by Bill O’Grady and Thomas Wash

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

Capping oil prices: On the eve of the first summer holiday, gasoline prices are becoming an issue.  The recent rise in crude oil prices has taken gasoline higher.  Although higher gasoline prices are a natural consequence of higher crude prices, perhaps no other price has greater visibility and political impact.  The president has tweeted against high oil prices in the recent past and now the issue is starting to have some political implications.[1]

There have been three reasons behind the recent rise in oil prices.  First, OPEC + Russian output discipline has been solid.  We believe Saudi Arabia has held production steady to support its IPO of Saudi Aramco, which we expect sometime next year.  Second, supply was curtailed further by falling output from Venezuela.  The potential for additional sanctions on Iran has boosted bullish sentiment.  Third, the dollar was weak for most of last year; most of the time, there is an inverse correlation between the dollar and oil.  The weaker dollar acted as a bullish factor for oil prices.

These factors have been reversing.  OPEC has enjoyed the rise in prices but has been disappointed with the loss of market share caused by the surge in U.S. shale production.  It does not want to cede market share indefinitely.  Consequently, the cartel is looking to boost production.[2]  Second, the dollar has been rising, mostly due to expectations of tighter monetary policy.  We note that the dollar is still expensive on a parity basis and history suggests rising deficits will pressure the dollar going forward.  Thus, we don’t expect the dollar to rise over the long run but, until the FOMC is set to “pause,” the dollar will tend to be underpinned by policy divergence.

The political fallout should not be underestimated.  President Trump has two policy levers at his disposal to bring down gasoline prices.  First, he can release oil from the Strategic Petroleum Reserve.  Although this oil is held for emergencies, in fact, previous presidents have tapped it to curb price increases.  Second, he can use his “tweet” bully pulpit to pressure OPEC into raising production.  Given that the Saudis have been actively trying to cultivate good relations with the president, it looks like this is the direction the kingdom wants to go in anyway.

We have been bullish on oil prices for several months.  Given the above factors, a more neutral position is probably warranted.  That doesn’t mean oil prices are heading to the basement.  Geopolitical risk remains elevated and we expect U.S. refiners to ramp up output for the summer driving season.  But, a pullback into the low $60s would not be a huge shock.

No summit: We were surprised by the president’s decision to walk away from the summit with North Korea but we do agree that Beijing was likely behind the breakup.  China has been afraid the U.S. would make an ally out of North Korea and, given the Koreas’ almost natural opposition to China, Chairman Xi had reasonable concerns that Kim could be turned.  Thus, he moved to ease sanctions on North Korea and we saw a near about-face in North Korea’s rhetoric.  The White House made some unforced errors, too.  John Bolton’s talk of the “Libya model” was a mistake, although it is also probable that Bolton wasn’t thrilled with the summit anyway.

The key issue is, “now what?”  We see two consequences from the summit’s cancellation.  First, trade negotiations with China will likely become hostile again.  It appeared the White House was pulling its punches in trade talks with China, likely hoping Beijing would assist the U.S. in negotiations with North Korea.  Now that the summit is canceled, we would expect the Navarro/Lighthizer hardline wing to return to the forefront.  Second, the risk of military action against North Korea will likely increase in the coming weeks.  If it occurs, it will tend to lift flight to safety assets.

Backdoor bonds: The EU is working on a proposal to create “sovereign bond-backed securities” (SBBS), which would create a securitized bond composed of the government debt of the various EU nations.  The stated reason for the creation of these instruments is to create a bond that European banks could buy in lieu of their national government bonds and reduce the odds of the “doom loop” that occurs during crises.  However, this probably isn’t the real issue.  One of the reasons the EUR can’t compete with the USD for reserves is that there is no single sovereign bond that is backed by the full faith and credit of the Eurozone.  Thus, if a nation wants to hold EUR as reserves, it has to pick a single country bond to invest in.  That reduces the attractiveness of the EUR.  Creating a securitized debt instrument with “all” the bonds in the Eurozone could be a substitute for the lack of a Eurobond (defined as a single full faith and credit instrument).

The Germans saw through the ruse.  Germany’s finance minister, Olaf Scholz, slammed the plan, correctly pointing out that if such a securitized instrument was viable the private sector would have already created it.  Germany has vehemently opposed any attempt to mutualize Eurozone debt, worried that higher spending nations (read: Italy) would borrow heavily against the credit of Germany and force the Germans to fund Italy’s spending in the case of a crisis.  This little dust up tells us that the mandarins within the EU still pine for a unified Eurobond.  

