US: Low CPI and soft Treasury Yields

The Consumer Price Index (CPI) and Core CPI (excluding food and energy) both came in at a low 1.7% p.a. for the 12 months ended July 2017.

Consumer Price Index (CPI) and Core CPI

Source: St Louis Fed, BLS

Long-term interest rates are trending lower as CPI moderates. Breach of support at 2.10% by 10-Year Treasury Yields would signal another primary decline with a target of 1.80%*.

10-Year Treasury Yields

Target: 2.10% – (2.40% – 2.10%) = 1.80%

Bank credit growth is slowing, to the level where it is tracking nominal GDP growth, avoiding some of the excesses of previous cycles. But if bank credit falls below GDP growth that would warn of tighter monetary conditions and the economy is likely to slow.

Bank Credit and GDP growth

Source: St Louis Fed, FRB, BEA

The S&P 500 is testing its long-term rising trendline, while bearish divergence on Twiggs Money Flow warns of selling pressure. But the market appears to have shrugged off Donald Trump’s promises of North Korean “fire and fury” and both of these movements seem secondary in nature. A correction is likely but the primary trend remains on track for further gains.

S&P 500

Target 2400 + ( 2400 – 2300 ) = 2500

Nasdaq and S&P500 meet resistance

July labor stats are out and shows the jobless rate fell to a 16-year low at 4.3%. Unemployment below the long-term natural rate suggests the economy is close to capacity and inflationary pressures should be building.

Unemployment below the long-term natural rate

Source: St Louis Fed, BLS

But hourly wage rates are growing at a modest pace, easing pressure on the Fed to raise interest rates.

Hourly Wage Rates

Source: St Louis Fed, BLS

Fed monetary policy remains accommodative, with the monetary base (net of excess reserves) growing at a robust 7.5% a year.

Hourly Wage Rates

Source: St Louis Fed, FRB

Our forward estimate of real GDP — Nonfarm Payroll * Average Weekly Hours — continues at a slow but steady annual pace of 1.79%.

Real GDP compared to Nonfarm Payroll * Average Weekly Hours

Source: St Louis Fed, BLS & BEA

The Nasdaq 100 has run into resistance at 6000. No doubt readers noticed Amazon [AMZN] and Alphabet [GOOG] both retreated after reaching the $1000 mark. This is natural. Correction back to the rising trendline would take some of the heat out of the market and provide a solid base for further gains. Selling pressure, reflected by declining peaks on Twiggs Money Flow, appears secondary.

Nasdaq 100

The S&P 500 is also running into resistance, below 2500. Bearish divergence on Twiggs Money Flow warns of moderate selling pressure but this again seems to be secondary — in line with a correction rather than a reversal.

S&P 500

Target 2400 + ( 2400 – 2300 ) = 2500

China holds its head above water

A quick snapshot from the latest RBA chart pack.

Manufacturing is holding its head above water (50 on the PMI chart) and industrial production shows a small upturn but investment growth is falling, as in many global economies including the US and Australia. Retail sales growth has declined but remains healthy at 10% a year.

China

Electricity generation continues to climb but steel, cement and plate glass production all warn that real estate and infrastructure development are slowing.

China

Interest rates remain accommodative.

China

Real estate price growth is slowing but remains an unhealthy 10% a year. Real estate development investment rallied in response to lower interest rates but is clearly in a long-term decline.

China

There are no signs of an economy in immediate trouble but there are indications that the real estate and infrastructure boom may be ending. Through a combination of fiscal stimulus and accommodative monetary policy the Chinese have managed to stave off a capitalism-style correction. But failure to clear some of the excesses of the past decade will mean that the inevitable correction, when it does come, is likely to display familiar Asian severity (Japan 1992, Asian Crisis 1997).

