Gold prices have been strong recently, supported by perceptions of easing monetary policy and oblique statements from the White House hinting at supporting a weaker dollar. Lower interest rates and dollar weakness are generally bullish for gold prices.
Our coincident gold price model suggests the recent rally is merely “catching up” from an undervalued condition.
This model uses the balance sheets of the Federal Reserve and the European Central Bank, the EUR/USD exchange rate, the fiscal account as a percentage of GDP and the real two-year Treasury yield. The model has been suggesting that gold was undervalued for the past two years. The recent rally has closed the gap; however, as the dollar weakens and the central banks return to expanding their balance sheets, the model’s forecast will rise and support gold prices.
On a longer term basis, the unscaled level of the deficit does tend to suggest a favorable environment for gold.
This chart shows the Congressional Budget Office’s level of the deficit (on an inverted scale) and forecast to 2025. The body is suggesting the deficit will worsen in the coming years which has tended to be supportive for gold prices. Interestingly enough, the mere level has the biggest effect on prices compared to scaling the fiscal account to GDP. Most likely, the level is easier for gold buyers to understand.
With inflation low and Modern Monetary Theory becoming popular, the likelihood of rising deficits is elevated. A position in gold is one way investors can position for a secular trend in rising deficits.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez
[Posted: 9:30 AM EDT] U.S. equity markets are higher this morning on hopes of a trade deal at this weekend’s G-20 meeting. The second leg of the first Democratic debate was held last night. Vice President Biden had a tough night; there are concerns that if Biden falters the odds of a left-wing populist winning rise, which is potentially a negative for health care. Here is what we are watching today:
The G-20: We have covered our thoughts on the G-20 over the past few days and don’t have a whole lot more to add. The key meeting of the weekend occurs at 10:30 EDT tonight when Trump and Xi hold their meeting. Consensus is that there will be a ceasefire; no new tariffs and promises to continue talking will be the outcome. U.S. hardliners on China are worried that the president could negotiate away the stiff sanctions on Huawei (002502, CNY 3.44). So far, President Trump has struck an optimist tone, not only with China, but with other free trade talks currently underway. The U.S. and Japan have agreed to accelerate talks, for example. In addition, Trump and Chancellor Merkel (who has been having her own problems recently) seemed to get along rather well. At the same time, the G-20 is deeply fractured; it is possible they won’t be able to put together a joint communiqué at the end of the meeting. We also note that Peter Navarro was a late add to President Trump’s entourage. Navarro is arguably the most hawkish member of the president’s advisors on Chinese trade and having him at the meeting might signal a harder stance than the markets are currently discounting. We also note that the U.S. and Turkey will hold leader talks at this meeting. This may be the last chance for Erdogan to avoid losing access to the F-35 fighter and undermining NATO.
Iran: President Trump made some hawkish statements on Iran, suggesting that a military conflict would not last long. That notion is probably wishful thinking. It does appear the U.S. is considering tanker escorts and an expanded monitoring system, which makes sense. Meanwhile, the EU is preparing to launch its payments system that would allow Iran to trade with it. So far, it looks like it won’t lead to a significant improvement in Iran’s faltering economy. The EU is trying to bring about enough trade to keep Iran in compliance with the current Iran deal and avoid upsetting the U.S., a tough line to hew. Although nothing too significant is happening today, we would expect traders to cover shorts into the weekend, which could support oil prices.
Trump and the dollar: President Trump said today that he wanted the Fed to ease in order to weaken the dollar. Chair Powell correctly noted that dollar policy isn’t the purview of the Fed. This discussion continues to frame a growing narrative that would support a “Plaza Accord II,” albeit a unilateral one, where the U.S. purposely depresses the dollar for trade advantage. We also note the BOJ is considering easing policy, which could lead to a weaker JPY and further anger the White House.
Capital gain cut? The Trump administration is apparently mulling the indexing of capital gains to inflation. Although this would infuriate the populists on both wings, it would be quietly cheered by the establishment.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez
[Posted: 9:30 AM EDT] U.S. equity markets are higher this morning on hopes of a trade deal at this weekend’s G-20 meeting. The first Democratic debate was held last night; although there is much analysis out in the media, keep in mind that this is like analyzing spring training. A debate with 20 participants doesn’t tell anyone very much. Here is what we are watching today:
G-20: Optimism is coming from reports out of China that the U.S. and China have a deal. The U.S. will not implement further tariffs and will not prevent exports to Huawei (002502, CNY 3.61). In addition, the U.S. will not demand additional exports from China. Reports suggest that the delay of tariffs was China’s demand for a meeting to occur.
