Daily Comment (January 11, 2019)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. equity futures are modestly lower this morning in a very quiet market.  Yesterday, we started the day lower but moved higher.  Although much of the rally was probably due to Chair Powell’s “patient” speech, it also points to a different market tone.  Last month, rallies were sold.  Yesterday, we saw weakness bought.  That pattern bears monitoring.  Here is what we are watching this morning:

Fed talk: We are seeing consistent messaging from members of the FOMC.  Yesterday, Chicago FRB President Evans signaled that the Fed should remain on hold for a while,[1] even though he still indicates that he supports three more hikes.  Vice Chair Clarida reiterated the patient language and Bloomberg made Powell’s repeat of the word “patience” in his talk yesterday into a meme of sorts.  There is also persistent discussion about the balance sheet.[2]  As we noted in last week’s Asset Allocation Weekly, the primary impact of the balance sheet seems to be psychological.  In reality, banks mostly held QE as excess reserves.  But, psychology shouldn’t be ignored.  Making investors and consumers feel better can be positive for the economy.

One of the unknowns is what level of the Fed’s balance sheet would be “normal.”  If we compare the balance sheet to GDP, we are a long way from achieving that goal.

Before the financial crisis, the balance sheet represented about 5.5% of GDP.  It ballooned to nearly 25% of GDP in 2014 but has been falling rapidly since.  The end of QE and the rise of GDP has contributed to the decline and actual reduction is accelerating the process.

We note that the balance sheet ranged between 15% and 23% of GDP during the Great Depression and the war years.  This is because the Fed simply expanded the balance sheet to absorb government spending, which accelerated during the war years.  After the war, the Fed mostly kept the balance sheet steady and allowed the overall growth of the economy to reduce its relative size.

Although that same procedure could work again, the Fed does seem to want to return to “normal order,” where fed funds are mostly determined by reserve levels.  Currently, due to the level of excess reserves in the system, monetary policy is managed by the interest rate on reserves (IROR).  The Fed pays banks 2.28% on their reserves; without that rate, the Fed would not be able to conduct interest rate policy because there are so many reserves in the system that rates would remain at zero all the time.[3]  Although the rate paid on reserves ranges between the upper and lower bounds of the fed funds range (currently 2.25% to 2.50%), the rate is getting high enough that it may actually be tight.

The blue line shows bank net income as a percentage of interest-earning assets (or, net interest margin) on bank holding companies with assets in excess of $500 bn.  The IROR rate is now in the neighborhood of the net interest margin (NIM) and begs the question—why should a bank risk lending when it can simply hold idle reserves and earn about the same net margin?  Now, it should be noted that smaller banks have higher margins[4]; banks with assets between $50 bn to $500 bn have NIM of 3.03% and banks with assets less than $50 bn have NIM of 3.81%.  Therefore, there still may be an incentive for them to lend instead of holding reserves.

The Fed should probably consider returning to the post-WWII plan, which is to simply hold the balance sheet steady and allow the natural growth of the economy to reduce its importance.   Over time, the reliance on IROR would likely become less important.

Brexit: There are rumors that the May government is going to ask the EU for an extension of the Article 50 deadline.[5]  The rumors have been denied but the report boosted the GBP overnight.

Trade talks: Chinese Vice Premier Liu is scheduled to visit the U.S. later this month,[6] as long as the current shutdown doesn’t make the trip moot.  Liu is a very important official in the Xi government and the visit signals that China is trying to bring a deal to fruition.  In related news, China may guide its GDP to around 6.0% compared to last year’s 6.5%.[7]

Shutdown issues: We are starting to hear that economists are downgrading their Q1 GDP forecasts due to the shutdown.  JP Morgan (JPM, 100.39) announced today it is lowering its growth projection to 2.0% from 2.5% due to the expected decline in government spending.  Of course, that likely means Q2 estimates will be revised higher if the shutdown ends at some point.  But, it also supports the Fed pause because Q1 economic data will be weaker than it would have been otherwise.  Adding to this problem has been a persistent seasonal adjustment issue with Q1 GDP data; we could see a rather dramatic drop in Q1 reports, which, assuming the government reopens, would be reported in Q2.  This adds to the case that if we are going to see any further rate increases they probably won’t happen until H2.

Iran oil exports: Reuters[8] is reporting that Iran is struggling to sell its crude oil despite waivers; according to reports, although eight nations were granted waivers, the U.S. did not make clear what level of sales would be permitted.  Thus, Iranian oil exports were around 0.9 mbpd in December and will likely remain at that level this month.  Prior to sanctions, Iran usually exported around 2.5 mbpd.

Syrian confusion:First, the president surprised his advisors and the Pentagon by ordering a rapid withdrawal of U.S. troops from Syria.  Second, National Security Director Bolton, supported by SOS Pompeo, confirmed the withdrawal but added conditions that essentially won’t be met for years (security for the Kurds, for example), which suggested the president’s staff had thwarted his plans.  However, reports today suggest the president has prevailed after all.  The Pentagon announced it is putting logistical plans in place to withdraw the troops as the president ordered.[9]  It is still unclear when exactly the troops will depart, but, as a military official noted, “We take our orders from the president, not John Bolton.”

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[1] https://www.bondbuyer.com/news/why-evans-thinks-rates-will-eventually-go-above-neutral

[2] https://www.wsj.com/articles/fed-debate-heats-up-over-the-size-and-composition-of-its-bond-holdings-11547202600

[3] Of course, one other policy tool that could be employed would be to increase required reserve levels dramatically.  Although that would allow for normal open market operations, banks would cry foul.  In addition, in the aggregate, the system is flush with reserves but that doesn’t mean the distribution is equal.  Thus, this move could lead to a severe reserve shortage in some banks and make managing fed funds difficult as well.

[4] It sort of begs the question—why should a bank drive to get large when it simply reduces NIM?  It also suggests the benefit of scale in banking probably doesn’t exist; in fact, there may be decreasing returns to scale.

