by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Although global equity markets are steady to lower this morning, there is a lot of action in the forex markets.  The dollar is sliding on a combination of lower expectations for Fed policy tightening and the lack of policy progress from the Trump administration.  Here are the news items we are tracking this morning:

GOP Senate healthcare dies:  Senate Majority Leader McConnell’s efforts to craft a replacement bill for the ACA fell apart overnight as he could not round up 50 GOP votes to pass a bill.  This is a deep blow to McConnell’s leadership.  There are reports he will now move to a straight ACA repeal, but our sources indicate this vote can’t occur as part of the reconciliation process and thus needs 60 votes, ensuring defeat.  If this is true, all the GOP senators would vote for it but the repeal will never reach the floor because the Democrats can filibuster it.  Why is this important?  It suggests the GOP can’t govern.  This is actually a characteristic we are seeing across the U.S. political landscape.  Two-party systems are forced coalitions.  There are wide divergences in the positions among various groups within parties (we believe these divergences will eventually lead to a realignment of the parties in the coming years).  When a party is out of power, these divergences tend to be papered over in the interests of returning to power.  However, once in power, these different groups believe they are the “real Democrats” or the “real Republicans” and they push a narrow agenda that, shockingly, fails to gain a majority.  The GOP is clearly divided and these divisions killed the healthcare effort.  Now the worry is that these divisions will not only prevent tax reform and infrastructure spending, they may not even get the debt ceiling increase accomplished without drama.   If the GOP can’t get legislation passed, it weakens the outlook for change.  We believe that is showing up today in dollar weakness; after all, if fiscal spending isn’t coming and investor sentiment weakens, the Fed won’t raise rates as much as expected.  On Friday, we will release our new Asset Allocation Weekly; its focus is on the dollar.

OPEC drama:  Oil prices have jumped this morning on rumors the Saudis are planning to cut oil exports.  We may actually see reductions but only because air conditioning demand in the Saudi summer is driving up consumption.  On the downside, Ecuador announced it will no longer comply with its 26 kbpd pledged cut in output because is simply can’t afford the loss of revenue.  Although Ecuador’s defection, by itself, won’t be a major factor in weakening prices, it may encourage other defections which would be a problem for the cartel.  We still expect the Saudis to make strenuous efforts to prop up oil prices into next year’s Saudi Aramco IPO (expected now in Q4 2018) which should prevent a sustained price decline.  In addition, dollar weakness is a major supporting factor for oil prices.

China crackdown continues:  Chinese banking regulators have instructed some lenders to lower the rates they offer on wealth-management products (WMP), which have become alternative investment products due to low deposit rates  As the PBOC tightened the money supply, lenders have raised the rates on WMP to a 17-month high in a scramble to acquire lendable funds.  The PBOC tightened the money supply to support deleveraging.  The banks are trying to offset the PBOC’s efforts via WMP funds.  The risk for the banks is that lowering rates on WMP will deprive them of lendable funds which will slow lending and economic growth.  And, households may again increase their attempts to move funds offshore in search of higher returns.  For years, China has abused the household sector through financial repression; this has led to rising real estate prices and the search for higher returns in overseas markets.  China has been trying to stem the currency outflow through a number of regulatory tactics but the best way to keep the money at home would be to offer higher domestic financial returns to the household sector.  Unfortunately, the more the household sector earns, the less the banking and business sector earns.  Policymakers have generally been captured by the business sector and thus have based their economy on household financial repression.

The RBA turns hawkish:  Although the Reserve Bank of Australia didn’t move on rates, in the minutes from its July 4^th policy meeting, the bankers suggested a policy goal of a “nominal neutral cash rate” of 3.5%, which would imply a 200 bps rise in rates is in the offing.  It is unclear if policymakers are really intending to lift rates this aggressively, but in an environment of increasing dollar disappointment, even offhand comments that suggest potential tightening lead to currency strength. The AUD has jumped to its highest levels since May 2015 on this news.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It was another quiet weekend.  Here are the news items we are tracking this morning:

China economy:  GDP, somewhat predictably, came in a bit stronger than expected, at 6.9% (y/y%).   It’s important to remember that China can generate any growth number it wants as long as it has debt capacity.  Total social financing, the broadest measure of lending, rose 14.7% in June (y/y%).  Recent media reports indicate that the housing boom is exhibiting signs of overheating;[1] we noted that property investment rose 8.5% in H1, above last year’s 6.9% rise over the same period.  Orders from Chairman Xi to the State Owed Enterprises (SOE) to reduce their debt levels does suggest that the Chinese leadership is aware it is creating a debt problem.  The tradeoff, however, is daunting; it’s about impossible for China to grow at the above rate and simultaneously deleverage.

