by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Beer Day![1]  Also, it’s employment data day.  We detail the data below but the quick take is that the data is a bit better than expected but not so strong as to change policy.  Financial markets are treating the report with some caution, mostly due to the weaker headline data on payrolls; initially, equities fell modestly on the news, the dollar retreated and bonds held mostly steady.  Here is what we are watching today.

Trade update: China has announced a series of retaliation acts against the U.S., a $60 bn list of goods for tariffs.  We have seen some pullback in equity markets on the news, although the impact was rather modest.  Meanwhile, talks with Mexico are showing signs of improvement and Canada appears poised to join the negotiations.  For now, trade hostilities are focused on China.[2]

Mileage standards: The Trump administration took action yesterday to roll back Obama-era mileage standards for autos.[3]  The new standard will be held at 2020 levels, which is around 37 mpg for fleets.  Obama’s original plan was for fleet standards to reach 54.5 mpg by 2025.  Perhaps even more important is the goal of ending California’s dominance in setting environmental rules by ending the state’s authority to establish its own auto emissions standards.  That will allow the auto industry to focus on a 50-state regulatory environment and no longer be forced to adjust to the actions of a single, but very important, state in terms of auto demand.

On its face, this is a major win for the automakers and oil companies.  For automakers, it will free them from difficult to achieve standards and allow them to sell cars Americans seem to prefer, which are larger SUVs and light trucks.  For the oil industry, the Obama mileage standards were part of a two-part nightmare.  Not only did the standards mean that gasoline consumption per vehicle was poised to decline but, in addition, the industry is dealing with a major trend change in miles driven.

The chart on the left shows total annual miles driven by autos and light trucks.  We have put gray bars during periods when that month is below the previous peak.  As the chart shows, most of the time, until 2008, we made new highs each month.  The chart on the right shows the level of miles driven per year relative to trend.  As the lower line shows, we fell below trend during the financial crisis and have not returned to trend.

The reason for the continued stagnation in miles driven is complicated.  The slow development of household formation among the 19-35 age cohort likely plays a role.  The advent of social media likely affects the trend as well (one no longer has to “cruise” the local burger joint or go to the mall to meet up with friends).  We may have reached “peak sprawl,” ending the ever-expanding commutes that bolstered the upward trend.  There is little evidence that we are returning to trend anytime soon, so the oil industry is being forced to cope with a loss of demand that will be hard to offset. Consequently, the change in mileage standards has to be welcome news for the oil industry because the miles driven trend coupled with increased efficiency is a clear path to weaker consumption.

Losers with this news are the electric car sector, copper and lithium and public transportation projects.  There will be a tendency for households to lean toward gasoline powered vehicles, which are usually less expensive.

However, there is an important underlying issue that this event highlights.  Put oneself into the position of a vehicle manufacturer.  If the Obama-era rules were to remain in place, about the only way to reach those standards would be through increased hybridization.  Building hybrid cars and introducing new generations of larger, battery powered electric motors, along with a plug-in capability, was the likely path forward.  And, doing research to expand and improve hybridization would be reasonable as well.  Now that the standards have changed, does the industry now stop that process?

There is a risk to doing so and it has to do with how government works now.  The Cold War consensus led to mostly steady policies in regulation.  That isn’t to say policies never changed, but change was usually legislated, making it “sticky,” and was maintained by the subsequent administrations with modest tweaks.  But, in our current age of discord, policy is often made by executive order.  Even when legislation passes, much of the actual rule-making is still done by regulatory bodies.  Thus, the next executive can simply reverse the previous policy by either changing it or not enforcing earlier rules.  If a populist left-wing government takes power in 2020 or 2024, these mileage rules could revert back to the Obama-era rules or perhaps become even stricter.  If an auto company abandons hybridization research, it could find itself at a horrible disadvantage of not being able to meet the new standards.

This age of discord means that the potential for policy “whipsaw” increases and forces companies to gamble on where future regulation will go.  In addition, it increases the stakes in elections, making them more “life and death,” and thus encourages not only more lobbying efforts but also election interference.

Although the media will focus on what just passed, investors and companies have to look beyond the present and estimate how likely it is that policy will change in the future.  That means forecasting political outcomes as well as the path of development and future consumer demand.   It will be interesting to see how automakers react to this change.

