Friday, July 14, 2017

Weekly Commentary: Yellen on Inflation

Global Markets rallied sharply this week. The DJIA rose 223 points to a record 21,638. The S&P500 gained 1.4% to a new all-time high. The Nasdaq100 (NDX) surged 3.2%, increasing 2017 gains to 20.0%. The Morgan Stanley High Tech Index rose 3.4% (up 24.6% y-t-d), and the Semiconductors surged 4.7% (up 21.8%).

Emerging markets were notably strong. Equities rallied 5.0% in Brazil, 5.5% in Hong Kong, 5.1% in Turkey, 2.5% in Russia, 2.2% in Mexico and 2.1% in India. The Brazilian real gained 3.2%, the Mexican peso 3.0%, the South African rand 2.7% and the Turkish lira 2.3%. Global bond markets also rallied. Yields (local currency) dropped 27 bps in Brazil, 18 bps in South Africa, 16 bps in Turkey and 22 bps in Argentina. Here at home, five-year Treasury yields dropped eight bps (to 1.87%). U.S. corporate Credit also enjoyed solid gains. Across global markets, it appeared that short positions were under pressure.

Markets reacted with elation to Janet Yellen’s Washington testimony – widely perceived as dovish. In particular, the chair’s timely comments on inflation were cheered throughout global securities markets. A headline from the Financial Times: “Fed Chair Yellen’s Inflation Concern Buoys Markets.” And Friday afternoon from Bloomberg: “S&P 500 Hits Record as Inflation View Turns Iffy”.

July 12 – Financial Times (Sam Fleming): “Janet Yellen acknowledged… that the US’s persistently subdued inflation could raise questions about the Federal Reserve’s current path of gradually raising interest rates and vowed to watch prices ‘very closely’ for signs they were stagnating. The Fed chair insisted it was ‘premature’ to second guess policymakers’ determination inflation was slowly headed to the central bank’s target of 2%. But her note of caution helped spark a rally in US Treasuries and equities, with investors hopeful Ms Yellen would keep the Fed’s easy money stance for longer… Ms Yellen was broadly positive about the economy’s recent performance…, stressing there had been a rebound in household spending over recent months and the Fed was still anticipating further rate increases. But she also said she was studying the low inflation numbers for signs that short-term drags on prices may not be the only factors holding it back. She added that rates may not need to be lifted a lot more to get back to a neutral stance. ‘We are watching inflation very carefully,’ Ms Yellen said... ‘I do believe part of the weakness in inflation reflects transitory factors, but well recognise that inflation has been running under our 2% objective, that there could be more going on there.’ Analysts said Ms Yellen’s remarks marked a small but significant change of thinking, putting the Fed’s path of gradually pulling back on economic stimulus in question. ‘Yellen’s statement today reveals that the Fed isn’t as sure about inflation as they led us to believe,’ said Luke Bartholomew, investment strategist at Aberdeen Asset Management.”

It’s fair to say that the whole issue of “inflation” confounds the Fed these days. Despite antiquated analytical frameworks and econometric models, the Federal Reserve is showing zero inclination to rethink its approach. At the minimum, objective policy analysis would recognize today’s nebulous link between monetary stimulus and consumer price inflation. Rational thinking would downgrade CPI as a policy guidepost, especially relative to indicators of broader price and financial stability. Still, consumer prices rising slightly below 2% have somehow become central to the argument for maintaining aggressive monetary accommodation.

The nature of economic output has fundamentally changed – from mass-produced high tech hardware, to limitless software and digitalized content, to endless pharmaceuticals and wellness to energy alternatives to, even, the proliferation of organic foods - just to get started. There is today essentially unlimited capacity to supply many of the things we now use in everyday life (sopping up purchasing power like a sponge). Much of this supply is sourced overseas, which further diminishes the traditional relationship between domestic monetary conditions and consumer price inflation.

These dynamics have unfolded over years and are well recognized in the marketplace. To be sure, ongoing tepid consumer price inflation seems to be the one view that markets hold with strong conviction. So when Yellen suggested that below target inflation would alter the trajectory of Fed “normalization,” the markets immediately took notice. When she again referred to the “neutral rate” and implied that the Fed was currently near neutral, this further signaled a Fed that has developed its own notion of what these days constitutes “normal.” Throw in that the FOMC plans to pause rate increases while gauging market reaction to its (cautious) balance sheet operations, and it has become apparent to the markets that the Fed won’t be pushing rates much higher any time soon.

We’ll wait to see if Fed officials push back against the market’s dovish interpretation of Yellen testimony. There’s certainly no conundrum. If the Fed is confused that financial conditions have loosened in the face of “tightening” measures, look in the mirror. Chair Yellen needed to choose her words carefully, especially on the subject of inflation. The markets were near all-time highs, with what has likely been a decent amount of hedging/shorting over the past month. An upside breakout risks a bout of destabilizing speculation. At the same time, there were early indications of fledgling risk aversion. Global yields had recently jumped. Weakness was notable in the periphery debt markets (i.e. Italy, EM), and even U.S. corporate Credit was hinting vulnerability.

Importantly, there was heightened market concern that a concerted effort was underway to begin removing central bank accommodation – that booming markets and stubbornly loose financial conditions might force central bankers to adopt more aggressive tightening measures.

Understandably, the markets will interpret a dovish Yellen – especially the nuanced language on the topic of inflation – as rushing to the markets’ defense. The view that the Fed won’t tolerate even a modest market pullback is, again, further emboldened. And quickly global markets will return to the view that central bankers may talk “normalization,” while their overarching anxiety for upsetting markets has diminished little.

July 12 – Bloomberg (Vivien Lou Chen): “Fed Chair Janet Yellen says that in looking at asset prices and valuations, the central bank is ‘not trying to opine on whether they’re correct’; instead, policy makers are assessing the risk of potential spillovers. As asset prices rise, there hasn’t been a substantial increase in borrowing, Yellen said. [The] financial system is strong and resilient.”

I assume chair Yellen is referring to U.S. non-financial and non-government borrowings. Clearly, central bank Credit and government borrowings have expanded spectacularly around the globe. I suspect as well there has been a major expansion in speculative leveraging and securities Credit at home and abroad.

