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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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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