by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

Happy National Drive-In Movie Day!  And kudos to our favorite outdoor movie theater, the Skyway Drive-In in Fish Creek, WI.[1]  Here is what we are watching this morning:

ECB tightening?  Peter Praet, the ECB’s chief economist, indicated today that policymakers would be taking a hard look at the central bank’s balance sheet, with the intent of beginning the end of additional central bank bond buying.[2]  German Bund yields jumped over 5 bps and Italian bonds rose nearly 15 bps on the news.  The EUR lifted on the news as well.  Praet delivered an upbeat economic message that was seconded by Bundesbank President Jens Weidmann.  This looks to us like the hawks are beginning to circle.  We would not be surprised to see the ECB lay out the end of balance sheet expansion later this year.

Iran: Although European leaders are trying to keep the Iran deal together, the threat of U.S. sanctions appears to be thwarting their plans.[3]  The European Investment Bank (EIB), which raises much of its funding in the U.S., is indicating it won’t cooperate with EU sanctions avoidance.[4]  The EIB is a lender that funds projects that foster European unity; many of its loans go to fund public transportation in the EU.  The EIB fears that the bank’s funding in the U.S. will dry up if it cooperates with the EU on busting Iranian sanctions.  Meanwhile, Iran is taking steps to resume uranium enrichment that are undermining the agreement as well.[5]  Israeli PM Netanyahu is touring Europe this week, pressing various European nations to follow the U.S. lead and jettison the nuclear deal.[6]  However, the “hammer” of any sanctions regime is the S.W.I.F.T. network, which is the backbone of interbank communications.[7]  The leadership of this organization, set in Brussels, fears that the continued weaponization of the network will lead rogue nations to create their own communication network, perhaps adopting a blockchain to avoid S.W.I.F.T.

Venezuela threatening force majeure: Due to falling oil production and logistical problems, Venezuela may be unable to meet its contractual agreements for oil sales.[8]  Oil prices have not risen despite this news as traders are more concerned about rising OPEC production rather than offsetting the loss of Venezuelan and potentially Iranian crude oil.

No NAFTA—two deals?  Larry Kudlow, the White House National Economic Council director, suggested yesterday that the U.S. may prefer to negotiate separate trade deals with Canada and Mexico.[9]  It appears less likely that a deal will occur before Mexican elections in early July; if current polls are accurate, AMLO, a populist, will become the next Mexican president.  He has been running on an anti-Trump platform and it is unlikely a NAFTA deal would be possible if he wins.  Thus, the idea of bilateral agreements might be the only feasible solution.  We note that Mexico has retaliated rather strongly to American steel and aluminum tariffs.[10]

Facebook again?  Facebook (FB, 192.94) continues to face a steady drip of difficult revelations.  The latest is that the company gave data access to several Chinese electronic companies, including Huawei (002502, CNY 5.82), a company suspected by U.S. intelligence agencies of inappropriate activity.[11]  This latest revelation is part of a broad public relations problem for the company.  Given the prominence of the so-called “FAANG” stocks, there is concern that the company’s problems could prompt a regulatory backlash and affect the broader equity market.

Bank of India: Yesterday, we reported that the Bank of India asked the Fed to slow its policy tightening after emerging markets have seen growing pressure.[12]  Today, the bank surprised the financial markets by raising interest rates for the first time since 2014.[13]  The Reserve Bank of India is just the latest policy tightening seen in the emerging markets, following Indonesia, Argentina and Turkey in raising rates.  These actions are due, in part, to tighter U.S. monetary policy.

A historic chart: Yesterday, the JOLTS report shows that there were more job openings in April than unemployed people.  This is the first time in the history of the JOLTS series (which began in 2000) that labor markets have been this tight.

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[1] https://www.doorcounty.com/business-directory/skyway-drive-in-theatre/

[2] https://www.ft.com/content/efbc13de-6954-11e8-8cf3-0c230fa67aec and https://uk.reuters.com/article/uk-ecb-policy-weidmann/plausible-that-ecb-can-end-bond-buys-this-year-weidmann-idUKKCN1J20RJ

[3] https://www.wsj.com/articles/european-officials-say-u-s-threat-of-sanctions-imperils-bid-to-save-iran-deal-1528257661

[4] https://www.reuters.com/article/us-iran-nuclear-europe-exclusive/exclusive-under-u-s-pressure-eib-balks-at-eu-plan-to-work-in-iran-idUSKCN1J11J3?utm_source=POLITICO.EU&utm_campaign=3bdb9433ee-EMAIL_CAMPAIGN_2018_06_05_04_10&utm_medium=email&utm_term=0_10959edeb5-3bdb9433ee-190334489

[5] https://uk.reuters.com/article/uk-iran-nuclear-france/irans-uranium-enrichment-plans-are-close-to-the-red-line-french-minister-idUKKCN1J20N3

[6] https://www.reuters.com/article/us-iran-nuclear-israel/seeking-french-support-netanyahu-raises-alarm-over-iran-enrichment-plan-idUSKCN1J11ER?wpisrc=nl_todayworld&wpmm=1

