by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT] Good morning!  Other than oil, most markets were lower this morning in front of Powell’s testimony.  However, in the wake of his prepared remarks, U.S. equity futures have rallied.  Precious metals are up, the dollar is down and Treasuries are flat.  Here is what we are watching today:

Powell: The Fed has released the chair’s prepared remarks.  There were no major surprises; it looks like the FOMC will likely cut rates at the end of July.  The path of policy from that point is still uncertain but we can safely say this tightening cycle is probably about done.  Financial and commodity markets are taking the tone as dovish.

The only new twist we have to the testimony today is an ominous signal coming from the New York FRB.  It has a recession indicator based on the yield curve and its most recent number is signaling recession.

In the past, a reading above 30 has correctly signaled recession.  We like to pair this indicator with another recession indicator from the Atlanta FRB based on GDP.  The latter acts to confirm the signal from the New York index.  We have not gotten confirmation yet, but the New York indicator on its own should give the FOMC enough evidence to at least make an “insurance cut.”

Although the administration continues to be critical of Powell’s conduct of monetary policy, he has rather firm support on Capitol Hill, likely because of Powell’s good relations with members.  Thus, the White House may face strong opposition to any moves to fire the Fed chair.

Mexico’s finance minister resigns: Finance Minister Carlos Urzúa resigned unexpectedly yesterday, citing “many disagreements over economic policy” between himself and President López Obrador and accusing the left-wing, nationalist president of making economic decisions based on extremist ideology.  In a press conference this morning, President López Obrador said he can’t rule out further resignations from his cabinet, but that his government would continue to work toward its goals.  Although Mexican equities and the peso fell on the news, the damage was limited by the president’s decision to replace him with Deputy Finance Minister Arturo Herrera, a respected NYU economist with experience in both the government and the World Bank.  All the same, the episode has rekindled investor concerns that Mexican economic policy could become more radical in the coming years.

U.K. news: The two leading Tory candidates held a debate last night.  Jeremy Hunt needed a “knockout” to seriously threaten Johnson’s candidacy, but it doesn’t look like he landed any major blows to the front-runner.  Worries about a no-deal Brexit continue to rise, leading to a steady decline in the GBP.  Acting Deputy PM Lidington warns that a no-deal Brexit could lead to a breakup of the United Kingdom.

Meanwhile, Britain’s ambassador to the United States, Kim Darroch, submitted his resignation today amidst a dustup surrounding leaked diplomatic cables in which he referred to the Trump administration as “inept.”  Sources say Darroch’s decision came after he watched a televised debate between the Conservative Party’s two remaining candidates for prime minister, Jeremy Hunt and Boris Johnson.  In that debate, Hunt offered a robust defense of Darroch, promised to keep him in place if he became prime minister and demanded that President Trump treat the U.K. with respect.  In contrast, front-runner Boris Johnson equivocated on Darroch’s future.  While the incident may seem like largely an internal issue for the British government, it offers strong evidence that Johnson would prioritize good relations with the Trump administration if he wins the prime minister’s job as expected.

U.S.-China trade talks: There are reports that President Trump has toned down his support for Hong Kong protestors in order to support trade talks.  That move is consistent with a report this week that the departing U.S. consul general in Hong Kong was told to tone down several critical comments about China in his final speech in the city.  Coupled with the fact that Hong Kong’s government still refuses to definitively withdraw an unpopular bill that would allow extradition from Hong Kong to China, and that protestors continue to agitate for Hong Kong Chief Executive Lam to resign, we suspect a U.S. promise to look the other way will help encourage President Xi and the Chinese leadership to keep a Hong Kong crackdown on the table for now.

Meanwhile, the Chinese are claiming that General Secretary Xi did not make a firm pledge to buy U.S. agricultural products.  In a concession to China arising from the Trump-Xi meeting at the G-20 summit, U.S. Commerce Secretary Wilbur Ross announced yesterday that licenses would be issued to U.S. firms seeking to sell any products to Chinese telecom firm Huawei (002502.SZ, $4.41) that do not present a “threat to national security.”  Both sides are trying to suggest the other has a greater need to capitulate.  Although China is putting on a brave face, there is growing evidence that China is starting to show signs of trouble from the trade conflict.

Other China news: Despite continued increases in food prices (up 8.3% from last year), overall CPI rose 2.7%.

Due to the African Swine Fever crisis, we do expect the trajectory of food prices to continue higher but the PBOC will likely view these price hikes as transitory and maintain easy policy.

Iran: In yet another sore point between Iran and the West, Iranian President Rouhani warned that the U.K. will face unspecified consequences for its seizure last week of an Iranian oil tanker that was purportedly carrying crude to Syria in violation of European Union sanctions.  Hardliners in Iranian media have called for the government to retaliate by stopping British tankers from operating in the Strait of Hormuz.  In a sign that at least some shipping officials are taking that threat seriously, reports yesterday said at least one British tanker sought shelter in a Saudi port yesterday in order to avoid transiting the passage.

European Union: In updated economic projections, the European Commission maintained its forecast that Eurozone gross domestic product (GDP) would grow a tepid 1.2% in 2019 as the stronger than expected growth in the first half would be offset by weakening momentum in the second half.  The forecast for 2020 was unchanged at 1.4%.

