by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Good (?) morning!  It’s ugly out there this morning; markets are in full risk-off mode, with all the flight to safety assets (yen, gold and Treasuries) rallying, while equities and commodities are falling.  A surprise new tariff was announced on Mexico.  Chinese data underwhelms and Beijing is preparing to retaliate against U.S. trade and technology policies.  Here are the details and more:

The Mexico tariffs: The White house announced a surprise 5% tariff on all Mexican imports; they are scheduled to be implemented on June 10 unless Mexico stops the flow of Central American immigrants to the U.S. border.  Financial markets did not take the news well.  The MXP plunged, 10-year Treasury yields broke 2.20%, the two-year briefly fell under 2%, German 10-year Bunds fell to their lowest level on record, at -0.204%, and equity markets worldwide stumbled.  U.S. automaker shares fell especially hard on the Mexico news.  Mexican President AMLO does not look like he will buckle in the face of the tariff threat.  Here are some potential ramifications of this move:

1. Mexico is an important trading partner; in terms of goods only, year-to-date, it is the largest trading partner with the U.S. The increase in tariffs will be modestly inflationary at best and disruptive at worst.  This assumes no retaliation from Mexico.  We don’t expect Mexico to apply widespread tariffs on the U.S. but it could target sensitive areas.  However, it is also possible that AMLO could counter Trump’s position by simply opening the borders and encouraging increased Central American immigration.  Things could get worse, in other words.
2. UMSCA is in deep trouble. How can Mexico and Canada agree to a free trade deal when the U.S. is willing to unilaterally use tariffs as a punitive tool for issues unrelated to trade?
3. Mexico was increasingly looking like a safe harbor if trade relations with China deteriorated further (we admit that this was our position). This action seriously undermines that outcome.

Overall, this surprise move further isolates the U.S. on trade issues.  The White House is now engaged in trade conflicts on multiple fronts and it is hard to see how these actions are friendly to risk assets.

China prepares for more aggressive retaliation: China is preparing steps to take against U.S. tech restrictions.  According to reports, it is creating a “blacklist” of U.S. firms that it views as taking hostile actions against China, which will seriously undermine their ability to maintain business in China.  As we noted yesterday (and will have more on this in next week’s WGR), exports of rare earth products to the U.S. may be restricted.  Huawei (002505, CNY 3.58) has reportedly ordered its employees to cancel contacts with U.S. firms.  Retaliation is starting to move beyond just “tit-for-tat” tariff responses.

The broader story: We are starting to see the outlines of what the administration is moving toward, which is deglobalization.  The White House has been indicating all along that it wants to see more production sourced in the U.S.  This position is consistent with the multi-front trade war that is underway.  There are reports of U.S. manufacturers starting to move production out of China.  The idea seemed to be that these facilities would move to Southeast Asia or Mexico, and that could still happen.  But, as the Mexico tariffs show, the U.S. can move with little warning against a foreign nation over all sorts of issues.  The only truly secure supply chain may be in the U.S.

Essentially, there is a case to be made that the White House is attempting to use tariffs to address the famous “elephant chart,” at least for the U.S.

This chart shows inflation-adjusted income growth by income distribution across the world from 1988 to 2008.  One can clearly see that the rise of the emerging world (China, India, etc.) has come at the expense of the Western middle class.  The upper income elites in the West have also benefited.  This chart illustrates one of the reasons for the rise of Western populism.  Resourcing production back to the U.S. would be an attempt to pull down those in the 25%-65% area and lift the 75%-90% part of the chart.  Since globalization is only part of this story (deregulation and automation are also important), tariffs and other trade restrictions, by themselves, might not work.  Nevertheless, that likely won’t stop the administration from trying.

It should also be noted that the resourcing policy, i.e., bringing production capacity back to the U.S., might fail as a foreign policy.  In other words, if the U.S. has a policy goal to thwart China’s belt and road project by increasing U.S. influence in Southeast Asia, then it might be better to support the shift of production out of China and into that region.  However, that would likely work at cross-purposes to breaking down the elephant chart.

A key question for the 2020 elections is whether President Trump is an anomaly or a trend?  The political establishment is desperately trying to confirm that he was a fluke.  We disagree and would offer that even if Trump doesn’t win re-election the trend in policy to address the elephant chart is the new normal.

The Fed’s conundrum: GDP is running over 3%.  Inflation remains tame.  Financial markets are screaming for policy easing.  So far, the FOMC continues to preach patience.  This has also led some governors to make nonsensical statements.  For example, Randy Quarles noted that the Fed’s primary job isn’t financial stability.  We know what he meant—the Fed shouldn’t create the impression of a “Fed put,” coming to the rescue every time equities stumble.  However, the origin of central banking was to create a backstop against bank runs; so, yes, the Fed’s primary job is financial stability, in the sense that the Fed needs to keep the banking system stable.  Failure to do so means that no matter how well the Fed does everything else, it will have failed at its most important job.

