by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Friday and good riddance to Q2!  It’s looking like a risk-on day.  Lots of news today.  Let’s dig in:

EU summit: A deal was struck on immigration and refugees in a nearly all-night session.[1]  The agreement says that seaborne migrants will be placed into processing centers in the EU itself.  These centers will sort out who are legitimate asylum seekers from those who are just migrating.  Nations will voluntarily establish these centers with support from the broader EU (read: Germany).  There are promises that enough money will be allocated to encourage border nations (read: Italy) to set up these centers.  Although the deal is being hailed (the EUR jumped on the news), in reality, no nation has yet agreed to actually establish such “controlled centers” and it also isn’t clear which nations will take the immigrants once they are accepted.  Merkel was able to get language put in place that requires the initial nation to keep tabs on the new immigrants to ensure they don’t move across borders.  It isn’t at all obvious how this can be executed under Schengen rules, which allow EU member citizens to freely move about the continent.  Merkel needed this element to quell the internal political threat from Bavaria.

Although Italy, Poland, Hungary and the Czech Republic are governed by populists, the agendas differ.  Italy wants refugees dispersed around the EU to relieve the burden on Italy, a frontline state.  Under EU rules, Italy is responsible for the migrants if they land on Italian soil.  Poland, Hungary and the Czech Republic resisted any plans that would force them to take refugees.  Essentially, no deal was reached other than to establish the processing centers.  The bottom line: it wasn’t the worst outcome but, in reality, little was accomplished.  The EU remains in trouble on this issue.

U.S. ditching the WTO?  Axios[2] is reporting that President Trump is indicating a desire to leave the WTO.  So far, no one in his administration, as best we can tell, is supportive of this action.  In reality, the U.S. is crippling the WTO by refusing to approve appellate judges that 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.[3]  So, by continuing to veto judges, the administration is effectively rendering the WTO into irrelevance.  However, the optics of the U.S. actually leaving the WTO would send an unmistakable sign that the postwar order, built on U.S. hegemony, is over.  One of the president’s strengths is “political theater.”  He knows how important visual symbolism is; the summit with North Korea is a good example.  Leaving the WTO would be part of that as well.  If the U.S exits the WTO, look for the dollar to rise and pressure on foreign equities to escalate as well.

Mexican elections: Mexico will hold elections on Sunday.  Barring an epic political surprise, Lopez Obrador, otherwise known as AMLO, will be the next president of the country.  Mexican voters are angry.  Corruption is rife, security is lacking due to narco-terrorism and the economy is struggling due to concerns around NAFTA and the weak peso.  AMLO is making broad promises to clean up corruption and improve the economy.  In addition, Mexicans want a leader who will stand up to the verbal assaults coming from Washington.  We view him as a populist in the model of Lula in Brazil, not Chavez in Venezuela.  Although his election is well anticipated and should have already been discounted by the financial markets, his actual election could put further pressure on Mexican financial assets.

Central bank notes: A couple of items.  Chair Powell will testify before Congress on July 17.[4]  Boston FRB President Rosengren, who for most of his career has been a dove, is signaling support for two more rate hikes this year.[5]  Today’s core PCE number, hitting 2%, supports higher rates.  The ECB is considering some form of “operation twist” to keep long rates low,[6]  which would be supportive for lower rates here.

Iran: Japan and India[7] are indicating they will reduce oil imports from Iran, which is boosting oil prices (mostly Brent) this morning.  The administration finds itself at cross-purposes.  It wants lower oil prices (thus the tweet storms against OPEC), but it is also sanctioning Iran, which is bullish for oil.

Banning cryptocurrencies:The U.S. government has apparently realized that cryptocurrencies could be a way for excessive and perhaps illegal campaign contributions.[8]  Mostly untraceable, cryptocurrencies could come into a campaign and be spent without a traceable record.  The Secret Service has apparently warned Congress to this threat.

