March 21, 2016

"Dovish Fed" is an adjective devoid of significance: these are what the Fed really wants to achieve

Commentary by Robert Balan, Chief Market Strategist

"The Fed remains cautiously upbeat on the prospects for the economy and expects to continue on the tightening path, but not until it is more confident that rate hikes are needed." James Knightley, analyst at ING

The phrase the media uses to describe the US central bank – "Dovish Fed" – does not signify anything. That attitude is in a flux – it can change in a month. There are a lot of circumstantial evidence which suggest that the central bank was neither "dovish" nor "hawkish". Nonetheless, with last week's FOMC decision, the Fed repudiated its previous forward guidance. And it is obvious now, that the Fed lags behind the market, and even lags behind the data which they profess to be dependent on. Could it be that they have become less driven by central banking dogma, and decided to be "wiser", more practical – like an "owl"?

The correct mental framework is essential if we ever are to obtain the answers to these questions: Why are they doing this to the market? What is it that they want to accomplish? If we accept the notion that the central bank had an epiphany, and had decided to do the right thing, then we can only think of several reasons for the change in the behavioural regime of the Fed, and they are: (1) desire to reflate; (2) mitigate the level (more accurately, the valuation) of US aggregate debt, and (3) political expediency. The Fed, and for that matter, any central bank, does not want to lose credibility, and risk fostering volatility, by pulling the rug beneath the feet of the market. But since the Fed did it anyway, we can think of no better reasons than these three factors, to explain their curious collective behaviour during last week's FOMC meeting.

Reflation

The Fed's chosen path for reflation is through a boost of financial assets' prices. It was a proven winner during the deepest trough of the Great Financial Recession. It has allowed households and the corporates (especially the Financial Sector) to deleverage. The Fed's preferred mechanism to reflate at the height of the Great Financial Crisis was Quantitative Easing. But now that QE has become saddled with political and some perceived economic liability, the widest path that is left open to the Fed is to keep policy rates as low as possible, for as long as possible.

However, this risks igniting inflation, and preventing run-away price rise is one of the central bank's remit. This issue was what actually surprised the market: before the FOMC met last week, both core CPI and core PCE had surprised the market and the central bank to the upside. In fact, Vice Chairman Stanley Fischer made exactly the prescient observation a few weeks ago that inflation is making a come-back. So the consensus coming into the meeting was that the Fed probably wouldn't do anything but would talk hawkishly to get the market to do its work. None of that happened, as we now all know. The four rate hikes previously envisioned for this year had been reduced to just two, and the trajectory of the policy rate rise became shallower. The effect was immediate – the US Dollar fell, and commodity prices jumped – a very powerful combination if someone wants to reflate hard assets and inflation-producing investables (see the first chart of the week below).

The Fed also mentioned "global economic and financial developments" twice in the statement after the FOMC meeting, leaving us to wonder whether this was the Fed's quid pro quo to the rest of the world made during the closed doors at that recent G-20 meeting. Maybe the reflation effort is not just limited to the US or the other developed nations – it could have been aimed at the emerging countries as well. In case one doubts the efficacy of the Fed's verbal restraint last week, we note that it had immediate, positive impact not only on the haemorrhaging US High Yield market, but to the suffering EM bond markets as well (see second chart of the week below).

Mitigating US aggregate debt

This comes hand in hand with reflation. Increasing households and corporate financial wealth levels (reflation) reduces the numerical level of aggregate debt. With reflation comes higher inflation – that too reduces the valuation of aggregate debt (in real Dollar terms). In the history of the financial world, the most effective reducer of aggregate debt valuation has been higher inflation rates. The Fed knows this too well. Increase in HH and CORP wealth levels and cutting down the USD FX valuation (to boost some aspects of the domestic GDP deflator) which should eventually help diminish the national debt burden via higher inflation rates.

