(NB: Due to the Thanksgiving holiday, the next report will be published on November 26.)
Last week, we discussed the issue of succession in the Kingdom of Saudi Arabia (KSA). In Part II, we will begin with a discussion of the regional power rivalry between Turkey and the KSA, then outline Turkish President Erdogan’s actions in the wake of Khashoggi’s homicide. We will analyze U.S. policy goals in the region followed by our expectations for the resolution of this incident. As always, we will conclude with market ramifications.
Turkey versus the KSA
The Khashoggi incident and Turkey’s involvement should be understood within the context of a long-running rivalry. Both nations want to dominate the Sunni-aligned nations of the Middle East. Turkey sees this role as its natural “birthright” due to the nearly 600-year dominance of the Ottoman Empire. Saudi Arabia believes the role of leading the Sunnis in the region is part of its position as defender of the Muslim holy sites of Mecca and Medina. Both nations have sharply differing views of how that dominance should be exercised.
[Posted: 9:30 AM EDT] It’s Monday and a bank holiday. Since Veteran’s Day fell on a weekend, the banking system is partially closed today, which means the cash Treasury market is closed. This is what we are watching this morning:
OPEC and oil: President Trump has been critical of OPEC and high oil prices, and the Saudis have been sensitive to his complaints. However, now that the midterms are over, it appears the kingdom is pressing for higher prices. The Saudi energy minister, Khalid al-Falih, suggested yesterday that the oil markets have overcorrected and prices should move higher.[1] In addition, the kingdom is officially pushing for a 1.0 mbpd cut by December.[2] Although Russia isn’t necessarily warm to the idea, it hasn’t shot it down either.[3] Oil prices have suffered a significant decline recently, mostly due to seasonal factors and rising U.S. output. The OPEC news may arrest the decline, but a reversal will need inventory reduction; a bit of dollar weakness would be helpful, too.
MbS: This week’s Weekly Geopolitical Report concludes our two-part series on the Saudi crown prince. We note a couple of articles today. First, the NYT reports that the crown prince was considering an assassination campaign against his and the kingdom’s enemies.[4] Second, as we note in our report, it is likely the other princes will try to rein in MbS.[5] His unstable decision-making is becoming a problem and could bring instability to a nation that strives for stability.
Brexit: Earlier this month, there was optimism that PM May would be able to strike a deal with the EU on Brexit. Although the substance of an agreement appeared to be lacking, hopes were high. It appears these hopes are fading rapidly. The EU has rejected a key compromise point[6] on the Ireland/Northern Ireland border. Negotiations have been intense but both sides can’t seem to come up with an agreement that will work for both parties.[7] The British prime minister is facing political broadsides from both Remainers and Leavers; May has been trying to weave a path that would give each side enough to accept a Brexit deal that would not leave the U.K. economy completely outside the EU. However, she has not been able to craft a compromise; in fact, such an arrangement may not be possible. The GBP has declined on the lack of progress. It should be noted that most EU deals don’t occur until the deadlines, mostly because there are so many parties involved that getting to an early answer is impossible. Thus, one should not conclude that a deal isn’t coming. However, if a plan isn’t in place by the end of November, it will be virtually impossible for the remaining members of the EU to agree in time for the March 29th deadline. A “hard” Brexit, which simply pushes the U.K. out of the EU and forces trade to WTO rules, would be a hard shock to the U.K. economy. Already, there are calls for government bailouts if such an event occurs.[8]
Chinese tensions rise: Chinese authorities have been cracking down against labor protests that have been springing up recently. These follow student activism at Peking University, where students, acting as good Marxists, supported a unionization movement for workers at the school.[9] Another issue facing the leadership is growing financial problems. China has been using financial repression against households for years; it is how it creates saving for investment. Households were generally only allowed to put their savings in banks that offered low interest rates, usually below the rate of inflation. Financial firms have sprung up over the years offering higher interest rates; however, these firms are loosely regulated and, occasionally, default, causing localized unrest. Peer-to-peer lending has been one of these industries. Now, it appears a major one, Ezubao, has failed and depositors are demanding the government bail them out.[10] We saw similar issues with wealth management products. There is a solution—allow banks to raise interest rates to market levels which would undermine these unregulated financial products. But, that would undermine the development model China has used since the late 1970s and, more importantly, reduce the wealth of powerful figures in the CPC. Finally, the PBOC is signaling that it will act to prevent the CNY from depreciating significantly.[11] Although the central bank may be successful in its goals, it should be noted that if the Trump administration does follow through on additional tariffs then CNY weakness is a nearly inevitable response.
