Last week, we introduced the characteristics of a reserve currency, including a discussion of the costs and benefits of providing the reserve currency. This week, we will conclude the report with a short explanation of the S.W.I.F.T. network and its importance to international finance. From there, we will discuss the potential competitors to the dollar as the reserve currency, examining the possibility of competing trade blocs. As always, we will conclude with potential market ramifications.
[Posted: 9:30 AM EDT] It’s Monday—financial markets are in clear risk-off mode amid lots of news. It is Columbus Day, a bank holiday, so commercial banks and the Treasury market are closed today. Here is what we are following:
China: Chinese markets reopened after a week-long holiday to a significant drop in equity values and a drop in the CNY.
(Source: Bloomberg)
The exchange rate is testing recent lows as trade tensions rise with the U.S. There was an exchange between Chinese Foreign Minister Wang Yi and Secretary of State Mike Pompeo that has been described as “frosty”[1] during a five-hour visit by Pompeo to Beijing. China indicated that U.S. policy was “misguided.”[2] Tensions between the two countries are clearly rising. There was a near collision between Chinese and U.S. destroyers recently and the U.S. is considering increasing the number of Freedom of Navigation operations near outcroppings that China has been fortifying in recent years. Meanwhile, on trade, the U.S. doesn’t seem to be anywhere close to easing pressure on China; in fact, the long-term goal of the Trump administration appears to be shortening the supply chains,[3] with a focus on pulling productive capacity out of China. Part of China’s retaliation will be a weaker currency; we note that China lowered its reserve requirements in a bid to boost the economy.[4] We believe the CPC will do all it can to maintain high levels of economic growth as it views growth as legitimizing the rule of the party. Although the Chinese government tends to keep a lid on dissent, we do note there were riots over the holiday when a real estate developer cut prices in a bid to sell remaining units. The current property owners were furious and attacked the sales office, smashing windows.[5] Falling real estate values may be a more significant threat to the CPC than trade.
Brazilian elections: As expected, Jair Bolsonaro won a plurality on Sunday,[6] taking 46% of the vote, nearly winning a majority. There will be a runoff on the 28th which will likely make Bolsonaro the new president of Brazil. Bolsonaro is a right-wing populist whose platform is law and order and has shown an affinity for the military dictatorships of the early 1980s. Equity markets in Brazil have welcomed the outcome.
Italy: After agreeing on a budget last week, the EU criticized Italy’s rising deficits. This criticism prompted a strong reaction from the League’s deputy PM, Matteo Salvini, who suggested that “the enemies of Europe are those sealed in the bunker in Brussels.”[7] The exchange triggered another sell-off in Italian bonds and a drop in the EUR. As the chart below shows, the spread between German bunds and Italian 10-year sovereigns widened out over 300 bps, with Italian paper hitting a yield of 3.60% and German yields easing lower. Italy is a mortal threat to the Eurozone; if Italy leaves, it will severely damage the single currency to the point where it would probably not survive in its current form. We would expect other southern tier nations to exit the single currency if Italy leaves. If Germany wants to keep the Eurozone in place, it will be forced to ease its restrictions on fiscal spending and probably accept a Eurobond, a sovereign backed by the full faith and credit of all members in the Eurozone. Germany will see this as giving the Italians a credit card, leaving Germans to service the debt. Simply put, it is unlikely that Germany will accept this change. Thus, tensions will likely remain elevated.
(Source: Bloomberg)
The long arm of the authoritarians: Last week, we noted that Jamal Khashoggi, a Saudi journalist who had been critical of the Salman reign in Saudi Arabia, had gone missing after entering the Saudi embassy in Istanbul. He was recently living outside the kingdom on apparent fears of arrest and writing for the Washington Post.[8] Turkey claims that a Saudi unit tortured and killed Khashoggi last week.[9] The Saudis have denied the report. Separately, the head of Interpol, a Chinese national named Meng Hongwei, has resigned after he was arrested while visiting China last week.[10] Although two unrelated events, both indicate that authoritarian regimes, which generally won’t tolerate dissent, are signaling to their citizens that (a) you can’t run away, and (b) the West won’t protect you. If this message is true, it may stem capital flight which has boosted coastal real estate markets in the U.S. and Britain.
