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

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s mid-week!  Here is what we are watching this morning:

A DPRK snag?  Yesterday afternoon, the Kim regime turned hostile, calling off talks with South Korea and threatening to cancel the summit meeting with President Trump.  There is a lot of uncertainty around this sudden change in tone.  However, here are some of our observations.  First, the Kims are famous for erratic behavior.  George Friedman of Geopolitical Futures used to call North Korean policy “ferocious, weak and crazy.”  In other words, the regime projected itself as strong (better not mess with us), weak (we are small fry, why bother) and crazy (don’t provoke us, we might do anything).  Kim’s actions are consistent with his father and grandfather’s behavior.  Second, Kim gets more from this summit with Trump than anyone—he gets to put his nation on the world stage with the preeminent superpower.  Thus, we doubt he will walk away.  But, it makes sense that he would try to shape the talks before they begin.  So, indicating that denuclearization ≠ unilateral nuclear disarmament is important for North Korea.[1]  NSC Director Bolton has suggested that North Korea will follow the Libyan model, which is an unfortunate parallel, not one that Kim would adopt.  North Korea wants “goodies” for each step in the denuclearization process.  It does not want immediate denuclearization.  Three, it’s important not to underestimate the impact of China; Beijing would prefer the status quo, so it may be giving Kim incentives to walk away from the summit.  However, our take is that Kim and Moon are really trying to make the Koreas independent.  If so, Kim wants to use the U.S. to distance himself from China.  We suspect Xi understands this goal and is probably trying to thwart it.  We will be looking for any change in China’s trade with North Korea.

For financial markets, there are two issues within this story.  First, does a hot war develop?  Second, how do the talks with North Korea affect U.S./Chinese trade relations?  Unless these two issues are affected, the North Korean situation won’t have a dramatic impact on the financial markets.

Tensions at the FOMC?  Reuters[2] is reporting that a dispute is developing over the issue of “R*Star,” which is otherwise known as the natural rate of interest.  It also describes what we often refer to as the “neutral rate.”  It’s the rate of interest that is neither stimulative nor restrictive.  The concept was first described by Knut Wicksell and suggests that the economy could overheat if policymakers set a rate below the R*Star, while a rate set above could trigger a recession.  R*Star is not directly observable; economists attempt to estimate it based on a number of methods.  The Phillips Curve is one attempt to determine this rate.  Others try to do it through combinations of long-term productivity and labor force growth.  The dispute is over how to define R*Star.  John Williams, recently appointed as president of the NY FRB, argues that slow productivity and labor force growth have led to a structural decline in R*Star, meaning the FOMC may be close to the peak of its rate cycle.  Randy Quarles, a Fed governor, has postulated the economy has a much faster growth potential and thus should have a higher rate.  In some respects, this is a normal “fight” within the Fed, one between hawks and doves.  The difference here is the arena—economists are fighting over R*Star.

On a related note, those who prepared Richard Clarida and Michelle Bowman for their hearings likely raised a glass last evening because the take on their confirmation testimonies was “boring.”  If one is preparing a nominee, boring is the goal.  Although Clarida didn’t offer us much in his testimony, he did indicate discomfort with QE and seemed to suggest he might not have supported the later versions of the program.  As we have noted in the past, we suspect a generation of young economists will write their dissertations on QE and its impact.  Simply put, we really don’t know what it did.  Our position is that the effect was mostly psychological.  It convinced the public that the zero bound was not a barrier for further policy support.  However, the liquidity injected seemed to sit harmlessly (and ineffectively) on bank balance sheets as excess reserves, so the real impact was probably limited.  However, if the Fed forgoes QE, its only recourse at the zero bound is negative nominal interest rates.

Italy: There were a couple of bombshells that emerged from the coalition talks.  First, a draft version of the coalition agreement sketched out a plan that would effectively return Italy to the pre-Maastricht world of a steadily depreciating lira.[3]  Although the plan does not call for Italy to leave the Eurozone, it wants to be freed from fiscal constraints.  Before joining the Eurozone, Italy maintained its economic growth through steady depreciation of the lira and expansive fiscal spending.  Joining the Eurozone did lead to lower interest rates but restricted fiscal flexibility; economic growth in Italy has suffered ever since.

This chart shows Italian industrial production from 1953 to the present.  Note that production rose steadily until Italy officially joined the single currency in 2000.  Since then, production has stagnated.  We don’t disagree with the populist coalition—joining the Eurozone was a mistake.  The question is how does Italy fix this issue?  There are two paths.  The first is a dramatic restructure of the Italian economy, similar to the labor market reforms in Germany (Hartz reforms) that occurred in the last decade.  Politically, this is probably impossible.  The second path is to leave the Eurozone.  We have always suspected this would be the eventual outcome.  The political trends suggest that exit is a growing possibility.

Another bombshell was that the potential coalition wants the ECB to cancel €250 bn of Italian government debt held on the ECB’s balance sheet.  This would probably be illegal under Eurozone rules, which prevents direct fiscal funding by the ECB.  This report has sent Italian yields rising.

This chart shows German and Italian 10-year sovereigns.  Note the spike in the spread.

Italian polls still indicate the majority of citizens want to remain in the Eurozone.[4]  However, it is tied with Greece with the most against the Eurozone and the lowest actual support.  The coalition probably doesn’t have the support to exit the Eurozone yet.  But, if Germany and the EU try to thwart Italy’s attempt to expand fiscally, we would not be surprised to see a swing toward favoring an exit (and we would also expect increasing capital flight to protect against just that outcome).

