Friday, March 3, 2017

Weekly Commentary: Reality vs. The Neutral Rate

How about a cursory look at recent economic data: February’s 57.7 ISM Manufacturing reading was the strongest since August 2014. New Orders at 65.1 matched the strongest level (Dec. 2013) since 2009. Prices Paid at 68 was only slightly below January’s 69, the strongest since 2011. February’s ISM Non-Manufacturing Index rose to 57.6, the highest since October 2015 (58.1). Auto sales in February were just below record levels. Last week’s Initial Jobless Claims (223,000) were the lowest since March 1973. Weekly mortgage purchase applications bounced back to near seven-year highs. Trade deficits are running at the widest level since before the crisis.

The PCE (Personal Consumption Expenditure) Deflator was up 0.4% in January, increasing y-o-y gains to 1.9%. This matched the highest y-o-y reading in almost five years. Core PCE was up 0.3% for the month, pushing y-o-y gains to 1.7%.

The Conference Board’s February Consumer Confidence reading rose to the highest level since July 2001. At 133.4, the Conference Board Present Situation index jumped to the high since July 2007 - and is now only five points away from a 15-year high. Personal Income added 0.4% in January, increasing y-o-y income growth to 4.0%.

After incredible 2016 inflows of $305 billion, Vanguard has attracted flows of $80 billion in just the first two months of the year.

March 3 – Wall Street Journal (Asjylyn Loder): “Investors poured $62.9 billion into exchange-traded funds in February, pushing the year-to-date world-wide tally to $124 billion, the fastest start of any year in the history of the ETF industry, according to… BlackRock Inc. U.S. ETFs accounted for $44 billion of that, pushing assets in U.S. funds to almost $2.8 trillion. Most of the money went to cheap, index-tracking ETFs…”

February 28 – Bloomberg (Sid Verma and Oliver Renick): “You can thank the little guy for Dow 20,000. That’s the takeaway from data tracking money flows into and out of stocks, according to… JPMorgan… The telltale sign retail investors are behind the longest string of U.S. stock highs in decades? An $83 billion surge of cash into passive strategies so far this year amid a $15 billion withdrawal from actively managed funds. That’s on top of evidence that institutional traders have backed away, the bank says.”

March 3 – Bloomberg (George Caliendo and Michael Hyler): “U.S. investment grade corporate bond sales totaled more than $281 billion in the first two months of the year, the most in at least 10 years. Exxon Mobil Corp is among the companies that could keep issuance at a record pace in the first quarter of 2017.”

They’ve really gone and done it this time. The Fed had cut rates from 8.25% in 1990 to a cycle low 3.0% in September 1992. Ignoring a policy-induced speculative bubble inflating throughout the bond and mortgage derivatives markets, the Greenspan Fed waited to begin normalizing rates until February 1994. In 2001, Fed funds began the year at 6.50% and were then slashed to only 1.00% by June 2003. The Fed didn’t take its first baby-step until June 2004, after several years of double-digit mortgage Credit growth and a mortgage finance Bubble that had gathered powerful momentum.

The current remarkable cycle has brought new meaning to the phrase “Behind the Curve.” Rates were cut from 5.25% starting back in September 2007. By December 2008, they had been slashed to zero (to 25bps), with the DJIA ending the year at 8,876. Now, with the DJIA at 21,000, Fed funds sit at only 0.75%. Rates have budged little off zero despite record securities prices, record corporate bond issuance, record home prices and a 4.8% unemployment rate.

While Q4 data will be out soon, it appears that 2016 posted the largest Credit growth since 2007. Through the first three quarters of 2016, non-financial Credit expanded at an annualized pace of just under $2.4 TN, not far off 2007’s record $2.503 TN. For comparison, non-financial debt expanded $1.259 TN in ‘09, $1.589 TN in ‘10, $1.309 TN in ‘11, $1.916 TN in ‘12, $1.545 TN in ‘13, $1.807 TN in ’14 and $1.931 TN in ‘15.

The strongest Credit expansion in years is led by robust growth in consumer Credit, corporate debt and federal borrowings. Even mortgage Credit has picked up to the fastest pace since 2007, after years in the doldrums. In my parlance, years of accelerating Credit expansion have engendered self-reinforcing inflationary biases throughout the economy, most notably in securities, real estate and asset prices more generally. Increasingly, however, rising incomes have begun fueling some inflationary pressure even in the consumer price arena.

U.S. Credit growth and economic activity had attained sufficient self-sustaining momentum by 2014 and 2015 for the Fed to have launched so-called “normalization.” It was a major policy blunder not to have this process well underway by 2016. The Fed basically disregarded domestic considerations as it postponed rate adjustments after its single December 2015 baby-step.