Georgia Senator David Purdue: “Thank you for being here and for your service. I just have two quick questions. I’m very concerned about global debt. The Institute of International Finance recently reported that their estimate of total global debt is $217 trillion, or more than 300% of global GDP. Do you agree with that?”

Chair Yellen: “So, I haven’t heard that number. That could be. I don’t have that number.”

Purdue: “Of that, $60 trillion is estimated to be sovereign debt. We have about $20 trillion of the $60 trillion. With that as background, the four large central banks also have their largest historic balance sheets. Japan, China, EU and US have collectively close to approaching $20 trillion now of balance sheet size. As you talk about reducing the size of the Fed’s balance sheet, are you coordinating with these other central banks and looking at emerging market debt - particularly the $300 billion that’s coming due by the end of 2018 - relative to the size of your balance sheet here in the United States?”

Yellen: “I wouldn’t say coordinate. We try to make sure we meet regularly and discuss our policy approaches; to make sure that central banks understand how we are looking at economies and policy options. I think the major central banks understand the approach that others are taking. But trying to ask in an aggregate sense how much debt is outstanding is something we’re not doing. Our economies are in rather different situations. While we all encountered weaknesses that were sufficiently severe that Japan, the ECB, the Bank of England, the United States, we all resorted to purchases of longer-term assets to support growth. It leaves the Bank of Japan and the ECB.”

Purdue: “Are you concerned about so much of that [debt] denominated in dollars today?”

Yellen: “It is a risk. A significant amount of that is in China, but that’s not the only country where there are substantial corporate dollar-denominated debts. And certainly that is a risk that we have considered that affects the global economy.”

Senator Bob Menendez: “Let me ask you finally, how does—we see high rising levels of household debt, widening inequality, a neutral interest rate at historically low levels. To me, it’s critical that the Fed has the ability to respond in the event of another economic decline. How does below target inflation impact household debt? And what signs do you see of inflation coming close to the Fed’s 2% target, let alone exceeding it by dangerous amounts?”

Yellen: “As I said, I think the risks with respect to inflation are two-sided. But we’re very aware of the fact that inflation has been running below our 2% objective now for many years, and we’re very focused on trying to bring inflation up to our 2% objective. That’s a symmetric objective and not a ceiling. We know from periods [when] we’ve had deflation, which of course we don’t have in this country. But that is something that has a very adverse effect on debtors and can leave debtors drowned in debt. Now, we don’t have a situation nearly that serious. But it is important when we have a 2% inflation objective to make sure that we achieve it and we’re focused on doing that.”

Yellen stated during that the Fed’s inflation mandate is “symmetrical.” Yet it’s unimaginable that the FOMC would keep monetary conditions extraordinarily tight for nine years in response to CPI modestly above its 2% target?

It’s by this point abundantly clear that contemporary monetary management exerts major direct influences on the structure of asset prices, while having dubious effect on aggregate consumer prices. This now discernable dynamic creates a momentous dilemma for central banks. Especially after the worldwide adoption of the Bernanke doctrine, it’s fundamental to their approach that central banks retain the power to inflate out of trouble as necessary. Why fret debt accumulation, speculation and asset price Bubbles when central banks can always inflate the general price level, thereby reducing debt burdens and asset overvaluation?

Central bankers have a penchant for speaking in terms of “fighting the scourge of deflation.” More specifically, they view inflation as the indispensable mechanism for reflating systems out of the consequences of debt and asset Bubbles. If central bankers were to admit they don’t control “inflation,” then their policy doctrine of promoting reflationary debt growth and higher asset prices turns spurious.

It has been my longstanding position that it’s not possible to inflate out of major Credit and asset Bubbles. As we’ve witnessed for years now, central bank stimulus fuels self-reinforcing speculative excess, with a resulting accumulation of speculative leverage and securities-related Credit more generally. At the same time, years of abundant cheap global liquidity work to feed overcapacity and attendant downward price pressure on many things. Rampant inflation within the Financial Sphere nurtures pricing vulnerabilities and instability throughout the Real Economy Sphere. Bubbles Inflate Only Bigger.

As such, if one accepts the reality that central banks don’t control inflation, the policy course of repeatedly inflating serial Bubbles can be viewed as risking eventual catastrophic policy failure. There’s simply no escaping the day of reckoning. This analysis certainly applies to China. Led by strong lending ($214bn), June growth in Total Social Financing jumped to $263bn. This puts first-half non-government Credit growth at $1.65 TN (up 14% from last year’s record pace), consistent with my expectation for total Chinese Credit growth this year to exceed $3.5 TN.

Along with Yellen’s testimony, China developments were likely a factor in this week’s global risk market rally. The view is taking hold that Chinese officials have at least temporarily pulled back from tightening measures, perhaps in preparation for this autumn’s 19th National Congress of the Communist Party of China.

July 12 – Wall Street Journal (Grace Zhu): “Chinese banks extended higher-than-expected volume of loans last month even as growth in the money supply continued to slow amid Beijing’s efforts to reduce leverage in its financial system. New yuan loans issued by Chinese banks surged to 1.54 trillion yuan ($226.38bn) in June, up from 1.11 trillion yuan in May… The volume was well above the 1.3 trillion yuan forecast by economists… June is typically a high point for new credit from Chinese banks’ as loan officers rush to meet quarterly targets. Beyond that, demand for credit from households—mostly for mortgages in the hot property market—remained strong, and companies too turned to banks for loans, instead of issuing bonds.”

