by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] BREAKING NEWS: THE IMF HAS LOWERED U.S. GDP GROWTH FORECASTS FOR 2017-18.  GROWTH FOR 2017 WAS CUT TO 2.1% FROM 2.3%.  FOR 2018, THE FORECAST FALLS TO 2.1% FROM 2.5%.  LACK OF FISCAL SPENDING ON INFRASTRUCTURE AND LACK OF TAX REFORM WERE CITED. 

Here are the news items we are watching:

Draghi the hawk?  ECB President Draghi gave a speech overnight where he offered a rather upbeat assessment of the Eurozone economy.  He suggested that growth is picking up, headwinds are abating and inflation is likely to rise.  Despite these improvements, he argued for continued monetary stimulus.  The financial markets are taking the speech as a precursor to eventual policy tightening; the EUR is up sharply this morning and commodities are rebounding off of recent lows.

Trump administration warns Syria: Late yesterday, the White House issued a press statement warning Syria that another chemical weapons attack would invite a response from the U.S. and the Assad regime “would pay a heavy price” if it uses these weapons.  The U.S. is suggesting that it has intelligence that Syria was taking steps to deploy these weapons.  Such public warnings coming directly from the White House are unusual; normally, this type of warning would have been sent from the Defense Department or State Department.  It would appear the president is taking a personal interest in this situation.  If Assad defies the U.S. there would almost certainly be a response given the White House statement, which could lead to a situation of Iran and Russia against the U.S.

Filling the Fed Governor vacancies: The administration has apparently decided that it wants to announce all three vacant Fed governor positions at the same time.  Randal Quarles and Marvin Goodfriend appear to have the inside track on two of the positions but the remaining position traditionally goes to a community banker to offer some representation from small banks on the FOMC.  The Trump administration is facing a similar problem to what the Obama administration faced—Fed rules require divestiture of ownership in most cases and that is an unattractive requirement.  So far, three candidates have withdrawn their participation because they didn’t want to sell their interests in their bank affiliations.  The delay in filling these spots reduces the administration’s influence on the FOMC and it would behoove them to act sooner rather than later.

The Italian job: Yesterday, we noted that Italy bent EU banking rules to bail out two banks with taxpayer funds while protecting bondholders.  The backlash has now begun in earnest.  Germany is apparently furious with Italy’s behavior and is pressing Brussels to tighten rules to prevent bondholders from being protected while taxpayers are hit with the bailout.  Germany’s concern is that, eventually, the Eurozone will have a unified banking system and it doesn’t want its taxpayers to be bailing out bank bondholders in other countries.  Italy argued that the failure of the two banks would not bring systemic risk to the Eurozone and thus could be resolved using Italian regulations.  The real problem was that most of the senior bondholders were ordinary depositors who were sold the bonds as savings alternatives.  The political fallout from liquidating the bondholders before the taxpayers would have been a major problem.  We will be watching for whether Germany can force the EU to close the loophole Italy used for this bailout.  If Germany can, future bank failures will tend to put senior bondholders at risk.  At the same time, bank failures always run the risk of becoming unexpectedly systemic and it seems unrealistic for Berlin to expect that Eurozone nations will allow a small bank to implode their national financial systems.  We still expect the Eurozone to eventually shrink due to the inconsistencies between Germany’s goals and the inability of much of the Eurozone to achieve Germany’s position.

May has a government: Yesterday, PM May officially built a coalition of the Tories and the Democratic Unionist Party (DUP) of Northern Ireland.  It’s mostly a marriage of convenience and may not last.  The DUP, first and foremost, received money; Northern Ireland is going to get an additional £1.0 bn in extra spending over the next two years.  The agreement could potentially upset the delicate peace process in this area of the U.K.  Currently, Northern Ireland has some degree of self-governance (devolution), but only if the Catholics and Protestant parties can agree (the DUP represents the latter).  The DUP was able to place strongly unionist language in the coalition agreement which will not sit well with the Catholic parties.  It is possible that London will need to take over the government in Northern Ireland if the two groups can’t agree.  The other problem is that the DUP is a “soft Brexit” party; although it did support Brexit last year, it does not want a hard border with Ireland as would be necessary if the Brexit agreement with the EU is strict.  Thus, the DUP could rebel if the May government pushes a hard Brexit policy.  On the other hand, this coalition may force May into a softer position on Brexit which could lead to a backbench revolt within the Tories.  Finally, the DUP is a socially conservative party that holds many positions the Tories find distasteful.  All this leads us to believe that this government may not have staying power.