[5] https://www.standard.co.uk/news/politics/brexit-to-be-delayed-beyond-march-29-cabinet-ministers-reveal-a4036326.html

[6] https://www.wsj.com/articles/xi-jinpings-top-economic-aide-to-visit-u-s-for-trade-talks-this-month-11547177759

[7] https://www.reuters.com/article/us-china-economy-targets-exclusive/exclusive-china-to-set-lower-gdp-growth-target-of-6-6-5-percent-in-2019-sources-idUSKCN1P50CJ

[8] https://af.reuters.com/article/commoditiesNews/idAFL8N1Z9370

[9] https://www.wsj.com/articles/u-s-military-prepares-for-syria-pullout-amid-uncertainty-11547156824

Daily Comment (January 10, 2019)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. equity futures are lower this morning as the markets take a “pause to refresh.”  Here is what we are watching this morning:

Oh, that’s what you meant: The FOMC minutes were released yesterday and signaled a decidedly dovish turn in policy.[1]  The text of the minutes spent some time discussing how swapping the word “expects” for “judges” was designed to show that the FOMC is much more data-dependent than path-dependent.  In addition, there was some discussion of how the current policy rate is close to neutral.  What is striking about the minutes is that they were clearly more dovish than the statement and the press conference.  Now, it should be noted that the minutes are the distilled summary of actual meeting comments; in 2023, we will get the actual transcripts that will show what the members really said.  What very likely occurred is that the Fed took note of market reaction and opted to write very dovish minutes to clearly signal that it is pausing and may be near the end of its rate hike cycle.  The fact that the statement and the press conference failed to deliver that message either means there was a communication breakdown or they really didn’t mean to pass such a dovish message across and underestimated how badly financial markets needed to hear that.  In any case, the supportive signal has now been sent.  And, in the post-meeting, committee members are clearly signaling pause.[2]

Brexit: PM May took another blow yesterday as a Labour measure passed with support of the opposition and some renegade Tories that would force a “plan B” to be formulated by the government in three days if the current bill fails (which it almost certainly will[3]).  The follow-up bill can be amended by MPs, which means it will become a “dog’s breakfast” of amendments that will likely have no chance of acceptance by the EU.[4]  Meanwhile, Labour’s Corbyn[5] is pressing for new elections if May can’t get her Brexit measures through Parliament.  It’s not clear that May would lose a no-confidence vote; although she has little support, Tories know that bringing down her government will almost certainly lead to election losses and the Conservatives’ removal from power.  It’s difficult to see how this process avoids a mess.

The Establishment strikes back: The White House is working on bills that would expand the president’s trade authority, giving him even more power to apply tariffs.  Sen. Grassley (R-IA) has responded by saying, “We ain’t going to give him any greater authority. We already gave him too much.”[6]  We also note that the president of the Chamber of Commerce is going to deliver his annual “State of American Business” in which he defends the U.S. role in fostering globalization.[7]  The interests of the establishment and the White House are diverging; we continue to watch for signs that this widening division begins to affect legislatures.  So far, the impact has been modest.

Weaker global economy: Car companies in Europe are announcing large job cuts.[8]  German industrial production is flirting with recession-level weakness.

China’s inflation data showed a sharp decline, with PPI sliding to a two-year low of 0.9% from 2.7% in November.  CPI dipped to 1.9% from 2.2%.  The PBOC has an inflation target of 3% for CPI; this data suggests the central bank could act to reduce rates further.  Global economic weakness will tend to widen the U.S. trade deficit regardless of tariff actions and hold down inflation.  Although the Federal Reserve generally doesn’t make comments about global growth in policy statements, we suspect the state of the world is having an effect on FOMC policymakers.

Energy update: Crude oil inventories fell 1.7 mb last week compared to the forecast decline of 1.8 mb.

In the details, estimated U.S. production was unchanged at 11.7 mbpd.  Crude oil imports rose 0.4 mbpd, while exports fell 0.2%.  Refinery runs declined 1.1% and should continue to fall in Q1.

Based on oil inventories alone, fair value for crude oil is $60.32.  Based on the EUR, fair value is $54.85.  Using both independent variables, a more complete way of looking at the data, fair value is $56.05.  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.

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[1] https://www.ft.com/content/330f234c-143b-11e9-a581-4ff78404524e?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[2] https://www.ft.com/content/5d3bbeca-1425-11e9-a581-4ff78404524e

[3] https://www.washingtonpost.com/world/europe/theresa-mays-brexit-plan-appears-headed-for-defeat-next-week/2019/01/09/ed50b4e0-1392-11e9-ab79-30cd4f7926f2_story.html?utm_term=.52d4d46e6ab4&wpisrc=nl_todayworld&wpmm=1

[4]https://www.wsj.com/articles/behind-xis-bluster-is-a-vulnerable-china-11547078609

[5] https://www.ft.com/video/21fee766-d183-4db5-b154-b9778ca41b5f

[6] https://www.reuters.com/article/us-usa-trade-grassley/senate-finance-chair-says-no-to-giving-trump-more-tariff-authority-idUSKCN1P32DU

[7] https://www.axios.com/newsletters/axios-am-11f09ade-5003-4375-870f-3859f1abe608.html?chunk=6&utm_term=emshare#story6

[8] https://www.bbc.com/news/business-46810473 and https://www.marketwatch.com/story/ford-in-talks-to-cut-thousands-of-jobs-in-europe-2019-01-10

Daily Comment (January 9, 2019)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. equity futures are higher again this morning as the recovery continues.  Here is what we are watching today:

Shutdown: The president went primetime last night to make his case for a wall.  The Democrats responded.  Nothing has changed and the shutdown drags on.  For the most part, financial markets have ignored the drama, which makes sense, because it really isn’t affecting the economy significantly…so far.  However, that situation may be changing.  Fitch has warned[1] that its AAA rating on U.S. Treasuries may be in danger if the shutdown collides with the debt ceiling, which officially becomes an issue on March 2 but probably won’t actually occur until early summer.  A second downgrade (S&P lowered the rating to AA in August 2011) could do serious damage to the global trading system.  We doubt there would be a wholesale retreat from the dollar on a downgrade, simply because there isn’t another alternative, but reserve managers would face pressure over time to diversify and perhaps hold more precious metals.  There are reports of rising TSA absences which are starting to affect air travel.  Landlords are being forced to use savings to avoid evictions of HUD tenants.  Disaster relief funds are being delayed.  Transportation projects are starting to be delayed.  There are reports that government workers are starting to make unemployment insurance claims that will boost initial claims (although we wonder if there are enough functioning parts of government to actually process the claims).  The SEC is delaying IPOs.[2]  And, realtors are indicating that buyers are being affected by the shutdown.[3]

The problem is that there doesn’t seem to be a workable “off-ramp” to end this impasse that doesn’t look like a loss for one side or the other.  We do look for the House to start sending a parade of spending bills to reopen various parts of the government in the coming days and there could be enough GOP defectors in the Senate to pass the bills, forcing the president to either sign them or face the optics of keeping the government from functioning.  If the financial markets start feeling the impact, we suspect the pressure to end this shutdown will escalate.

