by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It was a mostly quiet overnight session.  Here is what we are watching this morning:

Policy talk boosts greenback: Dovish comments from the ECB and BOE have lifted the dollar this morning.  The ECB is considering delaying the path of tapering due to recent economic weakness and BOE Governor Carney made similar statements as well.  We have been bearish the dollar based on valuation issues; using inflation parity, the dollar remains overvalued, although the degree of overvaluation has been reduced.  Monetary policy, under conditions of overvaluation, is usually not all that important.  However, the dollar has been range-bound in recent months and we suspect that condition will remain in place for a few more weeks before the dollar’s decline resumes.

Trump and OPEC: The president tweeted this morning that OPEC is “at it again” artificially boosting prices.  Oil prices dropped sharply on his comments.  He argued that there are “record amounts of oil all over the place.”  This is clearly wrong.  As we detailed yesterday, oil inventories are well off their peak and we have not seen the usual seasonal build in stockpiles that typically occurs in the first four months of the year.  The president suggested “this will not be accepted.”  There are two things the president could do to bring down oil prices.  First, he could authorize a release of oil from the Strategic Petroleum Reserve (SPR).  Although the government plans to sell oil out of the reserve in the coming years for budgetary reasons, there is still ample oil available in the reserve.  This action would be improper—the SPR is designed for emergencies, not for guiding prices.  However, other presidents have used the reserve in this way; President Clinton did so in the late 1990s (although officially this release was related to heating oil).  The second action he could take would be to recommend legislation to stop oil exports.  This would lower U.S. oil prices relative to the world and give OPEC + Russia what it really wants, which is an end to the supply threat from shale oil.  We remain bullish oil; the president could affect oil supplies but, in reality, this morning’s tweeting is simply jawboning.  However, politically, his comments make sense; high gasoline prices are never popular with the public and calling out OPEC is one way to react to higher gasoline prices.

In related news, Saudi Arabia and Russia will begin talks over the weekend “on sending a signal on what they will do beyond next year.”[1]  Saudi Arabia needs Brent around $75 per barrel to meet its fiscal obligations.  Russia can balance its budget with $53 oil.  The two must decide if they will continue their program to reduce supplies or begin to retake market share.  Although we are bullish crude oil, any news that OPEC is boosting supplies will be bearish for prices, at least in the short term.  Longer term, if the Iran deal ends or the conflict in Syria spreads, oil prices would likely rise.

North Korea: Media reports indicate that North Korea will not have preconditions for upcoming talks.  Although there is concern about strategic ambiguity (the U.S. and the DPRK say the same thing but mean something different), it does appear that Kim wants a deal of some sort.  The talks are a high-stakes gamble.  If negotiations are successful they could bring peace to a troubled part of the world and give President Trump an historic breakthrough.  If they fail, it’s hard to see how war doesn’t follow.

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[1] https://www.wsj.com/articles/an-oil-deal-between-saudi-and-russia-worked-now-what-1524130200

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

Castro era coming to an end: Today, Raul Castro, brother of Fidel Castro, is expected to step down as Cuba’s president. Castro will be replaced by his vice president, Miguel Diaz-Canel Bermudez, but will still retain his role as head of the Communist Party until 2021. Miguel Diaz-Canel will be the first non-Castro president since the end of the Cuban Revolution in 1959. His ascension to the presidency will likely be well-received by many Cubans, especially the younger population, as the country is in the midst of economic stagnation. Since Diaz-Canel has maintained a relatively low profile prior to his nomination, it is unclear what changes he is likely to make, if any. Many speculate that his nomination represents a subtle break in Cuban political continuity as he was born after the Cuban Revolution. At this moment, it is unclear what his nomination means for U.S.-Cuba relations, but it was reported that he was skeptical of Raul Castro’s attempt to normalize relations with the U.S.[1] Tensions have been elevated between the two countries following a sonic attack on the U.S. embassy in Cuba that left diplomats injured.