[7] https://www.ft.com/content/9f082a96-63f4-11e8-90c2-9563a0613e56?emailId=5b172fb8d20590000442f99c&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[8] https://www.reuters.com/article/us-venezuela-pdvsa-contract/venezuelas-pdvsa-raises-prospect-of-force-majeure-on-oil-exports-sources-idUSKCN1J132Q

[9] https://www.politico.com/story/2018/06/05/trump-nafta-2-deals-624244

[10] https://www.politico.eu/pro/mexico-slaps-retaliatory-tariffs-on-dozens-of-us-products/?utm_source=POLITICO.EU&utm_campaign=9b51019c2d-EMAIL_CAMPAIGN_2018_06_05_05_35&utm_medium=email&utm_term=0_10959edeb5-9b51019c2d-190334489

[11] https://www.nytimes.com/2018/06/05/technology/facebook-device-partnerships-china.html?action=click&module=Top%20Stories&pgtype=Homepage&utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[12] https://www.ft.com/content/a572d6fa-680f-11e8-8cf3-0c230fa67aec?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[13] https://www.ft.com/content/c08a9aa8-6969-11e8-b6eb-4acfcfb08c11

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Good morning—Happy National Moonshine Day![1]  Here is what we are watching this morning:

Oil and OPEC: The Trump administration has quietly asked OPEC[2] to boost oil output by 1.0 mbpd in a bid to lower oil prices and, as a result, gasoline prices.  Undoubtedly we will hear how this move is “unprecedented” from some of the media but it isn’t all that unusual.  Oil prices are a very important variable to the economy and administrations have often guided prices.  During the 1986 oil collapse, Vice President Bush nudged the Saudis into cutting output to lift prices to save the U.S. oil industry.[3]  Other presidents have boosted or reduced oil prices by adding or subtracting inventory out of the Strategic Petroleum Reserve.

The above chart shows how many gallons of gasoline a non-supervisory worker can buy for an hour’s worth of work.  Currently, it is 7.6 gallons, which is a bit below the average of 8.5 gallons.  Although not at an extreme, the direction is worrisome and thus the administration’s move to bring down oil prices, and thus gasoline prices, makes sense.

We expect Russia to support the increased output, whereas Saudi Arabia will be more inclined to make a symbolic increase of 300 kbpd.  Russia will probably win out.  In any case, our analysis has been indicating that prices were running a bit above fair value, based on inventories and the dollar.  Still, these cuts may do nothing more than arrest prices around the $60 per barrel level.  Venezuelan[4] output will continue to fall and we also look for lower Iranian production.  There is also the potential for output disruptions in Iraq due to political uncertainty there after recent elections.  We have probably been seeing weaker oil prices on fears that OPEC would try to make up some of the lost output.  Now that the news is out, we would not be surprised to see prices stabilize.

Iran and uranium: Although Iran has been careful not to take actions that would directly break the nuclear agreement, the country is signaling it will take actions that will be seen as hostile.  Ayatollah Khamenei indicated today that his nation is prepared to increase uranium enrichment if the deal is ended.[5]  The head of Iran’s Atomic Energy Organization, Ali Akbar Salehi, indicated today that Iran will begin building advanced centrifuges in light of recent developments.[6]  Rising tensions with Iran are a bullish factor for oil prices.

Italy: The new government is now in place.[7]  The EU is waiting to see how Euroskeptic the new government will be in practice.  There is evidence that the EU is quietly punishing Italy for its behavior; the ECB has reduced its purchases of Italian bonds, although the ECB has disputed the idea that there is any ulterior motive.  Instead, the ECB says the change in buying is technical in nature.[8]

Unwinding of the postwar order: A persistent theme in our geopolitical research has been the case that the U.S. is souring on the costs of the hegemonic role and wants to reduce its global involvement.  A tempest of comments have emerged overnight after the U.S. ambassador to Germany, Richard Grenell, made comments supporting right-wing nationalist movements in the EU.[9]  Although Grenell denied the intention to directly support parties in Europe, the U.S. has a long history of trying to shape European politics.  One of the goals of the Marshall Plan was to undermine communist parties in Europe after WWII.  However, the trend in place appears rather clear.  The U.S. has been pulling back from its hegemonic obligations since the Obama administration because the American people have concluded the costs exceed the benefits.  We disagree with this idea, but 73 years without a mass mobilization war will tend to skew the cost/benefit calculation for Americans.

That doesn’t necessarily mean the U.S. goes full isolationist.[10]  Instead, the U.S. is trying to change the rules of conduct, which means forcing allies in frozen conflict zones (Europe, Middle East, Far East) to play a more active (and costly) role in their own defense and no longer easily supplying dollars to global markets through U.S. unemployment.  However, managing this change is hard because (a) if nations in the conflict zones pay for their own defense, they will also very easily want a much greater say in how security is executed (which may not be in U.S. interests), and (b) without U.S. open trade policy, globalization has probably peaked.  It should be noted that the right-wing establishment is funding a “counter-reformation” to these trade changes.[11]  However, we suspect they are on the wrong side of the trend.