Navarro reacts: Senior trade advisor Peter Navarro accused major Wall Street firms of being “unpaid foreign agents”[12] for meeting with Chinese officials earlier this month. These strong words should be seen in the context of the divisions within not only the administration but the political system as well. Populist wings have emerged on both the left and the right and Navarro, along with Robert Lighthizer, represent the right-wing version, at least on trade. Populists of both stripes oppose globalization. However, it is a bit jarring for a GOP administration to label Wall Street as unpaid foreign agents.
North Korea lurks: Although the Hermit Kingdom has been off the front pages for a while, we note that the Kim government has been continuing to work on its weapons of mass destruction. According to the Washington Post,[13] the regime is working on its ballistic missile program at new “secret” bases. Kim Jong-un, like his father and grandfather, won’t be ignored indefinitely and the lack of progress on improving relations could mean new tensions in 2019.
In light of rising interest rates, this week we will take a look at credit spreads. But, before doing that, it makes sense to examine overall Treasury valuation.
This chart is our 10-year T-note model. It incorporates fed funds, the Japanese yen exchange rate, German sovereign 10-year yields, oil prices, the fiscal deficit as a percentage of GDP and an inflation proxy.[1]
This model does suggest current 10-year yields are elevated, but not at extreme levels. However, if we assume a terminal fed funds rate of 3.25%, assuming no change in the rest of the variables in the model, fair value for the 10-year rises to 3.27%, which is near current levels. Thus, we can postulate that current yields have discounted about 100 bps of further tightening. Another interesting note is that the most significant variables in the model are fed funds and the inflation proxy. Just using these two variables in the model yields a fair value of 3.60%; if we assume another 100 bps of tightening, the terminal 10-year yield ends up at 4.10%. Compared to the broader model, it is clear that overseas factors, especially German yields, are keeping U.S. yields from rising faster. Overall, we don’t expect these foreign factors or oil prices to change in such a way as to support higher yields, so we don’t expect a rise in the 10-year yield to exceed 3.50% unless (a) inflation expectations become unanchored, or (b) the FOMC signals it will raise rates much more than expected.
Thus far, the impact on credit spreads from rising Treasury yields has been minor. The chart below shows investment grade spreads. Current investment grade spreads are holding near their long-term average.
High-yield spreads have nudged higher but remain tight, with spreads holding near the bottom of their historical ranges.
The lack of spread widening is consistent with the continued low level of stress in the financial system.
This chart shows fed funds with the Chicago FRB National Financial Conditions Index; the index rises when stress increases (or, put another way, when financial conditions deteriorate). From 1973 (when the index data begins) until 1997, the two series were tightly correlated; if the FOMC raised rates, stress rose. Stress was a “force multiplier” for monetary policy. We believe increasing transparency has removed this “tool” from the Fed; now, financial participants can so easily project the path of policy that they don’t necessarily fear the rising rates. And so, instead of seeing participants react to stress as policy tightens, we now have a situation where stress remains low only to soar. Credit spreads are a key component of the aforementioned conditions index. If spreads begin to widen, they could do so rapidly, leading to significant market disruptions. For now, all is calm, but we continue to closely watch market conditions because when they begin to deteriorate they tend to so rapidly. In asset allocation, we have tended to favor investment grade spread products but are less favorable toward high yield. If conditions start to deteriorate, we will shift allocations toward Treasuries.
[1] For an inflation proxy, we use the 15-year moving average of the yearly change in CPI. This is based off research by Milton Friedman, who postulated that investors build their inflation expectations over a long time frame.