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[1] https://www.politico.com/story/2018/05/25/trumps-gas-prices-midterms-570916

[2] https://uk.reuters.com/article/us-global-oil/oil-prices-fall-as-opec-and-russia-weigh-output-boost-idUKKCN1IQ03C?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosgenerate&stream=top

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] The two big news items are the deterioration of conditions with North Korea and Trump’s call for a 25% tariff on autos.  Here is what we are watching:

BREAKING NEWS: PRESIDENT TRUMP CANCELS SUMMIT MEETING WITH NORTH KOREA. 

What’s going on with North Korea?  For most of last year into early this year, it looked like war was increasingly likely.  Then, everything turned with President Trump agreeing to a summit.  Now, the summit is off.  North Korea has returned to the nuclear rhetoric.[1]  What happened here?  There were a couple of missteps by the Trump administration.  Suggesting that North Korea could use the “Libya model” was clearly a blunder (the South Africa model would have been a better example).  Selecting John Bolton for national security director sent a hostile signal.  But we don’t think these issues were key.

Instead, what we think is going on is that China is using North Korea to manage U.S./China trade relations.[2]  China was generally comfortable with the status quo in North Korea.  However, it was afraid that the U.S. and South Korea were trying to pull North Korea out of China’s orbit and thus has taken steps to reel Pyongyang back in.  There are reports that China has eased up on sanctions.[3]  Now, Beijing may be sensing an opening in which it may be able to pull both Koreas into its orbit and isolate the U.S.  After all, Trump renegotiated the Korean Free Trade Agreement to be less favorable to South Korea.  If Xi can get North and South Korea to become friendlier he might be able to reduce U.S. influence in the region.  A failed summit might move that goal along.  Of course, the risk is that a failed summit leads to an open conflict.  But, if South Korea won’t cooperate militarily, the U.S. probably won’t act.  Trump’s decision to hold a summit with Kim was a bold move but the inability to complete the deal may lead to a new arrangement that is less favorable to the U.S.

Auto tariff threats: President Trump, citing national security concerns, is threatening a 25% tariff[4] on automobile imports.  Although the national security angle seems to be a stretch, the Commerce Department has opened a study to determine the threat.  This study will likely take months, so this issue will hang over the market for some time.  Although the administration’s trade actions have tended to be less onerous than the rhetoric, trade impediments are inflationary and will tend to pressure financial markets.

Fed minutes: The minutes were taken as dovish, although our read leans more toward neutral.  There was some support for allowing inflation to exceed target for a while, but that expectation wasn’t a complete surprise.  Although current policy rates were described as “accommodative” (which we would agree with), there were “some” members who suggested this could be revised soon.  This indication may mean that some members are thinking we are approaching a neutral policy rate.  If true, a “stall” in tightening could occur, but we don’t think this is the base case.  Although two of the Mankiw Rule variations have the current rate essentially at neutral (wage growth and the employment/population ratio), the unemployment rate and the involuntary part-time employment rate shows many more hikes in the pipeline.  Thus far, the FOMC has not had to face a situation where some of the variations show tight while others show loose, but that day is approaching.  We would expect dissention to increase for a couple members over rate increases.

Iran responds: The supreme leader of Iran, the Ayatollah Khamenei, laid out conditions for the European powers to remain in the nuclear agreement.  Specifically, there will be no new negotiations on Iran’s missile program or its security policy in the Middle East.  The Europeans must continue to buy Iranian oil and safeguard trade with Iran.  Europe must condemn the U.S. for breaking the nuclear deal and “stand up” to U.S. sanctions.[5]  These are effectively non-starters for the U.S.  Iran is clearly trying to separate the U.S. and Europe in terms of Middle East policy.  We believe that Europe’s best interests lie with the U.S. but following the Trump administration will tend to raise oil costs for European consumers.

Turkish lira rebounds: The Turkish central bank raised rates 300 bps to 16.5% yesterday afternoon, triggering a sharp short-covering rally in the TRY.  However, this morning the exchange rate has started to weaken again, although it has not made new lows…yet.  Usually, markets will test the resolve of a central bank, forcing it to raise rates enough to convince traders that it will “do what it takes” to stabilize the exchange rate.

1997 redux?  The turmoil in both Argentina and Turkey has raised fears that we may be on the cusp of another emerging market crisis.  The high levels of debt in the emerging space, much of it in dollars, has also brought concerns.

This chart, courtesy of the St. Louis FRB,[6] shows a surge in emerging market debt, although most of the growth is emanating from China.  And, since the financial crisis, the dollar has become the borrowing currency of choice.  This borrowing has made emerging markets more sensitive to dollar strength.

