by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s a modest risk-on day on this Monday in late winter.  Here is what we are watching this morning:

Fed meeting: As noted last week, the FOMC meets this week.  Although there are hopes that the Fed may set the terminal level for the balance sheet,[1] this action may not occur at this meeting.  The dot plot will be watched carefully to see if the FOMC is taking a dovish turn.[2]  Meanwhile, financial markets are clearly signaling that the Fed is on hold.

This chart shows the fed funds target with the implied three-month LIBOR rate on the two-year deferred Eurodollar futures market.  Historically, this rate has coincided with policy actions.  We have placed vertical lines where this spread between the target and the implied rate inverts.  The Greenspan Fed tended to cut rates when the spread inverted.  The Bernanke Fed did stop raising rates once the inversion occurred, but didn’t cut; this lack of action probably contributed to the 2007-09 recession.  The spread is currently sitting at zero.  The financial markets are not signaling a rate cut but they are clearly indicating that further tightening will increase the odds of a policy mistake.

OPEC+: OPEC and Russia are meeting in Baku to discuss oil policy.  This morning, the OPEC minister, Khalid al-Falih, suggested that inventories are still too high (we would agree) and that production cuts should remain in place.[3]  Oil prices have moved higher on the news.  However, Russia has been more cautious about cuts and future talks.[4]  The sticking point seems to be around extending the cuts into H2.  It appears the cartel and Russia will likely defer that decision until May.

Trade talks: It looks like China and U.S. trade negotiators are hitting the most difficult elements of the negotiations because we are starting to hear reports suggesting longer delays in a summit.[5]  The latest out of China is that a meeting might not occur until June.  Apparently, the U.S. is considering keeping the threat of tariffs in place to ensure Chinese compliance to the agreement.[6]  Not only will China probably not accept such a deal, but the continued threat of sanctions will affect U.S. domestic company behavior.  That is, the mere threat of trade sanctions will affect how American companies behave.  If the trade talks fail, it would have an adverse effect on U.S. equities as the stock market has mostly discounted an easing in trade tensions.

Yellow Vest unrest: The Yellow Vests returned to France over the weekend and targeted areas of elite wealth in violent riots.[7]  In some respects, the numbers in the protests are falling but the protests themselves are becoming increasingly destructive.  The Macron government continues to condemn the protests but it looks like its plan to deal with them is to simply wait out the movement.[8]

Brexit: Political machinations continue in Britain and the EU.  PM May could delay another vote on her exit proposal until next week, which would put it very close to the exit date.  May is pressing the junior partner in her coalition, the DUP, to support her exit plan.[9]  The EU is indicating that the U.K. can extend the deadline to July 1 and not participate in May’s EU Parliamentary elections.[10]  Otherwise, the U.K. would be required to participate in the vote, which is not the EU’s preference.  EU officials fear British participation would bolster the populist cause.

But, the most interesting insight on the issue may be a recent election in Fall River, MA, of all places.[11]  The mayor of the town, Jasiel Correia, was accused of defrauding investors, including some local residents, in a marketing app scheme.  Because of his alleged transgressions, the town mustered enough signatures to trigger a recall vote.  Correia, who denies any wrongdoing, was decisively voted out of office.  He received 38% support, or 4,911 votes; obviously, 62% of the electorate opposed him.  Thus, the recall effort was successful and he was removed from office.

However, the good citizens of Fall River needed a mayor if the recall effort was successful so they held a second ballot simultaneously with the first.  Correia boldly ran for mayor against four other candidates.  In the second ballot, he received about the same level of support but because of the multiplicity of candidates he won the mayoral race.  So, on the same day, Correia was ousted and elected to office.

So, how did this happen?  The Fall River vote highlights a weakness in voting.  Voting as a decision process is only effective if the choices are clear.  Otherwise, voting can lead to indeterminate outcomes.  That is why many nations use a run-off vote after an initial voting round to clarify choices.  Other political entities have tested rank choice voting,[12] where voters list their preferences if there are multiple candidates.  This weighted preference method tends to be better for situations of multiple candidates or voting decisions.

The Brexit referendum was poorly constructed.  The way the vote was perceived was either the status quo or something different.  Voters who were unhappy with their economic or social condition opted to leave.  But, the leave decision is actually quite complicated because what that looks like was never fully expressed.  In recent voting, Parliament has told us that it doesn’t like May’s plan, but it doesn’t want a hard break either.  Much like the Fall River vote, British voters opted for one outcome, to leave, but there probably isn’t a majority for any other outcome.  In Fall River, voters paradoxically voted to remove and elect the same man on the same day.  With Brexit, voters opted to exit the EU but with no clear preference for what comes next.

Perhaps PM May’s plan, after all, is the best there is to offer.  It won’t garner a preference of the majority but it may be the best outcome that can be negotiated.  If a new referendum is held, a rank choice vote may at least reveal a plurality that the British people and the EU can live with.

An interesting twist on bitcoin: Bitcoin has become popular in nations with capital controls or currencies in collapse due to hyperinflation.  Venezuela has both conditions.  Another coincidence is that Venezuela has cheap electricity due to hydropower.  Bitcoin mining absorbs a tremendous amount of electricity.  As a result, despite the government’s effort to prevent the use of bitcoin, which included the creation of its own cryptocurrency, Venezuelans have tried to produce bitcoin in a bid to create a store of value.  The recent power outage has created a crisis in bitcoin mining, which led to a 40% decline in volume.[13]

The Cheollima Civil Defense:A group^[14] by this name infiltrated the North Korean Embassy in Madrid during the Trump/Kim summit in Vietnam.  The shadowy group, which wants to oust the Kim regime, briefly took control of the embassy and got away with a treasure trove of confidential information.  We will continue to monitor this group going forward.