The European refugee crisis:As Italy and Greece harden their borders against refugee flows from North Africa, vessels bearing these souls are finding their way to other European island nations in the Mediterranean.  Cyprus and Malta have become new waystations.  However, both are small nations with limited resources so they are trying to manage the crisis in an ad hoc manner.  Malta usually only accepts seaborne refugees if other EU nations agree to take them in.  Cyprus’s handling of the situation is even more convoluted given the divided status of the country.  The northern part of the island, controlled by Turkey, mostly allows refugees easy access from Turkey.  Turkey does have an agreement with the EU to control the flow of refugees from the Turkish mainland but doesn’t enforce it in Northern Cyprus.  Once in Northern Cyprus, the refugees cross into the southern part of the island which is part of the EU.  Because Cyprus doesn’t have the resources to manage the influx, it is also trying to get other EU nations to voluntarily accept new refugees.

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by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT] Good morning!  It’s an “everything down day” this morning, with both risk-on and risk-off asset values lower.  Most likely this is position-squaring in front of Powell’s testimony.  Here is what we are watching today:

Powell: There isn’t too much more to add that we didn’t discuss yesterday in terms of the testimony.  If the FOMC wants to disabuse the markets of their expectations of a rate cut later this month, this is the best opportunity.  However, we seriously doubt Powell wants to do that; the actions in the financial markets alone are enough to warrant a rate cut.

This chart shows the implied three-month LIBOR rate from the two-year deferred Eurodollar futures contract and the fed funds target.  We have placed vertical lines at the points of inflection.  The upper line shows the spread.  The genius of Greenspan was to cut rates as soon as the spread broke zero.  By doing so, he was able to engineer the longest expansion in history up to that point.  In this expansion, the Fed hasn’t faced a similar threat…until now.  The last time the FOMC ignored this signal we had the 2007-09 recession.  With inflation dormant, the Fed would be reckless not to cut rates.

Art Laffer, who recently was granted the Presidential Medal of Freedom, told CNBC that the case for central bank independence isn’t logical.  This is the position most economists held after WWII; the idea was that policy would be more effective if fiscal policy and monetary policy were coordinated.  It was a real surprise that William M. Martin was able to convince President Truman to give the Fed independence from the Treasury.  The reason for central bank independence is that politicians can’t be trusted to contain inflation.  The political class is always worried about the next recession and will always tend to lean toward stimulus now, austerity later.  It does stand to reason that in a world where inflation has been low for a long time, the rationale for central bank independence is being forgotten.  We don’t view this development as an anomaly but a trend; the lessons of high inflation are steadily being lost as the generations that suffered from it pass this earthly plane.  Simply put, the attack on independence isn’t just a Trump issue.  We will be watching to see how Europe handles this issue.  The fact that a German didn’t get the ECB presidency is a potential sign that hard money policies are falling from favor everywhere.

The dollar scare: Currency markets tend to be difficult for most investors; as an asset, it has no generally accepted valuation metric and, under floating rates, can only be valued in relation to other currencies.  Thus, a nation cannot always unilaterally weaken its currency if other nations match the actions of that country.  In the 1970s, when dollar and pound weakness was endemic, the Germans, but especially the Swiss, maintained relatively hard money policies and their currencies appreciated strongly.  It has become clear that President Trump wants to bring a weaker dollar.

There is an old trilemma in international economics sometimes called the “impossible trinity.”  Assume there are three goals:

1. A fixed exchange rate;
2. Independent monetary policy;
3. Free capital flows.

The impossible trinity states that a nation can have two of the three, but not all.  So, if a nation wants free capital flows and a fixed exchange rate, then its monetary policy must adjust to maintain the exchange rate and is no longer independent.  If a nation wants a fixed exchange rate and independent monetary policy, then it needs to restrict foreign flows.  With independent monetary policy and free capital flows, policymakers must accept floating exchange rates.

The U.S. currently operates with the latter combination; we have independent monetary policy and free capital flows with a floating exchange rate.  President Trump seems to be leaning toward a different set of objectives—free capital flows and a fixed exchange rate, forcing the Fed to give up its independence.  In other words, the president wants a weaker dollar and he can’t have that without gaining control of monetary policy, too.  The president has tools to weaken the dollar.  He could openly intervene in the currency markets, using dollars to buy yen, euro, etc.  However, if the Fed offsets intervention with tighter policy (sometimes called “sterilization”), then the action will be for naught.

What is potentially unsettling for financial markets is that we could see a widespread move by nations to simultaneously and unilaterally attempt to weaken their currencies.  The last time we saw something similar was in the 1930s under conditions of fixed exchange rates and devaluations against gold.  The outcome was economic nationalism and dramatically reduced global trade.  The potential for a return to 1930s currency policy is probably underappreciated by the financial markets because it is so difficult to sort out the outcomes.  One could argue that we faced a similar situation in the mid-1980s; at that time, the monetary austerity policies of the Volcker Fed led to a very strong dollar that seriously undermined U.S. competitiveness.  The U.S. convened a meeting at the Plaza Hotel in New York and the outcome was a coordinated effort to weaken the dollar.  An interesting sidelight to that meeting is that Chinese leaders believe it was the beginning of the end of Japan’s economic rise and they fear that the U.S. wants to do the same thing to China.  The U.S. was able to essentially force cooperation because all the parties to the agreement were dependent on the U.S. for security.  The conditions for a “Plaza Accord II” are less optimal; the Chinese have no interest in participating in a program they believe is designed to contain their economy and the shadow of the Soviets no longer forces Asian and European cooperation.

