by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Trade concerns remain, while tensions with Iran increase.  Here is what we are watching:

China trade: Although Chinese negotiators are meeting with U.S. officials today, it appears we are heading toward tariffs at midnight EDT tonight.  China has vowed to retaliate.[1]  In a speech (granted, at a rally), President Trump accused China of “breaking the deal.”[2]  We have been seeing more color around the decision-making process in both countries.  When the written agreement went to Chinese officials, they realized it would require changes to the law; China apparently had assumed it could make adjustments through regulation, which would be easier to enact but also less difficult to reverse.[3]  It’s likely that, from the Chinese perspective, this adjustment met the spirit of the deal without the difficult process of new legislation.  From the American perspective, this was a deal breaker.  In reality, this is rather classic diplomatic behavior, called “strategic ambiguity,” where two parties say the same thing but each interprets it as something different.  USTR Lighthizer would be sensitive to such tactics and would likely see it as an attempt to circumvent monitoring and penalty (and he is probably correct in that assessment).

Another element that may have led to China’s behavior is the perception that the U.S. economy may be faltering, undermining the U.S. bargaining position.  President Trump’s persistent attacks on the Fed may have created this impression.[4]

So far, the financial markets have reacted with caution but not panic.  This may be due to what the NYT calls the “Trump put,” which means that every time equities run into trouble the president takes steps to lift confidence.[5]  We don’t disagree with this observation.  What one has to be careful with is the reason a Trump put might exist.  If the president believes a bear market would weaken his chances at re-election, then relying on it makes sense.  But, if the president concludes that playing tough with China is even better for his re-election, then the put might not be as reliable as the market seems to believe.

We note the president has suggested that China (and we believe the EU as well) may very well be playing a stall game,[6] where they try to push negotiations into 2020 with the idea that the White House will want to avoid the disruption of a trade conflict in an election year, or in hopes that a change in power might lead to a less confrontational trading partner.  We think Trump has a point here, but not the one he is making.  An establishment candidate would likely want to return to the pre-Trump multilateral trading system and would almost certainly not engage in the sort of tariff tactics deployed by the current administration.  However, a populist Democrat might very well conduct policy in a fashion similar to Trump and may be even more aggressive.  After all, we doubt a Sanders or Warren White House would have anyone resembling Steve Mnuchin in the cabinet.  The key point here is that if it becomes a campaign strategy to make statements suggesting China and the EU want to negotiate with a “weak Democrat,”[7] then the Trump put may not be as certain as financial markets seem to believe.

To some extent, the tradeoff between the Trump put and the trade warrior stance may come down to the degree and distribution of pain that occurs from a trade war.  The first element of risk is Chinese retaliation.  China is nearly out of U.S. imports to apply tariffs, so its next step would be to deny investment and simply not buy certain (politically sensitive) goods.  This is really bad news for the agriculture markets and probably a loser for companies with extended supply chains into China.[8]  The second element of risk comes from the U.S. tariffs themselves.  Up to now, most of the incidence of the tariffs has mostly affected primary and secondary goods, with less direct impact on consumer goods.  But, as the tariffs widen, the impact on consumers will become more direct.[9]  Winners could be foreign companies that directly compete with the U.S. for the Chinese market and foreign commodity suppliers, e.g., Brazil and Argentina.[10]  At the same time, a trade war between the world’s two largest economies creates a good bit of collateral damage.  World trade appears to have suffered.[11]

The bottom line in all of this is that the financial markets’ rather sanguine approach to the trade spat is probably based on the notion of a Trump put.  Clearly, the president’s pattern of behavior fosters this idea.  But, our fear is that the put is based on the president’s perception of political benefit, so things could get rocky if he concludes that a trade war brings him more benefit than an ebullient stock market.  In addition, as we have stated before, wars occur due to miscalculation.  We think China has misunderstood Trump.  Although we doubt Beijing will hear us, they should really read about the archetypes of American foreign policy.  Embarrassing a Jacksonian is a really bad idea.[12]

The Iran issue: Although the EU is trying to hold the nuclear deal together, we doubt it will work.[13]  The EU is caught between Iran and the U.S. and has more to lose by not toeing the American line.[14]  The U.S. has broadened sanctions on Iran,[15] further isolating the Iranian economy.[16] Meanwhile, Iran has indicated it will begin to enrich uranium again if the Europeans don’t support the Iranian economy, which would essentially scotch the deal.  One other item of note—there are reports, so far not confirmed from mainstream sources, that an Islamic Revolutionary Guard Corps (IRGC) commander has defected.[17]  Brigadier General Ali Nasiri ran the IRGC protection bureau, which performs some of the Secret Service protective functions for the Iranian regime.  There are rumors that he carried “sensitive” documents to a Gulf state embassy when he defected.  We will be watching to see if the report emerges in the Western media in the coming days.

Brexit: PM May survived another leadership challenge, indicating that there really isn’t an obvious alternative to her in the Tory Party.  She indicated that another Brexit vote will likely be held in a couple of weeks.[18]

Odds and ends: Cyril Ramaphosa won yesterday’s poll but the margin of victory was the lowest since the end of apartheid.[19]  North Korea launched more “projectiles.”[20]  Although Venezuela has defaulted on most of its bonds, it continues to pay on a portion of its debt, the bonds of Citgo and those held by Russia.  The former is being paid to avoid creditors seizing its refining assets in the U.S., while the latter is to keep Russia as an ally.[21]

Energy update: Crude oil inventories fell 4.0 mb last week compared to the forecast rise of 2.5 mb.  There was a 0.9 mb draw of the SPR, meaning the actual decline was closer to 4.9 mb.

In the details, refining activity fell 0.3% compared to the 0.9% decline forecast.  Estimated U.S. production fell slightly by 0.1 mbpd to 12.2 mbpd.  Crude oil imports fell 0.7 mbpd, while exports fell 0.3 mbpd.

This is the seasonal pattern chart for commercial crude oil inventories.  We are entering the spring/summer withdrawal season next week; this week’s decline is consistent with the normal seasonal pattern.  If this trend continues, we will see weekly draws in stockpiles until the third week of September.

Based on oil inventories alone, fair value for crude oil is $52.34.  Based on the EUR, fair value is $51.28.  Using both independent variables, a more complete way of looking at the data, fair value is $50.67.  This is one of those circumstances when the combined model fair value does not lie between the two single variable models.  Current prices are running well above fair value.  With this week’s focus on Iran, geopolitical risks are adding around $10 to $13 dollars per barrel to crude oil prices.  Assuming we see usual seasonal declines and a stable dollar, fair value for the two-variable estimate rises to $54.05.  Simply put, current prices have discounted a significant level of geopolitical risk and prices could see a sizable setback in the coming weeks if tensions don’t rise further.  Another factor for oil—it has been acting as a “risk-on” asset and oil will likely fall too if equity values tumble due to trade tensions.

