by Bill O’Grady and Thomas Wash

[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.

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.

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[1] https://apnews.com/cf5305d356fd49309543d711ea5ef6e9/Fed-chairman-defends-gradual-pace-of-rate-hikes

[2] https://www.youtube.com/watch?v=t9iIf4tFoyE

[3] https://www.bloomberg.com/news/features/2018-10-04/the-big-hack-how-china-used-a-tiny-chip-to-infiltrate-america-s-top-companies?srnd=businessweek-v2&utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[4] https://www.cnn.com/2018/10/03/politics/us-navy-show-of-force-china/index.html?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[5] https://www.nytimes.com/2018/10/03/us/politics/china-pence-trade-military-elections.html?action=click&module=Top%20Stories&pgtype=Homepage

[6] https://www.bloomberg.com/news/articles/2018-10-03/putin-tells-trump-to-blame-guy-in-the-mirror-for-high-oil-prices

[7] https://www.cnn.com/2018/10/03/politics/pompeo-icj-iran-ruling/index.html

[8] https://www.bloomberg.com/news/articles/2018-10-03/iran-oil-buyers-craving-obama-s-waivers-get-trump-shock-instead

by Bill O’Grady and Thomas Wash

[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.

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[1] https://www.theguardian.com/business/live/2018/oct/03/italy-budget-row-markets-eurozone-services-imf-growth-business-live

[2] https://www.reuters.com/article/us-usa-fed-powell/feds-powell-says-u-s-outlook-remarkably-positive-idUSKCN1MC2A7

[3] https://www.wsj.com/articles/fed-looks-to-pare-language-describing-future-of-rates-policy-1538472600

[4] https://www.politico.com/story/2018/10/02/trump-trade-canada-china-warning-825358

[5] https://twitter.com/jljzen/status/1047296954814750725

[6] https://apnews.com/cdbab66e07d64b4b9b9f0246be806339/Ripple-effect?-Amazon%27s-$15-wage-may-help-lift-pay-elsewhere

[7] https://www.wsj.com/articles/amazons-wage-increase-adds-pressure-for-employers-to-boost-pay-1538518368

[8] https://www.reuters.com/article/us-usa-trump-saudi/trump-i-told-saudi-king-he-wouldnt-last-without-u-s-support-idUSKCN1MD066

by Bill O’Grady and Thomas Wash

[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.

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[1] https://www.reuters.com/article/us-italy-budget-dimaio/italy-wont-change-2-4-percent-deficit-goal-despite-eu-pressure-di-maio-idUSKCN1MC0MD

[2] https://www.wsj.com/articles/fed-looks-to-pare-language-describing-future-of-rates-policy-1538472600

by Bill O’Grady and Thomas Wash

[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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[1] https://www.ft.com/content/8a43c9f4-c51e-11e8-8670-c5353379f7c2?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[2] Contact the Village People—I see music video potential.  https://www.youtube.com/watch?v=Vc0gYbTNctU

[3] https://www.ft.com/content/60f62f1a-c49c-11e8-8670-c5353379f7c2?emailId=5bb1a5ff2c91a600040730ff&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[4] https://www.nytimes.com/2018/09/28/business/china-censor-economic-news.html

[5] https://www.nytimes.com/2018/09/29/world/americas/trump-china-taiwan-el-salvador.html

[6] https://www.nytimes.com/2018/09/29/us/politics/iran-trump-zarif.html?action=click&module=In%20Other%20News&pgtype=Homepage&action=click&module=News&pgtype=Homepage

[7] https://www.reuters.com/article/us-saudi-us-oil/trump-calls-saudis-king-to-discuss-oil-supplies-idUSKCN1M90SE

by Bill O’Grady and Thomas Wash

[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.

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.

As the chart shows, yields are approaching recent highs.  Perhaps even more worrisome was the yield action in the Bund/Italian spread.

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.

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[1] https://www.ft.com/content/86777cfc-c28b-11e8-8d55-54197280d3f7?emailId=5badacb3274e29000456a327&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[2] https://www.reuters.com/article/us-usa-fed/fed-chief-powell-signals-central-bank-is-done-with-signaling-idUSKCN1M7299

by Bill O’Grady and Thomas Wash

[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.

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.

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. 

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[1] https://www.washingtonpost.com/politics/without-evidence-trump-accuses-china-of-interfering-in-us-midterm-elections/2018/09/26/c0069910-c19d-11e8-b338-a3289f6cb742_story.html?utm_term=.034d32e938fc&wpisrc=nl_todayworld&wpmm=1

[2] https://www.reuters.com/article/us-usa-china-un/trump-accuses-china-of-2018-election-meddling-beijing-rejects-charge-idUSKCN1M623Y

[3] https://twitter.com/JenniferJJacobs/status/1043916756522283008

[4] https://www.washingtonpost.com/world/2018/09/26/chinas-row-with-sweden-over-racist-tv-skit-has-citizens-urging-boycott-ikea-hm/?utm_term=.3d36b27c928f&wpisrc=nl_todayworld&wpmm=1

[5] https://www.scmp.com/comment/insight-opinion/united-states/article/2164981/what-chinese-tourist-row-sweden-says-about?wpisrc=nl_todayworld&wpmm=1

by Bill O’Grady and Thomas Wash

[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.

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[1] https://www.axios.com/russia-supply-syria-syria-missiles-rebuke-israel-d2603edf-c35a-48b1-a61a-ad8d647c52f8.html

[2] https://www.nytimes.com/2018/09/25/world/middleeast/bolton-threatens-business-iran.html?emc=edit_mbe_20180926&nl=morning-briefing-europe&nlid=567726720180926&te=1

[3] https://www.ft.com/content/b3a6a6fc-c138-11e8-8d55-54197280d3f7?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[4] https://www.nytimes.com/2018/09/25/world/europe/germany-merkel-party.html?emc=edit_mbe_20180926&nl=morning-briefing-europe&nlid=567726720180926&te=1

[5] https://www.ft.com/content/13e9193c-bb62-11e8-94b2-17176fbf93f5

[6] https://www.reuters.com/article/us-china-economy-tariffs/china-announces-fresh-import-tariff-cuts-amid-brewing-trade-war-idUSKCN1M61EH