by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. equity futures are roughly flat, giving up most of their overnight gains.  Asia was higher on hopes of Chinese stimulus, but the big news is that today is Brexit Day.  Here is what we are watching this morning:

Brexit: So, it all comes down to this.[1]  A vote on PM May’s Brexit plan is scheduled for 7:00 GMT, (which is 2:00 EST).  The only real question is how badly will the measure fail?  We note that MP Gareth Johnson, an assistant whip,[2] resigned from government, the 13^th member of May’s government to resign over Brexit.  The loss could be colossal, perhaps by more than 200 votes.  After the loss, we expect two things to occur.  First, May will have three days to come up with a “Plan B.”  Second, Labour leader Corbyn is expected to call for a no-confidence vote.  We have no idea what a Plan B will look like; we expect the MPs to offer tons of new amendments to the plan that May proposed but, since there is no consensus on what Brexit should look like, it seems unlikely that the House of Commons will draft a plan.  Thus, in three days, look for the government to ask for an extension of the March 29 deadline.  Corbyn’s bid to bring down the government will be interesting to watch.  Although May isn’t popular, the Tories loathe Corbyn and we suspect they will coalesce around May to prevent her loss.

Financial markets continue to lean toward some sort of resolution that avoids a hard Brexit.  Although that is the desired outcome by nearly everyone involved, there is no obvious plan to achieve this goal.  The fear is that, in the absence of a plan to go forward, Britain and the EU will stumble into a hard break that would be expected to crush the U.K. economy and the GBP.  Since neither side wants this outcome, the most likely result of all this is a delay.  That’s why the currency is holding up.  But, the risks of an unwanted hard Brexit are rising.

China: Bank lending for December came in a bit better than expected, rising CNY 1.08 trillion ($198 bn).  However, given the drop in reserve requirements, this level of loan growth won’t keep growth at the 6% level.  The Chinese government announced plans for tax cuts and other stimulus measures.[3]  Hopes surrounding those measures sent Asian equities higher overnight.  However, for growth to be sustainable, more of it needs to come from the household sector and less from investment.  We believe the most effective measures China could implement in support of consumption growth would be to extend the social safety net, including health care and pensions.  Both actions would reduce households’ incentives to save.  However, it would also deprive the powerful members of the Chinese Communist Party cheap money for investment.  Thus, aggressive action that would be effective in restructuring the economy isn’t likely.

China and Canada: China has issued a death sentence for Robert Schellenberg,[4] a Canadian citizen living in China.  He was arrested on a drug trafficking charge.  Ottawa strongly suspects that China is arresting Canadians in response to Canada’s arrest of Meng Wanzhou of Huawei.  Tensions between the two countries remain elevated with no obvious path to easing short of releasing Meng, who awaits extradition to the U.S. on sanctions-busting charges.

Shutdown issues: TSA absences are increasing rapidly, now representing 7.6% of the workforce, more than double normal levels.[5]  So far, the system is dealing with the security issues but if the absences increase, which appears likely, it will eventually affect the air transportation system.  There is no sign of budging from either side.

Iran oil: The State Department indicated yesterday that the Trump administration is not planning to issue further oil export waivers.[6]  If they stick to that position, Iranian oil exports will be further curtailed by the end of May.  Although we would not expect Iranian oil exports to fall to zero, they will decline from current levels.

Iranian populism?  U.S. sanctions have hurt the Iranian economy.  Interestingly enough, we are hearing reports of a backlash against the well-connected wealthy in Iran.  The ones catching most of the flack are the young of those connected to the government who have a habit of flaunting their lifestyles on social media (sound familiar?).[7]  What makes this trend dangerous for the ruling class is that they are pushing policies that have led to American sanctions and are calling for shared sacrifice in response.  If it isn’t seen as shared, they could face civil unrest.

Oil sales to China: The U.S. is exporting oil to China, likely part of the trade talks currently underway.[8]  Three cargos departed from the Gulf of Mexico on their way to China, the first oil sale in three months between the two countries.  We suspect this news lifted oil futures this morning.

