by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Today is the 75^th anniversary of D-Day.  President Trump is visiting the memorial sites today.  Equities are modestly higher this morning, and Mexico and the ECB are dominating headlines.  Here is what we are watching today:

The ECB: The ECB released its statement and it involves what looks like a modest tightening.  Although the bank promised to keep rates low into 2020, which would be dovish forward guidance, there was some disappointment on QE.  The loan rate to banks ticked up 10 bps, while all other rates were left unchanged.  Balance sheet policy was also left unchanged.  Financial markets were somewhat disappointed and the short end of the Eurozone yield curves are taking it as bearish; Eurozone short rates are higher, while longer duration rates fell and the EUR is up.  Nothing earthshattering emerged in the press conference.  Although on its face the actions by the ECB were not hawkish, the fact that the markets are taking the decisions as hawkish suggests that expectations were leaning toward additional stimulus.

Mexico: Mexico had a tough night.  First, trade talks continue but there isn’t much evidence of progress, which means the tariffs will likely go into effect next week as there was a surge in asylum seekers at the U.S. border.  Mexican officials fear a break in U.S. relations, which would undermine Mexico’s economy.  Second, rating agencies moved to downgrade Mexican sovereign debt.  Fitch lowered Mexico to BBB, nearing junk status, and Moody’s lowered its outlook to negative.  The MXP fell sharply on the news.  The former suggested that the trade conflict contributed to the downgrade.  Mexico has suffered significant damage over the past week, moving from what looked like a safe haven from the China/U.S. trade conflict to a new target of the Trump administration.  At this juncture, barring some breakthrough on border negotiations, it looks like the tariffs will go into effect and the Mexican economy is at risk.

The Beige Book: There isn’t much to report on the Beige Book, the Fed report that discusses economic activity across the nation.  All districts reported modest growth in April and May.  The trade war isn’t having much of an effect on manufacturing yet, while employment was reported to be moderate.  Despite tight labor markets, overall wage pressures remain moderate.  Prices for inputs were reported to be rising faster than final goods prices, which could signal some margin compression in the future.  Overall, though, the report didn’t indicate significant inflation concerns.  As expected, the report confirmed continued moderate growth with little price pressures.

Russia and China: The leaders of both nations met this week and declared their friendship.  These are not natural allies; Russia has feared that China will eventually spread its influence into Siberia and a hot war between the two states nearly occurred during the Cold War.  The Nixon to China moment occurred, in part, due to the deterioration of relations between the U.S.S.R. and China.  As the U.S. threatens both nations, they are making common cause in opposing American hegemony.  As is often the case, both nations want to end the dollar’s reserve currency status.  They made promises to use their own currencies in bilateral trade.  As long as both nations have goods to trade and have fairly balanced trade, avoiding dollar use is possible.  The problem begins when trade becomes unbalanced; would China want to hold Russian debt in reserve?

Meanwhile, in other news on China, the U.S. is preparing a major weapons sale to Taiwan, which will clearly anger Beijing.  From China’s perspective, this would be like a weapons sale from a European power to the Confederacy during the U.S. Civil War.  China is adding stimulus to the economy to overcome the negative impact of the trade conflict with the U.S., which includes actions to lift auto sales.  The trade conflict has led to a record outflow from Chinese equities.  As an update to this week’s WGR, China appears to be preparing to cut exports of rare earth products as the U.S. calls for steps to reduce reliance on overseas sources for these goods.

Brexit: Currently, Boris Johnson remains the front-runner to replace PM May in the Tory leadership election.  He generally leans toward a hard Brexit, but others in the leadership race are considered even more hardline.  Perhaps the most interesting development is that polls show Labour can’t win in a general election unless it supports a second referendum.  Corbyn has tried to avoid supporting a second referendum on fears that Brexit supporters in the Labour Party’s working class wing would ditch the party if it supports another Brexit vote.  Labour, like the Conservatives, is torn by the Brexit issue.

