Rates as of 05:15 GMT


Market Recap

Bad news is good news I guess – the ADP report came in far below expectations, showing the US added a mere 27k jobs in May, far below the 185k that the market had expected. The result was another leg down in Fed funds expectations:  a much steeper fall than Tuesday in expected rates at the short end of the Fed funds curve, and also declines further out than Tuesday– whereas Tuesday only rate expectations for this year declined, on Wednesday expectations out to June 2021 declined. The idea must be that the Fed’s dual mandate makes it easier for them to cut rates when the labor market is weakening.

Amazingly, the dollar gained nonetheless. It plunged when the ADP report came out, but quickly bottomed and began recovering to end the day higher.

Part of the recovery may have been because of some optimism on the trade front before a meeting between the two sides in Washington. Trump said that Mexico wants to make a deal to avoid the tariffs and US Director of Trade and Manufacturing Policy Navarro said that the tariffs “may not have to go into effect” if Mexico can show it’s taking steps to stop people from coming across the US-Mexico border.

After the meeting, Trump said that “not nearly enough” progress was made in the talks. Nonetheless, the +0.82% rise in the S&P 500 yesterday suggests that market participants are assuming that the tariffs won’t go into effect anyway (or maybe that if they do, the Fed will ride to the rescue by cutting rates). Even the pusillanimous Republicans are urging Trump to delay the tariffs, and there seems to be some question about whether he can legally impose tariffs on the basis that he’s claiming (that is, immigration problems).

The dollar may also have been boosted by a better-than-expected Institute of Supply Management (ISM) service-sector purchasing managers’ index (PMI). It rose to 56.9 instead of falling slightly to 55.4, as expected (previous = 55.5). Although the manufacturing PMI continued to fall, the service sector is actually a much larger part of the economy so the fact that it rose further from its already healthy level is a good sign for the US economy.

Oil fell further after the US Dept. of Energy announced a 6.8mn barrel rise in oil inventories for the most recent week, in contrast to the 2.0mn fall that the market was expecting. US oil inventories have been rising steadily since September last year. Although they’re not too far above average for this time of year (see graph), that must be seen in the context of a) the OPEC+10 agreement to bring down production, which should be causing inventories to fall, and b) the fact that the average includes some years when inventories were way above what’s necessary. So even the average level of inventories may actually be too much. Oil is now in a bear market (-22% from its 23 April high of $66.30). However, today’s price of $51.77 is still above the 24 December low of $42.53.

Igor Sechin, the CEO Russian oil company Rosneft, urged Russia to withdraw from the OPEC+10 agreement to restrict outoput. “Does it make sense (for Russia) to reduce (oil output) if the U.S immediately takes (our) market share? We have to defend our market share,” he said. Russian output, at 13.6mn barrels a day (b/d), is far bigger than any single OPEC member and indeed is equal to a little more than one-third of total OPEC output (37%, to be exact).  So if Russia backs out of the OPEC+10 production restraint agreement, it would be a serious blow to the cartel’s attempt to rein in global oversupply.


Today’s market

The big event today is the European Central Bank (ECB) Governing Council meeting. Not that anyone expects them to change rates, heaven forbid. The odds of a rate cut sometime this year are increasing, but are still seen as slightly less than 50%.  Rather, investors will want to get a sense of how concerned the Council members are about the slowdown in growth and the fall in inflation.

Inflation expectations have been trending lower in the EU. That’s sure to worry the Council members, particularly as the latest inflation data for the Eurozone (Tuesday’s data for May) showed inflation slowing to 1.2% yoy from 1.7%, and core inflation slowing to 0.8% yoy from 1.3%.

Growth in bank lending has accelerated slightly in recent months, but still is nothing compared to the 8% yoy growth rate that prevailed before the Global Financial Crisis. This may also call for some further loosening of monetary policy.

The new ECB staff forecasts will be another point of interest. Other central banks have expressed concern about the impact of the US-China trade war on growth. It’s likely that those concerns will manifest themselves in a slightly lower growth forecast for the EU. However, I would expect the inflation forecasts to remain the same (or nearly so) for political reasons more than economic. That is, if they lower the inflation forecasts significantly, then the market might expect them to take concrete steps to loosen policy further, which they may not want to do at this meeting. 

While no one expects them to move rates, I expect them to signal that further easing is possible if necessary, much as various Fed officials have this week. There are several tools under consideration.

At the last press conference (April 10th), ECB President Draghi signaled that they might consider a “tiering” system for deposit rates at this meeting. The ECB’s deposit rate is currently negative (i.e., banks have to pay to deposit money with the ECB). Under a tiered system, the Bank would charge less or even pay interest on deposits up to a certain level. The reason is that negative interest rates are not necessarily having the intended effect. The negative deposit rate is supposed to dissuade banks from depositing money with the central bank and encourage them to make loans instead. But if there is no demand for loans, they wind up paying for the privilege of depositing the money back with the ECB anyway, which makes them less profitable. There is some concern that less profitable banks are less able to take risks on borrowers, although the ECB’s own research has shown that this is not the case – banks that are subject to negative rates do tend to make more loans, they find.*

The ECB is also likely to consider the pricing of its new targeted long-term refinancing operation (TLTRO).

Draghi also once again stressed the willingness of the ECB to use “all instruments” if necessary to get inflation back up, including cutting the deposit rate further.

In short, while no one expects them to move rates, there are various ways in which they can signal their determination to “do whatever is necessary” to get inflation back up. They may well tinker with the statement accordingly. More dovish forward guidance is likely to be negative for the euro, in my view.

Aside from the ECB, Canada releases its merchandise trade figures. The trade deficit is expected to narrow somewhat as imports slow and energy exports pick up. The outlook isn’t great however as the recent fall in oil prices will pressure the deficit in future months. CAD-positive, although the market may look through the figure in anticipation of worse to come.

In the US, the trade deficit is expected to widen just a bit. Actually, it might be more accurate to say that it’s expected to stay in the same range that it’s been in for the previous three months. This would be in line with what happened to the “advance” trade figure, which only deals with trade in goods, whereas today’s figure includes trade in services as well. Since it’s likely to be barely changed and in line with what we already know, I”d expect it to be neutral for the dollar.

Finally, the disgraced Japan labor cash earnings are expected to show earnings still falling on a yoy basis but just not by as much as in the previous month. In fact the previous month was revised up from -1.9% to -1.3%, so this would just be a continuation of the vague amerliorating trend.

Still, the figure is unambigiously bad – there’s no hope of a Phillips Curve in Japan if wages are falling even with a 2.4% unemployment rate and 1.63 job-offers-to-applicants ratio.


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Marshall Gittler

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