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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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

Good morning!  Large protests hit Hong Kong overnight.  It’s CPI day today!  We cover the data below but, in general, price pressures remain subdued.  Here is what we are watching today:

Hong Kong: Widespread protests rocked Hong Kong overnight.  The protestors oppose a new extradition rule that would allow the mainland to bring suspects from the former British colony to the mainland for trial.  Given concerns about the Chinese legal system, Hong Kong residents worry the bill would give Beijing a method to further undermine the “one country, two systems” arrangement that was put into place when the U.K. turned over the colony.  Security forces have responded with tear gas and rubber bullets.  Despite the protests, we expect the bill to pass due to the existence of a majority of Beijing sympathizers in the legislature.

There are two ramifications of the bill’s passage that we are watching.  First, the U.S. has expressed “grave concern” over the extradition bill, indicating that the U.S. does not want to see Hong Kong’s special status undermined.  The Trump administration is engaged in trade talks with China and bringing up an issue that Chairman Xi will view as an internal matter will add pressure to the negotiations.  The protests and reaction will likely bring further support to those in Congress who have turned hawkish against China.  Second, when Hong Kong was turned over to China on July 1, 1997, there was great concern about how the CPC would treat the former colony.  At the time, there was evidence of capital flight from the colony.  However, the CPC did mostly live up to the two-system approach and the outflows slowed.  As Beijing tightens its grip on Hong Kong, we would expect to see increased outflows of capital and people, some of which will likely find its way to the West Coast of the U.S.

China: May CPI in China came in near expectations, up 2.7% from last year, led by rising food prices, which rose 7.7%.  Pork prices were up 18.2%, a 35-month high.  Pork prices are higher due to hog deaths caused by African Swine Fever.  However, the core rate, also on forecast, rose a much more modest 1.7%, up from 1.6% in April.  PPI was also on forecast but rather soft, only up 0.6%.  Overall, the lack of price pressures in PPI and core CPI suggests weakening demand.

Banks loans and credit growth were mostly steady in May.  May M2 rose 8.6% from last year, up from 8.5% in April.

There is growing pessimism over trade talks between the U.S. and China.  China is accusing the U.S. of demanding last-minute changes to the agreement, a charge the U.S. leveled at Beijing.  There is growing sentiment in China that no deal is better than a bad deal.  At the same time, we do note that China has brought Yu Jianhua out of a pre-retirement job to join the trade talks.  Yu has nearly 30 years of experience in trade negotiations and his involvement suggests that, despite the pessimism, China does want to continue to work toward an agreement.

There is a growing chorus of reports suggesting tech companies are considering pulling supply chains out of China (here and here), and the threats of sanctions and trade impediments have affected Chinese tech companies.  Another element of the breakdown is that because of China’s massive foreign reserves it will tend to be an overseas investor.  There are reports that Chinese venture capital is being rejected by Silicon Valley.  This decision will reduce funds available to U.S. tech firms (although given current interest rates in the U.S., finding money shouldn’t be a big challenge) but will also force China to find other ways to invest the “dollar pile.”

Finally, China has loosened its rules for local governments to issue bonds for infrastructure development.  This action was likely taken to offset the negative impact of falling exports.  However, the risk is that China repeats Japan’s “bridges to nowhere” experience of the 1990s, when Japan tried to offset the impact of a strong yen through fiscal spending.

Congressional pushback: We are seeing two areas where Congress is beginning to push back against the White House.  Sen. Charles Grassley (R-IA) is advancing bills that would reduce the executive branch’s power in trade, returning it to where the founders placed it, in Congress.  Second, the Senate leadership is indicating that it doesn’t want a confrontation over the debt ceiling and the budget in the fall.  Therefore, they are effectively telling White House negotiators that they won’t press for spending cuts to entitlements.

Iran: The IAEA has confirmed that Iran is accelerating its enrichment of uranium.  Iran hasn’t yet violated the nuclear deal but the enrichment activities suggest it is ramping up to do so in the event that Iran’s leadership decides the deal is dead.  The IAEA is usually very cautious in its language, fearful of escalating tensions, so the rather blunt assessment does indicate that the diplomatic situation is deteriorating.

