by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Risk assets are coming under pressure this morning as equities struggle.  Here is what we are watching today:

Powell, Part 2: Chair Powell testifies before the Senate Banking Committee today.  Usually, the second testimony is not closely watched; after all, we have already seen the formal testimony and Q&A either a day or two before and accordingly there shouldn’t be much new information.  However, we have seen instances when a Fed chair, concerned that the financial markets misunderstood the earlier message, attempts to adjust market expectations.  Thus, if Powell didn’t intend to signal that a fourth hike is possible this year, look for him to make a point that inflation remains under control despite economic strength.  He can make this case fairly easily with the Fed’s preferred measure of inflation, core PCE, remaining below target (see discussion below).

Energy recap: U.S. crude oil inventories rose 3.0 mb compared to market expectations of a 2.0 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—the usual seasonal build in stockpiles isn’t occurring this year.  The longer this continues, the more fundamentally bullish this becomes; thus, even with the higher than expected build this week, it is important to realize that the change in stockpiles is well below where it should be.

Based on inventories alone, oil prices are undervalued with the fair value price of $66.37.  Meanwhile, the EUR/WTI model generates a fair value of $75.32.  Together (which is a more sound methodology), fair value is $72.55, meaning that current prices are below fair value.

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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.

Financial markets are treading water this morning after a hard sell-off yesterday.  The proximate cause was Chair Powell’s testimony to the House Financial Services Committee.  Here is what we are watching this morning:

The Powell testimony: Although his prepared remarks were unremarkable, his comments on the economy were rather upbeat.  He suggested that the combination of a fiscal tailwind and improving exports are leading to accelerating growth.  These comments were made in the context of a question on whether the median FOMC forecast of three hikes this year is still relevant.  Powell suggested that the economic outlook has improved since then, leaving open the possibility of four hikes this year.  Market reaction was swift and relentless.  Equities and fixed income prices fell, commodities dropped and the dollar rose.  The Fed chair is suggesting that, at long last, cash may become an asset class again, which is unwelcome news for nearly all other asset classes.

Was the market reaction justified?  Although pundits were belaboring the point that there wasn’t really anything new in what Powell said, there is another issue that bears examination.  Powell isn’t an economist.  We cannot observe a record of academic publications that would offer us any insight into what he actually believes.  His voting record as a member of the FOMC doesn’t provide any real insight, either—he voted with the chair.  So, in reality, we really don’t know how he personally leans in terms of policy.  The upbeat assessment of the economy could be an indication that he is more hawkish than assumed (we rate him as a “3” on our “1” (extreme hawk) to “5” (extreme dove) scale).  Again, it isn’t clear if what we heard yesterday signals any clarity on Powell’s actual policy stance.  We will probably need a series of comments and speeches before we can determine what Powell really thinks.  Until then, expect higher than normal volatility around his comments.  We will get an important clue tomorrow—if Powell did not want to signal four hikes and didn’t welcome the market reaction, he has the chance to soften his position when he testifies before the Senate Banking Committee.  It is a rather common practice for Fed chairs to adjust market expectations by using the first testimony as a sort of trial balloon.  Thus, we will be watching to see how Powell reacts to the sharp market response we saw yesterday.

Expectations of policy tightening are rising: In observing the implied three-month LIBOR rate from the deferred Eurodollar futures, the financial markets are now taking the dots plot seriously.  The charts below show that the weekly implied three-month LIBOR rate is well above the highest levels seen in 2011.  The right-hand chart shows that the FOMC tends to raise rates until fed funds match the implied LIBOR rate.  This chart clearly indicates the Fed has “runway” to raise rates significantly, toward 3.0%.  It should be noted that the implied LIBOR rate falls to the level of fed funds in several tightening cycles, signaling to the FOMC that it should stop raising rates (the crossovers are shown with vertical lines).  Thus, the implied rate doesn’t necessarily mean that a 3% rate is a guarantee.  But, it does suggest that, for now, the financial markets are discounting tightening.

Is the economy doing all that well?  There is no evidence of recession, but the economy isn’t all that robust, either.  Below we note Q4 GDP data.  The Atlanta FRB GDPNow assessment is that Q1 growth is going to be in line with Q4.

In looking at the estimates of contribution to growth, weakening consumption is the largest element of the declining forecast, which began at 4.2% and has declined to 2.6%.

Brexit is evolving into a political crisis: PM May is rapidly being pulled into a political maelstrom.  Her party is a mix of “hard” and “soft” Brexit supporters.  The soft supporters accept an EU exit but want to remain in the trading union.  This would not be a good outcome; the U.K. will then be forced to accept migrants and EU rules without the benefit of representation.  However, remaining in the trading union will preserve London’s role in finance and bring less disruption to the economy.  The hard exit supporters want a complete break with the EU; this stance has proven difficult to manage.  The EU is pushing for a hard border between Northern Ireland and Ireland which could undermine the fragile peace deal between those two states.  The disruption to the economy from a hard Brexit could be massive.  PM May has been trying to weave a path between these two camps in her party; our read is that the majority of her members are hard Brexiteers but the actual majority in Parliament are soft Brexiteers.  This division is being exploited by the head of the Labour Party, Jeremy Corbyn, who has positioned the Labour Party to support a soft Brexit.  Corbyn’s position is threatening to divide the Tories, who only have a majority in government because of a coalition with a small Unionist party in Northern Ireland.  So far, 10 Conservative MPs have come out in favor of a soft Brexit.  Given that the Tory/DUP coalition only has a one-seat majority, PM May is under threat of a no-confidence vote.  If she loses, we expect elections and there is a real possibility that a Labour coalition could gain power.  A Corbyn-led government will terrify the financial markets.  For the U.S., it would be a preview of a Sanders or Warren presidency.  Although we still believe the GBP is cheap, all bets are off if the May government falls.

