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%.

by Bill O’Grady and Thomas Wash

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

ZTE relief? In a surprise announcement, President Trump tweeted that he is seeking some sort of relief for the embattled company.  ZTE (ZTCOF, 2.26, delayed) is under a rather harsh penalty from the Commerce Department for breaking Iranian sanctions.  Under U.S. rules, the company would not be able to access U.S. components for its devices.  According to reports,[1] President Trump was contacted by Chairman Xi who asked for help on this issue.  This action does appear contrary to the general direction of trade policy toward China but is probably also part of the administration’s broader negotiating stance.  In other words, the president may be using ZTE relief to accomplish other parts of his trade agenda.  We note that a high-level Chinese trade delegation is arriving in Washington on Friday, led by Vice Premier Liu He, a key member of Xi’s governing team.

This event highlights an element of this administration’s behavior.  Simply put, the president’s negotiating style is personal and improvisational.  He doesn’t over prepare and likes flexibility.  This characteristic makes for great risk but also has the potential for breakthroughs.  The North Korean negotiations are a case in point.  It may turn out that the talks with Kim end up as a disaster, leading to war.  At the same time, they might also lead to a new relationship and dramatic lessening of tensions.  Previous administrations have been very cautious in their dealings with Pyongyang and have gotten nowhere.  It is possible that Trump’s negotiating style is what is needed to move the discussion forward.

A similar trend may develop on trade.  The bellicose tone may morph into a workable trade deal that improves the global financial system and extends this business cycle.  It could also devolve into a trade war.  It is clear that Trump has gotten the world’s attention.  But, it is hard to know exactly what the result of these talks will be at their conclusion.  For financial markets, this is really hard because part of the markets’ role to discount the future.  The future is always uncertain but when a negotiator vacillates between war and peace, it increases the difficulty.  However, if Trump is offering Xi an “olive branch” on ZTE and it reduces trade tensions, it will be bullish for risk assets.  In order for Trump to do that, he will likely need a high-visibility “deliverable” to bolster his political fortunes.

Iran: Iranian officials are visiting nations that still remain in the nuclear deal.[2]  For now, it looks like the non-U.S. participants will remain in the agreement, although they will likely face the threat of secondary sanctions from the U.S.; National Security Advisor Bolton suggested this in the Sunday talk shows.[3]  For now, we expect the deal to hold but, eventually, Iranian hardliners will use the rupture to retake control of the government and at least threaten to restart uranium enrichment.  In the short run, oil prices have benefited from the risk of a decline in Iranian supplies.  Those supplies are probably not at risk for the moment.  We do note that China has opened an oil futures contract denominated in CNY.  Reports indicate that volume has increased in light of the sanctions.[4]  Although transacting in CNY will reduce the risk of dollar-based sanctions, it also reduces the value of Iranian oil as the CNY isn’t broadly convertible and China limits foreign ownership of Chinese financial assets, a key element of the reserve currency system.  Thus, Iran would be limited to buying Chinese goods and services.  Still, one of the rules of sanctions is that the more nations that participate in the sanctions effort, the better they work and thus, if the U.S. stands alone, the impact of sanctions is lessened.

Italian government: According to reports, the two major populist blocs, the Five-Star Movement and the League, are making progress toward forming a government.  Although the key sticking point, the prime minister position, hasn’t been resolved, they have put together a policy platform that includes a basic national income for the poor, a reversal of pension reforms and a flat tax of 15%.  Although the fiscal plan may meet the technical constraints of the Eurozone, it clearly doesn’t meet the spirit of structural reforms that the Eurozone has been asking of Italy.  A populist Italy will eventually threaten the fiscal rules of the Eurozone and, unlike Greece, Italy’s economy is large enough to threaten the integrity of the single currency bloc.  European equities have eased on the news while probably supporting modest EUR appreciation this morning.

Indonesia terror attack: It appears a set of bombings in Indonesia was executed by a family that had recently returned from Syria, reportedly[5] with ties to an Islamic State group.  Two Christian churches were targeted.  There have been fears among counterterrorism experts that the demise of Islamic State would lead to its followers spreading into other parts of the world and carrying out attacks in their new countries.  There was also an attack in Paris,[6] a knifing that may have been inspired by Islamic State, although the ties are not as clear as the Indonesian incident.

