The Federal Reserve plays defense in global currency war

Last week, the European Central Bank (ECB) fired its policy bazooka but followed the announcement with hawkish communication about future rate cuts, creating confusion and stoking volatility. This week, the U.S. Federal Reserve left key interest rates unchanged, but used dovish communication as a quasi-stimulus package, sending U.S. stocks higher and the dollar sharply lower. The juxtaposition highlights the importance of communication in central banking.

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The Federal Open Market Committee (FOMC) dramatically re-framed expectations for future monetary policy, bringing official forecasts more in line with market expectations by lowering its projections from four rate hikes in 2016 to just two. Former Fed Chairman Ben Bernanke expressed his opinion that the Fed has plenty of tools left at its disposal.  

If the Fed was truly data-dependent and focused exclusively on its dual mandate of employment and inflation, you would’ve expected this week’s policy decision to bring a rate hike or more hawkish statement. Former Treasury Secretary Larry Summers wrote last February the Fed should only raise rates when the “whites of inflation’s eyes are visible.” Well, we’re starting to get close enough to use a bayonet. This week’s consumer price index (CPI) showed core inflation, which strips out volatile food and energy costs, rising 2.3% in February (versus expectations of 2.2%), the highest reading since the financial crisis. 

But in today’s world of interventionist monetary policy, the Fed clearly feels it can’t operate in a vacuum. The FOMC pointed to “strong job gains” and signs “inflation picked up in recent months” as evidence the domestic economy is improving, but justified its dovish about-face by opining that “global economic and financial developments continue to pose risks.” More likely, though, the Fed looked around at recent central bank stimulus from the ECB and Bank of Japan (BoJ), wondering how it could pursue policy that would continue to strengthen the dollar. The dovish statement sent global currencies soaring, defying central bankers pursuing competitive devaluation. Together, central bankers could be, intentionally or not, softening the eventual effect of a likely Chinese yuan depreciation.
 
Oil may have rallied too far, too fast for its own good 

West Texas Intermediate (WTI) crude rallied for the fifth straight week, briefly climbing above $41/barrel Friday before fading into the close. Supply issues have been driving the volatility in oil over the past 18 months. An extreme glut sent prices careening into the lower $30s, lessening the incentive to drill for oil. As a result, the U.S. oil rig count fell by nearly 70% from its shale revolution highs back to 2009 lows. Naturally, fewer rigs meant less production, reducing the supply glut. Pesky rumors about OPEC product freezes and cuts, dovish monetary policy and a less-than-expected impact from Iranian oil, coupled with lower U.S. production, have caused oil prices to go up.

Now, with WTI crude more than 50% off its lows and briefly trading into the $40s, oil will have to cope with the effects of its resurgent popularity. The catalyst for crude’s sudden reversal Friday was news the weekly rig count climbed after 12 straight weeks of cuts. Shale companies are finding it hard to stop and start production because of idle equipment and the permanent migration of its workforce, but U.S. production will rise if prices hold at current levels. In that event, OPEC producers will also likely be less inclined to cut production and lose market share.

Without a significant increase in demand, which seems unlikely given the tepid economic growth around the world, expect to see oil continue to trade in a volatile range and highly-levered oil companies continue on a spiral toward restructuring.
 
Should we be bracing for a Saudi Aramco IPO?

The wildcard for global oil prices is the geopolitical environment in the Middle East. While the diversified U.S. economy has been able to cope with the effects of lower oil prices, oil-dependent economies like Saudi Arabia have not. The kingdom is expected to run a 20% budget deficit this year after a 23% shortfall last year, which has caused it to burn through cash reserves at an unsustainable rate. In fact, unless prices climb back above $60/barrel within the next year, economists believe the Saudi government could run out of cash reserves within 3-5 years. Given that sober reality, the royal family is faced with a set of difficult options: dramatically slash budgets, significantly devalue the riyal, which is overvalued by as much as 50% against other regional currencies because of its peg to the dollar, or consider an IPO of the state oil company, Aramco.

An IPO of Aramco, by far the most valuable company in the world potentially worth in excess of $2 trillion, would force the notoriously opaque Saudi regime to open its books for the first time. The next generation of leadership seems to acknowledge the necessity of that step, preferring to usher in a new era rather than be forced into deep budget cuts and currency depreciation that would diminish quality of life in the kingdom. Social unrest in Saudi Arabia would raise the threat of political upheaval in the most stable U.S.-allied power in the region, one which is already seeing a rise in sectarian violence. Regime change in Saudi Arabia would have the potential to disrupt supply from the world’s largest producer of crude oil and send prices spiking.