July 12 – Financial Times (Gabriel Wildau): “China’s central bank injected $53bn into the banking system on Thursday, the latest sign that policymakers have eased up on a fierce deleveraging campaign that has caused turmoil among lenders in recent months. President Xi Jinping told the politburo in April that ‘financial security’ was a top policy priority for the year. That led the central bank to tighten liquidity, while the ambitious new banking regulator unleashed a ‘regulatory windstorm’ that sent shockwaves through the banking system. The storm appears to be passing, as the People’s Bank of China has become more generous with cash injections while the China Banking Regulatory Commission has delayed implementation of a significant new directive. ‘There are clear signs in recent weeks of monetary and supervisory tightening being eased,’ Tao Wang, co-head of Asia economics at UBS in Hong Kong, wrote…”

For the Week:

The S&P500 gained 1.4% (up 9.8% y-t-d), and the Dow rose 1.0% (up 9.5%). The Utilities added 0.6% (up 6.0%). The Banks declined 0.9% (up 4.9%), while the Broker/Dealers increased 0.8% (up 11.3%). The Transports rose 0.5% (up 7.7%). The S&P 400 Midcaps gained 1.0% (up 6.3%), and the small cap Russell 2000 increased 0.9% (up 5.3%). The Nasdaq100 jumped 3.2% (up 20.0%), and the Morgan Stanley High Tech index advanced 3.4% (up 24.6%). The Semiconductors surged 4.7% (up 21.8%). The Biotechs were little changed (up 27.1%). With bullion rallying $16, the HUI gold index recovered 3.9% (up 2.0%).

Three-month Treasury bill rates ended the week at 102 bps. Two-year government yields dipped four bps to 1.36% (up 17bps y-t-d). Five-year T-note yields declined eight bps to 1.87% (down 6bps). Ten-year Treasury yields fell five bps to 2.33% (down 11bps). Long bond yields slipped a basis point to 2.92% (down 15bps).

Greek 10-year yields fell eight bps to 5.28% (down 174bps y-t-d). Ten-year Portuguese yields slipped a basis point to 3.15% (down 59bps). Italian 10-year yields declined five bps to 2.29% (up 48bps). Spain's 10-year yields dropped eight bps to 1.65% (up 27bps). German bund yields added two bps to 0.60% (up 39bps). French yields fell eight bps to 0.86% (up 18bps). The French to German 10-year bond spread narrowed 10 bps to 26 bps. U.K. 10-year gilt yields were little changed at 1.31% (up 8bps). U.K.'s FTSE equities index added 0.4% (up 3.3%).

Japan's Nikkei 225 equities index gained 1.0% (up 5.3% y-t-d). Japanese 10-year "JGB" yields were little changed at 0.083% (up 4bps). France's CAC40 gained 1.8% (up 7.7%). The German DAX equities index rose 2.0% (up 10%). Spain's IBEX 35 equities index added 1.6% (up 13.9%). Italy's FTSE MIB index jumped 2.3% (up 11.7%). EM equities posted strong gains. Brazil's Bovespa index surged 5.0% (up 8.6%), and Mexico's Bolsa rose 2.2% (up 5.3%). South Korea's Kospi gained 1.5% (up 19.2%). India’s Sensex equities index advanced 2.1% (up 20.3%). China’s Shanghai Exchange was little changed (up 3.8%). Turkey's Borsa Istanbul National 100 index surged 5.1% (up 34.6%). Russia's MICEX equities index rallied 2.5% (down 12.2%).

Junk bond mutual funds saw outflows of $1.144 billion (from Lipper).

Freddie Mac 30-year fixed mortgage rates jumped seven bps to 4.03% (up 61bps y-o-y). Fifteen-year rates gained seven bps to 3.29% (up 57bps). The five-year hybrid ARM rate rose seven bps to 3.28% (up 52bps). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed rates up four bps to 4.14% (up 47bps).

Federal Reserve Credit last week slipped $0.2bn to $4.427 TN. Over the past year, Fed Credit declined $4.9bn. Fed Credit inflated $1.616 TN, or 57%, over the past 244 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt gained $6.5bn last week to $3.323 TN. "Custody holdings" were up $100bn y-o-y, or 3.1%.

M2 (narrow) "money" supply last week declined $30.8bn to $13.515 TN. "Narrow money" expanded $691bn, or 5.4%, over the past year. For the week, Currency increased $0.6bn. Total Checkable Deposits jumped $43.5bn, while Savings Deposits dropped $79.9bn. Small Time Deposits added $2.6bn. Retail Money Funds gained $2.4bn.

Total money market fund assets were little changed at $2.627 TN. Money Funds fell $94bn y-o-y (3.4%).

Total Commercial Paper jumped $13.8bn to $961bn. CP declined $87bn y-o-y, or 8.3%.

Currency Watch:

July 11 – Wall Street Journal (Saumya Vaishampayan and Shen Hong): “China’s central bank is finding that some of the most stubborn yuan skeptics are lurking in its backyard. A tug of war between the People’s Bank of China and investors in the country’s domestic foreign-exchange market has played out almost daily in recent months, with the yuan consistently closing weaker than the level set by the central bank. While the central bank’s support has helped the yuan gain 2.2% against the U.S. dollar this year, after three years of declines, Chinese investors have been focusing in recent weeks on factors that could drag the currency lower in the coming months, traders say.”

The U.S. dollar index declined 0.9% to 95.153 (down 7.1% y-t-d). For the week on the upside, the Brazilian real increased 3.2%, the Australian dollar 3.0%, the Mexican peso 3.0%, the South African rand 2.7%, the Norwegian krone 2.2%, the South Korean won 1.9%, the Canadian dollar 1.8%, the British pound 1.6%, the Swedish krona 1.4%, the Japanese yen 1.2%, the New Zealand dollar 0.9%, the Singapore dollar 0.8%, the euro 0.6% and the Danish krone 0.6%. The Chinese renminbi gained 0.45% versus the dollar this week (up 2.50% y-t-d).

Commodities Watch:

The Goldman Sachs Commodities Index rallied 2.2% (down 6.3% y-t-d). Spot Gold gained 1.3% to $1,229 (up 6.6%). Silver recovered 3.3% to $15.933 (down 0.3%). Crude rallied $2.31 to $46.54 (down 14%). Gasoline popped 4.1% (down 7%), and Natural Gas also jumped 4.1% (down 20%). Copper gained 1.7% (up 7%). Wheat gave back 4.5% (up 25%). Corn fell 4.1% (up 7%).