Iraqi elections: Although results are preliminary, it appears the radical cleric Moqtada al-Sadr was the winner of parliamentary elections over the weekend.  Turnout was very low, around 45%, which may have contributed to his win.  Results suggest his party won 54 out of 329 seats, which means he will need to build a coalition in order to govern.  The expected winner, current PM Haider al-Abadi, came in third.  Al-Sadr is an interesting candidate because he is considered an Iraqi nationalist—he opposes both the U.S. and Iran.  Although a Shiite cleric, his relations with Iran are mixed and we suspect Tehran is not happy about his win as it will complicate relations between the two countries.

Hawkish Mester: Cleveland FRB President Mester indicated that better growth likely means she will support more rate hikes than she has in the past.  She is a voter this year and this stance increases the odds of four hikes this year.

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[1] https://www.wsj.com/articles/trump-in-tweet-says-working-with-chinese-president-xi-to-keep-zte-in-business-1526225831 ; https://www.washingtonpost.com/news/the-switch/wp/2018/05/13/trump-pledges-to-help-chinese-phone-maker-zte-get-back-into-business/?utm_term=.deb75d6f11f8

[2] https://www.rferl.org/a/iran-china-russia-nuclear-deal-zarif-trump/29223723.html?wpisrc=nl_todayworld&wpmm=1

[3] https://www.reuters.com/article/us-iran-nuclear-rouhani/rouhani-says-iran-may-remain-part-of-nuclear-accord-idUSKCN1IE0BY ; https://www.politico.com/story/2018/05/13/bolton-pompeo-trump-iran-sanctions-584206

[4] https://www.reuters.com/article/us-iran-nuclear-china-oil/chinas-crude-oil-futures-boom-amid-looming-iran-sanctions-idUSKCN1IF0SD

[5] http://www.bbc.com/news/world-asia-44101070?wpisrc=nl_todayworld&wpmm=1

[6] https://www.washingtonpost.com/world/europe/paris-police-respond-to-knife-attack-media-report-2-dead/2018/05/12/8fdf41e6-5623-11e8-a6d4-ca1d035642ce_story.html?utm_term=.2bb6f41e6179&wpisrc=nl_todayworld&wpmm=1

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

BOE meeting: The BOE results were neutral to hawkish.  Rates were left unchanged, as expected, but the vote was 7-2 with the dissenters voting for a hike.  The press conference and the statement were rather dovish, belying the vote.  Markets took the results as moderately dovish.

Israel v. Iran: Although we don’t think either side wants a full-blown conflict, Israel has launched a series of missile strikes against Iranian targets in Syria.  These targets appear to be command and control centers for Iranian operatives and proxies in Syria.  Iran has retaliated with similar strikes against military targets in the Golan Heights.  The tempo of attacks has clearly escalated since the president withdrew from the Iran nuclear deal.  Escalating tensions continue to support oil prices.  At this point, we would characterize conditions as tense but not necessarily a prelude to an open conflict.  However, the potential for escalation is rising.

Italian government:  The Five-Star Movement and the Northern League are trying to form a government.  It’s sort of a “damned if you do, damned if you don’t” issue for the markets.  A government based on this coalition would be decidedly populist.  Although all parties have moderated their stance on the Eurozone, the populists will push for fiscal stimulus and threaten the German-enforced order in the Eurozone.  At the same time, if the move to form a government fails, summer elections are possible and the odds of an even stronger showing by the populist parties would be elevated.  We have seen a modest rise in Italian sovereign yields; if conditions deteriorate, look for the spread between Italian sovereigns and Bunds to widen.

Fed policy: With the release of the CPI data we can update the Mankiw models.  The Mankiw rule models attempt to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative.  Mankiw’s model is a variation of the Taylor Rule.  The latter measures the neutral rate using core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy.  Potential GDP cannot be directly observed, only estimated.  To overcome this problem with potential GDP, Mankiw used the unemployment rate as a proxy for economic slack.  We have created four versions of the rule, one that follows the original construction by using the unemployment rate as a measure of slack, a second that uses the employment/population ratio, a third using involuntary part-time workers as a percentage of the total labor force and a fourth using yearly wage growth for non-supervisory workers.

