by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy productivity day!  Lots of news this morning; here is what we are watching:

The ECB: The ECB’s statement was a repeat of the one from a few weeks ago.  In the press conference, the reporters focused most of their questions on the exchange rate.  President Draghi deftly fended off these questions by not commenting on any particular level and by discussing the exchange rate outside the parameters of broader policy goals.  In response to the lack of direct opposition to the recent rise in the EUR, the currency rose rather sharply, shown in the chart below.

The fact that policy didn’t change and there is no indication that policy will markedly tighten anytime soon, the EUR’s rise suggests that (a) the financial markets realize the EUR is still undervalued (we put fair value around $1.300), and (b) the dollar’s weakness is originating from the U.S. and not from abroad.

The Trump Shuffle: President Trump stunned the GOP leadership (and probably much of the party) by cutting a deal with the Democrat Party leadership to pass a short-term debt ceiling bill.  House Minority Leader Pelosi and Senate Minority Leader Schumer engineered a deal that will raise the debt ceiling but only until December.  The media is full of reports from GOP activists apoplectic about this turn of events.  Although the degree of anger is understandable, we are somewhat surprised by the shock.  Our position has been that our two-party system is a program of enforced coalitions; history shows that these coalitions change over time.  The GOP houses a number of different factions.  The GOP establishment is mostly center-right; supportive of markets, deregulation and moderately conservative on social matters.  This group is generally resigned to large government and thus wants to shape that government to its own ends.  There is a small government faction, often called the “Tea Party” and includes the Freedom Caucus in the House, that wants to return government to the pre-Roosevelt period; Grover Norquist is the key leader of this group.  Social conservatives have also gravitated to the GOP.  The key to Trump’s victory was wooing the disaffected white working class voters; traditionally Democrats, this group has discovered that the Democrats are focused more on identity rather than class.  In other words, the Democrat Party leadership will celebrate differences in culture while purposely ignoring economic issues.  This explains why the Democrat leadership was caught flat-footed by the rise of Bernie Sanders.  Trump promised to restrict globalization (in both trade and immigration) and increase government support (he wanted a bigger health care program and infrastructure spending).

After the election, the GOP leadership wanted to accommodate the goals of the Tea Party and the establishment through tax cuts and spending reductions.  Although Trump wasn’t necessarily opposed to these measures, his focus was on the white working class.  When the Freedom Caucus wanted to tie spending cuts to the debt ceiling increase and was willing to risk hurricane aid to get what it wanted, Trump decided to get a better deal from the opposition party.  Although the media is suggesting Trump has no ideology,[1] we would suggest otherwise; he wants to help the working class who have been harmed by a nearly four-decade bipartisan policy of deregulation and globalization.  Note that he characterized the GOP health care plan as harsh and is ok with tax cuts, but has no worries about the deficit.  In other words, he sees no need to cut spending.

Although other presidents have “triangulated” between their own party and the opposition (Bill Clinton was a master at this), we see Trump as doing something different.  He is creating conditions that will lead to a realignment of party coalitions.  We don’t know how that will evolve; third parties might emerge for a time.  It’s important to remember that the Whig Party existed from 1834 to 1854 but was unable to hold together (slavery led to the dissolution).  A multi-ethnic (or, perhaps, multi-identity) working class party and a market-oriented party of globalization and deregulation could emerge.

In the short run, although the debt ceiling issue is probably off the table for now, it will return soon enough.  For the opposition party, making the majority vote to raise the ceiling multiple times before the midterm elections is a favorable outcome.  However, Democrats should be careful in how they embrace the president.  If Trump can craft a protectionist policy and raise infrastructure spending, he could woo some Berniecrats and widen the divisions within the Democrat Party as well.  In our opinion, the key point here is that the party coalitions are shifting; instead of thinking about party, investors should focus on factions.  Conditions will likely become increasingly confusing if one’s thinking remains in the framework of traditional GOP/Democrat characteristics.

