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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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

Fed rate decision: Today, the Federal Reserve is expected to leave interest rates unchanged, but rising inflation and steady economic growth has led many to speculate that the Fed could raise rates as early as next month.[1]

Presidential subpoena?  In early March, Special Counsel Mueller threatened to issue a subpoena to the president if he did not cooperate with the investigation, according to the president’s former attorney, John Dowd, who resigned later that month. The release of this report adds to the complexity of the ongoing investigation into Russian meddling. Yesterday, questions that Mueller planned to ask President Trump were leaked to the NYT, which drew the ire of Trump who called the leak disgraceful. Although negotiations are still ongoing for a possible interview between Trump and Mueller, it appears that the president’s counsel is trying to apply public pressure in order to gain leverage in negotiating the terms of the interview. A former assistant to Mueller claimed—citing grammatical errors as evidence—that the leak could have come from the president.[2] Furthermore, there has been growing speculation that Trump will try to shut down the investigation prematurely, possibly by removing the official overseeing the investigation, Deputy Attorney General Rosenstein. That said, we are confident a meeting between both sides will eventually take place. So far, markets have not reacted to the reports surrounding the president’s potential interview, but we will continue to monitor the situation.

Heightened trade tensions: There is growing speculation that trade tariff exemptions for U.S. allies will expire on June 1 unless each country agrees to a new trade deal. At a meeting of steel industry executives, White House Trade Adviser Peter Navarro stated that all countries receiving a trade exemption will face an import quota or other restrictions. This development will likely not go over well with the European Union, which has stated it will not negotiate until the exemption is made permanent. In the event that the U.S. imposes tariffs on European steel, the EU has made plans to retaliate in kind by imposing $3.5 billion worth of tariffs on U.S. goods. Although no goods were named specifically, the EU plans to target U.S. steel, industrial products and agricultural products.[3]

Brexit impasse: The likelihood of a “hard” Brexit has increased as pro-Brexit members of Parliament have placed pressure on PM May to drop her plan for a “customs partnership” model, which is one of the two models being discussed in the Brexit cabinet subcommittee meeting. Under the customs partnership model, the U.K. would collect tariffs set by the EU on goods coming into the U.K. on behalf of the EU. If these goods did not leave the U.K. and U.K. tariffs were lower, companies could claim a refund for the difference. The other plan would require the use of technology that would allow countries to pay duties in bulk every few months for access to the U.K. market. Brexit supporters describe the customs partnership as very complicated, unworkable and likely to leave the door open for the U.K. to rejoin the customs union in the future. On the other hand, proponents of the customs partnership model believe it will make it easier to strike future trade deals and satisfy the Irish border problem. The appointment of Sajid Javid as home secretary, who campaigned on remaining in the EU but is now believed to be in favor of Brexit, will likely be a determining factor in the decision.

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[1] Correction: in yesterday’s Daily Comment we reported the rate decision was yesterday.

[2] http://thehill.com/homenews/news/385602-muellers-former-assistant-says-grammatical-errors-prove-leaked-questions-came

[3] https://www.reuters.com/article/us-usa-trade-europe-measures-exclusive/exclusive-eu-may-target-3-5-billion-of-u-s-imports-for-trade-retaliation-sources-idUSKCN1GE2FO

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

Tariff extensions: Last night, President Trump announced he would extend the deadline for temporary trade tariff exemptions for U.S. allies by an additional 30 days. Earlier this year, citing national security concerns, President Trump placed trade tariffs on foreign steel and aluminum. The president wants U.S. allies to accept either quotas on steel or a deal on industrial goods tariffs in exchange for permanent exemptions. Deals with Argentina, Brazil and Australia are close to being finalized, while Canada and Mexico are also close to a deal.[1] Meanwhile, the European Union is reluctant to begin discussions without a permanent trade exemption first, claiming the temporary exemptions cause market uncertainty that affect business decisions. The temporary trade exemptions come as the U.S. prepares to send representatives to China to discuss trade.

Nuclear plans in Iran? Yesterday, Israeli Prime Minister Benjamin Netanyahu revealed an archive of stolen nuclear plans from Iran to prove that Iran lied about its nuclear program. The archive did not include any evidence that Iran has broken the nuclear agreement since it took effect in 2016. In response to the accusation, France Foreign Minister Agnes von der Muhll stated that this new information could provide leverage for getting additional assurances from Iran in order to keep the deal in place, but cautioned that the archived information will be studied before there is a final decision. Although there is still a lot of uncertainty about whether President Trump will pull out of the deal, it has been reported that he knew about the archive as early as March 5. Therefore, we do not believe the president’s position has changed.

