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OPEC Curb? Why Now?

Takeaway: Fundamental production data suggests OPEC is winning the longevity and market share story, so why now on a cut?

Below we expand on a note written this morning by Hedgeye energy policy analyst Joe McMonigle. Ping your sales contact or for access to the team’s work.

 

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The constant newsiness and lack of credibility around a speculated production freeze has been well covered by our energy policy analyst, Joe McMonigle. Below we raise two important points with regard to a quota revision in the near-term:

  • First, a topic we’ve harped on before - OPEC quotas have had no bearing on actual production levels historically – the only impact has been a short-term spot price impact.
  • The fundamental story at play is one that questions the timing of a speculated revision in quotas – why now for OPEC as they’re winning the global market share game for the first time in a long time? Saudi Arabia has alluded to U.S. Shale being a barometer for forward-looking policy.

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We have long been skeptical of OPEC’s desire to actually cut production. In a note before the double digit post-Thanksgiving decline for WTI in 2014 we highlighted a notable analysis on OPEC’s still meaningful aura along with the lack of incentive for a cut: OPEC Cut? Nope.

  • OPEC announcements have an ability to move spot prices for about 15-20 days, but there is no evidence that production levels are at all influenced
  • The correlation between OPEC quotas and oil prices is non-existent (r^2 =.15 since inception in 1982 according to the study)
  • During this period all OPEC nations except Iran and Venezuela over-produced 80% of the time based on monthly observations
  • The nine principal OPEC members produced on average 10% above their respective quotas in this period from 1
  •  In the same period there were 22 OPEC meetings where quotas were increased, and in 21 cases, the increase in quotas were still below what each country had produced the month before quotas were raised

Source: “The Emperor Has No Clothes: The Limits of OPEC in the Global Oil Market” – Jeff Colgan

 

We continue to maintain the stance that OPEC members are concerned with market share and influence with an emphasis on driving other producers out of the market over per unit pricing – Actions from the most influential OPEC members support this view, and fundamental data suggests this strategy has worked, something we’ll get into below.

 

OPEC Curb? Why Now? - OPEC Market Share

 

OPEC Curb? Why Now? - OSPs Asia Heavy Crudevf

 

OPEC Curb? Why Now? - OSPs Northwest Europe

 

As we outlined in this morning’s energy policy note:

  • The goal for OPEC is a production ceiling but the “how” remains a difficult challenge. It is the reason why a freeze deal was not achieved this week.
  • OPEC went with the newsy headline because they were faced with the prospects of price decline for not meeting self-imposed expectations of a freeze accord, another case of groupthink trying to manage expectations it has created
  • The 32.5 million b/d ceiling number that was selected for the statement represents OPEC’s own forecast demand for its crude in 2017.

All things considered, we believe the path out of Algiers is on thin ice and provide the following rationale - we are not optimistic about the prospects of successful collaboration.

Taking a closer looks at the OPEC statement raises skepticism on a deal…

For one, the OPEC President told reporters at a press conference Wednesday that the start date and duration of the revised production target are yet to be decided (maybe Jan. 1st), but Iraq has said recently that it can only agree to a duration period of several months. After the Algiers meeting ended, the Iraq oil minister questioned OPEC's own production data to determine baselines under any revised production target. "These figures do not represent our actual production," he told Reuters. "We cannot accept this and will ask for alternatives." Even the “target” is a moving target.

We also question why OPEC would agree to a cut now before a growing amount of non-OPEC production comes offline – a trend that is now finally in the works, greatly lagging expectations in 2H of 2014 when the U.S. dollar began its breakout. The benefit of a market share over price strategy appears to be accelerating. The largest OPEC countries continue to outlast U.S. Shale

  • OPEC production on the whole is +3.4% Y/Y, driven largely by Iran. A ratio series of OPEC to U.S. production has been running +10% Y/Y for the balance of 2016
  • US crude production today is about 600-700K B/D less than one year ago and down ~1MM B/D from the June 2015 peak. New Iranian production this year since nuclear sanctions were lifted has just replaced the declines in US production. If prices rise above $50/barrel, U.S. shale producers may end up replacing any OPEC decline from a production ceiling
  • Production in Saudi, Iran, Iraq, U.A.E. (the top 4 OPEC producers) is +3.6%, +8.3%, +28.9%, +4.2% respectively Y/Y

 

As we wrote in May to the energy policy vertical before the June meeting, we noted that the upcoming November 30 meeting could be the first time in two years that a change in OPEC and Saudi production policy would be under serious consideration. In particular, we said declining US production was a key barometer for the Saudis as well as continued cap-ex cuts. Since early summer, Saudi Energy Minister al-Filah has expressed that the Kingdom sees evidence the market is slowly coming into balance.