Javad Zarif, Iran’s foreign minister, has warned that the U.S. “cannot expect to stay safe” due to sanctions.  Zarif is also usually cautious with his words, so his blunt warning does suggest a hardening position from the regime.  There are reports that OPEC is struggling to find a date to meet, much less to determine policy, and the delay is due to Iranian obstruction.  Although the Saudis continue to insist that the cartel will maintain production cuts, Iran has little interest in cooperating on anything and will attempt to bring down oil prices by refusing to cooperate.  Iranian oil exports are plummeting, so it doesn’t really benefit much from higher prices, but the country knows that lower prices will harm its adversaries in the region.  Although we doubt Iran can scuttle an agreement by OPEC, it can, at a minimum, deny the Saudis a unified outcome.

Grain markets: The USDA admitted that poor planting weather will lead to a reduction in acreage and lower yields.  Corn prices have been rallying on reports of slow planting; a fallout from this weather is that we may see increased acres devoted to soybeans.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Good morning!  Unlike what we have had for the past couple of weeks, it’s a relatively quiet news day.  Here is what we are watching:

A deal with Mexico: As news spread that the tariffs on Mexico would be rescinded, stories broke that Mexico hadn’t agreed to anything that was not already in place.  Mexico has confirmed that no “secret” deal existed.  However, this characterization isn’t quite correct.  Mexico is taking a different tack with Central American immigrants, increasing enforcement on its border and appearing, at least, to be less welcoming.  And, despite comments from Mexican officials suggesting they didn’t offer anything new to the U.S., they did work hard to “sell” to the U.S. that Mexico is cracking down.  In the end, we suspect what is really going on here is a series of face-saving exercises on both sides of the border.  It is poison for a Mexican president to appear to kowtow to the U.S.  Therefore, the stories that suggest nothing new has emerged are part of that issue.  On the U.S. side, it is quite possible the president realized that applying tariffs could be an economic “own goal” and needed a way to back down without looking like he was doing so.  Thus, his tactic was to talk up the measures that Mexico is taking.  What we see is that Mexico is taking limited steps to try to control a serious and growing problem on the border that is going to get worse.  It won’t completely solve the problem but it is at least an attempt to bring some degree of control to it.  One item of note—Mexico is proposing to bring other countries into the asylum issue, including Guatemala, Panama and Brazil, which often act as transit nations for asylum seekers from other nations.  This action of broadening the discussion would improve the odds of slowing the flow of refugees.

Meanwhile, with China (and the Fed): President Trump is threatening to apply tariffs on an additional $300 bn of Chinese imports if Chairman Xi refuses to meet at the G-20.  China has indicated it will respond to any new trade actions by the U.S.  There are reports suggesting that plans are being made for the two leaders to meet in Japan.  Treasury Secretary Mnuchin has hinted that the two leaders might call a ceasefire, much like they did last year in Buenos Aires.  President Trump has indicated he thinks China will make a deal because he believes his bargaining position is superior.  At the same time, we note that China has announced new stimulus measures, which are helping to lift global equities.

Meanwhile, President Trump is suggesting the dollar is too strong and it’s because monetary policy is too tight.  This position has led to broadsides against the FOMC.  One of the more interesting comments has been that “these are not my people,” even though he appointed five of them to governor positions.  However, in the fog of media criticism, there are three important items to take away from these comments:

1. The people appointed to the FOMC by the administration are establishment figures. For the most part, the administration has been praised by the establishment media for the quality of his selections.  However, the president doesn’t really want sober economists making policy within the mandate of the Fed in an independent manner; what he really wants are policymakers who will do his bidding.  The president has populist leanings.  He would prefer loyalists.
2. The bigger issue is the tension between the White House and Fed independence. We have detailed how uncomfortable President Truman was with giving the Fed its independence in 1951.  We have also noted when President Johnson physically assaulted Fed Chair William Martin, and how President Nixon created a lie to make Chair Arthur Burns look like he wanted a pay raise to coerce him into easy policy.  Furthermore, we’ve discussed Reagan telling Volcker he can’t raise rates.  We had an unusually peaceful period between the White House and the Federal Reserve that began under President Clinton; however, that era was probably an anomaly and what we have now is more normal.  An independent Fed can torpedo a president and there isn’t much he can do about it.  The bigger issue is that Fed independence isn’t written in stone; it is important for inflation control but if the goal is stimulus then independence isn’t necessarily a positive feature.  President Trump knows his trade policy could act as a short-term drag on the economy and he wants monetary policy to offset the potential negative effects.  This desire isn’t out of line; it’s just that he has no direct way to force the Fed to do what he wants.  So, he has moved to public criticism.
3. The problem with public criticism is that it may lead the FOMC to resist policy easing even if it deems it might be necessary in order to defend the central bank’s independence. Thus, the president’s actions might actually undermine what he wants.

Overall, we think President Trump’s assault on Fed independence is the start of a trend.  If a left-wing populist gains office and MMT becomes the order of the day, a compliant Fed will be required for that policy to work.  Fed independence is critical when inflation control is a goal, but when inflation fears are dormant and the nation wants growth, a compliant central bank becomes necessary.  That is the path we are on.

Big tech under fire: President Trump offered a rare compliment to the EU, praising its fines on the tech industry.  Although he characterized it as a money grab, he did note that their actions have a point.  Meanwhile, the WSJ trotted out the consumer standard as a reason not to attack the tech industry.  Although that standard does offer a good reason to protect tech, the standard, like Fed independence, didn’t come down from Mount Sinai.  That standard is a legal construct that can be changed…and we suspect it will.

Odds and ends: Yesterday, we noted that Japan might go through with its plan to increase its consumption taxes.  It has now promised to use fiscal stimulus if the economy slumps.  Venezuela’s woes continue; it is now facing widespread fuel shortages and massive gas lines.  Greece has called snap elections.  Finally, yesterday’s JOLTS report, a labor market survey, showed a continued strong labor market.  One interesting data point is the elevated quits rate.  In general, a high level of quits suggests that workers feel confident they can find another job and suggests a tight labor market.  We note that quit rates are highly correlated to consumer confidence.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Monday!  It’s a risk-on day, with equities higher, and gold and Treasury prices lower.  The U.S. and Mexico have a trade deal.  The G-20 Finance Ministers’ meeting (the pre-meeting for the leaders’ meeting) didn’t resolve much.  Here is what we are watching today:

The Mexico deal: The U.S. and Mexico arrived at a deal, avoiding tariffs.  Financial markets were leaning toward this outcome so we are higher this morning, but the rally actually began last week.  Here are the key takeaways:

1. It isn’t completely clear that the U.S. got anything it didn’t already have.  According to reports, Mexico had already agreed to increase border security on its southern border.  The president has indicated there is more to the agreement but hasn’t detailed what additional concessions he received.  There have been reports that Mexico agreed to buy more U.S. agricultural goods.  However, that assertion has been denied by Mexico.  So, on its face, it doesn’t look like too much changed.
2. Mexico is clearly relieved that the tariffs were averted.  The MXP rose on the news.  However, the tariff threat, now introduced, could return if the White House determines Mexico isn’t delivering.
3. It still isn’t clear why the president reversed himself.  He may believe he did get something new from Mexico.  He may have concluded the economic damage from the tariffs would be too costly, thus retreated and declared a win.  If the first answer is right, then a return of the tariff threat is likely.  If it’s the second, we probably won’t hear of it again.  Unfortunately, we have no good insights as to which option is the correct one.
4. One of the important policy items to note is that this administration, unlike its predecessors, is aggressively mixing trade and security policy.  This is a major departure from previous administrations and has created some divisions within the current administration.  For example, USTR Lighthizer has tried to keep technology policy and trade separate in his negotiations.  Although the president has been criticized for this mixing of policy, and Senate GOP leaders seemed to join this opposition, there is some logic to putting the two together.  American hegemony is partly built on trade policy.  The U.S. deliberately accepted the reserve currency role; once that role was in place, the need from foreign nations to acquire dollars allowed the U.S. to weaponize trade.  Whether or not this policy continues post-Trump is not clear.  However, we note that Sen. Warren has argued the U.S. should “actively manage” the dollar’s exchange rate to promote domestic manufacturing.  In many respects, exchange rate manipulation would be much more effective than tariffs but would end up at the same endpoint—weaponizing trade.  Thus, by design, trade and national security policy could become linked.  How? Because the reserve currency nation can use trade as a foreign policy tool.  Both Trump’s and Warren’s policies would cause economic volatility.
5. Even after this outcome, the problem of Central American migration remains.  If anything, we expect it to become exponentially worse because, at some point, some of the four million Venezuelans that have fled their country will start heading north.  Interestingly enough, as Mexico and the U.S. become more hostile to these refugees, Europe is becoming a destination.
6. For now, this agreement is good news for financial markets and should provide a lift to Mexican assets.

