by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Welcome, 2018!  Back to the salt mines.  Here is what we are watching this morning:

Iranian unrest: Civil unrest broke out in the major urban areas of Iran.  The protests were widespread and have led to at least 22 fatalities so far.  Iranians are angry about weak economic growth; hopes were raised that the nuclear deal would lead to a general reduction in sanctions.  Although a large number of restrictions were lifted, the U.S. has maintained a significant number of unilateral sanctions and these have been enough to keep foreign investment below expectations.  Social media reports suggest that many of the protestors come from the lower economic classes and the chants indicate calls for more focus on the domestic economy and less on expanding Iran’s geopolitical footprint (populism isn’t only occurring in the West).  Another factor to consider is that the Iranian leadership was always able to blame the weak economy on international sanctions.  The goal of the nuclear deal was to end the sanctions and thus the ordinary Iranian assumed that the end of sanctions would lead to a much better economy.  As we noted above, most U.S. sanctions remain in place but that fact probably got lost in the narrative President Rouhani was selling.

We expect Iran’s security forces to maintain security; after all, the unrest after the 2009 elections was widespread but failed to bring regime change.  At the same time, the rather reserved response from the security forces thus far does add credence to the notion that the protestors are not the sophisticated children of the elite but the natural allies of the regime, the conservative lower classes.  If the protests continue, at some point, we would look for the security services to become more aggressive.  If unrest does threaten the regime, it would likely be bullish for crude oil.

Italian elections: Although we have been anticipating elections in Italy for some time, the government set a date for the actual vote of March 4, 2018.  The single currency has the lowest popularity rating in Italy among the major Eurozone countries, although most polls still show the majority favor remaining in the Eurozone.  There are parties that not only want to leave the Eurozone but also question EU membership.  Current polls suggest the election won’t yield a definitive outcome and may lead to months of wrangling to try to form a government.  Any election sentiment that appears to support an Italian exit from the Eurozone will be bearish for the single currency.

Eurozone PMIs: The final readings for December manufacturing PMIs are shown in the PMI table below, but the numbers continue to show impressive strength.  The dollar is falling this morning on the back of Eurozone economic strength.  We also saw weaker European equities due to rising interest rates.  The chart below shows 10-year yields for Italy and Germany.  Although European interest rates remain remarkably low, we have seen rates in both these nations rise rather significantly since mid-December.  The rise in German rates reflects stronger growth, while the rise in Italian rates is likely due to a combination of political uncertainty and economic expansion.  In any case, rising European yields does have a similar effect on U.S. yields.  Our 10-year T-note model suggests that for every rise in German yields of 100 bps, U.S. yields rise 15 bps (all else held equal).

North Korea: There were several news items that emerged from the Hermit Kingdom over the past few days.  Kim Jong-un claims he now has a “nuclear button” on his desk, indicating his nation is a fully nuclear power.  We have serious doubts that North Korea’s weapons can be launched immediately, but the “button” is highly symbolic.  The U.S. and South Korea released evidence of fuel oil smuggling; initially, it was first thought that Chinese vessels were involved but later it appeared that Russian ships were actually helping North Korea evade sanctions.  Kim Jong-un also made overtures to South Korea with regard to the Winter Olympics.  Finally, former Joint Chief of Staff Adm. Mike Mullen said over the weekend that nuclear war with North Korea is “closer than ever.”  He blamed President Trump’s rhetoric for increasing tensions.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

(Note to readers: The Daily Comment will go on hiatus next week after today; commentary will resume on January 2, 2018.  From all of us at Confluence, thanks for reading!  We wish you a Merry Christmas and Happy New Year.)

The big news was from Europe.  Here is what we are watching this morning:

Catalonia returns: Catalonia held regional elections yesterday and the results, though not completely conclusive, favored independence.  The coalition of parties that want separation won 70 seats, but Ciudadanos received the most votes and thus won the most seats, 37 out of 135.  Ciudadanos is a center-left party that opposes independence.  Of the top three parties in terms of seats in the regional parliament, the largest opposes independence while the next two support it.  Interestingly enough, the positions are becoming hardened; parties with no opinion on separation only won 9.1% of total votes compared to 13.1% in 2015.