Trade talks: Chinese and U.S. trade talks ended on a positive note after being extended an additional day.  We look for another round of talks to begin next week in Washington.  Bloomberg reports something that has been whispered for weeks—the president uses the equity markets as a real-time measure of his success and wants a trade deal to lift equity values.[4]  One of the primary reasons we are optimistic on equities this year is because of the “third year effect”; history shows that the year before the election tends to be a strong year for stocks as administrations try to goose growth to improve the odds of reelection.

Brexit: PM May faced a minor defeat[5] in the House of Commons when a measure passed that prevents the government from making adjustments to tax rules if it pursues a hard Brexit.  The idea behind the bill is to impede the government from deciding to follow a hard Brexit path.  It shows that the MPs want to avoid a hard Brexit but also don’t want May’s current agreement with the EU.  As we noted yesterday, the majority seems to want to leave the EU but on terms different from what May negotiated.  However, we have serious doubts that the EU will change its position.  There is growing talk in the U.K. of an extension of the March 29 deadline, but it is unlikely the EU would agree to this unless there is a referendum or new parliamentary elections in the U.K.  Furthermore, it is highly unlikely the EU would agree to an extension simply to restart negotiations.  Complicating matters further is that EU parliamentary elections will occur sometime between May and July and members of the EU want Brexit resolved before these elections are held.[6]  Although neither side really wants a hard Brexit, odds of such an event are rising due to the inflexibility of the EU and a May government that doesn’t have enough power to push through a flawed agreement.  It is a recipe for an undesired outcome.

Chinese stimulus?  Reports indicate there has been a flurry of schedule changes by regional governments in China at the behest of Beijing.  The rescheduling will open a window for a full meeting of the Central Committee between January 19 and 22.[7]  There is no evidence other than the rescheduling that a meeting will be called or a clue as to content.  If we had to guess, the most likely outcome is an announcement of stimulus for an economy that is clearly weakening.   We could see some sort of announcement on trade as well.  But, China has a long history of not tolerating slowing growth so the most likely reason for a Central Committee meeting is to announce measures to lift the economy.

Iran facing pressure: Recently, we discussed the potential for continued waivers on Iranian oil sales.  One factor working against waivers is that Iran’s continued extraterritorial actions in Europe have eroded support for Tehran in the EU.  The EU has decided to apply sanctions on Iran for a series of assassination plots against Iranian activists living in Europe.[8]   It will be hard for Iran to draw support for busting U.S. sanctions if the EU is applying its own.  This is likely bullish for oil prices.

World Bank downgrades global growth prospects:[9] Although the decline in the forecast isn’t huge, the trend is worrisome.  The body is expecting global growth at 2.9% this year, down from 3.0% in 2018.  However, our worry is that we will see further weakness this year and the downgrade is, to some extent, confirmation of that concern.

A reflection of the recent yen rally: Last week, the JPY had a wild overnight session, appreciating strongly on no real news.  We note today that the BOJ is considering easing measures in light of the Fed pause in case the JPY appreciates.  The fact that this action is being considered should be a red flag for the Treasury Department; in general, U.S. policymakers were willing to tolerate the currency depreciation that came with Abenomics on the idea that it was part of the reform process.  However, lack of labor market reforms from Abenomics suggests the program was, in the end, nothing more than a plan for yen depreciation.

This chart shows the relationship between the USD/JPY exchange rate and the current account as a percentage of GDP.  In general, the exchange rate tends to lead the current account by six quarters.  Note that the current account went into deficit when the exchange rate was around 80 yen to the dollar.  As the JPY weakened, the current account rebounded.  At some point, we expect U.S. policymakers to force Japan to adjust its exchange rate to a more justifiable level; most likely, this will occur when Abe leaves office or the Trump administration finally realizes a weaker dollar is in its interest.

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[1] https://www.reuters.com/article/usa-rating-fitch/fitch-sends-us-triple-a-rating-warning-idUSL8N1Z92B1?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosmarkets&stream=business

[2] https://www.politico.com/story/2019/01/08/government-shutdown-update-2019-1069133

[3] https://www.bloomberg.com/news/articles/2019-01-08/government-shutdown-sinks-home-sales-confidence-realtors-say?srnd=premium&utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosmarkets&stream=business

[4] https://www.bloomberg.com/news/articles/2019-01-08/trump-said-to-want-trade-deal-with-china-to-boost-stock-market

[5] https://www.ft.com/content/20e20694-1378-11e9-a581-4ff78404524e?emailId=5c358540de0b380004a4b311&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[6] https://www.ft.com/content/eeb341ca-1367-11e9-a581-4ff78404524e?emailId=5c358540de0b380004a4b311&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[7] https://www.bloomberg.com/news/articles/2019-01-09/rare-schedule-changes-suggest-major-china-policy-meeting-is-near

[8] https://www.nytimes.com/2019/01/08/world/europe/iran-eu-sanctions.html

[9] https://www.reuters.com/article/us-worldbank-growth/world-bank-sees-global-growth-slowing-in-2019-idUSKCN1P22EU

Daily Comment (January 8, 2019)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. equity futures are higher this morning as the recovery continues.  Here is what we are watching today:

Fed news: Atlanta FRB President Bostic suggested that the policy rate may be near neutral and perhaps only one more increase is needed.[1]  Bostic has made it clear he would not support a hike that would invert the yield curve, so based on that position alone his comments were consistent with that stance.  Cleveland FRB President Mester, who we rate as a “2” on the 1-5 hawk/dove scale (1 being most hawkish, 5 most dovish), told the WSJ that she thought the central bank has some “flexibility,” which we interpret as suggesting the Fed could hold rates steady for a while.[2]  This implies we probably won’t see rate hikes in the near future, if at all.  Bostic was a voter in 2018; Mester isn’t a voter this year.

Meanwhile, FRB economist Nellie Liang has withdrawn[3] from potential nomination for an open Fed governor seat.  It isn’t clear why she withdrew as it doesn’t appear the White House wanted her to quit.  Her stated reason was discomfort with the “limbo” of the nomination process.  We will be watching closely to see if the president takes a direct hand in the next nomination.  It appears to us that Treasury Secretary Mnuchin has been the primary source of governor nominations but, given the president’s desire for a dovish Fed, we would not be surprised to see him select someone much more radical to the position.  One possibility would be to appoint one of the dovish Fed presidents, e.g., Neel Kashkari or James Bullard, to the position.  Both would be reliable doves.  In fact, the president actually has two governor vacancies he could fill since Marvin Goodfriend’s nomination has been stalled for months.  Both these current regional bank presidents could likely be confirmed since they clearly have experience.

Trade talks: Trade talks between China and the U.S. continue in Beijing today.  Although nothing concrete has emerged, sentiment surrounding the talks is positive.  According to reports, the U.S. side is pressing China for verifiable goals as China has a tendency to offer vague promises that are difficult to check.[4]  We expect these talks to end shortly but resume in Washington in the near term.  Both sides need a short-term deal and we expect such an outcome.