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[1] https://www.ft.com/content/4831b0c8-7b52-11e8-bc55-50daf11b720d

[2] https://www.axios.com/trump-threat-withdraw-wto-world-trade-organization-f6ca180e-47d6-42aa-a3a3-f3228e97d715.html

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

[4] https://www.wsj.com/articles/powell-to-testify-before-senate-on-july-17-1530237985?mod=hp_listb_pos1

[5] https://www.wsj.com/articles/boston-feds-rosengren-says-its-time-to-take-away-monetary-policy-punch-bowl-1530192388

[6] https://www.reuters.com/article/us-ecb-policy/ecb-mulls-small-twist-to-keep-borrowing-costs-low-sources-idUSKBN1JP0XX

[7] https://www.reuters.com/article/us-india-iran-oil-exclusive/exclusive-india-preparing-for-cut-in-oil-imports-from-iran-sources-idUSKBN1JO18L

[8] https://www.ccn.com/congress-should-take-action-against-privacy-coins-secret-service-official/

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] As the second quarter winds down, this morning’s news flow is fairly quiet.  GDP came in a bit soft (see below).  Here is what we are watching this morning:

The EU summit: EU leaders are meeting today through the weekend.  The primary topic will be immigration and refugees.  There are two issues at hand—what to do with incoming refugees and what to do with them once they are in Europe.  Italy and Greece want to change the current rule, called the Dublin Agreement, which says the country that registers an immigrant is responsible for him/her and an EU nation can return the immigrant to the registering nation.  Italy and Greece tend to be the landing point for refugees coming from North Africa, so those countries would be required to keep them under the Dublin Agreement.  Both nations view this as unfair; however, Greece does appear open to a deal with Germany on this issue.[1]  It is unclear what Greece wants in return.  Perhaps this is the quid pro quo for the recent debt relief agreement.  Italy remains staunchly opposed to maintaining the Dublin Agreement and has been turning refugee vessels away.  Merkel is facing tensions within her ruling coalition and having the option of sending migrants back to the south where they landed, even if not exercised, might solidify her government.

One idea being floated is to create disembarking zones outside the EU,[2] perhaps in North Africa, to prevent EU migration rules from being triggered.  At these disembarkation points, potential asylum seekers could wait for asylum decisions.  If accepted, they could then, in theory, enter any EU nation.  Australia uses a similar model where asylum candidates are held on South Pacific islands.  The problem that arises is if asylum is rejected.  Sometimes rejected asylum seekers live in a form of legal limbo, unwilling to return but unable to enter.

The second problem for Merkel is that she wants migrant sharing among all members of the EU.  That position is strongly opposed by several members of the EU.  The leader of Austria, Sebastian Kurz, has been in talks with the leader of Bavaria, Horst Seehofer[3]; Kurz has indicated that Italy, Hungary, Austria and Bavaria would form an anti-immigration bloc and refuse to accept EU-mandated immigrant quotas.  The alliance with Kurz may give Seehofer enough standing to refuse to cooperate with Chancellor Merkel and potentially bring down her government.

There are other items on the agenda as well.  Agricultural interests are pressing for an EU response to trade threats from the U.S.  The Common Agricultural Policy (CAP) has come under scrutiny by the Trump administration; recently, tariffs on Spanish olives were implemented.  If the U.S. expands its attack on agriculture, the demise of CAP would likely lead to further pressure on the EU and may cause some states to follow the U.K. out of the EU.  Anything that threatens the solidity of the EU is probably bearish for the EUR.  There will also be discussions about EU reforms proposed by France and Germany.

U.S./Russia Summit: The two nations have agreed to meet on July 16^th in Helsinki.  Europeans are decidedly nervous.[4]  They fear the U.S. will attempt to improve relations with Russia at the expense of European defense, something the U.S. has underwritten since 1947.  We believe the Europeans have a right to be worried, although the fears should have predated the current president.  The U.S. has become jaded by the costs of hegemony and is probably willing to let Germany rearm to pay for its own defense.

Trade: Although there isn’t anything new today on this topic, we do want to point out a good article by Greg Ip of the WSJ.[5]  Companies are restructuring supply chains to deal with rising trade impediments.  Although the broad effect will be to raise costs and reduce efficiency, the beneficiaries will likely be those who have been left behind by globalization and deregulation.  The overall gains may just be relative; on an absolute basis, the “left behinds” might not be better off, but those who have benefited greatly from globalization and deregulation may suffer more.

Energy recap: U.S. crude oil inventories fell 9.9 mb compared to market expectations of a 2.5 mb draw.

This chart shows current crude oil inventories, both over the long term and the last decade.  We have added the estimated level of lease stocks to maintain the consistency of the data.  As the chart shows, inventories remain historically high but have declined significantly since March 2017.  We would consider the overhang closed if stocks fall under 400 mb.

As the seasonal chart below shows, inventories are well into the seasonal withdrawal period.  This week’s rather large decline, the second in a row, is consistent with that pattern.  If the usual seasonal pattern plays out, mid-September inventories will be 410 mb.

