Asset Allocation Weekly (February 23, 2018)

Posted on February 23, 2018 by Rebekah Stovall

by Asset Allocation Committee

Last week, we discussed the impact of the growing fiscal deficit on the economy and markets. We did note that fiscal deficits have tended to weaken the dollar. This week, we want to expand on that analysis. To start, we note that fiscal policy does not operate in a vacuum. To measure the combined effect of monetary and fiscal policies, we added real fed funds (fed funds less yearly change in CPI) and the fiscal deficit as a percentage of GDP to create a policy proxy variable. Real fed funds offset the impact of inflation and scaling the fiscal account to GDP shows the relative effect of fiscal policy.

The lower line of the chart is the sum of the upper two lines on the chart. The thesis is that policy is stimulative when the lower line is rising.

This chart shows the policy proxy with the JPM dollar index. The pattern seems to be that the dollar appreciates when policy tightens with at least a two- or three-year lag. The “Volcker dollar” rally in the early 1980s was due to the combination of very high interest rates and rising fiscal deficits. The dollar bull market from 1995 to 2002 was due to the combination of rather tight monetary and fiscal policies. The most recent bull market, surprisingly, was tight fiscal policy (especially in light of the sluggish economy) and rather easy monetary policy.

The first chart shows the Congressional Budget Office’s estimate for the future deficit. If the FOMC does not significantly tighten monetary policy in the coming months, it looks like the dollar could come under pressure. Obviously, if we were to get a repeat of Chair Volcker’s monetary policy, we would be bullish on the greenback. However, we strongly doubt monetary policy will be that tight. After all, real fed funds approached 10% in 1991. And, if the economy were to weaken, the fiscal deficit would widen more than expected due to the automatic spending that comes from higher unemployment insurance and other income support and the lower revenue for falling tax receipts.

Given the dollar’s current parity overvaluation, as we discussed earlier this month,[1] the current fiscal expansion and continued accommodative monetary policy have the potential to exacerbate the weakening dollar. A weak dollar is bullish for foreign equities and commodities, and usually boosts large capitalization stocks relative to small capitalization stocks. The policy proxy is also suggesting steady headwinds for the dollar in the coming years. Given how rarely changes occur in fiscal policy, we don’t expect major changes on that front anytime soon. Although monetary policy will likely tighten, it will take significant increases in the fed funds target to offset the overvaluation noted in the parity analysis discussed in an earlier report and the widening fiscal deficit. Thus, we look for dollar weakness to be a factor this year and into 2019.

View the PDF

[1] See Asset Allocation Weekly, 2/2/18.

Daily Comment (February 23, 2018)

Posted on February 23, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Looking for something to read? In our travels we are often asked about books we recommend. As a result, we have created The Reading List. The list is a group of books, separated by category, that we believe are interesting and insightful. Each book on the list has an associated review to help you decide if you want to read it. We will be adding to the list over time. Books marked with a “*” are ones we consider classics and come highly recommended.

Xi versus Anbang: The Chinese government has taken control of privately held Anbang Insurance Group and arrested its chairman, Wu Xiaohui, charging him with economic crimes. This is clear evidence that the Xi government is cracking down on foreign investment by China’s private sector. Anbang is a large conglomerate that owns some trophy properties, including the Waldorf Astoria in New York. The government is claiming the company had “illegal business operations which may seriously endanger the company’s solvency.” A number of other large conglomerates with large overseas holdings have also come under government scrutiny. There are two concerns; the first is that these conglomerates have sometimes used wealth products to fund their growth. Since these require higher interest payments, there is likely worry among regulators that if one of them cannot service the debt incurred then it could undermine confidence in all wealth products as a class. The second issue is more political; the CPC wants to maintain control over the economy and foreign investment tends to undermine that control. Thus, cracking down on these high-flyers may work to scare other wealthy Chinese from seeking to move assets overseas.