Growing tensions with China: Axios is reporting that the White House is becoming jaded with China.  The hope was that by offering trade concessions China would ratchet up pressure on North Korea.  The realization is setting in that Beijing isn’t ever going to put enough pressure on Pyongyang to stop its nuclear weapons program.  This was apparently the reason for inviting Indian PM Modi to Washington.  India is a geopolitical rival to China and the optics of the warm embrace won’t be lost on Chinese leaders.  It should be noted that Reuters reported yesterday that the U.S. plans to place China on its global list of worst offenders of human trafficking and forced labor.  The State Department compiles this report but there are leaks that indicate SOS Tillerson has decided to put China into “Tier 3,” the lowest grade, suggesting it is among the worst offenders.  In the 2016 report, Tier 3 nations included Iran, Russia, Sudan, Syria, Venezuela, North Korea, et al.  If this leak is true, it will anger China and suggest deteriorating relations.

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by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] Here’s a recap of the weekend news:

Italy bails out two banks: Veneto Banca and Banca Popolare di Vicenza were declared failed by the ECB on Friday.  Over the weekend, the Italian government bailed out the banks, shielding senior bondholders from losses.  EU rules are designed to force private investors to bear the first losses and so shareholders, junior bondholders and senior bondholders bear losses in that order.  Italy was able to inject public (taxpayer) money into the two banks before the bondholders faced losses by invoking the “public interest” loophole in the regulation—essentially, if a Eurozone government decides that following the normal liquidation procedure would lead to undue economic stress.  The Italian government sold the two banks to Intesa Sanpaolo, another Italian bank.  To transact the deal, the buying bank received €4.8 bn and also received €12.0 bn in additional guarantees.  It should be noted that these two banks are rather small—they only hold 2% of Italian bank deposits.  Of course, if the Italian government is willing to go to the mat for two small banks, it suggests that larger banks will almost certainly be bailed out, too.  The EU did approve the bailout but to not do so would have created a political crisis between the EU and Italy, and the fear was that it might trigger a broader run if the two banks failed.  The real takeaway from this bailout is that the EU is rather powerless to stop a national authority from bailing out a bank, short of the ECB refusing to act as lender of last resort.  The bigger risk for the EU is that other nations will flout the bailout rules too and further weaken the Eurozone banking system.

Qatar rejects ultimatum: Qatar, faced with a set of demands from the GCC to end the blockade, rejected the ultimatum.  It is not clear what the “or else” will be from the GCC.  Qatar still has a strong ally in Turkey, which could be using the dispute to undermine Saudi Arabia’s push to dominate the Sunni world.  Although President Trump has supported the GCC against Qatar, Secretary of State Tillerson has been much more critical of the GCC and has been pushing for reconciliation.  In fact, Tillerson has canceled a trip to Mexico this week to work on this situation from Washington.

Saudi security forces thwart an attack on Mecca: The NYT reports that Saudi security forces have prevented an attack on Mecca.  The sponsor of the attack wasn’t announced but apparently there were three militants.  Two were met in Jidda and one near the Grand Mosque.  The latter was a suicide bomber who detonated his weapon, wounding 11 people.  A successful attack on one of Islam’s most holy places would be a “black eye” for the kingdom, which gains part of its legitimacy from protecting the holy sites.

