by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Back to the salt mines!  The New Year, 2019 (hard to believe, isn’t it?), is starting out with a thud as weak Chinese data has sent equities into the red.  Here is what we are watching this morning:

The Chinese data: The PMI data[1] from China came in soft, with the Caixin PMI dipping under the expansion line of 50 with a reading of 49.7 in December.  This is the first time since May 2017 that the number has fallen below 50.  The official PMI report, which came out on New Year’s Eve, was also under 50 at 49.4.  Although the equity market mostly shrugged off the earlier report, the combination of both numbers under the expansion line has clearly raised fears that the Chinese economy is slumping.  And, the usual response from policymakers, which would be strong stimulus, seems to be lacking this time.  For example, the central government is warning local governments to avoid pushing property and real estate development to boost output.[2]  Although the position of the central government makes sense (boosting apartment building would likely only bring further overcapacity and bad debt), China may be moving into the phase where it can no longer rely on investment for growth.  In other words, China may now need to get serious about boosting consumption as its engine of growth.  The problem is that (a) consumption would have to grow very fast to absorb the excess capacity, and (b) this path will have significant political consequences as it will upend the business model that has made important members of the CPC billionaires.

This chart shows China’s GDP by sector in percentage terms.  A developed economy generally has consumption around 60% to 70% of GDP.  China’s development model was based on investment and net exports, which were funded by household saving, mostly through suppression consumption.  Although this model delivers strong growth, eventually excess capacity develops as investment becomes excessive and the “safety valve” of exports becomes stretched as foreign nations rebel against the loss of market share and unemployment.  One way China could address this issue would be to shift ownership of state owned enterprises to households; the increased wealth would likely boost consumption (wealth effect) but it would deny ranking members of the CPC the avenue to power.  This is why Beijing’s decision to signal to local governments that real estate development won’t be supported is important because it indicates that investment, at least for now, won’t be the path to support growth.  Unfortunately, the Xi government hasn’t signaled how growth will be lifted.[3]

Washington unrest: There are two items of concern, the shutdown and the Right-Wing Establishment (RWE) rebellion.

Shutdown: The partial government closure has moved into 2019.  Congressional leaders are meeting with the president today.  The Democratic House leadership is preparing legislation to end the shutdown that will not include the $5.0 billion for border wall funding.  It’s hard to see how the president won’t veto the bill and McConnell has already indicated he won’t approve a House bill that the president won’t sign.  For now, the shutdown isn’t having much impact on the economy or, for that matter, the financial markets.  But, it is causing individual hardship and we would not be surprised to see national park managers begin to close their facilities because they don’t have enough personnel to secure them.  That outcome is bad publicity and will increase pressure for an agreement.

Rebellion: Before the break, we noted there was growing pushback against the president from the RWE.  The situation with General Mattis was a key element in the criticism of the White House.  The latest censure comes from the newly elected senator from Utah, Mitt Romney.[4]   The op-ed, printed in the Washington Post, is a textbook response from the RWE.  Romney applauds the president’s policy successes of cutting corporate taxes, reducing regulation, appointing conservative judges and attacking China’s unfair trade practices.  What he slams the president on is character.  As we have noted before, until January 2018, the president’s policy mix was establishment-supportive by cutting taxes and regulations.  And, the financial markets rewarded the president with a strong rally.  But, once the president moved to a serious attack on global trade, the equity markets began to stumble and are now in bear market territory.  Although the RWE would like relief on technology transfers to China, it does not support tariffs or wants to see the loss of globalization, something the president favors.  Trump has responded to Romney’s comments via Twitter[5]; as these responses usually go, this one was actually rather tame (no new nicknames for Mitt, for example).  Romney is in a position to be critical of Trump; he is a senator, meaning he doesn’t face election for another six years, and he is nearly unassailable in his home state.

There are other new critics as well.  Retired Gen. Stanley McChrystal sent a broadside against the president, calling him “dishonest, immoral.”[6]  Trump’s response was more typical.[7]  Retired Gen. David Petraeus indicated he wouldn’t serve in a Trump administration.[8]  Probably the key issue that has led to the attacks from former generals is the sudden withdrawal from Syria.  In response, the White House is slowing the withdrawal to about four months instead of weeks.[9]

The key question politically is whether Trump can win the 2020 presidential election with only the support of Right-Wing Populists (RWP).  Much of that will be determined by who the Democrats nominate.  Sen. Warren put her name on the list over the holiday.  We would expect at least 19 more to participate in the nomination process.  The conventional wisdom will be to run a Left-Wing Establishment (LWE) figure (e.g., Mayor Bloomberg, VP Biden) that would act as a “unifier.”  This temptation will be strong; the GOP faced a similar situation in 2012 and lost by nominating Mitt Romney who failed to generate enthusiasm among the RWP.  A similar move by the Democrats is possible, which would improve the odds of another term for President Trump.  On the other hand, a Left-Wing Populist (LWP) would very well leave the financial markets with no favored candidate.  That outcome would justify the current weakness in equities.