May and the Tories formulate a Brexit plan: The Conservatives generally divide between hard and soft Brexit supporters. The former want a clean break with no close ties with the EU, while the latter want to keep a customs union in place to maintain free trade with the EU. Of course, with that outcome, the soft Brexit supporters will likely have to accept the free flow of immigrants and accept EU regulations, which creates the worst of all worlds—being in the EU but without any voice in shaping policy. Thus, the hard Brexit camp is at least logically consistent. However, leaving the EU’s customs union will mean severe economic disruption for the U.K. The plan that has emerged is that Britain will try to negotiate a free trade deal with the EU similar to the recently completed one with Canada. That deal would allow the U.K. to secure nearly all the benefits of the customs union without actually joining it in its current form. There is almost no chance the EU will go along with this outcome. We think the odds of another referendum are rising and May’s tenure is becoming increasingly shaky. Labour’s leader, Jeremy Corbyn, has indicated he will call for a soft Brexit policy and recommend joining the customs union. If enough Tories defect to this position, May could face a no-confidence vote and new elections could be in the offing.

Concern about Mnuchin: The EU minutes reveal that the ECB members were clearly worried the U.S. was about to embark on a pre-Rubin policy of currency jawboning, designed to weaken the dollar. A rapid appreciation in the EUR would complicate monetary policy for the ECB, forcing it to likely maintain an accommodative stance.

Energy recap: U.S. crude oil inventories fell 1.6 mb compared to market expectations of a 3.0 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. What we are seeing is very bullish as the usual seasonal build in stockpiles isn’t occurring this year. The longer this continues, the more fundamentally bullish this becomes.

Based on inventories alone, oil prices are undervalued with the fair value price of $67.34. Meanwhile, the EUR/WTI model generates a fair value of $75.69. Together (which is a more sound methodology), fair value is $73.14, meaning that current prices are below fair value.

View the complete PDF

Daily Comment (February 22, 2018)

Posted on February 22, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

FOMC meeting minutes: Yesterday, the Federal Reserve’s minutes revealed that Fed officials are confident that U.S. expansion will continue to gain momentum as a result of the tax bill and strong global growth. Furthermore, Fed officials also cautioned that inflation could be on the horizon in the medium term. As a result of the outlook on inflation, stocks reversed gains and bond yields rose. In our view, the minutes weren’t particularly surprising. Generally, when a country provides fiscal stimulus to an already expanding economy, it risks rising inflation in the short- to medium-term as it takes a while for supply to catch up with rising demand. Given that this meeting took place prior to the release of the stronger than expected wage report as well as the larger than expected government funding bill, we will hold judgment on whether we expect a faster pace in rate increases until after Fed Chairman Jerome Powell meets with the House Financial Services Committee on February 28.

McMaster exit? According to a CNN report, National Security Adviser H.R. McMaster is considering stepping down from his current position in the Trump administration and rejoining the military in the Department of Defense. It has been widely speculated that President Trump has grown annoyed with General McMaster. Tensions seem to have hit a boiling point when McMaster stated that the FBI indictment provided “incontrovertible” evidence that Russia interfered in the 2016 election. President Trump responded to the statement via Twitter, stating that McMaster should have also mentioned that Russian interference did not change the results of the election. The White House has since stated that the president still has confidence in his national security adviser. McMaster’s departure would represent a change of pace for this administration as the president would likely seek to replace the three-star general with someone less assertive; it has been rumored that McMaster has made a habit of correcting and undercutting the president during meetings. At this time, there does not appear to be a list of possible candidates to replace him.

The return of Boko Haram: On Monday, the Nigerian terrorist group Boko Haram attacked another school in the northern region of the country. Although Nigerian security forces were able to repel the attack, the school was unable to account for all of its students. As of today, it is believed that over 100 girls are still missing from the school. This incident marks the first large-scale attack from the rebel group in four years, when it kidnaped an estimated 276 girls from another school. Last year, the Nigerian Army claimed to have defeated Boko Haram “militarily” but had not eliminated the group. Boko Haram, which pledged allegiance to ISIS in 2015, represents a prominent threat to Nigeria as it struggles to recover from a two-year recession and rising inflation. Nigeria is one of the world’s largest suppliers of oil; therefore, instability within the region could be bullish for crude oil. We expect that the Nigerian government will be able to contain the threat but we will continue to monitor the situation.

View the complete PDF

Daily Comment (February 21, 2018)

Posted on February 21, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

FOMC meeting minutes: Today, we will be focused on the release of the January FOMC meeting minutes. The minutes are likely to shine light on how Fed officials expect the tax bill to affect the economy. There have been concerns that the tax bill could be inflationary; as a result, we expect the minutes to reflect the Fed’s willingness to speed up the pace of rate hikes as a counterweight to potential inflation. It is worth noting that this meeting took place prior to the release of the larger-than-expected wage growth data and government funding bill, therefore we suspect the market may have already priced in the possibility of faster rate hikes. That being said, we would not be surprised if the market overreacts to a very hawkish outlook.