Fed Drama: Vice Chair Fischer dropped a blockbuster yesterday by unexpectedly resigning, effective Oct. 13, for “personal reasons.”  We have no insight into what those might be, but we note he is 73 years old and the grind of central banking is probably a lot for anyone.  Although we expected Fischer to be out early next year, this removes a mainstream voter and a sage central banker from the FOMC.  At the same time, Gary Cohn, who was thought to be a lock for the Fed chair job, is apparently unlikely to get the position.  The president doesn’t handle criticism well; the very public criticism that Cohn expressed over the Charlottesville issue appears to have changed the president’s mind.  The combination of these two events probably means the odds that Yellen gets extended have increased markedly.  It is also worth noting that virtually all the candidates for governor positions reported in the media are hawks.  We suspect that Trump is figuring this out and has no interest in appointing a hard money person to the Fed.  Thus, we would not be shocked if none of the names mentioned are actually nominated and more dovish candidates are recommended by the White House.  As noted in the above discussion, the president really isn’t a small government, low inflation person.  He is ok with deficits and inflation and it would make more sense for him to choose Fed governors who share those positions.  And, we would not be surprised to see Cohn leave soon.

The Tropical Situation: We have three active hurricanes; one will likely hit Mexico, Jose will probably go out to sea, but Irma is another matter.  Its forecast path is to hit Florida and then move into the Atlantic Seaboard.  Next week, we could see weather disruptions in this region.

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[1] https://www.washingtonpost.com/opinions/trump-offers-us-a-glimpse-behind-the-curtain-theres-nothing-there/2017/09/06/c0b30556-933b-11e7-aace-04b862b2b3f3_story.html?stream=top-stories&utm_campaign=newsletter_axiosam&utm_medium=email&utm_source=newsletter&utm_term=.e46d8ed77cf2

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Financial markets are easing off the flight from risk exhibited yesterday.  There wasn’t a lot of breaking news overnight, but there are currently several significant news items.  Here’s a recap:

Hurricane Irma: There are three tropical events in the Atlantic but Irma is the current focus of attention.  It is a massive Category 5 storm that is presently hitting the Caribbean islands.  Yesterday, a majority of the computer models were showing the storm taking a northward hook into Florida by the weekend, but there were a couple of models that suggested the turn may occur late enough for the storm to enter the Gulf of Mexico.  If the path continued west, Texas and Louisiana might be hit again by a major storm.  However, there is universal agreement among the models this morning that Irma is going to move straight up the Florida peninsula by Monday.  The cold front that moved across St. Louis on Monday will steer the storm northward.  As we have covered energy since 1989, we do know that computer models are not perfect; if the cold front stalls, a more western drift is possible.  But, for now, it appears that the Sunshine State will be the target on the U.S. mainland.

This will be the second major storm to strike the U.S. this hurricane season.  The need for emergency government spending should end any uncertainty surrounding the debt ceiling passage, at least in the short run.  However, this issue may return by late December.  Interestingly enough, financial markets are not convinced that the hurricanes will force a debt ceiling reconciliation.

This chart shows the six-month T-bill rate along with the two-year T-note rate.  Note that the spread has significantly narrowed recently as bill rates increased while two-year rates fell.  We suspect that fears of a short-term disruption related to the debt ceiling are boosting bill yields, while the feared negative impact on the economy weighs on the potential for future Fed rate hikes, easing the note rate.  We would expect this spread to widen again if our analysis is correct and the hurricanes force a clean debt ceiling rise.