Based on inventories alone, oil prices are near the fair value price of $68.73.  Meanwhile, the EUR/WTI model generates a fair value of $60.63.  Together (which is a more sound methodology), fair value is $62.94, 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 is now 97.5%.  We will be reaching a point in the near future where domestic oil consumption growth will peak for the summer season, although we do expect the level to remain elevated.  

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[1] https://www.ft.com/content/5a5f1e8a-7a11-11e8-bc55-50daf11b720d?emailId=5b34612130d92200049bdb3c&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[2] https://www.ft.com/content/1e53958a-7a23-11e8-bc55-50daf11b720d?emailId=5b34612130d92200049bdb3c&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[3] https://www.washingtonpost.com/world/europe/as-merkel-teeters-austrias-kurz-seizes-the-moment-as-europes-rock-star-of-the-new-right/2018/06/26/b2560c2c-732f-11e8-bda1-18e53a448a14_story.html?utm_term=.262ef8a19c1e&wpisrc=nl_todayworld&wpmm=1

[4] https://www.washingtonpost.com/news/global-opinions/wp/2018/06/27/why-europe-is-very-nervous-about-a-trump-putin-summit/?utm_term=.9ef624550dd1&wpisrc=nl_todayworld&wpmm=1

[5] https://www.wsj.com/articles/as-trade-barriers-go-up-global-supply-chains-unravel-1530100987?mod=ITP_us_0&tesla=y

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Here we are at mid-week.  Financial markets are recovering this morning after a difficult overnight session.  Here is what we are watching:

Softening on trade?  Around 7:35 AM EDT, the White House[1] announced it would not create a new regime to scrutinize Chinese investments and instead will use the current foreign investment apparatus, the Committee on Foreign Investment in the U.S. (CFIUS) to analyze Chinese investments.  Risk markets have recovered on this news, likely for a couple of reasons.  First, going this route means China isn’t necessarily being targeted specifically, which does tone down tensions.  Second, using CFIUS appears to confirm Treasury Secretary Mnuchin’s position that all nations are being watched for intellectual property theft, not just China.  This notion refutes comments from Peter Navarro, which followed Mnuchin’s aforementioned comments by saying that no nations other than China were being investigated.

There is other evidence of softening.  Chairman Xi has instructed the Chinese media[2] to stop talking about “China 2025,” the controversial program to essentially move China up the value chain.  Using CFIUS and China backing away from at least talking about China 2025 are positive developments.  On the other hand, CFIUS can still effectively block Chinese investment.  And, we doubt Xi will give up on China 2025.  Given the nearly constant shifting positions of the White House, investors are clearly looking for some kind of sign that will accurately predict the future path of policy.  However, that clear path isn’t likely to emerge anytime soon.  Instead, financial markets are starting to look like the shoe scene from the Monty Python movie Life of Brian,[3] desperately searching for some indication in a cacophony of policy actions.

Meanwhile, China is clearly taking steps to protect itself from rising trade tensions.  As we noted yesterday, the PBOC cut reserve requirements.  There is talk of China subsidizing firms targeted for tariffs.[4]  We are also seeing financial authorities accepting a weaker CNY.[5]  As the chart below shows, the CNY had been appreciating from early 2017 until recently but the depreciation has accelerated over the past few days.  As we have noted before, the Trump administration appears to tolerate currency manipulation, unwilling to purposely jawbone the dollar lower to improve the U.S. trade situation.  We expect other nations to follow similar currency policies as a way to offset the impact of tariffs.  But, the bottom line is that policy-induced volatility is here to stay; from the president’s perspective, uncertainty is a feature of his administration, not a bug.

Iran sanctions: Oil prices surged yesterday after the White House warned allies that they should be prepared to cut oil imports from Iran to zero by November.[6]  Although this action was anticipated, the deadline was much quicker than expected.  Iran exports around 2.2 mbpd; we don’t expect all imports to end (China will likely continue to buy Iranian oil, roughly 0.7 mbpd), but a reasonable expectation is that Iran’s oil exports will fall to around 1.0 mbpd.  Saudi Arabia can absorb this lost oil but its spare capacity would fall to around 1.0 mbpd, leaving the world dangerously close to no slack in the oil markets.  Current oil prices are elevated relative to inventories and the dollar, and this geopolitical threat is keeping oil prices elevated.  The rial remains weak.[7]

About last night: There were a series of primaries last night and the net takeaway is that the political situation is becoming increasingly populist.  The headline shocker was from New York’s 14^th district, where Alexandria Ocasio-Cortez defeated Joe Crowley, a representative with nearly two decades of experience.  Crowley hadn’t faced a primary challenge since 2004.  There was talk that Crowley could mount a leadership challenge to Nancy Pelosi (D-CA).  His money advantage was 10-1.  Ocasio-Cortez ran on a progressive platform, calling for a federal jobs guarantee and the abolition of ICE.  We view this outcome as similar to David Brat’s win over Eric Cantor in 2014.  The populists on both sides (right- and left-wing) are gathering strength and establishment voters are increasingly being faced with candidates who want equality policies that will, at some point, lead to lower returns to capital and rising inflation.

