by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] We are seeing a bit of risk-off this morning on the big political stories from yesterday.  However, the emphasis is on “bit”; equity weakness isn’t excessive, the dollar is modestly weaker, gold is higher but not by a lot and Treasury yields are down but no panic has ensued.  So, let’s dig in:

The political news: As has been well documented, Paul Manafort[1] and Michael Cohen[2] were convicted yesterday.  The former was by a jury, while the latter plead guilty.  The basic charges were fraud.  We have received market-related questions about these events.  Here is our initial take:

1. Equities: We expect the equity market to take the news in stride.  Clearly, political turmoil affects sentiment and thus we could easily see further pressure on P/E multiples.  However, earnings remain robust, the economy is strong and, in what may be the most important factor, the tax cut benefits are probably already in place.  Although the likelihood of further initiatives being passed by this administration is low, those odds were already depressed.  As we have noted before, the most powerful period for a new president is the first 18 months.  After that, midterms loom and political capital has been exhausted.  In addition, if the president faces mounting legal woes, the momentum on trade talks could wane which would be bullish for equities.  As we have shown before, equities were on their way to “melt up” territory in January when the president turned his attention to trade and the P/E has declined since then.  A lessening of trade tensions would likely be bullish for equities, especially large caps.  Our expectation—neutral.
2. Debt: Treasuries will benefit from any flight-to-safety buying.  Legal distractions will likely reduce the White House’s focus on monetary policy tightening.  Our expectation—bullish.
3. Dollar: This is an area where the most impact is possible.  The dollar, on a purchasing power parity basis, is overvalued.  Tightening Fed policy has played a role in boosting the greenback but the potential for trade impediments is the primary reason for the bullish tone of the dollar.  After all, if the reserve currency nation restricts trade, other nations must go to ever greater lengths to gain access to the U.S. market.  The most likely way to do so is to support a weaker currency, boosting the dollar.  Furthermore, exchange rates, in some ways, reflect sentiment.  We note that the correlation between consumer sentiment and the dollar is very high since the late 1990s.

This chart shows the JP Morgan dollar index and the University of Michigan index of consumer sentiment.  Since 1997, the two series are highly correlated with a two-year lag.  Thus, if political turmoil begins to weigh on sentiment, it would probably put pressure on the dollar.  Our expectation—dollar bearish, which would be bullish for commodities, gold and foreign equities.

The political outlook: Yesterday’s news is damaging for the president but it hasn’t reached the level of critical quite yet.  The news highlights the importance of the midterm elections.  If the Democrats take the House, we would expect a drive to bring articles of impeachment against Trump.  As we saw with President Clinton in the late 1990s, that effort will likely fail in the Senate.  Even if the Democrats experience a major wave and take control of the Senate, it seems highly improbable that the threshold of 67 votes to remove the president would be met.

However, as we have noted above, the distraction level will be elevated.  That doesn’t mean that everything else would necessarily stop; President Nixon was able to come to the aid of Israel during the 1973 Yom Kippur War while in the midst of the Watergate investigation.  Nevertheless, it will be hard to maintain focus on other issues.  One subject we will be monitoring, especially if conditions deteriorate, is the power within the cabinet.  For example, if the Mnuchin/Kudlow wing of the administration gains power during the turmoil and overshadows the Lighthizer/Navarro wing, then the tenor of the trade conflict would likely moderate.  Our inclination is that Mnuchin will gain power and thus the trade conflict would be reduced.  Overall, as noted above, we look for increased political distraction; by itself, that won’t be enough to derail equities but it could put downward pressure on the dollar.

Another factor worth noting is that despite talk of Russian collusion the administration and Congress continue to target Russia for additional sanctions.  Earlier in the month, the administration applied additional sanctions on Russia over the U.K. poisoning.[3]  Yesterday, the administration added new sanctions for violating sanctions on North Korea.[4]  And, after we learned yesterday that Russia has hacked various right-wing think tanks, the Senate is preparing further sanctions.[5]  So far, it would be difficult to make a strong case for Russian favoritism, at least given these actions.

Trade: Progress on NAFTA continues as reports suggest that a “handshake deal” could be struck with Mexico by tomorrow.[6]  Talks on auto tariffs appear to be facing delays; as we noted earlier this month, the EU is expected to stall discussions into the midterms, likely hoping that more important issues will occupy the U.S. and thus allow the status quo to continue.[7]  Meanwhile, China and U.S. negotiators continue to talk but neither side appears optimistic about an agreement.[8]

Monetary policy: The Fed minutes will be released later today (see below).  We also note another report indicating that the BOJ is moving to end its aggressive easing stance.[9]

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[1] https://www.ft.com/content/14dc40c4-a22d-11e8-85da-eeb7a9ce36e4?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[2] https://www.ft.com/content/5de0b3fc-a5a4-11e8-8ecf-a7ae1beff35b?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[3] https://www.ft.com/content/0d1d64dc-9b41-11e8-ab77-f854c65a4465?emailId=5b7cdea30b4eba00040e5254&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[4] https://www.nytimes.com/2018/08/21/us/politics/new-us-sanctions-target-russia-for-defying-rules-on-north-korea.html?emc=edit_mbe_20180822&nl=morning-briefing-europe&nlid=5677267mbe_20180822&rref=collection%2Fsectioncollection%2Fpolitics&te=1