When doves cry: Fed Governor Brainard and Minneapolis FRB President Kashkari gave talks yesterday.  Both are doves; the latter has dissented from recent rate hikes and the former has expressed deep caution about moving rates higher too quickly.  Kashkari said yesterday that the recent hikes may have already adversely affected the economy.  We find this argument difficult to support; GDP growth is running around 3% and the current Atlanta FRB GDPNow forecast for Q3 GDP is 3.2%, incorporating the somewhat weaker than expected employment data.  Maybe Kashkari will be right in the future but, for now, the impact of recent hikes doesn’t appear onerous.  Brainard’s comments appear to be on more solid theoretical footing.  She suggests that current low inflation isn’t just a series of idiosyncratic events but is, in fact, structural in nature.  In other words, inflation is coming down on a secular basis, and running monetary policy on the premise that price levels will normalize will likely lead to overly tight policy and invite a recession.  Essentially, Brainard is arguing that inflation expectations are becoming unanchored to the downside and that monetary policy should take this idea into account and perhaps lean against this trend.[1]  Our economic work suggests that the central bank has little impact on inflation; instead, inflation is the intersection of aggregate supply and demand.  And, in a globalized and deregulated world, the aggregate supply curve is nearly horizontal, meaning that increased demand has little impact on inflation.  However, the central bank does have an impact on inflation expectations; if it appears too accommodative, it can spook businesses and households into precautionary spending.  Simply put, if a household or business fears future price increases, it “saves” by holding inventory, further boosting price levels.  The central bank isn’t the only factor in inflation expectations, though.  One’s experience of inflation over a 10- to 20-year time frame also affects inflation expectations.  Essentially, the Fed now has the opposite problem it faced in the 1970s.  At that time, inflation expectations were elevated and the Volcker Fed had to act aggressively to convince households and firms that it would take steps to bring down inflation.  Now, expectations of continued low inflation have become so entrenched that the Fed faces the need to convince economic actors that it won’t snuff out the economy prematurely.

The key question is whether or not Brainard’s position will sway her fellow FOMC members.  It’s probably unlikely.  Although it’s too simplistic to say that age affects the process of monetary policy, in fact, a significant number of influential members, including the chair and vice chair, came of age during the 1970s and are probably affected by that experience.  It is no coincidence that Brainard and Kashkari are among the youngest members of the FOMC.  Perhaps the only way the Fed becomes comfortable with persistently easy policy is through generational change.  It is true that policy has been persistently accommodative, but it is also true that the preponderance of policymakers at the Fed appear to view current policy as an emergency measure and not a structural shift.  Brainard is arguing for a structural shift.  We doubt her argument will carry the day at the current Fed but it may in the future.

DACA: We haven’t commented on this issue yet because our focus is on financial markets.  However, now that action is being taken, this issue will begin to affect the financial markets.  DACA now becomes another distraction for a Congress that has lots of them.  So, instead of working on tax reform or infrastructure spending or a budget, Congress will have to deal with this issue.  Given the deeply divided nature of Congress, it is hard to see how they can address such a contentious problem and thus working on DACA will delay other agenda items.

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[1] We recently discussed the issue of weak wage growth and noted that while nominal wage growth is running well below where it historically should be based on labor market conditions, real wage growth is actually consistent with current labor market conditions. https://www.confluenceinvestment.com/asset-allocation-weekly-july-14-2017/

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Goodbye summer!  We are now moving into autumn.  Here is what we are watching today:

North Korea: The Hermit Kingdom was active over the holiday weekend.  It detonated another nuclear device, claims to have miniaturized it for a warhead and is reportedly preparing for another missile test.  The U.S. is working with the UNSC on additional sanctions but the Russians appear to have killed the idea, suggesting additional sanctions won’t work.  In some respects, nothing has changed.  The U.S. doesn’t want to see North Korea acquire a nuclear weapon that can threaten the U.S.  South Korea doesn’t want any military action, fearing it will face an artillery barrage that will leave thousands dead.  China isn’t pleased with North Korea’s actions but (a) doesn’t want any drama before the CPC’s October meetings when Chairman Xi gets his second term and his own team of advisors, and (b) doesn’t want to lose a buffer state on the Korean peninsula.  Russia likes to see the U.S. occupied with something other than Russia.  Japan fears a North Korean attack; it also worries that the U.S. will be willing to sacrifice Tokyo to a nuclear attack in order to spare Los Angeles.  The situation is a mess; the U.S. must work quickly if it wants to prevent North Korea from acquiring a nuclear threat to the U.S. mainland.  Although the Hermit Kingdom has missiles and devices, it hasn’t proven it can actually deliver a warhead.  Clearly, it is working hard to acquire such capabilities.