Trade with China: We think the odds favor a short-term deal with China that would offer relief to the equity markets.  Trade Representative Lighthizer appears to oppose this outcome.[10]  The problem for Trump is that if he orders Lighthizer to make a temporary agreement, the latter might walk.  Although Lighthizer’s exit would be welcomed by the equity markets, it would seriously undermine the president’s efforts to change China’s trade behavior.

Taiwan: General Secretary Xi threatened to unify the island with the PRC.[11]  Although we still view such comments as rhetoric and not a call to arms, if China decides it needs a “splendid little war” to assert its power in the region then a forcible unification of Taiwan with the mainland would be attractive.  This issue did not reach a level to make our 2019 Geopolitical Outlook[12] list; however, it may reach this status by mid-year.

Italian banks:The ECB has appointed temporary administrators[13] to Banca Carige (CRG-IT, EUR .0015).[14]  Although the Italian government mostly caved to EU demands on its budget, the problems with Italian banking have not been resolved and could still trigger a problem in the Eurozone.

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[1] https://www.ft.com/content/6880779c-0e46-11e9-a3aa-118c761d2745

[2] https://www.reuters.com/article/us-china-property/china-warns-cities-to-cut-reliance-on-property-developers-shares-fall-idUSKCN1OW031

[3] https://www.scmp.com/tech/article/2180362/baidu-ceo-warns-winter-coming-amid-slowing-growth-economic-restructuring

[4] https://www.washingtonpost.com/opinions/mitt-romney-the-president-shapes-the-public-character-of-the-nation-trumps-character-falls-short/2019/01/01/37a3c8c2-0d1a-11e9-8938-5898adc28fa2_story.html?utm_term=.1d57684ca1f7

[5] https://www.cnn.com/2019/01/02/politics/donald-trump-mitt-romney-oped/index.html

[6] https://www.nbcnews.com/politics/donald-trump/retired-four-star-gen-stanley-mcchrystal-says-trump-dishonest-immoral-n953076

[7] https://deadline.com/2019/01/donald-trump-tweetstorm-new-years-nancy-pelosi-stanley-mccrystal-jair-bolsonaro-1202527771/

[8] https://thehill.com/homenews/administration/423311-david-petraeus-suggests-he-wouldnt-serve-in-trump-administration

[9] https://www.nytimes.com/2018/12/31/us/politics/trump-troop-withdrawal-syria-months.html

[10] https://www.nytimes.com/2019/01/01/us/politics/robert-lighthizer-president-trump.html?action=click&module=Top%20Stories&pgtype=Homepage

[11] https://www.reuters.com/article/us-china-taiwan/chinas-xi-threatens-taiwan-with-force-but-also-seeks-peaceful-reunification-idUSKCN1OW04K

[12] See WGR, The 2019 Geopolitical Outlook (12/17/18).

[13] https://www.cnbc.com/2019/01/02/italys-watchdog-reportedly-suspends-trading-in-carige-shares.html

[14] https://www.cnbc.com/quotes/?symbol=CRG-IT

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] 

[N.B.  The Daily Comment will go on holiday from December 24 to January 2.  From all of us at Confluence, but especially Thomas and me, thanks for reading and have a Merry Christmas and Happy New Year!]

On Friday, December 14, we published our 2019 Outlook: Red Sky at Morning report.  If you missed it, you can find the report linked here or on our website.

Happy Winter Solstice!  It’s another risk-off day—Washington unrest is the catalyst.  Here is what we are watching this morning:

Washington unrest: Although spending any time watching cable news could lead one to think that Washington is always in crisis, what is going on now is actually chaotic.  Here is the rundown:

Shutdown: It appeared the White House and Congress had a deal.  In fact, a large number of senators headed home after voting for a spending bill, thinking the issue was resolved.  The president, however, changed his mind and demanded border wall funding.  The House did vote for the measure but it has no chance in the Senate.  And so, we are heading into a partial shutdown.  Usually, financial markets pay little mind when we have a shutdown outside of a debt ceiling issue.  However, the sudden shift from an agreement to no deal has undermined investor confidence, which is already fragile.  The president indicated that the shutdown could last a long time; that outcome could eventually start delaying data releases, which would further unsettle conditions (imagine no employment data for a month, or relying on the API for energy data).

Mattis: General Mattis was the last constituent of the “committee to save America,”[1] members of the administration representing the establishment who saw themselves as the primary barrier preventing the president’s populist instincts from running rampant.  Since the president’s election, we have noted the continued battle between the establishment and the populists within his administration.  The establishment pushes for business and market-friendly policies, such as tax cuts and deregulation.  It opposes the populist goal of deglobalization, which includes trade impediments and immigration restrictions.  The president has tended to straddle these divisions; the establishment has clearly benefited from tax cuts and deregulation, but the populists cheer the tariffs, tough talk on the border and anti-immigration stance of the White House.

