by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

Fed minutes: The Fed minutes didn’t have a lot of surprises; we would characterize them as modestly dovish.  Going off the terms used, “several” members were uncertain about inflation and wanted more data to improve their confidence, while “a few” believed that additional increases should be delayed.  On the other hand, “many” thought another increase in the target before year’s end was warranted.  That would suggest a rate hike in December is probably likely, but the decision may not be as unanimous as the market seems to think.  Here are the current odds of a December hike in fed funds futures.

Current expectations call for an 80% probability of a December hike.  The odds didn’t decline after the minutes were released.

The Chair race: Politico[1] is reporting that Treasury Secretary Mnuchin is promoting Jerome Powell for the Fed chair job.  The secretary has worked with him on issues in the past and sees him as a safe pick that he will have some influence over.  At this point, we believe the two front-runners are Powell and Kevin Warsh and, of these two, we would wager that Warsh gets the nod.  However, Mr. Trump has a history of surprises.  Although his name isn’t on any lists, we would not be shocked to see the president appoint an überdove like Minneapolis FRB President Kashkari.  Kashkari is a Republican, which would make him acceptable to the GOP establishment.  President Trump has also indicated he prefers low interest rates.  We think Warsh is the front-runner because he will likely be beholden to the White House.  The president’s comments suggest he may be more Nixonian in his stance toward the U.S. central bank and, if so, it would be dollar bearish.

Brexit talks stall: EU Chief Negotiator Barnier indicated this morning that the two sides have not made any “great steps forward” and that talks are “deadlocked.”  Britain wants talks to shift to trade, but the EU wants the U.K. to inform the EU what it intends to pay to honor its EU commitments as the price of exit.  Naturally, the May government has no interest in spelling out the costs but it appears that the EU won’t negotiate on trade until the U.K. makes an offer.  Although talks are not doomed, there was some market impact from the announcement of a deadlock.

The GBP tumbled on the deadlock news but has started to recover.

Is NAFTA in trouble?  Although negotiations continue, reports indicate that talks are contentious and negotiators are struggling to save the agreement.  The impact of a repeal would be significant.  U.S. agricultural exports would be harmed; Mexican tariffs on agricultural goods are steep and thus U.S. exports of grain and meat would likely decline.  U.S. manufacturing is deeply integrated with Canada and Mexico, so production dislocations could be significant if trade flows are disrupted.  For example, if trade barriers prevent auto parts from flowing across borders, auto production could cease for a period until new arrangements are created.  More than 310 state and local Chambers of Commerce have sent letters to the White House urging the president to keep the U.S. in NAFTA.  On the other hand, leaders of the AFL-CIO are supportive of the president’s efforts.  Although we generally expect inflation to remain low, our position is that mild inflation is mostly a function of globalization and deregulation.  If either is disrupted, supply constraints and higher prices will result.  If such an outcome accelerates, it will have a significantly negative effect on financial markets.  Inflation lifts interest rates and lowers P/Es.  It is quite possible that NAFTA falls and is followed up with bilateral agreements that mimic NAFTA.  However, the shift would not be frictionless and, in the interim, an inflation scare could prompt tighter monetary policy and increase the odds of recession.  We are watching this issue closely.

Austrian elections: If current polls are correct, Austrian voters are going to side with the center-right People’s Party and its young leader, Sebastian Kurz.  At 31, he would be the youngest head of government in the world.  Usually, Austrian governments are grand coalitions of center-left and center-right parties.  However, Kurz is expected to form a government with the xenophobic Freedom Party.  Kurz has tried to limit the number of asylum seekers in Austria, opposing the German refugee policy.  The anti-immigrant policy has been popular; when Kurz became party leader, People’s Party polling rose 10%.  One of the other interesting elements of this election is that consultants for the Social Democrats apparently made fake Facebook (FB, 172.74) pages that purported to be from racist groups suggesting Kurz planned to open Austria’s borders at the behest of George Soros.  The campaign appears to be rather nasty by European standards but, in the end, Austria appears to be turning rightward which will raise worries for Germany and France.