The faltering Chinese Bubble from a year ago held sway, not only with respect to Fed policy but for the ECB and BOJ as well. A Chinese bust clearly had major ramifications for the global inflationary backdrop. Yet there’s always that thin line between a bursting Bubble and the acquiescence of irrepressible “Terminal Phase” excess. As it turned out, rather than a disinflationary shock catalyst for a susceptible world, China’s aggressive reflationary measures ensured record 2016 Credit expansion and attendant upside inflationary pressures at home and abroad. China's historic Credit Bubble is ongoing, and it’s pulling global inflationary dynamics along for the ride.

From the conclusion of Janet Yellen’s Friday Afternoon speech – “From Adding Accommodation to Scaling It Back:” “We [support continued growth… in pursuit of our… mandates], as I have noted, with an eye always on the risks. To that end, we realize that waiting too long to scale back some of our support could potentially require us to raise rates rapidly sometime down the road, which in turn could risk disrupting financial markets and pushing the economy into recession. Having said that, I currently see no evidence that the Federal Reserve has fallen behind the curve, and I therefore continue to have confidence in our judgment that a gradual removal of accommodation is likely to be appropriate.

Of course chair Yellen is not about to conceded that the Fed has fallen “Behind the Curve.” Her speech, however, was heavy on rationalizing and justifying why the FOMC has been incredibly reluctant to begin normalizing policy.

Gauging the current stance of monetary policy requires arriving at a judgment of what would constitute a neutral policy stance at a given time. A useful concept in this regard is the neutral ‘real’ federal funds rate, defined as the level of the federal funds rate that, when adjusted for inflation, is neither expansionary nor contractionary when the economy is operating near its potential. In effect, a ‘neutral’ policy stance is one where monetary policy neither has its foot on the brake nor is pressing down on the accelerator…”

In the Committee's most recent projections last December, most FOMC participants assessed the longer-run value of the neutral real federal funds rate to be in the vicinity of 1%...”

It is difficult to say just how low the current neutral rate is because assessments of the effect of post-recession headwinds on the current level of the neutral real rate are subject to a great deal of uncertainty. Some recent estimates of the current value of the neutral real federal funds rate stand close to zero percent...”

In 2015, the unemployment rate fell significantly faster than we generally had anticipated in 2014. However, a series of unanticipated global developments beginning in the second half of 2014--including a prolonged decline in oil prices, a sizable appreciation of the dollar, and financial market turbulence emanating from abroad--ended up having adverse implications for the outlook for inflation and economic activity in the United States, prompting the FOMC to remove monetary policy accommodation at a slower pace than we had anticipated in mid-2014…”

Future historians will be unimpressed with the Fed’s whole line of “Neutral Rate” analysis. It’s certainly reminiscent of chairman Greenspan’s late-nineties foray into the New Economy’s “faster speed limit” -- as rationalization for evading the tough action necessary to rein in excessively loose monetary conditions and resulting speculative asset markets. Yellen presented a reasonably comprehensive analysis of Fed thinking, yet her Friday speech does not include the either the word “Credit” or “money.” Regrettably, it’s the same flawed theoretical framework that has gotten the Fed – along with the rest of us - in repeated trouble for the past three decades.

Ten-year bond yields were 5.6% when the Fed moved to tighten policy in February 1994. Yields then shot all the way to 8.0% into early November. The Fed took from that experience the notion that it must clearly signal to the markets that rate increases will be gradual and quite measured. This fundamentally altered how the bond market responds to Fed policy changes. Indeed, a case can be made that since ’94 the Fed has avoided measures that would actually tighten financial conditions. 

Ten-year yields were at 4.7% when the Fed initiated tightening measures (at 1.25%) in May 2004, before ending the year at 4.2%. Fed funds were up to 5.25% by June ’06, though 10-year bond yields had increased to just over 5%. Bond yields then began 2007 at 4.7%, market rates sufficiently low to ensure quite loose financial conditions and prolong the dangerous Bubble.

Ten-year yields closed Friday trading at 2.48%. Clearly, the bond market has little fear of Fed tightening measures. At this point, the backdrop is showing similarities to the 2004-2007 Bubble period where Fed rate increases couldn’t keep up with rising inflationary biases – in securities and asset prices, as well as throughout the real economy.

The Fed’s focus on some abstract “Neutral Rate” is foolhardy central banking, especially when it comes at the expense of analysis of Credit and monetary factors. For a central bank supposedly “data dependent”, how are the markets to gauge and interpret such a nebulous theoretical concept (other than as rationalization for disregarding asset inflation and bubbles)?

What was the “Neutral Rate” one year ago, with China in trouble, global markets faltering, crude at about $40 and CPI measures pointing downward? How about today, with record global Credit growth, booming markets, crude at $53 and CPI trends pointing almost straight up? The ISM Prices Paid index was 33.5 in January 2016 – the low since 2009. By January 2017 it had more than doubled to 69, the highest in almost six years. “Neutral Rate” has no practical policy relevance in a period of such monetary and price disorder.