Oil prices: Oil prices have dipped on reports that the Trump administration is considering granting some waivers to nations wanting to import Iranian oil. That action may be necessary to contain the recent jump in oil prices. We will be watching to see if these waivers are permanent or if they need to be renewed after the midterm elections. If it’s the latter, we view this as a bid to lower oil prices in front of the midterms.
As the unemployment rate declines, there is a worry that wage growth may accelerate and lead to a wage-price spiral, forcing the FOMC to raise rates rapidly. Although possible, the key issue is slack in the labor market. Based on the unemployment rate, there would appear to be little; based on the employment/population ratio, employers should still be able to find workers without having to raise wages to attract them.
This chart shows yearly wage growth for non-supervisory workers. We forecast the results from two models of wages, one using the unemployment rate and the other using the employment/population ratio. Until the latest recovery, both models worked reasonably well; however, in the current recovery, there is a significant divergence. The model using the unemployment rate suggests wage growth should be closer to 4%. Using the employment/population ratio, wages should be growing around 2.5%, which is about in line with actual wage growth. This analysis would suggest there is probably more slack in the economy than the unemployment rate would indicate.
However, just because this pattern has been in place for several years doesn’t mean it will continue. One potential signal that the labor market is “running short of workers” would be if the unemployment rate remains low while non-farm payroll growth slows. To see if slowing payrolls occurs when the unemployment rate is low, we compared five periods since the 1950s when the unemployment rate was under 4.5% for an extended period. We compared payrolls to their maximum to see if payrolls turn down while unemployment is low.
There were four periods in the past that met this criteria.
The 1950-53, the 1955-57 and the 1998-2001 periods all had payrolls decline from their maximum even with low unemployment. However, it should also be noted that in all cases the unemployment rate began to rise as well. In other words, a decline in payrolls doesn’t necessarily offer any better signal than simply watching the unemployment rate. In the 1966-70 period, payrolls continued to rise even though the unemployment rate began to rise. Of course, we have the current event, which still shows rising payrolls.
So, what does this mean for markets? This analysis shows that slowing payrolls won’t necessarily offer a better signal for weakening labor markets than rising unemployment. And, for now, the employment/population ratio is a superior measure of slack. Based on this analysis, there is probably more room for additional increases in the labor force before wage growth accelerates.
[Posted: 9:30 AM EDT] It’s employment Friday! We cover the data in detail below, but the short recap is that the payroll data came in well below forecast at 134k vs. estimates of 185k. However, revisions added 87k, so the overall increase in payrolls did exceed estimates. The unemployment rate dipped to 3.7%, below the 3.8% expected. Wages were on forecast at 2.8%. Overall, it’s a solid report and should support further increases in the policy rate. We are seeing further weakness in bond prices and a stronger dollar. Equities are mostly steady. Here are other items we are watching today:
Brazil to the polls: Brazilian voters go to the polls Sunday in what has been a rather wild pre-election season. For much of the run-up to the election, former president Luiz Inacio Lula da Silva was the front-runner, although he had been convicted of corruption. The courts barred him from running. With Lula out of the way, Jair Bolsonaro is leading in the polls.[1] Bolsonaro, a former member of the military, is a controversial figure[2] running on a right-wing populist platform. He was recently stabbed during a campaign rally, but has recovered.[3] The electorate’s shift from favoring Lula, a hard-left candidate, to Bolsonaro, a hard-right candidate, is a pattern we have seen across the democracies of the world. The center-left and center-right are losing support, seen as the vanguard of globalization and deregulation. Voters want something different even if that “difference” is not ideologically consistent. We would not expect a final result from Sunday’s election; Brazil requires a majority to take the presidency and if no candidate exceeds 50% (polls don’t suggest any candidate will) then a runoff between the two largest vote winners will be held on October 28. Brazilian equities (in dollar terms) have been under pressure this year.