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[1] https://finance.yahoo.com/news/china-says-retaliate-trump-does-raise-tariffs-012123878–finance.html

[2] https://finance.yahoo.com/news/trump-says-china-broke-deal-004945552.html

[3] https://www.nytimes.com/2019/05/08/us/politics/china-trade-trump.html?wpisrc=nl_todayworld&wpmm=1

[4] https://www.wsj.com/articles/why-china-decided-to-play-hardball-in-trade-talks-11557358715?mod=hp_lead_pos1

[5] https://www.nytimes.com/2019/05/08/upshot/trade-war-stock-market-china-us-tariff.html

[6] https://www.politico.com/story/2019/05/08/trump-china-trade-2020-election-1311737

[7] https://www.theatlantic.com/politics/archive/2019/05/trump-biden-trade-china/588991/

[8] https://www.scmp.com/news/china/diplomacy/article/3009454/us-upping-ante-china-still-has-trade-war-cards-it-can-play

[9] https://www.axios.com/newsletters/axios-markets-b6a4df56-c655-4fc8-bacf-00dc10eed3b4.html?chunk=4&utm_term=emshare#story4

[10] https://www.axios.com/winners-losers-us-china-trade-war-227dd9e3-f7f1-4744-b091-a3ce4b7ba5aa.html

[11] https://www.ft.com/content/7a613b06-7118-11e9-bbfb-5c68069fbd15?emailId=5cd399f181c6410004afaf77&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[12] https://www.confluenceinvestment.com/wp-content/uploads/weekly_geopolitical_report_04_4_2016.pdf

[13] https://www.politico.eu/article/iran-europe-nuclear-united-states/?utm_source=POLITICO.EU&utm_campaign=3ae8b85be7-EMAIL_CAMPAIGN_2019_05_09_04_35&utm_medium=email&utm_term=0_10959edeb5-3ae8b85be7-190334489

[14] https://www.nytimes.com/2019/05/08/world/europe/eu-iran-nuclear-sanctions.html?emc=edit_MBE_p_20190509&nl=morning-briefing&nlid=5677267tion%3DtopNews&section=topNews&te=1

[15] https://www.wsj.com/articles/iran-to-stop-complying-with-some-nuclear-deal-commitments-11557297791?mod=hp_lead_pos4

[16] https://www.nytimes.com/2019/05/08/us/politics/iran-nuclear-deal.html?emc=edit_MBE_p_20190509&nl=morning-briefing&nlid=5677267tion%3DtopNews&section=topNews&te=1 and https://www.ft.com/content/6b47d1dc-7179-11e9-bf5c-6eeb837566c5?emailId=5cd399f181c6410004afaf77&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[17] http://isicrc.org/irgc-basij-and-hezbollah/exclusive-irgc-commander-believed-to-have-defected-to-the-west

[18] https://www.ft.com/content/0e5900da-718e-11e9-bf5c-6eeb837566c5?emailId=5cd399f181c6410004afaf77&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[19] https://www.theguardian.com/world/2019/may/09/south-africa-election-early-results-point-reduced-anc-majority

[20] https://www.reuters.com/article/us-northkorea-missiles/north-korea-fired-unidentified-projectile-souths-military-idUSKCN1SF0ON

[21] https://ftalphaville.ft.com/2019/05/09/1557374439000/Venezuela-is-paying-its-bondholders-/

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Risk-off continues.  Tensions with Iran are increasing.  South Africa holds elections today.  Here is what we are watching:

The Iran issue: SoS Pompeo abruptly canceled a meeting with German Chancellor Merkel and made an unannounced visit to Baghdad.[1]  According to reports, he made the detour due to renewed but unspecified threats from Tehran.  The U.S. would likely want to base troops and other assets in Iraq if action against Iran is being considered.  However, this might be difficult as Iran is deeply imbedded in Iraqi politics.  Iran indicated that it may reduce its level of compliance on the nuclear deal due to U.S. actions unless Europe can guarantee that Tehran continues to have access to global markets.[2]  France has indicated that if Iran does reduce its nuclear compliance and resumes nuclear enrichment activities then Europe would re-impose sanctions.[3]  Tensions with Iran are clearly increasing; the sudden detour by Pompeo has the look of preparations for some sort of action.  To some extent, this problem details dissonance within the Trump administration; on the one hand, the president’s instincts are to reduce American involvement in the world, including the Middle East.  On the other, his Jacksonian tendencies lead him to react strongly to perceived threats.  The concern is that he may be being led into a conflict by hawkish advisors.[4]  Oil prices are steady this morning.  Although the Iran news is supportive, U.S. inventory levels in the API data showed a build.  Oil has been behaving as a risk-on asset and is likely following equities lower.

China trade: Apparently, China did reverse numerous positions that were previously established, leading to the administration’s response.[5]  It seems highly probable that tariffs will be increased on Friday.  The more hopeful outcome is that China returns to what was previously accepted and the U.S. pulls back on sanctions.  However, doing that and saving face will be difficult.  We suspect Lighthizer is pressing China hard on monitoring the agreement and building in further sanctions if the agreement’s terms are not met.  This position is likely an anathema to China, which has a long history of accepting terms and then ignoring them.[6]

The chances of a significant trade rupture are increasing, mostly because both sides seem to underestimate the potential impact.[7]  We believe China’s position is weaker than it perceives; we note defaults are increasing[8] and recent trade data showed weaker exports.[9]  At the same time, tariffs would likely lead to rising inflation and may force the Fed into raising rates.  Thus, risks are increasing.[10]

The Fed: Vice Chair Clarida appears to have reversed his comments suggesting a prophylactic cut in rates might be wise in the face of weaker inflation and, instead, adopted the language of Chair Powell, suggesting that low inflation was likely due to “temporary factors.”[11]  Clarida is considered a top-flight economist and we would be somewhat surprised to see him toe the party line if he didn’t really believe it.  Unfortunately, his recent comments seem to suggest a reversal from his earlier stance.  One possibility?  It may be that Powell is asserting the Fed’s independence and is intent on keeping policy steady to show the White House that it cannot be bullied into a rate cut.  It is possible Clarida would be willing to accept that position even if his economic analysis suggests the Fed should cut rates.

Brexit: The May government has indicated that the U.K. will participate in the upcoming EU elections,[12] obliquely confirming that cross-party talks on Brexit have likely failed.[13]  There are increasing risks that May will be forced to step down, triggering either general elections or a hard Brexit Tory PM to replace her.

Venezuela: The U.S. lifted individual sanctions against a Venezuelan general who changed his allegiance from Maduro to Guaido.[14]  Caracas has ended a rigid program of tiered exchange rates, mostly because foreign reserves have reportedly dropped to $8.5 bn and most of this is in gold.[15]  Meanwhile, SoS Pompeo and Russian Foreign Minister Lavrov are scheduled to talk in Sochi later this month in a likely bid to ease tensions over Venezuela.[16]

South Africa elections: Although Cyril Ramaphosa will almost certainly win today’s poll, his party, the ANC, is suffering from widespread corruption.[17]  Ramaphosa is considered an honest candidate, but the bigger issue is increasing disillusionment with democracy itself.  This condition increases the chances of a coup or a call for dictatorship.  If unrest widens in South Africa, it could be bullish for precious metals, especially platinum.

Odds and ends:The U.S. has decided to implement tariffs against Mexican tomatoes.[18]  The U.S. had accused Mexico of dumping tomatoes on the U.S. market, beginning a formal investigation in 1996.  The investigation was suspended on a regular basis ever since.  Separately, China has begun construction on a third aircraft carrier, one that appears larger than the two it currently has, which are based on a Soviet platform.[19]  This would be China’s first full-sized flattop.   Lastly, we’re seeing more trouble for crypto currencies as a reported $41 mm was stolen from Biance, a crypto-exchange.[20]

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[1] https://www.washingtonpost.com/world/national-security/pompeo-makes-unannounced-visit-to-baghdad-amid-rising-tensions-with-iran/2019/05/07/dd96c766-70d4-11e9-8be0-ca575670e91c_story.html?utm_term=.6912b97b5c77&wpisrc=nl_todayworld&wpmm=1

[2] https://uk.reuters.com/article/uk-usa-iran-rouhani/iran-rolls-back-pledges-under-nuclear-pact-abandoned-by-washington-idUKKCN1SE0IJ and https://www.nytimes.com/2019/05/08/us/politics/iran-nuclear-deal.html?module=inline

[3] https://uk.reuters.com/article/uk-usa-iran/france-suggests-sanctions-could-be-reimposed-if-iran-reneges-on-deal-idUKKCN1SD0PB?utm_source=POLITICO.EU&utm_campaign=90bc1247eb-EMAIL_CAMPAIGN_2019_05_08_04_45&utm_medium=email&utm_term=0_10959edeb5-90bc1247eb-190334489

[4] https://www.washingtonpost.com/opinions/2019/05/07/are-we-watching-john-boltons-last-stand/?utm_term=.e9cff12de1c0&wpisrc=nl_todayworld&wpmm=1

[5] https://uk.reuters.com/article/uk-usa-trade-china-backtracking-exclusiv/exclusive-china-backtracked-on-nearly-all-aspects-of-u-s-trade-deal-sources-idUKKCN1SE0XB

[6] This is clearly evident in its behavior within the WTO.

