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.

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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.

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[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.

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[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.   

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[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/

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] It’s a rather quiet morning.  Here is what we are following:

Economic momentum is rising: The ISM manufacturing index continued to hold near the 60 mark, which is an unusually high level.

The ISM manufacturing index exceeds 59.0 only 17% of the time.  Equally impressive is the new orders index.

The current reading of 63.5 is the highest since 2004 and only happens about 16% of the time.  The ISM indices are sentiment indicators; purchasing managers indicate if conditions are “better, the same, or worse” for various subsectors, such as orders, supplier performance, etc.  In general, there is a positive relationship between the ISM manufacturing index and equity performance.

This chart shows a scatterplot of the ISM manufacturing index and the yearly change in the S&P 500.  The regression line shows that readings of 60 for the ISM index are consistent with yearly growth of 20% for the S&P 500.  Thus, the strength we are seeing in equities is consistent with economic activity.

Iran: Although protests continue in Iran, the intensity appears to be waning, as we expected.  Poor citizens don’t have the financial resources for weeks of protests.  We will be watching to see how the government responds to the recent unrest.  This issue is the topic of next week’s Weekly Geopolitical Report.

Winter storm: The Northeast is getting slammed by a winter storm that will reduce travel and boost energy demand in the short run.  So far, natural gas prices have not jumped significantly because supply capacity remains high.  There have been local price spikes but this is mostly due to the lack of pipeline capacity; adding pipeline capacity is usually unpopular but this is the cost of not overcoming NIMBY complaints.  We may see some impact on market liquidity but it will probably be much less of a factor than in the past due to continued trading automation.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] U.S. equities appear poised to grind higher.  Here is what we are watching this morning:

Iranian update: Iran has seen six consecutive days of protests with 22 dead and over 450 people incarcerated.  These protests are fundamentally different from the 2009 event we mentioned yesterday.  First, the participants are different.  The 2009 protests were a fight between competing elites—the “reformists” and “hardliners” were vying for power.  The hardliners won.  However, these terms should be used with great care.  The hardliners are fairly obvious in their views, but the reformers were not “reformers” in the Western sense.  They were as committed to the Islamic Revolution as the hardliners.  The reformers were simply willing to give more social and market freedoms compared to the hardliners, but neither group was willing to allow for full democracy.  When Akbar Hashemi Rafsanjani[1] is considered a reformer, it is clear the differences between the two groups aren’t all that great.

The current protests are similar to political issues we are seeing in the West, where populism has become widespread.  These protestors are angry about the state of the Iranian economy.  Officially, unemployment is 20%, but economists estimate that unemployment among Iranian youth is probably closer to 40%.  Many of the protestors are from the underclass from the countryside who have moved to towns and cities in the hope of finding work only to find unemployment.  These people have traditionally supported the regime.  In 2009, they would have been opposed to the Green Movement.  But, Iranian President Rouhani raised hopes of economic improvement as a benefit of the nuclear deal that has so far failed to materialize.  Apparently, one of the catalysts for the protests was a leaked government budget that showed billions of dollars going to the clerical elite and the Iranian Republican Guard Corps (IRCG), while cutting social spending and raising subsidized fuel prices and educational tuition.

Iran’s geopolitics are key to understanding this issue.  Iran is a mountainous nation with an internal flatlands of salt.  It is a difficult environment.  History shows it is very tough to invade—imagine a land army trying to march through the Rockies.  Thus, Iran has been mostly safe from invasion and, if invaded, the invaders were usually spent due to the effort.  At the same time, it is really costly for Iran to project power.  Just running the economy is costly and funding forces to take territory further increases the costs.  Throughout history, Persian empires used proxies to project power, just as Iran does today by co-opting the Iraqi government and through Hezbollah.

A common theme heard in the protests is the call for keeping resources at home to help the lower classes instead of expending those resources to project power.  This was also a theme in the U.S. presidential elections, not only in 2016 but also in 2008 and 2000.

So, what happens next?  The regime has been remarkably restrained so far.  We believe this is because it recognizes that it really doesn’t face much of a threat from the protests.  Relative to the 2009 event, the protestors are not well organized and they lack the resources to maintain the protests indefinitely because they are poor.  The young protestors in 2009 were children of the elite who had resources and were well versed in social media.  Those protests were a threat to the hardliners but not the regime.  These protests are a threat to both the hardliners and the reformers, but not a serious one.  At the same time, the simmering anger has to be a concern for the regime.  After all, such anger can be co-opted by revolutionary leaders.  The Russian Revolution of 1917 shows how a small group of talented leaders can use mass anger to bring revolution.  The most rational response from Rouhani and Khamenei would be to sack the aforementioned budget, take resources from the clerics and the IRCG, raise subsidies and cap prices of key goods and try to improve the lot of the poor.  However, that choice will limit Iran’s ability to project power just when it is on the cusp of winning—after all, it pretty much controls Baghdad, Islamic State is essentially defeated and Assad remains in power in Syria.  A path to the Mediterranean is opening up and the budget is designed to take advantage of that.  The protests might delay or undermine Iran’s ability to become the regional hegemon in the region.  Or, the leadership can decide to stay the course and hope that an alternative leadership doesn’t emerge.

Fed minutes: The FOMC minutes will be released later this afternoon.  Like most analysts, we will comb the report for clues about future policy, although, as we have noted at length, the voting composition will be unusually hawkish this year.  These minutes will reflect the Yellen Fed which will soon pass into the ether.

War of words: Yesterday, President Trump responded to Kim Jung-un’s threat of having a nuclear button ready to strike the U.S. by stating that his “nuclear button is bigger and more powerful.”  Although the escalation of rhetoric is nothing new, it does appear that Kim Jung-un is becoming increasingly bolder while seeking a dialogue with South Korea.  Reports from the Korea Times suggest that North Korea could be preparing to launch another ICBM test in the near future.  At the same time, the New York Times reported that North Korea has reopened its border hotline with South Korea, which could be a prelude to direct dialogue between the two countries.  South Korea has been open to talks with North Korea in an attempt to prevent any possible crises during the upcoming Olympics.  North Korea appears to be trying to drive a wedge between the U.S. and South Korea; the latter fears the U.S. will start a war with the North where the costs of war will mostly fall on South Korea.  The situation remains fluid.

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[1] https://www.confluenceinvestment.com/weekly-geopolitical-report-exit-shark-february-6-2017/