[5] https://www.nytimes.com/2018/08/21/us/politics/russia-sanctions-microsoft-hacking.html?emc=edit_mbe_20180822&nl=morning-briefing-europe&nlid=567726720180822&te=1

[6] https://www.politico.com/story/2018/08/21/trump-nafta-mexico-746332

[7] https://www.wsj.com/articles/trump-auto-tariff-timetable-likely-to-slip-amid-europe-nafta-talks-1534853144

[8] https://www.ft.com/content/cea76a70-a510-11e8-8ecf-a7ae1beff35b

[9] https://www.reuters.com/article/us-japan-economy-boj/japan-central-bank-may-dial-back-stimulus-before-price-goal-met-ex-boj-ishida-idUSKCN1L707U

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] The big story today is a bit of dollar weakness, which is putting some upward pressure on interest rates and helping precious metals.  Here is what we are watching today:

Trump talks: In a wide-ranging interview,[1] President Trump warned not to expect much from the Chinese trade talks[2] and stated that some trading partners, especially China and the EU, are manipulating their currencies, but the biggest news was another broadside against Chair Powell.  In a recent Asset Allocation Weekly,[3] we discussed the idea of Fed independence and examined the history of how presidents have managed their relations with the U.S. central bank.  Prior to the detente that was in place from 1993 until this year, presidents have refrained from commenting on monetary policy.  President Trump reiterated his desire for easy monetary policy and exhibited his displeasure with the current path of policy.  When the president criticizes the Fed, we tend to see higher long-duration Treasury yields and a weaker dollar.[4]

On the one hand, it’s hard to make the case that the FOMC is too tight.  After all, real fed funds are still below zero.

On the other hand, as we discuss in the current AAW below, the majority, but not all, of the Mankiw Rule variations argue for tighter policy.  However, the rate projection using core CPI and the employment/population ratio does suggest the Fed has achieved policy neutrality.  Although we are “not there yet,” policy is getting close to the point where mistakes have occurred in the past.  Leave rates too low and the risks of a lending and asset market bubble increase.  Tighten too much and a recession occurs.[5]  Powell’s speech at Jackson Hole on Friday will be closely watched for future guidance on policy.

We also note that Powell may be facing some internal dissent.  Atlanta FRB President Bostic[6] is calling for only one more hike this year and expressed concern about raising rates enough to invert the yield curve.  At current 10-year T-note yields, the Fed is clearly limited on how much further it can raise rates without inverting the curve.

Our expectation is that Powell will continue to raise rates despite White House criticism.  At the same time, it should be remembered that central bank independence is only valued when the goal is to contain inflation.  In circumstances where inflation fears have dwindled away, pressure to reduce central bank independence is likely.

In terms of trade, a trend does seem to be developing.  At first, the U.S. seemed to be threatening everyone with tariffs and trade sanctions.  However, the U.S. and EU appear to be trying to negotiate a deal.  As we noted last week, the U.S. and Mexico are close to an agreement.  The focus now appears to be China.  As noted earlier, the president downplayed any chance that upcoming talks with China will bring any breakthroughs.  Chinese officials appear to have concluded that the U.S. is using the trade issue as a way of slowing China’s rise.  China is taking steps to aid its economy,[7] which is slowing,[8] in part due to trade tensions.

Opening for cyberwar?  According to the Washington Post, President Trump is giving the military more discretion in using cyberwar tools against adversaries.[9]  This will give the military the ability to respond to foreign cyberattacks that have become increasingly frequent.  They may be busy soon.  The New York Times is reporting that Russian hacking groups targeted GOP think tanks.[10]

More on the BOJ: Reuters is reporting that the BOJ is becoming less concerned with falling equity prices and may be engaging in “stealth tapering.”[11]  According to reports, the bank has become more tolerant of equity price weakness, suggesting new flexibility at a minimum.   Governor Kuroda has been facing increasing criticism for ultra-accommodative monetary policy from the financial services industry, which is struggling with profitability in a low interest rate, flat yield curve environment.

Some inflation oddities: Our position is that price stability rests on three legs.  The first is globalization.  If firms and consumers have most of the world at their disposal to source goods and services, the breadth of competition should keep prices under control.  The second leg is deregulation, which we define as the ability to introduce new techniques and technologies unfettered by regulation.  So, if a firm decides to create an app that will allow you to rent out the room over your garage without interference or zoning changes, it will expand the supply of motel-style properties and lower prices.  The third leg is central bank independence.  Although difficult to strictly define, if investors and consumers believe the central bank will be able to implement monetary policy without interference, it should foster price stability.

Currently, we view the second leg as alive and well but the first and third are coming under fire.  Not only are trade barriers going up across the world, but the president has reportedly expressed discontent with the path of monetary policy.[12]  Inflation has been creeping higher but is still not at levels that cause us great concern.  However, a couple of anecdotes caught our attention.  First, there are reports that firms are starting to push price increases as their costs rise.[13]  Second, fears of trade impediments on autos are reportedly leading to pre-emptive increases at used car auctions.[14]  These actions, by themselves, are not worrisome.  But, if they begin to expand, it could signal a growing inflation problem that the financial markets are not prepared for.