Bank of India—HELP!The Bank of India has asked the Fed to slow its policy tightening after emerging markets have seen growing pressure.[12]  Although we understand the bank’s concern, history shows that the Fed doesn’t pay too much attention to foreign economies until a crisis develops of sufficient magnitude that it affects the U.S. economy in a significant way.  We do note the National Association of Business Economists is warning that the likelihood of recession will be elevated in 2020, mostly due to the negative impact of trade.[13]

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[1] https://www.economist.com/the-economist-explains/2018/06/05/why-america-still-has-dry-counties

[2] https://www.bloomberg.com/news/articles/2018-06-05/u-s-said-to-ask-opec-for-1-million-barrel-a-day-oil-output-hike

[3] Yergin, D. (1991). The Prize: The Epic Quest for Oil, Money and Power. New York, New York: Simon & Schuster. (pp. 756-758.)

[4] https://www.washingtonpost.com/world/national-security/pompeo-urges-kicking-venezuela-from-oas-and-more-sanctions/2018/06/04/32fbba1e-6806-11e8-bea7-c8eb28bc52b1_story.html?utm_term=.9918b3513f82&wpisrc=nl_todayworld&wpmm=1

[5] https://www.reuters.com/article/us-usa-election-opioids/voters-in-opioid-plagued-districts-demand-solutions-from-candidates-idUSKCN1J11BE?il=0&wpisrc=nl_todayworld&wpmm=1

[6] https://www.reuters.com/article/us-iran-nuclear/iran-to-start-building-advanced-centrifuges-salehi-idUSKCN1J113Q

[7] https://www.ft.com/content/01cae2cc-68b4-11e8-b6eb-4acfcfb08c11

[8] https://www.ft.com/content/8a688786-67f8-11e8-8cf3-0c230fa67aec?utm_source=POLITICO.EU&utm_campaign=9a915e1a62-EMAIL_CAMPAIGN_2018_06_04_04_11&utm_medium=email&utm_term=0_10959edeb5-9a915e1a62-190334489

[9] https://www.ft.com/content/60bfc106-67df-11e8-8cf3-0c230fa67aec?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56 and https://www.washingtonpost.com/news/world/wp/2018/06/04/trumps-envoy-to-germany-wants-to-empower-conservatives-but-he-doesnt-appear-to-mean-merkel/?utm_term=.f6a0a5af4e95&wpisrc=nl_todayworld&wpmm=1

[10] https://www.reuters.com/article/us-usa-taiwan-military-exclusive/exclusive-at-delicate-moment-u-s-weighs-warship-passage-through-taiwan-strait-idUSKCN1J030R

[11] https://www.reuters.com/article/us-usa-trade-koch/free-trade-puts-republican-megadonors-on-collision-course-with-trump-idUSKCN1J02C0

[12] https://www.ft.com/content/a572d6fa-680f-11e8-8cf3-0c230fa67aec?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[13] https://abcnews.go.com/Business/wireStory/business-economists-worry-recession-2020-55625966

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Monday!  Equities are ticking higher this morning, walking up a wall of worry.  Here is what we are watching this morning:

Trade friction: A couple of weekends ago, Treasury Secretary Mnuchin declared a ceasefire on trade.  It didn’t last very long.  Over the weekend, meetings with Commerce Secretary Ross and Chinese officials ended on a frosty note.[1]  No joint communiqué was released and China indicated it would respond with retaliatory action if the U.S. places tariffs on Chinese imports.  Some of the issue here is that China thought it had secured a “time out” from the treasury secretary; turns out that wasn’t the case.

Meanwhile, Treasury Secretary Mnuchin faced a hostile group of allies at the G-7 meeting.  The weekend pre-meeting with finance ministers ended with a public split between the U.S. and the rest of the group.[2]  The leaders meet in Quebec this weekend and all indications are that this will be a difficult meeting.

Here is the basic issue.  At the end of WWII, the U.S. created a hegemonic structure that was unique to world history.  Instead of creating colonies that would be forced to run trade deficits with the host nation, the U.S. fostered a global trading system that virtually guaranteed the U.S. would run trade deficits.  When Nixon closed the gold window, foreign nations shifted from a dollar/gold standard to a dollar/Treasury standard rather than adjust their economies.  Since the U.S. can create Treasuries rather cheaply and with no feasible limit, there was little foreign constraint on U.S. debt growth or the size of the trade deficit.  In return for this generosity, the U.S. demanded the nations in the American trade orbit submit to U.S. foreign policy goals.

This was a Cold War strategy.  It was designed to create a unified free world and it worked.  There were serious downsides, however.  Foreign nations structured their economies to generate trade surpluses that would lead to unemployment in the U.S.  If we use the saving identity from macroeconomics, (M-X) = (I-S) + (G-Tx), trade surpluses are created by excessive public or private saving (S>I, X>M) or (Tx>G, X>M).  The U.S., being open to trade, must absorb the excess saving in the form of a trade deficit, which is seen domestically as either a deficit in private saving or, more commonly, a fiscal deficit.  This is why the common comment often heard in the financial media that the U.S. “must attract foreign saving” isn’t really accurate.  If that were the case, U.S. interest rates would need to rise to attract the funds.  In fact, U.S. rates remain quite low.