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[1] https://www.wsj.com/articles/federal-reserve-rate-projections-could-show-greater-confidence-in-extended-pause-11552820400

[2] https://www.wsj.com/articles/fed-officials-wrestle-with-a-dot-plot-dilemma-11552901401

[3] https://www.reuters.com/article/us-oil-opec-falih/saudi-falih-optimistic-on-continued-commitment-to-opec-oil-supply-cut-idUSKCN1QY09C

[4] https://www.reuters.com/article/us-oil-opec-novak/russias-novak-says-talks-needed-in-may-to-decide-opec-next-steps-idUSKCN1QY0O8?il=0 and https://www.wsj.com/articles/opec-russia-deepen-oil-output-cuts-but-disagree-on-their-duration-11552860517?mod=hp_listc_pos3

[5] https://www.scmp.com/news/china/diplomacy/article/3001943/trump-xi-meeting-end-trade-war-may-be-put-back-june-sources

[6] https://www.nytimes.com/2019/03/17/business/trade-war-china-tariffs.html?action=click&module=Top%20Stories&pgtype=Homepage

[7] https://www.nytimes.com/2019/03/16/world/europe/france-yellow-vests-protest.html?emc=edit_mbe_20190318&nl=morning-briefing-europe&nlid=567726720190318&te=1

[8] https://www.politico.eu/article/french-politicians-condemn-violent-street-clashes-in-paris-yellow-jackets/?utm_source=POLITICO.EU&utm_campaign=3bf9274f14-EMAIL_CAMPAIGN_2019_03_18_05_49&utm_medium=email&utm_term=0_10959edeb5-3bf9274f14-190334489

[9] https://www.ft.com/content/449be1d0-4899-11e9-bbc9-6917dce3dc62?emailId=5c8f15f2584aeb00046099a6&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22 and https://www.ft.com/content/4a10a60e-48b3-11e9-bbc9-6917dce3dc62?emailId=5c8f15f2584aeb00046099a6&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[10] https://www.politico.eu/article/document-brexit-by-july-1-unless-uk-votes-in-eu-election/?utm_source=POLITICO.EU&utm_campaign=3bf9274f14-EMAIL_CAMPAIGN_2019_03_18_05_49&utm_medium=email&utm_term=0_10959edeb5-3bf9274f14-190334489 and https://www.ft.com/content/030dce3c-4749-11e9-a965-23d669740bfb

[11] https://www.nytimes.com/2019/03/16/world/europe/brexit-referendums.html

[12] https://www.fairvote.org/rcv#where_is_ranked_choice_voting_used

[13] https://bitcoinist.com/bitcoin-trading-plummets-in-venezuela-blackout-as-government-struggles-to-pay-money-printers/

[14] https://www.washingtonpost.com/world/national-security/a-shadowy-group-trying-to-overthrow-kim-jong-un-raided-a-north-korean-embassy-in-broad-daylight/2019/03/15/ae4208a4-c451-4886-b608-f5ac1f182d3d_story.html?utm_term=.babdc8624b28

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Ides of March Friday!  The National Party Congress (NPC) ended in China and New Zealand is reeling from a mass shooting.  U.S. equity futures are higher.  Here is what we are watching this morning:

The National Party Congress: Unlike previous events, this one was relatively quiet.  Three items emerged.  First, China will return to stimulus, with an increase of 0.8% of GDP in off-budget bond issuance for infrastructure spending.  Although tax cuts have captured the headlines, they are mostly a head fake as spending cuts elsewhere in the budget will tend to offset them.  There could also be some easing of bank reserve requirements.[1]  The stimulus is not all that great but should be enough to stabilize growth.  Second, there was much talk about changes in industrial policy, including little mention of the Belt and Road Initiative or China 2025.  But, the policies still remain in place.  Second, a leveling of the playing field for foreign firms was announced to great fanfare[2] but, in reality, such laws are not terribly meaningful in a nation where “rule of law” really means “do what the Party says.”  The law is mostly there to help bring a trade deal with the U.S.  Third, although there has been some easing of property controls in cities, the national level policy remains restrained.  There had been hopes for change.  Overall, the NPC will support China’s economic growth and likely increase the odds of a trade deal with the U.S., but it won’t lead to an economic boom.

Fed next week: The FOMC will meet next week.  Although no action on rates is expected, we will be watching for two signals.  First, it is quite possible that the FOMC will indicate it will be on hold for most of this year.  Although the usual commentary on data dependency should remain, financial markets are signaling to policymakers that the fed funds should not increase this year.  We will be watching to see if the dots plot reflects this.  Second, the markets will be looking to see if the FOMC signals anything on the balance sheet.  There is growing speculation that the Fed will target a level between $3.8 trillion to $3.5 trillion.[3]  If the FOMC does signal no rate hikes this year and a higher terminal number for the balance sheet, then equities will take this news as supportive.

North Korea: In the aftermath of the recent summit, it appears North Korea may be moving back to a more hostile stance.[4]  Relations between the U.S. and North Korea are complicated.  It appears to us that Kim Jong-un thought he could get a lot from the U.S. and give up little; President Trump clearly figured this out and walked out of talks.  Pyongyang probably wants to pull the U.S. back into talks and thus is using threats to accomplish this outcome.  However, we note the recent comments about restarting warhead and missile tests didn’t come from Kim but from other officials.  We would expect Kim to write another letter or two to Trump to try to get another round of talks.  In addition, a turn toward hostility would be a help to China, who may offer to help out for some easing of trade tensions.