We don’t know exactly how it would play out if the U.S. decides to make a unilateral and concerted effort to weaken the dollar.  The likelihood of foreign cooperation is low.  The Fed would probably have to be coerced to participate.  But, if the administration is successful, we could potentially see extreme volatility in foreign exchange rates that would make trade and investing difficult and could, paradoxically, foster dollar strength as foreigners move to accumulate dollars as a store of value.  One thing is for sure—gold would do well.  We note that the PBOC added gold to its reserves for the sixth consecutive month.

U.S.-China trade talks: According to a U.S. official, senior U.S. and Chinese trade negotiators are due to speak by telephone this week in an effort to get the trade talks on track again and set up a series of face-to-face meetings in the near future, likely in Beijing.  However, most observers seem to see little evidence that either side is ready to significantly change its demands.  Little near-term progress is expected.  In fact, China expert Derek Scissors, who works at the American Enterprise Institute and has served as a consultant to the Trump administration, was quoted by Reuters today as saying, “I expect this to drag out for months.”

Taiwan: The U.S. government has approved a $2.2 billion arms sale to Taiwan, consisting of 108 Abrams tanks, 250 Stinger missiles and related equipment.  The sale is the biggest to Taiwan since President Trump took office, and news of it came just days before Taiwanese president Tsai Ing-wen is due to make an unusual two-day visit to New York.  The sale and visit are the latest in a series of moves the Trump administration has made in support of Taiwan.  The Chinese government sees the new sale and visit as provocative, and it has already demanded that the sale be canceled, although it’s not clear whether it will have a direct impact on the U.S.-China trade tensions.

Hong Kong: Chief Executive Lam today said her controversial bill to legalize extradition to China is “dead,” but the declaration was seen as far short of the formal withdrawal demanded by the mass protests of recent weeks.  Protestors continue to push for Lam’s resignation, an independent inquiry into police conduct during the demonstrations and the dropping of charges against arrested protestors.  We believe Lam’s statement has done nothing to diffuse Hong Kong’s political protests, so the risk of a crackdown by Beijing remains alive.

Other China news: Protests against a trash incinerator continue in Wuhan.  Under normal circumstances, this protest would not cause concern.  Local protests in China are not all that unusual.  However, with the issues in Hong Kong, there are fears among policymakers that these protests could evolve into something more ominous.  African Swine Fever continues to be a huge issue for China; a report by Caixin confirms other reports we have noted recently, which suggest the problem is much more widespread than officially reported and ranchers are taking steps to protect their own economic interests at the expense of containing the disease.

A diplomatic dust-up: A leak of diplomatic cables has led to a row between the U.S. and U.K.   Cables tend to be candid; the dump a few years ago from Wikileaks revealed what diplomats thought of the leaders in various nations.  This most recent event has some interesting twists.  First, if one supports Brexit, this leak was fortuitous as it showed what the current government really thinks of the sitting U.S. president.  A Johnson administration would likely replace Sir Kim Darroch and the issue would be laid to rest.  Second, this event shows the tensions that develop between a professional diplomatic service and the political leaders they serve.  Often, the goals of the two diverge.  PM May would likely prefer to not have to deal with this issue in the waning days of her government.

Meanwhile, ballots have reportedly now been mailed to the Conservative Party’s rank-and-file members who will decide whether Boris Johnson or Jeremy Hunt will take over as party leader and prime minister.  As the campaign nears its conclusion, both candidates have been ramping up their rhetoric regarding their willingness to pull the U.K. from the European Union without a Brexit deal.

Iranian enrichment: There is not too much new to add on this issue from yesterday.  In an effort to persuade Iran to refrain from further breaches of its 2015 nuclear agreement, French President Macron will send diplomatic advisor Emmanuel Bonne to Tehran today for talks with the Iranian government.  Iran is continuing to threaten further violations of the nuclear deal but hasn’t set any path to negotiations.

India: Finance Minister Sitharaman has released her proposed budget for the coming fiscal year, including a surprise cut in the deficit to 3.3% of gross domestic product (GDP) from a previous goal of 3.4%.  Stimulus measures in the proposal include expanding an existing pension program and increasing the number of companies eligible for a reduced 25% tax rate.  However, the proposal was widely seen as lacking sufficient revenue-generating measures to pay for those initiatives.  Even worse, the proposal would require listed companies to float at least 35% of their stock to the public, up from 25% currently.  Skepticism over the fiscal target and fear of significant new stock issues have weighed on Indian stocks in recent days.

Venezuela: There is a growing side effect of fuel shortages in Venezuela.  The shortages are hampering efforts to plant and maintain crops and, when they mature, the lack of fuel is preventing shipping.  Just when it seems impossible for conditions to get worse in the country, they do.

Debt ceiling issues: Although we still think a last-minute deal will be struck, it is becoming clear the solution will be made at the last minute.  There have been so many of these events that financial markets are mostly ignoring them.  However, this one has enough imbedded issues that the potential for sequester is probably higher than the financial markets have discounted.

