by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy August!  Summer is winding down—it seems like it just started.  Here is what we are watching:

The Fed: The meeting ends this afternoon.  No rate hike is forecast.[1]  The only item of interest will be the statement, which probably won’t tell us anything.  Even so, in light of Q2 GDP, we would not be surprised to see a statement that focuses on strong growth, which would bolster the argument for raising rates.  However, that would mostly confirm the current expected policy path, nothing more.

Trade update: There is a trade truce with Europe.  Talks with Mexico are said to be doing well,[2] although in terms of NAFTA Canada seems to be sidelined at the moment.  However, talks with China, which are currently backchannel, don’t appear to be going well.  The Trump administration has indicated it will put 10% tariffs on $200 bn of Chinese goods later this month; according to reports the administration has boosted the threat to 25%.[3]  Beijing has been increasing fiscal and monetary stimulus to offset the tariff threat to exports.[4]  The country has also threatened retaliation if the Trump administration goes the route of increasing trade protection.[5]  Financial markets are hopeful that reports of informal talks with Chinese officials will lead to some sort of trade deal.  After all, there is a truce now with the EU and it looks like an agreement with Mexico is coming.  Nevertheless, it is important to remember that Navarro and Lighthizer are mostly focused on China.  Thus, the potential for a rupture and trade war with China is probably more likely than with other parts of the world.

BOE: We expect the BOE to raise rates 25 bps on Thursday.  That move is well discounted but still may be modestly bullish for the GBP.

Iran: The situation in Iran appears to be deteriorating.  The rial remains under pressure.[6]  President Rouhani has replaced the head of the central bank.[7]  Unrest is rising as inflation increases.  Although it is possible the regime could fall, we doubt that will happen.  A much more likely outcome is that Rouhani will be forced to throw his lot in with the IRGC and adopt hardline policies.  Of course, the secondary effect could be that unrest worsens and does become a threat to the regime.  In 2009, the IRGC proved to be very effective in containing the political threat.  However, that event was really an elite protest; in other words, the more liberal elite was in a fight with the conservative elite and the latter won.  This case could be different in that the masses may rise up against the state.  History shows that mass uprisings tend to fail without a leader and Iran’s security services have done a good job in decapitating any such leader from emerging.  If Iran devolves and the regime runs into trouble, a short-term disruption of oil production is possible.

Foreign buying of U.S. real estate[8]:One of the factors we follow is foreign buying of U.S. residential real estate.  Not only does it affect our markets, it is a measure of capital flight.  The latest data shows there was a 21% decline in inflows for the year ending March 2018, with $121 bn purchased.  Chinese buyers accounted for 25% of that total.  Compared to the previous year, Chinese buying fell about 4%, at $30.4 bn.  Chinese buyers purchased homes about 50% higher than the median price of $292,400, mostly because they tend to purchase in higher cost urban areas in states such as California, New York and Washington.  The largest state with foreign home buying is Florida, which tends to attract both European and South American buyers.  California is the second largest foreign market.

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[1] https://www.reuters.com/article/us-usa-fed/fed-set-to-hold-rates-steady-remain-on-track-for-more-hikes-idUSKBN1KL0LF

[2] https://www.reuters.com/article/us-usa-trade-coordination/mexican-officials-optimistic-about-nafta-news-in-coming-days-idUSKBN1KM3LI

[3] https://www.wsj.com/articles/u-s-talks-with-china-over-trade-dispute-show-little-progress-1533066018

[4] https://www.wsj.com/articles/chinese-economy-starts-to-feel-tariff-impact-1533015872

[5] https://www.reuters.com/article/us-usa-trade-china/trump-to-propose-25-percent-tariff-on-200-billion-of-chinese-imports-source-idUSKBN1KM3B3

[6] https://www.wsj.com/articles/irans-rial-at-historic-low-as-u-s-sanctions-loom-1532957022

[7] https://www.rferl.org/a/iran-names-new-central-bank-head-hemati-currency-collapse/29389655.html

[8] https://www.yicaiglobal.com/news/chinese-housing-buyers-splurge-most-us-amid-market-cooling

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s July 31^st, the Feast Day of St. Ignatius of Loyola, the founder of the Society of Jesus (Jesuits).  Here is what we are watching:

BREAKING: CHINA SEEKING NEW TRADE TALKS TO DEFUSE TRADE WAR.  EQUITIES RISE ON NEWS.

