by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s another quiet morning.  Here is what we are watching today:

More on Brexit: Yesterday, we covered some of the simmering issues on Brexit.  Here are some of the day-to-day factors we are watching.  The EU members, sans the U.K., are meeting in Salzburg, Austria to discuss exit issues.  These are informal meetings and probably won’t go anywhere.  One reason is that the Tories hold their party conference from September 30 to October 3 and PM May probably doesn’t want to look as if she is in compromise mode before her party meets.  She already torpedoed the idea of a customs border on the Irish Sea that would leave Northern Ireland in the EU for trade purposes.[1]  We actually don’t think she is all that opposed to the idea but can’t really accept it before the party conference.  There is growing talk of a “blind Brexit” where the U.K. separates from the EU but continues to negotiate terms after separation.[2]  Such an outcome is risky because it isn’t clear how much leverage the U.K. will have to negotiate once it is outside the EU (which will occur in about six months).

Trade: A few interesting storylines are starting to develop.  First, there has been a sharp increase in U.S. soybean exports to the EU.  For this crop year, they are up a whopping 133.3%, with American farmers more than doubling their share of the EU market, to 52.3% from 24.8% last year.  Canada is also increasing its sales to Europe.  South America is seeing falling sales, most likely because their beans are being diverted to China.[3]  So, we are already seeing rather dramatic shifts in trade patterns due to the administration’s tariff policy.  Second, we note that China announced tariff reductions on other nation’s imports, likely in a bid to keep costs down but also to bolster non-U.S. trade ties.[4]  Third, we also note that other nations are taking steps to grab market share from China that is potentially being lost to new tariffs.[5]  Mexico is the nation that likely has the best “inside track.”  And, finally, in another interesting twist, the EU has launched an initiative designed to counter China’s “one belt, one road” project.  The plan is designed to offer infrastructure investment in countries from the Middle East to the Far East.[6]

A new governor: In a surprise move, the Trump administration nominated Nellie Liang[7] to the position of Fed governor.  A perusal of Liang’s background suggests her expertise is in finance and financial markets.  Until proven otherwise, we will expect her to follow the chair on policy and thus we give her the same “hawk/dove” score.

We have put Bowman and Liang in blue on our roster because they haven’t been confirmed yet.  Goodfriend has not had a confirmation vote likely because his performance at the first testimony was so controversial.  His name hasn’t been withdrawn but we would not be surprised if he is replaced given his hawkish tendencies.  We have also added the voting roster for 2019.  It will be a more dovish FOMC next year.

Götterdämmerung for Merkel?  Chancellor Merkel has been seen as a strong leader and an effective political operative.  She famously undercut her mentor, Helmut Kohl, ending his political career.  She forced the end of nuclear power in Germany over strong objections from industry.  During the European debt crisis, she did offer finanical support but only in exchagne for deep austerity.  But, her stance on immigration appears to have exhausted her political capital.  In the last election, her CDU/CSU coalition was only able to remain in power by building another grand coaltion with the SDU.  A recent event shows further evidence of Merkel’s declining power.  Merkel wanted the head of Germany’s domestic spy service fired for comments he made suggesting that the threat from right-wing populists was not all that significant.  Hans-Georg Maaßen, the head of this body, was instead promoted by Interior Minister Horst Seehofer, a member of the CSU and a frequent critic of Merkel’s immigration policy.  The fact that Merkel could not remove Maaßen from office suggests her power has diminished significantly.  An end to Merkel’s career will raise concerns about the path of Germany’s future policy and may bring some weakness to the EUR.

Energy recap: U.S. crude oil inventories fell 2.1 mb compared to market expectations of a 2.5 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 2.2% to 95.4% last week.  Oil production rose 0.1 mbpd to 11.0 mbpd.  Imports and exports both increased, with exports rising 0.5 mbpd while imports rose 0.4 mbpd.  The rise in imports and consistent demand led to the decline in stockpiles.

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.