In terms of foreign policy, populists want to reduce the American superpower role while the establishment supports continued American hegemony.  That means continuing to freeze the three conflict zones,[2] which include the Middle East.  This policy goal has been coming under pressure well before Trump took office.  The Middle East became unstable after Bush removed Saddam Hussein from power and led Iraq into civil war.  President Obama’s support for the Arab Spring led to civil conflict in Syria.  The decision not to enforce the “red line” against Assad for using chemical weapons further weakened the U.S. position in the region.  The power vacuum led to the rise of IS and prompted the U.S. to insert troops in the region to weaken this group.  Russia has reasserted itself in the region.  Iran is attempting to expand its influence.  Saudi Arabia has been courting the U.S. to undermine the Obama-era policy of normalizing relations with Iran.

So, it’s not like President Trump inherited a well-functioning policy.  However, removing U.S. troops from Syria ensures the U.S. will have even less influence in the region.[3]  Secretary Mattis opposed removing the troops, but the president exercised his prerogative and ordered the withdrawal of the 2,000 American troops in the area.  Mattis apparently saw this as his red line and resigned.  And, he didn’t just resign—his exit letter lacked any of the usual expressions of gratitude to the president and instead offered a stinging rebuke.[4]  In the letter, Mattis defended the Liberal World Order of free trade and support for allies—in other words, the policy the U.S. has followed since the end of WWII.  Essentially, Mattis is indicating that, in his view, the president doesn’t support that policy, while Mattis does, and it is probably better for the president to have a defense secretary who has views consistent with his own.[5]  Already, U.S. allies are viewing the resignation with trepidation.[6]

This exit isn’t just the normal flow in and out of an administration.  Mattis is signaling to the GOP establishment that Trump is turning populist and the members of the establishment have to start considering their options.  And, we are seeing some pushback.  Sen. Ben Sasse, who has been critical of the president, was critical on this issue, too.[7]  Sen. Lindsey Graham, who has had an on and off relationship with the president, is in a full-on Twitter feud with the White House.[8]  However, perhaps the most unexpected response came from Sen. Mitch McConnell, who has generally been supportive of the president; he was actually rather critical of the decision that led Mattis to resign.[9]  Mattis represented, to some degree, a member of the administration that the establishment could look to for comfort.  That is now gone.

We will be watching how far this establishment rebellion goes.  Already we are seeing Sen. Grassley push back on steel and aluminum tariffs as part of USMCA.[10]  The shutdown will likely anger Senate Republicans.  At the same time, the president seems to be moving into an increasingly populist stance this year.  The trade conflict began in earnest in February.  The removal of troops is classic Jacksonian policy, who like to fight wars with overwhelming force and clear endings.  The president is planning on drawing down troops in Afghanistan,[11] likely opening up the country for the return of the Taliban.

Our view is that President Trump has been attempting to placate both the populists and the establishment but he is steadily being forced to choose.  If he decides to go populist, he will lose support in the Senate which may hurt him if impeachment occurs.  At the same time, his victory was mostly due to populist support.  The president has a difficult political path to hew.  It may be difficult to pull off.  But, the more he leans populist the greater the risk to equity markets.  It would make sense to delay this conflict as long as possible but it appears that option may not be available.  Thus, we will continue to closely watch how this situation evolves.

China: The U.S. has accused two Chinese nationals of a series of cyberattacks on the U.S.[12]  Other nations have made similar accusations.  So far, the U.S. and China have kept trade talks separate from security issues.  But, that condition may not last.  China has announced further measures to boost the economy, which has slowed due to earlier deleveraging and trade issues.[13]  Although China has been buying more American soybeans, thus far it has not purchased U.S. crude oil.[14]  That fact has likely added to recent crude oil weakness.

Brexit: According to reports, PM May is building options in case her Brexit proposal fails.  This may include delaying the exit,[15] a new referendum or new elections.[16]  Given that deadlines didn’t improve the chances of her plan, it probably makes sense to consider other options.  We still expect another referendum with the increased chance that Brexit may be rescinded.

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[1] https://www.axios.com/the-committee-to-save-america-1513304754-2e4002e8-5720-422a-a668-8db4210785fb.html

[2] For a more in-depth discussion, see our WGR, The Mid-Year Geopolitical Outlook (6/25/18).