If the reports are accurate, it looks like a major concession from the U.S. We note that the tone coming from the White House doesn’t line up with what we are hearing from China. The president is threatening new tariffs on China, for example. However, the new tariffs may not be the 25% level initially proposed and may only be implemented if the talks fail, which, in itself, may be hard to determine.
We expect both nations to issue their own statements. It is quite possible that we end up with strategic ambiguity—both sides say what appears to be the same thing, but each interpret their statements differently. However, the tone coming out from China seems to suggest U.S. capitulation. It would be surprising if the U.S. caves to China at this point. Thus, the optimism we are seeing this morning may not hold.
Presidents Trump and Xi meet Saturday morning in Osaka (a 13 hours difference from New York). As a result, by Saturday morning in the U.S., we should know the outcome of the meeting.
In other news in front of the weekend, President Trump criticized the EU for its treatment of tech firms. He also questioned the U.S./Japan security alliance. French President Macron indicated that action on climate change is a “red line” and he wouldn’t sign a statement without reference to action on this issue.
The other issue that bears monitoring is the U.S./Iran situation. Other than Saudi Arabia, the rest of the G-20 will oppose the U.S. position on Iran. We doubt this will get much airplay, but it might be part of bilateral meetings.
The problem with trade impediments: Yesterday, we noted the problem with trade impediments. Essentially, it comes down to the issue of arbitrage. Arbitrage is one of the oldest methods of making risk-free money. If one can buy in one market at a lower cost and sell the same good for more money elsewhere, it’s a good thing! Under free markets, arbitrage is usually ephemeral; others notice it and the advantage quickly evaporates. However, if there are regulations or trade barriers in place, the likelihood of the arbitrage holding for a longer period of time increases. Of course, there are potential legal risks for the party trying to perform the arbitrage. There are additional articles today about firms managing to avoid tariffs through various methods including transhipments—sending goods from the tariffed nation to a neutral nation and then shipping from the neutral nation to the U.S. The longer tariffs are in place, the more that this sort of activity will occur and undermine the impact of tariffs. Again, at some point, we expect President Trump to finally realize that the best way to get what he wants is to crater the dollar.
Brexit: Boris Johnson is pledging “do or die” for Brexit. The vote for PM occurs next month, and will be decided by a small subset of the U.K. voting population.
Energy update: Crude oil inventories fell 12.8 mb last week compared to the forecast drop of 2.9 mb.
In the details, refining activity rose 0.3%, below the 0.4% rise forecast. Estimated U.S. oil production fell by 0.1 mbpd to 12.1 mbpd. Crude oil imports fell 0.8 mbpd, while exports increased 0.3 mbpd. The combination of rising refinery demand and a modest drop in production, along with rising imports, all supported the larger than expected drawdown in inventories.
(Sources: DOE, CIM)
This is the seasonal pattern chart for commercial crude oil inventories. We are now well within the spring/summer withdrawal season. This week’s decline is consistent with the seasonal pattern, but the decline was much faster than normal. After contra-seasonal increases from March to June, we are now seeing a reversal in inventory accumulation. This drop in stockpiles is supportive for oil prices.
Based on oil inventories alone, fair value for crude oil is $51.52. Based on the EUR, fair value is $53.28. Using both independent variables, a more complete way of looking at the data, fair value is $51.76. Oil prices have based and are now working higher, bolstered by tensions with Iran. The reversal in inventory patterns is also supportive and helping to lift prices.
The business cycle has a major impact on financial markets; recessions usually accompany bear markets in equities. We have created this report to keep our readers apprised of the potential for recession, which we plan to update on a monthly basis. Although it isn’t the final word on our views about recession, it is part of our process in signaling the potential for a downturn.