The Fed surely hopes to offload some of their tightening work to the financial markets. So far, ebullient markets seem rather determined to sustain ultra-loose financial conditions. If inflationary forces have finally gathered self-reinforcing momentum, dillydallying several years to get Fed funds up to three or four percent is not going to cut it. It seems obvious that the Fed has fallen way Behind the Curve. And this may be irrelevant to markets currently, though this phase will pass. It’s sure disconcerting to see the public throw “money” at equity index products at this stage of the market cycle. The Fed has cultivated the misperception that it’s a whole lot safer than buying Bubble technology stocks in 1999 or Bubble equities and houses in 2007.

For the Week:

The S&P500 gained 0.7% (up 6.4% y-t-d), and the Dow increased 0.9% (up 6.3%). The Utilities slipped 0.3% (up 5.1%). The Banks jumped 2.0% (up 6.5%), while the Broker/Dealers dipped 0.2% (up 7.4%). The Transports gained 0.7% (up 5.0%). The S&P 400 Midcaps added 0.2% (up 4.8%), while the small cap Russell 2000 was unchanged (up 2.7%). The Nasdaq100 added 0.6% (up 10.5%), while the Morgan Stanley High Tech index declined 0.6% (up 10.9%). The Semiconductors were little changed (up 7.4%). The Biotechs surged 6.2% (up 16.9%). With bullion down $23, the HUI gold index sank 7.1% (up 7.1%).

Three-month Treasury bill rates ended the week at a nine-year high 70 bps. Two-year government yields jumped 16 bps to 1.31% (up 12bps y-t-d). Five-year T-note yields surged 20 bps to 2.01% (up 8bps). Ten-year Treasury yields jumped 17 bps to 2.48% (up 3bps). Long bond yields rose 17 bps to 3.22% (up 16bps).

Greek 10-year yields dropped 12 bps to 6.95% (down 7bps y-t-d). Ten-year Portuguese yields were unchanged at 3.94% (up 19bps). Italian 10-year yields declined nine bps to 2.10% (up 29bps). Spain's 10-year yields dipped two bps to 1.68% (up 30bps). German bund yields jumped 17 bps to 0.36% (up 15bps). French yields added a basis point to 0.94% (up 26bps). The French to German 10-year bond spread narrowed 17 to 58 bps. U.K. 10-year gilt yields rose 11 bps to 1.19% (down 5bps). U.K.'s FTSE equities index jumped 1.8% (up 3.2%).

Japan's Nikkei 225 equities index rallied 1.0% (up 1.9% y-t-d). Japanese 10-year "JGB" yields added a basis point to 0.08% (up 4bps). The German DAX equities index jumped 1.9% (up 4.8%). Spain's IBEX 35 equities index surged 3.6% (up 4.8%). Italy's FTSE MIB index recovered 5.7% (up 2.2%). EM equities were mixed. Brazil's Bovespa index added 0.2% (up 10.9%). Mexico's Bolsa increased 0.8% (up 3.9%). South Korea's Kospi declined 0.7% (up 2.6%). India’s Sensex equities index slipped 0.2% (up 8.3%). China’s Shanghai Exchange fell 1.1% (up 3.7%). Turkey's Borsa Istanbul National 100 index rose 1.7% (up 14.8%). Russia's MICEX equities index dropped 1.7% (down 7.9%).

Junk bond mutual funds saw outflows of $240 million (from Lipper).

Freddie Mac 30-year fixed mortgage rates fell six bps to a three-month low 4.10% (up 46bps y-o-y). Fifteen-year rates dropped five bps to 3.32% (up 38bps). The five-year hybrid ARM rate slipped two bps to 3.14% (up 30bps). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed rates up two bps to 4.30% (up 56bps).

Federal Reserve Credit last week expanded $3.0bn to $4.427 TN. Over the past year, Fed Credit declined $12.6bn (down 0.3%). Fed Credit inflated $1.616 TN, or 57%, over the past 225 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt fell $5.7bn last week to $3.176 TN. "Custody holdings" were down $75.3bn y-o-y, or 2.3%.

M2 (narrow) "money" supply last week gained $10.7bn to a record $13.302 TN. "Narrow money" expanded $805bn, or 6.4%, over the past year. For the week, Currency declined $0.8bn. Total Checkable Deposits jumped $34.5bn, while Savings Deposits fell $20.9bn. Small Time Deposits added $1.9bn. Retail Money Funds declined $3.9bn.

Total money market fund assets added $1.6bn to $2.678 TN. Money Funds fell $126bn y-o-y (4.5%).

Total Commercial Paper increased $4.1bn to $971.3bn. CP declined $112bn y-o-y, or 10.3%.

