by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. equity futures are under pressure again this morning.  Here is what we are watching today:

Trade: Yesterday, we noted that the lack of dollar depreciation was starting to become a problem for equities.  Although the reversal of the FOMC on monetary policy is, by itself, negative for the dollar, in forex, everything is relative and weakening global growth is triggering even easier policy abroad.  It appears dollar concerns, tied to weakening global growth, caused yesterday’s initial drop.  However, the decline was exacerbated by reports that Presidents Xi and Trump will not likely meet before the March 1 deadline for talks.[1]  That news was followed up by an appearance by Larry Kudlow, who suggested the parties are far away from a deal.[2]  The fact that the president’s meeting may be held later than March 1 isn’t by itself a serious problem; both parties could decide to postpone the deadline.  However, Kudlow’s comments are more worrisome.  We pair Kudlow with Mnuchin as part of the establishment wing of the administration.  The former member of the Reagan government and chief economist for Bear Stearns is usually upbeat and normally frames the trade talks in a positive light.  Thus, his caution either (a) reflects his personal concern, or (b) is a signal from the establishment wing of the administration that the talks are stalling and financial markets are being harmed.  In other words, Kudlow may be trying to push the president to intervene and make a deal over the heads of the anti-trade populists.  We would expect a market decline if a trade deal isn’t made and tariffs on China go into effect.  We still expect a trade deal simply because both sides need to reduce tensions in the short run.

There were two other trade items of note.  The recently negotiated USMCA is facing a serious challenge in Congress.  Democrats want additional worker and environmental protections and establishment Republicans are worried that the new treaty has too many impediments to trade.[3]  If the new trade deal fails to pass and NAFTA (which remains in force for now) ends, then it will be a major shock to all three economies but especially Mexico and Canada.  As we noted yesterday, President Trump is expected to issue an executive order which would ban telecom equipment produced by Huawei (002502, Shenzhen, CNY 3.47).  As part of this order, the U.S. will likely consider sanctions on countries that continue to use the equipment.[4]

France v. Italy: In an unusual inter-European spat, France recalled its ambassador to Italy[5] after the leader of the Five-Star Movement, Luigi Di Maio, met with leaders of the “yellow vest” movement.[6]  Di Maio is a deputy PM and his party is a major coalition partner in the government.  For a leader of a European government to meet with opposition leaders of another European government without warning is a serious breach of international protocol.  The meetings highlight the growing establishment/populist divide that is undermining European unity and cooperation.

OPEC and the crown prince: As is common with our news cycle, we move from outrage to outrage.  The horrific assassination of Jamal Khashoggi has mostly slipped from the headlines.  However, we note that two new stories emerged yesterday.  The first is evidence that Crown Prince Mohammed bin Salman had personally threatened Khashoggi more than a year before his murder.[7]  We also note the U.N. issued a report suggesting the Saudis interfered with Turkey’s investigation of the event.[8]

What we find interesting about these news items is that they come closely behind reports that OPEC is wooing Russia and other nations aligned with Moscow to join the oil cartel to increase the group’s market power.  The U.S. would oppose such an arrangement.  We also note that Congress is opening up an old threat to use American anti-trust laws against the cartel.[9]  We suspect the aforementioned reports are the U.S. signaling to Riyadh that Washington is opposed to the combination of OPEC and Russia.  Now we will watch to see the degree of decline of American influence in the Middle East.

Brexit: There are reports that the May government is moving rapidly to create emergency plans for a hard Brexit.[10]  The acknowledgement (or perhaps leak) is a signal that either (a) the government is coming to the conclusion that the likelihood of a hard Brexit is increasing, or (b) the government wants to signal to Parliament that if it wants to avoid a hard Brexit, it will need to accept May’s deal.  A hard Brexit will be difficult for policymakers because the event would be a supply side shock (the aggregate supply curve will move violently toward the origin and steepen), but the best short-term tools are demand side (tax cuts, fiscal spending, easier monetary policy).  If the government implements the latter into the former, a major inflation spike will result.  If the BOE accommodates the spike, the GBP will plunge; if it attacks the rise, the U.K. economy will suffer a nasty decline.

One of the factors we have been investigating lately is that a hard Brexit might actually accelerate the end of the United Kingdom.  Scotland has been holding periodic referendums to leave the kingdom; so far, they have all failed but leaving might be more attractive if the economy collapses after a hard Brexit.  The same problem exists in Northern Ireland.  Demographics are slowly moving toward unification of the island and an economic crisis in the U.K. might accelerate the process.  For now, these scenarios are rather distant but, seeing how the leadership is handling the current situation, it is hard to make a case that Scotland is better off in the U.K. and Northern Ireland could be better off aligned with Dublin.[11]  It should be noted that both areas voted for “Remain” in the referendum.  The irony of all this is that the goal of Brexit was to improve the sovereignty of the U.K.; it would be a bitter outcome if it ends the kingdom altogether.  At some point, we could see a move by moderates within both the Conservatives and Labour to join and prevent a hard Brexit.[12]  But, such a move would likely lead to a split in the Tories and Labour domination for the foreseeable future.

So, with all this uncertainty, why is the GBP holding on so well?  The PredictIt decision markets suggest that the March 29 deadline will be postponed.

Note that in November the odds of exiting at the end of March were at 70%; odds are now down below 40%.  As long as the market believes Brexit will be delayed, the selloff in the GBP will be avoided.

And, now for something completely different:Japan is apparently facing a crime wave led by senior citizens.  Poverty is leading some older people in Japan to opt for arrest.  At least in prison the government will provide basic food and shelter.[13]

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[1] https://www.axios.com/trump-xi-china-trade-war-meeting-401840ad-896f-4569-a569-c43829bf218d.html

[2] https://www.cnbc.com/2019/02/07/kudlow-theres-a-pretty-sizable-difference-before-a-china-trade-deal-happens.html

[3] https://www.nytimes.com/2019/02/06/business/nafta-trump-deal.html

[4] https://www.politico.com/story/2019/02/07/trump-ban-chinese-telecom-1157090

[5] https://www.nytimes.com/2019/02/07/world/europe/france-italy-ambassador-yellow-vests.html?emc=edit_mbe_20190208&nl=morning-briefing-europe&nlid=567726720190208&te=1

[6] https://www.france24.com/en/20190206-france-italy-di-maio-meets-yellow-vest-protesters-unacceptable?wpisrc=nl_todayworld&wpmm=1 and https://twitter.com/GerardAraud/status/1093518723913261056?wpisrc=nl_todayworld&wpmm=1

[7] https://www.nytimes.com/2019/02/07/us/politics/khashoggi-mohammed-bin-salman.html?emc=edit_mbe_20190208&nl=morning-briefing-europe&nlid=567726720190208&te=1

[8] https://www.ohchr.org/EN/NewsEvents/Pages/DisplayNews.aspx?NewsID=24143&LangID=E

[9] https://www.wsj.com/articles/congress-moves-to-counter-opecs-pursuit-of-pact-with-russia-11549573722

[10] https://www.ft.com/content/58637ad8-2a31-11e9-a5ab-ff8ef2b976c7?emailId=5c5d05bdd83b3f00042c1d53&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[11] No doubt hardline Protestants in Northern Ireland would blanch at joining the south.  But, their numbers are shrinking and they could always immigrate to Britain.