Crackdown on the crocodiles: Chairman Xi is going after a number of the large conglomerates in China, sometimes called “crocodiles.”  The official reason seems to be that these companies are rather leveraged and there are concerns that they could trigger a financial crisis if lending isn’t curbed.  However, it should be noted that all these firms are aggressive foreign investors and Xi may be going after them in order to contain capital flight.  And, like any purge in China, there is likely an element of political control as well.  This may be akin to Putin’s aggression against the oligarchs in Russia.

A rogue order hits gold: Gold prices are sharply lower this morning, much weaker than the action in the dollar would support.  Bloomberg[1] reports that at 9:00 am London time (4:00 am EDT), a massive 1.8 mm ounce order hit the Comex, leading to an 18,149 contract order.  An hour later, the trade was 2,334 contracts.  This has the classic look of a “fat finger” order, a mistake.  However, in a world of trading algorithms, this order could have been triggered by a computer with little human oversight.  Although these algorithms make the markets more efficient, they do create vulnerabilities to large market moves that may be unrelated to news or market conditions.

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[1] https://www.bloomberg.com/news/articles/2017-06-26/gold-plunges-as-1-8-million-ounces-traded-in-a-new-york-minute?cmpid=socialflow-twitter-business&utm_content=business&utm_campaign=socialflow-organic&utm_source=twitter&utm_medium=social

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] News flow overnight was rather slow.  This is typical of summer.  The Senate is working on its version of health care and, no surprise, is dealing with the same problems the House faced—to make the bill palatable to moderates, it fails to garner votes from the hard right.  Senate Majority Leader McConnell can only lose two GOP senators to pass the bill and most counts suggest he has four ‘no’ votes.  Of course, negotiations continue and there is a chance something might get done.  However, we are not convinced that McConnell is all that driven to execute a deal and would much rather move on to tax reform.  If this is the case, he will be less likely to use his political capital to pass health care legislation in order to conserve it for tax changes.  If the Senate health care bill fails to pass, it might actually be bullish for equities because it would raise hopes of tax changes this year.

The Gulf Cooperation Council (GCC), the representative body for the Arab Peninsula nations, has given Qatar its list of demands.  They include closing Al Jazzera, reducing ties to Iran and closing a Turkish military base in the country.  The other GCC nations want reparations for unspecified damages inflicted by Qatar over the years.  We assume these would include security and social spending costs that came from Qatar’s support of the Muslim Brotherhood.  Qatar has indicated it won’t negotiate while under a blockade; the GCC has given Qatar 10 days to comply, although no consequences have been signaled if Qatar doesn’t acquiesce.  We would not expect Qatar to comply.  Turkey is increasing support and we would expect Iran to do so as well.  The Trump administration appears divided, with the president offering support for Saudi Arabia’s hardline position while Secretary of State Tillerson has pushed the parties to end the tensions.  Although this issue hasn’t had any real market effects, we are watching for signs of escalation which would be bullish for oil prices.

St. Louis FRB President Bullard made comments yesterday suggesting that the path of interest rate hikes is probably not justified, although he fully supports reducing the balance sheet.  Bullard has become something of a renegade on the FOMC, arguing that monetary policy operates in a “paradigm” that keeps rates within a certain range and these rates should stay within that range until the paradigm changes.  We believe that monetary policy is at a crossroads of sorts; the FOMC essentially uses the Phillips Curve to formulate policy and it doesn’t necessarily have a good measure of economic slack, a key component of Phillips Curve analysis.  Bullard, Kashkari and Evans are questioning the path of rate hikes, which would suggest they believe more slack exists.  Currently, Evans and Kashkari are voting members of the committee; next year, none of these three will vote, which may give a more hawkish bias to the FOMC.  Of course, by next year, we may have five new governors so the path of policy could change significantly.  If Cohn and other establishment figures within the Trump administration are influential in filling current and future vacancies, monetary policy could tighten faster next year.