Tehran to Baghdad: Iranian President Rouhani visited Iraq this week, his first state visit to his neighbor.  The visit appears to be designed to undermine U.S. sanctions.[5]  Given the degree of influence that Iran has in Iraq, we expect Iraq to offer a “leaky border” for smuggling.  What was interesting about Rouhani’s visit was that the Iranian president was given a rare audience with Iraq’s leading religious authority, the Grand Ayatollah Ali Sistani.[6] Sistani has always been a political moderate; he does not ascribe to Iran’s “rule of the clerics” model developed by Ayatollah Khomeini, preferring the traditional quietist[7] position of the Shiites.  Sistani opposes Iran’s paramilitary influence in Iraq and apparently noted this in his conversation with Rouhani.  The meeting will lift Rouhani’s position in Iran among moderates and will likely tighten relations between the two governments.

Brexit: So, now what?  The next step is yet another vote on PM May’s exit plan.  Although this seems like a futile exercise[8] to have another vote after the plan has failed miserably twice, it may actually pass on a third turn.[9]  First, May’s minority partner, the DUP in Northern Ireland, is coming under significant pressure from the Northern Irish business community to avoid a hard border and that may mean accepting the backstop and May’s plan.[10]  Second, the EU is indicating that the only way it will agree to an extension is if there is a second referendum.  The Brexiteers are uncomfortable taking a chance on another vote, which might end up with a return to the EU.[11]  Third, it appears that the European Research Group, the collection of Tory MPs who support Brexit, is splitting.  The group, which numbers around 90, only has a core of about 20 MPs.  There are reports that the pragmatists in the group are having second thoughts about careening into a hard Brexit and may end up favoring May’s deal.[12]  And, finally, Labour is facing dissention in its own ranks[13] and may actually lose an election, based on recent polling.[14]  Labour leader Jeremy Corbyn has been pining to bring down the government and have an election, but if Corbyn can’t hold his party together then they might simply vote for May’s plan to avoid another referendum or a hard Brexit.  If May’s plan passes, look for the GBP to rally.

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[1] https://uk.reuters.com/article/us-china-parliament-economy/china-premier-says-can-use-interest-rates-other-policy-steps-to-help-economy-idUKKCN1QW09Y

[2] https://www.scmp.com/economy/china-economy/article/3001780/china-approves-new-foreign-investment-law-designed-level

[3] https://www.reuters.com/article/us-funds-pimco/fed-could-soon-announce-plan-to-stop-shrinking-balance-sheet-pimco-idUSKCN1QV2WB

[4] https://www.reuters.com/article/us-northkorea-usa/north-korea-may-suspend-nuclear-talks-with-gangster-like-u-s-diplomat-idUSKCN1QW0C9?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[5] https://www.washingtonpost.com/world/irans-rouhani-in-iraq-for-historic-visit-to-offset-us-sanctions/2019/03/11/24c6e88b-eb40-4da1-b091-c4eb64c0fce3_story.html?utm_term=.a056337ce629&wpisrc=nl_todayworld&wpmm=1

[6] https://www.washingtonpost.com/world/by-granting-rare-audience-iraqs-grand-ayatollah-sends-message-to-washington-and-tehran/2019/03/13/9a624870-4506-11e9-94ab-d2dda3c0df52_story.html?utm_term=.329425d52887&wpisrc=nl_todayworld&wpmm=1

[7] https://en.wikipedia.org/wiki/Political_quietism_in_Islam

[8] https://www.youtube.com/watch?v=UijhbHvxWrA

[9] https://www.youtube.com/watch?v=zMRrNY0pxfM

[10] https://www.ft.com/content/43ec8b9e-466a-11e9-a965-23d669740bfb?utm_source=POLITICO.EU&utm_campaign=154de0543d-EMAIL_CAMPAIGN_2019_03_15_06_44&utm_medium=email&utm_term=0_10959edeb5-154de0543d-190334489

[11] https://www.thetimes.co.uk/edition/news/eu-will-agree-to-extra-time-if-there-is-a-second-brexit-referendum-z6td8nvd7?utm_source=POLITICO.EU&utm_campaign=154de0543d-EMAIL_CAMPAIGN_2019_03_15_06_44&utm_medium=email&utm_term=0_10959edeb5-154de0543d-190334489

[12] https://www.ft.com/content/300a59e4-465b-11e9-b168-96a37d002cd3?emailId=5c8aeeb0cc534f000485fbec&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[13] https://www.telegraph.co.uk/politics/2019/03/14/mps-reject-second-referendum-labour-frontbencher-quits-partys/

[14] https://www.theguardian.com/politics/2019/feb/02/labour-slumps-in-polls-as-tories-open-biggest-lead-since-general-election

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Pi Day![1]  It’s a very quiet day so far this morning.  U.S. equity futures are modestly lower.  Here is what we are watching:

Brexit: As expected, MPs voted to avoid a no-deal Brexit, despite an 11^th hour plea from the PM to vote against it.[2]  May appears to want another round on her proposal,[3] suggesting that either they accept her program or put Brexit into what may be a never-ending delay process.[4]  Today, MPs vote to ask for an extension of the deadline; to be precise, they are voting on four amendments: (a) delay Brexit and try to build a new deal, (b) hold a second referendum, (c) indicate a non-binding vote on the future of Brexit proposals (e.g., joining the Customs Union), and (d) make PM May’s proposal the final version of Brexit.  An amendment to rule out a second referendum will not come up for a vote, torqueing off the hard Brexiteers.