Trump Administration Watch:

July 8 – Bloomberg (Bryce Bashuk): “Group of 20 leaders agreed to address growing overcapacity and rock-bottom prices in global steel markets, bowing to pressure from the Trump administration after it threatened to impose punitive tariffs on its allies. In talks that stretched into the early hours of Saturday, U.S. officials managed to get language inserted into the communique that sets deadlines for G-20 members to address excess steel production… Countries like China will also have to be more transparent about how they subsidize domestic producers. In return, the U.S. agreed to boilerplate language reiterating the G-20’s commitment to fight protectionism. The threat of a trade war on steel hung over this week’s G-20 summit in Hamburg and those fears were compounded Friday when German Chancellor Angela Merkel said negotiations were proving to be difficult.”

July 10 – Reuters (Susan Cornwell and Amanda Becker): “Republican senators returned to Washington… following a 10-day holiday recess still at odds with one another over legislation President Donald Trump wants passed to repeal major portions of Obamacare. With only three weeks left before a summer recess scheduled to stretch until Sept. 5, Senate Majority Leader Mitch McConnell appeared determined to keep trying to find agreement on a partisan, all-Republican bill. If he cannot, he will be faced with giving up on a seven-year Republican promise to repeal the 2010 Affordable Care Act, popularly known as Obamacare - and possibly turning to Democrats for help in fixing problems with U.S. health insurance markets.”

July 13 – Reuters (Susan Cornwell and Yasmeen Abutaleb): “Senate Republican leaders released… a revised plan to dismantle the Obamacare law, playing to the party's disparate factions by letting insurers sell cheap, bare-bones policies while retaining taxes on the wealthy, but quick criticism showed the healthcare overhaul is already in jeopardy. U.S. Senate Majority Leader Mitch McConnell, pushed hard by President Donald Trump to pass a healthcare bill and make good on Republicans' seven-year mission to gut Democratic former President Barack Obama's signature legislative achievement, is walking a tightrope. With Democrats united against it, McConnell cannot afford to lose more than two Republican senators to win passage. But moderate Susan Collins and conservative Rand Paul voiced opposition to even bringing the new plan up for debate.”

July 11 – Financial Times (Sam Fleming and Barney Jopson): “While Donald Trump once vowed to ‘do a number’ on Dodd-Frank, Washington’s central piece of post-crisis financial legislation, his regulatory appointees will probably prove more effective agents of change than Congress, which remains locked in a legislative logjam. The administration… named one of the key figures in its quest to ease the load of regulation, nominating Randal Quarles to be vice-chair for financial supervision at the Federal Reserve. Bankers are hoping Mr Quarles will reverse the hardline approach to bank oversight — and in particular capital standards — that was developed after the crisis by Daniel Tarullo, a former Fed governor who was the central bank’s chief regulator but who never formally occupied the role.”

China Bubble Watch:

July 12 – Wall Street Journal (Lingling Wei and Dominique Fong): “The more China tries to rein in its roaring housing market, the more obsessed people get about buying. In February, with this southern megalopolis in the throes of a property frenzy, state banks raised mortgage rates. Then came higher down-payment rules for second homes and limits on owning multiple apartments. The result: Prices in Guangzhou continue to climb, and the market one town over has heated up. Pei Zhiyong, a 56-year-old advertising executive, was barred by the new restrictions from buying a third apartment in Guangzhou. One Sunday in April, he drove his BMW SUV to Foshan, an hour away, to check out a new riverfront high-rise. He figures it’s the ideal time to buy. ‘The harder the government tries to control the market, the more prices will rise,’ Mr. Pei said. With each new policy intended to restrict home purchases, buyers are piling in. Stressed about the prospect of being left behind, many are borrowing heavily, believing prices will continue to rise... Another article of faith is that the Communist Party won’t allow housing prices to collapse.”

July 9 – Bloomberg: “On a recent morning in Shanghai’s Lujiazui financial district, Xiong Yun’s eyes darted around the four computer screens at his desk, scanning activity in China’s bond and futures markets. Staring at the matrix of numbers, the former BNP Paribas SA trader was making sure his algorithms pounced on any arbitrage opportunities that popped up between government notes and their derivatives contracts… While Xiong’s approach would seem standard in credit markets around the world, debt-linked derivatives have until recently been a non-factor in China. But they’re being used more after a central bank clampdown ended a three-year bull run and increased volatility: in the past year, trading in bond futures more than doubled and interest rate swaps volume rose by a third. The shift brings China’s $10 trillion bond market closer in line with developed economies…”

July 10 – Bloomberg: “China’s producer price gains held up, signaling that demand in the world’s second-largest economy is maintaining pace for now, even in the face of regulatory curbs. The producer price index rose 5.5% in June from a year earlier…”

July 12 – Bloomberg: “China’s overseas shipments rose from a year earlier as global demand held up and trade tensions with the U.S. were kept in check amid ongoing talks. At home, resilient demand led to a rise in imports. Exports rose 11.3% in June in dollar terms…, more than the estimate of 8.9%. Imports increased 17.2% in dollar terms, leaving a trade surplus of $42.8 billion.”

July 10 – New York Times (Sui-Lee Wee): “A year ago, the Chinese billionaire Wang Jianlin declared the dominance of his vast entertainment empire, Dalian Wanda Group, boasting that his theme parks were a ‘pack of wolves’ that would defeat the lone ‘tiger’ of Disney’s Shanghai resort. Now, Mr. Wang is retreating, in a sign that Wanda could be reaching the limits of its debt-fueled expansion. Wanda said… that it would sell the theme parks as part of a $9.3 billion deal that includes 76 hotels and a major chunk of 13 tourism projects. The cash from the deal… would be used to pay down debt. Wanda appears to be caught in a political and financial downdraft that has hit many big Chinese deal makers.”

July 8 – Reuters (Sumeet Chatterjee): “When Horan Fu decided to buy a 500-sq-foot apartment for HK$7.4 million last year, the biggest draw was the developer's offer of 85% financing with an option to defer interest payments for the first three years. ‘The interest rate could be a lot higher after three years, but there's also a chance that the interest would still be cheap because finance companies are competing fiercely,’ said Fu, who works in Hong Kong's financial services industry. ‘There's risk but there's also an upside. It's a good investment opportunity.’ With traditional financing drying up in Hong Kong at a time when property prices are at a record high, home buyers like Fu are looking to non-bank lenders, many of them the financing arms of developers, to get in on the boom.”

