by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] It’s a “red day” as we are mostly seeing trend reversals across many markets—equity futures are pointing to a rare lower opening, Treasury yields have broken 2.70%, foreign exchange is weaker (dollar stronger) and gold is lower.  Some of this looks like profit taking, although the continued rise in Treasury yields is a concern.  There is a lot going on this week.  Here is some of what the week has in store and what we are watching this morning:

SOTU: President Trump is giving his first State of the Union address tomorrow evening.  The key unknown is which Trump will give the talk—“Twitter Trump” or “teleprompter Trump”?  The financial markets are hoping for a repeat of Davos with a SOTU given by the latter Trump; this is what we are expecting.  A teleprompter speech without significant deviations will likely focus on a victory lap of tax cuts and regulatory reduction.  There will be comments about immigration and infrastructure but no significant details.  Although this describes what we are most likely to see, the president is capable of leaving the track and veering into other areas; again, this isn’t likely, but always possible.

FOMC: The FOMC meets tomorrow with no rate changes expected.  This is Chair Yellen’s last meeting, with Jay Powell at the helm from this point forward.  There is no press conference or dots at this meeting.  The next meeting, in mid-March, will almost certainly bring a rate hike as fed funds futures are putting the odds of a 25 bps increase at over 92%.  The next meeting will be a big deal; not only is a rate hike expected, but we will also get our first dots chart and press conference under the Powell regime.  Thus, this week’s meeting should be quiet but the March meeting will be closely watched.

Government budget: The government will run out of spending authority again on February 8.  Although the deadline is obviously next week, work on avoiding a shutdown should intensify this week.  Look for more media commentary on this issue after Wednesday.

A crypto hacking: Coincheck, a cryptocurrency exchange in Tokyo, was hacked late last week and nearly $500 mm of digital coins were taken.  The exchange is promising investors it will pay back part of the losses but it isn’t clear it has the resources to do so.  Although the blockchain offers security to individual users for transactions, the exchanges where holders park their cryptocurrencies clearly do not.  It’s a bit like saying, “The cash is real but the bank isn’t secure.”  The promise to make investors partially whole did spark a recovery in bitcoin and other cryptocurrencies, but the problem of insecure exchanges continues to plague the industry.

A prince released: Prince Alwaleed bin Talal, a Saudi prince and famous globetrotting investor, has been freed from detention from the Riyadh Ritz-Carlton (MAR, $147.14).  It appears he may be the last of the notable princes to be released; we suspect he gained his freedom by giving up some of his immense wealth.  It isn’t clear how much this cost him, but it does look as if the crown prince was able to pull off this anti-corruption shakedown without a serious threat to his power (at least so far).

Government in 5G: Axios^[1] is reporting that the Trump administration is considering nationalizing the 5G cellular network to ensure the U.S. keeps up with China.  The thinking in the administration is that the U.S. needs a centralized network fast and the most efficient way to accomplish this is for the government to build it and then lease it to the telecom providers.  If true, this is a serious departure from how the government has been working since 1980.  Although the federal government has been in the infrastructure business since the inception of the republic, it has mostly left the buildout of areas that are not obvious public goods to the private sector.  This action would be a definite change in policy and may indicate that the government-lite that Reagan introduced is coming to a close.  It’s still too early to get overly concerned but this investment does bear watching.

NAFTA optimism: U.S. representatives at the NAFTA talks in Montreal indicated a sense of optimism that talks to renegotiate the trade deal would avoid collapse and gain momentum.  Although progress is admittedly slow, as neither Mexico nor Canada is interested in changing the agreement, it does appear that neither wants to see it scuttled, either.  Thus, we would expect the U.S. to increase local content on goods that should narrow the trade deficit with both nations.