 

We know the early return of US shale production is a significant concern to the Saudis, but they also believe that it will take at least a year for US producers to regain previous levels and assume demand will also be higher in turn.

 

Certainly market conditions could change between now and November 30. Plus we do not believe the Saudis will want to forfeit any market share to Iran.

 

As a result many thorny issues lie ahead that present real challenges to achieving a revised “production target” in November.

 

As always, please reach out to us with comments or questions.

 

OPEC Curb? Why Now? - OPEC to U.S. Crude Production Ratio

 

OPEC Curb? Why Now? - Global Crude Production Monitor

 

OPEC Curb? Why Now? - Production By Region

 

 

 


TOP THREE CHALLENGES FOR US DEFENSE INDUSTRY IN NEXT ADMINISTRATION FRIDAY, 30 SEP 11AM

Takeaway: Join us for a call with Dave Melcher, Aerospace Industrial Assoc. CEO, to hear what industry is telling and hearing from the candidates

 

In 2015, America's aerospace and defense industry generated $605B in sales and produced a net export surplus of $81B. Further growth is challenged by a capped US defense budget, heavy regulatory burdens and strong competition overseas.  

 

Join us on Friday, September 30 at 11:00 AM. Our Defense Policy team is hosting the second of a series of calls running up to the election, when we talk to Dave Melcher, CEO/President of the Aerospace Industrial Association and past CEO of Exelis.  We will discuss what the aerospace and defense industry's leading advocate is telling the candidates and what feedback they are getting from those who will be players in the next Administration.  

 

David F. Melcher is President and Chief Executive Officer of the Aerospace Industries Association (AIA), an education and advocacy organization representing over 300 companies in the Aerospace and Defense industry.  Melcher joined AIA from Exelis Inc., where he served as Chief Executive Officer and President of a $5+ billion revenue company that was spun off from ITT Corporation in 2011, and ultimately merged with Harris Corporation in 2015.  Prior to becoming CEO, he was President of ITT’s Defense and Information Solutions group, and its Vice President of Strategy and Business Development. Lieutenant General (Ret.) Melcher joined ITT Corporation in August 2008 after a successful 32 year career in the United States Army.  

 

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2016 Election Outlook: Join Us For Dinner With Scott Reed

Takeaway: Please join us Tuesday, September 27th.

Hedgeye Potomac is hosting a dinner with one of Washington’s top political
strategists, Scott Reed, to share insight on the presidential election and outlook on
the state of play for Senate and House races this fall. We welcome you to join us for
this dynamic discussion.

 

The dinner will be held at 21 Club in New York City on Tuesday, September 27th with cocktails at 5:00p.m. and dinner at 6:00 p.m.

 

Please RSVP to sales@hedgeye.com

 

Scott Reed is the senior political strategist at the U.S. Chamber of Commerce. He is responsible for
overseeing the Chamber’s federal voter education program. Reed created and implemented the
blueprint for that strategy to help recruit business-friendly candidates, overseeing traditional and
digital advertising campaigns, and identifying credible messengers to showcase the importance of
the free enterprise system.

 

Reed was campaign manager for Bob Dole’s 1996 presidential campaign. He oversaw the national
campaign, which included political strategy, policy development, communications, and advertising
during the GOP primary and the general election. In addition, he directed preparations for the 1996
Republican National Convention in San Diego and the vice presidential selection process of Jack
Kemp. In 1993, Reed was appointed executive director of the Republican National Committee. He
served as chief operating officer of the GOP during the historic elections in 1993 and 1994 when
the Republicans gained control of both the House and the Senate for the first time in more than
40 years.