Trump versus the Wilsonians: As we noted yesterday, Trump tends to be best characterized by the Jacksonian archetype.[9]  However, most members of his foreign policy staff have tended to be either Hamiltonians (the early “generals”) or Wilsonians.  His current staff, Pompeo and Bolton, are clearly in the Wilsonian camp.  Wilsonians tend to have a moralistic view of foreign policy, seeing the world in terms of “good and evil,” unlike the Hamiltonians, who tend to view the world through the veil of “interests.”  Both groups have been attempting to prevent Trump from exercising his Jacksonian tendencies; Jacksonians are essentially isolationists who are driven to intervene globally on issues of “honor.”  Thus, President Trump sees no disconnect between firing cruise missiles against Assad and pulling troops from Syria.  Assad besmirched America’s honor by using chemical weapons after being told not to, but Trump has no interest in being tied up in the Middle East indefinitely.  Today, we are seeing reports that Trump was considering pulling out of NATO.[10]  Both the “generals” and the “Wilsonians” have been trying to corral the president from this action.  The paper of record, the NYT, frames the news as a “gift to Russia,” putting it in the narrative that Trump is favoring Putin.  Perhaps.  Our view is that the biggest risk to pulling out of NATO isn’t the risk of Russian influence on Europe, it’s that the “German Problem” will return, a conflict zone that was frozen by the U.S.  In other words, the real risk is the remilitarization of Germany and a return to the world of 1870-1945.

It’s worth noting that SOS Pompeo made pointed criticisms of President Obama’s policies in the Middle East during a speech in Egypt.  In our opinion, Obama was a Jeffersonian, the most isolationist of the four archetypes.  However, the primary difference between the Jacksonians and the Jeffersonians is the concept of honor.  In practice, both want to retreat from the world and avoid involvement.  Pompeo’s criticism of Obama could easily be said of Trump as well.  As time passes, we will be watching to see how long the president tolerates both his national security director and secretary of state working to prevent the execution of the president’s worldview.

And, one more thing to worry about: The world’s magnetic pole isn’t static; it moves around over time.  Usually, the movements aren’t enough to make compass readings unreliable; however, over geologic time, the North and South magnetic poles have actually flipped (the last time was estimated to have been 780,000 years ago).  The map below shows how the pole has moved over time.  The last maps adjusting to the movement of the magnetic pole were completed in 2015.  Although they weren’t scheduled to be updated until next year, the movement was enough to accelerate the process.  The new maps would have been published today, but have been delayed until January 30 due to the government shutdown.[11]  These maps are needed for navigation; not only do ships at sea and aircraft use them, but they are also now part of our everyday lives as they assist in smartphone navigation.

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[1] https://www.ft.com/content/efb7088a-17eb-11e9-9e64-d150b3105d21?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[2] A whip is a legislative role held by a member who counts and steers voters in the legislature.

[3] https://www.reuters.com/article/us-china-economy/china-signals-more-stimulus-as-economic-slowdown-deepens-idUSKCN1P9090

[4] https://www.washingtonpost.com/world/asia_pacific/china-sentences-canadian-man-to-death-in-drug-case-linked-to-huawei-row/2019/01/14/058306a0-17fb-11e9-a804-c35766b9f234_story.html?utm_term=.188f1c9e417d&wpisrc=nl_todayworld&wpmm=1

[5]https://www.apnews.com/a50e00cb683b4b9697c1c957bae39cd2?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[6] http://www.arabnews.com/node/1434591/business-economy

[7] https://www.washingtonpost.com/world/middle_east/crazy-rich-iranians-face-blowback-at-a-time-of-sanctions-and-economic-stress/2019/01/13/f45bc594-ffb6-11e8-a17e-162b712e8fc2_story.html?wpisrc=nl_todayworld&wpmm=1

[8] https://www.reuters.com/article/us-usa-crude-exports/first-u-s-crude-cargoes-head-to-china-since-trade-breakthrough-sources-idUSKCN1P82LN

[9] See WGR, The Archetypes of American Foreign Policy: A Reprise (4/4/2016).

[10] https://www.nytimes.com/2019/01/14/us/politics/nato-president-trump.html?emc=edit_mbe_20190115&nl=morning-briefing-europe&nlid=567726720190115&te=1

[11] https://www.livescience.com/64486-earth-magnetic-pole-moving.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s risk-off this morning.  Global equities are lower on fears of a Chinese economic slowdown and on the U.S. government shutdown.  Here is what we are watching this morning:

China: December exports fell 4.4%,[1] well more than forecast, but imports fell even more, slumping 7.6%.  The decline in export growth was exacerbated by a 3.8% decline in sales to the U.S.  The export decline was the largest in two years.[2]  Although tariffs played a role, the size of the decline points to weaker global demand.  Meanwhile, the drop in Chinese imports indicates a rapidly softening Chinese economy.  The combination of imports falling faster than exports led to a widening of the trade surplus.

This chart shows China’s monthly trade balance; note the sharp rise in December.