Complete denuclearization in NK? According to South Korean President Moon Jae-in, North Korea has expressed interest in an agreement to completely denuclearize without the condition of U.S. troop withdrawal from the Korean Peninsula.[2] This marks another breakthrough in normalizing relations between the two Koreas; yesterday the countries agreed to hold talks to formally end the Korean War. The caveat to possible complete denuclearization is that the U.S. would have to agree to end hostile policies against North Korea and guarantee its security. The comments appear to be a prelude to the proposed meeting between President Trump and Kim Jong-un. President Trump has expressed a limited amount of optimism regarding the meeting, stating that he is prepared to pull out of the meeting if it is not “fruitful.” We will continue to monitor this situation.

Return to $100 a barrel? Oil prices touched four-year highs due to speculation that OPEC will extend supply curbs into 2019. There have been rumors that senior Saudi officials are pushing to force prices to reach $80 or even $100 a barrel in order to boost the IPO price as well as support some Saudi economic initiatives, such as Vision 2030. Energy stock prices also rose on the news.

Energy recap: U.S. crude oil inventories fell 1.1 mb compared to market expectations of a 0.6 mb draw.

This chart shows current crude oil inventories, both over the long term and the last decade. We have added the estimated level of lease stocks to maintain the consistency of the data. As the chart shows, inventories remain historically high but have declined significantly since last March. We would consider the overhang closed if stocks fall under 400 mb.

As the seasonal chart below shows, inventories are usually rising this time of year. This week’s decline in stockpiles is counter-seasonal. Every week that fails to show a build on the seasonal pattern is a week where the seasonal factors become less bearish. We are approaching the end of the seasonal build period; assuming a strong summer driving season, this chart is bullish for crude oil.

Based on inventories alone, oil prices are undervalued with the fair value price of $64.99.  Meanwhile, the EUR/WTI model generates a fair value of $74.57. Together (which is a more sound methodology), fair value is $71.40, meaning that current prices are below fair value. Oil prices have been rising on geopolitical tensions and bullish fundamentals. We still view oil prices as undervalued but the degree of undervaluation is diminishing. However, as the above chart on seasonal pattern suggests, declining inventories this summer portends higher prices.

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[1] https://www.washingtonpost.com/world/the_americas/in-cubas-national-assembly-raul-castro-marks-last-moments-of-his-familys-rule/2018/04/18/82f82cd4-4293-11e8-b2dc-b0a403e4720a_story.html?utm_term=.a3d5e1585c0c

[2] https://www.reuters.com/article/us-northkorea-missiles-moon/south-koreas-moon-says-north-seeking-complete-denuclearization-idUSKBN1HQ119

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equity markets are quietly ticking higher.  Earnings remain strong.  Although there wasn’t much market news, there was a great deal of other news.  Here is what we are watching:

Pompeo to Pyongyang: Over Easter, CIA Director and SOS nominee Mike Pompeo was dispatched to North Korea and met directly with Kim Jong-un.  The meeting was confirmed by the president in an early morning tweet.  With the breakdown at the State Department under Tillerson, the White House has been using the intelligence channel to communicate with Pyongyang.  Reports indicate the CIA has been the conduit of backchannel talks with officials at the Reconnaissance General Bureau, the North Korean version of the CIA.  The president has also given his “blessing” to North and South Korea to begin peace talks.

There has been some discussion about the idea of denuclearization.  This has the potential to be an area of “strategic ambiguity,” where two parties say the same thing but mean something entirely different.  For the U.S., it is generally assumed that denuclearization means North Korea gives up its nuclear program.  For North Korea, the term means the U.S. and North Korea no longer threaten each other directly and U.S. troops leave South Korea.  Most analysts have considered the North Korean position a non-starter for the U.S.  Those American troops on the Korean Peninsula are part of U.S. power projection in the region.  However, that analysis may be misreading the president’s core position on foreign policy.  In terms of foreign policy, Trump is Jacksonian.[1]  That means he rejects the burdens of hegemony; foreign policy is mostly based on honor.  In this light, the Syrian policy is perfectly clear—the use of chemical weapons is a direct affront to the president and American honor but there is no need for the U.S. to shape policy in the region because it’s none of our business.  Thus, the White House might be perfectly fine with the withdrawal of U.S. troops from South Korea in exchange for an end to North Korea’s ICBM program.  In other words, the Far East would still be threatened by North Korea’s nuclear program but the U.S. would not.[2]

