by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

Leadership challenge in the U.K.? Yesterday’s resignations of both Boris Johnson and David Davis have raised concerns of a possible Tory leadership challenge against U.K. Prime Minister Theresa May. Tory Eurosceptics have criticized PM May’s handling of Brexit negotiations for not doing enough to cut ties between the U.K. and Europe. Although the Eurosceptics have enough support to muster a challenge, they are expected to struggle to get the votes needed to oust May. At this point, it may be in May’s best interests to force a leadership election while she still has the leverage. A win in the election would ensure she remains in power for the remainder of negotiations as the rules stipulate the leadership cannot be challenged for another 12 months. Negotiations are expected to finish in March 2019.

Trump goes to Europe: Today, the president is expected to land in Brussels for the NATO Summit. He is expected to chide NATO members for not spending enough on defense. According to NATO guidelines, each country should spend 2% of GDP on defense expenditures; currently, only four countries exceed that guideline.^[1] Preempting President Trump’s visit, European Council President Donald Tusk stated that Europe spends more than Russia and as much as China on defense. Markets will pay close attention to how President Trump treats his European counterparts as the U.S.-European alliance seems to be on shaky ground after his outburst during the G-7 summit. Furthermore, there is growing speculation that the president favors building closer relations with Russia as opposed to Europe, whereas others believe the president is using defense spending as leverage in U.S. trade negotiations.

Supreme Court choice: Yesterday, President Trump nominated Brett Kavanaugh to fill the Supreme Court seat vacated by Anthony Kennedy’s retirement. If confirmed, many believe Kavanaugh will make the Supreme Court the most conservative in decades.[2] Although Kennedy is viewed as moderate, he generally favored conservative causes. This can be seen in the latest Supreme Court rulings in which Kennedy voted against government unions and in favor of the president’s travel ban. Moreover, Kavanaugh’s place on the Supreme Court would be significant as his nomination could also impact Mueller’s Russia investigation. In the past, Kavanaugh has argued that sitting presidents should effectively be given immunity from prosecution and questioning while in office, stating it could cripple the federal government.[3] Democrats are expected to push for the confirmation hearing to occur after the mid-terms, but that is unlikely to happen.

Erdogan appointee: Yesterday, Turkish President Recep Tayyip Erdogan appointed his son-in-law, Berat Albarak, to lead the Treasury and Finance ministries. Fears that the independence of the central bank is in jeopardy as well as pessimism about the health of the Turkish economy led to a sharp sell-off in the Turkish lira. There has been growing speculation that President Erdogan might pressure the central bank to lower rates despite the Turkish economy showing signs of overheating. The chart below shows the immediate market reaction to the news. We will continue to monitor this situation closely.

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[1] https://www.washingtonpost.com/news/fact-checker/wp/2016/03/30/trumps-claim-that-the-u-s-pays-the-lions-share-for-nato/?noredirect=on&utm_term=.e0e42bb04557

[2] https://fivethirtyeight.com/features/justice-kennedy-wasnt-a-moderate/

[3] https://www.ft.com/content/f05b46bc-83de-11e8-96dd-fa565ec55929

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Monday!  It looks like a risk-on day so far, with Treasury prices lower and equities higher.  The dollar is a bit soft which has lifted metals prices.  The lack of comment from the White House about trade appears to be helping equity markets.  Here is what we are watching:

BREAKING NEWS: Boris Johnson, the U.K. foreign minister, has resigned.  Below we discuss the earlier resignation of David Davis.  Johnson’s resignation is far more serious as he could mount a leadership challenge to PM May.  The GBP is falling on the news.

North Korea disappointment: SoS Pompeo was in North Korea over the weekend and his visit didn’t go very well.[1]  The U.S. wanted to begin talks on North Korea dismantling its nuclear program, but North Korea wanted “goodies” before even beginning to talk about denuclearization.  North Korea called the U.S. “gangsters,” criticizing U.S. negotiating tactics.[2]  For anyone who has watched North Korea since the fall of the Soviet Union, this behavior isn’t a surprise.  North Korea’s negotiating stance has been mostly “Lucy with the football.”[3]  The West thinks it has a promise from Pyongyang but finds out that either the promise was broken or that the North Koreans never intended to take such actions and the West’s disappointment is merely a misunderstanding.