 

During the Bush administration, Reed served as chief of staff to Secretary Jack Kemp at
the Department of Housing and Urban Development. He directed personnel, political, and policy
matters, employing a long-term empowerment and privatization program.


Hawkish Doves and Dovish Hawks: Back to the Narrative Machine If You’re Short Duration

Key Takeaways:

 

  1. While the BoJ underwhelmed near-term easing expectations in the most confounding of manners, a detailed review of their policy statement in the context of preexisting cyclical and structural growth and inflation dynamics suggests incremental easing is likely to come in the not-too-distant future.
  2. Looking beyond the immediate-term TRADE duration, it’s safe to conclude that the potential for a protracted JGB “tantrum” has been dramatically reduced and the key implication of dramatically-reduced JGB “tantrum” risk is reduced upward pressure on U.S. interest rates.
  3. With respect to the Fed, if it looks like a dove, walks like a dove and coos like a dove – it’s probably a dove. Looking beyond the [likely] December rate hike guidance inserted into today’s FOMC statement, both the Summary Economic Projections and Yellen press conference offered a slew of dovish takeaways.
  4. Moreover, the confluence of their ongoing “data dependence” and our dour outlook for the U.S. economy and the labor market imply the 10Y Treasury yield’s intraday high of 1.73% may represent the peak of 2016 rate hike fears.
  5. All told, we reiterate our bullish bias on Treasury bonds and defensive (i.e. non-cyclical) dividend yields in the context of our “lower-for-longer” and #LateCycle slowdown themes, having likely just survived yet another round of [largely ungrounded] consensus fear of higher rates.

 

“Quantitative and Qualitative Monetary Easing with Yield Curve Control” = Hawkish Doves

Overnight the BoJ overhauled its monetary policy framework as part of its “comprehensive monetary policy assessment”. The most important features of the new program are as follows:

 

  • The bank will target a wider yield curve via controlling the level of both short-term and long-term interest rates (specifically a 10Y JGB yield of 0.00%). It seeks to accomplish the latter by implementing fixed rate JGB purchases across the curve and extending the duration of its existing fixed-rate funds-supplying operations from 1 year to up to 10 years.
  • The bank will adopt an “inflation-overshooting” commitment, in which it pledges to keep expanding the monetary base until core inflation has stabilized above their +2% price stability target.
  • While the new yield curve target gives the bank more flexibility in the timing and duration of JGB securities purchases, there were no changes to the existing pace of monetary base expansion (i.e. ¥80T/year).

 

In the context of the aforementioned overhaul, the bank was clear to point out that it now has an expanded list of options for additional easing, including: cutting the short-term policy interest rate (now at -0.1%), lowering the long-term interest rate target, adjusting the composition of LSAP and accelerating the pace of monetary base expansion outright.

 

Moreover, in the context of Japan’s preexisting cyclical and structural growth and inflation dynamics, we think betting on incremental easing in the next 2-3 quarters is as safe a macro bet you can make. For more details regarding said dynamics, please see our 9/20 BoJ meeting preview titled, “#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties?”.

 

If all you did was eyeball the TOPIX or the TOPIX Banks Index – which were up +2.7% and +7.0% on the day, respectively – you’d say the BoJ’s policy overhaul was well-received by Japanese investors. But a more-than-cursory glance shows that the market closed with the USD/JPY cross at its highs. The yen has since rallied and is now up over a percent on the day – heading into the Fed statement (it’s whipped around, but remains largely unchanged since). Holding preexisting trading relationship constant implies an open on the order of down -3% for the broader Japanese equity market – i.e. a reversal of today’s gains.

 

Hawkish Doves and Dovish Hawks: Back to the Narrative Machine If You’re Short Duration  - 1

Source: Bloomberg

 

Looking beyond the immediate-term TRADE duration, it’s safe to conclude that the potential for a protracted JGB “tantrum” has been dramatically reduced, given that the 0.00% 10Y JGB yield target represents a ceiling, rather than a floor in the context of the aforementioned economic gravity weighing on Japan’s sovereign yield curve. That 10Y and 30Y JGB yields backed up only +4bps and +1bps on the day to -0.03% and 0.52%, respectively, is supportive of this view.