[12] https://www.politico.eu/article/theresa-may-tory-mps-brexit-prisoners-dilemma/?utm_source=POLITICO.EU&utm_campaign=fe431629fe-EMAIL_CAMPAIGN_2019_02_08_05_46&utm_medium=email&utm_term=0_10959edeb5-fe431629fe-190334489

[13] https://www.bbc.com/news/stories-47033704?utm_source=pocket&utm_medium=email&utm_campaign=pockethits

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. equity futures are under pressure again this morning.  Here is what we are watching:

What’s eating the market?  We are seeing a series of foreign central bank easing actions or signals thereof.  Yesterday, the Reserve Bank of Australia surprised the markets with a rate cut.  Today, the Reserve Bank of India joined the parade.  The Bank of England didn’t ease at its meeting this morning (as expected) but offered a gloomy view for Brexit,[1] suggesting uncertainty surrounding the deal is undermining the economy.  In light of these actions, we are seeing the dollar move higher this morning.

The relationship between equities and the dollar is not all that straightforward.  There are periods when equities seem bolstered by dollar strength but other periods when dollar weakness is supportive to equities.  The upper lines on the chart below show the yearly change in the JPM dollar index and the S&P 500.  The lower line shows the 10-year rolling correlation.  During the 1980s, the correlation between the series was modestly negative; a stronger dollar tended to be a bearish factor.  In the 1995-2000 stock market boom, the two series were positively correlated.  But, since 2000, the correlation has been steadily weakening and is now quite negative.

One of the first items taught in basic statistics is that “correlation doesn’t equal causality.”  This is an important observation, especially now.  As the cost of computing power falls, it becomes rather easy to data mine and find all sorts of correlations.  In fact, some in the tech world seem to believe that correlations are all that matter.  But, most of us realize that correlations absent theories are not only a waste of time and resources, but they can be dangerous.

So, what’s the theory here?  A stronger currency is a form of monetary policy tightening.  Currency appreciation lowers the cost of imports, easing inflation, and makes exports less competitive, reducing labor demand.  In the 1990s, equities were rising on “new era” beliefs, that technology and the end of the Cold War were game-changers which gave a massive boost to investor confidence.  In addition, the Asian economic crisis occurred then and the resulting dollar appreciation was seen as a sign of strength.  But, outside that period, to a greater or lesser extent, a stronger dollar has been a negative factor for equities.  Usually, it isn’t a huge factor, so the impact either isn’t enough to matter all that much or it can be offset by the Federal Reserve by easing or not tightening.

We are seeing clear signs that the global economy is weakening.  The EU today lowered its growth forecasts.[2]  China’s economy is slowing.  Although the U.S. economy is also slowing, growth remains above trend.  The growth difference may be leading to renewed interest in the dollar.  Another factor is the prevalence of negative yielding debt around the world.

The U.S. doesn’t have such debt and thus the recent increase in negative yielding debt may be helping the dollar as well.

Our base case is that the dollar will depreciate this year.  On a parity basis, it is rich against most currencies at a level that usually leads to a reversal.  But, if the divergence in growth is leading to dollar strength, it will tend to weigh on U.S. equities.  In the face of appreciation, the FOMC should be open to easing; however, in U.S. policy, forex is the mandate of the Treasury (even though it lacks any policy tools to affect exchange rates) so the Fed tends to leave the dollar out of its discussions.  We have seen equities rise on the back of the Fed’s reversal on monetary policy.  Nevertheless, if global growth continues to slow and foreign central banks continue to ease, going neutral may not be enough for further market appreciation.

Brexit: It’s getting a bit nasty this morning.  European Council President Donald Tusk indicated that there is “a special place in hell” for U.K. Euroskeptics.[3]  PM May is trying to reopen talks on the Irish backstop but Tusk’s comments suggest she isn’t likely to get the EU to budge.[4]  What makes this worrisome is that Tusk has been openly encouraging the U.K. to reverse course and stay in the EU.  His comments seem to indicate he has concluded that all is lost and a hard Brexit may be inevitable.  Meanwhile, Labour Party leader Corbyn offered May conditional support for a soft Brexit.  He is demanding May accept a permanent customs union, a pledge to maintain the EU’s worker’s rights, commitments for U.K. participation in EU agencies and unambiguous agreements on EU security arrangements.[5]  Most of these are an anathema to the Brexiteers.  What Corbyn is doing is creating conditions where Labour MPs could vote for May’s plan (or something close to it) that may be enough to overcome Tory opposition.  His goal is to split the Tories permanently and hang what is bound to be an unpopular agreement on May.  As we noted yesterday, it looks like May can either have (a) a soft Brexit and break up the Tory Party, or (b) maintain Tory Party unity and a hard Brexit.  Obviously, she wants to split the horns of that dilemma so her plan seems to be to run out the clock and hope that the Euroskeptics in her own party cave at the last hour rather than suffer a hard Brexit.  In other words, she is risking option (b) in order to avoid being the party leader that will be remembered by history as the one who broke British Conservativism.  Thus, the risks of a hard Brexit are rising.

The farm problem: Chinese tariffs on U.S. grain have been a majorly negative factor for the farm belt.  Despite measures from the administration to lessen the blow from lost sales, economic conditions in the farm belt are deteriorating.  Bankruptcies are rising and debt levels appear unsustainable.[6]  There is no doubt that some farmers likely overexpanded during last decade’s biofuel boom and have taken on too much debt to maintain their operations as grain prices fell.  But, the loss of export markets has put vulnerable operations in grave danger.  This isn’t a new story in American agriculture.  The cycle of expansion and contraction is well known.  However, farmers now have a proximate cause for their woes—administration trade policy.[7]  That may not be completely fair; after all, the administration didn’t force them to overcommit.  But, the tariffs will be seen as the event that triggered the farm downturn.  Given how critical the farm belt is in Trump’s base, we would expect the growing crisis to add an incentive for a short-term trade deal with China.  And, obviously, our cited articles will be known to Chinese trade negotiators.  We would expect them to use this news to maximum leverage.

The government and 5G: The Trump administration is reportedly preparing a plan to expand the government’s role in developing the next generation of technology and artificial intelligence.  The administration is said to be unveiling a series of executive orders[8] to support efforts to gain superiority in these areas.  The U.S. is in a race of sorts with China on these new technologies, which China wants to dominate as part of its “China 2025” policy (which it currently disavows).

