by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Coalition deal in Germany: This morning, Chancellor Merkel announced that an agreement has been reached to form a conservative coalition with the Social Democrats (SPD).  This agreement will likely pave the way for Merkel to finally form a new government after months of negotiations following the results of the September election.  Recently, there has been speculation that Merkel may step down from her role as chancellor due to her inability to form a government; this agreement has quelled those fears.  The euro appreciated immediately after the news broke.  Although an agreement has been reached, it still needs to be finalized by members of the SPD during its party conference on January 21.

Pakistan intelligence: Yesterday, Pakistan announced it would withhold key ground intelligence from the United States in response to the State Department’s decision to withhold security aid.  The U.S. has accused Pakistan of harboring Afghan Taliban and has demanded that Pakistan do more to assist in the fight against terrorism if it would like to receive additional aid.  The lack of intelligence is likely to hamper U.S. war efforts in Afghanistan; however, the U.S. will still be able to gather intelligence from air surveillance and intercepted communications.  Pakistan’s retaliation is likely to escalate tensions and could push it to strengthen its relationship with China.  The waning relationship with Pakistan could be further evidence that the U.S. is pivoting its foreign policy toward improving relations with India, which it sees as a counterweight to China’s influence throughout Asia.  During a press conference in Norway, President Trump singled out India, in addition to Russia and China, as a country with which he would like to build a working relationship.  Furthermore, Pakistan and India have always had a tense relationship since Pakistan split from India in 1947.

DACA deal: Yesterday, a bipartisan deal to protect those who were brought into the U.S. as children illegally, also known as dreamers, was rejected by the president.  Clauses that caught the president’s ire involved maintaining the diversity lottery in developing countries, which the president has openly opposed in the past.  After hearing about its inclusion in the bill the president gave a somewhat salacious response questioning the logic behind diversity lotteries.  Those comments have been widely reported elsewhere, so we will not repeat them here, but instead we will focus on how it may impact his legislative agenda going forward.  The president’s remarks could make it harder to reach a deal on immigration in the future, which has held back budget talks.  In addition, Democrats will likely use President Trump’s harsh rhetoric as fodder for their base in the run-up to the mid-term elections.

Nuclear deal lives another day: President Trump is expected to extend sanctions relief to Iran on the condition that the U.S. and its allies come up with a better nuclear deal.  The president has never been a fan of the agreement, labelling it the “worst deal ever.”  There was some speculation that the president would pull out of the deal due to the Iranian government’s response to recent protests in the region.  We will continue to monitor this situation.

View the complete PDF

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Chinese pullback in Treasuries: Yesterday, citing an anonymous source, Bloomberg News reported that China is considering reducing or halting its purchases of U.S. Treasuries; China has since denounced the report as “fake news.”  Initially, U.S. Treasuries, the dollar and U.S. equities fell on the news, but have since rebounded.  The report is interesting for two reasons: 1) it shows that China’s use of soft power to reduce U.S. influence around the world also extends to delegitimizing the U.S. media; and 2) this report could be China’s way of signaling to President Trump that it will not back down in the event of a trade war.  China reducing its purchases of U.S. Treasuries could have a negative impact on the U.S. economy as the U.S. is currently under pressure to find alternative sources of financing in order to replace the loss in government revenue due to passage of the tax bill.  A decrease in demand for U.S. Treasuries may lead to higher interest rates which could also make it more expensive for households and corporations to borrow.  However, as long as China continues to run an enormous trade surplus with the U.S., its only alternative to buying Treasuries is to sell the dollars it accumulates.  This would have the effect of appreciating its currency relative to the dollar, not likely China’s desired outcome.  Hence, we tend to discount the validity of the report.

NAFTA exit imminent: Reuters reported this morning that Canadian officials expect President Trump to announce U.S. withdrawal from NAFTA later this month.  Mexico has already announced it would also leave NAFTA upon the U.S.’s exit.  Canada, on the other hand, is exploring other options and we suspect it may reconsider joining TPP.  If this report is true, President Trump would likely face staunch opposition in Congress, especially among establishment Republicans.  A U.S. departure from NAFTA would likely be bearish for U.S. equities, especially for automakers who rely on supply-chains set up throughout the three countries.  All things considered, Canada probably leaked this report in order to gain leverage in the next round of meetings in Montreal on January 23-28.  We will continue to monitor this situation.

Trump open to talking with North Korea: In a phone call to South Korean President Moon Jae-in, President Trump stated he would be open to setting up talks with Kim Jung-un under the right conditions.  At the moment, it is unclear what conditions the president would be willing to accept, but in the past he has stated that North Korea would have to abandon its nuclear program before discussions can begin.  Despite President Trump’s apparent willingness to hold talks with North Korea, there are also reports suggesting the president is considering punitive airstrikes.  This carrot-and-stick approach has been a signature negotiating style of this administration; therefore, we have not put much weight on the latter issue and expect tensions between the two countries to simmer down.

