by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s looking like a “tough Tuesday.”  Risk-off is clearly evident—Treasuries, the yen and the dollar are higher, while gold is flat and equities, especially emerging markets, are under pressure.  Oil and commodities are lower as well.  Here’s the story:

Trade: President Trump has threatened[1] an additional $200 bn in tariffs on Chinese imports; China has vowed to retaliate in kind.  At the same time, the Senate voted overwhelmingly to reinstate the penalties on the Chinese tech company ZTE (SHE: 000063, CNY 20.54).

What makes analyzing this brewing trade war so difficult is that we really haven’t had anything like this since the 1930s.  Under U.S. leadership, tariffs have been steadily declining since the end of WWII.  Even though there has been the occasional trade spat, such as the “voluntary” auto export restrictions in the late 1980s, a broad-based trade war is something that probably no living analysts remember.  The Smoot-Hawley Tariffs were passed in 1930.  A 30-year-old analyst at that time would be about 118 years old.  Accordingly, there probably isn’t anyone out there with actual adult experience of rapidly rising tariffs.

So, if this continues to escalate, what happens?  In our opinion, the most likely development is higher inflation.  The steady decline in inflation that began in the early 1980s was mostly due to supply-side reforms.  Globalization and deregulation led the way to improving efficiencies and reducing labor costs.  Although the latter remains in place, a trade war will obviously undermine globalization.  That development would lead to less efficiency and higher prices.  However, other than the trend, significant uncertainties still remain.  First, if markets remain deregulated, meaning the new introduction of technology will continue unabated, then rising labor costs will be partially blunted by increasing automation.  Second, the Federal Reserve can keep inflation expectations anchored by proving its independence and raising rates high enough to maintain low inflation expectations, even at the risk of recession.  If these two factors remain in place, inflation probably remains relatively tame.

Market behavior suggests investors believe these two factors will remain in place.  If investors believed otherwise, we would be seeing a rise in long-duration yields.  In fact, the opposite is occurring; bond yields are falling, suggesting the financial markets believe the risk of recession is higher than the risk of reflation.  Interestingly enough, there is nothing in the data to suggest a recession is on the horizon.  For example, the Atlanta FRB’s running estimate of Q2 GDP is now +4.8%.

Here is the evolution of the data by estimated contribution to growth.

Virtually all sectors are additive to growth, including net exports, which is surprising given how U.S. growth is outpacing most of our trading partners.  As one would expect, consumption is robust, accounting for more than half of the growth estimate.  There is nothing in this data to suggest an imminent slowing.

The dollar’s strength is a drag on equities, especially large caps and foreign equities.  The dollar’s rally is based on two trends.  First, the divergence on monetary policy is dollar supportive.  Historically, the record on interest rate differentials is decidedly mixed but, for now, the tightening Fed is bullish for the greenback.  Second, assuming the dollar remains the preferred reserve currency, restrictions on imports, the primary way the world acquires dollars, act as a reduction on the global dollar supply.  As a result, tariffs are dollar bullish until nations decide to use another currency for reserves.  At present, there is no real alternative to the dollar so we should assume the threat of tariffs will be dollar bullish.  A tariff-driven dollar bull market would be unprecedented in post-WWII history.

The other key issue to watch is the Fed’s independence.  If the economy begins to weaken, the White House will likely put pressure on Chair Powell to lower rates quickly.  We note the two-year deferred Eurodollar futures implied yield is holding around 3.00%, suggesting the market does not expect more than four more rate hikes.  If there were serious inflation fears, we would expect that implied rate to move higher.  That hasn’t happened, which is further evidence that the financial markets don’t expect this recent growth spurt to last.  The consensus also expects the FOMC to keep inflation expectations anchored.

The other factor that makes this situation so fluid and difficult is that the White House doesn’t appear to have a clearly detailed plan in place.  In other words, it’s hard to know what would constitute a victory.  There have been a parade of comments in the financial media suggesting these announcements are mere posturing and that a trade war isn’t likely.  Perhaps that is the case.  However, Treasury Secretary Mnuchin seems to have disappeared and the president seems to have taken over trade policy.  If victory requires foreign nations to admit they were wrong and simply accept tariffs, then that probably isn’t going to happen.  Although the EU, Canada or Mexico might eventually offer the president a symbolic win, we can’t see China doing that.