Using the unemployment rate, the neutral rate is now 3.91%, up from 3.75%.  The rise reflects the decline in the unemployment rate.  Using the employment/population ratio, the neutral rate is 1.59%, down from 1.68%.  Using involuntary part-time employment, the neutral rate is 3.28%, up from 3.22%.  Using wage growth for non-supervisory workers, the neutral rate is 2.02%, up from 1.67%.  The modest rise in core inflation (which was less than forecast) has lifted the forecast estimates for the neutral rate for all models.  Although the divergence is wide between the models, three of the four do signal that the FOMC is still accommodative, with the target rate running below estimated neutral rates.  Only the employment/population ratio version shows the neutral rate roughly equal to the current policy mid-point.  In other words, if the FOMC is basing policy on the employment/population ratio, they would have already achieved policy neutrality and should refrain from further rate hikes.  If anything, we suspect they lean toward the unemployment rate but, due to the high degree of uncertainty surrounding slack, the committee prefers to raise rates slowly in order to avoid a policy error.

Energy recap: U.S. crude oil inventories fell 2.2 mb compared to market expectations of a 1.3 mb build.

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 until mid-September.  If we follow the normal seasonal draw in stockpiles, crude oil inventories will decline to approximately 425 mb by September.

Based on inventories alone, oil prices are overvalued with the fair value price of $64.09.  Meanwhile, the EUR/WTI model generates a fair value of $65.38.  Together (which is a more sound methodology), fair value is $64.31, 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 425 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 barring a seasonal divergence that increases supply or a sharp rise in the dollar the case for higher oil prices remains.  We should note that worries over the Iran nuclear deal are supporting oil prices and this factor will likely remain in place for the foreseeable future.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] There is a lot going on this morning.  Let’s dig in:

Iran: As expected, President Trump withdrew the U.S. from the multilateral nuclear agreement with Iran.  Opinions on the move and projections of the decision’s impact vary widely.  We will have more to say on this issue in the coming weeks, but here is a quick view of our thoughts.