Uncertainty in Catalonia: The Catalan parliament is due to hold its first meeting at the end of the month but it is unclear who will be the next leader.  According to Catalan bylaws, the leader of parliament needs to be present in order to present the government program.  Given that the presumed two possible leaders are either in jail or in exile, it is unclear who will lead the parliament.  There have been discussions that Carles Puigdemont could present the government program via Skype, but skeptics claim that will be challenged in court as they would argue that he needs to be there physically.  Puigdemont’s second in command, Oriol Junqueras, is currently in jail.  Current Catalan President Carmen Forcadell has announced that she will not continue her duties as president in the upcoming parliament.

Possible second Brexit referendum?  The prospect of a second referendum on Brexit is currently gaining steam as Brexit campaigner Nigel Farage admitted earlier today that he is warming to the idea.  British Prime Minister Theresa May has come out against the notion of holding a second referendum as it would surely undermine the U.K.’s leverage with the EU during Brexit negotiations.  Since the U.K. announced its intention to leave the EU in March of last year, Theresa May has struggled to gain support for a cohesive Brexit strategy going into negotiations with EU officials.

View the complete PDF

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

The problem with bonds: Bond yields jumped yesterday with the 10-year T-note yield breaching 2.55%, breaking 2.50% for the first time since March.  There appear to be two catalysts behind the jump.  First, the BOJ reduced its purchases of bonds; it should be remembered that the Japanese central bank is adjusting its balance sheet to maintain a zero yield on JGBs.  If the demand from the private market rises for this bond, the central bank will buy less.  Thus, this adjustment probably doesn’t mean all that much.  If private demand falls in the future, BOJ buying will increase.  The second issue is more material.  Yesterday, we noted the growing Fed chorus calling for different policy constructs.  Currently, the FOMC uses the Phillip’s Curve as its primary economic construct, which postulates there is an inverse relationship between the unemployment rate and inflation.  Thus, policymakers focus on the unemployment rate and the Fed tends to lean toward rate hikes as it declines.  The problem the Fed has faced is that inflation has failed to decline despite the slide in the unemployment rate.  A number of FOMC members are now suggesting that the Fed consider other constructs, including targeting nominal GDP or the price level instead of the rate of change.  If such a shift is made, the mostly likely outcome would be that the Powell Fed will be tolerant of higher inflation rates.  A key reason for low long-duration Treasury yields is low inflation expectations.  These low expectations are partly due to beliefs that the FOMC will not tolerate higher price levels.  If that has changed, the yield curve will certainly steepen.  It remains to be seen whether this paradigm shift occurs.  The Fed doesn’t make these shifts all that often.  When Paul Volcker moved from targeting fed funds to bank reserves on Oct. 6, 1979, it was referred to as the “Saturday night massacre.”  Later, in the 1980s, the Fed returned to interest rate targeting after seeing inflation decline.  Although a number of FOMC members are calling for consideration of a new paradigm, an actual change is less likely.  If we hear statements in the near future from Powell or others indicating the policy construct hasn’t changed, we will be watching to see if long-duration rates decline.

Vice Chair comments: According to reports, President Trump is close to naming a vice chair nominee.  Richard Clarida is no longer said to be considered, with Larry Lindsey and Mohammad el-Erian as the remaining candidates.  The latter name is better known and would receive a warmer reception from the media, but Lindsey is more hawkish and could be being pushed by Cohn/Mnuchin.

Korea talks: Yesterday, North and South Korea held formal talks.  As expected, South Korea received some assurances that North Korea would not disrupt the Winter Olympics.  As we mentioned yesterday, North Korea also agreed to send a delegation to participate in the Winter Olympics next month in Pyeongchang, South Korea.  However, South Korea, at the urging of Japan and the U.S., brought up the nuclear issue with North Korean negotiators.  The latter suggested this was a breach of protocol.  Essentially, North Korea isn’t going to negotiate away its nuclear deterrent and there isn’t much the South can do about that fact.

Return of the earmarks: Yesterday, President Trump suggested bringing back earmarks in order to break up the gridlock in Washington.  Earmarks allow reluctant statesmen to receive extra funding for special projects in exchange for their support on legislation.  The practice is widely unpopular among constituents as it is commonly associated with mismanagement of public funds, such as Alaska’s “Bridge to Nowhere.”  Banning earmarks was a part of the Republican platform that helped take back Congress in 2010; as a result, they immediately balked at the idea of restoring them.  Although the president has received a lot of flak for the idea, if the Republicans lose their majority in the mid-terms, we would expect him to broach the topic again.