The G-20: The finance ministers from the G-20 nations met in Japan over the weekend to prepare the agenda for the leaders’ meeting at the end of June.  There didn’t appear to be much progress in easing tensions.  The group was critical of U.S. trade policy.  Treasury Secretary Mnuchin suggested that the U.S. and China would probably create a similar outcome to the Buenos Aires summit.  If so, it would imply that a deal won’t be finalized but a ceasefire might emerge.  It is interesting to note that Mnuchin suggested an advancement in trade talks could lead the U.S. to ease up on Huawei (002502, CNY 3.36); if so, it would confirm Chinese suspicions that the tech issue is merely being used for leverage and has less to do with national security.  However, as we note above, with this administration the two are more closely linked than in previous governments.  There was an agreement to create uniform tax rules; if put in place, it would be especially onerous for tech companies.

China and trade: We note that China’s May trade surplus widened due to an unexpected jump in exports, which rose 1.1% from last year.  Most likely, foreign buyers are stockpiling on worries about future trade impediments.  If so, the gains will not be sustained.  China has summoned U.S. tech firms to meet with officials and indicated that they should not cooperate with the U.S. restrictions on technology trade.  This action puts tech firms in a dilemma; either cooperate with the U.S. and lose business in China or break U.S. law.  China is planning export controls on “sensitive technology,” a retaliatory act against U.S. proposals.  Meanwhile, Vietnam is cracking down on firms re-exporting Chinese goods to avoid tariffs.  And, the U.S. is moving to undermine the ability of Chinese companies to list on American exchanges.  Finally, more Western newspapers are being blocked by the “great firewall.”

The Hong Kong protests: There were widespread protests against a new extradition law that would allow China to extradite people in Hong Kong to the mainland.  Fights broke out in the Hong Kong legislature over the measure.  Steadily, Beijing is expanding its control over Hong Kong despite treaty arrangements that were designed to protect the area from encroachment.  As this encroachment continues, Hong Kong will be seen as less independent from the mainland and therefore less attractive for investors and free thinkers alike.  As is its custom, Beijing blamed foreign influences for the unrest.

Middle East: The Pentagon is considering a request for a major troop buildup in the region.  This request will tend to run counter to the president’s desire to avoid being tied down to conflicts in the region.  The U.S. has given Turkey a deadline on the S-400 missile purchase from Russia.  If Turkey makes the purchase, the U.S. will cancel sales of the F-35 and end pilot training.  Saudi Arabia claims that OPEC is fully on board to maintain output cuts but Russia is still considering whether it will cooperate.  PM Abe of Japan is going to Iran to act as an intermediary between the U.S. and Iran.

Odds and ends: The leadership race begins in Britain today.  Speculation is rising that PM Abe will implement the consumption tax hike.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s employment Friday!  We cover the data in detail below but, in short, the data suggests economic weakness; bonds have rallied, the dollar tanked and equity futures have eased off their highs.  Although we don’t expect a Fed rate cut this month, pressure to reduce rates at the late July meeting may make a move unavoidable.  It’s also the Dragon Boat Festival in China, so markets are closed there today.  The G-20 meets this weekend.  Here is what we are watching today:

BREAKING: A RUSSIAN AND U.S. NAVAL VESSEL NEARLY COLLIDED IN THE PACIFIC.  EACH SIDE IS BLAMING THE OTHER. 