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by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT] Good morning and happy Monday!  We are essentially halfway through summer, semi-officially marked by the All-Star Game, the “midsummer classic.”  Trading is quiet; investors should note that activity tends to slow during the summer.  Europe is essentially on holiday to some extent from now into Labor Day.  Here is what we are watching today:

Powell speaks: Chair Powell will make his semiannual testimony to Congress on Wednesday and Thursday this week.  We also note that the Fed minutes will come out on Wednesday.  Although the strong labor market data on Friday quelled some of the ardor for rate cuts, the financial markets are still leaning toward a cut at the end of the month.  If Powell wants to affect that assessment, he will likely do so on Wednesday.  Thus, there is some risk that Powell could turn hawkish this week; we don’t expect that outcome but the potential does exist.

Meanwhile, the president continues to pressure Powell by threatening his position.  We, and others, have noted that some of the governor candidates the president has considered seem to have a hard money bias.  Stephen Moore had an affinity for the gold standard and strongly criticized the Fed’s monetary policy during the Obama presidency.  Judy Shelton, who has recently been considered for nomination, also has supported the gold standard.  President Trump isn’t a hard money person (most presidents aren’t, by the way—hard money can get in the way of re-election), so why is he consistently looking to such candidates?  It may simply be partisanship.  If one views the world in terms of loyalty to “teams” and not on the basis of ideology, then Trump may be recommending these gold bugs simply because he expects them to be loyal to his monetary aims regardless of their personal ideologies.  This thought process might explain the hostility toward Powell; the president put him in this job to do what he is asked, not to be loyal to the Federal Reserve as an institution.  We may need to start looking at members of the FOMC not on the basis of their economic leanings but their political affiliation.  If that were to be the case, policy would shift not based on the economy but on who occupies the White House; for example, if the governors lean toward the GOP, then a Democratic president could face hostile monetary policy.  We are not there yet but it is a trend that could develop over time.

So, in light of the employment data, should the Fed maintain current rates?  The employment data is notoriously volatile.  The May data looked really weak; that was reversed in June.  One shouldn’t become overly excited about any single month’s data but look at trends.  Since 2011, the three-month average of payrolls has averaged 200k+ per month.  It currently sits at 171k.

Average weekly earnings have been weakening as well.  We are seeing some declines in the work week which means that take-home pay may be stagnating even with hourly earnings rising.

Although Friday’s data was solid, there is some underlying weakness.  If the Fed doesn’t ease at the next meeting, it could face a weak July employment report which would bring further criticism.  Overall, we think there are enough pockets of weakness to give the Fed cover if it wants to lower rates.

China foreign reserves: Foreign reserves in June rose $18.2 bn, well above the $2.0 bn forecast.  The rise suggests China has not been spending reserves to support the value of the CNY.

In other China news, credit card debt by households is growing rapidly and has caught the attention of the credit rating agencies.  Household debt has increased steadily since 2008; although it remains well below U.S. levels compared to GDP, the pace of growth is concerning.

The problem is that the Chinese financial system doesn’t have much experience with widespread defaults and loan deterioration at the household level.  With businesses, loan deterioration is usually masked with rollovers and covert restructuring; that probably won’t occur with households due to the relative debt size.[1]  A household debt crisis in China would not only lead to weaker growth but might also foster social unrest.

Hong Kong: In the fourth mass demonstration of the last month, thousands of political protestors again marched through Hong Kong.  The difference this time, however, was that the protesters targeted a shopping area frequented by Chinese tourists, where mainland law is enforced.  An organizer said the aim was to make sure mainlanders become more aware of Hong Kong’s anger over the gradual erosion of civil liberties as Beijing tries to assert more control over the territory.  Although the protests were reportedly peaceful, there is the continuing risk of a crackdown from Beijing.

Greece: In parliamentary elections over the weekend, the center-right New Democracy Party came out on top with approximately 39.8% of the vote, beating the incumbent left-wing Syriza Party’s 31.5%.  New Democracy will have 158 seats within the 300-seat legislature,[2] making its leader, Kyriakos Mitsotakis, the country’s new prime minister.  The New Democracy Party will represent the first single-party government in Greece in a decade.  Mitsotakis has promised tax cuts, reduced bureaucracy, increased investment and much stronger economic growth.  It remains to be seen whether he can deliver on those goals given the fact that Greece is still subject to stringent fiscal terms under its bailout deal with the EU.  Nevertheless, having a traditional, business-friendly party back in power in Greece is likely to be positive for both Greek assets and overall European assets.

Turkey troubles: Although we did see a sizeable improvement in Turkey’s CPI, which fell from 18.5% in May to 16.0% in June, President Erdogan moved to fire his central bank governor, Murat Cetinkaya, a full year before his term ended.  He was replaced by Murat Uysal, who until recently was an executive at Halkbank, a state-owned commercial bank in Turkey.  The action will likely weaken the independence of the central bank and raise concerns about Erdogan’s management of the economy.  Erdogan has been critical of interest rates in Turkey; the official policy rate is 24%, which is well above inflation.

As this chart shows, the current real rate is well above what it has been in recent years.  The firing of a central bank governor simply due to tight policy will worry international investors.  The lira is weaker this morning.