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by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] Most of the overnight news surrounds the oil market; we have our analysis of the weekly data below and we will offer our views on oil there.  We are seeing reports that China is trying to work out a deal with North Korea in which the Kim regime will cease missile tests in return for a smaller U.S. military footprint in South Korea.  Of course, China would probably like to see the THAAD installations removed, and the new Moon administration is pushing for lower key military exercises.  The problem with this proposal is that such measures have been tried before with little success; the North Koreans have repeatedly violated agreements.  China is afraid to press the Kim government too hard, fearing the regime will fail and cause a refugee crisis and perhaps a hostile government on the Yalu River.  We remain highly concerned about an escalation to conflict.

U.S. crude oil inventories fell 2.4 mb compared to market expectations of a 1.2 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.  We also note that, as part of an Obama era agreement, there was a 0.8 mb sale of oil out of the Strategic Petroleum Reserve.  This is part of a 17.0 mb sale to partially pay for modernization of the SPR facilities.  We note that sales have reached 11.3 mb this year, which likely means we should see these sales end in the coming weeks.  International agreements require that OECD nations hold 90 days of imports in storage.  Due to falling imports, the current coverage is near 140 days.  Taking that into account, the draw would have been 3.2 mb, which is well more than forecast.

As the seasonal chart below shows, inventories are usually well into the seasonal withdrawal period.  This year, that process began early.  Although the actual level of stockpiles remains quite high, we have seen rather sharp stock declines until the past three weeks.  We would expect the draws to increase as the recent rise in imports should fade.

 

Based on inventories alone, oil prices are overvalued with the fair value price of $38.35.  Meanwhile, the EUR/WTI model generates a fair value of $52.03.  Together (which is a more sound methodology), fair value is $47.75, meaning that current prices are well below fair value.  Currently, prices are below our expected trading range; we view oil prices as attractive on a short-term trading basis.

This chart shows the nearest WTI futures price.  We have drawn a box between $45 and $55 per barrel.  Note that nearly all prices have fallen within this range since early October.  This range has developed because OPEC’s cuts are being offset by rising U.S., Canadian and Brazilian output, leaving a mostly balanced market.  As the chart shows, prices at this level have been attractive entry points.  Of course, the risk is that we are seeing a downside breakout but we view further weakness as unlikely without strong evidence of OPEC cheating.  Thus, a recovery should develop in the coming weeks.  If we are correct, we should see two patterns develop.  First, the market will need to stop declining on bullish news.  Second, in the commitment of traders’ data, we will need to see a sharp decline in the number of speculative long positions.

Most of the time, oil markets trade in ranges because the market has a cartel structure.  A cartel usually keeps some production idle to bolster the price.  This excess capacity can be brought on line if prices rise, so the net effect is stabilization.  On the other hand, the media hates trading ranges; they simply aren’t news.  Thus, there is a tendency for reporters to talk up the breakout.  That’s why most of the talk is bullish near the tops and the talk is bearish at the bottom of ranges.  Current prices are well below fair value and we expect prices to stabilize in the coming weeks.

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by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] In the overnight news:

MSCI opens up for China: The index producer has been reluctant to add domestic shares of Chinese companies due to numerous concerns, including capital controls, lack of accounting transparency, etc.  This is something of a big deal, but also not.  Chinese shares are already in the MSCI EM indices; in fact, China currently represents 28.6% of the index.  However, the companies in this share of the index are internationally traded and generally follow Western accounting rules.  The domestic “A-shares” will only add 0.7% of new Chinese shares to the index.  So, in actual money terms, it’s not a huge deal.  However, it is another signal, similar to the CNY’s inclusion in SDRs, that China is joining the major economies on an equal scale.