North Korea meeting: Last night, Bloomberg reported that envoys representing Kim Jong-un ditched a secret meeting with Vice President Mike Pence. The meeting would have been the highest level of talks between the U.S. and North Korea regarding the latter’s nuclear program. The U.S. has long supported talks on the condition that North Korea gives up its nuclear ambitions, a requirement North Korea has consistently rebuked. It is unclear why North Korea decided to pull out of talks at the last minute, but it may have something to do with a report that South Korea and the U.S. agreed to hold joint military exercises later this year.[1] North Korea has long asserted that these drills represent rehearsals for a possible invasion. Although nothing came of this meeting, the fact that it was even scheduled is significant as it suggests that either the U.S. or North Korea blinked with regard to the aforementioned nuclear precondition. At the moment, it is not obvious which country actually did the blinking but we are somewhat more optimistic that a meeting could take place between the two rivaling countries.

Crypto-regulators: A report from Reuters suggested that U.S. lawmakers may consider imposing stricter federal oversight on cryptocurrencies. Although cryptocurrencies have long been considered a speculative bubble, regulators from around the world have expressed concerns that cryptocurrencies could pose security risks. Cryptocurrency exchanges have been criticized for aiding money launders and funding terrorist organizations. Currently, the Department of the Treasury is the primary overseer of cryptocurrency exchanges within the U.S. but its ability to crack down on the exchanges has been limited because the exchanges fall into a regulatory gray area. For example, tax evasion and securities fraud fall under the jurisdiction of the IRS and SEC. Any law proposed by Congress will likely provide clarification as to which agency has the ability to enforce regulations on the exchanges.

View the complete PDF

[1] https://www.ft.com/content/b204f9f4-15e7-11e8-9376-4a6390addb44

Daily Comment (February 20, 2018)

Posted on February 20, 2018February 20, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

The next Japanese PM? The NYT[1] had a profile on Taro Kono, a 55-year-old LDP leader who is setting himself up to be the next PM when the current holder, Shinzo Abe, likely retires in five years. Kono is the current foreign minister; he was educated at Georgetown, interned with both Alan Cranston and Richard Shelby in the 1990s (when the latter senator was a Democrat) and speaks fluent English. Although he has mostly stayed aligned with the Abe government’s policies, he is thought to be more liberal (in Japanese political structure, that would mean less nationalistic) and would probably be a figure American policymakers could negotiate with given his familiarity with the U.S. Of course, in five years, Japan may be looking for someone who will foster a more independent Japan.

Is the U.S. comfortable with Europe rearming? The FT[2] reports that the U.S. is expressing concern about an EU effort to coordinate military activity among the 27 member nations. Although it’s nearly a ritual for U.S. administrations to complain about European nations free riding their military commitments to NATO, Americans tend to forget this isn’t really a bug in the system but part of the design. After WWII, the U.S. set up NATO and essentially guaranteed European security. The goal was to create conditions where another world war would not originate among the nations of Europe which, for a number of reasons, were predisposed to conflict. By taking over European security through NATO, Europe was mostly forced to follow U.S. foreign policy goals. Although there were costs to American taxpayers and generations of GIs forced to deploy in Europe, the policy was successful; we haven’t fought another world war over European issues since 1945. However, recent comments from President Trump seemingly have encouraged the EU to think about its own collective defense absent the U.S. If the EU continues down this path, the U.S. could find itself not only with a competitor on the global stage but one that would develop foreign policies that may contradict U.S. goals. American administrations are all for more EU defense spending under NATO because the U.S. can generally control that organization. A larger EU military sans NATO could be a serious problem.

Tariff and quota threats: The Commerce Department has declared that the inflows of industrial metals from abroad pose a national security threat to the U.S. The metals were found to harm American firms and thus could put the U.S. at risk if war were to occur. The recommendations included a sweeping 24% tariff hike on all steel imports. There is no doubt foreign nations take steps to improve the competitiveness of their products through policy; the provider of the reserve currency is going to be subject to these sorts of behaviors. For the financial markets, closing trade is risky because it will (a) reduce the efficiency of the U.S. and world economy, and (b) invite retaliation and reduce global trade, in general. We are adherents of hegemonic stability theory, which means the world economy cannot function effectively without a superpower that provides global security and a reserve currency, which also requires being the importer of last resort. Protectionism is a retreat by America from this hegemonic role, and it raises the potential for an inflation problem.

