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 Friday!  It’s the summer solstice today. In the news, an operation against Iran was about to start but was called off by the president.  There are elections in Istanbul over the weekend and the G-20 meets.  Additionally, the global ISM data was mostly steady to better than expected.  Here is what we are watching today:

Iran: As we noted yesterday, Iran has downed a U.S. drone.  President Trump warned Iran against such actions.   According to reports, the U.S. was about to conduct an air operation against Iranian targets but President Trump called off the action.  According to reports, the action was designed to target radar facilities that use missile or artillery against Persian Gulf shipping or aircraft (hence a response to the aforementioned drone attack).   It isn’t clear as to why the action was rescinded.   However, we do note that there is a key divergence within the administration, between hawks, such as Bolton and Pompeo, and the president himself, on such matters.  President Trump was to avoid deep involvements in the Middle East—and other areas too.  That isn’t how a superpower usually acts and is certainly not how the U.S. has behaved since the end of communism.  However, populists in the GOP oppose foreign interventions, while the establishment tends to support them.

So, where does this leave us?  Clearly, the potential for escalation is still in place.  Although, it also shows great reluctance to dive into a conflict.  We now await to see what sort of response we get from Tehran.  At the same time, we don’t know why the action was halted.  Was it due to something as simple as “cold feet?”  Did President Trump get information, perhaps from a foreign source, that led him to rethink the action?  We may never know but for now, the mere threat of a conflict will tend to support risk assets, such as oil, gold and the yen.

Trade talks: There isn’t too much new on the trade front.  China appears to be framing the discussion between Presidents Trump and Xi as occurring because the U.S. is asking for talks.  The trade teams have resumed negotiations.  The best outcome is the two leaders not only restart talks but make progress in a compromise deal.  The worst outcome is both leaders walk away from discussions and end trade talks.  The most likely outcome?  A freeze on new tariffs and a promise to return to negotiations in earnest.  The problem for both the U.S. and China is the easy parts have been discussed and fleshed out, while the remainder gets to core issues that will determine the direction of relations going forward.  Those issues are very difficult.  The other issued we are concerned with is both leaders may be overestimating the strength of their positions and thus feel no need to compromise.  We are assuming a neutral outcome, but the chances of a hard break are not insignificant.

Brexit: It’s now down to two candidates, Boris Johnson and Jeremy Hunt.  This outcome, in a sense, is already a win for Johnson, who likely didn’t want to face the formidable Michael Gove in the final vote.  There were rumors of “tactical voting” where Johnson supporters voted for Hunt to prevent Gove from winning second place; the outcome for second was close, with Hunt besting Gove by a mere two votes.  From here, the Tory party members will vote for a new PM.  We expect Johnson to win this vote on July 22.

EU woes:  The EU is in turmoil after being unable to agree on a new leader to replace Juncker.  In some respects, the leadership vote in the EU is in flux because the establishment is losing its grip on the union.  At the same time, the viciousness of the vote reminds us of an old line from Henry Kissinger, who once noted that “academic politics are so vicious precisely because the stakes are so small.”

Italy:  Deputy PM Salvini is threatening to resign if he doesn’t get his way for budget conflicts with the EU.  Salvini is trying to push through a tax cut that will lift the deficit and threaten to break EU budget rules.

Hong Kong:  Although the extradition bill has been postponed the city is preparing for another weekend of protests.  Apparently, protests are already underway.  With President Xi focusing on the G-20 and North Korea, the protestors likely have another weekend to act.  However, when Xi gets back to normal business, we will be watching to see how long he tolerates this behavior.  Investors will be taking notice as well. 

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

Happy post-Fed Day!  It’s all bullish today; equities are higher, bond yields are lower and gold is on a tear (and the dollar is weaker).  The only worry?  Iran claims to have shot down a U.S. drone, sending oil higher.  Here is what we are watching today:

The Fed: We were concerned the Fed would be hawkish.  It turns out our worry was unfounded.  In the statement, the word “patient” was removed and replaced with “uncertainties,” making it clear the balance of risks has moved from balanced to recession.  The statement also openly discussed acting to “sustain the expansion.”  Normally, one does not do that by raising rates.  As expected, St. Louis FRB President Bullard dissented, calling for a rate cut; this represents the first dissention in the Powell era.

The median dots look like this.