GOP holds two seats: In the sixth Georgia Congressional district, Karen Handel, a veteran Republican politician, fended off a well-funded[1] young Democrat named Jon Ossoff.  Given that the GOP has held this seat for four decades, this was the expected outcome and the win wasn’t huge—Handel won 51.9% to 48.1%.  Meanwhile, in South Carolina, Republican Ralph Norman defeated Democrat Archie Parnell 51.1% to 47.9%, holding the seat vacated by Mick Mulvaney.  The win was narrower than his predecessor’s 20-point margin but still a comfortable win. Although the president remains a divisive figure, these two elections suggest that discomfort with the president probably isn’t enough to change control of Congress.  The problem for the Democrat Party is a path to increase popularity.  The leadership, tied closely to parts of Wall Street and Silicon Valley, wants to run as center-left technocrats.  The rest of the party wants to go hard left, becoming a “Corbyn/Sanders” party.  We believe the broader issue is that we are seeing a restructuring of the coalitions that form both parties and therefore navigating the landscape will become increasingly difficult.

A Saudi shakeup: Saudi King Salman announced that Crown Prince Nayef was demoted and he has elevated his son, former Deputy Crown Prince Salman, to crown prince.  Nayef will also lose his important power base of interior minister; this ministry oversees domestic security and counter-terrorism and was the base of power for the late King Abdallah.  The new interior minister will be Prince Abdulaziz bin Saud bin Nayef, a nephew of the ousted crown prince.   The decision was apparently approved by 31 of the 34 members of the Allegiance Council, which oversees succession.

This decision has three elements of risk.  First, CP Salman is very young and has conducted an aggressive foreign policy.  He has managed the war in Yemen and is a hardliner with Iran.  His appointment to next in line for the throne suggests that Saudi foreign policy will likely become increasingly bellicose.  Second, the king’s appointment of his son as successor raises the problem of primogeniture.  The founder of Saudi Arabia, Ibn Saud, unified most of the Arabian Peninsula through war and marriage.  At the time of his death, he reportedly had at least 44 sons, 22 wives and four known prominent concubines.  His successor was his oldest son, Saud, who proved to be a feckless spendthrift and was ousted in a royal coup.  Ibn Saud never made it completely clear how he wanted succession to occur.  By appointing his oldest son, if the kingdom had followed primogeniture, Saud could have then selected his oldest son, leaving 43 sons of Ibn Saud out of kingly succession.  The ouster of Saud instead created a system where the kingship would transfer to the sons of Ibn Saud.  Although there are some available (albeit elderly) sons of Saud remaining, the royal family has agreed that the time has come for the grandsons of Ibn Saud to take control.  That was the reason Nayef was made crown prince.[2]  By selecting his son as the next crown prince, Salman has introduced the precedent of primogeniture.  According to reports, the Allegiance Council considers this appointment as a “one-off” but, now that it has occurred, the precedent of the next king selecting one of his sons is in place.  If such an event occurs, the potential for a civil war of sorts within the royal family increases.  Third, why now?  It is quite possible that the king’s health is failing and he wanted to open the path of the throne to his favorite son before he died.  King Salman is old (81 years) and there have been unconfirmed reports he suffers from dementia.  If Salman passes soon, his controversial decision to elevate his son could become contentious.[3]

A century with Argentina: The South American country recently sold $2.75 bn of 100-year bonds with a coupon of 7.125%, giving it an annual yield of 7.9%.  It had a bid/cover ratio of 3.5x.  On the surface, this bond sale is amazing.  Argentina has defaulted eight times since its independence in 1816.  However, the risks may not be as large as they seem.  First, the duration on a 100-year bond isn’t significantly different from a 30-year bond.  There will be very little principal paid for years.  Second, given the high coupon, an initial investor recoups his investment in about 12 years.  So, as long as Argentina doesn’t default during that time, an investor should at least get paid back the initial stake.  On the downside, it is dollar-denominated paper, which almost guarantees the bonds will face default at some point in the next century.  However, we doubt any of today’s buyers care; they are simply looking for a high coupon.  This is one of the problems that comes with low policy rates; investors become tempted by debt that carries a higher yield with a high probability of default.

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[1] Total spending in this election topped $50 mm.

[2] He had another attractive feature: no sons!

[3] For more background, see WGR, 1/20/15, Saudi Succession, and WGR, 5/11/15, The Next Generation.