The Saudis as price hawks: The Kingdom of Saudi Arabia (KSA) was instrumental in the Arab Oil Embargo in 1973. The KSA wanted to punish the West for its support of Israel in the Yom Kippur War. The jump in oil prices contributed to the 1973-75 recession and stoked higher inflation in the U.S. From that point, the KSA was mostly moderate on boosting prices though OPEC price actions. The KSA did cause some major price declines when it was defending market share but it generally didn’t support aggressive actions to boost prices. The KSA and its other Arab Peninsula neighbors are “high oil reserve/low population” nations that generally support moderate prices to avoid demand destruction. Comments over the weekend[3] from

Saudi Energy Minister Khalid Al-Falih clearly indicate that the KSA is willing to keep production cuts in place even if supplies tighten and oil prices rise. His comments not only signal that the KSA is favoring higher oil prices, but they suggest a change in policy direction. For the time being (we suspect until the Saudi Aramco IPO prices), the KSA is going to be a price hawk on oil.

View the complete PDF

[1] https://www.nytimes.com/2018/02/17/world/asia/japan-taro-kono-political-maverick.

[2] https://www.ft.com/content/a1e82b7a-147c-11e8-9376-4a6390addb44

[3] https://www.bloomberg.com/amp/news/articles/2018-02-19/once-opec-s-oil-price-dove-saudi-arabia-takes-a-harder-line?__twitter_impression=true

Asset Allocation Weekly (February 16, 2018)

Posted on February 16, 2018February 16, 2018 by Rebekah Stovall

by Asset Allocation Committee

Do fiscal deficits matter? This is one of the more polarizing topics in economics. The recent tax bill and budget agreement will increase the deficit, which has led to all sorts of worries and claims. Here are a few observations:

Politically, deficits matter to the party out of power. Protesting against deficits are one of the few ways a party out of power can restrain the party in power. Thus, the party in power tends to ignore deficits because it doesn’t want to be restrained. In addition, there is always a fear that borrowing capacity could become constrained, so by the time the party out of power regains a majority, it will be stuck with implementing austerity. Each party believes there are some types of public expenditures that are good for their own sake and should be paid for even if the deficit increases. Although a generalization, Republicans tend to support defense spending and tax cuts; Democrats tend to support health care and social spending. Thus, what angers each side about the other side’s priorities is that they view their own priorities as sacred and the others’ as buying votes.
The economic impact is complicated and dependent upon market and economic conditions. One of the most common mistakes people make in terms of the deficit is the error of composition. This is a classic logic error where one postulates that what is true on a small scale is also true on a large scale. Thus, it’s common for politicians[1] to note that a household can’t borrow money to unsustainable levels and neither can the government. However, there is a big difference between a government and a household. First, the former can use force to collect revenue to service debt (if you don’t pay your taxes, the government can use coercion), and second, the government prints the currency used to pay the debt. If households could use force to service their debt and print money, they would be like the government and thus could borrow much more.
The major issue with deficits is spending priorities. The government of a developing nation should run deficits to build out infrastructure because the return on the investment will likely exceed the cost. In wartime, borrowing money to fund the war effort makes sense because the state will cease to exist if the nation loses the war. Education is arguably a good public investment, as is domestic security. One would expect strong debates about how much of these public[2] or quasi-public goods should be provided. The reality is that it’s difficult to estimate the value of public investment and spending, and arguments over these issues will be perpetual.

Do deficits matter? Yes, but not in the simple form that pundits suggest. When the government spends more money than it takes in from taxes, that saving has to be acquired from the other major sectors of the economy, the private sector (households and businesses) or the foreign sector (through the trade account).

Private saving balance = (business revenue less business investment) + (household saving less consumption)

Public saving balance = (taxes less government spending and transfers)

Foreign saving balance = inverse of the current account

The above chart shows the three sectors of the saving balance; it’s a macroeconomic identity, meaning that it will always equal zero. Thus, when the government deficit expands, it must be funded by saving created by either the foreign sector or the private sector. When the government runs a surplus, it depletes private sector saving or reduces foreign inflows.