North Korea isn’t going to give up its nukes.  It may be willing to have the IAEA count some of them and it may be willing to split the U.S. alliance in the Far East by restricting its missiles to ones that cannot reach the U.S.  But, complete denuclearization is a demand that is unlikely to be met.  The real question is the reaction from the White House.  If President Trump concludes he’s been “played” then we could move quickly from summits and handshakes to war.  Although we haven’t seen any movement yet, we would not be shocked to see a rapid escalation in tensions.  On the other hand, the White House will tend to react based on commentary from the right-leaning media.  The fact that John Bolton is inside the government removes a prominent pundit voice that would have been harshly critical of the summit and would have likely pushed for a hard line after the Pompeo visit.[4]  In addition, the potential negative impact of this news is lessened due to the expected announcement of the president’s selection for the Supreme Court, which will occur later tonight.

May moves to soft Brexit: PM May took her cabinet out to her summer place in Chequers last Friday and appeared to move her advisors to her vision of Brexit,[5] which is mostly a series of measures designed to limit the impact of leaving the EU on the U.K. economy.  Initially, it appeared May had earned unanimous approval, winning over the hard Brexit members of her cabinet.  However, last night David Davis,[6] the minister in charge of the EU exit, resigned.  Dominic Raab has taken Davis’s ministry.  Davis is hoping his sacrifice will prevent any further concessions to the EU, while May is hoping his departure from the cabinet will give her more freedom to act.  We expect Davis to agitate for a hard Brexit now that he is out of the cabinet; our read is that support for Brexit has waned a bit and Davis may not have all that much sway.  The GBP took the resignation well, suggesting the markets believe May will not only survive but negotiate a soft Brexit, which would be favorable for the pound.

Japan returning to nuclear power?  After the Fukushima disaster, Japan pulled back from nuclear electric power.  Public sentiment turned sharply against it.  However, Japan faces another policy goal, energy security.[7]  The Trump administration’s actions against Iran[8] have made it clear that the island nation is vulnerable to energy flow disruptions.  If Japan returns to nuclear power, it could give a boost to a moribund uranium industry.

President Trump to Europe: As we noted last week, the president is traveling to the U.K., attending the NATO summit and visiting with Russian President Putin.  We have been discussing this upcoming meeting for the past few reports.  Fears among Europeans are elevated; President Trump has been critical of the alliance and has been pressing the EU to boost defense spending.  We will be watching to see how the president deals with our EU allies this week.

Energy recap: As we noted last week, the DOE weekly energy data was delayed.  As promised, we are publishing our recap in today’s comment due to the delay.

U.S. crude oil inventories rose 1.2 mb compared to market expectations of a 5.0 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.

As the seasonal chart below shows, inventories are well into the seasonal withdrawal period.  This week’s increase in stocks was unusual, but some adjustment was not a huge shock given last week’s rather large decline.  If the usual seasonal pattern plays out, mid-September inventories will be 411 mb.

Based on inventories alone, oil prices are near the fair value price of $68.31.  Meanwhile, the EUR/WTI model generates a fair value of $61.24.  Together (which is a more sound methodology), fair value is $62.80, 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.  The action to suppress Iranian oil exports has boosted oil prices, but the rapid decline in oil inventories over the past week is very supportive for prices.  It should be noted that a 410 mb number by September would put the oil inventory/WTI model in the high $70s per barrel.  Although dollar strength could dampen that price action, oil prices should remain elevated.  At the same time, refinery utilization remains above 97.0%.  We will be reaching a point in the near future where domestic oil consumption growth will peak for the summer season, although we expect the level to remain elevated.