The financial markets are clearly telling the Fed it needs to cut rates ASAP.  A key problem for the Fed is discerning whether the financial markets are accurately projecting that the White House’s trade and technology policies are dramatically increasing the odds of recession.  If the financial markets are right, and the FOMC wants to extend the expansion, then it needs to act.  Then again, cutting rates creates two other problems.  First, given all the pressure the president has put on the Fed to cut rates, will a rate cut for good reasons look like a surrender?  In other words, will a rate cut lead to the impression that policymakers acquiesced to the president and thus undermine their independence?  Conversely, if they hold steady and the financial markets are correct in their assessment of the outcome of trade policy, is a recession better than the impression of being politically undermined?  Worse yet, if the Fed allows a recession to occur, will Congress and the White House simply end Fed independence and make the central bank the facilitator of Treasury borrowing as it was prior to 1951?  Second, should the Fed ease policy in the face of what it sees as ill-advised trade and technology policies?  In other words, if the goal of maintaining the expansion forces monetary policy to accommodate what it sees as inappropriate trade and technology policies, what’s the point of being independent?  Imagine in the future that there is a White House aggressively using an MMT model to boost fiscal spending; should the Fed stand against that policy or accommodate it?

In the face of such paralyzing uncertainties, the path of least resistance is to do nothing.  This path probably does increase the likelihood of recession.

Odds and ends:There are reports, thus far unconfirmed, that Kim Jong-un has executed Kim Hyok Chol, who led negotiations for the February summit in Hanoi.  Chancellor Merkel gave a speech at Harvard that was deeply critical of U.S. foreign policy.  Despite the proximity to Washington, she did not visit there.  Belgium is beginning the process of forming a new government; deep divisions between the Flemish and the Walloons have made forming other governments very difficult.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Good morning!  It was a quiet overnight session with some modest recovery in risk assets after the recent sell-off.  The U.S. released a plethora of data this morning, which we cover in detail below.  Most of Europe is closed for Ascension Thursday.  Here is what we are watching:

The eastern front of the trade war: EU Trade Commissioner Malmström warned officials that the U.S. is preparing to level “billions” of EUR in tariffs this summer.  The tariff threat comes from the subsidies that the WTO has determined Europe gives to Airbus (EADSY, 31.86).  Car tariffs remain the most significant threat.  If the U.S. moves forward with tariffs on Europe, the most likely response would be a weaker EUR.

The dollar threat: We tend to take a relaxed position on the dollar’s reserve currency status.  Although it does confer benefits to the U.S. economy, it also brings significant costs.  Essentially, the U.S. economy has foreign savings thrust upon it (that’s the inverse of the trade deficit), which causes either higher levels of unemployment or debt, depending on how the foreign savings is allocated into the U.S. economy.  At the same time, U.S. consumers benefit from a broad array of goods and services and low prices.  Furthermore, because these foreign savings must touch the U.S. financial system, it gives policymakers enormous power to coerce other nations into accepting U.S. foreign policy goals.  If they don’t, the U.S. can deny access to its financial system and deny them the use of the dollar for global transactions.  This power is being observed with the Iran nuclear deal.  Europe wants to keep the deal together even without U.S. participation.  But, to do that, European companies would have to continue to do business with Iran in violation of American sanctions.  As long as these companies don’t use dollars in the transaction and don’t contact the U.S. financial system, this is possible.  Good luck with that!  To facilitate this trade, Europe has created a special vehicle that would, in theory, allow trade with Iran to occur and hide the transactions from the U.S. financial system.  India is reportedly setting up a separate but similar system to trade with Iran.  It is unlikely that these programs will completely isolate Europe from U.S. financial rules.  These alternative payment systems could undermine the dollar’s reserve status and reduce American power.  But, they come at a cost; to really be effective, the EU must start running large trade deficits and accept foreign saving, something that would be an anathema to Germany.  These alternative payment systems represent a threat to U.S. hegemony, but it will not be a serious threat until other nations are willing to accept the whole cost of the reserve role, which, to date, none have been willing to bear.

The EU and Italy: The EU is threatening to sanction Italy for its fiscal spending.  Italy, at least according to Ambrose Evans-Pritchard, is considering issuing micro sovereign bills, a type of tax anticipatory notes that could act as a parallel currency.  Although the EU will probably manage Brexit and survive, a rupture with Italy would be a serious threat to the Eurozone and may fracture the single currency.

Brexit: Labour leader Corbyn suggested today that another referendum would not be merely about staying or going, but other alternatives as well.  Although British leaders continue to indicate that the EU will renegotiate the May agreement, there is no evidence to suggest the EU will budge.  U.K. voters in the EU elections showed a clear preference for parties that wanted to either (a) leave with or without a deal, or (b) stay in the EU.  The problem for the political classes is that they are trying to find a middle ground between these two positions when one probably doesn’t exist.  If they were to hold 50 referendums, they would probably find that, like the coin flip experiment done in entry level statistics, the outcome to stay or leave would likely be about equal.  The inability to craft a middle ground increases the odds of a hard Brexit.  It’s a bit like when there is a review of a call in Major League Baseball; when the review is inconclusive, the call on the field stands.  The fact that Article 50 has been invoked means the call leans to a hard Brexit.  Avoiding this outcome would likely require a general election and, in the current political environment, it isn’t obvious that any party in Britain can achieve a majority.