Currency Watch:

The U.S. dollar index increased 0.4% to 101.54 (down 0.8% y-t-d). For the week on the upside, the Mexican peso increased 2.1%, the Swedish krona 0.6% and the euro 0.6%. For the week on the downside, the New Zealand dollar declined 2.5%, the Canadian dollar 2.2%, the South Korean won 2.1%, the Japanese yen 1.7%, the Australian dollar 1.0%, the South African rand 0.6%, the Norwegian krone 0.5%, the Singapore dollar 0.4% and the Brazilian real 0.2%. The Chinese yuan declined 0.4% versus the dollar this week (up 0.7% y-t-d).

Commodities Watch:

The Goldman Sachs Commodities Index declined 0.8% (unchanged y-t-d). Spot Gold lost 1.8% to $1,235 (up 7%). Silver sank 3.6% to $17.74 (up 11%). Crude declined 66 cents to $53.33 (down 1%). Gasoline fell 4.8% (down 1%), while Natural Gas gained 1.4% (down 24%). Copper was unchanged (up 7%). Wheat gained 1.2% (up 11%). Corn jumped 2.7% (up 8%).

Trump Administration Watch:

February 27 – Politico (Rachael Bade, Sarah Ferris and Shane Goldmacher): “Congressional Republicans… panned Donald Trump’s call to finance a military buildup by slashing domestic agencies and ignoring entitlement programs — undermining the president’s budget even before it’s been finalized. The consternation spanned the party’s ranks just one day before Trump addresses Congress for his first time Tuesday evening: House GOP fiscal hawks said it was ludicrous to think they’d pass a budget that did not address ballooning costs in Medicare and Social Security, the main drivers of the national debt. Pragmatic-minded GOP appropriators scratched their heads over where Trump would siphon off $54 billion in domestic cuts. And GOP defense hawks said the Pentagon budget boost doesn’t go nearly far enough.”

February 28 – Wall Street Journal (Michael C. Bender): “One day after his budget team promised dollar-for-dollar cuts to offset a request for more military spending, President Donald Trump said… the additional money he is seeking for the defense budget would be paid for by a surge in tax collections sparked by the improving economy. ‘The money is going to come from a revved-up economy,’ Mr. Trump said… ‘I mean, you look at the kind of numbers we’re doing, we were probably GDP of a little more than 1%. And if I can get that up to three, maybe more, we have a whole different ballgame.”

March 1 – Bloomberg (Andrew Mayeda): “The U.S. isn’t bound by decisions made at the World Trade Organization, President Donald Trump’s administration said in outlining a new trade agenda that promises to root out unfair practices by foreign countries. America plans to defend its ‘national sovereignty over trade policy,’ the Office of the U.S. Trade Representative said in an annual document laying out the president’s trade agenda. Under the terms of its entry into the WTO, the U.S. didn’t abandon its trade rights, according to the document, obtained by Bloomberg News and titled ‘2017 Trade Policy Agenda.’”

China Bubble Watch:

March 1 – Bloomberg: “China’s banking regulator outlined wide-ranging efforts to rein in financial risks, including clamping down on shadow lending and curbing funding for property speculation. Guo Shuqing, three days on the job as chairman of the China Banking Regulatory Commission, said he will coordinate with other financial authorities, including the central bank, to plug loopholes in regulations for cross-market financial products and update rules that no longer fit with banks’ current business and risk management. ‘Banks, trusts, fund-management firms, brokerages and insurers all have asset-management operations, but because they have different regulators and are subject to different rules, there’s been some chaos,’ Guo said…”

February 28 – Reuters (Kevin Yao): “China plans to target broad money supply growth of around 12% in 2017, slightly lower than last year's goal, policy sources said, signaling a bid to contain debt risks while keeping growth on track. Under its new ‘prudent and neutral’ policy, the People's Bank of China (PBOC) has adopted a modest tightening bias in a bid to cool torrid credit expansion, though it is treading cautiously to avoid hurting the economy. The M2 growth target was endorsed by leaders at the closed-door Central Economic Work Conference in December…”

February 25 – Reuters (Shu Zhang and Matthew Miller): “Guo Shuqing, who is stepping down as governor of Shandong province to take control of China's banking regulator, returns to Beijing at a decisive moment for the country's financial system following years of breakneck economic growth. The immediate challenge for the new chairman of the ChinaBanking Regulatory Commission (CRBC) is formidable - Guo must vigorously address troubled lending in the country's 232 trillion yuan ($34 trillion) banking sector and implement tougher measures to control lightly regulated shadow banking activities.”

February 26 – Reuters: “China will focus on stable development of its capital markets this year, but will press ahead to further open its markets to foreign companies, the top securities regulator said… ‘We will not waver from reforms (to make China's capital markets) more market-based, law-based and international,’ Liu Shiyu, chairman of the China Securities Regulatory Commission (CSRC), told a news conference… Chinese regulators have turned their sights on controlling risks in financial markets as speculative activity and leverage in the economy rise, with the securities regulator vowing to clear out "abnormal phenomena" from capital markets. The CSRC recently pledged to target ‘barbaric’ leveraged buyouts and to restrict excessive fundraising by some listed companies, with a focus on private share placements.”