[Posted: 9:30 AM EDT] It’s Friday, just not a very happy one. The market tone is definitely risk-off. Today’s weakness is mostly made in China but there are other concerns as well. Here is what we are watching:
China: The inflation data (see below) was mostly in line with expectations. There was some welcome easing of inflation at the producer level. We may see a pickup in import prices in the coming months due to recent CNY weakness. Easing price pressures could give the PBOC room for further stimulus. However, other media reports are raising concerns. For example, over the past year, companies were trying to maintain borrowing when the PBOC was cracking down on shadow banking. The response was to circumvent these restrictions by borrowing from banks using shares that were pledged as collateral. As any financial advisor in the U.S. knows, this is a form of margin lending and the risk of such borrowing is that the value of the collateral declines, leading to the dreaded margin call. In China, the pledged shares were not used for additional share-buying but for business needs. The bear market in Chinese stocks has now raised concerns about the collateral of these loans, which are said to be about $620 bn, or about 10% of market capitalization.[1] So far, lenders have not forced borrowers to sell shares and pay back the loans; we suspect financial regulators are pressing banks not to take this action.[2] However, by not forcing the sale of shares, banks are now reserving against these loans, which will further crimp lending.
This isn’t the only area of concern in China. For the fourth straight month, car sales have shown negative yearly growth, falling 12% in October. For the year through October, sales are down 0.1% compared to the same period last year. It appears a confluence[3] of events, including worries over trade, falling equity values and tightening credit standards, is undermining car sales.[4] Sentiment weakness has also led to falling Chinese tourism.[5]
The geopolitical situation is deteriorating as well. The Trump administration is accusing China of violating an Obama-era cyber-theft agreement.[6] In fact, it appears cyber-theft jumped after Obama left office. The U.S. has already responded with the DOJ starting a “Chinese initiative” to counter China’s activity.[7] In the meantime, the U.S. Navy and the People’s Liberation Army Navy continue their dangerous encounters in the South China Sea.[8] Defense Secretary Mattis has been working hard to maintain open lines of communication to reduce the chances of a spiraling conflict.[9] Although President Trump has made no secret of his dislike for his SoD,[10] for now, his position appears safe.[11]
In summary, China’s financial situation is becoming increasingly perilous. Although a sudden debt crisis is possible, we don’t think it is the most likely outcome. Instead, we suspect China is going the route of Japan, post-1990, where growth slows to a level where additional debt isn’t necessary to support growth. The key unknown is whether the CPC can change its political legitimacy from delivering high growth to something else. Chairman Xi has amassed enough power to make changes that will address this issue; what we don’t know is whether he can come up with a new form of legitimacy that allows China to remain a single-party state. The most likely outcome is a long period of slowing growth. But, that doesn’t mean that a sudden stop isn’t possible—it’s just not as likely.
The Fed: There were no surprises in the FOMC action or statement.[12] The Fed did acknowledge that unemployment is really low but also noted that business investment has been disappointing. There is no doubt the Fed will raise rates in December.[13] It should also be noted that every meeting going forward will have a press conference. In theory, this could make every meeting live but we note that forecasts and dots will still only occur quarterly. We will be watching to see if the FOMC will take action on rates when there are no new dots.
Oil prices continue to decline: Oil prices remain under pressure this morning, with WTI dropping below $60 per barrel. The catalyst today was a report that the Keystone Pipeline project was halted by a federal judge, arguing that the administration didn’t take environmental concerns into account.[14] To some extent, the market reaction doesn’t make a lot of sense. If the Keystone project was functioning, it would be bringing Canadian tar sands oil to the Gulf Coast, adding to supplies there. The bigger reason for the weakness is rising domestic inventories that are partly due to seasonal factors and partly due to rising U.S. production. In addition, Iraq may be close to a deal with the Kurds that would restart exports from Kirkuk.[15] Oil remains oversold but clearly hasn’t found a bottom yet.
Cabinet changes: Although the Sessions resignation has been the focus of the media, there are rumors that Wilbur Ross may be out at Commerce.[16] A potential replacement could be Linda McMahon; she is considered a free trader and may signal a shift toward trade deals and away from punitive tariffs. Although we doubt China will get much relief, a McMahon Commerce Department may be more open to deals with the EU and Japan.
[Posted: 9:30 AM EDT] It’s Fed day! The FOMC meets today but it is one of those meetings without new forecasts (“dots”) or a press conference. Thus, we are expecting no change in rates or in the statement. We are seeing some consolidation in equities this morning after a strong rally yesterday. Here is what we are watching this morning:
More on the midterms: We have some additional observations about the impact of the midterm elections:
Waiting didn’t help foreign nations—China and the EU were stalling on trade talks, perhaps hoping for a Democratic Party sweep of Congress that would reduce the power of the White House. Although this was a long shot, the costs of waiting weren’t all that high. But, given the result, we would look for more serious negotiations to begin. The U.S. will likely meet with China at the G-20 and we would expect EU negotiators to move faster now.[1] The EU will be particularly concerned with the potential for auto tariffs.