 

In fact, we can envision a scenario whereby the BoJ is forced to dump bonds into the secondary market to prevent yields from forcefully breaching its target to the downside. In this scenario, it’s highly likely that the bank opts for a wholesale downshifting of its targeted term-structure of interest rates given that it is unlikely that they would want to be perceived by market participants as tightening monetary policy.

 

From a global macro perspective, the key implication of dramatically-reduced JGB “tantrum” risk is reduced upward pressure on U.S. interest rates – which themselves have backed up from their early-July all-time-lows as Japanese demand for U.S. Treasuries has waned amid rising funding costs in the FX market. And though the yield pickup on 10Y and 30Y paper is now at negligible levels from the perspective of Japanese investors, we view the BoJ’s long-term interest rate target as an effective cap on the long end of the JGB curve – which implies little spread erosion from here.

 

Hawkish Doves and Dovish Hawks: Back to the Narrative Machine If You’re Short Duration  - Japan Currency Adjusted Yield Pickup 10Y

 

Hawkish Doves and Dovish Hawks: Back to the Narrative Machine If You’re Short Duration  - Japan Currency Adjusted Yield Pickup 30Y

 

In short, the aforementioned dynamic implies Japanese demand for U.S. Treasuries should stabilize after crashing in recent weeks. On the margin, that’s positive for long end of the Treasury curve. As such, we are keen to reiterate our bullish bias on Treasury bonds and defensive (i.e. non-cyclical) dividend yields in the context of our “lower-for-longer” and #LateCycle slowdown themes, having likely just survived yet another round of [largely ungrounded] consensus fear of higher rates.

 

Hawkish Doves and Dovish Hawks: Back to the Narrative Machine If You’re Short Duration  - Japan Net Foreign Securities Investment   Bonds

 

“The Case For a Rate Hike Has Strengthened, But We’re Content To Remain On Hold For Now” = Dovish Hawks

Earlier this afternoon the Fed pandered to consensus expectations of their September meeting being used as a springboard to set the stage for a December rate hike by inserting the following language (all incremental) into their policy statement:

 

“The Committee judges that the case for an increase in the federal funds rate has strengthened but decided, for the time being, to wait for further evidence of continued progress toward its objectives.”

 

In her presser, Yellen reiterated that every FOMC meeting is indeed “live” from the perspective of “policy normalization”, but we side with the market in eschewing their 11/1-11/2 meeting as a real candidate given that it lacks December’s offering of additional “communication tools”, which are identical to today’s press conference and Summary Economic Projections.  

 

Hawkish Doves and Dovish Hawks: Back to the Narrative Machine If You’re Short Duration  - 5

 

Dissenting from today’s policy statement were Esther George, Loretta Mester and Eric Rosengren – all of whom were calling for a rate hike at today’s meeting; three total dissenters represented a directionally-hawkish increase of +2 over the July statement.

 

That and [inappropriately] labeling domestic economic growth as having “picked up from the modest pace seen in the first half of the year” is about where the hawkish takeaways end. Downward revisions to the “Dot Plot” and Summary Economic Projections, as well as Yellen’s dovish tone throughout her press conference all coalesced to render today a huge win for long bond bulls:

 

The “Dot Plot” Heads South (Again):

 

  • Consistent with the trailing two-year trend, the FOMC’s infamous “Dot Plot” saw wholesale downward revisions across the maturity curve.
  • The median forecast for the Fed Funds Rate at year-end 2016 among FOMC members was revised down to 0.625% from 0.875% prior – effectively implying only one rate hike for the year.
  • The median forecast for the Fed Funds Rate at year-end 2017 among FOMC members was revised down to 1.125% from 1.625% prior – effectively implying a more gradual pace of “policy normalization” in the form of only two rate hikes for the year vs. a median projection of three prior.
  • The median forecast for the Fed Funds Rate at year-end 2018 among FOMC members was revised down to 1.875% from 2.375% prior.
  • Consistent with recent downward revisions to the neutral rate, the median forecast for the Fed Funds Rate in the “long run” was revised down to 2.875% from 3% prior.

