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

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s a quiet Tuesday so far.  Equity markets are rising around the world and the White House has been mostly dormant this morning.  Here is what we are watching:

Chinese stimulus: Since the mid-1990s, China has managed its economy for high levels of growth.  Most of the growth until 2008 was driven by investment and exports.  Since then, growth has been mostly a function of domestic investment, although there is growing evidence that consumption is improving as well.  The key point is that China has been able to manage its growth by building debt.  Although Chinese officials are acutely aware that debt capacity isn’t infinite, they also know capacity hasn’t been reached quite yet.  In general, China tends to go through short cycles where it tries to slow the growth of its debt but then officials reverse course as the economy weakens to restore economic growth.  We all know that there will come a time when this process cannot continue.  At the same time, China has a mostly closed financial system and can still tap global financial markets for borrowing if it so chooses.  To some extent, that would be the beginning of the end.  So, as an informal rule, we have generally looked for China opening its debt markets to global investors as an indicator that we are nearing the apex of China’s borrowing capacity.

When Chairman Xi gathered power and extended his term limits, we wondered if he was preparing to tackle the debt problem.  We still think he might.  But, as is often the case, humans tend to prefer “Augustine’s dictum.”[1]  In response to a slowing economy, China announced fiscal measures to support China’s economy.[2]  This fits the aforementioned pattern; CPC officials simply appear to have no appetite for slowing growth.  When growth slows, they react with policy stimulus which usually leads to higher debt levels.  Chinese equities lifted on the news.

Turkey again: The Central Bank of Turkey left rates unchanged this morning, prompting a strong sell-off in the Turkish lira[3] to new record lows.  The policy rate remains at 17.75%.  The fear is that President Erdogan, bolstered by last month’s election, will curtail the central bank’s independence and bring higher inflation.

Iran: Yesterday, tensions between Washington and Tehran escalated.  Not too much new has emerged this morning, although we do note that Turkey has indicated it won’t implement U.S. sanctions on Iran.[4]  This development bears watching.  The effectiveness of sanctions is based on the cooperation of foreign nations.  During America’s superpower era, the U.S. used its military and economic power to compel compliance.  Compliance was never perfect but, if the U.S. “leaned into” a sanctions regime, it could improve its effectiveness.  This influence has grown over the year as financial globalization improved the effectiveness of sanctions because the U.S. was able to “weaponize” the dollar’s reserve role.  Nations that needed access to the U.S. financial system were generally compelled to comply with U.S.-led sanctions.  However, if a border nation isn’t all that dependent on the U.S. economy or security, it could mostly ignore sanctions, thus undermining their effectiveness.

Last year, Turkey exported $9.4 bn of goods to the U.S., while Turkey’s total exports were $166.0 bn, meaning the U.S. isn’t a huge factor in Turkey’s trade.  Simply put, Iran will be able to continue to trade with Turkey, meaning oil will “leak” into global markets through this conduit.  We will be watching to see if the Trump administration begins to lean on Turkey in light of its refusal to cooperate with Iranian sanctions.  The U.S. does have tools at its disposal.  The administration could increase its support of the Kurds, for example.  It could refuse to sell Turkey arms (a deal for F-35s[5] is currently under scrutiny).  However, given the fragile nature of Turkey’s financial system, the U.S. could prevent the World Bank or the IMF from aiding Turkey unless it complies with the U.S.  At the same time, if conditions in Turkey deteriorate, don’t be surprised to see Turkey open the floodgates for Middle Eastern refugees, allowing them to move into Europe, which would increase political turmoil in the EU.  There is the potential for things to go wrong the more the U.S. presses against Iran.

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[1] “Lord, make me chaste, but not just yet…”

[2] https://www.reuters.com/article/us-global-markets/china-shares-hit-one-month-high-on-stimulus-hopes-bonds-tire-idUSKBN1KE023

[3] https://www.ft.com/content/5f389ec8-8f23-11e8-bb8f-a6a2f7bca546

[4] http://www.hurriyetdailynews.com/turkey-tells-us-delegation-it-will-not-implement-iran-sanctions-134928

[5] https://www.defensenews.com/smr/nato-priorities/2018/06/21/turkey-gets-first-f-35-as-congress-put-pressure-on-pentagon-to-stop-future-deliveries/

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Although it was a quiet weekend, we have had a busy morning.  Here is what we are watching:

Iran: There was media sniping this morning, which appears to have started in Iran.  First, President Rouhani of Iran warned the U.S. not to escalate tensions with his country, suggesting that a confrontation would lead to the “mother of all wars.”  He also indicated that the U.S. could not stop Iran from exporting its oil.[1]  This statement is, obviously, incorrect.  Although Iran has often threatened to shut down the Strait of Hormuz, which is perhaps the most important oil shipping chokepoint in the world, the U.S. could actually close off Iranian shipping and exports through financial sanctions and the U.S. Navy’s ability to implement a blockade.  President Trump reacted through social media, sending out an all-caps response late last night.