There remain numerous positive factors.  As noted above, economic growth remains strong.  Earnings are great.  Consumer and business sentiment remain elevated.  Household cash is rising, which could fuel equity buying.  Simply put, there are clear positive factors that could fuel an equity rally.  But, the high uncertainty surrounding a trade war is offsetting these bullish factors.  If these bullish factors begin to fade, increasing financial stress is likely.

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[1] https://www.ft.com/content/acd48414-7360-11e8-aa31-31da4279a601?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Monday!  It’s a risk-off day so far this morning.  Here is what we are following:

Tariffs and trade: While there wasn’t any major news on this issue over the weekend, financial markets are discounting the potential outcome of a trade war.  Although there are legitimate concerns about the long-run impact of a breakdown of the global trade system, the short-run benefits to the administration are clear—talk of tariffs is boosting the president’s popularity.

The chart on the right overlays the president’s average approval ratings with the Google Trends tracking of the work “tariff.”  The low point in approval occurred as the tax law was being enacted last December.  Soon after, the president’s policy emphasis shifted from taxes to trade and his approval ratings rose.  Although the tax cuts are clearly popular with the right-wing establishment, the right-wing populists were not all that impressed.  However, the prospect of tariffs has clearly boosted sentiment.  The chart on the left shows a scatterplot of the series on the right.  The conclusion to be drawn by the White House is that trade impediments are resonating.

Equity markets, however, are not impressed with trade impediment rhetoric.

This chart shows the data from Google Trends on the word “tariffs” and the S&P 500 weekly close.  Since trade impediment talk has heightened, equities have declined from their highs and moved sideways.  It’s interesting to note that equities recovered when the rhetoric eased a bit recently.  As talk of trade impediments has escalated, equities have started to stall again.

A common remark we hear is that, “The president won’t want a weak equity market going into midterms.”  This data would suggest that the president probably isn’t all that concerned as recent equity market weakness hasn’t dented his approval ratings.

OPEC: Last week there were great fears that OPEC was planning to boost production by 1.0 to 1.5 mbpd.  Current comments suggest a much less increase of only 0.3 to 0.6 mbpd.  Russia is pushing for a bigger increase and we suspect Russia will simply cheat if it doesn’t get it.  The nations within OPEC that lack excess capacity, mostly Venezuela, Iraq and Iran but others within the cartel as well, are reluctant to boost output.  Saudi Arabia is in a tough spot.  President Trump has deployed social media to criticize OPEC for keeping prices too high and the Saudis are sensitive to those comments.  However, the kingdom also has an IPO to price at some point and wants higher oil prices to boost the value of the sale.  Thus, it looks like we are getting a compromise which, given recent price weakness, is bullish.

On the topic of oil, we have seen the Brent/WTI spread widen out, in part due to the lack of American capacity to move oil into the export market.  We are hearing reports that China is considering targeting oil and other energy products (perhaps even coal) for the second round of tariffs.  In theory, which assumes a frictionless world, the loss of exports to China would be offset by exports to other places.  And, over time, that would happen.  But, in the short run, where “friction” exists, the China threat is bearish for WTI.

Merkel wins: Last week, we noted the refugee spat between Chancellor Merkel and CSU leader and interior minister Horst Seehofer.  Seehofer had threatened to block refugees coming into Germany who mostly enter through Bavaria, where the CSU dominates.  This morning, it appears a compromise has been achieved where any new policies would be introduced gradually.  Merkel is trying to build an EU-wide policy on refugees; we think she is probably going to fail on this effort as rising populism will thwart her efforts.  But, for now, Merkel has fended off this threat.

Egypt implements fuel price increases:In a bid to introduce austerity measures as part of an IMF agreement, Egypt has increased fuel costs, boosting transportation costs by at least 20%.^[1]  Historically, when governments take steps to introduce austerity and raise subsidized prices, civil unrest often follows.

