by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Fed Day!  U.S. equity futures are higher this morning in light of some solid earnings reports.  Here is what we are watching this morning:

Fed meeting: The FOMC ends its two-day meeting today.  Although we won’t get new dots or forecasts, Chair Powell begins his new policy of press conferences after each meeting.  No action on rates is expected, but we will be watching for any hints on future policy (are risks “balanced” and will rate hikes be removed from the statement or contain the usual “gradual” language?).  In addition, the markets will be looking for any flexibility on the balance sheet.  We expect a mostly neutral statement; it would be a surprise to see them turn hawkish but it would also be a surprise to see them move toward a clear dovish stance.

Trade talks: Talks with China begin today and, so far, trade is being kept separate from the Huawei (002502, Shenzhen, CNY 3.32) issue.  China is offering protection for foreign investors[1] and is also preparing a timeline of reforms to address structural trade concerns.[2]  Although we doubt this will satisfy USTR Lighthizer, it will likely be enough for the president.  While we think U.S./China relations are on a deteriorating path, as we noted yesterday, both Chairman Xi and President Trump need peace this year.[3]  Thus, we remain optimistic that some sort of deal will be negotiated.

Venezuela: Conditions are deteriorating further in Venezuela.  The courts, firmly under the control of Maduro, have frozen opposition leader Guaido’s banks accounts and have prevented him from leaving the country.[4]  Maduro did indicate he was willing to “negotiate” but it is unclear who would mediate.  In response to the freezing of Guaido’s assets, the U.S. is giving Guaido control of some Venezuelan government accounts held by the U.S. at the NY FRB.[5]  The situation is a mess and oil prices are rising on fears that oil production from Venezuela will fall further.  Saudi Arabia has indicated it has no plans to offset any decline in output from Venezuela; in fact, the Saudi oil minister indicated the U.S. should use the SPR if shortfalls develop.[6]  The Saudis believe they were wrong-footed on the Iran sanctions issue and are making it clear it won’t happen again.[7]

Brexit: Things got rather weird yesterday.  Parliament rejected a series of proposals but did approve a non-binding measure to avoid a hard Brexit.  And, they approved an amendment that sends PM May back to Brussels to negotiate a different border agreement in Ireland.[8]  However, May was not given any specific instructions as to what the border agreement should look like.  It isn’t that there was no direction; May was told that Parliament doesn’t want a hard Brexit and the Euroskeptics don’t want an Irish border solution that effectively keeps the U.K. in the EU with few of the benefits.  This outcome isn’t really possible.[9]  The EU has made it clear that it won’t renegotiate the current agreement.[10]  With such uncertainty, it would seem the most logical outcome would be to delay Article 50; however, that solution is a problem for the EU because it holds EU Parliamentary elections in May.  If the U.K. is still in the EU, Britain would seemingly participate in these elections even though it wants to leave.  Although there is universal desire to avoid a hard Brexit, the chances of stumbling into one remain elevated and not fully discounted by the market.

Our parity model suggests fair value for the GBP/USD exchange rate is 1.65, which means we would have a much stronger pound in the absence of Brexit.  We assume a hard Brexit would lead to a rapid drop in economic output and yield an exchange rate of 1.10.  Thus, if a deal ends up with the U.K. leaving but maintaining most of the benefits of the EU (or not leaving at all), then we get 1.65.  The current exchange rate should indicate the market’s estimate of the odds of either outcome.  So, if P = good Brexit and 1-P = bad Brexit, then (P*1.65) + ((1-P)*1.10) = current exchange rate.  Solving for P at current exchange rates would indicate the market thinks there is about a 40% chance of a good Brexit and a 60% chance of a hard Brexit.

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[1] https://www.scmp.com/economy/china-economy/article/2184138/china-rushing-through-overseas-investment-reform-unprecedented

[2] https://asia.nikkei.com/Economy/Trade-War/China-to-kick-off-trade-talks-with-timeline-for-structural-reforms

[3] https://www.wsj.com/articles/as-china-trade-talks-begin-trump-faces-pressure-to-make-a-deal-11548808477

[4] https://www.washingtonpost.com/world/the_americas/venezuelan-officials-seek-to-block-us-supported-opposition-leader-juan-guaido-from-leaving-the-country-freeze-his-assets/2019/01/29/1a4791a0-232c-11e9-b5b4-1d18dfb7b084_story.html?utm_term=.453c43ca259c&wpisrc=nl_todayworld&wpmm=1

[5] https://www.nytimes.com/2019/01/29/us/politics/venezuela-bank-accounts-guaido-pompeo.html?emc=edit_mbe_20190130&nl=morning-briefing-europe&nlid=567726720190130&te=1