To Iranian President Rouhani: NEVER, EVER THREATEN THE UNITED STATES AGAIN OR YOU WILL SUFFER CONSEQUENCES THE LIKES OF WHICH FEW THROUGHOUT HISTORY HAVE EVER SUFFERED BEFORE. WE ARE NO LONGER A COUNTRY THAT WILL STAND FOR YOUR DEMENTED WORDS OF VIOLENCE & DEATH. BE CAUTIOUS![2]

This escalation appears to have been prompted by comments from SoS Pompeo, who described Iran’s leaders as the “mafia” and promised to back Iranians unhappy with their government.[3]  Pompeo reiterated the U.S. goal of lowering Iran’s exports to “as close to zero as possible” by November 4.  While it is obvious this administration is taking a hostile line toward Iran, Pompeo’s comments about supporting anti-government elements in Iran are probably a mistake.   There has been rising unrest in Iran due to the deteriorating economy.  But, the elements opposing the mullahs in Iran may not necessarily be pro-U.S.  By indicating the U.S. would aid such groups, they are immediately tainted as not being loyal to Iran.  This is a mistake that is common for Western governments; regime change may not necessarily make conditions better or empower a new, Western-friendly government.

The comments appear to have lifted oil prices.  However, prices are also higher on reports that some North Sea oil platforms have been hit with a 24-hour strike.[4]

Change at the BOJ?  We did see a jump in Japan’s 10-year government yields overnight on fears of tightening monetary policy.  The Bank of Japan continues to struggle with policy.  The central bank continues to see inflation below its 2% target with little evidence it’s rising.

This chart shows Japan’s core CPI (y/y% change).  Although we did see a jump in 2014, that was due to a hike in consumption taxes.  Currently, the inflation rate is zero.   At the same time, zero interest rates are distorting the economy and undermining how the financial system functions.  What does the BOJ need to do?  The best outcome it could achieve would be to steepen the yield curve, which would help the financial system.  Currently, the BOJ pegs the 10-year rate at zero.  There is talk that it may allow the 10-year rate to become more volatile, but the risk to this policy is that it further confirms the low inflation policy and lifts the JPY.  The central bank meets next week; we suspect these “leaks” are really trial balloons, and the market’s reaction thus far (rising 10-year yields and a stronger JPY) will support the doves on the board to leave policy unchanged.

Trade: Trade issues continue unabated.  SoT Mnuchin was at the G-20 over the weekend in Argentina.  By all accounts, not much changed.  The Trump administration continues to press for bilateral trade agreements and the rest of the world doesn’t want anything to change.[5]  Mnuchin added to the president’s recent currency comments about foreign nations depreciating their currencies for trade advantage.[6]  It should be remembered that Mnuchin made weak dollar comments at Davos earlier this year.  On Wednesday, the president of the EU Commission, Jean-Claude Juncker, will meet with President Trump in a bid to forestall auto tariffs.[7]  We would not be surprised to see some sort of deal on autos; it appears President Trump is rather isolated even within his own administration on this issue.[8]  However, we do offer one note of warning: U.S. light trucks enjoy 25% tariffs which date back to the Johnson administration (the “chicken tax”[9]).  If that gets negotiated away, it would likely be a major negative factor for U.S. automakers.

Q2 GDP: The latest reading from the Atlanta FRB’s continuous forecast for GDP is suggesting a robust quarter.

The current estimate is for a 4.5% quarter.  In looking at the contributions to growth, consumption, net exports and inventories account for about 3.3% of that growth.  Government spending is adding 57 bps.  New investment is the remainder.  Such growth bolsters the Fed’s case for higher interest rates.