War isn’t inevitable.  Diplomacy can still work.  However, it appears that warlike actions will be necessary in order to really deter North Korea.  One way to achieve this would be a total blockade, which is considered an act of war; to work, China must be on board.  China has mixed aims with North Korea but probably wouldn’t support a blockade, which would cut off oil supplies.  There are reports the military has a year of oil reserves in storage but the rest of the economy has only about a month; on the other hand, the Kim regime has historically been willing to tolerate extreme deprivations of the civilian economy to achieve its aims.

We continue to monitor the situation.  Clearly, the financial markets are worried but don’t think war is imminent.  Our position is that the potential for conflict is still well below the 50/50 threshold but probably higher than the market expects.  In today’s market, we are seeing some risk-off trading, with Treasuries and the JPY higher.

Good world growth: As the PMI data below shows, the global economy is doing rather well.  The JPMorgan Global Manufacturing PMI hit 53.1, the highest level since May 2011.  In addition, 96.3% of nations are seeing readings above the expansion line of 50, and 92.6% are seeing positive yearly readings.  Developed markets are outperforming emerging and Europe is putting in the strongest data.

Hurricane Irma: This cyclone is now a Category 5 hurricane.  The five-day forecast cone shows it entering the Gulf of Mexico on Sunday.

There is a high-pressure cell over the mid-Atlantic; meanwhile, a cold front passed through St. Louis yesterday evening, bringing rain and cooler temperatures.  The steering of these two factors will determine the path of Irma.  At present, forecasters are assuming the combination of these two factors will push Irma up into Florida, Georgia and the Carolinas.  Nearly all the models show it taking a sharply northern turn early next week.  However, if the cold front stalls, Irma could end up in the GOM and perhaps affect recovery efforts in Texas.

The debt ceiling: We believe the debt ceiling issue is now probably resolved with the spending needed for Texas’s recovery.  We will be watching for how far borrowing limits are extended.  If they are not moved significantly, we could revisit this issue by December.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Employment Day!  We recap the numbers below.  Here is what we are watching today:

Q3 GDP looking strong: Q2 GDP was revised to 3.0%, and the Atlanta FRB is projecting a 3.3% growth rate for Q3.  We present the relevant charts below.

The estimated growth rate is coming down but is still stronger than the consensus estimate.  Below is the breakdown by contribution.

Consumption remains strong and inventories are expected to add a point to growth; in fact, inventories and PCE contribute most of the growth in the forecast, representing all but 40 bps of the expected increase.  The data suggests a steadily improving economy.  We will be watching to see the impact of Harvey in the coming weeks.

CPC meetings in October: The Communist Party of China (CPC) announced that its 19^th Party Congress meetings will begin October 18.  This is the meeting where Xi Jinping will announce his new Standing Committee, the body that is effectively his cabinet.  In a Chinese leader’s second term, he gets to select his own Standing Committee, whereas the Standing Committee is usually filled with allies of the previous leader in the initial election.  So, unlike the U.S. system, the Chinese leader has more power in his second term.  We will be watching closely for an “heir apparent”; if Xi fails to pick a Standing Committee member that looks like the next president, it is possible that Xi might try for a third term.