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[1] https://www.axios.com/trump-team-debates-nationalizing-5g-network-f1e92a49-60f2-4e3e-acd4-f3eb03d910ff.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Happy Friday!  President Trump just ended his speech in Davos and GDP came in soft.  Here is what we are watching this morning:

Trump’s speech in Davos: The speech can best be described as “selling America” as a place to invest.  As we discussed yesterday, if protectionist threats encourage foreign firms to invest in the U.S. to avoid trade impediments, it’s supportive for the U.S. economy.  We would expect some increase in inflation from sourcing production in the U.S. instead of overseas but it would probably not be excessive.  The postwar U.S. “contract” with the world was to be the global importer of last resort and the supplier of the reserve currency.  These policies have led to the development of the “rust belt” and harmed lower skilled labor.  President Trump is trying to adjust that policy by forcing foreign firms to build in the U.S. to gain access to the American consumer.  It isn’t known what effect that will have on the rest of the world.  Our expectation is that it won’t be as favorable.

The administration and the dollar: Comments from Treasury Secretary Mnuchin sent the dollar lower on Wednesday.  Yesterday, President Trump appeared to contradict his Treasury secretary by calling for a strong dollar.  Mnuchin protested that he has made similar comments before and nothing has happened (which is true).^[1]  So, did we see a change in policy, as we speculated earlier in the week?  Who knows?  If the administration wants a narrower trade deficit, jawboning the dollar lower is one way to support this outcome.  After Trump’s comments yesterday, the dollar rallied but it has resumed its downtrend this morning.  Our position is that the dollar is overvalued on a longer term basis and is simply correcting from that valuation issue, but the confusion on policy is clearly boosting currency market volatility.

The TPP: President Trump indicated yesterday that he might be willing to revisit TPP if it was a “better deal.”  We suspect much of this is pandering to the globalists and Davos.  Negotiating a multilateral trade deal is difficult, and then to suggest that the U.S. could renegotiate the current agreement is very unlikely.  The media is reading much into this; we would not.

NAFTA: Negotiations continue on the agreement but there appears to be some movement on developing a new deal.  According to reports, Canadian negotiators offered some new frameworks on trade and U.S. negotiators were moderately positive.  Maintaining NAFTA would be supportive not only to U.S. financial markets but would likely boost Mexican and Canadian equity markets as well.

Mueller: The NYT reported that the president was prepared to fire Special Council Mueller in June but his White House counsel opposed the action and threatened to resign if he moved to do so.  To some extent, this isn’t a major surprise.  On the other hand, we find it interesting that this news is emerging now.  We suspect members of the White House legal team are trying to shape the narrative regarding how it makes them look personally.  As always, we mostly focus on how such events affect markets.  Clearly, it isn’t bearish for equities and it hasn’t been bullish for Treasuries, either.  But, this turmoil may be affecting the dollar and is probably supportive for gold.

Saudi Arabia: The FT^[2] is reporting that the November corruption arrests are going to allow the crown to take direct control of the Middle East Broadcasting Center, the largest in the region.  While ostensibly this is a corruption crackdown, there is an element of asset grab by the king and the crown prince.  As we noted earlier this month, the Ritz-Carlton (MAR, 145.50) in Riyadh has reopened but the report suggests that some princes and other dignitaries are still detained in the facility, as the leader of the broadcasting firm, Waleed bin Ibrahim al-Ibrahim, was calling from the hotel.  So far, there has been little negative repercussions for the crown prince’s crackdown; instead, he is gaining support from ordinary Saudis who are unhappy with the privileges the royal family princes have enjoyed and, at the same time, the crown appears to be gathering important assets in return for releasing those arrested.

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[1] It is actually rather surprising this sort of thing hasn’t happened sooner.  New cabinet members, especially those without government experience at a high level, are accustomed to speaking frankly without much ramification.  Once a person becomes a cabinet member, their comments suddenly take on much more importance.  Usually, in the first year of the first term of a new president, so-called “gaffes” of truth are common but they become less common over time as the new cabinet members learn that what they say makes things (like markets) move.