Political expediency

Yellen also risks becoming a one-term Fed Chairman if a Republican president wins in November (never mind which, Yellen will be replaced if the US elects a Republican president in November). The idea is not to saddle the incumbent administration, which appointed Ms. Yellen to the post with economic issues during an election year. So why tighten aggressively? There is very little reward for the current Fed leadership to tip over the economy into a new recession. Remember: All past US recessions have been caused by Fed tightening at the very root. But Yellen et al are also academics with professional pride. So they tightened in December after dithering for more than a year. And now they lowered the trajectory of policy rate rise after misjudging the trajectory of US growth in H2 2015. We had issues with US growth in Q4 and the global financial landscape became very dangerous in Q1 2016. What they have done so far is to inflict the least damage to the markets and to the real US economy – in other words, they have acted like “owls”. The Fed lost some credibility in the process with the flip flops, but what they have done so far is more than enough to diffuse any charge that they are asleep at the wheel.

Conclusions

So, the US Dollar has been weakened, and we now look past June this year when the Fed will likely bump up policy rates a second time. This could cause another US Dollar strengthening, but by Q3 the US unit will probably be in decline. That would further push headline CPI higher in a catch up bid with surging core CPI and Core PCE. That also implies higher interest rates, steeper yield curves (which improve commercial bank Net Interest Margins), higher prices of real (hard) assets, and dominance of cyclical assets over defensives. In short – “reflation”. And we could trace all those positive developments to the fact that the Fed last week decided to be “owls” – practical, and cognizant of the lingering weakness in the US economy, the parlous condition of the Emerging Market universe and the still weak foundations of the Eurozone and Japanese economies. If the Fed follows through with the same mind-set for the rest of the year, growth and activity in 2016 will be almost a done deal.

The next CIW will be published on 4th April, owing to the Easter bank holiday break

Commodities and Economic Highlights
Commentary by Robert Balan, Chief Market Strategist and Sammer Khatlan, Oil Analyst

Are grains the next sector to benefit from investor inflows?

Annual demand for wheat and soybeans has reached record highs: demand for corn is within 1% of the record high level set last year. But while investors are increasing their allocations into gold and crude oil in early 2016, we have not yet seen the same thing happening to grains. However, we believe this will soon change – grains could be the next investment category to attract investment Dollars. There are grounds for this delayed inflow of investments to grains: the grain market fundamentals have been bearish for some time, and that has coloured the thinking of many potential investors. In fact, those less than solid fundamentals have attracted short sellers. The most recent CFTC data show that there are currently large short speculative futures positions, in some cases record (or near record) short positions, in the corn, wheat and soybean futures markets.

These large short positions followed in the wake of reports of large stockpiles of grains as the result of three record breaking years of global grain production. Grain prices have therefore declined due to this mountain of supply which were the biggest seen in several years. Nonetheless, like other commodities (e.g., gold and crude oil), grain prices appear to have made important bottoms earlier in the year. And many analysts say that it was perhaps not coincidence that the trough occurred near what many farmers perceive as the current cost of production. Specifically, both corn and soybeans may have put in a double bottom trough in January and March, and wheat may have bottomed recently during the first half of March.

It is also important to note that grains are entering a seasonal period when supply uncertainty surrounding the Northern Hemisphere's spring planting season rises. The reason: few, if any, springtime seeds are planted in the ground yet for the coming 2016/17 growing season. Official government estimates for the coming season suggest that this year the world will use more grains than ever before. But countering that, the US corn market enters planting season with a considerable supply cushion. The March 9 USDA supply-demand report shows US corn ending stocks at 1.837 billion bushels, the highest in a decade. US stocks to usage is projected at 13.6%, the highest since 2007/08. That is why the expectation for prices has been depressed so low that a little positive surprise in this regard will go a long way.

Here are the numbers: Corn plantings for 2016 are projected at 90 million acres, up 2.0 million acres from the 2015 final estimate. US 2016 corn production is estimated up 2% over 2015, with 2016/17 supplies pegged at 15,702 million bushel - a new all-time record. Globally, the picture remains similar. The USDA pegs world corn 2015/16 ending stocks at 206.97 million metric tons, the highest since 2005.