View the complete PDF

---

[1] http://www.politico.com/story/2017/10/11/jerome-powell-federal-reserve-chair-243679

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Although overall market activity is quiet this morning, there is a good bit of news.  Here is what we are watching this morning:

Catalonia blinks—Rajoy presses: Yesterday, Catalan leader Carles Puigdemont declared and suspended independence, asking for talks with Madrid.  PM Rajoy is having none of this, calling for Puigdemont to either send him a document outlining what he intends or stop talking about independence.  If Catalan leaders follow through on independence, we expect Rajoy to respond with force and disband the provincial government.  Puigdemont his trying to thread a needle, holding his independence coalition together while avoiding a crackdown from Madrid.  We suspect the Catalan leadership doesn’t have enough support to risk civil conflict and so it will back down.  Clearly, that is what the market expects.

PM May backtracks on Brexit?  In a series of interviews, PM May would not say she would vote to leave the EU if another referendum were held today.  May made a rookie political mistake—never comment on hypothetical questions.  May has indicated she voted “remain” and we suspect she probably would again.  This is raising pressure on her from Tory backbenchers who strongly lean toward Brexit.  May is on shaky political ground which is making it difficult for her administration to negotiate Brexit with the EU.  Political risks in the U.K. are rising.  Corbyn’s Labour Party would probably win if an election were held today.  There is great dissent within the Tories over May’s leadership but the party wants to avoid a leadership challenge, fearing a no-confidence vote and new elections.

Minutes today: The Fed minutes are due later this afternoon.  We will be watching this release closely to monitor the degree of dissent from the recent path of policy tightening.

Rattling sabers: The U.S. flew two strategic bombers over the Korean Peninsula and President Trump met with military leaders to discuss a response to the North Korean threat.  In addition, the U.S. Navy performed a freedom of navigation operation, sailing near islands claimed by China in the South China Sea.  Perhaps the most interesting comment to emerge from the White House is that NBC is reporting that President Trump said in a meeting earlier this year that he wants to increase the U.S. nuclear arsenal.[1]  This idea flies in the face of established trends and international agreements.  The U.S. nuclear arsenal peaked in terms of warheads in the 1960s.  From a strategic standpoint, the U.S. arsenal is large enough that the survivability of the human race would be in question if deployed.  Thus, adding to that number of warheads seems counterproductive.

IMF upbeat: The IMF annual meetings are being held in Washington this week and the new World Economic Outlook is favorable.  The IMF says the world is enjoying its most widespread and fastest growth spurt since the bounce observed in 2010, which was off the low base of the 2008 Great Financial Crisis.  The world economy’s growth forecast was raised by 0.1%, with advanced economies increased by 0.2%.  The Eurozone forecast was raised by 0.4% while the U.S. was reduced by 0.1%.  Global growth is expected to rise 3.6% this year and 3.7% in 2018.  Emerging economies are forecast to see 4.6% growth, with 4.9% in 2018.

Turkey increases tensions: A court in Turkey has sentenced a WSJ reporter, Ayla Albayrak, to two years in prison on terrorism charges based on an article she wrote.  Albayrak is currently residing in New York, and carries dual citizenship in Finland and Turkey.  Her article reported on the war between Kurdish militants and the Turkish state.  We suspect this high-profile sentencing was designed to raise tensions with the U.S, which are already elevated due to a spat over travel visas.

