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

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Monday!  It’s going to be a busy week.  The Federal Reserve meets this week.  The president is having his historic meeting with Kim Jong-un.  On Friday, we are expecting details on the steel and aluminum tariffs.  Here is what’s happening today:

Kim and Trump in Singapore: Early comments from SOS Pompeo were very positive.  We don’t expect a substantive deal to emerge from this first meeting but we would look for this summit to kick off a series of negotiations.  As we have noted before, the U.S. is moving down a path to reduce America’s global obligations (see G-7 to follow), so if President Trump can ensure the U.S. won’t be attacked in return for easing sanctions then a deal is likely.  Both Japan[1] and China[2] are concerned they are going to be left on their own.  The Koreas have a longstanding desire to become independent from all outside powers.  Kim is likely using the summit to increase his power at home.[3]  The outside powers would prefer to have some degree of influence, if not domination, over the peninsula.  So, there are lots of conflicting narratives among North Korea, the U.S. and surrounding powers.  Our expectation is that the talks will be friendly, there will be more talks to come and the region will become increasingly nervous.

The G-7: As we expected, the meeting was difficult.[4]  Although initially agreeing to it, President Trump decided not to sign the communiqué following Canadian President Trudeau’s criticism of the American president.  Ultimately, as we noted last week, the U.S. has been moving to change the way it exercises hegemony, perhaps on the way to giving it up all together.  The other six nations in the G-7 have become accustomed to how the U.S. has managed the world since WWII and would prefer to maintain the status quo.

The chart below shows how the Eurozone and Germany have become net current account surplus areas, essentially absorbing demand from abroad (read: U.S.).  Prior to the creation of the Eurozone, Germany was less able to expand its currency account surplus because the D-mark would appreciate, reducing its export competitiveness.  The creation of the Eurozone effectively reduced the exchange rate (the broader currency appreciated less than the D-mark would have done on its own), making Germany an export powerhouse.  As the chart shows, Germany’s current account surplus to GDP is nearly 7%; even more insidious, German-inspired fiscal and monetary rules have forced the Eurozone to adopt German policies, making the entire Eurozone Germany writ large.

The world looks similar.

The blue line on the chart shows the Dallas FRB world trade indices (world less U.S.) along with U.S. household (and non-profits) debt to GDP ratio.  Note that to foster global trade growth, the U.S. economy was forced to take on larger levels of debt.  This is because the reserve currency role requires the U.S. to act as global importer of last resort.

Simply put, the role of providing the reserve currency has distorted the U.S. economy.  Although we have serious reservations with President Trump’s continued focus on tariffs as a way of addressing the distortion, the distortion is real and it is partly to blame for American inequality and loss of jobs.

Bloomberg’s Tom Keene recently conducted an interesting interview with Robert Kaplan on the topic of American hegemony.  Kaplan, a prolific writer on foreign affairs, holds views similar to Samuel Huntington.  In the aforementioned podcast,[5] Kaplan argues that the period of the last 70 years has been an anomaly.  The duopoly of power exhibited by the U.S. and U.S.S.R. was unusual in world history and a more regional, contentious “great game” world is more consistent with world history.  We tend to agree.

The Shanghai Cooperation Organization (SCO) meeting: While the G-7 was imploding, the SCO[6] was having an uneventful gathering in Qingdao.  This group includes China, Russia, the “Stans,” India and Pakistan, with numerous observer states, including Iran.  The group agreed to support the WTO and the Iran nuclear deal.  In the long run, we would not expect this group to hold together.  Our view is that China is using the SCO to promote its domination of the Eurasian landmass, a move that will be strongly opposed by both India and Russia.  Of course, Russia will probably be unable to resist China’s encroachment due to its abysmal demographics, but India will be a much more formidable impediment to China’s aims.  Still, the parallels between the G-7 and the SCO paint the world democracies in an unfavorable light.

Iraq election turmoil: A fire destroyed a warehouse containing ballots from recent elections.[7]  The ballots were being held to facilitate a full manual recount in an election plagued by voter fraud allegations.[8]  It is unclear how the Iraqi government will handle this development.  A new vote is possible, although Moqtada al-Sadr, the highest vote winner, will surely protest another election.  We note that oil prices are lower this morning due to reports of rising Russian output; however, the oil markets do have to take rising geopolitical risk into account and this news from Iraq is simply more evidence of stress.