Nonetheless, the sector, which is highly dependent on weather, could surprise. Through winter, prices had tended to climb as the market worked through stockpiles from the previous Fall harvest. Then, as planting season approaches, anxiety can build ahead of planting – weather concerns and uncertainty often bring speculators into this market. As planting gets underway and the crop gets in the ground, anxiety fades and sometimes prices do flag as well. But this seasonal pattern is not carved in stone; the weather could change – then the market goes through a paroxysm of sharply higher prices. One element which loads the dice in favour of buyers this year may be the transition from El Nino to La Nina. As we noted in an earlier report, grain prices in the US are not skewed by El Nino -- it is La Nina, the successor event, which had caused several severe grain price dislocations in the past. It may be a little early, but if the transition does take place, we could be seeing much higher grain prices by July or August.

Oil market will be range-bound but longer-term trajectory is positive

Developments in the oil markets since our last note are becoming increasingly positive. It is not unreasonable or unfeasible to conclude that we are beginning to see a floor under crude prices – there are several factors worth considering at this stage for grounds of hope of a price recovery.

From a positioning perspective, a change in sentiment is evident. On Jan 15th 2016, total short crude positioning (Brent + WTI) reached its highest level at 392 million barrels – since then markets have covered over 193 million barrels, reaching this week’s figure of 199 million. Long positioning also helps illustrate the change in sentiment: using Jan 15th 2016 as our base level, total crude longs stood at 238 million barrels – since then 282 million barrels have been added, reaching 520 million barrels this week. There are still ample shorts in the market but the changes in positioning are encouraging bulls that the complex’s expectations of oversupply are diminishing.

As we have previously written, the oil freeze, especially at these elevated output levels, will not tighten the market. What is significant, though, is that the producers are and have been coming together for frequent and productive talks. This has had positive impact on crude prices, rallying some 20%, and crucially we feel this strengthens the possibility of a potential collective output cut later in the year. If relations and channels remain strong until 2H16, any swift intervention by OPEC and select non-OPEC could substantially impact oil prices to the upside.

Last week, we wrote about the amount of unplanned production outages in the market and we have continued to note the sustained output slowdowns around the world. With material supply reductions happening, market rebalancing is already underway: in the last eight weeks, US production has fallen by 167mbd; year-on-year, output is now down by 351mbd. Nigeria’s revised official January production was down by 192mbd; nearly 300mbd of Forcados exports were suspended last month and are expected to remain off-market until April. Loading problems, technical issues and power shortages are contributing to lower Venezuelan production; since November 2014 (when OPEC launched its market share strategy policy) output has fallen by 213mbd – a sharp fall in production is expected in March. In February, Colombian production dropped to its lowest level since July 2015 at 960mbd, with YoY declines at 72mbd; pipeline attacks have driven these losses leading to force majeures being declared. In Iraq, the suspension of Kirkuk exports through the Kurdish pipeline has cut national output by ~150mb. In Mexico, decline rates at key mature fields are being felt with output declining 160mbd in 2015; 100mbd of production has already been shut due to economic constraints, a trend expected to continue this year as Pemex faces a ‘liquidity crunch’. Kazakhstan’s production fell a sixth straight month, dropping 22mbd in January with natural declines and higher maintenance expected to increase this year. In Azerbaijan, output is lower 2.7% YoY.

There is a global crude overhang and markets still need to clear. What we are currently witnessing is the beginning of the process rather than an actual deficit of crude supplies. To accelerate the reduction of inventories, cuts are needed rather than production freezes. Physical crude differentials and crude spreads have remained elevated – in an environment of weak margins, run cuts and peak refinery maintenance, there is a perception that there is not enough crude in the market. The oil futures curve is flattening with spot prices rising – which is helping the market contango narrow.

Macro traders will correctly point to the danger of any negative Chinese or US data/news that can drag the global picture into disarray and oil players will need to be mindful of these headwinds whilst continuing to heed the actual crude macro fundamentals. The expectation that we will see a supply gap from 2017 onwards combined with the scale of current unplanned outages is exacerbating bullish sentiment at the moment but the market clearing will not happen overnight – it will be a process that will likely take until year end but by then, natural declines, economic upstream constraints and seasonal global demand should keep markets supported. As fundamental conditions improve, OPEC and select non-OPEC will have the perfect opportunity to trigger the next great oil rally.

Charts of the week: USD, commodities and inflation; Fed restraint and US high yields and EM bond markets

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Last update on January 12, 2015