The impact on the economy depends on the return from government spending relative to the return from the private sector or the foreign sector. If public spending has a higher rate of return than investment in the private sector, then fiscal deficits are reasonable. However, this calculation is extraordinarily difficult. Think of the rate of return on the Strategic Petroleum Reserve; if the world experiences a major war in the Middle East and oil rises to $150 per barrel, the investment when oil was cheaper would almost certainly be positive. The same would be true for peacetime defense spending when war breaks out. However, outside of dire situations and under shorter time frames, private sector investment probably has a higher rate of return.

Our concern is the market impact. The classic fear is that deficits trigger inflation and higher interest rates. The theory is that if the government runs a deficit, the private sector will offset it, which will require a drop in consumption and crowd out private investment. The drop in consumption is usually facilitated by higher prices and the contraction of investment would usually constrain output and lift inflation as well. The data actually shows that higher deficits did seem to boost interest rates from the late 1950s into the early 1980s; however, the relationship became uncorrelated thereafter.

Since 1983, long-duration Treasury rates have steadily declined despite the trend in the deficit. In comparison to the first graph, what changed in 1983 was the expanding current account deficit, which brought in another source of saving to fund the fiscal deficit.

One area that will likely be affected is the dollar. The dollar was mostly uncorrelated with the fiscal balance until the peak of the “Volcker dollar” in 1985. However, since then, with a two-year lag, the fiscal account correlates directly with the dollar at a level of 70%. A fiscal surplus tends to be dollar bullish, while a widening deficit is dollar bearish.

We believe this occurs because of the dollar’s reserve status. There is a constant demand for dollars on world markets to facilitate trade. A wider fiscal deficit makes more dollars available for world markets; rising supply tends to weaken the dollar’s price, the exchange rate. On the other hand, a fiscal surplus (or narrower deficit) means the supply of dollars is less, boosting the exchange rate.

Although it is possible that a weaker dollar could lift prices, the evidence is scant; foreign countries use exports for growth and to lower unemployment in their nations. As a result, they tend to accept margin compression rather than give up market share through higher prices. Accordingly, we think the preponderance of the evidence suggests the expanding fiscal deficit will be dollar bearish and supportive for foreign assets.

View the PDF

[1] Usually the party out of power, but not always. There are a few political figures that are consistently opposed to deficits and government debt regardless of whether or not their party is in control of Congress.

[2] In public finance, a public good is a good that cannot be easily excluded and is non-rivalrous, meaning that it is either provided to all or none. Fire protection cannot be easily segregated, for example. In theory, one could argue that the fire department should only put out fires from households that pay their “fire bill.” In reality, it is probably impossible to allow one house to burn down and not adversely affect neighboring homes who did pay their fees. Police services, libraries, etc. are examples of pure public goods. If the government or a non-profit entity doesn’t provide the good, no private sector firm will provide it because it cannot ensure it will get paid (getting back to the government’s ability to use coercion to collect taxes). Quasi-public goods are goods that can be provided by the private sector but is sometimes provided in less quantities than considered optimal. If households don’t earn enough to provide for the wellbeing of a family, a quasi-public good would be public assistance. The private sector does provide food and shelter but it may not produce enough to be a feasible option for a low income household.

Daily Comment (February 16, 2018)

Posted on February 16, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

It looks like we are having a pause day after a strong week for equities and foreign exchange and steadily rising interest rates. Equity futures have turned to unchanged, while the dollar and Treasuries are higher. However, market moves are fairly benign. The Chinese New Year is today; as we mentioned yesterday, Chinese markets will be closed into next week and several other Asian markets were closed as well. Here is what we are watching today:

Tariff hikes in India: PM Modi has been promoting a “Make in India” policy that has been something of a disappointment. In response, earlier this week, his government announced duty increases on a wide range of products. India’s development has deviated from the rest of Asia. From Japan in the 1960s to China in the 1980s, the path to development was based on building a manufacturing base through mercantilism. Policies were designed to stifle domestic consumption through non-existent safety nets, consumption taxes and an undervalued exchange rate. As long as the U.S. was willing to play the role of importer of last resort, a function tied closely to providing the reserve currency, the development model worked quite well.