To a great extent, this vote solved nothing.  It was a real political blow for PM Rajoy.  His center-right Popular Party only won three seats, a dismal showing.  This election suggests that a center-left government is probably the only hope for a national government that can keep Catalonia in Spain.  In addition, it isn’t clear how the separation coalition can govern.  Its leaders are in exile and face arrest if they return to Spain.  If new leaders emerge, Rajoy may simply arrest them too.

For the time being, Catalonia will be governed from Madrid until a new government is formed.  There is no obvious solution to the current impasse.  However, it appears to us that Rajoy probably won’t be the leader to resolve the problem.  The problem for the financial markets is that Ciudadanos is an unknown quantity; Rajoy has embraced austerity and can argue that it has worked to some degree.  The chart below shows Spain’s unemployment rate.  Although it remains elevated, at 15.1%, the trend is clearly going in the right direction.  The fear in the markets is that if Rajoy’s government falls on this issue, a left-wing government may reject austerity and put the Eurozone at risk again.

We will be watching to see if any of the established parties in Madrid decide to call a no-confidence vote and trigger new elections.  Currently, Rajoy is running a minority government so there is the potential for new elections, which would be bearish for the EUR and Spanish financial assets.

Government funding: As expected, Congress passed a temporary spending bill, but nothing was really resolved.  A whole host of issues will need to be addressed by January 19.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

(Note to readers: The Daily Comment will go on hiatus after Friday; commentary will resume on January 2, 2018.)

Happy Solstice!  Here is what we are watching this morning:

Tax bill passes: While there was some last-minute drama, the tax bill passed.  We will be watching to see how the economy reacts, although our expectation is that the impact will be rather small.  We have taken note of a few large firms that have announced increases in their minimum wage levels, a lift in investment and one-off bonuses due to the tax cut.  We view these actions as mostly done for positive publicity; as a thought experiment, it’s worth noting that equity prices usually rise when firms announce layoffs.  But, the actions will blunt some of the negative media coverage that has developed as part of the tax measure, giving pundits talking points.

Government funding: We don’t expect a shutdown (lawmakers want to get home for Christmas), but the rhetoric will get heated before a deal is completed.  Expect a short-term funding agreement that will push the next “crisis” into late January.

The bond market: We continue to see a backup in yields, especially at the long end of the curve.  Concerns about the deficit expansion may be behind this rise but, in reality, the relationship between deficits and Treasury yields isn’t very strong.  The chart below shows the fiscal deficit as a percentage of GDP and 10-year Treasury yields.  The correlation is 0.08, which is virtually uncorrelated.  The two most important variables to yields are the policy rate and inflation expectations.  The rise we are seeing in long-term yields is a combination of fears of tightening monetary policy and the chance that the tax bill could boost inflation.  After all, fiscal stimulus with a very low unemployment rate is a textbook combination designed to raise inflation.  However, we aren’t all that worried because (a) we doubt the tax bill will have much of an impact on growth, and (b) any lift in growth will probably be offset by rising imports.  At the same time, if the administration is successful in erecting trade barriers, our concern level would rise significantly.  Thus, for now, we view the rise in bond yields as probably more of a year-end position-squaring event…but we are watching it closely.

Equities remain elevated: We have seen some weakness in the past couple of days, which we would attribute to profit-taking after the tax bill passed yesterday.  Given the recent strength in the market, we want to examine a couple of indicators we monitor.  First, retail money market funds continue to rise despite the strength in equities.

The orange bars on the chart show periods when retail money market funds have fallen to $920 bn or below.  These tend to be periods when equities correct.  We suspect this is because equities run out of liquidity to bid them higher.  What is fascinating about the current rally is that it is occurring while retail money markets have increased to $1.2 trillion.  It would appear that retail investors may not be fully participating in this recent leg up in equities.  Second, flows into equity mutual funds and ETFs have slowed as well.

This chart shows the 26-week average of flows.  Although they remain positive, the pace has slowed for new flows, confirming there is some slowing in instruments used by retail investors.  This suggests to us that sentiment is not excessive (despite what the sentiment surveys suggest) and that further gains in equities are likely.

Energy recap: U.S. crude oil inventories fell 6.5 mb compared to market expectations of a 3.1 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 this year.  We also note the SPR rose by 0.4 mb, meaning the net draw was 6.1 mb.