The dots show an interesting divide.  The median year-end rate hasn’t changed; it remains steady.  However, eight voted to push rates lower by year-end, eight are calling for no change and one still leans toward a hike.

Although it isn’t quite appropriate to use an average calculation with such a small sample size, it is interesting that the average is lower than the median because more dots are at the low end relative to the high end of the range.  The averages for this year and subsequent years show a dovish shift.

The large green dots show the March meeting and the red blocks are yesterday’s result.  There is a clear move downward in the average, although it is also clear the Fed doesn’t see a recession on the horizon and any cuts will be reversed in a couple of years.  That means the Fed thinks it can bring a soft landing.

The market reaction was consistent with dovish policy: yields fell, gold rose and the dollar declined.  Equities did rise later in the day but the initial reaction was modest.

What did Powell accomplish?  It was actually a move that Greenspan would appreciate.  He was able to bring a result consistent with a rate cut without actually making one.  The cost is that he will need to make a cut at the July meeting (which is not a quarterly meeting, when cuts have become traditional) or risk a significant market retreat.  If the FOMC doesn’t follow through on rate cuts, political pressure will rise and the bond market, which is rallying in part on expectations of future rate cuts, will reverse.

Iran: Iran has downed a U.S. drone.  Iran claims the plane was over its airspace, while the U.S. says it was in international air space.  Oil prices, which were lifting on dollar weakness, took another leg higher in response.  There are reports that the administration is suggesting ties between al Qaeda and Iran, raising fears of similar accusations that preceded the Iraq War.  We still doubt the U.S. and Iran will end up in a full-scale conflict, but the odds of a mistake rise when there is “ordinance in the air.”  One interesting sidelight—firms that provide private shipping security are seeing their business soar.

Trade talks: There isn’t too much new on the trade front.  China appears to be framing the discussion between Presidents Trump and Xi as occurring because the U.S. is asking for talks.  The trade teams have resumed negotiations.

At the same time: We note an interesting report that suggests China is taking steps to appreciate the CNY into the weekend meeting.  Some of this could be to temper capital flight, which is likely to accelerate from Hong Kong but could spread if the CNY weakens.  Yesterday, we noted that the White House hasn’t taken what we view as the most potent step to reduce the trade deficit, which would be a concerted effort to weaken the dollar.  Although dovish policy from the Fed would help in that process (check!), open jawboning by the president and his Treasury secretary could accelerate the process.  A weaker dollar and even modest tariffs would be an extremely powerful mix; we could see something akin to “Plaza Accord II.”

Brexit: It’s now down to four candidates; Rory Stewart did not get enough votes to survive.  Boris Johnson continues to dominate, with nearly three times more votes than the next two.  Although it’s not a done deal, it looks like Johnson will be one of the candidates when the Tory membership votes for a new PM.

Odds and ends: Budget fears remain elevated.  Reports suggest the deadlock in Venezuela has led the White House to lose interest.  The acting defense secretary may not be able to negotiate missile talks with Turkey.  Mexico has passed USMCA, the first of the three nations involved to do so.

Energy update: Crude oil inventories fell 3.1 mb last week compared to the forecast drop of 1.8 mb.

In the details, refining activity rose 0.7%, above the flat forecast.  Estimated U.S. production fell by 0.1 mbpd to 12.3 mbpd.  Crude oil imports fell 0.3 mbpd, while exports declined 0.2 mbpd.

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 seasonal patterns.   We should see continued inventory declines into September; it would be bearish if stockpiles start to rise again.

Based on oil inventories alone, fair value for crude oil is $47.45.  Based on the EUR, fair value is $52.69.  Using both independent variables, a more complete way of looking at the data, fair value is $49.87.  As oil prices move closer to fair value, the risk of a sharp rally from a geopolitical event is elevated.  Technically, oil prices are trying to stabilize, although they remain in a downtrend.  Overall, the bear case for oil is starting to “age” and we are probably heading into a period of recovery if oil inventories follow the usual seasonal pattern.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Juneteenth!  After a wild day yesterday, all is quiet before the conclusion of the FOMC meeting.  Here is what we are watching today:

The Fed: The Fed meeting concludes today.  We are expecting a hawkish tone, at least initially, from the statement and the dots.  This is based on our hawk/dove analysis.