[3] https://www.nytimes.com/2018/12/20/world/middleeast/syria-us-withdrawal-iran.html?emc=edit_mbe_20181221&nl=morning-briefing-europe&nlid=567726720181221&te=1

[4] https://www.politico.com/story/2018/12/20/mattis-to-retire-in-february-trump-says-1072150

[5] https://www.bloomberg.com/opinion/articles/2018-12-21/mattis-resigns-and-puts-trump-s-presidency-in-peril?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[6] https://www.nytimes.com/2018/12/20/world/asia/mattis-resign-afghanistan-withdrawal-trump.html?emc=edit_mbe_20181221&nl=morning-briefing-europe&nlid=567726720181221&te=1

[7] https://www.sasse.senate.gov/public/index.cfm/press-releases?ID=A6A8DA56-49E5-44B3-8E76-25CD20A2D182&utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[8] https://www.postandcourier.com/politics/lindsey-graham-and-president-trump-are-feuding-on-twitter-and/article_a1e66484-0490-11e9-baee-df7f0ecc2475.html

[9]https://twitter.com/senatemajldr?ref_src=twsrc%5Egoogle%7Ctwcamp%5Eserp%7Ctwgr%5Eauthor&utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[10] https://www.axios.com/chuck-grassley-trump-tariffs-section-232-national-security-613bb759-acac-4a36-9703-9a2ee1958f28.html

[11] https://www.nytimes.com/2018/12/20/us/politics/afghanistan-troop-withdrawal.html?emc=edit_mbe_20181221&nl=morning-briefing-europe&nlid=567726720181221&te=1

[12] https://www.nytimes.com/2018/12/20/us/politics/us-and-other-nations-to-announce-china-crackdown.html?emc=edit_mbe_20181221&nl=morning-briefing-europe&nlid=567726720181221&te=1 and https://www.ft.com/content/f5f0b42c-046c-11e9-99df-6183d3002ee1?emailId=5c1c6e9b0e56a1000466bc18&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[13] https://www.bloomberg.com/news/articles/2018-12-21/china-says-more-tax-cuts-coming-signals-easier-monetary-policy?utm_source=google&utm_medium=bd&cmpId=google

[14] https://www.reuters.com/article/us-usa-trade-china-oil/crude-refusal-china-shuns-u-s-oil-despite-trade-war-truce-idUSKCN1OK0FG

[15] https://www.ft.com/content/e8d70ba8-03a7-11e9-99df-6183d3002ee1?emailId=5c1c6e9b0e56a1000466bc18&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[16] https://www.bloomberg.com/news/articles/2018-12-20/u-k-s-may-is-hatching-secret-brexit-plan-b-to-avoid-armageddon

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] 

[N.B.  The Daily Comment will go on holiday from December 24 to January 2.  From all of us at Confluence, but especially Thomas and me, thanks for reading and have a Merry Christmas and Happy New Year!]

On Friday, December 14, we published our 2019 Outlook: Red Sky at Morning report.  If you missed it, you can find the report linked here or on our website.

There isn’t a whole lot going on this morning; most of the market commentary is a post mortem on the Fed.  We offer our views on the U.S. central bank below.  Equity markets are trying to rally this morning but oil prices are testing recent lows.  Here are the updates:

The Fed: Yesterday, we offered four outcomes from the Fed meeting.  Essentially, the FOMC split the difference between outcomes #3 and #4.  To recap, #3 was a hike with a clear signal of no further increases, while #4 was no change in the previous policy path.  What we actually got was a hike with a reduction in the path forward.

The yellow dots show yesterday’s meeting, while the gray dots show the meeting from September, the last time we had a dots plot.  The lines show the median rate path.  Note that there has been a cut of about 25 bps in the path for next year and 2020.  The statement had few changes, with the most significant being an acknowledgement of monitoring global and financial market conditions.  The economic projections were mostly unchanged; there was a modest increase in forecast GDP growth for next year to 2.5% from September’s 2.3%, while core PCE is expected at 2.0%, down from 2.1% in September.

Clearly, financial markets were disappointed.  The yield curve (2yr/10yr Treasury) flattened further.

The spread narrowed to just over 11 bps.  Equity markets fell; the decline from peak to yesterday’s low has now reached about 15.4%.  In general, a correction is 10% and a bear market occurs at 20%.  The latter is usually associated with recession.  Sentiment indicators are reaching levels that usually signal a washout.  If recession is avoided, the chances are elevated for a rally in equities.

At the same time, financial markets were clearly disappointed.  The Fed is dealing with what has been called the “Tinbergen dilemma,” named for the economist Jan Tinbergen, who first described it.  The dilemma describes when a policymaker faces two policy problems but only has one policy tool.  It is sometimes described as “trying to shoot two bad guys with one bullet.”  The Tinbergen dilemma can only be resolved if the two policy problems can be fixed by the same solution.  The Fed is facing an economy that is still rather strong (though momentum is clearly weakening), which supports tighter policy, and financial markets that are signaling increasing stress, which begs for easing.  What has the financial markets so upset is that there is evidence that, in the past, the Fed has tended to placate the financial markets when facing a similar Tinbergen dilemma.

This chart shows the fed funds target with the yearly change in the S&P 500.  When the yearly growth in the S&P becomes negative, the Fed has tended to take notice.  Perhaps the clearest evidence of the Fed favoring financial markets was in 2000-04 when the Greenspan Fed kept cutting rates to what were historic lows at the time, even though the economy was recovering.