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[1] https://www.ft.com/content/721ba908-8286-11e8-96dd-fa565ec55929?emailId=5b42e658f885cc00043968c4&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[2] https://www.washingtonpost.com/world/pompeo-pushes-back-against-north-koreas-gangster-like-criticism/2018/07/08/a6261b3e-825e-11e8-9200-b4dee4fb4e28_story.html?utm_term=.db990966f032&wpisrc=nl_todayworld&wpmm=1 and https://www.theatlantic.com/international/archive/2018/07/america-north-korea-nuclear/564620/?wpmm=1&wpisrc=nl_todayworld and https://www.nytimes.com/2018/07/07/world/asia/mike-pompeo-north-korea-pyongyang.html?hp&action=click&pgtype=Homepage&clickSource=story-heading&module=first-column-region&region=top-news&WT.nav=top-news

[3] https://www.youtube.com/watch?v=055wFyO6gag

[4] http://quotes.yourdictionary.com/author/quote/570850

[5] https://www.ft.com/content/aeb53c82-82ac-11e8-96dd-fa565ec55929

[6] https://www.ft.com/content/fef0e51c-8300-11e8-96dd-fa565ec55929

[7] https://www.ft.com/content/66c37158-801a-11e8-bc55-50daf11b720d?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[8] https://www.reuters.com/article/us-iran-nuclear/iran-calls-for-eu-help-as-shipping-giant-pulls-out-for-fear-of-u-s-sanctions-idUSKBN1JX0NQ?feedType=RSS&feedName=worldNews

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s employment day!  We cover the data in detail below but the quick read is bullish.  The key data point was a huge jump in the labor force, which increased 601k after falling 382k over the past three months.  Thus, even with a rise in payrolls, the unemployment rate rose due to the increase in the labor force.  The data is bullish for financial assets because it suggests there is remaining slack in the economy.  Perhaps today is the day historians will mark as the beginning of the Great Trade War as the U.S. and China implemented tariffs against each other.

A note on our comment—we update the U.S. petroleum weekly data on Thursday but, this week, the numbers were delayed until yesterday due to the Independence Day holiday.  Because of the length of the recap and our coverage of the employment report, we will delay our energy recap until Monday’s comment.  Here is what we are watching:

Trade wars: The $34 bn[1] of tariffs on China were implemented at midnight EDT.[2]  China has undertaken similar measures.  In 10 days, another $16 bn of tariffs will be added.  And, President Trump upped the ante by suggesting he could apply tariffs to more than $500 bn in flow, essentially everything China exports to the U.S.[3]  China is blaming the U.S. for the “war,”[4] which will only infuriate Trump, who holds the position that the U.S. is merely correcting what has been an unfair situation.  We have talked about the trade conflict at length in recent weeks but one thing we want to reiterate is that winning a trade war is not about how much pain a nation can inflict on another but how much pain a nation can absorb.  Note the difference between Europe and China.  As we noted yesterday, the EU, at German urging, is considering ending tariffs on imported automobiles, something they would not have done without U.S. pressure.  This suggests to us that the EU is simply not prepared to take the pain associated with a drop in car production.  Consequently, they are suing for peace.  On the other hand, China appears to be digging in for a long, protracted trade war.[5]  The Chinese media is framing the trade war as the West’s attempt to contain China’s rise.  In other words, Chairman Xi is planning on using nationalism to “steel”[6] his citizens for absorbing the pain by making the trade war more like a real war.  Xi has often referred to the “century of humiliation” that began with the First Opium War in 1842.  The Opium War narrative is that the Chinese failed to rally behind the emperor in 1842 and foreigners defeated and “carved up” the country and it could happen again if China fails to rally behind Chairman Xi.

In some respects, the timing of this trade war is unfortunate for China.  The country is trying to deleverage while maintaining growth and the usual way to do this is to export one’s way out.  The trade war will likely close that avenue of maintaining growth.  At the same time, now Xi can blame any slowdown on Trump and can therefore use a slowdown to take the necessary steps to contain debt growth.  In any case, China isn’t planning on backing down and our take is that the White House doesn’t think it can lose.  Strictly speaking, we can’t.  China has much more to lose because it runs a trade surplus with the U.S.  However, a trade war will inflict pain and Americans will be less likely to rally around Trump when the economy begins to stumble because of trade disruptions.  Thus, if winning a trade war is dependent upon the willingness to accept pain, China may be in a better position than generally expected.