[7] https://www.scmp.com/news/china/diplomacy/article/3009305/china-can-keep-calm-and-carry-despite-donald-trump-tariff

[8] https://www.bloomberg.com/news/articles/2019-05-07/china-defaults-hit-record-in-2018-the-2019-pace-is-triple-that

[9] https://finance.yahoo.com/news/china-april-exports-unexpectedly-fall-044034753.html

[10] https://www.washingtonpost.com/politics/trade-war-threatens-to-roil-2020-race-as-republicans-complain-about-the-tariffs-trump-loves/2019/05/07/d8697ea4-70d5-11e9-8be0-ca575670e91c_story.html?utm_term=.7fdec20fb02d

[11] https://www.wsj.com/articles/fed-vice-chairman-richard-clarida-says-u-s-monetary-policy-is-in-a-good-place-11557240130

[12] https://www.ft.com/content/438eed32-70c6-11e9-bf5c-6eeb837566c5

[13] https://www.politico.eu/article/uk-confirms-participation-in-european-election/?utm_source=POLITICO.EU&utm_campaign=90bc1247eb-EMAIL_CAMPAIGN_2019_05_08_04_45&utm_medium=email&utm_term=0_10959edeb5-90bc1247eb-190334489

[14] https://www.wsj.com/articles/pence-to-announce-u-s-will-lift-sanctions-on-venezuela-gen-manuel-cristopher-figuera-after-he-broke-ranks-with-maduro-11557256618?mod=newsviewer_click

[15] Ibid.

[16] https://worldview.stratfor.com/situation-report/russia-us-pompeo-and-lavrov-continue-venezuela-talks-sochi?id=87179e919a&e=4d1f592612&uuid=e5d7544b-3ed3-4772-b71c-539b5278fbdf&utm_source=Daily+Brief&utm_campaign=88fcb04bd8-EMAIL_CAMPAIGN_2019_05_08_12_00&utm_medium=email&utm_term=0_87179e919a-88fcb04bd8-53536341&mc_cid=88fcb04bd8&mc_eid=%5bUNIQID%5d (paywall)

[17] https://www.washingtonpost.com/world/africa/most-south-africans-are-unhappy-with-their-democracy-can-cyril-ramaphosa-fix-it/2019/05/06/02040e64-6b95-11e9-bbe7-1c798fb80536_story.html?utm_term=.414c84feb1f2&wpisrc=nl_todayworld&wpmm=1

[18] https://www.ft.com/content/bc808a1e-7082-11e9-bf5c-6eeb837566c5?utm_source=GPF+-+Paid+Newsletter&utm_campaign=bcd713cb9f-EMAIL_CAMPAIGN_2019_05_07_03_13&utm_medium=email&utm_term=0_72b76c0285-bcd713cb9f-240037177

[19] https://www.reuters.com/article/us-china-military-carrier-exclusive/exclusive-analysts-images-show-construction-on-chinas-third-and-largest-aircraft-carrier-idUSKCN1SD0CP

[20] https://finance.yahoo.com/news/hackers-steal-41-million-worth-052132540.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Trade tensions remain.  Parsing the Iran threat.  Here is what we are watching:

Trade turmoil: So, is the tariff threat real or a bluff?  Equity markets decided yesterday that it was more the latter than the former.[1]  This morning, equity markets seem less convinced.  This is what we know:

1. The U.S. is calling out China for reneging on previous agreements.[2] Lighthizer appears to have taken the lead in talks with China, edging out Treasury Secretary Mnuchin.  Lighthizer, as we have noted before, is a hardliner on trade.  He was instrumental in getting Japan to agree to “voluntary” auto export reductions in the late 1980s and is known as a relentless negotiator.  Although President Trump seems to really want a deal, he trusts Lighthizer and the change in course likely reflects that the president agrees with his trade negotiator that China was trying to pull a fast one.  It’s also important to remember that for Lighthizer these talks are perhaps his last chance to fundamentally change the U.S./China trade relationship to favor America, much like he did with the U.S./Japan relationship.  Thus, he is less concerned about China’s “feelings” and the 2020 elections.  It had appeared Trump was leaning toward Mnuchin and against Lighthizer so a deal could get done, but Lighthizer may have appealed to Trump’s “inner Jackson” and convinced the president that a hardline position was justified.  But, come what may, Lighthizer’s goal doesn’t necessarily coincide with the president’s in all areas.  If Trump decides to follow Lighthizer, a rupture in U.S./China trade relations is much more likely.
2. So far, China’s response has been measured. Vice Premier Liu will come to Washington, but not until Thursday and will leave the next day.  He was originally scheduled to arrive on Wednesday and stay until Saturday.[3]  Although the visit does avoid a complete rupture, it is hard to see how we can avoid the tariff increase.
3. Both sides may have overplayed their positions. The White House is basking in historically low interest rates and surprisingly strong GDP, while China is coming off a successful OBR meeting and better economic data.[4]  Wars often start because the participants overestimate their own positions and underestimate their opponents.
4. China may have concluded that continuing to negotiate was a better outcome because elections in 2020 would likely force the U.S. to capitulate. Lighthizer likely sniffed out this position and may have recommended that the president renew the tariff threat.[5]
5. It is possible the White House believes that an increase in trade tensions might prompt the FOMC to cut rates. Although we are not sure that would occur, a breakdown in talks would likely weaken sentiment and may lead the Fed to ease.  Thus, the president may think he has the Fed at his back if things go south.
6. Financial markets continue to expect a deal to be finalized. There is good reason to expect that outcome.  But, it isn’t certain and there could be an equity correction looming if trade talks fail.[6]

Iran: According to reports, the U.S. received credible intelligence that Iran was planning to attack U.S. assets in the Middle East.[7]  The U.S. response is something of a half measure.  If the U.S. was really going to war with Iran, we would see three carrier groups in the region, not one.  At the same time, the CVN Abraham Lincoln is a formidable asset and will get Iran’s attention.  We suspect Iran has “fired up” Hamas and Islamic Jihad to attack Israel, leading to the recent missile strikes.[8]  Iran’s problem is that the reduced U.S. exposure in the Middle East has led to a quiet alliance between the Arab states and Israel.  Iran, under sanctions, is finding it difficult to respond to this pressure.  Its “softest” target is Iraq, but it already has influence there anyway.  Syria is a less reliable party because of Russian influence.  Therefore, the desire to strike back at the Sunni Arab states makes sense.  It should be noted that if Iran does “something” (e.g., cyberattack on Saudi Arabia, etc.), then the only real targets for U.S. warplanes are in Iran itself.  Thus, the chances of escalation are probably increasing.  However, it still is not obvious that Iran will act in such a way that makes it obvious Iran is the perpetrator.  Iran is a master of the covert.

Turkey: President Erdogan’s party has forced a new municipal election in Istanbul.[9]  The initial vote was allegedly corrupt.  We have no doubt that, compared to Western standards, the election process was probably open to question.  However, our reading of the process suggests there was nothing all that unusual in last month’s local elections.  New elections will be held on June 23.[10]  It appears Erdogan is unwilling to accept adverse results and that is unnerving foreign investors.[11]  The TRY has weakened on the news; however, our position is that the currency has already discounted significant bad news.