This is our hawk/dove table.  We rank members from 1 to 5, with 1 being most hawkish and 5 most dovish.  We also note their leanings.  Moderates, doves and hawks all derive some guidance from the Phillips Curve structure, where doves use the structure to call for easing, while hawks call for tightening.  The moderates continue to use the structure but have less faith in it and are more willing to use discretion in deviating from it.  Our take is that the committee is dominated by moderates.  The financial-sensitive members follow the path laid by Jeremy Stein, former Fed governor and economics professor who has argued that the Fed needs to take financial markets into account when setting policy.  Fed policy since Greenspan has been to ignore bubbles, in theory, because they are too hard to determine either in advance or in real time, but, in practice, it’s because using monetary policy to end bubbles is politically fraught.  If a bubble occurs, the Fed should simply assist in the cleanup.  The financial sensitives argue that the costs of bubbles are too high to ignore; the rising equity market will tend to lead the financial sensitives to hold off on cutting rates.

To move the dots chart median lower, we would need to see a minimum of eight members vote for a rate cut.  The March dot plot had 10 members vote for steady policy, with six looking for hikes.  It would be a huge reversal for any of those calling for a rate increase in March to shift to a cut in June, so it makes sense that we would need to see a minimum of eight members move from a steady posture to a cut in order to move the average dot lower.  That shift is unlikely.  We will see some move in this direction; Bullard, Kashkari and Daly will likely signal a cut.  Bostic might change due to his earlier discussions of the yield curve.  However, the moderates have mostly signaled steady.  We doubt Powell will tip his hand toward a cut.  The “financial sensitives” will worry that moving to cut rates will trigger a market bubble, so they will likely hold their fire as well.  Thus, the median dot may signal steady policy but not a cut.

Now, let’s look at the actual voters.  We would expect all the moderates to vote for no change.  The financial-sensitive voters will also likely vote for no change, worried about the behavior of the asset markets.  The traditional hawks won’t move either, so the only one to likely vote for a cut is Bullard.  We expect the Fed meeting to yield the removal of a rate hike from the dot plot, with no change in rates and one dissent for a rate cut.  Powell’s press conference will be more dovish than the materials offered.  Overall, the Fed will likely disappoint but the financial markets feel pretty confident that the economy is weakening, therefore we still expect risk-on assets to digest the bearish news without serious incident.

A couple of new twists to the meeting occurred yesterday.  As we noted, ECB President Draghi indicated that, without a rise in inflation, the Eurozone bank is prepared to add stimulus.  This news caught the attention of President Trump, who suggested the easing was being done to deliberately weaken the currency.  Although establishment economists defended Draghi, the president isn’t wrong about his assessment; additional stimulus will likely weaken the EUR.  It may not have been Draghi’s intent but there is no doubt that additional stimulus would likely depress the currency.  We suspect the president is using Draghi’s speech to further pressure the FOMC to cut rates.  The second twist came from reports that the president had inquired about the legality of demoting or removing Chair Powell.  It’s clear the president is pressuring the Fed to cut rates to maintain the expansion; what isn’t clear is if the pressure will hurt or help his efforts.

One issue that has surprised us thus far is that the president hasn’t used all the stimulus tools at his disposal; currency policy is set by the Treasury and he could demand that Mnuchin begin intervening in the currency markets to depress the dollar.  Although Fed cooperation would be helpful in this effort, it isn’t necessary.  So far, the president has avoided anything that would weaken the greenback; we remain mystified as to why he hasn’t taken this route.

Trade talks: The other item that lifted risk assets yesterday were reports that Presidents Trump and Xi will meet at the G-20.  Although unconfirmed, China has suggested that “Trump made the call” suggesting the U.S. wants the deal more than China.  This has raised hopes that a deal might get done.  We have serious doubts this is possible, because trade policy has now become tied to national security policy.  We note reports from firms looking to move their supply chains from China as evidence that companies are viewing the relationship as irrevocably changed.

Investor pessimism: A recent survey suggested that fund managers are unusually defensive, almost preparing for recession.  We have noted levels of retail cash consistent with recession or even financial crisis.

This chart shows the S&P and the level of retail money market funds.  The latter has reached a new record for this business cycle.  The economy was in recession the last time money market funds were at this level.  This pessimism highlights the Fed’s problem, especially for FOMC members who are financial sensitives.  If the Fed cuts rates and it lifts investor sentiment, then a melt-up is possible, if for no other reason than there is ample liquidity and it might find its home in equities if confidence returns.