Economic data released for May suggests the economy remains strong but is showing some signs of weakness. Currently, our diffusion index shows that 10 out of 11 indicators are in expansion territory, with several indicators approaching warning territory. The index currently sits at +0.818.[1]
The chart above shows the Confluence Diffusion Index. It uses a three-month moving average of 11 leading indicators to track the state of the business cycle. The red line signals when the business cycle is headed toward a contraction, while the blue line signals when the business cycle is headed toward a recovery. On average, the diffusion index provides about seven months of lead time for a contraction and three months for a recovery. Continue reading for a more in-depth understanding of how the indicators are performing.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez
[Posted: 9:30 AM EDT] U.S. equity markets are higher this morning after taking a tumble yesterday. Optimism on trade is lifting domestic equity futures. The Democrats start their debates tonight and Robert Mueller will publicly testify. Consumer confidence data deserves a second look. Here is what we are watching today:
G-20: Treasury Secretary Mnuchin gave the markets hope this morning after indicating a deal is “90% complete.” This comment has raised hopes this morning, but it should be noted that he made similar comments in May. Essentially, talks stalled in early May after the U.S. accused China of reneging on the agreement. Expectations for this weekend’s trade talks are mostly about preventing additional tariffs from being implemented, a temporary ceasefire. However, the odds of a full agreement are nearly zero. Still, this morning’s rally does show that the financial markets are focused on this issue and want to see a full-blown trade conflict avoided.
The problem with trade impediments: Arbitrage is one of the oldest methods of making risk-free money. If one can buy in one market at a lower cost and sell the same good for more money elsewhere, it’s a good thing! Under free markets, arbitrage is usually ephemeral; others notice it and the advantage quickly evaporates. But, if there are regulations or trade barriers in place, the likelihood of the arbitrage holding for a longer period of time increases. Of course, there are potential legal risks for the party trying to perform the arbitrage. We note this morning that some tech firms have apparently figured out a way to skirt the trade ban with Huawei (002502, CNY, 3.53). Although the companies involved may not have violated any laws, their actions do raise the question of compliance with the spirit of the regulations. One of the problems with creating arbitrage opportunities with regulation is that they encourage ways to capture the gains.
The Fed—when doves cry: There is dovishness and then there is real dovishness. First, Chair Powell gave a speech with few surprises, especially in light of his press conference. He noted risks to the economy and worries about low inflation. However, he didn’t clearly signal a rate cut and hinted at the problems of political pressure, and these issues spooked the equity market. But, the real hit came from St. Louis FRB Bullard, who dissented at the last meeting, wanting the FOMC to reduce rates. Bullard suggested that although he supports a rate reduction, he believes only a 25 bps move is warranted at this time. The market clearly wanted more. In response, markets reacted as one would expect—the yield curve flattened and equities slumped. Does this mean the Fed is changing course? Not really. It’s just that the financial markets have gotten a bit ahead of themselves. On the other hand, if the economy decelerates further, a more aggressive cut might make sense.
A sub-2% 10-year: The 10-year T-note yield fell below 2% yesterday. This is the lowest rate since 2016.
(Source: Bloomberg)
Chair Powell is walking a delicate line; he is clearly getting tremendous pressure from the White House on policy and he fears the loss of institutional independence. One way he appears to be dealing with this problem is by reducing transparency. We are big fans of this idea; transparency has led market participants to complacency.
You heard it here first: The White House has created a “short list” of candidates for the two open governor positions on the FOMC. St. Louis FRB President Bullard has confirmed that the administration has contacted him about the position. We have noted in the past that Bullard and Minneapolis FRB President Kashkari would be choices for these positions that would align with the interests of the White House. Both are consistent doves and would likely make it through the confirmation process without incident. Bullard appears to have demurred, but we still expect him and perhaps the aforementioned Kashkari to be on the list.
A confidence problem: We rarely comment on data that comes out after 8:30 EDT because it is usually covered by the media. However, on occasion, the information is so important that it warrants analysis. Yesterday’s consumer confidence was that important. The data for June came in much weaker than forecast, at 121.5 compared to forecasts of 131.1. The May data was revised to 131.3 from 134.1.
Big declines like this often occur before recessions. Perhaps even more concerning is the present situation component of the data.
This is the present situation index with a two-year moving average. Although breaking that average isn’t a perfect indicator, falling below it from a high level has tended to presage recessions in the past. The economy is decelerating and the risks of recession are increasing.