European news: A day after Germany unveiled its new industrial policy[9] designed to support large industrial combinations to create national champions, the EU shot down a merger between two large railroad companies on competition concerns.[10]  The U.S. ambassador to the EU, Gordon Sondland, suggested the EU and the U.S. should “lock arms” against a common enemy, China.[11]  There has been increasing commentary about how Europe can keep the U.S. in NATO and maintain America’s support for Europe.  The tradeoff may be that Europe severs its relations with China in return for American support.  Northern Macedonia (reflecting its new name[12]) has formally joined NATO, becoming the 30^th member of the treaty group.[13]

Energy update: Crude oil inventories rose 1.5 mb last week compared to the forecast rise of 1.3 mb.

In the details, estimated U.S. production was unchanged at 11.9 mbpd.  Crude oil imports were steady, while exports rose 0.9%.  Refinery runs unexpectedly rose 0.6%.  Gasoline inventories rose less than forecast.

This is the seasonal pattern chart for commercial crude oil inventories.  We would expect to see a steady increase in inventory levels that will peak in early May.  This week’s increase, like last week, was below the seasonal norm.  If this continues, it would be a bullish factor for oil prices.

Based on oil inventories alone, fair value for crude oil is $58.27.   Based on the EUR, fair value is $55.51.  Using both independent variables, a more complete way of looking at the data, fair value is $55.74.  By all these measures, current oil prices are generally in the neighborhood of fair value.  However, we still expect prices to move toward $60 later this year on rising oil exports. 

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[1] https://www.fxstreet.com/analysis/bank-of-england-lowers-the-growth-forecast-as-brexit-uncertainty-makes-more-damage-201902071239

[2] https://www.cnbc.com/2019/02/07/germany-economy-raises-fears-as-european-commission-lowers-forecasts-.html and https://www.bloomberg.com/news/articles/2019-02-07/italian-bonds-euro-fall-after-eu-cuts-economic-growth-forecasts?srnd=fixed-income

[3] https://www.ft.com/content/5d79d8e6-2a09-11e9-a5ab-ff8ef2b976c7?emailId=5c5bc7a31533c300044fb54e&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[4] https://www.ft.com/content/dddd1d26-295b-11e9-a5ab-ff8ef2b976c7 and https://www.nytimes.com/2019/02/06/world/europe/theresa-may-brexit-tusk-brussels-backstop.html?emc=edit_mbe_20190207&nl=morning-briefing-europe&nlid=567726720190207&te=1

[5] https://www.ft.com/content/11938442-2a66-11e9-a5ab-ff8ef2b976c7?emailId=5c5bc7a31533c300044fb54e&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[6] https://www.wsj.com/articles/this-one-here-is-gonna-kick-my-buttfarm-belt-bankruptcies-are-soaring-11549468759

[7] https://www.politico.com/story/2019/02/06/farm-crisis-trump-trade-policies-1147987

[8] https://www.wsj.com/articles/trump-preparing-plan-to-boost-ai-5g-technology-11549474459

[9] https://www.politico.eu/article/peter-altmaier-railbus-germany-promotes-champions-as-eu-moves-to-kill-railbus/?utm_source=POLITICO.EU&utm_campaign=1f4bc9d6d3-EMAIL_CAMPAIGN_2019_02_06_05_40&utm_medium=email&utm_term=0_10959edeb5-1f4bc9d6d3-190334489

[10] https://www.nytimes.com/2019/02/06/business/eu-siemens-alstom-train.html?emc=edit_mbe_20190207&nl=morning-briefing-europe&nlid=567726720190207&te=1

[11] https://www.politico.eu/article/gordon-sondland-us-ambassador-eu-donald-trump-against-china-trade-influence/?utm_source=POLITICO.EU&utm_campaign=2e1ae2b28b-EMAIL_CAMPAIGN_2019_02_07_05_44&utm_medium=email&utm_term=0_10959edeb5-2e1ae2b28b-190334489

[12] https://www.nytimes.com/2019/02/06/world/europe/macedonia-nato.html?emc=edit_mbe_20190207&nl=morning-briefing-europe&nlid=567726720190207&te=1

[13] https://www.politico.eu/article/macedonia-signs-nato-agreement/?utm_source=POLITICO.EU&utm_campaign=2e1ae2b28b-EMAIL_CAMPAIGN_2019_02_07_05_44&utm_medium=email&utm_term=0_10959edeb5-2e1ae2b28b-190334489

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. equity futures are a bit lower this morning in a very quiet trade.  Here is what we are watching today:

State of the Union: For financial markets, there wasn’t much in the speech that mattered.  There was nothing on taxes and the potential for any major spending program is low.  For the most part, these speeches have become a political spectacle that usually lack substance.  However, there were two items of note that will bear watching.  First, the president indicated that the U.S. will “never be a socialist nation.”  Although there are some baby boomers attached to the term (Sen. Sanders perhaps the most notable), socialism has become a generational divide.  Those old enough to have seen communism and socialism on a large scale are quite familiar with its failings.  David Hume’s view that the only power that can offset self-interest is self-interest itself is perhaps one of the most radical insights into human behavior.  Accordingly, for baby boomers, it is ludicrous to suggest that socialism is an idea whose time has come.

So, other than the fact that history isn’t taught anymore,[1] why the interest in socialism from millennials?  One of the problems of socialism is that it tends to disadvantage capital.  This tendency leads to underinvestment and, eventually, scarcity and inflation.  Inflation trends likely explain the generational attitude toward socialism.

This chart shows the average experience of inflation from age 16 to the age on the X axis.  In other words, a current 60-year-old’s experience spans from 1974 to 2018.  The line on the chart shows the adult experience of inflation for each year listed on the X axis.  We have calculated the average experience by generation.  Baby boomers have the highest inflation experience, whereas millennials have the lowest.  We would argue that the low inflation experience of millennials means that one of the key negatives to socialism, the tendency toward inflation, is less of an issue for that generation because it hasn’t experienced it.  Instead, that generation has tended to focus more on inequality and slow growth.

Politically, socialism could become a wedge issue that the GOP will use against the Democrats, especially against the left-wing populist constituency within that party.  This could be an effective tool in the short run.  However, demographics will become a problem for the GOP over time if it adopts opposition to socialism as a wedge issue.