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[1] https://www.ft.com/content/a819ec8a-79f4-11e8-8e67-1e1a0846c475

[2] https://www.politico.com/story/2018/06/26/beijing-made-in-china-2025-trump-trade-651852

[3] https://www.youtube.com/watch?v=Ka9mfZbTFbk

[4] https://www.reuters.com/article/us-china-trade-usa/china-should-take-self-defense-measures-in-trade-war-global-times-idUSKBN1JN01G

[5] http://www.scmp.com/business/banking-finance/article/2152669/yuan-drops-through-660-level-beijing-signals-it-favours

[6] https://www.washingtonpost.com/world/national-security/us-pushes-allies-to-cut-oil-imports-from-iran-as-sanctions-loom/2018/06/26/c1d20e78-794f-11e8-aeee-4d04c8ac6158_story.html?utm_term=.4e682cb86412&wpisrc=nl_todayworld&wpmm=1

[7] https://www.reuters.com/article/us-iran-economy-rial/iran-rial-plunges-to-new-lows-as-us-sanctions-loom-idUSKBN1JK0HZ?wpisrc=nl_todayworld&wpmm=1

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] After a rough day yesterday, financial markets are attempting to stabilize this morning.  Here is what we are watching:

Trouble in Iran: Protests are escalating in Iran.  Comments on Twitter suggest there is widespread dissatisfaction with the government.  Unconfirmed reports of crowds chanting “Leave Syria, think of us” and “Death to Palestine” suggest that Iranians are getting tired of their country’s foreign adventures while the economy languishes.  Adding to trouble, the unofficial Iranian rial rate has dropped to 90k/USD, down from 43k/USD at the beginning of the year.  The return of sanctions is undermining the economy but there is also growing discontent with the current government.  We haven’t seen much of a crackdown yet, which makes us wonder if the hardliners are allowing the protests to expand in order to remove President Rouhani from office and put a hardliner into power.  This is a risky strategy because without elections any new president will struggle with legitimacy and simply being appointed by the Grand Ayatollah may not be enough to quell unrest.  It is always difficult for outsiders to discern what is going on in Iran; it should be noted there was genuine surprise by the Shah’s fall in 1978.  Since the theocracy was established in the late 1970s, it has been very effective in containing unrest.  However, that doesn’t mean it will always be true.

Although regime change has been a goal of the U.S. since the revolution in 1978, it is unclear who would govern Iran if the government falls.  Nevertheless, any new government would likely sue for peace with the Trump administration in a bid for sanctions relief.  And, we suspect they would get it.  So, it could be bullish for oil in the short run but long-term bearish if a new government leads to increased exports.

Trade: The EU applied tariffs on items it views as politically sensitive.  Harley-Davidson (HOG, 41.57), the maker of iconic American motorcycles, was an obvious target for the EU.  In response, the company announced it would move production outside the U.S. to prevent the tariffs from being applied to U.S. exports.[1]  The president accused the company of “waving the white flag”[2] on this issue.  Here is an important point.  The president and his followers[3] are economic nationalists; they view trade through the viewpoint of nation against nation.  Major companies, for the most part, are run by members of the establishment who view the world from a global perspective.  Thus, in light of trade actions, they tend to think in terms of supply chains,[4] not national employment.