The Fed: The Fed minutes were released yesterday and they had a little something for everyone.  The Fed intends to stay on its tightening path, although it did acknowledge the risk coming from the aforementioned trade war.  Interestingly enough, Fed economists didn’t view the uncertainty surrounding GDP, unemployment and inflation to be different than the past two decades.  We view this position as strikingly naïve.  Market reaction to the employment data suggests a dovish response from the FOMC.  This reaction is probably not warranted; after all, it’s only one month’s data in a notoriously volatile series.  But, the key takeaway from the minutes is that the Fed is not altering its course.[7]

Brexit: PM May is meeting with her cabinet today[8] with the goal of establishing a unified vision of the economic and trading relationship the U.K. will have with the EU after Brexit.  There is the potential for a breakup; watch for resignations.  If some of her cabinet members quit, a leadership challenge is likely and there is a chance the government will fall.  May has remained in office by weaving a perilous path between a hard and soft Brexit but, in the end, she leans toward the latter.[9]  Elections could bring a Corbyn-led Labour government which would likely be profoundly bearish for U.K. financial assets.

Trump to Europe: The president travels to Europe next week and he blasted the Europeans at a rally in Helena, MT last night, which may be a forewarning of what his talks will be like.[10]  The president is also meeting with President Putin,[11] which has raised fears not only with the U.S. establishment but also with European leaders.  If the U.S. abandons NATO, the Europeans will be forced to defend themselves against the Russians.

Oil: A couple of quick notes and a reminder that we will recap the weekly data on Monday.  First, there are growing doubts that the Saudis will ever introduce the Saudi Aramco IPO.[12]  The key sticking point appears to be the scrutiny that going public would bring to the Kingdom of Saudi Arabia (KSA).  Saudi Aramco is essentially the funding arm of the KSA.  When outside investors see how much profit is taken by the royal family, it would not only tell the Saudis where the money is going, but it would undermine the valuation of the stock.  If the IPO isn’t going to happen, the Saudis will have less incentive to keep prices high and may decide to boost production and capacity to (a) take advantage of high prices, and (b) eventually undermine the shale revolution.  Second, South Korea has suspended Iranian oil loading for this month, the first time since 2012, suggesting that U.S. sanctions are beginning to affect Iranian oil sales.[13]

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[1] https://www.ft.com/content/5c5b66a8-80a6-11e8-bc55-50daf11b720d?emailId=5b3ef34663ab2e00040aceba&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22 and https://www.nytimes.com/2018/07/05/business/china-us-trade-war-trump-tariffs.html?emc=edit_mbe_20180706&nl=morning-briefing-europe&nlid=567726720180706&te=1

[2] https://www.ft.com/content/bd99c39c-8024-11e8-bc55-50daf11b720d?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[3] https://www.cnbc.com/2018/07/05/trump-says-us-will-impose-16-billion-in-additional-tariffs-on-china-i.html

[4] https://www.reuters.com/article/us-usa-trade-china/china-state-media-slams-trumps-gang-of-hoodlums-as-tariffs-loom-idUSKBN1JW07L?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[5] https://www.wsj.com/articles/u-s-china-prepare-for-trade-battle-1530824054?mod=hp_lead_pos1

[6] See what I did there?

[7] https://www.wsj.com/articles/fed-expects-to-keep-raising-rates-ending-years-of-stimulus-1530813720

[8] https://www.ft.com/content/4e844a06-7f96-11e8-bc55-50daf11b720d?desktop=true&segmentId=7c8f09b9-9b61-4fbb-9430-9208a9e233c8#myft:notification:daily-email:content

[9] https://www.ft.com/content/36eafa08-804e-11e8-8e67-1e1a0846c475?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56 and https://www.ft.com/content/44fbf0e6-8041-11e8-8e67-1e1a0846c475?emailId=5b3ef34663ab2e00040aceba&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[10] https://www.axios.com/trump-nato-nightmare-defense-spending-europe-germany-74d2d010-e32a-40b2-8e71-920601f0e9a0.html