Iran: The tensions between Iran and the U.S. are putting Europe in a bind.  The U.S. is pressing for the EU to adopt the U.S. sanctions regime, while Iran wants the EU to circumvent U.S. financial sanctions.  The EU realizes it does not want to fall afoul of U.S. financial sanctions.  It also hopes Iran doesn’t exceed the terms of the agreement on uranium enrichment; if the EU finds that Iran is out of compliance, the JCPOA is dead.  In the end, we expect the EU to support the U.S. with great reluctance; the costs of siding with Iran are simply too great.

Hong Kong: Carrie Lam has offered a formal apology, but it hasn’t been enough to placate the protestors.  Chairman Xi’s usual modus operandi would be a crackdown.  However, that may not be possible in the current environment.  We can only conclude that Beijing overplayed its hand with the extradition bill, mistakenly believing the specifics of the case that led to the bill would hide the underlying goal.  We would look for Xi to bide his time and a crackdown will come when it is more opportune.

Facebook (FB, 187.01) into crypto: Facebook announced that it is creating a new token to facilitate payments in the social media platform.  The best analysis of this move we have seen is here and here.  We note that regulators are watching this with interest; it has attracted the attention of Congress as well.

Brexit: After yesterday’s Tory MP vote, we are down to five PM candidates.  Boris Johnson continues to lead.  The biggest gainer was Rory Stewart, the only candidate still indicating he won’t support a no-deal Brexit.  Johnson did hint at snap elections if he wins, which is a risky strategy; however, to bring a deal, he needs a bigger majority and that might not be a bad plan given the divisions within the Labour Party.

Odds and ends: The EU has delayed a decision on adding Albania and North Macedonia to the group.   There is growing fear of a budget crisis in September.  China’s home prices are surging, complicating stimulus plans.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Good morning!  It’s a risk-on morning following a speech by ECB President Draghi.  The Fed meeting starts today.  Here is what we are watching today:

Draghi: The Eurozone is holding meetings in Sintra, Portugal; these meetings are considered this region’s equivalent of the Jackson Hole meetings for the Fed.  At this meeting, ECB President Draghi suggested additional stimulus if the economy fails to reach its inflation target or increase growth.  His speech was dovish.  What is interesting isn’t that Draghi gave a dovish talk; after all, he has made numerous stimulative moves in his tenure, which ends in October.  What we find surprising is that the markets have taken the news as completely unexpected.  Equities jumped on the news, gold rallied and sovereign yields tumbled.  German 10-year Bunds dropped to -32 bps[1] and French 10-year sovereigns fell to 0% for the first time in history.  Even President Trump weighed in, with a less than subtle nudge to Jay Powell.

The Fed: The Fed meeting begins today.  A rate cut isn’t expected today, but the markets will be looking for “tells” that signal future easing.  The chances of disappointment are high.  Take a look at our hawk/dove table.

To move the dots chart median lower, we would need to see a minimum of eight members vote for a rate cut.  The March dot plot had 10 members vote for steady policy, with six looking for hikes.  It would be a huge reversal for any of those calling for a rate increase in March to shift to a cut in June.  To move the median dot lower, you would need a minimum of eight members to move from steady to cut, which is unlikely.  We will see some move in this direction; Bullard, Kashkari and Daly will likely signal a cut.  Bostic might change due to his earlier discussions of the yield curve.  However, four members changing their vote to ease won’t be enough to lower the median dot to signal a cut. Among the rest, the moderates have mostly signaled steady policy.  We doubt Powell will tip his hand toward a cut.  The “financial sensitives” will worry that moving to cut rates will trigger a market bubble, so they will likely hold their fire as well.  Thus, the median dot may signal steady policy but not a cut.

Now, let’s look at the actual voters.  We would expect all the moderates to vote for no change.  The financial-sensitive voters will also likely vote for no change, worried about the behavior of the asset markets.  The traditional hawks won’t move either, so the only member to vote for a cut will likely be Bullard.  We expect the Fed meeting to yield the removal of a rate hike from the dot plot, with no change in rates and one dissent for a rate cut.  Powell’s press conference will be more dovish than the materials offered.  Overall, the Fed will likely disappoint but the financial markets feel pretty confident that the economy is weakening, therefore we still expect risk-on assets to digest the bearish news without serious incident.