Based on inventories alone, oil prices are below fair value price at $75.96.  Meanwhile, the EUR/WTI model generates a fair value of $60.54.  Together (which is a more sound methodology), fair value is $65.39, meaning that current prices are well above fair value.  The most bearish factor for oil is dollar strength.  At the same time, falling inventories have been supportive and concerns over falling Iranian exports, due to the administration’s sanctions,[9] are giving oil a bit of “geopolitical premium.”  We would expect oil prices to remain elevated, although we note that the Trump administration is clearly worried about high oil prices denting consumer confidence.  According to reports, the administration is working to boost production from other oil producers, including the U.S.[10]   

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[1] https://www.ft.com/content/4fcea392-bb83-11e8-94b2-17176fbf93f5?emailId=5ba323b2c9e4110004679de4&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[2] https://www.nytimes.com/2018/09/19/world/europe/blind-brexit-theresa-may-european-union.html?emc=edit_mbe_20180920&nl=morning-briefing-europe&nlid=567726720180920&te=1 and https://www.theguardian.com/politics/2018/sep/19/theresa-may-tells-eu27-she-wont-delay-brexit-despite-lack-of-a-deal

[3] https://www.politico.eu/wp-content/uploads/2018/09/Screen-Shot-2018-09-19-at-23.11.37.png?utm_source=POLITICO.EU&utm_campaign=a503006651-EMAIL_CAMPAIGN_2018_09_20_04_34&utm_medium=email&utm_term=0_10959edeb5-a503006651-190334489

[4] https://www.reuters.com/article/us-usa-trade-china-tariffs/china-plans-import-tariff-cuts-as-soon-as-october-bloomberg-idUSKCN1M00MU

[5]https://www.ft.com/content/a6b16faa-bc23-11e8-94b2-17176fbf93f5?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[6] https://www.ft.com/content/bbcda96a-bc1b-11e8-8274-55b72926558f?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[7] https://www.wsj.com/articles/trump-to-nominate-former-fed-economist-nellie-liang-for-board-seat-1537392151

[8] https://www.nytimes.com/2018/09/19/business/energy-environment/iran-oil-sanctions.html?action=click&module=Top%20Stories&pgtype=Homepage

[9] https://www.ft.com/content/521dca6e-bc56-11e8-8274-55b72926558f?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] The news flow is unusually quiet this morning.  The Kavanaugh hearings and trade continue to dominate the headlines.  Here is what we are watching today:

Trade: Financial markets are still struggling to discount the impact of the recent tariff announcement and China’s retaliation.  It has become generally acknowledged that the Xi government underestimated President Trump’s intentions with regard to trade.  U.S. presidential candidates bashing China is nothing new; Bill Clinton made it a point to frame the Bush administration as soft on China back in the early 1990s.  However, all U.S. administrations have generally supported China’s integration into the world economy regardless of the rhetoric expounded during campaigns based on the American belief that democracy and free markets are the only reasonable organizing principles for government and that all nations eventually move toward such governments once reaching a certain level of development.  It appears the Chinese leadership expected similar behavior from the incoming U.S. president.  Trump has proven to be different and China is scrambling to respond.[1]

The newest tariffs appear to be hitting private Chinese companies harder than state-owned enterprises.[2]  This could give Xi more power as private companies will likely come to the CPC for help.  China is trying to maintain the idea that it is a good place to invest.[3]  As a result, this morning, Premier Li Keqiang pledged a set of pro-business policies and offered equal treatment to foreign investors.  In addition, he also promised not to “weaponize” the CNY through depreciation.[4]  At the same time, China has put new tariffs in place against U.S. goods.[5]  We do note that there have been some surprises; China’s announced tariffs on LNG proved to be less than forecast, lifting natural gas prices yesterday.

On another important front, negotiations continue with Canada on NAFTA.  Canadian leaders are facing increasing pressure from political and business leaders on both sides of the border.  Canadian business leaders are coming to realize that the potential losses from a break in trade relations will be extraordinarily damaging to the Canadian economy.[6]  And, U.S. congressional leaders are pressing Canada to accept the deal already made with Mexico.[7]  We suspect Canada will acquiesce and accept U.S. terms to maintain the treaty.

Overall, U.S. equity markets appear to be discounting the trade issue.  We note that P/Es have lost about two turns since the rhetoric escalated, which is probably a reasonable adjustment to the current level of tensions.  At the same time, a prominent wirehouse noted yesterday that “America First” wouldn’t last.  We think this position is likely incorrect; in fact, America First began with President Obama (remember “leading from behind”?) and the process of American adjustment to the hegemonic role is well underway.