Europe Watch:

July 8 – Wall Street Journal (Simon Nixon): “The recent volatility in bond markets has stirred up old fears in Europe. Investors have long been concerned about the possible impact of the end of the European Central Bank’s quantitative easing program on the eurozone’s periphery, not least Italy—the country long-regarded as too big to save. Now with markets abuzz with talk of central bank monetary policy ‘normalization,’ those concerns are once again front of mind: Without the fire blanket of ECB government bond-buying, will Italian borrowing costs soar once again, plunging the eurozone back into crisis?”

Central Bank Watch:

July 13 – Reuters (Francesco Canepa): “The European Central Bank is likely to signal in September that its bond-buying scheme will be gradually wound down next year and ECB chief Mario Draghi could give the next clue on the plans in late August, the Wall Street Journal said… Financial markets overwhelmingly expect the ECB to decide in September on the future of its stimulus policy beyond the end of this year. Some investors expect an extension with a one-off reduction while others see a gradual but steady wind-down, known as tapering.”

July 8 – Bloomberg (Carolynn Look, Mark Deen, and Caroline Connan): “The European Central Bank is likely to decide on the next change in its stimulus settings in the fall, when it will continue the process of tweaking its measures to reflect the euro area’s upturn, according to Governing Council member Francois Villeroy de Galhau. ‘What we have to do, and what we started to do, is to adapt the intensity of this accommodative monetary policy to the progress toward our inflation target and toward economic recovery,’ Villeroy de Galhau said... ‘In the future, and this will be our decision next fall, we will go on adapting the intensity of this monetary policy.’”

July 8 – Bloomberg (Carolynn Look): “European Central Bank policy makers continued to air their differences over when to rein in stimulus, sending conflicting signals on whether pumping cash into the economy for much longer will help the euro area or hurt it. ‘Underlying inflationary pressure remains subdued’ and ‘we still need a long period of accommodative policy,’ Executive Board member Peter Praet, the ECB’s chief economist, told Belgian newspaper De Standaard… Governing Council member Klaas Knot… warned that the central bank is ‘very close to the point’ of keeping quantitative easing for too long.”

July 12 – Bloomberg (Luke Kawa): “A North American central bank hiking rates in the face of strong job growth and deteriorating core inflation rates, citing temporary factors for the drop-off in price pressures. No, it’s not Janet Yellen’s Federal Reserve -- it’s Stephen Poloz’s Bank of Canada. On Wednesday, the Bank of Canada delivered its first interest-rate hike in almost seven years, becoming the first Group of Seven central bank to join the Fed in policy normalization, the first concrete step toward global monetary policy convergence.”

July 12 – Financial Times (Roger Blitz): “Canada’s first rate rise in nearly seven years puts it in the vanguard of central banks outside the US Federal Reserve shifting monetary policy in response to better global economic growth. The market had fully priced in the move upwards of 25 bps to 0.75%, which leaves two obvious questions for investors: what next for Canada, and how soon could other central banks join the retreat from easy monetary policy? Judging by the reaction of the ‘loonie’, nickname for the Canadian dollar, the answer to the first question has already been answered by investors.”

Global Bubble Watch:

July 11 – Bloomberg (Cindy Roberts): “JPMorgan… Chairman Jamie Dimon said the unwinding of central bank bond-buying programs is an unprecedented challenge that may be more disruptive than people think. ‘We’ve never have had QE like this before, we’ve never had unwinding like this before,” Dimon said at a conference in Paris… ‘Obviously that should say something to you about the risk that might mean, because we’ve never lived with it before… When that happens of size or substance, it could be a little more disruptive than people think,” Dimon said. ‘We act like we know exactly how it’s going to happen and we don’t.’”

July 7 – Financial Times (Chris Flood): “BlackRock pulled more cash into its exchange traded fund arm in the first six months of 2017 than over the whole of last year, when the world’s largest asset manager attracted record ETF inflows. Investors have ploughed around $140bn into BlackRock’s ETF business so far this year, already exceeding the annual record of $138bn gathered over the whole of 2016… Vanguard… registered ETF inflows of around $82bn by the end of June. It is on course to beat its annual record of $97bn, also registered in 2016… Global investor inflows into ETFs have reached around $335bn so far in 2017, comfortably on track to beat 2016’s record of $390bn.”

July 12 – Reuters (Simon Jessop): “European corporate bond markets could prove a bigger source of market instability during the next big shock than during the 2008 financial crisis, a study by the Bank of England showed. The study is the first to try to model how non-bank lenders would react in a stressed market environment, with the BoE particularly concerned about the effect on corporate funding rates and their impact on the real economy. The need to model the risk has arisen because capital markets have provided a bigger slice of corporate funding since the financial crisis and many of the often-illiquid bonds are held in mutual funds offering daily exits to investors.”

July 12 – Reuters (Marc Jones): “More governments are likely to see their sovereign credit ratings cut this year, S&P Global said… An average of more than one country a week has had its rating cut by the big rating agencies - S&P, Moody's and Fitch - since the start of 2014. A new report from S&P showed it had 30 sovereigns on downgrade warnings, or ‘negative outlooks’ in rating firm parlance, at the start of the month, compared with just six on positive outlooks. ‘This outlook distribution suggests that negative rating actions are likely to continue to outnumber positive actions over the coming 12 months,’ S&P said in a mid-year review of its rating moves.”

July 12 – Bloomberg: “China’s outbound investment slumped in the first half of the year as policy makers imposed curbs on companies’ foreign acquisitions following a record spending spree in 2016. Outward direct investment dropped to $48.19 billion in the six-month period, down 45.8% from a year ago… Spending fell 11.3% to $13.6 billion in June alone… Foreign direct investment fell 0.1% in yuan terms in the first half, to 441.5 billion yuan… A surge in overseas purchases last year saw firms snap up everything from soccer teams to property.”