 

Hawkish Doves and Dovish Hawks: Back to the Narrative Machine If You’re Short Duration  - 6

Source: Bloomberg

 

Hawkish Doves and Dovish Hawks: Back to the Narrative Machine If You’re Short Duration  - 7

Source: Bloomberg

 

Hawkish Doves and Dovish Hawks: Back to the Narrative Machine If You’re Short Duration  - 8

Source: Bloomberg

 

Hawkish Doves and Dovish Hawks: Back to the Narrative Machine If You’re Short Duration  - 9

Source: Bloomberg

 

Downward Dog Summary Economic Projections:

 

  • The Fed took revised down its 2016 real GDP growth forecast to +1.7-1.9% from +1.9-2.0% prior.
  • The Fed revised down its 2016 PCE price index forecast to +1.2-1.4% from +1.3-1.7% prior. The committee revised down the high end of its 2017 inflation forecast by -10bps to +1.9% and the low end of its 2018 inflation forecast by -10bps to +1.8%.
  • The Fed revised up its 2016 unemployment rate forecast to 4.7-4.9% from 4.6-4.8% prior.

 

Hawkish Doves and Dovish Hawks: Back to the Narrative Machine If You’re Short Duration  - 10

Source: Federal Reserve

 

Key Highlights From A Less-Than-Hawkish Yellen’s Press Conference:

 

  •  “I agree the projections for growth are slow and that reflects productivity growth likely to remain low for a long time. Slow productivity growth is a factor that influences the longer term normal level of interest rates.”
  • “Inflation is running below our +2% objective and it is important that inflation gets back to the goal.”
  • “The Fed wants the expansion to last as long as possible.”
  • “Investment spending has been weak for some time -- part of it is oil, but we're not quite sure why.”
  • “There is little risk to falling behind the curve in the near future so the FOMC can be gradual in its rate hikes.”

 

Don't Forget That "Data Dependence" = Lower Rates If We Continue To Be Right On the Data

In the context of everything highlighted above, it’s very clear that nothing has changed with the Fed’s propensity to err on the side of caution with respect to its policy normalization objectives. Assuming the Fed remains “data dependent”, we believe our dour forecasts for domestic economic growth will force policymakers to maintain their dovish bias (relative to expectations). To recap, those forecasts are currently:

 

  • Q3: +1.1% YoY/+1.7% QoQ SAAR vs. a Bloomberg Consensus forecast of +2.8%
  • Q4: +1.0% YoY/+0.4% QoQ SAAR vs. a Bloomberg Consensus forecast of +2.4%
  • Q1: +0.6%% YoY/-0.8% QoQ SAAR vs. a Bloomberg Consensus forecast of +2.1%

 

Hawkish Doves and Dovish Hawks: Back to the Narrative Machine If You’re Short Duration  - GIP Model Baseline

 

With domestic economic growth slowing on a sequential, trending and quarterly average basis across the preponderance of key high-frequency indicators within our predictive tracking algorithm, we anticipate negative revisions to both consensus and official GDP forecasts over the intermediate term.

 

Hawkish Doves and Dovish Hawks: Back to the Narrative Machine If You’re Short Duration  - U.S. Economic Summary Table

 

Whether or not the labor market deteriorates fast enough to pump the brakes on a rate hike in December is likely beside the point at this point. What we do know is that labor itself remains at a very asymmetric point in the context of the ongoing recession in corporate profits – a recession that we do not see ending anytime soon. That plus continued degradation in the broader growth matrix likely implies some accelerated pace of labor market deterioration likely into and certainly beyond year-end.

 

Hawkish Doves and Dovish Hawks: Back to the Narrative Machine If You’re Short Duration  - 13

 

Hawkish Doves and Dovish Hawks: Back to the Narrative Machine If You’re Short Duration  - 14

 

Hawkish Doves and Dovish Hawks: Back to the Narrative Machine If You’re Short Duration  - 15

 

In short, it would be wise for investors to adhere to the old mantra of “don’t fight the Fed” in that our “lower-for-longer” theme has legs with respect to the intermediate term. They (i.e. policymakers) have repeatedly told you as much.

 

As we’ve said a million times, the most exploitable risk across global macro markets was always the Fed’s own forecasts and we think investors will benefit from continuing to take advantage of said projections on the long side of duration.

 

DD

 

Darius Dale

Director


ELECTION UPDATE: CALL INVITE WITH CHARLIE COOK OF THE COOK POLITICAL REPORT

Hedgeye Potomac is hosting a call with Charlie Cook - one of the nation’s leading authorities on American politics and U.S. elections, and founder of the Cook Political Report.