Although we expect the EU to give the U.K. an extension, the noise coming out of Brussels does suggest the EU will need cause.[5] The EU wants to avoid a hard Brexit, but it also wants to prevent the U.K. from voting in the European Parliament elections in May.  And, finally, if the May government does allow Brexit without a hard border between Ireland and Northern Ireland, it will create conditions for a thriving smuggling economy as U.K. tariffs will become effectively unenforceable.[6]  It could also shift trade routes away from France and toward Ireland.

Trade: It appears, as has been rumored, that the trade summit between China and the U.S. will be delayed until later in April.[7]  Gary Cohn, a former administration economic advisor, was quoted on a podcast as saying that President Trump is “desperate” for a trade deal with China.[8]  No surprise there, but coming from someone who was in the administration adds confirmation to other similar comments.  It appears that farmers are banking on either (a) trade relief with China, or (b) increased sales elsewhere because intentions for soybean planting remain high.  Of course, some of this decision is due to the lack of alternatives.[9]

According to reports, Democratic Party leaders in Congress are “cool” toward USMCA.[10]  If the new law fails to pass, it could lead to an end to the treaty.  This would have adverse effects on the economies of Canada and Mexico.

Facebook (FB, 173.37): The company, along with other tech firms, is being criminally investigated for data arrangements made to collect user data.[11]  Increased scrutiny of these tech firms could affect the overall equity market.

Energy update: Crude oil inventories fell 3.8 mb last week compared to the forecast rise of 3.0 mb.

In the details, estimated U.S. production fell 0.1 mbpd to 12.0 mbpd.  Crude oil imports fell 0.3 mbpd, while exports fell 0.5 mbpd.  Refinery runs rose 0.2%, roughly on forecast.

This is the seasonal pattern chart for commercial crude oil inventories.  We would expect to see a steady increase in inventories that will peak in early May; the pattern coincides with refinery maintenance.  This week’s decline puts the market further behind the storage injection curve and is bullish.

Based on oil inventories alone, fair value for crude oil is $57.63.  Based on the EUR, fair value is $52.91.  Using both independent variables, a more complete way of looking at the data, fair value is $53.76.  By all these measures, current oil prices are at the high end of fair value.  Without some dollar weakness soon, oil prices will likely be rangebound until spring.

OPEC cut production in February by 0.2 mbpd, taking the year-to-date reduction to about 1.0 mbpd.  Much of the reduction came from falling Venezuelan output.[12]  The latter situation continues to support prices.  The U.S. is taking additional steps to enforce sanctions on Iranian oil exports, with the aim of reducing Iran’s exports to under 1.0 mbpd by May.[13]

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[1] https://www.nytimes.com/2019/03/14/science/pi-math-geometry-infinity.html

[2] https://www.nytimes.com/2019/03/13/world/europe/brexit-no-deal.html?emc=edit_mbe_20190314&nl=morning-briefing-europe&nlid=567726720190314&te=1

[3] https://www.politico.eu/article/theresa-may-brexit-no-deal-uk-asks-for-one-more-week/?utm_source=POLITICO.EU&utm_campaign=e4c483d49a-EMAIL_CAMPAIGN_2019_03_14_05_48&utm_medium=email&utm_term=0_10959edeb5-e4c483d49a-190334489

[4] https://www.ft.com/content/2fc6b504-45c5-11e9-a965-23d669740bfb?emailId=5c89d5514f943b00041f8d07&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[5] https://www.politico.eu/article/eu-negotiatior-michel-barnier-brexit-extension-for-what-no-deal/?utm_source=POLITICO.EU&utm_campaign=e4c483d49a-EMAIL_CAMPAIGN_2019_03_14_05_48&utm_medium=email&utm_term=0_10959edeb5-e4c483d49a-190334489 and https://www.ft.com/content/c985950e-45af-11e9-b168-96a37d002cd3?emailId=5c89d5514f943b00041f8d07&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[6]  https://www.politico.eu/article/smugglers-paradise-ireland-no-deal-brexit/?utm_source=POLITICO.EU&utm_campaign=e4c483d49a-EMAIL_CAMPAIGN_2019_03_14_05_48&utm_medium=email&utm_term=0_10959edeb5-e4c483d49a-190334489

[7] https://uk.reuters.com/article/usa-china-trade-stocks/european-stocks-and-chinas-yuan-hit-by-report-of-delay-in-china-us-trade-summit-idUKL8N211359

[8] https://www.washingtonpost.com/business/economy/gary-cohn-says-trump-is-desperate-for-trade-deal-with-china/2019/03/13/56af2396-45c9-11e9-8aab-95b8d80a1e4f_story.html?utm_term=.4524af084582

[9] https://www.reuters.com/article/us-usa-trade-china-soybeans/why-u-s-growers-are-betting-the-farm-on-soybeans-amid-china-trade-war-idUSKCN1QV0CP

[10] https://www.reuters.com/article/us-usa-trade-democrats/democrats-cool-toward-nafta-replacement-question-labor-standards-idUSKCN1QU2PC?il=0

[11] https://www.nytimes.com/2019/03/13/technology/facebook-data-deals-investigation.html

[12] https://www.wsj.com/articles/opec-slows-pace-of-production-cuts-11552564800

[13] https://www.reuters.com/article/us-usa-sanctions-iran-oil-exclusive/exclusive-us-aims-to-cut-iran-oil-exports-to-under-1-million-bpd-from-may-sources-idUSKCN1QU35V

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. equity futures are modestly higher this morning in a quiet news environment.  Here is what we are watching this morning:

Brexit: As expected, PM May’s plan failed again;[1] although the vote was closer this time, it was nowhere close to passing.[2]  Today, Parliament votes whether to allow or prevent a hard Brexit.[3]  May is allowing Conservative MPs a “free vote,” meaning party whips won’t press members for any particular outcome.  Voting will begin at 7:00 PM GMT (3:00 EDT).  Although it is possible, there isn’t much evidence to suggest that MPs will accept an outcome that allows a hard Brexit (the economic disruption would cause a backlash among voters).  Assuming a hard Brexit option is eliminated, the next step is for a vote tomorrow to ask for an extension from the EU.  The EU has made noise that it won’t grant an extension without cause, but, in reality, the EU doesn’t want a hard Brexit either so we expect an extension will be granted.