[2] https://www.ft.com/content/a50075d2-0069-11e8-9650-9c0ad2d7c5b5?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] The president arrived in Davos this morning and will give the keynote speech tomorrow, and the ECB met today.  Here is what we are watching:

The ECB: The ECB made no monetary policy changes, as expected.  In his press conference, ECB President Draghi didn’t veer from anything he has said before.  Interestingly enough, this was taken as hawkish.  The dollar slumped, the EUR jumped, European and U.S. bond yields rose and European equities dipped.  It does appear the financial markets were expecting a dovish statement or press conference and the aforementioned market action developed when it became evident that wasn’t coming.

Another side of protectionism: Discussions of trade policy tend to be based on academic theory.  The theoretical structure is fairly simple—mercantilism, the policy of forcing a trade surplus, will eventually lead to inflation in the nation running the surplus.  This theory goes back to David Hume (1711-1776).  The theory of competitive advantage was developed by David Ricardo (1772-1823).  Perhaps one of the most misunderstood parts is trade macroeconomics, which shows that changes in trade are tied to changes in public, private and foreign saving.  Another area that is generally underestimated is the effect of the dollar’s role as the reserve currency.  The U.S. gets to play by trade rules that no other nation gets to use.  Other nations need dollars to conduct trade; they don’t have an interest in accumulating balances in the Vietnamese dong and will thus try to conduct trade with Vietnam in dollars.  In addition, consumption represents 70% of U.S. GDP and America acts as the global importer of last resort.  If a normal nation puts trade barriers in place, import prices quickly rise as the supply contracts.  On the other hand, if the U.S. puts trade impediments in place, the foreign nation facing these restrictions still needs dollars.  Thus, they may decide to absorb the costs of the tariff by cutting prices.  In addition, the firms affected still want access to the large, open American market, which may mean directly sourcing production in the U.S. to avoid losing access to the American market.  Interestingly enough, building productive capacity in the U.S. appears to be part of the adjustment process on the recently announced tariffs on washing machines.[1]  South Korean firms have indicated they will hike prices to account for the tariff but they also announced they have built productive capacity in the U.S.

There are numerous reasons why foreign nations want to export to the U.S.  One reason is to acquire dollars.  Another is to use American consumers to build their industrial base.  Others want to boost domestic employment.  Moving productive capacity to the U.S. does undermine these goals.  However, it is also an acknowledgement that there are limits to what the U.S. will tolerate; after all, foreign nations do create structures to suppress domestic consumption and wages and undervalue their exchange rates to sell to the U.S.  These policies adversely affect some sectors of the U.S. economy, especially manufacturing.[2]  One way nations can pacify American policymakers is to move production to the U.S.  During the 1980s, after President Reagan negotiated “voluntary” auto export restraints with Japan, Japanese automakers built car plants in the U.S.  Although President Trump’s trade threats could have significant effects on America’s superpower role and global growth, foreign nations can blunt the impact by moving production into the U.S.  And, in fact, that should be the administration’s goal.  Although some members do see the trade deficit itself as a problem, in reality, nearly all elected officials in a democracy are most focused on job creation.  If foreign companies shift production to the U.S. in a bid to reduce protectionist pressures, this would be a major win for the president.  That isn’t to say there won’t be an impact on inflation.  Reducing competitive pressures from foreigners (which is also affected by a weaker dollar) will tend to lift domestic prices.

This chart shows the current account as a percentage of GDP and CPI.  As the chart shows, a wider current account deficit is consistent with lower inflation.

The bottom line is that if the administration’s trade policies lead to an influx of direct foreign investment and jobs in those facilities (which may not hire that many people, based on the degree of automation in these new factories), it could boost U.S. growth and improve the president’s approval rating.  If this is the outcome, it will probably be a net positive for the U.S. and help, at least partially, rebalance the costs of hegemony.

Energy recap: U.S. crude oil inventories fell 1.1 mb compared to market expectations of a 2.3 mb draw.

This chart shows current crude oil inventories, both over the long term and the last decade.  We have added the estimated level of lease stocks to maintain the consistency of the data.  As the chart shows, inventories remain historically high but have declined significantly since last March, by over 120 mb.  This decline doesn’t take into account the withdrawal from the SPR, which added an additional 31 mb to supply.  Taking the SPR into account, inventories fell a whopping 152 mb.