India did not follow that model. Instead, Indian policy following its independence was essentially autarky. The country didn’t trade much and built quasi-public national champions that dominated domestic markets. The model followed the British Labour Party policies after WWII (and advocated today by Jeremy Corbyn). This policy led to high inflation and slow growth. As India began to develop, it had more success in services and developed a sophisticated trade in financial, medical and technology services. However, manufacturing lagged in part due to the aforementioned autarkic policies. To build mass employment, India needs manufacturing to expand. Modi has tried to build India’s manufacturing with apparently little success. We are not at all surprised to see India move in the direction of increasing duties; this is part of the mercantilist policy mix that has worked well for others. However, conditions that made that policy mix successful have and are changing. The U.S. is becoming increasingly unwilling to play the importer of last resort role and could retaliate against India’s actions. It is possible that India’s manufacturing base never rivals China, Japan, et al. because it is missing a key element—a willing buyer.

Growth estimates come down: The Atlanta FRB has released its GDPNow estimate for Q1 GDP. As the chart below shows, it was initially quite elevated but has declined rather sharply.

GDP is expected to rise 3.2% in Q1, which is still quite robust but well below the nearly 5.5% rate estimated earlier this month. The culprits for slower growth are weakening consumption and investment.

The recent retail sales and CPI data have shaved 60 bps from GDP and weaker residential investment was responsible for the rest of the decline. Net exports have become an increasing drag on growth; we expect the net export sector’s drag on growth to rise as the data flows the rest of the quarter.

Rising stress: We closely monitor a number of stress indices. The two we rely on most come from the FRBs of Chicago and St. Louis. The former has a longer history while the latter tends to be more sensitive and thus give earlier (but more noisy) signals. The St. Louis FRB Stress Index jumped last week.

This is a decade graph of the two series. Note that the St. Louis number rose sharply last week. Both numbers remain below zero, which indicates that stress really isn’t a concern at this point. However, if it continues to rise, it will signal broader problems in the financial markets.

View the complete PDF

Daily Comment (February 15, 2018)

Posted on February 15, 2018February 15, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

It’s Chinese New Year’s Eve, the year of the dog! The Chinese New Year is tomorrow so Chinese financial markets are closed today and will remain so until the 21^st. This will slow Asian trading for the next week. Here is what we are watching this morning:

Cyprus trouble: Last week, on Feb. 9^th, Turkish naval vessels blocked an Italian ship contracted by Italy’s oil firm Eni ($33.85) that was planning to explore for natural gas around the island nation. In response, Italy has dispatched a naval frigate to the area, although the Italians have indicated their vessel is under orders not to engage with the Turkish military ships.

Cyprus’s population is roughly 25% Turkish and 75% Greek. Both groups have vied for control of the island, which is geopolitically important in that the holder of that island could project naval power into the Levant and block shipping from the Black Sea. The British held Cyprus as a colony until 1960. During the colonial period, as was often the case, the British gave the minority Turks extensive rights. This was a common ploy by European colonists—they would offer strong support to minority groups in a colony, making them dependent on the colonial power. This practice made managing the colony easier since the minority group was dependent and usually didn’t have enough power to manage independence. At independence, the British wrote a constitution that gave the Turkish Cypriots extensive minority rights. It was a recipe for discord and, by 1963, the island was embroiled in a low-level civil war. The Johnson administration was able to prevent the war from escalating but only by supporting a U.N. peacekeeping mission that essentially partitioned the island. In 1974, a coup ousted the Greek Cypriot president and the junta planned to forcibly merge the island. Turkey invaded the northern Turkish zone to prevent unification and declared (an almost universally unrecognized) Turkish Republic of Cyprus in the northern zone. It has remained divided ever since.

What triggered the current dust-up was that the Greek Cyprus government, which is generally recognized as the legitimate government of the island, licensed blocs offshore for energy exploration as it appears there could be significant natural gas deposits around Cyprus. However, most of these blocs sit in an area that Turkey has claimed as under its control, even though this area is on the southern end of the island. However, no other nation in the world, save Turkey, recognizes the Turkish Republic of Cyprus and thus the exclusive zones claimed by this republic are also unrecognized.