March 2 – New York Times (Sui-Lee Wee): “Mao once branded capitalists enemies of the Chinese people. In the era of President Xi Jinping, those capitalists are billionaire lawmakers — and they’re getting even wealthier. The combined fortune of the wealthiest members of China’s Parliament and its advisory body amounts to $500 billion, just below the annual economic output of Sweden. Among that group of 209 entrepreneurs and business tycoons, the 100 richest saw their net worth rise 64% in the four years since Mr. Xi took power…”

February 27 – Financial Times (Jennifer Hughes and Don Weinland): “Chinese companies have borrowed more money from the international bond market than from domestic investors so far this year, breaking with tradition as authorities in Beijing focus on curbing capital outflows. Banks and other corporate borrowers have been quietly encouraged to raise money offshore in other currencies, limiting the need for Chinese companies to sell renminbi to finance overseas investments. Borrowing more outside the mainland also allows for the possibility companies will remit some of the cash back home, bolstering the Chinese currency in the process. Led by banks and property developers, corporate China has raised $26.1bn from offshore bond sales compared with $21bn at home, according to Dealogic.”

March 2 – Reuters (Elias Glenn): “China's factory activity expanded for the eighth straight month in February as export orders picked up, a private survey showed…, giving authorities more room to tackle financial risks in the economy as debt continues to rise. The Caixin/Markit Manufacturing Purchasing Managers' index (PMI) rose to 51.7 on a seasonally adjusted basis, up from 51.0 in January and beating analysts' forecasts of 50.8.”

February 28 – Wall Street Journal (Jacky Wong): “China’s housing-market party is winding down for now, and the country’s biggest developer could have a painful hangover. China Evergrande Group, the poster child for an overleveraged industry, proved again its debt-fueled ambitions haven't yet been reached. According to a filing Tuesday, total borrowings have risen to 565 billion yuan ($82.2bn) as of mid-January, a 48% increase from its June level. Netted out of cash, Evergrande is the most indebted real-estate company globally… The developer, which also owns a soccer club and a plastic-surgery hospital, intends to raise 30 billion yuan by selling stakes in its major subsidiary.”

February 27 – Financial Times (Tom Hancock): “Bankruptcy cases surged in China last year, indicating growing economic stress as well as progress in the ruling Communist party’s efforts to use the country’s courts to deal with indebted ‘zombie’ companies and reduce industrial overcapacity. Chinese courts accepted 5,665 bankruptcy cases in 2016, an increase of 54% from the year before… About 3,600 of those cases were resolved, with 85% of the resolved cases resulting in liquidation. ‘It is linked to getting rid of zombie companies and making the economy more efficient,’ said Susan Finder, law scholar in residence at Peking University’s Shenzhen Graduate School.”

February 27 – Financial Times (Don Weinland): “Has China’s crackdown on capital flight claimed its biggest name to date? The fate of a $1bn deal struck in November by Dalian Wanda, the Chinese real estate and entertainment giant, is in doubt. People with knowledge of Wanda’s buyout of the US’s Dick Clark Productions, the company behind the Golden Globe Awards, said last week that it was struggling to get approval to move money offshore, putting the transaction at risk. Wanda’s deal could survive if approvals come in time, people close to the matter said. But the delay highlights a shift in Beijing’s economic priorities.”

Global Bubble Watch:

March 1 – Reuters (Saikat Chatterjee): “Asian factories extended a global manufacturing revival as activity picked up steam in February… Manufacturing surveys for Asia, including for its two biggest economies China and Japan, showed a broadly positive impulse for exports in a welcome sign for many of the companies tapped into the global supply chain. ‘Encouragingly, the data indicated that the current upturn in demand remains broad-based across both domestic and international markets, while a further steep increase in purchasing activity raises the prospect of continued production growth in coming months,’ said Annabel Fiddes, economist at IHS Markit…”

February 28 – Bloomberg (Simon Ballard): “The moment of truth for debt markets beckons. Given the extent to which monetary stimulus in Europe has helped to compress corporate bond spreads and flatten the credit curve, fears may grow over the coming months as to how investors will react to the end of the monetary backstop bid. That will depend on the speed of any reversal. The Bank of England bought 7.4 billion pounds ($9.2 billion) of corporate bonds in the five months through Feb. 22.”

March 3 – Bloomberg (Katia Dmitrieva): “Toronto home prices jumped more than 20% in February for the sixth straight month as listings dried up, pushing the price of a suburban house beyond C$1 million ($750,000) for the first time, according to the city’s real estate board. The average home in Canada’s biggest city… climbed 28% to C$875,983 last month from the prior year as active listings were cut in half to 5,400.”

