by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Equity markets failed to hold yesterday’s tax adjustment gains.  We are mostly marking time this morning.  Here is what we are watching:

Brexit problems: As we noted yesterday, it appeared PM May had resolved the Northern Ireland/Ireland border problem.  Her plan was to keep Northern Ireland in the EU Customs Union, thus creating a situation where there would be no hard border between Ireland and Northern Ireland.  Under normal circumstances, that decision would have held.  However, because of the Tories’ poor performance in the spring elections, the government needed support from the Democratic Unionist Party (DUP), a Northern Ireland-based Unionist (Protestant) political party.  The DUP opposes the action because it fears any legislation that makes it a special zone different from the rest of the United Kingdom will eventually lead to unification with Ireland.  At the same time, there is great concern that a hard border between Northern Ireland and Ireland will lead to an increase in sectarian activity and put the Good Friday agreement that brought peace to Northern Ireland into question.  If the DUP left the government, it is possible that the May government would fall and bring new elections.  If so, a Corbyn-led Labour Party could win which would roil the U.K. economy.  The other “can of worms” that has been opened is that Scotland and the City of London are suggesting that if Northern Ireland can stay in the Customs Union, they should be able to as well.  Our basic position has been that the U.K. would come up with an agreement that would generally allow it to function outside the EU with close relations.  This position is mostly based upon the idea that Germany wants as little disruption as possible.  However, if the U.K. faces devolution pressure due to the differences between the “remain” and “leave” camps, then there is a question as to what the U.K. will look like when Brexit occurs.

Tax drama: In what should have been a procedural vote, the House, by a 222-192 margin, approved a motion to go to conference with the Senate.  The drama came from the Freedom Caucus who were withholding support to gain control over spending that will be part of this week’s expected continuing resolution to fund the government.  At one point, the vote was tied.  Although Speaker Ryan was eventually able to get his way and appoint conference negotiators, this event shows how fragile the political consensus is at this point and how subgroups and factions gain leverage under such conditions.

More tax drama: Part of the reason equity gains fizzled yesterday was the realization that the Senate version of the tax bill, the one most likely to be the actual finished product, included a corporate version of the Alternative Minimum Tax (AMT) that was not included in the House version.  The corporate AMT wasn’t much of an issue before; under a statutory rate of 35%, very few companies were caught by the AMT.  However, with a statutory rate cut to 20%, suddenly a whole host of companies would find themselves subject to the AMT.  Technology firms are most vulnerable to this change, which led to a selloff in that sector yesterday.  Needless to say, the lobbyists are in full force to press against this measure but the revenue would need to be found somewhere else if the House version is adopted.  We expect that it will, probably by a modest increase in the corporate rate.  This sort of turmoil is inevitable as the “sausage is being made.”[1]

Yemen: The ex-president of Yemen, Ali Abdullah Saleh, has been killed by Houthi forces in Yemen.  Saleh was allied with the Houthis against the current (or what remains of the current) leadership in Yemen.  But, Saleh turned against the Houthis, relying on various tribes to protect him; that was apparently a poor decision.[2]  Saleh governed Yemen for nearly four decades, deftly managing tribal and sectarian differences to keep the country intact.  However, his reaction to the Arab Spring led to his ouster.  Instead of going quietly into exile, he formed an alliance with the Houthis to retake power.  It is unclear if it was a faction of the Houthis that executed Saleh but it is probable that coalitions of tribes and sectarian groups are now in flux which will certainly lead to increased bloodshed but also may allow the GCC countries to make gains during this period of disunity among the opposition.

Alabama election: The GOP has decided to endorse Roy Moore for the Senate after President Trump made his support a formal endorsement as well.  This chart probably explains why:

After seeing the bettors turn against Moore when the allegations surrounding his dating activity surfaced, his losses failed to hold.  Current betting activity shows nearly 80% likelihood that Moore will prevail later this month.

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[1] Bismarck is usually attributed with the quote, “Laws are like sausages. It is better not to see them being made.”  However, it appears to have been originally coined by an American poet named John Godfrey Saxe.