[11] https://www.nytimes.com/2018/07/05/world/europe/trump-putin-summit-election-meddling.html?emc=edit_mbe_20180706&nl=morning-briefing-europe&nlid=567726720180706&te=1

[12] https://www.wsj.com/articles/doubts-grow-aramco-ipo-will-ever-happen-1530813982

[13] https://af.reuters.com/article/energyOilNews/idAFS6N1R4016

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Welcome back!  Here is what we are watching this morning:

On trade, it’s good news and bad news:  The good news first…German automakers met with Richard Grenell, the U.S. Ambassador to Germany, and reaffirmed their support for zero tariffs on EU/U.S. auto trade.[1]  The German automakers also indicated they would maintain their investments in the U.S. if tariff increases were averted.   The EU, as expected, is following Germany’s lead.[2]  This change in Europe’s stance does suggest that U.S. pressure might lead to policy changes, which is the political establishment’s hope.  In light of U.S. trade pressure, China is wooing Europe to join an anti-U.S. alliance on trade.  Thankfully, so far, the EU sees the folly of China’s offer and has demurred.[3]  The news on auto trade has lifted risk assets this morning. Now, the bad news…at midnight, the U.S. is planning to implement tariffs on $34 bn of Chinese goods.  China is expected to retaliate in kind.[4]  At worst, the Chinese tariffs could be the opening salvo in a significant trade war.

Oil talk:  Over the holiday, President Trump reiterated his call for OPEC (read:  Saudi Arabia) to increase oil production in an effort to lower oil prices.  In fact, the tweet was blunt—we are paying for your defense so bring down gasoline prices.[5]  In reality, there isn’t a whole lot more OPEC can do to lower oil prices.  Falling production in Libya, Venezuela and Nigeria are curtailing supply.  The U.S. sanctions on Iran will simply exacerbate the problem.  The U.S. might be expected to fill the global gap and is working to do so.  But, pipeline constraints in west Texas are limiting the supply that can be made available for export.  That pipeline problem won’t be resolved for about a year.  The president correctly understands that rising gasoline prices will be unpopular with his populist base.  The key unknown is this—are the tweets simply jawboning, so even if prices stay high, voters will still credit him for trying to bring down prices?  Or, do voters really want lower prices or else?  If it’s the latter, the president may have only one tool left, which is an SPR release.  However, the risk is that if the SPR release fails to lower prices, there are no other policies available to lower prices in the short run.  In other words, the threat of an SPR release might be more powerful than the actual announcement.  After all, if the market believes that shortages do exist, adding oil from the SPR could very likely trigger hoarding, leading to a condition where inventories rise at the commercial level but prices rise as well.  For the most part, the greatest threat for higher oil prices is in the summer.  When demand falls after Labor Day, price pressures will likely ease.

Iran:  Iran has threatened to reduce its cooperation with the IAEA, the body that determines if Iran is meeting its obligations with the nuclear deal.[6]  Reducing cooperation would likely end the treaty because without inspections, the fear that Iran is secretly enriching uranium would undermine trust.  The commander of the al Quds Force of the Iranian Revolutionary Guard Corps, the infamous Qassem Solaimani, indicated that his nation would block the Strait of Hormuz if the U.S. stops Iranian oil sales.[7]   This is a serious threat; casual calculation suggests that about 30% of world oil exports pass through this chokepoint.  Most of the oil goes to the Far East.  The U.S. can prevent Iran from blocking the strait permanently, but it would involve military action.  It should be noted that Gulf producers, cognizant of this threat, have increased pipeline capacity to avoid the strait.  Still, a blockade, or a serious threat of one, will lead to oil hoarding and drive prices higher.

ECB:  Hawks on the ECB indicated today that interest rates may rise sooner than President Draghi suggested in the bank’s last meeting.  Although we doubt that the ECB will move rates higher anytime soon, the report has boosted the EUR this morning.

