Since late August, interest rates have been steadily rising. The 10-year T-note yield made its recent low at 2.82%[1] on August 4th. Since then, yields have moved above 3.00%.
Our 10-year T-note model suggests rates are a bit elevated.
This model includes fed funds and the 15-year moving average of inflation (a proxy for inflation expectations) as the core variables. These two variables explain more than 90% of the variation in the interest rate on this T-note. The additional variables, the yen, oil prices, German bund yields and the fiscal deficit, are all statistically significant but have much less explanatory power than the core variables. Based on the core variables alone, the fair value yield is 3.45%. The weak yen and low German rates (currently around 42 bps) are mostly responsible for the lower fair value reading in the full model.
In the short to intermediate term,[2] the two variables we are watching most closely are fed funds and German yields. Fed funds expectations have been increasing due to robust economic growth and expectations that the FOMC will contain any potential inflation threat.
The chart on the left shows the implied three-month LIBOR rate two years into the future. It has recently ticked higher to 3.135%. The chart on the right shows that FOMC policymakers tend to use this rate as a policy target.[3] In a tightening cycle, the FOMC tends to raise rates until fed funds reach the aforementioned implied LIBOR rate. The vertical lines on the right chart show when inversion occurs. Policy tightening usually stops at that point. Given the current implied rate, this would lead to a terminal fed funds target of 3.25%.
If we assume a 3.25% rate and no other changes, the fair value for the 10-year yield rises to 3.28%. Thus, it is reasonable to assume that much of the rise in yields over the past month has been due to the market preparing for future rate hikes. The low level of German yields is also a concern but even taking bunds to 1.00% only raises the fair value yield to 3.40% (assuming a fed funds rate of 3.25%).
The long-run concern is inflation expectations. A modest rise to 3.00% (from the current 2.10%) and a 3.25% fed funds rate would take the fair value yield to 3.86%. Major bear markets in long-duration assets are mostly a function of unanchored inflation expectations. Although the Federal Reserve has limited capabilities to restrain actual inflation (inflation control is mostly a function of the supply side of the economy), central banks are critical to managing inflation expectations. If investors, households and firms conclude that the central bank won’t raise rates in the face of rising inflation, their behavior will likely change to adapt to steadily rising prices. Alan Greenspan’s definition of inflation control is when economic actors no longer take inflation into account when making consumption and investment decisions. If inflation fears emerge, these actors will tend to increase inventories, rush to purchase before prices rise and set the stage for a price spiral. The control of inflation expectations is one of the reasons modern central banks are given policy independence. Anything that infringes on this independence runs the risk of un-anchoring inflation expectations. To date that hasn’t occurred but the rise of populism increases the odds that central banks will lose their independence, which increases the risk of higher long-duration yields.
[Posted: 9:30 AM EDT] Happy Friday! After a tumultuous week, financial markets are being roiled today by Italy. Here is what we are watching:
The Italian crisis: The populist government in Italy has been pressing against the EU budget rules. In general, a 2% deficit/GDP ratio is the highest allowed and Italian Finance Minister Giovanni Tria has been signaling that his country would not go over that limit. However, in the end, the coalition refused to abide by the EU rules and brought a budget with a deficit of 2.4% to GDP.[1] Tria is not a member of the coalition’s parties; he got the post because of EU pressure. Market reaction has been swift.
(Source: Bloomberg)
This chart shows the Italian 10-year yield. On the news, the yield jumped over 30 bps.
For context, here is a longer term chart.
(Source: Bloomberg)
As the chart shows, yields are approaching recent highs. Perhaps even more worrisome was the yield action in the Bund/Italian spread.
(Source: Bloomberg)
As one would expect, the spread (the lower part of the chart) widened. However, it widened not just because Italian yields rose but also because German 10-year Bund yields fell. The drop in Bund yields has pushed U.S. yields lower. This suggests some flight to safety within Europe as Italian investors flee to the safety of Germany.
Italian equities also fell, with bank share trading being halted for part of the day as price limits were hit. The EUR also tumbled despite rising inflation. The fear is that a crisis in Europe could lead to a breakup of the Eurozone. This uncertainty is weighing on the currency this morning.