Iran: The U.S. announced that another 1,000 troops will be sent to the Middle East.  Although this has raised worries, in reality, this move is not much more than posturing.  If a real war was brewing, tens of thousands would be sent; invading Iran would likely need 300k to 400k to secure the country.  As we noted in this week’s WGR, Iran is much larger than Iraq with a greater population and difficult terrain.  Moving 1,000 troops is a signal for concern but not an indication of imminent military action of consequence.  Meanwhile, Iran is moving to increase its uranium enrichment activities, which will turn Europe against Tehran.  While the hawks in the administration continue to push for a conflict, we suspect the president really does want to negotiate.  This sort of fits the pattern with North Korea, which was to bluster and threaten, then talk.  The problem is that, from Iran’s perspective, it’s hard to see how the Americans can be trusted from administration to administration.  After all, if Tehran concludes that Trump may not win in 2020, it will likely take its chances on the next administration.

It is also worth noting that a Navy analyst noted that Iran’s placement of limpet mines above the waterline of the tankers was designed not to sink but to damage.  This suggests Iran isn’t going to war (sinking a vessel in the Strait of Hormuz would be a big deal) but is posturing.  We are further from a hot war than the media would suggest.

Hong Kong: China is continuing to back Carrie Lam despite the protests.  With the G-20 meeting coming this weekend, we doubt Beijing will move against the former British colony.  However, given Xi’s history, he won’t accept this behavior much longer.

Facebook (FB, 187.01) into crypto: Facebook announced it is creating a new token to facilitate payments in the social media platform.  The best analysis of this move we have seen comes from here and here.  We note that regulators are watching this with interest.

Odds and ends: There is some speculation that Xi’s visit with Kim might be a play to restart nuclear talks.  This could be a way to offer a win for President Trump that may help China on trade.  On trade, China is trying to suggest the U.S. needs a deal more than it does, perhaps reacting to growing business sector criticism of the president’s trade policy.  Egypt’s former president, Mohammed Morsi, died in court yesterday.  The GBP is falling on fears that Boris Johnson will bring a hard Brexit.  Russia is starting to back away from support for Venezuela’s President Maduro due to the continued downward spiral of the Venezuelan economy.

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[1] Fahrenheit financial freezing?

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

Happy Monday!  Tensions remain high with Iran, and protests expanded in Hong Kong. Meanwhile, it’s central bank week, with the Federal Reserve as the headliner.  Here is what we are watching today:

Iran:  Hawks are calling for military strikes against Iran.  However, there is no evidence of the significant build-up that one would expect before a major operation.  For example, there is only one aircraft carrier group in the region; three would be required for 24/7 operations.  Meanwhile, Iran continues to hew to a belligerent tone, threatening to breach uranium limits of the Iran nuclear deal (JCPOA).  Another factor is the high level of skepticism surrounding the U.S. evidence of Iran’s mining of the tankers.  This skepticism is, in part, due to previous intelligence missteps, including the Bush administration allegations of an Iraqi nuclear program, which was never found.  The allegations were a major reason for the incursion into Iraq.  Even the video evidence has been called into question.

To some extent, how this plays out is more a function of who has power within the Iranian regime and the Trump administration.  In the latter, SoS Pompeo and National Security Director Bolton are pressing the hawkish case; in Iran, the Islamic Revolutionary Guard Corps (IRGC) are likely pressing for confrontation.  President Trump has made it clear he doesn’t support a lengthy military involvement in the region and we suspect that, in the end, he will win out.  At the same time, the hawks in Iran can also make this calculation and try to force the U.S. into either (a) an unwanted escalation, or (b) backing down and looking weak.  Since President Trump is a Jacksonian, he won’t easily take option (b) so some sort of middle ground will be sought.  Our expectation is that the U.S. will begin escorting tankers in the Persian Gulf, and if Iran attacks those vessels then the U.S. will attack Iran’s naval facilities along the Persian Gulf.  But, we don’t expect a full-scale attack on Iran’s nuclear facilities or against civilian targets.  This assessment appears to be the oil market’s take too, as oil prices are lower this morning despite the tensions.