Shutdown woes: The government shutdown continues.  So far, we haven’t said much about it because it hasn’t affected financial markets significantly.  However, we are now starting to reach a point where it might as critical government functions could be affected soon.  There are reports that the IRS is struggling to make refunds (although they apparently can take your tax dollars without issue), and food stamps may be delayed.  There are scattered reports that TSA officers are taking sick days in response to working without pay, causing airport delays.  And, there are also reports that farmers are finding their trade relief checks delayed due to the shutdown.  In addition, crop loans could be affected soon.[5]  The president is going on television for a primetime address tonight and there are rumors he may try to declare a national emergency to fund his border wall proposal.  The National Emergency Act of 1976[6] gives the president broad powers and could conceivably be used for this goal, although it would almost certainly face court challenges.  House Democrats are preparing partial funding bills that would fund various parts of the government.  This tactic is rather standard in shutdowns; the bills fund popular parts of government (e.g., national parks) that would likely find some GOP support in Congress.  The goal would be to fund everything but wall building.  Of course, the president could veto these bills, but then he is seen as preventing Americans from going to Yellowstone or receiving welfare.  As noted above, so far, the impact on financial markets has been modest but that may change the longer this shutdown continues.

OPEC and oil prices: The Saudis are apparently considering new plans to further cut oil exports with a goal of lifting Brent prices to at least $80 per barrel.  The need for increased government spending is behind the policy.[7]  Meanwhile, Iran is hoping nations that currently have waivers from U.S. sanctions will apply to extend them,[8] which does undermine the Saudis’ goal of higher oil prices.  Although the hawks in the administration (Bolton and Pompeo) will likely try to curtail waivers, the president does appear attuned to the price of oil and may be open to waiver extensions.

Syrian policy update: As we noted yesterday, John Bolton effectively reversed the president’s Syrian withdrawal policy by setting preconditions that will likely not be met for a generation.   Turkish President Erdogan was not pleased.  Bolton was in Turkey apparently to meet with Erdogan, but the Turkish president snubbed Bolton, leaving the American national security director to enjoy a two-hour meeting with Erdogan’s spokesman.  Turkey was quite pleased with President Trump’s announcement of the U.S. troop withdrawal because it would give Ankara a nearly free hand in dealing with the Kurds.  We will be watching to see if Bolton and Pompeo prevail or if the president orders the withdrawal over the objections of these members of the administration.  If Bolton and Pompeo lose on this one, it may also impact the aforementioned Iranian oil embargo waivers.

Brexit:The Irish PM Leo Varadkar offered PM May an olive branch of sorts, suggesting the EU could offer some moderating language on the Ireland/Northern Ireland border issue.[9]  The “backstop” has become the most contentious issue of Brexit.  Essentially, if a hard Brexit occurs, a border is erected on the Ireland/Northern Ireland frontier.  The worry is that the open border has lowered sectarian tensions in Northern Ireland and closing the border will bring the troubles back.  The U.K. is quite uncomfortable with a return of sectarian tensions because it will almost certainly require British troops to return to the area for security.  So, the backstop is about keeping the Ireland/Northern Ireland border within the EU to prevent a hard border.  However, this also means the U.K. would remain tied to the EU, but not in it, thus preventing Britain from negotiating new trade deals.  Hard Brexiteers worry the backstop will become permanent, putting Britain into some sort of trade limbo where it isn’t really part of the EU but not really separate.   PM May wants assurances from the EU that the backstop won’t last forever, but it isn’t really obvious how a hard border can be avoided.  There was consideration given to putting the EU/U.K. trade border at the Irish Sea, effectively putting Northern Ireland in the EU; this possibility horrifies the Unionists in Northern Ireland because it would separate Northern Ireland from the U.K. and eventually lead to unification with Ireland.  Varadkar’s comments are welcome but lack substance as there really is no good solution to the Northern Ireland border issue.  The noted article does suggest that the deadline for leaving could be extended but, as we noted yesterday, that would likely require full EU approval and getting the entire group to agree on anything is hard, which is why the deal in place probably can’t be adjusted.  As we stated yesterday, the longer Brexit goes on, the odds of a hard separation are rising.

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[1] https://www.cnbc.com/2019/01/07/feds-bostic-sees-one-interest-rate-increase-for-2019.html

[2] https://www.wsj.com/articles/cleveland-feds-mester-expects-higher-rates-but-sees-no-urgency-11546896645

[3] https://www.cnbc.com/2019/01/08/nellie-liang-withdraws-her-nomination-to-federal-reserve-board.html

[4] https://www.wsj.com/articles/u-s-pushes-china-to-follow-through-on-trade-promises-11546869147

[5] https://www.jsonline.com/story/money/2019/01/04/government-shutdown-makes-already-rough-farm-markets-even-rougher/2475446002/?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[6] https://en.wikipedia.org/wiki/National_Emergencies_Act

[7] https://www.wsj.com/articles/saudis-plan-to-cut-crude-exports-to-7-1-million-barrels-a-day-say-opec-officials-11546877089

[8] https://www.reuters.com/article/us-india-iran-oil/iran-hopes-india-will-seek-fresh-waiver-from-u-s-sanctions-deputy-foreign-min-idUSKCN1P20MX

[9] https://www.ft.com/content/49c33f0e-1320-11e9-a581-4ff78404524e

Weekly Geopolitical Report – Reflections on Inflections: Part I (January 7, 2019)

by Bill O’Grady

History seems to move in broad cycles.  Beliefs come into and fall out of favor.  Despite evidence of these cycles, people tend to “forecast with a straight edge.”  In other words, we assume trends that are in place will remain in place forever.  And, thus, it can come as a shock to society when trends shift.

One key reason why people tend to be surprised by inflection points is because we are mortal.  Once we identify the trends in place there is an incentive to buy into those patterns.  There are pundits who warn us that changes are in the offing but they are often warning us well in advance of the shift, and thus can either become like “Cassandras” who always signal calamity or like “stopped clocks that are right twice a day.”

In Part I of this report, we will offer some observations about inflection points—points in history when conditions change and a new regime of policy and thinking becomes dominant.  These observations will lay the groundwork for Part II, where we will examine in detail what we believe are two coming inflection points.  As always, we will conclude with market ramifications.

