by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy St. Ignatius of Loyola Day!  The weekend was news heavy—here’s what we are watching this morning.

A new Chief of Staff: Reince Priebus was removed from the Chief of Staff position at the White House late Friday.  Although it does appear he resigned the day before, his removal played out on national TV with him standing in the rain on the tarmac in Washington.  Gen. John F. Kelly moved from DHS to the Chief of Staff role and begins his job in earnest today.  There is much being discussed about the problems Kelly will face in trying to streamline the Byzantine organizational structure of the Trump White House.  From a market perspective, probably the most important signal this appointment sends is that Gary Cohn is the frontrunner for Fed Chair.  There was speculation that Cohn could become Chief of Staff if (or when) Priebus was removed.  Of course, if Cohn took that job, it reduced the chances that he would take the FOMC role.  With Kelly’s appointment, Cohn remains in the running.  Although we think odds still favor Cohn getting the Fed Chair position, it wouldn’t shock us if Trump decides to keep Yellen in place.  Yellen is a dove and Cohn would probably be more hawkish.  In addition, it should be noted that Priebus’s exit from the White House reduces establishment GOP influence.  The establishment GOP generally favors higher rates—establishment Republicans tend to be creditors who like low inflation, a strong dollar and higher interest rates.  Trump has made it clear he isn’t a hawk on monetary policy and thus may find Yellen is a better fit for his policy goals.  We still think odds favor Cohn to replace Yellen but the likelihood isn’t overwhelming.

On to taxes…maybe?  Congressional Republicans have signaled that with the failure to repeal Obamacare the agenda will move to tax reform.  However, the president continues to urge lawmakers to pass a repeal measure.  Each day that tax reform (or cuts) are delayed means more political capital is lost and reduces the odds that anything gets accomplished.  Lurking in the background is the debt ceiling.  The Freedom Caucus is apparently planning to trade spending cuts for permission to raise the limit; this may mean we could see a shutdown develop by late September or early October.

Another North Korean missile test: North Korea successfully launched another ICBM and, by all accounts, this one could reach the continental U.S. and maybe all the way to the Midwest.  The U.S. response was multipronged.  First, American B-1 bombers flew over South Korea, accompanied by South Korean F-16s.  Second, the South Koreans requested and the U.S. approved longer range missiles in South Korea.  Third, the U.S. is strongly considering additional sanctions against China to encourage China to pressure Pyongyang to restrain its behavior.  The North Korean problem is a major concern of ours as the U.S. is rapidly facing a binary choice of either accepting North Korea as a nuclear state or fighting a very costly war on the Korean peninsula.  Although the more likely outcome is the former, President Trump is capable of aggressive action.

The Russians toss U.S. diplomats: Russia didn’t initially respond to the Obama administration’s decision to remove some Russian diplomats and close two Russian facilities but, in light of recent sanctions, the Kremlin his decided to send 755 U.S. diplomatic personnel home.   Despite attempts by the president to improve relations, it appears that the trend of a new cold war with Russia has resumed.

The mess in Venezuela: The Venezuelan government held an election on Sunday to select a constituent assembly to create a new constitution.  The vote was rigged by design; voters only got to select the members of the assembly, not decide whether the constitution should be rewritten.  The government claims eight million Venezuelans voted, but independent observers think it was about half that level at best.  It is unclear where we go from here.  The Trump administration has threatened sanctions if the elections were held.  We are waiting to see what the U.S. will implement.  At a minimum, we expect the administration to restrict access to the U.S. financial system.  At worst, the U.S. could ban Venezuelan exports.  Given that Venezuelan crude oil is heavy and sour, there are few outlets for its oil.  China and Russia are especially nervous because they are significant creditors to the regime.  If the government falls, the incoming government may repudiate the debt.  We are seeing signs that the economic situation is becoming untenable.  Venezuela is having difficulty generating inflation because it can’t print enough banknotes.  The country imports its currency from foreign printers and, since they haven’t been paid, new currency isn’t coming in which is stabilizing prices.  In addition, the market for dollars has seized up in Venezuela as those holding greenbacks are hoarding them and won’t trade them at any price.  If Venezuela collapses, it may be short-term bullish for crude oil.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Unlike the past few days, there was a lot of news overnight.  Here’s what happened:

The Senate fails to “repeal and replace”: In the wee small hours of the morning,[1] three GOP senators joined the full contingent of Democrats to kill any chance of ending the ACA.  After seven years of opposing Obamacare, the GOP had no real replacement plan.  Healthcare is hard.  The Charlie Gard situation in the U.K. shows the fears Americans have over a single-payer system.  On the other hand, medical care spending in the U.S. is very high and the outcomes we enjoy from that spending are not superior to what is seen elsewhere.  The GOP, in retrospect, couldn’t figure out how to reduce costs and maintain coverage.  The troubling part of the ACA is rising costs, which will continue to plague the law.  At the same time, both the ACA passage and the failure of its replacement scream for some sort of bipartisan solution.  Sadly, in our highly divided political environment, bipartisan actions are usually career-enders for politicians.  Anyway, now that the healthcare situation is behind us, we can move on to tax reform.

Taxes?  We expect the House and Senate to move on to tax reform.  Financial markets were never all that concerned about healthcare but are keenly focused on tax reform.  Unfortunately, there don’t appear to be any detailed tax proposals prepared.  The White House, Treasury and congressional leaders issued a six-paragraph statement of goals yesterday.  The only detail we received is that the beleaguered border adjustment tax (BAT) is now officially dead.  Although controversial, the BAT actually resolved a couple of problems.  First, it was a major revenue generator; using a BAT would have created enough revenue to allow for large marginal cuts.  Second, it accomplished the president’s goals of improving America’s trade imbalance by raising import prices (although a stronger dollar would have offset some of this effect).  It was terribly unpopular with retailers and refiners (who import oil) but quite popular with manufacturers.  Our read is that the president found it too complicated and it reduced his ability to micro-focus on firms and industries to harm or help over trade.  But, without it, we will probably see smaller cuts in marginal rates.  Congressional Republicans want tax reform that is revenue neutral.  The White House appears less concerned about deficits and may press for much bigger cuts than Congress can live with in the absence of offsets.  Another sideshow we will be watching is Steve Bannon, who lobbed a proposal to raise the highest marginal tax rate to 44% on incomes over $5.0 mm.  That idea will be an anathema to the establishment GOP but might actually be a powerful bargaining chip to attract Democrat votes.  We will be watching to see how quickly the establishment GOP moves to kill this idea; Grover Norquist will probably be front and center on this issue.

The Mooch fires away: Anthony Scaramucci was in the press over the past two days expressing extreme displeasure with Chief of Staff Priebus and Senior Advisor Bannon, using colorful language that we won’t repeat here.  Although interesting to watch, it could have an impact on financial markets if the tensions lead to resignations and firings in the White House.  The White House appears thinly staffed as it is; this kind of tension may lead to exits which would exacerbate problems and reduce the effectiveness of the president.

The Russians respond: After the elections, President Obama forced the Russians to leave two facilities in the U.S. that had long been suspected of being listening posts.  Obama made this move in response to evidence of Russian interference in the U.S. presidential election.  Russia didn’t initially respond to the U.S. moves, likely in order to see how the incoming administration would act toward Russia.  The recent sanctions overwhelmingly passed by Congress have triggered a Russian response; the number of people tied to the U.S. embassy in Russia will be reduced to 455 people, the same number of diplomatic staff Russia has in the U.S.

Iran has an ICBM, too: Iran launched a missile that is capable of reaching space and can carry a payload of 550 lbs.  Although Iran still remains compliant to the deal it signed with the Obama administration, the Trump administration is clearly unhappy with the deal and is threatening to scuttle it.  If the Iran deal is rescinded, we would expect Iran to rapidly move to finish the nuclear cycle and build a weapon.  How the U.S. and Israel react to such a development will be clearly worth watching.  It’s possible the U.S. could launch airstrikes against Iran’s nuclear facilities; a more likely outcome would be a nuclear arms race in the region.

Amazon disappoints: We usually don’t comment on individual stocks in this report but the tech sectors (and the NASDAQ) are lower this morning after Amazon (AMZN, 1046) earnings came in below expectations.  Shares are off 3.6% in the pre-market trade.  Given the dominance of a few tech stocks in driving the overall indices higher, an earnings disappointment might lead to a broader consolidation.  At the same time, as we discuss in this week’s Asset Allocation Weekly Comment below, there is still enough sideline cash to likely prevent a significant pullback in equities.

