3 Things - The Fed, Rig Counts And Employment, ECB

Yesterday, I wrote a fairly lengthy discussion on the biggest fear of the Fed is deflation. As I stated:

"The biggest worry of the Federal Reserve, and frankly every Central Banker on the planet, is deflation. The reason is that deflation, as an economic pressure, is dangerous and once entrenched becomes difficult to break."

Another point can be seen more clearly in the chart below of 5- and 10-year breakeven inflation rates versus GDP. While the consensus of economists expect GDP to accelerate in the months ahead, there are many data points (oil, copper, lumber, shipping rates, etc.) that suggest real economic activity is actually slowing down. The current trend and level of interest rates confirm the same as money continues to seek safety over risk.

Inflation-Breakeven-GDP-012215

This potentially puts the Federal Reserve in a box given that they are laying the verbal groundwork that they will begin raising interest rates in 2015. However, the inflationary data is suggesting that this will likely not be the case. As I wrote previously:

"During the past 25 years, there has never been a period when the Fed has initiated a tightening cycle with inflation below its 2% target as it is currently. Furthermore, the decline in the breakeven inflation rates suggests that inflation will decline further in the months ahead which puts the Fed at risk of exacerbating economic weakness if they move forward with interest rate hikes."

This is the risk to investors the in domestic markets. The news and data flows have been deteriorating post the "rebound" from the first quarter slump. With the Fed leaving the "party" the realization that a world without liquidity driven support could turn "bad news" into "bad news." This is particularly the case when economic growth is running on razor thin margins and an exogenous event, such as plunging oil prices, leaves a very low margin of error.

As shown in the chart below, the markets have historically had a fairly tight correlation to breakeven inflation rates. This makes perfect sense as inflation should be related to economic growth and better profitability. However, since the onset of the Fed's massive monetary intervention at the end of 2012, the markets deviated far away from that correlation. The risk now is a reversion back to historical trends as deflationary pressures continue to build in the months ahead.

Inflation-Breakeven-SP500-012215

The real concern for investors and individuals is the actual economy. There is clearly something amiss within the economic landscape, and the ongoing decline of inflationary pressures longer term is likely telling us just that. The big question for the Fed is how to get themselves out of the potential trap they have gotten themselves into without cratering the economy, and the financial markets, in the process.

It is my expectation, unless these deflationary trends reverse course in very short order, the Fed will likely post-pone raising interest rates until at least the end of the year if not potentially longer.  However, the Fed understands clearly that we are closer to the next economic recession than not and that they can not be caught with rates at the "zero bound" when that occurs.

Effects Of Oil Price Plunge Showing Up In Jobless Claims

Economists were taken by surprise last week when jobless claims shot above 300,000. However, the recent plunge in oil prices is the culprit and is now taking its toll on energy based employment with Haliburton, Schlumberger, Baker Hughes, Suncor and many other companies now shutting in wells and reducing employment.

Unfortunately, we are only in the very early innings of what is shaping up to be a long game. The longer that oil prices remain suppressed, the lower that rig counts are likely to go reducing employment along with it. As I discussed earlier this month:

"This is a very important point as oil prices continue to fall towards the $40/bbl range. As oil prices rise and fall so does the number of rigs being utilized to drill for oil which ultimately also impacts employment. This is shown in the two charts below.  The first is oil prices versus rig count, and the second is rig count versus employment in the oil and gas sector of the economy."

Oil-3mo-Chg-Rig-Oil-012215

Oil-RigCount-Employment-012215

Not surprisingly, with rig counts being rapidly "shut-in" the rise in jobless claims are likely to continue in the near term. However, more importantly will be to watch the ancillary effects to employment elsewhere in the economy. As discussed previously, given the high-wage paying status of energy related jobs there has been a "multiplier effect" throughout the economy of 2.8 jobs elsewhere. Of course, this multiplier effect also runs in reverse.

As I stated, we are very early in this process, and the plunge in oil prices is already being readily dismissed. This could be a mistake given the importance of the energy sector across the broad economy from employment to capital expenditures. 

 ECB Attempts QE

Today, the ECB announced that they will engage in a "QE" type program buying €60 Billion (Euros, not Dollars) a month of investment grade sovereign bonds.

While the markets may welcome another source of liquidity to replace the vacancy left by the Federal Reserve, the are several problems that the ECB will still have to hurdle. The first, and arguably the most important, was identified by Axel Merk in his recent newsletter:

"It should be clear, though, that the negative deposit rate at the ECB makes comparing today’s balance sheet to that of 2012 akin to comparing apples to oranges. 

Let’s keep in mind that anyone selling bonds to the ECB must do something with the cash. QE programs in other countries allowed banks to earn some interest on their excess cash. At the ECB, sellers will have to pay the ECB to in order to hold excess cash. As a result, sellers will think twice before selling.Having said that, at the right price, there will be sellers. However, we are now moving from apples and oranges to bananas – pardon the pun: any amount of buying by the ECB will be more potent with negative interest rates on cash deposits at the ECB, casting serious doubts over whether it is appropriate to state that the 2012 size of the balance sheet is the appropriate size."

This is crucially important. With the ECB leaving interest rates unchanged, the negative interest rate carry makes this QE program much less attractive to sellers.

Secondly, given the fact that "QE" programs have failed to spark "inflation" anywhere else on the planet, the question really becomes "what is the point?" The deflationary pressures in Europe are Draghi's real concern, and since QE suppresses interest rates and inflation, the whole process seems to contradict the stated goals. 

Lastly, the issue of "risk sharing" has yet to be fully addressed. It appears that the ECB has bowed to Germany's demands that taxpayers are not liable for any losses incurred on other countries' debt. Such restrictions may reduce the overall scale of the program over time and render it less effective.

The problem for the Eurozone remains quite simple.  Economic strength is notachieved by "rearranging the deck chairs on the Titanic" but by instituting policies that allow countries to reverse course and begin to create employment and prosperity for its citizens. Only then can the wheels of economic growth begin to turn.

Of course, only time will tell.

Lance Roberts

Lance Roberts is the General Partner and Chief Portfolio Strategist for STA Wealth Management. He is also the host of "Street Talk with Lance Roberts", Chief Editor of "The X-Factor" Investment Newsletter and the Streettalklive daily blog. Follow Lance on Facebook, Twitter and Linked-In.

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