• First, this action is bullish for oil. Although we don’t expect Europe or China to participate in U.S. sanctions, the potential to be isolated from the U.S. financial system and the reserve currency will temper Iran’s ability to export oil.  At a minimum, nations accepting Iranian oil will likely require a discount to bear the risk of buying from Iran.  The reduction in supply is supportive for oil prices and is being reflected in the market.  We note that China is Iran’s biggest customer for oil; it exports about 650 kbpd to China.  India is second at just over 500 kbpd.  We suspect these two nations will continue to buy Iranian oil regardless of sanctions, although Iran may be forced to accept CNY from China instead of USD.  However, South Korea is third at just over 300 kbpd and it will likely respond to the sanctions.
• Second, the administration’s action highlights a growing problem with American foreign policy, in general. Increasing partisanship in the U.S. political system means that each change in administration increases the odds that what was previously in place is at risk of reversal.  During the Cold War years, there was remarkable consistency in U.S. foreign policy.  Regardless of party, policy shifts were rare and, when they did occur, the changes remained in place after the implementing administration left office.  For instance, “Nixon to China” and the policies that followed didn’t shift when Carter took office.  That consistency now looks to be at risk.  It isn’t difficult to imagine a Democrat administration reaching out to Iran to bring the Obama deal back.  However, nations will no longer be sure that any deal made will last past the next presidential election.
• Third, the Trans-Atlantic partnership that was forged after WWII is coming under serious strain. This trend began well before President Trump.  President Bush’s decision to invade Iraq was opposed by much of Europe.  President Obama’s unenforced “red line” in Syria was not appreciated in Europe, either.  President Trump has continued this trend, not only with this action but by supporting Brexit and pulling out of the Paris Accord.  There is a natural anti-European strain of U.S. politics that was mostly quashed during the Cold War years.  That anti-Europe, pro-isolationist sentiment is on the rise and this decision is part of that trend.
• Fourth, it isn’t obvious how Iran will react to this decision with regard to its nuclear program. President Rouhani had pressed against the hardliners in Iran to negotiate the deal in hopes that the lifting of sanctions would (a) boost the economy, and (b) reduce the power of the Iranian Republican Guard Corps which had increased its grip on the sanctions-affected Iranian economy.  Neither outcome has occurred.  In fact, the economy’s downward spiral is worsening.[1]  The U.S. withdrawal from the nuclear deal will strengthen the hardliners in Iran and reduce the odds of any sort of accommodation with the regime.
• Fifth, the move draws questions about the administration’s Iran strategy. To be fair, the Iranian nuclear deal was seriously flawed.  It was limited to uranium enrichment alone when the real concern of the U.S. was Iran’s power in the region.  Thus, Iran’s continued covert activity in the Middle East and the expansion of its missile program were seen by the U.S. as evidence of Iranian duplicity.  However, Iran can counter that these actions were never part of the deal President Obama negotiated.  Our take on the nuclear deal was that President Obama had concluded the pivot to Asia required reduced American involvement in the Middle East, and the nuclear deal was the first step in normalizing relations with Iran to allow it to become the regional hegemon and enforce order in an unruly region.  Of course, that normalization required Clinton to defeat Trump and continue Obama’s foreign policy, which wasn’t certain.  For obvious reasons, Saudi Arabia, the Gulf Emirates and Israel did not want that to happen.  The problem is that none of these powers can effectively offset Iran’s influence without U.S. support.  So, either the U.S. must (a) change the regime in Iran, or (b) maintain and build a stronger U.S. presence in the Middle East to contain a strengthening Iran.  Given President Trump’s desire to pull out of Syria, it’s hard to see how (b) is the preferred option, and (a) will be difficult.  Due to its geography, invading Iran would be really tough—think about invading the Rockies.  Perhaps sanctions can force Iran back to negotiations and bring about the deal the U.S. should have secured originally, which is to contain Iran’s ambitions in the region.  But, it could just as easily lead to hardline domination in Iran and the resumption of Iran’s nuclear program.  If there is a workable plan here, it isn’t obvious.  And, when there is no obvious plan, the potential rises for geopolitical risk and market volatility.

So, from a market perspective, this is bullish for oil and likely gold (look for Iranian gold demand to rise).  It may be bullish for cryptocurrencies which offer an alternative to gold, although we suspect the Mullahs will try to prevent cryptocurrencies from gaining share, fearful it would undermine the regime.  It may support Treasuries if conditions in the region deteriorate.  It is also supportive for energy equities and defense stocks.  However, it’s a potential negative for equities, in general, as conflict isn’t something that lifts multiples.

North Korea: Kim flew (yes, flew) to Dalian, China yesterday for a second meeting with Chairman Xi.  We suspect Kim wanted some sanctions relief.  Xi wants to be sure that he doesn’t face a hostile power on the Korean border so he wants Kim to remain an ally.  Meanwhile, Secretary of State Pompeo visited Kim and is bringing back three Americans held in North Korea, which will be seen as a goodwill gesture.  We expect the summit to occur, but what emerges from it is anyone’s guess.

NAFTA: Mexico has offered a compromise on automobile manufacturing, raising North American parts content to 70% from 62.5%.  The U.S. has pressed for 75% but may be willing to concede that point.  Mexico also wants a gradual implementation, which is probably slower than the U.S. would prefer.  The U.S. and Canada have pressed Mexico for wage calibrations that would force Mexican wages to U.S. and Canadian levels.  Mexico, fearful of the loss of competitiveness, has pushed back against this demand.  However, it is showing some flexibility on the issue.  Still, it does appear that negotiations are moving forward, which is a positive sign.