Meanwhile, there is much drama going on behind the scenes.  There is growing talk of a second referendum.[4]  Brexiteers seem poised to bring down May and replace her with one of their own.[5]  Labour wants to do the same.  These plays at power are the most likely avenue for a chaotic exit.  So far, however, financial markets are betting that there will be an extension of the deadline and muddling will continue; the GBP is trading in a tight range awaiting some clear outcome.

Venezuela: As the country spirals into the “heart of darkness,”[6] there is one news item of note—opposition leader Guaido has indicated he would reopen Venezuela’s oil industry to foreign investment.[7]  Venezuela, unusual for an OPEC nation, welcomed foreign investment in the era before Chavez.  Chavez chased the foreigners out; as he did so, oil production steadily declined.  Guaido’s promise will be popular with developed nations but, over time, would be a serious threat to OPEC.  Saudi Arabia’s decision to take market share away from Venezuela in the late 1990s led oil prices to near $10 per barrel.  Given the current chaos in Venezuela, it would take a few years to rebuild the nation’s oil industry.  But, the longer term implications would be bearish for oil prices.

Bouteflika’s presidency nears its end: Algerian president Abdelaziz Bouteflika has postponed the April 18^th elections and has indicated he won’t stand for a fifth term.[8]   Even though he has promised not to run for a fifth term, protests are continuing in a bid to oust him.[9]  So far, civil order has mostly held.  But, if the regime begins to feel threatened, a harder response and potential oil flow disruptions are possible.

The college bribery scandal: Although we don’t expect any direct market effects, at least in the near term, the bribery scandal could have important political and social effects.  Unless you have been in a news vacuum over the past 24 hours, the outline of the scandal is this: wealthy parents took a number of extreme measures to get their offspring into elite colleges.  The actions included fake athletic entries and falsified college entrance exams.[10]

The well-heeled already have advantages in the college admissions process.  Their parents probably went to college and understand the process.  The parents can pay for test tutors and multiple attempts at the exam, whereas poor kids can maybe buy or borrow a test prep book and can afford one try at the exam.  Rich kids have enriching summers, while poor kids work at menial jobs; these experiences create bias for acceptance letters.  So, even when criminal action isn’t taken, the playing field is far from even.  And, at the very wealthy levels of society, legacy admissions tied to large donations have been around for a while.  None of this is some great revelation.  However, this scandal takes the process even further, showing that some families of means are willing to resort to fraud.  So, why does this happen?

We live in an age of meritocracy.[11]  Instead of being ruled by a hereditary elite, we are now, in theory, led by the best and brightest.  If we really believed that, then the parents would recognize that their less stellar offspring probably shouldn’t take the place of a less fortunate but smarter kid at that elite college.[12]  But, in this case, natural affinities overruled good sense and the newly rich of the “best and brightest” went beyond what is already unfair to criminal to advantage their children.

Here is the social and political problem this scandal brings—the less fortunate kids in the middle who don’t get the benefits of legacy or wealth or the help of affirmative action will view this scandal as further evidence that the deck is not just unfairly stacked against them but is criminally so.  Therefore, when someone from the best and brightest class tries to explain why policies, let’s say, climate change policies, are worthy, those outside the meritocracy class will view this not as wise and well thought out policy but probably just another government action to disadvantage them further.  Meritocracy as a system can be justified but if it is delegitimized by the behavior exhibited in this scandal, then faith in those who have positions of power are undermined.  Such actions support the rise of populism.

Chinese trade: USTR Lighthizer was encouraging in his comments yesterday.[13]  And, Congress is pushing back against auto tariffs, reducing their likelihood as well.[14]  The news is supportive for equities.

Coffee bear: Coffee prices fell to their lowest level in more than a decade and supply exceeds demand.[15]  A weak BRL lowered production costs (one of the reasons a strong dollar is bearish for commodities is that most commodities are priced in dollars but production costs are in local currencies, so a stronger dollar encourages more production) which led to more tree investment that is now producing more beans.  However, the drop in wholesale prices will not lead to lower prices at the consumer level, at least not immediately.  Instead, it will boost margins for roasters.

Mankiw Rule update: The Taylor Rule is designed to calculate the neutral policy rate given core inflation and the measure of slack in the economy.  John Taylor measured slack by the difference between actual GDP and potential GDP.  The Taylor Rule assumes that the Fed should have an inflation target in its policy and should try to generate enough economic activity to maintain an economy near full utilization.  The rule will generate an estimate of the neutral policy rate; in theory, if the current fed funds target is below the calculated rate, then the central bank should raise rates.  Greg Mankiw, a former chair of the Council of Economic Advisors in the Bush White House and current Harvard professor, developed a similar measure that substitutes the unemployment rate for the difficult-to-observe potential GDP measure.

We have taken the original Mankiw rule and created three other variations.  Specifically, our model uses core CPI and either the unemployment rate, the employment/population ratio, involuntary part-time employment and yearly wage growth for non-supervisory workers.  All four models compare inflation and some measure of slack.  Here is the most recent data:

Three of the models would suggest the FOMC is well behind the curve and needs to be increasing the policy rate.  However, the employment /population ratio does suggest some slack in the economy and implies the Fed has already lifted rates more than necessary.  Until recently, the wage growth variation was also suggesting caution.  In September, it was signaling a neutral rate of 2.78%.  However, as the line shows, the projected rate has moved up sharply as wages have increased.  We suspect some of this wage increase has been mandated by various state and local increases in minimum wages.  If so, the rise in wages should slow later this year.