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[1] https://www.nytimes.com/2018/06/16/world/middleeast/egypt-imposes-steep-fuel-price-increases.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s Friday, the close of a very busy week.  Today will be active, too.  Here’s what we are following:

Tariffs: As expected, the Trump administration leveled tariffs on $50 bn of Chinese imports this morning.  The action will be broken into two tranches; the first set, applied to 818 product lines and $34 bn in value, will come into force on July 6.  The remainder, on 284 product lines and $16 bn in value, will be applied later after further review.  These tariffs will affect mostly aerospace, robotics, manufacturing and auto parts.  China has already indicated it will retaliate[1] in kind, with the focus being on agricultural products.

In other trade news, Mexico is considering another $4 bn in tariffs[2] that would be applied to corn and soybeans.  We note that soybeans peaked near $10.62 per bushel in late May; this morning, prices are trading at $9.28 per bushel, down just over 12.5%.  Corn is acting in a similar fashion, down 13.7% from the recent high.  Although trade fears are playing a major role in the weakness, we note that growing conditions are nearly perfect.  Soils were moist, but favorable breaks in the rain allowed the crop to be planted on time.  Now we are seeing warm and wet conditions, which will offer the promise of another bumper crop.

In addition to Chinese tariffs and Mexican retaliation, the president wants to put tariffs on foreign cars before the midterms.[3]  The Reagan administration implemented “voluntary” import restraints on steel and cars in the 1980s[4] but conditions were much different then.  Country of origin could be more easily determined at that time.  Now, auto manufacturing is truly global, with parts and production dispersed around the world.  Optically, a foreign auto tariff could be popular before an election but actually executing it could prove harder than it looks.

In watching how markets are taking this news, it is clear that equities are not pleased.  Tariffs should be considered inflationary (it’s a consumption tax on imports, after all) but bond yields are continuing to decline, suggesting that long-duration buyers are confident the Fed will raise rates enough to counter the potential inflationary impact of tariffs.  We are less confident; our position is that Trump is Nixonian in his stance on monetary policy and, once policy tightens enough to “bite,” Chair Powell will find himself the target of tweet eruptions.  But, so far, nothing like that has happened so the bond market is focusing on the economic depressant effect of tariffs.

Merkel under siege[5]: Chancellor Merkel actually leads two parties, the Christian Social Union (CSU) and the Christian Democratic Union (CDU).  The CSU, though conservative, is a regional party.  It operates only in Bavaria and currently holds 46 seats (out of 709) in the Bundestag.  The CDU, on the other hand, has 200 seats and operates in the other 15 German states.  The CSU is generally more conservative on social matters and less market oriented compared to the CDU.  The CSU has been quite uncomfortable with Merkel’s open border policy on refugees.  Recently, Horst Seehofer, the leader of the CSU and current interior minister, offered a plan to tighten Germany’s asylum program.  Part of this plan would give German police the power to prevent asylum seekers from crossing into Germany if they have registered as refugees in another EU state.  This policy runs in direct contradiction to Merkel’s border and refugee policy.  It’s likely that Seehofer is worried that the AfD, a right-wing populist party, could gain a majority in Bavarian elections expected later this year.  The AfD holds an anti-immigrant policy stance that, as in other countries, has become favored among right-wing populists.

There have been rumors that this internal spat could lead to a collapse of the Merkel government.  We doubt that’s the case but it is clearly undermining support for Merkel, and her government is rather fragile anyway.  What it is clearly doing is focusing Germany inward during a period when leadership would be welcomed.  For example, Italy is threatening to scuttle the recently negotiated Canada/EU free trade deal.[6]  A distracted Germany makes such events more likely.

A new Colombian president: Ivan Duque appears likely to become the next president of Colombia in Sunday’s elections.  He is 42 years old and, if elected, would become the youngest president in the nation’s history.  A conservative, he is supported by former President Alvaro Uribe.

Bitcoin is not a security:The SEC ruled yesterday that Bitcoin and Ethereum are not securities.  It isn’t clear who will become the regulator (our bet is that the CFTC will get the role), but Initial Coin Offerings are securities.  Bitcoin jumped on the news.