BOJ: The BOJ has spoken and not much has changed.[1]  The bank will continue to peg the JGB 10-year at 0.0% with a variation tolerance of 20 bps, which is double from the previous policy.  But, overall, the bank still intends to keep the rate at the long end near 0%.  The BOJ will offer some relief to banks in the form of lowering the level of reserves that are charged with a negative interest rate.  It also extended forward guidance, indicating that low interest rate levels will remain “for an extended period of time.”  Finally, the BOJ buys equity ETF as part of its assets and it intends to buy more of the Topix-linked instruments and less of the Nikkei-linked instruments; the former is considered a broader based index and thus will be less distorting to the equity markets.  Globally, long-term interest rates fell while the JPY depreciated.

Oops, I did it again: The Washington Post is reporting that U.S. spy agencies have evidence that North Korea is working on a new missile factory.[2]  Pyongyang made a show of dismantling another site[3] recently but this new development suggests the country is still working on building a nuclear deterrent.  We note that SoS Pompeo recently admitted that North Korea may have a uranium-enrichment facility near Kangson Station.[4]  Although the U.S. and North Korea held talks, the Hermit Kingdom is continuing to develop its nuclear weapons and delivery systems.  That doesn’t mean it won’t stop at some point but it is clear that North Korea views the summit as the start of negotiations and little more.  The risk is that President Trump concludes he has been “had”; if that occurs, look for escalating tensions.

Iran talks?  Yesterday, President Trump agreed to meet with Iran’s leaders “without preconditions.”  This offer probably won’t go anywhere but it does suggest the president is following a similar tactic he used with North Korea, which was to threaten and then agree to talks.  The problem, as noted above, is that talks with North Korea haven’t changed its behavior on its nuclear weapons program.  In addition, the Iranian and North Korean government structures are quite different.  Kim Jong-un can generally act unilaterally and policy can change rapidly as a result.  Iran is much more complicated.  Although Supreme Leader Ayatollah Khamenei has a great deal of power, he cannot act unilaterally.  In fact, the real power in Iran may lie with the Iranian Republican Guard Corp, which would oppose talks.  Iran has indicated it will not join any new talks before the U.S. rejoins the nuclear deal that the U.S. withdrew from in May.  We don’t see this going anywhere unless Iran can get the U.S. to postpone the implementation of sanctions during negotiations.  That concession will likely be the necessary component if the Trump administration is serious about talks.

The Fed: The meeting ends tomorrow.  No rate hike is forecast.  The only item of interest will be the statement, which probably won’t tell us anything.  Even so, in light of Q2 GDP, we would not be surprised to see a statement that focuses on strong growth, which would bolster the argument for raising rates.  However, that would mostly confirm the current expected policy path, nothing more.

BOE: We expect the BOE to raise rates 25 bps on Thursday.  That move is well discounted but still may be modestly bullish for the GBP.

Another tax cut?  SoT Mnuchin has indicated the administration is considering whether it can change the definition of an asset’s cost for determining the cost basis when calculating the capital gains on an asset.[5]  The proposal is to adjust the cost basis by inflation.  Here’s a quick example.  Assume a wealthy investor buys $100k of stock in January 2000.  He sold it last month for $200k.  He would be taxed at a 20% long-term capital gains rate on the $100k gain, paying $20k in taxes.  If we use overall CPI to adjust the cost basis, it rises to $149,282.58, lowering the capital gain to $50,717.42 and the tax liability to $10,143.48.

The key issue is whether or not the Treasury can make this change unilaterally, without legislation from Congress.  In the early 1990s, the Bush administration sought a legal opinion on the issue and the opinion concluded that Congress could not be bypassed.[6]  A couple of thoughts.  First, such a move would be popular with the GOP establishment (and although they would feign opposition, the Democrat Party establishment would like it, too) but would not do anything to fire up the base.  Thus, it may be that this is a Kudlow/Mnuchin ploy to cut taxes that didn’t originate from the president.  If so, it may not have legs because it won’t do much for the GOP in November.  Second, this would be more complicated than it looks.  For example, it would reduce the value of donated stock to charities.  It would further increase the value of capital gains over dividends and interest and make stock buybacks more attractive.  In the short run, we would likely see a flurry of asset sales; after all, if an administration can unilaterally change the cost basis calculation, it can change back just as easily.  This may not be anything but it would be a short-term boost for equities if the idea gains traction.