Further reflections on U.S. monetary policy: We are seeing two emerging trends from the Powell Fed. First, Powell seems to be slowing the central bank’s drive for transparency and guidance.[2] We have seen a steady increase in transparency over the years. Until the late 1980s, changes in monetary policy were not announced. The only rate discussion made available was the discount rate, but changes to that rate did not always coincide with changes in the fed funds target. During the 1990s, Chair Greenspan began issuing statements when the FOMC made changes to the target. Later in the decade, statements were issued with each meeting. The statements themselves became longer with more information. In 2011, press conferences at four meetings each year were introduced and the dots plot was initiated a year later. Press conferences will now follow every meeting.
We have commented at length that this steady expansion of transparency is in line with American society. We have become increasingly open about our lives, with many of us commenting at length on social media. However, transparency isn’t without its costs. One of the problems we have noted is that as the FOMC has become more open, financial markets have become increasingly comfortable with the path of policy and thus investors will take more risk than they otherwise would if they were uncertain about future monetary actions. Chair Powell, in his latest press conference, told the media that they should focus less on the words and more on the data, indicating the path of policy could change if the data moves in unexpected directions. In other words, watch the data, not the commentary.
The other item we think might be evolving is that Powell, a non-economist, is less likely to be blinded tied to any particular model of the economy. In other words, he may not be a Phillips Curve adherent and thus may be less driven by theory. This can be good or bad. It’s good if the theory doesn’t work; that may be especially true with regard to the Phillips Curve. It can be bad if Powell has no theory on how the economy works. That could lead to “winging it.” Thus, policy might be more volatile in the future.
The impact of trade: The Atlanta FRB GDPNow advance forecast for Q3 GDP turned lower due to the unexpected widening of the trade deficit, released yesterday.
The trade data lowered the forecast from 4.4% to 3.8%. Here is the path of the forecast by sector contributions to growth.
If there is an area where growth could come under pressure it would be trade. Dollar strength and the relative growth rates favoring the U.S. will tend to widen the trade deficit and thus weaken the expansion. Tariffs may reduce that effect but may also lift inflation.
[Posted: 9:30 AM EDT] Financial markets are mostly steady this morning (although the dollar is stronger) after a rather large number of economic releases this morning. The FOMC meeting ended as expected, with no major surprises. Economics will take a back seat to politics on this Thursday. Here is what we are watching today:
Politics: There are two major events in Washington today. Deputy AG Rosenstein is scheduled to go to the White House today (although we would not be surprised to see the meeting postponed); we are assuming Rosenstein has decided he would rather be fired than resign and we don’t expect Trump to do that until after the midterms. The second event, of course, is the Kavanaugh hearing. We haven’t said a lot about this because it hasn’t had much of a market impact. However, that doesn’t mean we aren’t paying attention. There is a lot going on here. From our perspective, one of the key elements that has been overlooked is that our constitution was written for a decentralized republic that was not in the business of hegemony. But, as our country took to the role, we quickly found that Congress, designed as a deliberative body, moved too slowly for a superpower. Thus, power has steadily shifted from the legislative to the executive branch. As a result, presidents have much more power than the founders envisioned.
The strain of providing global public goods to the world has distorted our economy and left us with a dilemma—we can have low inflation, but only at the cost of rising inequality. Or, we can reduce inequality at the risk of rising price levels. It may be possible to eliminate this dilemma but, to date, no one has come up with a feasible economic and political solution that works. Therefore, widespread disaffection with how “the system” works has led to a very fluid political situation that is currently leading to adjusting coalitions. As the legislature struggles, agents looking to create change have turned to the courts to make policy. And so, the Supreme Court, created to adjudicate constitutional matters, has become embroiled in policy issues that should have been decided in Congress. When the founders created a system of lifetime appointments, the goal was to create a body that would rationally decide if a law was in line with the constitution; now, we have created a body that resembles lifetime legislators.
With this development, court appointments have moved from a cool analysis of the legal competence of the nominee to a full-contact political fight. Conditions could become much worse. Watching the arguments from partisan pundits begins to take on the tone of two brothers arguing their case before parents (“he started it…did not!”). In our opinion, the beginning of this current predicament was the Bork nomination, but now we have reached a point where the opposition party may decide that changing the court is their best option. We would not be surprised to see term limits introduced and increases in the number of justices.
For the markets, this is important because policy is likely to change more rapidly than it has in the past. The country and financial markets have been fortunate to have enjoyed a series of long business cycles. After suffering four recessions from 1970 through 1982, we have seen only three since (although, admittedly, the last one was a doozy). Rapidly changing policy, including on regulation and taxes, will make investing decisions difficult and likely lead to shorter business cycles and shorter equity cycles, too.