Second, the other note from the speech that caught our attention was the comment about no more “endless wars.”  Endless wars are part of being the global hegemon because this role requires global military power projection (in part, the ability to project power globally is one element of how we define hegemony).  The goal of the superpower is to limit interventions and avoid needless conflicts in areas that have little strategic importance.  The U.S. has gotten itself into trouble on this issue when it lacks a clearly defined mission; once the goalpost moves from a specific aim to mission creep, e.g., “fostering democracy,” then the ability to limit involvement is undermined.  So, on the one hand, the president has a good point: we should engage in conflicts with clear goals in mind.  For example, if our goal in Afghanistan was to eliminate the country as a base of operations for al Qaeda and remove the Taliban from power, then we would have been out of the country a long time ago.  But, once we are on the hook to transplant democracy, we could be there forever.  On the other hand, there are some elements of hegemony that require a constant presence of American military power.  Keeping peace in Europe to resolve the German problem and preventing militarism in Japan by securing the country’s trade routes require long-term commitments.  It isn’t obvious that the president sees the difference.  We have no quarrel with his goal of leaving Afghanistan or even Syria (although the shift to a build-up in Iraq doesn’t look like a good idea); leaving NATO, on the other hand, could be a serious mistake.

Brexit: PM May is going to leave the Irish backstop in place in her agreement.  She is negotiating with the EU to either limit the time that the backstop would be in place or adjust it to prevent the open border on the Irish frontier from keeping the U.K. in the EU Customs Union indefinitely.  There is evidence that the DUP, her Unionist coalition partner, is flexible on this issue which is a good sign.  Unfortunately, the hard Brexit groups within the Tories want no backstop at all which would likely lead to border controls on the Ireland/Northern Ireland border.  Instead, this group wants new border technology (which doesn’t currently exist) to allow trade and people to move seamlessly across the frontier.[2]  Increasingly, it looks to us that May can either have (a) soft Brexit and break up the Tory Party, or (b) maintain Tory Party unity and hard Brexit.  Although it’s hard to say how she will lean, our concern is that she will take option (b).

OPEC and Russia: The cartel is seeking a formal arrangement with Russia that would, in effect, expand the cartel.  Russia has some influence on some of the former Soviet states as well, which would broaden OPEC even further.  Some producers within OPEC, such as Iran, oppose adding Russia for fear that cartel policy would effectively be set in Riyadh and Moscow.[3]  If OPEC were to expand to include Russia and other nations, its ability to move prices would be enhanced.  The fact that the Saudis are even contemplating such an arrangement is a clear indication of waning U.S. influence in the Middle East.  At the same time, we doubt Russia would be a reliable coalition partner.  It has a history of breaking promises and would not likely adjust output in a way that would harm its national interests.  If OPEC is able to bring Russia and aligned nations into its fold, it would tend to be bullish for oil prices.

Another dove: Dallas FRB President Kaplan is staking out a clearly dovish position on monetary policy.  In an interesting reversal from his predecessor, who tended to be persistently hawkish, Kaplan has indicated he wants “no further action on rates.”[4]  Although his openly dovish position is supportive of the idea that this tightening cycle may be over, it should be noted that he isn’t a voter this year.

Trade talks: The U.S. negotiating team is off to Beijing next week.  The presidents of the two nations haven’t agreed to a meeting yet; it appears that if such a meeting is held, it will likely be a signal that an agreement has been reached.  We still expect a deal to be made, but not one that includes all the issues on technology that the U.S. wants.  President Trump needs a deal with China to help his reelection effort.  Increasing trade tensions with China would be a significantly negative factor for U.S. equities.[5]  Meanwhile, it appears the Europeans are slow-walking talks to run out the clock[6] and avoid auto tariffs.  Trade positions appear almost impossible to overcome; the U.S. wants open trade in agriculture which would upset the EU’s carefully negotiated Common Agricultural Policy.  The EU wants open trade on industrial goods which the U.S. isn’t likely to give.  The whole point of the Transatlantic Trade and Investment Partnership (TTIP) was designed to overcome these hurdles on a systemic basis.  But, since it and the TPP have been shelved, we are back to talks with little hope of success.  We suspect the Europeans may be hoping that Trump fails to win reelection and the pressure will be relieved.  That will be true only if the Democrats (a) nominate an establishment candidate, and (b) that person wins.  It is quite possible that the Democrats nominate a populist (e.g., Sen. Brown) who would be even tougher on trade than Trump.

German industrial policy:Although the news will likely only excite the most wonky of analysts, Germany is creating a new industrial policy[7] designed to support large industrial combinations to create national champions.  Essentially, Germany wants the EU to support an anti-competitive industrial policy led mostly by Germany and France.  One of the underlying assumptions in Berlin is that when the Germans say “EU” they really mean Berlin and Paris.  It will be interesting to see if the EU will acquiesce to German policy goals or prevent such combinations to maintain competition.

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[1] Yeah, I’m sounding a bit like the grumpy old man… https://www.nbc.com/saturday-night-live/video/weekend-update-segment—dana-carvey-as-grumpy-old-man/n9948 and http://www.nbc.com/saturday-night-live/cast/dana-carvey-14886/character/grumpy-old-man-73276

[2] https://www.ft.com/content/7bd0b65e-2967-11e9-a5ab-ff8ef2b976c7?emailId=5c5a5f749aa9160004850ede&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[3] https://www.wsj.com/articles/opec-pursues-formal-pact-with-russia-11549394604

[4] https://finance.yahoo.com/news/dallas-fed-president-robert-kaplan-interest-rates-180000672.html

[5] https://www.wsj.com/articles/u-s-trade-negotiators-heading-to-beijing-next-week-11549408957

[6] https://www.politico.eu/article/the-great-transatlantic-trade-charade-european-union-us-donald-trump-tariffs-cars/?utm_source=POLITICO.EU&utm_campaign=1f4bc9d6d3-EMAIL_CAMPAIGN_2019_02_06_05_40&utm_medium=email&utm_term=0_10959edeb5-1f4bc9d6d3-190334489

[7] https://www.politico.eu/article/peter-altmaier-railbus-germany-promotes-champions-as-eu-moves-to-kill-railbus/?utm_source=POLITICO.EU&utm_campaign=1f4bc9d6d3-EMAIL_CAMPAIGN_2019_02_06_05_40&utm_medium=email&utm_term=0_10959edeb5-1f4bc9d6d3-190334489

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. equity futures are modestly higher this morning in a very quiet trade.  Much of Asia remains closed for the New Year.  Here is what we are watching this morning:

The President and the Chair: President Trump, Treasury Secretary Mnuchin, Chair Powell and Vice Chair Clarida met for an informal dinner yesterday.[1]  It doesn’t appear that much new emerged.  Monetary policy has become less of a threat to the economy so the White House had little incentive to create a hostile environment.  The inclusion of Mnuchin and Clarida reduced the odds of confrontation.  If this meeting had been held in November, it could have been tense but the recent change in monetary policy defused the situation.

A warning sign for the economy: Car dealers are reporting high levels of inventory; cars on deal lots are up 3% from last year (January), with nearly 4.0 mm vehicles available.  If inventory levels remain high, automakers will begin slowing production which will tend to depress economic growth.[2]  We also note that the Atlanta FRB’s GDPNow forecast shows growth falling to 2.5%.