Venezuela:  In a completely unexpected move, the central bank of Venezuela published several spreadsheets detailing its economic performance.  The country hasn’t officially published this data since 2015 so the fact that the information was even being gathered is a bit of a surprise.  It isn’t clear why this data was released; it is quite possible that it was a rogue operation because it’s hard to see how this data burnishes Maduro’s position.  Nevertheless, there were some interesting highlights.  In Q3 2018, GDP fell 22.5% on a yearly basis.  Inflation in 2018 was 130,000%.  GDP has contracted every quarter since 2014.  Everyone thought conditions in Venezuela were bad, but now we have some data to back up that perception.

A positive for nuclear power: The IEA warned this week that nations should reconsider closing aging nuclear power plants because nearly all the alternatives will boost greenhouse gases and increase costs to consumers.

Odds and ends: Benjamin Netanyahu was unable to form a government, so new elections will be held in Israel.  It appears Russia is violating the nuclear test ban.  Turkey is threatening to put missiles on the Mediterranean; most likely this is to threaten Cyprus.  Turkey is in a dispute with Cyprus over offshore hydrocarbon assets that both nations claim.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Good morning!  Risk-off is dominating the financial markets this morning.  Here is what we are watching:

Global bonds: U.S. 10-year Treasury yields are falling toward the 2.20% level and yields around the developed world continue to spin lower.  Although most economic indicators continue to signal slowing but positive growth, the behavior of the interest rate markets are sending warning signs of potential recession.

This chart shows two recession indicators, one from the NY FRB, which forecasts recession based on the yield curve, and the second from the Atlanta FRB, which estimates the odds of recession from GDP.  When the NY indicator breaks above 20% it is a warning signal of a downturn, but we like using the two indicators in concert to reduce the odds of a false positive reading.  For example, in the late 1990s, the NY indicator was signaling recession as it is now but it wasn’t confirmed by the Atlanta indicator and the recession didn’t occur.  The opposite condition existed in the mid-1980s.  For now, the NY indicator is clearly signaling recession concerns but the likelihood of recession is still low until we also get confirmation from the Atlanta indicator.  However, our “antenna” is up.

The European Commission presidency: The process now turns to selecting a president for the European Commission (EC), the position currently held by Jean-Claude Juncker, who is leaving office.  The appointment of the president of this body is a complicated process; essentially, this person must be (a) considered a leader of the EU Parliament, thus an important, known figure, officially called a Spitzenkandidat, and (b) acceptable to the leaders of the EU countries.  In terms of condition (b), not all nations are equal so, in practice, the EC president must be acceptable to Germany and France.  Going into the election, Manfred Weber, Merkel’s favorite, was considered the front runner.  Given that Weber’s EPP won the largest share of the vote, he has a claim to the job.  However, while he may have passed requirement (a), requirement (b) is becoming a problem because French President Macron is objecting to Weber’s appointment.  Instead, Macron, along with other leaders in the EU, are pushing other candidates.  Complicating matters for Merkel is an apparent political rupture within her CDU Party; she is now defending her hand-selected successor, AKK, after reports surfaced yesterday that Merkel believed she was incapable of leading the German center-right coalition.  Merkel has indicated she wants the president named next month, but it is possible the appointment could become protracted.  An important side note is that if Merkel loses on Weber, look for Germany to press hard for the ECB presidency.  Jens Weidmann, the current president of the Bundesbank, is considered hawkish and his appointment could give a boost to the EUR but would be bearish for Eurozone bonds, especially the periphery.

Hardening on Brexit: The EU is making it abundantly clear that it is in no mood to renegotiate Brexit.  In fact, the current president of the EU Council (the body of EU heads of state), Poland’s Donald Tusk, indicated that he views the Pro-EU win in the elections as partly due to the hardline take on Brexit, calling the position a “vaccine” to populism.  The candidates for Tory leadership are all arguing they will renegotiate a better deal, but it is more likely that we either get a new vote or a hard Brexit before the EU changes its position.

The Populist Right and the EU: Although Tusk noted that the Pro-EU position “won,” in reality, the election showed the strength of the populist right.  Although these parties didn’t win power, they are a significant enough majority that they will have increasing influence. It is interesting to note that these parties are no longer pushing to break up the EU but instead are trying to change the EU to implement policies more to their liking, including deglobalization (against immigration and trade) and anti-environmental regulation.

Currency manipulators: The Treasury has a process whereby it can name a country a “currency manipulator,” indicating that it is using its exchange rate unfairly.  If a nation is found to have achieved currency manipulator status, the Treasury then opens an investigation which can lead to trade retaliation.  The tool has been rarely used, in part, because nearly all nations outside of a few major industrialized nations allow a full float.  But, over time, policymakers have tightened the definition of what manipulation looks like.  Although the Treasury didn’t name a particular nation as being a manipulator, it has tightened the rules and expanded the number of countries being monitored, setting up a structure to allow this process to become more important in trade policy.  Exchange rates have been an item of interest for Treasury Secretary Mnuchin (part of his department’s mandate) as he seems concerned that countries hit with tariffs will use exchange rates to mitigate the impact.

Rare earths: In recent days, China has sent clear signals that it is considering using its dominance in rare earth minerals as a weapon against U.S. trade and technology restrictions.  There is precedent for such actions; China cut off Japan from these minerals in 2010 over disputed islands in the South China Sea.  This issue will be the topic of next week’s WGR.