FOMC meeting recap: The statement did what we expected—the word “accommodative” was removed but in the press conference Chair Powell quickly indicated that we shouldn’t read too much into the change. In other words, as we noted yesterday, this change likely has more to do with reducing forward guidance and is less about achieving neutrality. The press conference itself was a meandering affair, flipping between suggesting more hikes to come and then reversing to when cuts will commence. This uncertainty is to be expected. We are approaching the point where policy has become less easy and thus we are closer to shifts in policy than we were before.
Here are some charts that detail what we know. Here are the “dots.”
The red dots represent yesterday’s meeting. The changes from June are not significant and probably reflect the votes of the new vice chair Clarida. The dots signal at least two hikes in 2019, to 3.00% to a potential of 3.25%. The terminal rate is forecast at around 3.25%, and rates are expected to come down in 2020.
Market projections for rates continue to suggest the path is moving higher. Fed funds futures are putting a high probability on a December rate hike.
(Source: Bloomberg)
The odds for a December hike are around 75%.
The three-month implied LIBOR rate from the two-year deferred Eurodollar futures suggests more hikes to come.
The implied LIBOR rate is up to 3.185%, and the spread between this rate and the Fed’s target is suggesting a terminal rate of 3.25% to 3.50%. Of course, the difficult question is when does the rate increase enough to hurt the economy? The chart on the right offers the best clue; when the implied LIBOR rate intersects with the fed funds target, further rate hikes risk recession. Thus, we are about 100 bps from “trouble.”
Although the removal of the word accommodative was initially taken as dovish, we really don’t see it that way. In yesterday’s report, we noted that some of the governors and regional bank presidents are adjusting positions. The hawkish shift from Governor Brainard is of particular interest. The fear, of course, is that the FOMC overtightens. We are not there yet but we are also now entering a rate level where each increase could begin to adversely affect the economy. Today’s market action suggests a more hawkish concern.
And, finally, the president did object to the latest rate hike. Although his comments didn’t create much of a stir, we are still watching closely to see if he begins to increase pressure on the Fed to adjust policy. We really haven’t seen anything like this since Nixon, but if the U.S. government’s goal is reflation then a compliant Fed is a necessary component.
Italian job: Italy is facing a deadline for its budget today; the official word is that the deficit is likely to come in around 2.4% of GDP or less. However, elements within the populist coalition are making noise about increased spending and thus we could see Italian debt pressure develop if the final budget comes in anywhere north of 2.4%.
China: There were a couple of news items on China that caught our attention. First, President Trump accused China of meddling in U.S. elections.[1] There was no evidence offered to substantiate the claim, and China has indicated it is not true.[2] It is possible there is classified information that shows Chinese interference. Or, he could be referencing ads taken out recently in the Des Moines Register indicating that China was planning on buying South American soybeans due to the administration’s trade policy.[3] Tensions with China are clearly increasing; we would not be shocked by evidence of Chinese interference but the CPC should realize that Trump represents a trend in U.S./Chinese relations, not a one-off. The second issue is a growing row between Beijing and Stockholm. According to reports, Chinese tourists arrived a day early at a Swedish hotel and decided to decamp in the lobby. When the proprietors objected to this plan, a shouting match ensued and security forces became involved. A Swedish media outlet made a satirical video skit that has been taken offensively by Chinese officials.[4] China has had tense relations with Sweden due to the Nobel organization giving awards to ostracized Chinese artists. We don’t know if anything more will come from this,[5] but the level of anger is surprisingly high.
Energy recap: U.S. crude oil inventories rose 1.9 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 fell 5.0% to 90.4% last week. Oil production rose 0.1 mbpd to 11.1 mbpd. Exports increased, rising 0.2 mbpd, while imports fell 0.2 mbpd. The rise in stockpiles was a function of falling refining demand.
As the seasonal chart below shows, inventories have reached the end of the seasonal withdrawal period. We should begin to see inventories 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 $75.35. Meanwhile, the EUR/WTI model generates a fair value of $60.81. Together (which is a more sound methodology), fair value is $65.78, meaning that current prices are well above fair value. The most bearish factor for oil is dollar strength, while the decline in inventories this driving season has been a significant supportive factor.
We note that oil prices lifted this morning on reports that DOE Secretary Perry indicated the U.S. would not release oil from the SPR to lower oil prices. Although this news is bullish if true, the chance that the president could shift quickly on this policy isn’t trivial.