Hong Kong: Mass protests continued over the weekend despite the Hong Kong government’s decision to postpone the vote on the extradition bill.  Even an apology didn’t ease tensions.  Protestors have increased their demands, with some now calling for Carrie Lam, Hong Kong’s chief executive, to resign.  It is clear that Lam misjudged the reaction but so did Beijing.  We continue to watch how Chairman Xi reacts to these events.  The protests are a clear challenge to his authority. A massive crackdown, similar to Tiananmen Square, would lead to a major international reaction and force not just the U.S. but other western nations to apply economic sanctions on China, at a minimum.  We expect the authorities in Hong Kong and Beijing to try to wait out the protests; however, if Lam is forced to resign, it will create a very uncomfortable precedent for Beijing and President Xi.

The Fed: Although the BOJ and BOE also meet this week, the real “big deal” is the FOMC meeting.  First, our expectations are for no rate cut, a decline in the dots chart to reflect no more rate hikes and a potential dissent if the vote is for no-action by the Fed.  Second, Chair Powell must navigate financial markets that are pressing for rather aggressive easing going forward.  Fed funds futures have discounted an 87.9% chance of at least two rate cuts by year’s end.  In fact, the futures markets have an 85% chance of a cut at the July meeting.  By the October meeting, the odds of a target rate below 2% are 77.9%.  The analog being offered is 1995, one of the three soft landings engineered by the FOMC.

For the Fed, there are two concerns.  First, rate cuts that avoid a recession would likely trigger an asset rally.

This chart shows the P/E ratio and the Fed funds target.  The P/E was a rather pedestrian 15.6x when the “insurance” cut occurred.  By July 1998, the ratio had hit 25.4x; the rate cuts that occurred during the Long-Term Capital Management Crisis sent the multiple to 28.5x.  Simply put, rate cuts could trigger a flight to risk assets that would raise worries for the Fed, especially in an era of populism.  In other words, the rate cut may not help the average American very much, but it could be a boon for the wealthy. Second, the president has made it clear that his relentless criticism of the central bank will continue.  The worry for the Fed is that its independence would be questioned if it appears the central bank cut rates under duress.  That implication would raise serious concerns about the bank’s ability to make difficult rate decisions during inflation periods.  Thus, the Fed will be trying to “thread these needles” the rest of the year.

China trade news: Commerce Secretary Ross made it clear that a trade deal won’t happen between China and the U.S. at this weekend’s G-20 meeting in Japan.  About the best one can hope for would be that a face-to-face meeting between the two leaders might restart talks.  Meanwhile, there is a good bit of behind-the-scenes jockeying among political and business leaders.  We note that President Trump delayed a planned speech by VP Pence, likely concerned that a hostile presentation would undermine any chance of fostering better relations going into the G-20.  U.S. chipmakers, concerned about losing Chinese customers, are lobbying to ease the Huawei (002502, CNY 3.45) ban.  U.S. firms, especially retailers, are warning that another round of tariffs will be damaging for the U.S. economy.  At the same time, some Chinese firms, much like what Japanese firms did in the late 1980s, have started to move some operations to the U.S.

Turkey news: This weekend, the redo of the mayoral elections in Istanbul will be held.  The candidates held a debate over the weekend, and the opposition candidate continues to hold a narrow lead in the polls.  Moody’s downgraded the country due to recent turmoil.

OPEC: OPEC ministers continue to try to boost prices with promises to cut production in the second half of this year.  So far, the markets are more concerned about rising U.S. inventories and weakening global demand.

Odds and ends:  Congressional leaders are continuing to meet to head off an autumn budget crisis.  So far, not much progress has been made.  There was a massive power outage in South America yesterday.  It isn’t clear what caused it, although cyber sabotage has not been ruled out.  U.S. cyber officials have indicated they have infiltrated Russia’s power grid.  It isn’t completely clear why such information would be published.  The article made a point to mention that President Trump wasn’t told of the operation.  Volkswagen (VWAPY, 15.78) workers in Tennessee rejected an effort by the UAW to unionize the plant.  China is cracking down on the “underground railroad” that facilitates North Koreans who leave the Hermit Kingdom for China and beyond.  Chairman Xi is scheduled to make a visit to Pyongyang on Thursday, the first visit by a Chinese leader to North Korea in 14 years.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Flag Day!  Tensions remain high with Iran and protests continue in Hong Kong.  Here is what we are watching today:

Pompeo blames Iran: Yesterday, we reported that two tankers were attacked in the Gulf of Oman.  SoS Pompeo has assigned blame to Iran.  Pompeo suggested the attack was delivered by divers attaching limpet mines to the tankers.  The U.S. Navy provided video giving strong evidence that Islamic Revolutionary Guard Corps (IRGC) commandos were removing previously attached limpet mines.  This action by Iran is a significant escalation; the U.S. is taking the matter to the UNSC but, given that Russia and China have veto power, we doubt the U.N. will do anything.  We note that Iran continues to dispute the U.S. claim that Tehran is responsible for the attack.