Brexit: Although there is hope that May and Corbyn can put together a coalition to approve a customs union, this outcome may not have staying power.  It appears that even if a deal is made we are probably still looking at either a new referendum[12] or new general elections.[13]  It isn’t clear that a new referendum will offer any more clarity and the second outcome probably either leads to a Corbyn government (and market panic) or Johnson (panic, but less so).  Stay tuned…

Fed governors:Senate GOP leaders are putting together a list of potential governor candidates for the White House to avoid a repeat of the Stephen Moore/Herman Cain situation.[14]  Although this makes sense, the candidates offered will likely be hard money policy hawks, exactly the opposite of what the president wants.  So, we expect no short-term resolution on this issue.

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[1] https://www.ft.com/content/c55a12f6-6ff4-11e9-bbfb-5c68069fbd15?emailId=5cd0fd378585b10004f43b27&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[2] https://www.ft.com/content/ea07e70e-7044-11e9-bbfb-5c68069fbd15?emailId=5cd0fd378585b10004f43b27&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22 and https://www.washingtonpost.com/business/economy/trump-administration-accuses-chinese-officials-of-reneging-on-earlier-commitments-in-trade-talks/2019/05/06/808e91f4-7037-11e9-8be0-ca575670e91c_story.html?utm_term=.3020cae82078

[3] https://finance.yahoo.com/news/china-says-vice-premier-liu-063138953.html

[4] https://www.wsj.com/articles/lighthizer-says-china-reneging-on-trade-talk-commitments-11557176867?mod=hp_lead_pos1

[5] https://www.scmp.com/news/china/diplomacy/article/3009163/chinese-vice-premier-liu-he-go-washington-trade-talks

[6] https://www.nytimes.com/2019/05/06/business/china-trump-trade-economy-markets.html

[7] https://www.axios.com/israel-warned-trump-of-possible-iran-plot-bolton-34f25563-c3f3-41ee-a653-9d96b4541984.html and https://www.washingtonpost.com/world/national-security/as-tensions-with-us-rise-iran-threatens-to-curtail-cooperation-in-the-nuclear-deal/2019/05/06/e38e29b6-7034-11e9-9f06-5fc2ee80027a_story.html?utm_term=.5bdfddf71b78&wpisrc=nl_todayworld&wpmm=1

[8] https://www.washingtonpost.com/world/middle_east/israel-and-gaza-militants-agree-to-cease-fire-after-weekend-of-violence/2019/05/06/255f9b6a-6f89-11e9-9f06-5fc2ee80027a_story.html?utm_term=.6959fc91ff75&wpisrc=nl_todayworld&wpmm=1

[9] https://www.washingtonpost.com/world/turkish-election-board-orders-new-vote-for-istanbul-mayor-after-ruling-party-loss/2019/05/06/3e22c8c2-701d-11e9-9331-30bc5836f48e_story.html?utm_term=.03a6516a8820&wpisrc=nl_todayworld&wpmm=1 and https://www.nytimes.com/2019/05/06/world/europe/turkey-istanbul-mayor-election.html?emc=edit_MBE_p_20190507&nl=morning-briefing&nlid=5677267tion%3DtopNews&section=topNews&te=1

[10] https://www.politico.eu/article/turkish-authorities-cancel-istanbul-mayoral-election/?utm_source=POLITICO.EU&utm_campaign=d782f561bf-EMAIL_CAMPAIGN_2019_05_07_04_55&utm_medium=email&utm_term=0_10959edeb5-d782f561bf-190334489

[11] https://www.ft.com/content/c9fc455e-701c-11e9-bf5c-6eeb837566c5?emailId=5cd0fd378585b10004f43b27&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[12] https://www.ft.com/content/47d955b0-6fdd-11e9-bbfb-5c68069fbd15?emailId=5cd0fd378585b10004f43b27&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[13] https://www.ft.com/content/543d8a74-6ff1-11e9-bf5c-6eeb837566c5?emailId=5cd0fd378585b10004f43b27&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[14] https://www.ft.com/content/36ce59a6-704a-11e9-bf5c-6eeb837566c5

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Monday as we clear out the “tequila cobwebs” this morning!  Cyclone Fani made landfall over the weekend.[1]  Ramadan begins.[2]  Trade turmoil returns.  It’s a massive risk-off day so far.  Here is what we are watching:

Trade turmoil: On Sunday afternoon, President Trump tweeted that, due to the slow progress of trade talks and reports that China was backtracking on some earlier agreements, he would increase the scale and scope of tariffs by Friday.[3]  There has been a steady drumbeat of reports that President Trump was pressing his trade negotiators to make a deal;[4] it appears that his mood has changed.  It is unclear what triggered the change.  We have doubted that USTR Lighthizer would agree to a modest agreement, although Treasury Secretary Mnuchin has been seen as pushing for a less comprehensive deal.  Perhaps the recent upturn in the economy emboldened the president or China may have crossed some sort of red line.  At the same time, economic conditions in China have improved, which may have led Chinese negotiators to push back on some issues that appeared previously resolved.  And, it’s quite possible the Chinese, again, misread President Trump and believed his desire for a deal would allow them to press for a more favorable agreement.  China did announce cuts on reserve requirements for small business loans.[5]  At the same time, in what might signal concern in the Xi government, China has lowered the daily limit on foreign currency withdrawals.[6]  If there is a trade war, one would expect Chinese households to accumulate dollars on fears of CNY depreciation.  The move by the PBOC to limit withdrawals could be in anticipation of rising concerns.

China has indicated it may cancel this week’s scheduled meetings in Washington, which were expected to start on Wednesday.  It has backed away[7] from fully cancelling the meeting but may not send Vice Chair Liu[8] or could delay his arrival, which would almost certainly mean Trump’s tariffs will go into effect.

Financial markets reacted as one would expect.  Equities around the world plunged.[9]  The yen and dollar rallied and Treasury yields dipped.  Most importantly, the CNY nosedived; it is possible that Beijing prevented the CNY from depreciating during trade negotiations.  But, it should be noted that the textbook response to tariffs is depreciation.  Gold lifted, but industrial metals fell.  Another key market move occurred in grains.  Even though the Midwest continues to deal with unrelenting rain, which is slowing planting progress and potentially constraining supply, grain prices fell hard on the prospects of a trade disruption.

Financial markets have mostly expected a deal to be made and for disruption to be avoided.  The president’s policy reversal is important; we will be watching to see if there has been a significant rupture in relations or if the president is simply posturing.  In other words, what we don’t know the answer to is if this is a bargaining tactic or an ultimatum.  If it’s the former, financial markets will reverse today’s losses.  If it’s the latter, a more serious pullback is in the offing.  At this point, we don’t have much confidence in either outcome.  It is possible President Trump is overly confident in the ability of the U.S. economy to overcome tariffs on China; the same overconfidence may be occurring in Beijing, too.  Therefore, a mistake could be made.  It is also possible that the president believes being tough on China will play well with his voters and that a trade war is a plus so long as recession is avoided.  What we are concerned about, as noted above, is that financial markets have generally moved on from worrying about this issue and thus will need to recalibrate.

There have been a number of questions into our office about the impact of tariffs.  In general, the best answer is “it depends.”  At one extreme, the Chinese exporter cuts his price by the amount of the tariff and absorbs the tax (this is where currency depreciation helps); at the other, the tax simply passes through to the consumer.[10]  So far, most studies have suggested that the incidence from metals tariffs have been borne by U.S. consumers.  But, that might not be the case if tariffs broaden.