Iran: The country’s atomic energy agency confirmed this morning that Iran has started enriching uranium to a level of 4.5%, breaching the 3.67% limit in the 2015 nuclear agreement.  This action marks Iran’s second significant breach of the agreement, following last week’s move to boost its stockpiles of enriched material beyond the 300 kg limit in the deal.  The Iranians also said they would breach further unspecified limits under the deal in 60 days if the recent U.S. sanctions on Iran aren’t lifted.  The moves aim to raise costs for the Trump administration’s decision last year to pull out of the deal, but they could backfire.  In response to Iran’s moves, the European parties to the deal suggest they may invoke an agreed upon dispute procedure that could end with a full snap-back of the sanctions that were in place before 2015 and an outright end to the deal.  Pressures continue to mount, raising the risk of miscalculation and further tensions or even a military confrontation that would likely boost oil prices.

Venezuela: Opposition leader and self-declared president Juan Guaidó announced he will soon take part in talks with the government of Nicolás Maduro to find a way out of the country’s political deadlock.  In addition, the opposition will apparently meet this week with the EU’s special envoy for Venezuela.  The talks follow two earlier rounds of negotiations in Oslo, suggesting momentum continues for a political solution that could potentially result in Maduro leaving office and market-friendly reforms finally being implemented in the country.

Budget worries:As the summer wears on, the clock is ticking toward a series of fiscal deadlines.  Divisions within both parties are hardening positions and increasing the odds of a fiscal crisis in September.  If an agreement to lift the debt ceiling isn’t reached, the budget sequester process will occur which will lead to reduced fiscal spending and reduced spending in the economy.

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[1] As John Maynard Keynes once noted, “If you owe the bank $100 and can’t pay, you have a problem; if you owe the bank $100,000,000 and can’t pay, the bank has a problem.”

[2] Greece gives an additional 50 seats to the party with the largest electoral margin, which reduces the need for coalition governments and makes the political system more stable.

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT]

(NB:  We are publishing an abbreviated report today.  Because of the all-important labor market data, we wanted to provide our coverage of that issue and the usual energy market update as well.  Additionally, the AAW will be updated.  But the headings in yellow are not updated.)

Happy employment Friday!  We cover the data in detail below, but the quick take is that the report was much stronger than forecast.  It is bearish for bonds and has led equity futures lower this morning.  Otherwise, it was a quiet overnight session for most markets with the U.S. taking yesterday off for the Independence Day holiday.  There was an earthquake in California yesterday; damage appears to be minor.  Here’s what we are watching today:

Getting to know you, EU style: Ursula von der Leyen, the candidate for EU Commissioner, is making the rounds in Brussels to introduce herself and drum up support for confirmation of her appointment. So far, it appears her reception has been less than warm.  Despite the chilliness, we do expect her to be approved, mostly because the EU leadership will dole out positions to groups that could block her elevation.  The key to watch is the Greens; they haven’t been much of a power before and if they flex their new electoral muscles, the center-left could be mostly shut out.

Iranian oil tanker seized:  The Royal Navy seized a Panamanian-flagged tanker thought to be carrying Iranian oil that was in route to Syria.  Although the EU has not signed on to the U.S. sanctions against Iran (and this oil shipment would violate U.S. sanctions) the British captured the vessel because shipments to Syria would violate EU sanctions against the Assad regime.  The tanker was seized near Gibraltar, which is controlled by the U.K.  Needless to say, Iran is furious about the act.

China on trade: Although the financial markets celebrated the China/U.S. trade ceasefire negotiated at the G-20, the odds of a lasting deal look rather long.  China said today that a precondition of a deal is that the U.S. must remove all tariffs.  Robert Lighthizer, the USTR, has made it clear that he wants to keep the threat of tariffs in place as a way to maintain Chinese compliance on any trade agreements.  It would be hard for the U.S. to back away from tariffs because Lighthizer is right—China probably won’t comply with the agreement without the threat of tariffs.

Snap elections in the U.K.? Tory officials are quietly preparing for snap elections in case he can’t get a better deal from the EU (a new deal from the EU is highly unlikely) and the current Parliament won’t accept a no-deal Brexit.  New elections would be risky; it is quite possible that a Corbyn-led Labour Party would win which would send financial markets into a downspin.

A deal in Sudan: Civilian and military leaders have reached an agreement on power sharing.  Power will rotate between military and civilian leaders over the next three years.  At that point, the military will end the arrangement and Sudan will be under civilian rule.  Although the agreement should bring peace to the country, the obvious sticking point is if the military will really leave power when the time comes.

German factory orders: As noted above, we are not updating the foreign economic releases  but we did want to note that German factory orders fell 8.6% from last year.

This chart shows German manufacturing orders on a yearly basis, with recession shading reflecting German recessions.  The current decline is consistent with previous downturns and would suggest that the German economy is probably in recession.  The German 10-bund fell to a -0.40%, a new record low.

Energy update: Crude oil inventories fell 1.1 mb last week compared to a forecast drop of 3.0 mb.

In the details, refining activity unchanged, above the 0.3% decline forecast.   Estimated U.S. oil production rose by 0.1 mbpd to 12.2 mbpd.  Crude oil imports rose 0.9 mbpd while exports fell 0.8 mbpd.  Rising production, flat refining demand, rising imports and falling exports led to a lower than expected draw in crude oil stockpiles.

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.  After a period of variability, we are seeing the seasonal trend reassert itself.

Based on oil inventories alone, fair value for crude oil is $51.89.   Based on the EUR, fair value is $53.47.  Using both independent variables, a more complete way of looking at the data, fair value is $52.04.  Oil prices have based and are now working higher, bolstered by tensions with Iran.  The re-emergence of the summer season inventory pattern is also supportive for oil prices.