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[1] https://www.ft.com/content/45b4fe28-946f-11e8-b67b-b8205561c3fe

[2] https://www.washingtonpost.com/world/national-security/us-spy-agencies-north-korea-is-working-on-new-missiles/2018/07/30/b3542696-940d-11e8-a679-b09212fb69c2_story.html?utm_term=.460dc2b4a386

[3] https://www.38north.org/2018/07/sohae072318/

[4] https://thediplomat.com/2018/07/exclusive-revealing-kangson-north-koreas-first-covert-uranium-enrichment-site/

[5] https://www.nytimes.com/2018/07/30/us/politics/trump-tax-cuts-rich.html

[6] https://www.justice.gov/file/20536/download

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Today we kick off central bank week.  The BOE, BOJ and Fed all meet this week.  The last meeting is probably of least consequence.  Here is what we are watching:

BOJ: The BOJ has clearly spooked the market; the Japanese central bank’s current policy is to fix the 10-year JGB interest rate at 0% and buy all the bonds required to fix the rate.  This practice has generally put the rate around 5 bps.  Now, the BOJ is considering adjusting that policy and fears of policy tightening have lifted yields and forced the BOJ to increase market intervention to prevent yields from rising.[1]

This has also led to a very flat yield curve.

Despite all this stimulus, Japan appears no closer to reaching any sort of rising price levels.

So, if forcing the long-term rate to zero isn’t generating any inflation, why is the BOJ thinking about allowing the 10-year yield to rise?  It’s probably about the yield curve.  Banking is a spread business; one borrows at the short end of the curve and lends at the long end.  The usual spread between long- and short-term rates generally represents bank margins.  Thus, the flat yield curve is hurting the banking system and the BOJ probably wants to help that sector.  The problem is that if the BOJ signals that the long rate may be allowed to rise, which will likely be seen as tightening, the JPY could appreciate.  A stronger currency will undermine Abenomics and thus the BOJ will try very hard to avoid that outcome.  We expect the BOJ to offer a tepid promise to allow some rise in the long-term interest rate but prevent too much of a rise. Consequently, the fear may overshadow what actually happens.

The Fed: No rate hike is forecast.  The only item of interest will be the statement which probably won’t tell us anything.  Nevertheless, in light of Q2 GDP, we would not be surprised to see a statement that focuses on strong growth which will bolster the argument for raising rates.  However, that is mostly to confirm the current expected policy path, nothing more.

BOE: We expect the BOE to raise rates 25 bps.  That move is well discounted but still could be modestly bullish for the GBP.

China in South America: China has been making investments in South America for some time.  Since 2000, China has been the world’s largest consumer of numerous commodity products and friendly ties would make sense since the region is a major producer.  However, a report in Sunday’s NYT[2] caught our attention; China has built a space station in Argentina that could be for dual use.  In other words, the facility could have military applications.  This facility is a troubling development, a clear violation of the Monroe Doctrine.  The article notes that U.S. interest in the region has been waning for some time, and China is moving to fill the void in what is essentially America’s backyard.

Russia dumps Treasuries: Despite the controversial meeting between President Trump and President Putin, which has raised fears in some quarters of a risky thaw in relations, Russia isn’t acting as if it believes conditions will improve.  Reports over the weekend indicate that Russia has sold nearly all of its Treasuries held in its official foreign reserves.[3]  This is an unusual move and would normally only be made if a nation wanted to diversify into some other reserve currency, e.g., euros.  However, there isn’t much evidence that any such action occurred.  It has been noted that Cayman Island holdings rose by over $20 bn in the past two months, which may suggest some Russians are trying to hide the assets.  Clearly, the move didn’t move yields.

A government shutdown?  President Trump indicated he would be willing to shut down the government if Congress fails to fund his border wall.[4]  So far, the financial markets are not taking the threat seriously.  It would be politically risky to shut down the government just before mid-terms; if the GOP were blamed, it could cost them votes.  In addition, the distraction could prevent Brett Kavanaugh from being confirmed in this term.  The market take, so far, is that this is bluster but if the president is serious the usual market pattern would be risk-off.

Iranian sanctions loom: Iran will face new sanctions on August 7, with the final phase being implemented in early November.  The Iranian rial plunged,[5] falling to 111,500 rials/USD on the open market, a new record low.  The Iranian currency has lost over half its value since April.  There have been reports of scattered unrest as the economy stumbles.  This week’s WGR will kick off a three-part report on Iran’s potential responses to sanctions.  The first part will be published later today.