However, it should also be noted that there are significant differences between now and 1997.  First, many of the emerging economies pegged their exchange rates to the dollar.  When the pegs failed, debt service costs for dollar borrowers took a discrete jump and exacerbated the crisis.  Once one pegged currency failed, it led to a contagion that became impossible to control.  This time around, currencies are floating, meaning that they will not rise with discrete jumps, which should make debt management easier.  And, it should reduce the risk of contagion.  That being said, the emerging space needs dollar weakness to flourish and the debt data is a major reason why.

Energy recap: U.S. crude oil inventories rose 5.8 mb compared to market expectations of a 2.0 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 last March.  We would consider the overhang closed if stocks fall under 400 mb.

As the seasonal chart below shows, inventories are usually rising this time of year.  This week’s rise is inconsistent with the onset of seasonal patterns.  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 429 mb by September.

Based on inventories alone, oil prices are overvalued with the fair value price of $61.73.  Meanwhile, the EUR/WTI model generates a fair value of $64.76.  Together (which is a more sound methodology), fair value is $63.39, meaning that current prices are above fair value.  The combination of a stronger dollar and the unexpected rise in inventories means current oil prices are overvalued.  Using the oil inventory scatterplot, a 429 reading on oil inventories would generate oil prices in the high $70s.  The current high price is mostly a function of growing geopolitical risk which we don’t see abating anytime soon.  However, oil prices cannot continue to defy fundamentals; at some point, a correction may be in the offing.

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[1] https://www.washingtonpost.com/world/north-korea-says-its-up-to-us-whether-they-meet-at-a-table-or-in-anuclear-showdown/2018/05/23/45f97960-5ee9-11e8-8c93-8cf33c21da8d_story.html?utm_term=.e23d81c2a52c

[2] https://www.nytimes.com/2018/05/24/world/asia/trump-xi-jinping-north-korea.html

[3] https://asia.nikkei.com/Spotlight/North-Korea-crisis-2/Border-town-thrives-as-China-eases-up-on-North-Korea-trade

[4] https://www.wsj.com/articles/trump-administration-weighs-new-tariffs-on-imported-vehicles-1527106235

[5] http://www.dw.com/en/iran-lists-tough-conditions-for-europe-to-save-nuclear-deal/a-43904326

[6] https://www.stlouisfed.org/on-the-economy/2017/november/global-debt-rising-emerging-economies

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s looking a bit ugly out there this morning for risk assets.  Equities and most commodities are lower, while gold, Treasuries and the JPY are higher.  This is a classic pattern of flight to safety buying.  Here is what we are watching:

Twin crises: Turkey and Italy are the primary problem areas this morning.  Turkey is facing a full-blown currency crisis.

The above is a three-decade chart of the TRY/USD exchange rate in terms of lira per dollar.  We are not only making new lows but making them in rapid fashion.  The drop in the TRY is a classic example of why leaders shouldn’t undermine the independence of the central bank.  The textbook response to this sort of decline is a massive increase in short-term interest rates.  This action increases the cost of shorting (the short has to borrow in the shorted currency) and usually arrests the decline.  However, President Erdogan is strongly opposed to interest rate increases so we have a showdown between the financial markets and the president.  Compounding the problem is that the Turkish private sector has borrowed in foreign currencies, meaning the drop in the TRY is rapidly escalating the cost of debt service.  S&P[1] is threatening a downgrade.  Turkey is holding national elections on June 24.  Erdogan is hoping to solidify his political position to change the nature of the presidency, boosting the executive’s power.  A currency crisis that triggers a debt crisis won’t help Erdogan’s popularity.

Meanwhile, the travails of Italy continue.  The Five-Star Movement and the League are close to forming a government but have hit two snags.  First, their candidate for PM, Giuseppe Conte, a politically unknown law professor, appears to have either lied about or inflated his accomplishments on his resume.[2]  Second, the coalition is recommending Paolo Savona for finance minister, an avowed Euroskeptic.[3]  President Mattarella, who must approve any government, is not comfortable with either choice for PM or FM.  Italian credit markets are showing signs of stress.  First, sovereign interest rates are rising.

This chart shows the Italian vs. German 10-year sovereigns.  The spread is widening out rapidly; what is worrisome is that while Italian yields are rising, German yields are declining (albeit modestly).  This suggests we may be seeing capital flight out of Italy into German paper.  Second, Italian bank bonds, especially those with elevated levels of non-performing loans, are coming under pressure.[4]

OPEC: Oil prices slipped yesterday afternoon on reports that OPEC may boost output to offset declines in Venezuelan production.[5]  The cartel probably does not want to see the U.S. gain market share due to Venezuela’s woes.  If it actually occurs, we don’t see this change in OPEC as necessarily bearish but it will tend to cap some of the recent enthusiasm.  Oil prices have mostly ignored the recent rise in the dollar, but eventually the stronger greenback will tend to adversely affect oil prices.

