- FOMC minutes are slightly dovish
- OPEC set to renew its weak prop for oil prices
- Unemployment claims continue to indicate strong U.S. labor market
- 7-year T-note auction to yield near 2.06%
FOMC minutes are slightly dovish — Wednesday’s minutes from the May 2-3 FOMC meeting indicated that a rate hike is virtually assured for the upcoming FOMC meeting on June 13-14. The minutes said that “it would soon be appropriate” to tighten monetary policy again. However, the federal funds futures curve turned a bit more dovish for 2018-19 after the Fed indicated some uncertainty about the economy by saying that “members generally judged that it would be prudent to await additional evidence indicating that the recent slowing in the pace of economic activity had been transitory.”
The minutes were also bullish for the T-note market because the Fed indicated that its plan for a balance sheet draw-down will be slow and smooth, rather than one big run-off. The minutes said the plan will allow a capped run-off of maturing securities each month and then slowly raise that cap every three months until a full phase-in level is reached. The Fed gave no details about monthly run-off amounts or an eventual target level for the balance sheet.
OPEC set to renew its weak prop for oil prices — OPEC and non-OPEC countries appear ready at their meeting today to extend their 1.8 million bpd production-cut agreement for nine months through Q1-2018 (1.2 million bpd cut for just OPEC). The group originally reached that production-cut agreement back in Nov 30, 2016 to cover the first six months of 2017.
OPEC members had hoped that the 6-month agreement would be enough to bring OECD crude oil inventories down to the 5-year average. However, the nearby chart illustrates how that goal is far from being met. World oil inventories have barely budged mainly because U.S. oil producers have taken advantage of higher oil prices to ramp up production by 621,000 bpd since Nov 2016, thus offsetting about a third of the overall OPEC/non-OPEC 1.8 million bpd production cut. The OPEC production cut was also foiled to some extent by increased oil production by Libya, which is not subject to the production-cut agreement.
Oil producers now hope that an extension of their agreement through Q1-2018, along with higher demand, will achieve their goal of bringing inventories down to the 5-year average. Whether that goal is reached, however, depends heavily on whether U.S. oil producers continue to ramp up their production. That goal also depends on whether oil producers start cheating on their production cuts in 2H-2017 after strong compliance in 1H-2017.
WTI oil prices initially rallied sharply on the Nov 30 production-cut agreement from about $46 per barrel to about $51, and then traded sideways in a narrow range of about $51-55 in Jan-Feb. However, oil prices then saw sharp downdrafts to $47 in March and $44 in early May mainly because of the steady rise in U.S. production. Over the last three weeks, oil prices have rallied sharply by $7 to the $51 area because of (1) Saudi Arabia’s indication that the production cut agreement might be extended into 2018, and (2) a recent modest decline in U.S. oil inventories closer to the 5-year seasonal average.
The outlook for oil prices now depends mainly on whether the production cut agreement is successful in causing world oil inventories to fall on a sustained basis towards the 5-year average. If oil inventories do start to decline, then oil prices should be able to hold in the $50-55 area. However, if U.S. producers continue to ramp up their production, or if OPEC or non-OPEC oil producers start to cheat on their quotas, then oil prices are likely to see some new downdrafts such as the ones seen in March and April.
Over the long-run, oil prices likely need to trade in a range of about $40-50 in order to keep higher-cost producers out of the market and bring supply and demand into balance. Oil prices need to be low enough to discourage U.S. production increases and eliminate the need for OPEC and non-OPEC members to engage in artificial production cuts, which are not sustainable over the long-run. The current production cut agreement is only a temporary prop for oil prices that cannot substitute over the long-run for an adjustment in prices to levels that truly balance supply and demand.
Unemployment claims continue to indicate strong U.S. labor market — The U.S. unemployment claims data continues to show a strong U.S. labor market with businesses clinging to their employees. The initial claims series is only +5,000 above the 44-year low of 227,000 posted in February, while continuing claims last week fell to a new 28-1/2 year low. The consensus is for today’s initial claims report to show a +6,000 increase to 238,000 (after last week’s -4,000 decline to 232,000) and for continuing claims to show a +27,000 increase to 1.925 million (after last week’s -22,000 decline to 1.898 million).
7-year T-note auction to yield near 2.06% — The Treasury today will sell $28 billion of 7-year T-notes, concluding this week’s $101 billion T-note package. Today’s 7-year T-note issue was trading at 2.06% in when-issued trading late yesterday afternoon. That translates to an inflation-adjusted yield of 0.29% against the current 7-year breakeven inflation expectations rate of 1.77%. The 12-auction averages for the 5-year are as follows: 2.54 bid cover ratio, $13 million in non-competitive bids, 4.5 bp tail to median yield, 19.7 bp tail to the low yield, and 37% taken at the high yield. The 7-year is the second most popular Treasury coupon among foreign investors and central banks behind the 10-year TIPS. Indirect bidders, a proxy for foreign buyers, have taken an average of 66.8% for the last twelve 7-year auctions, well above the average of 59.9% of all recent Treasury coupon auctions.