[6] https://www.wsj.com/articles/saudis-not-rushing-to-respond-to-venezuela-oil-ban-11548794233

[7] https://www.youtube.com/watch?v=gqzA1VOiC-M

[8] https://www.washingtonpost.com/world/europe/brexit-theresa-may-tells-a-divided-parliament-she-wants-to-reopen-talks-with-eu/2019/01/29/66ebca3a-1fe9-11e9-a759-2b8541bbbe20_story.html?utm_term=.4dc5921db939&wpisrc=nl_todayworld&wpmm=1

[9] https://www.ft.com/content/8ecf0b4c-2328-11e9-8ce6-5db4543da632?emailId=5c512e3432bcbc000472fcc1&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[10] https://www.nytimes.com/2019/01/29/world/europe/brexit-theresa-may-eu-irish-border.html?emc=edit_mbe_20190130&nl=morning-briefing-europe&nlid=567726720190130&te=1 ; https://www.ft.com/content/75f24764-23c9-11e9-8ce6-5db4543da632 ; and https://www.ft.com/content/390709e2-23de-11e9-8ce6-5db4543da632

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. equity futures are modestly higher this morning after a drop yesterday.  It’s the last week of the Year of the Dog—my two are sad about its end.  The Year of the Pig starts next week.  Here is what we are watching this morning:

Trade talks and Huawei (Shenzhen, 002502, CNY 3.68): The U.S. DOJ has issued indictments against Huawei.[1]  This action was not a huge surprise.  The U.S. has also requested formal extradition of Meng Wanzhou, the CFO of the company (and daughter of the founder).[2]  The worry is that the indictment and potential extradition could scuttle U.S./China trade talks.  Although it could, we think odds favor the two issues remaining separate.  That doesn’t mean the trade talks will be much easier.  China is likely to offer to buy lots of commodities from the U.S. in a bid to narrow the trade surplus with the U.S.  Robert Lighthizer will insist on structural changes that will undermine China’s ability to move up the value chain.[3]  If both leaders didn’t need a deal, these talks would be pointless.  But, both Trump and Xi need some sort of face-saving win; Trump needs a better economy to help his reelection odds and Xi wants to avoid a bigger slowdown.[4]  We expect a deal but not the deal, which will delay the evolving break between the Chinese and U.S. economies.  Eventually, though, the U.S. seems to be heading toward the recognition that China is a strategic competitor and will work to reduce the ties between the two economies.[5]  Interestingly enough, we are starting to hear reports that Chinese capital flight is leaving the U.S.[6]  However, this likely reflects the Xi regime’s extending grip on flows and less of a lack of desire from Chinese citizens to find a safe place for their money.

Venezuela: The U.S. announced new sanctions on Venezuela, targeting the state oil company, PDVSA.[7]  With this action, the U.S. has effectively outlawed American businesses from transacting with PDVSA.  The U.S. imports around 0.5 mbpd from the country; that loss should be manageable, although it does affect the grade mix.  U.S. refineries are configured to utilize heavy/sour crude which is more difficult to refine.  The loss of Venezuela could complicate some refiners’ production.  In the short run, the U.S. refining industry is in maintenance season so the negative impact will likely be less than normal.  The U.S. has indicated that sanctions will end if Guaido is installed as president.  Companies can apply for waivers and oil at sea can still land.  Thus, it will be a couple of weeks before this action starts to bite.  However, the sanctions will soon reduce Caracas’s cash flows, which depend on refining dollars from Citgo, the PDVSA-owned U.S. subsidiary.[8]  These cash flows are important.  We note the stances taken by governments on Venezuela tend to neatly follow the interests of bondholders.[9]  Most U.S. and European bondholders, who are holding defaulted bonds, would benefit from a new government and an IMF deal, while China and Russia would not benefit from a change in government.

Fed meeting: The FOMC starts its two-day meeting.  While we won’t get new dots or forecasts, Chair Powell begins his (ill-advised, in our opinion) new policy of press conferences after each meeting.  No action on rates is expected; the markets are watching for comments on the balance sheet, although the committee’s comments on the economy will be interesting in light of the government shutdown (see below).  Our take on the balance sheet is that the impact was mostly psychological,[10] a position held by many policymakers and economists.[11]  The financial markets would love an endpoint, for Powell to indicate that the reduction will end at a certain level.  They won’t get that; most likely, Powell will indicate “flexibility” on both rates and the balance sheet, offering hope that policy tightening will be on hold if the economy continues to slow.