The contributions table shows that falling commercial building and declining inventories weighed on growth.

The data flow to calculate this number has been affected by the government shutdown but the overall trend does suggest that GDP is falling back toward the 2.0% to 2.5% growth level.

Thinking about the next recession: Over the past 11 years since the financial crisis, central banks have deployed unconventional policy tools; the two primary ones were balance sheet expansion and negative interest rates.  Both are controversial.  The impact of quantitative easing (QE) on the economy remains in dispute.  In Europe, negative interest rates were used; although there wasn’t a lot of evidence of disintermediation,[3] it wasn’t obvious there was much economic stimulus from the action either.  A new study[4] from the San Francisco FRB suggests the Federal Reserve should have used a negative fed funds target instead of QE.  The report suggests that inflation would have increased faster and growth would have been stronger with negative rates.  Although we doubt this will be the final word on the issue, we would expect the FOMC to consider negative interest rates in the next downturn.

Will the China hawks lose?  Our most recent WGRs[5] discuss the trend of U.S. policy toward China.  The conclusion of the report is that the U.S. and China are likely moving toward an antagonistic geopolitical stance.  Current trade talks reflect this issue.  On the one hand, using trade to change China’s behavior should be the long-term policy of the U.S.  However, in the short run, such a policy might lead to financial market turmoil and undermine the president’s reelection campaign.  Reports suggest that trade hawks are worried the president might be inclined to take a short-term deal to boost financial market sentiment at the cost of delaying the inevitable shift to a more hostile policy stance.[6]

The Bundesbank returns?  ECB President Draghi’s term ends in October.  The race to replace him has been underway for months.  The EU has been developing some informal rules for key positions.  The ECB has had a southerner with Draghi, so a northern European nation should get a “turn.”  The leading candidate is Erkki Liikanen, a Finn and former member of the ECB.  Recently, though, Jens Weidmann’s star has been ascending.[7]  Merkel has been using Weidmann for leverage on other EU issues; most of the southern nations are leery of Weidmann, fearful he will implement Bundesbank-era hard money policies.  We still view Weidmann as a long-shot candidate.  But, if he does get the job, we would expect the EUR to appreciate on the news.

Populism on the rise:Yesterday, we commented on the growing war on capital.  We note the establishment is pushing back against the Jacksonian thrust of the White House.[8]  The president’s instincts are to pull troops out of the Middle East, for example, concluding there is no end to these conflicts.  He isn’t wrong on this assessment; however, enduring never-ending conflicts is part of the hegemonic role.  At the same time, what the establishment doesn’t seem to understand is that the bulk of the nation’s voters are at a loss as to why the U.S. must play the superpower role.  In our opinion, the Truman administration sold hegemony to the American public as necessary to contain communism.  Although it was certainly true, it was only partially true.  To avoid WWIII, the U.S. also needed to contain long-standing geopolitical confrontation zones in Europe, the Middle East and Asia.  The partial truth worked—Americans did get behind the role, but only as long as communism was a threat.  The fall of the Soviet Union signaled to most Americans that the U.S no longer needed to expend the resources to police the world (remember the “peace dividend?”).  From that point forward, Truman’s ruse was exposed.  The establishment knew a withdrawal from the world was fraught with risk but it has been unable to create a new narrative to sell to the American people.  Bush tried to do it with Islamic terrorism, but it didn’t really take.  The establishment runs the risk of further losing the support of the American people unless it can show why the U.S. needs to maintain the role.  From the perspective of most Americans, the superpower role goes hand in hand with globalization.  And that’s because it does!  Unless the establishment can convince the average American that globalization is more than trading a good-paying manufacturing job for cheap imports then the cause will be lost.  So, for now, the establishment is taking advantage of Trump’s missteps to push back against troop withdrawals.  But, it may be losing the broader policy goal.[9]  In a related op-ed, Gideon Rachman of the FT notes that one of the unknowns is whether the current populist uprising is a permanent change or merely a blip on the screen of a Davos-led globalized world.  He concludes that the change is permanent, that Brexit, the yellow vests and Trump represent a multi-decade change in trend.[10]  This reflects our analysis of equality/efficiency cycles.[11]

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[1] https://www.ft.com/content/ef1bc0fe-28e5-11e9-88a4-c32129756dd8 and https://www.ft.com/content/ef1bc0fe-28e5-11e9-88a4-c32129756dd8

[2] https://www.wsj.com/articles/car-dealer-lots-are-flush-with-unsold-cars-as-sales-are-expected-to-drop-11549319709

[3] Disintermediation is when households and firms withdraw money from the banking system for alternatives.  The Eurodollar market in the 1960s and 1970s occurred because economic actors could not get a positive real interest rate from the U.S. banking system due to regulation and moved money into the unregulated Eurodollar market.  In theory, if a bank offers negative nominal rates, households and firms will simply remove money from the banking system to earn a real yield on the cash.

[4] https://www.frbsf.org/economic-research/publications/economic-letter/2019/february/how-much-could-negative-rates-have-helped-recovery/

[5] See WGRs, What to do with China: Part I (1/28/2019) and Part II (2/4/2019).

[6] https://www.bloomberg.com/news/articles/2019-02-04/trade-hawks-quietly-bristle-as-trump-guns-for-deal-with-china

[7] https://www.bloomberg.com/news/articles/2019-02-05/weidmann-comeback-could-yet-jolt-ecb-race-for-draghi-succession

[8] https://www.washingtonpost.com/opinions/global-opinions/congress-is-beginning-to-check-trumps-worst-foreign-policy-impulses/2019/02/04/9d16f970-28a1-11e9-984d-9b8fba003e81_story.html?utm_term=.f3999a15da02

[9] https://www.wsj.com/articles/trumps-foreign-policy-critics-are-losing-11549325062

[10] https://www.ft.com/content/debb6f2c-285c-11e9-a5ab-ff8ef2b976c7?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[11] See WGR, Reflections on Trade: Part IV (5/22/2017)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] The Year of the Pig begins!  Several Asian markets were closed and China will be closed all week.  Thus, it was a very quiet overnight session.  Here is what we are watching this morning:

Venezuela: Although the EU did not act as a group to call for Maduro’s exit, Guaido did receive endorsements from a large number of European nations.[1]  For the EU to issue anything as a group, it must have unanimity.  Hungary and Italy did not cooperate.  Protests continue in Venezuela but the key to removing Maduro rests with the military.  There have been a few notable defections, including the acting head of the Venezuelan Air Force, Gen. Francisco Yanez.[2]  Overall, though, the military still seems to cling to Maduro.  It should be noted that history shows sentiment within the military can swing quickly, so we could see the military shift to the opposition at some point.  Meanwhile, the oil markets appear to have discounted the turmoil for now as prices are stabilizing.