Denmark elections: The center-left Social Democrats won the largest share of votes in yesterday’s election.  What swung the election was a move by the Social Democrats to support rather harsh anti-immigration measures, which pulled traditional supporters of the center-left who had drifted to anti-immigration parties over immigration issues.

Italy versus the EU: As expected, the EU has put Italy on notice for breaching EU spending rules.  Italian officials remain defiant, indicating that adjustments to fiscal spending are not being considered.

An assertive Germany?  The German government is considering sending one of its warships through the Taiwan Strait in what would be a rare confrontational action.  In the postwar world, Germany has tended to avoid hard power projection.  If the Merkel government were to take this step, it would likely be welcomed by the U.S.  We will be watching to see if China reacts by targeting German auto firms in China or by other measures.

Energy update: Crude oil inventories jumped 6.8 mb last week compared to the forecast drop of 1.8 mb.

In the details, refining activity rose 0.6% as forecast.  Estimated U.S. production rose slightly by 0.1 mbpd to 12.4 mbpd, a new record.  Crude oil imports rose sharply, up 1.0 mbpd, while exports were unchanged.

This is the seasonal pattern chart for commercial crude oil inventories.  We are now well within the spring/summer withdrawal season so the recent increase in stockpiles is bearish for prices.   The seasonal pattern, after holding below normal since January, has now seen a build back to normal levels.  Continued increases in stockpiles will be very bearish for prices as stock levels should be declining due to rising refining activity this time of year.

Since early April, we have seen a surge in crude oil imports.

This increase in imports, coupled with record domestic production, is weighing on prices.

Based on oil inventories alone, fair value for crude oil is $47.06.  Based on the EUR, fair value is $51.16.  Using both independent variables, a more complete way of looking at the data, fair value is $48.64.  In the past two weeks, oil prices have corrected significantly and are getting closer to fair value, although rising inventory levels have also reduced the fair value price.  Without reductions in inventory levels soon, prices are likely to fall below $50 per barrel.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Good morning!  The risk-on rally that began yesterday is continuing this morning.  The ADP employment data was very weak (see below) and is prompting a strong rally in fixed income.  Here is what we are watching today:

What prompted the rally?  Much of the lift seen yesterday into today has been credited to Chair Powell, who suggested in a speech yesterday that the Fed could cut rates, especially if the trade issues weaken economic growth.  The attribution seems to suffer from a common malady seen among editors in the financial media, the post hoc, ergo proctor hoc[1] fallacy.  After all, the financial markets have been convincingly signaling that the Fed should be cutting rates aggressively and soon.  So, the only way Powell could have been bearish is if he had signaled that the FOMC is not inclined to cut rates, which would contradict what several members of the committee have been signaling for weeks.  A better case could be made that the market had fallen too far, too fast and that, perhaps more importantly, the current levels in equities have likely discounted the impact of recent trade news in the absence of recession.  So, how far will the rally carry?  Probably not to new highs, but we wouldn’t be shocked to see a move toward the upper end of the recent range, or around 2900 on the S&P.

World growth forecasts cut: The World Bank has cut its global growth forecast from 2.9% to 2.6%, and has reduced its forecast for global trade as well.  The IMF has reduced its forecast for China’s GDP to 6.0% from 6.2%.

Trouble in Africa: We are watching developments in three nations.  First, in Sudan, protests earlier this year ousted President Omar Hassan al-Bashir.  The military and the protestors were uncomfortable allies in the effort to remove the strongman from his three-decade grip on the country.  Now, the military has moved against the protestors.  It is unclear who is in charge as the military isn’t unified and various factions are trying to take control.  Civilians continue to oppose military control.  Although Sudan isn’t the oil producer it once was since the creation of South Sudan, it remains a significant transit point for oil so unrest there could reduce oil flows.  In Libya, fighting continues and has intensified.  General Khalifa Hifter, who controls the eastern part of Libya, is trying to invade the western part but has faced fierce resistance as the conflict is becoming a proxy war, with Hifter getting support from Egypt, the UAE, Saudi Arabia, France and Russia, while Qatar and Turkey are aiding the various groups aligned against Hifter.  Libya is a member of OPEC and the war has threatened to reduce oil supplies.  In Algeria, protests continue but the military government has been slow to accede to civilian demands.