Brexit: It’s a big day for Brexit.  With 60 days to exit, Parliament is debating a number of measures to address the Irish backstop and proposals to prevent a hard Brexit and maybe allow for another referendum.  PM May addressed the body today and indicated that now is the time to tell the EU what it wants, not just what it rejects.  This article gives a rundown of the current amendments;[12]  it should be noted that the one given the best odds is designed to extend Article 50.  We suspect the outcome of all this will be to delay the exit and try to avoid a hard break.  That outcome would be mildly bullish for the GBP.

Shutdown’s over—when does the data return? Because the shutdown lasted so long, government statisticians will be forced in many cases to calculate two data sets, one for the lost month and one for the current month.  Other data will simply be delayed.  For example, the first release of Q4 GDP will be postponed due to the loss of work.[13]  In some cases, such as the retail sales report, the data is a survey; this may require canvassers to ask questions such as, “How were things six weeks ago?” that might be hard to answer.  Although economic data may not seem like a big deal compared to the world’s problems, it will affect the continuity of some series and may result in significant revisions over time.  In other words, the view of the economy may change in a period of uncertainty.

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[1] https://www.ft.com/content/c8e6d5b0-2375-11e9-8ce6-5db4543da632?emailId=5c4fe8dc1930b50004fbcc61&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22 and https://www.nytimes.com/2019/01/28/us/politics/meng-wanzhou-huawei-iran.html?emc=edit_mbe_20190129&nl=morning-briefing-europe&nlid=567726720190129&te=1

[2] https://www.washingtonpost.com/world/national-security/justice-dept-charges-huawei-with-fraud-ratcheting-up-us-china-tensions/2019/01/28/70a7f550-2320-11e9-81fd-b7b05d5bed90_story.html?noredirect=on&utm_term=.3e706d8d0ad4&wpisrc=nl_todayworld&wpmm=1

[3] https://www.wsj.com/articles/big-divides-remain-as-u-s-china-trade-talks-resume-11548717555

[4] https://www.cnbc.com/2019/01/28/reuters-america-update-2-china-to-offer-some-subsidies-on-cars-appliances-to-lift-weak-demand.html

[5] The topic of this week’s and next week’s Weekly Geopolitical Reports.  See WGR, What to do with China: Part I (1/28/2019).

[6] https://www.wsj.com/articles/chinese-exiting-u-s-real-estate-as-beijing-directs-money-back-to-shore-up-economy-11548757800

[7] https://www.nytimes.com/2019/01/28/us/politics/venezuela-sanctions-trump-oil.html?emc=edit_mbe_20190129&nl=morning-briefing-europe&nlid=567726720190129&te=1

[8] https://www.washingtonpost.com/national/health-science/trump-administration-announces-sanctions-targeting-venezuelas-oil-industry/2019/01/28/4f4470c2-233a-11e9-90cd-dedb0c92dc17_story.html?utm_term=.d54b378da587&wpisrc=nl_todayworld&wpmm=1

[9] https://www.axios.com/following-money-venezuela-nicolas-maduro-bonds-3022bbb1-42cd-4825-a27d-e81307510be3.html

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

[11] https://www.wsj.com/articles/a-4-trillion-scapegoat-for-market-volatility-the-feds-shrinking-portfolio-11548671432

[12] https://www.politico.eu/article/commons-brexit-showdown-watch-like-a-pro/?utm_source=POLITICO.EU&utm_campaign=58c6c0d451-EMAIL_CAMPAIGN_2019_01_29_05_43&utm_medium=email&utm_term=0_10959edeb5-58c6c0d451-190334489

[13] https://www.nytimes.com/2019/01/28/business/economy/economy-government-shutdown.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Welcome back; we are sure the Pro Bowl captured your attention over the weekend.  There is a lot going on this week, including unemployment data, Chinese/U.S. trade meetings and Brexit votes in Parliament.  The U.S. government has reopened, at least temporarily, and it’s going to get real cold in the Midwest to the Northeast this week.[1]  Here is what we are watching this morning:

Venezuela:  There are still two presidents in Venezuela with no clear end in sight.  Some European nations indicated they would no longer recognize Maduro if he does not call for new elections in 10 days.[2]  Maduro rejected the EU ultimatum.[3]  We do note that Maduro is avoiding a showdown with the U.S. by not ousting American diplomats.[4]  Oil markets have been rallying on tensions in the face of bearish inventory data but, this morning, we are seeing a slump as the crisis continues.

An interesting insight into the differences between the foreign policy of left-wing versus right-wing populists has emerged from Italy.  That nation is the only one currently being governed by a “Nader coalition,”[5] a government made up of populists from both wings.  The left-wing populists, led by the Five-Star Movement, oppose foreign intervention in Caracas.  The right-wing populists, led by the League, support the EU and the stance of the major European governments noted above.[6]  Politically, this experiment in Italy is very important because, in most states, neither the right- nor left-wing populists hold a majority but if they were united they would usually command a large majority.  Since they are usually unable to unite, both populist groups are susceptible to being co-opted by establishment groups.  Nader’s argument is that to truly gain power, populists must work together.  So far, in Italy, the government has functioned but tensions have been mounting.