There are two other items that are part of these meetings.  First, it is notable that Pompeo met with Kim over Easter, which was just after Kim met with Xi in Beijing.  The timing would suggest Washington and Beijing are vying for the attention of the “young general.”  Second, Pompeo is struggling with Senate confirmation.  The announcement that he is in the midst of sensitive talks with North Korea will probably be enough to encourage the senators to approve him so as not to disrupt negotiations.

China and telecom: The U.S. is limiting the ability of ZTE (ZTE: CNY 31.31) to use American technology for seven years.  The White House has been complaining about China’s confiscation of U.S. intellectual property and thus has decided to punish one of the few truly international Chinese telecom companies.[3]  ZTE also engaged in business with nations under U.S. trade restrictions.  Huawei Technologies (SHE: CNY, 7.20) announced it will refocus on existing markets due to difficulty in doing business in the U.S.[4]  Although there has been much focus on tariffs and commodities, the real battle is in technology, where the U.S. is opposing China’s attempts to establish high-tech dominance.

Is Clarida more dovish than we thought?  Barron’s[5] offers analysis suggesting the president’s nominee for vice chair may be more dovish and less conventional than at first glance.  We will have more on this idea in the coming days but we have been concerned the president would lean dovish in picking Fed officials and may berate the central bank for rate hikes at some point.  In other words, relations between the Fed and the White House could eventually become Nixonian, which would mean higher inflation, lower nominal yields and a weaker dollar.

IMF and growth: The IMF is forecasting 3.9% GDP growth for this year, the strongest year since 2011.  The group noted that the global economy is in a widespread expansion, but did warn that a trade war could undermine the current good times.

Nickel prices jump: Nickel prices are higher this morning on fears that new sanctions on Russian nickel producers could restrict supplies.

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[1] For background, see WGRs, American Foreign Policy: A Review, Part I (10/3/16) and Part II (10/10/16)

[2] The meetings with PM Abe must have been awkward in light of the Pompeo news.

[3] https://www.nytimes.com/2018/04/16/technology/chinese-tech-company-blocked-from-buying-american-components.html

[4] https://www.wsj.com/articles/huawei-looks-to-existing-markets-as-tech-becomes-target-in-u-s-china-trade-spat-1523966693

[5] https://www.barrons.com/articles/reading-richard-clarida-hawk-or-dove-1523929538

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It was mostly quiet overnight.  Continued robust earnings are lifting equities this morning.  Here is what we are watching:

Abe to Florida: Japanese PM Abe will meet today with President Trump at Mar-a-Lago.  The meetings come at a difficult time for Japan.  Abe is facing domestic scandals that have weakened his popularity ratings, and he faces party elections in the fall which may lead to his ouster as PM.[1]  Japan was caught off-guard by the White House’s decision to hold talks with North Korea.  Abe fears the U.S. will focus on mitigating North Korea’s ICBM threat while leaving a potent short-range missile program in place, which threatens Japan.  The anti-trade rhetoric of the Trump administration also has to be a concern as Japan runs a large bi-lateral trade surplus with the U.S.  The chart below shows the rolling 12-month goods trade deficit with Japan.  Exports represent about 18% of Japan’s GDP.

The “dirty little secret” for Japan is that the JPY is deeply undervalued.  The chart below is Japan’s parity calculation using relative CPI.  The current fair value is ¥60.56 to the USD compared to the current ¥107.00.  A leg of Abenomics was a weaker JPY to buy time for restructuring.  In reality, the restructuring didn’t really occur (true restructuring would require increasing income to the household sector and reducing it to the corporate sector) so allowing the JPY to remain weak is counterproductive to U.S. interests.  So far, the president hasn’t figured out the exchange rate issue but, at some point, we expect him to use this tool in his trade policy.

