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Inflation and ECB

More date is forthcoming which appear to continuously underpin the scarcity of pricing power. Core Inflation in Eurozone just out just stabilised at 1%. At the same time labour costs actually fell from 1,6% last month to 1,5%.

Labour costs Eurozone vs Eurozone CPI Core yoy

CPI and lbour 2018-03-18

Source: Bloomberg

We all get involved into the discussion that there must be inflation somewhere lurking behind the scenes. Economic growth in Europe continues on a very nice pace and the unemployment rate in Europe keeps falling. However, the unemployment may be low in selected countries like Germany. Overall Europe has still vast untapped resources which could exert pressure on labour costs for quarters even years to come.

The Eurozone unemployment rate come down from 12% in 2013 to 8.6% currently. This is still a very long way to progress before anybody in Europe can proclaim a full employment.

ECB will not be in a rush to change either interest rates or run down the current QE. Even during the best times Europe had an unemployment of 7.3% in 2007.

During those haydays Eurozone CPI reached 4% and the core inflation was just under 2%. At the moment it appears that neither core inflation nor labour costs are exerting any pressures on ECB. Thus the phantom of inflation may remain just that for a prolonged time.

Eurozone core inflation vs Eurozone CPI

CPI and core 2018-03-16

Source: Bloomberg

 

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Tariffs

Now we know how it feels when a trade war is in making. There was a time when the markets felt nervous about NAFTA, TTIP, APAC and other economic cooperation treaties. WTO still holds on. However with the current speed at which the US President tries to upset the trading partners the question is only when and not if he will propose to remove US from the WTO. Does it sound excessive? Let me hear your opinion.

Tariffs on airplanes was just the start followed by tariffs on solar panels. Now we follow up with steel and aluminium. It appears that the consequences are not too obvious to the Washington administration or in a worst case they do not care.

What appears to be good for the steel and aluminium producers it is pretty bad for the car manufacturers. This was also the index which suffered most yesterday. It appears that President Trump wants the US car industry to be even less competitive. Yesterday price action shows precisely the worry.

S&P 500 Automobile Industry (intraday)

S5Auto 2018-03-02

Source: Bloomberg

Tariffs tend to have a negative influence on the pricing environment in general. This could add to the current inflationary pressures in the US economy. Although the inflation expectation did not react but the US-Dollar did as it just sold out against Euro and other currencies.

Dollar Index Spot – DXY (intraday)

DXY 2018-03-02

Source: Bloomberg

Tariffs will not be left unanswered by the trading partners. If China, Canada and EU increase their tariffs on steel and aluminium this would clearly lead to a spiral or retaliation. World economy and equity markets would react negatively to a trade war and yesterday’s price action shows it very clearly.

MSCI Wold in USD (intraday)

MXWO 2018-03-02

Source: Bloomberg

America First might be a great slogan but soon it could turn into the opposite as the world creates barriers against US and continues efficient trading and economic policies for the other countries. The danger increases that the world economy turns against US united.

 

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Vix indicates worry

Do not be fooled by the good fundamental numbers. It appears that the market are still in the defensive mood. Lately all the early morning market rallies are weakening toward the afternoon just to finish negative. The same message comes from the Vix.

VIX vs S&P 500

Vix spx 2018-02-23

Source: Bloomberg

Market participants appear not to be convinced by the recent market rebound. The hedging is still going on as the participants are looking at elevated VIX levels. Situation very similar to 2011 and 2015. The market may need a bit longer to find its footing.

 

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Fed and Inflation

Or just an interpretation of uncorrelated events?

Equity and bond markets are infatuated by the inflation expectations and the potential trajectory of the inflation going forward. The discussion circles around cyclical vs acyclical inflation, weak currencies, costs of labour and others. However there is little discussion if the Federal Reserves does care about the inflation. Obviously if inflation is an important input factor into the rate settings process then surely there must me some relation between changes in inflation and changes in Fed rates.

The following charts show that since the financial crises of 2008/09 the inflation defined here by US Urban CPI including all the volatile components have seldom been above 2%. Even inflation expectations has barely looked above 2% for the last years.

Inflation expectations and US Urban Inflation

Inflation expectation 2018-02-22

Source: Bloomberg

It appears that during the period prior to financial crises inflation remained well anchored above 2%.

Since 1990 it is very hard to find a good relationship between the Fed Funds and various measures of inflation. The following chart shows the development of inflation in the US and the changes in Fed Fund Rates. An inflation around 2% was related to 5% Fed Funds in the 90s and 2006/07. In the meantime as the inflation dipped below 2% the Fed Fund Rate fell to below 2% too. The relationship is rather coincidental then well-defined and correlated.