In a related observation, we note Howard Schultz’s consideration of a third-party run; essentially, Schultz could become a magnet for establishment votes from both the Democrats and the GOP (combined are probably 20% to 30% of the electorate).  The Democrats are unhappy with his potential run, fearing it will split the left-wing populists and left-wing establishment.  However, that would only happen if the Democrats nominate an establishment figure.  If Warren were to get the nomination, her voters would not likely support Schultz.  In other words, a Schultz presidential run could upset both parties by taking the establishment vote away.  Previous third-party candidates tended to split one party but Schultz could split both.  It’s hard to see Schultz winning but it is also hard to see either party gaining a majority if he has a successful run.  That might move the presidential vote out of the Electoral College and into the House of Representatives.

Brexit: We are now in the amendment phase of Brexit negotiations.  There are currently nine different proposals offered, most of which are designed to exclude a hard Brexit and a few call for another referendum.  Many include extending the deadline.[7]  May is supporting a couple of efforts by MPs to limit the time frame of the Irish backstop,[8] hoping to bring the hardline Brexit supporters to her original position.  Ireland has indicated it will not support any plan to limit the time of the backstop[9] and has further indicated that Ireland may be required to return physical barriers to the frontier, including troops.[10]  Financial markets continue to hold that a hard Brexit will be avoided which is why the GBP has been rising recently.  However, there is still a chance that Britain and the EU stumble into a hard Brexit despite efforts to avoid that outcome.

One other interesting development on Brexit.  There is some speculation that the crown may get involved in the Brexit talks.  Queen Elizabeth usually avoids the political fray; in her role as constitutional monarch, her powers are sweeping on paper but rarely used.  However, she made reference to the negotiations in a recent speech, calling on parties to “seek common ground.”  She has the power of “prorogue,” which allows her to adjourn a rebellious Parliament.  She also has the power to withhold “royal assent” from legislation which could end Brexit altogether.  Neither of these actions has been deployed by a British monarch in centuries and it goes to show the seriousness of Britain’s current constitutional crisis.[11]

EU and Iran: The EU has created a Special Purpose Vehicle to avoid U.S. sanctions on Iran.[12]  If the EU follows through on this plan and allows Iran to increase oil exports, it would be bearish for oil prices.  However, the EU is running the risk of souring relations with Washington and we will see if it has the resolve to see this through.

China/U.S. trade talks: Talks restart in the U.S. this week.  The key issue is whether President Trump will accept a short-term deal that boosts U.S. exports to China and leaves the technology issue unresolved.  We suspect he will take such an arrangement because the technology issue probably can’t be resolved[13] soon and very likely cannot be resolved at all.  It appears that we may not have a global standard for 5G, the next generation of technology that will, if it meets expectations, create the backbone for the “internet of things” and driverless cars.[14]  Our expectation is that both Xi and Trump need a short-term deal to bolster confidence.  But, the long-run positions are hardening into a superpower confrontation.

Chinese industrial profits fall:Chinese profits fell for the second straight month, falling 1.9%.[15]  Weak demand was cited for the decline.

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[1] https://www.axios.com/life-threatening-cold-polar-vortex-midwest-weather-dad70dfb-fb02-4cbb-8818-f6e84d364813.html

[2] https://www.thelocal.fr/20190127/eu-nations-put-venezuelas-maduro-on-notice

[3] https://www.politico.eu/article/venezuela-nicolas-maduro-rejects-eu-call-for-new-election-juan-gaido/

[4] https://www.nytimes.com/2019/01/26/world/americas/nicolas-maduro-juan-guaido-venezuela-diplomats.html?emc=edit_mbe_20190128&nl=morning-briefing-europe&nlid=567726720190128&te=1

[5] Nader, R. (2014). Unstoppable:  The Emerging Left-Right Alliance to Dismantle the Corporate State. New York, NY: Nation Books.