View the full report

Daily Comment (January 7, 2019)

by Bill O’Grady and Thomas Wash

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

Powell the dove: Chair Powell participated in a panel discussion on Friday that included former Fed Chairs Bernanke and Yellen.  He pretty much said everything the market wanted to hear.  He indicated that there is “no preset path” for policy, including raising rates and adjusting the balance sheet.  The financial markets interpreted these comments as an indication that the FOMC is taking financial market action seriously and that a pause is possible.  As we noted last week, the implied LIBOR rate from the two-year deferred Eurodollar futures suggest the Fed should stop raising rates now.  The Fed seems to have taken that news to heart.[1]  We have been favorable to the idea that the Fed would manage a soft landing, a tightening that doesn’t bring a recession.[2]  Our research suggests the Fed is now at the point where further tightening increases the risk of a policy error.  Powell’s comments suggest he is aware of the risks.

The Syria withdrawal…nevermind:[3] After President Trump ordered the withdrawal of U.S. troops from Syria, Defense Secretary Mattis left the administration.  Op-eds argued the move was leaving the field to Iran.  However, the hawks in the administration, at least for now, appear to have reversed this move.  National Security Advisor Bolton has placed conditions on fulfilling the action, which could delay the actual withdrawal for a long time.[4]  The two primary conditions are that IS must be destroyed and the Kurds’ safety must be guaranteed.[5]  Although American troop presence in the region is part of the U.S. superpower role, President Trump, consistent with his Jacksonian archetype, wants to reduce this role to only direct threats to the U.S. and any nation that besmirches American honor.  Will Bolton (and, to some extent, Pompeo) be successful in reversing the president on Syria?  We will be watching for two items; first, does the right-wing pundit class start criticizing the decision, and second, does Trump see Bolton’s actions as a direct refusal?  With regard to the first, it should be noted that the president was prepared to avoid a government shutdown over the wall until the pundits began to criticize his decision.  We doubt the Syria issue will raise the same degree of ire but, if it does, look for the president to push for withdrawal.  Second, Bolton has been smart to not openly defy the president but to put conditions in place that essentially mean the troops will be there for a long time.  Kurdish safety alone likely requires American troop presence.  So, for now, the U.S. will be maintaining its role in Syria.

Another split in Ukraine: The Eastern Orthodox Church has formally split by recognizing the independence of the Orthodox Church of Ukraine as separate from the Russian Orthodox Church.[6]  The church in Ukraine has been under the jurisdiction of the Russian church since 1686 when the Russian Church split from the Eastern Orthodox Church, which was centered in Constantinople.  What will make its break difficult is that there are church members in Ukraine who maintain their allegiance to Moscow.  This fact could further undermine Ukrainian unity.  We would look for the Kremlin to use this dissention to further weaken the government in Kiev.

Trade talks: China and the U.S. will begin trade talks in Beijing today.  Discussions will last two days and are designed to lead to further negotiations.[7]  In the short run, we expect an agreement that will reduce trade tensions.  China’s economy has been slumping and Xi needs to reduce trade pressure.  The U.S. economy, though in much better shape than China’s, is showing some signs of weakness in the pivotal political year, the year before the election year.  President Trump needs to avoid recession in 2019 at all costs or his reelection chances are doomed.  However, the long-run situation remains difficult.  The U.S. and China are strategic competitors, with China attempting to exclude the U.S. from its sphere of influence.  This long-run condition means that, over time, the odds of a full-scale military confrontation are growing and the interconnectedness between the two economies will likely break down.  Although that condition is not supportive for either economy, we expect a hiatus in 2019.

Hard Brexit looming?  We have generally expected the U.K. and the EU to eventually reach a settlement that would not result in a sudden disruption of trade relations.  However, as time passes, we are becoming increasingly concerned about the odds of a sudden break.  PM May’s plan will go to a vote in Parliament on the 15th after a debate is held this week.[8]  May is trying to sway MPs to her plan, but it doesn’t look like it has much chance of passage.  May is hoping she can take this failure to the EU for concessions.  However, here is the rub—the EU needs a unanimous vote to approve changes and the EU isn’t united on what it wants from Brexit.  If Merkel were still powerful, she may have been able to bring enough influence to bear to give May some help.  But, with Merkel on her way out, there really isn’t anyone on the EU side that could make concessions in short order.

If the EU can’t adjust, the U.K. could hold a second referendum.  However, that option is fraught with risk.  Structuring a vote that will reflect the will of the people will be hard.  If the vote is between hard Brexit and remain, we would expect remain to narrowly win because the public won’t want the economic disruption that follows.  But, that isn’t the only option.  A different relationship with the EU is probably what most British voters want, but what exactly that entails is impossible to divine in a simple vote.  It’s pretty clear that what May negotiated wasn’t it.  The constant talk, even from the Labour Party, is that a different deal is wanted.  Unfortunately, there isn’t any evidence that new negotiations would yield a deal better than what May got.  If the referendum is simply hard Brexit or remain, and remain wins, then markets will rejoice but there will be a significant minority of U.K. voters who will believe their decision to exit the EU was stolen from them.  The Tory party will likely split over this issue, ushering in Labour Party dominance for years.  A Corbyn-led Labour government would have sharply negative connotations for U.K. financial markets.  In general, the GBP has held up rather well throughout this turmoil, mostly because the dollar is overvalued versus the pound.  Nevertheless, a hard Brexit and a Labour government would severely undermine investor confidence and send both the GBP and British equities lower.  We are beginning to worry that we, and the markets, have been underestimating the odds of a bad outcome.

China’s reserves: China’s foreign reserves rose $11 bn in December, pretty much in line with expectations.  The modest change suggests there was little selling pressure on the CNY in December.

As this chart shows, China has managed reserve stability for the past few years.  The lack of pressure on the CNY likely reflects success in restraining capital flight.  Although capital flight is always difficult to track down (by design—if I am trying to secretly move my assets out of the country, it should be difficult to figure out what I am doing), the Net Errors and Omissions account in the balance of payments is probably the best measure available.