A deal with Mexico: Yesterday, equities rallied on reports that the U.S. may delay implementing a 5% tariff on Monday due to reported progress on border talks.  Mexico has apparently offered to increase security personnel on its southern border.  Mexico has also indicated it will take additional steps to limit the number of migrants from Central America using Mexico as a transit point.  Meanwhile, there has been a surge of asylum seekers moving to the U.S./Mexican border, likely trying to reach the U.S. before it becomes more difficult to achieve this goal.  It does look like the Mexican government is working hard to avoid the tariffs being applied, which would be a major risk to its economy.   There are two takeaways we see at this point.  First, Mexico may need to do “whatever it takes” to avoid tariffs.  Second, if President Trump finds success with this tactic with Mexico, he will likely be inclined to use it more often, leading to increased market volatility.

The G-20: This will be an unusually important meeting because it will offer a forum for U.S. and Chinese trade negotiators to meet and perhaps discuss issues.  President Trump has indicated that tariffs on China will be decided after this meeting.  Meanwhile, it does appear that Chinese officials are preparing to support their economy.  The head of the PBOC suggests there is ample room to ease if the trade conflict weakens the Chinese economy.  China is also indicating it will shift trade patterns, warning that it will expand its agricultural imports from Russia.  The impact of tariffs on the U.S. economy, so far, has not been significant.  But, we may begin to see some effects by late summer.

Oil news: Oil prices have bounced after entering a bear market earlier this week.  The primary catalyst appears to be renewed signals from Saudi Arabia that OPEC + Russia are prepared to extend their supply cuts.  In addition, the U.S. has tightened trade sanctions on Venezuela, which will likely curtail production even further.  There are also reports that Iran is threatening U.S. military assets in the Middle East.  This being said, we are also picking up reports that the U.S. and Iran are negotiating an oil-for-food deal, where Iran would export oil through Iraq in return for U.S. agricultural aid.  If true, the U.S. may be using the deal to create backchannel contacts to restart negotiations with Tehran.  Or, it could be trying to preempt similar actions by the EU.  Regardless, it does suggest there are attempts by the Trump administration to talk to the Iranians.

German growth: The Bundesbank has cut Germany’s growth forecast in the wake of weak industrial production data.

As the chart shows, this is the weakest monthly report since 2014.

The end of May: Today is PM May’s last day in office, although she will stay on in a caretaker role until the new party leader is selected.  The Tory leadership contest officially gets underway on Monday.  There is growing speculation that Labour will call for a no-confidence vote soon after the new PM takes office.  The current Tory coalition partner, the DUP, is already pushing for “goodies” to support the Conservatives in a no-confidence vote.

The Japanese VAT: There is growing speculation that PM Abe will postpone a scheduled increase in the VAT.  Previous hikes have tended to adversely affect growth and Abe could use global economic weakness and uncertainty about trade as reasons to postpone the hike.  In reality, a VAT increase is boneheaded; Japan’s economy suffers from under-consumption, so taxing it is exactly the wrong policy.

The problem of European defense:A major reason for Pax Americana is that the U.S. solved the German problem in Europe.  By guaranteeing the security of Europe, but especially Germany, Europe has enjoyed over seven decades without a major war.  Anyone with a cursory knowledge of European history has to be impressed by prolonged peace in a region that has seen multiple major conflicts.  But, the cost of that peace to American taxpayers has been significant and successive presidents, including the current one, have complained about free-riding by the EU.  However, new problems will arise from European nations increasing their defense spending.  If they start spending money on their own defense, they will tend to direct that spending in ways the U.S. doesn’t like and conduct their own foreign policies instead of following the lead of the U.S.  Recent meetings between the U.S. and the EU have been quite tense as the U.S. fears that increased European security spending will be used as a form of industrial policy and reduce American defense exports to the EU.  The underlying problem is that if the U.S. forces the EU to spend more to defend itself, the outcome may make the region more volatile in the long run.

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