US inflation and Fed Fund Rates

Fed and CPI

Source: Bloomberg

After all the markets should look beyond the inflation discussion and focus on other economic fundamentals to judge the coming normalisation of the monetary policy. Here comes the unemployment.

History shows as the unemployment dips and falls so Fed Fund Rates rise. Plateauing when the unemployment rate bottoms just to fall fast as soon as the unemployment rate increases.

This relationship can be clearly seen in the following chart marked by the red circles. Low unemployment rates has been reached in 2000/01 and 2006/07. Those low unemployment levels were related to Fed Fund Rates above 5% with core inflation not really un-similar to today.

Inflation, Unemployment U-6 and Fed Fund Rates

Fed and Unemployment

Source: Bloomberg

It is clearly hard to argue that the rates will increase anywhere close to the levels seen in the past. However it appears that the Federal Reserve normalises its rates independent of the inflation trying to regain a comfortable level which makes monetary policy gaining traction again and permits for a wind down of QE over the coming years.

Zooming in on the two relevant factors unemployment (U-3) and Fed Funds Rates shows the relationship clearer. Fed Fund Rates top around the bottom in unemployment rate and vice versa bottom around the tops of the unemployment rate.

U-3 Unemployment and Fed Fund Rates

Fed and normal unemployment 2018-02-22

Source: Bloomberg

The projection for the Fed Fund Rates will not be easy. The best guesstimations for the trajectory of the upcoming Fed Fund Rates is to follow the unemployment rate. As long as the unemployment rate does not bottom and rise, we may reasonable expect a rise in rates. However, if the unemployment should stall or even reverse Federal Reserve could have a second thoughts about the speed of rate increases independent of inflation.

 

ECB vs. FED

Let us assume that we can learn from history. It may not repeat itself but it rhymes – as the famous quote goes.

At the moment all eyes are on ECB and its path out of QE. Parallel there is a discussion about the next interest rate step by ECB which some hawks would love to see in the second half of 2018.

Over the last years ECB erred rather on the cautious side and did not strike any observer and analyst as particularly aggressive. ECB does not change its view overnight and does not jump to conclusions. The lessons from Mr. Trichets have been understood and incorporated in the current policy.

If Fed can be any guide it is advantageous to look at how QE and interest rates developed over the last 4 years.

Fed Funds and the development of the Federal Reserve balance sheet

Fed and QE 2018-01-26

Source: Bloomberg

FED stopped QE in December 2014 and has been slowly and gradually unwinding its balance sheet. In December 2015 the first interest rate increase happened just to feel the water and see how the market would react. It took another 12 month till December 2016 for the next step up in the fed funds. Only 2017 did finally see any meaningful further steps which took the fed funds up by 0,75 percent to 1,5.

If the same process would be applied to ECB we could see the end of QE as flagged and discussed by Mr. Draghi in September 2018. 12 Months on the first interest rate would be taken in September 2019 which could bring the interest rates from -0.40 to -0.15. Add another 12 months and we arrive in September 2020 when the rates could see positive terrain again with an increase of 0.25 to 0.10. This could be followed by 3 steps in 2021 which would bring the interest rates towards 1%.

Does it all sound farfetched? Obviously it may. We could make numerous assumptions about the change in the ECB as Mario Draghi will be replaced with potentially more hawkish decision maker. Inflation could increase dramatically. Economy may overheat forcing ECBs hand.

However till any of those events materialise a very good base case scenario remains to look at the history and see if any of the developments could impair the base case.

 

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Equities and bond yields have been at the forefront of all the discussions about valuations and market turns. Investors appear to have accepted that falling interest rates – especially the short-term like US 2 year yields – tend to move in tandem with stocks. See the following chart.

2 years US government yields (black) vs S&P 500 (blue) 1997 till 2018

2 year vs spx 1997-2018

Source: Bloomberg

The relationship have been rather tight over the last 20 years. Interestingly 1997 was the year of LTCM and the time when Federal Reserve did see the necessity to “save” the world form potential systematic disaster which could have developed from the highly leveraged hedge fund. The world has been saved and the relationship between Fed, yields and the stock market established.

This was the time when investors who has been seasoned in the prior 20 years of stock market might have overlooked the changes in the investment weather. (Not only the dot.com) The years till 1997 did see very little of a correlation between 2 year yields and the stock market. See the following chart.