There charts show what we think is the president’s worldview:

 

The upper line on both charts is the level of U.S. manufacturing payrolls.  We have regressed a trend through the data from 1945 to 1978 and extended that trend past 1978.  Note that actual manufacturing employment began to fall below trend in the late 1970s and has continued on that path into the present.  The lower line on the left-hand chart shows the yearly change in CPI.  When manufacturing employment began to fall below trend, so did inflation and inflation volatility.  The lower line on the right-hand chart shows net exports along with the aforementioned trend data on manufacturing employment.  The impact of globalization is abundantly clear—the widening trade deficit has pushed manufacturing employment well below trend but has also been instrumental in reducing inflation.  We believe one of President Trump’s core beliefs is that manufacturing employment is the key to middle class prosperity and he wants to move the red line on the above charts back to trend.  To do so, he needs to reduce globalization by ending the trade deficit.  If he does that, we anticipate a return of inflation.  Harley-Davidson’s reaction to tariffs is perfectly rational if a company is a profit-maximizing firm as it is trying to keep its costs under control and its products competitive, thus moving production makes sense.  But, if one’s goal is to bolster nationalism through an increase in manufacturing employment, Harley-Davidson’s behavior is inappropriate.  Instead, the company should keep production in the U.S. and assume (hope?) that Europeans will be willing to pay more for the brand.

This divergence of goals is a key element in the current debate between the political establishment and insurgent populism, not just in the U.S. but in Europe as well.  What makes this issue tricky is that each side of the debate sees its own position as a self-evident truth and accordingly perceives the other side’s viewpoint as untenable.

Is China blinking?  Bloomberg[5] is reporting there is growing opposition to a trade war in China.  Important voices in China appear to be arguing that Chairman Xi doesn’t really have the country ready for a trade war and therefore making peace with the U.S. is a better course of action.  We have our doubts that Chairman Xi can back down as the leader of China has also stoked nationalism to solidify his political power, so caving to the U.S. will look like a surrender.  We may be too pessimistic, but our read on Xi is that he won’t give in to President Trump on China 2025 or any other Chinese policy goal.

Is Trump’s political capital exhausted?One of our positions is that new presidents have about 18 months of political capital; from inauguration into the summer of the second year, a president sees a steady diminishment of power.  Usually, when presidents realize they cannot pass any major legislation as Congress’s attention shifts to the midterms, they focus their attention on foreign policy, where they are less reliant on Congress to accomplish their goals.  This may also explain why the president is focusing on trade.[6]

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[1] https://www.ft.com/content/54a6cc82-7867-11e8-8e67-1e1a0846c475

[2]https://twitter.com/realDonaldTrump/status/1011360410648416258?utm_source=POLITICO.EU&utm_campaign=90fa10452d-EMAIL_CAMPAIGN_2018_06_25_08_13&utm_medium=email&utm_term=0_10959edeb5-90fa10452d-190334489 ; https://www.reuters.com/article/us-harley-davidson-tariffs/trump-blasts-harley-plan-to-shift-u-s-production-to-avoid-eu-tariffs-idUSKBN1JL185

[3] https://www.ft.com/content/29f24644-78f1-11e8-bc55-50daf11b720d

[4] https://www.reuters.com/article/us-usa-trade-supplychains/trump-tariffs-force-companies-to-rework-supply-chains-idUSKBN1JL2LR ; https://www.wsj.com/articles/trump-rides-a-harleyto-europe-1529968178

[5] https://www.bloomberg.com/news/articles/2018-06-25/as-trade-war-looms-china-wonders-whether-it-s-up-for-the-fight

[6] https://www.axios.com/donald-trump-administration-gridlock-congress-legislation-house-midterms-14ee0143-6f8e-4228-b7b5-653e6e6ea027.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s Monday.  This morning, it’s trade, Turkey and OPEC.  Here are the headlines:

Trade: The Trump administration is preparing to put capital controls against Chinese investment in a variety of U.S. industries deemed critical for security.  The industries are mostly in the technology sector.  The president is using emergency powers granted to him to protect national and economic security.[1]  In addition, the U.S. will begin implementing tariffs on China by July 6^th unless some action is taken to delay the move.  And, the president is threatening even more trade sanctions on additional countries.[2]  It appears the Navarro/Lighthizer wing of Trump’s inner circle has overwhelmed the establishment Mnuchin/Kudlow wing.  Worries about an escalating trade war sent emerging markets lower.  Treasuries and the yen rose.  Equities, in general, are weaker as well, although the risk-off trade has weakened throughout the morning.

Turkey: As we noted last week, illegal polls in Turkey were suggesting that President Erdogan would win a first round victory.  Because polls are not supposed to be conducted 10 days before an election we were unsure if the surveys were accurate.  Turns out they were.  Although results are not official, opposition candidates have conceded and it appears Erdogan took 52.5% of the vote.[3]  In addition, combined with his coalition partner, the Nationalist Movement Party, Erdogan will enjoy a majority in parliament.  Recent changes to the constitution will give the incoming president very strong powers.  The lira initially rose on the news but has turned lower.