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[1] https://www.reuters.com/article/us-usa-trade-china-ministry/china-promises-fast-response-as-trump-readies-tariffs-idUSKBN1JB0KC

[2] https://www.reuters.com/article/us-usa-trade-mexico-exclusive/exclusive-mexico-studies-tariffs-on-billions-of-dollars-of-us-corn-soy-idUSKBN1JA353

[3] https://www.politico.com/story/2018/06/14/trump-tariffs-foreign-cars-midterms-627528

[4] Robert Lighthizer, the current USTR, was a deputy USTR when these voluntary restraints were negotiated. https://www.nytimes.com/1984/09/20/business/voluntary-import-restraint.html

[5] https://www.ft.com/content/e6a9315a-707f-11e8-92d3-6c13e5c92914

[6] https://www.ft.com/content/13ce4184-6fe5-11e8-92d3-6c13e5c92914?emailId=5b234205317bb80004a73d83&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s ECB decision day!  The World Cup also begins today in Russia.  It’s also Flag Day and President Trump’s birthday.  The financial markets are trying to figure out if the Fed was hawkish or not.  Here is what we are watching today:

ECB: The European Central Bank left rates unchanged, as expected, although did hint that rates may begin to rise by the end of summer 2019.  However, the big news is that the bank intends to taper its QE by €15 bn starting in October (from €30 bn) and end QE at the end of December.  Thus, QE in the Eurozone is coming to an end…with caveats.  The word “intends” was not used for flourish but reflects the ECB’s position that it expects to taper but does want the flexibility to maintain asset purchases.  The markets took the statement as dovish.  The EUR initially rallied but fell sharply on the “intends” signal; in fact, the EUR is facing its biggest single-day drop since October 2017.  European equities moved from red to green on the dovish take.

During the press conference, President Draghi emphasized that the central bank has “optionality” in its decision making, suggesting the path of policy tightening isn’t necessarily inevitable.  At the same time, he did note that the vote on today’s policy announcement was unanimous, which would suggest support for tightening is reasonably solid.  Overall, the market take on the ECB is very dovish.

The Fed: The FOMC, as expected, moved to lift rates 25 bps, with a range of 1.75% to 2.00%.  Effective fed funds usually trade around the mid-point.  The median dot plot is signaling two more hikes this year, although the average is signaling a year-end rate of 2.25%.  The average plot shows rates hitting 3.00% next year and peaking around 3.5% in 2020.  The dispersion did narrow, suggesting a consensus is developing among the members.

The statement itself was a bit odd.  The “accommodation” language remained but Chair Powell indicated in the presser that the FOMC is approaching a neutral rate.  In addition, the phrase “warrant further gradual increases in the fed funds rate” was removed.  Equity markets slumped on the news (although the banks initially rallied), but the dollar failed to hold early gains and precious metals recovered.  In the press conference, Powell downplayed the potential for higher inflation, which probably led to the dollar’s decline.  The other important item was that the chair will hold a press conference after every meeting, beginning next year.  This isn’t a big surprise but, as we noted yesterday, we see it as an unfortunate development.

Financial markets continue to look for a rate two years from now around 3.10% for fed funds.

This chart shows the fed funds target with the implied three-month LIBOR rate, two years deferred from the Eurodollar futures market.  In general, the FOMC has tended to raise rates until the target moves above the implied LIBOR rates; such events are shown on the chart with vertical lines.  The Eurodollar futures are suggesting another 125 bps of tightening over the next eight quarters.

The other factor we note in the aftermath of the meeting is that the yield curve is continuing to flatten.  The chart below shows the 10-year T-note less the two-year T-note spread.

The curve is the flattest it’s been since 2007, just before the recession began.  The fact that the 10-year yield is rising slower than the two-year does suggest long-duration investors remain confident that inflation will remain under control.  The flattening of the curve is a concern as inversion is a very reliable signal of recession.  At present, the vast majority of indicators are signaling little risk of recession but the continued narrowing of the yield curve could lead the FOMC to pause sooner than their comments yesterday would suggest.

Brexit: Pressure on PM May remains high as she tries to weave a path between the “leavers” and “remainers” among the Tories.  However, Labour leader Corbyn faced a rebellion in his party yesterday.  The action was tied to the vote on an amendment that would have forced the government to negotiate staying within the European Economic Area (EEA, or the “Norway option).  Corbyn ordered Labour MPs to abstain from the vote.  Corbyn doesn’t like the EEA because it would have required the U.K. to abide by EU rules and immigration.  One shadow minister[1] and five secretaries resigned after Corbyn’s order.  The amendment failed but Corbyn’s leadership took a serious hit, which is probably good news for the GBP.