Warsh speaks: Ben White is a columnist for Politico, focusing on the financial markets.  In a recent podcast, he interviewed Kevin Warsh, a former Fed governor who was being considered for the Chair position that eventually went to Jay Powell.  Warsh noted that in his discussions with President Trump the president didn’t really seem to understand that the Fed is an independent entity.  Warsh’s comments confirm our suspicions that President Trump is ending the informal truce that has existed between the Fed and the White House since Bob Rubin convinced President Clinton that leaving the Fed alone to implement policy would lead to a better economy and improve Clinton’s popularity.  Since then, it has been rare to see the White House interfere with Fed policy.  Our feeling has been that President Trump has no interest in an independent Fed.  Instead, he wants all levels of government to do his bidding.  It should be noted that central bank independence was not brought down from Mount Sinai by Moses as part of the 10 Commandments.  Central bank independence has been steadily adopted by industrialized nations over the past 70 years, but there was a theory that monetary and fiscal policy should be coordinated to improve their effectiveness.  It was only when policymakers decided that quelling inflation was their key goal and elected officials could not be trusted to do the job that central bank independence became generally accepted wisdom.  If Warsh’s insights are correct, it would suggest that if monetary policy begins to “bite” then the White House will lash out at the Fed and try to stop further rate hikes.  Such actions will raise fear of a return to the Arthur Burns/G. William Miller years of persistently accommodative monetary policy and rising inflation.  If the Fed’s independence comes into question, it would be profoundly bearish for the dollar, bullish for commodities and gold and bearish for equities and bonds.

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[1] https://www.nytimes.com/2018/05/08/world/middleeast/iran-crisis-nuclear-deal.html?wpisrc=nl_todayworld&wpmm=1

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s a quiet morning in a very busy week.  Here is what we are monitoring this morning:

The Iran deal: The president will announce his Iran decision at 2:00 (EDT).  Although we expect him to end U.S. participation in the pact, it is unclear what he will actually do with the withdrawal.  Will he delay resuming U.S. sanctions?  Will Europe go along?  Given the mercurial behavior of President Trump, even after the announcement it is possible it won’t be completely clear what has occurred.  The White House seems to believe that ending the Obama agreement will prompt Iran to renegotiate with the Trump administration.  We think a more likely outcome is that Iran threatens to “race for a bomb.”  However, Iran knows that actually having a bomb might trigger a nuclear response from Israel.[1]  Thus, it may refrain from racing to the bomb, making it clear the nuclear program was a bargaining position all along.  Simply put, after the announcement, things could get complicated quickly and a “drop dead” position isn’t likely.  That explains why oil prices have declined this morning.  Ending the deal is bullish for oil but maybe not as immediately bullish as recent market action has signaled.

The 2^nd Fleet returns: The 2^nd Fleet was deactivated in 2011.  It was part of the Atlantic Fleet, covering the U.S. East Coast (see map below).  Its primary mission was to defend the eastern U.S. from Soviet naval incursions; for example, it was heavily involved in the Cuban Embargo in 1962.  It was also responsible for training at the Naval Station Norfolk.  It was decommissioned in 2011 in an effort to husband resources.

The resurgent Russia has led the administration to recommission the fleet, a recognition of the growing threat from Putin.

A hawkish turn: As we have noted, San Francisco FRB President Williams is going to take over for NY FRB President Dudley on June 17.  Thus, Williams’s position will be vacant after that date.  Until the San Francisco FRB selects a new president, Mark Gould, the first VP at the bank, will be acting president.  According to Federal Reserve rules, Gould can participate in the discussion but cannot vote on policy.  Instead, rules require that an alternative from one of the non-voting regional banks vote in San Francisco’s place and it just so happens that Esther George, the KC FRB president, will fill that role.  George is perhaps the most hawkish member of the FOMC.  Although this won’t change the June vote (fed funds futures put the odds of a rate hike at 100%), she might push for increases in the meetings without a press conference.  Although we suspect she would be outvoted, she could dissent which would give the meetings a more hawkish tone.  She will continue to vote until the San Francisco FRB appoints a new president.

Italy: President Mattarella has asked the political parties in Italy to allow him to form a non-partisan caretaker government after negotiations following recent elections have led to a stalemate.  The caretaker government would rule Italy until (a) new elections are held, or (b) the parties form a new government.  The announcement has raised fears that choice (a) will be selected, meaning that another round of elections may lead to another chance for a populist government to gain a majority.  Fears of another vote have pressured the EUR and sent Italian bond yields higher this morning.