Brexit: There isn’t a lot of news to report.  PM May goes back to the EU this week[3] to renegotiate her Brexit plan.  We don’t expect much to change.   Hardline Brexit supporters are warning May that mere promises from the EU won’t be enough—they want an entirely new treaty.[4]  That is unlikely to occur.  May is likely betting that the hardliners will blink at the prospect of a hard Brexit; that probably isn’t true.  May might be able to get her plan through Parliament with mere promises from the EU, but only with significant Labour support.  At some point, May might be forced to choose between saving her party and saving her plan.  She probably can’t do both.  So far, May appears unwilling to go down in history as the party leader who destroyed the Tories and would rather go down in history as the PM who led to a hard Brexit.

Another blow against globalization: French industrial policy has tended to support “national champions,” which are state-supported firms that are given special favors to achieve global prominence.  In practice, this means these firms are protected from foreign competition to achieve scale.  In development theory, this is known as the “infant industry argument,” which postulates that nations trying to develop should nurture and protect small companies to allow them to grow.  It might be legitimate for a developing nation but it is mostly pure protectionism for a large economy.  Being a major global exporter, Germany has tended to avoid national champions but, in the face of rising competition from China and the U.S., Germany is about to propose new industrial policies to help create national champions.[5]  One of the other factors that has tended to prevent France from fully developing such policies is that the EU would block them due to its anti-trust rules.  However, one of the key nations that supported general market liberalization was the U.K.  Thus, Brexit may be creating conditions where France and Germany will cooperate on protecting companies.  This new policy is a reflection of the general retreat from globalization that is now underway; simply put, nations are now viewing each other as enemies and are less open to cooperation.

The growing war on capital: Populism is a direct threat to capital.  Whether it comes from the right or left, over time, populism will reduce margins and increase inflation.  The right-wing version tends to be less dependent on tax rates and direct transfers; instead, it presses for regulation that reduces the supply of labor and lifts wages, reducing margins.  Regulations usually include work rules that require a certain number of workers for a job regardless of whether or not regulation has eliminated them.  For example, until the Staggers Act of 1980, U.S. interstate commercial traffic was regulated by the Interstate Commerce Commission.  This act, along with others, led to the deregulation of the railroads, airlines and trucking.  In the aftermath, cabooses were no longer put on freight trains with the required labor inside, airlines competed on price and the Teamsters Union was deeply undermined as truckers became independent.  Right-wing populists would support bringing back such measures; in addition, they tend to support significant barriers to legal immigration to keep the supply of labor curtailed.

The left-wing variant tends to support regulation as well, although it is less strict on immigration.  However, the left-wing variant is much more supportive of new public transfers (bigger safety net) and higher taxes on upper incomes and capital.  For example, the Democrats are looking at expanding Social Security.  To maintain the fiction of the program being a retirement plan, the payroll tax rate would rise to 14.8% and incomes above $400k would be included in the payroll tax (creating a “dead zone” for the tax between $132,900 and $400,000 that would not be taxed).[6]  Senators Schumer and Sanders are calling for legislation to limit stock buybacks.[7]   Anti-trust rules appear to be turning back to an earlier period where size alone was enough to trigger action.[8]  In the mid-1980s, anti-trust rules reflected the idea that as long as consumers were not harmed by the firm, size was generally acceptable.  What legislators failed to grasp was that size could create labor monopsony, which means that businesses had enough power to restrain wages.

Overall, this issue isn’t something that will affect financial markets today; on the other hand, we have been warning for several years that we are coming to the end of an efficiency cycle that will be replaced by its opposite, an equality cycle.  Although equities can thrive in an equality cycle (as evidenced by the 1960s equity market), that only comes after equities revalue from the high margin/high multiple efficiency cycle (the revaluation that occurred during 1929-1957).  When does the equality cycle begin in earnest?  Not next week, but likely in the next decade or sooner; as we referenced above, the evidence of a turn is growing.  After all, it wasn’t so long ago, under President Bush, that reforming Social Security meant reducing benefits.  That era seems long past. 

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[1] https://www.wsj.com/articles/juan-guaido-recognized-as-venezuelas-president-by-major-eu-countries-11549275207

[2] https://www.washingtonpost.com/world/the_americas/venezuela-protests-guaido-vs-maduro/2019/02/02/ef043b00-2660-11e9-b5b4-1d18dfb7b084_story.html?utm_term=.05b98c6a4e6c&wpisrc=nl_todayworld&wpmm=1

[3] https://www.politico.eu/article/theresa-may-vows-to-battle-in-brussels/?utm_source=POLITICO.EU&utm_campaign=5f84c6d0b5-EMAIL_CAMPAIGN_2019_02_04_05_33&utm_medium=email&utm_term=0_10959edeb5-5f84c6d0b5-190334489

[4] https://www.ft.com/content/01ca3026-278f-11e9-a5ab-ff8ef2b976c7?emailId=5c57bb738d8e400004ee789f&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[5] https://www.politico.eu/article/germany-industrial-plan-signals-europes-protectionist-lurch/?utm_source=POLITICO.EU&utm_campaign=5f84c6d0b5-EMAIL_CAMPAIGN_2019_02_04_05_33&utm_medium=email&utm_term=0_10959edeb5-5f84c6d0b5-190334489

[6] https://www.nytimes.com/2019/02/03/us/politics/social-security-2100-act.html?action=click&module=Top%20Stories&pgtype=Homepage

[7] https://www.nytimes.com/2019/02/03/opinion/chuck-schumer-bernie-sanders.html

[8] https://www.ft.com/content/c27a517a-2631-11e9-8ce6-5db4543da632?emailId=5c57bb738d8e400004ee789f&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s employment day!  We cover the data in detail below but here is a quick rundown.  The payroll data came in much stronger than expected, but there was a large downward revision to December.  The unemployment rate ticked higher, but that was likely due to the government shutdown.  Overall, the data show (a) the economy is still doing well, and (b) there is still slack in the labor force.  Here is what we are watching this morning:

BREAKING NEWS: As expected, the U.S. will withdraw from the Intermediate-Range Nuclear Forces Treaty.[1]  The U.S. has accused Russia of violating the treaty; this is the reason for the withdrawal.  This treaty has been in place since 1987.

China: Although the trade talks ended with something of a whimper, more meetings are expected to follow and the president’s upbeat assessment of the talks makes it look like a deal of some kind is coming.  In particular, Chairman Xi and President Trump will meet in February, perhaps to hammer out and announce the final deal.[2]  We will likely see a partial deal by March 1 with more talks to follow.  To some extent, both leaders benefit by extending the clock.  Once the elections pass, we expect U.S. and Chinese relations to become more hostile, but neither leader is relishing the economic dislocation that comes from breaking the relationship now.  Consequently, we expect some sort of deal soon and maybe talks that stretch into next year.  The key figure to watch is Lighthizer.  If the trade negotiator figures out he is being played and won’t be allowed to construct the deal he really wants with China, then he will likely leave the government.  As long as he stays, we suspect he thinks that an agreement to fundamentally change the trade and investment relationship with China is still possible.