An interesting political development: The Koch brothers have been important funders of the GOP in recent years.  They are demonized on the left in a similar fashion to George Soros being lambasted from the right.  However, we believe it is naïve to view the Kochs or Soros purely through the perspective of party.  The Kochs are mostly right-wing establishment with some libertarian leanings; Soros is left-wing establishment with similar market-friendly positions.  Over the weekend, Charles Koch shocked the political world by suggesting he would work with Democrats who share some of his policy goals.[6]  The reaction was swift; Steve Bannon essentially told the Kochs to pipe down and fund the president’s favored candidates.[7]  We believe the proper way to view this “spat” is through the lens of our recent WGRs on class and identity in politics.[8]  Soros and the Kochs are establishment in terms of class.  The Kochs apparent defection likely stems from their perception that the GOP is being taken over by right-wing populists who will support policies that eventually harm capital (e.g., trade impediments, restrictions on foreign investment, immigration restrictions).   That doesn’t mean the Democrats will now become the party of the establishment class; after all, the Democrats are facing their own internal revolt between the left-wing establishment and left-wing populists.  What this does show is that the party affiliations are becoming increasingly fluid as we are going through a significant restructuring of the U.S. political system.  The Kochs opening up to the idea that Democrats may be friendlier to their interests is an element of this restructuring. 

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[1] https://www.ft.com/content/d1606352-9309-11e8-b747-fb1e803ee64e?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[2] https://www.nytimes.com/2018/07/28/world/americas/china-latin-america.html

[3] http://www.dailymail.co.uk/news/article-6003457/amp/Mystery-Russia-LIQUIDATES-holdings-Treasury-securities.html?__twitter_impression=true

[4] https://twitter.com/realDonaldTrump/status/1023557246628900864

[5] https://www.aljazeera.com/news/2018/07/iran-currency-plunges-record-sanctions-loom-180729135733789.html?utm_source=Sailthru&utm_medium=email&utm_campaign=ebb%2030.07.18&utm_term=Editorial%20-%20Early%20Bird%20Brief

[6] https://www.politico.com/story/2018/07/29/koch-democrats-funding-747501

[7] https://www.politico.com/story/2018/07/29/bannon-koch-brothers-midterms-trump-747650

[8] See Weekly Geopolitical Reports, Reflections on Politics and Populism: Part I (7/16/18) and Part II (7/23/18).

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s GDP day!  We detail the data below but the quick take is that it was a very solid number, up 4.1%.  Unfortunately, hyperbolic comments from the White House in front of the report increased the odds of disappointment.  The initial market reaction is showing disappointment.  However, it should not be lost that this was a really strong report.  Other than that, it was a fairly quiet overnight session.  Here is what we are watching:

Trade: The recent truce between the EU and the U.S. has sparked all kinds of speculation of a process behind the rhetoric.  Some see the potential for an EU/U.S. united front against China; this idea is being pushed by Larry Kudlow.[1]  If the U.S. makes a trade deal with the EU, the two could isolate China.  This is a very worthwhile geopolitical tactic.  However, that process was already underway—it was called the Transatlantic Trade and Investment Partnership, or TTIP.   The president killed that deal but it was already on the rocks before his election.  The combination of TPP and TTIP[2] would have completely isolated China and Russia and forced them to deal with the lynchpin state, the U.S., to remain relevant to trade.  It should be noted that both were dead letters before the last election.  And so, the real issue isn’t Trump, it’s that the American people are no longer on board to support American hegemony.  Is it possible that Kudlow is correct?  Sure, but the risk is that there isn’t sufficient support for any such program.

We are working from the position that the president’s primary goal is to reduce imports and boost domestic manufacturing activity by forcing firms to shorten supply chains.  If we are correct, the “Juncker truce” is a tactical retreat.  The pushback the White House is getting from sectors of the economy adversely affected by trade impediments is leading the president to moderate his trade position in front of the mid-term elections.  But, we see no evidence that his central policy goal is changing.

A take on Russia: There are reports that former SoS Henry Kissinger suggested to Trump administration officials that they should consider a reversal of the policy that became “Nixon to China” in the 1970s.[3]  Kissinger offered the idea that the incoming administration should improve relations with Russia and use that to isolate China.  This isn’t a bad idea.  Russia naturally fears China; the former is facing a demographic catastrophe and fears that China will eventually take the far eastern reaches of Russia.[4]   The problem with this policy is that it isn’t clear whether the friendliness the president shows to Vladimir Putin is to isolate China or if he just likes the Russian leader.  At this point, we don’t know, but if it is the latter the improvement in relations may not lead to isolating China at all.  It may simply isolate our post-WWII allies, Japan and the EU.

Bitcoin strikes out again: The SEC rejected an application by the Winklevoss twins to launch a Bitcoin ETF.  This is the second time in two years that the SEC has rejected the application.  Bitcoin fell on the news.

