMIs showed that September Eurozone business activity expanded at its weakest rate since the start of 2015. Markit's Composite Flash PMI fell below expectations to 52.6 from 52.9 in the previous month. The disappointing data saw the euro fall initially although it soon recovered its footing as last week’s path of least resistance was dollar weakness.
The sell-off in the greenback was triggered by the Fed’s decision not to tighten monetary policy. The US central bank kept its key interest rate in a band between 0.25% and 0.50% where it has been since last December. This was expected. Despite this the dollar sold off, even as Fed Chair Janet Yellen sought to convince investors that all the central bank’s meetings were “live” when it came to the possibility of a rate hike. Of course, the notion that the Fed would even consider tightening in November, just one week ahead of the US Presidential Election, is patently ridiculous. But then Janet Yellen and her colleagues clearly have little problem treating investors as idiots.
As an example, a key sentence from the FOMC statement said that the “committee judges that the case for an increase in the federal funds rate has strengthened….” Yet over the last month we’ve had a disappointing Non-Farm Payroll number, weak manufacturing and services PMIs, ditto industrial production and retail sales, while the latest housing data (previously a bright spot) has been patchy. There was a pick-up in inflation (this is considered a “good thing” by the Fed if not by pensioners and other savers) as measured by the CPI. But as the Fed uses Core PCE as its preferred inflation measure, this is irrelevant. So, if the case for a rate hike has strengthened, it’s not because the economic data is improving. But despite last week’s pick-up in volatility, the dollar remains range bound. The EURUSD is trading smack-bang in the middle of the 1.1000/1.1400 range that has been in place for the last six months.
Meanwhile, and despite the best efforts of the Bank of Japan (BOJ), the yen strengthened for the third successive week. The USDJPY pushed higher in the immediate aftermath of the BOJ’s announcement of its latest monetary policy tweaks. But it wasn’t long before the pair hit a fresh monthly low and was once again threatening a break below 100. The yen’s rally felt as if it was less a case of the market being underwhelmed by the BOJ’s policy measures, rather than a growing realisation that the central bank has run out of sensible policy options. The trouble is that Japanese policymakers have also failed to impress the market with their fiscal measures.
There was some speculation that the BOJ intervened early on Thursday to weaken the yen. Chief Cabinet Secretary, Yoshihide Suga, told investors that "recent FX moves have been nervous and if this continues, the gov't is ready to take the appropriate action."
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