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[1] http://ec.europa.eu/eurostat/web/products-eurostat-news/-/EDN-20180803-1?inheritRedirect=true&redirect=%2Feurostat%2F and https://www.youtube.com/watch?v=e3WkVUe8xRI

[2] https://www.ft.com/content/425448b8-9674-11e8-b747-fb1e803ee64e?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[3] https://www.nbcnews.com/business/autos/trump-administration-revokes-obama-era-fuel-economy-standards-n896846

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s a risk-off morning.  The news driving the weakness in equities appears to be related to escalating trade tensions with China.  Here is what we are watching this morning:

Trade update: Yesterday, there were reports that the White House was considering increasing the tariff rate on $200 bn of Chinese goods from 10% to 25%.  Social media confirmed these reports later in the day.[1]  China has indicated it will retaliate in kind.  Although talks are continuing, there isn’t much evidence to suggest that progress is being made.  The CNY dipped on the news.[2]

The key unknown with the administration’s trade policy is whether the tariff threats are simply a negotiating tactic or if the president really wants to move toward outright protectionism and autarky.  There is evidence for both positions.  For the former, the apparent progress with the EU and Mexico would suggest that the White House wants to adjust trade regimes but not end imports.  The positions taken with China suggest the latter.  The lack of clarity represents policy uncertainty.  President Trump seems to hold that one of his greatest strengths is his ability to negotiate and his style is one of free-wheeling, which means he avoids situations that restrain his ability to maneuver.  If true, it would mean that none of his statements are expressions of deeply held positions but are, instead, tools to engineer deals.  Thus, extreme statements and escalating tensions are part of his negotiating pattern, meaning if the other party refuses to budge the outcome will be an impasse or worse.

The financial markets are expecting someone to blink.  So far, Mexico and the EU appear to be conceding, although with the latter we may simply be seeing a stall to see how the mid-term elections go.  China, on the other hand, probably can’t concede without triggering a political crisis.

China will be holding its annual CPC meetings sometime in the next two weeks.  These meetings are rather informal and secretive.  We expect trade to be a dominant issue at these meetings.  We have been hearing rumblings that Chairman Xi is facing internal criticism.  A recent vaccine scandal hasn’t helped.[3]  Xi is also being seen as not handling Trump effectively.[4]  All this leads us to believe that Xi cannot back down on trade without losing face; thus, escalation is probably a higher likelihood than the market currently expects.  Furthermore, the potential for greater volatility remains elevated.

BOE: The BOE voted 9-0 to raise rates; although the outcome isn’t a shock, the unanimous vote was more hawkish than expected.  The consensus was 8-1, and some calling for 7-2, with the dissents wanting to keep rates steady.  However, in the press conference, Governor Carney’s guidance was for a very gradual rate increase, with Brexit perhaps leading to an even slower tightening.  The financial markets took the guidance as dovish; the GBP sold off and Gilts rallied.  We see none of this as necessarily surprising and believe the market reaction was more of a sale after the event.

The Fed: The Fed also followed the expected script.  There were no changes in rates but the statement was upbeat, leaving little doubt that the current path of tightening will continue.  We have been seeing an uptick in implied LIBOR rates—the market is nearing a level (though it hasn’t quite reached it yet) that would imply a terminal rate of 3.25% for fed funds, which would mean three hikes, instead of two hikes, next year.

The green line is the implied three-month LIBOR rate from the two-year deferred Eurodollar futures.  In other words, this is the market estimate of where the LIBOR rate will be in August 2020.  History shows that the Fed tends to tighten until it reaches this rate and doesn’t usually raise rates much past that level.  Thus, investors should expect the Fed to stop raising rates once the target hits 3%, although the chances of a hike above that level are rising.

Energy recap: U.S. crude oil inventories rose 3.8 mb compared to market expectations of a 3.0 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 unexpected increase occurred because of a sharp decline in oil exports which offset a recovery in refinery operations.  It is unclear if the drop in exports was a fluke or structural.  We are leaning toward the former.

As the seasonal chart below shows, inventories are well into the seasonal withdrawal period.  This week’s rise in stocks was inconsistent with seasonal patterns.  If the usual seasonal pattern plays out, mid-September inventories will be 406 mb.

Based on inventories alone, oil prices are near the fair value price of $71.32.  Meanwhile, the EUR/WTI model generates a fair value of $60.97.  Together (which is a more sound methodology), fair value is $64.16, 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 406 mb number by September would put the oil inventory/WTI model in the range of low $80s per barrel.  Although dollar strength could dampen that price action, oil prices should remain elevated.

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[1] https://www.politico.com/story/2018/08/01/trump-tariffs-china-1715000 and https://www.nytimes.com/2018/08/01/business/china-tariffs-trump.html?emc=edit_mbae_20180801&nl=&nlid=6067543320180801&te=1

[2] https://www.reuters.com/article/uk-china-yuan/chinas-yuan-weakens-on-renewed-sino-us-trade-tensions-despite-firmer-fixing-idUSKBN1KN0FN

[3] https://www.scmp.com/news/china/society/article/2157647/top-chinese-official-charge-immunisation-critical-condition-after

[4] https://www.ft.com/content/f83b20e4-8e67-11e8-9609-3d3b945e78cf?desktop=true&segmentId=d8d3e364-5197-20eb-17cf-2437841d178a#myft:notification:instant-email:content

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