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[1] https://www.nytimes.com/2019/03/12/world/europe/uk-brexit-vote.html?emc=edit_mbe_20190313&nl=morning-briefing-europe&nlid=567726720190313&te=1

[2] https://www.ft.com/video/b8a9776f-3766-4537-ac2a-e4464ef7fe5a?emailId=5c8885c89bf68b0004839367&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[3] https://www.ft.com/content/391ed220-44ef-11e9-b168-96a37d002cd3?emailId=5c8885c89bf68b0004839367&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[4] https://www.washingtonpost.com/politics/2019/03/12/could-there-be-second-brexit-referendum/?utm_term=.7db5360f03f2&wpisrc=nl_todayworld&wpmm=1

[5] https://www.ft.com/content/dff1acce-44ec-11e9-b168-96a37d002cd3?emailId=5c8885c89bf68b0004839367&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[6] https://www.amazon.com/Heart-Darkness-Joseph-Conrad/dp/1936594145

[7] https://www.reuters.com/article/us-venezuela-politics-energy-law/venezuelas-guaido-readies-to-open-up-oil-industry-after-years-of-nationalization-idUSKBN1QT2HP

[8] https://www.nytimes.com/2019/03/11/world/africa/algeria-president-election.html?emc=edit_mbe_20190312&nl=morning-briefing-europe&nlid=567726720190312&te=1

[9] https://www.washingtonpost.com/world/protests-continue-after-algerian-leader-drops-bid-for-fifth-term/2019/03/12/628be796-44cd-11e9-94ab-d2dda3c0df52_story.html?utm_term=.6f7d76d1696b&wpisrc=nl_todayworld&wpmm=1

[10] https://www.washingtonpost.com/world/national-security/fbi-accuses-wealthy-parents-including-celebrities-in-college-entrance-bribery-scheme/2019/03/12/d91c9942-44d1-11e9-8aab-95b8d80a1e4f_story.html?utm_term=.7e32ab03dcdd&wpisrc=nl_todayworld&wpmm=1 ; https://www.theatlantic.com/education/archive/2019/03/college-admissions-scandal-fbi-targets-wealthy-parents/584695/?wpmm=1&wpisrc=nl_todayworld ; https://www.nytimes.com/2019/03/12/us/college-admissions-cheating-scandal.html?emc=edit_mbe_20190313&nl=morning-briefing-europe&nlid=567726720190313&te=1

[11] https://www.nytimes.com/2018/12/05/opinion/george-bush-wasps.html

[12] https://www.youtube.com/watch?v=eiRGRvE_Wqg

[13] https://www.wsj.com/articles/u-s-china-trade-deal-is-getting-closer-lighthizer-says-11552407913

[14] https://www.wsj.com/articles/momentum-slips-for-auto-import-tariffs-11552383000

[15] https://www.axios.com/newsletters/axios-markets-2397805b-f1f9-4fd9-909d-1c17966edcdf.html?chunk=5#story5

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. equity futures are flat this morning after a strong run yesterday.  Here is what we are watching this morning:

Brexit: In an 11^th hour attempt to seal a deal,[1] PM May and EU Commissioner Juncker offered statements to clarify and ease the Irish backstop issue.  Although May suggested that she had secured “legally binding” assurances that the U.K. would not be forever trapped in the backstop, Geoffrey Cox, her attorney general, disagreed.[2]  In reality, if Juncker had offered something new it would have needed ratification from the 26 other members of the EU; since he didn’t ask, these “assurances” were not a real change.  Cox’s decision is probably a deal killer.  If Cox would have agreed with May’s description, his approval might have swayed Tory Brexiteers.  But, his assessment likely means that when the vote on May’s plan is held at 7:00 GMT (3:00 pm EDT) it will almost certainly be defeated.  That sets up tomorrow’s vote, which will determine whether or not there can be a hard Brexit.  We expect hard Brexit to be defeated, which means a delay in Brexit is coming; the exit could be delayed for up to a year.

When the May/Juncker agreement was announced, the GBP rallied strongly.  It has given up nearly all of its gains.

A customs workers’ strike in France, protesting the lack of French preparation for Brexit, could be a sign of how chaotic a hard Brexit would be.[3]  Trucks are reportedly backed up for miles.  Current arrangements allow for the seamless movement of goods.  After Brexit, cargos will need to be inspected.

Venezuela blackouts: The blackouts in Venezuela are continuing with no clear end in sight.[4]  The U.S. is pulling all of its embassy staff from the country.[5]  The persistent power outages are affecting oil production and exports.[6]  There are unconfirmed reports that oil production may have fallen to 0.5 mbpd; for world markets, the lack of exports means that Venezuela is no longer contributing to global supply.  Oil prices moved higher on the news.

Bouteflika’s presidency nears its end: Algerian president Abdelaziz Bouteflika has postponed the April 18 elections and has indicated he won’t stand for a fifth term.[7]  Algeria has been hit with protests against the president, who is 82 years old and incapacitated from a stroke.  It appears a caretaker government will take control of his administration until new elections are held.  Bouteflika has been in office since 1999.  The fact that it appears there will be a peaceful transition of power is remarkable and modestly bearish for oil prices (although Venezuela’s news is probably a more important factor).

Chinese trade: Chinese Vice Premier Liu discussed the text of a trade agreement with USTR Lighthizer yesterday evening.[8]  Although there is no date for a Xi-Trump trade summit, the fact that these two high-ranking officials are talking is a good sign that there are attempts at progress.