As the seasonal chart below shows, inventories fell this week.  We are at the beginning of the Q1 seasonal build season.  The fact that oil inventories fell again this week is quite bullish.  If this pattern continues we could see stockpiles drop below 400 mb later this year, which would be at the high end of normal.

Based on inventories alone, oil prices are undervalued with the fair value price of $69.95.  Meanwhile, the EUR/WTI model generates a fair value of $70.91.  Together (which is a more sound methodology), fair value is $70.59, meaning that current prices, while elevated, are below fair value.  The weak dollar and falling oil inventories are bullish for oil prices and suggest there is more upside, especially if inventories fail to rise in their normal seasonal fashion.

The Saudi Oil Minister suggested in an interview at Davos yesterday that the IPO for Saudi Aramco may not occur this year unless conditions are favorable.  There is a general belief (which we agree with) that Saudi oil policy will be designed to boost oil prices into the IPO.  Once the offering is made, we would not be surprised to see OPEC try to regain market share which would weigh on oil prices.  If the IPO is delayed, it is bullish for oil prices.

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[1] https://www.reuters.com/article/us-lg-elec-tariffs/south-koreas-lg-to-hike-washer-prices-in-u-s-after-tariffs-idUSKBN1FD2Z9

[2] Interestingly enough, it boosts other sectors, such as finance, which recycles foreign saving into dollar assets.

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] The big market mover this morning is the dollar.  Here is what we are watching:

Treasury shift?  During the 1980s into the 1990s, U.S. Treasury secretaries frequently tried to move the currency markets.  James Baker was part of the Paris Accord in 1985 that led to a massive dollar depreciation and Lloyd Bentsen openly called for a stronger yen.  But, Bob Rubin declared a truce in the mid-1990s by indicating that, going forward, the U.S. would always support a “strong dollar.”  The content of the policy was hollow; strong was never defined and could have easily meant that the paper didn’t tear easily.  Nevertheless, what Rubin really signaled was that the U.S. would no longer try to adjust exchange rates by jawboning.  Instead, the policy of the U.S. Treasury was that markets should set the exchange rate and the U.S. would not intervene.  For the most part, Treasury secretaries since have followed this policy.^[1]

This morning, Steven Mnuchin appears to have ended the Rubin policy, openly declaring at an event in Davos that a weaker dollar is “good” for American trade.  If one wanted to send a clear message, it would be difficult to find a better venue.  Key political and business leaders are all in Switzerland (the president arrives tomorrow, by the way) and so either this statement was (a) an incredible blunder, or (b) clearly calculated to signal the U.S. is going to become more active in trying to close the trade deficit and will use a weaker dollar as one tool (trade impediments could be the other) to accomplish this goal.  We think it’s probably (b).  The fact that his comments are occurring just after the U.S. announced new tariffs is probably not a coincidence.

As one would expect, the dollar has fallen on the comments.  Gold prices have also lifted.  Foreign equities are coming under pressure, but there is mostly a net gain for a dollar-based investor.

In addition to Mnuchin’s remarks, Commerce Secretary Wilbur Ross indicated that “trade wars are fought everyday…the difference is that U.S. troops are now coming to the ramparts.”  Both Mnuchin and Ross indicated that further trade actions are likely in the areas of intellectual property, steel and aluminum.  We expect the president to support these comments during his visit tomorrow.

Here are a couple of interesting charts.  First, a weaker dollar will tend to push up import prices.

This chart shows the yearly change in the JPM dollar index and import prices.  The two are rather highly correlated.  However, we would note that the correlation between import prices and core CPI is not all that strong, only about 31%, and import prices lead CPI by about 18 months.  So, a significant weakening of the dollar will eventually push up inflation, but not for a while.

The dollar’s impact on trade isn’t all that clear.

What is interesting is that it takes a rather large depreciation to affect trade and the trade deficit worsens in the initial stages of the dollar’s decline.  This is known as the “j-curve” effect.  What we haven’t seen before is protectionism and dollar weakness at the same time.  That combination would likely be inflationary.