[6] https://www.politico.eu/article/5star-league-italian-government-split-over-venezuela-crisis-alessandro-di-battista/?utm_source=POLITICO.EU&utm_campaign=06bdd12864-EMAIL_CAMPAIGN_2019_01_28_05_09&utm_medium=email&utm_term=0_10959edeb5-06bdd12864-190334489  It isn’t the only issue dividing the two.  https://www.politico.eu/article/salvini-di-maio-the-green-clash-tearing-apart-italys-coalition-government/?utm_source=POLITICO.EU&utm_campaign=06bdd12864-EMAIL_CAMPAIGN_2019_01_28_05_09&utm_medium=email&utm_term=0_10959edeb5-06bdd12864-190334489

[7] https://www.nytimes.com/reuters/2019/01/23/world/europe/23reuters-britain-eu-planb-factbox.html?module=inline

[8] https://www.ft.com/content/da21a8aa-22da-11e9-8ce6-5db4543da632 and https://www.politico.eu/article/mays-brexit-assault-will-target-backstops-threat-to-peace-dup-theresa-may-good-friday-agreement/?utm_source=POLITICO.EU&utm_campaign=06bdd12864-EMAIL_CAMPAIGN_2019_01_28_05_09&utm_medium=email&utm_term=0_10959edeb5-06bdd12864-190334489

[9] https://www.ft.com/content/3cecf28e-222a-11e9-8ce6-5db4543da632

[10] https://www.ft.com/content/6e9c5762-20c1-11e9-b126-46fc3ad87c65

[11] https://www.nytimes.com/2019/01/25/world/europe/queen-elizabeth-brexit-britain.html

[12] http://time.com/5514136/european-union-iran-sanctions/

[13] https://www.nytimes.com/2019/01/21/us/politics/china-trade-pessimism.html?module=inline

[14] https://www.nytimes.com/2019/01/26/us/politics/huawei-china-us-5g-technology.html

[15] https://finance.yahoo.com/news/chinas-december-industrial-profits-shrink-again-weak-demand-041845449–business.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equities are rallying around the world.  Here is what we are watching this morning:

Venezuela: As we noted yesterday, China and Russia[1] would be on the hook for billions of bad debt that a new government could simply default on, arguing the debt was incurred by an illegitimate government.[2]  China usually tries to avoid taking outright positions on international issues, a legacy from the Mao-Deng years.  At the same time, if it doesn’t get involved, it could lose billions.[3]  China is officially supporting Maduro but the endorsement is far from ringing.  Senior military officials have signaled they continue to back Maduro.[4]  However, it is unclear if the upper ranks can continue to control the sentiment and behavior of the lower ranks.  There is also an impending concern about U.S. embassy staff.  Maduro has ordered them to leave this weekend, but Pompeo indicated earlier that the diplomats will stay because the U.S. no longer recognizes Maduro as the legitimate ruler of Venezuela.  Apparently prudence has partially overruled valor and the U.S. has ordered non-emergency staff out of the country and “advised” other Americans to leave.[5]  But, senior diplomats will stay and the embassy will stay open, creating the potential for conflict.  It is important to remember that Trump is a classic Jacksonian; an attack on the embassy would almost certainly trigger a military response.

Here is a snapshot of global allegiances toward Maduro and Guaido.

As we discuss below, this week’s DOE data was decidedly bearish as crude oil inventories rose sharply.  We are seeing steady to higher oil prices this morning, in part due to the fact that oil and equities have been positively correlated recently (both are reflecting sentiment about economic growth),  and probably also on expectations of at least a short-term disruption of oil flows from Venezuela.  We also note that Venezuelan bonds, many of which are in default, are rallying on hopes that Maduro will go and the new regime will be willing to restructure and service the bonds.[6]

Fed policy: Two items of note.  First, the FOMC is reconsidering its balance sheet normalization plan and may end its reduction much sooner than planned.[7]  Our position on the balance sheet is that the actual impact is difficult to determine, but the primary value of QE was psychological; it showed the Fed still had policy tools available even after the fed funds target hit zero.[8]  Although we doubt stopping the reduction of the balance sheet would have any “real” effects (other than to keep bank reserves excessive and keep the money multiplier and velocity depressed), there will almost certainly be a positive reaction in financial markets due to the psychological effects.  Second, reflecting comments we have made recently about the two open governor positions, the administration signaled it is “looking for doves.”[9]  This adjustment is very important because the appointment of two committed doves would weaken the Fed’s ability to hike rates.  Although not set in stone, two persistent dissents from governors would tend to undermine Powell’s position and could lead to his resignation.[10]

Energy update: Crude oil inventories rose 8.0 mb last week compared to the forecast decline of 0.5 mb.

In the details, estimated U.S. production was unchanged at 11.9 mbpd.  Crude oil imports jumped 0.7 mbpd, while exports fell 0.9 mbpd.  Refinery runs declined 1.7% and should continue to fall in Q1.  Gasoline stocks continued to rise while distillates fell, likely reflecting increased demand for heating oil.

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.  This week’s increase, though well above expectations, was mostly in line with seasonal norms.