OPEC: On Friday, oil prices soared on the idea that OPEC would not increase oil supply as much as initially feared.  Over the weekend, Saudi Arabia suggested that supplies would rise enough to ensure ample supply, which probably means the kingdom could expand output to meet the 1.0 mbpd increase in quota even if it produces over its individual country quota.  The news led oil prices lower this morning.  Most likely, we are seeing an evolution to price stability.  OPEC doesn’t want a return to the low $50s for oil prices, but the Saudis are facing political pressure from the U.S. and Riyadh wants to improve relations with the Trump administration after the deterioration under President Obama.  One of the truisms of oil is that rapidly changing prices attract attention but the cartel can get away with high, but stable, prices.  That is mostly OPEC’s goal, which means we are probably heading to a period of very low oil price volatility.

PBOC: The Chinese central bank lowered reserve requirements by $100 bn in order to protect the economy from the negative effects of tariffs and other trade actions.[4]  What is important from this action is that it took the CNY lower.  Currency depreciation is one way China could counteract the Trump administration’s trade actions.  So far, President Trump remains opposed to weakening the dollar to address trade, so as long as this avenue is open we look for more nations to take advantage of this policy and use a weaker currency to offset trade restrictions.

Merkel’s problem:A weekend meeting[5] didn’t resolve the chancellor’s problems.  Merkel faces an internal rebellion in her coalition that wants to restrict acceptance of immigrants.  To quell the rebellion, Merkel wanted to send refugees back to the country where they initially entered the EU (the “Dublin Principle”), which is current policy.  Clearly, this policy adversely affects countries like Greece and Italy, where many of the refugees first land.  Italy decided against helping Chancellor Merkel, demanding the first landing policy be abandoned.[6]  If Merkel can’t come to some sort of compromise, her government is in trouble and we may see new elections in Germany before year’s end.  That outcome would probably be bearish for the euro.

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[1] https://www.politico.com/story/2018/06/24/trump-china-export-controls-647091 ; https://www.ft.com/content/c002dadc-766b-11e8-b326-75a27d27ea5f?emailId=5b306e2f18cc4a00043573ad&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22 ; https://www.wsj.com/articles/trump-plans-new-curbs-on-chinese-investment-tech-exports-to-china-1529883988

[2] https://apnews.com/c5a7fdde33b84ca9b100a8862326d6d4/Trump-lobs-new-threats-against-countries-trading-with-the-US

[3] https://www.ft.com/content/9ab2404e-7786-11e8-bc55-50daf11b720d?emailId=5b306e2f18cc4a00043573ad&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[4] https://www.ft.com/content/ae641456-77c1-11e8-bc55-50daf11b720d?emailId=5b306e2f18cc4a00043573ad&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[5] https://www.washingtonpost.com/world/europe/european-leaders-talk-migration-as-germanys-merkel-tries-to-save-political-future/2018/06/24/89a23266-764e-11e8-bda1-18e53a448a14_story.html?noredirect=on&utm_term=.bb30ec9ef264&wpisrc=nl_todayworld&wpmm=1

[6] https://www.ft.com/content/bc42c746-77c3-11e8-bc55-50daf11b720d?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56 ; https://www.nytimes.com/2018/06/24/world/europe/eu-migration-dublin-regulation.html?emc=edit_mbe_20180625&nl=morning-briefing-europe&nlid=567726720180625&te=1

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] We made it to Friday!  Markets are rather quiet this morning as immigration has overshadowed trade concerns.  We are seeing a bit of “risk-on” today after a rather rough week.  Here is what we are watching this morning:

OPEC: We have a deal. The cartel agreed to a 1.0 mbpd increase in quotas but not in production.  Since many of the members lack excess capacity, the real increase is about 0.6 to 0.8 mbpd.  That is a bullish outcome.  We are still waiting to see the Russian reaction but our expectation is that Russia will increase production to take market share from the formal cartel.  But, overall, this is a bullish result relative to fears of a much larger rise in output.  At the same time, we think Saudi Arabia is trying to guide prices modestly lower (low $60s to high $50s) in response to President Trump’s persistent criticism of high oil prices.  The president wants lower oil (and gasoline) prices going into the mid-terms.  Thus, don’t be surprised to see bearish comments from the Saudis in a bid to cool today’s early price spike.