Facebook (FB, 183.80): Mark Zuckerberg was given kudos for coming to testify in Europe; that’s where the praise ended.  The apology was more in the vein of, “I’m sorry you were upset,” and it was apparent that the company has no interest in changing its advertising-driven business model.  At this point, social media’s greatest threat comes from Europe.

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[1] https://www.reuters.com/article/us-turkey-ratings-s-p/turkeys-woes-could-quickly-sour-governments-finances-sp-idUSKCN1IN1WB

[2] https://www.cnbc.com/2018/05/23/conte-italy-populists-face-setback-on-their-new-leader.html

[3] https://www.ft.com/content/360dc63a-5dd3-11e8-9334-2218e7146b04

[4] https://www.ft.com/content/0ed87bcc-5e6f-11e8-9334-2218e7146b04

[5] https://www.reuters.com/article/us-global-oil/oil-dips-as-market-eyes-possible-easing-of-opec-supply-curbs-idUSKCN1IO01M?il=0

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Financial markets are quiet this morning.  This is what we are watching this morning:

The problem of priorities: There is a stock scene in most action movies where the hero is surrounded by bad guys but, inexplicably, they attack one at a time.  The hero fends them off, showing he can defeat a group aligned against him…assuming they don’t all attack at once.  When one runs for president, it seems there is an assumption that the world behaves like an action movie.  In real life, the “bad guys” (“issues”) don’t take turns.  They come at the POTUS all at once.  President Trump is dealing with the multiplicity of issues and performing triage.  Here are the evolving issues:

1. North Korea has become the most important item on the agenda.[1]  President Trump is running the risk his predecessor had with Iran; he may want a deal more than the other party.  If the president can reach a substantive agreement with North Korea, it would be historic, something none of his predecessors have been able to pull off.  The lure of this achievement may be overtaking the real possibilities of an agreement.  It’s critical for both parties to know exactly what they want.  The U.S. should press for an elimination of the nuclear risk to the United States. Anything beyond that is a mere plus.  Note that we didn’t say “denuclearization.”  That may come over time, but if there is anything Kim wants to avoid it’s the fate of Muammar Gaddafi.  He will keep some form of a nuclear threat for that reason alone.  What the U.S. should try to accomplish is an end to the delivery mechanism to the U.S.  North Korea should want sanctions relief and an eventual peace treaty that will foster economic development.  This outcome may be achievable, but if John Bolton[2] has hijacked the president’s policy on North Korea then the summit could end up in a stand-off, with the next logical step being war.
2. Focusing on North Korea means that trade negotiations with China are less important.  China is willing to give the impression of a trade win to the White House; for example, today China announced a large reduction in car tariffs, to 15% from 25%.[3]  There were non-binding promises for more imports, mostly grain and energy.  The ZTE (ZTCOF, $2.26, 4/26/18) situation is getting resolved with a less rigorous U.S. response.[4]  The president has put Treasury Secretary Mnuchin in charge of the China negotiations, sidelining hardliners such as Peter Navarro.  Steve Bannon criticized Mnuchin’s trade negotiations as a “giveaway.”[5]  In reality, we think the president wants to hew a hard line toward China on trade but he cannot have a trade war with China and a historic agreement with North Korea at the same time because China could scuttle U.S. negotiations with Kim.  China, so far, is the winner on trade; its key goal remains intact, which is to maintain the industrial policy toward becoming a tech powerhouse.
3. What about Iran? Secretary of State Pompeo outlined U.S. goals with Iran.  Essentially, the U.S. wants Iran to end its nuclear program permanently, stop developing missile technology and withdraw its influence across the Middle East.  As one would expect, the response from Iran has been less than open.[6]  Agreeing to this proposal would be tantamount to unilateral surrender and, in fact, would essentially require regime change.[7]  The Iranian Revolution was not just about Iran but about spreading Shiite theocracy throughout the region.  The U.S. goal may be regime change.  If so, this could be setting the preconditions for war.  However, there is another item to consider.  If the Iranian leadership actually withdraws, a power vacuum would develop in Syria and Iraq.  It is unclear who would fill it.  At first glance, it would seem that any replacement for Iran would be better for the U.S.  However, the last “vacuum filler” was Islamic State.