Why is it so hard to forecast interest rates? | San Francisco Fed

Interesting paper by Michael Bauer at the San Francisco Fed:

….The difficulty of predicting changes in interest rates mainly arises from two features that characterize their evolution over time. First, like other financial variables, interest rates vary widely from day to day, which makes them difficult to link to economic fundamentals such as monetary or fiscal policy. This well-documented “excess volatility,” was first pointed out in Shiller (1979), and it reflects the importance of frequent changes in investor sentiment due to a never-ending stream of economic data releases and other news.

Second, as evident from 10-year Treasury yields since 1971, seen in Figure 1, interest rates have not fluctuated around a stable average level over this period. Instead of “mean reversion” around a constant average, they exhibit slow-moving trends, such as the rise during the “Great Inflation” period of the 1970s, and the long-lasting decline since then.

….the gap model does not assume that the level of the series will revert to some constant mean, but instead that the gap between the series and its trend component will revert to zero. Estimating trend components and gaps underlies most macroeconomic forecasting, and Faust and Wright (2013) recently demonstrated the gap model’s excellent performance for inflation forecasting.

….Since inflation is ultimately determined by monetary policy, the long-run inflation trend corresponds to the perceived inflation target of the central bank. This can be estimated reasonably well from surveys. Figure 1 plots the publicly available and mostly survey-based inflation trend estimate (red line) that underlies the Federal Reserve Board’s structural model of the U.S. economy, FRB/US. For the trend in the real interest rate, also called the natural or equilibrium real interest rate, Laubach and Williams (2003) suggested a way to estimate it from macroeconomic data and popularized its use in policy analysis (see also Williams 2016). Figure 1 includes an estimate of the equilibrium real interest rate (green line) taken as the average of several popular estimates, as discussed in Bauer and Rudebusch (2017).

Figure 1 also plots the sum of these two trends (red line); this estimate of the trend component in interest rates has exhibited a very pronounced decline since the 1980s. The 10-year yield generally fluctuated near this trend, and both are currently very low in historical comparison, with important consequences for policymaking (Williams 2016). Figure 1 suggests that it may be useful to take into account the level of the trend when forecasting interest rates.

….the final piece required for a practical forecast rule is an assumption about the transition of interest rates to their trend. Based on how quickly interest rates have historically reverted back to the trend, a reasonable assumption to make for this forecasting exercise is that 20% of the remaining gap is closed each quarter. But the precise speed of reversion to the trend is typically not crucial for forecasting performance (Faust and Wright 2013). Furthermore, it becomes essentially irrelevant for long-horizon forecasts, since forecasts are approximately equal to the estimated trend…..

Source: Federal Reserve Bank of San Francisco |

Bob Doll: Lack of  infrastructure stimulus might benefit stocks

Bob Doll at Nuveen makes a good point about Trump’s failure to get infrastructure spending through the House.

Washington, D.C. seems mired in gridlock, despite the fact that Republicans control the House, Senate and White House. No significant economic legislation has been passed, and the optimism from January about health care reform, infrastructure spending and tax cuts has all but vanished. Political attention will soon be focused on the 2018 midterm elections, and the window for pro-growth policy action is closing.

The lack of fiscal stimulus is disappointing, but it comes with a silver lining: We are unlikely to see the significant and sharp advance in interest rates or in the U.S. dollar that would probably result from such stimulus. The lost opportunity on the political front might therefore have the ironic effect of prolonging the bull market in stocks.

It seems crazy when you consider that both Clinton and Trump campaigned on a platform of major infrastructure programs to boost the economy. Just shows how dysfunctional Washington has become.

But I agree with the silver lining. Infrastructure spending would have boosted employment — the US is already below its long-term natural rate of unemployment — and upward pressure on wage rates. Which would have drawn a sharp increase in interest rates from the Fed, to combat inflation. Populist policies often ignore the hidden/unforeseen consequences and can produce the opposite result to that intended.

Unemployment v. LT Natural Rate

Source: Weekly Investment Commentary from Bob Doll | Nuveen

Stronger dollar, weaker inflation could check rate hawks

Jens Meyer at the AFR says that a stronger Dollar and low inflation are likely to prevent the RBA from raising interest rates for some time:

Inflation is expected to remain below the Reserve Bank’s comfort zone when second-quarter CPI data is unveiled on Wednesday. Despite a jump in vegetable prices due to damage caused by Cyclone Debbie, economists predict consumer prices rose just 0.4 per cent over the second quarter and 2.2 per cent over the year.