The attack does seem oddly timed.  Japan’s PM Abe was in Iran trying to ease tensions; to attack two vessels with cargoes en route to Japan seems to send a belligerent message.  One possibility is that rogue elements within the IRGC, wanting to prompt escalation, moved without authorization.  If this is the case, we could see reports in the coming weeks of officials in the Corps being demoted or retired.  The IRGC’s power has been increasing in recent years and it could be that elements of the group want to challenge the leadership of the clerics.  We will be watching for evidence of this theory in the coming weeks.

So, with conditions escalating, why aren’t oil prices soaring?  We suspect the next step will be for the U.S. and allies to send military escort vessels to the region as was done in the “tanker war” during the Iran-Iraq War.  Although the escorting process is expensive and will slow shipping out of the Gulf, it will prevent escalation (it would be foolhardy for Iran to directly attack U.S. Naval vessels) and keep the waterways open for shipping.

Worries about global demand are also pressuring prices.  The IEA cut its forecast for 2019 crude oil demand by 0.1 mbpd to 1.2 mbpd, blaming worsening trade conditions.  We note that China’s May industrial production came in weaker than forecast (5.0% vs. 5.4%), and fixed investment eased to 4.3% in May from 5.7% in April on a year-to-date basis.  Weakening economic growth in China will obviously dent oil demand and may lead the IEA to make further cuts in demand estimates.

Next week’s WGR looks at the issue of war with Iran.

Hong Kong: Another mass rally is planned for this weekend.  We note that Chairman Xi has been touring central Asia during the recent uprising.  As he returns to Beijing, we continue to watch to see if China’s calm response to the protests continues.  The Chinese leader has a hardline reputation and we can’t see him tolerating this insolence much longer.  At the same time, a highly visible crackdown will almost force the Trump administration to react with trade sanctions and could scuttle any chances of a deal at the G-20.  Other actions are being considered as well.  Therefore, this weekend could be key to the upcoming talks.

China trade news: China announced new anti-dumping measures against U.S. and European steel pipes and tubes.  Although China has indicated it wants to move up the tech value chain, it apparently has a serious gap in semiconductors that will severely hamper its desire for tech independence.  Six-hundred companies have issued a public letter to the White House asking for the president to resolve the trade dispute with China.

Brexit: Boris Johnson is the front-runner to replace PM May.  Although a no-deal Brexit is still being considered, the risks of such an event for the U.K. economy are significant.

Odds and ends: Social media firms have been granted relief from legal liability stemming from posts on their sites.  Congress is apparently revisiting this relief and considering if the legal protections should be reduced or removed.  If the law is changed, it could open up these firms to legal liability for the content on their platforms.  A recent survey suggests that 23% of households believe they are still worse off than they were before the financial crisis.  With the expansion nearing record levels, the high number of those still feeling left behind could trigger a strong social reaction in the next downturn if conditions don’t improve further.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

Good morning from the new home of the Stanley Cup!  Two oil tankers were attacked in the Gulf of Oman overnight.  Large protests continue in Hong Kong.  Here is what we are watching today:

Tanker attacks: Two oil tankers, one licensed in the Marshall Islands and the other from Panama, were attacked in the Gulf of Oman, just south of the Strait of Hormuz.  Both were carrying hydrocarbons en route to Japan.  Although we don’t know who is responsible for the attack, initial suspicions will point to Iran as the culprit.  However, the timing would be odd if Iran was the source of the attack; PM Abe is in Tehran for a two-day visit.  Attacking vessels bound for Japan would either be a ham-fisted threat from Iran or perhaps a warning to Tokyo from a nation other than Iran against cooperating with Tehran.  Or, the attack may have been done by an Iranian proxy whose interests do not fully align with Tehran.  For example, it wouldn’t be a shock that the Houthis might consider such an attack to hurt Saudi Arabia, or some unit within Iran has decided to go rogue.  According to reports, it appears the tankers were hit with some sort of artillery shell.  Oil prices jumped on the news.