The bond market is worried about GOP fiscal management, or worse—Yesterday, we noted the market volatility surrounding shifts in election forecasts that led to some violent moves in the Treasury market. To reiterate, 528, Nate Silver’s site, shifted the odds of a GOP hold on the House that led to a spike in Treasury yields. The forecast was being driven by partial results and, in retrospect, was probably too sensitive to this data. The jump in yields was either due to fears of further fiscal expansion or rising inflation expectations. Comparing the TIPS yield to the nominal leads one to conclude that financial markets are starting to view the GOP as the party of reflation.[2] We note that in yesterday’s trade the two-year yield rose while longer duration yields fell, despite a sloppy 30-year T-bond auction. The flattening of the curve in the aftermath of the election suggests that fixed income investors view divided government as a check on spending and further tax cuts, and thus were willing to buy the long end of the curve.
How to think about investigations—The president wasted no time ridding his administration of AG Sessions. There is much media frenzy over the appointment of a temporary head of the Justice Department and the Mueller investigation. For now, we don’t expect these events to have much impact on financial markets. The firing of Mueller won’t stop the House from investigating the White House. The news on this front will be the focus of cable news but financial markets will still focus on the economy; turmoil means there will be less chance of tax law changes. If the investigations begin to undermine confidence, then it will be time to worry. But, there is no evidence to suggest that is in the offing.
Red states are supporting populism—Arkansas and Missouri both passed minimum wage hikes.[3] Earlier this year, the latter state repealed right to work. Although both are generally reliable GOP states, their voters are openly rejecting the free market ideology of the libertarian wing of the Republican Party. We should also note the president hinted yesterday that he might be willing to claw back some of the recent tax cuts on higher income households to give the middle class more tax relief.[4] In other words, investors should note that the GOP may not be a reliable partner in supporting the interests of capital as time passes.
The regulatory world is becoming less tech friendly—The incoming Congress will be populated with Democrats skeptical of the tech companies on privacy and the GOP is opposing the monopoly power of the platforms. As time passes, the perception of the tech firms has steadily moved from their leaders being seen as folk heroes to being seen as predatory. The risk of increasing regulation is rising.[5]
China’s trade data: China’s trade data for September did not show any significant effects from recent tariffs. Import growth was robust, up 21.4% from last year, well above the consensus growth of 14.5%. With import volumes up 15.4%, there may be some anticipatory buying underway. China’s surplus with the U.S. hit a new record; more interestingly, China is running nearly balanced trade with the rest of the world.
These numbers will tend to trigger tough rhetoric from the Trump administration and raise worries about further tariff measures.
Italian budget negotiations: The EU has raised its forecast for the Italian budget deficit, mostly by assuming a lower growth rate than Italy did in its budget calculations.[6] Both parties appear to be in a standoff. We still expect the EU to offer some concessions to Italy but the rhetoric makes it hard for the EU to compromise. Meanwhile, Italy is using Brexit for leverage, suggesting it will support the British in their negotiations over leaving the EU. Since the EU side needs unanimous approval, Italy’s threat may require the EU to offer concessions on the budget to secure its Brexit position.[7]
Energy update: Crude oil inventories rose more than expected, coming in at 5.8 mb compared to forecasts of 2.0 mb.
U.S. crude oil production continues to surge, rising 0.4 mbpd this week to 11.6 mbpd. Although refinery runs did rise to 90.0% of capacity, it was only a 0.6% increase from last week. Oil imports rose 0.2 mbpd, while exports fell 0.5 mbpd. Needless to say, it was a bearish report.
(Sources: DOE, CIM)
We are approaching the end of the inventory build season. Refinery operations should rise in about two weeks, which should reverse some of the recent inventory gains.
Based on inventories alone, the fair value for crude oil is $63.71. Using the EUR as the independent variable, oil prices are fairly valued at $55.21 per barrel. Using both, fair value is $57.61. Simply put, the most bearish factor for oil now is dollar strength. We do expect oil inventories to begin their seasonal decline into year’s end soon, which may offer bullish support in a deeply oversold market. But, the dollar needs to weaken in order to stage a major rally.