View the complete PDF

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Crypto problems: The major cryptocurrencies fell sharply yesterday after wide price divergences on South Korean exchanges led the exchanges to limit data on pricing.  South Korea, worried about excessive speculation in the cryptocurrencies, has been cracking down recently which is leading to growing concern about the stability and liquidity in this market.  We don’t have any strong feelings about this market nor do we recommend any positions, but we do warn investors this is a very immature market that is unstable and prone to illiquidity.  In other words, caveat emptor!

A rethink on policy structure: The FOMC has used the Phillips Curve as its guide to policy for years.  The concept of NAIRU (non-accelerating inflation rate of unemployment) has been the primary tool for policymakers.  In general, the idea is that there is a level of unemployment that will tend to lift inflation and policymakers expect to raise the policy rate if that level is breeched.  Chair Yellen has generally maintained that policy despite the fact that we have seen a steady drop in unemployment without a commensurate rise in price levels.  A growing number of FOMC members[1] are calling for incoming Chair Powell to consider other policy guidance frameworks.  These frameworks could include a target for price levels as opposed to the rate of change or a nominal GDP target.  Either method would probably lead the Fed to slow its pace of rate hikes; if this call gains traction, we would consider it bearish for the dollar and bullish for equities and the short end of the yield curve.

North Korea in the Olympics: Yesterday, North Korea agreed to send a delegation to participate in the Winter Olympics next month in Pyeongchang, South Korea.  South Korea has been seeking to reduce tensions with its northern neighbor to ensure a peaceful environment during the Winter Olympic Games.  In 1987, when South Korea was preparing for the 1988 Olympic Games, North Korea was accused of having terrorists hijack and crash a Korean Air Passenger plane in retaliation for a breakdown in discussions between the two countries to co-host the event.  North Korea’s participation is believed to be a forerunner for future military discussions to reduce tensions on the Korean Peninsula.  Skeptics claim that North Korea may be using the possibility of warmer relations in order to drive a wedge between South Korea and the U.S.; after all, this would not be the first time North Korea has agreed to hold discussions and then later reneged.  However, South Korean President Moon Jae-in remains optimistic about future discussions.  While campaigning to become president, Moon promoted dialogue with North Korea as opposed to seeking U.S. involvement and criticized the prior administration’s decision to prematurely deploy a U.S. anti-missile system.[2]  Furthermore, President Trump has also expressed optimism, stating that North Korea’s decision to hold discussions with South Korea is a sign that sanctions are working.  We will continue to monitor this situation.

View the complete PDF

---

[1] https://www.reuters.com/article/usa-fed-policy-analysis/in-test-for-powell-internal-groundswell-grows-to-rethink-feds-inflation-approach-idUSKBN1EU24U

[2] https://www.reuters.com/article/us-southkorea-politics/south-korea-presidential-hopeful-u-s-missile-defense-should-wait-idUSKBN1440QJ

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Happy Monday!  We may be on a path to the first down day of the year for equities, although it is obviously early.  Here is what we are noting this morning:

Abandoning the Palestinians: We have always believed that the Palestinian cause was more for show than reality among the Arab governments.  In other words, it was expected that Arab leaders would support the cause of the Palestinians against Israel.  In reality, however, none of the Arab states were willing to do a whole lot to push for an actual two-state solution.  In fact, not having a separate Palestinian state worked in their favor because the messy realities of governing become a problem once a state is born.  A report in the weekend NYT[1] discussed how an Egyptian intelligence officer placed phone calls to influential talk show hosts asking them to publically denounce the U.S. move of its embassy to Jerusalem but persuade their viewers to accept it.  Essentially, the article indicates that the building of a Sunni bloc to oppose the rising Shiite bloc, led by Iran, requires the Sunnis to have good relations with Israel.  It was noted that King Salman denounced the move but has “quietly signaled…tacit approval for the Israeli claim to Jerusalem.”  This shows that support for the Palestinians in opposition to Israel is a luxury the Arab states can’t afford in light of the Iranian threat.

German coalition talks: Chancellor Merkel and SDP leaders are meeting to try to build a new grand coalition.  There are numerous sticking points.  Two big ones are over the EU and immigration.  The SDP is the party of a “United States of Europe,” which is becoming increasingly unpopular in Europe; in fact, this stance has probably been one of the key factors in the overall demise of the center-left across Europe.  The SDP supports French President Macron’s call for a unified Eurozone budget and an EU finance minister.  German conservatives blanch at this goal because they fear the rest of Europe will try to expand fiscally at the expense of German taxpayers (which is probably true).  In addition, the SDP wants open immigration, another policy that appears out of step with the direction of policy across Europe.  Talks are expected to continue until Thursday; at that point, either the SDP and CDU/CSU will begin formal negotiations on forming a government (deciding which party gets what ministries) or end discussions.  If talks end, then Merkel must either (a) form a minority government, which she opposes, or (b) call snap elections.  Both the SDP and CDU/CSU are uncomfortable with another round of elections, fearing their unpopularity will lead to even greater political fracture.  At the same time, Merkel has mostly ruled out a minority government, fearing it would be unworkable.  No such arrangement has occurred in the postwar period.