As the seasonal chart below shows, inventories fell this week.  We are now nearing the end of the late Q4 seasonal draw.  As the new year starts, stockpiles usually begin their largest seasonal build from early January into early April.

Oil prices rose on the bullish report.

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 $63.83.  Together (which is a more sound methodology), fair value is $62.98, meaning that current prices 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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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

(Note to readers: The Daily Comment will go on hiatus after Friday; commentary will resume on January 2, 2018.)

Markets are showing more of the same—U.S. equities are rising and bond yields are also rising.  Here is what we are watching this morning:

Tax bill update: It’s essentially a done deal.  The House will need to vote again on the tax bill due to procedural issues in the Senate that required a vote late last night.  The vote was strictly by party line, 51-48.  We expect a similar outcome in the House.  The president will have the bill no later than tomorrow; although there is some talk he might sit on it for a few days, we suspect he will sign it immediately.

Some thoughts on the tax bill: First, this bill got finished at record speed.  Kudos to the GOP congressional leadership.  Whether one likes the outcome or not, the fact that it was done so quickly is remarkable, especially given the disarray evident this fall.  Second, don’t expect durability.  In the hyper-partisan political environment in Washington now, both parties are looking for retribution when they get power.  Look how hard the GOP worked to unwind the ACA.  Universal healthcare is a totem for the Democrat Party.  And, even though a full “repeal and replace” failed, the GOP has undermined the ACA with various measures, including removing the insurance mandate as part of this tax legislation.  One should fully expect the Democrats to try to unwind this tax bill if they gain political power in 2018 and 2020.  Why?  Because tax cuts are a totem for the GOP.

Compare the current tax reform bill to the last one.  The 1986 Tax Reform Act only had 12 Democrat senators vote against it in its final form.  It passed 74-23; 11 Republicans opposed the measure.  Three decades ago, party discipline was clearly not as strong as it is today.  To get that degree of bipartisanship, legislators from both sides had to work in concert to craft the bill.  When bills have that degree of bipartisanship, they tend to remain unchallenged by future administrations.

This is a key point.  We are rapidly reaching a status where households and businesses can only rely on the current regulatory and legislative environment to endure as long as the party in power remains in place.  Once the government shifts, one should expect a wholesale reversal to occur.  This fact will make it increasingly difficult to invest and plan.  The current tax bill’s support is completely partisan, which means a new environment will develop if and when the opposition gains power.

The other issue to remember is that this tax bill has all sorts of surprises embedded in it, due in part to the haste in which it was fashioned.  The sunset provisions, which “everybody” knows will be extended, won’t be if the Democrats are in power.  An interesting sidelight is a provision that will eliminate the ability of cryptocurrency holders to transfer their holdings into another similar instrument and defer taxes.  Before this legislation, cryptocurrencies were treated as property, allowing tax deferral for like-kind exchanges.  In the media, there is lots of talk about how other, lesser known cryptocurrencies are jumping in value relative to bitcoin.  This buying may be tied to the tax legislation.

We will have more to say on the tax bill next year.  But, for now, it will boost corporate earnings, anywhere from 5% to 10%, and is clearly bullish for equities.  That fact will support stocks into Q1.

The EU rules on Uber: The EU’s top court says Uber is a transportation company, not a platform company, and thus is subject to EU regulation on livery companies.  This is a huge blow to the company, which was mostly built on regulatory avoidance.  If this ruling becomes precedent, other platform firms may find themselves subject to similar laws in their markets.

The shutdown: Although the GOP leadership in Congress is celebrating its tax win, the looming spending bill has to be passed by Friday or the government will run out of spending authority.  We expect a shutdown will be avoided but we will likely only get a short-term extension.  This issue will probably return by mid-January.

Catalan vote tomorrow: Catalonia will hold regional elections tomorrow.  Current polling shows that separatists and unionists are in a dead heat, with nearly 20% of the electorate undecided.  The most likely outcome is an indecisive election and weeks of jockeying before a regional government is formed.  However, if the separatists win decisively, a constitutional crisis could develop in Spain.