Brexit: This is what we know: neither side wants a hard Brexit.  The majority in the British Parliament want a different deal than what PM May negotiated.  The EU is not likely to change the agreement.  Thus, we are heading into a binary outcome where either (a) Britain accepts May’s plan, or (b) we get a hard Brexit.[3]  May seems to believe the best way to get outcome (a) is to run the clock down until the end of March and see Parliament acquiesce to her plan.[4]  We also suspect that May agreed to go back to the EU to try to change the deal knowing full well there is little likelihood of that outcome, although, perhaps, the odds aren’t zero.[5]  May might hope to get some cosmetic changes so that she can frame another vote as a “new deal.”  Meanwhile, new twists have developed.  Spain wants Gibraltar to be treated as a colony of the U.K. rather than territory.[6]  Reopening negotiations with a body that requires a unanimous vote can bring unexpected complications.

Venezuela: John Bolton hinted on Twitter that the U.S. might support safe passage for Maduro and other regime officials.

I wish Nicolas Maduro and his top advisors a long, quiet retirement, living on a nice beach somewhere far from Venezuela. They should take advantage of President Guaido’s amnesty and move on. The sooner the better.

Other than that, not much has change on the Venezuelan front.

Fed Governors: Although the administration has not formally withdrawn Marvin Goodfriend from consideration, in reality, there is little chance he will get approved and there is an even smaller likelihood that the president would want a hawk for the position.  In something of a surprise, there were reports that Herman Cain, once a GOP presidential candidate, was being considered for the post.  It should be noted that Cain does have relevant experience—he was on the board of the K.C. FRB, spending some time as chairman.  The K.C. FRB has become the most consistent hawkish member of the FOMC, so Cain’s consideration does appear at odds with the president’s desire for doves.  It would appear the establishment wing of the administration is still trying to slip centrists and hawks past the president and onto the FOMC.

An Iran sanctions workaround?  The EU has created a Special Purpose Vehicle that would allow companies in the EU to get around U.S. sanctions on Iran.[7]  The new vehicle, called the “Instrument in Support of Trade Exchanges,” or INSTEX, is designed to avoid using dollars and may simply use barter for the trade of humanitarian goods.  We doubt it finds much use; without using a currency, a seller of EU agricultural goods would need to accept Iranian oil, for example.  It isn’t obvious if that cargo could be insured due to U.S. sanctions.  Most likely, this body will represent a signal that the EU can operate independently of U.S. policy but, in reality, it can’t.  We expect the administration to be harshly critical of this action and no major EU company to participate for fear of running afoul of U.S. sanctions.[8]

Another reason for Iran to be unpopular with Americans: Tehran has banned public dog walking or riding in cars with dogs.[9]

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[1] https://en.wikipedia.org/wiki/Intermediate-Range_Nuclear_Forces_Treaty

[2] https://www.wsj.com/articles/china-trade-negotiators-proposing-trump-xi-meeting-in-china-next-month-11548940089 and https://www.ft.com/content/8cddb4d4-2565-11e9-8ce6-5db4543da632?emailId=5c53d7385117e90004fae6fc&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[3] https://www.nytimes.com/2019/01/31/business/brexit-european-union.html?emc=edit_mbe_20190201&nl=morning-briefing-europe&nlid=567726720190201&te=1

[4] https://www.ft.com/content/484b050c-2578-11e9-8ce6-5db4543da632?emailId=5c53d7385117e90004fae6fc&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

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

[6] https://www.ft.com/content/ab72fb3a-2578-11e9-b329-c7e6ceb5ffdf?emailId=5c53d7385117e90004fae6fc&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[7] https://www.politico.eu/article/trump-iran-europe-sanction-powers-set-up-firm-to-thwart/?utm_source=POLITICO.EU&utm_campaign=1f45bc1d0f-EMAIL_CAMPAIGN_2019_02_01_05_45&utm_medium=email&utm_term=0_10959edeb5-1f45bc1d0f-190334489

[8] https://www.nytimes.com/2019/01/31/world/europe/europe-trade-iran-nuclear-deal.html?emc=edit_mbe_20190201&nl=morning-briefing-europe&nlid=567726720190201&te=1

[9] https://www.bbc.com/news/blogs-news-from-elsewhere-47041611

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Yesterday brought a strong rally in U.S. equities.  Here is what we are watching this morning:

Fed meeting: The Fed meeting delivered more than what was expected.[1]  First, the FOMC removed language from previous statements suggesting the path for the policy rate was on a gradual path higher.  Second, the statement suggested the balance sheet could be adjusted in either direction, although it did reiterate that the fed funds target remains the primary policy vehicle.  Essentially, policymakers moved from a path of steady tightening to signaling that further tightening may well be on hold.

What led to the change?  Chair Powell noted the events that led to what appears to be an end to the current tightening cycle.  First, slower global growth apparently entered the discussion.  Although the Fed’s mandate precludes acting as the global central bank (even though it is), the Fed will, on occasion, pay attention to world events.  However, this usually occurs when the world economy encroaches on the U.S. economy.  We are seeing a clear slowing of U.S. growth so the Fed may be thinking the slowdown is coming from abroad.  Second, trade tensions were mentioned, and third, so was the government shutdown.  We do note that the Treasury will hit the debt ceiling in March, although the real funding crunch won’t occur until summer.  Perhaps the Fed is trying to get in front of all that.

We note the financial media is carrying stories from economists and analysts with words such as “perplexed” and “puzzled,” meaning, of course, that they had forecast multiple hikes this year and now appear wrong.[2]  The doves who have been crying for the Fed to stop are now celebrating their influence.[3]

So, what do we think happened here?  It appears to us that two things may be unfolding.  First, Chair Powell may be finally killing the Philips Curve.  The theory, which has guided Fed policy for decades, states that inflation is caused by the degree of slack in the economy.  When slack is removed, the chances for inflation increase.  One of the best measures of slack is the labor market.  Essentially, the Phillips Curve argues there is a trade-off between unemployment and inflation; if you want less of the latter, you have to accept more of the former.  Fed policymakers have clung to the theory even when evidence supporting it has become increasingly thin.

This chart shows the relationship between core CPI and the unemployment rate.  Visually, the unemployment rate tends to lead inflation by a bit more than five quarters.  During the 1960s into the early 1980s, one can observe a pattern that supports the Phillips Curve.  However, in the 1990s, inflation and the unemployment rate fell simultaneously and the level of unemployment seen around the turn of the century supported a peak in core CPI of 2.5%.  During the 1970s, the same level of unemployment triggered inflation near 12%.  So, something clearly changed.  We believe globalization and deregulation flattened the aggregate supply curve, meaning there is lower inflation at each intersection of aggregate demand.