March 1 – Bloomberg (Emily Cadman): “Dwelling values in Australia’s largest city rose at the fastest annual pace in 14-years in February as record-low interest rates outweighed regulatory efforts to avert a housing bubble. Average values in Sydney surged by 18.4%, the biggest jump since December 2002 when the nation was at the tail-end of the early 2000’s housing boom, according to… CoreLogic…”

Greece Watch:

February 26 – Reuters (Michelle Martin): “Greece must not be granted a ‘bail in’ that would involve creditors taking a loss on their loans, Germany's deputy finance minister said…, reiterating the German government's opposition to debt relief for Athens. ‘There must not be a bail-in,’ Jens Spahn told German broadcaster Deutschlandfunk… ‘We think it is very, very likely that we will come to an agreement with the International Monetary Fund that does not require a haircut,’ he said, referring to losses that Greece's creditors would have to take if debt was written off.”

Europe Watch:

March 2 – Bloomberg (Maria Tadeo and Lorenzo Totaro): “Euro-area inflation accelerated to the fastest pace since January 2013, providing fresh arguments to those calling for an exit from the European Central Bank’s monetary stimulus program. Consumer prices rose 2% in February from a year earlier… In a sign of further increases ahead, producer-price growth jumped to the highest in almost five years, rising 3.5% in January on annual basis…”

March 1 – Reuters (Balazs Koranyi): “Euro zone inflation is likely to be sharply higher in 2017 than projected but will still dip towards the end of the year, Bundesbank president Jens Weidmann said…, arguing that accommodative monetary policy remains appropriate. With inflation surging on higher oil prices, and criticism of the European Central Bank (ECB) mounting in Germany ahead of September's elections, pressure has increased on the ECB to at least start a discussion about when and how it would scale back its extraordinary stimulus measures… Weidmann stopped short of calling for any particular measures but argued that keeping borrowing costs low for too long risked getting budgets addicted to cheap cash, making eventual tightening even harder. ‘Monetary policy has to avoid the markets' perception that the central bank is only willing to counter downward pressure on financial markets with an accommodative policy stance but refrains from tightening the reins in times of higher price stability risks due to the fear of triggering market turbulences,’ he said.”

March 1 – Reuters (Michael Nienaber): “German inflation, a politically- and emotionally-charged issue for consumers heading for the polls later this year, soared to its highest level in four-and-a-half years in February, bounding past the European Central Bank's euro zone target. Manufacturing was also reported as growing at the strongest rate since 2011, in a further sign that Europe's biggest economy is firing on all cylinders. The inflation data nonetheless triggered fresh calls from Germany for an end to the ECB's loose monetary policy, particularly with the federal election set for September.”

March 1 – Bloomberg (Alessandro Speciale): “Euro-area manufacturing accelerated for a sixth month in February amid signs that inflation pressures may be starting to build as factories struggle to keep up with demand. A Purchasing Managers’ Index climbed to 55.4, IHS Markit said… Companies raised output charges at the fastest pace in more than five years as higher commodity prices and a weaker euro drove up costs, while suppliers took longer to fill orders…”

February 28 – Bloomberg (Stefania Spezzati): “France’s bonds may suffer the most if there is a greater-than-expected populist election victory in Netherlands in March, one month before the country’s own presidential vote. The French securities have recovered in February after falling in recent months, as anti-euro candidate Marine Le Pen leads polls for a first round in April but is seeing fading momentum in surveys for a second-round runoff in May. The anti-EU Dutch Freedom Party, or PVV, is forecast in polls to become the largest in parliament and a big victory would again unsettle nerves among investors in euro-area government bonds.”

Federal Reserve Watch:

February 28 – Reuters (Ann Saphir and Jonathan Spicer): “A handful of Federal Reserve policymakers on Tuesday jolted markets into higher expectations for a March U.S. interest rate increase, with comments that suggested rate-setters are worried about waiting too long in the face of pending economic stimulus... New York Fed President William Dudley, among the most influential U.S. central bankers, said on CNN that the case for tightening monetary policy ‘has become a lot more compelling’ since the election of President Donald Trump and a Republican-controlled Congress. John Williams, president of the San Francisco Fed, said that with the economy at full employment, inflation headed higher, and upside risks from potential tax cuts waiting in the wings, ‘I personally don’t see any need to delay’ raising rates. ‘In my view, a rate increase is very much on the table for serious consideration at our March meeting.’”

February 28 – Wall Street Journal (Ben Leubsdorf): “U.S. inflation is closing in on the Federal Reserve’s long elusive 2% annual target, the latest evidence of firming price pressures that could bolster the case for the central bank to raise short-term interest rates as soon as this month. The personal-consumption-expenditures price index, which is the Fed’s preferred inflation gauge, rose a seasonally adjusted 0.4% in January from the prior month and climbed 1.9% from a year earlier… Excluding the often volatile categories of food and energy, prices rose 0.3% from December and 1.7% compared with January 2016.”