Turkish elections: Most recent polls show Erdogan’s party coming in at 51.6%; if accurate, he would win Sunday’s election outright.  On the other hand, if he fails to achieve 50%, he would face a run-off election.  It should be noted that the most recent polls are illegal; Turkish electoral law indicates that no polls should occur 10 days before the election.  Thus, the veracity of the most recent polls is questionable.  The last legal polls showed Erdogan with 45.8% support.  The second place party is the Kermalist CHP; the policy platform of this party isn’t remarkably different than Erdogan’s except that the CHP leadership is campaigning on the goal of improving global relations.  We expect a close election and wouldn’t be surprised by a run-off.  But, in the end, we expect Erdogan to eke out a narrow victory.

Greek deal: After eight years, the Greek bailout is finally complete.[1]  Greece did not get a debt write-off but it did receive a 10-year extension of the loan terms and a decade deferral on interest and amortization.  Although this buffer will likely give Greece enough financial space to be able to tap the financial markets for loans, its government debt/GDP ratio remains at 180% and terms of the deal require austerity to remain in place.  In our opinion, this is another “can kicking” solution but, given that Greece has essentially more than a decade to build cash reserves, we shouldn’t see Greece affecting financial markets for a while.  Greece will be making mere token payments on its debt unit 2030.

German/French EU reform hits opposition: France and Germany reached an agreement on EU reforms.  The agreement was not all that ambitious but it is facing rather strong opposition from a number of EU nations, including the Netherlands, Finland and Austria, which are questioning the need for any Eurozone fiscal capacity.[2]  The economic theory of currency unions usually requires some sort of fiscal unity to address growth divergences within the union.  The Eurozone lacks this feature; instead, the Germans tried to use strict fiscal spending limits to address this problem.  What has developed instead is wide growth divergences.  The natural split in the Eurozone is between the north and south.  The opposition to France’s plan is mostly coming from the north.  Thus, we have doubts that anything of substance will come from Germany and France’s plan.

European immigration problems: The U.S. isn’t the only part of the world with immigration turmoil.  Chancellor Merkel is facing a breakup of one of the most durable coalitions in European political history, the CSU/CDU union.  Differences on immigration policy are threatening this long-standing arrangement.  The CSU, based solely in Bavaria, wants to block refugees from entering Germany.  Since Bavaria sits on Germany’s southern border, this action is essentially a national policy.  Merkel opposes this policy.  She is trying to work out a compromise but Italy scuttled her plans by rejecting a proposal that would have allowed refugees in Germany to be returned to their nation of entry which, in most cases, is Italy for migrants coming from Africa.[3]  It is possible that the Merkel government could fall over this issue.  German media is reporting that the other party in Merkel’s grand coalition, the SPD, is planning for snap elections.[4]  New elections would likely boost the AfD and lead Germany in a more populist direction, which would likely be bearish for the EUR.

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[1] https://www.ft.com/content/b1cba7c4-75a2-11e8-a8c4-408cfba4327c

[2] https://www.ft.com/content/19eba02a-75fd-11e8-b326-75a27d27ea5f

[3] https://www.ft.com/content/6d2a2c3c-7564-11e8-aa31-31da4279a601?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[4] https://www.forexlive.com/news/!/germanys-spd-is-said-to-prepare-for-new-elections-report-20180622

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Summer Solstice!  Here is what we are watching this morning:

Trade and the dollar: India joined other nations by applying tariffs against the U.S.[1]  EU officials are worried that U.S. trade policy will upend its longstanding Common Agricultural Policy (CAP), which is a system of subsidies critical to maintaining EU unity.  Earlier this month, the U.S. applied trade restrictions to Spanish olives but the fear is that the action will broaden.  It is interesting to note that French President Macron criticized CAP,[2] but we don’t see this as a commonly held position among European leaders.  Essentially, nearly all nations offer some degree of support for agriculture.  Food security is simply too important politically and countries want control over the food supply.  This leads to preferential treatment for farmers in all sorts of ways.  CAP, a system of farm subsidies, is how the EU maintains a free trade zone, essentially preventing overt trade restrictions within the EU.  However, these restrictions reduce foreign imports of agricultural products.  This is what the U.S. is attacking.  But, if the CAP system devolves, the EU could very easily fall apart, too.  Nations within the EU would almost certainly put up internal barriers to agricultural trade to protect their domestic farmers and ranchers, and once internal barriers for one product are implemented it would not be a surprise to see other industries ask for protection.  It’s important to remember that the EU began as a free trade zone and has morphed into a much larger entity.