 

Cook will share his outlook on the presidential race, discuss the state of play for House and Senate elections, and give a preview of the upcoming presidential debates later this month.

 

The call will take place TODAY, September 20th at 2:00 PM EST with prepared remarks from Cook followed by Q&A.

 

ABOUT CHARLIE COOK

 

Charlie Cook is the Editor and Publisher of the Cook Political Report and a political analyst for National Journal magazine, where he writes a twice weekly column. Charlie is considered one of the nation’s leading authorities on American politics and U.S. elections. In 2010, Charlie was a co-recipient of the American Political Science Association's prestigious Carey McWilliams award to honor "a major journalistic contribution to our understanding of politics." In the spring semester of 2013, Charlie served as a Resident Fellow at the Institute of Politics at the Kennedy School of Government at Harvard University.

 

Charlie founded the Cook Political Report in 1984 and became a columnist for Roll Call, the newspaper of Capitol Hill, in 1986. In 1998 he moved his column to National Journal. Charlie has served as a political analyst or election night analyst for CBS, CNN and NBC News and has been a frequent political analyst for all three major broadcast news networks and has appeared on Meet the Press and This Week.

 

The New York Times has called Charlie “one of the best political handicappers in the nation" and has said the Cook Political Report is "a newsletter which both parties regard as authoritative." The late David Broder wrote in the Washington Post that Charlie was "perhaps the best nonpartisan tracker of Congressional races," while CBS News' Bob Schieffer called the Cook Political Report, "the bible of the political community."

 

CALL DETAILS

 

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#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties?

Conclusion: Investor consensus is far too focused on the risk of policy action (or inaction) out of the BoJ perpetuating a potentially violent backup in bond yields globally and not nearly enough on the underlying drivers of “lower-for-longer” and negative-yielding debt securities – drivers that are set to remain in place for quite some time.

 

Before we offer our thoughts on the BoJ’s 9/21 monetary policy statement and “comprehensive assessment” of their [failed] policies to inflate, let us briefly review where we’ve been on Japan, as well as where the Japanese economy is currently. We’ve been negative on Japan for a little over a year now and much of that negativity stems from our #BeliefSystem investment theme, which argues that the BoJ’s policies would fail to produce desirable and sustained levels of economic growth, consumer price inflation and/or asset price reflation.

 

On the growth front, every key category of high-frequency data is tracking in contraction territory per the latest data.

 

#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties? - HOUSEHOLD CONSUMPTION

 

#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties? - REAL INCOME

 

#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties? - INDUSTRIAL PRODUCTION

 

#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties? - EXPORTS

 

#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties? - COMPOSITE PMI

 

#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties? - CONSUMER CONFIDENCE

 

#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties? - BUSINESS CONFIDENCE

 

On the inflation front, headline CPI and PPI are both in deflationary territory per the latest data, the BoJ’s +2% inflation target remains fantastically elusive from the perspective of key core inflation readings that are both trending lower. Additionally, both market and survey-based measures of inflation expectations are crashing.

 

#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties? - CPI

 

#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties? - PPI

 

#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties? - Japan Core CPI

 

#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties? - Japan Inflation Expectations

 

That the aforementioned failure to launch is occurring at a time where the BoJ is expanding its balance sheet at a near +25% annual clip speaks volumes the inefficacy of the BoJ’s existing monetary easing platform. And while market participants have yet to defend critical ratios with respect to the size of the BoJ’s balance sheet or the pace of its accumulation of JGBs, the seemingly egregious nature of both is worth flagging. Specifically:

 

  • The BoJ’s balance sheet is nearly three times the size of the next closest G4 counterpart when adjusted for the size of the respective economies.
  • When assessed as a ratio to total nonfinancial sector credit (a good proxy to evaluate where LSAP programs may face frictional resistance), the BoJ’s balance sheet is twice the size of the next closest G4 counterpart.
  • Prior to the start of Abenomics, the BoJ was a fairly distant third with respect to JGB ownership at 12% of the float. It’s now far and away the #1 holder at 33.9% of the total. Monetizing over half of annual JGB issuance has a tendency to do that for you.