New York tax: State and city officials are considering a “pied-à-terre” tax[9] on second homes in New York City.  The city is a destination for the wealthy to purchase apartments and homes that are not their primary residence.  The tax would apply to non-primary homes worth $5.0 mm or more.  What makes this tax interesting to us is that New York residential real estate has been attractive to foreign capital flight for years.  It is unclear if the tax will be enough to deter these funds to other venues, but other cities that are also areas for capital flight, such as London, may be watching to see if the city remains a destination for capital flight after the tax is enacted.

Populism v. establishment: Since the election, we have characterized the Trump presidency as a battle between the populists and the establishment.  Trump shrewdly determined that populists, especially the right-wing variety, had perceived themselves as being shunted aside.  By running as an anti-global Jacksonian, he was able to capture that vote.  At the same time, Trump also catered to the right-wing establishment.  In governing, Trump mostly acted as an establishment figure, at least on domestic economic policy, until January 2018.  After the tax bill passed, Trump’s policies of trade impediments and border security were pure right-wing populism.

However, on foreign policy, Trump has been more consistently populist.  The establishment supports America as hegemon, which means the U.S. acts to bring global security and provides the reserve currency.  In the latter role, the U.S. is open to trade and willingly accepts a trade deficit.  It also remains open to immigration, which provides the capital-owning class an expanding (and compliant) labor force.  Trump has put up trade barriers and moved U.S. trade policy to a bilateral stance, which virtually guarantees that the U.S. will dominate every trade relationship (at the cost of undermining U.S. security projection).  Trump has also moved to restrict immigration.

The right-wing establishment has an uneasy relationship with Trump.  Although it clearly supports the tax cuts and aggressive deregulation, it would prefer the U.S. maintain the superpower role and have relaxed immigration policy.  The WP is reporting that, in a discussion with VP Pence, former VP Dick Cheney accused Trump of running a foreign policy similar to his predecessor, Barack Obama.[10]  In terms of substance, Cheney is closer to being accurate.  Trump’s unilateral decision to leave Syria is reminiscent of Obama’s hasty retreat from Iraq.  Obama’s “pivot to Asia” required a reduction in resources to the Middle East.  One of the common mistakes made in the current environment is to analyze politics from the traditional right/left, Republican/ Democrat or conservative/liberal viewpoints, but the real underlying trend, in our view, is populist/establishment.  And, it isn’t just a U.S. issue.  Europe is being riven by similar trends.  The noted exchange between Cheney and Pence is an interesting example of the populist/establishment divide.

Turkey slips into a downturn: Last year’s currency crisis in Turkey has weighed on growth and finally taken GDP into negative territory for the second consecutive quarter, which is considered a “rule of thumb” definition of recession.

However, it wasn’t all bad news.  The drop in the TRY has led to a significant improvement in net exports, which will, over time, support the economy’s recovery.  The improvement in trade confirms that a floating exchange rate is a powerful tool to combat a downturn.

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[1] https://www.washingtonpost.com/world/europe/in-a-big-week-for-brexit-parliament-will-vote-on-theresa-mays-deal-and-possibly-a-delay/2019/03/11/52d3f5d4-4403-11e9-94ab-d2dda3c0df52_story.html?utm_term=.fc13b814458f&wpisrc=nl_todayworld&wpmm=1

[2] https://www.ft.com/content/bbb893a6-44b8-11e9-b168-96a37d002cd3

[3] https://www.nytimes.com/2019/03/11/world/europe/france-border-protest-brexit.html?emc=edit_mbe_20190312&nl=morning-briefing-europe&nlid=567726720190312&te=1

[4] https://www.nytimes.com/2019/03/11/world/americas/venzuela-blackout-maduro.html?emc=edit_mbe_20190312&nl=morning-briefing-europe&nlid=567726720190312&te=1

[5] https://www.wsj.com/articles/u-s-to-withdraw-remaining-embassy-staff-families-from-venezuela-11552370940

[6] https://oilprice.com/Geopolitics/South-America/Blackout-Shuts-Down-Venezuelas-Oil-Exports.html

[7] https://www.nytimes.com/2019/03/11/world/africa/algeria-president-election.html?emc=edit_mbe_20190312&nl=morning-briefing-europe&nlid=567726720190312&te=1

[8] https://www.scmp.com/news/china/diplomacy/article/3001162/chinese-vice-premier-liu-he-discusses-trade-deal-text-us

[9] https://www.nytimes.com/2019/03/11/nyregion/mta-subways-pied-a-terre-tax.html?action=click&module=Top%20Stories&pgtype=Homepage

[10] https://www.washingtonpost.com/politics/former-vice-president-cheney-challenges-pence-on-trumps-foreign-policy/2019/03/11/ecddbff6-4436-11e9-aaf8-4512a6fe3439_story.html?utm_term=.f2b69fdea40d&wpisrc=nl_todayworld&wpmm=1

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equity futures are mostly higher this morning, although Dow futures are lower on the Ethiopian airlines crash.[1]  Here is what we are watching this morning:

Chinese trade: It appears the trade summit between China and the U.S. will likely be delayed, probably into April.[2]  There was some movement on the enforcement mechanism.  China is uncomfortable with giving the U.S. unilateral power to decide whether China is violating the terms of the agreement, but would be willing to accept a joint plan.[3]  China has also indicated it won’t engage in competitive devaluations,[4] most likely because any threat of a weaker CNY would trigger capital flight.  We still expect the Trump administration to make a deal with China as a failure of talks would harm the president’s reelection campaign.[5]

Meanwhile, we note that China’s exports appear to be rebounding this month.[6]  There is evidence that China’s economy is starting to benefit from recent stimulus measures.[7]

Brexit: It’s decision week for Brexit.  There are three votes this week.  The first occurs tomorrow on May’s exit deal.  Although her administration has been negotiating with the EU, there has been no discernable progress made.[8]  Thus, we are assuming her plan will go down in defeat again.  The following day Parliament will vote on whether it wants a “no-deal” Brexit.  That will likely also be defeated as few MPs want to be seen as supporting the chaos that a fast, hard break would bring.  On Thursday, assuming our assessment of Tuesday’s and Wednesday’s votes are correct, Parliament should vote to ask for an extension.[9]  Although it would appear logical that they should vote for an extension, stranger things have happened.