This chart shows the rolling four-quarter sum of the Errors and Omissions Account.  Note that it declined rapidly in 2015, suggesting a rapid increase in capital flight.  For illustration purposes, we have included the FHFA Home Price Index for the Pacific region.  Although home prices began to recover in 2013 in this region, they accelerated rapidly in 2015 and have remained strong, rising about 7.5% per year.  Anecdotal evidence has indicated for some time that at least some of Chinese capital flight was ending up in West Coast real estate markets.  The home price data would tend to support this notion.[9]

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[1] https://www.cnbc.com/2019/01/04/powell-says-fed-will-be-patient-with-monetary-policy-as-they-watch-how-economy-does.html

[2] https://www.wsj.com/articles/fed-faces-a-fresh-test-engineering-a-soft-economic-landing-11546822609

[3] https://www.youtube.com/watch?v=OjYoNL4g5Vg

[4] https://www.nytimes.com/2019/01/06/world/middleeast/bolton-syria-pullout.html?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[5] https://www.washingtonpost.com/world/national-security/bolton-promises-no-troop-withdrawal-from-syria-until-isis-contained-kurds-safety-guaranteed/2019/01/06/ee219bba-11c5-11e9-b6ad-9cfd62dbb0a8_story.html?utm_term=.6c457663d5de&wpisrc=nl_todayworld&wpmm=1

[6] https://www.nytimes.com/2019/01/06/world/europe/orthodox-church-ukraine-russia.html?emc=edit_mbe_20190107&nl=morning-briefing-europe&nlid=567726720190107&te=1

[7] https://www.ft.com/content/1e242378-1158-11e9-a581-4ff78404524e?emailId=5c32cc6b103e78000488abb0&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[8] https://www.ft.com/content/1859237a-11a9-11e9-a581-4ff78404524e?emailId=5c32cc6b103e78000488abb0&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[9] Although not shown, on a yearly change basis, Pacific region home prices rose faster than any other area of the country except the Mountain region, which may have also garnered some benefit from the capital flight.

Asset Allocation Weekly (January 4, 2019)

by Asset Allocation Committee

Quantitative easing (QE) was an element of unconventional monetary policy that emerged from the Great Financial Crisis.  When the Federal Reserve lowered the fed funds target to zero (known as the “zero interest rate policy,” or ZIRP), policymakers decided that taking the policy rate below zero would not further stimulate the economy.  Once interest rates fall below zero, idle cash generates a return and there was fear that negative interest rates would cause cash hoarding, which was exactly what the Fed wanted to avoid.  However, policymakers also feared that signaling they lacked additional tools to support the economy could trigger a panic in financial markets.  Thus, they created an additional tool, QE, which bought Treasuries and mortgages from the financial system and pushed additional cash into the economy.

The policy was controversial.  Some feared it would trigger inflation as the high levels of cash would “inevitably” cause rising prices.  Others argued that the process would distort financial markets.  But, in the end, the effects of QE were difficult to parse.  For example, one of the Fed’s arguments for QE was that it would lower long-term interest rates.  In fact, at times, it seemed to have precisely the opposite effect.

This chart shows the 10-year T-note yield.  The gray bars show periods of QE.  In all three events, yields rose at the onset of the balance sheet expansion.  Yields eventually fell during QE2, although that decline was probably more due to turmoil in Europe.  Why did yields rise when the Fed was reducing the supply of bonds?  Most likely, investors worried that QE would be successful in bringing about inflation and thus demand was adversely affected.  Anticipation of the end of QE always led to a drop in yields.

What about all that money that was injected into the system?  Much of it remained on bank balance sheets in the form of excess reserves.

Using the equation of exchange (money supply x velocity = price x quantity), the increase in the money supply mostly led to a sharp drop in velocity, instead of boosting prices or quantity.

So, if QE mostly sat idle on bank balance sheets then the withdrawal of QE should not have had much of a real impact on the economy.  And, that is likely true.  However, this isn’t to say that QE had no effect.  As we have noted in the past, there has been a close correlation between the S&P and the Fed’s balance sheet.

The chart on the left shows the original balance sheet model; note that after Trump’s election in 2016 the S&P rose much more than the model would have projected.  To account for this move, we built a variable that adjusted for expectations surrounding corporate tax cuts.  The additional variable improved the model dramatically; however, assuming no further reductions in corporate tax rates, the market is once again tracking the balance sheet.

Essentially, it appears that the impact of QE was mostly psychological; it signaled to investors that the Fed was supportive.  Interestingly enough, the withdrawal appears to be adversely affecting investor sentiment.  It is hard to determine how much, simply because there are other factors, such as trade conflicts and FOMC criticism, which are also affecting sentiment.  However, this data suggests that a pause in the balance sheet reduction would likely improve investor sentiment.

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Daily Comment (January 4, 2019)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] After a hard sell-off in equities yesterday, we are seeing a bounce this morning.  Boosting sentiment are hopes for a dovish tone from Chair Powell, a reserve rate cut in China and the opening of formal trade talks between the U.S. and China.  We cover the employment data in detail below but the quick take is that the data came in “hot”—payrolls rose 312k, well above expectations, and wage growth was strong.  We did see a rise in the unemployment rate, mostly because the labor force rose.  Here is what we are watching this morning:

Signs the Fed needs to stop:[1]  One of the key indicators we use for monetary policy is the two-year deferred Eurodollar futures.  Essentially, it tells us what the market thinks three-month LIBOR will be in two years.  It has an uncanny knack for signaling when policymakers should target policy rates.

First, the implied rate has fallen sharply in the last few weeks.

The implied LIBOR rate was 3.30% in late October.  It has dropped almost 100 bps since then to 2.35%.  As noted, this implied rate is closely tied to fed funds.

This chart shows the implied LIBOR rate along with the fed funds target on a weekly basis.  The inflection points are shown by vertical lines.  Recessions are in gray.  Note that the Fed tends to stop raising rates when the upper line falls below zero.  In fact, the Greenspan Fed tended to move rates based off this implied rate.  We have seen a significant drop in the implied LIBOR rate to the level of the current mid-point of the policy rate range.  Although the Fed may not necessarily need to lower rates, increasing rates at this point would be a serious policy mistake.  Chair Powell is participating at a closed panel interview along with former Chairs Bernanke and Yellen at the American Economic Association in Atlanta today at 10:30 EST; we will be watching to see if he suggests any thoughts of a pause.  We note that Dallas FRB President Kaplan told Bloomberg yesterday he supports a pause.  The above data suggests the FOMC should take the advice seriously.  At the same time, if Powell does lean toward further increases, he will likely cite today’s employment report.

Reserve rate cut: China cut its required reserve ratio[2] for banks by 50 bps on January 15 and an additional cut of the same magnitude will follow on January 25.  That will take the reserve ratio for large banks down to 13.5%.  Although this is good news, the action is modest at best.  First, the PBOC’s Medium-Term Lending Facility will expire later this year and the ratio cut is designed to partially offset that loss.  Second, the bank is anticipating the usual liquidity problems associated with the Chinese New Year (which is on February 5 this year; in the Chinese zodiac, it’s the year of the Pig).  Although the financial markets appear to be treating the action as policy stimulus, in reality, there isn’t a lot here; in fact, the PBOC could offset any stimulus by raising the repo rate.  However, we do expect to see rate cuts later this year to offset slowing growth.