For now, North Korea is the #1 priority.  That means the U.S. will go easy on China and will probably not move beyond rhetoric on Iran.  But, once the North Korean situation is resolved, attention will need to shift to other priorities.  Our guess is that Iran becomes next “in the barrel.”  If true, that should underpin oil prices.

Zuckerberg in Brussels[8]: The Facebook (FB, 184.49) CEO will go to Brussels to discuss his company as Europe prepares to unleash its new regulations on privacy, known as General Data Protection Regulation (GDPR), which appears to restrict social media’s ability to track user behavior.  We expect Zuckerberg to offer investment and promises to do better[9] but, in reality, GDPR potentially could seriously harm the business model of social media[10] by reducing the amount of data that can be collected and sold to advertisers.

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[1] https://apnews.com/f2e5aa3856b44b4b823064834dfb819d

[2] https://www.washingtonpost.com/world/asia_pacific/whos-to-blame-for-the-hiccup-in-north-korea-talks-south-koreans-say-bolton/2018/05/21/f5099324-5cdf-11e8-8c93-8cf33c21da8d_story.html?utm_term=.895661ce1c71

[3] https://www.ft.com/content/dbda0d5c-5d89-11e8-9334-2218e7146b04

[4] https://www.wsj.com/articles/u-s-china-agree-on-broad-outline-to-settle-zte-controversy-1526959695

[5] https://www.bloomberg.com/news/articles/2018-05-21/steve-bannon-condemns-mnuchin-s-trade-truce-as-china-giveaway (paywall)

[6] https://www.ft.com/content/972765b8-5cfa-11e8-9334-2218e7146b04?emailId=5b039e04f872430004412604&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[7] https://www.ft.com/content/2b97380a-5d63-11e8-9334-2218e7146b04?emailId=5b039e04f872430004412604&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[8] https://www.ft.com/content/cd745340-5d47-11e8-ad91-e01af256df68?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[9] https://www.politico.eu/pro/mark-zuckerberg-hearing-eu-european-union-brussels-cambridge-analytica-antonio-tajani/?utm_source=POLITICO.EU&utm_campaign=db3d564eca-EMAIL_CAMPAIGN_2018_05_21&utm_medium=email&utm_term=0_10959edeb5-db3d564eca-190334489

[10] https://www.politico.eu/article/gdpr-survival-guide-europe-privacy-data-protection-general-data-protection-regulation-may-25-facebook/?utm_source=POLITICO.EU&utm_campaign=f3892c4dc9-EMAIL_CAMPAIGN_2018_05_22&utm_medium=email&utm_term=0_10959edeb5-f3892c4dc9-190334489

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Monday!  There was a lot of weekend news.  Let’s dig in:

Trade war postponed: Yesterday, Treasury Secretary Mnuchin announced that China and the U.S. have postponed any trade actions while talks continue on the structure of the trading relationship.  Equity prices rose, the dollar moved higher and grain prices jumped.  Grains are up on relief that corn, sorghum and soybeans won’t be targeted by China for retaliation.[1]  It doesn’t appear that anything has been resolved; the reason for the delay in trade action may be due to the next item.

Does Trump have a bandwidth issue?  All presidents find that the office is complicated; pulling on one thread leads to issues somewhere else.  The upcoming summit with North Korea has become increasingly fraught with risk.  Earlier, it looked like the path to the summit was going smoothly.  Talks between the North and South appeared warm.  Kim had hinted at denuclearization.  Then, last week, North Korea turned hostile, indicating it would never trade away its nukes.  It’s unclear what prompted the change.  It may be due to John Bolton’s appointment as national security director as he has held hardline positions against North Korea (and many other countries as well).  We note that Kim visited Beijing just before the turn in tone; it may be that China urged Pyongyang to turn hostile to give China leverage in trade talks.  That might explain the “time out” on trade noted above.

The president has pressed the DOJ to open an investigation into the FBI’s actions during the 2016 election.  The administration is trying to negotiate a trade deal with China.  NAFTA talks appear stalled.  The president seems to want a historic summit with North Korea.  There is the Iran issue.  And Venezuela, too.  Needless to say, there are a lot of “plates spinning.”  We suspect the trade postponement with China is due, in part, to having so many policy actions underway.

We note the media is viewing the China postponement as a “climb down.”[2]  That take is probably unfair but the administration did raise hopes for sectors of the economy that want trade protection.  Backing away disappoints those sectors.  In addition, there is obvious confusion on the part of the negotiations.  China is using its usual playbook—it is promising to buy lots of raw materials (grains, LNG, oil) but does not want to give in at all on technology.  There have been discussions about a $200 bn reduction in the deficit with China, but no nation has indicated it will change policy to reduce the trade imbalance.

