by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

Framing the Fed: The FOMC meeting begins today.  Here we lay out the basic path for monetary policy.

The chart on the left shows the implied three-month LIBOR rate, two years deferred, derived from the Eurodollar futures market.  Note that the yield has increased dramatically since mid-2017, coinciding with optimism and then the passage of the tax bill.  The chart on the right compares that rate to the fed funds target, with the spread between the two rates shown on the upper line of the chart.  In general, LIBOR rates exceed fed funds (fed funds have less credit risk), but the two rates do become a good guidepost for policy.  We have set vertical lines where the two lines cross.  Usually, this marks the end of a tightening cycle.  The Greenspan Fed seemed to closely watch this rate and stopped raising rates when the implied rate fell below fed funds.

The current spread indicates the FOMC will raise rates another 150 bps, to a terminal rate of 3.00%, in two years.  Assuming 25 bps per hike, that implies seven more increases before this time in 2020.  That could mean three hikes this year and four in the remaining 15 months, or four this year and three in the last 15 months.  The number for this year is the topic of discussion.  We expect a clear signal for three and the potential for an additional hike.  It is worth noting that it was not unusual in previous tightening cycles for the implied rate to decline to the target.  Thus, we may not make it to 3.00%.  However, for that to happen, the implied rate will need to decline at some point.

The other issue is that this meeting will be the first press conference for Chair Powell.  A number of pundits have applauded the new Fed leader for speaking plainly.  This is not actually a virtue in our estimation.  Clarity in policy dampens fear and encourages investors to take on more risk until financial markets become unstable.  Thus, a little obscurity should be welcomed.

The prince is in Washington: Saudi Crown Prince (CP) Mohammed bin Salman is visiting the U.S. capital today.  There are a number of items on his agenda, including an attempt to pull the U.S. into a harder line on Iran and likely feeling out policymakers for their reaction to the Kingdom of Saudi Arabia (KSA) acquiring nuclear power.  CP Salman would like to diversify the KSA’s energy away from hydrocarbons, but getting nuclear reactors could give the country the infrastructure to develop indigenous nuclear weapons.  The harder line on Iran should be a bit like pushing an open door—the nomination of Pompeo to the State Department puts an Iran hawk in place and the president has been consistently critical of the Iranian nuclear deal.  In May, the president has to recertify the Iran deal and there is growing speculation he won’t do so.  Finally, the KSA is considering limiting the listing of its Saudi Aramco IPO to the Saudi equity market only.  We suspect the KSA doesn’t want to tackle the intrusive reporting requirements of London or New York.  However, we would not count out Beijing as it would not be a shock to see China offer placement for the IPO and wave Western-level compliance.  Concerns surrounding Iran may be behind the rise in oil prices today.

More Facebook (FB, 172.56) fallout: Shares are lower again this morning as the company struggles to get in front of the fallout from the Cambridge Analytica scandal.  Perhaps the most interesting development is that Democrats are turning on the company.[1]  Generally speaking, industry groups line up politically and technology has tended to land with Democrats.  The extractive industries and much of manufacturing has been captured by the GOP, while the financial sector tends to be divided between both parties.  The Democrats are angry that Facebook may have assisted the GOP during the presidential election and are thinking of exacting revenge.  If this broadens to the entire sector it may affect donation flows for the upcoming mid-terms and the 2020 presidential race.

China trade issues: It appears the president is poised to impose some $60 bn in tariffs against Chinese products on Friday.[2]  So far, China appears to be following two tracks on this issue.  First, China is trying to be conciliatory; Premier Li Keqiang promised in a speech at the end of the National Party Congress to do more to protect intellectual property.[3]  Chairman Xi’s top economic advisor, Liu He, told a group of business leaders that he intends to takes steps to open up China’s economy.[4]  It appears China is trying to manage the relationship and avoid an all-out trade war; however, President Trump seems to be spoiling for a fight.  Second, if a trade war does start, look for China to attack U.S. agriculture.

