by Bill O’Grady and Thomas Wash

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

A deal with Mexico: As news spread that the tariffs on Mexico would be rescinded, stories broke that Mexico hadn’t agreed to anything that was not already in place.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

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

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

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

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

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

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

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by Bill O’Grady and Thomas Wash

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

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

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

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

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

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

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

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

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by Bill O’Grady and Thomas Wash

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

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

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

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

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

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

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

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

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

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

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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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