[Posted: 9:30 AM EDT] Happy Wednesday! No more political ads on TV! Here is what we are watching this morning:
Election takeaways: The midterms came out about as expected, with the House going to the Democrats and the GOP expanding its hold on the Senate. Although, in the end, things turned out roughly as forecast, there was a lot of drama throughout the night. Some of the closely watched political pollsters and pundits caused all sorts of swings in the overnight markets. Here is what we are seeing:
Hardening bases—The president’s plan of creating voter interest by focusing on immigration worked with voters that are his key constituency, which would be rural and suburban older white voters, especially men, with less than a college degree. The GOP dominated the less populated areas of the country. The Democratic Party plan of focusing on women in the suburbs worked. Democrats not only did well in cities but also in more affluent suburbs. Democrats continue to make gains with those holding college degrees.[1] Progressive candidates in red states didn’t fare well. Moderate Democratic candidates for Midwestern governors did quite well. One of the hardest issues of leadership is understanding the correct lessons to learn from victory or defeat. GOP leaders will note that moderate Republican candidates lost in suburban districts. They could decide that moderates can’t win. Democrats may decide that the countryside is lost for good. It is highly likely that the lesson both parties will take from this election is to keep pounding on the same themes to the same voters. Although this may lead to narrow victories, it won’t create any sort of national unity. In summary, the likely lesson learned by both parties will increase national divisions.
The race for the White House begins today—Although we expect the president to take a breather after a punishing campaigning schedule, the rallies he held recently will likely continue, although the pace probably won’t be as frenetic. But, expect Democratic presidential hopefuls to emerge. Who are we watching? Sherrod Brown (D-OH) was easily re-elected to his Senate seat even as the GOP won the governor’s race. Brown is a true blue collar populist; he was anti-trade before it was cool. The national media is focused on a lot of other candidates but Brown would pose a real alternative for the Trump constituency.
Markets are good with gridlock—Perhaps the most interesting market response to the election has been a drop in the dollar. It is possible traders are thinking that the House will now run a parade of investigations against Trump and distract him from his trade agenda. Although possible, we haven’t seen much evidence to suggest the Democrats have become ardent free trade supporters. In addition, gridlock likely reduces the chances of further fiscal spending, which is supportive for Treasuries. Equities have bounced this morning and Treasuries are rallying.
Overall—The results were as expected. We would look for equities to follow their usual pattern after midterm elections and rally. If dollar weakness holds, it will be bullish for commodities.
Chinese foreign reserves: China’s foreign reserves fell $34.0 bn, a bit more than forecast. We suspect the decline was due to the PBOC’s support for the CNY, although the pace of declines would suggest that Chinese authorities are trying to guide the currency lower, not prevent it from falling.
Oil supply cuts? Now that the elections are out of the way, OPEC appears to be shifting gears and returning to price supports. OPEC ministers are meeting in Abu Dhabi this weekend and are planning to discuss production cuts for next year.[2] Oil prices are up today despite a large jump in oil inventories reported by the API. We get the DOE data later this morning.
BOJ again: Another member of Japan’s central bank board, Yukitoshi Funo, said today that the BOJ may need to raise rates soon to support the banking system.[3] This is the second time in a week that members of the BOJ have hinted at reversing accommodative policy.
[Posted: 9:30 AM EDT] It was a very quiet overnight session. Media attention is focused on the midterms. Here is what we are watching this morning:
Midterms: We have already discussed the election at length. Here is our simple guide. The consensus outcome is a Democratic House and a Republican Senate. If this outcome is the result, market action shouldn’t be significant. If the Democrats take both houses, we would expect a pullback in equities on fears that there will be a parade of investigations and perhaps an attempt to reverse the tax bill. This fear is overblown. We suspect the Democratic Party establishment is cool to impeachment and thus will try to quell the more aggressive tendencies of the party’s left-wing populists. And, never forget, the president can veto bills. If the GOP holds both houses, expect an initial equity rally on ideas that even more tax relief may be coming. However, some of that bullishness will be tempered by fears of further trade impediments. Our expectation is the consensus.
Although this year’s midterm pattern in equities hasn’t exactly followed the average pattern, it should still be noted that equities tend to have strong gains after the midterms. Such seasonal studies should always be taken as guides; Ned Davis, a well-known market analyst, used to suggest that the pattern, and not level, was the important factor to watch.