China tariffs: The administration is preparing for $50 bn of new tariffs on China,[2] although the president hasn’t decided if he wants to delay the action.  So far, the markets are taking the move in stride.  Since trade policy does tend to vacillate from initial harsh announcements to a middle ground, the financial markets appear to be reacting less, waiting for the final decision.

Energy recap: U.S. crude oil inventories fell 4.1 mb compared to market expectations of a 1.5 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 usually starting their seasonal decline this time of year.  This week’s decline is consistent with that pattern.  If the usual seasonal pattern plays out, mid-September inventories will be 424 mb.

 

Based on inventories alone, oil prices are overvalued with the fair value price of $63.60.  Meanwhile, the EUR/WTI model generates a fair value of $62.17.  Together (which is a more sound methodology), fair value is $62.23, meaning that current prices are above fair value even with the recent pullback.  Although prices remain richly valued, the degree of overvaluation improved from last week as the dollar eased modestly and inventories fell.  Falling crude oil imports and strong refining activity offset the continued relentless increase in U.S. output.

Meanwhile, Saudi CP Salman and Russian President Putin are meeting during the Saudi/Russian opening match at the World Cup.  Russia wants to resume full production.  Much of OPEC opposes any Saudi changes[3] because they lack the spare capacity to boost output.  OPEC meets on June 22-23.

Yemen: Saudi Arabia and the GCC coalition are launching an offensive[4] on the port city of Hodeida.[5]  Controlled by Houthi rebels, the port is the main entry point for food and humanitarian aid in Houthi-controlled areas.  If Saudi forces are successful in capturing this city, it will cut off the Houthis from resources.  At the same time, it would also trigger a humanitarian crisis.  Although we don’t expect this offensive to affect oil supplies, it could trigger retaliatory missile attacks on Saudi infrastructure.  If successful, oil prices would likely rise.

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[1] A shadow minister would take this role if the minority party were in power; thus, there is a shadow exchequer, for example.

[2] https://www.wsj.com/articles/u-s-preparing-to-proceed-with-tariffs-on-chinese-goods-1528915167

[3] https://www.reuters.com/article/us-oil-opec-dissent/iran-other-dissenters-complicate-opec-oil-output-boost-sources-idUSKBN1J9252

[4] https://www.washingtonpost.com/world/middle_east/saudi-arabia-led-military-coalition-launches-offensive-on-yemen-port-city-of-hodeida/2018/06/13/eda3cf52-6ef8-11e8-9ab5-d31a80fd1a05_story.html?utm_term=.40942aeb277a&wpisrc=nl_todayworld&wpmm=1

[5]https://www.google.com/maps/place/Al+Hudaydah,+Yemen/@13.8291721,44.2364663,6.5z/data=!4m5!3m4!1s0x16053be363aba37b:0x7aea559347f1b8a2!8m2!3d14.7909118!4d42.9708838

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s Fed Day!  Financial markets are quiet in front of the “festivities.”  Here is what we are watching:

The Fed: We did a deeper dive in yesterday’s comment using the Mankiw models, but there are a few other important items.  First, in the statement, there are three lines that could be adjusted.

• The FOMC has been consistently saying that “the stance of monetary policy remains accommodative.” Although that line probably won’t get removed, it could be modified by the word “somewhat.”  Yesterday’s Mankiw analysis noted that three of the four variations show the FOMC is still accommodative, but the variation using the employment/population ratio is currently neutral.  Adding a term like “somewhat” would suggest the end of policy tightening may be approaching.
• The clause “will warrant further gradual increases in the federal funds rate” will likely remain without change, but if this part of the statement is toned down then it’s a dovish statement.
• The FOMC has also been saying that “the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.” That part could be pulled outright.

We will also be watching Chair Powell’s performance in the press conference closely.  Every meeting will give him the opportunity to put his own stamp on the central bank and we will get a better feel for his policy positions.  Another thing to watch is that he might be open to the possibility of a press conference after every meeting,[1] which would make every meeting “live” or raise the potential for action every six weeks instead of every quarter.  And, it is consistent with American society’s continued belief that transparency is an unalloyed positive feature.