Swedish elections: Sweden holds elections on September 9; a spate of violence has struck the country recently and migrants are being blamed for the attacks.[15]  Recent polls show the Sweden Democrats, a nationalist, anti-immigrant party, have been fading but they were the strongest polling party in Sweden in mid-June.  At present, the Social Democrats, a center-left party, are leading in the polls at 25.2%.  The Sweden Democrats are polling at 18.7%.  The concern is that if the Sweden Democrats pull 20% of the electorate it may be difficult for the center-left or center-right to form a government.  Thus, even Sweden is facing rising discontent from populist parties.

German current account: The IFO, a German economic think tank, indicated that Germany’s current account surplus will remain the world’s largest compared to the size of its economy.[16]  The IFO forecasts the surplus will represent about 7.8% of GDP, just below last year’s 7.9%.

This surplus began with the onset of the Eurozone and was aided by reforms that curtailed wage growth.  Germany uses the Eurozone in the same way 19^th century imperialists used colonies, a place to force the absorption of excess productive capacity.  We note that President Trump suggested in the aforementioned interview that he believes China and the Eurozone are manipulating their currencies.  The German current account data does bolster than argument.

As Greece ends, Italy begins?  Although we haven’t said much about it, the media is making a big deal out of the fact that Greece is exiting its bailout.  Early career experiences suggest to us that Greece will eventually return to trouble, but probably not until the end of the 2020s.  However, with attention leaving Greece, the financial markets are beginning to notice the persistent problems in Italy.[17]  Italian political leaders say they will fend off these attacks,[18] but the potential for trouble is elevated when a government issues debt in a currency it doesn’t control.

Turkey news: Turkey has ended the travel ban on a German journalist who was being detained on terrorism charges.[19]  We view this as an attempt to gain favor from Germany, who could help Turkey in its current plight.  However, recent comments from EU officials suggest that EU or German help isn’t likely.[20]

And, finally: Be careful with those rented scooters…just sayin’.[21]

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[1] https://www.reuters.com/article/us-usa-trump-fed-exclusive/exclusive-trump-says-not-thrilled-with-feds-powell-for-raising-rates-idUSKCN1L5207

[2] https://www.reuters.com/article/us-usa-trump-china-exclusive/exclusive-trump-doesnt-expect-much-from-china-trade-talks-this-week-idUSKCN1L5226

[3] https://www.confluenceinvestment.com/wp-content/uploads/AAW_July_27_2018.pdf

[4] https://www.ft.com/content/0c5dfdbc-a4e8-11e8-8ecf-a7ae1beff35b?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[5] https://www.ft.com/content/c6d86ad0-a4b4-11e8-8ecf-a7ae1beff35b?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[6] https://www.reuters.com/article/us-usa-fed-bostic-rates/feds-bostic-still-expects-one-more-rate-increase-in-2018-idUSKCN1L51SD

[7] https://money.usnews.com/investing/news/articles/2018-08-21/china-central-bank-says-will-keep-liquidity-reasonably-ample and https://www.ft.com/content/03441782-a37d-11e8-8ecf-a7ae1beff35b

[8] https://www.wsj.com/articles/chinas-economy-cooled-further-in-july-1534214209

[9] https://www.washingtonpost.com/world/national-security/trump-gives-the-military-more-latitude-to-use-offensive-cyber-tools-against-adversaries/2018/08/16/75f7a100-a160-11e8-8e87-c869fe70a721_story.html?utm_term=.d8afa24cddfa

[10] https://www.nytimes.com/2018/08/21/us/politics/russia-cyber-hack.html?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top-stories and https://www.ft.com/content/0ef4d264-a4c8-11e8-8ecf-a7ae1beff35b?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[11] https://www.reuters.com/article/japan-stocks-boj/rpt-boj-may-be-stealth-tapering-in-stock-markets-analysts-say-idUSL4N1V837V

[12] https://www.marketwatch.com/story/trump-ramps-up-criticism-of-powell-reports-2018-08-20

[13] https://www.ft.com/content/500a359c-a369-11e8-8ecf-a7ae1beff35b

[14] https://www.cnbc.com/2018/08/17/used-car-prices-are-weirdly-spiking-and-tariffs-may-be-to-blame.html?__source=twitter%7Ctech

[15] https://www.ft.com/content/5655711c-a389-11e8-8ecf-a7ae1beff35b?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[16] https://www.ft.com/content/07610a3a-a492-11e8-926a-7342fe5e173f?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[17] https://www.wsj.com/articles/as-euro-crisis-ends-italy-stokes-fear-of-a-revival-1534676400

[18] https://uk.reuters.com/article/us-italy-markets-salvini/italys-salvini-says-government-will-stand-up-against-market-attacks-idUKKCN1L512Z?utm_source=POLITICO.EU&utm_campaign=d33dbf1091-EMAIL_CAMPAIGN_2018_08_21_04_24&utm_medium=email&utm_term=0_10959edeb5-d33dbf1091-190334489