The two Crown Princes currently running Saudi Arabia have been floating the idea of at least a partial IPO of Aramco and this week took another step that could pave the way for that sensational possibility. Royal Dutch Shell and Saudi Aramco announced plans on Wednesday to break up joint-venture Motiva Enterprises, ending a two-decade partnership, with an Aramco official saying, “It is now time for the partners to pursue their independent downstream goals.”

Over the last decade, oil has been both a key driver and clear reflection of powerful economic and geopolitical cycles. Don’t expect that to change any time soon.   
 
President Obama's Supreme Court mousetrap

President Obama this week nominated Merrick Garland to fill the seat of late Justice Antonin Scalia on the Supreme Court, setting a classic mousetrap into which the GOP looks set to stumble. Garland is über-qualified, having graduated with honors from Harvard University and Law School before embarking on a decorated career in the private and public sector. As a federal prosecutor, he successfully led the investigated and won a conviction in the Oklahoma City bombing case. He currently serves as Chief Judge on the DC Appeals Circuit, the second-most powerful court in the land, after being confirmed by a bi-partisan vote in 1995. He’s widely-respected and well-liked on both sides of the political aisle, with a centrist judicial record characterized by restraint, not activism.

Republican Orrin Hatch said in 2010, regarding another Supreme Court vacancy, “I know Merrick Garland very well… He would be very well supported by all sides and the President knows that.” Just a few weeks ago Hatch said, “The president told me several times he’s going to name a moderate, but I don’t believe him. He could easily name Merrick Garland, who is a fine man. He probably won’t do that because this appointment is about the election. So I’m pretty sure he’ll name someone the [liberal Democratic base] wants.” The President called his bluff, and the entire Republican leadership is taking another anxious look at its busted hand.

The GOP saw its collective approval rating dip when it attempted to shut down the government in 2013 over budget quarrels. Now it risks even greater reputational damage by obstructing the appointment of a judge who enjoys almost universal admiration. That doesn’t even take into account the reality that Republicans could do a lot worse than Judge Garland under President Clinton – or President Trump.

Ultimately, the situation is playing out as another demonstration of the Republican establishment’s growing tone deafness and hypocrisy.

European Central Bank (ECB) stimulus exposes eurozone rifts

The European Central Bank’s (ECB) decision to expand its quantitative easing (QE) program to include select corporate bonds has companies clamoring to issue massive amounts of debt. But it has also reignited regional rifts within the eurozone. The move was welcome news for banks in Southern Europe with liquidity issues, but criticized by Northern European institutions flush with excess cash. The dispute is the latest reminder of the challenges of setting singular monetary policy in a 19-member union containing sovereign nations with starkly contrasting fiscal positions.   
 
Brazilian circus

Emerging markets got so bad they became good risk-reward investment opportunities. But has the recent rally in emerging market currencies been too good to last? Just as the Brazilian people cheered the comeuppance of justice regarding pervasive political corruption, embattled President Dilma Rousseff doubled down by naming recently-arrested former President Luiz Inácio Lula da Silva as her chief of staff, presumably to shield him from prosecution on charges of fraud and money laundering. Brazilian markets tanked on news of Lula’s appointment, but spiked when a judge issued an injunction barring his appointment to the cabinet. The appointment prompted millions of Brazilians to protest against the President last weekend and threatens to drag out the country’s efforts to make structural reforms necessary to repair its credit rating and rehabilitate its economy.

Free trade alarmism

Reagan’s ‘protectionism is destructionism’ message was true—but free trade is being derided in the 2016 race. Global trade creates higher-paying jobs in the U.S. by helping move capital and workers into stronger businesses and new opportunities, but a rise in nationalism in the current cycle threatens to derail decades of progress that have made the U.S. a resilient, diversified and cutting-edge economy. Today’s protectionists seem to be focusing on an image that is 10 years out of date.
 
Benchmarking distortions

While benchmarking against market indices is supposed to limit the damage that can be done by incompetent fund managers, it has actually created distortions in which “high risk stocks are driven up and their future returns down, while low risk stocks are pushed down and their prospective returns up.” Index investing is creating long-term market mispricings.

In addition, stock exchanges are being forced to consolidate because nobody bothers buying individual stocks anymore.
 
In other news

While a legion of intelligent investors are warning about China’s looming currency crisis hedge funds are getting burned on yuan bets to the tune of $562 million.  
 
Amazon plans to take over your living room by providing low-margin technology essentials at scale.  
 
With global temperatures soaring to record levels, one of the last remaining coal giants prepares to seek bankruptcy protection.
 
The Treasury Department eases restrictions on travel and other dealings with Cuba.