The future U.K./U.S. trade deal: Brexiteers have argued all along that if the U.K. were to exit the EU it would have the freedom to make new trade agreements that would be more suited to its economy and improve the island nation’s prospects.  Perhaps.  But, the other side of being able to make new deals is that the U.K. outside the EU will have much less leverage in negotiations.  President Trump, perhaps inadvertently, gave the Brits an insight into what it will look like when negotiating with the U.S. from a position of weakness.  Yesterday, the president suggested that the hallowed National Health Service might be part of trade negotiations.  The backlash was swift and fierce and Trump did back away from the comment.  Although the president seemed to preserve the “sacred” nature of the NHS, in reality, the U.K. will be dealing with the U.S. from a deep position of weakness.  Not only will the NHS be in play, but so will agriculture and financial services.  President Trump did the British a favor by giving them a glimpse of what post-Brexit will look like.  Let’s see if they take the hint.

The Mexican tariffs: President Trump continues to insist that the tariffs will be applied.  Senate Republicans are showing a rare sign of opposition to the White House.  The FT highlights the states that would be most affected by the trade impediments.  There is a possibility that President Trump might accept some gesture by Mexico and delay implementation but, so far, it looks like a multi-level pile-up between Mexico, the White House, the Senate and American businesses.

Establishment versus the Populists: One theme we have regularly discussed is how the Trump presidency has been straddling both the establishment and the populists.  His tax cuts and deregulation are firmly establishment policies, whereas his immigration and trade policies are populist.  The establishment is starting to realize that the president isn’t always its ally and a pushback may be developing.  The aforementioned discussion of Senate opposition to the Mexican tariffs is one element of this counterattack.  Campaign funding may be another.  At the same time, this establishment versus populist divide is also playing out in the Democratic Party.  We note that Sen. Warren, one of the plethora of Democrats running for president, has offered an economic plan that fully skews toward job creation and against capital and efficiency.  The 2020 presidential election may not offer any candidate fully to the liking of the establishment.

Italy versus the EU: As we have noted in recent days, Italy is facing potential sanctions from the EU over fiscal deficits and government debt.  Although the Italian government continues to insist it will avoid a confrontation with the EU, Deputy PM Salvini (and the real power in the government) is warning that Italy might issue a parallel currency that could be used to pay government debt.  The issuance of a parallel currency would be a significant threat to the Eurozone as other indebted nations might take similar actions.

Continued trouble in the farm belt: Last weekend, I[2] took a trip through the middle of Illinois.  Nearly all the fields, which would usually have emerging corn plants, were fallow.  Cold weather and heavy rain have delayed planting in key parts of the Corn Belt at unprecedented levels.  We are very close to the point where corn planting becomes impossible, thus farmers may either move to soybeans or simply not plant.  At the same time, farmers are famous for moving aggressively once conditions improve.  So, we may still see a soybean crop this year.

Odds and ends: U.S. colleges and universities are watching with great concern as the flow of Chinese students to the U.S. is under threat.  Walmart (WMT, 102.56) is offering high school students free SAT prep and partial scholarships in a bid to find new employees, a sign of how tight the labor markets have become. 

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[1] “after this, therefore because of this”

[2] This is Bill talking…

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Good morning!  It’s the 30^th anniversary of the Tiananmen Square crackdown.  President Trump’s visit to the U.K. continues today.  We are seeing a bit of risk-on this morning as equities make a modest recovery.  Here is what we are watching today:

Fed meets in Chicago: The Federal Reserve is holding a conference in Chicago today and tomorrow to discuss the inflation target.  Members of the FOMC have expressed concerns for some time about the target and how it is interpreted by the market.  For the most part, it has evolved into a 2% ceiling on price changes; although this target is clearly workable, the Fed wants to avoid, at all costs, being boxed in to a policy that it might not want to adopt.  This has always been the argument against rules-based policy.  For years, economists have argued that the Fed could put policy on a sort of autopilot where the model would generate the “correct” policy rate depending on whether a certain combination of factors exist.  The benefits of such a program would be certainty; we would always know what the policy rate would be going forward.  The downside is that unexpected conditions could develop that were not in place when the model was created and force policymakers into rate adjustments that may be inappropriate.