Turkey threats: Andrew Brunson is a Christian pastor who has been in a Turkish prison for 21 months; he is one of 20 other Americans who were arrested after the failed coup against President Erdogan.  It seems highly unlikely that Brunson participated in any action to support the coup.[5]  He has been working in Turkey for 23 years.  Instead, Erdogan is using Brunson as a bargaining chip to swap Fethullah Gulen, an Islamist figure who was once allied with Erdogan to oppose Turkey’s then secularist government.  However, as Erdogan rose to power, the two had a falling out and the current Turkish president has feared that Gulen’s followers will try to oust him.  Gulen currently lives in a rural Pennsylvania compound.  The U.S. has, so far, refused to extradite Gulen.  On this issue, instead of swapping Gulen for Brunson, the Trump administration worked out an agreement where Israel would trade Ebru Ozkan, a 27-year-old Turkish woman currently imprisoned on smuggling charges, for Brunson.  From the perspective of Turkey, this wasn’t much of a trade.  The case against Ozkan isn’t very strong; in fact, it’s weak enough that an Israeli court released her to house arrest.  That agreement apparently fell apart when a Turkish court kept Brunson under house arrest, although they did release him from prison.  Both President Trump and Vice President Pence reacted with great anger to this development and both promised new sanctions against Turkey.[6]  The embattled Turkish lira took another leg down on the U.S. reaction.   From our perspective, Turkey overplayed its hand.  The U.S. does not appear compelled to extradite Gulen.  He may be useful to American interests because he does seem to threaten Erdogan and thus can be used to control Erdogan’s behavior. After all, Turkish and American interests don’t completely align; Turkey systematically oppresses the Kurds who are a reliable U.S. ally in the region.  Erdogan has also flirted with Russia and has allowed Middle Eastern refugees to surge into Europe.  As a result, the U.S. views Turkey as rather unreliable.  The idea that this pastor would be important enough to swap Gulen is fairly farfetched.  The U.S. could inflict rather severe pain on Turkey; the drop in the lira is causing problems for the economy[7] and the administration could sanction the country for dealing in Iranian oil.  We would expect Turkey will realize at some point that it isn’t going to get Gulen and conclude that continuing to hold Brunson isn’t worth the trouble.

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[1] https://www.reuters.com/article/us-usa-trade-eu-kudlow/white-houses-kudlow-says-eu-will-help-trump-confront-china-idUSKBN1KG2FF and Weekly Geopolitical Report, The TTIP and the TPP: An Update (10/17/16)

[2] See Weekly Geopolitical Report, The TTIP and the TPP (1/27/14)

[3] https://www.thedailybeast.com/henry-kissinger-pushed-trump-to-work-with-russia-to-box-in-china?ref=home

[4] https://www.nytimes.com/2016/08/01/world/asia/russia-china-farmers.html and https://www.scmp.com/week-asia/geopolitics/article/2100228/chinese-russian-far-east-geopolitical-time-bomb

[5] For background, see Weekly Geopolitical Reports, The Turkish Coup, Part 1 (7/25/16); Part II (8/1/16); and Part III (8/8/16).

[6] https://www.washingtonpost.com/politics/trump-says-us-will-impose-large-sanctions-on-turkey-for-detaining-american-pastor-for-nearly-two-years/2018/07/26/75dcde32-90e5-11e8-bcd5-9d911c784c38_story.html?utm_term=.e6b299282fd1 ; https://www.nytimes.com/2018/07/26/world/europe/turkey-sanctions-trump.html?emc=edit_mbe_20180727&nl=morning-briefing-europe&nlid=567726720180727&te=1

[7] https://www.ft.com/content/c114d1ca-90d6-11e8-b639-7680cedcc421

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

A deal…sort of: President Trump and EU Commission President Juncker announced a trade deal has been reached.[1]  Equities rose, interest rates moved higher and the dollar eased as investors took the news as a “risk-off” event.  We were surprised by the outcome.  And, on its face, it looks like the EU “blinked.”  However, it should be noted that the “deal” is really nothing more than an opening for negotiations.  Trade negotiations usually have excruciating detail and that isn’t what this meeting was about.  Still, the outcome suggests the Europeans have concluded that the costs of a trade war are too high and they must accept some concessions.  The problem will be that all member states of the EU have to agree on any changes and it is very hard to get an agreement passed.  The recent free trade deal with Canada and the EU took years to finalize and Italy continues to threaten to scuttle the agreement.  But, for now, this is good news.