Would Italy’s departure from the Eurozone be the end of the single currency?  Although losing Italy would be significant, we suspect that it would likely lead to a two-currency bloc.  It would be easy to make the case that Spain, Greece, Portugal, Italy and perhaps some of the Eastern European nations could join a currency bloc, while the Northern Europeans keep the euro.  That scenario would probably lead to a much stronger EUR, while the southern bloc, by design, would depreciate.  The key nation in this scenario is France.  France should probably be in the southern bloc but it would want to stay linked to Germany.  This outcome isn’t imminent but, as history shows, a process like this can go quite quickly once it starts.

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[1] https://www.ft.com/content/cb6413ce-588d-11e8-bdb7-f6677d2e1ce8?emailId=5afbaa115c5dad00042d6753&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22 and https://www.nytimes.com/2018/05/15/world/asia/north-korea-postpones-talks.html?emc=edit_mbe_20180516&nl=morning-briefing-europe&nlid=567726720180516&te=1

[2] https://www.reuters.com/article/us-usa-fed-nominees/at-top-of-fed-a-dispute-on-policy-picks-up-steam-idUSKCN1IG257

[3] https://www.ft.com/content/890ba3f4-588b-11e8-bdb7-f6677d2e1ce8

[4] https://www.ft.com/content/eb6bcbee-57e8-11e8-bdb7-f6677d2e1ce8

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Risk markets are under some pressure this morning.  Here is what we are watching this morning:

Clarida to the Hill: Richard Clarida, Columbia University economist and Global Strategic Advisor for PIMCO, testifies before the Senate Banking Committee on his way to a confirmation vote.  Michelle Bowman, a Kansas banking regulator, will join him today in this endeavor.  Clarida is up for the position of vice chair and, given Chair Powell’s lack of academic experience, the vice chair position will be of great importance.  We view Clarida as a moderate on policy and expect him to be easily confirmed.  Bowman will fill the role reserved for community banks; this position routinely votes with the leadership.  Filling out the FOMC is important.  Meanwhile, Marvin Goodfriend’s nomination remains in limbo; we doubt he can get confirmed and expect the administration to eventually find a replacement.

Today in trade: Every day seems to bring new information on trade.  Today’s trends indicate that NAFTA talks, so far, are not progressing fast enough to meet the May 17^th (Thursday) deadline.  But, it’s probably too soon to declare negotiations “dead” because Washington seems to only accomplish things when deadlines loom.  The president is trying to navigate the ZTE (ZTCOF, $2.26, delayed) issue.  It appears the White House may be trading ZTE for grain tariffs, backing down on punishing ZTE in return for China not raising tariffs on grain.[1]  There are suggestions that the China hawks may be losing influence[2]; specifically, it appears that Wilbur Ross may have acted rashly to punish ZTE.  Although ZTE acted improperly, the punishment Ross approved was probably overly harsh and prompted the White House to walk it back.  If this is the case, Treasury Secretary Mnuchin is likely becoming a more important influence on trade.  If so, we could see a moderating tone on the trade war front.

Italian populists granted an extension: The Five-Star and League parties asked the Italian president for more time to form a government and the extension was granted.  The policy platform does appear to be coming together but the sticking point is the prime minister.  Neither party has enough power to press for its own party leader so they are trying to find a compromise candidate that both parties can live with.  The possibility of a populist party is putting some pressure on the EUR.

Venezuelan woes: As the state oil company, PDVSA, defaults on bonds, creditors are taking steps to seize assets outside the country.  In an especially crippling move, ConocoPhillips (COP, 69.59) has seized Caribbean tank farms and related export facilities owned by PDVSA.[3]  ConocoPhillips won a court ruling against PDVSA for assets nationalized in Venezuela.  There are reports of oil tankers owned by the company being seized by creditors.[4]  The bottom line here is that PDVSA may find itself unable to export product and crude oil because creditors may seize the asset before it can reach its destination.  Supply disruption from Venezuela may become a bigger issue than Iran for oil supplies.

Summer and gasoline: One of the ways we measure the impact of the price of gasoline is to compare it to the average hourly wage for non-supervisory workers.

The chart on the left shows how many gallons of gasoline the average worker can purchase with an hour’s worth of work.  Thus, the larger the number the more beneficial it is to the worker.  The long-term average is about 8.6 gallons per hour.  We recently fell below 8.0 gallons, suggesting gasoline prices are getting a bit lofty.  The chart on the right compares the aforementioned ratio to consumer confidence.  It’s not a perfect fit but, in general, a high ratio correlates with high consumer confidence.  The recent decline in the ratio is diverging from the current high levels of consumer confidence.  There was a similar pattern around the turn of the century that eventually led to a drop in confidence.

The impact of confidence on the economy is mixed.  It sometimes coincides with stronger retail sales but other times diverges.[5]  However, it does appear that confidence affects voting behavior.  The chart below shows presidential parties, with gray showing Republican presidents.  The relationship isn’t perfect, but we note that confidence declined in the early 1990s and in 2007, leading to changes in power.  Interestingly enough, confidence was mostly elevated at the end of Clinton’s term as well as Obama’s, but neither saw his party hold onto power.  We note recently that the president criticized OPEC for keeping oil prices high.  He may be worried that rising summer gasoline prices might undermine his popularity and hurt the GOP in the midterms.  If oil gets to $80 per barrel or higher, we would not be shocked to see a large SPR release in a bid to ease prices.

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[1] https://www.wsj.com/articles/u-s-china-discussing-deal-on-zte-agricultural-tariffs-1526313679

[2] https://www.politico.com/story/2018/05/14/ross-trump-china-trade-commerce-539279

[3] https://oilprice.com/Energy/Energy-General/ConocoPhillips-Moves-To-Seize-Venezuelan-Oil-Assets.html

[4] https://www.ft.com/content/fd86ae66-5504-11e8-b24e-cad6aa67e23e?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[5] The correlation between the yearly change in the control group of retail sales and consumer confidence is only +32%.