[19] https://www.nytimes.com/2018/08/20/world/europe/turkey-germany-mesale-tolu.html?emc=edit_mbe_20180821&nl=morning-briefing-europe&nlid=567726720180821&te=1

[20] https://www.politico.eu/article/europe-turkey-germany-gunther-oettinger-not-job-to-help-financially/?utm_source=POLITICO.EU&utm_campaign=d33dbf1091-EMAIL_CAMPAIGN_2018_08_21_04_24&utm_medium=email&utm_term=0_10959edeb5-d33dbf1091-190334489

[21] https://www.buzzfeednews.com/article/katienotopoulos/e-scooter-injuries-are-becoming-common-in-emergency-rooms

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s Monday…back to the salt mines!  It’s a “green” day so far this morning—equities are higher, but so are longer duration Treasury prices and beleaguered metals are even bouncing a bit higher.  The dollar is a bit lower.  Here is what we are watching today:

Turkey update: The TRY is lower this morning despite news that the country has set up a currency swap line with Qatar.[1]  Turkey’s financial markets will be closed this week for holiday.  There doesn’t appear to be much evidence of a thaw between Ankara and Washington.  According to reports, Turkey has offered to release Pastor Brunson in return for the U.S. dropping the investigation into state-owned Halkbank, which has been fined for violating sanctions with Iran.[2]  The Trump administration’s position is becoming clear—the U.S. doesn’t intend to give Turkey anything for releasing Brunson.[3]  This puts Turkey and President Erdogan in a tough spot as Turkey will need U.S. help to extricate itself from a difficult economic position.  The U.S. appears ready to force Turkey to back down and lose face, something that Erdogan will try desperately to avoid.  This suggests to us that although the TRY is very cheap, it may take a while before Turkey becomes an attractive investment venue.  At the same time, we do note that the credit rating agencies have downgraded Turkey.[4]  Since they often make this type of move when all the bad news is known, paradoxically, this could be a good sign.

Oh, woe, Venezuela: The Maduro government administration is taking some steps to manage the nearly unmanageable situation of hyperinflation.  Today, the country is releasing a new currency, the “sovereign bolivar,” which has lopped off five zeros (instead of the three announced earlier).[5]  This is a fairly common tactic, often seen in South America.  It really never works by itself.  The new currency will be tied to the state-issued cryptocurrency, called the “petro,”[6] which has had a checkered history.  Maduro also announced the Orinoco Basin oil reserves will be transferred to the central bank and will be included in the country’s foreign reserves.

Official reserves plus gold are approaching $7.5 bn; although, in theory, a country can add any assets to foreign reserves, the key issue is liquidity.  Those oil reserves are not liquid and the fastest way to make them liquid would be to allow foreign firms to move in and develop them.  That isn’t likely.  In response to this news, Venezuelans spent the weekend converting their bolivars to stuff.  Maduro did announce a 3,000% increase in the minimum wage but didn’t set a start date.  The longer he waits (in a nation with 1,000,000% inflation,[7] waiting is deadly), the less impact it will have.[8]  Another indication of how bad things have gotten is that the U.S. Navy has sent the USNS Comfort, a hospital ship, to the coast of Colombia to assist that country with the crush of refugees coming from Venezuela.[9]  Finally, as we reported last week, Maduro did confirm that gasoline prices will be allowed to rise to market levels.[10]  This decision is perhaps the most politically risky one he has made and indicates the degree to which conditions have deteriorated.

Trade update: One of the “known/unknowns” is what is the eventual goal of the Trump administration’s trade policy?  Is the goal to scare foreign nations to the negotiating table to get better deals or is the president bent on making the U.S. an autarky?  Evidence for either position is available.  Comments coming from China, for example, suggest that the CPC has concluded that the U.S. goal for American/Chinese trade policy is containment.[11]  At the same time, there is growing talk that the U.S. and China will reach some sort of agreement by November.[12]  And, there are reports that negotiations between the U.S. and Mexico are approaching an agreement as well,[13] although it may just be a bilateral agreement as Canada hasn’t been privy to these talks.  Still, if the administration’s trade rhetoric is designed to force negotiations and it is working, we would look for a pop in equities.  Equity indices have been marking time since peaking earlier this year, despite robust earnings.  We have seen a drop in earnings multiples, which we believe is mostly due to worries over trade.  If the Trump administration is really just trying to change global trading arrangements and not trying to destroy them, such an outcome should be a huge relief for investors.

Jackson Hole:The KC FRB will hold its annual meetings near the majestic Grand Tetons in Wyoming in the town of Jackson Hole.  The full roster of speakers will be announced later in the week but Chair Powell is scheduled to speak on Friday.  Previous Fed chairs have used this venue to make important policy announcements.  We don’t expect this from Powell, but we would expect confirmation that the current path of policy will remain in place.