AMLO—let’s make a deal!  The president-elect of Mexico penned a letter[10] to President Trump indicating he is ready to “start a new stage of U.S.-Mexico relations” and wants to conclude the renegotiation of NAFTA.  Although there have been worries about deteriorating relations due to AMLO’s nationalist stance, it does appear he is trying to work with the U.S.  If the Trump administration responds positively, it could be supportive for Mexican financial markets.

Meat Mountain:[11]Although macroeconomic theory highlights the inflationary impact of trade impediments, the reality is somewhat more complicated.  Yes, the combination of higher import prices and the loss of efficiencies that come from trade is inflationary.  However, there is the short-run effect that exporters, whose markets become closed in retaliation, find themselves sitting on rising inventories.  Eventually, these inventories are worked off and production is cut to adapt to lower demand.  However, this can lead to “fire sale” prices during the adjustment process.  It appears U.S. exports of meats are facing trade impediments and inventories are rising.  This will eventually lead to lower meat prices in the U.S. (although this is dependent upon the competitive structure of the grocery and restaurant markets; some of this price decline could show up as better margins in those industries).  Declining meat prices, while not as important to consumer confidence as energy, could be a popular event as we head into the mid-term elections.

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[1] https://www.aljazeera.com/news/2018/07/play-lion-tail-rouhani-warns-trump-180722162909627.html

[2] https://www.ft.com/content/14e607ac-8e29-11e8-b639-7680cedcc421?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[3] https://uk.reuters.com/article/uk-usa-iran-pompeo/pompeo-assails-irans-leaders-compares-them-to-mafia-idUKKBN1KD04E?il=0&utm_source=POLITICO.EU&utm_campaign=5a3b984308-EMAIL_CAMPAIGN_2018_07_23_04_38&utm_medium=email&utm_term=0_10959edeb5-5a3b984308-190334489

[4] https://www.reuters.com/article/us-total-strike-north-sea/totals-north-sea-oil-platforms-hit-by-24-hour-strike-idUSKBN1KD144

[5] https://www.ft.com/content/cbe1f2e2-8dc3-11e8-bb8f-a6a2f7bca546?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[6] https://www.ft.com/content/97105928-8db4-11e8-b639-7680cedcc421?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[7] https://www.ft.com/content/7fe120f0-8d8e-11e8-b639-7680cedcc421?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[8] https://www.politico.com/story/2018/07/22/trump-foreign-car-tariffs-juncker-735555

[9] https://en.wikipedia.org/wiki/Chicken_tax

[10] https://www.wsj.com/articles/in-letter-to-trump-mexicos-president-elect-seeks-common-path-1532285296

[11] https://www.wsj.com/articles/meat-piles-up-as-production-grows-and-exports-slow-1532268000

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] There is a lot going on.  Let’s dig in:

The president speaks: For the most part, President Trump has been opposed to a weak dollar.  At Davos this year, Treasury Secretary Mnuchin suggested a weaker dollar might be in U.S. interests if the goal was a narrower trade deficit.  President Trump publicly criticized Mnuchin’s comment, suggesting the dollar should be strong.  For many Americans, currency markets are something of a mystery.  Unlike consumers of other countries, Americans are mostly insulated from dealing with exchange rates.  We note that President Reagan was supportive of a strong dollar until it reached a level that became unsustainable.  In response, at the Plaza Hotel in NYC the G-5 adopted the “Plaza Accord,” which was a multi-lateral policy shift to deliberately weaken the dollar.

We may be seeing a shift.  This morning, on social media, President Trump openly criticized the EU and China for currency manipulation.  The dollar has plunged on the news, while gold and other commodities are higher.[1]  Although it’s difficult to know for sure, this development could be quite significant.  Tariffs, by themselves, are dollar bullish as they reduce the supply of dollars on world markets (see this week’s Asset Allocation Weekly below).  But, if the president has figured out that foreign nations are allowing their currencies to depreciate in order to offset tariffs, and he begins to jawbone the dollar lower, we will likely see a declining dollar.  It should be remembered that the dollar is overvalued by most valuation metrics, so an official weak dollar position could find a path of little resistance.

But wait…there’s more!  However, this isn’t the only thing the president has said over the past 24 hours.  He also indicated he is ready to slap $505 bn of new tariffs on China.[2]  We note that the National Economic Council’s director Larry Kudlow has noted there are no talks with China.  There is a school of thought that China may be concluding that the GOP will lose the House in November.  If that’s the case, President Trump will find himself dealing with everlasting investigations and thus will be less able to prosecute a trade war.  We note that the prediction markets are projecting a change in control for the House.