Bitcoin tumbles: Reports that a South Korean cryptocurrency exchange was hacked[9] pushed bitcoin lower overnight.  As the chart below shows, bitcoin remains well off its highs.  The hacking news can be seen at the far right-hand of the chart.

Turkish elections:Turkey will hold elections on June 24.  Although polls show that President Erdogan holds a 13-point lead over his closest challenger, election rules require a majority.  If the polls are correct, a run-off will be necessary.  This is a critical election because the winner will inherit a new centralized presidency, giving the new president unprecedented powers.  Meanwhile, the opposition appears unusually united in the goal of denying Erdogan power.[10]  Although we expect Erdogan to eventually prevail, it isn’t a certainty.  If Erdogan loses, we could see a “knee-jerk” rally in the lira and Turkish equities.

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[1] https://www.npr.org/2018/06/07/617146338/trump-meets-with-japanese-prime-minister-ahead-of-north-korea-summit

[2] https://www.nytimes.com/2018/06/10/world/asia/trump-kim-korea-china.html

[3] https://www.washingtonpost.com/world/asia_pacific/for-kim-jong-un-meeting-trump-is-about-cementing-power-at-home/2018/06/08/5fef0720-6832-11e8-a335-c4503d041eaf_story.html?utm_term=.91b8b9aebf15&wpisrc=nl_todayworld&wpmm=1

[4] https://www.ft.com/content/89eecb5c-6c9f-11e8-852d-d8b934ff5ffa?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56 and https://www.ft.com/content/8e9d3a30-6ca9-11e8-852d-d8b934ff5ffa?wpisrc=nl_todayworld&wpmm=1

[5] https://www.pastimeapp.com/pod/Bloomberg-Surveillance

[6] https://www.ft.com/content/5d5e4244-6c85-11e8-92d3-6c13e5c92914?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[7] https://www.washingtonpost.com/world/middle_east/fire-engulfs-warehouse-storing-iraq-election-ballots-in-latest-setback-for-troubled-vote/2018/06/10/9fcae9b8-6cbf-11e8-9ab5-d31a80fd1a05_story.html?utm_term=.58e0308e8376&wpisrc=nl_todayworld&wpmm=1

[8] https://www.washingtonpost.com/world/during-wait-for-iraqi-election-results-foreign-states-scramble-for-influence/2018/05/17/a1d111d0-59da-11e8-9889-07bcc1327f4b_story.html?utm_term=.e1c1fa39c09a

[9] http://money.cnn.com/2018/06/11/investing/coinrail-hack-bitcoin-exchange/index.html

[10] https://www.nytimes.com/2018/06/09/world/asia/turkey-election-erdogan.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Friday!  Equities dipped overnight but are recovering a bit as we head toward the opening bell.  There is a lot of news.  Let’s dig in:

G-7?  Acrimony rules in front of the G-7 meeting.  President Trump told reporters, “Russia should be allowed back in,” just at the moment when the group may be on the brink of irrelevance.  To be completely fair, this group, which dominated the Free World during the Cold War, has become increasingly superfluous.  It doesn’t include China and is dominated by Europe.  This weekend’s meeting in Quebec may be important because historians could mark it as the official beginning of the end of U.S. hegemony, at least the version practiced after WWII.  Ian Bremmer, the founder of the Eurasian Group, has argued for some time that we are heading toward a “G-0” world.[1]  We have agreed with this assessment over the long term but that long-term outlook may now be upon us in this moment.

The world wants the U.S. to provide free security and remain the global importer of last resort.  In our opinion, the political turmoil seen in America since 2008 has been driven by the fact that the policies we need to take on as a hegemon to provide the global public goods are in conflict with domestic needs.  President Obama had started down this path (“leading from behind”) and President Trump is accelerating this process.  I heard a commentator on the radio suggest that we were creating a power vacuum that “China will be willing to fill.”  Only if…a much more likely outcome is that no nation will step up to fulfill the hegemonic role and the world will devolve into regional blocs that conflict with each other and have wars within some of the blocs.