It’s notable that the real pattern break was last year, when the big rally in stocks was due to the passage of the tax bill. The midterm year is usually rather flat. Although we did make new highs, it has arguably been a sideways year. If the pattern holds, we should see a strong market into the middle of next year. Why does this pattern exist? In general, there are two factors behind it. First, the election fosters some degree of uncertainty and getting the results ends that uncertainty and supports sentiment. Second, the incumbent president is interested in re-election and thus pushes for economic stimulus to avoid the worst political outcome, a recession into the election year.
Iran sanctions: Although eight nations have been granted waivers for buying Iranian crude oil, it’s not clear how they will pay for it. S.W.I.F.T. has confirmed that it is severing ties with Iran’s banks.[1] This will make it nearly impossible for the nations able to buy Iranian crude to easily pay for it. European leaders are trying to create an alternative messaging network but are struggling to make progress. One factor is that no nation is keen to house the network, fearing that nation will become a target for U.S. sanctions.[2] It’s apparent that the EU won’t have a workaround in place as sanctions go into effect.
China and U.S. trade: There are growing hopes of a thaw developing between the U.S. and China over trade as the G-20 meeting looms on November 29. The two parties are holding security talks which were previously delayed.[3] American business leaders offered optimistic comments as well.[4] Although we are not convinced that a major reduction in trade tensions is in the offing, some minor deals are possible. The U.S./China issue is existential, the problem of a rising power threatening an established hegemon.[5]
Natural gas prices: Yesterday, natural gas prices rallied strongly as a significant cold front is expected to bring wintery weather to the central and eastern regions of the U.S. Inventories are at their lowest levels since 2014 on a seasonally adjusted basis. In that year, Henry Hub prices peaked at $6.55 per MMBTU.
This chart shows natural gas inventories with a seasonal adjustment factor. The lower line on the chart shows the deviation from normal. The growth of shale oil produces natural gas as a by-product and that extra supply has tended to keep prices low. This year, rising exports to Mexico and LNG processing has offset production, leading to the lower inventory situation. A key factor in yesterday’s rally was the early cold snap. In general, inventory managers want to keep storage for later in the winter; therefore, when faced with early cold weather the supply usually comes mostly from current production, which tends to boost the price. Overall, early cold weather has a bigger impact on natural gas prices than later cold weather, depending on the storage situation. The combination of early cold weather and low inventory levels is bullish for natural gas.
Jamal Khashoggi, a well-connected Saudi journalist, entered the Saudi consulate in Istanbul on October 2nd and has not been seen since. His apparent death (at the time of this writing, no body has been produced) has caused an international incident.
The assumed death of Khashoggi highlights a number of issues for the Middle East that we will explore in this two-part series. This homicide did not occur in a vacuum and the context of this event could have broader ramifications for the region. We will not recount the events leading to his death nor dwell on the details of the apparent murder, which have been widely reported in the world media. However, our decision to not discuss the details of the event does not mean we overlook it on a human level. What happened to Khashoggi was terrible, but the focus of this report is to give context to this ugly event.
In Part I of this report, we will begin with the particular problem of kingly succession in the Kingdom of Saudi Arabia (KSA). We will pay particular attention to the generational change in power that Crown Prince Mohammad bin Salman (MbS) represents. We will note the history of earlier successions and examine the potential for instability if King Salman dies and MbS remains crown prince. Part II will deal with the regional power rivalry between Turkey and the KSA, along with Turkish President Erdogan’s actions in the wake of this homicide. We will analyze U.S. policy goals in the region followed by our expectations for the resolution of this incident. As always, we will conclude with market ramifications.
[Posted: 9:30 AM EDT] Equity markets are mixed this morning on the eve of a big week. Midterm elections are tomorrow (don’t know about you, but we won’t miss the political ads), and the FOMC ends its meeting on Thursday. Here is what we are watching this morning:
Elections: The decision markets put the odds of a Democrat-controlled House at 68%.[1] That will lead to divided government and likely gridlock. Although there is some concern that a divided government could bring the reversal of policy on taxes and perhaps regulation, in reality, the president can veto laws and, with the Senate almost certain to remain in GOP hands (decision markets put the odds at 87%),[2] the ability to actually move legislation is nil. That being said, we wouldn’t be surprised to see an infrastructure bill make it through. We will be watching for attempts by the House to undermine the White House on trade policy. We doubt they can do much (the executive branch has great latitude on trade), but attempts will likely be made. At the same time, look for the Democrat party leadership (read: center-left establishment) to try to restrain the investigation and impeachment activities that the populist left is clamoring for. The Democrat Party establishment fears that a parade of investigations could make President Trump a sympathetic figure, much like Bill Clinton during the impeachment. We are not expecting significant disruption, in any case.