This trade arrangement is a vestige of the Cold War.[3]  The U.S. has every right to call for a new arrangement.  This change will be very painful for the rest of the world as it will force a restructuring on those economies.  Imagine Germany having to reduce its saving, as an example.  There are no stone tables anywhere saying that the U.S. must act to absorb the world savings.  However, this doesn’t mean that there won’t be costs of adjustment to the U.S., too.  First, foreign nations will be less beholden to the U.S. if they no longer rely on American consumption to absorb their excess production.  Thus, it would not be a shock to see the alliance system the U.S. built during the Cold War collapse.  And, second, it will almost certainly cause higher U.S. inflation.

This chart shows the relationship between foreign saving flows (the inverse of the current account deficit) and CPI.  Since inflows have increased, inflation has declined.  This is part of the impact of globalization.

Is there a more effective way of prompting this change?  We doubt negotiations would work.  A good example is China, which shows no interest in changing its policies and simply wants to promise to buy more soybeans.  That isn’t reform, that’s a bribe.  The border adjustment tax would have been a good tool for this change.  Another would be to use the self-adjustment mechanism from the gold standard—force the dollar to depreciate.  Under the gold standard, a nation running a large trade surplus would accumulate gold and face inflation, while the deficit nation would have the opposite problem.  The changes in prices would naturally lead to a reversal of trade flows.  The large foreign reserve surplus nations are (or have done so in the past) purposely preventing their currencies from appreciating buy purchasing dollars (Treasuries).  The U.S. could counter that action by aggressively buying foreign assets.

Politically, though, the trade war makes more sense.  The average American better understands tariffs rather than exchange rates.  President Trump’s approval ratings have been steadily rising since the policy focus shifted from taxes to trade.  With mid-terms looming, we don’t see any reason why the White House would change tack.

Merkel on the EU: French President Macron has pushed for an expansion of powers for the EU.  Chancellor Merkel offered her position[4] which is far less ambitious and more or less solidifies the existing fiscal rules.  Merkel is trying to show she isn’t a roadblock to further European integration but she won’t permit an expansion that occurs on the back of German economic credibility.

Slovenia goes populist: In weekend elections, the Slovenian Democratic Party (SDS) took 25% of the vote, giving the anti-immigrant party 25 of the 90 elected seats.  Although the dominant party, it will be a while before a government is formed as most of the other parties dislike the SDS.[5]

Kim fires senior military officials[6]: As the summit with President Trump approaches, Kim Jong-un reportedly replaced three senior military officials.  Although it is always difficult to know for sure what is going on in the Hermit Kingdom, there are strong suspicions that these military officials may have opposed Kim’s upcoming meeting with Trump and the potential thaw with the U.S.  On the one hand, removing these officials just prior to a historic summit may indicate that he is facing significant internal dissent and thus if the meeting doesn’t go well it could lead to political instability in North Korea.  At the same time, taking this action before a major summit does indicate that Kim probably intends to press for a change in policy and will not brook potential opposition.

The employment report: We have received some questions about our non-farm payroll recession indicator, which shows that recessions tend to follow when the 12-month rolling total of payroll changes falls below 1.5 mm.  There is some confusion on causality; the real culprit that causes recession is the FOMC.  As the labor markets tighten, the Fed raises rates and the increase in rates is the real reason recessions occur.  The drop below 1.5 mm signals when the Fed has overtightened.

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[1] https://www.ft.com/content/26efcf88-670e-11e8-b6eb-4acfcfb08c11?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56 and https://www.nytimes.com/2018/06/03/world/asia/us-china-trade.html

[2] https://www.ft.com/content/7b5fab1e-66c9-11e8-8cf3-0c230fa67aec?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56 and https://www.wsj.com/articles/global-trade-tensions-intensify-1528070538

[3] https://www.washingtonpost.com/business/economy/trump-thinks-hes-saving-trade-the-rest-of-the-world-thinks-hes-blowing-it-up/2018/06/02/27afa736-6678-11e8-a768-ed043e33f1dc_story.html?utm_term=.69f5d08211fa

[4] https://www.ft.com/content/0b0bd67a-6706-11e8-8cf3-0c230fa67aec?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[5] https://www.politico.eu/article/anti-immigration-sds-party-wins-slovenian-election-janez-jansa-miro-cerar/?utm_source=POLITICO.EU&utm_campaign=63318497f2-EMAIL_CAMPAIGN_2018_06_04_04_42&utm_medium=email&utm_term=0_10959edeb5-63318497f2-190334489

[6] https://www.reuters.com/article/us-northkorea-usa-military/north-koreas-top-three-military-officials-replaced-u-s-official-says-idUSKCN1IZ0XY

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

Happy employment day!  We cover the data in detail below but the quick snapshot is that the numbers are showing clear and increasing evidence of a tightening labor market.  The unemployment rate dipped to 3.8% (out to three digits, it was 3.755%), payrolls exceeded expectations and earnings ticked up to 2.7%.  The data all support further policy tightening by the FOMC and thus the initial market reaction is a bit bearish for equities, dollar bullish and bearish for bonds.