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[1] https://www.politico.com/story/2018/03/19/angry-democrats-facebook-424456

[2] https://www.washingtonpost.com/business/economy/trump-prepared-to-hit-china-with-60-billion-in-annual-tariffs/2018/03/19/fd5e5874-2bb7-11e8-b0b0-f706877db618_story.html?utm_term=.33ce92d9800c

[3] https://www.bloomberg.com/news/articles/2018-03-20/china-to-open-manufacturing-cut-tariffs-and-taxes-premier-says

[4] https://www.bloomberg.com/news/articles/2018-03-02/top-xi-aide-is-said-to-promise-u-s-ceos-action-on-china-reforms, https://www.reuters.com/article/us-china-parliament/chinas-premier-hopes-trade-war-can-be-averted-pledges-more-open-economy-idUSKBN1GW0AO

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Monday!  We are seeing weaker equity markets and rising Treasury yields this morning.  There is a lot going on—let’s dig in:

A Brexit deal: Negotiators for the U.K. and EU have announced they mostly have an agreement in place.  Although some problems remain unresolved, mostly the Ireland/Northern Ireland frontier, both sides have made significant progress on an exit agreement.  The GBP jumped on the news and is holding its gains as further details become available.  The currency market reaction does suggest this outcome was not expected.

Mueller worries: Financial markets, for the most part, have ignored the personnel news out of the White House.  There have been one-day blips surrounding significant departures, such as Gary Cohn, but they generally haven’t started a trend.  Overnight, we saw another downward drop, seemingly tied to a series of Twitter quotes suggesting the president may dismiss Robert Mueller.  This area may be a red line.  The AG can fire Mueller[1] but the president, at least directly, cannot.  This is dangerous ground for the president.  Firing Mueller will raise the “taint” of scandal even if one doesn’t exist.  If Mueller is forced out, it could trigger a constitutional crisis that would likely affect investor sentiment.  As we note in this week’s Asset Allocation Weekly Comment (see below), the “misery index” P/E model suggests the S&P is fairly valued and equities should do better if earnings continue on their current path.  However, P/Es are always vulnerable to sentiment shocks and such a crisis might trigger one.  It does appear the White House is trying to ease tensions as recent tweets suggest no action will be taken against Mueller, but that hasn’t lifted equities yet.

A new PBOC Chief: After 15 years as governor of the People’s Bank of China, Zhou Xiaochuan has retired, passing on the position to Yi Gang.  Yi is a Western-educated economist with 20 years of central banking experience.  He should be considered a continuity candidate.  Yi is committed to financial reform and, like his predecessor, wants to see debt levels reduced.  However, the PBOC, like nearly everything in China, is not independent of the CPC.  Although there is broad agreement between the CPC and PBOC on the need to delever, the former always loses its nerve when it becomes apparent that such actions will slow economic growth.  We see no reason for this to change in the near term, although Chairman Xi has amassed enough power to press for this significant change.  In fact, if he fails to bring lower debt growth, it begs the question as to why he bothered to gather such control.

Problems at Facebook: In this report, we don’t comment on individual companies unless the news surrounding them has macro implications.  Facebook (FB, 185.09) is down sharply in the pre-market trade after several articles in the U.S. and Britain suggested the company was either duped or willfully negligent during the 2016 election.  Cambridge Analytica was able to gain access to personal data for the social media firm’s users and the company used this information to directly target potential voters.  Using technology to receive news from political organizations is nothing new.  However, if the data was gained without authorization, it likely violates privacy rights of users and is a potential risk for the company.  Given that “big tech” has been a major support to the equity markets, a large decline in one of these companies will tend to have outsized effects on the overall equity market, which is why this issue bears watching.[2]

Putin wins!  In a weekend of historic upsets, one outcome was never in doubt—Vladimir Putin won another six-year term as president.  What he intends to do with this power is uncertain but, in a clearly rigged election (there were no real alternatives in the election), the real issue was turnout.  It looks like about 65% of eligible voters cast ballots, which isn’t bad but not the 70% Putin was hoping for.