FOMC: This is a non-press conference meeting so don’t expect much. In fact, we would be surprised by any statement change or dissents. The meeting is a non-event except that it will lay the groundwork for a December hike.
Iran sanctions: Sanctions go into effect today. The U.S. is implementing all the sanctions that were in place before the nuclear deal. Initially, it appeared the U.S. was going to exempt the S.W.I.F.T. network. News of this exemption triggered a reaction in Congress; Ted Cruz was considering sponsoring legislation to force the administration to include the bank messaging system. However, by adding specific Iranian banks to the sanctions list, the S.W.I.F.T. network will be pulled into the sanctions regime.[3] Because some nations were given exemptions, there had been an impression that the sanctions on Iran would not be all that stringent.[4] This narrative, coupled with recent increases in inventories, has been bearish for oil prices. However, even for nations that are allowed to buy Iranian oil, it isn’t obvious if they can make financial arrangements. For example, financial sanctions may restrict the availability of insurance for cargos. Thus, the sanctions may be more effective than currently thought.[5]
Law of the Jungle: President Xi of China lashed out at U.S. trade policy, calling it a return to the “law of the jungle.”[6] Xi was speaking at an international business fair in Shanghai over the weekend. The strong rhetoric may signal that the hope of a truce in the trade war with China is unlikely. Xi did suggest he was planning to reduce import tariffs[7] but actual moves to lower trade barriers have tended to disappoint. If there is no thaw on the trade front, financial markets will likely take this as a bearish factor.
The BOJ to tighten? In a speech to business leaders, BOJ Governor Kuroda indicated that the massive monetary stimulus that has been in place for years is likely coming to a close.[8] Although actual rate tightening probably isn’t imminent, once policy turns, the JPY could appreciate significantly. On a purchasing power parity basis, the JPY is fairly valued around ¥60. In general, an appreciating currency is a negative factor for the Japanese economy.
Troika of Tyranny: National Security Director Bolton has dubbed a new group of evil nations the “troika of tyranny.”[9] The members are Cuba, Venezuela and Nicaragua. All three are leftist nations. He used his speech to outline new sanctions on Cuba and Venezuela and is threatening U.S. action against Nicaragua.[10] Specifically, the sanctions against Venezuela restrict the gold trade; the Maduro government has been using gold reserves to skirt U.S. financial sanctions. Although it’s hard to see how new sanctions could make things worse in Venezuela (they are already awful), we have noted a steady stream of refugees pouring out of the country.[11] If conditions deteriorate further, the outflow could increase and a new “caravan” of Venezuelan refugees could be heading to the U.S.
Business groups side with Modi versus RBI: Recently, we have discussed a conflict that has developed between India’s central bank and the government. The latter is trying to influence monetary policy, mostly to moderate tightening. The RBI has pushed back and its governor has threatened to resign. It is not a huge surprise that business groups, interested in easy money, have decided to align with the government in this spat.[12] Of course, anything that undermines the independence of the central bank will tend to pressure the exchange rate and could hurt financial asset values.[13]
Update on the CDU: The FT carried a flattering portrait of Friedrich Merz, a candidate for head of the CDU.[14] Last week, we touched on the candidates for Merkel’s party leadership. Merz represents a wing of the party that is socially conservative and market friendly. As we noted earlier, Merz was effectively bumped out of politics by Merkel 16 years ago.[15] Merz would likely pull disgruntled former CDU voters that have drifted to the AfD; he has a hardline stance on immigration. An ally of Wolfgang Schäuble, Merz would also likely be a stanch defender of the rules-based fiscal order, which would pit Germany against Italy. At the same time, Merz isn’t a Euroskeptic; he supports European integration and may be closer to French President Macron.[16] Given the history between Merkel and Merz, if he does get control of the CDU, Merkel’s position as chancellor will likely become untenable. However, we would expect a Merz government to end Merkel’s immigration policy and not tolerate Italy’s actions on its fiscal budget. How this unfolds in Germany will bear watching.
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