Second, our position is that monetary policy transparency has taken away one of the Fed’s most potent tools, the ability to manage financial stress.

This chart shows the Chicago FRB Financial Conditions Index and fed funds.  The index is a measure of financial stress and is calculated by measuring credit spreads, the level of interest rates, volatility, etc.  The two series were closely correlated from the index’s inception in 1973 to mid-1998.  Financial conditions deteriorated when the Fed raised rates.  This meant that when the U.S. central bank tightened policy, the markets responded with actions that would slow credit growth and raise investor fears, dampening economic activity.  When the FOMC lowered rates, the opposite occurred.  Until the late 1980s, the Fed worked mostly in secret.  It announced changes in the discount rate but the market had to guess if the fed funds target had changed.  As time passed, the Fed became increasingly transparent, actually signaling a change in the fed funds rate, then telling us with a statement when actual changes occurred, moving to statements after every meeting to holding press conferences.  The more they tell us, the more we can predict their actions and the less fear we have of monetary policy.  And, since mid-1998, the Fed has completely lost control of financial stress.  It can no longer induce stress by raising rates nor can it reduce stress quickly by lowering rates.  Note that stress has mostly declined as this tightening cycle has begun.  The really unfortunate development is that when stress rises it can jump almost uncontrollably and nearly “out of nowhere.”  Although we would expect the financial media to cheer if Powell goes to a presser after each meeting, we will view it as a step backward.  Simply put, a little fear created by uncertainty would be a good thing.

Brexit: PM May continues to struggle to manage a middle ground between the “hard” and “soft” Brexit supporters within her party.  Making it particularly difficult is that the “softs” could align with Labour and bring down her government.  The “softs” have forced May into a new deadline for talks, Nov. 30 of this year.  If London and Brussels don’t have a deal in place by then, the House of Commons will decide on a path forward.  It is not inconceivable that Brexit may be so soft as to not matter much (e.g., the U.K. remains in the trade union and abides by the rules of the EU but gives up the right to vote in the EU) or that Brexit doesn’t happen at all.  Even another referendum isn’t out of the question.  A failure to leave would be bullish for the GBP.[2]

Trade: Although the North Korean summit has taken up much of the media bandwidth, there are trade events continuing.  The U.S. has slapped tariffs on Spanish olives.  What makes this rather obscure action important is that this trade action by the U.S. directly attacks the EU’s Common Agriculture Policy (CAP), which is how the EU manages farm policy.  The U.S. is specifically accusing the EU of giving illegal subsidies to Spanish olive growers but, if broadly applied, it would undermine Europe’s agriculture policy.  In addition, the U.S. could put more tariffs on China as soon as Friday.[3]  Trade tensions are an important policy “wildcard” as this year unfolds.

OPEC: The Russians are pushing for an end to production cuts; the Saudis are not so keen on the idea.  It is possible that Moscow’s recent foray into cooperation with OPEC may be about to end which would add a little more than 0.2 mbpd to global oil supplies.  If the Saudis decide to maintain production levels, or only increase modestly, then the threat of lower oil prices would be reduced.  We do note that President Trump tweeted this morning calling for lower oil prices.  As we have noted before, the president has the SPR oil at his disposal and could jawbone prices lower to ease gasoline prices during the summer vacation season.

Antitrust: The Time-Warner (TWX, 96.22)/AT&T (T, 34.35) merger was approved yesterday.  In general, we don’t comment too often on individual equities in this report; the only time we do is if an individual company’s actions or news has a broader effect on the economy or markets as a whole.  What is important about this decision is that it allowed a “vertical” merger.  Mergers are either vertical or horizontal.  Horizontal mergers are when similar firms in the same industry combine.  These approvals tend to turn on whether or not the combined firm becomes so large that it can restrain trade in an industry.  For example, if gasoline stations merge, it might reduce competition and lead to higher gasoline prices for consumers.  Assessing the impact of vertical mergers can be a bit tricky.  Using our previous example, it would be like a refiner buying a chain of gasoline stations.  It is possible that the refiner could manipulate the market to give its own stations an advantage, but that may not be in the best interest of the refiner anyway.  The last time the DOJ contested a vertical merger was in 1977 (U.S. v. Hammermill Paper), where the U.S. lost.  The last successfully blocked vertical merger was in 1972 (U.S. v. Ford Motor Company [F, 12.11]), where Ford was trying to purchase Autolite spark plugs which would have combined the #1 and #2 producer of spark plugs.  Given that this particular case also involved characteristics of a horizontal merger, the government won that case.[4]