A side note: The WP[1] is reporting that President Trump appeared to break protocol in a tweet that read, “Looking forward to seeing the employment numbers at 8:30 this morning,” about 69 minutes before the release.  Given that the numbers were very strong, it would appear the president tipped off the financial markets to the data.  The White House gets the numbers about a day before they are officially released (news media gets it a bit in advance as well—that’s why they can write stories on the data so quickly), but previous presidents hadn’t commented on the reports before the official release.  Here is why this matters: financial markets are like poker players, all looking for a “tell.”  Finding something that gives one advance information is highly prized.  For the markets, if next month he doesn’t signal anything, will the financial markets then assume the data is weak?  Or, if the president knows it’s weak and tries to preempt the information by discrediting it in advance, will that lead to early sell-offs?  This act has added another layer of uncertainty surrounding this report; we will be watching next month for clues to the numbers.

Italy gets a government: President Mattarella approved a coalition government of populist parties, the two main groups being the Five-Star Movement and the League.  The new PM is Giuseppe Conte, with Giovanni Tria, a professor of political economy, as finance minister.  It was the finance mandate that led the president to scuttle an earlier configuration.  Paolo Savona, the Euroskeptic, will be the minister for EU affairs (that should be interesting).  The coalition’s fiscal plans are estimated[2] to cost about 6% to 7% of GDP.  If those plans are acted upon, it will lead to a confrontation with the EU (read: Germany).  The financial markets are taking this outcome as better than new elections but it isn’t a good outcome for financial markets.  At the same time, the two major coalition parties barely won 50% of the vote and this may end up being a short-lived government anyway.

Rajoy out: This morning, Mariano Rajoy lost the no-confidence vote and was replaced by socialist party (PSOE) leader Pedro Sanchez.  Upon accepting the position, Sanchez promised to keep the budget plan of the previous administration as well as open up dialogue with secessionists in Catalonia.  Even though PSOE does not support secession, the group has historically been open to making concessions to appease Catalonia.  That being said, Sanchez’s legitimacy has been questioned by political rivals Cuidadanos and PP because he doesn’t have the backing of the people; he lost the previous two elections.  Sanchez’s party currently holds 84 seats in parliament, making it unclear how long his administration will last.  In the event of an election, the party we will pay close attention to is Ciudadanos, which will likely pose a challenge to the establishment parties PSOE and PP.

The problem with trade policy: The private sector in capitalist economies are remarkably flexible.  It is part of the reason capitalism triumphed over communism.  Capitalist economies react better to change; production methods, supply chains, customers, etc. can all be adjusted to maximize profits, sales or whatever the business is trying to accomplish.  Businesses constantly complain about regulation, for example.  For the most part, however, history shows that industries do manage to adjust.

But, this system functions only if conditions are reasonably stable.  Rapidly changing price levels, regulations that vary on a whim or the perception of a wide range of potential outcomes can freeze managers into a position where it becomes difficult to make long-term plans.  How does one invest when conditions are rapidly changing?  Only with great difficulty.

Herein lies the problem with the administration’s trade policy.  It is becoming difficult to tell what future trade arrangements will emerge.  If the aluminum tariffs are going to remain in place, a consumer should probably build stockpiles to protect against future price increases…unless the policy changes for some other reason.  And, what should a company do if it finds itself as the target of trade retaliation?  Invest in lobbying to try to reverse the policy?  Woo foreign governments to change their minds?

The U.S. has engaged in a reserve currency system that brings costs and benefits.  The beneficiaries are most consumers (we get lots of imports that keep prices down) and the financial system (foreigners need U.S. dollar assets to hold their reserves until needed).  The reserve currency is also a source of influence; Iranian sanctions were successful, in part, because other nations feared the loss of access to the U.S. banking system.  The costs were borne by those working in import-competing industries.  The dollar/reserve policy has been partly responsible for rising inequality.  The U.S. has every right to change the rules of the game to help those adversely affected by the policy.

However, the dollar/reserve system is deeply imbedded in how the global economy functions and changing it requires careful adjustments to avoid causing an unexpected crisis.  Moving fast and breaking things raises the risks of an unforeseen consequence that will tend to make investors cautious; this will likely play out in the equity markets in the form of multiple contraction.

Energy recap: U.S. crude oil inventories fell 3.6 mb compared to market expectations of a 0.9 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 last March.  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.  We expect steady stock withdrawals from now until mid-September.  If we follow the normal seasonal draw in stockpiles, crude oil inventories will decline to approximately 426 mb by September.