Brexit: As negotiations continue, the potential for a “hard Brexit” is both increasing and fears of such an outcome are focusing efforts on both sides.  The EU is softening its position in a few key areas, including the border on Northern Ireland.  The fear is that a hard border could foster a return to the sectarian tensions that dominated the Irish Isles for centuries.  The plan is to keep Northern Ireland effectively in the EU for trade purposes while having a hard border on the British Island itself.[8]  There is also growing talk of a second referendum.[9]  The current environmental secretary and perpetual candidate for PM, Michael Gove, has suggested that any deal reached now could be altered by a future PM.  Gove hopes to encourage the hard-core Brexit supporters to support PM May’s “Checkers” proposal by arguing that if they don’t like it, they should still support May’s plan to avoid the chaos of a sudden break[10] and eventually change it in the future.  Meanwhile, important car companies are warning of closure plans if Brexit is disorderly,[11] and security officials are telling lawmakers that losing EU crime-fighting tools could make it harder to protect U.K. citizens.[12]  Simply put, supply chains are deeply imbedded between the EU and the U.K. and a hard border will cause significant disruptions.  Already, there are reports of hoarding or plans of such measures.[13]  If the Brexit plan turns out to be “soft” or mostly symbolic, seamless and avoiding major disruptions, the GBP will likely rally.  On the other hand, a hard Brexit will likely lead to a deep decline in U.K. financial assets.

An American base in Poland?  Even with America First, other nations still want U.S. involvement.  Poland, geographically situated on the Great Northern European Plain and lacking natural defenses, has been invaded repeatedly from east and west.  Fearing Russian expansion and clearly worried that Western Europe is a military “paper tiger,” the president of Poland, Andrzej Duda, offered financial support for the building of “Fort Trump” in Poland to house American troops.  Currently, the U.S. has 4,000 troops in Poland.  Poland would like to make that permanent and is apparently willing to pony up resources for that protection.

Economy humming:  The most recent iteration of the Atlanta FRB’s GDPNow forecast shows growth projections at 4.4% for Q3.

The biggest contributors to growth are consumption and inventory rebuilding.

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[1] https://www.ft.com/content/f41efb80-bb4d-11e8-94b2-17176fbf93f5?emailId=5ba1ccdee399330004c6912d&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[2] ibid

[3] https://www.ft.com/content/ef8cc604-bbbd-11e8-94b2-17176fbf93f5?emailId=5ba1ccdee399330004c6912d&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22 and https://www.ft.com/content/92c8f00e-bbbe-11e8-94b2-17176fbf93f5

[4] https://www.reuters.com/article/us-usa-trade-china-media/china-wont-weaken-currency-to-boost-exports-premier-says-idUSKCN1LZ01J

[5] https://www.ft.com/content/a12104b6-bb14-11e8-94b2-17176fbf93f5?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[6] https://www.reuters.com/article/us-trade-nafta/canadas-trudeau-under-growing-pressure-to-get-nafta-deal-done-idUSKCN1LY2RY

[7] https://www.ft.com/content/bf42e1f2-bb97-11e8-94b2-17176fbf93f5

[8] https://www.ft.com/content/22091da0-bb80-11e8-94b2-17176fbf93f5

[9] https://www.ft.com/content/f95ce454-ba80-11e8-8274-55b72926558f

[10] https://www.ft.com/content/36c83612-b9a1-11e8-94b2-17176fbf93f5

[11] https://www.ft.com/content/5e4db246-bb56-11e8-94b2-17176fbf93f5

[12] https://www.ft.com/content/4f833bae-bb39-11e8-8274-55b72926558f

[13] https://www.washingtonpost.com/world/europe/theresa-may-just-warned-of-a-no-deal-brexit-here-are-some-of-the-doomsday-scenarios/2018/09/17/3507ab2c-943b-11e8-818b-e9b7348cd87d_story.html?utm_term=.961b9e79c01a&wpisrc=nl_todayworld&wpmm=1 and https://www.washingtonpost.com/world/britain-seeks-to-calm-fears-of-no-deal-brexit-doomsday-but-the-assurances-still-stir-worry/2018/08/23/d8fcff06-a6ca-11e8-8fac-12e98c13528d_story.html?utm_term=.08d3b7b36559&wpisrc=nl_todayworld&wpmm=1

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Good morning and G’mar Hatima Tova this Yom Kippur, the Day of Atonement.  Equities are ticking higher this morning and oil is up strongly.  Here is what we are watching today:

Trade: As expected, the White House did put new tariffs in place on China.  The initial act affects $200 bn of goods[1] at a 10% rate.  If nothing changes, that rate will rise to 25% at year’s end.  China has just announced that it will apply new tariffs to $60 bn of U.S. goods—we have no details at this time.  That puts China’s tariffs at $120 bn of U.S imports, which is 92% of U.S. exports to China.  Equity markets are taking this news in stride; there are a couple of reasons for the lack of reaction.  First, this move was well telegraphed, and it should be noted that the announcement was not as draconian as it could have been.  For example, various goods were excluded, including child safety devices and some consumer electronics.  This shows some degree of sensitivity from Washington.  And, starting at 10% offers hope that this announcement is an opening of negotiations.  Now that China has sanctioned just about all U.S. imports, we will be watching for additional measures.  There is some speculation that China may try to affect supply chains[2] along with other measures.[3]  If China were to take these steps, it would represent a major escalation of the trade conflict.  It is still difficult to tell whether the president is really just trying to bring Xi to negotiations and is creating conditions to improve the U.S. position or if this is really all about containing China and there is nothing to discuss.  If the latter is the real goal, conditions will deteriorate.  But, if the former is the goal, the situation will improve.  Currently, the financial markets seem to be leaning toward the former outcome.