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[1] There are two reasons behind this thought.  First, Israel has stated on numerous occasions that a nuclear-armed Iran is an existential threat.  If that statement is more than rhetoric, Israel should react strongly before Iran actually has a deliverable weapon.  Second, Israel’s air force cannot conduct a long conventional air campaign by itself that can guarantee the elimination of the nuclear threat.  Thus, if the threat is really existential, it should use its poorly kept secret nuclear capacity to attack Iran.  We believe Israel’s real goal is to quietly threaten to use nuclear weapons as a way to draw the U.S. into a conventional air campaign against Iran, and the U.S. does have the capacity to conduct a massive air war that could dramatically reduce Iran’s nuclear program.

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Good morning! Today was a relatively slow news morning but here are a few stories we are following:

NAFTA negotiations: Today, trade representatives from Mexico, Canada and the United States will meet in Washington to discuss an agreement in principle for NAFTA.  Currently, there appears to be a stand-off between the countries over instituting a wage floor for autoworkers, an increase in the place of origin provision from 62.5% to 75% of the value of the vehicle as well as implementing a sunset provision that would allow the agreement to expire if it is not renewed after five years.[1]^{, [2]} Although both Mexico and Canada have resisted changes to the place of origin clause proposed by the U.S., the primary focus of recent negotiations appears to be the wage floor. In the event that Mexican wages were to fall below $16 an hour, the U.S. and Canada could place tariffs on autos entering either of their countries. Mexico does not like the provision as it fears a wage floor could deter companies from building cars in Mexico and therefore has been reluctant to budge; currently the average Mexican autoworker receives $8 an hour. Despite its reluctance, the Mexican government is expected to issue a counterproposal or come to a compromise later this week as it would like an agreement before the July 1^st general election.

Iran uncertainty: The price of crude oil rose to a three-year high as Iran escalates tensions with the U.S. and Saudi Arabia. There is growing speculation that President Trump will not renew the sanction waivers before the May 12^th deadline. In response, Iranian President Rouhani stated that if the U.S. were to pull out of the agreement it would consider restarting its nuclear energy program. President Trump has long expressed pessimism about the ability of the Iran deal to prevent Iran from getting a nuclear weapon. Many fear that if the U.S. were to pull out of the agreement it would lead to inevitable conflict between the U.S. and Iran, with the U.S. refusing to accept a nuclear Iran and Iran refusing to be bullied by the U.S. On Saturday, former New York mayor and presidential attorney Rudy Giuliani added fuel to that speculation by stating that the president is “committed to a regime change” in Iran.[3] In addition to increasing tensions with the U.S., Iran has also stirred up controversy among its fellow OPEC members. This morning, Iran notified its fellow OPEC members that it does not support Saudi Arabia’s goal of pushing crude prices to $80 a barrel, instead preferring a target of $65 a barrel. This dissention will likely heighten its rivalry with Saudi Arabia, which it is already fighting in a proxy war in Yemen.

Putin’s new term: This morning, Russian President Vladimir Putin was sworn in for a fourth term. It has been speculated that this could be his last term in office. President Putin won the general election with over 77% of the vote largely due to his ongoing standoff with the West. In his acceptance speech, Putin stated that his focus will be on domestic matters such as improving the economy as Russia’s economy has been hit hard by international sanctions and falling oil prices. At the moment, it is unclear who will succeed President Putin after his six-year term ends, but current favorites are Head of Rosneft Igor Sechin, Defense Minister Sergie Shoigu, former Putin body guard Alexei Dyumin and Moscow Mayor Sergei Subyanin.

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[1] http://www.elfinanciero.com.mx/economia/hoy-inicia-reunion-decisiva-de-tlcan

[2] https://www.reuters.com/article/us-trade-nafta/nafta-talks-enter-critical-week-with-u-s-still-pushing-hard-line-idUSKBN1I80BK

[3] https://www.politico.com/story/2018/05/05/giuliani-trump-iran-regime-change-570744