 

#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties? - Central Bank Balance Sheet to GDP

 

#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties? - Central Bank Balance Sheet to Private Nonfinancial Sector Credit

 

#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties? - Japan JGB Ownership by Holder

 

Shhh. Don’t tell any of this to the Japanese equity market (TOPIX down -15.2% YTD) or the Japanese yen (up +18% vs. the USD YTD), which have both gotten many investors run over in in 2016. Money printing was supposed to get everyone paid on the long side of stocks and on the short side of the currency; at least that’s what was taught to us at the School for Keynesian Economics up in New Haven, CT. “Print lots of money”, burn the currency, inflate corporate profits, rinse and repeat.

 

Kuroda’s inability to execute the aforementioned game plan has been real disadvantage to Japanese corporations. Specifically, aggregate net income growth turned negative for the first time in four years in Q2 (down -21% YoY) as the JPY rallied +24% off its mid-2015 lows on a REER basis.

 

So what more can Kuroda do? He and his colleagues on the BoJ monetary policy board are already targeting an ¥80T expansion of the monetary base (mostly through JGBs, but also ¥6T in ETFs and ¥90B in J-REITs) and they’ve already implemented NIRP (the policy rate is currently at -0.1%). I guess they could do more of one or both and that seems to be in line with the general consensus heading into their two-day meeting. Specifically, the latest Bloomberg survey of economists showed 51% of respondents expect a rate cut, while 33% forecast a higher pace of monetary base expansion.

 

I think it’s very clear to most now, however, that doing more of the same is unlikely to achieve the desired results. As such, there’s been an intense focus across the global investment community on what qualitative elements are likely to be added to the BoJ’s QQE program. The proposals we’re seeing gain the most traction among investors and economies alike are:

 

  1. Scrapping the strict two-year timeframe for achieving the inflation target; and
  2. Targeting a yield curve expansion by focusing their purchases on the 7-12 year range.

 

From our vantage point, neither represents an act of outright easing. In fact, you could make the case that #1 only serves to reduce pressure upon them to act at every interval going forward. Additionally, #2 could perpetuate a short-lived bout of material volatility across global bond markets – especially from the current depressed level of the JGB yield curve and also in the context of Japan potentially moving into the hawkish #Quad2 for the next two quarters. That being said, however, I can’t see how backing up the long end of the curve would be construed as helpful to spurring consumption, investment and wage increases in Japan – but the entire concept might be above my pay grade.  

 

#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties? - JGB 30Y 10Y Spread

Source: Bloomberg L.P.   

 

#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties? - JAPAN

 

What is not above my pay grade is outlining precisely why no matter what they introduce tomorrow, interest rates in Japan and throughout many advanced economies the world over are highly likely to continue to make a series of lower-highs and lower-lows on an intermediate-to-long-term basis. Demographics have always been the tail wagging the dog with respect to structurally-declining rates of both growth and inflation, and Japan has some of the worst characteristics of them all – particularly with respect to population ageing and the growth rate of the 35-54 year-old core consumption cohort.

 

#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties? - G7 Old Age Dependency Ratio

 

#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties? - JAPAN 35 54 YEAR OLD

 

#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties? - G7 35 54 YoY vs. GDP vs. CPI

 

All told, the purpose of this note isn’t to speculate on what the BoJ will or won’t do tomorrow. For all I care, Kuroda could tightrope across the towers of the Tokyo Metropolitan Government Building wearing nothing but whitiey tighties and I would be largely unfazed.

 

While there’s no doubt the BoJ has the potential to shock global bond markets for a TRADE, there’s also no doubt that nothing they do tomorrow or in the not-too-distant future will outweigh economic gravity in the pricing of interest rates over the long term. How they plan to achieve the aggressive growth and inflation targets as mandated by Abenomics remains well beyond our purview – and likely theirs too (hence the stench of desperation and policy fatigue).

 

#BeliefSystem Breakdown: Will Kuroda Tightrope In Whitey Tighties? - Japan Nominal GDP CAGR

 

See the forest, not the trees. The central planning #BeliefSystem continues to break down right before your very eyes.

 

DD

 

Darius Dale

Director


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