Trade talks: The U.S. and China will begin formal trade talks on Monday.[3]  Jeffrey Gerrish, the deputy U.S. trade representative, will lead the talks.  Gerrish is closely aligned with Lighthizer, so we would expect him to hold to his boss’s hard line in negotiations.  It is generally expected that these talks will lay the groundwork for higher level negotiations next month.

The U.S. and China: Apple’s (AAPL, 142.19) warning yesterday[4] highlights a problem in the geostrategic relationship between the U.S. and China.  Both nations are now rivals, but unlike the U.S./Soviet rivalry during the Cold War the U.S. and Chinese economies are closely tied together.  CEA Chair Hassett’s comment yesterday suggesting that U.S. companies with ties to China “are going to be watching their earnings be downgraded next year until we have a deal with China” sent tremors through the equity markets.  We note the editorial boards of major papers are waking up to this problem.[5]  China’s economy is clearly coming under pressure, in part due to the trade actions by the U.S.[6]  But, the drop in the U.S. manufacturing PMI data yesterday shows that the American economy is also feeling a pinch from tightening monetary policy and issues with China.

The British faced a similar problem in the late 1800s as two rising nations, Germany and the U.S., threatened its global dominance.  The U.K. managed the U.S. by essentially ceding the Western Hemisphere to America, quietly acknowledging it would be unable to defend Canada from a U.S. invasion.  It turned its focus to Germany; sadly, that issue led to WWI.  The U.S. needs to redefine its relationship with China.  The idea that the Chinese would follow the path of Germany and Japan and align with U.S. geostrategic interests has been proven false.  However, this redefinition will likely have an adverse impact on the economies of both nations.  We also note the State Department has raised its warnings to Americans in China.[7]

Brexit: Our position has been that the May government or its successor will avoid a hard Brexit.  However, the odds of such an outcome do appear to be increasing.  One factor that appears to be driving the Tories to this outcome could best be described as “delusions of empire.”[8]  There seems to be this belief that Britain, freed from the constraints of the EU, could “get the band back together” and recreate the Commonwealth.[9]  We expected these ideas to fade as Brexit approached, but that doesn’t seem to be happening.  In fact, polls suggest that 57% of Tories would rather have a no-deal Brexit than PM May’s plan.[10]  The general consensus is that a no-deal Brexit would bring a nasty economic shock for the economy.  However, the Tories simply don’t trust that narrative.  For the rest of the population, 42% prefer to remain in the EU, 25% opted for no deal and 13% would accept May’s plan.

One potential outcome could be a split in the Conservatives between the leave and remain camp, which would lead to a position of dominance.  A Corbyn-led government would be a major negative for British financial assets.  Corbyn’s policy goals include renationalizing major industries and punitive taxes.  This isn’t our base case but the country seems unable to come to a consensus about its position, and the longer indecision reigns the greater the chance of a crisis.

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[1] https://www.youtube.com/watch?v=AkX6JcHdkdw Substitute “stop the car” with “stop raising rates.”

[2] https://www.reuters.com/article/us-china-economy-rrr-cut/china-cuts-banks-reserve-ratios-by-100-bps-as-economy-slows-idUSKCN1OY0RL?feedType=RSS&feedName=businessNews

[3] https://www.ft.com/content/d6b174de-0fca-11e9-a3aa-118c761d2745?emailId=5c2f063d7d55ce00044ac256&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[4] https://www.reuters.com/article/us-usa-economy-china/china-warnings-signal-trumps-trade-war-finally-hitting-home-idUSKCN1OX1XA

[5] https://www.wsj.com/articles/the-iphone-canary-11546560144 and https://www.washingtonpost.com/opinions/chinas-economic-slowdown-will-be-a-major-challenge-trump-should-tread-wisely/2019/01/03/4cbfd1e6-0f8c-11e9-831f-3aa2c2be4cbd_story.html?utm_term=.0a1c52c77409

[6] https://www.nytimes.com/2019/01/03/business/china-consumer-economy-apple-iphone.html

[7] https://www.nytimes.com/2019/01/03/world/asia/china-travel-advisory.html?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top and https://www.ft.com/content/9b1114e8-0f7a-11e9-a3aa-118c761d2745?emailId=5c2f063d7d55ce00044ac256&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[8] https://www.washingtonpost.com/news/worldviews/wp/2017/03/31/brexit-and-britains-delusions-of-empire/?utm_term=.69ab407f9d86&wpisrc=nl_todayworld&wpmm=1

[9] https://www.thetimes.co.uk/article/ministers-aim-to-build-empire-2-0-with-african-commonwealth-after-brexit-v9bs6f6z9 ; https://www.ft.com/content/bc29987e-034e-11e7-ace0-1ce02ef0def9 ; and https://www.bbc.com/news/uk-politics-46528952?wpisrc=nl_todayworld&wpmm=1

[10] https://www.nytimes.com/2019/01/03/world/europe/brexit-no-deal-conservatives.html?emc=edit_mbe_20190104&nl=morning-briefing-europe&nlid=567726720190104&te=1

Daily Comment (January 3, 2019)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It was all about Apple (AAPL, 157.92), which is down around 8% in the pre-market trade, and the yen.  Here is what’s going on:

AAPL: Apple[1] released a letter warning investors that the company would miss revenue estimates.  Two reasons were given for the decline, weaker economic growth in China and disappointing upgrades.  We won’t discuss the latter issue but the former is important.  The trade conflict between the U.S. and China hit the Middle Kingdom at an inopportune time, just as China was trying (again!) to implement deleveraging.  The act of reducing debt growth would, on its own, slow growth and cutting exports to the U.S. added to that issue.  To some extent, the slowdown in Chinese growth isn’t a surprise; recent purchasing managers’ data already showed that the Chinese economy was slowing.  However, the AAPL news suggests the trade war may be affecting U.S. equity earnings.  There are already rising worries about 2019 earnings due to slowing economic growth.  For a prominent company like Apple to confirm these concerns has led to a sharp decline in U.S. equity futures this morning.

At the same time, as our P/E chart at the end of this report shows, much of this worry has probably already been discounted.  The multiple has declined significantly and is unusually low given the level of economic activity.

This chart is a scatterplot of the four-quarter trailing P/E and the misery index, the sum of the unemployment rate and the yearly change in inflation.  The arrow shows the current ordered pair of these variables.  Essentially, this ordered pair usually indicates either a P/E in the low 20x or a misery index in the neighborhood of 10 (e.g., 6% unemployment with 4% inflation) instead of the current 5.9.  Obviously, markets are forward-looking but this data suggests that the financial markets are discounting a plethora of economic weakness.  So, to some extent, the Apple news should be seen as a confirmation rather than a new insight.