It does look like PM May’s remarkable run could be coming to a close.[10]  Although she has suffered historic losses in Parliament, she has hung on to power, in part, because no one else has any better ideas on how to proceed.  However, the Tories are concluding that the party needs a new leader to negotiate trade arrangements with the EU.  From our vantage point, we don’t see a leader in the Conservatives who will have any easier of a time concluding Brexit.

Meanwhile, the BOE has ordered banks to triple their “easy to sell” asset buffers on fears of a hard Brexit.[11]  Businesses are in varied states of preparation.[12]  So far, the GBP has held its value on the belief that a hard Brexit will be avoided.  We suspect this supposition is true, but there remains a chance that Britain stumbles into a crisis.

Venezuela blackouts: Venezuela suffered massive power outages over the weekend[13] that are continuing into this workweek.[14]  The Maduro government has accused outsiders of sabotage, but the most likely reason is the ineptitude of the regime.  Protests against the government continue despite the blackout,[15] but it increasingly appears that the opposition cannot swing the military to its side.  Thus, the slow-motion collapse continues.[16]

Saudi oil cuts extended into April: Saudi sale intentions for next month are signaling that oil production cuts will continue, which is supportive for oil prices.[17]

Indian elections begin mid-April: The world’s largest democracy will begin elections on April 11.  Six subsequent elections will be held over the next five weeks, ending on May 19 with final results due on May 23.[18] 

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[1] https://www.washingtonpost.com/world/ethiopian-airlines-flight-bound-for-nairobi-crashes-with-157-on-board/2019/03/10/0be5826c-4310-11e9-90f0-0ccfeec87a61_story.html?noredirect=on&utm_term=.1847abc5605e&wpisrc=nl_todayworld&wpmm=1

[2] https://www.wsj.com/articles/u-s-china-trade-deal-isnt-imminent-ambassador-branstad-says-11552031163 and https://www.ft.com/content/e089b6de-42b4-11e9-b168-96a37d002cd3

[3] https://www.nytimes.com/2019/03/09/business/china-trade-talks-trump.html?action=click&module=Latest&pgtype=Homepage

[4] https://www.wsj.com/articles/u-s-china-near-currency-deal-beijing-vows-not-to-devalue-yuan-to-help-exports-11552204378

[5] https://www.bloomberg.com/news/articles/2019-03-08/trump-says-china-deal-will-mean-very-big-spike-for-markets

[6] https://www.scmp.com/economy/china-economy/article/2189454/china-exports-rebound-strongly-early-march-after-februarys-20

[7] https://www.ft.com/content/c085c2e4-4235-11e9-b168-96a37d002cd3

[8] https://www.ft.com/content/dceee028-43ca-11e9-a965-23d669740bfb

[9] https://www.nytimes.com/2019/03/08/world/europe/brexit-uk-may-endless.html?emc=edit_mbe_20190311&nl=morning-briefing-europe&nlid=567726720190311&te=1

[10] https://www.ft.com/content/618ad20c-4316-11e9-a965-23d669740bfb?emailId=5c85da12a114dd0004a40895&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[11] https://www.ft.com/content/7450737a-4356-11e9-b168-96a37d002cd3?emailId=5c85da12a114dd0004a40895&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[12] https://www.washingtonpost.com/world/europe/will-brexit-happen-when-and-how-the-uncertainty-is-maddening-for-business/2019/03/09/900525fe-3468-11e9-8375-e3dcf6b68558_story.html?utm_term=.48613f282d57&wpisrc=nl_todayworld&wpmm=1

[13] https://www.washingtonpost.com/world/the_americas/rotting-food-and-endangered-patients-how-venezuelans-are-faring-during-continuing-nationwide-power-outages/2019/03/10/137e14a2-4343-11e9-94ab-d2dda3c0df52_story.html?utm_term=.2b67fedfc403&wpisrc=nl_todayworld&wpmm=1

[14] https://www.ft.com/content/65940e9a-3c6d-11e9-b72b-2c7f526ca5d0

[15] https://www.washingtonpost.com/world/the_americas/demonstrators-jam-venezuela-anti-government-protest-despite-blackout/2019/03/09/75c328c0-404e-11e9-85ad-779ef05fd9d8_story.html?utm_term=.eb167a5fa2a4&wpisrc=nl_todayworld&wpmm=1

[16] https://www.washingtonpost.com/opinions/2019/03/10/venezuela-is-truly-verge-collapse/?utm_term=.ab11763ea5f8

[17] https://www.bloomberg.com/news/articles/2019-03-11/saudi-arabia-is-said-to-extend-deep-oil-output-cuts-into-april

[18] https://www.washingtonpost.com/world/india-elections-to-launch-on-april-11-unfold-in-seven-stages/2019/03/10/8b94916e-4320-11e9-9726-50f151ab44b9_story.html?noredirect=on&utm_term=.9cac09849a42&wpisrc=nl_todayworld&wpmm=1