Adding to evidence of a Chinese slowdown are reports that car sales fell 13% in December compared to last year, the sixth straight month of declines.[3]  Although there are reports that Chinese officials are planning policy stimulus, we are not seeing signs that Beijing is doing anything significant.  If China fails to move aggressively, it will mean slower global growth.[4]

We have been reporting that there appears to be some progress on trade talks with China.  However, the reality may be less than meets the eye.  Much like what we saw with Japan in the 1980s, China has mastered the art of non-tariff trade barriers, using regulation and approval delays to protect critical industries.  Today we learn that U.S. credit card companies are the latest firms to have received official approval for entry into China, only to find they are facing other impediments.[5]  This is exactly the behavior that the U.S. and others complain about with China.

Brexit: PM May delivered a letter today in which she suggested that if her proposal loses the most likely outcome will be no Brexit at all.[6]  Her argument is that the majority of MPs don’t want to leave and support for a hard Brexit is nil, so if her plan is rejected it is unlikely the majority will vote for a hard Brexit.[7]  She may be right on this point.  Although support for her exit plan is very weak and it will almost certainly lose in tomorrow’s vote, there is no consensus on what should occur.  There is increasing talk that the government should suspend the Article 50 declaration until the U.K. can figure out what it really wants.[8]  Assuming May’s plan falls to a stinging defeat, Labour Leader Corbyn is promising to hold a vote of no-confidence designed to bring down the government and trigger new elections.  For the Tories, suspending Article 50 and delaying Brexit is a better outcome than a Labour government.

We have seen the GBP rise steadily on the prospects of a delay in Brexit.[9]  If the whole plan fails to occur, we could see a strong rally in the currency.  However, the prospects of a populist Labour government facing a permanently divided opposition due to the Brexit failure would tend to temper any rallies.  We are expecting a rather tumultuous week for the U.K.

Shutdown issues: Up to this point, financial markets have mostly ignored the government shutdown.  After all, markets have seen this sort of thing before and, until now, none have had lasting effects.  However, in a world where uncertainty surrounding the strength of the economy is increasing, one of the fallouts of the shutdown is that economic data will likely start to be delayed.  For example, we probably won’t see this week’s retail sales and housing data for December.[10]  Both numbers come from the Commerce Department, which lacks funding.  Financial market confidence is still rather shaky; uncertainty about the path of the economy won’t help matters.  In related news, we are hearing increasing reports of airport delays caused by falling numbers of TSA workers who have been working without pay.[11]  We are not sure how this plays out but we would not be shocked to see some airports attempt to hire private security to man the lines (we are not sure if this is legal, by the way).  When air travel starts to become affected, pressure to resolve this matter will increase.

The bill comes due: Last year, when the tax bill passed, the administration moved to recalculate the withholding tables to increase after-tax pay.  Now, that action will likely have an impact.  Many households use the tax refund as a sort of self-funded bonus; although it is rather obvious that a tax refund is simply an interest-free loan to the government, some people who lack the discipline to save use it as a tool to receive an annual lump sum of money.  The changes to withholding mean that refunds will likely be smaller this year, which may affect the sales of consumer durables, such as autos[12] or appliances.

Turkey threatened: Although there is still confusion on the timetable of the U.S. troop withdrawal from Syria, worries that the withdrawal will spell doom for the Kurds were countered over the weekend by a threat from President Trump.  The president indicated that Turkey would face “economic devastation” if it attacks Kurdish forces in Syria.[13]  Turkey argued that it isn’t against all Kurds, just terrorists.  However, the Erdogan government has characterized the groups the U.S. is allied with in Syria as terrorists.  We will be watching to see if the White House follows through on the threats or if Turkey avoids confronting the Kurds due to Trump’s comments.

Iran war?  According to reports, National Security Director Bolton asked the Pentagon for military options to attack Iran.[14]  Bolton has a long history of supporting attacks on Iran[15] and opposed President Trump’s plans to withdraw U.S. troops from Syria.  Although it would seem that such aggression won’t be supported by the president, who seems to want to leave the Middle East, we caution that Trump leans Jacksonian and this foreign policy archetype[16] is sensitive to honor.  Thus, Trump may be swayed to act militarily if Iran does something that he perceives as besmirching the U.S.  We note the president wanted to attack Iran’s “fast boats,” which are small vessels that often harass U.S. Naval ships in the Persian Gulf.[17]  The important characteristic about Jacksonians and war is that they prefer conflicts with clear objectives and quick outcomes.  Although they will fight long wars, they want unconditional surrenders and ticker tape parades when they are over.  War with Iran would probably not have such outcomes.  Iran’s terrain consists of mountains, deserts and salt flats; imagine invading Utah.  While the U.S. would certainly prevail, it would not be a short war and it isn’t clear what the ending would look like.  Defeating Tehran is one thing, but controlling it post-conflict would be a whole other matter.  Nevertheless, the U.S. could stumble into a conflict with Iran if the Iranians did something provocative.  Our belief is that Iran understands this and will likely avoid doing anything rash.  On the other hand, it’s hard to control all your proxies.