Iran: The U.S. is considering sanctions on other Iranian industries, although they have not been officially specified yet.[11]  John Bolton, the National Security director, issued a press release indicating the U.S. was sending the CVN Abraham Lincoln to the Middle East.[12]  He tied the move to increased tensions with Iran.[13]  We do note that the carrier group has been in the area for a while (it’s currently in the Red Sea), so the announcement does appear to be stating what was already in place.  In some respects, this carrier group in the region isn’t a big deal.  The U.S. often has a carrier group in the Fifth Fleet’s area of operations; recently, it has had a lower presence in the region.  If the U.S. was preparing for a conflict, it would have a minimum of two carrier strike groups and would prefer three, which would support 24-hour sorties.  Meanwhile, the EU is continuing to support the Iran nuclear deal,[14] although business dealings with Iran have declined precipitously.  Even with this news, we are seeing lower oil prices today.  Oil has been trading as a risk asset, so lower equities are weighing on oil prices.

Gold: Although you wouldn’t necessarily notice it in terms of price, central banks have been increasing their gold reserves.  Last quarter, central banks boosted their holdings by 145.5 tons over the same quarter a year ago.[15]  Russia led the buying, likely in a bid to circumvent sanctions.

North Korea: As relations deteriorate, Pyongyang is returning to its old patterns of provocative actions.  On Saturday, the regime launched a number of “projectiles” offshore.  It is believed these were short-range missiles.[16]  So far, the Trump administration has acted with restraint to these events, likely because they don’t include ICBM tests, which would directly threaten the lower 48.[17]  We doubt Kim’s missile tests are sitting well with the hawks in the administration, namely Pompeo and Bolton.  But, as long as Kim doesn’t test a missile that could hit the U.S., he will likely avoid a significant breakdown with Washington.  To a great extent, Kim wants attention[18] and these short-range tests give him that without significant cost.

The Fed: With Herman Cain and Stephen Moore out of the picture, the administration returns to looking for two more candidates.  Two names have emerged, Paul Winfree[19] and Judy Shelton.[20]  Winfree’s economic work appears to be in fiscal policy, while Shelton seems to be a gold supporter.  Winfree did complete an MA in economics; Shelton has a Ph.D. in management.  What we find interesting is that Trump seems to really want a policy dove, but what he keeps getting are hard money types who promise to do the president’s bidding.  But, once seated, will they keep their promise or will their hard money instincts kick in, especially since it’s hard to remove a sitting Fed governor?

Meanwhile, the Fed continues to examine the low inflation issue, building a case for keeping policy easy for longer.  Chicago FRB President Evans,[21] St. Louis FRB President Bullard[22] and NY FRB President Williams[23] all indicated that rate cuts may be needed if inflation remains low.

Infrastructure?  Forget it!  The Congressional GOP has no interest.[24]

Elections: South Africa goes to the polls this week.  Corruption appears to be the biggest issue.[25]  Although the ANC is expected to maintain control, the margin of victory is likely to be less than the last election.  Meanwhile, in North Macedonia, the incumbent party maintained power.[26]

Brexit: Although it’s still a long shot, there does appear to be some progress in building a cross-party coalition for a customs union with the EU.[27]  However, while the leadership is close to an agreement, the backbenchers on both parties will likely howl and still scotch an agreement.  And, it should be noted that the next PM could pull the U.K. out of the customs union anyway.  Thus, we may see a bounce in British assets if an agreement is struck on a customs union, but it may not have legs.

The 2020 elections: We are starting to get questions about the 2020 elections, especially given the large number of candidates vying for the Democratic Party nomination.  We are not handicapping anything currently.  And, to profile why we aren’t, try this quiz.

These were the 12 candidates running for the Democratic nomination in 1976; until this year, that was the highest number of Democratic Party candidates running for president.  How many can you name?[28]  Check the footnote to see how you did.

The point of this test is that a crowded field signals a high level of political turmoil, so much so that a plethora of candidates are willing to take the plunge (the winner was Jimmy Carter, top right).  As the 2016 GOP primary showed, as did the 1976 primary, it’s anybody’s guess who will win.  We are watching what is going on but, at this point, picking the Democrat from a field of 22 is an exercise in being wrong.  After all, few pundits thought Trump would win in 2016 and Jimmy Carter wasn’t considered a strong candidate in 1976 either.  Simply put, it’s too early to handicap the outcome and it probably isn’t affecting markets yet anyway.

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[1] https://www.bbc.com/news/world-asia-48165795?wpisrc=nl_todayworld&wpmm=1 and https://www.nytimes.com/2019/05/04/world/asia/india-cyclone.html?emc=edit_MBE_p_20190506&nl=morning-briefing&nlid=5677267ion%3DwhatElse&section=whatElse&te=1

[2]https://www.apnews.com/fa390b923dac4400b51276976882a741?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[3] https://www.ft.com/content/c5847a30-6f56-11e9-bbfb-5c68069fbd15 and https://www.nytimes.com/2019/05/05/business/trump-tariffs-china-trade-talks.html?action=click&module=Top%20Stories&pgtype=Homepage

[4] https://www.washingtonpost.com/business/trump-says-he-will-increase-tariffs-on-chinese-goods-on-friday-as-he-complains-about-pace-of-trade-talks/2019/05/05/774c2e92-6f53-11e9-9eb4-0828f5389013_story.html?utm_term=.9110ff6625ff

[5] https://www.reuters.com/article/us-china-economy/china-gives-modest-boost-to-economy-with-rrr-cut-amid-renewed-trade-tensions-idUSKCN1SC02D

[6] https://www.scmp.com/business/banking-finance/article/3008795/chinese-banks-quietly-lower-daily-limit-foreign-currency

[7] https://www.scmp.com/economy/global-economy/article/3008973/china-vice-premier-liu-he-likely-delay-us-trip-three-days

[8] https://finance.yahoo.com/news/china-trade-team-still-going-085151521.html

[9] https://www.ft.com/content/6b022c0e-6fa3-11e9-bbfb-5c68069fbd15?emailId=5ccfad7bfe6b0b0004aa5b4c&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[10] https://www.reuters.com/article/us-usa-trade-tariffs-explainer/explainer-who-pays-trumps-tariffs-china-and-other-exporters-or-u-s-customers-idUSKCN1SB0UF?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosmarkets&stream=business

[11] https://www.wsj.com/articles/after-oil-washington-mulls-sanctions-on-irans-other-sources-of-u-s-dollars-11556811882

[12]https://www.apnews.com/86e17a4f133046d9a054b68e7cd675cf?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top and https://www.nytimes.com/2019/05/05/world/middleeast/us-iran-military-threat-.html?action=click&module=Top%20Stories&pgtype=Homepage

[13] https://www.politico.eu/article/navy-strike-group-deployed-to-send-message-to-iran/?utm_source=POLITICO.EU&utm_campaign=4d73cf16d2-EMAIL_CAMPAIGN_2019_05_06_04_40&utm_medium=email&utm_term=0_10959edeb5-4d73cf16d2-190334489

[14] https://www.politico.eu/article/europe-vows-to-uphold-iran-nuclear-deal-as-trump-raises-pressure/?utm_source=POLITICO.EU&utm_campaign=4d73cf16d2-EMAIL_CAMPAIGN_2019_05_06_04_40&utm_medium=email&utm_term=0_10959edeb5-4d73cf16d2-190334489

[15] https://www.gold.org/goldhub/research/gold-demand-trends/gold-demand-trends-q1-2019?utm_source=GPF+-+Paid+Newsletter&utm_campaign=1540bf30e3-EMAIL_CAMPAIGN_2019_05_03_02_39&utm_medium=email&utm_term=0_72b76c0285-1540bf30e3-264773073

[16] https://www.nytimes.com/2019/05/03/world/asia/north-korea-missile.html?action=click&module=Top%20Stories&pgtype=Homepag

[17] https://www.nytimes.com/2019/05/04/world/asia/trump-north-korea-missile-tests.html?emc=edit_MBE_p_20190506&nl=morning-briefing&nlid=5677267tion%3DtopNews&section=topNews&te=1