More importantly for the central bank, ongoing softness in wages growth is tipped to have kept a cap on the less volatile core inflation, coming in at 0.5 per cent over the quarter and 1.8 per cent over the year, below the Reserve Bank’s target band of 2 to 3 per cent.

Rising iron ore prices helped the Aussie Dollar break long-term resistance at 78 cents, testing 80 against the greenback. This goes against the wishes of the RBA who need a weaker Dollar to assist exports and boost import substitution.

Aussie Dollar

But the RBA is in a cleft stick. It cannot lower rates in order to weaken the Dollar as this would encourage speculative borrowing and aggravate the property bubble. It also can’t raise rates when inflation is low, the Aussie Dollar is strong and the economy is weak. Like Mister Micawber in Charles Dickens’ David Copperfield, the RBA has to sit and wait in the hope that something turns up.

Source: Stronger dollar, weaker inflation could check rate hawks

Australia: Job gains

ABS June figures reflect solid gains for the labor market. Justin Smirk at Westpac writes:

“….The annual pace of employment growth has lifted from 0.9%yr in February to 2.0%yr in May and it held that pace in June. In the year to Feb there was a 106.9k gain in employment; in the year to June this has lifted to 240.2k. The Australian labour market went through a soft patch in 2016 that was particularly pronounced through August to November when the average gain in employment per month was a paltry 2.2k. We have clearly bounced out of this soft patch and now holding a firmer trend.”

My favorite measure, monthly hours worked, jumped (year-on-year) by 3.1%.

Monthly Hours Worked

Infrastructure spending, particularly in NSW and Victoria, is doing its best to offset weakness in other areas.

Wage rate growth remains subdued, indicating little pressure on the RBA to lift rates.

Monthly Hours Worked

VIX hits record low

The CBOE Volatility Index (VIX) made a new low of 9.30 indicating record low levels of stock volatility. High levels of stock buybacks and large ETF fund inflows may both have contributed, but this is only the third time in its 27-year history that index has broken below 10%. The first was in late 1993. The second, in late 2006, was followed a year later by a massive market snap-back. This time is no different. Volatility is unlikely to remain at such low levels and eventually we will see a market down-turn, accompanied by high volatility, but there is no crystal ball that can tell us whether this will be in one year or five.

CBOE Volatility Index (VIX)

Corporate bond spreads are also falling, with the spread between lowest investment grade Baa (10-year) and equivalent Treasury yields at their lowest point since 2008.

Corporate Bond Spreads

Source: St Louis Fed & Moody’s

The yield curve is flattening but remains comfortably above a flat or negative yield curve when
the yield differential (10-year minus 3-month yields) falls below zero. A negative yield curve is a reliable warning of recession within 12 months.

Yield Differential

Source: St Louis Fed

The Freight Transportation Services Index displays a steady increase in economic activity.

Freight Transportation Services Index

Source: St Louis Fed & US Bureau of the Census

And the S&P 500 continues its advance towards 2500.

S&P 500

Target 2400 + ( 2400 – 2300 )