Although FOMC members were aware of these changes, a theory one was raised on is hard to shake.  Accordingly, members of the FOMC continued to use the language of the Phillips Curve even though they tended to ignore it in terms of policy.  Thus, we would often see deviations from the Taylor Rule or the Mankiw Rule, both of which are tied to the Phillips Curve.  Over time, policy seemed to pay an increasing amount of attention to financial markets (hence the idea of the “Fed put”).

Powell appears to be finally ditching the Phillips Curve once and for all.  Why now?  Age probably plays a role.  The idea that scientific progress occurs “one funeral at a time” is part of it.  The economists who came of age in the 1970s are aging out and the newer economists live in a world of lower inflation.  Of course, if policy shifts to deglobalization and reregulation, both very likely given the rise of populism, then the Fed may by ending its use of the Phillips Curve just when it becomes useful again.  But, for now, it appears the Phillips Curve is dead.

This leads us to the second change; if the Phillips Curve is out, what has replaced it?  For now, nothing is official.  But, we suspect the Fed is focusing on inflation and the financial markets.  In a recent Asset Allocation Weekly, we discussed the relationship of policy to the VIX.[4]  The recent jump in the VIX would have been enough to signal a pause to the FOMC.  Another item the FOMC seems to track is the implied LIBOR rate from the Eurodollar futures contract, two-years deferred.

This chart shows the fed funds target and the implied LIBOR rate, with the spread on the upper line of the graph.  We have placed vertical lines at points of inversion.  In general, the Fed tends to stop raising rates at the point of inversion.  The rapid drop in the implied LIBOR rate is a clear signal that the Fed should stop raising rates and, right on cue, that’s what Powell indicated yesterday.

We should note one of the dangers the FOMC has now created for itself with this reversal is that financial markets will struggle to cope if conditions improve and it decides it needs to tighten further.  At the same time, the slowing we are seeing in the U.S. economy and abroad, along with controlled inflation, will likely allow the Fed to stop raising rates here without serious problems.

In terms of market impact, the most obvious was yesterday’s rally in the front end of the yield curve and in equities.  However, we also saw the dollar fall sharply.  As we noted in the 2019 Outlook and elsewhere, we have been expecting the dollar to weaken this year.  The reaction to the FOMC statement supports that idea.

Gold: Dollar weakness supported a strong rally in gold yesterday.  Another factor helping gold is that nations that have run afoul of the U.S. and face financial sanctions are turning to gold in their foreign reserves.  Although gold doesn’t offer a yield, it is transferable and is mostly protected from the U.S. Treasury.  Last year, gold-buying by central banks reached its highest level in nearly 50 years.  The highest year was when President Nixon ended Bretton Woods by closing the gold window.[5]  A weaker dollar combined with central bank buying should support further strength in gold.

China: In this week’s WGR, we opened a two-part report on U.S. relations with China. [6]  Overall, it looks like relations will become more hostile over time.  That doesn’t mean we won’t get a trade deal, but it likely won’t be anything more than a “can-kicking” exercise to help the U.S. and Chinese economies for the next 18 months.  There are reports that Foxconn (TPE: 2354, TWD, 59.20) is considering a significant reduction in its announced direct investment into the U.S.[7]  Although the company is based in Taiwan, it has large facilities in China and may be signaling that it is going to side with China if relations cool between the two countries.

Venezuela: There’s not much new to report as the standoff continues.  However, the WSJ reports that the effort to oust Maduro is part of a broader policy to extend U.S. influence in South and Central America and curb Russia’s and China’s forays into the region.[8]  Succeeding in that goal would also undermine Cuba.  In a historical sense, the policy is consistent with the Monroe Doctrine.  The U.S. has historically worked to thwart leftist regimes in the region that could have, or did, offer alliances with the communist bloc.  Undermining Chinese influence would also make sense.  However, we do wonder how much of this policy change is coming from the president himself and how much is coming from John Bolton.  Given Trump’s Jacksonian leanings, it would make sense for him to push back against Maduro, especially when he was going to oust U.S. diplomats.  At the same time, Jacksonians tend to avoid such open-ended foreign entanglements that intervening directly in Venezuela would entail.  In other Venezuelan news, Maduro is cracking down hard in the poor neighborhoods that used to be the backbone of regime support.[9]  Chavez built his coalition on the military and the poor, isolating the merchant and middle classes.  He paid for this policy by raiding PDVSA’s oil coffers.  The drop in oil output, due in part to the lack of investment, has forced Maduro to choose between the brass and the poor.  The latter have lost out.

Energy update: Crude oil inventories rose 0.9 mb last week compared to the forecast rise of 3.0 mb.

In the details, estimated U.S. production was unchanged at 11.9 mbpd.  Crude oil imports dropped 1.1 mbpd, while exports were unchanged.  The drop in imports may reflect the impact of Venezuelan sanctions.  Refinery runs declined 2.8% and should continue to fall in Q1.  Product stocks fell.

This is the seasonal pattern chart for commercial crude oil inventories.  We would expect to see a steady increase in inventory levels that will peak in early May.  This week’s increase was well below expectations and a bit below seasonal norms.

Based on oil inventories alone, fair value for crude oil is $58.76.  Based on the EUR, fair value is $55.61.  Using both independent variables, a more complete way of looking at the data, fair value is $55.99.  By all these measures, current oil prices are generally in the neighborhood of fair value.  We still expect prices to move toward $60 in the coming weeks, although rising oil inventories will tend to be a bearish factor for the market.

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[1] https://www.ft.com/content/2565e154-24b7-11e9-b329-c7e6ceb5ffdf?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56 and https://www.nytimes.com/2019/01/30/us/politics/fed-interest-rate.html?emc=edit_mbe_20190131&nl=morning-briefing-europe&nlid=567726720190131&te=1

[2] https://www.ft.com/content/36cb58ba-24ef-11e9-8ce6-5db4543da632?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56 and https://www.wsj.com/articles/the-feds-mysterious-pause-11548893175

[3] https://www.wsj.com/articles/the-fed-apologizes-11548894046

[4] See Asset Allocation Weekly (1/11/2019).

[5] https://www.ft.com/content/8148a8f0-2479-11e9-8ce6-5db4543da632?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[6] See WGR, What to do with China: Part I (1/28/2019).

[7] https://www.politico.com/story/2019/01/30/foxconn-manufacturing-jobs-1136919

[8] https://www.wsj.com/articles/u-s-push-to-oust-venezuelas-maduro-marks-first-shot-in-plan-to-reshape-latin-america-11548888252

[9] https://www.nytimes.com/2019/01/30/world/americas/venezuela-maduro-protests-faes.html?emc=edit_mbe_20190131&nl=morning-briefing-europe&nlid=567726720190131&te=1