The tragedy in the farm belt: It has been a cold, wet spring for the nation’s midsection, with persistent flooding and otherwise lousy weather.  As a result, farmers have been unable to get into the fields to plant.  As of May 26, 58% of the nation’s corn crop has been planted compared to the past 10-year average of 90% by this reporting week.  The southern states, which have been spared from the deluge, are nearly all planted (but are now getting too dry), while Indiana and Ohio are only 22% planted.  Illinois, another key corn state, is only 35% planted.  We are rapidly reaching the point where the potential loss of yield by planting this late will force farmers into other crops.  The most likely alterative is soybeans but planting is well behind normal there as well.  Only 29% of the soybean crop is planted compared to the decade average of 62%.  There is still time for soybeans to get in the ground if the rain stops soon, but forecasts show rain continuing into the weekend.  Complicating matters is the recent tariff relief program announced by the administration which pays farmers only if they put a crop in place.  The program incentivizes farmers to plant something and the “something” is most likely soybeans.  Of course, the point is moot if the rain doesn’t let up.  Corn (shown below) and soybean prices, which have been under pressure due to Chinese retaliatory tariffs, are rising sharply on supply fears.  But, if the rain stops, there is potential for a sharp drop in soybean prices in the coming weeks.

More on Baoshang:Yesterday, we reported that Chinese financial regulators had taken over Baoshang Bank due to worries about its solvency.  There were two additional news items on this issue.  First, China appears to be forcing a 30% “haircut” on bank bondholders.  Second, the PBOC made a massive injection of liquidity into the Chinese financial system, an indicator that regulators are concerned about the stability of the banking system in the wake of the takeover.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Good morning and welcome back from the long weekend.  Although financial markets are mostly steady, there was lots of news over the holiday.  Here is what we are watching:

European elections: EU elections ended over the weekend and the cross-currents are complicated.  Here are the highlights:

1. The results were not clear cut. The centrist parties lost favor, while the center-left/center-right no longer command a majority.  Right-wing populists increased their representation but much less so than feared.  The Greens, an environmental party, did surprisingly well, as did more leftist parties.
   1. Anti-EU parties held a majority in Poland, Italy and Hungary. Le Pen’s right-wing populists narrowly defeated Macron’s party as the traditional right- and left-wing centrist parties in France are looking increasingly irrelevant.  Only in Spain and Ireland did Euro-skepticism fail.
   2. After the EU elections, Austrian Chancellor Sebastian Kurz lost a no-confidence vote. Elections are scheduled for September but may occur sooner.
   3. Greek PM Alexis Tsipras called for snap elections after his party did poorly in the elections.
   4. Chancellor Merkel has lost faith in her hand-picked replacement and is signaling that she intends to stay in power until 2021.
2. U.K. voters sided with parties that had clear positions on Brexit. Neither Labour nor the Conservatives did well.  Parties that polled the best were the Brexit Party, which, of course, wants to leave the EU, the Liberal-Democrats and the Greens, which both want to remain.  Although it’s a bit early, Boris Johnson has the inside track to replace May.  The odds of a hard Brexit increase if he becomes PM given his mercurial nature.  At the same time, the Remain supporters are pushing for another referendum and the Alliance Party, a cross-community party in Northern Ireland, did very well and is also pressing for another referendum.  May’s Tories do not command a majority in Parliament and only have power due to their coalition with the DUP, a Unionist party.  The good performance of the Alliance undermines the value of the DUP in future governments.
3. It isn’t obvious who will become the new president of the European Commission (EC). Germany had been pushing for Manfred Weber but, after the election, French President Macron is arguing for a different (read: French) candidate.  Meanwhile, the Greens and the Liberals are intending to use their newfound power to attain top EU positions.
4. The EU and Italy may be setting up for another tussle over the latter’s debt problems. Eurozone officials indicated that the EC will likely start disciplinary steps early next month to force austerity on Italy.  A conflict is likely given the fact that the League won the plurality of votes in Italy.  Italian sovereign yields rose on the news.

The bottom line is that Europe is a mess.  The centrist parties have not figured out how to co-opt either the left- or right-wing insurgencies.  In fact, right-wing centrist parties that have moved to the right have tended to get swamped by the fringe.  So far, financial markets are taking all this in stride, probably because there is so much liquidity in the financial system that there is no clear alternative to holding bonds and stocks.  But, there is no obvious path for Europe at this point, which will eventually weigh on EU financial assets.

The Japan trip: For the most part, President Trump’s visit to Japan was mostly a photo opportunity.  There were hopes that a trade deal between the U.S. and Japan might be signed, but negotiations were not finished by the time of the trip.  The administration still favors getting a deal done with Japan.  President Trump did comment on a number of issues during his journey:

1. Trade negotiations between China and the U.S. appear to be deteriorating further.
   1. The president suggested the U.S. is in no hurry to complete an agreement and suggested that China needs a deal more than America.  In addition, the president favors more tariffs on China.
   2. Meanwhile, China is signaling that the U.S. cannot dictate its policy on state-owned enterprises, which the U.S. believes receive unfair subsidies.
   3. We also note that China has warned the financial markets not to short the CNY; this statement suggests policymakers are getting worried that the lack of a trade deal could trigger a currency crisis and capital flight.
   4. Taiwan indicated it is changing the name of the U.S. foreign office in Taipei, calling the unofficial “embassy” the Taiwan Council for U.S. Affairs. The inclusion of the term “Taiwan” will be an issue for Beijing as it suggests separation from China.  This is an issue fraught with risks—if anything were to prompt a hot war in the region, Taiwan declaring independence would do the trick.
   5. During his trip to Japan, the president complained about the Fed again.
2. There appear to be some differences between President Trump and National Security Director Bolton over North Korea. The president indicated that he is not troubled that Pyongyang had recently fired short-range missiles (his hosts were not as sanguine about the launches).  Bolton has indicated that the launches violated U.N sanctions.

