Daily Note – Arabia Unravels

Ottoman EmpireSummary

What could oil at $120 a barrel do for the global economy?

United States: June Fed meeting. Like watching Spain, boring

United States: Growth steady as inflation picks up

United Kingdom: A second view of Carney’s conversion


Good morning,

We are a bit frazzled today as our literary festival ‘The Dalkey Book Festival‘ kicked off last night and runs till late, very late Sunday night! We have a great line up from Amos Oz to Salman Rushdie, John Banville, Sebastian Barry and Kirsty Wark. Given that fiction writers give economists a good name, I am strongly of the belief that we should always be in touch with the right side of our brain. Too much left side brain thinking with all its logic, maths and calculus makes us all dull and more egregiously unable to entertain the madness of the human condition, which drives our world.

So if you are in Ireland this weekend, come up to Dalkey, enjoy the weather, the literature and the ideas.

Just to note we won’t be publishing a daily note on Monday, normal service will resume on Tuesday morning.

On Wednesday night I spoke in the Four Seasons at the annual bash for the Irish Funds Industry. Interesting people and it is fascinating to see that in the search for yield and in the absence of a functioning banking system, how many big funds are thinking about getting into the banking business.

Funds, flush with cash, are keen to create a shadow banking system in countries like Ireland where the banking system is still banjaxed. This will happen, and I fear it will create an unregulated shadow banking system, whose Minsky moment will not be too far off. But as this cycle from too little credit to too much credit might take some time, it is hard to see the big funds not playing this game.

Funny how little we learn and how things come around again and again.

Human nature, such as it is, has no real memory and while we all know this to be dangerous, Wednesday night I thought I heard someone actually say “this time it will be different”!

Now let’s have a gander around the globe to see what is happening.

US equities hit new highs yesterday with utilities up 85bps and Consumer staples up 64bps. Relatively quiet session as the market continued to digest what the FOMC said Wednesday. Seems like the slow grind higher will continue as long as the data stays positive.

Treasuries sold off following a 30y TIPS auction that tailed 2.8bps to clear 1.116%. This is an indication of investors seeing higher inflation in the months ahead. We tend to agree (see section on FOMC below).

Oil prices reached a nine-month high as the instability in Iraq continues; Brent settled up 0.7%, with WTI up 0.4%, widening the Brent premium over the US benchmark. Gold saw gains, rising 3.3% and breaking the $1,300/oz level on flights to safety as well as a reaction to dovish inflation rhetoric from the Fed. Gold has had three such rallies this year. Investors have used each move to sell into. Let’s see if this time is different.

We have made a number of small amends to our portfolio over the last couple of days (see @globalmacro360 for more). We have reduced our core short 5 Year note position, move some of that capital to the 10 Year sector of the curve.

What could oil at $120 a barrel do for the global economy?

This is the question we need to answer or at least entertain particularly as the Middle East looks set to descend into civil war. At this stage it’s important to get the big picture right.

One hundred years ago this summer the Ottoman Empire got involved in a war in the Balkans, it’s European Empire in the West, which culminated in it losing its Arab Empire in the East too. The resulting peace and the Sykes/Picot Agreement saw the map of Arabia redrawn into the countries we now know as Syria, Iraq and the Gulf States. This map is about to be redrawn. It is not a matter of if, but when. The implication is a massive sectarian land grab, which is now going on from Kuwait to the border of Turkey.  Keep this in mind as we take you through the details.

Overnight, Iraqi government forces regained full control of the country’s biggest oil refinery after heavy fighting with Sunni insurgents attempting to seize it. Sunni insurgents had stormed the complex in Baiji, south of Iraq’s second city Mosul setting fire to several storage tanks for refined products in a move that sent jitters through world oil markets.

“The security forces are in full control of the Baiji refinery,” Lieutenant General Qassem Atta, Prime Minister Nouri al-Maliki’s security spokesman, said in televised remarks.

A day after the government publicly appealed for US air power, there were indications Washington is skeptical about whether this would be effective, given the risk of civilian deaths that could further enrage Iraq’s once-dominant Sunni minority.

Economists are already beginning to worry about a global drag from higher prices, Bloomberg writes.