Here are the “sort of” issues: Existing tariffs are apparently excluded from negotiations.  Thus, the tariff on imported light trucks will remain in place as will steel and aluminum tariffs.  Nothing will change on agricultural trade except for soybeans, which is the only part of this trade that Juncker has any authority.  It should be noted that Europe was poised to buy more soybeans anyway because China’s trade restrictions will essentially shift global oilseed trade.  South America will become the primary supplier to China but the oilseeds that would have been sold to Europe and elsewhere will now be supplied by the U.S.  The EU already doesn’t have tariffs on U.S. LNG.  However, the U.S. can’t sell LNG to any nation where it doesn’t have a trade agreement in place.  As a result, there is an incentive for some sort of agreement on this issue alone.  The EU is already building regasification facilities so any concession made by Juncker on this issue really isn’t a concession.  We note that LNG isn’t competitive with piped gas from Russia; Juncker has been a proponent of building LNG import facilities to diversify supply sources but the idea that the U.S. will send lots of LNG to Europe is probably misplaced.

In other words, the deal announced yesterday is much less than meets the eye.  We do note that Peter Navarro was nowhere to be seen in these negotiations but Larry Kudlow was involved.  We (and others) have noted the divide in the administration between the anti-trade wing (Navarro and Lighthizer) and the pro-trade wing (Kudlow and Mnuchin).  The two sides seem to rise and fall in influence.  It is quite possible that rising criticism from GOP congressmen toward the administration’s trade policy led to a return of the pro-trade wing.  But, there is no guarantee that this will last.

Another item we are watching comes from what we would characterize as ill-advised post-meeting comments from Juncker.  The president of the EU Commission touted a “major concession” from the U.S. on autos.[2]  It is rarely productive to suggest a “win” over President Trump because he seems to view the world as a zero-sum game.  Thus, a Juncker “win” means a Trump “loss.”  We would not be surprised to see a pushback on Juncker’s comments.

ECB: The ECB held its regular meeting.  There was no change in policy.  Interest rates were held steady.  The central bank will stop buying bonds in December but will continue to reinvest maturing bonds, meaning the balance sheet will remain steady.  The ECB plans to consider raising rates by the summer of 2019.  The only item of note in the press conference was that President Draghi suggested there are no signs of accelerating inflation.  The EUR weakened modestly on the news; the currency rallied on yesterday’s trade news so some of the “give back” may simply be due to a more sober view of the aforementioned trade agreement and less about the ECB meeting.

Pakistan elections: We haven’t spent a lot of time on this election but Imran Khan is likely to become the new prime minister.  As is common in emerging nations, there were widespread accusations of voting irregularities.  Khan is a former professional cricket player; in general, civilian leaders in Pakistan are constrained by the powerful military, so we have doubts that a new leader will foster significant changes in policy.

Energy recap: U.S. crude oil inventories fell 6.1 mb compared to market expectations of a 3.1 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 decline occurred because of a decline in imports which offset another unexpected drop in refinery operations.  The slower refining activity led to a drop in gasoline stocks.  We would expect a rebound in refining activity next week which will probably bring a drop in oil inventories.

As the seasonal chart below shows, inventories are well into the seasonal withdrawal period.  This week’s drop in stocks was consistent with seasonal patterns.  If the usual seasonal pattern plays out, mid-September inventories will be 399 mb.

Based on inventories alone, oil prices are near the fair value price of $72.65.  Meanwhile, the EUR/WTI model generates a fair value of $61.05.  Together (which is a more sound methodology), fair value is $64.69, meaning that current prices are above fair value.  Currently, the oil market is dealing with divergent fundamental factors.  Falling oil inventories are fundamentally bullish but the stronger dollar is a bearish factor.  It should be noted that a 399 mb number by September would put the oil inventory/WTI model in the high $80s per barrel.  Although dollar strength could dampen that price action, oil prices should remain elevated.

Saudi suspension: Saudi Arabia has temporarily suspended oil shipments through the Bab-el-Mandeb Strait in the southern part of the Red Sea.  According to reports,[3] two tankers owned by the Saudi National Shipping Company were attacked by Houthi forces.  The tankers suffered minor damage.  The Bab-el-Mandeb Strait is one of the global oil chokepoints.  About 4.8 mbpd of oil and product flow move through this strait daily, which makes it the fourth most trafficked of the listed chokepoints.  Thus, this action is important but it is probably (a) temporary, and (b) likely offset by other flows.  We note that Brent crude oil prices rose this morning but there was little effect on WTI.