Meanwhile, the rest of the world puts on a brave face: Canadian PM Trudeau announced that his nation has concluded discussions for a new Pacific Rim trade agreement to replace the TPP.  Although the agreement is expected to be signed in March, we view it as a shell; without the U.S. being part of it, it is hard to see who will play the role of “importer of last resort” that these multilateral trade agreements need.

Going forward: As the administration moves on from its tax reform victory, it appears the next shift will be trade policy, which is almost certain to be protectionist.  Unlike the tax deal, trade interference will not be universally accepted by the business community.  We have not commented extensively on Special Council Mueller’s investigation because we believe, at their core, the outcomes of such investigations are dependent on politics.  Thus, as long as the GOP controls Congress, the president is probably in no danger of censure or impeachment.  However, that could change if establishment Republicans, who have gotten what they most wanted, a tax cut, see the turn against trade as a threat to business and support Mueller’s investigation.  We don’t think we are anywhere close to that yet, but it is a potential development that bears watching.

Powell wins, Goodfriend struggles: As expected, Jay Powell easily won confirmation as the next Fed chair.  Markets expect Powell to maintain Yellen’s policies, although we reiterate that we really don’t know what Powell’s positions are on monetary policy.  He is not an economist and we have no trail of position papers to examine his policy stances.  He was confirmed 84-13; the “nays” were actually quite interesting, mostly the extreme left and right of the spectrum.  How often do you see Elizabeth Warren (D-MA) join Ted Cruz (R-TX) and Rand Paul (R-KY) in a vote?  Meanwhile, Marvin Goodfriend faced a much more hostile questioning from senators.  He did indicate he supports the dual mandate (after stating publically that the Fed should only focus on inflation) and was asked why he predicted a jump in inflation if the unemployment rate fell below 7%.  If Goodfriend is confirmed, it will probably be along party lines.

Germany: The SDP has noted a surge in membership applications, which may be caused by left-wing activists trying to expand the rank and file to vote against joining the CDU/CSU in a grand coalition.  If that coalition vote fails, Germany will likely be forced to hold new elections, unprecedented in the postwar experience.

Venezuela: President Maduro indicated he wants to call new elections for the end of April in a bid to solidify his political power.  On the one hand, it’s really difficult to imagine Maduro winning re-election given the horrible state of the Venezuelan economy.  For example, recent studies show that 75% of the population has lost an average of 19 pounds due to the lack of food.^[2]  However, the opposition is divided and so polarized that Chavistas will vote for Maduro rather than any opposition figure regardless of the state of the economy.  As conditions worsen, it is likely that oil production will continue to decline, which is bullish for prices.

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[1] The notable exception was George W. Bush’s first Treasury secretary, Paul O’Neill.  As a former executive of an industrial metals firm, he noted the dollar’s strength in the early part of the century and suggested it was overvalued.  There was a firestorm of negative comments and O’Neill rapidly retreated from his comments and said that if there was an official change in the strong dollar policy, he would invite all interested parties to Yankee Stadium for the announcement.

[2] https://www.upi.com/Venezuela-75-of-population-lost-19-pounds-amid-crisis/2441487523377/

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] After all the news from yesterday, markets are fairly quiet this morning.  This is what we are watching today:

The shutdown ends: And it ends with mostly a whimper.  Democrat Party leaders essentially ended the shutdown with a promise for a vote on DACA and an extension of CHIP.  The populist wing of the party is furious; the GOP is spiking the football.  However, it’s not as dire as it looks for the Democrats or as great for the Republicans.  First, funding was only extended until February 8.  We can then do this all over again.  On DACA, the Senate might pass a bill that offers a path to citizenship but it isn’t obvious if the House will pass something and it’s anyone’s guess if the president would sign it.  Second, this was only a battle; the real war is the debt ceiling issue, which will likely come up by early April.  That could lead to a more serious crisis.  The trade that would avert a crisis is DACA in return for more defense spending, but the GOP now believes the Democrats will cave on DACA so they will be less likely to negotiate.  If the left-wing populists push establishment Democrats hard enough, we may have a debt ceiling impasse in a couple of months.