A Bolsonaro victory may be a catalyst for an equity rally as he would be seen, at least initially, as friendly to capital.
The disappearing journalist:Jamal Khashoggi is a Saudi journalist who has been living outside the kingdom recently on apparent fears of arrest. Earlier in the week, he entered the Saudi consulate in Istanbul.[4] He hasn’t been seen since. The Saudis say they don’t have him but it is generally believed that the kingdom has detained him. Khashoggi has been critical of Saudi Crown Prince Salman,[5] a leader who has shown he will not tolerate dissent. We would not look for the U.S. to get deeply involved in this issue, but Khashoggi is well known and if he has been arrested it could be a public relations issue for Saudi Arabia.
[Posted: 9:30 AM EDT] It’s a global down day for equities. Rising long-duration interest rates are the most cited culprit. Here is what we are watching today:
Rising long-duration yields: Long-duration yields are mostly a function of the policy rate and inflation expectations. Determining the policy rate is a snap. Determining inflation expectations is another matter. History tends to show that inflation expectations change slowly, although some factors, like oil, can cause short-term shifts in anticipated inflation.
The chart on the left shows oil prices and 10-year yields. From the mid-1970s into 1990, the two series were positively correlated at the level of +83.9%. Since then, the two series are negatively correlated at the level of -69.0%. During the 1980s into the 1990s, anyone building a yield model incorporated oil prices because yields were very sensitive to oil prices. However, as investors began to believe that the central banks would prevent oil prices from triggering wider inflation, the correlation flipped. Simply put, until the early 1990s, investors believed that high oil prices lifted inflation. After the early 1990s, investors believed that high oil prices depressed economic activity and thus was bullish for Treasury prices (leading to lower yields).
However, the chart on the right shows that there are short periods when there is a positive correlation between oil prices and yields. We use a five-year rolling correlation which shows that even in the post-1990 period, when the general correlation was lower, there are episodes when the correlation turns positive for short periods of time. It would seem that these phases tend to occur when economic growth is strong, such as the one we are in now. Thus, part of the rout we are seeing in the long end is due to high oil prices, which, as we note below, are mostly due to fears of Iranian sanctions.
At the same time, there are growing worries about the policy rate. Recent speeches by Chair Powell and other FOMC members mostly lean hawkish.[1] Although the Phillips Curve seems to be rapidly falling out of favor (as it probably should), we are entering a period where there is no dominant model for inflation and its effect on policy. Instead, we are increasingly left with anecdotes. For example, here is one from Chair Powell’s recent speech which measures reported bottlenecks or shortages in the Beige Book.
Pretty scary, huh kids?[2] Well, in the 1998 period, when bottlenecks were being widely reported, core CPI topped out at 2.5%. In 2001, when reported bottlenecks nearly disappeared, core CPI peaked at 2.8%. Simply put, reported bottlenecks seem to have little relationship to actual inflation.
So, what’s driving bond yields higher? Fears of continued policy tightening and oil prices. The two-year deferred Eurodollar futures have ticked up to an implied yield of 3.27%, suggesting a terminal fed funds target of at least 3.25%. And, oil prices are raising short-term inflation worries. But, the recent move is excessive and smacks of short-covering and we suspect it won’t be maintained.
China: The news flow on China overnight was quite negative. First. Bloomberg broke an important story alleging that Chinese spies used a hardware hack to essentially use our smart phones to monitor our behavior.[3] The U.S. Navy is proposing a major show of force in the South China Sea.[4] VP Pence is said to be preparing a speech outlining Chinese aggression.[5] Overall, relations are looking increasingly strained. The breakdown in relations will tend to pressure Chinese financial assets with residual effects on other EM markets.