We look for a very difficult meeting,[2] with the non-U.S. members of the G-7 lashing out at the U.S. in a fashion similar to teenagers when the parents take away the smartphone.  The other members of the G-7 have taken the global public goods provided by the U.S. as the natural order.  That order is coming to an end.

Brexit: PM May has been trying to negotiate the U.K.’s exit from the EU in such a way that it placates the “hard” Brexit supporters who want a complete break and also maintains enough ties so that the economy doesn’t stall from the loss of trade.[3]  One of the critical pieces is how to avoid a hard border returning to the Ireland/Northern Ireland frontier.  May is trying to fashion a short-term arrangement where the customs union will exist on the frontier that will effectively become never-ending.  David Davis, who is in charge of Brexit, will have nothing of it; he wants a drop-dead date when the customs union ends.[4]  At the other end of the negotiations is the EU’s chief negotiator, Michel Barnier, who indicated today that any arrangement to avoid a hard border on the Irish Isles can’t be used to put the entire U.K. in the customs union.[5]  His position does put May’s plan in serious jeopardy.  The GBP slipped on his comments.

Politically, this situation is dicey.  May only holds the PM role because she has a few MPs from the DUP, a small Northern Ireland Unionist party.  If the hard Brexit supporters push too hard and trigger a no-confidence vote, they might lose power.  Jeremy Corybn, the leader of Labour, has already indicated he supports a “soft Brexit” that would put the U.K. in the EU’s customs union.  Current polls show the Tories are still more popular than Labour but would not carry a majority, meaning that Labour could put together a working coalition.  A Corybn-led U.K. would put a scare into the financial markets; he is an unreconstructed socialist that would aim to return Britain to a post-WWII world where major industries were nationalized.

Turmoil in emerging markets (EM):Brazil is facing political turmoil and widespread transportation strikes.  Turkey is raising rates rapidly to fend off a currency crisis.  Argentina is struggling, although it did secure IMF funding.[6]  Central bankers in India and Indonesia are warning the Federal Reserve that U.S. policy tightening is creating problems for their economies.  In our opinion, the key issue is the dollar.  Dollar strength is weighing on EM sentiment; in general, the relative performance of EM comes from currencies.  Weak dollar periods favor EM.  It appears the driving force behind recent dollar strength is policy divergence.  The Fed is raising rates while the rest of the developed world is not, leading to dollar strength.  However, another worry is that Trump’s developing trade policy will lead to dollar scarcity.  We will be watching the FOMC statement at the June 12-13 meeting for any hints that the FOMC may pause.  We are getting to a point in the tightening cycle when doves will become nervous.  Once there is sign of a potential pause, we will know better if the dollar is being driven by monetary or trade policy. 

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[1] https://www.foreignaffairs.com/articles/2011-01-31/g-zero-world ; https://www.breakingviews.com/considered-view/g7-risks-becoming-g-zero-without-consensus/?SID=57436e5d498ecfca83d095fe&content_alert_status=Ready&utm_source=Sailthru&utm_medium=email&utm_campaign=G7%20summit%2C%20U.S.%20water%20M%26A%20Thu%2C%2007%20Jun%202018%2019:33%20bkellerman&utm_term=BV%20-%20Asia%2C%20EMEA%20and%20US%20Daily ; https://www.nytimes.com/2018/06/07/opinion/g7-europe-trump-macron-leadership.html?rref=collection%2Fsectioncollection%2Fopinion&action=click&contentCollection=opinion&region=rank&module=package&version=highlights&contentPlacement=5&pgtype=sectionfront&wpmm=1&wpisrc=nl_todayworld

[2] https://www.politico.com/story/2018/06/07/trump-g7-trudeau-macron-632988 and https://www.washingtonpost.com/business/economy/trump-plans-confrontational-approach-with-world-leaders-at-economic-summit/2018/06/06/78291868-68ea-11e8-9e38-24e693b38637_story.html?noredirect=on&utm_term=.fe11ffedfd46&wpisrc=nl_todayworld&wpmm=1