We will be watching to see the U.S. reaction to the attack.  In a tanker attack last month, National Security Director Bolton blamed Iran for the attack but offered no clear evidence to back the claim.  At the same time, Iran has a clear incentive to trigger such attacks; as shown on the chart below, its oil exports have plunged and higher oil prices are one way to strike a blow against the Trump administration.

Hong Kong and the trade war: The island’s legislature has postponed a vote on the controversial extradition rule but that hasn’t led to any reduction in protest activity.  Meanwhile, there is little evidence that either China or the U.S. is preparing for a breakthrough on trade talks.  In fact, there is growing concern in China that Trump will use the Hong Kong situation for leverage in talks.  Vice Premier Liu, who has been leading the Chinese delegation on trade talks, called for additional stimulus, suggesting he doesn’t expect an agreement.  If no deal is reached, we would expect the U.S. to increase tariffs on China  at some point, both in terms of the level of the tax and the breadth of products.

A Brexit update: The Tories are in the midst of their leadership elections.  Ten candidates will be winnowed down to two in a series of votes among the Conservatives in Parliament.  The first vote, held earlier today, has reduced the field to seven.  The next round will be held in five days.  In that round, the cutoff is 32 votes.  If necessary, ballots will be cast the following two days until two candidates remain.  Then the 160,000 members of the Conservative Party will vote on the two remaining candidates and the winner becomes PM.

The problem for the candidates is that the MPs oppose a hard Brexit and want some sort of middle path to leaving, but the Conservative members want Brexit now and do not fear a hard Brexit.  So, to win in Parliament, a candidate must suggest he or she isn’t a fan of a hard Brexit, but in the hustings, a hardline is more popular.  Thus, expect a good bit of inconsistency from the candidates.  We do note that a Labour-sponsored bill to prevent a hard Brexit failed, so that outcome is still possible.

Europe: Poland’s leader visited the White House yesterday and President Trump warmed to the idea of boosting troop strength in that European nation.  Later in the day, President Trump threatened Germany with sanctions if it didn’t end the Nord Stream 2 natural gas pipeline project.  Although it isn’t completely clear, the president seemed to suggest that the new troops to Poland could come from Germany.

There are two takeaways from this event.  First, for Western Europe, the shift of the Russian buffer region eastward made cooperating with the U.S. less important.  Without the Eastern Bloc to fear anymore, Western Europe felt it could defy the U.S.  Consequently, the Europeans didn’t support the Bush administration in Iraq, for example.  A decline in enthusiasm for basing American GIs in Western Europe was also evident.  On the other hand, the former nations of the Warsaw Pact that are still familiar with the tender mercies of Russia are more than happy to offer support for the presence of American troops to prevent a return of the Russians.  Thus, there is a division within Europe regarding how to deal with the U.S. and Russia.  Second, both actions from yesterday will clearly be unpopular with Moscow.  Russia does not want a large American troop contingent closer to its border and wants the U.S. to allow it to make commercial deals with European nations without interference.  Therefore, expect some negative reaction from Russia in response to yesterday’s developments.

Mankiw Rule update: The Taylor Rule is designed to calculate the neutral policy rate given core inflation and the measure of slack in the economy.  John Taylor measured slack by the difference between actual GDP and potential GDP.  The Taylor Rule assumes that the Fed should have an inflation target in its policy and should try to generate enough economic activity to maintain an economy near full utilization.  The rule will generate an estimate of the neutral policy rate; in theory, the central bank should raise rates if the current fed funds target is below the calculated rate.  Greg Mankiw, a former chair of the Council of Economic Advisers in the Bush White House and current Harvard professor, developed a similar measure that substitutes the unemployment rate for the difficult-to-observe potential GDP measure.

We have taken the original Mankiw Rule and created three other variations.  Specifically, our model uses core CPI and either the unemployment rate, the employment/population ratio, involuntary part-time employment and yearly wage growth for non-supervisory workers.  All four compare inflation and some measure of slack.   Here is the most recent data:

This month, the estimated target rates were little changed.  Three of the models still suggest the FOMC is behind the curve and needs to be increasing the policy rate.  However, the employment/population ratio suggests a rather high level of slack in the economy and would indicate that the Fed has already lifted rates more than necessary.  The Mankiw Rule array gives those FOMC members who still ascribe to the Phillips Curve enough information to maintain a steady stance on policy.

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