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[1] https://www.washingtonpost.com/business/economy/trump-pushes-25-percent-auto-tariff-as-top-advisers-scramble-to-stop-him/2018/07/25/f7b9af04-8f8a-11e8-8322-b5482bf5e0f5_story.html?utm_term=.b9940dc840bf&wpisrc=nl_todayworld&wpmm=1

[2] https://www.politico.com/story/2018/07/25/trump-juncker-trade-concession-tariffs-1661543

[3] https://www.ft.com/content/f0858962-9005-11e8-b639-7680cedcc421

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Markets are quiet this morning, typical for mid-summer.  Here is what we are watching:

Juncker to the White House: The president of the EU Commission, Jean-Claude Juncker, visits the White House today.[1]  It is expected he will offer the U.S. some sort of narrow trade pact on industrial goods and autos.  We suspect this meeting will probably end in failure; the auto trade is too important for Germany to give up much and it isn’t obvious what would appease the president.  Juncker has made it clear that the EU will retaliate if the U.S. implements tariffs, most likely against agriculture.

The crux of the trade issue: The biggest issue emerging from the trade issue is that the president’s goal is unclear.  He appears to view trade from a mercantilist perspective—surpluses are wins, deficits are losses.  Although economic theory discredited this viewpoint about 250 years ago, it still remains a common belief among most people.  So, how does a mercantilist win?  The goal would seem to either be opening foreign markets to U.S. exports or restricting imports, or some combination of these policies.  The president has concluded, it seems, that the only lever he really controls is import restrictions.  If we are correct in this assessment, the tariff war will almost certainly escalate.  The end result will be increased employment and higher inflation in the trade deficit nations, and lower employment and lower inflation in the trade surplus nations.

How this policy plays out politically is complicated.  First, the microeconomic impact is quite difficult to parse.  Some sectors of the economy are simultaneously benefiting and being harmed.  They are facing less import competition for their finished goods, for example, but higher input costs.  Over time, these price effects will lead to production adjustments but it could cause political fallout as we head into mid-terms.  Second, we are seeing the GOP establishment tentatively push back against Trump’s trade policy[2]; as we noted in the last two WGRs,[3] the class interests of the establishment benefit from free trade so it isn’t a huge surprise that the center-right is finding their voice against protectionism.  Our read is that support for free trade has been waning for some time, although recent polls have shown increasing Democrat Party support for free trade.  This change is consistent with the idea that the GOP is steadily taking on a constituency of nationalist, working-class voters while the Democrats are becoming the party of globalist elites.

Another problem starting to emerge from the trade tensions is that Chinese investors are apparently liquidating commercial real estate holdings in the U.S.[4]  Some of these sales appear to be tied to pressure from the Xi government to curtail potential capital flight.  The loss of Chinese investment could be a negative factor for real estate, especially in the coastal regions.

May takes control of Brexit: PM May has taken direct control of the Brexit negotiating team,[5] transferring about 50 staff members from the Department for Exiting the EU.  That department’s role will be downgraded to focusing on preparing the domestic U.K. for Brexit.  May has been forced to deal with high levels of dissent within her government on this issue and has apparently concluded that she is better off streamlining the process.  Most likely, those “hard” Brexit supporters will see this as an attempt to silence their dissent.[6]  We suspect this is the case.  However, if May can pull this off, the odds of a “soft” Brexit will increase.

Cyberwar worries: The Department of Homeland Security warns that Russian hackers[7] have penetrated the control rooms of U.S. utilities.  Although the utilities were thought to be safe because they were “air gapped” from the internet, the hackers used portals created by trusted vendors and used those vulnerabilities to access the control rooms.  This development is a major threat because it could cause extended blackouts which would seriously undermine domestic security.

Israel downs jets: The Israel Defense Force has indicated it shot down a Syrian military jet that entered the airspace over the Golan Heights.  Israel and Russia are in negotiations to secure Israel’s borders; Israel wants the Russians to create a large buffer zone that will keep Hezbollah and Iran from being able to attack Israel with missiles.  Russia has, so far, been unable to create a plan that Israel accepts.  The Syrian incursion could be a signal that Israel is taking a hardline stance on its border.  Although we don’t expect a flare-up, this could be a new conflict zone if Russia is unable to stabilize the region.