Overall, the trip didn’t have significant market implications, but the lack of a deal and the U.S. president’s apparent indifference to the threat that the short-range missiles possess for Japan signal that the U.S. is less committed to Japan’s security.  That indication holds long-term implications for the region.

Chinese financial system: For the first time in two decades, China’s government took control of a bank.  Baoshang Bank was taken over by regulators after it was said to have “serious” credit risks.

Iran: It appears the president is trying to calm tensions with Iran.  Although his secretary of state and national security director seem to support increasing tensions, President Trump indicated that he is not seeking regime change in Tehran.  There are reports of diplomatic contacts between the two nations.  However, backing out of the Iran nuclear deal has soured Iran on talking to the U.S.; Tehran views Washington as unreliable.  The president clearly wants to avoid a military escalation with Iran, but there is no obvious path forward.  The tensions have generated a significant geopolitical premium into oil prices.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Good morning!  U.S. equity futures are recovering after a hard break yesterday.  PM May is on her way out.  There is hope of a break on the China/U.S. trade dispute.  Here is what we are watching:

Trade: There was mixed news on the trade front.  Late afternoon yesterday, President Trump suggested that the technology restrictions the U.S. was putting in place against China could be part of trade negotiations.  However, at the same time, the Commerce Department is changing regulations on tech exports to China, making such trade more difficult.  Meanwhile, China is considering measures to block American firms from buying Chinese technology.  Although the president suggested that U.S. policy toward the Chinese tech sector could be part of trade negotiations, increasingly, it appears that trade and technology are on two separate tracks and the latter may be far more important.  Today’s rally in risk assets has been attributed to the president’s comments yesterday about resolving both trade and tech together but those comments appear to be contradicting what we are seeing in practice.

In other Chinese trade news, pork imports jumped 24% in April, mostly due to the loss of supply in China caused by the African Swine Virus.  Even the U.S., which faced tariffs in China, has seen exports increase.

May leaving: For the past few weeks, it has been more a question of when, rather than if, PM May would step down.  She plans to leave office officially on June 6, although there is some speculation she could be around until the end of June if the Tories struggle to name a new PM.  The focus now shifts to her replacement.  The leading candidate is Boris Johnson, who has, in the past, advocated for a hard break.  Although there are concerns that Johnson will simply move to exit without a trade arrangement, it’s important to remember that it’s easy to be radical when you have no power.  At least in the short run, a hard break will have a detrimental impact on the U.K. economy and could lead to the loss of Northern Ireland.  In other words, if Johnson gets the reins of power, he will likely find himself in the same spot May was in; a painless Brexit is impossible to deliver.  We note that Johnson made comments today suggesting the U.K. should leave on Halloween, deal or no deal.  The GBP has weakened in the wake of his comments.

Dollar politics: The Treasury Department announced that it’s considering a new rule that will allow it to implement duties on nations that it deems have undervalued their currencies.  The U.S. already has a review process in place on exchange rates but, in practice, it has been mostly irrelevant.  The current regulations appear to give the U.S. the ability to prevent currency policies designed to lift exports to the U.S. but, in reality, the reserve currency nation will always encourage other nations to undervalue their currencies to acquire the reserve currency.  The Treasury has not indicated what the new regulations would entail but we do expect policy to change and the U.S. to use exchange rates as a reason for increasing tariffs.  On a related note, there is growing speculation that the PBOC is trying to dampen expectations that it will defend 7.0 CNY/USD.  The PBOC, a bit like the Bundesbank of old, seems to enjoy baiting traders into overweight positions only to hit them with intervention.  Thus, this seeming signal of weak defense could be a ploy to lure traders into being overly short the CNY, only to hit them with intervention.

Saturday in Japan: President Trump is heading to Japan for the weekend for talks with PM Abe.  Abe usually goes out of his way to personalize visits with Trump; he seems to have the idea that it helps to have a close personal relationship with the U.S. president.  Thus, expect lots of photo opportunities.  However, the U.S. is pressing Japan hard on trade and we doubt the personal relationship between Abe and Trump will give Japan much slack.  One potential market fallout—referencing the aforementioned Treasury policy change, we could see the U.S. press for a stronger JPY.  At the same time, the Abe government downgraded its assessment for economic growth but is still signaling it will continue to support the proposed consumption tax increase.

Weaker economy: Yesterday, we noted the Atlanta FRB GDPNow forecast is signaling GDP for Q2 at 1.2%, a significant slowdown from the Q1 3.2% growth.  Here is the forecast chart.

Although we tend to take a jaundiced eye toward using weather as an excuse, this time around there may be something to the claim.  Spring weather in the Midwest has delayed planting and caused severe flooding.  If weather has played a role, we could see a bounce later in the summer.