Good news and bad news from Syria: In a recent WGR,[4] we discussed the situation in Idlib, the current focus of the conflict in Syria.  There have been a couple of important new developments.  First, Russia and Turkey have announced the creation of a demilitarized zone (DMZ) in Idlib.[5]  Details are sketchy at this point.  It isn’t exactly clear what area the DMZ will cover and there is no evidence that Assad has agreed to the proposal.  But, the mere fact that Russia and Turkey are trying to prevent a catastrophe is a welcome development.  Second, the bad news is that a Russian reconnaissance plane, an Il-20, was accidently shot down by Syrian anti-aircraft defenses (supplied, ironically, by Russia, an S-200[6] system).  The Syrians were under attack by Israeli air assets and were responding when the incident occurred.[7]  Although there are always concerns of escalation after incidents such as these, we doubt the Russians will intensify the issue with Israel.  Russia, in attempting to play the superpower role in the region, is trying to balance the interests of Syria, Turkey, Israel and Iran.  Even casual observation makes it clear that managing these interests will be next to impossible (welcome to our world, Vlad!).  We suspect Russia’s solution will look much like America’s, which was to simply keep the groups separate.  However, now that borders in the region have become fluid, this may be impossible.  Unfortunately, Russia does not have the military or economic means to actually pacify the region.  And, the U.S. can play the role of spoiler by supporting Israel’s power projection.  Still, at least for today, the good news is probably more important than the bad.

The Kingdom undermines Trump: Saudi Arabia indicated today that it is “comfortable”[8] with oil prices higher than $80 for Brent, signaling to traders that breaking this level won’t trigger higher oil flows.  President Trump has been critical of OPEC and the Saudis for lifting oil prices, calling for lower oil prices and greater supply.  Although the president has plenty of distractions, we will be watching for a response, which could include an SPR withdrawal.  In addition, there is growing evidence that the proposed sanctions on Iran are reducing Iran’s oil flows.[9]  Despite lots of rhetoric about avoiding sanctions and jettisoning the dollar, in the end, the dollar’s reserve role remains in place and most nations are either ending or reducing oil imports from Iran.  The Saudi comments and Iran’s reduced flows are boosting oil this morning.

Japan war games:Japan conducted naval exercises[10] last week and what is notable is that it involved a submarine along with three destroyers.  The vessels were practicing anti-submarine tactics and conducted the games in the South China Sea before making a port of call at Cam Ranh Bay in Vietnam.  China’s response, thus far, has been unusually mild, which may reflect the fact that China and Japan have been holding high-level talks in light of concerns from both nations about U.S. trade policy.  Japan’s military action does suggest that the Abe government does not feel secure with regard to China’s territorial ambitions and is sending a signal that, despite a pacifist constitution, it is actually a potent military power.

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[1] https://www.politico.eu/article/trump-to-slap-tariffs-on-200b-more-chinese-goods/?utm_source=POLITICO.EU&utm_campaign=2094c1a441-EMAIL_CAMPAIGN_2018_09_18_04_42&utm_medium=email&utm_term=0_10959edeb5-2094c1a441-190334489 ; https://www.nytimes.com/2018/09/17/us/politics/trump-china-tariffs-trade.html?emc=edit_mbe_20180918&nl=morning-briefing-europe&nlid=567726720180918&te=1 ; and https://www.ft.com/content/a88cec7e-babf-11e8-94b2-17176fbf93f5?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[2] https://www.cnbc.com/2018/09/17/the-associated-press-chinese-official-beijing-should-target-goods-needed-by-us.html?wpisrc=nl_todayworld&wpmm=1

[3] https://www.ft.com/content/4bacf050-7396-11e8-aa31-31da4279a601

[4] See WGR, The Battle for Idlib (9/10/18).