The yen: Overnight, the JPY soared in value.

(Source: Barchart)

This is a five-day chart of the yen futures (which are priced at 100 JPY per dollar).  In cash terms, the yen jumped to 105.  There is a lot of speculation about why this occurred,[2] ranging from an algorithm-driven event to perhaps related to the Apple news.  The JPY is seen as a safety asset and if fear of a global recession is increasing then it makes sense that the JPY would rally.  We note the AUD fell hard, which would tend to confirm the China story.  We have been favorable to the yen for some time; on a purchasing power parity basis, the currency should be trading around 60 yen to the dollar.  Because Japan has been a persistent current account surplus nation, it is forced to invest overseas.  However, if Japanese domestic savers become fearful, they tend to repatriate, leading to a stronger yen.  That happened last night, although some of it was likely exacerbated due to thin trading conditions.  Still, the rise in the JPY is a warning that concerns are elevated.

Paygo: “Pay as you go” is a budget policy that requires the government to make all discretionary actions budget-neutral.  Thus, if taxes are cut, spending must fall to offset the action.  This is why there are discussions about “dynamic vs. static scoring” for budget actions.  Supply side economists will argue that tax cuts stimulate the economy and boost revenue so the potential loss of revenue from a well-structured tax cut is less than the mere revenue loss measured with a static score.  In its most extreme form, tax cuts are thought to not only be revenue-neutral but perhaps even revenue-increasing.

President G.H.W. Bush implemented this policy.  It was a statutory requirement from 1990 to 2002.  His son allowed the measure to expire which permitted the 2003 tax cuts and the Medicare prescription drug expansion to be enacted.  Both widened the deficit.  After taking back the House, the Democrats made Paygo the House rule from 2007 to 2010.  However, in reality, the Paygo rules had loopholes for emergency spending and the like.  Still, they acted as a brake on spending and revenue adjustments.

There is a major battle brewing between the Left-Wing Establishment (LWE) and Left-Wing Populists (LWP) on this issue.[3]  Incoming speaker Pelosi wants to return to Paygo; her progressive wing opposes her on this measure.  The LWE wants to be the responsible “adults in the room” and use Paygo to restrain the spending measures from the LWP and further tax cuts and extensions from the GOP.  The LWP sees Paygo as an unnecessary restraint on environmental and social spending.

On its face, this is just a run of the mill fight over spending priorities.  However, there is something much more important underlying this fight.  The person to watch here is Stephanie Kelton, an economics professor at Stony Brook.  Kelton is rapidly becoming the face of Modern Monetary Theory (MMT), a heterodox theory on money and the economy.  She spent 17 years at the University of Missouri-Kansas City (UMKC) in the economics department and was the chair during her tenure.  UMKC is the center for MMT with some of its seminal thinkers on the faculty.  She was also the chief economist for the Senate Budget Committee and senior economic advisor to the Sanders campaign.[4]

We will have more to say about MMT later this year but, in a nutshell, the theory suggests that the government is the primary issuer of currency.  We use and trust our currency because it is necessary to pay taxes.  Taxes are designed, like monetary policy, to manage the economy.  Taxes are not required to fund the government; the government can fund itself at any level simply by issuing currency.  Instead, taxes, like interest rates, should be adjusted to constrain inflation and for other social goals.  So, a deficit isn’t bad but normal, and should only be reduced when the economy is overheating.  As long as slack exists in the economy and there are needs in society, the government should simply spend the money until inflation becomes a problem.

There are some caveats.  First, these rules only apply to governments that issue fiat currencies and borrow in their own currencies.  So, state and local governments, which don’t issue their own currency to pay for stuff or service their debt, cannot run deficits.  Thus, nations under a gold standard or nations with fixed exchange rates can’t use MMT.  For example, the Eurozone nations cannot use MMT (as the Greeks discovered) because they don’t borrow in a currency they issue.  Second, in practical terms, it is really hard for citizens to believe that their taxes aren’t necessary to fund the government.  If they are not necessary, why pay them?  Even if MMT is correct, the belief that taxes fund the government (which is true on a state and local level) may be a useful fiction.

However, during periods of economic stress, the government should run deficits but needs a theory that becomes the narrative to defend and explain the deficits.  During the Great Depression, Keynes offered that narrative.  In the early 1980s, when the U.S. was trying to quell inflation through high real interest rates, deregulation and globalization, there was a need for deficits to act as a safety valve for the economy.  Supply side economics offered that narrative.  Kelton’s MMT could very well be the theory that becomes the LWP’s narrative to explain how we can provide free college and health care to all without raising taxes to pay for it.  Another thought is that high marginal tax rates are not necessary to fund the government but they can act to change the behavior of business leaders.  If high salaries are mostly taxed away, CEO pay no longer acts as a “scorecard” for success and firms may be inclined to pay their workers more.

Our position has been, for some time, that the level of inequality in the U.S. was unsustainable and that a cycle of equality was coming.  But, for that cycle to develop, a narrative is necessary; MMT will likely be that narrative.  The key area to watch is the forex market.  If the LWP is victorious and deficits soar, the exchange rate market will become the arena for how markets adjust.  The first nation to go MMT will likely also have a weaker currency.  In fact, the exchange rate may become the only constraint on deficits.  As the past four decades have shown, a nation open to trade and technology disruption (which are not necessarily separable) can keep inflation under control.  But, a decline in the currency might act as a constraint.  Perhaps, under MMT, we could end up with something resembling a loose gold standard.  However, this assumes that some nation doesn’t adopt MMT and become the standard bearer, much like gold did.

So, this fight is a big deal.  If Pelosi loses it, watch Kelton and MMT.  It could become the new narrative for the equality cycle.

Oil: OPEC output is declining[5] and there are growing worries that U.S. production cannot be maintained[6] without rising investment, which is unlikely with tighter financial conditions and low oil prices.  Our position is that oil prices are well below fair value.  We would look for a recovery in the coming months.

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[1] https://www.ft.com/content/433fd028-0ed6-11e9-a3aa-118c761d2745?emailId=5c2db165ed6949000407cf16&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[2] https://www.bloomberg.com/news/articles/2019-01-02/yen-surge-algos-set-off-flash-crash-moves-in-currency-market

[3] https://www.politico.com/story/2019/01/02/house-democrats-feuding-1077467

[4] https://stephaniekelton.com/2013/06/28/biography-2/

[5] https://www.bloomberg.com/news/articles/2019-01-02/opec-output-falls-most-in-almost-two-years-as-saudis-begin-cuts

[6] https://www.wsj.com/articles/frackings-secret-problemoil-wells-arent-producing-as-much-as-forecast-11546450162