This chart shows the yearly change in real GDP.  Greenspan didn’t start raising rates even with GDP growth exceeding 4% in 2003, most likely due to continued weakness in equities.  In 2016, Yellen paused on rates as equities fell, but the economy has softened, too.

Essentially, financial markets have become accustomed to being favored when the aforementioned Tinbergen dilemma exists.  Powell is trying to weave a path that addresses both but, in reality, it looks like the Fed is more concerned about the economy overheating than it is about a weak stock market or a flattening yield curve.  This position increases the likelihood of a policy mistake, one of our four potential threats to the expansion we discussed in our 2019 Outlook.

So, what happens now?  Equity market valuations are improving and sentiment is becoming increasingly negative.  Both tend to favor a bounce at some point.  The proverbial “Santa Claus Rally” probably won’t happen this year, but we would expect a January bounce.

U.S. out of Syria: President Trump announced that the 2,000 U.S. troops in Syria will be leaving very soon.  The foreign policy and military establishment[1] is horrified at the prospect of having no influence in this part of the world.  The winners in this decision are Iran, Russia, Turkey and Assad.  The losers are Israel (due to the improvement in Iran’s position), Europe (will likely see a rise in refugees) and the Kurds.  The Kurds are especially harmed; they have supported U.S. efforts in this part of the world since the early 1990s when the U.S. began protecting northern Iraq with a no-fly zone.  However, now they will be subject to the tender mercies of President Erdogan.  The reaction from Washington is actually rather interesting; populists are applauding the president.  Even some former Obama officials are supporting Trump.  Meanwhile, establishment figures on both sides of the aisle oppose the move.[2]

What are the ramifications?  We will likely see the powers in the region turn on each other.  Iran will try to maintain its “Shiite arc” from Tehran to Beirut, while Turkey will attempt to contain the Kurds.  There will be conflict points between these two.  Israel will try to prevent Iran from projecting power.  Russia will likely try to manage the parties but we would not be surprised to see Moscow caught in a trap of maintaining peace.  Meanwhile, the likely chaos will help Islamic State revive.  Iraq will also be threatened by the ensuing conflict.  The problem for the U.S. is that the commitment is never-ending.  Trump, like a true Jacksonian, sees no reason why the U.S. should concern itself with the region.  The consequence is that the region will likely descend into chaos.

At the same time, it is important to remember that the last three presidents have struggled to craft a working policy for the Middle East.  President Bush made a critical error by removing Saddam Hussein from power without being able to replace him, creating a power vacuum in the region that still hasn’t been filled.  President Obama tried to extricate the U.S. from the region by putting Iran in charge; although a defensible policy, it was far from ideal.  President Trump reversed the Obama-era Iran policy but found that none of the other parties in the region can stabilize it.  It appears that U.S. policy is now to allow the chips to fall where they may.  This policy will allow one of the three frozen conflict zones to thaw; how this works out is anyone’s guess but we doubt it will be smooth.  The primary market beneficiary will likely be oil.

Energy update: Crude oil inventories fell 0.5 mb last week compared to the forecast decline of 3.3 mb.

In the details, estimated U.S. production was unchanged at 11.6 mbpd.  Crude oil imports and exports were essentially unchanged, while refinery runs rose a modest 0.4 mbpd.

The seasonal chart suggests the usual easing of inventory accumulation into year’s end is underway.  Inventories usually decline into the new year.

Based on oil inventories alone, fair value for crude oil is $60.35.  Based on the EUR, fair value is $54.30.  Using both independent variables, a more complete way of looking at the data, fair value is $55.70.  By all measures, current oil prices are undervalued.  Although fears of a weaker global economy do play a role in price weakness, it appears that even modest action by OPEC to restrict output should lift prices to the mid-$50s in the coming weeks.

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[1] https://www.washingtonpost.com/opinions/2018/12/19/trump-undermines-his-entire-national-security-team-syria/?noredirect=on&utm_term=.9cf4f85a3cda&wpisrc=nl_todayworld&wpmm=1

[2] https://www.axios.com/trump-syria-troops-withdrawal-isis-6ccb1c80-b702-4ae0-8087-546830c02158.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] 

[N.B.  The Daily Comment will go on holiday from December 24 to January 2.  From all of us at Confluence, but especially Thomas and me, thanks for reading and have a Merry Christmas and Happy New Year!]

BREAKING NEWS: The U.S. is preparing to make an immediate and full withdrawal of troops from Syria.  We will discuss the ramifications in tomorrow’s comment.

On Friday, December 14, we published our 2019 Outlook: Red Sky at Morning report.  If you missed it, you can find the report linked here or on our website.