At present, we don’t expect this situation to escalate. Europe appears unable to conduct war without the U.S. and we don’t see the Trump administration getting involved. In addition, Turkey has significant leverage over the EU; if sufficiently angered, Turkey would release a flood of refugees into Europe. The last wave has had significant political ramifications and another would likely exacerbate those problems. At the same time, Turkey has its hands full managing its southern border with what was once Syria and northern Iraq. It can’t really deal with a full-scale naval battle in the Mediterranean. We see this spat as jockeying for position in negotiations, with the prize being the control of natural gas reserves. At the same time, the chances that this situation escalates, while remote, are higher than normal because the U.S. has created a global power vacuum by its steady withdrawal from the world. Russia, for example, could tip the scales in either direction; supporting Italy might give Moscow an ally to attain EU sanctions relief, while cozying up to Turkey could help it project power in the Middle East. We believe this event is an example of what we will see more of for the foreseeable future.

The JPY: Japan’s Finance Minister Aso indicated overnight that the recent strength of the JPY is not a major concern, opening the Japanese currency to further appreciation. Reuters^[1] is reporting that Governor Kuroda, who we recently noted is likely to get a rare second term as head of the BOJ, may face a less cooperative group of deputy governors at the central bank. Overall, we expect the BOJ to allow for steady appreciation of the JPY as long as it doesn’t accelerate. Openly calling for a weaker currency runs the risk of antagonizing the Trump administration, and Japan would prefer good relations with Washington while it is dealing with significant tensions on the Korean Peninsula and with China.

View the complete PDF

[1] https://www.reuters.com/article/us-japan-economy-boj/choice-of-deputies-may-complicate-kurodas-job-at-the-boj-helm-idUSKCN1FZ0WT

Daily Comment (February 14, 2018)

Posted on February 14, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

We are seeing a sharp flip in financial markets following a higher than expected print in CPI (see below). Here is what we are watching:

Is Netanyahu in trouble? The Israeli police have recommended that Israel’s PM, Benjamin Netanyahu, be indicted for the crimes of bribery and fraud. Although the PM says he will fight the charges, they do appear serious and may derail his political career. From here, the attorney general must decide if the evidence supporting the recommendation is solid enough to proceed with the indictment. We expect this process to take several months but, during that time, it will act as a cloud over Israeli politics.

Zuma faces a no-confidence vote: South African President Zuma is facing a showdown in the legislature in the form of a no-confidence vote. Zuma has so far refused to leave office despite being ordered to do so by his party, the African National Congress. Zuma has tried to negotiate an exit that would last several months but his party wants him out. He faces serious corruption charges and could face years of costly litigation if he leaves the presidency. Thus, we suspect he is trying to make a deal to leave office in return for some sort of amnesty. The no-confidence vote could force him from office perhaps as soon as tomorrow. Zuma’s departure is bullish for the ZAR and precious metals.

Mester for vice chair? Cleveland FRB President Loretta Mester is apparently under consideration for the vice chair position on the Board of Governors. We rate Mester as a hawk (we put her at a “2” on our 1 to 5 scale, with 1 being most hawkish). Although the president promised to shake up the Fed, his selections thus far have been rather conventional and this one would also fit into that characterization. The White House has indicated the president is not close to filling this position and it is clear more candidates are being considered.

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 3.24%. Using the employment/population ratio, the neutral rate is 0.97%. Using involuntary part-time employment, the neutral rate is 2.64%. Using wage growth for non-supervisory workers, the neutral rate is 1.25%. The rise in core CPI has lifted the various neutral estimates higher but, as we have seen for several months, two of these measures of slack suggest the FOMC has achieved rate neutrality, while two suggest the FOMC is well behind the curve. We still expect the FOMC to mostly split the difference and end up between 2.25% to 2.50% for the target at the end of this year. However, the rise in inflation does increase the odds that the hawks on the FOMC will push for continued rate hikes into 2019; in other words, we may see a repeat of the 2004-06 tightening cycle with steady increases in the fed funds target, perhaps with hikes occurring at meetings lacking a press conference.

The CPI data is clearly bearish for equities, as shown by the quick and sharp reversal from higher to lower in this morning’s futures trade. The usual impact of higher inflation is to lower the P/E multiple, which occurs as interest rates rise. We are also seeing the dollar lift, although we doubt that can be sustained given the headwinds the fiscal deficit will cause…unless the FOMC finds its “inner Volcker.” We wouldn’t count on that. In fact, if monetary tightening worries begin to weigh on equities, expect the president to go “full Nixon” and tweet against Fed tightening. Instead of Volcker, think Arthur Burns.

View the complete PDF