[Posted: 9:30 AM EDT] The FOMC meeting ends today but, to a great extent, the Fed is being overshadowed by political events. Here is what we are watching today:
The FOMC meeting: The FOMC meeting ends today with near certainty of a 25 bps rate hike. There is a press conference with this meeting so we may get some indication of future policy, although we would not expect Chair Powell to tip his hand in any particular direction. In the statement, we will be watching closely for whether the word “accommodative” is removed. If it is, it could tell us one of two things; first, the Powell Fed is done with forward guidance and we will have to estimate the bank’s policy stance in the future, or second, forward guidance is still operating and the FOMC believes policy is closer to neutral. A call that policy has achieved neutrality would be dollar bearish, Treasury and equity bullish. If the removal of the word accommodative merely means the Fed is out of the forward guidance business, then the market impact should be mostly neutral. However, unless Chair Powell makes explicit reference to ending forward guidance (if we were in the press conference, this is the issue we would press for a clear answer to), then look for the market to take the language change as dovish.
Here is the latest iteration of our Mankiw Rule models. The Mankiw rule models attempt to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative. Mankiw’s model is a variation of the Taylor Rule. The latter measures the neutral rate using core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy. Potential GDP cannot be directly observed, only estimated. To overcome this problem with potential GDP, Mankiw used the unemployment rate as a proxy for economic slack. We have created four versions of the rule, one that follows the original construction by using the unemployment rate as a measure of slack, a second using the employment/population ratio, a third using involuntary part-time workers as a percentage of the total labor force and a fourth using yearly wage growth for non-supervisory workers.
Using the unemployment rate, the neutral rate is now 3.94%, down from 4.02%, reflecting the fall in core CPI. Using the employment/population ratio, the neutral rate is 1.68%, down from 1.84%, reflecting both the decline in inflation and the decline in the employment/population ratio. Using involuntary part-time employment, the neutral rate is 3.79%, up from 3.68%, due to falling involuntary part-time employment. Using wage growth for non-supervisory workers, the neutral rate is 2.47%, up modestly from the last calculation of 2.42%.
Given this model, the FOMC can defend its tightening policy; even using the most dovish of the variations, the FOMC would need to raise rates to 2.75% to achieve a tight policy. The other models support multiple rate increases. At present, we are not in a situation where there should be a high degree of dissention but we could see divisions develop by the middle of next year.
We have also updated our hawk/dove table and have made a few significant adjustments. Governor Brainard’s position that policy tightening is necessary to prevent asset mispricing (or, in normal language, bubbles) changes her from a 4 (on a 1-5 scale, with 1 being most hawkish) to a 3. Boston FRB President Rosengren and Chicago FRB President Evans have echoed Governor Brainard recently, shifting the former from 3 to 2 and the latter from 4 to 3. NY FRB President Williams’s comments on the term premium moves him from 2 to 3. Atlanta FRB President Bostic’s comments regarding the policy rate and the yield curve shifts him from 3 to 4, and similar comments on the yield curve from Dallas FRB President Kaplan and Philadelphia FRB President Harker take them both from 3 to 4 as well. In total, these changes suggest the overall FOMC is slightly dovish, while the configuration of voters from this year and next is remarkably similar.
Russia’s Middle East struggles: Russia engaged in the Syrian civil war because it didn’t want to see an ally fall. The Assads have been allies of the Soviet Union/Russia since WWII. In addition, the Putin regime wanted to project power and show it could replace or compete with the U.S. on a global scale, harkening back to the Cold War days. Now, Russia is discovering the region is difficult and expensive to manage. Russia is trying to keep Iran and Israel apart; Iran will not cooperate with Russia if it means reducing its reach into Lebanon. Israel, as the bombing shows, is opposed to Iran’s goals. Recently, Syrian anti-aircraft missiles were deployed by the regime against Israeli aircraft and the Syrians inadvertently shot down a Russian military aircraft. Initially, both Russia and Israel appeared determined to prevent the incident from upsetting relations. However, that goal has apparently passed. Russia has indicated it will, at long last, supply Syria with the S-300, a sophisticated anti-aircraft system.[1] Russia has indicated it would “sell” this platform to Syria for years but never did so in order to not anger the Israelis and the Americans. This is a serious escalation of tensions and increases the odds of expanding the already existing conflict in the region.