We find this important because there is a theory circulating that increased industry concentration has created monopsonies and oligopsonies that are holding down wages.  If there are fewer firms then they could have market power in the labor markets, and increased concentration may be part of the reason wage growth has been sluggish.  Given how badly the government fared in this case, we doubt the DOJ will contest another vertical merger anytime soon.

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[1] https://www.wsj.com/articles/should-the-fed-hold-more-press-conferences-powell-weighs-taking-questions-after-every-meeting-1528823472

[2] https://www.politico.eu/pro/mps-force-major-soft-brexit-shift/?utm_source=POLITICO.EU&utm_campaign=2025a5ce2c-EMAIL_CAMPAIGN_2018_06_12_05_10&utm_medium=email&utm_term=0_10959edeb5-2025a5ce2c-190334489 ; https://www.politico.eu/article/uk-government-avoids-brexit-defeat-with-promise-to-tory-rebels/?utm_source=POLITICO.EU&utm_campaign=70f5c03b97-EMAIL_CAMPAIGN_2018_06_13_04_36&utm_medium=email&utm_term=0_10959edeb5-70f5c03b97-190334489 ; https://www.nytimes.com/2018/06/12/world/europe/brexit-may-uk-parliament.html?emc=edit_mbe_20180613&nl=morning-briefing-europe&nlid=567726720180613&te=1 ; and https://www.ft.com/content/00c5a1f0-6e2c-11e8-92d3-6c13e5c92914?emailId=5b20988d52c414000437d602&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[3] https://www.politico.com/story/2018/06/12/trump-china-tariffs-trade-622935

[4]https://about.att.com/content/dam/sitesdocs/AT%26T_TimeWarner/FINAL%20DOJ%20Merger%20Precedent%20One%20Pager%2011.19%203pmET.PDF

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Although the news is historic, the market reaction is very quiet.  Most likely, the financial markets are much more interested in what the FOMC does rather than the meetings in Singapore.  Here is what we are watching:

Singapore: To some extent, the odds favored a meeting with more show than substance.  That is pretty much what emerged.  The major media is probably underestimating the mere fact that Trump and Kim even met is pretty amazing.  It wasn’t too long ago that it looked like a hot war between the U.S. and North Korea was possible.  We suspect this meeting will open up the potential for improving relations, which is important.  The most substantial impact is that the president has suspended military exercises with South Korea.  It appears that neither the Pentagon nor South Korea was informed beforehand.  Although this is an important concession, it should be noted that the U.S. can always resume participation.  China has been pushing for a “freeze for freeze” scenario (U.S. stops exercises, DPRK gives up nuclear and missile tests), so Beijing should like this outcome.  The rest of the promises were mostly aspirational.[1]  U.S. sanctions will remain in place but the key to these measures is Chinese cooperation and it looks like China is planning to ease enforcement.[2]  We should know more in the next few days, but our initial conclusion is that North Korea did well and China got some of what it wanted, although Beijing still fears the U.S. could pull Pyongyang out of its orbit.  The two most worried leaders have to be Abe and Moon of Japan and South Korea, respectively.  The fact that the U.S. would suspend military exercises without telling either leader shows that the two countries have little influence on the path of future negotiations.  This is especially true for Tokyo.

Overall, this meeting is a promising start.  However, real denuclearization with inspections is still a long way away.  At the same time, our take is that North Korea is steadily moving toward a market economy[3] in a fashion similar to China’s growth path.  That means that North Korea will need a nation to absorb its eventual exports.  The nation willing to run a trade deficit with North Korea probably ends up being the one with the greatest influence.

