For the first time in a while we saw some volatility in the markets. Equities bounced around quite a bit this week on mixed economic news, a possible change of heart by central banks, and a renewed stalemate over the healthcare bill. For the week the S&P lost -0.6% while small-cap equities were basically flat. The worst of the selling for the week was in the FANG stocks. The NASDAQ lost -2.0% with Facebook, Amazon, Netflix, and Alphabet down between -2.6% and -5.9%. Conversely, overseas markets were stable in dollar terms. The EAFE was up +0.1% while EM was down modestly. China and Brazil were actually up +1.1% and +3.0% respectively.
Interestingly, in a week where equities lost ground, bonds managed to do the same. The yield on the 10-year increased +16bps, pushing intermediate-term government bonds down -1.1%. High-yield and bank loans added between +0.2% and +0.4%.
Oil prices bounced back significantly after a rough few weeks. WTI closed at $46.33, up +8.0% for the week. But we should keep the bounce in perspective, as you can see below.
Weakness this year in crude continues to be a supply story. Certainly OPEC oil producers are trying to put a lid on their output in an effort to prop up prices. However, U.S. producers continue to pump like mad (as you can see below).
As The Economist notes:
“This time round, the issue seems to be excess supply. OPEC, a cartel of oil-producing countries, has been attempting to cut production. But its output increased in May, thanks extra activity in Libya, Nigeria and Iraq. Meanwhile, the attempts of the Saudis to cripple America’s fracking production seem to have failed; figures from Baker Hughes show that the number of American oil rigs has increased for 22 consecutive weeks. American oil producers, which had financial problems in 2015, seem to have reorganised themselves and can cope with a lower oil price. The oil price slump in 2015 caused a sell-off in bonds issued by those American producers. This time, says Jim Reid of Deutsche Bank, the spreads (excess interest rate) on such bonds have risen to 531 basis points (bp), the widest for the year; but that compares with 1932bp in 2016.
If cheap oil is caused by excess supply, it is the equivalent of a tax cut for Western consumers; that ought to be good for equities. It also means lower headline inflation, which may explain why Treasury bond yields have been drifting down; the ten-year yield is 2.15%.”
Where’s the Inflation?
If there has been a surprise this year it is how tame inflation has been. On Friday we learned that the Fed’s preferred inflation barometer fell for the third month in a row in May, leaving it well below the central bank’s target. The core personal consumption expenditures price index, which excludes food and energy prices, rose at a year-over-year pace of 1.4% in May (see chart below), down from 1.5% the previous month, and 1.8% as recently as February.
The Fed is targeting core inflation of around 2%, and policymakers have been frustrated that price growth has not accelerated despite a continued tightening in the labor market.
Falling Inflation = Rising Bond Yields? Really?
So far this all makes sense. Lack of inflationary pressures have led to lower bond yields this year. But why did rates move higher this week on the soft inflation report? That seems counterintuitive.
First, we probably should keep the recent increase in yields in perspective. The increase in 10-year Treasury yields from 2.14% last Friday to 2.30% today merely brings them back to their level at the end of May. You can see that below – the upper blue line is the yield on the U.S. 10-year.
However, what also jumps out from this chart is that the increase in yields was global this week. Only Japan stands out as not seeing any movement, and that is because the Bank of Japan has committed to buy all the bonds they can to keep rates at 0%.
Shouldn’t the low inflation data have pushed yields down?
The Hawks Spread Their Wings
Maybe in a normal world, but markets are as much driven by policy makers as they are fundamentals. Over the last two weeks we have heard from a number of central banks about future policy, and material changes are coming down the pike. For example, the Bank of England and the Bank of Canada are now seen as more likely than not to join the Federal Reserve in raising rates before the year is out. Few expected this at the start of the year.
This week Mario Draghi, head of the European Central Bank (ECB), jolted the markets with his speech at the ECB Forum on Central Banking. He hinted that the ECB might end their bond purchases by year-end and possibly start to nudge rates higher in 2018. While subsequent comments from other ECB members tried to walk the comments back, perceptions about future policy are shifting. To quote Capital Economics:
“On balance, we think that the Bank will be confident enough in the outlook for inflation to
announce in September its plan to taper asset purchases in the first half of next year.”
The chart below shows odds of a rate hike by year end in various countries. The orange bars show the odds on June 15th. The blue bars show the odds on June 28th. In all four examples the odds of a hike have increased.
The immediate impact was felt in both the bond and currency markets. As we noted, bond yields popped higher globally. Also, the dollar sold off. The chart below shows how rapid the dollar decline has been the last few days.
For the week the euro gained +2.0%, the Canadian dollar +2.3%, and the pound +2.4%.
The Question for the Second Half
All this talk about rate hikes and balance sheet reduction seems a little strange in a world where the inflation data is coming in below expectations. What are central banks looking at to justify future tightening?
It all comes back to the Phillips Curve. This is the idea that there is an inverse relationship between unemployment and inflation. When unemployment is high, wages increase slowly and inflation typically falls; when unemployment is low, wages rise rapidly, as does inflation. At least historically this theory has generally worked. The chart from BCA below shows this inverse relationship.
The red box above is where we are today. Unemployment at roughly 4% is usually associated with wage growth of between +2.5% to almost +5.0%. The Fed feels that the odds are on the side of accelerating wage growth and thus accelerating inflation in the months to come. Other central banks are using similar models.
So the second half of the this year is setting up for a big test of this economic theory. Will inflation hook higher as job growth persists? Central bankers are setting the stage to take their foot off the gas to avoid inflation overshooting on the high side. As you can see below, central bank balance sheets have grown tremendously the last few years in all the main economies. Central bankers would like to either stop the growth or shrink the size of their bond holdings in the quarters to come.
They are pitted against a global economy that is simply showing no signs of accelerating inflation. Maybe it is coming, but maybe the Phillips Curve model of yesteryear no longer works. Only time will tell.
‘Right Now Apple is selling zero phones a year…’
I’m personally struggling with the idea that the first iPhone went on sale 10 years ago this week (June 29th, 2007 to be exact). 10 years???!! While it is fun reading Steve Ballmer’s (Microsoft CEO at the time) comments at the time…
“500 dollars? Fully subsidized? With a plan? I said that is the most expensive phone in the world. And it doesn’t appeal to business customers because it doesn’t have a keyboard. Which makes it not a very good email machine. … Right now, we’re selling millions and millions and millions of phones a year. Apple is selling zero phones a year. In six months, they’ll have the most expensive phone by far ever in the marketplace.”
…there is no way this was 10-years ago!! But the Netscape IPO on August 9th, 1995 still stands out to me as well. Before that did we really not have web browsers? What did people do at work all day??
It is easy to forget how transformative the iPhone was. It wasn’t just a hit. It was a once in a lifetime event and created a whole new way of interfacing with technology. The chart below shows adoption rates for other iconic consumer products. Needless to say, the iPhone caught on pretty quickly.
By the end of 2016 it is estimated that almost 1.2 billion phones will have been sold. It is a good bet that a number of us have owned three or four in the last ten years. Happy birthday iPhone!!
Have a good weekend.
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