We are starting to see the trade actions causing secondary effects.  Daimler (DAI, EUR 58.20) warned today that tariffs could adversely impact its profits.[3]  This is the first time we have seen trade offered as a reason for lower earnings.  This news led European automaker shares lower.  And, in what has to be a most bizarre situation, the Commerce Department is reportedly “probing steel profiteering after tariffs.”[4]  Often, the left is criticized for implementing regulations and then being surprised that prices rise.  A GOP administration being “shocked” that steel prices rose and companies are making more money after the government takes steps to restrict foreign supply is really surprising.  Meanwhile, U.S. agriculture is being roiled by retaliatory tariffs.[5]

The bottom line is that global trade impediments are a reversal of nearly 90 years of steadily falling tariff barriers.  This trend only occurred because of U.S. leadership; the U.S. essentially traded access to the U.S. consumer in return for cooperation on global security.  For example, Japan and Germany gained access to the U.S. market and we got to place military bases on their territories.  That system worked great during the Cold War but in its aftermath we haven’t created a rationale for continuing it.  Although Trump is catching the blame for disruption, the reality is that domestic political support for free trade has been under pressure for a long time.  Trade impediments act like a restriction on the dollar supply and thus, all else held equal, the wider the “trade war” goes the greater the bullish impact for the dollar.

BOE: The Bank of England left policy unchanged as expected, but the vote was 6-3, indicating rising opposition to current policy.  The dissenters wanted to raise rates.  The idea that rates could rise in the near future boosted the GBP.

OPEC: Oil prices reversed yesterday’s gains on bullish inventory data (see below) due to fears that OPEC would boost output significantly.  There are reports that Iran is softening its opposition to raising production.  Russia has been pressing for an increase of 1.5 mbpd.  We believe Saudi Arabia is supportive of that level of increase (since it will provide most of it), but the kingdom wants to keep peace within the cartel, which means a compromise.  We have been in the compromise camp, expecting a token increase of 0.4 to 0.6 mbpd.  The latest suggests that Saudi Arabia is more in the 1.0 mbpd camp.[6]  This level of increase may not add all that much to world supply as disruptions in Libya and Venezuela will offset some of this proposed increase.  However, it is a bearish surprise for the market.  In addition, U.S. output, which has been rising at a surprising clip, is about to stall because of the lack of pipeline capacity in the Permian Basin.  Reports indicate “DUCs” are rising rapidly, which will reduce current supplies but represents future production.[7]  As we note below, a strengthening dollar is a bearish factor for oil; rising supply probably caps current prices.  On the other hand, there doesn’t appear to be enough oil on global markets to cause a major bear market to develop.

Energy recap: U.S. crude oil inventories fell 5.9 mb compared to market expectations of a 1.0 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 rather large decline is consistent with that pattern.  If anything, the draw was stronger than normal.  If the usual seasonal pattern plays out, mid-September inventories will be 418 mb.

Based on inventories alone, oil prices are near the fair value price of $65.51.  Meanwhile, the EUR/WTI model generates a fair value of $60.96.  Together (which is a more sound methodology), fair value is $62.05, 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.  And, as we noted above, if OPEC increases output the rising trend in oil prices will probably stall.

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[1] https://www.hindustantimes.com/business-news/india-raises-import-duties-on-agri-steel-products-to-protest-us-tariff-hike/story-fung5wX88UshIfORNCwPBK.html

[2] https://twitter.com/EmmanuelMacron/status/1009530411591065600

[3] https://www.ft.com/content/aae48d3a-7521-11e8-b6ad-3823e4384287

[4] https://www.reuters.com/article/us-usa-trade-steel/u-s-commerce-department-investigating-steel-price-hikes-after-tariffs-ross-idUSKBN1JG22W

[5] https://www.ft.com/content/bdbc9e3a-73d6-11e8-aa31-31da4279a601 and https://www.reuters.com/article/us-usa-trade-hog-margins/trade-woes-shrink-u-s-pork-packer-margins-to-three-year-low-idUSKBN1JG2LW and https://www.reuters.com/article/us-usa-trade-china-tariffs/double-whammy-u-s-pork-fruit-producers-brace-for-second-wave-of-chinese-tariffs-idUSKBN1JH0KZ

[6] https://www.cnbc.com/2018/06/21/opec-kingpin-saudi-arabia-just-threw-down-the-gauntlet-in-its-push-to-ramp-up-production.html

[7] https://www.bloomberg.com/news/articles/2018-06-21/unfracked-oil-wells-growing-as-permian-pipeline-scarcity-worsens