[3] https://www.politico.eu/article/brexit-northern-ireland-theresa-may-staggers-over-the-line-with-plan/?utm_source=POLITICO.EU&utm_campaign=72f5b6ae65-EMAIL_CAMPAIGN_2018_06_08_04_39&utm_medium=email&utm_term=0_10959edeb5-72f5b6ae65-190334489 and https://www.ft.com/content/5ace73e8-6a58-11e8-b6eb-4acfcfb08c11?emailId=5b1a0c86f9a0850004934bef&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[4] https://www.ft.com/content/38f6a1e6-6a67-11e8-8cf3-0c230fa67aec?emailId=5b1a0c86f9a0850004934bef&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[5] https://www.reuters.com/article/us-britain-eu-barnier/irish-border-backstop-fix-cannot-be-for-whole-of-uk-eus-barnier-idUSKCN1J41S2

[6] https://www.ft.com/content/cf13acba-6aa2-11e8-b6eb-4acfcfb08c11?emailId=5b1a0c86f9a0850004934bef&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22 and https://www.ft.com/content/98b6f6fc-6ab3-11e8-8cf3-0c230fa67aec?emailId=5b1a0c86f9a0850004934bef&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Financial markets are in the midst of a quiet rally as the S&P challenges the high end of the recent range.  Oil is up and the dollar is down.  Here is what we are following this morning:

BREAKING: The Trump administration and ZTE (0763 HKD, 25.60) have reached an agreement.[1]  We expect details to emerge in the coming hours but the agreement will help in ongoing trade negotiations with China.

G-7: President Trump will be facing a hostile group this weekend[2]; in fact, reports indicate he may prefer not to go.[3]  The president has already had difficult conversations with Canada’s PM Trudeau.[4]  The real issue on trade is that the U.S. is changing its trade policy with the world.  America’s Cold War trade policy was designed to bolster Free World economic recovery and growth and, to do so, the U.S. had open markets that provided a steady source of demand for foreign nations.  The dollar was the reserve currency and nations were able to acquire dollars for trade purposes.  In return, the Free World followed U.S. lead on security policy.  Access to the U.S. consumer was the incentive that allowed the U.S. to ensure compliance with policies designed for the containment of communism.

After the Cold War ended, the policies continued.  The benefits to the U.S. economy were a plethora of low cost goods that help contain inflation and, consequently, low interest rates.  The costs are job loss and higher inequality.  The American public is making it clear it no longer believes the benefits outweigh the costs.  Consequently, the Trump administration is breaking the Cold War-era arrangement; what the end point looks like, however, is unclear.

One likely outcome is that the U.S. will find it more difficult to control allies.  If they are no longer able to freely export to the U.S. and are forced to restructure their economies (and are required to pay more for their own defense) then they will likely also want to go their own direction on foreign and security policy.  Globalization requires a hegemon that provides a reserve currency and suffers persistent trade deficits.  If the U.S. decides it is no longer willing to provide these global public goods then the outcome is regional wars, less trade, higher inflation but more employment (at least in the U.S.—that may not necessarily be the case abroad).  What is making the rest of the world upset is that the U.S. is unilaterally changing the structure of the global economy[5]; although world leaders aren’t happy, there isn’t much they can do about it but adapt.

EU wants exemptions on Iran: As we noted yesterday, the EU is asking the administration for exemptions on Iran sanctions.[6]  We doubt that will happen.  The Trump administration is signaling it wants to tighten controls on Iran to renegotiate a new nuclear deal that would include reducing Iran’s influence in the region.  We would not bank on the EU getting any relief on this issue.

Fed news: Richard Clarida and Michelle Bowman will have their confirmation votes on Tuesday next week.  We would be shocked if they don’t breeze through and become the newest members of the FOMC.  In comments to questions, Clarida hinted that he believes there is still slack in the economy which would argue he could lean dovish.[7]  Bowman will fill the community banker slot of the FOMC that traditionally votes with the chair on policy.

We note that the real policy rate is about to turn positive.

In fact, at the next hike, the real rate will likely move above zero for the first time since April 2008.  As we cross this point,[8] expect divisions on the FOMC to develop as the more dovish members will argue that pauses in the rate hike cycle will be justified as stimulus is being withdrawn.  Any hint of a slowdown in hikes will likely be bullish for equities and bearish for the dollar.