Greek trouble: The naming issue with the former Republic of Macedonia has been a sore spot with Greece for years.  The Greeks object to the term “Macedonia” as this refers to a region that was part of ancient Greece.  However, as long as the Republic of Macedonia remained outside the EU, the tensions were mostly an issue for Greece only.  However, the Republic of Macedonia wants to join the EU and NATO and Greece can veto that goal.  So, there was an official name change over the weekend; we now have the Republic of North Macedonia.  Unfortunately for the current Greek government, accepting that outcome has weakened the ruling coalition as the right-wing Independent Greeks Party has withdrawn from the government.  The move triggered PM Tsipras to call for a confidence vote in his government.[18]  This outcome is problematic; if Tsipras wins, he will be ruling a minority government and we doubt this arrangement will endure.  New elections are more likely.  Austerity has wrecked the Greek economy and new elections might bring a radical government to power.  With tensions already simmering between Italy and the EU, new issues with Greece would not be helpful.

Political violence: The mayor of Gdansk was stabbed while on stage at a political rally over the weekend.[19]  Unfortunately, according to recent reports this morning, Pawel Adamowicz did not survive the attack.  The incident raises concerns about political stability in Poland.[20]

U.S. sanctions on Germany: The U.S. is warning German companies that their involvement in the Nord Stream 2 natural gas pipeline could trigger financial sanctions.[21]  The U.S. has been concerned that German dependence on Russian natural gas could compromise its relations with Europe and the U.S.  In addition, America would prefer that Germany buy U.S. LNG.

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[1] https://www.reuters.com/article/us-china-economy-trade/china-posts-strongest-export-growth-in-seven-years-in-2018-despite-trade-war-idUSKCN1P8047

[2] https://www.ft.com/content/713ee398-179a-11e9-9e64-d150b3105d21

[3] Op. cit., Reuters.

[4] https://www.ft.com/content/32576258-1651-11e9-9e64-d150b3105d21

[5] https://www.ft.com/content/8dee4b22-13ef-11e9-a581-4ff78404524e?emailId=5c3c19af40142700048786e9&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[6] https://www.politico.eu/article/theresa-may-brexit-deal-rejection-risks-democratic-catastrophe/ and https://www.ft.com/content/99879042-1714-11e9-9e64-d150b3105d21

[7] https://www.ft.com/content/99879042-1714-11e9-9e64-d150b3105d21?emailId=5c3c19af40142700048786e9&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[8] https://www.theguardian.com/politics/2019/jan/13/eu-preparing-to-delay-brexit-until-at-least-july

[9] https://www.reuters.com/article/uk-britain-eu-donors-exclusive/exclusive-leading-brexit-donors-say-britain-will-reverse-decision-to-leave-eu-idUSKCN1P50UU?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosmarkets&stream=business

[10] https://www.apnews.com/2eac470724434029b728f54abe364557

[11] https://www.chron.com/business/bizfeed/article/TSA-closes-security-checkpoint-at-IAH-Terminal-B-13530619.php

[12] https://www.axios.com/automobile-sales-trump-tax-plan-smaller-refunds-13c98a56-a442-4be0-98ee-9e15e3e7eea3.html

[13] https://www.ft.com/content/9967e02a-1797-11e9-9e64-d150b3105d21?emailId=5c3c19af40142700048786e9&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[14] https://www.wsj.com/articles/white-house-sought-options-to-strike-iran-11547375404

[15] https://www.nytimes.com/2015/03/26/opinion/to-stop-irans-bomb-bomb-iran.html?mod=article_inline

[16] See WGR, The Archetypes of American Foreign Policy: A Reprise (4/4/2016).

[17] https://www.countable.us/articles/19241-don-t-sink-trump-s-obsession-iranian-boats-tormented-mattis

[18] https://www.nytimes.com/2019/01/13/world/europe/greece-tsipras-confidence-vote-kammenos.html

[19] https://www.reuters.com/article/us-poland-stabbing/mayor-of-gdansk-stabbed-onstage-at-polish-charity-event-idUSKCN1P70T8?wpisrc=nl_todayworld&wpmm=1

[20] https://www.theguardian.com/world/2019/jan/13/gdansk-mayor-stabbed-on-stage-during-charity-event-in-poland?wpisrc=nl_todayworld&wpmm=1

[21] https://www.reuters.com/article/us-germany-usa-russia-pipeline/u-s-warns-german-firms-of-possible-sanctions-over-russia-pipeline-idUSKCN1P70FR

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

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

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

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