Rethink on TPP?  At an NPR interview, Treasury Secretary Mnuchin indicated he is engaged in “high level talks” with the other 11 members of the TPP and the U.S. might consider rejoining the group.  His comments were not a complete surprise; President Trump suggested something similar at Davos.  Without details, it’s hard to understand what rejoining TPP would look like, but we think this is further evidence of the establishment/populist divide within the Trump government.  The populists are horrified by trade and see multilateral agreements as job killers; the establishment sees agreements like NAFTA and TPP (and TTIP) as (a) ways to contain inflation and labor costs, and (b) methods of maintaining America’s superpower role.  We suspect the president uses the TPP comments as a way to encourage the establishment members of his coalition but, without actual action (and we don’t expect any to occur), this is just talk.

Consumer confidence: Yesterday, the Conference Board reported that consumer confidence hit a new cycle high.  We note that consumer confidence correlates highly with P/Es.  Thus, the rise in confidence is a bullish factor for equities.

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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.

Financial markets are very quiet in front of Chair Powell’s testimony before the House Financial Services Committee.  Here are the news items we are watching:

Powell’s formal comments: A quick reading of Chair Powell’s first formal testimony indicates that the Fed sees the economy as strong and inflation remains under control, although some of the low readings are due to transitory factors.  Thus, gradual rate increases are to be expected.  Although we have seen a mild uptick in rates since the release of his comments, in reality, nothing here is a shock.  Oral testimony begins at 10:00 EST.  While we expect Powell to conduct himself in a professional manner, since he is new to the role, there is always a chance of fireworks.

Military shakeup in Saudi Arabia: The Kingdom of Saudi Arabia (KSA) fired its top military commanders, including the chief of staff and the heads of the air force and ground forces.  We suspect two reasons for the move.  First, the war in Yemen is going badly and new leadership is probably needed.  Second, the crown prince, who is essentially the de facto leader of the KSA, is likely promoting his own loyalists to these positions.  Having the loyalty of the armed forces is a necessary component of political stability.

View the complete PDF

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.

There was a lot going on this weekend.  The Winter Olympics ended without incident and there was lots of news out of China.  Here is what we are watching:

Xi as leader for life: At the CPC meetings in October, the party suggested that Chairman Xi could be planning to remain head of the communist party after two five-year terms.  Xi has systematically eliminated rivals and surrounded himself with allies.  It should be noted that the policy of chairing the CPC for just two terms is not law but a custom created by Deng Xiaoping to prevent another Mao.  However, the chairman of the CPC is also the president of China; in other words, that person is both head of the party and head of state.  The president is (or, at least, was) restricted by law to two five-year terms.  Over the weekend, the government indicated that the term limit law would be abolished at government meetings.  In some respects, this is a surprise.  Although the real power in China lies with the CPC, a formal change in the constitution to allow for more than two terms as president is important because it gives Xi (and his successors) formal power.  We will have more to say on this issue going forward; for now, given the jump we saw in Chinese equities, this is being seen as positive.  However, in the long run, it sets up another potential Mao and a new cult of personality.

Chinese debt: Last week, we commented on the Chinese government’s effective seizure of Anbang insurance.  We suspect that much of this action is designed to corral debt growth.  A handful of Chinese conglomerates have used leverage to buy foreign assets, a practice that, at one time, was supported by Beijing.  As Xi moves to deleverage it signals to these debt-laden conglomerates that it is now time to not only stop borrowing but it is also necessary to actually reduce debt.  However, it isn’t clear to us whether it will be sufficient.  Local government borrowing is also significant and will be much harder to reduce without significantly slowing growth.  At the same time, if Xi wants to move in this direction, he clearly has amassed enough power to do so.

North Korea: There are two trends we are watching.  First, North Korea is apparently signaling a willingness to negotiate with the U.S.[1]  It isn’t clear what would actually be discussed; the U.S. wants North Korea to give up its nukes and that is probably a non-starter for Pyongyang.  North Korea would probably like a formal end to the Korean War, which the U.S. has never fully granted, and sanctions relief.  Washington will only give in to those desires when the nukes are gone.  At the same time, the U.S. has now sanctioned individual vessels apparently engaged in sanctions busting.  We are getting about as close to a blockade as one can get without a formal blockade, which is an act of war by most measures of international law.  We continue to watch these parallel tracks but believe we are probably closer to war than peace.

Trump 2.0: In the administration’s first year, despite lots of populist rhetoric and fiery tweets, this has looked like a GOP establishment government.  Regulations and taxes have been reduced.  However, we are approaching the period when the first principal figures begin to leave the administration.  In other words, we may shortly begin to see the generals and industry leaders exit to be replaced by persons less independent of the president.  The area we are focusing on is trade.  The White House is apparently considering a promotion of Peter Navarro to an assistant to the president.[2]  Navarro is a hardline trade warrior who wants to lift tariffs and bring about a trade surplus.  We also note that the White House is considering punitive tariffs on steel for national security purposes; interestingly enough, the military is cool to the idea, worried about undermining allies.  Overall, it is still unclear how this administration will evolve but, if we see a more populist government emerge later this year, then multiple contraction could offset the earnings boost facilitated by the recent tax cuts.

Other items: Chair Powell gives his first Congressional testimony later this week in his new role.  Italians go to the polls this Sunday, and we will also find out if the German Socialists will join with the conservatives to form a grand coalition. 

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[1] https://mobile.nytimes.com/2018/02/25/world/asia/north-korea-us-talks.html?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top-stories&referer

[2] https://www.nytimes.com/2018/02/25/us/politics/peter-navarro-trade.html

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

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.

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

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.

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.

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