May reshuffle: PM May announced she will reshuffle her cabinet, which has been rocked by recent resignations.  Most of the changes will likely be to non-core ministries and we expect the PM to name younger ministers to these roles.  It is possible, but not likely, that May will shift or fire some of her rivals, e.g., Boris Johnson.  We would not expect it, but it might happen.  If it does, it would suggest May feels emboldened.

Cohn pushes back: With SALT deductions limited in the tax bill, high tax states are considering other ways to maintain revenue and deductibility.  One idea being floated is to shift the income tax to a payroll tax paid by employers, which remain deductible.  Another is to establish a donation fund that citizens can contribute to in lieu of taxes.  Cohn suggested the administration would fight such moves as it would reduce Federal tax revenue.

2018 policy: Trump administration officials met over the weekend to begin the process of policy priorities in the new year.  Usually, these are outlined in the State of the Union address.  There is growing concern that the president will push for trade restrictions; this is where the GOP establishment will try to thwart the president’s agenda.  An increase in trade restrictions will almost certainly raise inflation and interest rates and put the current equity bull market at risk.

View the complete PDF

---

[1] https://www.nytimes.com/2018/01/06/world/middleeast/egypt-jerusalem-talk-shows.html?emc=edit_mbe_20180108&nl=morning-briefing-europe&nlid=5677267&src=twr&te=1

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Happy employment day!  We show all the details below but the quick analysis is that the report was a bit soft; payrolls came in below forecast and wage growth remains tepid.  The report was dollar bearish, Treasury bullish and neutral for equities.  Here is what we are watching today:

Korean talks: North and South Korea appear headed for talks as Pyongyang is trying to drive a wedge between South Korea and the U.S.  The South Korean leadership likely welcomes the talks as they are fearful the U.S. will trigger a conflict in which they would suffer most of the damage,[1] but we doubt negotiations will go anywhere because South Korea can’t deliver what North Korea wants.  In other words, North Korea wants sanctions lifted and the elimination of the threat of regime change.  Only the U.S. can give Pyongyang those outcomes.  And, the U.S. has no interest in giving North Korea those goals without the latter giving up its nuclear threat.  However, talks will give North Korea some space to further develop its nuclear weapons; after all, the U.S. and South Korea have delayed military exercises without Kim giving up anything.

The Wolff book: We are not going to go into any of the sensational revelations from the Wolff book but there are two takeaways that we see as important.  First, Steve Bannon is becoming increasingly isolated.  His funding source has abandoned him and the media firm he is associated with, Breitbart, may be forced to cut ties with him or cease to exist.  This is significant because Bannon was the real standard bearer of right-wing populism in the White House.  It’s important to remember that Bannon’s trial balloon for tax policy was a 44% marginal tax rate on incomes above $5.0 mm.[2]  His “defrocking” will increase the power of the right-wing establishment surrounding the president and steer that path of policy in a more traditional GOP direction.  Trade policy remains the item we are watching most closely and the president is inclined to put restrictions in place.  But, losing Bannon may hurt that effort.  Second, our primary concern is the impact on financial markets.  If the Wolff book causes tumult and undermines the presidency, the most likely negative impact will be on the dollar.  After all, the tax bill is now law and will continue to support equities.  Thus, concern about political stability will likely shift to the exchange rate market.

Energy recap: U.S. crude oil inventories fell 7.4 mb compared to market expectations of a 5.0 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 stockpiles have declined significantly this year, by 114 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 145 mb.

As the seasonal chart below shows, inventories fell this week.  We are now at the end of the late Q4 seasonal draw.  Next week, stockpiles will begin their largest seasonal build that lasts from January into early April.  This seasonal factor will become a major test for oil prices; if oil prices can hold their current levels as stockpiles rise it will be bullish for the commodity (assuming, of course, that they do rise because if they don’t oil prices could rise significantly).

Based on inventories alone, oil prices are undervalued with the fair value price of $62.27.  Meanwhile, the EUR/WTI model generates a fair value of $64.46.  Together (which is a more sound methodology), fair value is $66.17, meaning that current prices, although elevated, are below fair value.  Overall, oil prices are within normal ranges of current fundamentals but we are generally bullish toward crude oil at this time.   

View the complete PDF

---

[1] https://www.theatlantic.com/international/archive/2017/08/lindsey-graham-north-korea/535578/

[2] http://fortune.com/2017/07/31/steve-bannon-tax-cuts-paul-ryan/