March 1 – Bloomberg (Christopher Condon and Matthew Boesler): “One of the Federal Reserve’s biggest skeptics about the strength of the global expansion signaled the U.S. economy may be strong enough to withstand an interest-rate increase soon, as key policy makers coalesce around tightening at their next meeting in mid-March. ‘Assuming continued progress, it will likely be appropriate soon to remove additional accommodation, continuing on a gradual path,’ Fed Governor Lael Brainard said... ‘We are closing in on full employment, inflation is moving gradually toward our target, foreign growth is on more solid footing and risks to the outlook are as close to balanced as they have been in some time.’”

U.S. Bubble Watch:

March 1 – CNBC (Jeff Cox): “Forget the dot-com boom with its ‘irrational exuberance’ and the real estate bubble that was supposed to be invincible: Current market sentiment eclipses all of that. In fact, bullishness has never been this high going all the way back to 1987. That's through three rousing bull markets, a couple of crashes, the ‘Great Moderation’ of the 1990s and all sorts of other history-making events. A market that was supposed to flounder this year under a new president instead has taken off, and investors are pumped. Bullishness is at 63.1% of market professionals responding to the latest Investors Intelligence survey. That's the highest level since the year of the infamous ‘Black Monday’ Oct. 19, 1987, crash that sent the U.S. market down nearly 23% in one day.”

March 2 – Financial Times (Robin Wigglesworth): “The number of US exchange traded funds has passed the 2,000 mark, as providers churn out an array of increasingly esoteric products that target investment ‘themes’ from evangelical values to entrepreneurship and marijuana — with a Trump ETF possibly waiting in the wings. Passive investment funds have continued to suck in record amounts of money this year, despite the improving performance by traditional asset managers.”

March 3 – Bloomberg (Sid Verma): “Hedge the inauguration, bet the presidency. That’s the mantra of investors diving into the U.S. stock rally with only modest downside protection despite a gale of headwinds, from elevated corporate leverage and Federal Reserve rate hikes to U.S. policy risks. Data from Goldman Sachs… show investors have discarded hedges bought in the first leg of the global rally -- between the November election and the end of last year – as they rush headlong into risk. ‘Our indicator is now in-line with its most complacent level in the past six years, suggesting investors are generally unhedged across both equities and credit,’ derivatives strategists at Goldman, led by John Marshall, wrote…”

March 1 – Financial Times (Robin Wigglesworth): “President Donald Trump wants corporate America to invest more in factories, but since the financial crisis more companies have preferred to hoover up their own shares. Yet have buybacks provided bang for their buck? There have been many critics of the recent corporate buyback bonanza, with figures from former US vice-president Joe Biden to BlackRock founder Larry Fink contending companies have eschewed growth-boosting investments in favour of short-term share repurchases, increasingly financing them with cheap debt rather than earnings. But perhaps the most notable thing about the buyback spree — more than $2tn of shares have been repurchased in the past five years — is how it has arguably provided only a modest boost to equity prices, at least compared to the scale of the purchases.”

March 2 – Bloomberg (Tom Metcalf): “Snap Inc.’s Evan Spiegel and Bobby Murphy each added $1.6 billion to his fortune Thursday after shares in the photo-sharing mobile app closed at $24.48, 44% above their listing price. Investor appetite for the first technology listing of the year boosted the net worth of each co-founder to $5.3 billion, propelling Spiegel, 26, and Murphy, 28, up more than 150 places on the Bloomberg Billionaires Index…”

February 28 – Bloomberg (Austin Weinstein): “Consumer confidence unexpectedly increased in February to the highest level since July 2001 as Americans grew more upbeat about present and future conditions, according to… the… Conference Board. Confidence index advanced to 114.8 (forecast was 111) from a revised 111.6 in January. Present conditions gauge increased to 133.4, the highest since July 2007, from 130…”

March 2 – Bloomberg (Patricia Laya): “The fewest Americans in almost 44 years filed applications to collect unemployment benefits last week, indicating the job market continues to power forward. Jobless claims fell by 19,000 to 223,000 in the week ended Feb. 25, the fewest since March 1973…”

February 28 – CNBC (Elizabeth Gurdus): “Low inventory and mortgage rates pushed home-price gains to a 30-month high in December, according to the S&P/Case-Shiller U.S. National Home Price Index. The index, which measures all nine U.S. census divisions, found that home prices rose 5.8% year over year, up from November's 5.6% annual gain. The December rise was the highest annual increase since June 2014, when it rose 6.3% vs. to June 2013.”