It’s Fed day!  Equity markets are trying to rally this morning and oil prices are steady despite bearish API data.  Here is what we are watching today:

The Fed: There are four likely outcomes from today’s meeting.  Here is the lineup:

1. The Fed hikes rates but signals a slowdown of the balance sheet reductions (most bullish for equities).  Although the impact of the balance sheet remains in debate, market participants have begun to focus on the balance sheet and suggest it is tightening conditions more than expected.  Here is why that idea is gaining traction—QE created a massive amount of excess reserves in the banking system.  When the reserves were injected into the banking system, in reality, it was an asset swap.  Banks gave up loans, commercial paper, bonds, etc., for cash.  The cash stayed on balance sheets.  But, to keep control of those reserves, the Fed started paying interest on reserves, something it hadn’t done in the past.  The fed funds target used to be a single rate but in the wake of QE it is now a 25 bps range; that “rate” we talk about is really the upper bound.  Thus, actual fed funds trade in a range between the upper and lower limit.  However, as the chart below shows, the fed funds rate has been remarkably sticky at the upper end of the rate, so much so that the Fed has put a ceiling on the interest on reserves at 5 bps below the upper limit of fed funds.  And, interestingly enough, the rate has been staying very close to that ceiling.  This seems to show that there is some scarcity of reserves in the system, meaning banks would prefer to hold more reserves, perhaps for regulatory purposes or as a reaction to 2008, and thus are demanding the highest rate allowed.  This has led some analysts to argue that the balance sheet reduction is “biting” much sooner than expected.  However, it could also reflect a structural imbalance in the system, where large banks are awash in reserves but smaller banks are not and thus the larger banks are able to demand the highest rate on reserves.   Therefore, a slowdown in “quantitative tightening” (QT) would be seen as very bullish.

1. The Fed hikes and signals the cycle has ended (very bullish for equities).  This doesn’t end the tightening, as the balance sheet would continue to contract, but it would be a clear signal that the Fed is trying to engineer a soft landing.  This outcome is consistent with only one of the Mankiw Rule variations, the one using the employment/population ratio.
2. The Fed hikes and signals a pause, but still shows at least one hike in 2019 (neutral to bullish for equities).  This is the most likely outcome and is consistent with the uncertainty surrounding the neutral rate.
3. The Fed hikes and signals no real change in policy path (bearish for equities).  This outcome would essentially ignore warning signs from the financial markets and focus solely on the economy.

The highest probability outcome is #3, although we would not discount a fairly high probability of #2.  Here’s why:

The chart on the left shows the implied three-month LIBOR rate, two-years deferred, from the Eurodollar futures market.  Note how the rate has fallen sharply since peaking in late October (around the time Chair Powell said we were “a long way from neutral”).  The chart on the right shows that this rate tends to act as a policy marker.[1]  When the fed funds target is higher than the implied LIBOR rate shown on the right, the Fed tends to stop raising rates.  Alan Greenspan was able to extend the 1991-2001 expansion by deftly adjusting to this implied LIBOR rate (there is no evidence that he actually used this rate in setting policy, but it is uncanny how close it was followed).  The spread has narrowed from 125 bps in late September to 29 bps now, implying one hike after today.  And, the implied LIBOR rate is falling rapidly, which could mean even that rate might be scuttled.  The above chart should signal to the FOMC that they are close enough to neutral so as to pause.

So, stay tuned…

Italy makes a deal:Italy has come to a deal with the EU, averting the potential for a crisis.[2]  This agreement reduces the odds of an immediate crisis but the underlying issues have not been resolved.  Thus, we will revisit this issue again.  But, for now, this is good news.

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[1] We have assumed a 25 bps rate hike today in the spread calculation.

[2] https://www.ft.com/content/ca7a713e-037c-11e9-9d01-cd4d49afbbe3

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] On Friday, December 14, we published our 2019 Outlook: Red Sky at Morning report.  If you missed it, you can find the report linked here or on our website.

U.S. equity futures are lifting this morning after another hard decline yesterday.  Oil prices are falling, with WTI trading under $50 per barrel.  Here are the details:

Equities (again!): We are seeing a bit of a bounce this morning but there are no guarantees it will hold.  The pattern for the past six weeks has been that rallies have mostly failed; investors appear to be using every rally to reduce equity exposure.  As we showed in yesterday’s comment, retail investors have been rapidly building cash levels.  We see two immediate worries—a policy error by the FOMC and a trade war.  Although the first worry is legitimate, it does appear the FOMC is aware of its situation and is likely to signal a pause in its policy path after a rate hike tomorrow.  There has been much focus recently on the balance sheet reduction.  Our position has been that the primary impact of the balance sheet expansion was psychological.  It signaled that the central bank was not out of policy tools even at the zero bound of interest rates.  But, most of the expanded balance sheet went to banks in the form of excess reserves.  Withdrawing those reserves shouldn’t have much actual impact.  Still, if the FOMC signals any slowing of the balance sheet contraction, it would be taken as a bullish signal.

The second issue is a serious concern as well.  The trade war with China is a symptom of the much larger trend of deglobalization.  To a great extent, the rise of populism is a visceral reaction against global integration in all its forms, including trade, immigration and social relations.  Although understandable, the problem is that globalization was a key component of inflation suppression.  If the world moves away from economic integration, inefficiency will rise and inflation will as well.  Rising inflation may be a cost that the majority of citizens in the West are willing to pay for regaining control over their lives but, over time, the cost will prove to be substantial.