In another related issue, although the economy has bounced in recent years, the problem of inequality remains.  A map by the Economic Innovation Group shows the economic problems of rural America, especially in the South.  A Fed survey noted that 40% of Americans would struggle to cover an unexpected $400 expense.  The tensions caused by inequality are part of the political shift to populism.

Sunlight: Anyone who has dealt with the U.S. healthcare system is usually baffled by the inability to determine exactly what they are paying for drugs or services and why.  The administration is preparing an executive order to force healthcare providers to be transparent about their billing practices.  The industry, not surprisingly, is fighting the measure but the recent dive seen in the healthcare sector is partly due to such rules designed to force transparency.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Good morning!  U.S. equity futures are modestly lower this morning.  There is a lot of news to digest this morning.  Here is what we are watching:

Trade wars: There is little evidence that the trade situation in China is improving.  If anything, conditions are worsening.  Here is what we are seeing:

1. The trade negotiations are turning from a mere discussion of tariffs and the trade deficit to a direct attack on China’s tech sector. As we have noted in the past, China’s economy is in the midst of transitioning from a high-growth/low-cost manufacturer to a moderate-growth, mature economy.  Like virtually all nations that have developed since the industrial revolution, China has developed by expanding investment and has now reached the point in its development where it has excess capacity.  It needs to address that excess capacity through a combination of methods: (a) finding new markets for this production, (b) writing down the value of this investment to make it profitable for a new buyer, and (c) transforming the old investment capital into new higher value-added capital.  It is mostly trying to deploy options (a) and (c); the former is through the belt and road project, a modern form of 19^th century imperialism, and the latter through the China 2025 project, where it wants to dominate the tech sector.  The U.S. is trying to prevent either method; if China is forced to deploy option (b) then it can either take the American sub-option, which is also affectionately known as the “Great Depression,” or the Japan sub-option, which means 30+ years of stagnation.  Needless to say, China is resisting.  Preventing China from dominating tech seems to be rapidly evolving into the thrust of U.S. policy.  If this is truly the goal of U.S. policy, relations between the U.S. and China will be forever changed.  Consequently, the trade talks, though they still matter, may not give the financial markets the boost that a deal would have given us just a few weeks ago.
2. We are starting to see other developed nations fall in line with U.S. tech policy regarding China. Initially, it looked like other nations were defying Washington; however, that defiance has waned.  It is possible that continued bad behavior by Chinese tech firms has changed sentiment.  This adds to the argument that we are seeing a fundamental shift.  Essentially, since Deng, American policy has been to foster China’s economic development, assuming that increased development would eventually lead to democratization and acceptance of the U.S. global order.  That idea was steadily fraying under Obama but it’s dead under Trump.
3. We fear financial markets are misreading the situation with China. Faith in the “Trump put” remains high.  The assumption is that Trump will cave to China if financial markets buckle and accept a trade agreement, lifting risk assets.  However, financial markets may be missing the fact that there is strong bipartisan support for opposing China.  It appears blue collar workers are very supportive of Trump’s China policy.
4. China may be misreading the U.S. and President Trump’s situations as well. Yesterday, we saw scheduled infrastructure talks canceled in anger as the president ended them due to Speaker Pelosi’s comment that the White House was engaged in a “cover up.” Although we view this as normal political sniping, it could have wider implications if Beijing views the cycle of investigations and lawsuits as evidence that Trump is under pressure and needs a trade deal.  In fact, that assumption may be completely wrong; given the support the president gets from his tough stance on China, he may need that support more than a deal…unless the economy tanks.  And, that may have more to do with the FOMC (see below) than the China trade deal.  In fact, Trump may hold even tighter to his hardening position on China with the leading Democratic Party candidate downplaying the Chinese threat.
5. China appears to be dusting off a ploy it first unveiled in 2010—using its dominant position in rare earths as negotiation leverage. Rare earth minerals are critical components of modern technology, including not just smartphones but also green energy and missile guidance systems.  To some extent, the term “rare” is a misnomer.  The minerals are actually accessible in most of the world, but the production is extraordinarily “dirty,” causing serious environmental problems in mining.  Because China doesn’t have strong environmental regulations or a tort bar, China became the leader in rare earth production because it was willing to bear the environmental costs internally.  The U.S. and others could restart rare earths production but, given our environmental restrictions, the costs of these minerals would increase.
6. Meanwhile, the U.S. is continuing to build pressure on China in other ways, such as sailing U.S. Navy vessels through the Taiwan Strait.

The bottom line is that the likelihood is falling for a trade deal at next month’s G-20 meeting.  Although President Trump’s mercurial nature could lead to a surprise agreement, in reality, China and the U.S. are now strategic competitors.  While it’s possible the two nations could eventually accommodate each other, that sentiment suggests a level of optimism we struggle to share.  In the immediate situation, financial markets continue to cling to hope that this will all pass.  That hope is becoming increasingly difficult to maintain.

Gaming trade: Trade restrictions have been around for centuries and producers and consumers have worked on ways to evade them.  A prominent American protein producer has apparently figured out a way to evade Chinese trade sanctions.

Gaming tech: Drivers for the various ride-sharing companies have developed a new tactic to force up their pay.  At large airports, all the contractors coordinate to shut off their apps, leading the algorithms to assume there is a shortage of drivers.  This leads to surge pricing, allowing the drivers to increase their pay.