Based on oil inventories alone, fair value for crude oil is $59.05.  Based on the EUR, fair value is $55.52.  Using both independent variables, a more complete way of looking at the data, fair value is $56.03.  By all these measures, current oil prices are generally in the neighborhood of fair value.  However, we still expect prices to move toward $60 in the coming weeks, but rising oil inventories will tend to be a bearish factor for the market.  Still, assuming the roughly current price of $53.00 per barrel and a steady EUR, the market has already discounted a 25 mb rise in inventory levels.  A rise of that level, assuming we continue to track the usual seasonal pattern, would occur in early to mid-March.  If inventories rise to their normal peak and the dollar remains stable, oil prices would be fairly valued around $50.50.  Thus, the markets haven’t completely discounted the normal inventory build but have assumed part of it.

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[1] https://www.ft.com/content/0d4b54be-1fc1-11e9-b126-46fc3ad87c65?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[2] Russia is well aware of this ploy.  It refused to service Tsarist bonds for years.

[3] China is owed around $55.0 bn from Venezuela. https://www.scmp.com/news/china/diplomacy/article/2183519/wary-china-offers-support-embattled-venezuelan-president

[4] https://www.ft.com/content/13081fd4-1ff5-11e9-b126-46fc3ad87c65?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56 and https://www.nytimes.com/2019/01/24/world/americas/venezuela-news-maduro-russia.html?emc=edit_mbe_20190125&nl=morning-briefing-europe&nlid=567726720190125&te=1

[5] https://www.nbcnews.com/news/latino/u-s-orders-all-non-emergency-diplomatic-staff-out-venezuela-n962471

[6] https://ftalphaville.ft.com/2019/01/24/1548348776000/Venezuela-bondholders-are-betting-on-Maduro-s-downfall/

[7] https://www.wsj.com/articles/fed-officials-weigh-earlier-than-expected-end-to-bond-portfolio-runoff-11548412201

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

[9] https://www.wsj.com/articles/white-house-adviser-says-fed-board-nominees-should-support-easy-money-policies-11548375931

[10] https://www.forbes.com/sites/johntamny/2010/11/22/modern-fed-history-points-to-ben-bernankes-resignation/#103619784d6d

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equities are rising modestly this morning.  Here is what we are watching:

Venezuela heats up: Venezuela has been a problem for a while.  Its economy and government have essentially stopped functioning.  Hyperinflation has set in.  There is a massive exodus of Venezuelans[1] to other parts of South and Central America (and, at some point, it is safe to assume they will come to the U.S. border).  The state oil company, PDVSA, has been gutted by replacing competent workers with lackeys loyal to the regime; oil production has declined to 1970s levels.  In fact, it is such a mess that the real mystery is why the current regime remains in power.  It appears this mystery may be getting resolved.  Protests in Venezuela have taken on a different tone.  For years, the Chavez/Maduro leadership was able to control the country due to loyalty from the working class.  Protests generally came from the middle and professional classes; the rich mostly live in Miami now.  What is new is that the working classes are turning on the government.  For a time, Chavez was able to funnel resources to the poor, which helped maintain support, but now the economy has become so weak that it can’t buy off the lower classes anymore.[2]

Juan Guaido, the president of the National Assembly, has declared himself interim president.  The Trump administration has recognized him as the new president of Venezuela[3] and, more importantly, the military and security services are not moving against him.  Regional governments have turned against Maduro, led by Brazil’s new leader, Jair Bolsonaro, but also with support from Argentina and Paraguay.[4]  Maduro responded by giving U.S. diplomats 72 hours to leave Venezuela.  SoS Pompeo, following the logic that Maduro is no longer president of Venezuela, indicated the diplomats would stay.[5]  As we noted yesterday, the Trump administration is considering oil sanctions on Venezuela[6]; if implemented, they would remove the last prop keeping the Venezuelan economy functioning (as badly as it is).  Meanwhile, Russia has warned the U.S. not to use military force against Maduro, which is, in a sense, an idle threat.  There is no way Russia could maintain a major military effort over such a long distance.  Instead, we would look for Russia to do its usual move in these sort of circumstances, which is to create pressure on U.S. interests where it can, e.g., Ukraine, Moldova, etc.[7]  Besides Russia, Maduro’s dwindling international support comes from Turkey, Cuba, Nicaragua, Bolivia and South Ossetia (a state only in the mind of Putin).

We suspect Maduro is finished.  What follows will be critical.  The most pressing issue is to restart the economy, which means getting oil flowing again.  The quickest way to accomplish this is to open the oil sector to foreign investment and allow foreign ownership of reserves.  We doubt a new government would go quite that far, but generous production-sharing agreements would likely be a minimum.  Still, it would probably take at least two or three years for output to return to the 3.0+ mbpd level it was before Chavez undermined PDVSA.  The second major issue is debt; Venezuela needs to restructure its debt and will almost certainly require an IMF bailout.  China and Russia, which have both become major creditors, are likely to be disadvantaged by a U.S.-supported regime.