Xi prepares for October:  The PRC holds its annual leadership meetings in late October and this is a special one because it will announce Chairman Xi’s nomination for a second term.  Over the weekend, the party announced that Sun Zhengcai was being replaced as Party Secretary of Chongqing.  Sun was considered a possible successor to Chairman Xi in five years so removing him from power and indicating he is under investigation (effectively ending his political career) at least allows Xi more power in building his own Standing Committee of the Politburo and may be an early ploy to give Xi a third term which would be the first chairman to have more than two terms since Mao.  In the Chinese political system, the second term is usually the most important for a leader because in the first term, his rivals usually pick some of the members of the Standing Committee to maintain their influence.  In the second term, the chairman gets more leeway in building his own Standing Committee.

ECB, BOJ meet this week:  We don’t expect any surprises from the BOJ.  Market speculation suggests that ECB President Draghi will try to ease expectations of policy tightening by signaling the pace of balance sheet reduction will be very slow.  Although we don’t disagree with this goal, we do have doubts that Draghi can pull it off.  As former Fed Chair Bernanke discovered, once markets become fixated on easy policy forever, even the most modest of stimulus withdrawal can have surprising effects.  With Eurozone interest rates still negative in some countries, any hint of tapering will likely be a factor; we believe the most sensitive asset class will likely be forex, meaning any signal of tightening will appreciate the EUR.

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[1] https://www.nytimes.com/2017/06/15/opinion/chinas-real-estate-mirage.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] The CPI data came in weaker than expected, sending the dollar and Treasury yields lower.  We examine the data in the context of policy using our Mankiw model variations below.  Outside the inflation numbers, here are some of the other news issues we are tracking this morning:

More trouble for Donald Jr.:  It appears that there were other persons that met with Donald Trump, Jr., Paul Manafort and Jared Kushner.  Reports this morning suggest that there was also a lobbyist who was a former Soviet counterintelligence officer with suspected ties to Russian intelligence.  Whether this additional person is important or not isn’t really the problem.  The problem is that as new information continues to drip out, the administration is forced to deal with the Russian problem constantly and this is burning political capital that isn’t being used for other policy goals, e.g., deregulation, tax cuts, infrastructure rebuilding, etc.

Abe’s support declines to critical levels:  A new poll shows that Japan’s PM Abe’s favorable ratings have dropped to 29.9%, the lowest since he took power for a second time in 2012.  He has been hit be a couple of scandals.  Although Abe’s term won’t expire until September 2018, such low ratings will tend to undermine his ability to push through policy changes.  If Abe falls, it is probably bullish for the JPY, as it will appear that Abenomics has failed and the experiment of aggressive BOJ QE, fiscal spending and deregulation didn’t resolve Japan’s problem and thus, nothing will work.  That would likely lead to expectations that the BOJ will have to lift its extremely accommodative monetary policies because they will appear to have failed.

The debt ceiling:  While the Senate continues to work through its vacation on health care, the debt ceiling clock continues to tick closer to “midnight.”  Bloomberg[1] is carrying a report today suggesting that the Treasury is dusting off old Obama administration procedures to deal with potential default, including a program to prioritize paying interest on Treasuries while delaying other spending.  The Obama plan would pay interest on the Treasury debt, Social Security, veterans benefits and entitlements, roughly in that order.  All other spending would likely be delayed and the longer the crisis extends a higher probability some entitlement payments might be delayed as well.  The markets seem to be comfortable that nothing bad will happen; credit default swap prices for 5-year T-notes is running around 22 bps.  At the peak of the last debt ceiling crisis in 2011, they almost hit 70 bps.  Although there is probably no good reason for this issue to become a crisis, the constant distractions in the White House may lead to the U.S. stumbling into a problem here due simple management failure.  We will report on the 5-year CDS periodically for signs of concern.

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[1] https://www.bloomberg.com/news/articles/2017-07-14/trump-may-have-to-use-obama-s-secret-debt-plan-worrying-markets

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Here’s what we are watching today:

Yellen, Round 2:  There was nothing in Yellen’s testimony that differed from her opening statement which the markets took as dovish.  Our comments yesterday appear to be mostly confirmed; the FOMC is shifting to emphasizing balance sheet reduction and less focus on rate hikes, which is being taken as bullish by financial markets.  Upon further reflection, the FOMC seems to be tying rate changes to inflation and balance sheet contraction to the economy.  If this is the case and inflation remains below target but labor markets continue to be tight, balance sheet reduction could begin as early as autumn.  If this impression is what the Chair wanted to signal, we shouldn’t see any deviation from yesterday’s discussion.  On the other hand, if the market’s impression was flawed, the Chair may signal otherwise.  Although it’s rare for this adjustment to occur, Chair Greenspan did make that change when he felt the markets overestimated his position.  We don’t expect that today.