“The rule of thumb favored by many economists is that every $10 increase in the price of a barrel of oil ends up cutting global growth by about 0.2 percentage point.”

I’m skeptical that oil prices will rise much further in the near term, the largest producer in the Middle East, Saudi Arabia has capacity if needed to boost production. Therefore I’m struggling to see a catalyst unless the situation in Iraq worsens in the coming days. Overtime we do expect the situation to deteriorate.

Figure 1: Brent Crude %

Chart 1 20 June

United States: June Fed meeting…move along nothing to see here

Table 1 20 JuneChanges to the June FOMC statement were limited. In general the Fed was slightly more dovish than we expected.

The Committee noted “the unemployment rate, though lower, remains elevated” and that business fixed investment “resumed its advance.”

However, recovery in the housing sector “remained slow”. The language on inflation was unchanged. No reference was made to the firmer core inflation readings in recent months and the likelihood that the key PCE deflator number will be above the 2% target later this month.

Yellen signaled some willingness to let inflation overshoot the 2% target if the employment side of the mandate continues to disappoint. (See our note More Bob Dylan than Bob Rubin)

These remarks differed slightly in tone from her April 16 remarks at the Economic Club of New York, and she downplayed the recent firmer inflation data by stating that “the data we are seeing is noisy” and that “broadly speaking, inflation is evolving in line with the Committee’s expectations.”

She also stressed that wage inflation remains very low “at 2%”.

As you can see from the chart below, the market continues to see the first rate hike in the first half of next year. While most market participants anticipated the pickup in US growth in Q2, the pickup in inflation wasn’t quite so well identified. This complicates the job of the Fed, as growth is no longer the primary driver

Figure 2: United States Fed Fund Expectations

Chart 2 20 June

Yellen underplayed the importance of the recent pickup in inflation on Wednesday night. She argues that this is temporary. In contrast, I see little prospect of the trend in higher prices reversing in coming months. Consider the chart below of Food prices YTD.

Figure 3: CRB Food Stuff Price Index

Chart 3 20 June

Look at where the CPI deflator is moving. It’s upwards (see chart below).

Figure 4: Fed Funds PCE Deflator

Chart 4 20 June

United States: Growth steady as inflation picks up

Table 2 20 JuneThe US current account deficit widened to -$111.2bn in Q1 (vs. consensus -$97.0), from -$87.3bn in Q4. The widening was due in part to a more negative trade balance. Imports have picked up in recent months, indicating again the positive growth trend in the US economy. It is interesting to note from the chart below, while we have seen some improvement in recent years, the large current account deficit remains a structural drag on the US economy.

Figure 5: United States Current Account $b

Chart 5 20 June

The economy continues to create jobs. Initial jobless claims edged down to 312,000 in the week ended June 14 (vs. consensus 313,000), from 318,000.

Weekly initial claims remains one of the pillars of our positive view on the US economy (see below). Normally yields move with the four week average. We expect they will again.

Figure 6: United States Initial Claims 4WK MA vs US 10 Year Note Yield %

Chart 6 20 June

The reason they will move is that now, along with a better growth outlook, inflation is beginning to appear. Consider the increase in the inflation component of the Philadelphia region manufacturing survey.

Figure 7: United States Phili Fed Prices Paid

Chart 7 20 June

United Kingdom: BoE worried

Wednesday’s BOE minutes indicate that last week’s speech by Governor Carney was motivated by concerns over a perceived lack of risk premium in front-end UK rates. This is interesting because it may diminish the likelihood of a rise in the bank by year-end.

Prior to the minutes release, many thought that the steady accumulation of stronger-than-expected UK activity data, prompted the Governor to experience a complete change of heart regarding the need for tighter policy.

Another view doing the rounds was that the Governor’s central expectation remains that the first hike is likely to be delayed until 2015 but, reflecting the possibility that growth will not moderate in the second half of the year and that the speed of the decline in unemployment will not slow, he felt the need to warn financial markets.

The minutes indicate that the second – more dovish – view is the more accurate.

Interest rate expectations were only marginally changed on the back of the news (see chart below), suggesting that the market has got the message.

Figure 8: United Kingdom Interest Rate Expectations

Chart 8 20 June


Table 3 20 June

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