OECD boosts growth forecasts: The G-20 meets this week.  This group has become so unwieldy that it doesn’t really function as a policy group.  However, the OECD does put out forecasts before the meetings and it lifted its global GDP growth forecast to 3.9% for this year and next year, the highest growth forecast since 2011.  The group did warn that trade restrictions would weigh on growth if they become widespread.

A shutdown on Friday?  Congress is preparing to send a budget to the president this week.  He needs to sign it by Friday or the government will shut down.  The bill, introduced last month, will increase spending and not necessarily meet the goals of the administration on all spending priorities.  Will the president, who has become increasingly mercurial lately, simply refuse to sign the measure?  Although this outcome isn’t on investors’ radar screens, there is a chance that we won’t have an agreement and a shutdown will occur.  If this occurs, expect some weakness in equities and a decline in Treasury yields.

The Fed: The FOMC also meets this week.  Fed funds futures put the likelihood of a 25 bps hike at 99.3%, with a 0.7% chance of 50 bps.  We will have more on this tomorrow but policy concerns are likely weighing on financial markets today.

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[1] This is true under normal circumstances.  However, the sitting AG has recused himself from the Russian investigation, meaning one of his deputies would actually have to fire Mueller.  Nixon faced the same problem when he wanted to fire Archibald Cox.  Two officials resigned before Robert Bork did the firing. See: https://en.wikipedia.org/wiki/Saturday_Night_Massacre

[2] Here are some relevant articles: https://www.cnbc.com/2018/03/18/facebook-failing-zuckerberg-and-sandberg-absent-commentary.html?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top-stories ; https://www.nytimes.com/2018/03/17/us/politics/cambridge-analytica-trump-campaign.html?hp&action=click&pgtype=Homepage&clickSource=story-heading&module=first-column-region&region=top-news&WT.nav=top-news ; https://www.bloomberg.com/news/articles/2018-03-19/facebook-s-zuckerberg-under-pressure-to-answer-for-data-breach?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top-stories ; https://www.cnbc.com/2018/03/18/whistleblower-christopher-wylie-says-hes-now-been-blocked-by-facebook.html ; https://www.ft.com/content/7ed1572c-2aa4-11e8-a34a-7e7563b0b0f4?emailId=5aaf3a4f92ba4800049585ec&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22 ; https://www.theguardian.com/news/2018/mar/17/data-war-whistleblower-christopher-wylie-faceook-nix-bannon-trump?CMP=share_btn_tw&wpisrc=nl_todayworld&wpmm=1 ; https://www.nytimes.com/2018/03/18/us/cambridge-analytica-facebook-privacy-data.html?emc=edit_mbe_20180319&nl=morning-briefing-europe&nlid=5677267&te=1

by Bill O’Grady and Thomas Wash

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

The shakeup continues:  Numerous media sources indicate that Gen. McMasters is on his way out as National Security Director.  The most rumored replacement is John Bolton, a well-known hawk.  If Bolton does get the job, the odds increase significantly that the Iran nuclear deal gets overturned.  Bolton and Pompeo are harsh critics of the Iran deal and would support the president’s instincts to break it.  Iran’s reaction will be interesting to watch.  The pragmatists, led by President Rouhani, would be under tremendous pressure from the hardliners, who are also critical of the pact.  It all comes down to the Supreme Leader, Ayatollah Khamenei, who approved the original treaty.  We suspect he has never trusted the U.S. and would view a treaty break as just another example of American duplicity.  It is possible the Trump administration thinks it can negotiate a new deal with Iran.  Maybe he can, but it is more likely that Iran will dump the deal and rush to build a nuclear weapon.  This leads to two possible outcomes, both bad.  First, we note that the Saudi crown prince indicated that if Iran gets a nuke, the kingdom will acquire one too.^[1]  Nuclear proliferation in an unsettled part of the world is not a good outcome.  Second, if Iran does “go for nuclear,” Israel would likely view this as an existential threat.  Although its first choice would be for the U.S. to fight Iran, if Netanyahu determines that isn’t going to happen he may decide to attack Iran directly.  The most likely response would be a nuclear first strike; Iran’s nuclear program is too large and dispersed to be successfully attacked with Israel’s conventional forces.  Although we are still a ways from this worst case scenario, the trends are not looking favorable.  From our standpoint, all this points to the potential for a supply disruption in the energy markets.