Based on inventories alone, oil prices are overvalued with the fair value price of $62.88.  Meanwhile, the EUR/WTI model generates a fair value of $63.52.  Together (which is a more sound methodology), fair value is $62.92, meaning that current prices are above fair value even with the recent pullback.  The stronger dollar is putting downside pressure on oil prices, which is only partially being offset by falling stockpiles.  Although we don’t expect a bear market to emerge (there is probably too much geopolitical risk for a decline below $50 per barrel), prices did get a bit ahead of themselves and some consolidation would be normal.

Assad threatens U.S. forces in Syria: Recent comments from Syrian President Assad are an example of the level of geopolitical risk we are seeing.  Yesterday, he warned that his government would “wage war” to expel U.S. troops from northeastern Syria if negotiations for withdrawal fail.[3]  U.S. troops have supported the Kurds who have established control in parts of Syria.  Assad’s comments are really ill-advised.  President Trump has already indicated he wants to leave Syria.  At the same time, Trump is a Jacksonian; besmirch his honor and he will react harshly.  Even threatening to attack U.S. troops could lead the president to react harshly.  Assad appears to be overconfident; if he simply keeps quiet, it is likely the U.S. will exit without fanfare.  It should be noted that without Russian and Iranian support, Assad would likely be out of power.  We doubt either of his supporters would countenance a direct attack on U.S. troops.  But, if conditions suddenly escalate, it increases the chances of a geopolitical event in the Middle East and could support oil prices if it spreads.

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[1] https://www.washingtonpost.com/news/business/wp/2018/06/01/trump-breaks-protocol-sends-markets-a-clear-signal-on-jobs-report-before-numbers-are-released/?utm_term=.9f2569a198e7

[2] https://www.politico.eu/article/silvia-merler-italy-politics-populists-program-violates-all-eu-and-domestic-fiscal-rules/?utm_source=POLITICO.EU&utm_campaign=982742a3a1-EMAIL_CAMPAIGN_2018_06_01_04_26&utm_medium=email&utm_term=0_10959edeb5-982742a3a1-190334489

[3] https://www.washingtonpost.com/world/middle_east/assad-threatens-to-expel-us-troops-from-syria-by-force/2018/05/31/e4ba8400-64d3-11e8-81ca-bb14593acaa6_story.html?utm_term=.f48f971744b4&wpisrc=nl_todayworld&wpmm=1

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s the last day of May!  Markets are mostly steady, the dollar is a bit weaker and Treasuries are seeing a modest bump in yields.  Here is what we are watching this morning:

Italian populists try to form a government: Italy’s president has given the populists more time to form a government,[1] but the League’s leader, Matteo Salvini, has been reluctant to finish the deal, likely hoping that his party’s standing would improve with new elections.  Hopes that new elections could be avoided sparked a strong rally in Italian bonds and a pullback in flight to safety instruments, such as the yen and U.S. Treasuries.  It seems a bit odd that the formation of a populist government is preferred to new elections, but the fear of new elections is that they will turn into a referendum on the Eurozone and Italians will decide to leave.

In reality, the populist coalition in Italy is rather unusual and may not survive.  We have dubbed it a “Nader coalition” of left- and right-wing populists.  Why is this rare?  It’s a bit like the Tea Party and Occupy forming a government in the U.S.  Nader’s argument is that both populist wings share similar goals on economic policy and thus should subsume their social differences to improve their economic conditions.  History shows that a more durable coalition is when a center party aligns with a populist party, with the former giving enough economic “goodies” to the populists to keep them together.  Franklin Roosevelt’s center-left coalition with the white working class lasted from the 1930s into the mid-1960s.

If the populists do form a government, we doubt it will last long.  The League’s base is in northern Italy, which is industrial and economically successful.  The Five-Star Movement is based in economically depressed southern Italy.  That’s why you see a policy mix that includes tax cuts, anti-immigration and basic national income.  The only way such a policy mix works is if the EU simply stops enforcing fiscal rules.  However, the financial markets will pressure Italy if such policies are adopted.  If we get new elections, look for fear to pressure financial markets but, in reality, new elections are probably necessary and we don’t see Italy leaving the Eurozone in the short run.  In fact, about the only way Italy exits the Eurozone is if Five-Star dominates the government.

Trade war looming?  The deadline for steel and aluminum tariff exemptions is tomorrow and there is every indication that the Trump administration is moving to implement some form of tariffs, although a short-term waiver is possible.  If trade actions are taken, we expect the U.S. to implement quotas on imports, with tariffs applied once the imports exceed the quota level.  The real worry is retaliation.  We would expect all nations adversely affected to apply their own trade retaliation.  Expect the retaliation to be targeted to politically sensitive areas of the economy, including agriculture, bourbon and motorcycles.  The tariff threat could also kill this weekend’s scheduled talks between Commerce Secretary Ross and Chinese officials.

Rajoy in trouble: The formal debate to hold a confidence vote on the current Spanish government begins today.  Rajoy might survive even though his support is weak because of party rivalry; voting Rajoy out puts the Socialists in power, which the center-left parties don’t want.  We expect the eventual outcome to be new elections.  Although political turmoil is a bearish factor for confidence assets, this problem is more normal.  What is going on in Spain is all about domestic issues, while Italy affects the foundation of the Eurozone.  Thus, we would not expect Spain to turn into a Eurozone crisis.