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[1] https://www.youtube.com/watch?v=sqCLsp5owY8

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] We are seeing stronger equities, weaker bond prices and a stable dollar this morning.  Here’s the news we are following:

The FOMC: The Fed statement didn’t offer too many surprises.  It did admit that inflation is running below target but didn’t elaborate about the future path of inflation.  As expected, rates were left unchanged and the Fed indicated that balance sheet reduction would begin “relatively soon.”  Fed funds futures have now removed any more rate hikes this year, essentially indicating that balance sheet reduction will become the path of tighter policy.  The biggest market reaction came from the dollar, which fell sharply in the wake of the statement.  The greenback has stabilized this morning.

A new Sino-Indian War?  China and India fought a border war in the Himalayas in the early 1960s and the dispute has mostly been simmering ever since.  Although China and India really don’t want a war, partly because the ability to fight a war at the elevations involved is a deterrent, we are seeing a rise in tensions.  The issue is China’s decision to extend a gravel road in the disputed region between China, Bhutan and India, which has led India to boost troop strength in the area.  Under normal circumstances, we would expect mostly a war of shouting and then negotiations.  However, conditions have changed.  Chairman Xi is preparing for important party meetings in late October that will install new members of the Standing Committee of the Politburo.  This is his chance to surround himself with a “cabinet” aligned with his interests.[1]  Looking weak will undermine Xi’s ability to select his own supporters.  Meanwhile, Indian MP Modi has been pushing a nationalist agenda and cannot be seen backing down.  Finally, this conflict is escalating at a time when U.S. influence is waning and thus the ability for the U.S. to step in and stop the squabble has lessened.  As a result, what should normally be a local problem could become something more troublesome.  If a war breaks out, it would be bearish for risk assets of both China and India.

The end of LIBOR: The London Interbank Offering Rate (LIBOR), the benchmark for some $350 trillion of financial products, will be phased out by 2021.[2]  U.K. regulators are moving to scrap the current system, which is based on a rate set by a survey of large British banks in London.  The rate-setting process has been proven to be prone to manipulation and thus regulators want to change the current system.  In the U.S., LIBOR is really the overnight interbank rate and we expect some similar rate to replace the current LIBOR quote.  However, there may be some confusion until a new benchmark develops.

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[1] In China’s political structure, the first term of a new president is usually hampered by a Standing Committee that is packed with allies of former presidents.  In the second term, the sitting president gets to select more of his own allies.  Thus, unlike what we usually see in the West, a Chinese leader can become more powerful in the second term than in the first.

[2] https://www.bloomberg.com/news/articles/2017-07-27/libor-to-end-in-2021-as-fca-says-bank-benchmark-is-untenable-j5m5fepe

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Good Wednesday morning!  It’s Fed day.  Other than that, we continue to see the major U.S. equity indices quietly make new highs.  Good earnings and nothing earthshattering coming from Washington are playing a role in lifting equity values.  Here are the news items of interest today.

Fed day: There are two factors to watch for in today’s statement.  First, although we don’t expect the FOMC to actually begin balance sheet contraction today, we do expect them to signal strongly that it will begin in September.  Our take on balance sheet adjustment is that the doves on the committee are selling the hawks on the idea that reduction is tightening.  In reality, it shouldn’t be the case as most of the balance sheet sat innocently on commercial bank balance sheets as excess reserves.  Thus, reducing those reserves a bit probably shouldn’t affect the economy significantly.  Therefore, if Chair Yellen can convince the hawks that balance sheet reduction is tightening, it should lead to fewer rate hikes.  The problem for Yellen is the possibility that balance sheet cuts will actually act as a tightening by undermining investor confidence.  We don’t think this will be the outcome, but it is possible.  Second, we will be watching for comments surrounding inflation.  The FOMC has continually suggested that the weakness in inflation has been due to a succession of one-off events.  We suspect this simply isn’t the case; deregulation, globalization and the subsequent suppression of labor costs are keeping inflation down.  What isn’t part of this equation is monetary policy.  Really, since probably the early 1990s, monetary factors have become mostly irrelevant to inflation (but not to asset prices).  Unfortunately for the Fed, they have a mandate for inflation and probably have no tools to achieve that mandate, at least not under current conditions.  Thus, if they admit that inflation remains low and perhaps for structural reasons, it begs the question as to why raise rates at all?  The best answer is to prevent “irrational exuberance” in the asset markets.  But, that means the Fed would be targeting equity values as policy, a “third rail” in the Fed’s relations with Congress.  To recap—we look for no rate change and no balance sheet reductions, but signaling for reductions to commence in September.