Kenya elections: Last night, Kenya’s Supreme Court ruled that the results from last month’s presidential election were invalid; as a result, new elections will take place within 60 days.  The unprecedented ruling was a stunning blow to the incumbent, President Uhuru Kenyatta.  The previous election’s results showed that he had defeated his opponent, Raila Odinga, with 54% of the vote.  Although it is likely that there were some forms of voter intimidation and voter fraud on both sides, which are fairly common in developing countries, we believe these irregularities are unlikely to explain the margin of victory.  The decision is the first time in Kenya’s history, as well as Africa, in which an election was overturned by the Supreme Court and is likely to raise tensions as the new election draws near.  Trading on the Nairobi stock exchange was halted temporarily due to fears that political uncertainty could harm the economy.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s the last day of August.  Here is what we are watching today:

Russian bank problem: Otkritie is a bank in Russia that has become insolvent.  The bank has close ties to the government and has apparently enjoyed rapid growth by absorbing the assets of smaller failed banks, often buying the assets at a deep discount.  Some of the deals are less than transparent and there are concerns that the bank’s management may have enriched itself at the expense of the state.  Otkritie represents about 3.7% of Russian bank assets,[1] making it the fourth largest bank in the country.  This is important because, if not contained, it could trigger a broader financial panic.  Although we do expect the Russian central bank to engineer a bailout, the potential for a broader problem does exist.  Bank panics are crises of confidence; they can occur easily and once underway become difficult to contain.

Kurds to vote: The Kirkuk Provincial Council voted on Tuesday to hold a Kurdistan independence referendum on September 25.  Iraq, the U.S. and Turkey will oppose this vote because a “yes” vote could begin the process of a Kurdish breakaway region.  Although Iraq probably can’t militarily force the Kurds to remain in Iraq, Turkey does have the capacity to prevent the creation of a Kurdish state, something it has opposed for nearly a century.  This vote should be viewed in the broader context that the post-WWI borders drawn up by French and British colonialists are steadily eroding and creating conditions where conflict could become constant.

New America: The NYT reports[2] that the New America Foundation, a center-left policy shop, has fired one of its members, Barry Linn.  Linn was the director of the Open Markets program that operated at New America.  Linn was thus part of the think tank and wrote extensively on the dangers of industry concentration, especially in technology.  According to reports, Linn supported the EU’s recent €2.4 bn fine on Google (GOOGL, 943.63). [3]  All this seems rather appropriate; an analyst who studies industry concentration commenting on a fine levied by a legitimate government against anti-competitive behavior would be a normal part of the job.  However, New America received more than $21 mm in funding from Google and others tied to the company.  Eric Schmidt, Google’s executive chairman, was also the chairman of New America until last year.  Linn’s comments were taken down from New America’s website, but then they returned.  Later, Linn was relieved of his duties.

We have watched the steady concentration of market power in the tech sector for years.  As students of history, the behavior of the tech industry now is strikingly similar to the behavior of the robber barons of 1890-1910.  It should be noted that the former era ended when President Teddy Roosevelt began a trust-busting campaign that eventually led to the Sherman Anti-Trust act.

Why do we comment on this?  First, equity markets have been supported by the performance of the tech sector, especially the large cap area of the sector.  Although there is no doubt that the companies in this sector provide wildly popular products and services, they are sometimes provided from the aggressive suppression of wages.  In the earlier era, the trusts often abused their market power by high prices.  The tech companies, for the most part, don’t act in this fashion.  In fact, their influence in improving market transparency is one of the causal factors for keeping inflation at bay (technology’s role in globalization should not be underestimated either).  But, the tech firms have kept a lid on wage growth, sometimes through nefarious means.[4]  Although Google denies any role in Linn’s firing, it looks pretty obvious that Anne-Marie Slaughter[5] felt compelled to quash Linn’s complaints.  If the government concludes that the tech sector’s influence has become dangerous, we could see attempts to constrain it through regulation.  This could mean that the large firms are broken up (à la Standard Oil) or heavily regulated, which may affect equity market performance.

Second, the tech issue exposes the political fault lines in the U.S.  The center-left establishment, primarily the establishment of the Democrat Party, is tightly aligned with the tech sector.  Technology has less representation in the center-right, the establishment wing of the GOP.  Interestingly enough, populist leaders on both the right and left are becoming quite jaded with the tech firms.[6]  Political support for the tech sector may be narrowing, which may increase the likelihood that an adverse regulatory environment will develop.