One trend that seems to be developing is that Iran is facing increasing isolation. India announced yesterday it will stop buying Iranian oil after U.S. sanctions are fully implemented on November 1. Russia’s decision to create a demilitarized zone in Syria supports Turkey’s goals. Russia may have concluded it has little interest in helping Iran extend its power in the Middle East and may end up supporting Syrian independence from Iran and supporting Israel against Iran as well. We are watching Saudi/Russian relations. The recent OPEC decision not to boost output despite President Trump’s insistence on lower oil prices (and his U.N. speech calling out OPEC for “ripping off the world”) may be more due to Russia offering support to the kingdom against Iran. For Russia, curtailing Iran probably makes sense; the most effective policy in the region is creating a balance of power where no nation in the area dominates the others. The U.S. abandoned this policy with the invasion of Iraq in 2003 and the Middle East has been in turmoil ever since. As Russia attempts to expand its influence, it appears to be trying to rebalance power in the region and the loser in this effort may be Iran. We do note that Russia would be getting help from the U.S. in isolating Iran; National Security Advisor Bolton warned European nations not to violate American sanctions as they would face “terrible consequences.”[2]
MSCI increasing China’s representation?[3] MSCI is apparently considering increasing its weighting to China by adding more “A” shares to its emerging market index. Four months ago, the index added 235 “A” shares to its index, making it 5% of the total index and, with the “H” shares, lifting China’s exposure in the EM index to roughly 31%. MSCI is proposing to double the number of “A” shares, which would boost the total Chinese component to 40.3%. Given the growth of passive investment, such a move would lead to China dominating this emerging market index, making the overall performance of emerging markets very dependent on China.
Another defeat for the Chancellor: Chancellor Merkel suffered another political defeat when her close ally, Volker Kauder, was defeated by Ralph Brinkhaus for the positon of parliamentary leader.[4] Merkel has suffered a series of defeats and challenges within her coalition. The junior partner of her “grand coalition,” the SDP, recently demanded the firing of her head of intelligence, Hans-Georg Maassen, for comments he made supporting right-wing groups. Although he was removed from his post, he remains part of government as a special advisor to CSU Leader Horst Seehofer,[5] who earlier this year had a row with Merkel over border security. One of the growing fault lines within the CDU/CSU coalition is immigration and the rise of the populist right AfD party. Elements within the CSU, including Brinkhaus and Seehofer, are open to contact with the AfD, seeing the populist insurgent party as a potential ally. The more establishment CDU, of which Merkel is a member, loathes the nationalist bent of the AfD and wants to quash the movement. As we are seeing nearly everywhere in the West, populist nationalism is on the rise, in part a function of income inequality. A retreat from globalization is a key element of populism; it is worth noting that this was an element of President Trump’s speech yesterday to the U.N. General Assembly. So far, Merkel has fended off these challenges, but they are weakening her grip on power. It isn’t obvious who would succeed her. Political uncertainty in Europe will likely put some degree of bearish pressure on the EUR.
China blinking? China announced a tariff cut to over 1,500 items,[6] taking the average to 7.8% from 9.5%. We view this adjustment as mostly cosmetic, although it could be seen as (a) a concession to the U.S. and the world that China’s tariffs are too high, or (b) China trying to build its goodwill with the rest of the world, offering a contrast to the U.S. We suspect this is more of the latter, although we will be watching to see if the Trump administration frames the move as the former.
[Posted: 9:30 AM EDT] Good morning, all! There was a lot of overnight news; below are the stories we are paying the most attention to:
Labour to reject Brexit deal? Earlier this morning, Labour’s Brexit spokesman Keir Starmer fueled speculation of a second Brexit referendum by suggesting the Labour party will likely reject the Brexit deal as it currently stands.In addition, he stated that remaining in the EU has not been ruled out. Starmer’s remarks will likely harden the stance of EU negotiators who would welcome a second vote. PM May is in a precarious situation as she is currently fighting a multiple-front war in order to secure a deal. In addition to battling EU officials, she is taking on Tory rebels who want a clean break from the EU and Labour Party members who are pushing for more cooperation with the EU following Brexit. At this time, it is unclear whether there will be a second referendum but the possibility is becoming increasingly likely. We will continue to monitor this situation.
New Swedish government: Last night, Swedish PM Stefan Lofven was voted out in a confidence vote, which has led to the end of the Social Democrats’ four-year reign in parliament. At the moment, the two establishment blocs, the Social Democrats and Sweden Democrats, are vying to take control of parliament with neither side holding a clear advantage. The confidence vote came only two weeks after Swedish elections saw the rise of far-right populist groups at the expense of the Social Democrats. Rising concerns over immigration appear to be the driving force behind the Social Democrats’ loss of support. Although expectations are relatively low for new elections, we are uncertain what the new government will look like. Currently, the speaker of parliament is expected to meet with members of the coalition to discuss the formation of a new government, with many speculating that Ulf Kristersson, the leader of the Swedish Moderate Party, will be chosen as the next PM.