If China has taken this position, then it would make sense for the Chinese to simply stall until November and then see U.S. trade policy moderate due to distractions at the White House.  Of course, the administration can do this calculation as well and may try to force an agreement.  Although it is still not clear whether this is really China’s policy, it makes sense to us and thus we would not be surprised to see mostly silence from Beijing.

Trump and the Fed: As noted above, the dollar has been strong this year.  As we noted in this week’s Asset Allocation Weekly (see below), one of the factors boosting the greenback is the potential for a trade war.  Rising tariffs, in theory, are bullish for the dollar because they act as a constraint on dollar supply.  U.S. monetary policy is another factor that has supported the dollar.  The Fed has been steadily raising rates when the rest of the world has mostly been holding to accommodative monetary policy.

One of the factors we have been monitoring is the White House’s position on monetary policy. Earlier this year, Larry Kudlow, the director of the National Economic Council, hinted that the Fed shouldn’t raise rates due to fiscal stimulus because the tax cuts would boost investment and thus add to productive capacity.  Although that point is debatable (as we noted in last week’s AAW, it appears the tax cuts may be going to stock buybacks), the bigger issue was the interference in monetary policy.  During Bill Clinton’s presidency, Robert Rubin, who became his treasury secretary, convinced the administration to avoid commenting or criticizing the conduct of monetary policy.  The idea was that if the White House allowed the Fed to run policy and bring down inflation, the decline in long-term interest rates would be the best stimulus the economy could receive.  Since then, the unwritten rule has been that administrations leave the Fed alone.  And, for the most part, they have.  Despite what you are seeing in the media,[3] prior to Rubin’s directive, administrations often commented on, or overtly tried to sway, monetary policy.[4]  In the footnote below, we cite Mallaby’s biography of Alan Greenspan.  This history shows that presidents not only tried to manipulate monetary policy, but Greenspan himself likely participated in a scheme to undermine Chair Arthur Burns to force him to conduct an inappropriately accommodative policy during the Nixon years.  Rubin’s argument was that Fed independence would yield a better outcome than giving the impression that politicians were guiding policy.  In other words, Fed independence would lead to lower inflation expectations and a better long-term economy.

In a CNBC interview[5] and in a “hailstorm” of tweets this morning,[6] President Trump has become increasingly critical of the Fed’s tightening policy.  Although this action is clearly a divergence from policy of the past two decades, as we note above, it isn’t at all unprecedented.  One of the hallmarks of President Trump is his desire to overturn precedent.

To some extent, we have been expecting the president to become critical of the Fed.  It is important to remember that the Fed wasn’t always “independent.”  Until 1951, the Fed acted as the funding arm of the Treasury.  That is partly how the government funded the war effort with almost no rise in interest rates; the Fed simply expanded its balance sheet, absorbing the government’s borrowing.  William Martin negotiated an “accord” with the White House and Congress in 1951 which gave the Fed independence from the Treasury.  However, there is nothing written on stone tablets that says a central bank must be independent.  In fact, central bank independence is really more a function of inflation policy.  If the goal is low inflation, central bank independence is a good idea.  If a nation wants to reflate, preventing the central bank from thwarting that goal is also appropriate.  If populism is really about reflation, reducing Fed independence is likely going to occur.  We may be seeing a move in that direction.

Bottom line: We have policies that are divergent.  On the one hand, tariffs are dollar bullish.  On the other, jawboning for a weaker dollar and threatening Fed independence could be significantly dollar bearish.  We note that any move to undermine Fed independence will also increase the risk of rising inflation expectations, which would play havoc on the bond market.  So, risks are rising.

Italy again:The populist coalition is threatening to oust Italy’s finance minister, Giovanni Tria, over Tria’s nominations for the state lending bank, CDP.  Tria is considered an establishment figure and his appointment led to stabilization of the Italian bond market.  We note that this news led the Italian 10-year rate to jump from 2.50% to 2.58%.