Energy recap: U.S. crude oil inventories rose 8.0 mb compared to market expectations of a 1.5 mb draw.
This chart shows current crude oil inventories, both over the long term and the last decade. We have added the estimated level of lease stocks to maintain the consistency of the data. As the chart shows, inventories remain historically high but have declined significantly since March 2017. We would consider the overhang closed if stocks fall under 400 mb. Refinery utilization was unchanged at 90.4% as was oil production at 11.1 mbpd. Exports declined 0.4 mbpd, while imports rose 0.2 mbpd. The rise in stockpiles was mostly due to falling exports and slower refining activity.
As the seasonal chart below shows, inventories have begun their seasonal build period. We should see inventories continue to rise in the coming weeks as refinery operations decline for autumn maintenance.
(Source: DOE, CIM)
Based on inventories alone, oil prices are below fair value price at $70.20. Meanwhile, the EUR/WTI model generates a fair value of $60.88. Together (which is a more sound methodology), fair value is $64.77, meaning that current prices are well above fair value. Oil prices have been in a strong bull market for the past several weeks, mostly on fears of supply constraints from sanctions on Iranian oil exports. In fact, Russian President Putin suggested to President Trump today that he should stop blaming OPEC and foreign oil suppliers for high oil prices and instead “look in the mirror.”[6] Although this week’s data is bearish for oil prices, news that the U.S. was pulling out of a 63-year oil treaty with Iran after the Iranians won a verdict at the International Court of Justice boosted prices.[7] Relations with Iran continue to deteriorate and the increase in tensions is supporting higher prices in the face of rising stockpiles.[8] It is possible that, at least in the short run, oil prices are getting a bit ahead of themselves. But, fear of supply losses in the coming weeks is keeping a bid under the price of oil.
[Posted: 9:30 AM EDT] Risk-on is in the air this morning. Here is what we are watching:
Italy: Financial markets are showing some signs of relief this morning following the populist government’s promise to lower fiscal deficits after 2019.[1] This has the look of a common promise made around the holidays, when one says that dieting will commence right after New Year’s. Promises are easy to make, austerity isn’t. We strongly doubt there will be any change in policy but the mere promise suggests that the EU and Italy can avoid a direct confrontation in the short run.
Powell speaks: The Fed chair’s remarks were no surprise.[2] Policy is largely laid out into next year, with another 100 bps of tightening expected. Given the flux over policy structure we expect the FOMC to raise rates slowly until we see fed funds around 3.25%. At that point, if the 10-year yield doesn’t rise significantly, the yield curve will likely curb any desire to raise rates further.
Yesterday, we described the Powell Fed’s communication policy as “less is more.” We have media confirmation today.[3]
More on USMCA: In the new treaty, there is a clause that will further isolate China. There is a provision that requires any nation in the agreement to give three months’ notice to the other parties if it enters trade negotiations with a non-market economy[4] (read: China). If any of the three nations make a deal with a non-market economy, that nation can be driven out of USMCA. Again, this isn’t much different than the goals of TPP but the enforcement is much different. TPP attempted to isolate China by creating “carrots” for joining the free trade group. USMCA uses a “stick” approach, penalizing nations in the pact for making trade deals with China. We would not be surprised to see future trade arrangements (Japan and the U.S. are in negotiations now) contain similar clauses.
How close was it?[5] Last week, there was an incident where the U.S.S. Decatur, an Arleigh Burke-class destroyer, and a Luyang-class Chinese destroyer came within 45 yards of each other as the Chinese vessel challenged the U.S. Navy ship in the South China Sea. The U.S. and China are becoming increasingly confrontational on multiple fronts (as noted in the above comment) and the odds of escalation are rising. At this point, we are not putting a high probability on open conflict, but the chances are rising and neither side appears willing to back down.