Fed minutes: Overall, the minutes were a bit hawkish, more reflecting Chair Powell’s press conference comments about transitory inflation than leaning toward a rate cut.  There were comments expressing concern that continued low inflation might lead to lower inflation expectations, with the term “several” being used.  But, the general tenor is that current low inflation is an aberration and won’t be maintained.  One reason for this position is based on the Dallas FRB Trimmed Mean PCE.  The “trimmed mean” process essentially throws out the most extreme component readings of the PCE that could be skewing the data.  Their yearly reading does show stable prices.

At the same time, it does not suggest a decline in inflation that would strengthen the need to cut rates.  In looking at the extreme distributions, 26.7% of the PCE components indicated monthly price changes in excess of 26.7% annualized.  Price changes from zero to 2% were around 14%.  Overall, this distribution would suggest caution on being overly worried about disinflation.  The minutes suggest a Fed on hold, with a “few” members pressing for tightening, but the financial markets are leaning even more heavily toward a rate cut.

This chart shows the two-year deferred implied LIBOR rate from the Eurodollar futures market and fed funds.  The upper line shows the spread.  The relationship has been remarkably accurate in signaling when policymakers should end tightening cycles.  We inverted these rates in late March; the implied LIBOR rate is now down to 2.01% (see chart below), suggesting monetary policy is too tight.  That is not the message the FOMC is sending, which is increasing the risk of a policy error.

The end of May: It finally looks like the end for PM May is coming.  Andrea Leadsom resigned from her cabinet position yesterday, indicating she could no longer support the PM’s Brexit plan.  Tory MPs are furious with May’s flirtations with Labour by offering a customs union and hinting at supporting a second referendum.  At the same time, the Brexit Party looks like it will win the majority of EU Parliament seats, a further blow to May.  Internal Tory party leadership is expected to meet with May in the coming days and will likely press her to step down.  All this political turmoil has been bearish for the GBP.

Weaker economy: The Atlanta FRB GDPNow forecast is signaling GDP for Q2 at 1.2%, a significant slowdown from Q1 3.2% growth.  Here is the forecast chart.

And the contributions.

The largest drag on growth is inventory liquidation, which accounted for 65 bps of growth in Q1.

Those pesky Russians: Russian warplanes were buzzing the coast of Alaska earlier this week; two incidents were reported that led the U.S. to intercept in both cases.  The Russians sent two Tu-95 bombers and two Su-35 fighter escorts.  The Tu-95 is a Cold War-era large turboprop bomber; it is essentially Russia’s answer to the B-52.  The bomber is a lumbering aircraft; although it can act as a platform for cruise missiles, its ability as a bomber is minor due to its large size and low speed.  But, it is a perfect aircraft to send a message as one can’t miss it in the air.  However, it isn’t obvious what that message is except to signal that Russia isn’t afraid to make provocative acts.

Foreign political news: EU parliamentary elections begin today.  We covered them in detail in yesterday’s report.  Election disputes in Indonesia led to riots yesterday.  It is hard to see how Joko Widodo could have won by fraud given the size of his win, but the loser, Prabowo Subianto, protested the outcome and apparently triggered the response.  We continue to wait to see how the incumbent responds.  In India, as expected, Narendra Modi has returned to power in a landslide.

Energy update: Crude oil inventories rose 4.7 mb last week compared to the forecast drop of 1.9 mb.  There was a 1.1 mb draw of the SPR, meaning the actual build was closer to 3.6 mb.

In the details, refining activity unexpectedly fell 0.6% compared to the 0.5% increase forecast.  Estimated U.S. production rose slightly by 0.1 mbpd to 12.2 mbpd.  Crude oil imports fell 0.7 mbpd, while exports fell 0.4 mbpd.

This is the seasonal pattern chart for commercial crude oil inventories.  We are now well within the spring/summer withdrawal season so the continued build is bearish for prices.  The seasonal pattern remains below normal but the gap is closing rapidly.

Based on oil inventories alone, fair value for crude oil is $49.10.  Based on the EUR, fair value is $51.24.  Using both independent variables, a more complete way of looking at the data, fair value is $49.45.  Geopolitical risks are adding nearly $13 per barrel to crude oil prices.  Although the geopolitical risks are formidable, this spread is unusually wide and raises the odds of a deeper price correction in the coming weeks, assuming that inventories remain elevated and the dollar remains strong.  Of course, this rich price is due to geopolitical risks; Iran has been using covert actions in response to U.S. sanctions, and the U.S. is considering boosting its troop presence in the Persian Gulf.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

(N.B.  We are making a modest change today in this report.  Instead of footnoting links to news items, we are moving to using hyperlinks.  To see the linked story, simply click the underlined and highlighted item in the report.  This is a more “modern” way of linking and will make our reports less cluttered.)

Good morning!  U.S. equity futures are modestly lower this morning.  The Fed minutes are out later today and trade tensions remain elevated.  Brexit looks a mess and EU Parliamentary elections are coming.  Here are the details:

BREAKING: Russian aircraft, for the second day, have threatened U.S. airspace, leading American warplanes to intercept.  We will have more on this tomorrow.