Cyberattacks: The Trump administration is accusing Russia of a series of cyberattacks on the U.S. and Europe that targeted key infrastructure of electric and water systems.  Apparently, this gave Russian hackers control of these systems and, if triggered, the attacks could have caused a power shutdown.^[2]  The NYT^[3] is also reporting that a cyberattack on a Saudi petrochemical facility appears to have been designed to cause an explosion at the plant and the only reason it didn’t work was because the undisclosed attackers made errors in their computer code.  Their errors inadvertently shut down the plant before the more deadly aim of sabotage could take place.  The West does appear to be mobilizing against Russia.  New sanctions have been announced but we will be watching for Western cyberattacks on Russia.  In the current environment, nations are engaging in belligerent acts that essentially come just short of triggering a war response.  For example, China’s militarizing shoals in the South China Sea, Russia’s annexation of Crimea, Abkhazia, South Ossetia and parts of Ukraine, undermining the democratic process in the West and cyberattacks are all elements of this “hybrid war.”  At some point, the West will need to respond.  How it responds will be important.  If a Cold War model is adopted, look for the West to try to isolate China and Russia.

More trouble for Abe: Polls show that PM Abe’s support is down to 39%, a nearly 9.5% point drop, as the land scandal will simply not go away.  Although Abe continues to indicate he won’t resign, if it becomes apparent his position is untenable the end of Abe means the end of Abenomics.  That outcome will likely bring a stronger JPY.

A couple of economy concerns: Although we don’t see signs of recession, there are some signs of slower growth.

The Atlanta FRB’s GDPNow forecast for Q1 has fallen rather precipitously.  They haven’t updated their contributions to their model so we can’t yet pinpoint where the weakness is coming from, but it appears weakening consumption is weighing on growth.  Q1 GDP has had a seasonal adjustment problem; over the past four years, Q1 has been weaker than trend in three of those years.  In addition, we should see a boost in consumption as the effects of the new tax law on withholding are implemented.  Still, this drop in growth with the Fed raising rates is a worry.

In addition, the yield curve has been flattening again.

After steepening last month, the curve has rapidly flattened to nearly the lows seen in early January.  Some of this is because German Bund yields have declined.  Nevertheless, the flattening should be a signal to policymakers to exercise caution.

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[1] https://www.nytimes.com/2018/03/15/world/middleeast/mohammed-bin-salman-iran-hitler.html?emc=edit_mbe_20180316&nl=morning-briefing-europe&nlid=5677267&te=1

[2] https://www.nytimes.com/2018/03/15/world/middleeast/mohammed-bin-salman-iran-hitler.html?emc=edit_mbe_20180316&nl=morning-briefing-europe&nlid=5677267&te=1

[3] https://www.nytimes.com/2018/03/15/technology/saudi-arabia-hacks-cyberattacks.html?emc=edit_mbe_20180316&nl=morning-briefing-europe&nlid=5677267&te=1

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s the Ides of March!  Be careful out there.  Markets were very quiet overnight.  Here is what we are watching:

Trump 2.0: As expected, Larry Kudlow is replacing Gary Cohn as NEC director.  This should be a somewhat market supportive appointment.  Kudlow isn’t an economic heavyweight; he doesn’t have a degree in the subject and his claim to fame is mostly as a supply side pundit.  On the plus side, he is a skilled media spokesman and will improve the profile of the administration, whereas Cohn could be a bit stiff in front of the cameras.  Kudlow will be in his element.  We doubt he will push back too hard against the president’s policies but we do expect him to frame the policies as pro-growth and pro-market.  Contorting trade impediments into being pro-growth and pro-market will be a feat but, if anyone can do it, Larry is the best candidate.  He has already come out in favor of a “strong dollar” in a public statement; the forex markets ignored his comments.  Kudlow likely assumes the strong dollar of the early 1980s was due to supply side economic policies.  We doubt they played a major role; a more important part was played by Paul Volcker’s tight money policies.  But, returning to allowing the markets to set exchange rates is a better policy stance than Treasury Secretary Mnuchin’s comments at Davos.