Often, in the financial media, one will hear offhand comments like, “The U.S. runs a trade deficit because we under save.”  Although true on its face, it makes it sound as if it’s all the fault of spendthrift Americans.  These commentators don’t seem to get that in a world with open trade a nation that purposely creates policies to generate saving over investment will lead to trade deficits elsewhere.[3]  The only way to stop that from happening is to (a) change the saving/investment policy in high trade surplus nations, or (b) enact trade barriers.  Until we trade with Martians, the world cannot run a trade surplus since one nation’s surplus, by definition, becomes another nation’s trade deficit.  This condition is exacerbated by the dollar’s reserve status as nations are willing to run trade surpluses with the U.S. to acquire dollars.[4]  If the U.S. really wants to end the trade deficit, policies designed to boost saving should be implemented.  These would include higher interest rates, a weak dollar policy, consumption taxes and a weaker social safety net.  However, if the U.S. did this, the world economy would implode.  The absence of a global hegemon was a major cause of the Great Depression.[5]

Will the EU prompt a sanctions war?  Reuters[6] is reporting that the EU is considering direct sovereign transfers to Iran to pay for oil exports.  Individual companies are uncomfortable with violating American sanctions because they want access to the U.S. financial system.  The EU is taking the position that the administration won’t prevent a whole country from accessing the U.S. financial system.  Although we tend to agree with the EU that the U.S. probably would not go after countries, the damage that this action would do to transatlantic relations would be significant.  Relations have been strained before but if Europe decides to “go it alone” it could lead to a “thaw” in another frozen conflict area.  At the same time, there are reports that the EU, Russia and China are working on a new agreement that would address U.S. concerns over Iran’s missile program and its support of proxy groups in the region.[7]  Thus, the EU threat may be part of the bargaining process.

Italian politics: Reports indicate that Giuseppe Conte, a 54-year-old law professor, is likely to be nominated as Italy’s next prime minister.  He is a little known figure, which is the usual ploy when coalition partners don’t really agree on a candidate.  If Italy’s president agrees to Conte, we will be watching to see how the key ministries are distributed in the new government.

Maduro wins[8]: This is not really news as his victory was widely expected.  The turnout was very low, only 48%; the last election had an 80% turnout.  Some pundits noted that letting one of the other independent candidates win would have been a savvy policy.  Most of the world has refused to recognize this election as legitimate and there are expectations of further sanctions on Venezuela.  Letting another candidate win would have made new sanctions less likely.  Since Maduro clearly didn’t feel secure enough to take that path, we expect further action against Venezuela.  If the U.S. embargos Venezuelan oil imports, oil prices will likely move higher.

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[1] An additional factor supporting grain prices is that the Midwest continues to receive heavy rainfall, which has slowed fieldwork and may result in less acreage being planted.

[2] https://www.washingtonpost.com/news/wonk/wp/2018/05/20/china-is-winning-trumps-trade-war/?utm_term=.39d94a9fc198 and https://www.ft.com/content/fdf48df2-5c46-11e8-9334-2218e7146b04 (Interesting to note is that Chinese media commentators are just as critical of Chinese trade negotiators, feeling they were also weak.)

[3] The best analysis of this issue comes from Michael Pettis.  Pettis, M. (2013). The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy. Princeton, NJ: Princeton University Press.

[4] To put it another way, we get stuff for T-bills.

[5] Kindleberger, C. (1986). The World in Depression, 1929-1939 (2^nd ed.). Berkeley, CA: University of California Press.

[6] https://www.cnbc.com/2018/05/18/eu-considers-iran-central-bank-transfers-to-beat-us-sanctions.html

[7] https://www.reuters.com/article/us-iran-nuclear-meeting/europe-china-russia-discussing-new-deal-for-iran-newspaper-idUSKCN1IL016

[8] https://www.ft.com/content/23bdde0a-5ca4-11e8-9334-2218e7146b04?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Friday!  Financial markets are mostly flat this morning.  This is what we are watching:

Italy: The FT[1] is reporting that the Five-Star Movement and the League have reached a deal to form a government, although the prime minister post has not been settled.  We would expect a compromise candidate, a figurehead, to emerge at some point for this role.  The final deal does remove the talk of a return to “pre-Maastricht” and calls on the Italian bonds held by the ECB to not count against debt/GDP calculations.  But, the agreement calls for both tax cuts and increased spending which will almost certainly lead to fiscal deficits that will run afoul of Eurozone rules.