A hawk flies away: The BOE’s Monetary Policy Committee bid adieu to Ian McCafferty and announced that Jonathan Haskel will be joining the group.  McCafferty has been a recent dissenter to steady policy, voting to raise rates.  It is unclear how Haskel will vote.  He is an economics professor and specialist in productivity and growth measurement.  Most likely, the committee has become a bit more dovish.

The OECD boosts growth forecasts:The OECD is forecasting global GDP to rise 3.8% this year, up from its last forecast of 3.5%, mostly due to stronger U.S. growth.  Although the strong dollar’s impact on emerging markets was noted as a risk factor, the group remains optimistic about the near term.

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[1] https://www.ft.com/content/91937214-63d4-11e8-90c2-9563a0613e56

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Financial markets are a bit calmer this morning.  Equities are rebounding and Treasury yields are rising.  The EUR is also higher.  Here is what we are watching:

Italy: The populist coalition is trying to revive talks to form a government, perhaps coming up with a less controversial slate of ministers.  However, disputes between the Five-Star Movement and the League have developed as they both try to jockey for power.  Meanwhile, Carlo Conttarelli has been assigned the task of putting together a government by Italy’s president and has made little progress on that front.  It looks like the most likely outcome is a new vote, which will occur in late July at the earliest but more likely by mid-September.

The EU has also weighed in on the turmoil.  Germany’s EU commissioner, Günther Oettinger, indicated that the financial markets would show Italian voters they should reject populist parties.[1]  He faced harsh criticism from the president of the EU council, Donald Tusk, but the general feeling is that his comments were not incorrect, but rude.  And, this statement coming from a German, the nation being blamed for the woes of southern Europe, didn’t help matters.

This is what we are seeing in the political trends.  The populist coalition could have been saved but the League seems to want new elections.  Polls suggest its support is growing and the leadership of the party seems to believe new elections would designate it as the senior partner in a coalition with Five-Star.  The establishment in Italy wants to make the next election a full-blown referendum on the Eurozone, betting that Italian voters, though unhappy with the fiscal restrictions of the Eurozone, will not support exiting the single currency for fear of the high costs involved with moving from the euro to a new currency.  It looks like the most probable outcome is (a) new elections, but (b) no party will be able to build a working coalition, and thus (c) more muddling through.

When one forecasts anything, there is the short run (now to three years roughly) and the long run (the eventual outcome).  In reality, the long run is really nothing more than an envelope of short runs that eventually travel toward the most likely equilibrium.  The Eurozone has a structural problem.  Successful currency blocs (such as the U.S.) have:

1. Common political and, more importantly, fiscal transfer systems which allow for some degree of equality across regions;
2. High labor and product mobility;
3. Jointly held debt.

Or, in simple terms, states and regions in a currency bloc have limited sovereignty.  In the U.S., for example, states have some sovereignty but not complete power; they don’t print their own money.  For the Eurozone to really work, European nations have to give up sovereignty to the EU.  Absent of some unifying war, there is little chance that these nations will willingly give up enough sovereignty for the Eurozone to work.  Here is a milestone that would show the Eurozone will work—when Germans are willing to underwrite a Eurobond that allows Greece to issue debt that is guaranteed by the whole Eurozone (read: Germany).  It could happen…but it’s not likely.  In other words, Europeans can have the Eurozone and the single currency at the cost of reduced sovereignty or keep the current level of sovereignty but give up the single currency.  They can’t have both.  Every Eurozone crisis could be the “one”; however, conditions are probably not quite dire enough to push Italy to vote to exit the Eurozone, which would be expressed by voting in a massive coalition of populists.

Trade:The Trump administration has moved to put tariffs on $50 bn in Chinese imports, just a few days after it appeared a truce was in place.  We will be watching to see if North Korea suddenly turns hostile again.  The U.S. has also decided to impose greater limits on Chinese visas, perhaps in a bid to reduce China’s ability to send students to the U.S. to study and boost China’s tech prowess.[2]  Commerce Secretary Ross is scheduled to meet with Chinese officials this weekend.  The new tariff announcement could scuttle these talks.  On June 1, the temporary postponement of steel and aluminum tariffs on numerous American allies expires; it isn’t clear if they will be postponed further or not.  If they are not, look for retaliation.  The trade drama continues but the direction is steadily moving toward a change in the trade relationship with the world.