Novichok returns:  Two British citizens, Charlie Rowley and Dawn Sturgess, have reportedly been stricken by Novichok, the nerve agent used against a former Russia spy four months ago.[8]  It is possible that this poisoning was accidental; the couple had visited a botanical garden that the Russian spy and his daughter had visited during the previous attack.  It doesn’t appear that Rowley and Strugess are spies, so what this event may prove is that it is difficult to decontaminate an area after Novichok is used.

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[1] https://www.ft.com/content/77d1671c-7fa6-11e8-bc55-50daf11b720d

[2] https://www.ft.com/content/87bf0aa0-7ed2-11e8-8e67-1e1a0846c475

[3] https://www.reuters.com/article/us-usa-trade-china-eu-exclusive/exclusive-china-presses-europe-for-anti-us-alliance-on-trade-idUSKBN1JT1KT

[4] https://www.wsj.com/articles/u-s-will-shoot-itself-in-the-foot-if-it-pulls-the-tariff-trigger-china-says-1530767200

[5] https://www.ft.com/content/6168aae0-7fd2-11e8-8e67-1e1a0846c475

[6] https://www.reuters.com/article/us-iran-oil-sanctions/iran-threatens-to-cut-cooperation-with-nuclear-body-after-trump-move-idUSKBN1JU1E9

[7] https://gulfnews.com/news/mena/iran/iran-threatens-to-block-strait-of-hormuz-1.2246857

[8] https://www.nytimes.com/2018/07/04/world/europe/salisbury-poison-skripal-amesbury.html?emc=edit_mbe_20180705&nl=morning-briefing-europe&nlid=567726720180705&te=1

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] From all of us at Confluence Investment Management, have a safe and happy Independence Day!

The “dog days” of summer officially begin today.[1]  It looks like a risk-on day so far.  U.S. financial markets close early for the mid-week Independence Day holiday.  Equity markets close at 1:00 EDT and bond markets close one hour later.

A German deal: Chancellor Merkel and Interior Minister Seehofer reached a deal[2] on immigration yesterday, preventing a potential government collapse.  Germany will create transit centers on the German/Austrian frontier to collect asylum seekers from across the EU.  The plan is to give Germany the right to send those immigrants back to the nation where they first arrived.   Seehofer wanted to see asylum seekers immediately turned away from the border.  Merkel refused to endorse that plan, fearing it would end the Schengen rules which have created passport-free travel within the EU.  An end to Schengen would certainly undermine EU unity, which is already under stress.

Although this compromise was seen as a loss for Seehofer, Merkel has clearly backed away from her 2015 position of nearly open borders for refugees.  And, the reaction of other EU nations toward the German plan appears hostile.[3]  Austria announced it is considering measures to protect its southern border from immigrants.  Austria is arguing that Germany is taking “national measures” instead of EU measures to deal with asylum seekers.  If this policy becomes the norm, it would represent a major retreat from EU rules of free movement.

Perhaps the most important takeaway from this row is that the mainstream parties are being steadily pulled toward populism.  This event is just another example of the retreat from globalization.  Obviously, this is not just a European issue but is roiling the U.S. political landscape as well.  One comment we hear often is that politicians will back away from populist policies when they adversely affect equity markets.  To some extent, Wilbur Ross indicated that the administration isn’t moving policy based on equity market performance.[4]

CNY jawboning: Chinese authorities eased concerns that the PBOC is using a weaker CNY to offset the impact of tariffs against Chinese goods.[5]  PBOC Governor Yi Gang tried to calm markets by suggesting the dollar’s recent strength against the CNY is due to “pro-cyclical behavior.”  There were reports that state banks were buying CNY, a form of quasi-public currency intervention.  Without tightening monetary policy, such moves will have a limited impact on stemming CNY weakness.  The rally in the CNY has lifted global equity markets.