Eventually, a renewed Venezuela will be bearish for oil prices; recovery would add 2.0 mbpd to global oil supplies.  However, that recovery will take at least a couple of years.  In the short run, turmoil could reduce Venezuela’s oil output even further and is thus supportive for crude.

ECB: The ECB, as expected, left policy rates unchanged.  However, the press conference comments were decidedly dovish.  The line from ECB President Draghi from H2 2018 was that prosperity was just around the corner.  In these prepared comments, he has finally admitted that the Eurozone economy has slumped and he indicated the ECB will keep policy easy until growth and inflation rise.  The EUR slumped on the news.

World growth: As we note below, flash PMI estimates from Asia and Europe were well below expectations.  Eurozone PMI is now hovering just above the 50 expansion line at 50.5.  Japan is sitting at 50.0, down from 52.6 in December.  By its mandate, the Federal Reserve does not act as the central bank of the world but, in reality, it is because of the dollar’s reserve status.  Thus, if the FOMC members are looking at a pause, world economic performance does offer an excuse for maintaining steady policy.

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[1] See WGRs, The Venezuelan Migration Crisis: Part I (9/17/2018) and Part II (9/24/2018).

[2] https://www.washingtonpost.com/opinions/2019/01/23/venezuelans-take-streets-again-could-democracy-be-won-this-time/?utm_term=.520b71843986&wpisrc=nl_todayworld&wpmm=1

[3] https://www.axios.com/venezuela-juan-guaido-nicolas-maduro-us-donald-trump-96db1b60-62e4-411b-bbe8-e03f27344821.html and https://www.ft.com/content/4ac66f4e-1f3b-11e9-b126-46fc3ad87c65?emailId=5c4952cdba3bc100043c5744&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[4] https://www.axios.com/trump-regime-change-venezuela-maduro-pence-video-b2a231d5-af89-4b49-bf68-dae2fc2a2f8e.html

[5] https://www.washingtonpost.com/world/the_americas/opposition-launches-protests-to-oust-maduro-as-us-venezuela-tensions-rise/2019/01/22/0416687a-1e4f-11e9-a759-2b8541bbbe20_story.html?utm_term=.437758d096b0

[6] https://www.reuters.com/article/us-venezuela-politics-usa/us-weighs-oil-sanctions-on-venezuela-as-it-steps-up-pressure-idUSKCN1PH22B

[7] https://www.reuters.com/article/us-venezuela-politics/as-world-looks-on-venezuelas-guaido-to-keep-up-pressure-on-maduro-idUSKCN1PI0CY?feedType=RSS&feedName=topNews

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] After a hard drop yesterday, equities are rising modestly this morning.  Here is what we are watching:

The importance of trade: Equity market action on Friday and Tuesday made it abundantly clear how focused financial markets are on trade.

This is a five-day chart of the S&P futures.  On Friday, reports that China was prepared to bring the bilateral trade deficit to zero over six years led to a strong rally, shown by the blue line.  The red line shows the drop on reports that the U.S. rebuffed a Chinese offer to send officials for preparatory talks before the already scheduled meeting at the end of January.[1]  However, in the afternoon, National Economic Council Director Kudlow did an interview where he indicated that trade meetings were still on, leading to the rally shown by the green line.[2]

What we suspect is happening is that the Mnuchin/Kudlow wing of the administration is battling for the “heart and mind” of the president against the Navarro/Lighthizer wing and are making dueling press statements that are affecting equity markets.[3]  On the one hand, 2019 is critical to the 2020 elections; if a recession begins this year it would doom Trump’s re-election chances, and even if recovery occurs in 2020 it will likely be too late to offset the weakness that would have already occurred.  This fact would suggest the president will take a deal with China that boosts optimism.  On the other hand, China is now a strategic competitor.  China is becoming a serious military threat to the Far East and is working to move up the value chain by dominating technology, an area that the U.S. has ruled for years.  Thus, there are longer term issues of resetting Chinese relations to a hostile stance.  The actions against Huawei (002502, Shenzhen, CNY 4.15) are part of that policy direction.[4]  Our position is that Trump will make a short-term trade agreement with China and delay additional tariffs.  However, in the long run, U.S. policy toward China will take a more aggressive turn which will disrupt global supply chains.  If the president decides the long-term goal outweighs the short-term goal, then the potential for a recession and further economic weakness rises significantly.