[2] https://www.youtube.com/watch?v=VA7J0KkanzM

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] The big news is the tax reform bill passed by the Senate early Saturday morning.  Market response has been as one would expect—equities are higher, Treasury yields are rising and the dollar is up.  Here are the items we are watching this morning:

Tax bill: Our stance has been to avoid deep analysis of the bill until something is actually signed by the president.  This is because the bill is being written on the fly and what emerges in the final version will be much different from what is currently being discussed.  However, there is one factor common to both bills, which is that the fiscal deficit will rise.  We are not deeply concerned about this outcome and, in fact, would argue that the public sector should borrow more during private sector deleveraging.  When the government doesn’t borrow during private sector deleveraging, you get a 1930s outcome.

This chart shows non-financial corporate, household and non-profit debt scaled to GDP.  Debt peaked during the Great Financial Crisis and fell into 2014.  It has been rising modestly but a more fair reading is that debt levels are consolidating.  The real issue is deciding which fiscal stimulus is most effective for boosting growth—tax cuts or public investment?  Our position is that it depends on where the economy is at a given time.  If inflation is high with low growth, tax cuts are probably the best action because tax cuts should boost private investment.  If inflation is low along with low growth, public investment makes more sense.  Why?  High inflation suggests a lack of productive capacity and the best way to boost capacity is to foster private investment.  Low inflation indicates an excess of productive capacity so tax cuts probably won’t trigger new investment.  Thus, the tax cuts may simply be transfers to businesses and households that become spending or purchases of existing assets.

The ultimate problem with deficits is inflation.  As long as a nation services its debt in its own currency, default isn’t a problem.  There is an acknowledgement among the GOP that deficits may be a problem.  The answer appears to be to cut entitlement spending.[1]  President Reagan attempted this during the 1980s with little success.  It remains to be seen if it will work this time.  It should be noted that President Trump promised during his campaign that Social Security and Medicare would not be the targets of cuts.

Brexit talks: The EU and U.K. are engaged in Brexit talks today and there is evidence of progress.  Ireland and the U.K. have agreed on a border deal,[2] which was a major sticking point.  Last week’s “alimony” agreement also addressed a key problem.  The issue of EU courts in Britain remains unresolved, as does the fate of Europeans living in the U.K.  But, there is progress; we note the GBP is higher this morning, bucking the overall stronger dollar trend.

December 8^th: The continuing resolution funding the government will expire on Friday.  Although we don’t expect a shutdown, we do expect the Democrats to only support a very short-term extension to keep the issue in the news and extract more of their legislative goals.  However, President Trump has indicated he thinks a shutdown would be blamed on his opposition and thus may be open to closing the government for a while.  A shutdown would likely ease some of the current bullish sentiment.

Bitcoin: The CFTC has approved cash settled futures contracts for the CME and CBOE for bitcoin.  This is an important development for cryptocurrencies mainly because now there will be an easy forum for taking short positions.  It should be noted that having the ability to short doesn’t necessarily mean that shorting will be successful.  The chart below shows the Nikkei 225 Index.  The vertical line shows when the joint Singapore/CME contract on the Nikkei 225 futures began trading.  The Nikkei peaked three years after the contract began trading.  Until then, shorting the Nikkei was a futile activity.  However, having a futures contract will allow participants to hedge their long positions and develop option strategies.  Although it may, over time, end the strength, it will also help stabilize the market and improve its legitimacy.

Richmond Fed: The Richmond FRB announced it has nominated Thomas Barkin as its new president.  Barkin is not a professional economist, although he does have an undergrad degree in the discipline.  He was with McKinsey as a consultant.  We expect Barkin will be confirmed (he would be confirmed by the Board of Governors, not the Senate).  For now, we would expect him to be a level “3” on policy; we have not been able to find anything on his monetary policy views, so he will likely develop them over time.

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[1] https://www.nytimes.com/2017/12/02/us/politics/tax-cuts-republicans-entitlements-medicare-social-security.html

[2] https://www.ft.com/content/983b64e8-d8e0-11e7-a039-c64b1c09b482

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] There was a lot of overnight news, but below are the stories we are following today:

Tax bill hits a snag: In an attempt to appease the deficit hawks, Senate Republicans have agreed to pare back $350 bn in tax relief.  The two proposals being floated are an alternative minimum tax for wealthy individuals and a revenue trigger that would roll back tax relief if economic growth fails to meet expectations.  Tea Party members have expressed their displeasure with these proposals, specifically tax hikes of any sort, but, despite their reluctance, they have not publicly come out against the tax bill.  Even though the bill is planned to be put to a vote sometime this morning, there is growing speculation that it could be pushed into next week.