North Korea: Although North Korea has been accused of not taking steps to denuclearize, we are starting to see some movement on the promised dismantling of a missile launch facility.  The group 38 North reports there is evidence that Pyongyang is taking concrete steps to decommission the facility.[8]  It is always difficult to determine what exactly is happening in North Korea, but the evidence supports that the regime is making an effort, at least at this facility, to move toward some sort of agreement.[9]

It’s bad in Venezuela: How bad is it?  It’s so bad that the IMF is projecting inflation could reach 1,000,000% this year.[10]  It’s so bad that the government can’t afford to print banknotes of sufficient denomination and is just putting “money” electronically into bank accounts.  Interestingly enough, this hyperinflation event is only the 23^rd worst in modern history.  The worst case was Hungary post-WWII, which saw prices double every 15 hours.  Still, some of the anecdotal reports are stunning; a kilogram of chicken (2.2 lbs) costs 3.3 mm bolivars last week, a bargain compared to the current price of 4.2 mm bolivars.  The collapse of the economy is leading to a significant brain drain.[11]  Those with skills are leaving the country for better opportunities elsewhere.  Oil production fell below 2.0 mbpd last year; in the late 1990s, the country produced about 3.3 mbpd.  To a great extent, recent increases in output by the OPEC cartel are designed to offset the production declines by Venezuela.

NAFTA: Earlier this week, we reported that AMLO, the president-elect of Mexico, wrote a letter to President Trump calling for good relations between the two nations and offering to complete a renegotiation of NAFTA.  President Trump has responded in a similar fashion, which may improve the chances of an agreement.[12]

Taiwan:China has been pressing U.S. airlines to stop calling Taiwan “Taiwan” as Beijing sees the island as a breakaway province that will eventually “return to the fold.”  The agreement about “one China” that Nixon and Carter approved was really a bit of strategic ambiguity; both China and the U.S. said there was “one China” but the U.S. held that Taiwan could remain independent indefinitely.  The Obama administration shied away from selling Taiwan large military systems because it felt such sales only angered China.  Instead, the doctrine was that Taiwan should make a defense of the island that would increase the costs of invasion to the point where China would simply not want to bear the cost.[13]  However, as relations between the Trump administration and China have deteriorated, the U.S. is now considering arms sales of greater capabilities.  This action will obviously anger the Chinese but it is an area where the U.S. does have some leverage.

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[1] https://www.nytimes.com/2018/07/24/business/juncker-trump-trade-europe-autos.html?emc=edit_mbe_20180725&nl=morning-briefing-europe&nlid=567726720180725&te=1

[2] https://www.politico.com/story/2018/07/24/trump-farmers-bailout-reaction-republicans-congress-737517

[3] See WGRs, Reflections on Politics and Populism: Part I (7/16/18), and Part II (7/23/18)

[4] https://www.wsj.com/articles/chinese-real-estate-investors-retreat-from-u-s-as-political-pressure-mounts-1532437934

[5] https://www.ft.com/content/2bf327ec-8f44-11e8-bb8f-a6a2f7bca546?emailId=5b58005a4f1aa40004f6ef35&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[6] https://www.ft.com/content/d523ad9a-8f63-11e8-bb8f-a6a2f7bca546?emailId=5b58005a4f1aa40004f6ef35&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[7] https://www.wsj.com/articles/russian-hackers-reach-u-s-utility-control-rooms-homeland-security-officials-say-1532388110

[8] https://www.38north.org/2018/07/sohae072318/

[9] https://www.ft.com/content/881897c0-8eed-11e8-b639-7680cedcc421?emailId=5b56a5635931240004dafefd&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[10] https://www.washingtonpost.com/world/venezuelas-inflation-rate-may-hit-1000000-percent-yes-1-million/2018/07/24/90d59086-8f4a-11e8-ae59-01880eac5f1d_story.html?utm_term=.c3e1ad920fb2&wpisrc=nl_todayworld&wpmm=1

[11] https://www.washingtonpost.com/world/the_americas/a-historic-exodus-is-leaving-venezuela-without-teachers-doctors-and-electricians/2018/06/03/8c6587a8-62d7-11e8-81ca-bb14593acaa6_story.html?utm_term=.b2678473638c&wpisrc=nl_todayworld&wpmm=1

[12] https://www.reuters.com/article/us-pacific-alliance-mexico/trump-mexico-expect-progress-in-stalled-nafta-talks-idUSKBN1KD25Y

[13] https://www.washingtonpost.com/news/global-opinions/wp/2018/07/23/the-u-s-makes-a-new-push-to-bolster-taiwans-military-defenses-china-wont-like-it/?utm_term=.d34d715ca1b3&wpisrc=nl_todayworld&wpmm=1