When the April non-farm payrolls number fell short of expectations, most Fed watchers shut the door on the lingering possibility of a summer rate hike. Heading into this week, Fed Funds Futures handicapped only a 4% chance of a June rate increase and 20% chance of a tightening by July. However, a raft of strong economic data, several positive statements by current Fed governors and hawkish Fed minutes released this week caused a major uptick in rate hike expectations. After the minutes were released Wednesday, odds of a June hike shot up to 34% while the odds of a rate increase by July climbed to 56%. Both figures receded slightly by Friday's close, but the odds still favor a rate hike at or before the July 26 meeting.
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From Wednesday's Fed minutes:
"Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen and inflation making progress toward the [FOMC's] 2% objective, then it likely would be appropriate for the [FOMC] to increase the target range for the federal funds rate in June... Participants generally agreed that the risks to the economic outlook posed by global economic and financial developments had receded over the intermeeting period."
The Fed's more upbeat tone reflected a desire to bring the market's policy expectations more in-line with its own. Several Fed officials believed market odds for a June hike had become "unduly low," which increased the risk it could spring a dangerous surprise if it did decide to raise rates this summer.
The public messaging from Fed officials this week was eerily consistent, almost as if coordinated. "I think that the data to my mind are lining up to make a good case for rate increases in the next few meetings," San Francisco Fed President John Williams told the Wall Street Journal Tuesday. Atlanta Fed President Dennis Lockhart echoed that sentiment, saying he wouldn't take the possibility of a June increase off the table. Dallas Fed President Robert Kaplan said he would advocate for a June/July move if current conditions persist. On Thursday, influential New York Fed chairman William Dudley, a permanent voting member of the FOMC, joined the chorus, saying, "we are on track to satisfy a lot of the conditions" for a rate increase and that he was "quite pleased" investors had started to buy into the real possibility of a summer rate hike.
Equity markets haven't quite known how to react to recent changes in monetary policy expectations. The market has retreated nearly 2.5% from late-April highs despite reduced expectations for Fed tightening. Following the release of Wednesday's minutes, stocks dropped sharply before paring losses and finishing near the flat line. The U.S. Treasury market has told a more consistent story. Yield on the U.S. 10-year note fell as low as 1.70% on May 13 and was sitting at 1.75% prior to Wednesday's minutes release. Following the release, yields spiked to 1.88% before settling Friday at 1.85%. Resurgent expectations for a short-term rate rise has also pushed the yield curve to its flattest since 2007. After falling to multi-year lows in late April, the dollar has also been resurgent in recent weeks, capped off by a nearly 0.8% rally against a broad basket of currencies Wednesday.
Strong economic data this week helped make the Fed's communication more credible. Inflation is creeping toward the central bank's 2% minimum expectations, with the Consumer Price Index (CPI) climbing 0.4%, its strongest reading in more than three years. Core prices were up 2.1% from a year ago. Industrial Production rose a robust 0.7% in April while growth in Housing Starts was stronger than expected at 6.6%.
The only factors capable of dampening the Fed's desire to raise rates this summer would be a British exit ("Brexit") from the European Union or a surprise Chinese currency devaluation, which appears unlikely in that timeframe. The U.K. referendum takes place one week after the Fed's June meeting, with poll results varying widely between "Remain" and "Leave." Betting odds still favor the "Remain" camp, but unless there is more clarity by mid-June the Fed will likely, as it has since the financial crisis, err on the side of caution.
China changes its tune
Over the past two weeks the Chinese government has made a concerted communications shift emphasizing its desire to deal with a massive debt overhang. The People's Daily newspaper, considered the Communist Party mouthpiece, ran an article citing an anonymous "authoritative" figure from within government as saying increasing leverage to cope with deflationary forces was like "growing a tree in the air." The article's narrative would seem to run counter to the explosion of credit within the Chinese economy during the first quarter. Observers view the piece as a warning to Chinese speculators who have again started to make levered bullish bets in material and property markets.
The Chinese government had little choice but to change its tune given the deterioration in credit markets. Rising public bond defaults have caused overall bond market sentiment to turn sour. In response, China's banking regulator has sought to limit off-balance sheet risk by suspending the issuance of classified asset management products and re-opening securitized bad debt markets for the first time since the 2008 financial crisis. BlackRock CEO Larry Fink thinks everyone should be worried about China's mounting debt, but remains bullish long-term.
Rampant cross-border mergers and acquisitions (M&A) activity also a serves as a reminder that Chinese companies are hedging against an eventual renminbi devaluation. Cross-border M&A is already at a full-year record - and we're not even through May. Renewed strength in the dollar means Chinese corporations likely missed their best opportunity to repay $430 billion in debt.