Possible shutdown looming: Congressional Republicans are working on a temporary stop-gap spending bill to keep the government funded through December 22.  Democrats have rejected an initial offer from the Senate GOP that would link concessions on DACA with funding for a border wall.  Meanwhile, President Trump appears to be using the threat of a possible government shutdown in order to gain leverage in negotiations with Democrats.  According to the NYT, the president has told people close to him that a shutdown would be beneficial to him politically.  Although we are inclined to believe the president has a better understanding of his base than most, in the past, government shutdowns have been risky for everyone involved.  Moreover, a government shutdown would almost certainly mean that tax reform gets pushed into early next year and possibly even further if Republicans lose the Senate seat in Alabama.  We will continue to monitor this situation.

White House year-end cleanout? Reports suggest that SOS Rex Tillerson, Gary Cohn and Jared Kushner could all be headed for the exit door.  Yesterday, multiple reports linked SOS Rex Tillerson with an imminent departure from the State Department; his replacement is rumored to be CIA Director Mike Pompeo.  SOS Tillerson and President Trump have expressed alternative approaches to foreign policy.  President Trump has favored a hawkish foreign policy compared to the diplomatic approach of Tillerson, and Mike Pompeo is believed to be more aligned with the president’s way of thinking.  In other news, Gary Cohn is rumored to be considering leaving the White House following the conclusion of the tax bill; rumors have circulated about his departure since he came out publicly against Trump.  In addition, Jared Kushner, who has seen his role diminish in the White House, might be considering an exit in order to deal with legal matters associated with the Russia investigation.

Russian influence spreading: Russia appears to be expanding its influence throughout the Middle East.  According to the NYT, Russia and Egypt have reached a preliminary agreement that would allow Russian military jets to use the airbases in Egypt.  In addition, The Economist reports that Turkey, a NATO member, has considered purchasing Russian-made weapons such as the S-400 missile-defense system.  This comes on top of news that Trump ceded Syrian postwar planning to Russia earlier this year.  It appears that Russia is taking advantage of the Trump administration’s willingness to take a step back from the U.S. superpower role.  If this pattern persists, we expect there to be more uncertainty in global markets as other countries will likely compete to fill the power vacuum following U.S. withdrawal.

Tensions rise in Catalonia: Early this morning, effigies were seen hanging from a bridge in Catalonia bearing logos of parties from the remain camp in Spain.  This is likely an effort to intimidate voters into supporting separatist parties in the December 21 regional election in Catalonia.  Polls suggest that separatist parties may be losing support; however, there are concerns that PM Rajoy’s aggressive response following the October 1 referendum could lead to more violence within Catalonia, similar to separatist groups’ actions in the Basque Country.  Tensions are likely to escalate further as separatists await the ruling on Monday as to whether politicians and advisers who supported the October 1 referendum will be freed from prison.  Following the Catalan declaration of independence, several politicians and advisers we arrested on grounds of sedition, misappropriation of funds and treason.  Rajoy is supposedly in favor of freeing them so there will be no excuses following the results of the upcoming election.  We will continue to monitor this situation.

Eurozone reform: The leader of the Social Democrats (SDP), Martin Schulz, has named his price to link the SDP with the CDU/CSU.  In an interview with the German publication Der Speigel, Schulz suggested that supporting Eurozone reforms similar to those proposals made by French President Macron would be key to gaining his party’s support.  Earlier this year, Macron expressed interest in setting up a Eurozone finance minister, budget and parliament, in addition to allowing the currency bloc to issue its own bonds.  With the exception of a Eurozone bond, Chancellor Merkel has expressed a level of interest in implementing some of Macron’s ideas; as a result, we are still optimistic that a grand coalition will be formed between the SDP and CDU/CSU.

Energy recap: U.S. crude oil inventories fell 3.4 mb compared to market expectations of a 3.5 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.  The DOE has revised its data (an exercise it does periodically) and inventories are falling faster than previously estimated.  As the chart shows, inventories remain historically high but have declined significantly this year.  We also note the SPR fell by 2.4 mb, meaning the net build was 0.1 mb.

Refinery operations continued to rise last week, in line with seasonal norms.  We expect them to peak very soon.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] There was a lot of overnight news, but below are the stories we are following today:

Trade war with China?  The U.S. has formally declined China’s bid to be treated as a market economy within the World Trade Organization (WTO).  The move will likely heighten tensions between the two countries.  If China is named a market economy it would limit U.S. ability to impose duties on Chinese exports.  The Trump administration has consistently argued that China engages in unfair competition.  Yesterday, the Department of Commerce opened an investigation into Chinese steel, in which China has been accused of making its steel artificially cheap in order to push down global prices and price out competitors.  Although the U.S. has failed to place any trade restrictions on China, it appears to be signaling that it may do so down the road.  We will continue to monitor this situation.