There are reports^[1] that the president is preparing to replace more of his cabinet and aides, including Chief of Staff Kelly, National Security Director McMaster and AG Sessions.  Financial markets have not reacted well to previous departures, although we expect the impact will decline over time.  As we noted yesterday, this is a normal pattern that presidents follow.  They usually attract strong characters in the first year but by the time their first four years end presidents tend to surrounded themselves with people who can execute the president’s plans, not comment on the plans themselves.

Russia and Britain: We are still awaiting Russia’s official response but the commentary has been denial and contempt.  Russia is trying to portray itself as a great power and actions like executing old double agents are part of that narrative.  The U.S., Germany and France have joined the chorus demanding that Russia accept responsibility for the attack, although we note it hasn’t been a universal position.  In France, a spokesman suggested Britain’s proof of Russian involvement is “fantasy politics.”  However, the Macron government did later indicate that it believes the British claims of Russian involvement.  In the U.K., Labour leader Corbyn refused to endorse May’s claim of Russian responsibility, reminding British voters what a “PM Corbyn” would look like.  We don’t think diplomatic expulsions will make much difference and we don’t expect major sanctions to follow.  Sadly, the lack of an effective response will only embolden Putin to take more aggressive steps.

Abe’s woes continue: The land scandal that has ensnared Finance Minister Aso is expanding.  If Aso and perhaps Abe either ordered or knew documents were altered, it could bring down his government.  The end of Abe would likely end Abenomics as well.  We would expect a “knee-jerk” rally in the JPY and a weaker Nikkei.

Energy recap: U.S. crude oil inventories rose 5.0 mb compared to market expectations of a 1.9 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 was more in line with a normal increase in oil inventories during late winter into spring.  If this pattern continues, oil prices may come under further pressure in the short run, although it still appears to us that prices are undervalued.

Based on inventories alone, oil prices are undervalued with the fair value price of $63.90.  Meanwhile, the EUR/WTI model generates a fair value of $75.13.  Together (which is a more sound methodology), fair value is $71.45, meaning that current prices are below fair value.  Oil prices have been struggling on fears that U.S. production is going to overwhelm OPEC supply cuts.  Earlier this week, we published our Quarterly Energy Comment[2] looking at the rapid rise in production without a commensurate increase in rig counts.  We wonder if that production level can be maintained without an increase in resources.  If not, oil prices should move higher once seasonal pressures dissipate. 

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[1] https://www.vanityfair.com/news/2018/03/trump-swinging-the-axe-at-tillerson-mcmaster-sessions-jared-and-ivanka

[2] See Quarterly Energy Comment, 3/13/18

by Bill O’Grady and Thomas Wash

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

May responds: The Russians ignored Britain’s deadline so PM May is expelling 23 Russian diplomats, the biggest expulsion since the Cold War.  Expect a similar response from Russia.  This is an issue that bears watching.  We expect that Chairman Xi is closely observing the West’s response to Russia’s rather blatant attacks on its expats in the U.K.  China also has an interest in controlling the actions of its nationals living abroad.  If troublesome characters can be killed with impunity in the West, it would not be a shock to see China engage in similar behavior.  This reaction is probably the best May can muster; without a broader response, we can expect more of these killings carried out by more nations in the democratic West.

Trade talk: One of the evolving features we continue to watch closely is what we call “Trump 2.0.”  In the president’s first year, especially after the appointment of John Kelly as Chief of Staff, the White House became much more orderly.  Populist voices, such as Stephen Bannon, were banished.  The flow of information and persons to the Oval Office was monitored and restricted.  Gary Cohn and the establishment steadily gained control and the key issue the GOP establishment wanted, the tax act, was passed.  That order is now being unwound.  SOS Tillerson’s firing was announced yesterday and Mike Pompeo was nominated as his replacement (conditional on Senate approval).  Cohn has moved on.  As the president becomes more comfortable with the office, he is taking control of the job and the “controllers” are steadily losing power.