China foreign reserves: China’s foreign reserves fell modestly last month, dropping $14 bn from April.  Reserves remain ample.

Energy recap: U.S. crude oil inventories rose 2.1 mb compared to market expectations of a 3.0 mb draw.

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

As the seasonal chart below shows, inventories are usually starting their seasonal decline this time of year.  This week’s rise is inconsistent with that pattern.  In fact, if we had followed the normal seasonal pattern since early May, inventories should be down to 455.9 mb; we are currently about 12 mb higher than the seasonal pattern would suggest.  It is possible that the old pattern shown below was due in part to the legal restrictions on oil exports.  When refiners cut runs for seasonal maintenance oil inventories would rise because the oil had nowhere to go, and oil inventories fell once refiners returned to full production.  With exports, when refiners go into maintenance the excess oil would be exported.  Exports fall when refiners come back from maintenance, keeping inventories stable.

It’s still a bit early in the process to see if this is occurring.  It didn’t happen last year.  But this year, we did see exports rise in April and early May.  Another factor is the continued increase in U.S. production.  U.S. production reached 10.8 mbpd last week, up nearly 1.3 mbpd since the beginning of the year.  And so, even with rising refining activity and elevated exports, inventories can’t fall because output is too strong.

Based on inventories alone, oil prices are overvalued with the fair value price of $62.24.  Meanwhile, the EUR/WTI model generates a fair value of $61.39.  Together (which is a more sound methodology), fair value is $61.20, meaning that current prices are above fair value even with the recent pullback.  Although we have seen prices decline in recent weeks, we are still above fair value because of rising geopolitical risk.  Oil prices will likely remain under pressure until the dollar weakens or inventories decline.

OPEC meets on June 22.  There are growing concerns that the meeting could be acrimonious[9] as Russia and Saudi Arabia are leaning toward increasing production while other members would prefer higher prices.  Since most other members lack excess capacity, falling prices are a net loss to them whereas Russia and Saudi Arabia can at least offset the lower prices with higher output.  Although there is talk of a 1.0 mbpd increase in output, we would look for a compromise that leads to a smaller increase in quotas.  If we are correct, prices would likely rise.

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[1] https://www.axios.com/wilbur-ross-us-deal-china-zte-trump-trade-war-0872509e-6f55-4e90-bf8b-b57c8d27cb55.html?stream=politics&utm_source=alert&utm_medium=email&utm_campaign=alerts_politics

[2] https://www.politico.eu/pro/trump-tariffs-g7-summit-stir-up-angst-ahead/?utm_source=POLITICO.EU&utm_campaign=4ad502b82d-EMAIL_CAMPAIGN_2018_06_06_03_38&utm_medium=email&utm_term=0_10959edeb5-4ad502b82d-190334489 and https://www.washingtonpost.com/business/economy/trump-plans-confrontational-approach-with-world-leaders-at-economic-summit/2018/06/06/78291868-68ea-11e8-9e38-24e693b38637_story.html?utm_term=.32720a78d4aa&wpisrc=nl_todayworld&wpmm=1

[3] https://www.washingtonpost.com/politics/trump-complains-about-traveling-to-canada-ahead-of-singapore-summit-with-kim/2018/06/06/651d8dd8-69be-11e8-9e38-24e693b38637_story.html?utm_term=.2c93925b7b8f

[4] https://www.cnn.com/2018/06/06/politics/war-of-1812-donald-trump-justin-trudeau-tariff/index.html

[5] https://subscriber.politicopro.com/trade/whiteboard/2018/06/kudlow-suggests-us-could-ignore-wto-decisions-1360700

[6]https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/714262/Joint_E3_letter_on_JCPoA.pdf

[7] https://subscriber.politicopro.com/f/?id=00000163-d825-d101-a167-ff27017d0000

[8] https://www.reuters.com/article/us-usa-fed-rates-analysis/fed-clambers-back-to-positive-real-rates-now-debate-is-when-to-stop-idUSKCN1J30DE

[9] https://www.cnbc.com/2018/06/07/opec-meeting-on-june-22-likely-to-see-disagreements.html