Policymakers have become increasingly concerned that the perception of the 2% ceiling on inflation may not be appropriate and are considering making changes to the inflation bogey to give themselves more flexibility.  There are several potential adjustments being considered.  We suspect that none will be decided upon at this meeting but the groundwork will likely be laid for an adjustment.  The bottom line is that the Fed wants an inflation target that is less rigid but still provides a guideline for the markets to follow.

Weakening global growth: We are seeing reports from the transportation sector suggesting the global economy is coming under pressure.  Additionally, the global PMI index has dipped under the 50 expansion line.  Weaker global growth will add to pressure on U.S. policymakers to ease.

Tightening fiscal policy?  The U.S. has been engaging in fiscal stimulus, but there are two issues that could reverse this policy.  First, the debt ceiling issue will return by September and automatic spending cuts will be enforced if a deal can’t be reached.  Second, although the full effects are difficult to determine, tariffs are, essentially, a form of consumption tax and raising them is an act of fiscal tightening.  Tightening fiscal policy may force the FOMC to start cutting rates.

Bullard and rate cuts: St. Louis FRB President Bullard chased a short-term rally in equities when he suggested the FOMC may need to cut rates soon.  We rate Bullard a level 5 dove in our rating system (1 = most hawkish, 5 = most dovish), so his stance isn’t a shocker.  However, we suspect his position probably isn’t the consensus on the FOMC.  One reason why is that the ISM Manufacturing Index is still in expansion mode.

This chart looks at the ISM Manufacturing Index and the monthly change in the fed funds target.  Since 1983, a period of 403 months, the FOMC has cut rates when the ISM index was above 50 in 21 occasions.  We do note there were a series of cuts that began in August 2007 even though the ISM was safely above 50.  The trigger for these cuts came from a sharp deterioration in financial conditions in Q3 2007.  In the absence of a drop in financial conditions, which are currently benign, the FOMC will likely need to see more economic weakness to trigger rate reductions.

More on tech: Tech shares took a beating yesterday, with the Technology sector SPDR (XLK, 70.63) falling 1.8%.  It does appear that a bipartisan move to regulate the large firms in the sector, including anti-trust actions, is progressing.  Although it is unclear how this will play out, and it will likely take years to fully develop, the regulatory move will distract these firms and likely have an adverse impact on their performance.

Mexico: There are a number of cross-currents affecting the situation with Mexico.  First, Mexico is creating multiple responses to the tariff threat.  It has threatened retaliation, although the impact of any retaliation will be disproportionate to the damage the U.S. can inflict on Mexico.  There are also indications that Mexico is starting its own crackdown against illegal migration, but the government has indicated it will not grant Mexican asylum to Central Americans moving into the country.  Second, Mexico is trying to negotiate a deal that might prevent the tariffs from being implemented.  Third, there is an apparent effort by Congress to take back some of its trade authority by blocking the president’s proposed tariffs on Mexico.  Congress has mostly given up its role in shaping trade policy after making a hash out of it in the 1920s in a bill known as the Smoot-Hawley Tariff.  However, the administration’s strategy of using tariffs as its main foreign policy tool appears to be stirring a congressional response.  If Congress limits the White House’s ability to unilaterally act on tariffs, this policy tool may not be as easy to implement going forward.