View the complete PDF

---

[1] https://www.nbcnews.com/politics/donald-trump/trump-wanted-dramatic-increase-nuclear-arsenal-meeting-military-leaders-n809701?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top-stories

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Although it was mostly quiet overnight, we are awaiting a potential declaration of independence from Catalonia.  Here is what we are tracking this morning:

A declaration of independence?  Catalan Leader Carles Puigdemont is expected to address the regional parliament in Barcelona at 11:00 EDT amid growing speculation that he will declare independence.  According to reports, the Spanish national police are poised to arrest him if he follows through.  However, there is a bit of nuance in the announcement.  Puigdemont may make a declaration of independence but it may not be immediate or unilateral.  That outcome would be crafted to avoid his arrest and open a dialogue with Madrid.  Of course, that action would disappoint much of his separatist coalition.  On the other hand, if he goes for a unilateral declaration of independence, the region could face a military crackdown.  The risk of a hard response from Madrid is that it could trigger sympathy for independence.  Reliable polling is rather scarce but the latest polls from July indicate 41% support for independence, with 49% opposing separation.  We suspect these numbers are a reasonably accurate reflection of voter attitudes.  If Rajoy simply allows for a broad vote without interference (last week’s vote was boycotted by supporters of remaining in Spain), we suspect independence would lose.  Apparently, Madrid feels uncomfortable with taking that chance.  So far, problems in Spain have mainly been contained in Spanish financial assets.  However, a breakaway problem in Spain could trigger similar movements elsewhere and lead to a collapse of the unity movement create by the European Union.  If such a drive to self-determination gains momentum, the EUR could be undermined and depreciate.

North Korean hack: Korean lawmakers said yesterday that there is evidence North Korea hacked into classified South Korean military documents which included the blueprint for leadership decapitation operations against Kim Jong-un.  North Korea is known to have sophisticated cyberwar capabilities.  They are believed to have hacked into Sony Pictures (SNE (ADR) $37.04) and recently have attempted to steal bitcoin from South Korean cryptocurrency exchanges.[1]  This news should be treated with caution.  Although it is quite possible that North Korea was able to steal this information, it is also possible that South Korea allowed the North to take the data as part of a disinformation campaign.

Macron, Merkel disagree on EU reform: French President Macron has proposed reforms to the EU that include a unified fiscal budget and loose rules about debt restructuring.  Germany, as expected, wants strict restructuring rules, which would likely lead to a greater divergence in Eurozone borrowing costs and reliance on individual nations to manage their fiscal affairs.  Germany is a creditor state; it has no interest in making things easier for debtor nations.  What the Germans fail to realize is that their pile of savings will do them little good if they can’t find a place to loan and invest these funds.  For now, both nations remain in their respective corners with little likelihood of massive changes along the lines of further unification of the EU.

View the complete PDF

---

[1] https://www.ft.com/content/c245372a-a4e0-11e7-9e4f-7f5e6a7c98a2 (paywall)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s a slow news morning.  Columbus Day is being celebrated, which means the Federal Government and Treasury market are closed.  Equities are open.  Here is what we are tracking this morning.

A Turkish spat: Turkish financial markets have been roiled this morning after both the U.S. and Turkey limited travel visas.  The proximate cause was the arrest of a Turk employed by the U.S. Consulate.  However, it is important to put this action into context.  Turkey has been aggressively arresting Americans working or living in Turkey, claiming they were part of last year’s coup.  The key actor in this event is Fethullah Gulen, a Turkish Muslim leader living in Pennsylvania.  Gulen has built a broad, and mostly moderate, Islamic movement in Turkey that was ultimately designed to undermine the secular Turkish state.  President Erdogan and Gulen were initially allies but had a falling out in recent years.  Erdogan believes Gulen was behind the 2016 coup attempt and wants the U.S. to extradite him for trial.  So far, the U.S. has refused.  Thus, Erdogan is arresting Americans or Turks working for Americans as a way to create “hostages” he can trade for Gulen.  Worries about deteriorating relations are pushing the Turkish lira lower this morning.  We expect tensions to remain elevated on this issue as we don’t expect the U.S. to send Gulen to Turkey.