July 10 – Bloomberg (Colin Simpson): “There could be trouble ahead for developed world equity markets with ‘frothy’ valuations as central banks start shifting policy, according to Deutsche Bank AG. Price-to-earnings ratios increased steadily after the global financial crisis as waves of monetary stimulus pulled down the yields on safe assets, spurring investors into riskier options. That dynamic may be on the verge of reversing with a turnaround in policy now underway in developed nations other than Japan, Mikihiro Matsuoka, chief economist of the Japanese unit of Deutsche Bank AG, wrote… The average of the standard deviation of stock-market capitalization as a percentage of GDP in seven major developed countries has been approaching the previous peaks of 2000 and 2008, Matsuoka highlighted.”

Fixed Income Bubble Watch:

July 12 – Bloomberg (Sid Verma): “Credit markets didn’t get the memo. After hawkish rhetoric two weeks ago by central bankers led by Mario Draghi set off a sharp surge in government bond yields, the investment-grade and high-yield debt markets have collectively shrugged. Since then, the extra compensation investors demand to hold high-yield bonds around the world over similar-maturity government debt has increased by a whisker at five bps…, while spreads on high-rated debt in euros and dollars have tightened -- now sitting near post-crisis lows. If markets are braced for a new dawn for risk assets bereft of monetary stimulus to juice returns amid record U.S. corporate leverage, credit investors remain remarkably sanguine. That’s in contrast to the tantrums of 2013 and 2015, when the fear of a fading central bank put triggered a disorderly selloff across debt markets.”

Federal Reserve Watch:

July 12 –CNBC (Jeff Cox): “Interest rates may not have to rise that much for the Federal Reserve to meet its goals, central bank Chair Janet Yellen said… In prepared remarks to Congress, Yellen reiterated statements that Fed Governor Lael Brainard gave Tuesday, namely that rates are close to a ‘neutral’ level and not in need of a significant move higher. The neutral level is the point where the Fed's benchmark rate is neither accelerating nor restraining the economy. The current target for the funds rate is 1% to 1.25%, while inflation is around 1.4%. That puts the real rate close to zero, where Yellen and her dovish allies on the Federal Open Market Committee believe it needs to be. ‘Because the neutral rate is currently quite low by historical standards, the federal funds rate would not have to rise all that much further to get to a neutral policy stance,’ Yellen will tell Congress.”

July 12 –Bloomberg (Craig Torres and Christopher Condon): “Federal Reserve Chair Janet Yellen said the U.S. economy should continue to expand over the next few years, allowing the central bank to keep raising interest rates, while also stressing the Fed is monitoring too-low inflation. ‘Considerable uncertainty always attends the economic outlook,’ Yellen said… in remarks prepared for delivery to the U.S House Financial Services Committee. ‘There is, for example, uncertainty about when -- and how much -- inflation will respond to tightening resource utilization.’”

July 12 – Wall Street Journal (Nick Timiraos): “Federal Reserve Chairwoman Janet Yellen, faced with a recent, puzzling slowdown in global inflation, said she expects the forces holding down consumer prices to fade in the months ahead, allowing the central bank to stick to its plans for gradual interest-rate increases. But she left herself an out, saying the Fed could veer from its policy plans if inflation weakness proved more stubborn than officials expect. Ms. Yellen repeated her view that a tightening labor market would put upward pressure on wages and prices. ‘It’s premature to reach the judgment that we’re not on the path to 2% inflation over the next couple of years,’ she said… during a hearing of the House Financial Services Committee. But, she added, ‘We’re watching this very closely and stand ready to adjust our policy if it appears that the inflation undershoot will be persistent.’ Stocks rallied and bond yields fell after her testimony.”

July 11 – Reuters (Swati Pandey and Wayne Cole): “A top U.S. central banker… said he still expected one more rise in interest rates from the Federal Reserve this year and for it to start unwinding its massive balance sheet in the next few months. …San Francisco Federal Reserve Bank President John Williams said he believed a recent softening in U.S. inflation was transitory and that inflation would pick up to around 2% over the coming year. Williams emphasized that if inflation did not accelerate as expected, that would argue for a much slower pace of rate rises than currently projected.”

July 8 – Financial Times (Sam Fleming): “The Federal Reserve has set out a vigorous argument to retain broad discretion over monetary policy, in the teeth of a campaign by Republican lawmakers to push it to a more rules-based system ahead of the possible departure of Janet Yellen next year. Five days ahead of what could be one of Ms Yellen’s final testimonies on Capitol Hill as Fed chair, the central bank argued that relying too heavily on rate-setting rules could lead to perverse outcomes for the US economy. Conservative lawmakers argue the Fed has made use of its broad discretion to conduct hazardous policies that risk inflation or asset price bubbles. The Fed’s report suggests it is preparing for further battles with GOP lawmakers at a particularly sensitive time given changes in personnel in the Fed board and the potential for President Donald Trump to decline to give Ms Yellen a second term.”

U.S. Bubble Watch:

July 12 –CNBC (John W. Schoen): “Faced with tight revenues, tax-weary voters and uncertainty about the impact of federal tax and budget policies, lawmakers and governors are wrestling over what has become one of the toughest rounds of annual state budget battles since the Great Recession. More than a week after the start of the traditional July 1 fiscal year, seven states are still operating without an approved budget. In Connecticut, Rhode Island and Wisconsin, lawmakers have yet to resolve disagreements about how to close ongoing budget gaps in their states or fund new budget initiatives. Legislatures in Massachusetts, Pennsylvania, Oregon and Michigan have approved their tax and spending plans, which are waiting for signature or veto in those states. Lawmakers in a dozen states have called special sessions to resolve outstanding differences over the latest tax and spending plans.”