However, in the short run, we expect a truce of sorts on deglobalization.  President Trump would likely prefer reelection (presidents rarely turn down the chance for a second term), so making peace with China for the next year makes sense.

Given the degree of weakness seen in equities, we would expect a recovery in the next few weeks.  As the money market chart from yesterday showed, the lift could be rather robust if sentiment shifts.  Overall, the U.S. economy is doing fine; we look for slower growth in 2019 but no recession appears likely.  The world economy is sluggish and that issue probably remains next year.

China: China is celebrating its 40^th anniversary of market reforms started by Deng.  In a speech[1] at the meeting, Xi pressed the centrality of the Communist Party of China (CPC), giving no indication of any relaxation of policy to expand market reforms.  The CPC under Xi will maintain control even as the economy slows; reports suggest the growth target for 2019 will be between 6.0% and 6.5%, down from the current target for this year of “around 6.5%.”  There was hope Xi would unveil economic stimulus.  It wasn’t mentioned in the speech, suggesting China won’t take steps to boost the economy over current measures.

Crude oil: Oil prices have come under further pressure.  We suspect three issues are weighing on prices.  First, U.S. oil production continues to rise.

U.S. oil production is now up to 11.6 mbpd.  Although the recent drop in oil prices will eventually lead to reduced output, the process will take a while.  In recent years, there is about a 10-month lag between price changes and changes in production.  Thus, the recent drop in prices will tend to affect production in the summer of 2019.  Second, worries about demand are surfacing due to weakness in the global economy.[2]  China’s lack of new stimulus, noted above, adds to this concern.  Third, oil is considered a risk asset; as equities decline, oil prices have been similarly affected.

On the other hand, the U.S. isn’t the only producer in the world.  OPEC is cutting output and Russia has indicated it will reduce output, too.[3]  Global growth is a worry but if the U.S. avoids recession, as we expect, then demand should not fall precipitously.  Finally, oil prices should participate if risk assets rally.  Based on inventories and the dollar, oil prices should be in the mid-$50s at a minimum.  Therefore, we view the drop in oil prices as overdone and a recovery in the coming weeks is likely.

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[1] https://www.cnbc.com/2018/12/18/amid-trade-war-xi-jinping-says-china-must-stay-the-course-on-reform.html

[2] https://www.ft.com/content/85ad16fe-0284-11e9-99df-6183d3002ee1

[3] https://finance.yahoo.com/news/russia-signals-oil-output-decline-2019-10-years-084212503.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] On Friday, December 14, we published our 2019 Outlook: Red Sky at Morning report.  If you missed it, you can find the report linked here or on our website.

The big event this week is the FOMC meeting that ends on Wednesday.  Equity markets continue to face pressure.  Here are the details:

FOMC preview: There is great anticipation for Wednesday’s meeting.  Financial markets are hoping for some indication that the Fed will pause after this hike and perhaps signal that it is closer to ending this tightening cycle.  We note this morning that a former Fed governor and a prominent hedge fund manager are begging calling for the U.S. central bank to not only stop raising rates but to end balance sheet reduction as well.[1]

We do expect the FOMC will signal a potential pause by emphasizing its decisions are “data dependent” and will downplay forward guidance.  Of course, that will make explaining the dots chart difficult.  On that item, we would expect the FOMC to signal only two hikes next year.

This chart shows fed funds against the implied three-month LIBOR rate from the two-year deferred contract in the Eurodollar futures market.  In general, the Fed has tended to end tightening cycles when the two rates invert.  We are assuming a 25 bps hike on Wednesday.  This hike, coupled with a recent contraction in the implied rate, has led to a sharp narrowing of the spread.  This chart would still imply two more rate increases of 25 bps next year.  At the same time, it does indicate we are rapidly coming to the end of this tightening cycle.  It’s also interesting to note that Yellen paused when the spread reached this level in 2016.

Next month we will have a new set of voting members for the FOMC.

This is from our analysis of the various members of the FOMC; we rate them 1-5, with 1 being most hawkish and 5 most dovish.  Governors are on top and always vote.  We assume the governors will be a bit more dovish next year with the addition of Bowman.  The average estimate for this year was 2.78 (anything < 3 leans hawkish); therefore, next year, we are looking for a modestly easier voting mix.  The mix of Bullard and George will likely be an offset and they will mostly cancel each other out.  Although Evans has traditionally been a dove, he has been calling for tighter policy recently to reduce financial speculation.  Thus, he may be more hawkish than we are characterizing him.  On the other hand, the flattening of the yield curve may have eased his concerns about excessive “froth” in the financial markets.

Overall, we expect the FOMC to follow expectations—look for a hike with a mostly dovish statement and press conference.  If this doesn’t happen, we could see further weakness in the equity markets.

