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

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 take is that it was weaker than expected. Although the unemployment rate fell to a new cycle low, it appears to be due to people leaving the workforce. The other major issue is that wage growth still remains subdued. Here is what we are watching this morning

Changes to Iran deal? In an attempt to salvage the Iran deal, the EU settled on a supplementary agreement that would allow the U.S. to impose sanctions on Iran if it attempts to develop an ICBM. The arrangement was made in response to criticism from President Trump that the Iran deal is too lax. There has been growing speculation that President Trump may not renew the sanction waivers on May 12 unless there are drastic changes to the deal. Global powers seemed to be on edge regarding his decision because if this deal were to fail a second one will be much harder to secure. Hawks in both Iran and the U.S. have expressed an unwillingness to compromise in the event of new negotiations. We will continue to monitor this situation.

Argentina default? A combination of rising inflation and weakness of the Argentine peso has called into question Argentina’s debt quality. Argentina’s central bank has struggled to meet its annual inflation target of 15%, with the latest annualized CPI reading at 25.4%. The central bank has responded by raising rates aggressively, hiking rates by 300 bps two times this week and again this morning by 675 bps; currently its benchmark interest rate is 40.0%. Meanwhile, the Argentine peso has weakened against the dollar as markets prepare for the FOMC to raise rates in June. As a result, Argentine Century Bond, which are U.S.-dollar denominated, have tumbled. The chart below shows the historical price—at the time of this publication, Argentine Century Bonds were trading at a discount of $86.15.

China negotiations: Earlier this morning, the U.S. trade delegation demanded that China lower its trade deficit with the U.S. by $200 bn by 2020. Last year, the U.S. trade deficit with China was $337 bn. In addition, the U.S. asked China to eliminate all subsidies linked with its “Made in China 2025” initiative and lower import tariffs to levels similar to the U.S. This appears to be the opening offer from the U.S. and therefore probably will not resemble the final deal. That said, China has expressed a willingness to lower its trade deficit with the U.S. — as it tries to make a switch from an export-based economy to a consumption-based economy — but wants to do so on its own terms. China will be reluctant to accept any deal that will make it look weak to its public and will likely keep its hand close to its chest. Yesterday, it was announced that China’s largest news outlets were banned from reporting on the negotiations.[1] We will continue to monitor this situation.

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[1] https://www.bloomberg.com/news/articles/2018-05-03/china-is-said-to-order-reporting-ban-on-mnuchin-led-trade-talks

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

The FOMC: Yesterday, the FOMC decided to maintain interest rates. We currently expect three hikes this year, with the next rate increase coming in June. Although the recent core PCE report shows that inflation is only 10 basis points shy of the FOMC, we are reluctant to revise our forecast from three to four rate hikes because we are not sure about the level of inflation that the Fed is willing to tolerate.

The chart above shows the projected fed funds rate based on the Taylor Rule and the effective fed funds rate. Using the PCE deflator and the projected output gap as control variables, the Taylor Rule projects the effective fed funds rate should be 3.63%. Currently, the effective fed funds rate sits at 1.63%. Although the chart above suggests the Fed has room to raise rates, there have been concerns that a possible rate hike could have adverse effects on the economy. Tight monetary policy generally dampens consumption by making it more expensive for households to borrow.

Energy recap: U.S. crude oil inventories rose 6.3 mb compared to market expectations of a 1.0 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 rise in stockpiles is normal. We note that next week’s report is usually the seasonal peak in inventories. If we follow the normal seasonal draw in stockpiles, crude oil inventories will decline to approximately 427.4 mb by September.

Based on inventories alone, oil prices are undervalued with the fair value price of $62.28. Meanwhile, the EUR/WTI model generates a fair value of $73.44. Together (which is a more sound methodology), fair value is $69.68 meaning that current prices are below fair value. Using the oil inventory scatterplot, a 427 reading 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 an increase in supply or a sharp rise in the dollar, the case for higher oil prices is improving.

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