For our purposes, what does this mean for financial and commodity markets?

• We would expect more turnover until the president shapes his staff to his liking. The president is making it clear he wants voices around him that are not contradictory.  In reality, most presidents make this shift, although perhaps not as quickly as this one.  Early in the first term of a new president, especially when the party has been out of power, there are a group of political operatives ready and willing to accept appointments.  These are usually “stars” of the party with strong personalities and their own agendas.  As presidents become more familiar with the job, they tire of all the “advice” and replace the stars with people who will execute the vision of the president.  Mike Pompeo will more likely be willing to execute the vision of the president, whereas Rex Tillerson often clashed with the White House.
• This turnover will raise uncertainty but markets will adapt. A similar pattern emerges with geopolitical issues; the first terrorist attack is a big deal.  Over time, markets become inured and they have less effect.
• Our read on President Trump is that he is an economic and geopolitical nationalist. The U.S. is going to become increasingly stingy with providing global public goods, including acting as importer of last resort.  Although Trump will get criticized for doing so, in fact, this is just the most recent attempt to develop a post-Cold War policy.  None of them, since Clinton, have managed to create a lasting policy response to the fall of the Berlin Wall.  It does appear that Trump’s policy of reducing global exposure is popular; although the establishment is horrified (mostly because it has benefited greatly from globalization), the majority of Americans feel that all they get from the superpower role is cheap foreign goods that reduce their employment opportunities.  This doesn’t necessarily mean the U.S. becomes autarkic, but open trade and providing the reserve currency to the world will now come with strings attached.  The big issue to watch is if the world decides that it will reduce using the dollar as a reserve currency.  For now, we don’t really see an alternative; neither Europe nor China is willing to run persistent trade deficits, the requirement to be the primary reserve currency.  But, if foreigners stop using the dollar for reserve purposes, then fiscal deficits suddenly matter…a lot.
• The key market issue is whether trade impediments become serious enough to change inflation and, even more critically, inflation expectations. So far, the rhetoric on trade has far outpaced the actual impact.  But, we know the president has China in his sights and is threatening more serious measures against China’s trade with the U.S.^[1]  If these come to fruition, we would expect inflation fears to become an increasingly negative factor for financial markets.
• Iran will likely become a more serious issue.  President Obama wanted to pivot to Asia and, to do so, he needed to reduce America’s interests in the Middle East.  He decided he was willing to allow Iran to become the regional hegemon and provide order as the U.S. shifted its focus to Asia.  The nuclear deal was a step toward normalization; we suspect Obama assumed Clinton would win in 2016 and finish the normalization process with Iran.  Needless to say, this was a very controversial decision.  Although some regional experts had suggested this outcome as the most rational policy,^[2] Iran is a long-time adversary for the U.S. and it is politically unpopular to support any sort of normalization with the Mullahs.  This president wants to “rip up the script” of the Iranian nuclear deal by May of this year.  If the Iranians disagree, we expect the latter to move quickly to acquire a nuclear weapon.  Rising regional tensions increase the odds of an oil supply disruption.  Keep in mind that the Iran issue will be occurring at nearly the same time as when the president is expected to meet with Kim Jong-un, so the White House will be busy.

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[1] https://www.politico.com/story/2018/03/13/trump-demands-aides-strengthen-china-tariffs-460416

[2] See Baer, R. (2008). The Devil We Know: Dealing with the New Iranian Superpower. New York, NY: Crown Publishing Group. and Friedman, G. (2011). The Next Decade. New York, NY: Doubleday (especially chapter 7).

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] CPI came in on forecast.  Financial markets were fearing faster inflation and so we are seeing the dollar ease and equities rally on the news.  Here is what we are watching this morning:

NEC Chair: Shahira Knight has signaled she doesn’t want the job, and Chris Liddell didn’t move the president.  Instead, Larry Kudlow has emerged as the front-runner.  Kudlow has become a well-known television personality, positioned as a defender of free markets and low taxes.  He has an undergrad degree in history from the University of Rochester and did begin a master’s program at the Princeton Woodrow Wilson School of Public and International Affairs but left before completing his degree.  According to reports, the president is impressed with how he handles himself on television.  Kudlow, if appointed (and until he is announced and seated nothing is certain), will be a relief to the financial markets.  Although we still expect the president to lean toward trade protection, Kudlow will act as a counterpoint to that sentiment.