[18] https://www.washingtonpost.com/world/north-korea-fires-several-short-range-projectiles-south-korean-military-says/2019/05/03/511efe92-6e0f-11e9-be3a-33217240a539_story.html?utm_term=.4dc6a6b5b1f8&wpisrc=nl_todayworld&wpmm=1

[19] https://www.wsj.com/articles/paul-winfree-under-consideration-for-federal-reserve-11556912790

[20] https://www.wsj.com/articles/gop-traditionalists-thwart-trumps-push-to-install-loyalists-at-the-fed-11556875800?mod=newsviewer_click

[21] https://www.wsj.com/articles/feds-evans-if-inflation-weakens-fed-may-have-to-lower-rates-11556892905?mod=newsviewer_click

[22] https://www.reuters.com/article/us-usa-fed-evans/some-u-s-fed-officials-are-more-worried-by-weak-inflation-idUSKCN1S91CC

[23] https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr887.pdf

[24] https://www.washingtonpost.com/politics/trumps-bipartisan-infrastructure-plan-already-imperiled-as-mulvaney-gop-lawmakers-object-to-cost/2019/05/03/bc1d1e74-6dae-11e9-be3a-33217240a539_story.html?utm_term=.429bce2dd317

[25] https://www.washingtonpost.com/world/africa/south-africas-election-campaigning-peaks-in-johannesburg/2019/05/05/6b4f67ba-6f1e-11e9-9331-30bc5836f48e_story.html?utm_term=.7865c912cb2f&wpisrc=nl_todayworld&wpmm=1

[26] https://www.politico.eu/article/ruling-partys-pendarovski-wins-north-macedonia-presidency/?utm_source=POLITICO.EU&utm_campaign=4d73cf16d2-EMAIL_CAMPAIGN_2019_05_06_04_40&utm_medium=email&utm_term=0_10959edeb5-4d73cf16d2-190334489

[27] https://www.politico.eu/pro/can-theresa-may-reach-a-brexit-deal-with-labour/?utm_source=POLITICO.EU&utm_campaign=4d73cf16d2-EMAIL_CAMPAIGN_2019_05_06_04_40&utm_medium=email&utm_term=0_10959edeb5-4d73cf16d2-190334489

[28] https://www.washingtonpost.com/history/2019/05/01/last-time-democratic-field-was-so-crowded-peanut-farmer-won-white-house/?utm_term=.85d08c58ffb4&wpisrc=nl_daily202&wpmm=1

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s employment Friday!  We cover the data in detail below, but the quick take is that it was a blowout report.  Payrolls were well above forecast and the unemployment rate fell to its lowest level since December 1969.  Here is what we are watching:

Moore out: Stephen Moore is no longer in the running for a Fed governor seat.  The official line is that he withdrew.[1]  Moore has made a number of controversial statements that ended up dooming his chances.[2]  To some extent, the president is pressing the boundaries of who he can nominate for these positions.  What lesson may have been learned?  Try to meet your goal with candidates that are less divisive.  We still think Larry Kudlow will be the next to be “run up the flagpole.”  His views are similar to Moore’s but Larry has the reputation of being a genuinely nice guy.[3]  The president could also appoint a committed dove to the FOMC, such as Minneapolis FRB President Kashkari or St. Louis FRB President Bullard, and get the same policy outcome without the controversy.  If the president continues to seek out difficult candidates, it suggests he sees some value in the battle and is less concerned about getting doves for the last two open spots.

European inflation: Eurozone inflation rose more than forecast, up 1.7%, which was good news, although the data may have been distorted by the late Easter holiday.  Core CPI also rose.[4]

Low inflation has weakened the ECB’s ability to stimulate the economy through rate cuts, so the central bank will welcome this rise.

U.K. local elections: As expected, the Tories took a beating in local council elections.[5]  Interestingly enough, so did Labour.  The Liberal-Democrats, a center-left party, had the best showing.  These elections have the tenor of a protest vote, which probably means they don’t really tell us much about the path of national politics.

Politics and money: A couple of articles caught our attention.  First, Silicon Valley is finding the flow of cash impeded a bit by the Treasury department, which is vetting inflows from China and Saudi Arabia.[6]  Second, the Chamber of Commerce, a bastion of the GOP establishment, is finding itself on the outs with the White House.[7]  As the GOP becomes more populist, establishment bodies, like the Chamber and the Koch brothers’ Americans for Prosperity, have seen their influence wane.

A German at the ECB?  Jens Weidmann has been a controversial candidate for the ECB.  His nationality is an issue; the rest of Europe, but especially the southern nations, are worried that a German at the helm will turn the ECB into the Bundesbank.  In addition, Weidmann has been a critic of the extraordinary measures adopted by Draghi.  Over the past couple of years his star has risen and fallen, but it appears the Merkel government is pushing for Weidmann to get the nod.  Today, European Commission President Juncker, who is near the end of his term, has signaled he would support Weidmann.[8]  We would expect a more hawkish bank if Weidmann does become ECB president, which would be bullish for the EUR.

Japan and consumption taxes:Japan used an investment-led development model after WWII.  The model generated domestic saving by suppressing household consumption.  Part of that effort was national consumption taxes.  This method of taxation was appropriate for Japan’s development period, but that ended in 1990 and the inability to adapt to the post-development era has led to over three decades of economic stagnation.  The Abe government has been proposing to increase the consumption tax to 10% from 8% to address a huge fiscal deficit.  However, it has delayed the move twice due to economic conditions, once in 2014 and again in 2016.  Policymakers are indicating they will raise rates this year.[9]  In the past, such increases have undermined Japan’s growth; we would expect a negative reaction again if the country makes good on an increase this year.

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[1] https://twitter.com/realDonaldTrump/status/1123987855053873154

[2] https://finance.yahoo.com/news/gop-senator-on-moore-i-dont-think-hell-be-nominated-160341954.html

[3] A couple of observations.  First, (Bill speaking here) I have been interviewed by Larry Kudlow on CNBC.  Although I don’t necessarily share his views on the economy, he was a fair questioner and allowed my viewpoints to be expressed.  Second, he usually goes on Bloomberg with Jonathan Ferro after the labor or GDP data are released.  While they do spar, it is done with respect and Kudlow goes to great lengths to make his point but in a fair manner.

[4] https://www.washingtonpost.com/business/eurozone-inflation-ticks-up-in-hopeful-sign-for-central-bank/2019/05/03/fc8ea7cc-6d89-11e9-bbe7-1c798fb80536_story.html?utm_term=.85b0d21f59fd

[5] https://ig.ft.com/uk-local-elections-2019-results/?emailId=5ccbb52869c104000476e16f&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[6] https://www.vox.com/recode/2019/5/1/18511540/silicon-valley-foreign-money-china-saudi-arabia-cfius-firrma-geopolitics-venture-capital?stream=top

[7] https://www.wsj.com/articles/washingtons-biggest-lobbyist-the-u-s-chamber-of-commerce-gets-shut-out-11556812302?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[8] https://www.ft.com/content/c1f0056e-6d77-11e9-80c7-60ee53e6681d

[9] https://asia.nikkei.com/Editor-s-Picks/Interview/Japan-sales-tax-to-rise-as-planned-ruling-party-heavyweight

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Some markets, notably China and Japan, remain closed for May Day.  Here is what we are watching:

The Fed: As expected, the FOMC left rates unchanged.  The statement acknowledged the pickup in economic growth but tempered that positive comment by indicating that household spending and business investment had weakened.  It also noted low inflation.  The Fed did act to lower the IOER rate from 2.40% to 2.35%, as expected, leaving the policy range unchanged at 2.25% to 2.50%.[1]  The fed funds rate had moved above 2.45% so the IOER rate was lowered.  Initially, the lowering of the IOER rate was taken as dovish.  However, Chair Powell specified that this action wasn’t a policy move and described it as “technical,” and financial markets reversed the dovish take.  Essentially, not much happened but the financial markets misread the IOER cut as a precursor for easing; Chair Powell put that idea to rest and the dovish position reversed.  A second factor weighed on sentiment when the chair characterized recent low inflation as “transitory.”  Low inflation was mentioned and has been discussed among some members of the FOMC as a potential problem that may require easing.  Powell’s characterization of low inflation as transitory seemed to contradict those concerns.