July 10 – Financial Times (John Plender): “It is 10 years, almost to the day, that Chuck Prince, then chief executive of Citigroup, told the Financial Times: ‘When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.’ Those fateful words bear thinking about, especially when looking at today’s equity market where investors are dancing furiously despite the Federal Reserve, the European Central Bank and the Bank of England adopting increasingly hawkish rhetoric about tightening policy. While the bond markets have been rattled, the party in equities continues with a swing. And quite a party it has been. According to Harry Colvin of Longview Economics, the US equity bull market is now the second longest since 1896. It is also the third largest, delivering a cumulative 328% total return to early July… The cyclically adjusted price/earnings ratio is at a level previously only seen before the 1929 Wall Street Crash and in the dotcom bubble of the late 1990s. With the Fed likely to raise rates further this year and actively discussing how to shrink its balance sheet, the more nervous dancers may be tempted to make an exit.”

July 10 – Bloomberg (Adam Tempkin and Claire Boston): “‘I’d like to know: Why now?’ asked Steve Eisman. It was July 10, 2007, and the hedge fund manager was on a 10 a.m. conference call with analysts at Standard & Poor’s, which had just decided to put $7.3 billion of subprime mortgage bonds on watch for downgrade. A growing number of investors like Eisman had been betting on a crash as overdue home loans rose. But up to that point, much of the world was still putting its faith in the safe-as-Treasuries ratings that had been awarded to the bonds, which helped bankroll $445 billion of risky mortgages in 2006 alone. From that day onward, even the most cautiously optimistic economist or sanguine Federal Reserve governor should have known that the housing mess and the subprime debacle wasn’t going to be contained. ‘The news has been out on subprime now for many, many months; the delinquencies have been a disaster for many, many months,’ Eisman said on the call. ‘I’d like to know why you’re making this move today instead of many months ago.’ Over the next year, S&P analysts (who told Eisman they had to wait until the bonds were adequately ‘seasoned’ before they would downgrade them), would join Moody’s… and other credit raters in downgrading more than $1 trillion of mortgage-related securities.”

July 8 – Barron’s (Kopin Tan): “We still call it a stock market, but these days it has many more indexes than it does stocks: There are nearly 6,000 indexes today, up from fewer than 1,000 a decade ago. Meanwhile, the number of stocks in the Wilshire 5000 Total Market Index has shriveled to 3,599, from 7,562 in 1998… How is this boom in index products affecting the stock market? The question is especially pertinent these days, as benchmarks such as the Standard & Poor’s 500 index and the Nasdaq Composite nuzzle serial new highs, and actively managed funds struggle to keep up… Investors have been pulling money from active funds and plowing it into their passive peers. Through the first five months of this year, investors steered $338 billion into passive mutual funds and ETFs—that’s on top of last year’s record inflows of $506 billion… If this pace keeps up, passive funds could take in more than $800 billion in 2017, a 60% jump from 2016’s record and nearly double the haul from 2015.”

July 12 – Bloomberg (Charles Stein): “Investors haven’t soured on all active fund managers -- only those who pick U.S. stocks. Actively managed mutual funds and exchange-traded funds that own domestic stocks experienced $98.5 billion in net redemptions in the first six months of 2017, according to… Morningstar Inc. Active funds that buy international stocks attracted inflows of $8.7 billion and active funds that buy bonds gathered $106.5 billion. ‘The trend for U.S. stocks funds keeps going and going,’ said Russel Kinnel, director of manager research at Morningstar. ‘There is a perception that they can’t beat their benchmarks, especially when it comes to large-cap stocks.’”

July 13 – Reuters (Ernest Scheyder): “U.S. shale producers survived an oil price crash and confounded OPEC's efforts to drain a global glut by employing innovative drilling and production techniques. Now, some of these producers are turning to creative investments to pump more oil. Drilling joint ventures, called ‘DrillCos’ for short, combine cash from investors like Carlyle Group LP with drillable-but-idle land already owned by producers. Investors get a pledge of double-digit returns within a few years, while producers can raise productivity without spending more of their own money.”

July 12 – CNBC (Diana Olick): “The appetite for riskier mortgages is rising, and a small cadre of investment firms is ready to feed it. Angel Oak Capital Advisors just announced its second rated securitization of nonprime residential mortgages this year, a deal worth just more than $210 million and its largest ever. Its first deal was slightly less, but demand from borrowers and investors alike is growing, and the securitizations are growing with it. Angel Oak is one of very few firms offering these private-label mortgage-backed securities — the ones that were so very popular during the last housing boom and which were later blamed for the financial crisis.”

Japan Watch:

July 9 – Reuters (Kaori Kaneko and Elaine Lies): “Japanese Prime Minister Shinzo Abe will reshuffle his cabinet and party leaders early next month, moving to shore up his worst levels of popular support since returning to power in 2012, following a historic loss in a Tokyo assembly election. Last week's loss… spotlights Abe's potential vulnerability after nearly five years in power, with many blaming voter perceptions of arrogance on his part and that of his powerful Chief Cabinet Secretary, Yoshihide Suga. Opinion polls… showed Abe's popularity at its lowest since he returned to power late in 2012, with support of 36%...”

July 11 – Bloomberg (Isabel Reynolds): “Unpopular policies and a slew of scandals triggered a slide in public support for Japanese Prime Minister Shinzo Abe that led to a heavy election defeat. That was in 2007, when he abruptly resigned, citing health issues, after losing in the upper house of parliament. Ten years on, his situation looks uncomfortably familiar. Abe returned to Tokyo… from a curtailed European trip to face lost public trust and record low voter support. Ministerial gaffes and his failure to allay suspicions over a cronyism scandal involving a close friend contributed to his ruling party suffering an historic defeat in a recent Tokyo election. The public is wary of his plan to rush through a revision to the pacifist constitution.”

July 13 – Reuters (Leika Kihara, Sumio Ito, Tetsushi Kajimoto, Stanley White, Minami Funakoshi and Kaori Kaneko): “Bank of Japan policymakers see little to cheer in successfully defending their yield target as European and U.S. central banks start to pull the plug on ultra-cheap money, casting doubt on their view that global bond yield gains will be short-lived. Rising global yields forced the Japanese central bank to rev up bond buying last Friday to cap 10-year Japanese government bond (JGB) yields around its zero percent target, putting it at odds with its counterparts eyeing an exit from ultra-loose policy. On top of an increase in regular bond buying, the BOJ offered to buy unlimited amounts of 10-year JGBs at 0.110% - employing its most powerful tool for only the third time since adopting yield curve control (YCC) in September.”