Trouble for Maduro: Venezuelan President Maduro has suffered another blow as Russia begins to pull advisors out of the country.  The defense firm Rostec, which was training Venezuelan security forces, has decided to reduce the number of trainers, mostly because the country can’t afford to pay them anymore.  This news not only shows the degree of economic deterioration in Venezuela, but it also highlights the transactional nature of Russian foreign policy.  Essentially, Russia can’t afford to support all its allies and we suspect the costs of supporting operations in Ukraine and Syria are affecting Moscow’s ability to remain involved in Caracas.

A threat to the CPC: There are reports that the Chinese middle class is becoming worried about the trade war with the U.S.  The message from leadership is to prepare for hard times, which isn’t what those who have put together some savings want to hear.  Online reports suggest some households are considering diversifying out of the CNY into other foreign currencies or perhaps precious metals.  These Chinese citizens don’t threaten the regime as much as students would (no less on the 30^th anniversary of the Tiananmen Square crackdown) by calling for democracy or mobilizing against the regime, but they are an economic threat.  The potential for capital flight exists as does a simple “hunkering down” in spending that would weaken consumption.

Odds and ends:It appears the SPD will continue to be part of the German coalition government, easing fears of snap elections.  China is warning its citizens that the U.S. isn’t a safe place to travel.  China also appears to be stockpiling soybeans, an indication that it is preparing for a long trade dispute with the U.S.  Inventory accumulation will be part of deglobalization as the world moves from “just-in-time” to “just-in-case” logistics.  Kevin Hassett fired off a parting shot, arguing that tariffs and deficits are bad for the U.S. economy.  Hassett is leaving his post as head of the CEA and is not a candidate for Fed governor.  The EU is close to making a decision on Italy’s punishment for ignoring fiscal and debt rules.  The Italian PM has threatened to quit over internal squabbling over this issue.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] We bid welcome to June!  Like the St. Louis Cardinals, we are more than happy to see May in the rearview mirror.  However, like the other major league baseball team in the state, June may not be much better.  POTUS is in the U.K.  Trade wars are spreading.  Here is what we are watching today:

The dizzying effect of trade wars: Washington is opening new battles on the trade front at a pace that is nearly impossible to digest.  Here is what developed over the weekend:

1. India: The Trump administration has removed India from the developing nations list.  Being on this list gives a nation preferential treatment on trade.  This action will increase the number of Indian imports now subject to tariffs.  This decision does make sense; India is clearly a major economic power now and treating it like a small developing nation doesn’t reflect reality.  At the same time, no one wants to have preferential treatment removed and India has intimated that it will retaliate in kind.  In addition, the U.S. has been wooing India for some time to participate in America’s goal of containing China’s geopolitical ambitions.  Boosting tariffs on India won’t support that goal.
2. China retorts: China published a 23-page white paper explaining its position on the recent trade rupture with the U.S.  Not surprisingly, Beijing blames Washington for the recent rise in trade tensions.  China is also investigating FedEx (154.28, -3.70) for diverting shipments that were to be sent to China and instead ended up in Japan.  China is implying the company is a “tool” of U.S. policy; if it decides that is the case then the company’s business in China could be affected.  The U.S. does appear to be trying to ease tensions, considering sending “good cop” Mnuchin to meet with Chinese officials at the G-20.  Meanwhile, the fallout from the tech and trade conflict continues as tech firms are starting to look at their supply chain risk and the conflict is prompting China and Russia to improve relations.  China has also officially warned its students about getting their education in the U.S.
3. Mexico: It seems President Trump was mostly on his own in the decision to apply tariffs on Mexico over the border situation.  Automakers are scrambling to adjust their supply chains that will be disrupted if the tariffs are implemented.  It does appear that the Mexican tariffs are likely to be implemented.  First, it isn’t obvious what Mexico can do to address Washington’s concerns; the White House did not offer any specific actions it wants from Mexico.  Second, because President Trump doesn’t seem to grasp that tariffs are, essentially, a consumption tax, he is under the impression that foreigners pay the tax.  Like the mayor of a locality where the only shopping center exists, he seems to think that sales taxes are fully paid by outsiders.  Accordingly, he apparently thinks the Mexican tariffs can be used to fund his border wall.  Mexico’s president, AMLO, is trying to defuse the situation, sending a delegation to Washington.
4. Australia: Although the Trump administration has indicated it won’t take action, apparently the White House considered attaching tariffs on Australia due to a surge of imports of Australian aluminum.  This surge makes perfect economic sense; if some tariffs are applied to parts of the world, the parts that are not affected gain an advantage and thus their shipments will tend to increase.  Given the mercurial nature of the Trump administration, we would not be surprised to see this threat reemerge later.
5. Kevin Hassett: The head of the Council of Economic Advisors is leaving, likely due to his opposition to the administration’s tariff policy.  Hassett was instrumental in supporting the corporate tax cuts but he is a free trader and we suspect he couldn’t continue to work with a government that was expanding tariffs.  This position requires Senate approval so we would expect it to remain vacant as the Senate probably won’t approve a tariff supporter (the Senate is quietly opposing Trump’s trade policy), and we doubt Trump will bother to have a voice near him that opposes his position on tariffs.