Response to NK threat: Following North Korea’s recent missile launch, the U.S. has been urging the rest of the world to cut off ties with the rogue nation.  Yesterday, U.S. ambassador to the UN, Nikki Haley, threatened to disrupt Chinese oil shipments to North Korea if China continues to supply North Korea with oil.  It is unclear whether China will comply, but it does signify a dramatic shift in rhetoric.  China has been reluctant to cut off oil supply to North Korea due to the humanitarian crisis it might cause.  In addition, as mentioned in yesterday’s comment, cutting off oil to North Korea may not change the trajectory of its nuclear program.

Debate on tax bill: The tax bill is headed to the Senate floor for debate.  Although there seems to be support for the bill, recent revisions have led to speculation on whether it will pass.  Sen. Bob Corker’s (R-TN) insistence on a trigger component that would raise taxes if revenue requirements are not met has drawn the ire of some of his colleagues.  At this point, some Republicans are skeptical of the bill as there were many concessions made in order to satisfy various factions within the Republican Party.  Most notably, the desired 20% corporate tax rate is rumored to have increased to around 22%.  Assuming the Democrats keep a united front, the tax bill can only afford to lose two votes from Republicans to ensure passage.  The bill is expected to be put to vote by Friday at the latest.

Post-Brexit U.K.: Yesterday, the U.K. and the EU agreed on a Brexit “divorce bill” of about €50 bn, therefore setting up talks for a future trade arrangement with the EU.  In the wake of discussions, we expect the U.K. to begin to showcase itself as a viable place for investment and trade following its departure from the EU.  Yesterday, Mark Carney stated that the U.K. could abandon a rule imposed by the EU that placed a cap on bonuses for financial institutions.  Financial institutions have railed against the measure since its inception.

New Fed governor: Yesterday, President Trump nominated Marvin Goodfriend to the Fed’s Board of Governors; he will fill one of the four vacancies on the Board of Governors.  In the past, Goodfriend has advocated for more transparency and less independence of the Fed, in addition to his belief that Fed policy should be measured against a mathematical rule like the Taylor Rule.  Although Goodfriend has been labeled a hawk, he has warned that the Fed should be prepared to push interest rates back to zero; he has been known to favor negative rates over quantitative easing.  Goodfriend’s nomination will likely be viewed positively by Senate Republicans.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Although yesterday was a news-heavy day, financial markets are relatively calm following North Korea’s missile launch and an upward revision to GDP.  Below are the stories we are following:

Nuclear North Korea: Yesterday, North Korea had its most successful missile launch and says it is capable of hitting anywhere on the U.S. mainland.  Following the launch, North Korean Leader Kim Jong-un announced that his nuclear program is now complete.  It is unclear how the United States plans to respond to the launch, but officials within the Trump administration have stated that the U.S. will continue its current policy of isolating North Korea and reaffirming its threat of possible military action.  It has been suggested that China could be pressured into cutting off oil supply from North Korea.  Although China’s “technical difficulties” with its oil pipeline in 2003 forced North Korea to the negotiating table then, China’s recent attempt at limiting oil supply to North Korea has failed to yield a similar result.[1]  Nevertheless, while the recent missile launch has increased the likelihood of a potential preemptive strike by the U.S., markets have been relatively mum.  We will continue to monitor the situation.

Possible trade war: It appears the warm relationship that had developed between President Trump and President Xi has finally cooled.  Yesterday, the Trump administration initiated an investigation into imports of aluminum sheets from China, marking the first time since 1985 that the Commerce Department has initiated an investigation without a formal request.  If the Commerce Department determines China has aided in unfair trade practices that have hurt the U.S. steel industry, it will instruct the U.S. Customs and Border Protection to collect duties from U.S. companies that purchase the steel.