July 10 – Financial Times (Leo Lewis and Dan McCrum): “The Bank of Japan faces a ‘protracted battle’ for control over yields on the benchmark 10-year government bond, say analysts, as global markets and the sliding popularity of Prime Minister Shinzo Abe threaten to push market interest rates higher. Warnings of repeated summer confrontations between the BoJ and the Japanese government bond (JGB) market come as investors spent Monday adjusting to BoJ governor Haruhiko Kuroda’s decision last week to draw a clear line in the sand, after the 10-year JGB yield crept above 0.1%... By stepping into the market with an offer to buy an unlimited amount of JGBs on Friday, traders said the BoJ was deploying the most potent weapon at its disposal as the central bank defended its 10-month-old policy of holding the 10-year benchmark at ‘around 0.0%’.”

July 10 – Bloomberg (Chikafumi Hodo and Netty Idayu Ismail): “While the Bank of Japan faced down the market on Friday with its offer to buy an unlimited amount of bonds, the battle over yield control may have only just begun. The swift action allowed the BOJ to quickly assert authority over the 10-year yield, bringing it down from a five-month high of 0.105%. The question is how far the central bank would have to go, and at what costs to its balance sheet, as the hawkish tilt adopted by its peers increases the extra yield offered by U.S. Treasuries and German bunds over Japanese bonds. ‘It hinges on whether the BOJ can inspire confidence and establish credibility on its intent to hold yields,’ said Vishnu Varathan, head of economics and strategy at Mizuho Bank… ‘The option of shifting to a target referenced to spreads -- as global yields move higher -- rather than fixed levels, may be a policy consideration.’”

EM Bubble Watch:

July 10 – Bloomberg (Lisa Abramowicz): “Emerging-market debt funds had a phenomenal first half of 2017, with record inflows and solid returns. But the ebullience is running out of steam and that sentiment will most likely deteriorate even further in the weeks to come. The biggest emerging-market debt ETF just had its largest one-week outflow in its history. In the past week, investors withdrew $826.8 million from the biggest emerging-market debt exchange-traded fund, the largest withdrawals in the $11.5 billion fund's history.”

Leveraged Speculation Watch:

July 10 – Bloomberg (Dani Burger and Sid Verma): “The trend is not your friend -- at least not lately. Between sleepy movements in global assets and short-lived macro shocks, programmatic investors who make their fortunes chasing momentum have had a particularly rough year. In fact, by some measures, commodity trading advisers are on track to post the worst yearly return since 1987... CTAs, the majority of which bet on price trends using futures contracts across asset classes, are known for being volatile strategies, billed for their low correlation to equities. Hit by choppy trends, especially in fixed income and the dollar, they’re are now finding it difficult to live up to return and diversification expectations, said Pravit Chintawongvanich, head of Derivatives Strategy at Macro Risk Advisors. ‘From 2014 to early 2015, the combination of a rising dollar, falling crude, and declining yields led to strong performance among trend followers,’ Chintawongvanich wrote… ‘Over the past year, the only trend that is working is equities. Clearly, that is not a very helpful diversifier to long equities.’”

July 10 – Bloomberg (Saijel Kishan): “Financial markets no longer make sense to macro managers like Mark Spindel. After spending three decades focusing on things like economic trends, currency moves, politics and policy, Spindel has been confounded by markets shaped by low volatility, algorithms and more. He finally gave up and closed his nine-year-old hedge fund. ‘I felt the intensity of following markets at a time of increasing political and economic confusion very hard,’ said Spindel, founder of Potomac River Capital… ‘My entire career had centered on an understanding of monetary politics and I had trouble getting my head around it all. It was exhausting.’ These are troubled -- and troubling -- times for macro managers, those figurative heirs of famed investor George Soros who were once dubbed the masters of the universe. They’ve barely made money this year and once again, their returns pale next to those of cheaper index funds. Many investors are looking elsewhere.”

July 12 – CNBC (Leslie Picker): “A revitalization in the hedge-fund industry may be more dependent on machines than humans. After years of outflows, new reports show many of the larger funds and their current and prospective investors, are keenly focused on words like ‘quant’ and ‘data science.’ As one indication, take a look at this chart that was highlighted in a recent client report by Jefferies that was obtained by CNBC. This is based on Google Trends, showing the relative interest in the words ‘hedge fund’ versus ‘data science.’ ‘2016 seems to have marked a tipping point for the hedge fund industry's mainstream embrace of data science,’ Jefferies wrote…”

July 11 – Bloomberg (Hema Parmar): “Investor interest in hedge funds is back on the upswing. Hedge funds saw the biggest jump in demand among asset classes examined in a Credit Suisse Group AG report... More allocators plan to boost their exposure to the funds than reduce it this year, it said. That’s a pivot from mid-2016, when more investors intended to make redemptions, according to the survey which polled 212 investors globally last month representing almost $660 billion invested in the industry. Continuing the bullish sentiment, 81% of investors surveyed said they plan to put at least some money to work in hedge funds over the next six months, compared with 73% last year.”

Geopolitical Watch:

July 11 – Reuters (Ben Blanchard): “China hit back… in unusually strong terms at repeated calls from the United States to put more pressure on North Korea, urging a halt to what it called the ‘China responsibility theory’, and saying all parties needed to pull their weight. U.S President Trump took a more conciliatory tone at a meeting with Chinese President Xi Jinping on Saturday, but he has expressed some impatience that China, with its close economic and diplomatic ties to Pyongyang, is not doing enough to rein in North Korea.”

Friday Evening Links

[Bloomberg] S&P 500 Hits Record as Inflation View Turns Iffy: Markets Wrap

[Bloomberg] Inflation Data Weakens the Fed's Case for Another Hike

[Bloomberg] JPMorgan Just Had the Most Profitable Year in the History of Banking

[Reuters] JPMorgan's Jamie Dimon lashes out against Washington politics