Mueller interview: This morning, questions that special counsel Robert Mueller would like to ask the president were leaked to the NYT. Currently, the president’s lawyers are negotiating the terms of a possible interview between President Trump and Mueller in order to speed up the investigation. Although most of the questions were related to accusations of obstruction of justice due to the president’s handling of James Comey, there were also questions about the president’s ties to Russia and the relationship he had with his advisers. That said, impeachment is still very unlikely and the Russia investigation appears to be headed to a close.

Taiwan in retreat: The NYT reports that China was able to convince the Dominican Republic to sever diplomatic ties with Taiwan in exchange for increased trade. The deal will likely lead to further isolation of Taiwan, which China still considers a part of its territory. The relationship between Taiwan and China has become tenser with the election of Tsai Ing-wen, who has earned the ire of China after refusing to endorse the “one China” policy. In response to Ing-wen’s rejection, China has pressured countries to cut diplomatic ties with Taiwan in order to force her government to reconsider its stance. As of right now, it appears China will use soft power to force Taiwan back into its orbit but this approach may change as China is becoming more assertive throughout the Pacific. We will continue to monitor this situation.

Fed rate decision: Today, the Federal Reserve is expected to leave interest rates unchanged, but rising inflation and steady economic growth has led many to speculate that the Fed could raise rates as early as next month. As a result, the dollar has strengthened against peer currencies.

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[1] https://www.theguardian.com/australia-news/2018/may/01/australia-avoids-trumps-steel-tariffs-as-deadline-passes-reports

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Monday!  It’s the last day of April (which felt more like early March temperature-wise).  Here is what we are watching today:

Trade week: There is a lot of trade action scheduled this week.  First, the trade delegation is in China this week.  Treasury Secretary Mnuchin, NEC Director Kudlow, USTR Lighthizer and NTC Navarro will discuss trade with Chinese negotiators.  This team is divided; the first two tend to support free trade, while the latter two usually want trade impediments.  It’s not clear if much will come of these negotiations.  Since they don’t face a deadline, we would be surprised by a breakthrough.  China will likely try to divide the group, which would appear to be an easy task.  It is interesting to note that Lighthizer didn’t want this trip now.[1]  He wanted to focus on other trade negotiations.  This brings us to the second trade event this week, the steel tariff exemptions, which are expected tomorrow.  Commerce Secretary Ross told Bloomberg that not all nations will get an extension of tariff relief.[2]  Currently, Australia, Argentina, Brazil, Canada, the European Union, Mexico and South Korea were granted temporary tariff exemptions.  South Korea is the only nation on this list that has been granted permanent relief due to its agreement on steel and car imports.  The EU has indicated it will retaliate if steel and aluminum tariffs are applied to the group.  Third, NAFTA negotiations were expected to wrap up this week but it doesn’t appear that will happen, in part, because Lighthizer is in China.  We still expect a deal with NAFTA to be completed soon.

May trouble: PM May has seen her inner circle move to a harder stance on Brexit after her home secretary, Amber Rudd, stepped down and was replaced by Sajid Javid.  Rudd was involved in the Windrush scandal, where the descendants of Caribbean immigrants from Commonwealth nations, originally brought to the U.K. in the 1960s, were subjected to deportation due to their lack of clear documentation.  Rudd misled Parliament on the scale and scope of the deportations.  Rudd was a “soft Brexit” supporter, who leaned toward joining the EU customs union.  Javid is considered a hard liner on the issue.  The shift has contributed to recent GBP weakness.

Iran nuclear deal: There is growing speculation that the Trump administration will likely pull out of the Iran nuclear deal.  President Trump has been a frequent critic of the deal, calling it “the worst deal ever” because it allows Iran to install more centrifuges after 10 years at its Natanz facility as well as enrich uranium at its Fordo facility in 15 years.  In addition, new Secretary of State Mike Pompeo expressed over the weekend a distrust for Iran, describing its activities in the Middle East as “destabilizing.”  EU leaders are trying to keep the deal together; if the U.S. does end the pact, it isn’t clear whether Europe will cooperate on sanctions.  And, it is almost certain that China will not.

A looming threat: President Trump has indicated he will shut down the government in September if Congress doesn’t give him more funding for his Mexican border wall.  Although it’s too early for the financial markets to care, by mid-summer this could become an issue, especially so close to the midterms.  Historically, such turmoil in front of elections hurts the instigating party but this time around we are not so sure it would be all that harmful to the GOP.  The upcoming elections will be “base v. base” and actions that enthuse base voters may be more important than wooing independents.  A case in point:

This is a chart we ran last week that shows the S&P 500 along with Trump’s approval rating. The low in his approval rating came around the time the tax bill passed.  Note that the president’s approval rating has improved as the administration has shifted toward trade impediments.  The congressional GOP wants to run on the tax cut; this data suggests that such a plan probably won’t work because the right-wing populists were not impressed with that bill because most of the benefits go to the right-(and left-)wing establishment.  On the other hand, “going to the mattresses” on the border wall will likely energize the right-wing populists.  Although President Trump’s negotiating style is to stake out an extreme position and then move to a more conciliatory agreement, the secret of his success is that he has no problem with watching the other party become uncomfortable in negotiations. [3]  Thus, the chances of brinkmanship and shutdown threats could become quite rampant by late summer.