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by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT]

(NB: We will publish an abbreviated report on Friday.  Because of the all-important labor market data, we wanted to provide our coverage of that issue and the usual energy market update as well.  Additionally, the AAW will be updated.  But the headings in yellow on Friday will not be updated.)

There is a lot of central bank news today.  The media is abuzz over the July 4^th parade.  U.S. and European equities are doing well this morning.  Here is what we are watching today:

The EU returns to the back room:  In the last election cycle, the EU built an open process for choosing new leaders, ending a backroom process where France and Germany would essentially make the selections.  The open process failed in this cycle to settle on new leaders and so the EU presidents and chancellors returned to the backrooms to make their picks.  Ursula von der Leyen, the German defense minister, was the selection for EU Commissioner.  She is a somewhat controversial pick and still requires MEP approval.  Chancellor Merkel abstained from voting for her; there is speculation that her coalition partner, the Social Democrats, were still smarting from the rejection of a socialist for the commissioner role.  However, it is also quite possible that Merkel is quietly cheering her selection because it removes a potential competitor for her role.  Although Merkel intends to leave office when her term ends, one can never be too sure.   At the same time, there are increasing concerns about the chancellor’s health, which may speed her exit from public life.

The other major announcement was that Christine Lagarde was named to replace Mario Draghi as president of the ECB.  Lagarde has deep experience in managing financial crises—she was the French finance minister during the 2008 Great Financial Crisis.  In addition, she can clearly manage large public sector entities, as shown by her management of the IMF.  However, she isn’t an economist and thus we would not expect her to develop any new plans to what Draghi has already put in place.  Needless to say, the French are happy and policymakers are pleased that they won’t be dealing with a German hawk as ECB president.

Meanwhile, one thing Lagarde won’t have to deal with is a fiscal crisis in Italy.  A deal between Rome and Brussels was made today.

Fed Governors:  President Trump announced two candidates for the two open spots on the Fed’s Board of Governors.  Christopher Waller, the director of research for the St. Louis FRB and Judy Shelton, were named as candidates.  Waller is a more traditional pick; Jim Bullard, the President of the St. Louis FRB, was reportedly asked about a governor’s spot but he demurred.  Selecting Waller is probably the next best thing as we suspect Waller reflects the dovish views of his boss.  Shelton is much more controversial.  She has argued for a return to the gold standard as a way to prevent competitive devaluations.  The gold standard was part of the supply side economist toolbox, but it was never seriously considered for policy.  There are a plethora of reasons why the gold standard would be problematic, the biggest is that the gold standard failed when suffrage expanded after WWI. The gold standard requires the cost of policy adjustment to be borne by labor; when common people got to vote, they opposed such policies.  In addition, the gold standard tends to be a hawkish position, which seems to counter what the president wants from policymakers.  It is possible that President Trump believes Shelton will be politically reliable but there is no guarantee that is the case as she could prove to be an ideologue and a hawk.

We expect the Senate to easily approve Waller, adding a dove to the policy vote.  Shelton will likely have a more difficult time with her approval.   It should also be noted that the Senate probably takes around six months to approve Fed governor nominations and so by the time either or both would be approved, the easing might be done.

A Russian military accident:  A Russian submarine had a fire earlier this week, killing all on board.  It is unclear exactly what happened, and we will continue to monitor this situation.

Iran:  Tehran has announced it will expand its enrichment activities in the very near future.  Iran continues to evade sanctions but it is clear it’s economy is suffering.  For now, we expect Iran to stall on any potential negotiations until the 2020 elections; if Trump is reelected, we would expect talks to occur shortly thereafter.  If a Democrat wins, look for the JCOPA to return.

Japan:  Despite the general momentum toward a re-loosening of monetary policy around the world, it’s important to remember that there is also a significant subset of policymakers who want to delay or minimize any rate cuts.  For example, Bank of Japan board member Yukitoshi Funo said today that Japan doesn’t need to loosen policy right now because a moderate economic acceleration is expected later this year.  That comes as U.S. monetary policy officials like Cleveland Fed President Mester said this week that they’re still not yet convinced that rate cuts are necessary.  In other news from the Land of the Rising Sun, Japanese officials said they were considering making more products subject to restrictions on exports to South Korea beyond the high-tech goods announced earlier this week.  The move is in retaliation against South Korean demands for compensation for forced labor by the Japanese during World War II.

India:  Monsoon rains in the region around Mumbai have reached the highest level in more than a decade, leaving more than 80 people dead, partially closing the airport, raising concerns about crops, and putting pressure on Prime Minister Modi to improve infrastructure.

Brazil:  A special committee of Brazil’s Congress looks set to pass a watered down version of President Bolsonaro’s proposed pension reform, which would then allow the bill to be presented to the full chamber for a vote.  The amendments reduce the projected savings from the bill to approximately $245 billion over the next ten years, but that still is widely seen as insufficient to avert a fiscal crisis as the country’s pension costs continue to explode.  The proposed pension reform has been a key reason for the rise in Brazilian stocks since Bolsonaro’s election.

UAE/Yemen:  Western officials say the United Arab Emirates have been pulling tanks, attack helicopters, and other military assets out of Yemen, as it tries to extricate itself from the Saudi-led campaign against the country’s Iran-backed Houthi rebels.  The sources say one reason for the UAE’s action is fear that its continued participation in the campaign could spark retaliatory strikes from Iran.