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[1] https://www.bloomberg.com/news/articles/2018-07-20/trump-says-china-eu-have-been-manipulating-their-currencies-jjtzde52?cmpid=socialflow-twitter-business&utm_campaign=socialflow-organic&utm_source=twitter&utm_content=business&utm_medium=social

[2] https://www.cnbc.com/2018/07/19/trump-says-hes-ready-to-put-tariffs-on-all-505-billion-of-chinese-.html

[3] https://www.cnbc.com/2018/07/19/trumps-fed-criticism-is-nearly-without-precedent-in-us-history.html

[4] https://twitter.com/jimtankersley/status/1020111873923043328. Also see: Mallaby, Sebastian. (2016). The Man Who Knew: The Life and Times of Alan Greenspan. New York, NY: Penguin Books. [NB: we have reviewed this book on our Reading List]

[5] https://www.cnbc.com/2018/07/19/watch-president-trump-full-interview-with-cnbc.html

[6] https://www.cnbc.com/2018/07/20/trump-hits-the-fed-again-in-tweet-tightening-now-hurts-all-that-we-h.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Global equity markets are lower this morning.  The EuroStoxx 50 is down 0.3% from the last close.  In Asia, the MSCI Asia Apex 50 was down 0.2% from the prior close.  Chinese markets were down, with the Shanghai composite down 0.5% and the Shenzhen index down 0.8%.  U.S. equity index futures are signaling a lower open.  With 55 companies having reported, the S&P 500 Q2 earnings are above expectations at $39.31 compared to the $39.20 forecast for the quarter.  The forecast reflects a 19.9% increase from Q2 2017 earnings.  Thus far this quarter, 92.7% of the companies reported earnings above forecast, while 3.6% reported earnings below forecast.

We are in the back half of the week!  Everything is down this morning except the dollar.  Here is what we are watching:

Brexit thoughts:  Yesterday’s vote in the House of Commons actually suggests a rather interesting informal coalition may be evolving.  As we noted yesterday, PM May avoided a no-confidence vote by gathering enough Remain supporters among the Tories and by finding a few Labor MPs to support her as well; the Labor defectors also support either a soft Brexit or staying in the EU.  The Labor MPs could have easily forced a no-confidence vote and new elections where the Labor Party would have a good chance of winning control of Parliament.  However, that is not necessarily a favored outcome if one is a “Blairite” Labor MP, which is essentially an establishment center-left politician.  In other words, pushing for elections that lead to Jeremy Corbyn becoming prime minister is probably not an attractive outcome.  Thus, we may be seeing an informal grouping of Blairite Labor MPs joining Tory Remainers to keep Theresa May in office.  If our theory is correct, May will remain as PM and there will be a soft Brexit.  That would be a bullish outcome for the GBP.

Trade talk:  The G-20 Finance Ministers meet this weekend.  Discussions are expected to focus on trade.  The Commerce Department is holding a day-long hearing today on auto tariffs.  There are 45 witnesses scheduled; only one, Jennifer Kelly of the UAW, is expected to be supportive of auto tariffs.  Companies are uniformly opposed to tariffs as automobile production has become increasingly globalized.  Later this month, EU President Jean-Claude Juncker is expected to visit Washington, and there are hopes he will bring some tariff concessions on European tariffs.[1]  Even trade hawks in the Trump administration see the auto tariffs as misguided and would like to see some modest concessions offered that would allow the president to declare victory[2].  The administration is apparently investigating the uranium market to see if U.S. miners are being unfairly affected; if so, we could see tariffs implemented on that commodity[3].  Meanwhile, NEC’s Larry Kudlow blamed Chairman Xi for the lack of movement on Chinese/U.S. trade negotiations.[4]  The Chinese suggest otherwise.[5]  The bottom line is that there are no talks occurring between the two nations.  As we note in the next segment, China appears to be using the currency as a weapon.

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[1] Actually, the history of light-truck tariffs, where the U.S. imposes a 25% tariff on imported light trucks, is fascinating.  Here is a like to the background:  https://en.wikipedia.org/wiki/Chicken_tax

[2] https://www.politico.com/newsletters/morning-money

[3] https://www.ft.com/content/f23cc632-8ac2-11e8-b18d-0181731a0340?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[4] https://www.bloomberg.com/news/articles/2018-07-18/trump-economic-aide-blames-china-s-xi-for-stalling-trade-deal

[5] https://www.reuters.com/article/us-usa-trade-china/china-says-u-s-blaming-xi-for-blocking-trade-deal-is-bogus-idUSKBN1K90UF

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