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[1] https://www.reuters.com/article/us-turkey-currency-qatar/qatar-and-turkey-central-banks-sign-swap-agreement-qatar-central-bank-idUSKCN1L40NS

[2] https://www.wsj.com/articles/u-s-rebuffs-effort-to-tether-bank-fine-to-pastors-release-1534721674

[3] https://www.cnbc.com/2018/08/17/trump-us-will-not-pay-turkey-for-release-of-detained-american-pastor-brunson.html

[4] https://www.ft.com/content/ba68708a-a22d-11e8-85da-eeb7a9ce36e4

[5] https://www.ft.com/content/3edcdf1a-90fc-11e8-b639-7680cedcc421?emailId=5b7a439a87c35600041c545b&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22 and https://www.wsj.com/articles/venezuela-devalues-currency-and-hikes-wages-stoking-fears-about-instability-1534629512

[6] https://ftalphaville.ft.com/2018/03/07/1520419383000/About-that-Petro/

[7] https://www.washingtonpost.com/opinions/venezuelas-inflation-will-hit-1-million-percent-thanks-socialism/2018/07/27/44b5ac16-91e0-11e8-b769-e3fff17f0689_story.html?utm_term=.9750b01b7c2e

[8] https://apnews.com/04c33db9752f4d8ba62346f32701bc6c/Venezuelans-jittery-ahead-of-sudden-economic-reforms

[9] https://www.navytimes.com/news/your-navy/2018/08/19/us-to-send-navy-hospital-ship-to-colombia-amid-refugee-crisis/

[10] https://www.dw.com/en/inflation-wracked-venezuela-forced-to-end-cheap-oil-and-gas/a-45121732

[11] https://www.bloomberg.com/news/articles/2018-08-17/china-unsure-of-how-to-handle-trump-braces-for-new-cold-war

[12] https://www.wsj.com/articles/u-s-china-plot-road-map-to-resolve-trade-dispute-by-november-1534528756

[13] https://www.reuters.com/article/us-trade-nafta-hassett/white-house-adviser-says-trade-deal-with-mexico-very-very-close-idUSKBN1L221J?feedType=RSS&feedName=topNews

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Friday!  It’s a mixed market situation and somewhat less volatile than action earlier in the week.  Here is what we are watching today:

End of quarterly earnings?  President Trump tweeted[1] this morning that he is directing the SEC to study the costs and benefits of going to a biannual earnings reporting system.  The concern is that businesses have become overly focused on short-term results and thus easing the pressure of the earnings focus might make businesses more concerned about longer term growth.  To some extent, this is the argument made by private equity, whose proponents often argue that private firms can concentrate on long-term results even if their actions harm short-term earnings.  Of course, the flip side is that a shareholder is the owner and deserves to know how his business is doing.  We doubt this goes anywhere; moving to a biannual reporting structure won’t necessarily change the term focus because the difference between three and six months isn’t all that significant.  But, this tweet will dominate the news cycle at least for this morning.

Turkey update: The TRY has slumped this morning, which is probably to be expected given the lift in the past few days.  Turkey’s financial markets will be closed next week for holiday, so traders are probably squaring positions.  There doesn’t appear to be much evidence of a thaw.  Treasury Secretary Mnuchin signaled yesterday that the U.S. has prepared new measures against Turkey.[2]  President Trump’s position has clearly hardened as he indicates he won’t “pay anything” for the release of Pastor Brunson.[3]  Turkey does appear to be trying to initiate some sort of resolution; the foreign minister stated that his nation “does not wish to have problems with the U.S.”[4]

Iran sanctions: The administration is threatening to apply sanctions on all nations that buy Iranian oil after November 4, specifically including China.[5]  This threat is a major escalation of tensions between the U.S. and China and probably explains the rise in oil prices this morning.  In general, China has mostly ignored Iranian oil sanctions because it conducts business outside the dollar; Iran can sell to China but doesn’t receive dollars in return.  To make sanctions effective, the U.S. has to penalize China as if it were buying oil in dollars.  That would give the U.S. the power to deny China access to the U.S. banking system.  If China were to comply (which we view as a long shot), the pressure on Iran would be significant and would likely trigger an aggressive response.[6]  Most of Iran’s responses would be bullish for crude oil.

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[1] https://twitter.com/realDonaldTrump/status/1030416679069777921

[2] https://www.ft.com/content/ce39a2ae-a157-11e8-85da-eeb7a9ce36e4

[3] https://www.cnbc.com/2018/08/17/trump-us-will-not-pay-turkey-for-release-of-detained-american-pastor-brunson.html

[4] https://uk.reuters.com/article/uk-turkey-currency-usa/turkey-does-not-wish-to-have-problems-with-u-s-foreign-minister-idUKKBN1L12AJ?il=0&utm_source=POLITICO.EU&utm_campaign=ef9e266c20-EMAIL_CAMPAIGN_2018_08_17_04_42&utm_medium=email&utm_term=0_10959edeb5-ef9e266c20-190334489

[5] https://www.wsj.com/articles/pompeo-announces-new-action-group-to-target-iran-1534445395

[6] To read our discussion of potential responses, see WGRs, Iran Sanctions and Potential Responses: Part I (7/30/18), Part II (8/6/18), and Part III (8/13/18).