[5] https://www.nytimes.com/2018/09/17/world/middleeast/idlib-syria-russia-turkey.html?emc=edit_mbe_20180918&nl=morning-briefing-europe&nlid=567726720180918&te=1 and https://www.washingtonpost.com/world/turkey-and-russia-agree-on-de-militarized-zone-in-syrias-last-rebel-held-enclave/2018/09/17/f37e76dc-b6ad-11e8-ae4f-2c1439c96d79_story.html?utm_term=.bd38b52c1d51&wpisrc=nl_todayworld&wpmm=1

[6] https://missilethreat.csis.org/defsys/s-200-sa-5-gammon/

[7] https://www.bloomberg.com/news/articles/2018-09-18/russia-says-military-plane-lost-during-israeli-attack-on-syria

[8] https://www.marketwatch.com/story/oil-rallies-as-saudi-arabia-said-to-grow-comfortable-with-crude-above-80-a-barrel-2018-09-18

[9] https://www.livemint.com/Politics/ctuzaEXF5PrAAfAufnFmDK/In-big-win-for-Trump-US-sanctions-cripple-Iranian-oil-expor.html

[10] https://www.ft.com/content/708a5af8-ba62-11e8-94b2-17176fbf93f5?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] The weekend news was dominated by tropical events in the U.S. and the Far East, and the travails of SCOTUS candidate Kavanaugh.  In addition, there were a plethora of retrospectives across the media focusing on “10 years after the crisis.”  Here are the other items we are watching today.

Trade: It appears that President Trump will announce sometime this week that China will be hit with tariffs on another $200 bn in goods.[1]  Instead of a 25% rate, it appears the U.S. will start with a 10% rate.  We would expect China to retaliate in equal measure.[2]  From there, we will be watching to see if conditions escalate.  Last week, there was a glimmer of hope for a reopening of talks between Washington and Beijing.  However, China is indicating that it will not join talks if the U.S. signals new tariffs.[3]  Emerging equities fell on this news.  Industrial metals,[4] a likely target of tariffs, are under pressure this morning as well.

India disappoints:[5] Last week, the Modi government indicated it was developing a strategy to arrest the decline in the rupee.  The market has found the measures wanting; essentially, the government plans to put import barriers in place on “non-essential imports” but hasn’t detailed the exact list.[6]  This plan is a high-risk strategy.  Not only will it upset trading partners in a period when the U.S. isn’t going to give India a pass on trade impediments, but the likely outcome is higher inflation.  It does appear the Modi government is trying hard to avoid the most effective response, higher interest rates, with elections looming next year.

A new Fed president: The San Francisco FRB announced that Mary Daly has been appointed as the new president of the San Francisco FRB, effective October 1.  Daly has been director of research at the bank since 2017 and succeeds John Williams, who became the president of the New York FRB.  Her focus area is labor economics.  However, the most interesting part of her appointment, at least to us, is her academic background, most notably at the undergraduate level.  Her MA is from the University of Illinois (Champaign-Urbana) and Ph.D. is from Syracuse.  However, her undergraduate degree is from the University of Missouri—Kansas City in economics, philosophy and psychology.  UMKC along with the Levy Institute at Bard College are, by our estimation, the leading schools for heterodox economics.  This is where neo-Marxists, Modern Monetary Theorists (MMT) and neo-Keynesians dwell.  We have been paying very close attention to MMT and think it may become the intellectual construct for the next major development in economic policy.  In other words, in the next equality cycle, MMT will be how large fiscal deficits are justified.  Daly will be a voter the rest of this year but not at the next meeting.  In her place, KC FRB President George has been acting as the alternate voter and, given that George is perhaps the most hawkish member of the board, she will surely vote to raise rates at the upcoming meeting.  The December vote might be more contentious.  However, Daly would need an excess of ego strength to dissent against a rate hike in her first vote.  Fed fund futures are indicating a near 80% chance of a 2.50% upper target for the policy rate at the December meeting, suggesting another rate hike is highly probable.

A couple of weekend thoughts: First, Adam Tooze is a historian who currently teaches at Columbia University.  He has published a number of well-regarded histories and his most recent is on the Great Financial Crisis.[7]  We spent part of the weekend listening to numerous podcasts where he discussed his book.  Although we haven’t read it yet, it will go on the list.  But, one of the thoughts we had as we listened to the podcasts and read various “where were you” retrospectives on the crisis was how the impact of this event may not be past us.  Think of it this way…there could have been discussions and analyses 10 years after the 1929 Crash but they would not have captured the crisis that WWII brought.  We should be careful about thinking that the last decade may be the final story of how the world financial system recovered; simply put, the story may not be over yet.