Weekly Top Themes from Bob Doll | Nuveen

  1. U.S. monetary policy should remain equity-market friendly. In her comments last week, Janet Yellen stated that the neutral rate for the fed funds rate is “currently quite low,” and rates would not have to rise much more to become neutral. In our view, a neutral fed funds rate is closer to 2% than the 3% currently implied by the fed funds futures market. If this is accurate, it would likely be good news for economic growth, corporate earnings and the stock market.
  2. Global monetary policy is starting to normalize, but still supports stocks. The Bank of China raised rates by 25 basis points last week and other central banks are becoming less dovish. We think this is good news since it reflects improving global economic growth, while overall policy remains easy. Central banks are still promoting liquidity, which should support equities and other risk assets.
  3. Inflation remains surprisingly low. Although economic growth is improving and the Fed is normalizing, inflation has not increased similarly. Inflation should eventually react to tightening labor markets, but the process is taking a long time.
  4. If the “Goldilocks” environment persists, we think equities can continue to make all-time highs. Low inflation, slow-but-positive economic growth, climbing earnings and a cautious Fed have contributed to record-high stock prices. We think these conditions should remain in place for at least the next 6 to 12 months.
  5. Active fund manager performance has improved. According to Merrill Lynch, 54% of active large cap U.S. equity managers outperformed their benchmarks for the first half of the year and more than half also outperformed for the last four months. This is the longest such streak since Merrill Lynch began tracking this data in 2009, and it marks the first time a majority of managers outperformed for the first half of a year.

Global monetary policy supportive of stocks, low inflation and slow-but-stable earnings growth. Nothing much wrong here. Inflation is the one to watch though. A surge in wage rates as the labor market tightens would tighten monetary policy, with a domino effect on earnings and stock performance.

Source: Weekly Investment Commentary from Bob Doll | Nuveen

Icarus trade continues, with the next global crisis further away than you think

Good to see Ambrose Evans-Pritchard weighing in on the (absence of) the next global financial crisis:

….If corporation tax drops to 25 per cent and incentives are offered to repatriate up to $US4 trillion of US corporate cash held offshore – tinder for stock buy-backs – you might see the sharemarket’s price earnings ratio breaking the all-time high of the dotcom boom.

Whether any of this stimulus is wise is another matter. The Bank for International Settlements chides central banks for making a Faustian Pact long ago, rescuing markets every time there is trouble but letting asset bubbles run unchecked in the good times.

They have created “intertemporal” imbalances that require ever lower real interest rates with each cycle. The deformity is worse today than before the Lehman crisis after eight years of emergency stimulus.

The global debt ratio is 40 percentage points higher at 327 per cent of GDP. Nobody knows what the sensitivity may be to even a modest degree of tightening.

Yet if the Sword of Damocles hangs ever over us, that does not mean it is about to fall. My humbling discovery after decades of amateur observation is that such episodes take longer to play out than you imagine.

I was convinced that the global financial system was spiralling into crisis at least 18 months before Fannie Mae, Freddie Mac, and Lehman Brothers collapsed over those terrifying weeks of late 2008.

That was a bad call. Even disasters have their proper sequencing.

Source: Icarus trade continues, with the next global crisis further away than you think

Australia: APRA capitulates to Big Four banks

From Clancy Yeates at The Age:

Quelling investor fears over moves to strengthen the financial system, the Australian Prudential Regulation Authority on Wednesday said major banks would have until 2020 to increase their levels of top-tier capital by about 1 percentage point, to 10.5 per cent.

The target was much more favourable to banks than some analyst predictions, with some bank watchers in recent months warning lenders may need to raise large amounts of equity or cut dividends to satisfy APRA’s long-running push for “unquestionably strong” banks.

Markets are now confident banks will hit APRA’s target, estimated to require about $8 billion in extra capital from the big four, through retained earnings or by selling new shares through their dividend reinvestment plans…..

“The scenario where banks had to raise significant capital appears to be off the table for now,” said managing partner at Arnhem Asset Management, Mark Nathan.

Mr Nathan said the banks’ highly prized dividends also looked “safer”, though were not likely to increase. National Australia Bank and Westpac in particular have high dividend payout ratios, which could put dividends at risk from other factors, such as a rise in bad debts……

APRA’s chair Wayne Byres said the changes could be achieved in an “orderly” way, and the new target would lower the need for any future taxpayer support for banks.

“APRA’s objective in establishing unquestionably strong capital requirements is to establish a banking system that can readily withstand periods of adversity without jeopardising its core function of financial intermediation for the Australian community,” he said.

APRA chairman Wayne Byres used the words “lower the need for any future taxpayer support.” Not “remove the need…..” That means banks are not “unquestionably strong” and taxpayers are still on the hook.