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] A bit of risk-on has returned this morning.  Trade hopes appear to be the key reason.  The dollar is a bit weaker, while equities and commodities are higher as are Treasury yields.  Here is what we are watching today:

China trade talks: China is sending the Commerce Ministry’s Vice Minister Wang Shouwen to Washington for what are being described as “low level” trade talks.[1]  China announced measures to liberalize foreign participation in its finance sector in a bid to find allies among U.S. financial firms.  The U.S. side will be represented by David Malpass, the undersecretary for international affairs at the Treasury.  Given the low profile of these talks, we would be surprised if much comes from them, but the fact that talks are occurring at all is being taken optimistically.

The Italian bridge problem: Last week, a span in Italy collapsed; reports vary but there may be as many as 40 fatalities.  This tragedy is rapidly becoming a political problem for the Five-Star Movement, the left-wing populist party in the governing coalition.  According to reports, leaders in the party strongly opposed plans to refurbish and upgrade the bridge, apparently for environmental reasons.[2]  The party described safety fears about the bridge as “children’s tales.”[3]  In the wake of the bridge’s collapse, Five-Star leaders are scrambling to contain the damage.  The League, the right-wing populist party in the coalition, is a strong supporter of infrastructure projects and will likely use the event to further marginalize its coalition partner.  If the scandal broadens, it would not be a huge shock to see Berlusconi’s party try to crack the coalition which would further move the government to the right.

Turkey update: Turkey was able to secure $15 bn of direct foreign investment from Qatar.[4]  Although helpful, it won’t be nearly enough to bail out Turkey.  Unfortunately, by supporting the Muslim Brotherhood and opposing the blockade on Qatar, Turkey probably won’t be getting any help from the other Gulf States.  The U.S. is showing no signs of backing down; VP Pence warned of additional measures if Turkey doesn’t release Andrew Brunson.[5]  And, the U.S. has indicated the steel tariffs will remain even if Brunson is freed[6] (which begs the question as to why Erdogan would release Brunson if he doesn’t get anything in return).

For some perspective, we built a purchasing power parity model for the TRY.  Here is a chart of the results.

Purchasing power parity values exchange rates based on relative inflation; the idea is that in a higher inflation nation, the exchange rate will depreciate to make prices equal.  It is far from perfect as a valuation model because not all goods are tradeable and completely harmonized inflation indices are not really available.  But, at extremes, it is a useful tool.  We are using the monthly average exchange rate in this model.  At present, the current exchange rate is nearly six standard errors from parity, meaning the TRY is incredibly cheap.  Once this crisis passes, Turkey’s exports will be very competitive…if they can avoid permanent trade impediments.

More on the BOJ: A former BOJ member told Reuters that the central bank may allow the 10-year JGB yield to rise up to 40 bps, in effect, creating a platform for “stealth” rate hikes.[7]  Hideo Hayakawa indicated the bank would let rates rise as long as it doesn’t trigger an unwelcome appreciation of the JPY.  That is probably not possible; the yen is deeply undervalued and any sign of tightening, especially of this magnitude, would likely trigger a jump in the exchange rate.

China returning to form: Since the Great Financial Crisis, China has been dealing with oppositional policy goals.  On the one hand, it wants to tame its massive debt situation, which was caused by maintaining growth after global export markets weakened in the aftermath of the crisis.  At the same time, it wants to maintain high growth rates.  Addressing one problem exacerbates the other so we have tended to see moves to reduce debt until growth slows and then the government fosters additional investment spending (adding to the debt) to lift growth back to target.  According to Reuters, China is at it again, addressing weakening growth by increasing infrastructure investment.[8]  This will alleviate the immediate growth problem at the cost of worsening the debt problem.

Wonder where the tax cuts are going?  So did we.  Apparently, we are dining out.

This chart shows retail sales at restaurants.  At the beginning of the year, sales were rising 1.4% per year.  In June, they were up 9.5%.  And, we aren’t spending it at fast food restaurants, either.  Full service restaurant sales are up 13.6%.

Energy recap: U.S. crude oil inventories unexpectedly rose 6.8 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.  This week’s increase in inventories was quite unexpected, especially given that refinery utilization jumped to 98.1% of capacity, up from 96.6% last week.  Oil imports rose sharply, to 9.0 mbpd, up over 1.0 mbpd from the prior week.  And, oil exports fell modestly as well.  We do note that U.S. production rose 0.4 mbpd to 10.9 mbpd.

As the seasonal chart below shows, inventories are late in the seasonal withdrawal period.  This week’s rise in stocks was obviously inconsistent with seasonal patterns.  If the usual seasonal pattern plays out, mid-September inventories will be 407 mb.

Based on inventories alone, oil prices are near the fair value price of $69.50.  Meanwhile, the EUR/WTI model generates a fair value of $57.34.  Together (which is a more sound methodology), fair value is $61.08, meaning that current prices are well above fair value.  The combination of a stronger dollar and unexpectedly high crude oil inventories is bearish.  We were rather surprised by this week’s build but it may be due to unusually low stockpiles at the delivery hub in Cushing, OK.  Stocks at the hub fell to 21.8 mb last week, an unusually low level.

There have been discussions in the media about these low stocks causing potential delivery problems.  The tanks cannot be completely drained without causing problems; the DOE estimates that 15.0 mb is probably the working minimum.  Thus, the jump in imports may be designed to address this shortfall at Cushing and thus isn’t really a build in inventory for immediate use.  We will be watching this in the coming weeks to see if imports remain elevated to boost Cushing stocks.