Powell indicated that the Fed is on hold.  He said the Fed could just as easily ease as tighten, which is a very good definition of neutral policy.  Financial markets continue to signal that the next move should be a rate cut.

The chart on the left shows the implied three-month LIBOR rate from the Eurodollar futures for the contract two years in the future.  Note that the rate has declined from over 3.30% last October to 2.16% now, a significant decline.  The chart on the right compares this implied rate to the fed funds target.  We have placed vertical lines when the two rates invert.  When these two rates invert, it signals that the Fed needs to start easing to avoid a recession.  With the rate inversion in February, which has persisted, these charts would argue for an “insurance” rate cut as recently discussed by Vice Chair Clarida.  Thus, Powell’s description that policy is at neutral, meaning the FOMC could move rates in either direction, doesn’t fit the financial market’s position.  Without a rate rise in the short end of the yield curve, the most likely next move is for lower rates, unless the Fed is determined to trigger a recession.

By the way, for those of you keeping score at home, here is the S&P on the dates of Chair Powell’s press conferences.

In seven meetings with press conferences, six had negative closes.  We think the Fed’s policy transparency is a terrible mistake; policy functioned much better when little was said.

This chart shows the Chicago FRB National Financial Conditions Index, which is a reading of financial stress, and fed funds.  From 1973 to mid-1998, the two series were highly correlated.  Since then, they are virtually uncorrelated.  The Fed began to slowly increase the level of transparency beginning in the mid-1990s.  By mid-1998, we were getting statements and regular comments from FOMC members.  During the period of relative opaqueness, financial stress was a force multiplier for the Fed, so raising or lowering rates had a dramatic impact on financial market behavior.  Thus, tightening tended to reduce borrowing and raise the cost of risk, and lowering rates had the opposite effect.  By increasing transparency, allowing market participants to accurately assess the direction of policy, the Fed’s ability to affect financial conditions has essentially been lost.  So, when the Fed tightens it does little to inhibit risk activity, and easing does little to encourage risk-taking.

Powell’s decision to increase the number of press conferences is a good example of this problem.  As the above table shows, the chair seems to have a remarkable ability to bring lower equity values.  Now, if this is his goal, he should be commended.  But, we doubt that is the case; instead, we suspect he is trying to sound “reasonable,” which gives a muddled picture and leads to selloffs.  If the FOMC position on low inflation is transitory, then why have a meeting in June to discuss changing inflation targeting?  On Friday, NY FRB President Williams and Vice Chair Clarida will give speeches.  We will be watching to see if these two essentially walk back Powell’s comments.  If they do, it would suggest the chair misspoke.

U.K. elections and other things: The U.K. is holding local elections today.  The Tories are expected to take a drubbing, although the U.K. Independence Party isn’t competing which may limit the damage.[2]  Turmoil continues within May’s government; she sacked her defense minister overnight, blaming him for the leak around Huawei (CNY 4.02, +0.17).[3]  It appears PM May is leaning toward a customs union with the EU, the position supported by Labour, as a way of avoiding a hard Brexit.  If she can gather enough supporters in the opposition, she might be able to close a deal soon.[4]  However, there is a wild card in this idea.  There is a sizeable number of hard Brexit supporters within Labour that may put Corbyn’s leadership at risk if he supports such an arrangement.  The downside of a customs union is that it would prevent the U.K. from making its own free trade agreements, at least on goods trade, with other nations.  The Bank of England (BoE), as expected, left policy unchanged.  However, its comments struck a decidedly hawkish position, indicating that rate hikes will be needed in the future to offset stronger economic growth.  Although the tone was hawkish, it is clear the BoE is in no hurry to tighten policy.[5]

Venezuela: It still isn’t exactly clear what happened this week.  It does appear that Guaido thought he had splintered the security forces enough to unseat Maduro.  It also seems that administration officials thought so, too.[6]  Clearly, that plan didn’t work out.  But, if the action failed (we would not call it a coup because there is a case to be made that Guaido is the legitimate leader of Venezuela), then why didn’t Maduro arrest Guaido?  It is possible Maduro has concluded that he doesn’t have the power or the skill to return Venezuela to prior prosperity.  Therefore, he wants to leave but the Russians[7] and Cubans have “convinced” him to stay.[8]  There are reports of negotiations between the opposition and the regime.[9]  Meanwhile, Guaido is trying to maintain momentum after what appears to be a significant disappointment.[10]  Protests continue with no end in sight.[11]  If Maduro were to exit, we would likely see a correction in oil prices.  For now, Maduro is hanging on but we wonder whether he actually wants to stay.  One possible outcome—Russia, Cuba and China could remove Maduro and replace him with another member of the regime, perhaps a military figure, that would protect their position in the country and defuse the protests and the opposition.  Such an outcome would put the U.S. in a difficult position—would the administration support the new government or take steps to oust it?  Although there are elements in the administration and GOP who would support a military intervention, we think President Trump would be very reluctant to commit troops to Venezuela.

Chinese pork imports and ASF: As African Swine Fever (ASF) decimates the Chinese pork industry, Beijing has taken two actions that perhaps offset each other.  Due to continued tensions between Ottawa and Beijing over the arrest of Meng Wanzhou of Huawei, China has been taking steps to punish Canada, including arresting Canadian nationals in China.  Today, China announced it was suspending pork imports from two Canadian pork producers,[12] likely another step in its attempts to pressure Canada to release Meng.  However, this action by China risks driving up pork prices further, so why target this industry?  Perhaps because China has found alternative sources for pork in Argentina.[13]

Capital flight: One position we have held for some time is that if the U.S. does back away from its hegemonic role, world stability would suffer and the wealthy worldwide would be looking for an “escape portal” to protect their wealth and person.  We have contended that the U.S. would be a prime destination for this capital flight.  The U.S. has deep financial markets and a stable legal system, making it a good place to land if one’s homeland turns hostile.  Recent data suggest an increase in “wealth migration” last year, with the U.S. seeing some of that flow.[14]

Europe and LNG: U.S. LNG exports to Europe are surging, up 272% over the past year.[15]  The exports began to rise in the wake of meetings between President Trump and President Juncker last summer.  The chart below shows how shipments have jumped after the meeting.  It appears the EU may be using LNG as a potential bargaining chip in upcoming trade talks.[16]

U.S. natural gas prices have been depressed due to the high associated gas production tied to surging U.S. oil output.  But, expanding LNG exports could reduce this supply overhang and eventually lift prices.

Energy update: Crude oil inventories rose 9.9 mb last week compared to the forecast rise of 1.8 mb.

In the details, refining activity expectedly fell 0.9% compared to the 0.5% increase forecast.  Estimated U.S. production rose slightly by 0.1 mbpd to 12.3 mbpd, a new record.  Crude oil imports rose 0.2 mbpd, while exports fell 0.1 mbpd.

This is the seasonal pattern chart for commercial crude oil inventories.  We are entering the spring/summer withdrawal season next week, so if inventories continue their rise it will become a significant bearish factor for prices.  The recent upswing in inventories is remarkable; stockpiles have increased 30 mb over the past six weeks.  Although we did not achieve seasonal parity with regard to inventories, the gap clearly narrowed.