Fed minutes: We will be watching for any insight into the committee’s thinking on the nature of inflation.  Members have indicated at least some degree of dissention as to whether the current low inflation is due to structural issues or if, as Chair Powell stressed in his post-meeting press conference, current low inflation is due to “transitory factors.”  Our take is that it’s probably more permanent, but we don’t vote on the committee!  Although the minutes are heavily edited, look for words that suggest any sort of numbers, such as “some” or “a few” or “most.”  If the minutes suggest the permanent inflation group appears to be larger, it might mean a dovish tilt.

Tech trade war: Positions on both sides are hardening.  The Trump administration is considering blacklisting Chinese surveillance technology firms, which would prevent them from purchasing U.S. technology.  This action would further escalate tensions.  The Chinese appear to be “digging in” as well; Chairman Xi told his people to prepare for difficult times, relating the current situation to Mao’s “Long March.”  American firms operating in China report increasing difficulties, including rising costs and increased regulatory scrutiny.  A rising number are looking to relocate, with Southeast Asia and Mexico as the most favored destinations.  The growing trade conflict increases the risk of global recession.

EU parliamentary elections: We analyze and comment on domestic and foreign politics on a regular basis.  That being said, we haven’t been overly enthusiastic about delving into the upcoming parliamentary elections.  The rules are devilishly complicated and it has never been clear to us how powerful the body actually is.  Often, the EU Parliament vote is a protest action against the established domestic governments.  However, with all that being said, the elections are looming and this is what you need to know:

1. What does the EU Parliament do? It passes EU wide laws, supervises the European Commission (EC) and oversees the EU budget, which is currently around €145 bn.
2. This vote will replace Jean-Claude Juncker, the outgoing president of the EC.
3. The body has 751 seats and more than 350 mm EU voters can participate in the election. It is the only chance EU citizens have to directly vote on EU matters.
4. The U.K. will participate in this vote but, if the country leaves the EU as planned, its 73 seats will be allocated in the following manner—27 will be distributed among 14 nations deemed to be “underrepresented” and the rest will be held in reserve for new members.
5. In the voting, national parties within EU countries organize with like-minded members in other nations. Polling suggests the fringes are gaining ground and the center-left and center-right parties are losing power.  Right-wing populist parties are especially gaining ground.  Although the centrist parties will probably still have the largest bloc, they will need to add coalition partners from the populist-leaning parties.  The populists want an autarkic trade policy and stronger actions against immigration.  The Schengen policy of free movement might be restricted.
6. Although Germany and France will remain the heavyweights in the EU, especially if the U.K. departs, the ability of these two nations to determine the path of EU policy will be adversely affected if the populists gain influence in the EU Parliament. That might mean trade negotiations with the U.S. will become more difficult and it likely increases the odds of a trade rupture with the U.S.  It might make a trade deal with the U.K. after Brexit more difficult as well.  It may also have an impact on relations with Turkey.  The populist opposition to immigration will give Ankara the ability to upset EU relations by merely allowing Middle East refugees transit across its territory to Europe.

Overall, we don’t expect an immediate market impact, regardless of the outcome (which is why we haven’t had much to say before now).  The EU moves slowly by design.  But, over time, it could change economic and regulatory policy and increase dissention in Europe.  The more power the populists receive, the greater the odds of an eventual EU/Eurozone breakup.  Again, this isn’t anything we expect in the next few years, but by 2025 we could be seeing clear signs of trouble.

Brexit: PM May is offering a fourth vote for her plan and has suggested she will allow a second referendum vote by Parliament.  The response has been overwhelmingly negative.  It appears that PM May tried to lean toward supporting Labour’s ideas for a Brexit deal, which has infuriated the hardline Tory members but failed to woo the opposition.  The GBP has held up rather well, edging lower but not breaking down.  The real risk to the currency is probably a Corbyn government, not Brexit.  May probably won’t survive another month and the polling suggests Boris Johnson will be the next Tory PM.  Johnson is a bit of a rogue but has tended to lean toward a hard Brexit.  If Johnson pushes the country toward a hard Brexit, we would not be shocked to see new general elections.  Overall, the political trends are not favoring the GBP, but nothing looks catastrophic…yet.

Debt limits: It looks like we are actually close to getting a budget deal.  If so, the potential for autumn drama will be reduced.

Japan consumption tax: Japan’s fiscal situation is famously bad.

Its government debt/GDP is over 200%; for years, bond vigilantes have been shorting JGBs because “someday, this has to lead to inflation and falling bond prices.”  The trade has been so spectacularly bad it has become known as the “widow maker.”  Japan, like most nations that developed after WWII, used export promotion to constrain consumption, boost saving and use the saving for investment.  That works very well until a certain level of development is achieved.  Then, the economy needs to (a) shift to consumption instead of exports to drive growth, and (b) use various methods to deal with the inevitable malinvestment that develops from subsidizing investment.  Japan has essentially done neither and has suffered through 30 years of stagnation.  A holdover from this policy is the reliance on consumption taxes to raise fiscal revenue.  This is harebrained—the last thing the overburdened household sector needs is more taxes.  But, because policy inertia is so strong, the country continues to look at raising consumption taxes to address the aforementioned deficit.  Under Abe, the government has tended to back away from planned hikes and we expect them to continue that policy.  But, the recent surge in GDP may undermine the short-term political argument for postponing the hike and thus the odds may have increased for it to go through.  If it does, we would look for a cyclical downturn in the economy.  The BOJ is warning it will consider further easing measures if the tax boost is enacted.

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