A capital ratio of 10.5% sounds reasonable but the devil is in the detail. Tier 1 Capital includes convertible (hybrid) debt and risk-weighted assets are a poor reflection of total credit exposure, including only that portion of assets that banks consider to be at risk.

Recent bailout experiences in Europe revealed regulators reluctant to convert hybrid capital, included in Tier 1, because of fears of panicking financial markets.

Take Commonwealth Bank (Capital Adequacy and Risks Disclosures as at 31 March 2017) as a local example.

The Tier 1 Capital Ratio is 11.6% while Common Equity Tier 1 Capital (CET1), ignoring hybrids, is more than 17% lower at 9.6%.

But CBA risk-weighted assets of $430 billion also significantly understate total credit exposure of $1,012 billion.

The real acid-test is the leverage ratio which compares CET1 to total credit exposure. For Commonwealth this works out at just over 4.0%. How can that be described as “unquestionably strong”?

Minneapolis Fed President Neel Kashkari conducted a study last year in the US and concluded that banks need a leverage ratio of at least 15% to avoid future bailouts. Even higher if they are considered too-big-to-fail.

New Bailouts Prove ‘Too Big to Fail’ Is Alive and Well | WSJ

By Neel Kashkari:

Three strikeouts in four at bats would be barely acceptable in baseball. For a policy designed to prevent taxpayer bailouts, it’s an undeniable defeat. In the past few weeks, four European bank failures have demonstrated that a signature feature of the postcrisis regulatory regime simply cannot protect the public. There’s no need for more evidence: “bail-in debt” doesn’t prevent bailouts. It’s time to admit this and move to a simpler solution that will work: more common equity.

Bail-in debt was envisioned as an elegant solution to the “too big to fail” problem. When a bank ran into trouble, regulators could trigger a conversion of debt to equity. Bondholders would take the losses. The firm would be recapitalized. Taxpayers would be spared……

The problem is that it rarely works this way in real life. On June 1, the Italian government and European Union agreed to bail out Banca Monte dei Paschi di Siena with a €6.6 billion infusion, while protecting some bondholders who should have taken losses. Then on June 24, Italy decided to use public funds to protect bondholders of two more banks, Banca Popolare di Vicenza and Veneto Banca, with up to €17 billion of capital and guarantees. The one recent case in which taxpayers were spared was in Spain, when Banco Popular failed on June 6……

The Minneapolis Fed President has hit the nail on the head. Conversion of bondholders to equity may be legally plausible but psychologically damaging. Similar to money market funds “breaking the buck’, conversion of bondholders to equity in a troubled bank would traumatize markets. Causing widespread panic and damage far in excess of the initial loss. Actions of Italian authorities show how impractical conversion is. Especially when one considers that the affected banks were less than one-tenth the size of behemoths like JPMorgan [JPM].

Banks need to raise more equity capital.

Source: New Bailouts Prove ‘Too Big to Fail’ Is Alive and Well – WSJ

US adds 222 thousand jobs

From the Wall Street Journal:

U.S. employers picked up their pace of hiring in June. Nonfarm payrolls rose by a seasonally adjusted 222,000 from the prior month, the Labor Department said. The unemployment rate ticked up to 4.4% from 4.3% the prior month as more people joined the workforce…..

Job Gains

Source: St Louis Fed & BLS

Forecast GDP for the current quarter — total payrolls * hours worked — is rising, showing an improving economy.

Real GDP Forecast

Source: St Louis Fed, BLS & BEA

Declining corporate profits as a percentage of net value added (RHS) is typical of mid-cycle growth, while employee compensation (% of net value added) is rising at a modest pace. Peaks in employee compensation are normally accompanied by troughs in corporate profits…..and followed by a recession.

US Corporate Profits and Employee Compensation as percentage of Value Added

Source: St Louis Fed & BEA

Average wage rate growth, both for production/non-supervisory and all employees, remains below 2.5% per year. Absence of wage rate pressure suggests that the Fed will be in no hurry to hike interest rates to curb inflationary pressure.