What really caught our attention, however, was the government’s proposal to issue “mini-BoT,” which are short-term, small denomination sovereign bills.  Denominated in euros, they are designed to be “tax anticipation notes.”  Cash-strapped governments have issued such instruments; California did so eight years ago.[2]  Still, previous notes were electronic entry; Italy plans to use its lottery presses to print these BoT, which makes them bearer bonds and potentially a parallel currency.  Now, as one would expect, the coalition is downplaying this potential, indicating that no entity will be required to accept BoT.  But, if the government follows through on this plan, it is a major threat to the Eurozone.  It should be noted that the former Greek FM Yanis Varoufakis proposed similar instruments in 2015.  In fact, the Five-Star and League negotiators consulted with Syriza on how to structure these instruments, yet even the radical Varoufakis wouldn’t go so far as to issue printed bearer bills.  It isn’t hard to envision how these notes, issued at a discount to face value (say, €90 with a face value of €100), would fall to even deeper discounts as more are issued.  Essentially, the BoT will potentially become a way for Italy to expand its fiscal debt in a quasi-currency.  This coalition is turning into a significant threat to the Eurozone.

This chart shows the level and spread between German and Italian 10-year sovereigns.  What is notable is that German yields have been steady to lower since the run up in Italian yields.  We would expect Italian capital flight to develop and usually Germany is the first stop.  We are also not seeing any unusual behavior in the Swiss franc.  Perhaps investors are waiting for the PM to be appointed before deciding a populist threat in the Eurozone’s third largest economy is meaningful.

In the short run, the problems in Italy are bearish for the euro.  But, if we get a north/south split, the euro becomes the new D-mark and a new southern euro becomes the new lira/drachma.  The euro soars, while the southern euro depreciates.  That may be the final outcome but getting there could easily mean a period of euro weakness.

Trade: There were two items on trade.  First, there are reports that China will offer $200 bn in trade concessions.[3]  Essentially, China will offer to increase its imports from the U.S. if the Trump administration relaxes the technology trade restrictions.  Implied is the idea that Beijing will help in the negotiations with North Korea.  The president now finds himself facing a problem often seen with his predecessors; the U.S. has multiple goals and has to “thread the needle” to meet all of them.  And, in reality, it is usually impossible to get everything you want.  China’s desire to expand and develop its tech industry seems paramount and it is willing to promise to buy grain,[4] natural gas and perhaps even oil to narrow the trade deficit if it will allow Beijing to maintain access to U.S. intellectual property.  The problem is, of course, that this runs at cross-purposes to the U.S. goal to maintain tech supremacy.  In addition, the buying China does with the U.S. means that other nations, e.g., Brazil, Argentina, Australia and perhaps Iran, will see their exports to China fall.  Second, it appears that the NAFTA negotiations have failed.  It isn’t clear if the administration will simply leave the treaty or if it will remain in limbo as talks drag on.

Venezuela: Elections will be held on Sunday; there is little doubt to the outcome.[5]  President Maduro will likely win.  Real opposition candidates have been prevented from running.  Only two independent candidates share the ballot with Maduro and they won’t likely win more votes than Maduro unless powerful people in the ruling class have decided Maduro needs to go.  If the expected occurs, most governments have already indicated they don’t recognize this election as legitimate which could mean new sanctions are imposed.  If we get a surprise and Maduro is forced out, outside governments will have to decide whether this illegitimate election is now legitimate.  Our expectation is that Maduro wins and Venezuelan oil supplies are further reduced.

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[1] https://www.ft.com/content/e0cd0f22-5a7c-11e8-bdb7-f6677d2e1ce8

[2] https://www.municipalbondstoday.com/tag/california-revenue-anticipation-notes/

[3] https://www.nytimes.com/2018/05/17/us/politics/china-trade-trump-concessions.html?hp&action=click&pgtype=Homepage&clickSource=story-heading&module=first-column-region&region=top-news&WT.nav=top-news

[4] https://www.wsj.com/articles/china-drops-probe-into-u-s-sorghum-shipments-1526629000

[5] https://www.ft.com/content/edd6c4a0-5906-11e8-b8b2-d6ceb45fa9d0?emailId=5afe55bf3305f4000487e5a5&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Financial markets are quiet this morning.  This is what we are watching:

More in Italy: Governments are powerful but not omnipotent.  When financial markets turn on a country, it can force unwelcome policy changes.  The populists in Italy are finding this out the hard way.  As we noted yesterday, Italian sovereign yields rose sharply.  Markets have offered little relief today as 10-year Italian sovereigns hit a high yield this morning of 2.15%; on May 4, the yield troughed at 1.71%.  It should be noted that this 44 bps rise in rates has occurred without any tightening from the ECB.  We did get some clarification on the debt write-down; the coalition doesn’t necessarily want the debt written off but wants any bonds held by the ECB as part of QE to not be counted in the debt/GDP calculation,[1] which, of course, is essentially the same thing.  The leader of the League, Matteo Salvini, complained about market “blackmail.”[2]  Although the populists have, to some extent, toned down their rhetoric about the Eurozone (they have dropped earlier calls for a referendum, for example), the coalition is proposing increases in fiscal spending that will break Eurozone rules.  The coalition seems to be daring the Eurozone to sanction them; unlike Greece, Italy is a large economy and the populist leaders seem to be willing to force a showdown.  If the coalition forms and does increase government spending, Germany’s reaction will be key.  We doubt Germany will tolerate Italy’s actions and will press the Eurozone and the ECB to punish Italy.  Although we have been bullish the EUR, for parity reasons, an internal fight will likely be bearish in the short to intermediate term.

Our long-term view has always been that the Eurozone was unsustainable; the single currency was not an economic policy but instead done for political goals, namely, to contain Germany.  The real fight is whether Germany’s or some other European nation’s vision dominates.  The story of Europe since 1870 has been all about the German problem.  Germany is the strongest power in Europe but not strong enough to fully dominate it.  In the long run, we expect the Eurozone to split into workable economic units, with the north and south creating their own currencies.  As we noted yesterday, the “known/unknown” is which group France joins.

No NAFTA[3] today: Today is the deadline for NAFTA talks but it doesn’t look like a deal is in the offing.  The deadline is somewhat artificial—negotiations can continue.  However, in order to put the bill through under the complicated Fast Track Promotion Authority, which passes trade bills on an “up or down” vote without amendments, Speaker Ryan needs to put the bill into place today.  In addition, exemptions for the steel and aluminum tariffs for Mexico and Canada end on June 1; it is hard to argue for an extension without a NAFTA deal.  And, Mexican elections loom on July 1 and polls continue to show that Orbador still holds a dominating lead.  He is a populist and negotiating a NAFTA deal under his government might not be possible.  A breakup of NAFTA would be very disruptive to all three economies.

Energy recap: U.S. crude oil inventories fell 1.4 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 last March.  We would consider the overhang closed if stocks fall under 400 mb.

As the seasonal chart below shows, inventories are usually rising this time of year.  This week’s decline is consistent with the onset of seasonal patterns.  We expect steady stock withdrawals from now into mid-September.  If we follow the normal seasonal draw in stockpiles, by September, crude oil inventories will decline to approximately 424 mb.

Based on inventories alone, oil prices are overvalued with the fair value price of $63.55.  Meanwhile, the EUR/WTI model generates a fair value of $65.68.  Together (which is a more sound methodology), fair value is $64.68, meaning that current prices are above fair value.  The combination of a stronger dollar and the peak of seasonal inventories has weakened our fair value calculations.  However, we do expect the dollar to weaken in the coming months and oil inventories to decline based on seasonal factors.  Using the oil inventory scatterplot, a reading of 424 on oil inventories would generate oil prices in the high $70s to low $80s range.  At present, we have no reason to believe that inventories won’t follow their usual path so the case for higher oil prices remains, barring a seasonal divergence that increases supply or a sharp rise in the dollar.  We note today that Total (TOT, (ADR) 63.21) warned it will likely pull out of Iran unless it can be guaranteed sanctions relief.[4]  The French oil company is the largest foreign investor in Iran’s energy sector.  If it does pull out, it would represent a significant blow to Iran and signal that, despite all the brave talk, Europe will be beholden to the American sanctions regime.  Issues like this, plus the Venezuelan elections on Sunday, are a major reason why oil prices are running in front of where the dollar and inventories suggest they should be.  In other words, the observed risk premium is reasonable.

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[1] https://video.repubblica.it/economia-e-finanza/governo-borghi-lega-nessuna-richiesta-di-condono-debito-i-mercati-non-conoscono-l-economia/304980/305610?ref=RHPPLF-BH-I0-C8-P1-S1.8-T2&utm_source=POLITICO.EU&utm_campaign=1671a38515-EMAIL_CAMPAIGN_2018_05_16&utm_medium=email&utm_term=0_10959edeb5-1671a38515-190334489

[2] https://www.ft.com/content/0dcc8412-591f-11e8-bdb7-f6677d2e1ce8

[3] https://www.politico.com/story/2018/05/16/nafta-trade-deal-delay-547034

[4] https://www.ft.com/content/723155ce-591d-11e8-bdb7-f6677d2e1ce8?emailId=5afd0450da2c1e000444e8f0&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22