We live in an age of mostly unfettered technological change; that wasn’t always the case.  In the past, regulators would slow the advent of new technology through regulations that made the investment in new technology appear less attractive.  As a thought experiment, how attractive would it look to shift to driverless trucks if two human drivers had to be in the cab and paid even if they had nothing to do?  In an era of low inflation and low inflation expectations, there will be a growing temptation to preserve jobs by limiting the disruptive effects of technological change.  The “ham-fisted” firing of Mr. Linn is perhaps an indication that the sector’s leaders are becoming concerned.  This is a trend we will continue to monitor.

Energy Recap: U.S. crude oil inventories fell 5.4 mb compared to market expectations of a 2.0 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 they are declining.  In fact, we are now below last year’s seasonal low, made in September.

As the seasonal chart below shows, inventories are usually well into their seasonal withdrawal period.  Even with the SPR sales, we have already seen a larger than normal seasonal decline; in fact, the drop is rather remarkable.  It should be noted that the seasonal trough is coming soon.

Based on inventories alone, oil prices are deeply undervalued with the fair value price of $55.05.  Meanwhile, the EUR/WTI model generates a fair value of $64.39.  Together (which is a more sound methodology), fair value is $60.13, meaning that current prices are well below fair value.  Although the most bullish factor for oil currently is dollar weakness, the rapid decline in inventory levels is also supportive.

So far, the oil market is assuming that Harvey will be bearish for oil prices.  This makes sense, although it should be noted that oil inventories took several weeks to rise during Hurricane Katrina.

This chart shows when Katrina made landfall, indicated by the vertical blue line on the chart.  It dissipated about eight days later.  Note that inventories declined.

During Katrina, refinery operations did drop significantly.  We expect them to decline again but in a much quicker fashion this time.

What the markets may be missing is that crude oil imports will drop as well.  Obviously, U.S. oil production is significantly higher now than it was in 2005.  But, this weakness in oil prices is probably not justified given the rather impressive decline in inventories and dollar weakness.  Still, we expect the markets to need evidence of slower inventory increases before prices recover.

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[1] https://www.ft.com/content/efc08f26-8d96-11e7-9084-d0c17942ba93?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56 (paywall)

[2] https://www.nytimes.com/2017/08/30/us/politics/eric-schmidt-google-new-america.html?_r=0

[3] https://www.nytimes.com/2017/06/27/technology/eu-google-fine.html

[4] https://www.theguardian.com/technology/2014/apr/24/apple-google-settle-antitrust-lawsuit-hiring-collusion

[5] Ms. Slaughter is a proponent of the “responsibility to protect” doctrine, a Wilsonian interventionist foreign policy stance. https://en.wikipedia.org/wiki/Anne-Marie_Slaughter

[6] http://www.breitbart.com/tech/2017/07/28/report-steve-bannon-wants-google-facebook-to-be-regulated-like-utilities/ and https://www.recode.net/2016/6/29/12060804/elizabeth-warren-apple-google-amazon-competition

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy GDP day!  We cover the GDP data below, but the report showed 3.0% annualized growth.  Interest rates have ticked higher and the dollar is recovering from yesterday’s weakness.  Here is what we are following this morning:

Harvey hits Louisiana: After slamming Texas with massive rains, TS Harvey moved back over the Gulf of Mexico (GOM) and has made a second landfall just east of the Texas/Louisiana border.

The market most sensitive to the storm in the short run has been energy.  This morning, the massive Motiva 600 kbpd refinery announced it would shut down due to flooding.  Gasoline futures jumped about four cents per gallon on the news but have settled back.  Crude oil prices continue to slide on fears that depressed refining activity will lower demand; in addition, the Texas coast is the exporting hub for U.S. crude oil so we would expect a decline for a while.  We are probably on the “backside” of this crisis, but the rebuilding will be slow and it is likely the damage from Harvey will be extensive.