Trump ♥ Yellen?  It has been widely expected that the president is planning to replace Chair Yellen in February, with Gary Cohn as the lead candidate.  That is probably still the most likely outcome.  However, Trump is, at heart, a soft money guy…he wants low rates and easy credit conditions.  That is, by the way, a common position with presidents.  Establishment Republicans represent the creditor class; they are hard money types.  Thus, when one hears “rules-based policy,” that really means, “higher interest rates, tight money.”  After all, for a creditor, easy money is an anathema.  As a lender, I would get paid back in less valuable dollars.  There may be one of two things going on here.  First, Trump may be leaning toward replacing Priebus with Cohn, meaning that he may decide his next best alternative is Yellen.  Second, Trump wants a soft money Cohn and is beginning the signaling process to let Cohn know that if he wants the chair job, he needs to be a soft money guy.  Otherwise, he will stay with who he has now, a dove.

North Korea and ICBM: The WP[1] is reporting that North Korea could cross the ICBM threshold as early as next year, two years sooner than earlier estimates.  There are still two hurdles North Korea faces to directly threaten the U.S.  First, it must manage to build a warhead capable of reentry.  The stresses of leaving space and entering the atmosphere are formidable but there are clear indications that the country is working on it.  Second, North Korea hasn’t proven it has built a miniaturized bomb that can be put on a missile.  So far, all we have seen from the Hermit Kingdom are nuclear devices, which are essentially lab experiments.  A missile-deliverable bomb may still take a while to achieve.  But, it is clear that the U.S. is not saying anything to deter North Korea from its path toward directly threatening the U.S.

Macron mediates peace in Libya: Libya’s two main rival leaders, Fayez al-Sarraj and Khalifa Haftar, have agreed to a ceasefire and promised to hold elections next year.  The former is the UN-backed PM of the official government of Libya, while the latter is a military leader that controls much of the eastern part of the country.  This action is important on a number of levels.  First, peace coming to Libya would be a bearish factor for oil as we would expect Libyan oil production to recover.

Libyan production could reach its pre-crisis levels of 1.5 mbpd.  Most recent production estimates are around 0.8 mbpd, so the additional oil would be difficult for the market to absorb.  There are still issues to be resolved.  Al-Sarraj is the UN-selected PM but has little power.  Militias control much of western Libya’s oil and may not be impressed with this deal.  Second, peace in Libya might reduce the flow of refugees into Europe, which would be supportive for the European economy (at least in the short run).  Italy is a bit miffed that Macron has acted as mediator.  Libya was an Italian colony and it still believes it should have the most European influence in the country.  Macron is showing, again, that he is a disruptive actor in Europe.

The EU acts against Poland: The EU is opening an investigation into Polish legislation that would change the court system.  We doubt this will stop the ruling party in Poland from moving forward on this legislation but Poland could find itself increasingly isolated from the EU.  In the end, after Brexit, that might not matter much.

Dovish talk from the Reserve Bank of Australia (RBA): The RBA Governor Lowe indicated today that, due to low inflation, he remains “comfortable” with low policy rates.  The AUD has been strengthening recently on expectations of better growth, but continued low inflation readings will likely keep the RBA from raising rates in the near term.  We do view the AUD as undervalued and would not expect the RBA statements to lead to a reversal in recent trends.

Iran vs. U.S.: The U.S.S. Thunderbolt fired two bursts of machine-gun fire at an Iranian naval vessel that approached at a very fast pace.  The Iranian warship came within 150 yards of the U.S. ship before the American vessel opened fire.  According to reports, these provocative acts have been increasing recently.  We suspect the Iranians (and, for that matter, the Russians and the Chinese as well) are testing the new U.S. administration for its reaction to these provocations.