Australia looks at tax cuts:  The conservative government is close to passing a major tax cut.  This cut might give the Australian markets a boost.

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by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT] We are seeing quiet financial markets this morning after a strong equity rally faded throughout the day yesterday.  Hong Kong, a new threat of tariffs on the EU and the Iran nuclear violation are topping the news.  Also, an apology—we forgot to mention one of our favorite holidays yesterday.  July 1 is “Bobby Bonilla Day,” the day the Mets send Mr. Bonilla a check for $1.19 mm as part of a deferred compensation plan that was affected by the Bernie Madoff scandal.  Here is what we are watching today:

Hong Kong: This is starting to get ugly.  Protesters broke into the legislature building yesterday and defaced the interior before being forcibly removed by security forces.  Carrie Lam has condemned the violence, but the real issue is the patience of Chairman Xi.  Our concern is that Beijing isn’t going to tolerate these protests much longer and may force a serious crackdown on the former British colony.  There is some evidence to suggest the protest movement itself is divided, that a smaller group of protesters invaded the legislature but that action wasn’t supported by a broader group.  The protests do not seem to be supported in the mainland all that much.

One of the lessons from Tiananmen Square was that the West will protest and put China in a sort of geopolitical “penalty box” for a crackdown, but ruptures are not permanent.  Simply put, the interests of doing business with China will weigh more than defending the civil rights of Hong Kong residents.  The protesters are clear representation of the frustration and fears that Hong Kong residents have of encroachment from the mainland.  However, as much as they would prefer otherwise, this encroachment is likely to continue.

If Beijing deploys troops and forcibly restores order, there will be an immediate pullback in Chinese equities.  Protests in the West will be loud; stern letters will be written.  Even sanctions might result.  But, no foreign government is going to come to the aid of Hong Kong against the mainland.  We suspect that capital flight from Hong Kong will increase.  Taiwan will view what is happening in Hong Kong as a warning that it cannot allow the PRC to take over; look for a strong lobbying effort from Taipei to woo the U.S. to support its continued separation from China.

Iran breech: The U.N. has confirmed that Iran finally increased its uranium enrichment to violate the JCPOA and admitted to it.  The action, by itself, isn’t all that significant.  The level of enrichment is consistent with nuclear power but not nuclear weapons.  However, the symbolism is clear and the real test now comes from Europe.  The Europeans don’t want to completely kill JCPOA, or at least be seen as doing so.  Nevertheless, it is hard for the EU to continue to support an arrangement where the U.S. is applying sanctions while Iran is increasing enrichment.  European leaders are trying to maintain order in a situation that has become disorderly.

EU tariffs?  The U.S. is considering imposing additional tariffs on $4.0 bn of goods exported to the U.S. from Europe.  The action would be in retaliation to EU aircraft subsidies.  Currently, the U.S. has imposed tariffs on $21 bn of goods over this issue.  Although the financial market’s focus has been on China, trade frictions with the EU continue at a “slow boil.”

Israel missile strikes: The IDF carried out missile strikes in Syrian territory[1] against suspected Iranian and Hezbollah targets.  The broader geopolitical implications are interesting.  Syria is managing the influence of two important outside powers, Iran and Russia.  Israel wants to eliminate the influence of the former; interestingly enough, Moscow probably supports that goal.  Thus, the Russians, who might be able to prevent such airstrikes, clearly allow them to occur probably because they don’t want Iran in Syria either.  At the same time, Russia doesn’t want a direct confrontation with the Islamic Revolutionary Guard Corps or Hezbollah; both are more familiar with conditions on the ground and would draw Russia into a protracted asymmetric war that is probably unwinnable.  As a result, Russia will likely try to at least give the appearance of being on the sidelines, while quietly cheering Israel’s actions against Iran and its allies in Syria.

What to do with Huawei (002502, CNY, 3.59)?  Now that the U.S. has granted Huawei a reprieve, the bigger issue is what will policymakers do with the company?  In the short run, the company is a major customer of American chipmakers, who lobbied hard to see export controls eased.  These companies will continue to try to influence policymakers to continue to do business with the company.  At the same time, Huawei appears to be a significant commercial and national security threat and moving to address this issue would be the natural progression.  Often, the short-run/long-run tensions yield to the former in capitalist democracies.  We will be watching to see how this plays out.

And, finally: Yesterday, we noted that European leaders appeared to have a deal for the new EU commissioner.  That deal unraveled in what now looks like a major political blow to Chancellor Merkel.  Overall, this is another indication that the German leader is losing power, putting Europe into a situation of uncertainty.

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[1] Which, in itself is something of a misnomer, in that what was “Syria” really no longer exists.

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT] Global equity markets are sharply higher in a relief rally from the G-20 meeting.  Oil is up on OPEC+ news.  Although it’s not exactly official yet, we are unofficially enjoying the longest economic expansion in U.S. history.[1]  Here is what we are watching today:

The G-20: We pretty much got what we expected from the G-20.  Presidents Trump and Xi agreed to a set of items that were mostly anticipated.  Huawei (002502, CNY 3.59) got a modest reprieve; it will be allowed to trade with the U.S., although there will be restrictions.  The U.S. agreed to not implement another round of tariffs.  China agreed to buy some soybeans.  All this was anticipated but, despite the expectations, we are seeing a strong risk-on rally today.  Equities and the dollar are higher, while gold and Treasury prices are lower.  On the one hand, not much was resolved.  On the other hand, it clearly could have been much worse.