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[1] https://www.wsj.com/articles/china-plans-trade-offers-for-u-s-envoys-on-high-stakes-trip-1525029506

[2] https://www.bloomberg.com/news/articles/2018-04-29/ross-says-u-s-to-extend-duty-relief-to-some-allies-but-not-all

[3] https://www.axios.com/one-trick-pony-inside-trumps-negotiating-style-3b60acf3-76e1-4c7d-9c6b-8792ad38479b.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s a busy Friday.  Here is what we are watching:

Korean leaders meet: In a historic event, the leaders of North and South Korea met and Kim Jong-un became the first DPRK leader to visit the South since the war.  The two leaders vowed to work on denuclearization (with a strong dose of strategic ambiguity) and promised to actually draft a peace accord, which would officially end the Korean conflict.  Currently, the armistice that ended the war is in place but a formal peace has never been negotiated.  The symbolic importance of this meeting should not be underestimated.  It is an important development; not too long ago we were preparing for war.

However, what it means in the end remains in doubt.  One issue to remember is that Koreans, in general, would prefer to reduce outside influence.  The peninsula is valuable land; throughout history, China and Japan have controlled the area to project power.  The U.S. also has an interest.  A potential outcome is one that enhances the independence of both Koreas at the expense of China, Japan and the U.S.  The next big event is the U.S./North Korea summit.

The other big meeting: Overshadowed, but in many ways just as important, is the meeting today between Chairman Xi and PM Modi in Wuhan, in the Hubei province of China.  Relations between the two countries have been tense recently.  There was a flare-up on the northern border several months ago over disputed boundary areas.  India is concerned about rising Chinese investment in its arch-rival Pakistan and is also worried about the one belt, one road (OBR) project that seems to be engulfing the region.  India is facing a difficult path.  If it joins the OBR, it will receive welcome investment and likely gain access to China’s growing consumer market but it will also become a Chinese satellite.  Unfortunately, India does not have a strong enough military or economy to hold out against being surrounded by Chinese allies (purchased with investment from OBR).

Under normal circumstances, India would ally with the U.S.  Geopolitically, this would be a win/win for both nations.  India’s position in the region would be a potential barrier to the OBR and would allow the U.S. to threaten Chinese expansion.  But, the U.S. is in withdrawal mode and Washington may not be reliable.  India’s historical default position is non-alignment.  It was one of the founders of the Non-Aligned Movement and thus would prefer to not team up with either China or the U.S.  Unfortunately, for Modi, remaining non-aligned is probably not an option.  Even if India resists China’s “charms,” it will face a growing threat from Pakistan which will be fueled by Chinese investment.  And, India’s neighbors are increasingly acquiescing to Chinese OBR pressure.  We doubt a resolution will come from this meeting today but the pressure on India is rising.

And yet another meeting: President Trump and Chancellor Merkel meet today in Washington.  Unlike Macron, Merkel does not have a warm personal relationship with President Trump so we would expect a businesslike meeting.  Criticism of Germany’s trade surplus is likely.

A portrait of discontent: A recent Pew poll[1] shows that the political divide is hardening.  Democrats have traditionally preferred officials who compromise.  We believe that’s because Democrats generally see government as a force for good and thus want to see government work, which entails compromise.  The majority of Republicans oppose compromise.  However, this recent polling suggests the majority of Democrats now oppose compromise, a significant hardening of position that will make it very difficult to govern under conditions of gridlock.  But, the most significant finding was that two-thirds of Americans believe their side “loses” more than it “wins” in politics.  Some of this is probably due to a hardening of partisanship; getting partial wins when you think you should get everything you want seems like a “loss.”  But, the most likely reason for this finding is that Americans seem to believe the entire system doesn’t work for them and thus whomever is in office won’t lead to a “win.”  This would explain the attraction of rogue candidates like Obama and Trump.  Our contention is that the voters in 2008 who favored Obama thought they were getting Sanders.  The disappointment was palpable and if the GOP had not run the poster child of the establishment in 2012 then Obama would have been a one-term president.  We would not be at all surprised to see the Democrats repeat the “Romney error” in 2020.

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[1] http://www.pewresearch.org/fact-tank/2018/04/26/key-findings-on-americans-views-of-the-u-s-political-system-and-democracy/?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top-stories