Based on oil inventories alone, fair value for crude oil is $50.83.  Based on the EUR, fair value is $51.96.  Using both independent variables, a more complete way of looking at the data, fair value is $50.55.  This is one of those circumstances when the combined model fair value does not lie between the two single-variable models.  Current prices are running well above fair value.  Geopolitical risks, including the turmoil in Libya, continued problems in Iraq, unrest in Venezuela and the end of Iranian oil export waivers, are all lifting prices.  However, our data does suggest that the markets are getting a bit rich so any evidence that these situations are improving will likely lead to at least a period of consolidation, if not a pullback, in prices.

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[1] https://www.bloomberg.com/news/articles/2019-05-01/fed-makes-third-tweak-to-interest-on-excess-reserves-rate

[2] https://www.politico.eu/article/theresa-may-tories-labour-electoral-damage-limitation-exercise-british-local-elections/?utm_source=POLITICO.EU&utm_campaign=a962824d19-EMAIL_CAMPAIGN_2019_05_02_04_58&utm_medium=email&utm_term=0_10959edeb5-a962824d19-190334489

[3] https://www.ft.com/content/248b5e68-6c32-11e9-80c7-60ee53e6681d?emailId=5cca5e27b16ea8000441f4b6&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[4] https://www.ft.com/content/c8d0f45a-6c10-11e9-a9a5-351eeaef6d84?emailId=5cca5e27b16ea8000441f4b6&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[5] https://www.ft.com/content/13d4d3da-6cc6-11e9-a9a5-351eeaef6d84

[6] https://www.theatlantic.com/politics/archive/2019/05/white-house-venezuela-maduro-failed/588454/

[7] https://www.washingtonpost.com/world/national-security/in-venezuela-russia-pockets-key-energy-assets-in-exchange-for-cash-bailouts/2018/12/20/da458db6-f403-11e8-80d0-f7e1948d55f4_story.html?utm_term=.b29d3681aa80&wpisrc=nl_todayworld&wpmm=1

[8] https://www.nytimes.com/2019/05/01/us/politics/trump-venezuela-maduro-guaido.html?emc=edit_MBE_p_20190502&nl=morning-briefing&nlid=5677267ion%3DwhatElse&section=whatElse&te=1

[9] https://www.wsj.com/articles/venezuelas-opposition-held-talks-with-government-on-ousting-maduro-11556767656?mod=hp_lead_pos6

[10] https://www.ft.com/content/3d30a5f4-6c28-11e9-80c7-60ee53e6681d?emailId=5cca5e27b16ea8000441f4b6&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[11] https://www.washingtonpost.com/world/the_americas/venezuela-guaido-maduro-live-updates/2019/05/01/20553c6e-67ab-11e9-a698-2a8f808c9cfb_story.html?utm_term=.038158562388&wpisrc=nl_todayworld&wpmm=1

[12] https://www.reuters.com/article/us-canada-trade-china-pork-exclusive/exclusive-canada-farm-minister-informed-that-china-has-blocked-two-canadian-pork-exporters-idUSKCN1S74UV?utm_source=twitter&utm_medium=Social

[13] https://en.mercopress.com/2019/05/01/argentine-pork-to-china-which-is-suffering-from-an-african-swine-fever-epidemic?utm_source=GPF+-+Paid+Newsletter&utm_campaign=a53757fc7b-EMAIL_CAMPAIGN_2019_05_01_03_32&utm_medium=email&utm_term=0_72b76c0285-a53757fc7b-240037177

[14] https://www.bloomberg.com/news/articles/2019-04-30/millionaires-flee-their-homelands-as-tensions-rise-taxes-bite

[15] http://europa.eu/rapid/press-release_IP-19-2313_en.htm

[16] https://www.reuters.com/article/us-usa-trade-eu/eu-will-seek-sharp-increase-of-u-s-lng-imports-by-2023-idUSKCN1S80J8

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy May Day, the international Labor Day!  It’s also Fed day.  Here is what we are watching:

The Fed: The president continues to press the FOMC to cut rates.[1]  So far, his demands have not had much effect, although we can make a cogent case that the financial markets are clearly signaling that a rate cut would be justified.  It appears support for Stephen Moore is deteriorating in the Senate.[2]  Although Moore is well-connected in the GOP, he has apparently made some enemies along the way and his comments about women are turning out to be rather damning to his support.  Moore may fail to get nominated, but we still expect Trump to put doves in the two remaining governor positions.  We still would not be surprised to see Larry Kudlow get the nod.

As far as today’s meeting goes, there is little chance of a rate move but we might see some technical adjustments to free up reserves in the banking system.  We expect Powell to deal with questions about falling inflation in the press conference, but he should be able to deflect these to the early June meeting when policymakers are going to discuss changing the inflation target.

The mess in Venezuela: Yesterday, Juan Guaido called on the military to revolt against the Maduro regime.[3]  It had the look of a staged event;[4] in other words, Guaido seemed to have gotten some assurances that there was support for an overthrow,[5] otherwise his actions bordered on treason.  There are lots of reports in the media, which are difficult to substantiate, saying that a coup was indeed in place but Guaido may have moved prematurely.[6]  In any case, as the dust clears, Maduro is still in office and Guaido’s position appears even shakier.  Maduro supporters have violently pushed back against the opposition.[7]  Although Guaido continues to call for protests, it looks like the bulk of the military are remaining loyal to the regime.[8]  The situation remains fluid but Maduro seems to have more staying power than Washington expected.  As long as turmoil continues, it will be a supportive factor for oil prices.

China trade deal:There are reports that the U.S. has watered down its demands for preventing Chinese cybertheft in order to get a deal finished.[9]  We continue to closely watch USTR Lighthizer.  His longstanding goal was to address China’s trade practices but we would expect him to resign if he is forced to negotiate a deal that he opposes.  If he does, it might reduce the otherwise positive impact that an agreement would bring.

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[1] https://www.politico.com/story/2019/04/30/donald-trump-fed-interest-rates-1294038 and https://finance.yahoo.com/news/trump-calls-for-a-fed-rate-cut-while-praising-chinas-great-stimulus-180933300.html

[2] https://www.politico.com/story/2019/04/30/stephen-moore-fed-republicans-congress-1293236

[3] https://www.ft.com/content/b4ec0c2e-6b37-11e9-a9a5-351eeaef6d84?emailId=5cc90f9532c082000458df7e&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[4] https://www.reuters.com/article/us-venezuela-politics-usa-envoy/u-s-envoy-says-top-venezuelan-officials-negotiated-to-help-restore-order-idUSKCN1S62HH?wpisrc=nl_todayworld&wpmm=1

[5] https://edition.cnn.com/2019/04/30/politics/pompeo-maduro-russia/index.html and https://www.axios.com/pompeo-says-russians-convinced-venezuelas-maduro-not-to-flee-df6b4392-8994-48d7-9a62-388f641e11bb.html?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosmarkets&stream=business

[6] https://www.washingtonpost.com/world/the_americas/venezuelan-opposition-leader-juan-guaido-appears-to-stage-military-backed-challenge-to-president-maduro/2019/04/30/c7028eee-6b35-11e9-8f44-e8d8bb1df986_story.html?utm_term=.8babd60f7442&wpisrc=nl_todayworld&wpmm=1

[7] https://www.washingtonpost.com/world/2019/04/30/footage-shows-armored-vehicle-ramming-into-venezuelan-protesters-white-house-says-it-was-maduro-regime/?utm_term=.5cf2145ca4cc&wpisrc=nl_todayworld&wpmm=1

[8] https://www.theguardian.com/world/live/2019/apr/30/venezuela-opposition-leader-juan-guaido-claims-coup-underway-live-news?page=with:block-5cc8f82f8f08d5e277b5803c#block-5cc8f82f8f08d5e277b5803c

[9] https://www.ft.com/content/3cb5bfda-6b0e-11e9-80c7-60ee53e6681d?emailId=5cc90f9532c082000458df7e&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22