$15 per hour: Amazon (AMZN, 1971.31) made headlines earlier this week by announcing it would boost its base wage to $15 per hour.[6] We suspect there are multiple reasons why the company made this move. There is no doubt that labor market conditions have been tightening. Companies tend to avoid moving salaries higher because it is hard to reduce them when economic conditions deteriorate. When labor costs need to be cut, wage rigidity tends to lead to layoffs rather than wage cuts. Thus, companies have been increasing pay in the form of bonuses and benefits which can be adjusted more easily. Thus, Amazon’s move does press against that trend. To some extent, this action may give Amazon a competitive edge; its distribution network isn’t all that labor intensive relative to its competition, so this move will tend to force its “brick and mortar” competition to raise wages too,[7] which will pressure their margins more than Amazon’s. The policy and political optics are favorable. Sen. Sanders (I-VT) was pressing the company with legislation designed to force it to pay for transfer payment support to its workers. The hike was lauded by Sanders and will likely force other retailers to go along.
Retailing represents about 10.7% of total non-farm payrolls.
As the chart shows, the uptrend line was broken around the turn of the century, most likely due to the rise of online retailing. We note that transportation and warehouse worker counts have been rising rapidly since 2010.
Assuming much of the rest of retailing is forced to match Amazon, we will see a sharp rise in wages for about 10.7 mm workers. And, restaurants, which likely use the same labor pool that supports retailing, may face increased worker shortages. This could boost wages at the low end and is something we will be watching closely in the coming months.
Trump and the king:President Trump noted, at a campaign rally last night, that the U.S. protects Saudi Arabia and it “wouldn’t last two weeks” if the U.S. were to withdraw that support.[8] Although they would likely make it longer than a fortnight, over time, there is no doubt that the Saudis would be in trouble without U.S. security support. Of course, the kingdom could seek help from others. Russia would be a natural partner. A more overt alliance with Israel is possible, too. The onset of fracking has made the U.S. commitment to Middle East security obsolete and we have seen a steady decline in American interest in maintaining borders and organizing security. The president isn’t happy with OPEC actions and current oil prices, albeit the recent rally is mostly due to the announcement of sanctions on Iran. Still, higher oil prices are something of a mixed bag for the U.S. Rising gasoline prices undermine consumer confidence (but not spending—this is the “pundit’s canard” because the GDP consumption data doesn’t care if you spend $5 on a slurpee and burrito or on gasoline…it’s still spending), but higher oil prices also boost investment activity in the oil patch and thus, unlike what we used to see, higher oil prices do act to support parts of the American economy. The key takeaway here is that if Saudi Arabia can’t rely on the U.S. it will find other partners for security. They may not be as effective or generous, but alternatives do exist.
[Posted: 9:30 AM EDT] We are seeing a bit of weakness this morning, mostly due to comments coming out of Italy. Here is what we are watching:
Italy: The head of the finance committee in the lower house of Italy’s legislature, Claudio Borghi, was quoted as saying that Italy would not have a debt problem if it weren’t part of the Eurozone.[1] Although his comments are imprudent, they are mostly true. Outside the Eurozone, Italy would have higher interest rates but would likely have depreciated its exchange rate against the dollar and euro in a bid to keep Italy’s economy competitive. There would be no government solvency crisis because it could print its own debt service instrument. Although there is much handwringing about the Italian budget and fears of the populist government that heads the country, the real problem is that the euro project was faulty at its onset. A nation loses some of its sovereignty when it loses control of its currency.
It has been our position that a point will be reached where the euro project fails and nations exit the single currency. This is because the Eurozone, as it currently operates, allows Germany to dominate the single currency bloc. This setup is becoming increasingly unacceptable to some nations within the Eurozone, especially along the southern tier. We would not be surprised to see two currency blocs emerge, a northern and a southern euro. The problem nation in this configuration is France; economically, it should be in the southern euro, but, politically, it will want to be in the northern euro.