Kudlow: Larry Kudlow suffered what appears to be a mild heart attack yesterday evening.  Although it looks like he will survive, reports suggest the pace of work at the White House may have contributed to this event.[4]  If Kudlow decides he can’t work for the president for health reasons, the economic advisors surrounding the president will lose a voice for establishment economics.  At the same time, it isn’t obvious to us that any of these advisors matter all that much.

Fed policy: The FOMC begins its two-day meeting today.  Fed funds futures put the odds of a 25 bps rate hike at a virtual certainty, with a 65% chance of another hike at the September 26^th meeting.  As usual, the statement, due tomorrow, will be parsed for clues about future policy.  We will expect the term “gradual” to remain in the statement but there is the potential that the phrase “below long-run levels” has probably outlived its usefulness.  That phrase was part of the FOMC’s forward guidance used to convince investors they could safely take leverage risks because the Fed wasn’t likely to quickly take away stimulus.  Rates are now reaching a point where that statement isn’t necessarily accurate.

With the release of the CPI data we can update the Mankiw models.  The Mankiw Rule models attempt to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative.  Mankiw’s model is a variation of the Taylor Rule.  The latter measures the neutral rate using core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy.  Potential GDP cannot be directly observed, only estimated.  To overcome this problem with potential GDP, Mankiw used the unemployment rate as a proxy for economic slack.  We have created four versions of the rule, one that follows the original construction by using the unemployment rate as a measure of slack, a second that uses the employment/population ratio, a third using involuntary part-time workers as a percentage of the total labor force and a fourth using yearly wage growth for non-supervisory workers.

Using the unemployment rate, the neutral rate is now 4.14%, up from 3.89%.  Using the employment/population ratio, the neutral rate is 1.81%, up from 1.59%.  Using involuntary part-time employment, the neutral rate is 3.50%, up from 3.27%.  Using wage growth for non-supervisory workers, the neutral rate is 2.48%, up from 2.10%.

Until May’s data, we have generally expected a benign tightening cycle.  The new data is much more problematic for those expectations.  In all the iterations, the rise in core CPI did lift the fair value.  However, the improving employment/population ratio and rising wages are pushing the fair value higher for the most dovish formulations of the model.  In other words, the only variation that is policy neutral is the one using the employment/population ratio; all other variations show that policy is too easy and will be so even if rates increase as expected.  We suspect the FOMC is much more sensitive to the wage variation so even the doves will likely grow talons.  The risk that policy tightening begins to affect financial markets is rising.  If the Fed follows the normal script, expect a more hawkish statement.  If the FOMC surprises by talking like it is near neutral, look for an equity rally and a dollar slump.  We think odds favor the first scenario but it is possible that Chair Powell is, at heart, a dove.  We could get a clue as to the “real Powell” tomorrow.

Summer of pork: As the trade war picks up, nations are targeting U.S. pork exports for retaliation.[5]  Mexico and China, the two largest export customers, have increased tariffs in recent weeks.  This should lift domestic supplies, lowering prices.  Of course, the market isn’t perfect and grocers will tend to try to increase margins, at least initially.  However, the bigger discounters will probably push these decreases along fairly soon.

Just how bad is it?Venezuela reported its first case of polio[6] after officially eradicating the disease three decades ago.  This is additional evidence of how conditions have deteriorated in Venezuela due to the economic mismanagement of Hugo Chavez and Nicolas Maduro.

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[1] https://www.politico.com/story/2018/06/12/full-text-trump-kim-korea-summit-637541

[2] https://www.reuters.com/article/us-northkorea-usa-china/china-suggests-sanctions-relief-for-north-korea-after-u-s-summit-idUSKBN1J80F5?il=0

[3] https://www.washingtonpost.com/news/worldviews/wp/2017/12/15/the-jangmadang-generation-new-film-shows-how-millennials-are-changing-north-korea/?utm_term=.91175f37ba8b&wpisrc=nl_todayworld&wpmm=1

[4] https://www.politico.com/story/2018/06/11/kudlow-suffers-heart-attack-trump-tweets-637534

[5] https://www.ft.com/content/d14decea-6b5e-11e8-b6eb-4acfcfb08c11

[6] https://edition.cnn.com/2018/06/11/health/venezuela-polio-who/index.html