Iran blinks first? Last night, Iranian President Hassan Rouhani stated that he would consider reopening nuclear talks if President Trump reverses his decision to exit the 2015 Iran nuclear accord. Iran-U.S. tensions have been high since President Trump decided to exit the nuclear accord in 2017, and will likely be on display during the UN Summit, where both Rouhani and Trump are expected to take aim at each other. Despite rumors, both leaders have stated they will not meet with the other during the summit.
Trade talks: As trade talks with China begin to cool and NAFTA negotiations near an end, the Trump administration has focused its attention on establishing bilateral trade deals with Japan and Europe. While the president is in New York for the UN Summit he is expected to try to persuade Japan to enter into bilateral trade talks. The negotiations will likely revolve around opening up Japan’s markets to more U.S. agricultural goods and setting new terms for trade in the automotive sector. Currently, Japan is resisting trade negotiations as it fears the ultimate U.S. aim is to lower its trade surplus. Meanwhile, discussions with Europe will likely focus on regulatory standards. It is too early to conclude whether these negotiations have made any meaningful changes to the current trade arrangement, but the recent trade deal with South Korea suggests it may not be on par with the president’s rhetoric. That said, we believe the president’s most prominent shift in U.S. trade will most likely be with NAFTA members and China.
Rosenstein lives: Although Rod Rosenstein verbally resigned from his position as deputy attorney general, he was convinced to take a meeting with President Trump on Thursday to determine whether or not he should remain in his position. Rosenstein has been under increased pressure due to a New York Times article stating he was willing to wear a wire in order to build a case for invoking the 25th Amendment, which would start impeachment proceedings if the president is declared mentally unfit to be president. It is worth noting that Rosenstein was believed to have said it sarcastically, but the remark will still not go over well with the White House. It is unclear what the president will do as he has often questioned Rosenstein’s position as the overseer of the Mueller investigation. It is widely expected he will be fired following the Thursday meeting, but the actual outcome is uncertain at this time.
Last week, we discussed Venezuela’s economic and political situations. Part II begins with a discussion on migration with a focus on emigrant flows. We include an analysis of the problems caused by migration followed by an examination of the possible end to this crisis and the broader geopolitical issues. As always, we will conclude with potential market ramifications.
The Migration
The total number of Venezuelans that live abroad is estimated to be between 4.0 and 4.5 million,[1] roughly 13.5% of the country’s total population, suggesting that Venezuela has seen steady outflows due to the turmoil that Chavez’s revolution brought to the economy and political system. Since 2015, the International Organization for Migration estimates that 2.3 million Venezuelans have migrated, representing about 7% of the population. Surveys suggest that 54% of remaining upper income Venezuelans want to leave, while 43% of lower income citizens have the same goal.
[Posted: 9:30 AM EDT] There is a lot going on this week. The FOMC meets, U.N. meetings are underway in New York and SCOTUS nominee Kavanaugh is facing new accusers. Also, financial markets were closed today in Japan, mainland China, Taiwan and Korea for an autumn holiday. Here is what we are watching today:
Trade: As $200 bn in new tariffs against China are put into place today,[1] China has canceled military talks with the U.S. after the Trump administration implemented sanctions for China’s purchase of Russian military equipment.[2] Trade talks were canceled as well.[3] There are reports that the Trump administration is planning a major expansion of hostile policies toward China that will go beyond trade, including cyber.[4] This news coincides with an announcement by National Security Director Bolton that the U.S. will engage in more offensive measures in the cyberwar theater.[5] Meanwhile, on NAFTA, an important milestone date is set for September 30. If a deal isn’t reached by that date then Mexican President-elect AMLO would be the one to sign the new deal. Given his nationalist and populist proclivities, it would be easier politically for the current president to approve the measure. At this juncture, we doubt a deal will be made by Sunday. Overall, the trade situation remains fluid; although many in the media continue to argue that equity markets have been unaffected, as our P/E chart below shows, we have lost about two turns in the multiple and we attribute that decline to trade uncertainty. Thus, we have seen an adverse effect, but not a severe one quite yet.