2 years US government yields (black) vs S&P 500 (blue) 1977 till 1997

2y vs SPX 1977-1997

Source: Bloomberg

In those 20 years the relationship was rather positive for falling 2 year yields and rising stock market although also this relationship did not occur all the time. Especially 1977 till 1981 and 1986 till 1990 would challenge this point of view.

The length of the two periods of 20 years might be a pure coincidence. However, it is important to entertain the idea that our views of relationships between yields and stock market might be just the backward looking short-terminism. The future will show.

 

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Oil price revival

Positive assessment of the oil price for nearly the last 2 years is now looking a bit stretched. The long-term prices target may be much higher than the current price. In the meantime, however, long oil appears to be the consensus investment as OPEC complies with production cuts and the US-production, although growing, does not appear to be threatening the stable increasing prices.

Oil chart enters a congestion zone which has been established back in 2015. The action within this congestion zone will be very important for the continued future price development. Any break out of this congestion zone could deliver important clues as to the future price direction.

WTI weekly price Chart

CL1 2018-01-03

Source: Bloomberg

Now enters the futures markets. The current long positions in the WTI oil futures are at all-time highs and continue to rise. This obviously adds to the speculative character.

As investments in oil increase and the market maintains strong momentum the volatility is falling a reach lowest levels since 2014.

WTI price chart, volatility and long futures positions

CL1 vola 2018-01-03

Source: Bloomberg

Additionally, the current forward curve shape is providing additional food for though. Just 6 months ago the forward curve showed the normal shape as it was in contango. The current shape is backwardation as the prices for immediate deliveries are higher than future settlement prices. This make a long position in oil futures profitable as the investor can buy futures at lower prices than the current deliveries and through holding the position it continues to appreciate.

WTI oil futures curves

CL1 curve 2018-01-03

Source: Bloomberg

An oil futures curve in backwardation can be an indication of currently tight supply in the markets which would correspond to geopolitical tensions, production cuts or constrains and weather related issues. Furthermore recent continued long-term hedging activities of the various producers could have depressed future prices in the intermediate term.

Volatility and futures positioning create some risk around the positive environment for oil. This negative technical background is mitigated by continued geopolitical developments in Iran as well as the extremely cold weather in USA. If those conditions subside and/or the futures markets reverses there could be some setback to the current price momentum which would neatly coincide with the congestion zone.

 

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Surprises for 2018

Looking back on own predictions can be very revealing and exciting. I did not make any predictions in 2017 but 2016. Quite surprisingly it took 2 years for many of those to come true. Thus it often will take longer than one expect.

Here the link to the blog entry from January 2016 http://blog.ad-vanced.de/index.php/2016/01/8-market-surprises-for-2016/

All the market predations were actually defined as surprises. According to a long standing believe the market does everything to surprice an unexpected investor. Now with the end of the year 2017 approaching fast I embarked on the tedious quest to look for more market surprises for 2018. Or shall I rather do it for 2019 as it seems to take 2 years for the surprises to materialise.

  1. Most daring would follow the idea that somehow Bitcoin would be shown as the world’s biggest Ponzi scheme run by…….…now you can pick Russia or North Korea or China. The real surprise would come if it was not a state that run this Ponzi scheme but rather a group of rogue gamers who enjoyed the greatest game of their life.
  2. Federal reserve is expected to increase interest rates by 3 to 5 times over the course of 2018. A real surprise would be 0 or 7! Now both implications are rather disturbing to think of. The markets would really experience a turmoil and the correction which is so widely predicted for 2018 would finally hit.
  3. Oil rising is a more or less done deal. So the magnitude might be a surprise. Here like with the Federal Reserve the real surprise would come from the price deviating substantially from exceptions. Oil at 100 USD or 30USD would be real hit. –  The very high oil prices would lead to some adjustments in growth and pricing levels. Possibly driving inflation to around 2% – 2.5% in developed countries. This would support some stronger response from Fed supporting case in point 2. –  Global excessive production of oil and a stronger focus on e-mobility could drive oil price toward to 30 USD. This in turn would upset numerous scenarios. Fed would not raise rates, inflation could fall dramatically, worries about Middle East and fraking would reappear, high yield anxiety especially in US-oil companies would resurface, market wobbles.
  4. Equity bull market does not finish 2018. Against all odds the equity market will not make a pause and continue at the nice pace for a low double digit performance. All calls on valuation would go unheard as equity market would see new excesses in valuation.
  5. Euro collapses toward 1:1 to the US-Dollar. This used to be the most common prediction for 2017 and now we are closer to 1.20 then 1.00. The surprise would come with the reversal of fortune for the Euro as most of the market participants are now calling for lower USD and higher Euro.
  6. Gold revival will not materialise and the price falls by 30%. In 2016 we were close to 1000 USD per ounce. So this surprise is not as substantial, nonetheless a decent surprise. Obviously, this could come as cryptocurrencies are winning the battle for the hearts of the investors and equity markets could continue the rally
  7. Europe continues to crumble with Catalan pressing for independence, Poland and Hungary drifting further away from the EU, Five Star Movement winning Italian elections and Germany is forced into Minority Government which does not last the next 12 months.
  8. A combination of the issues in Europe could force ECB to prolong the current lose monetary policy beyond 2018 pushing rates continuously below zero in Europa and embarking on new QE round. Sounds dramatic. Yes, however this definitely would be a surprise for the markets.