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[1] https://www.washingtonpost.com/world/national-security/north-korea-could-cross-icbm-threshold-next-year-us-officials-warn-in-new-assessment/2017/07/25/4107dc4a-70af-11e7-8f39-eeb7d3a2d304_story.html?utm_term=.59ce09a7c18c

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s another quiet summer trading day.  Here are the items making news:

The FOMC meeting begins later today: The Fed has created a problem for itself.  The U.S. central bank meets every six weeks (or eight times per year), but because it makes four meetings out of each year more important by issuing dots, economic forecasts and holding a press conference, the markets mostly ignore the meetings that don’t have those events.  This is one of those meetings.  Although the Chair and other FOMC members continue to warn us that all meetings are “live,” that perception isn’t going to change until they actually take significant policy action outside of the meetings with press conferences.  So, the Fed finds itself in a situation where it really only meets four times a year.  That probably isn’t enough for a major central bank.  The solution?  Either end the dots and press conferences altogether, add them to all meetings, or make a major policy change at a meeting without a press conference.  How does this affect markets?  The financial markets are mostly ignoring this week’s meeting and so we could see some volatility if the FOMC actually does something.  However, we view the likelihood that anything happens as very low.

German business—I’m so happy!  The German IFO index (see below) unexpectedly hit a new record high, with the July number reaching 116.0.  The monthly survey of some 7k firms operating in Germany is reaching “euphoria,” according to IFO Chief Clemens Fuest.  According to interviews with German firms, the recent rise in the EUR is being managed successfully which probably means further gains in the exchange rate are possible.  European equities lifted on the news.

Is shale drilling starting to slow?  One feature of the oil market has been the relentless rise in U.S. production.  Bloomberg[1] is reporting that Halliburton (HAL, 42.51) warned that exploration companies are “tapping the brakes.”[2]  Anadarko (APC, 44.21) fell sharply overnight after reporting a larger Q2 loss than expected.  The company announced a cut in its capital budget and its production forecast for next year.  If this becomes a trend among other companies, the price pressure coming from shale could ease.  This would be good for oil prices in the short run, even though it may not be helpful for oil equities, at least initially.

These charts show U.S. oil production with a long-term view on the left chart and production over the past 32 years on the right.  Note the lift in production since November 2016.  If that production begins to stall, we could see oil prices move higher.  We note that oil prices are higher this morning.

China prepares for war?  The WSJ[3] is reporting that China is increasing its military presence along its border with North Korea.  In some respects, this is merely an update to reports we have been hearing for some time about troop movement on the North Korean frontier.  However, the article did note some policy signals from Beijing.  China wants to avoid a flood of refugees and doesn’t want a hostile power aligned with the U.S. directly on its border.  Thus, the article hints that the People’s Liberation Army (PLA) is likely drawing up plans to invade North Korea to set up a safe zone so that refugees will move there instead of into China, and it also may be taking steps to secure the nuclear facilities.  Essentially, if the U.S. attacks, China wants to remove the Kim regime and establish another buffer government, one that can more easily be controlled by the U.S. and China.  The danger is that China is making it clear that if the U.S. intervenes militarily in North Korea, the Chinese will as well.  This could lead to a bigger war if both sides are not careful in their actions.

China and Russia hold joint naval exercises: The FT reports[4] that Russian and Chinese warships are holding exercises in Baltiysk, the home port of Russia’s Baltic fleet in the Russian enclave of Kaliningrad.  China is slowly expanding its naval “footprint” and joining up with Russia clearly gets the attention of the West.  The NATO frontier nations, especially the Baltic States, will be watching these exercises closely.

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[1] https://www.bloombergquint.com/business/2017/07/24/anadarko-cuts-drilling-plan-as-oil-explorers-bow-to-price-slump

[2] https://www.bloomberg.com/news/articles/2017-07-24/frack-giant-halliburton-adds-1-billion-in-sales-during-recovery

[3] https://www.wsj.com/article_email/china-prepares-for-a-crisis-along-north-korea-border-1500928838-lMyQjAxMTE3ODI4NDkyMDQ0Wj/ (paywall)

[4] https://www.ft.com/content/1dfabf08-7076-11e7-93ff-99f383b09ff9?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56 (paywall)