China blinks (again): The WSJ[1] is reporting that the Xi regime is dialing back its deleveraging program to support economic growth.  This has been a consistent pattern from the CPC; although the need to deleverage is obvious, the restructuring necessary will lead to a slower growth economy, something the leadership fears.  That is good news in the short run because China is an important component to global growth.  However, the debt level is clearly unsustainable and the safest way to address it is to slow growth and shift resources to the household sector.

Cryptocurrency woes: Two cryptocurrency exchanges had issues yesterday—one in South Korea was forced into bankruptcy after a cyberattack and another in the U.S. is investigating the potential of insider trading.[2]  These issues highlight the security problems of the new currencies.

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[1] https://www.wsj.com/articles/china-seeking-growth-softens-focus-on-cutting-debt-1513700557

[2] https://www.ft.com/content/aa9fdd64-e536-11e7-97e2-916d4fbac0da?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

(Note to readers: The Daily Comment will go on hiatus after Friday; commentary will resume on January 2, 2018.)

Markets are quiet this morning as investors begin to wind down for the holiday weekend.  Here is what we are watching this morning:

Tax bill update: The House will vote on the tax bill in the early afternoon.  Although no Democrats are expected to support the measure and a few Republicans from high SALT states are also expected to vote against the bill, it looks like it will pass with little drama.  The Senate will take up the measure as early as tomorrow.  With Sen. Collins (R-ME) now supporting the bill, it should pass easily.

Fed speakers: Minneapolis FRB President Kashkari and Dallas FRB President Kaplan were on television this morning, both striking a cautious tone about future rate hikes.  Kashkari may be the most dovish member of the FOMC at this point; his argument is that the policy rate should not be moved higher until the inflation target is achieved.  Kaplan’s concern is that the yield curve is flattening, which should slow the pace of tightening.  These two presidents were voters in 2017 but will be non-voters in 2018.  As we noted before, the composition of the voting roster next year will be profoundly more hawkish than in 2017 even without the appointment of new governors.  Currently, fed funds futures project a 70% chance of a rate hike in March of 25 bps.

Another Houthi missile: The Saudi military indicated they successfully intercepted a ballistic missile launched by Houthi rebels from Yemen.  The Houthis said it was a Brukan 2H missile, a variant of the SCUD.  The missile was fired at Riyadh as was the earlier missile in November.  The last time this situation occurred, the Saudis declared it a casus belli against Iran, which they accuse of supporting and arming the Houthis.  So far, oil markets have not reacted strongly to the news, although oil prices are higher this morning.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] It’s a “green” day, with global equity markets mostly higher on the back of a strong Friday rally in the U.S.  Here is what we are watching this morning:

Tax bill update: The clouds have parted and it looks like passage is likely.  Various tweaks were made to placate wavering senators and it looks like it will gather enough votes to pass, even with Sen. McCain (R-AZ) missing a vote due to cancer treatment.  Although no one seems to expect the House to object to the bill, we could still see a close vote there.  But, in the end, we expect the president to have a bill to sign by mid-week.

From where we sit, this bill appears to have been put together in a hurry and thus there will be surprises.  If political conditions were normal, fixes to problems would occur in the coming years.  However, that won’t be likely given the partisan nature of the country at present.  In fact, if the Democrats take back Congress at the mid-terms, look for all sorts of new tax bills that would raise marginal rates on the upper income brackets to be sent to the president for the sole purpose of triggering vetoes.  Still, at least until 2020, the tax bill will be the law of the land.

What’s next?  President Trump is scheduled to announce his National Security Strategy at 2:00 today.  The main elements will be to call China a “strategic competitor” and accuse the PRC of pursuing policies of “economic aggression” against the U.S.  It appears to us that the administration is now shifting from domestic policy to foreign policy and will focus on trade.  This makes sense; the president has used much of his political capital on the repeal of the ACA and taxes.  He will likely lose on the first but win on the second.  On trade, the White House has greater powers to act without Congress but there may be bipartisan support for trade restrictions.  Americans have become increasingly jaded about globalization; we are paying close attention to this issue because we believe that globalization and deregulation have been the keys to continued low inflation.  These factors expand and flatten the aggregate supply curve and thus lead to lower inflation at every equilibrium.  If these factors are reversed, there is the potential for rising future inflation.  Although we are probably early in the process of changing policy on trade, impeding trade will likely boost inflation.