On the other hand, the need for emergency rescue spending may end the drama around the debt ceiling.  Texas is a red state and the GOP would usually want to exercise caution on spending, worried that lawmakers would try to sneak pet spending projects into an emergency bill.  If the Texas contingent puts forth a clean aid bill, it could create conditions of bipartisanship and lead to an easy debt ceiling vote.  If so, this outcome would reduce the potential for a government shutdown later next month.  After all, shutting down FEMA in the middle of a massive recovery effort would be a huge unforced error.

North Korea update: Kim Jong-un renewed his threats on Guam, suggesting the missile test over Japan was a test for attacking the U.S. base on the U.S. territory.  Meanwhile, President Trump did say that “all options are on the table” with North Korea.  In the midst of all this noise we are trying to figure out if there is a “signal” from this mess.  Although Japan was angry with the violation of its airspace, it didn’t attempt to shoot down the missile.  There are three potential reasons.  First, perhaps Japan has little faith in its anti-missile defenses and didn’t want to shoot at the North Korean missile for fear the impotence of the defense system would be revealed.  Although possibly true, if Japan actually believed it was under attack, an unreliable system is better than none.  Thus, the lack of Japanese response to the overflight suggests something else.  A second explanation is that Japan knew in advance that the missile was unarmed.  There have been reports of backchannel discussions with North Korea[1]; it is quite possible that interested parties were told in advance of the launch.  If Japan thought this missile was the opening salvo of a nuclear or chemical attack, it would make sense to use its anti-missile defense even if it is rather unreliable.  On the other hand, if one knew in advance that this wasn’t an actual attack, revealing the unreliability of the anti-missile defense wouldn’t make much sense.  Third, reactions from South Korea and the U.S. suggest that North Korea had made it clear that this missile launch wasn’t a preemptive strike, which would add to evidence that this launch was indicated in advance among these backchannel contacts.

This doesn’t mean war is more or less imminent.  The fact that the sides are talking is better than if they were not, but nothing has really changed.  North Korea’s ultimate goal is peninsula unification under Pyongyang’s rule.  In its estimation, the primary obstacle to this goal is the U.S.  Thus, the goal is to either talk the U.S. out of the region or make the U.S. look ineffective as a defender.  The flaw in the discussion is that North Korea may not be strong enough militarily to defeat South Korea.  Authoritarian regimes consistently underestimate the fighting resolve of democracies; they observe the divisions that naturally occur in the democratic process and “see” weakness.  At the same time, North Korea’s actions may not be helping its goal; there are reports that National Security Advisor McMaster and his South Korean counterparts are considering the movement of U.S. strategic assets to South Korea.  This would include the basing of B-1, B-52 and F-35 warplanes that are not currently on South Korean soil.  The U.S. is considering short-range ballistic missiles in South Korea as well.

Market action: One characteristic we have noted is that there is enough liquidity in the financial markets that equity pullbacks tend to be shallow and short.  We saw some of that yesterday; although the market opened lower, it moved higher throughout the day as the North Korean situation didn’t deteriorate further.  To measure liquidity, we have been using retail money market funds (MMK).

This chart shows the level of retail money market funds and the S&P 500; we have placed orange bars on the chart to show periods when the level of money market funds approached $900 bn.  At that point, equities have tended to weaken; in our opinion, this is because buying power is depleted.  Current liquidity levels are high enough to put power behind the “buy the dip” mentality we have been seeing in stocks for a while.  Barring a recession or some other factor that increases the demand for liquidity (war would do it, by the way), we expect this pattern to continue.

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[1] http://nypost.com/2017/08/11/white-house-has-quietly-engaged-in-back-channel-talks-with-north-korea/

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Financial markets are in “risk on” mode this morning after the North Korean missile test.  Treasuries and gold are higher, while equities and the dollar are weaker.  In fact, the EUR broke above the 1.200 level for the first time in two years.  Here is what we are watching this morning:

The North Korean missile test: North Korea launched what appeared to be a medium-range missile over Japan late yesterday afternoon (Eastern Daylight Time).