NATO warning: The White House has sent a stern warning to NATO members indicating that they need to boost their defense spending.[6]  The problem of NATO “freeriding” on the U.S. security guarantees has been a constant complaint by American presidents.  However, the concern was somewhat half-hearted; the success of NATO was based on resolving the “German problem.”  Due to the lack of natural geographic defenses (no mountains or impassable rivers), Germany was vulnerable to invasions from east and west since its unification in 1870.  The inability of Europe to resolve German insecurity was the primary cause of two world wars.  The U.S. solved the problem by essentially taking over Germany’s defense.  Not only did this resolve German militarism, but it forced Germany to follow U.S. foreign policy.  This was true of most of the rest of Europe as well (France did try to hew its own foreign policy, with some success).  If Germany rearms, it will almost certainly, at some point, want to manage its own foreign policy.  History suggests the outcome won’t be favorable.  It is not unreasonable for the U.S. to prompt NATO to pay more for its defense but the U.S. must be ready for Europe to break away from America’s orbit in terms of foreign policy.

Oil prices: Oil prices continue to move higher this morning on growing skepticism that Saudi Arabia and Russia have enough spare capacity to offset production shortfalls in Venezuela and Libya and the impact of sanctions on Iran.  In addition, U.S. production is hitting pipeline bottlenecks, a legacy problem based on an American oil supply system that was built for importing oil as opposed to supplying oil domestically.  President Trump is clearly aware of the potential negative effects of higher gasoline prices; we would not be shocked to see an SPR withdrawal announcement to try to cap recent price increases.

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[1] https://www.almanac.com/content/what-are-dog-days-summer

[2] https://www.ft.com/content/126ab2d6-7e0f-11e8-bc55-50daf11b720d

[3] https://www.ft.com/content/767e8bc6-7e96-11e8-bc55-50daf11b720d

[4] https://www.cnbc.com/2018/07/02/cnbc-transcript-us-commerce-secretary-wilbur-ross-on-cnbcs-squawk.html

[5] https://www.ft.com/content/1e49cc2c-7e73-11e8-bc55-50daf11b720d

[6] https://www.nytimes.com/2018/07/02/world/europe/trump-nato.html?emc=edit_mbe_20180703&nl=morning-briefing-europe&nlid=567726720180703&te=1

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s the first day of Q3!  So far, it’s not an auspicious start.  We did celebrate “Bobby Bonilla Day” yesterday, one of our favorite holidays.[1]  There is lots of news this morning.  Let’s dig in:

Mexican elections: As expected, Lopez Obrador, otherwise known as AMLO, easily won Sunday’s election, taking an estimated 53% of the vote.  All of his competitors have conceded defeat.  In addition, it appears he will have a majority in the legislature.  There is great fear among the business class in Mexico.  AMLO ran on an anti-corruption platform with a clear bias for the poor of Mexico.  In some respects, AMLO is a bit like President Obama; many in Mexico are pinning their hopes and dreams on the new president with expectations that are sure to disappoint.  We do expect him to negotiate a hardline with the Trump administration over NAFTA, but AMLO has not indicated he wants to end the free trade agreement.  The peso has weakened on the news.

Trade: First, on Friday, $34 bn of sanctions on Chinese goods are set to be implemented with expected retaliation.  Second, the president is expressing his disappointment with firms that have announced job shifts in response to the foreign retaliation.[2]  This is additional evidence that Trump’s trade policy is nationalist in design.  It’s all about jobs and economic activity here rather than elsewhere.  While that’s good for American jobs, it almost certainly won’t be good for American earnings.  Axios[3] is reporting the administration has drafted a bill that would essentially give complete trade authority to the White House.  In some respects, this leaked report is how this administration negotiates.  It starts with an outrageous position and retreats back to what it wanted all along.  By all accounts, the chance that this bill would get passed is nil.  However, given current conditions in Congress, it isn’t clear whether the leadership is up for taking on the social media attacks the president can make.

There are three takeaways from this report.  First, although this bill is unlikely to become law, the “dead on arrival” statements are probably incorrect.  Second, this bill is further evidence of the anti-globalist core of this administration.  Third, even if the bill fails, the president can run on it in 2020; there isn’t really much difference between the left- and right-wing populists regarding trade and this trade position could cause even broader splits within the Democrat Party.  So, even if the bill fails to gain traction, it may have political value.