Second, we have been thinking a lot about the amplitude shifts coming out of the political system.  Our founding fathers created a system that was designed to prevent sudden shifts in policy.  Checks and balances and the requirement of a supermajority in the Senate were all put in place to temper changes, make them more gradual and reduce the odds of a sudden shift in policy.  Since WWII, we have been steadily eroding these measures.  The superpower role created the need for a stronger executive; the presidency is now described as “imperial.”[8]  We have recently weakened the power of the filibuster; although this measure has slowed progress it also forces lawmakers to make changes that are palatable to opponents.  Without the filibuster, we now have two legislative houses that are almost identical.

What this could mean is that we will be facing a future where changes in government mean massive changes in policy.  One party passes infrastructure spending only to have a change in government halt the projects.  One party passes tax changes only to see them reversed by the next administration.  It could become even more radical; a party could try to expand or reduce the number of judges on the Supreme Court to undermine changes brought by the previous administration.  If this becomes the norm, not only will American democracy become dysfunctional, but it seems hard to imagine how businesses could make rational investment decisions.  Although neither of these factors affect the markets today, it is something we are watching.[9]

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[1] https://www.wsj.com/articles/trump-to-announce-new-tariffs-on-200-billion-in-china-goods-1537040325

[2] https://www.wsj.com/articles/china-weighs-skipping-trade-talks-after-u-s-tariff-threat-1537115334

[3] https://www.axios.com/trump-tweets-mnuchins-credibility-china-trade-talks-4c450538-b6c7-4c5c-94df-fdd98643a15b.html

[4] https://www.ft.com/content/70917a9a-ba67-11e8-94b2-17176fbf93f5

[5] https://www.ft.com/content/54ece0f8-ba2c-11e8-94b2-17176fbf93f5

[6] https://www.ft.com/content/1ce01368-b83f-11e8-b3ef-799c8613f4a1

[7] https://www.amazon.com/Crashed-Decade-Financial-Crises-Changed/dp/0670024937

[8] https://www.amazon.com/Imperial-Presidency-Jr-Arthur-Schlesinger/dp/0618420010

[9] https://www.axios.com/2020-democrats-rebels-restorationists-080c9e81-c961-4b20-8c96-103c45ed0905.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

Big tech under fire: Tech companies are coming under increased scrutiny from both left- and right-wing populists.  Yesterday, Breitbart released a video of Google executives showing disappointment after President Trump’s victory over Hillary Clinton in the 2016 election.  Prior to this incident, President Trump and other conservatives have accused the tech companies of censoring conservative viewpoints.  In response to the backlash, Attorney General Jeff Sessions has expressed interest in investigating big tech social media firms, while the Federal Trade Commission opened a hearing on Thursday to investigate possible antitrust violations.  Meanwhile, Senator Elizabeth Warren has suggested that Amazon (AMZN, $1,989.87) has become too big and should be broken up.  As we have discussed in the past, the big tech firms have taken advantage of litigation arbitration caused by deregulation and technological advancement to the detriment of labor wages, and this will become a growing issue as populism grows in popularity.

Koreas establishing ties: As denuclearization talks between North Korea and the United States appear to be in a lull, South Korea has taken steps to build closer ties with its northern neighbor.  Today, North Korea opened a liaison office along its border with South Korea.  The office will allow the two sides to discuss issues directly on a day-to-day basis.  Although Kim Jong-un has stated that he would like to secure a denuclearization deal with the U.S. before the end of President Trump’s first term in office, it is unclear what is stalling the process.  There is growing speculation that countries such as Russia and China may be contributing by helping North Korea flout sanctions.  Although it is unclear whether opening the liaison office will hamper the denuclearization negotiations, the U.S. appears to be a bit uneasy about the pace at which the two countries are recreating ties.  Following the announcement, the U.S. State Department stated that Inter-Korean relations should follow the same pace as the denuclearization talks.  We will continue to monitor this situation.

New York primaries: Last night, New York Governor Andrew Cuomo was able to beat populist-backed Cynthia Nixon to win the Democratic Party nomination.  Although Cuomo had a comfortable lead in the polls throughout the entire campaign, it did appear that Nixon had much of the momentum going into the primary.  Following the surprise victory of Alexandria Ocasio-Cortez over Joseph Crowley in June, there was growing speculation that the Bernie Sanders wing of the party could pull off a Tea Party-style route in the primaries.  Governor Cuomo’s victory will likely calm fears of a possible populist takeover of the Democratic Party; however, the battle between the establishment and populists is far from over.

Hurricane Florence: Hurricane Florence has made landfall along the North Carolina coast.  Upon hitting the coast the hurricane is expected to weaken into a tropical storm before making its way to South Carolina and Georgia.  The storm is expected to cause damage due to large amounts of flooding.  As a result, we expect economic numbers for this month to come in relatively weak as the states affected by the storm recover.