One of the more difficult issues to resolve with the administration’s trade policy is that it works in cross-purposes.  The White House wants to pass USMCA but then applies tariffs on Mexico over a different issue; if there is no movement, we can’t see how Mexico will support the new treaty.  The U.S. needs India as a foil to China but hurts its economy with new tariffs.  We expect the administration will start to face more significant retaliation in the coming months that will affect the economy, both domestic and global, in ways that will be hard to predict.  We are already seeing weaker PMI data due, in part, to trade tensions.  One trend that is likely to emerge is the creation of trade blocs, where local trade will be dominated by regional hegemons with little trade activity between blocs due to impediments.  This would mean a world of higher inflation and lower profitability, but it will likely also be more equal and there will be less “creative destruction.”  In the meantime, the tariff actions have roiled financial markets; we are actually seeing the yield curve steepen this morning because rates at the short end are falling rapidly in anticipation that the Fed will need to cut rates soon.

Talking to Iran?  The Trump administration appears to be “ready to talk” to Iran.  In some respects, it’s hard to see why Iran would want to negotiate with the U.S. because whatever deal is struck may not survive the next U.S. administration.  At the same time, the Iranian economy is in shambles and if Trump offers an acceptable deal Tehran might just take it.  However, we suspect the U.S. wants a permanent end to uranium enrichment, something we doubt Iran would accept.  But, if the economic “carrot” is large enough, it might just work.  A deal with Iran would be profoundly bearish for crude oil.

Oil higher: After getting slammed the past few sessions, oil prices are up today on reports that both Saudi and Russian oil production declined in May.  It appears the former made cuts to lift prices, while the latter was adversely affected by an industrial accident that tainted a large shipment of Russian oil.

European political turmoil: The head of the SDP in Germany has resigned due to her party’s poor showing in the latest European elections.  The current German government is a grand coalition of the SDP/CDU-CSU; if the SDP exits the coalition, the government will fall and result in new elections with an uncertain outcome.  Many SDP members believe that membership in the government is destroying their party and want to shift toward the opposition.  However, the fear is that if the government falls then the centrist bloc may fail altogether.  A reflection of this fear is shown in Denmark, which goes to the polls on Wednesday.  The center-left Social Democrats are expected to do well by taking an anti-immigration stance.  A truism of politics has been that one can have a large social welfare state or open borders, but not both.  If a nation has both, resentment tends to build because taxpayers feel they are supporting foreigners.  The Danish Social Democrats have decided they want a broad social safety net and are willing to take a hardline position against immigration.

Tech and regulation: Both Google (GOOGL, 1063.70, -42.80) and Amazon (AMZN, 1765.27, -9.80) are facing increased anti-trust scrutiny.  To some extent, regulation is the greatest threat to both companies’ business models.

Not dead yet:Rumors that Kim Yong Chol had been demoted or executed over the failure of the Hanoi summit with the U.S. are apparently untrue.

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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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