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] There were five news items worth noting overnight:

Carney goes dovish: Last week, the BOE voted to keep policy steady but had three dissenters.  In a speech today, BOE Governor Carney focused on the economic problems that could be triggered by Brexit and suggested it wasn’t time to raise rates.  The GBP fell on his comments.  Britain is rapidly heading to a point where it will be forced to decide which policy problem it will address—inflation or weak growth?  A Dutch economist, Jan Tinbergen, suggested that policymakers need to have an equal number of tools for an equal number of problems.  In other words, if a nation faces weak growth and rising inflation, it needs to address each problem with separate policies.  Usually, in this case, the ideal policy mix would be to use fiscal policy to address weak growth and tighter monetary policy to deal with inflation.  Given the political turmoil in the U.K., the BOE is likely on its own.  Thus, it must decide if it will raise rates to deal with inflation or keep rates low to support the economy.  Carney indicated his choice would be the latter and so the GBP is falling this morning.  It isn’t clear whether the rest of the Monetary Policy Committee will go along with this sentiment.

More Fed hawks than doves: Boston FRB President Rosengren, who has been a reliable dove over the years, gave a fairly hawkish speech in Europe this morning.  He is suggesting that easy monetary policy could be leading to inflated asset markets and, if so, the Fed should raise rates to prevent excessive valuations and the potential market risk such valuations might bring.  Although other FOMC members have made such statements in the past (Jeremy Stein, most notably), such views are not predominant among members because it smacks of setting policy based on asset markets.  Although theoretically defensible, such positions are fraught with political risk.  Alan Greenspan briefly touched this “third rail” once, with his famous speech in 1996 when he coined the phrase “irrational exuberance.”  He faced severe criticism on the idea that the Fed would raise rates because equity valuations were “too high.”  Although we don’t expect Rosengren’s views to sway policy, he is joining others on the FOMC who hold more hawkish views on expectations of higher inflation.  In the end, regardless of viewpoint, the outcome is tighter policy.  We note that NY FRB President Dudley made hawkish comments yesterday as well.  By the way, the WSJ has an article today about the FOMC’s poor record on soft landings.[1]

Special election in Georgia: The state of Georgia is holding a special election to fill the Congressional seat of Tom Price.  This is usually a safe GOP seat (the party has held it for nearly four decades), but the race between Democrat Jon Ossoff and Republican Karen Handel is close.  The Democrats have poured money into this race, suggesting it is a referendum on the Trump administration.  In fact, this has become the most expensive Congressional race in U.S. history.[2]  Ossoff has eschewed the Sanders platform, running as a centrist; it should be noted that Trump narrowly won what is usually a reliable GOP state.  If Ossoff wins, the establishment Democrats will use it to argue that the Sanders/Warren wing doesn’t win elections.  If Handel wins, the hard left will argue that the Democratic centrists can’t win.  Our view is that there will probably be few takeaways regardless of the outcome, although the pundits will try to use the election as a harbinger for 2018.

Otto Warmbier dies: The UVA student who was recently incarcerated by North Korea died yesterday.  Our condolences and prayers go out to his family.  We are in the middle of a two-part examination of the possibilities for war with North Korea.  His passing won’t necessarily increase the odds for war but it does reduce the chances of any sort of negotiated settlement and that, by itself, could lead us into a conflict.

Saudi Navy captures three Iranian Republican Guard Corp troops: The Saudi Navy captured three IRGC members in the Persian Gulf Friday.  The Saudis claim the three were manning a vessel loaded with explosives and headed toward a Saudi offshore oil rig.  The Iranians claim they were civilian fishermen and claim that the Saudis killed one of the Iranians.  We don’t know who is telling the truth here but it is part of a broader trend of rising tensions in the region.  So far, oil prices are clearly unconcerned about these tensions but that position is probably underestimating the potential for supply disruption.

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[1] https://www.wsj.com/articles/the-feds-poor-record-on-soft-landings-1497890842 (paywall)

[2] http://www.politico.com/story/2017/05/06/georgia-special-election-spending-record-238054