Merkel under pressure: German Chancellor Angela Merkel’s grand coalition has come under pressure due to comments made by Germany’s intelligence chief, Hans-Georg Maassen.  On Wednesday, Maassen claimed that video footage of foreign people being hunted down by far-right protestors was fake—a direct contradiction to Chancellor Merkel’s statements.  Members of Merkel’s own coalition as well as members of her opposition have called for Maassen’s resignation, with the most vocal group being the Social Democrats.  Nevertheless, it does appear that Maassen still has the support of Christian Social Union Leader Horst Seehofer, who has stated he doesn’t believe Maassen has done anything wrong.  The coalition that was reached in March between the CDU/CSU and Social Democrats appears to be on thin ice.  A meeting regarding possible disciplinary actions is due to take place on Tuesday.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Thursday!  Here is what we are watching today:

Trade talks back on: Equities are elevated this morning after it was revealed that the U.S. and China are open to restarting trade negotiations.  This breakthrough came on the heels of President Trump’s threat to impose tariffs on an additional $200 billion of Chinese goods.  Recently, President Trump has received flak from businesses about the escalating trade conflict.  Last week, Apple (AAPL, $221.07) wrote a letter to the president stating that tariffs would force the company to raise its prices; the president shrugged off the criticism and said the company should relocate its facilities back to the U.S.  Although we do not expect a deal to be made prior to the midterm elections, this development does suggest that the two sides have softened their stances.

Turkish Central Bank: This morning, Turkey’s central bank raised its main interest rate from 17.75% to 24.00% in order to combat rising inflation; as a result, the lira strengthened against the dollar.  Rising inflation and high amounts of foreign currency debt have called into question Turkey’s solvency.  Although Turkey’s economic crisis is far from over, the central bank’s decision did restore some degree of confidence in the lira.

Beige Book and the Fed: Reports on growth were surprisingly mixed.  The St. Louis, Kansas City and Philadelphia districts reported below-trend growth, while the Dallas district indicated above-trend growth.  Residential real estate was mixed, with the New York district reporting a sharp decline in New York City real estate activity.  The Federal tax law changes were cited as a reason for the weakness.  All the districts reported tight labor market conditions.  The Minneapolis district reported that anecdotal comments from businesses said it was difficult to attract recruits with hourly wages of less than $15 per hour.  Half of the districts reported that labor shortages were constraining economic activity.  There were also reports of signing bonuses, increased benefits and training as a way to attract workers.  Price pressures remain somewhat elevated, but not at levels that seem to be a significant problem.

A rate hike at the September 26^th meeting is a near certainty.  More importantly, we are seeing the financial markets discount a rising probability of another increase at the December 19^th meeting.

The current probability of a 25 bps hike at the December meeting, taking the target’s upper limit to 2.50%, is 76.3%.

The three-month implied LIBOR rate, two-years deferred, from the Eurodollar futures market has ticked higher, reaching 3.10%.  Recent history has shown that the FOMC tends to end its tightening cycle when this implied rate and the target rate inverts.

This rise in the implied LIBOR rate suggests a terminal rate closer to 3.25%.  That would mean two more hikes this year and three next year.

Real family income: The Census Bureau released its annual report on median household and family income.  We prefer the latter number because it has a longer track record.  We have a new record at $75,938 in 2016 dollars.  Household income also made a new record on the same basis at $61,375.

This chart shows real family income data; we have regressed time trends through the numbers, one trend line for the period 1947-69 and the other from 1970 to the present.  The compound annual growth rate in median real family income in the 1947-69 period was 3.3%; in the latter period it’s a mere 0.5%.  If the country had stayed on the earlier trend line, real median family incomes would be $110,910.  This trend change goes a long way in explaining the political and social unrest we are seeing in the country.

Energy recap: U.S. crude oil inventories fell 5.3 mb compared to market expectations of a 2.3 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 rose to 97.6%, up 1.0% from last week.  Oil production dipped to 10.9 mbpd.  Imports fell and exports increased; between falling imports, lower production, high refinery runs and higher exports, oil inventories continue to slide.

As the seasonal chart below shows, inventories are near the end of their seasonal withdrawal period.  This week’s decline was rather high.  As we discussed in the recent Quarterly Energy Comment,[1] oil exports may change the seasonal pattern and lead to a less cyclical stock situation.