IEA bearish:  The IEA reported that OPEC compliance declined to 78% in June, down from a remarkable 95% in May.  The violators were Algeria, Ecuador, Gabon, Iraq, the UAE and Venezuela.  Saudi Arabia, Kuwait, Qatar and Angola remained compliant.  Because of this increase in cheating, the IEA suggests rebalancing will be further delayed.

SOS Tillerson in the Gulf:  The SOS left Qatar this morning on his way back to the U.S. after a tour of the region.  Tillerson is trying to calm tensions between Qatar and the rest of the Gulf Cooperation Council (GCC) nations.  We do note that Tillerson and Qatari officials signed an agreement on counterterrorism earlier in the week in a bid to respond to the GCC’s claim that Qatar was soft on terrorism.  The GCC indicated that the agreement “wasn’t enough” which suggests terrorism has little to do with the current disagreement; we suspect this is mostly about Al Jazeera.  The other GCC nations strongly dislike the news channel because it is an independent source of news that these nations can’t control.  It appears to us that the Saudis, after a warm set of meetings with President Trump, felt they had the backing of the White House to bring Qatar to heel.  Although the president seems to have sided with the Saudis, Tillerson and the rest of the national security apparatus appear to want this issue smoothed over.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] The Chair speaks: The text of Chair Yellen’s comments has been released in front of her testimony to Congress.  Market reaction is consistent with a dovish stance.  Here is the excerpt that is probably triggering the weaker dollar/stronger equities/stronger Treasuries/higher gold trade:

…based on our view that the federal funds rate remains somewhat below its neutral level—that is, the level of the federal funds rate that is neither expansionary nor contractionary and keeps the economy operating on an even keel. Because the neutral rate is currently quite low by historical standards, the federal funds rate would not have to rise all that much further to get to a neutral policy stance.

Essentially, Yellen is signaling that the path of rate hikes will probably be gradual; if we were allowed a question, it would be, “So how does this comment relate to the “dots” chart?”  We suspect that Yellen is signaling that she is at the lower end of the dots dispersion.  She also indicated that the reduction of the balance sheet will commence soon.

The balance sheet issue: We remain quite concerned about the balance sheet reduction.  Although the real impact of QE will be the subject of dissertations for the next decade, in our analysis, the primary effect was to bolster confidence.  In reality, the bulk of QE ended up on bank balance sheets as excess reserves.  Thus, removing these reserves shouldn’t have much of an effect, either.  However, given the unprecedented nature of this event, there is still the risk of unexpected outcomes.  We are noticing something interesting, though.  Yesterday, a five-star dove, Governor Brainard, said that she sees a “low cap” on interest rates but supports balance sheet reduction (similar to Yellen’s above quote).  It appears that there is near unanimity on the FOMC that reducing the balance sheet is a good idea and we suspect the doves are supporting this plan because it will divert the hawks from raising rates.  If it turns out that withdrawing QE is a non-event, the doves will win if the reduction slows the pace of rate hikes.

Cohn for Chair? Politico[1] has a long report suggesting Gary Cohn will likely be the next Fed Chair, replacing Yellen when her term expires in early February.  Cohn checks a number of boxes.  He is likely a moderate on policy, which will suit a “low interest rate” president.  Although the nationalists (Bannon, et al.) don’t really like Cohn and would like to see him back at Goldman Sachs (GS, 226.95), they would rather see him at the Fed than as chief of staff, another job he has been rumored to be heading toward.  He isn’t an academic economist, which is probably favored by a business president.  The hardline rules-based GOP members of Congress would not be all that pleased with a Cohn Chair, who has been a Democrat, but they would likely go along.  Although predicting a mercurial president is always tough, and reports suggest Trump isn’t focused on this issue yet, we do think this is probably Cohn’s job if he wants it.  And, if the administration is struggling (its political capital will be nearly depleted by Q1), exiting to the Fed might be a good career move.