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[1] https://www.ft.com/content/8edfb128-631f-11e8-90c2-9563a0613e56

[2] https://apnews.com/amp/82a98fecee074bfb83731760bfbce515?__twitter_impression=true

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s clearly another “risk off” morning—equities are lower around the world, the dollar, yen and Treasury prices are up, and most other currencies are lower.  Europe is the culprit.  Here is the story:

The Italian job: Over the Memorial Day weekend, Italy’s president, Sergio Mattarella, refused to allow a populist coalition of the Five-Star Movement and the League to form a government.[1]  The sticking point was the group’s decision to name Paolo Savona as finance minister.  Savona is deeply skeptical of the Eurozone and would likely press for Italy to exit the single currency.  So, Mattarella scuttled the negotiations and instead appointed Carlo Cottarelli as a caretaker PM.  Cottarelli is an anathema to the populists; he is a former IMF official and represents everything the populist coalition detests.

Italian bond yields continue to rise on the news.

Perhaps what is most impressive isn’t the spike in Italian yields but the drop in German Bund yields, which are now down to 31 bps from mid-60 bps before the crisis.  The drop in German yields is a clear indication of capital flight, most likely from Italy.

The disgruntled coalition has called for Mattarella’s impeachment and there are reports that demonstrations and strikes are possible.[2]  Assuming Cottarelli cannot form a government (and it is highly probable he won’t be able to), elections are likely to be scheduled for September.  This election could be pivotal for the future of the Eurozone and the euro.  Up until this point, the Italian parties have not really campaigned on leaving the single currency.  The populist parties, instead, planned on flouting fiscal restrictions, daring the EU to stop them.  However, the September poll is shaping up to be about Italy’s status in the Eurozone.  Most polls show a slim majority support for continued membership in the Eurozone; only about 55% support the single currency, the second lowest of any Eurozone nation.  Only Cyprus is marginally lower.  Still, that means the majority of Italians still support remaining in the Eurozone.  Thus, if the election does become a referendum on the single currency, the populists may not win.  At the same time, the centrist parties are in deep disarray and may not be able to form a government anyway.  Thus, the risks are unusually elevated that the September vote leads to a radical outcome.

What we find most interesting about the Italian situation is that Italy has created the “Nader coalition” of populist right and left wings.[3]  Nader’s vision is that the economic goals of the right- and left-wing populists are close enough to build a dominant political coalition.  Nader wrote his book for U.S. voters; however, to date, a Trump/Sanders coalition looks like a low probability event.  Italy may be closer to Nader’s idea; interestingly enough, the policy mix of lower taxes, immigration restrictions and a basic national income doesn’t fit with any degree of fiscal restraint.  Perhaps the secret to the Nader coalition is to jettison fiscal control.

Although purchasing power parity clearly favors the euro over the dollar, the potential for a bust-up of the Eurozone will hang as a major threat to the single currency and consequently weigh on the exchange rate.  Of course, the worst case scenario rests on a significant populist win in September, which may not happen.  Although Italy’s debt/GDP ratio is a whopping 132%, most of that debt is held domestically…in euros.  If the Italian government leaves the Eurozone and tries to change the debt currency to the “new lira” instead of euros, the backlash would be significant.  Our read is that most Italians like the external governor that Eurozone membership provides but oppose the fiscal constraints.  Leaving the Eurozone would almost certainly be painful for Italian savers; thus, if the September vote becomes a referendum on remaining in the Eurozone, we suspect the populists will fail to form a government.  But, the vote will be close and any casual observation of Italy’s economic performance since joining the Eurozone makes it clear that Italy will be better off outside the Eurozone once the painful adjustment process is complete.  Getting to that “promised land,” however, requires a great deal of disruption that no one wants in the short run.

Spain, too: PM Rajoy faces a confidence vote on Friday.  Rajoy’s center-right government has faced a series of scandals that have undermined sentiment.  If the vote goes against Rajoy, the odds of new elections increase.  Additional European political turmoil adds to concerns about the euro.

North Korea dialogue: After postponing talks, North and South Korea have moved aggressively to support negotiations.  The leaders of the two Koreas have met[4] and envoys from both the U.S. and North Korea are meeting; in fact, a high-ranking North Korean official, Kim Yong Chol,[5] has arrived in New York for discussions.  Although the Trump/Kim summit isn’t officially on, in reality, there are indications that talks are likely.

China trade: Breaking at the time of this writing, the Trump administration indicated it would proceed with tariff plans against China.[6]  Given that negotiations continue, we see this as mostly posturing rather than signaling action. 

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[1] https://www.ft.com/content/f495fc3a-6283-11e8-90c2-9563a0613e56?emailId=5b0cd171da224c00049b3d0f&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[2] https://www.reuters.com/article/us-italy-politics/italys-league-leader-dismisses-talk-of-presidents-impeachment-idUSKCN1IT0GK

[3] Nader, R. (2014). Unstoppable: The Emerging Left-Right Alliance to Dismantle the Corporate State. New York, NY: Nation Books.

[4] https://www.reuters.com/article/us-northkorea-missiles/south-korea-calls-for-more-impromptu-talks-with-north-korea-as-u-s-seeks-to-revive-summit-idUSKCN1IT0JK

[5] https://www.cnn.com/2018/05/29/asia/kim-yong-chol-united-states-intl/index.html

[6] https://www.nytimes.com/2018/05/29/business/white-house-moves-ahead-with-tough-trade-measures-on-china.html