Pressure on Venezuela: The U.S. has mostly stayed out of the turmoil hammering Venezuela.  The Bush administration did make positive comments about the 2002 coup attempt that failed against Hugo Chavez but there was no evidence of active support.  Subsequent administrations have applied various sanctions but avoided any that would seriously disrupt the Venezuelan oil industry (Chavez and Maduro accomplished that all on their own).  Although the government has systematically undermined a divided opposition through arrests and domestic intelligence, conditions have deteriorated to the point where forces opposing the government are rising under new leadership.[5]  More ominously for the government, there are increasing reports of military unrest.[6]  Chavez did a good job of keeping the military aligned with the regime, playing on his veteran status, but Maduro does not have the same ties.  Now, it appears the Trump administration is taking a more active role to undermine Maduro.[7]  The most likely outcome is a military coup which would overthrow the regime.  In the short run, if the takeover is “messy” it is a bullish factor for oil; although Venezuela’s oil production has plummeted to just over a million barrels per day (it once produced over three million per day), chaos would likely reduce output to zero.  However, if Maduro is ousted and the next government is supportive of foreign investment, then an eventual rise in output is very likely.

Shutdown: There is some movement on the government shutdown; the Senate is expected to vote on competing plans to temporarily fund operations.[8]  We don’t expect either to pass the House or be signed into law but the fact that votes are taking place is some form of progress.  There are widespread reports of government workers who are not being paid but are required to work who are not coming in.  Especially critical are those working for the IRS; if they don’t go to work, tax refunds could be delayed.[9]  Here are all the economic releases that have been delayed:

Brexit: There’s not too much new to report.  We are seeing tensions rise between Ireland and the EU on the border issue.  Ireland wants to avoid a hard border with Northern Ireland on fears that a return to a hard border will lead to sectarian conflict.  Ireland suggested it would not enforce a strict border even with a hard Brexit, while the EU indicated Ireland would need to put hard border controls in place if a hard Brexit occurs.[10]  Hard Brexit supporters have argued that technology could allow for trade to be monitored without a hard border control.  However, a soft border could become a headache for the U.K. as well because it could become a conduit for people to cross into the U.K. without papers being checked.  Still, divisions within the EU increase the odds that the union may be more willing to adjust than it has been indicating.  We are also noting softening opposition to May’s plan.  Although the vote failed spectacularly last week, Brexiteers are beginning to fear that their desire for a hard break with the EU is not a majority position; in fact, the majority support avoiding hard Brexit at all costs.  If the choice is to remain in the EU or May’s proposal, the latter is starting to look much better.[11]  Although we fear a hard Brexit could occur because neither the EU nor the U.K. will budge, there is some evidence of movement that is raising hope for a more orderly outcome.  That factor is why the GBP is doing better.  Meanwhile, we continue to hear reports of firms leaving the U.K. on fears of a hard Brexit.[12]

Davos: This picture says it all:

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[1] https://www.ft.com/content/466cc9e2-1e4c-11e9-b126-46fc3ad87c65

[2] https://www.cnbc.com/video/2019/01/22/the-full-interview-with-national-economic-council-director-larry-kudlow.html

[3] https://www.reuters.com/article/us-usa-china-trade-analysis/trump-wont-soften-hardline-on-china-to-make-trade-deal-advisers-idUSKCN1PH02I

[4] https://www.reuters.com/article/us-usa-china-huawei-tech/u-s-will-seek-extradition-of-huawei-cfo-from-canada-idUSKCN1PG2HL

[5] https://www.nytimes.com/2019/01/22/world/americas/who-is-juan-guaido.html?emc=edit_mbe_20190123&nl=morning-briefing-europe&nlid=567726720190123&te=1

[6] https://www.nytimes.com/2019/01/21/world/americas/venezuela-maduro-national-guard.html?module=inline

[7] https://www.axios.com/trump-regime-change-venezuela-maduro-pence-video-b2a231d5-af89-4b49-bf68-dae2fc2a2f8e.html

[8] https://www.ft.com/content/06b2765c-1e98-11e9-b126-46fc3ad87c65?emailId=5c47f93d51f118000497abae&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[9] https://www.washingtonpost.com/business/economy/hundreds-of-irs-employees-are-skipping-work-that-could-delay-tax-refunds/2019/01/22/1885e74e-1e7d-11e9-8e21-59a09ff1e2a1_story.html?utm_term=.50d990d9fc2e

[10] https://www.ft.com/content/05114d7e-1e42-11e9-b126-46fc3ad87c65?emailId=5c47f93d51f118000497abae&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[11] https://www.ft.com/content/2848f57c-1e3c-11e9-b126-46fc3ad87c65?emailId=5c47f93d51f118000497abae&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[12] https://www.ey.com/uk/en/newsroom/news-releases/19-01-07-ey-financial-services-brexit-tracker-heightened-uncertainty-drives-financial-services-companies-to-move-almost-800-billion-pounds-of-assets-to-europe?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosmarkets&stream=business