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[1] http://www.politico.com/story/2017/07/11/trump-cohn-yellen-fed-240421

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s another quiet summertime morning.  Here are the headlines we are watching:

It’s official—Randal Quarles is likely the newest Fed governor: The Trump administration formally nominated Quarles for the chair vacated by Dan Tarullo.  His name has been in the media for several weeks, so the actual news wasn’t a surprise (since the GOP controls the Senate, his approval is a virtual lock).  In fact, the surprise is that it took this long to make it official.  It seems the administration wanted to fill all three openings at once; however, it was struggling to come up with a third candidate who would represent the community banks (it is widely expected that Marvin Goodfriend will also be nominated soon).  We expect Quarles to be bank friendly; he has supported lower capital requirements and has mostly represented the industry in his private law career.  He has also supported rules-based monetary policy, although there isn’t a lot of evidence that this is a core belief that would turn him into a hawk.  Overall, we look for moderate voting pattern from Quarles until proven otherwise.

U.S. to move unilaterally on North Korea: The WSJ is reporting[1] that the administration is unilaterally tightening sanctions on the Hermit Kingdom and targeting Chinese companies and banks that do business with the Kim regime.  The Treasury is specifically going after offshore dollar accounts held by North Korea with the cooperation of Chinese companies.  We have doubts that these moves will make much difference but it does suggest the White House is in no hurry to engage North Korea militarily.  The same paper has an interview with Robert Gates on how he would address the North Korean problem; as one would expect, it relies on China to bring the Kim regime to heel.[2]  There’s a lot to like in the Gates proposal.  One thing we would add—if China fails to deliver, the U.S. would support strategic nuclear weapons in Japan.  Nothing would get China’s attention faster.

 

War games: The U.S., Japanese and Indian navies are holding exercises in the Indian Ocean.  The People’s Liberation Army Navy has been sending an increasing number of warships into the Indian Ocean, raising India’s concerns.  Sea lanes are a critical part of China’s “one belt, one road” trade route goal and India is a potential road (or better, “sea”) block to completing this goal.  India has historically focused on its northern border with China as a security threat (India’s primary threat remains Pakistan), but is now realizing that the PRC’s rapidly improving blue water navy means it is now facing a southern naval threat as well.  India’s response appears to be to team up with the U.S. and Japan to constrain China.  We note that Australia has traditionally participated in these exercises but pressure from China led the country to withdraw from the games.  The fact that China’s economic influence is affecting how Australia manages its participation in regional security is a worry.

Rising U.S. oil exports: The FT[3] is reporting that an influential study says the U.S. will be exporting more oil than most OPEC members by 2020.  Surging U.S. production and changes in trade regulation are expected to boost exports to perhaps four times the current level by the aforementioned year.  According to the report, U.S. exports could reach 2.3 mbpd by 2020, which would exceed the exports of all OPEC members except for the UAE, Iraq and Saudi Arabia.  The U.S. is rapidly becoming a supply threat to OPEC and, over the longer term, lower oil prices are probably inevitable.  However, in the near term, the Saudi IPO will likely keep prices mostly in the $45 to $55 price range.

The battle for bitcoin: Although this issue is well known among the cryptocurrency cognoscente, there is a rapidly rising ideological split in the bitcoin community.  The issue, simply put, is whether the cryptocurrency should evolve into a payment system that would be used by mainstream corporations and the financial system or whether it should be a libertarian alternative to precious metals.  When bitcoin was created, to protect it from cyber-attacks, the design put a ceiling on the number of transactions the blockchain (the distributed ledger of transactions) could process.  As bitcoin has become more popular, this limit has slowed processing times and processing fees have increased.  This has made bitcoin less popular as a medium of exchange; simply put, a credit card within the banking system is looking more attractive as a means of payment.  To create bitcoin, “miners” process algorithms using large computers; the miners want to solve the problem by boosting the size of each blockchain.  The other proposal, supported by the developers of the bug-proof software, is to move some of the ledger data off the blockchain to be managed outside the network.  A compromise is possible.  The miners could get a partial increase in the blockchain size in return for moving some of the data off the main network.  The key date is August 1.  On that day, the majority of miners must adopt a new protocol called “SegWit.”  If they don’t, it is possible that two versions of bitcoin could begin circulating.  Although bitcoin remains a bit of a sideshow in the financial system, a breakdown could have unexpected effects in the financial system.  We will continue to monitor this issue.[4]

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[1] https://www.wsj.com/articles/u-s-prepares-to-act-alone-against-north-korea-1499707831?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top-stories

[2] https://www.wsj.com/articles/what-would-gates-do-a-defense-chiefs-plan-for-north-korea-1499697227?tesla=y

[3] https://www.ft.com/content/96df15aa-65b7-11e7-8526-7b38dcaef614?emailId=5964507e4c37ad0004e739fb&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[4] https://www.bloomberg.com/news/articles/2017-07-10/bitcoin-risks-splintering-as-civil-war-enters-critical-month