Iran: The president appears to be setting a “red line” of sorts, indicating that a military response will occur if an American dies due to actions taken by Iran. Although we suspect this is true, the problem with red lines is that one has to act once they are crossed; in addition, it gives an enemy a clear target if they want to escalate. If Iran views the president as soft, it will move to cross this red line. Given Trump’s Jacksonian tendencies, a strong response will likely follow. Iran is expected to reach a uranium enrichment threshold in the very near future; we will be watching the response from Europe because boosting enrichment will tend to be viewed in Europe as breaking the Iran nuclear agreement.
Brexit: Boris Johnson is pledging “do or die” for Brexit. The vote for PM occurs next month, and will be decided by a small subset of the U.K. voting population.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez
[Posted: 9:30 AM EDT] It’s a slow news day so far this morning. Lots of Fed speakers throughout the day. Here is what we are watching today:
The Fed: There is a plethora of Fed speakers today (see below), including Chair Powell. We did see the president continue to lambast the central bank. We doubt we will get any new information from all these speakers; we note, for example, that Dallas FRB President Kaplan continues to hold his neutral position closely. As we have noted before, the committee is divided along four lines—the pragmatists, the Phillips Curve hawks and doves (that’s two in our count) and the financial sensitives. Neither group commands a large enough contingent to set a definitive policy path. In the absence of consensus, the Fed seems to be letting the financial markets dictate policy, which likely means easing in the near future.
Iran: As promised, President Trump implemented additional sanctions on Iran, including direct sanctions on its supreme leader. Iran’s response indicated that these additional sanctions end any hope for diplomacy. SoS Pompeo has been visiting nations in the region; it appears the U.S. is preparing for tanker escorts. However, the president has indicated that he doesn’t like the fact that the U.S. is paying for protection that the rest of the world enjoys. Although understandable, this is the burden of hegemony; if the U.S. does end this role, the world becomes a much more dangerous place. Markets continue to bid up safety assets, with gold and bitcoin moving higher in recent days. There are also reports that Iran has been increasing its cyberattacks against the U.S.
Brexit:Boris Johnson is dealing with the travails of being the frontrunner for PM, replacing Theresa May. Although we still expect him to win next month, he is mercurial enough to snatch defeat from the jaws of victory.
EU battles:The EU continues to struggle to name a new commissioner. Germany is accusing French President Macron of being “anti-German.” German leaders continue to stump for their candidate, Manfred Weber. If Germany loses the EU commissioner position, look for Berlin to insist on getting the ECB presidency, which would be bullish for the EUR.
(Due to the Independence Day holiday and a short summer hiatus, the next report will be published July 15.)
As is our custom, we update our geopolitical outlook for the remainder of the year as the first half comes to a close. This report is less a series of predictions as it is a list of potential geopolitical issues that we believe will dominate the international landscape for the rest of the year. It is not designed to be exhaustive; instead, it focuses on the “big picture” conditions that we believe will affect policy and markets going forward. They are listed in order of importance.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez
[Posted: 9:30 AM EDT] NB: Our strategy team is expanding! Patrick Fearon-Hernandez has joined our firm as Market Strategist. He comes to us from a broad and interesting career, including a stint at A.G. Edwards and the Central Intelligence Agency. You will be seeing his work in the coming weeks and we are excited to have him aboard.
Happy Monday! Erdogan loses big in the Istanbul “do over,” protests emerge in the Czech Republic and the markets are digesting the Iran situation. Here is what we are watching today:
Istanbul: After his party suffered a narrow loss three months ago in mayoral elections, President Erdogan claimed there were irregularities and this led to a second vote, which was held over the weekend. In a rather stunning development, the opposition candidate, Ekrem Immoglu, won in a landslide, taking 54% of the vote compared to 45% for the AK Party’s candidate. This loss is a blow to the Turkish president. He was once the mayor of the city and considers it a base of operations. In an equally interesting development, financial markets cheered the outcome, with Turkish equities and the lira rallying on the news. We suspect financial markets would like to see Erdogan’s power lessened so as to achieve less erratic policy.
Trouble in Prague: An estimated 250k protestors flooded Prague in Wenceslas Square, the same place where the Velvet Revolution started which led to the overthrow of communism. The protests were calling for PM Andrej Babis to resign on corruption issues. He appointed a crony to justice minister, which has raised fears that she won’t prosecute the PM for his alleged criminal activity.