February 28 – Financial Times (Adam Samson): “The US equities market as a whole has gotten off to their most tranquil start this year since the mid-1960s, although a look under the hood shows ‘major disturbances happening on a stock level,’ according to new research from JPMorgan… Over the first two months of the year, the S&P 500 has not posted a gain or loss of greater than 1%, the first time this has occurred since 1966… Underscoring the sense of calm on Wall Street, the Vix index, a measure of expected S&P 500 volatility over the next month, has hovered between 10 – 12 since mid-January, far below the average of 19.6 since 1990…”

February 26 – Wall Street Journal (Aaron Back): “Lending growth has recently been slowing in the U.S., a potentially ominous economic signal… Total loans and leases by U.S. commercial banks are currently rising at an annual pace of about 5%, based on weekly seasonally adjusted data from the Federal Reserve. That is down from a 6.4% pace for all of last year and peak rates of around 8% in mid-2016. The deceleration has been broad-based across business, real estate and consumer lending and is at odds with the idea of a stronger economy and rising sentiment. The slowdown has been particularly stark in commercial and industrial lending, which was growing at around 10% in the first half of last year, but is now up just 5.7% from a year earlier.”

February 28 – Bloomberg (Gabrielle Coppola): “For the first time in his 37 years working at New Jersey car dealerships, Larry Kull had to rent extra space to store unsold new Honda vehicles -- one of the latest signs that the record U.S. auto market is cooling. Across dealer lots in America, inventory is piling up as automakers produce more cars than are being bought. Dealers had about 85 days worth of cars and trucks on hand at the beginning of February -- about 22 days more than at the beginning of 2017 and eight days more than a year earlier, according to Automotive News Data Center.”

February 26 – CNBC (Stephanie Landsman): “The man often hailed as the original 'Dr. Doom' is warning investors that the U.S. stock market is vulnerable to a seismic sell-off—one that could start any time in a very unassuming way. Marc Faber, the editor of ‘The Gloom, Boom & Doom Report,’ predicted the rally's disruption won't be caused by any single catalyst. His argument: Stocks are very overbought and sentiment is way too bullish for the so-called Trump rally to continue. ‘Very simply, the market starts to go down. As it goes down, it will start triggering selling, and then it will be like an avalanche,’ said Faber recently on ‘Futures Now.’ ‘I would underweight U.S. stocks.’”

Japan Watch:

February 28 – Financial Times (Robin Harding and Elaine Moore): “The Bank of Japan published detailed schedules of planned asset purchases for the first time on Tuesday as it seeks to prove its commitment to a zero per cent cap on 10-year government bond yields. Japan’s central bank said it will buy a minimum of ¥1.375tn and a maximum of ¥2.175tn of government bonds during March… Setting out the purchase plan in advance makes it less likely that the BoJ will skip an auction — a common subject of market speculation as the central bank accumulates an ever larger share of outstanding government bonds through its programme of monetary easing.”

Leveraged Speculation Watch:

February 28 – Bloomberg: “Hedge funds are raising their exposure to commodities as prices rally and investors respond to macro shifts including the prospect of accelerating inflation under U.S. President Donald Trump, according to Citigroup Inc. ‘After two years of scaling back exposure to commodities, the fund community finally appears to be growing interested in the sector again,’ the bank’s analysts including Aakash Doshi and David Wilson wrote… They attributed record net-long positions… in markets including Comex copper and Nymex crude oil, at least partly to increased allocation of fund money.”

Geopolitical Watch:

March 3 – Reuters (Adam Jourdan): “South Korean firms are being squeezed in China, in suspected retaliation for Seoul's deployment of a U.S. missile defense system, highlighting the tools China can deploy to hit back at the corporate interests of trade partners it disagrees with. The chill facing Korea Inc, from cosmetics and supermarket chains to autos and tourism, points to a potential risk for American companies… In China, state media and grassroots political groups have led angry calls to boycott popular Korean products. Photos on social media and local news websites showed crowds vandalizing a Hyundai Motor Co. car, and some Chinese tourism firms moved to cancel Korean tours.”

February 25 – Reuters (Ben Blanchard and Michael Martina): “The PLA Navy is likely to secure significant new funding in China's upcoming defense budget as Beijing seeks to check U.S. dominance of the high seas and step up its own projection of power around the globe… Now, with President Donald Trump promising a U.S. shipbuilding spree and unnerving Beijing with his unpredictable approach on hot button issues including Taiwan and the South and East China Seas, China is pushing to narrow the gap with the U.S. Navy. ‘It's opportunity in crisis,’ said a Beijing-based Asian diplomat, of China's recent naval moves. ‘China fears Trump will turn on them eventually as he's so unpredictable and it's getting ready."

Friday Evening Links

[Bloomberg] Yellen Says March Hike 'Likely Appropriate' If Progress Persists

[Bloomberg] Traders Start Betting on Quicker Fed Path Through 2019

[Bloomberg] Fund Managers Seeking Redemption Lag Behind Indexes in February

[Reuters] Deutsche Bank prepares 8 billion-euro capital increase

[NYT] Janet Yellen Says Fed Is Likely to Raise Interest Rates This Month