No OPEC: OPEC+Russia ruled out any immediate increase in oil production over the weekend[6]; oil prices are up sharply this morning. We note that Saudi Arabia is running short of its most prized oil, the light/sweet variety.[7] The problem may be, simply, that Saudi Arabia and Russia do not have enough excess capacity to boost supplies significantly. The loss of Iranian and Venezuelan crude oil is driving prices higher. This is a victory for Iran, which opposed any increases, and a defeat for the U.S. The Trump administration has been pressing for higher output, fearful that higher prices would weaken consumer sentiment going into the midterm elections. The U.S. isn’t without resources in this area. We would not be shocked to see an SPR release in a bid to push prices lower. The risk of such a release is that if it fails to deliver lower prices then the only other tool left would be a major appreciation of the U.S. dollar, which would run counter to the administration’s trade policy.
Adding to oil pressure was an attack on a military parade in Iran, allegedly by the Ahvaz National Resistance, although Islamic State has also claimed responsibility. Twenty-five people were killed including 12 IRGC members. Iran accused numerous actors of supporting the attack, including the Persian Gulf states and the U.S. Tensions between Iran and the U.S. have been rising and will likely be expressed this week at the U.N. meetings.[8]
We note that Venezuela is in the news as well. First, China has sent its hospital ship, the Peace Ark, to Venezuela to offer basic medical care to Venezuelans.[9] It joins the USNS Comfort, which is off the Colombia coast supporting Venezuelan refugees. Second, the U.S. is reportedly considering “actions” against the Maduro regime.[10] It is unclear what exactly is being considered. And, finally, Spanish PM Pedro Suarez is coming under fire for his left-wing coalition’s ties to the Maduro government.[11]
A deal for Pastor Brunson? There are reports that the American pastor being held in Turkey might be released in the near future. The pastor is scheduled to appear in court on October 12 and there is some speculation he might be released at that appearance.[12] If he is released, we would expect a knee-jerk rally in Turkish assets as it would likely lead to some easing of U.S. sanctions. However, this action would not solve Turkey’s other problems, mainly excessive dollar-denominated debt.
More on Brexit: There is growing talk in the U.K. about a second referendum. Labour Party leader Corbyn has always been cool to the EU, fearful that German-inspired austerity and labor rules would undermine any radical Labour Party agenda. At the same time, he is loath to support the hard-right Brexit camp. Thus, over the weekend, Corbyn did offer some support for rethinking Brexit, but only in the context of a new government.[13] In other words, Corbyn would prefer elections to remove the Tories from power and have Labour renegotiate the EU relationship.[14] His fear is that a second referendum would change the U.K. stance on the EU and leave the Tories in power.
Italian news: Elements within the Italian government have been issuing calming statements recently, suggesting that budget deficits will be well within EU guidelines.[15] However, there are protests emerging from the more populist elements within the coalition.[16] We view Italy as a major threat to the EU and the Eurozone as Italy needs more fiscal spending and a weaker currency to flourish. It would be better off outside the Eurozone but the turmoil of leaving would be significant.
Tech woes: President Trump is considering an executive order to open an anti-trust probe against the major tech firms.[17] The administration’s concern is that social media firms introduce bias into their searches and platforms. Meanwhile, European regulators are pressing against the firms for their data collection policies.[18] Social media firms are vulnerable to both charges; if they are merely platforms, then it will be difficult for them to restrict any stories or language. On the other hand, if they are media companies, then they will fall under the rules governing media which will make their data-gathering less effective because they will be restricted.
And a couple of interesting items: Peking University is apparently threatening to close a student club called the “Marxist Society” for supporting low-level workers on campus.[19] House GOP members are pushing to get out of town by week’s end to go campaign but the White House may still surprise and shut down the government for border wall funding.[20] Finally, in an article that expresses our view of the withdrawal of U.S. hegemony, Robert Kagan discusses his new book and argues that “the jungle” is returning.[21]
In this week’s report, we will focus on the U.S. economy. Since the 1987 crash every major equity market decline has coincided with a recession. Thus, we pay close attention to the economy with the goal of projecting the next recession.
This expansion, which began in June 2009, is now the second longest in U.S. history.[1]
(Source: NBER, CIM)
If the expansion makes it another eight months, it will tie the longest expansion, which ended with the 2001 recession. Business cycles have been lengthening in recent years.
Since the Great Depression, expansions have been lengthening. Moving off the gold standard has allowed for discretionary monetary policy which has tended to support longer expansions. However, the most important factor that has supported longer business cycles in the past forty years has been falling inflation. As inflation declines, the Federal Reserve has less need to aggressively tighten credit which supports economic expansion.