Pressure builds on North Korea: The WSJ reports that more than 20 nations have reduced operations with North Korea as the U.S. steps up economic and financial sanctions.  Although the consensus of analysts is that North Korea will never relinquish its nuclear weapons program, President Trump has managed to unify nations against the regime.  Economic pain may work to start talks; however, there is no clear roadmap as to what goals could be salvaged at this point.  The stated position of the U.S. is that Pyongyang must give up its nuclear weapons, while North Korea’s starting point is world recognition that it is a nuclear power.  Clearly, these are not compatible goals.  But, talks might yield a workable outcome short of war.  One possibility is that North Korea gets to keep its nukes but allow supervision to ensure the program doesn’t get larger, i.e., a freeze.  For now, the president’s comments suggest the march to war is more likely.

Counter-protests in Catalonia: Large rallies were held in Barcelona over the weekend where Catalonians who oppose independence called for the province to remain in Spain.  Polls have suggested that the independence movement is a minority in the province and there is an argument that PM Rajoy overreacted; allowing the referendum to go forward and fail would have been a stronger outcome than using force to prevent it.  Canada’s experience with Quebec separatism bears this out.  We have seen Spanish assets rally after initially declining on the idea that support for independence may not be enough for Catalonia to declare independence.

View the complete PDF

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy employment data day!  We cover the release in detail below but the quick view is the report is mixed; payrolls actually declined but the unemployment rate did, too.  The data was affected by weather events.  The dollar rose on the news and Treasury yields rose as well, while equities eased modestly.  Here is what we are watching this morning:

PM May is in trouble: The FT is reporting that up to 30 Tory MPs are pushing for PM May to resign.  They are being led by Grant Shapps, a former party chairman.  The broader party leadership is trying to suppress the rebellion, worried that the leadership challenge could lead to a no-confidence vote and new elections.  If elections are held, it is quite possible that Labour could win.  The GBP continues to slide on fears that political turmoil will stall potential rate hikes and the possibility of a Corbyn government.

Madrid continues to tighten its grip on Catalonia: Spain’s constitutional court has suggested Catalonia can’t declare independence and the head of the province’s police force has appeared in court under investigation for sedition.  Some large businesses in Catalonia have indicated they would quit the province if independence is declared.  In the end, independence usually requires applying one’s claims through force.  Catalonia doesn’t have the military resources to separate.  When a region finds itself in this situation, it usually petitions other nations to support its goal.  For example, the emerging U.S. benefited greatly from French support during the American Revolution.  The South may have been able to successfully secede if the British had come to its aid.  We don’t see any outside power willing to go to war with the rest of Spain to bolster Catalonian independence.  The bigger problem is that Madrid will now have a restive province that will sullenly defy Spain at every turn.  Madrid should have used the Canadian model; allow the vote to go on but shower Catalonia with “goodies” to sway the average voter that staying in Spain was a better deal.  PM Rajoy is winning the battle but setting up for a long-term war that should have been avoided.  This problem is weighing on the EUR.

Decertifying Iran: It appears the White House is planning to decertify the nuclear deal with Iran, forcing Congress to deal with the issue.  However, it also appears that the president won’t recommend new sanctions.  This will allow the White House to express its displeasure with the Obama-era agreement without triggering a crisis.  The president may not be able to avoid it.  Once Congress gets control of the policy, there is no guarantee they won’t push new sanctions to his desk, forcing him to either break the current deal or defy his own party.  In addition, it is highly unlikely that Europe or Russia will cooperate on new sanctions, meaning the U.S. will be implementing the action unilaterally.  About the only way the U.S. can make unilateral sanctions stick is if the American financial system is involved.  Of course, if the nuclear deal ends, we would expect Iran to rapidly move to acquire a nuclear weapon which increases the potential of further destabilization in the Middle East.  The White House is trying to weave a middle path—it wants to express its displeasure with Iran, which is a way to gain “points” politically without causing a crisis.  It’s a risky move because we doubt the president wants to go to war in the Middle East.

Quarles confirmed: The FOMC gained a new governor (finally!) as Randal Quarles was confirmed yesterday.  He will take over Dan Tarullo’s role as guiding bank regulation.  Quarles is expected to be much more bank friendly, especially compared to Tarullo.  As a voter, he will probably be moderate to hawkish.

View the complete PDF