Iran: In the aftermath of the president’s decision to scrub a bombing mission, here is what we are seeing:
The U.S. is opting for new sanctions and cyberattacks in lieu of limited airstrikes. The president also indicated he is open to talks with Iran on its nuclear program and sanctions. It is clear that President Trump wants to avoid escalation with Iran.
The decision to scrub the mission appeared to be due to a couple of factors. First, the president was concerned that the action was “disproportionate.” Although shooting down the drone was clearly a hostile act, no Americans died in the incident; that would not have been the case with U.S. action. Second, there are reports, not fully confirmed, that the missile strike on the drone may have been ordered by a lower ranking military officer in Iran and the Mullahs were not happy about the result.
The unknown factor is how Iran views U.S. behavior. If the Iranian leadership views this event as evidence that President Trump has no interest in a war but intends to keep sanctions in place, they may simply keep “upping the ante” until a military strike occurs. We would expect the U.S. to signal, through backchannels, that such a response would be a mistake. Nevertheless, it would not be unreasonable for Iran to take this position.
Iran has a myriad of ways to respond to sanctions. The two we are most concerned about would be a cyberattack on the U.S. and its allies, and/or actions in the Persian Gulf that would cause a rapid rise in oil prices. The first option is problematic because it may be very difficult to determine the source which would make it hard to retaliate. The second option can be managed through SPR releases, but the world economy is already fragile and a spike in oil prices might be enough to put the world economy into recession.
Another interesting facet of the Iran issue is that much of the rest of the world is looking at the 2020 elections and making the decision to stall and hope for a new resident in the White House. The EU appears to be doing just that with trade policy. However, in Iran’s case, it isn’t obvious if a new administration would make much of a difference. The Iran nuclear deal wasn’t a treaty because there was no way Congress would approve it. Going back to the old agreement will be a trick because why would Iran trust any American government?
Our market take is that recent events are bullish for crude oil and risk-on assets. The opportunity cost of aborting the bombing mission is that it may simply embolden Iran to act rashly and get away with it. We think this is a misread of Trump’s Jacksonian nature but, as noted in point #3, it would not be an unreasonable position to take.
Trade talks: There isn’t too much new on the trade front, although there is activity in front of the G-20 meeting this weekend. Our expectation is that we will see a promise to continue talking but a full deal probably isn’t possible.
Brexit:Boris Johnson had a tough weekend. There were reports of a domestic disturbance and Steve Bannon has apparently been consulting with the PM hopeful. Although we still expect Johnson to win, he isn’t really running on policy but on personality, so these reports are a problem for him. The vote of the Tory party members will occur on July 22. It appears the next PM will get to choose the new BOE Governor.
Italy gets a reprieve (of sorts): The EU has decided to delay any disciplinary actions against Italy to give more time for the Italian government to address its fiscal budget issues.
In 2017, we introduced an indicator of the basic health of the economy and added it to the many charts we monitor to gauge market conditions. The indicator is constructed using commodity prices, initial claims and consumer confidence. The thesis behind this indicator is that these three components should offer a simple and clear picture of the economy; in other words, rising initial claims coupled with falling commodity prices and consumer confidence is a warning that a downturn may be imminent. The opposite condition should support further economic recovery. In this report, we will update the indicator with May data.
This chart shows the results of the indicator and the S&P 500 since 1995. The updated chart shows that the economy did slip late last year but has recovered in 2019. We have placed vertical lines at certain points when the indicator fell below zero. It works fairly well as a signal that equities are turning lower, but there is a lag. In other words, by the time this indicator suggests the economy is in trouble, the recession is likely near or already underway and the equity markets have already begun their decline.
To make the indicator more sensitive, we took the 18-month change and put the signal threshold at -1.0. This provides an earlier bearish signal and also eliminates the false positives that the zero threshold generates. Notwithstanding, we will pay close attention when the 18-month change approaches zero as it did in January.
What does the indicator say now? The economy has decelerated but is not yet at a point where investors should become defensive. Breaking below the red line would be our signal to expect a broader downturn. Most likely, we are going through a period similar to what we experienced in 2016. If this is the case, and the economic data begins to improve, then equities should remain supported into H2.
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