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[1] https://www.ft.com/content/98157b42-a0fa-11e8-85da-eeb7a9ce36e4 and https://www.wsj.com/articles/u-s-china-to-resume-trade-talks-as-tariffs-bite-1534395737

[2] https://www.politico.eu/article/five-looming-problems-for-italys-populist-government-s-5star-movement-far-right-league-matteo-salvini/?utm_source=POLITICO.EU&utm_campaign=87fdb54007-EMAIL_CAMPAIGN_2018_08_16_04_34&utm_medium=email&utm_term=0_10959edeb5-87fdb54007-190334489  (see point #2).

[3] https://www.politico.eu/pro/giuseppe-conte-danilo-toninelli-5stars-italy-under-fire-after-genoa-bridge-collapse/ (paywall) and https://www.nytimes.com/2018/08/15/world/europe/italy-genoa-bridge-collapse.html?emc=edit_mbe_20180816&nl=morning-briefing-europe&nlid=5677267mbe_20180816&rref=collection%2Fsectioncollection%2Fworld&te=1

[4] https://www.ft.com/content/7400fac2-a0a2-11e8-85da-eeb7a9ce36e4 and https://www.nytimes.com/2018/08/15/world/europe/turkey-andrew-brunson-tariffs.html?action=click&contentCollection=world&contentPlacement=8&emc=edit_mbe_20180816&module=package&nl=morning-briefing-europe&nlid=5677267riefing-europe&pgtype=sectionfront&region=rank&rref=collection%2Fsectioncollection%2Fworld&te=1&version=highlights

[5] https://www.ft.com/content/9464d4ae-a125-11e8-85da-eeb7a9ce36e4

[6] https://www.reuters.com/article/us-turkey-usa-tariffs/u-s-tariffs-to-stay-on-turkey-qatar-offers-ankara-aid-idUSKBN1L00BI?il=0

[7] https://www.nasdaq.com/article/japan-cbank-may-tolerate-yield-rises-to-around-04-pct–exboj-executive-20180816-00030

[8] https://www.reuters.com/article/us-china-economy-projects/china-nearly-quadruples-infrastructure-approvals-in-july-idUSKBN1L106N

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Risk-off has returned with a vengeance this morning.  Despite a continued lift in the Turkish lira (TRY), global equity markets are lower.  Some of this decline is being driven by a stronger dollar and cratering commodity prices.  Here is what we are watching today:

Contagion fears:[1] The current weakness in emerging markets has raised fears that another 1997 is looming.  In 1997, the Asian Economic Crisis, which started in Thailand, spread throughout Asia and into South America.  It even led to the Russian Debt Default in 1998.  Our position is that another event of similar magnitude isn’t likely because most emerging economies now use floating exchange rates.  In the late 1990s, most emerging economies used fixed exchange rates that gave emerging market borrowers confidence that they could borrow in hard currencies at lower interest rates without fear that debt service costs would rise due to currency weakness.  Unfortunately, the pegs were not sustainable and debt service costs soared when the currencies reset, forcing a whole series of countries to go to the IMF for support.

To compare the 1997 situation, we will use Indonesia as an example.  First, in 1997, the rupiah was overvalued.

This chart shows a purchasing power parity model for the Indonesian rupiah; parity is based on relative inflation rates between Indonesia and the U.S.  The currency is quoted in rupiah/USD, which means a higher number indicates a weaker currency.  Before the crisis, the exchange rate was fixed at roughly 2,500 per dollar.  The parity rate was closer to 3,800 per dollar.  When the crisis hit, the country allowed its currency to float; it depreciated rapidly, hitting 14,000 before settling in around 8,000.  Because currencies are so basic to the functioning of an economy and are difficult to value, there is often a tendency to overshoot parity during a crisis.  Although this hurts initially, the currency weakness does tend to improve export competitiveness and sow the seeds of recovery.  And, that’s what we saw with Indonesia.

This chart shows Indonesia’s current account as a percentage of GDP and the exchange rate.  Immediately after the currency collapse, the current account swung into surplus and remained in surplus until 2012.  The currency has steadily weakened since the country began running current account deficits.  Because the currency floats, Indonesia avoids the discrete drops in the exchange rate that we saw in 1997.  In addition, Indonesian borrowers who want to take out loans in hard currency have a better idea of their funding costs because the weaker exchange rate that coincided with the current account deficit offers a more accurate picture of future borrowing costs.

Although the use of floating exchange rates should prevent the discrete collapses that characterized the 1997 Asian Economic Crisis, it doesn’t mean that problems won’t develop.  We note that Indonesia unexpectedly raised rates 25 bps to 5.25% overnight in a bid to stabilize the currency.  Fears of broader emerging market weakness, triggered by the stronger dollar, trade concerns and Fed tightening, are legitimate concerns.  But, we don’t expect a repeat of 1997; if we are correct in this assessment, we shouldn’t see the sudden collapses in exchange rates that we saw during that earlier event.  That doesn’t mean we won’t see further pressure, but the “glide path” lower should be more manageable.