We expect these meetings will be frustrating for PM Abe.  President Trump should focus on North Korea.  Japan lacks other allies and thus will need to accept whatever the U.S. offers.  Thus, the goal for Abe should be to at least give the appearance of camaraderie.

China’s GDP: This report is always taken with a degree of skepticism because it is so stable.  Growth rose 6.8%, although independent estimates put the real growth number closer to 4.8%.   Property investment rose 10.4% after being in single-digits since 2014.  Infrastructure spending rose 9.0%, which is unusually slow; usually this number rises between 15% and 20%.  Overall, China continues to ensure growth remains solid even if that means “goosing” real estate activity.  On a trade note, China indicated it will impose surcharges on U.S. sorghum exports of 178.6% as part of a “dumping” allegation.  China did indicate the finding is “preliminary,” which may mean it will be adjusted.  The U.S. exports around $1.0 bn per year of sorghum.  The majority of sorghum is grown in western Kansas, eastern Colorado and western Texas with a belt of production in south-central South Dakota.  However, some of the crop is planted in most states; nearly 40 of the lower 48 states record some sorghum planting.

Fed governor nominees: The White House confirmed it is nominating Richard Clarida and Michelle Bowman for two open positions on the Fed’s Board of Governors.  Clarida is a professor at Columbia University and is also on the payroll of PIMCO.  Bowman has extensive experience in community banking and will fill that position on the board.  We expect both to sail through the nominating process.  We have adjusted our “hawk/dove” spreadsheet.  Our current read on the two new nominees is that they are both centrists.  We have also pulled John Taylor from our potential roster of vacancies.  Marvin Goodfriend remains on the list, although his performance during his nomination hearing was weak enough that the administration may consider a different candidate.  We have also moved Williams to the NY FRB, although Bill Dudley will be in office until June.  We are estimating that a moderate will replace Williams at the San Francisco FRB.  Below is our view of the current composition of the board.

The current composition including projected members has an average of 2.64, making it mildly hawkish.  Last year’s voters averaged 3.20, a mildly dovish composition.  We are continuing to research Chair Powell and may change his position to a more hawkish leaning.  But, for now, we believe the new governors make the voting roster a bit less hawkish.

Russia cyberwar: The U.S. and U.K. issued warnings that Russia is targeting Western internet infrastructure with intrusions into home and business routers.  By taking control of routers, Russia can control internet traffic.  On a related note, President Trump decided to delay expected sanctions on Russia tied to its support of Assad.  UN Ambassador Haley indicated these would occur on the weekend news shows, but the president didn’t feel comfortable executing them.

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[1] This is a possible, but unlikely, outcome.

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s relief Monday!  There was an attack on Syria but it was quite limited.  Equities have moved higher, Treasury yields have lifted, oil prices have dipped and the dollar is lower.  This is what we are watching this morning:

Parsing Syria: Late Friday, the U.S., U.K. and France launched a missile and bombing raid on three suspected chemical weapons sites in Syria.  Although it appears damage to the facilities was extensive, there was no leakage or any reports of casualties.  This suggests that Syria fully anticipated what targets would be hit and evacuated the facilities.  Russia was essentially warned to ensure no Russian personnel would be harmed.  The strikes were calculated to show American resolve against chemical weapons without expanding the conflict or threatening the Assad regime.  Although B-1 bombers did use the Qatar facilities in the attack, there was no evidence of direct Gulf State participation.

What can we take away from this action?  First, we think Trump’s recent comments about leaving Syria are where his preference lies.  The reaction of some right-wing populist commentators was interesting as there was strong condemnation of the attacks.  Right-wing populists are opposed to American hegemony and want an end to the inconsequential wars that accompany that position.   This group represents the president’s core supporters and he will be conscious of their opposition.  Thus, we would not be surprised to hear him return to the withdrawal position soon.  Second, the action will not deter Assad from his goal, which is to retake all the territory lost.  He may stop using chemical weapons to achieve this aim but attacking Syria for using chemical weapons but allowing his military to use indiscriminate bombing, i.e., attacking civilian areas and hospitals, is just as bad.  Why does the U.S. tolerate the latter but respond to the former?  There are probably a couple of reasons: (a) chemical weapons are weapons of mass destruction and the U.S. wants to restrict other nations from having them because they reduce America’s ability to project power, and (b) President Obama didn’t enforce the red line on this issue and President Trump is something of the “anti-Obama” in terms of policy.  In other words, he perceives that his base reviles Obama and thus does not want to do anything that smacks of a similar policy.