Based on inventories alone, oil prices are below fair value price at $75.27.  Meanwhile, the EUR/WTI model generates a fair value of $59.51.  Together (which is a more sound methodology), fair value is $64.78, meaning that current prices are well above fair value.   However, the most bearish factor for oil is dollar strength.  It will be difficult for oil prices to move higher without some reversal in the greenback.  Oil prices have been bolstered by concerns surrounding Hurricane Florence and the expected increase in product demand.  That issue should dissipate in the next few days.

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[1] See Quarterly Energy Comment, 9/7/2018

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Financial markets are mostly quiet this morning.  PPI (discussed below) came in lower than expected.  Here are the other items we are watching today:

EU pushes back against Hungary: With populists gaining political leverage in the EU, the establishment is fighting back and targeting Viktor Orban, the PM of Hungary.  Orban has been aggressively promoting populism.  He has erected barriers to African and Middle Eastern refugees, curtailed the domestic press and has described his government as “illiberal democracy.”  The European Parliament will vote today[1] on whether to suspend Hungary’s voting rights within the EU.  Sanctioning Hungary will require a “yes” vote from 28 leaders of nations in the EU, which might not be possible; it is not certain that Italy[2] will vote to sanction Hungary.  The sanction vote, called “Article 7,” is described in this reference.[3]

Trade: There does appear to be some progress on NAFTA.  According to reports, Canada is willing to offer at least some degree of access to its dairy market.[4]  The American business sector is beginning to ramp up objections to tariffs.[5]  As we noted earlier, U.S. trade actions against China have led Beijing to improve relations with Japan, which is also facing threats from the U.S.[6]  The United Steelworkers are pressing steel companies to boost wages in light of tariff-driven price increases on domestic steel.  We believe this outcome is what the Trump administration wanted but will be unwelcome for financial markets.[7]

Tech under the gun: Although anti-trust theoreticians are debating the underlying principles of enforcement, any change in policy could be years in the making.  A more immediate threat could come from the Federal Trade Commission.  The FTC will hold public hearings tomorrow which could set the stage for regulation surrounding data, privacy and other corporate behaviors.[8]

Rupee recovery?  The Indian rupee (INR) has come under pressure along with other emerging market currencies, recently falling to new all-time lows against the dollar.

This weekend, PM Modi is holding an economic review meeting[9] to come up with measures to bolster the exchange rate.  Indian equities and the INR bounced on the news.

Tropical situation: Hurricane Florence remains a significant threat, although we have seen a change in the path forecast over the past 24 hours.  Yesterday, we were expecting a more northerly path.  The current forecast has the storm turning south, making landfall near the border of South and North Carolina and heading toward Georgia.  Most of the Eastern Seaboard, excluding Florida, will be affected by the storm.  We have seen a jump in oil prices due to expectations of rising gasoline demand for evacuation.  The other event we are tracking, a disturbance now over the Yucatan, probably won’t develop into anything more than a tropical depression.  It is expected to reach the Texas coast later this week but probably won’t disrupt energy flows. 

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[1] https://www.nytimes.com/2018/09/11/world/europe/viktor-orban-european-peoples-party.html?emc=edit_mbe_20180912&nl=morning-briefing-europe&nlid=567726720180912&te=1

[2] https://www.lapresse.it/politica/ue_berlusconi_sente_orban_fi_vota_contro_sanzioni-571360/news/2018-09-11/?utm_source=POLITICO.EU&utm_campaign=6c7501ff37-EMAIL_CAMPAIGN_2018_09_12_04_34&utm_medium=email&utm_term=0_10959edeb5-6c7501ff37-190334489

[3] https://www.politico.eu/article/graphic-what-is-article-7-the-eus-nuclear-option/?utm_source=POLITICO.EU&utm_campaign=6c7501ff37-EMAIL_CAMPAIGN_2018_09_12_04_34&utm_medium=email&utm_term=0_10959edeb5-6c7501ff37-190334489

[4] https://www.cnbc.com/2018/09/11/reuters-america-update-1-canada-ready-to-allow-u-s-dairy-access-in-nafta-talks-sources.html

[5] https://www.wsj.com/articles/u-s-businesses-ramp-up-lobbying-against-trumps-tariffs-1536724811

[6] https://www.wsj.com/articles/japan-and-china-find-common-ground-in-trumps-tariffs-as-leaders-meet-1536732536

[7] https://www.wsj.com/articles/steel-workers-demand-higher-pay-raises-as-tariffs-lift-profits-1536668815

[8] https://www.axios.com/ftc-hearings-competition-tech-industry-innovation-58c116fa-5e93-485f-9a30-4c0163fdf857.html

[9] https://economictimes.indiatimes.com/news/economy/policy/pm-modi-may-call-review-meet-to-check-fall-in-rupee/articleshow/65781598.cms