Turkey: The TRY did rebound overnight after the Erdogan administration halved the limit on total forex swaps to 25% of banks’ shareholder equity.  Although this won’t stop Turkish citizens who want to protect their liquidity from buying dollars, it will reduce the ability of professional investors to short the currency with leverage to gain from further weakness.

As this chart shows, the TRY bounced overnight.  We doubt this action can be maintained but it does appear the shorts are worried about a recovery; in other words, if Turkey releases the pastor or boosts interest rates, the shorts could be caught.  Thus, we are seeing what should be described as skittish market action.

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[1] https://www.wsj.com/articles/plunging-turkish-lira-indian-rupee-raise-specter-of-contagion-1534252079

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] We are seeing some risk-on behavior this morning; the Turkish lira is higher but it looks more like a deceased feline rebound rather than anything of substance.  Here is what we are watching today:

Turkey: As noted above, the TRY is higher this morning, rebounding about 6%, after Turkish President Erdogan gave a speech calling for a boycott of U.S. technology products.  Erdogan reiterated a strong stance against the weak lira and rising inflation but offered nothing that would end the crisis.  He continues to avoid orthodox measures, such as a jump in interest rates or going to the IMF for a bailout package.  National Security Advisor Bolton met with the Turkish ambassador to the U.S., Serdar Kilic, at the White House at the request of the Turkish official.[1]  According to reports, the meeting was over the detained U.S. pastor, Andrew Brunson.  We suspect Turkey has concluded that the benefit of holding Brunson isn’t worth the cost but is struggling to hand him over to the U.S. without looking weak.  At the same time, we doubt President Trump has any interest in allowing Erdogan a face-saving exit.  Thus, the tensions continue.  So, for today, we are seeing a respite but there is no sign of steps to resolve the crisis.

Turkey’s government issues bonds denominated in lira and U.S. dollars.  We note that yields on both instruments have increased but, more importantly, the spread has widened well more than normal.  As the chart below shows, for most of the past seven years, the spread between the two instruments was 500 bps.  The spread is now out over 1,200 bps, a reflection of worries about the future path of Turkish policy.

A terrorist act at Parliament: It appears a man in the U.K. used his vehicle to strike several people in front of the Parliament building before crashing his car into protective barriers.  There have been no reported fatalities but several injuries.  Scotland Yard is treating the event as a terrorist act.  This may have been a spur of the moment attack; we note Parliament is not in session and most MPs are off for the summer.  Thus, the potential disruption to government was low.

The Iran standoff continues: Ayatollah Khamenei announced today that he is forbidding Iranian officials from any negotiations with the U.S.[2]  Interestingly enough, Khamenei acknowledged the economy’s poor performance but blamed domestic mismanagement and corruption as the cause.  In other words, sanctions are not really a problem but the Rouhani government is inept.  We have recently discussed Iran’s options in a three-part series in our Weekly Geopolitical Reports.[3]  We note that Khamenei said today that Iran would not start a war with the U.S. and he isn’t worried that the U.S. would attack Iran.  Khamenei’s stance looks like he is betting that sanctions won’t be all that difficult to deal with and non-compliant nations, like Russia and China, will offer enough support to keep the Iranian economy going.  The comments also suggest he is preparing the country for slower growth and appealing to nationalism.

China critical of defense act: Yesterday’s signing of the new defense act has drawn criticism from China as the Committee on Foreign Investment in the United States (CFIUS) has been strengthened as part of that new legislation.[4]  The Chinese feel (correctly) that the investment scrutiny is targeted at them.  In addition, the new law calls for strengthening Taiwan’s defense, which is seen as a direct threat against China.

Maduro recommends a risky step:According to reports,[5] Venezuelan President Maduro is calling for an end to gasoline subsidies due to their increased cost to the government’s budget.  With rapidly rising inflation, the gasoline subsidy has led to severe distortions.  Venezuelan gasoline costs about $0.01 per liter,[6] the lowest in the world.  The going price in Colombia is $0.80 per liter, so naturally there is a brisk business in smuggling Venezuelan gasoline to its neighbor.  Many OPEC nations subsidize gasoline prices; it is seen as a national perk.  History shows that raising the price of gasoline can cause internal unrest.  Given that conditions are already difficult, this action may lead to widespread problems.  We don’t disagree with the action but see it as a major risk.

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[1] https://www.reuters.com/article/us-turkey-security-usa-bolton/trump-aide-bolton-met-turkish-envoy-to-discuss-u-s-pastor-white-house-idUSKBN1KY278

[2] https://www.ft.com/content/b3e22fd6-9f16-11e8-85da-eeb7a9ce36e4?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[3] See WGRs, Iran Sanctions and Potential Responses: Part I (7/30/18), Part II (8/6/18), and Part III (8/13/18).

[4] https://www.cnbc.com/2018/08/14/china-angered-by-new-us-defense-act-says-to-assess-content.html

[5] https://www.reuters.com/article/us-venezuela-economy/venezuela-gasoline-prices-should-rise-to-international-levels-maduro-idUSKBN1KZ01Z

[6] https://www.globalpetrolprices.com/Venezuela/gasoline_prices/