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

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