Senate tax bill makes it out of committee: Yesterday, the Senate tax bill barely made it out of the committee after the two Republican holdouts were finally cajoled into voting for the bill. Concessions appear to have been made to Sen. Bob Corker (R-TN) to ensure the bill is more revenue-neutral, while Sen. Ron Johnson (R-WI) may have succumbed to pressure.  The bill is expected to come to the Senate floor on Thursday, which would put it on track to meet the president’s Christmas deadline.  That being said, there is still speculation that there is not enough support among Senate Republicans, although there have been rumblings that at least two Senate Democrats, Joe Manchin (D-WV) and Heide Heitkamp (D-ND), may support the bill.  At this time, we believe it is a coin toss as to whether or not the bill is able to make it through the Senate this week.

Government shutdown?  Nancy Pelosi and Chuck Schumer skipped a bipartisan meeting with President Trump to discuss the government budget following comments the president made on Twitter.  President Trump accused the two of being weak on illegal immigration and crime, in addition to wanting to raise taxes.  The spat between the two sides has increased the likelihood of a government shutdown; the government is currently funded through December 8.  Presently, there is not enough support among Republicans to secure funding, therefore the Democrats are using their leverage to gain assurances that the children in the DACA program will remain protected as well as secure financing for the Children’s Health Insurance Program.  It is unclear whether a budget deal is imminent and therefore it is likely that another stopgap spending bill will be passed to keep the government funded past next week.

EU/Brexit bill: It appears the EU and U.K. are close to coming to terms on a Brexit “divorce bill.” It is believed the U.K. will pay a little under €50 bn to settle claims with the EU, whereas the estimated liabilities were €100 bn.  After the agreement is finalized, the two sides will begin discussions on a free trade pact, a “hard” Irish border and the rights of EU citizens in the U.K.

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[1] https://www.economist.com/news/letters/21726670-populism-north-korea-childlessness-renewables-shipping-eurocrats-bullets-iceland-st

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Financial markets are relatively quiet this morning.  We are watching the following news events:

Senate tax bill: Today, the Senate’s tax reform bill awaits approval from the Senate Budget Committee.  Although approval from the committee is usually a formality, there is growing speculation that the bill might not achieve the majority votes needed to make it through.  Senators Ron Johnson (R-WI) and Bob Corker (R-TN) have publicly come out against the bill in its current form.  Sen. Johnson would like deeper tax cuts for pass-through businesses, while Sen. Corker would like to place a penalty provision in the bill that would raise taxes if economic growth fails to ensure the bill remains revenue-neutral.  These demands seem steep given the political factions that exist within the Republican Party.  The budget committee is split between 12 Republicans and 11 Democrats, so the bill needs support from both Republican senators as the Democrats have refused to support it.  If this bill fails to make it out of committee, it will further delay tax reform.

Tension before coalition talks: Yesterday, the European Commission voted to renew the license for the controversial weed killer glyphosate.  Germany was not expected to support the renewal so the approval came as a surprise (Germany had abstained from the previous vote when the license was rejected).  Upon approval of the license, France and Italy maintained they would continue to ban the use of glyphosate in their respective countries.  Glyphosate is a substance used in weed killer that became controversial after a WHO report claimed the substance was “probably carcinogenic.”  The vote could complicate talks for a coalition government in Germany between the CDU/CSU and the SPD as the SPD has consistently supported the ban on glyphosate.  Although this issue may have damaged trust between the sides, it appears that talks to form a coalition government will continue.  So far, the euro has remained stable which suggests there is still optimism that a deal will be struck.  We will continue to monitor the situation.

The return of AMLO: In Mexico, Andres Manuel Lopez Obrador (AMLO) is currently leading the polls for the presidential election planned for July 1, 2018.  AMLO, a populist candidate with a loyal following, is expected to finish within the top two contenders for the third consecutive election.  In the previous two elections, AMLO led in the polls early only to lose in the general election.  A win by AMLO would increase the likelihood that Mexico will exit NAFTA as AMLO believes the agreement hurts Mexican farmers.  That being said, it is widely believed the establishment parties, PAN and PRI, will do everything in their power to ensure AMLO does not win the presidency.  These parties have recently seen a dip in support on corruption suspicions.

Jerome Powell: Later today, Fed chair nominee Jerome Powell is expected to meet with the Senate Banking Committee to begin his confirmation hearing.  Prior to the hearing, he sent a statement to the committee in which he expressed broad support for Chair Yellen’s agenda and signaled that he will continue down the path of gradual rate increases and shrinking the Fed balance sheet.  He also mentioned that he would be open to considering “appropriate ways” to ease rules on banks.  After making it through two confirmation hearings without resistance, Powell is expected to be confirmed, replacing Yellen when her term ends in February.

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