Banks brace for potential Brexit
The European Central Bank (ECB) is encouraging banks to prepare contingencies in case of a "Brexit" despite odds favoring the "Remain" camp. Bank of England governor Mark Carney isn't equivocating on his referendum position, saying a vote to leave the E.U. could trigger a recession in the U.K. due to its effect on the exchange rate and aggregate demand.
The fact a "Brexit" has even gone to referendum is causing global banks to re-evaluate their exposure to the U.K., with Ireland hoping to capitalize. The Irish government has an ambitious plan to lure 10,000 finance jobs to the country within four years.
Brazilian boys club
Dilma Rousseff was suspended from the Brazilian presidency when the country's lower house voted 55-22 to proceed with impeachment charges, but she isn't done fighting back. Rousseff conducted an interview with The Intercept's Glenn Greenwald this week to discuss what she sees as a sexist, right-wing coup. Despite calls for unity from new acting President Michael Temer, the decision to appoint23 white male cabinet members in the ethnically diverse country has exacerbated skepticism in his ability to govern effectively. Reflecting that lack of confidence was the fact a $6.75 billion bond issue this week from state-owned oil company Petrobras resulted in higher-than-expected yields.
The rightward shift in Brazilian politics is the latest rebuke of far-left populist policies in Latin America that have driven Venezuela and Argentina to economic ruin.
Lifting the veil on Saudi Arabia
Saudi Arabia's Deputy Crown Prince Mohammed bin Salman is moving quickly on his ambitious government shake-up, with the kingdom saying it plans to increase crude oil output ahead of the partial Saudi Aramco IPO. Despite the Saudis' progressive plans, Moody's downgraded the country's debt last week, saying its "buffers will continue to erode."
After keeping the breakdown of Saudi Arabia's holdings of U.S. debt secret for more than forty years, the U.S. Treasury Department this week revealed the kingdom holds $116.8 billion in American debt. The figure is ostensibly relevant given Saudi Arabia's threat to sell its Treasury holdings if Congress approves a bill, which passed the Senate this week, allowing 9/11 victims' families to sue the Saudi government.
Goldman Sachs says supply disruptions mean the major problems in the oil market are over.
Apple's identity crisis
Apple (AAPL) has been stuck in a downward drift since seeing iPhone sales contract for the first time ever last month, but is the company ready to settle into life as a dividend value dinosaur? Supporting evidence for the affirmative case comes in the form of a new $1 billion position from Warren Buffett's Berkshire Hathaway (which was initiated by one of Buffett's lieutenants, rather than the Oracle himself). While value investors are increasingly attracted to Apple's cash flow and yield, David Tepper is among the hedge fund managers dumping the stock.
Meanwhile, Apple's $1 billion investment in Chinese ride-sharing giant Didi Chuxing reminds us the company still harbors considerable ambition beyond smartphones. Apple has several potential motivations for making the investment, not the least of which is to make further inroads in China. Didi is reportedly eyeing a 2018 U.S. IPO.
Merger boom rumbles on
It's been a busy couple of weeks for U.S. corporate M&A. In the latest wave of consolidation within the agricultural sector, $90 billion German drugs and chemicals company Bayer (ETR: BAYN) has proposed a merger with $42 billion agribusiness giant Monsanto (MON). The deal, however, is expected to faceconsiderable regulatory hurdles.
Pfizer (PFE) is planning to buy biopharma company Anacor (ANAC) for $5.2 billion. Oil services companies FMC Technologies (FTI) and France-based Technip (EPA:TEC) are planning a $13 billion merger.
Staples (SPLS) and Office Depot (ODP) are being forced to scrap their mergerover anti-trust concerns.
Hedge funds fight back
Fresh off the SALT Conference, where David Rubenstein, Michael Bloomberg and John Boehner urged Wall Street to wage a more aggressive PR campaign, hedge fund industry heavyweights are teaming up for collective benefit. Activist investors have formed a new lobbying group called the Council for Investor Rights and Corporate Accountability (CIRCA) while a group of major funds convened a meeting of top biotech and pharma lobbyists, urging them to defend the industry more diligently.
Did Goldman go beyond the wall on Tesla?
Before the open of trading Wednesday, Goldman Sachs put out a bullish research note on Tesla (TSLA), triggering a more than 3% rally in the stock. After the close, Tesla fell by around the same amount upon announcing a $2 billion secondary offering - and guess who was a joint-lead book runner on the deal? Goldman Sachs. A "Chinese wall" is supposed to separate a bank's research and investment banking divisions, making the optics of the situation suboptimal - even though such brazen wrongdoing would seem unlikely.
IMF role complicates Greek debt negotiations
Remember Greece? Last week the Greek government passed unpopular tax and pension reforms to pave the way for the latest debt relief offer from Eurozone finance ministers. However, hopes for a quick agreement faded as the International Monetary Fund (IMF) increased demands for Greek debt relief.