Additionally, the president really does want to end American hegemony.  We believe this process began with the last administration and continues with this one.  The majority of Americans appear to have tired of the role and don’t see any reason, in light of the end of the Cold War, to maintain America’s superpower role.  A recent Washington Post article[1] notes the president wanted Europe to “handle the Ukraine problem.”  Actually, the policy of demilitarizing Europe and taking over its security was deliberate—Europeans don’t get along (just look at how they handled the Greek debt problem) and have been the fount of two world wars.  Letting Europeans handle security problems will lead to a rearming of Europe and, a generation from now, an environment for conflict.  President Obama concluded that the U.S. could not afford to maintain stability in three regions (Europe, Middle East and Far East) and therefore prepared to remove American influence in the Middle East by allowing Iran to become the regional hegemon.  Trump’s election put that plan aside but its replacement is a free-for-all.  Leaving the Middle East may be necessary but the fallout could be difficult.  The refugee crisis in Europe is partly due to this withdrawal and, at some point, we would expect a disruption of oil flows.

The U.S. has announced further sanctions on Russian firms, those involved in Syria’s chemical weapons industry.  Expect much consternation but no real change in circumstances.

So, the worst outcome for the markets, which would have been Russian casualties, Iranian attacks on Gulf State oil facilities and a wider conflict, did not and probably will not occur.  The result has led to weaker oil prices, higher Treasury yields, dollar weakness and stronger equities.  The good news is that a broader war with deep U.S. involvement isn’t likely.  The bad news is that the Middle East will devolve, bringing further instability.

The currency dog: Sherlock Holmes, in the short story Silver Blaze, talked about the absence of an expected outcome.  In the story, there was a house abduction and the “dog didn’t bark.”  One of the oddities of the Trump administration has to do with the dollar.  At Davos, Treasury Secretary Mnuchin noted that a weaker dollar would support America’s trade policy aims.  The president quickly scotched the idea of dollar weakness for that goal.  However, pressing dollar weakness looks like a policy that a president intent on reducing the trade deficit should support.  Over the weekend, we learned that the Treasury won’t name several nations,[2] including China, as “currency manipulators.”  Naming China with this designation was part of Trump’s campaign, so the reluctance is something of a surprise.

We suspect the president, always conscious of the visibility of his actions, wants tariffs for the dramatic effect.  That way he can show his base something clear he is doing to punish trade miscreants in ways they can see.  On the other hand, the border adjustment tax, which was part of the tax reform discussion but jettisoned, and a weaker dollar would have likely been more effective than tariffs in reducing the trade deficit.  However, using these tools to affect trade is complicated and takes time.  The president appears to have made the decision that visibility is worth more than potential effectiveness.

Nevertheless, we note with interest a tweet from the president this morning that said, “Russia and China are playing the Currency Devaluation game as the U.S. keeps raising interest rates.  Not acceptable!”  Two issues are contained in this statement.  First, the president seems to have discovered that a weaker currency can offset the effects of tariffs, and second, this may be a shot across the bow to the Powell Fed that the White House is becoming uncomfortable with tighter monetary policy.  Will the president soon discover the benefits of a weaker dollar?  We will be watching to see if more comes of this; if it does, the dollar will likely weaken.

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[1] https://www.washingtonpost.com/world/national-security/trump-a-reluctant-hawk-has-battled-his-top-aides-on-russia-and-lost/2018/04/15/a91e850a-3f1b-11e8-974f-aacd97698cef_story.html?utm_term=.dcfd4031c578&wpisrc=nl_politics&wpmm=1

[2] https://www.nytimes.com/2018/04/13/us/politics/trump-china-currency-manipulator.html