For the time being, Italy will remain a tension point in Europe. If the Eurozone cannot accommodate its goal of expanded fiscal spending and faster growth, it could trigger a crisis similar to the Greek problem. However, given Italy’s size, the Italian problem will threaten the structural integrity of the Eurozone. In the near term, we think Germany will eventually allow Italy to overspend. However, that outcome won’t be permitted indefinitely.
Powell speaks: As noted below, Chair Powell will give a talk this afternoon. The WSJ[2] points out this morning that the Powell Fed is becoming increasingly parsimonious in its forward guidance. This trend is, in our opinion, a favorable one. Our research has shown that increasing transparency has weakened the relationship between fed funds and financial stability.
This chart shows the relationship between fed funds and the Chicago FRB National Financial Conditions Index (NFCI). The NFCI is a measure of financial stress; the higher the reading, the higher the level of financial stress. From 1973 to mid-1998, the two series were highly and positively correlated; the higher the level of fed funds, the more financial conditions deteriorated. Thus, as the FOMC raised rates, financial conditions deteriorated, leading to weaker economic activity. When the FOMC lowered rates, financial stress would dissipate, boosting growth. Financial stress became, in effect, a force multiplier for monetary policy.
Since mid-1998, the two series have become increasingly uncorrelated. We believe this is due to increased Fed transparency. As the FOMC became more open in publicizing its policy goals, financial markets could anticipate policy changes. This reduced financial stress, which is probably seen as a good thing (we are not so convinced), but it also removed stress as a policy force multiplier. Thus, in the mid-aughts, the Fed raised rates without a commensurate rise in stress. This lack of stress was part of the “Greenspan conundrum” – the Fed was raising rates but long rates and borrowing did not respond as expected. Then, when the financial crisis hit in 2008, the FOMC aggressively cut rates to no avail; stress rose significantly and it took years of ZIRP before stress levels fell to pre-crisis levels.
Thus, Powell’s shift to a “less is more” approach should be lauded. Although financial stress is usually unwelcome, it should be noted that financial stress injects caution into the minds of investors and can act, in part, to prevent excessive enthusiasm.
Another factor that seems to be developing is that allegiance to the Phillips Curve may be waning as the FOMC ages. At present, there is no other model to replace it. In the absence of a new working model, policymakers appear to be taking a wait-and-see approach. At present, we suspect the term “market signals” is all about the yield curve and a growing majority on the FOMC may take a cautious approach and vote to pause the rate hike cycle as we approach inversion. We will be looking for any hints of such ideas in Powell’s comments today.
In May, the Trump administration exited the Joint Comprehensive Plan of Action (JCPOA), otherwise known as the Iran nuclear deal.[1] In conjunction with its exit, the U.S. implemented new sanctions and the goal of U.S. policy is to reduce Iran’s oil exports to zero barrels by November.
The other parties in the agreement, China, Russia, the EU and Iran, are unhappy with the U.S. decision. The EU is working to create a payment structure which will not use the U.S. financial system.[2] The plan, which creates a special purpose vehicle that will process trade-related payments between Iran and the EU, could become an alternative to the S.W.I.F.T. network, the current system. Although S.W.I.F.T. is headquartered in Europe, it is dominated by the U.S. financial system because of the dollar’s reserve currency role.
Because the U.S. has a tendency to implement financial sanctions against its perceived adversaries, there have been growing calls for an alternative to dollar-based trade. It is not clear whether an alternative system would end up facing U.S. sanctions as some of its users will likely also use the American financial system. Still, the concern about the U.S. “weaponizing” the dollar has raised the idea of a global reserve currency.
In Part I of this report, we will introduce the characteristics of a reserve currency, including a discussion of the costs and benefits of providing the reserve currency. Part II will begin with a short explanation of the S.W.I.F.T. network and its importance to international finance. From there, we will discuss the potential competitors to the dollar, examining the possibility of competing trade blocs. As always, we will conclude with potential market ramifications.