As we noted last week, the president is already weakening the WTO by refusing to approve appellate judges who handle trade dispute appeals.  In September, an appellate judge is expected to retire and once he does so the body won’t have a quorum, therefore disputes cannot be appealed.[4]  So, by continuing to veto judges, the administration is effectively rendering the WTO into irrelevance.

Central bank notes: A couple of items here.  First, the Fed is finding that managing reserves while paying interest on them and removing them at the same time is causing some degree of turmoil in the short-term interest rate markets.[5]  This may lead the Fed to keep the balance sheet higher than expected and end the reduction of the balance sheet sooner than expected.  Second, the administration’s director of the National Economic Council, Larry Kudlow, made a statement[6] late last week suggesting the Fed shouldn’t raise rates too quickly because growth doesn’t cause inflation.  This positon is classic supply-side economics; this school assumes that supply will always expand to meet demand if conditions are right.  In other words, in a deregulated and globalized economy with low tax rates, supply will always increase to meet demand and therefore monetary policy should only tighten on clear evidence of overheating (which should be addressed with more supply expansion).  The important takeaway from his comment is that the administration is skirting close to breaking the “Rubin consensus” that administrations should not comment on monetary policy.  We believe a major risk factor is that the Trump administration could adopt the Nixon playbook of managing the Fed, which set the stage for the inflation of the 1970s.

Oil: President Trump has asked the Saudis to boost output to lower oil prices.  Over the weekend, we heard from relatives and neighbors asking us, “Why are gasoline prices so high?”  We indicated that the combination of strong demand, falling supply in Iran, Libya and Venezuela and the lack of adequate pipeline capacity in Texas are all conspiring to raise prices.  The response was that no one cared…they just want gasoline prices to decline.  So, the president is leaning on the kingdom to help.  Although there are some doubts as to whether the president really did ask,[7] we have no doubt that Trump, like nearly all American presidents (G.W. Bush was perhaps an exception), wants lower gasoline prices.

German drama:The head of the CSU and the government’s interior minister, Horst Seehofer, is threatening to resign.  He is expected to meet with the chancellor today to see if a compromise can be met.  If he does resign and the CSU pulls out of the government, it could fall, bringing new elections and probably the end of Merkel’s political career.  It is possible that Merkel could simply replace Seehofer, but a CSU exit will almost certainly trigger a crisis.  A fall of the Merkel government would be a bearish event for the EUR.

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[1] In 1999, after the Mets released Bonilla, they owed him $5.9 mm.  Rather than pay him the money, they negotiated a deal where he would be paid $1,193,248.20 per year, starting on July 1, 2011, with continuing payments each July 1^st until 2035 (when Bonilla will be 72 years old).  That amount assumed an 8% return on investment on the original $5.9 mm.  However, the reason the Mets negotiated the deal was that the Wilpon family, the owners of the Mets, were investors with Bernie Madoff, who, at the time, was returning 12% to 15% per year with an eerie lack of volatility.  The owners figured they could put the money with Madoff and earn the spread over the 8%.  Of course, things didn’t work out that way but Bonilla still gets his money each year. http://www.espn.com/mlb/story/_/id/16650867/why-mets-pay-bobby-bonilla-119-million-today-every-july-1-2035

[2]  https://www.politico.com/story/2018/07/01/trump-harley-davidson-689614

[3] https://www.axios.com/trump-trade-war-leaked-bill-world-trade-organization-united-states-d51278d2-0516-4def-a4d3-ed676f4e0f83.html

[4] https://www.politico.eu/article/wto-donald-trump-protectionism-brussels-fears-trump-wants-the-wto-to-fail/

[5] https://www.wsj.com/articles/fed-faces-decisions-on-shrinking-its-huge-bond-portfolio-1530466910

[6] http://thehill.com/policy/finance/394810-kudlow-fed-should-move-very-slowly-on-rate-hikes

[7] http://fortune.com/2018/07/01/white-house-trump-tweet-saudi-arabia-oil/