Equity markets: The S&P 500 has dipped back into correction territory as liquidation continues.  Friday’s weakness didn’t have any particular catalyst; it was sort of a “Seinfeld” market.[2]  There are rising worries about the economy and it is clear that international economies are coming under pressure.  But, none of this is new; what has clearly changed is investor sentiment.

The blue line on the chart shows the level of cash held in retail money market funds, while the red line shows the S&P 500 (weekly close).  The gray area shows the Great Recession; the orange areas show when retail money market funds fell below $920 bn.  In this bull market, we note that when money market funds have fallen below $920 bn, the equity markets have tended to stall.  It’s a bit like the equity markets ran out of liquidity and had to rebuild cash levels before making another advance.  In 2007, and now, we saw a similar increase in money market funds.  There is clearly an increasing preference for liquidity which is, in part, coming out of equities.

It is important to note that money market funds exceeded $1.3 trillion in 2008 and equities, though under pressure, were not in a free fall.  From the peak to mid-summer, the S&P was off around 20%, a bear market but not a crash.  And, we were in recession.[3]  The real downdraft for equities occurred after the Lehman failure that exposed problems in the money market funds and in the derivative markets.

So, what does this chart tell us?  First, the rapid accumulation of cash is important as it shows households are clearly worried about the future and want to hold more liquidity.  Second, in 2007, when we saw a similar rise in liquidity, economic conditions were markedly worse.  The housing market was imploding from a wildly overleveraged level.  As the chart below shows, homeowners’ equity in their houses had fallen to 47% by the onset of the recession in Q4 2007; it is currently at 60%, which is essentially normal.  And, as we noted above, there was clear evidence that a recession was underway.

It is important for investors to remember that the 2008 bear market was really a two-part event.  The first was the 20% pullback driven by a “garden variety” recession; the second leg, which led to the full 40%+ decline, was a financial crisis.  It is not unreasonable to fear another financial crisis but the odds are not all that high.  Yes, there are areas of concern.  Private equity has become rather frothy, for example.  But, one of the major factors that led to the collapse in 2008 was the undermining of the money market funds.  When important funds “broke the buck,” it led to panic.  Although one can never say that such an event isn’t possible again, these events are rare and we don’t think it is in the cards.

Third, if a recession is avoided, the level of money market funds suggests ample liquidity and the potential for a strong equity recovery.  Avoiding recession will take some luck and skill.  The Fed will need to engineer that rarest of outcomes, the “soft landing.”  Although one could argue that the Fed has made four soft landings in the past 60 years, in reality, it has only occurred twice as two of these events were due to exogenous factors.  One occurred when the Fed lowered rates during Nixon’s wage/price freeze and the other occurred when the Fed dropped rates in 1985 when oil prices rolled over.  Still, if the Fed does become data dependent going forward, the odds of a soft landing improve.  The other issue is trade.  Recession odds increase if the administration maintains a hard line on trade with China.  Although we think that U.S. policy toward China is now hostile, we would not be shocked to see the administration go soft in 2019 to improve the odds of Trump’s reelection.

So, this is where we are.  We are seeing a high degree of caution from investors, in part due to memories of 2007-09.  This fear is completely understandable.  However, it is important to note that conditions are quite different from that period and thus worries may be excessive.  If we avoid recession in 2019, a rally in the S&P into the 2950/3000 area is reasonable.

Brexit: PM May is facing pressure to test different versions of Brexit in Parliament to see what will pass.[4]  These could include a hard Brexit and a second referendum.  May isn’t keen on the idea.  First, a version of Brexit that would be acceptable to the MPs probably won’t pass the EU.  Second, another referendum is fraught with risk.  How the choices are listed on the ballot could swing the vote in unexpected ways.  May has staked her political future on either the deal she negotiated or chaos.  Thus, she is fighting against other deals.  In reality, her plan won’t pass Parliament and the MPs likely believe that the EU will blink if faced with the choice between another plan more acceptable to the U.K. or a hard Brexit.  That’s probably a mistake but this seems to be where we are heading…at least for today.

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[1] https://www.wsj.com/articles/quantitative-tightening-not-now-11544991760 It is worth noting that Mr. Warsh’s policy stance used to be much more hawkish: https://www.cnbc.com/2017/10/03/kevin-warsh-would-take-a-hammer-to-the-fed-but-he-wouldnt-break-it.html

[2] https://www.youtube.com/watch?v=jUWiv5r_CZw

[3] Although, to be fair, the recession issue was a raging debate at the time.  There were a number of economists who disputed the claim and in the August 2008 FOMC meeting transcripts policymakers were leaning toward starting rate hikes in the autumn, fearing they had overreacted to the problems in financial markets earlier in the year.  It should be noted, however, that most of our indicators were in recession territory; for example, the Chicago National Activity Index, even on a six-month average, signaled recession by January 2008 and the unemployment rate compared to its rate two years earlier had inverted by December 2007.

[4] https://www.ft.com/content/8e240890-0119-11e9-99df-6183d3002ee1