Hourly Wage Rate Growth

Source: St Louis Fed & BLS

Which should mean further growth ahead.

The disconnect between long-term and short-term rates

Bob Doll highlighted the disconnect between long-term and short-term rates in his latest review. The chart below plots the 3-month T-bill rate against 10-year Treasury yields.

Spot Gold/Light Crude

At this stage, the disconnect is not significant. But a disconnect as in 2004 – 2005 is far more serious. Large Chinese purchases of Treasuries prevented long-term rates from rising in response to Fed tightening, limiting the Fed’s ability to contain the housing bubble.

Draining the swamp?

WASHINGTON—The Trump administration proposed a wide-ranging rethink of the rules governing the U.S. financial sector in a report that makes scores of recommendations that have been on the banking industry’s wish list for years.

….If Mr. Trump’s regulatory appointees eventually implement them, the recommendations would neuter or pare back restrictions from the Obama administration, which argued the rules were necessary to guard against excessive risk taking and a repeat of the 2008 financial crisis.

Seems to me like the exact opposite of ‘draining the swamp’. The new administration proposes removing or limiting the rules intended to reduce risk-taking in the financial sector.

This could end badly.

Especially with bank capital at current low levels.

Source: Trump Team Proposes Broad Rethink of Financial Rulebook – WSJ

Australia: RBA hands tied

Falling wage rate growth suggests that we are headed for a period of low growth in employment and personal consumption.

Australia Wage Index

The impact is already evident in the Retail sector.

ASX 300 Retail

The RBA would normally intervene to stimulate investment and employment but its hands are tied. Lowering interest rates would aggravate the housing bubble. Household debt is already precariously high in relation to disposable income.

Australia: Household Debt to Disposable Income

Like Mister Micawber in David Copperfield, we are waiting in the hope that something turns up to rescue us from our predicament. It’s not a good situation to be in. If something bad turns up and the RBA is low on ammunition.

Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery. The blossom is blighted, the leaf is withered, the god of day goes down upon the dreary scene, and — and in short you are for ever floored….

~ Mr. Micawber in Charles Dickens’ David Copperfield

Beijing eases pressure

China’s PBOC eased up on its crackdown on wealth management products (WMPs) and related bank lending. The resulting fall-off in new credit and a spike in interbank lending rates threatened to precipitate a sharp contraction.

Copper rallied off long-term support at 5400. The reaction is secondary and breach of 5400 remains likely, signaling a primary down-trend.

Copper A Grade

Iron ore is consolidating in a narrow bearish pattern above support at 60. Breach seems likely and would signal another decline, with a target of 50*.

Iron Ore

* Target: 60 – ( 70 – 60 ) = 50

Shanghai’s Composite Index rallied to test its new resistance level at 3100, after breach signaled a primary down-trend. Respect would confirm the decline, with a medium-term target of 2800*, but government intervention may bolster support. Recovery above 3100 would mean all bets are off for the present.

Shanghai Composite Index

* Target medium-term: May 2016 low of 2800

ASX banks break support

The big banks fell sharply on the week’s turmoil, with the ASX 300 Banks Index breaking support at 8500. Breach signals a primary trend reversal, offering a medium-term target of 8000*.

ASX 300 Banks

* Target: 8500 – ( 9000 – 8500 ) = 8000

Resources stocks rallied over the week. Expect strong resistance on the ASX 300 Metals & Mining index at 3000.

ASX 300 Metals & Mining

Iron ore continues in a bearish narrow consolidation above support at $60. Breach would offer a short-term target of $50*.

Iron ore

* Target: 60 – ( 70 – 60 ) = 50

These are ominous signs for the ASX 200 which is testing medium-term support at 5700. A sharp fall on Twiggs Money Flow flags strong selling pressure. Breach of primary support at 5600* would signal a reversal, offering a target of 5200*.

ASX 200

* Target medium-term: 5600 – ( 6000 – 5600 ) = 5200