The G-20 did manage to agree on a communiqué but only because it didn’t promise much.

One of the benefits of the G-20, despite its unwieldy nature, is that side meetings can occur among leaders.  EU leaders looked like they had put together a plan to end the leadership fight over the European Commission.  Chancellor Merkel agreed to give up the commissioner job to Frans Timmerman, a Dutch center-left socialist.  Manfred Weber would get the European Parliament presidency as a consolation prize.  A Frenchmen would get the ECB presidency; a dark horse candidate could be Christine Legarde, the current managing director of the IMF.  However, it appears the deal fell apart on opposition from the smaller EU nations.

Since I was in the neighborhood: In a bold move, President Trump made history yesterday by being the first sitting president to cross into the demilitarized zone separating North and South Korea.  He met Kim Jong-un and promised to restart nuclear talks.  There is a proposal that would halt new weapons but allow the current arsenal to remain in place.  Perhaps the most telling item from this visit is that National Security Director Bolton was apparently in Mongolia.  Bolton has been a target of Pyongyang’s ire, so the optics of sending him to exile are significant.

Historic trade deal: The EU and Mercosur, the South American trading bloc, has reached a trade agreement.  Mercosur is a trading zone made up of Argentina, Brazil, Paraguay and Uruguay.  Something that should give the U.K. pause is that negotiations for this deal have been going on for two decades.  If the British think the EU will make a trade deal with them quickly they are probably mistaken.  A lesser free trade deal was also finalized with Vietnam.

OPEC+: Russia and Saudi Arabia have reached an agreement to extend the current output restrictions for another six months.  Although it is possible the rest of OPEC might balk, it isn’t likely.  Iran will probably complain but it has little influence on the final decision since its exports have collapsed.

Iran: Friday’s talks with the EU were not enough to forestall Iran from increasing uranium enrichment.  We expect tensions to continue to rise.

Something to watch: President Trump indicated that he wants to change the U.S./Japan security agreement, a plan that was crafted after WWII.  Under that plan, Japan agreed to not project offensive military power and only have forces for self-defense, and the U.S. agreed to guarantee its external security.  The point of the plan was two-fold; Japan, a leading industrial power, had almost no natural resources and is heavily dependent on secure sea lanes for raw materials.  The rest of Asia was always worried about Japan’s power projection to secure these resources.  By taking over Japan’s security, it no longer needed to worry about being cut off from raw materials and other Asian nations no longer had to fear Japan’s power.  The arrangement has prevented a mass industrialized war from occurring in Asia.[2]  Changing this arrangement could open the door to pre-WWII conditions that would likely destabilize Asia.

Venezuela: There were two items of note.  First, the U.S. has extended sanctions to the son of Maduro.  Second, the number of Venezuelans fleeing the country continues to increase; the Organization of American States warns that the total number of Venezuelan refugees could reach as high as 8.2 mm by the end of 2020.  That volume would make the Venezuelan refugee crisis larger than the Syrian crisis.  So far, the U.S. hasn’t seen a major influx of Venezuelans.  It is hard to imagine that we won’t at some point.

Hong Kong protests: Protests have developed on the 22^nd anniversary of the handover of Hong Kong from the British to China.  The protests have become violent; if they continue, we will be watching closely for Beijing’s reaction.  You can follow along here.

Protests in Sudan: Protests have also developed in Khartoum against the provisional military government in Sudan.  The potential for a crackdown is high.

A spat with Switzerland: Until today, Swiss equities could be traded on EU exchanges due to a process called equivalency.  But, the agreement has expired and now such stocks can only be exchanged on the Swiss bourse.  The same shares cannot be traded on European exchanges.  The root of the problem is a dispute between the EU and Switzerland over political ties.  So far, the shares are trading without incident but the issue could emerge later this year if we get a hard Brexit.  If hard Brexit occurs, British companies may not be able to trade on EU exchanges after Halloween.

Fed talk: Although we have no additional speakers today, Vice Chair Clarida did talk early this morning in Finland.  As expected, he suggested the Fed would “act as appropriate.”  Richmond FRB President Barkin cooled expectations for a rate cut, suggesting such a move might be premature.

Turkey and Libya: Turkey has accused forces allied with Khalifa Hifter of detaining six Turkish nationals.  In addition, these same Libyan forces claimed to have destroyed a Turkish drone parked on the tarmac of Tripoli’s airport.  Outside forces have been turning Libya into a proxy conflict.  Turkey has been siding with Islamist forces in the western part of the state, while the UAE and others have been supporting Hifter.

Odds and ends: Taiwan’s president is scheduled to visit the U.S. later this month, an event certain to upset Beijing.  African Swine Fever may be killing much faster than reported.

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[1] There are two caveats.  First, the NBER, which dates the business cycle, doesn’t establish when recessions start for months after one begins.  Thus, if a downturn starts soon, the NBER could decide that a recession started in June, meaning we are not at a record.  Second, the dating of cycles didn’t begin until 1850, so, strictly speaking, a longer expansion may have occurred at some point between 1789 and 1850.

[2] The Vietnam War, though significant, was not a mass industrial war similar to WWI and WWII.