In Japan, warning sirens blared and text messages were sent to residents of the northern areas of Japan to take cover.  This is the third North Korean missile to overfly Japanese territory since 1998.  This test complicates the situation significantly.  The recent missile tests, in which three short-range missiles flew into the Sea of Japan, have been seen as something of a conciliatory gesture by the Kim regime.  The U.S. refrained from severely criticizing North Korea after this earlier launch.  However, yesterday’s action is far more provocative.  The U.S. has been Japan’s defender since the end of WWII.  If the U.S. is seen as not defending Japan, it will raise fears that American policy in the region has changed and likely bring a sharp escalation of defense spending among our allies.

In response, South Korea dropped eight MK-84[1] bombs from four South Korean Air Force warplanes near the 38^th parallel as a show of force.  The UNSC is meeting to discuss additional sanctions.  Overall, though, it is doubtful that sanctions will have much of an impact.  So far, the Trump administration’s response to yesterday’s action has been guarded.  The president hasn’t mentioned anything on Twitter yet and is visiting Texas today; thus, the opportunity to say anything provocative may be delayed.  It should be noted that during last week’s rally in Phoenix the president suggested his tough talk appeared to be working as Kim Jong-un was not acting out; that perception has been shattered by this launch.

Overall, North Korea’s action is quite worrisome.  This missile proves it can attack American military bases in Japan and Guam.   The launch appeared to come from a mobile launcher that was positioned near Pyongyang; most of the time, North Korea launches missiles from remote areas.  If the site is confirmed, this launch would suggest that Kim is putting missiles near areas of high population with the idea that the U.S. is less likely to strike missile sites before launch if they are near civilians.  If North Korea can demonstrate it can hit the U.S. mainland, Kim Jong-un may decide to test the idea that the Trump administration won’t risk a major U.S. city if Guam or Tokyo is attacked.  In other words, if North Korea lobs a nuclear weapon on Guam, will the U.S. respond with a major nuclear first strike and risk a city in the western U.S.?  Simply put, the North Korean situation is getting complicated fast.  If conditions continue to escalate, it will put additional pressure on equity markets and the dollar.

Harvey update: Although the storm isn’t over yet, it does appear that some refining capacity is being restarted.  Currently it appears that about 2.2 mbpd (roughly about 12.5% of capacity) is either down or at sharply reduced levels.  However, there are reports that some refiners, especially those south of Houston, are in the process of trying to restart their facilities.  Those facilities closer to Houston and the Ship Channel may take weeks before they can restart.  The Houston economy is roughly the size of Chicago; it will have a modest dampening impact on Q3 and Q4 GDP (perhaps a 0.2% drag on GDP), but that will be offset early next year by rebuilding.

More on tariffs: Last month, China and the U.S. were near an agreement where the former would cut its steel productive capacity in lieu of trade restrictions.  According to reports, Commerce Secretary Ross supported the decision but President Trump rejected it.  Instead, the president wants tariffs.  There are probably two reasons for this.  First, the president likely views any Chinese overture on trade skeptically.  Although the steel industry has too much global capacity, every producer wants some other producer to take the cuts.  Thus, China’s offer, if legitimate, was important.  However, there is no way for the U.S. to enforce China’s actions.  In the final analysis, the president may not have trusted China to follow through.  Second, tariffs are clear evidence to his base that he is taking steps to cut the U.S. trade deficit.  In other words, capacity cuts may or may not work and they are not obvious to the American people that U.S. steel jobs are being protected.  Tariffs are clear and convincing.  As we noted yesterday, tariffs invite retaliation.  We would expect China to put trade barriers on U.S. natural gas and agriculture products in response.  In addition, tariffs will make China less open to cooperating on the North Korean issue.

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[1] This weapon is the largest of the MK-80 series of standard purpose weapons; although an unguided bomb, it is potent.  At 2,000 lbs, it is considered the third largest bomb in the U.S. conventional arsenal.