This chart measures real fed funds (effective fed funds less yearly CPI). Note that since the early 1980s, each cycle has had a lower average real rate over the term of the recovery. Much of this is because the Federal Reserve has successfully lowered inflation expectations. With lowered expectations of inflation, the U.S. central bank can keep rates lower for longer without triggering overheating. The ability to keep rates low has allowed for longer business expansions.
The current economy is doing quite well.
This chart shows the Chicago FRB National Activity Index, a broad-based index of economic indicators which are structured against trend. When the reading is above zero, the economy is growing above trend and vice versa. We smooth the data with a six-month moving average. Overall, the economy is running well above trend.
The most interesting issue with the economy is potential growth.
This chart looks at the long-term pattern of real GDP; we have put the data on a log scale and regressed it against a time trend. The deviation line on the lower part of the graph shows the deviation from the long-term trend. We have only seen two periods of well below-trend growth, during the Great Depression and the current environment. It is unknown whether or not the long-term trend still represents potential output. If it does, not only will the economy easily absorb the stimulus without triggering inflation but the FOMC should be very careful about tightening monetary policy. Note the dip in the deviation chart in 1937; that was due to premature fiscal and monetary tightening that led to a short but deep recession. We tend to think there is more slack in the economy than generally thought. Although the odds are rising that the FOMC will overtighten monetary policy, given the current path of policy, we probably won’t reach the point of concern until the middle of next year.
[Posted: 9:30 AM EDT] Happy Friday! Equities are up as the dollar softens and Treasury yields are higher. Here is what we are watching today:
More on Brexit: Well, that was ugly…the British press is describing the Salzburg conference as a “humiliation” and a “disaster.”[1] In a somewhat unexpected move, the EU forcefully told PM May that her Chequers plan was a non-starter. Instead, the EU leadership has given May an ultimatum—either come up with a plan for the Irish border or talks are over. To reiterate, the Irish problem is this: without a deal, a hard border will form on the Ireland/Northern Ireland frontier.[2] A hard border will undermine the peace deal between the two nations that has been in place for years now and has been very successful. The EU plan was to keep Northern Ireland within the EU trade platform and put the border, effectively, in the Irish Sea. May has rejected that plan, rightfully arguing that such an outcome would essentially mean losing sovereignty over Northern Ireland. May was ultimately angling for the same trade rules for Northern Ireland to be applied to all of the U.K. If the Northern Ireland border remained open and in the EU trading platform, and the U.K. remained as well, then Britain would get all the benefits of EU membership without the costs, such as free movement within the EU. Not surprisingly, this outcome, as we see today, wasn’t acceptable to the EU.[3] The EU leadership has given May four weeks to come up with a new plan.[4] Of course, complicating this situation is that the Tories hold their party conference from September 30 to October 3 and, given the debacle in Salzburg, May looks weak and vulnerable. On the other hand, a collapse of May’s government could lead to new elections in the U.K. and the potential for a Labour government led by Jeremy Corbyn. However, it should be noted that another solution may be developing. If May is unable to deliver a deal there could be a second referendum[5] which might lead to a reversal of Brexit. No deal would be profoundly bearish for the GBP, while a decision to remain would likely lead to a strong rally in the currency. Roughly, a no-deal outcome would likely lead to $1.100 and a new vote to stay would take us to parity at $1.650. We note the GBP is coming under pressure this morning in the wake of these developments.
Turkey: Turkey has offered a new plan to support the lira.[6] The primary component is an austerity program which will cut spending by $10 bn. Although the plan was welcomed, the general belief was that it didn’t go far enough to show how the financial system will be supported as the country tries to deal with rising debt service costs. Still, this plan is evidence that the Erdogan government is aware it has a problem and is trying to stabilize the situation.
OPEC meeting: OPEC is meeting this weekend in Algeria, but there is little chance the cartel will agree to a production increase.[7] Iran has already indicated it will veto any plan to boost supplies. To some extent, OPEC is becoming moot; the oil market is now being controlled by supply decisions in the U.S., Russia and Saudi Arabia. We don’t expect sharp supply increases from the major producers so oil should remain well supported.
No NAFTA deal yet:[8]Although negotiations continue between the U.S. and Canada, no agreement has been reached. The key sticking point is auto tariffs; Canada wants guarantees that the U.S. won’t put tariffs on cars. The U.S. essentially wants Canada to simply accept the deal the U.S. has already made with Mexico. We still think odds favor a deal, but the longer negotiations extend, the less confidence one should have in that assessment.
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