So, what are our takeaways from the shutdown?  First, Democrats really can’t do government shutdowns because, at heart, they like government and view it as a force for good.  Republicans view government as a necessary evil, a testament to the fallen nature of humans.  For Democrats, shutting down the government is a repudiation of something they hold dear; for Republicans, it’s “time off.”  Second, although there is great handwringing about immigrants, in reality, neither party is willing to deplete significant political capital for them.  Remember, President Obama could have done something about immigration in his first two years when he had a veto-proof majority in the Senate.  Instead, he used his political capital on the ACA.  The Democratic leadership knows they will still carry the majority of Latino voters in November and beyond.  Thus, the leadership isn’t compelled to move heaven and earth for their issues.  Third, for markets, the takeaway is to mostly ignore Washington.  That could make April an issue.

President to Davos: With the shutdown ended, we expect the president to make his way to Switzerland later in the week.  Expect an “America First” speech and some comments about trade (see next).

Trade action: After running as a protectionist and promising to take steps to reduce the trade deficit, the Trump administration finally acted yesterday by putting tariffs on solar panels and washing machines.  Solar panels and cells will face a 30% tariff and washing machines could face up to a 50% duty.  The actual impact will be complicated.  For manufacturers in the U.S., this action is a cause for celebration.  However, this only works if foreign manufacturers don’t cut prices further.  In the past, when the U.S. has put temporary duties on imports, foreign manufacturers have usually responded in two ways.  First, they cut prices further.  Since the duties were put in place to offset foreign government subsidies, the government could simply give more support.  It’s important to remember that for foreign governments the exports are designed to boost employment and gain foreign reserves.  The companies involved may not actually care about profits.  Second, if additional government support isn’t likely and the firm wants to maintain profit margins, it may simply move the production to another nation—that approach may not work in this case (it appears the duties are not specific to a country but to the product).  What is also missing is that manufacturing, especially for solar panels, is only part of the business.  There are an estimated 260k jobs in the solar electricity industry; about 40k are in manufacturing, with the bulk in sales, support and installation.  Overall, the solar industry views the final outcome as better than expected; a 35% duty was the consensus and 50% was possible.  And, the duties decline every year for the next four years.  Thus, as trade actions go, this was not overly punitive.  However, given the specificity of this action, it may not be indicative of future trade policies.

Yield action: BOJ Governor Kuroda indicated this morning that his central bank is not abandoning QE or policy accommodation.  In the wake of his comments, global long-duration sovereign yields declined.  We didn’t really expect Kuroda to say anything different but there has been growing speculation that the BOJ was going to follow the ECB in tightening policy.  We note that over $14 trillion of global government bonds carried a negative yield in early 2016.  That number has fallen to $9.6 trillion.

The lesson of UKIP:  The U.K. papers[1] are carrying reports about the steady decline of the U.K. Independence Party, the party of Nigel Farage, who was a driving force behind Brexit.  Farage stepped down from party leadership last year and his successor is failing to hold the party together.  Essentially, movements usually don’t last; their ideas are co-opted by mainstream parties and shift the political discussion.  In one sense, UKIP was successful beyond all measure; whole groups of people in the country that had been ignored by the two main political parties found a voice in UKIP.  But, now that these citizens have found their voice, they will have more power by being part of the Tories or Labour.

A troubling decline: The U.N. reports that foreign direct investment (FDI) fell 16% in 2017, the second consecutive year of decline.  The “Greenfield” project, investment that creates new plant and equipment, fell 32% to $571 bn, a 14-year low.  It’s hard to tell if the drop was due to fears of increased protectionism, government interference or part of an overall decline in investment activity, but falling FDI does suggest globalization is in retreat and could eventually lead to higher inflation.

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[1] https://www.ft.com/content/cff64e3c-ff84-11e7-9650-9c0ad2d7c5b5?emailId=5a66a827f3e8d400040bd1d0&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22