[Posted: 9:30 AM EDT] It’s Monday! It’s a risk-on day and the U.S, Canada and Mexico have struck a deal on NAFTA. U.S. equity futures are higher, while precious metals and Treasury prices are lower. Here is what we are watching:
A NAFTA deal: Although the deadline wasn’t as “dead” as it looked, Canadian and U.S. negotiators reached a deal late yesterday.[1] Mexico’s president-elect had indicated he would sign whatever deal was made, meaning the deadline wasn’t as crucial. There had been fears that AMLO would not go along with the arrangement and thus a deal had to be reached before September 30 for the current Mexican president to approve it. Still, a deal was reached. Although details are still sketchy, it does appear that U.S. dairy farmers will get access to the Canadian market while the dispute mechanism that Canada wanted to keep was retained. In fact, the new arrangement appears to have a new name—the United States, Mexico and Canada Agreement (USMCA).[2]
It should be noted that Congress will have to approve USMCA and the composition of the House will almost certainly change. It is unclear if congressional approval will occur because the White House has lost “fast-track” authority. Still, the president is making some progress on revamping U.S. trade patterns. His administration has a free trade arrangement with South Korea and is negotiating with Japan and the EU. So, for the most part, we are seeing some positive movement. Of course, the real issue remains with China, and trade policy with Beijing appears to be going beyond mere trade.
Conservatives meet: The Tories in Britain are meeting this week and tensions are elevated between the hardline Brexiters and the rest.[3] It is possible that Boris Johnson could make a leadership challenge; if he does, it raises the chances that the government will face a no-confidence vote and broader elections. We expect lots of strong headlines but little new movement from these meetings.
China news: There were some interesting articles regarding China in the weekend media. First, the NYT reported that Chinese authorities are directing journalists to refrain from making negative comments about the economy.[4] Specifically, they are to avoid discussing worse than expected economic data, local government debt risks, the trade war with the U.S., any signs of weakening consumer confidence, stagflation and personal interest stories showing economic hardship. It is not clear exactly what is going on here. One possibility is that the economy is worse than it looks and the Xi regime wants to avoid a crisis of confidence. Another is a trend we have seen for some time, which is that the CPC derives its legitimacy from delivering strong growth and if growth slows it fears that the result won’t be just a downturn but will undermine the legitimacy of the communist party.
A second interesting development is that the Trump administration actively considered cutting aid to El Salvador for ending diplomatic relations with Taiwan in favor of China.[5] The idea of punishing nations that end relations with Taiwan in favor of China gets into a very touchy issue. The U.S. and China have employed strategic ambiguity regarding Taiwan. This diplomatic term means that two parties use exactly the same words but the words have different meaning to each party. For the U.S., Taiwan should, maybe someday, in a time far, far, away, formally become part of China. For China, Taiwan should be absorbed into China soon. Hardliners within the Trump administration (Bolton, mostly) are agitating to support a more independent Taiwan. As relations between China and the U.S. deteriorate, using Taiwan as “the point of the spear” is looking increasingly attractive. However, from China’s perspective, this would be like Beijing encouraging Florida to separate from the U.S. Simply put, the harder the U.S. pushes for Taiwan independence, the greater the chances are of a Chinese overreaction. These odds may be higher than we think, considering the above analysis. If the Chinese economy is undermining CPC legitimacy, a war would do wonders to boost it.
Oil:The EU and Iran are said to be close to an agreement, which would allow the latter to continue its oil sales to the Europeans.[6] We really don’t see how this will work but, for now, we will continue to monitor this development. Our expectation is that the largest European oil companies, which need access to the U.S. financial system, will likely decline to participate. If we are correct, European governments will be forced to buy the oil and the Trump administration will have to sanction governments directly. The U.S. will need to decide if the escalation is worth it. There are reports that President Trump called King Salman,[7] most likely to press for higher oil supplies. We doubt the Saudis will make significant changes because the kingdom is running out of excess capacity.
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