Global politics: In Chile, Sebastián Piñera, the conservative billionaire former president of the country, has won re-election.  Local equity markets have been rallying on expectations of his victory.  In Austria, the People’s Party and the Freedom Party, a right-wing and far right-wing party, respectively, have formed a coalition and will rule the country.  Protests developed on the news.  So far, the EU and other European leaders are showing caution with the new government.  The Freedom Party has ties to the National Socialists and the EU put sanctions on Austria when it joined the government in 2000.  In South Africa, the ANC is holding party nominations.  Markets are hoping that Cyril Ramaphosa, a business leader running on an anti-corruption platform, will win against Nkosazana Dlamini-Zuma, the current president’s ex-wife who is running as a continuity candidate.

North Korea: On Friday, we discussed the recent execution of a high-ranking member of the North Korean military.  Although disloyalty was signaled as the reason, we pondered whether military leaders were grumbling because Kim Jong-un was shifting resources away from the military to the civilian sector of the economy.  One item we neglected to note was that on November 13^th a North Korean soldier defected by running through the DMZ.  He was shot and wounded by North Korean border troops but was brought to safety by allied forces.  While treating the soldier, doctors discovered dozens of parasitic worms, some as long as 11”, in his digestive track.  Although such infestations are commonly found among defectors, mostly because North Korean agricultural practices use human waste as fertilizer which spreads the parasites, we would expect better treatment for the military as they were given priority in resources under Kim Jong-il.  Another clue emerged over the weekend; in a long article in the NYT, there was a discussion of how well soldiers and scientists tied to the missile and nuclear program are treated.[1]  Kim Jong-un may be shifting resources to the nuclear program at the expense of the conventional military.  This would make sense.  The U.S. expanded development of its nuclear capabilities in the 1950s as a lower cost way of deterring the Soviets.  North Korea may be working from the idea that a nuclear program will be cheaper than conventional military forces and as a result is allowing some diversion of resources to the civilian sector.  Finally, in a speech to the Atlantic Council last week,[2] SOS Tillerson noted that the U.S. assured China that if U.S. troops land in the North to secure the nukes, American forces would leave once their work is complete.  We suspect that China, South Korea and the U.S. are quietly making plans to secure North Korea if there is a coup or a fall of the Kim regime.  The cited report suggests the U.S. will rely on China and South Korea to secure the country while American Special Forces secure the nuclear warheads.

Government funding: The Treasury will run out of spending authority by Friday unless Congress moves to approve spending.  Although we expect a deal to be reached, there will be added tensions because of the tax bill.  We look for the Democrat leadership in Congress to try to extract some support for DACA.  A shutdown just before Christmas would be in bad form and both parties will probably try to avoid it, but the potential exists.  If a shutdown occurs, look for Treasuries to rally.

Gold loses its luster: Bloomberg[3] reports that hedge funds are leaving the gold market, moving to equities and cryptocurrencies.  To some extent, cryptocurrencies are a potential replacement for gold; if one is uncomfortable with fiat currencies, the chance to own bitcoin has allure.  It can be traded anonymously and can be held in such a way that government and taxing authorities don’t know you have it.  And, unlike gold, it can be easily transferred without the weight of gold (at least in theory—in reality, the infrastructure to move cryptocurrencies is rather clunky as reports surface of traders taking days to execute a transaction).  At the same time, the security of cryptocurrencies is still uncertain; we may be only one security crisis away from a debacle.  At least with gold, one who has it can touch and feel it.  Even with the advent of a second futures contract (it now trades on the CBOE and CME), we still view price action as a bubble.

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[1] https://www.nytimes.com/interactive/2017/12/15/world/asia/north-korea-scientists-weapons.html?emc=edit_mbe_20171218&nl=morning-briefing-europe&nlid=5677267&te=1

[2] https://www.nytimes.com/2017/12/17/us/politics/tillerson-north-korea-china.html?emc=edit_mbe_20171218&nl=morning-briefing-europe&nlid=5677267&te=1

[3] https://www.bloomberg.com/amp/news/articles/2017-12-15/-nobody-cares-about-gold-as-hedge-funds-seek-thrills-elsewhere?__twitter_impression=true