Tillerson out: Rex Tillerson, the former Exxon (XOM, 75.24) CEO, is out as Secretary of State and will be replaced by CIA Director Pompeo.  This isn’t a huge shock; Tillerson has never really gotten along with the president and was expected to leave sometime this year.  We will be watching to see who gets the CIA position.  Tom Cotton, the GOP senator from Arkansas, is a likely candidate.  Pompeo will require Senate approval but that shouldn’t be a major issue.

48 hours: PM May has accused the Russian government of involvement in the recent assassination attempt of a former Russian spy in the U.K.  Although the Putin regime has denied the report, it should be noted that the nerve agent used was Novichok, a Soviet-era nerve agent said to be 10x more powerful than VX.  The use of such a weapon makes it almost certain that the Russian government, in some fashion, was involved.  It is possible that this was a rogue operation, but we doubt that is the case.  First, this is another brazen act by Russia to intimidate its critics that live in the U.K.  Britain has become a haven of sorts for Russian capital flight and discontented Russians.  This isn’t the first attack; a former Russian security member was killed with Polonium in 2006, and other Russians and fellow travelers, either critical of Putin or thought to be involved in money laundering, have also died under suspicious circumstances.[1]  The use of a military-class nerve agent that was only formulated in Russia suggests that whoever was involved was not concerned about plausible deniability.  Second, PM May is clearly angry, giving Russia 48 hours to explain itself.  The Russians have denied involvement, as one would expect.  Britain has been trying to generate international support but, so far, the Trump administration has been mostly quiet outside of Tillerson’s indication of likely Russian involvement (see above).  At the same time, most other NATO states have also remained mostly quiet.  We expect some diplomatic expulsions and U.K. sanctions on Russia, but major sanctions won’t be possible without international support.

Broadcom (AVGO, 262.84) and Qualcomm (QCOM, 62.81): The White House has stepped into this proposed merger and quashed it on national security grounds.  At first glance, this reasoning looks tortured; Broadcom is based in Singapore, a nation that is no national security threat to the U.S.  However, Qualcomm has made a major R&D investment in 5G technology and it was feared that the merger would undermine that investment and give the lead in the next generation of wireless to China’s Huawei (CNY, 7.71).  It appears the administration may be taking the position that high tech is a key military industry and the U.S. intends to prevent foreign firms from owning these key assets.  In other words, globalization is starting to be curtailed as industries are going to become off limits to foreign buyers.

Slovakia in turmoil: Slovakia’s government is teetering on collapse after a journalist working on tax evasion and corruption was assassinated in a gangland fashion.  For good measure, the killers also shot and killed the journalist’s fiancée.  The attack was so blatant that it has triggered mass protests in the country and it appears new elections may be coming.

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, 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 3.27%.  Using the employment/population ratio, the neutral rate is 1.25%, a 28 bps rise over last month.  Using involuntary part-time employment, the neutral rate is 2.58%.  Using wage growth for non-supervisory workers, the neutral rate is 1.44%, a 19 bps rise over last month.  Although inflation remains steady, the sharp improvement in the employment/population ratio and the modest rise in wages suggest that some of the slack is leaving the labor market.  However, the differences are still very wide between the wage growth and employment/population ratio variations compared to involuntary part-time employment and the unemployment rate.  If the FOMC is using the former two variations, policy is essentially neutral.  Overall, the CPI data does not suggest anything unusual in price levels and thus, monetary policy will likely continue to tighten on its current cautious path.

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[1] https://www.buzzfeed.com/heidiblake/from-russia-with-blood-14-suspected-hits-on-british-soil?utm_term=.pkzDdmmwZr#.ygJqyRRv8a