There could be also numerous black swans which would be great surprise for the markets. However, black swans are not easily predictable and due to the nature are rather pure luck to identify beforehand. Thus I refrain from any crystal ball predations here. If you have any other great surprises for 2018 I am more than happy to hear from you or discuss your views on my humble list of surprises.

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The time has come that central bankers stopped talking about inflation and allow the monetary policy to deviate strongly from the inflation. The best example is Bank of England. Since 2010 it has continuously disregarded the inflation pressures and kept the base rate low. Despite plenty of historical precedence from the 80s till 2008 that base rate typically stayed above the RPI rate.

It appears that nobody cares about this development. Neither the politics which are now deeply entrenched in Brexit nor central banker which are supposedly protecting the consumer from inflation. The magic 2% has been reached surpassed and….Bank of England does pretty nothing about it.

BoE Base Rate vs RPI Inflation Index

Base rate and RPI 2017-10-23

Source: Bloomberg, Bank of England

Central bankers must have a new goal now which is not inflation. There could be the intrinsic government financing goal which nobody would want to happen due to historical cases in Germany or Japan which show the shortcomings of any government financing through the central bank.

However, with long-term rates in UK below 2% and below the inflation rate it all has the writing on the wall. The government can continue borrowing money at long-term depressed rates. Additionally BoE continues buying government debt.

Rising government debt even at low and depressed financing costs can become unbearable over time if the government does not use the low rate environment to lower the debt burden. Unfortunately, very few do.

If the central bank is doing nothing about the inflation so the currency does. This is the second reason after Brexit why the British Pound loses its value. The pressure needs a vent. Bank of England supports the government so the currency needs to move in order to balance the new situation. If BoE decides to rise the base rate one day in the future it will be great for currency but very difficult for the debt.

The question remains if the other central banker will follow BoE example. Forget the inflation and focus on affordable government debt financing.

BofA Merrill Lynch UK Inflation Linked Gilt Index vs Bloomberg Barclays Series-E UK Gov all Maturities >1 Bond Index

UK ILB 2017-10-23

Source: Bloomberg

The only protection appear to be inflation linked bonds. They have outperformed nominal bonds over the last years and as the inflation in the UK settles on a higher level and could be even rising with weaker currency this outperformance is scheduled to continue.

 

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Oil rising

The time of electric cars is dawning and the whole International Automobile Fair in Frankfurt was all about electric cars as well as autonomous driving. The demise of the fuel driven car has been discussed and the government are pushing for ever stricter environment standards.

China, United Kingdom are already discussing the end of the combustion and the beginning of the e-automobile era.

At the same time there is different narration. Saudi Arabia is planning the biggest IPO with Aramco coming. Clearly allow oil price would not be a great news for such a high profile IPO.

The oil production in the US is strong reaching nearly highs registered in 2015 and highest level in more than 40 years.

Despite production cuts by the OPEC the global oil production as reported by the Energy Intelligence Group reached the same levels as 2016 and is expected to continue growing in the coming years.

Oil price weekly (WTI future continuous)

CL1 2017-09-27

Source: Bloomberg

The oil price is suddenly and mostly unexpected by the most investors higher. There is very little indication that the consumption increases. The imbalances of the last years appear to be working out slowly particularly as strategic holdings by the governments normalise.

The price development looks very much like the price chart of the emerging markets. It might be difficult to call for USD 80 on oil on fundamental ground or any data that is currently available. Charts like to follow patters and if history is any guide and emerging markets oil may appreciate stronger than most anticipate.

There is little indication why the price of oil is increasing and breaking higher. However, listening to the market is important to see the early signs of change. Oil is currently indicating that it might move higher. The market anticipates fundamental improvement.

 

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