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

[Posted: 9:30 AM EDT] In Iran, a gunman and suicide bomber attacked the Iranian parliament and the Ayatollah Rullah Khomeini shrine.  The Sunni-led group ISIS has claimed responsibility for both attacks, its first significant attack in Iran, which is majority Shiite.  According to the Iranian news media, previous attempts have been thwarted over the past three years.  These attacks have raised fears that the ongoing sectarian violence may spread throughout the Middle East.  If conflict persists, we expect oil prices to rise as conflicts in the region typically disrupt oil production.  As of this morning, oil has been trading lower than the previous day’s close as the U.S. has increased oil exports.

In a morning tweet, Trump announced that he has nominated Attorney General Christopher Wary for FBI director.  Wary had previously worked as the assistant attorney general under the Bush administration.  This announcement comes a day before former FBI Director Comey’s testimony, and amidst a number of headlines regarding Trump’s contentious relationship with AG Sessions.  It would seem prudent to simply wait for Comey to testify but the comments will be the focus of the media come Thursday.  So far, equity markets are mostly shrugging off the news as it is widely believed that Comey will stop short of saying that Trump tried to obstruct justice.  It is worth noting that the dollar has been weakening and Treasuries have been showing price strength; gold has also been stronger.  There are some concerns in the financial markets but the attention has been outside the equity space.

Bloomberg reports that the ECB is considering downgrading its inflation outlook through 2019 and slightly revising its GDP forecast higher.  The downgrade is due to pessimism as to whether energy prices will rise in the future.  Despite Eurozone strength, the ECB is likely to remain dovish for the foreseeable future.  This report comes a day before the ECB is due to hold its policy meeting.  Currently, the euro has fallen 54 bps relative to the USD.

Yesterday, the JOLTS report showed a surge in job openings and only modest hiring.  The chart below illustrates the odd behavior of the labor markets.

The blue line on the chart shows the ratio of hires to openings; when the ratio is below one, it means there are more openings than hires and would suggest a tight labor market.  The JOLTS report doesn’t have a long history but the ratio has never been this low.  Note that the previous business cycle low, in 2006, led to wage growth of 4%.  It is shocking that labor markets can seem to be this tight and wage growth remain subdued.  It may be that labor fears of being substituted for machines or the huge pool of discouraged workers are keeping wage growth low, but, clearly, firms are looking for workers and struggling to fill positions.  Basic economic theory would suggest that if demand is this strong, the price of labor should rise unless the supply curve is perfectly flat; if that were the case, the openings would be filled.  This gap will likely encourage the FOMC that the proper course for monetary policy is to tighten further.

View the complete PDF

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

[Posted: 9:30 AM EDT] Although there has been some market uncertainty due to political risks in the U.S. and U.K., the overnight news was relatively quiet.  Market jitters seem to be due to concerns that tax and healthcare reforms have stalled, doubts as to whether Theresa May will be able to pull off a decisive win in Thursday’s election and the Middle East’s isolation of Qatar.

Today, President Trump is meeting with congressional GOP members to get an update on healthcare and tax reform.  Republicans have been reluctant to put the bill to a vote without receiving any support from Democrats.  The Russian investigation and the travel ban have made Democrats hesitant to support any initiatives promoted by the Trump administration.  It is believed that President Trump would like healthcare reform put to a vote by summer and tax reform by fall.  Former FBI Director James Comey could possibly play a role in ensuring that Congress is able to meet this deadline, assuming his testimony doesn’t further implicate President Trump in the Russian investigation.  Congress has about 80 days left to pass legislation for this congressional session.

In the wake of the London Bridge attack, Theresa May has faced calls that she should resign as prime minister.  While serving as home secretary, May agreed to cut the police budget by 18% which is believed to have contributed to a drastic reduction in the police force.  Her opponents suggest that had the police budget not been cut, the attack could have been prevented.  Although this assumption is probably baseless, it is likely to resonate with many Brexit supporters.  May’s fondness for ambivalence suggests that these critiques will force her to pivot toward a harder stance with the EU.[1]  A hard Brexit would heighten uncertainty for businesses located in the U.K., hence we are bearish on the GBP.  That being said, polls still suggest that May’s party should win in Thursday’s election.

Qatar remains at odds with its neighbors, but a bit more interesting information has emerged.  According to the FT,[2] what has angered the rest of the Gulf Cooperation Council (GCC) states is that Qatar paid up to $1.0 bn to jihadist groups linked to al Qaeda and Iranian militants, in part to secure the release of a group of Royal Family falconers who were kidnapped in Iraq on a hunting trip.  Qatar has been accused by the GCC of funding various militant groups, perhaps to ensure these groups don’t attack Qatar.  According to reports, these payoffs were so egregious that they prompted the recent harsh measures taken by the GCC.  We suspect this will be a temporary event, but if the embargo evolves into a blockade, a military conflict could emerge.  It will be interesting to see how Iran would manage such an event.

The Atlanta FRB GDPNow forecast is still indicating a strong Q2 GDP report.

The contributions to growth suggest that one percent of the growth is coming from inventory accumulation.

Consumption has remained rather steady and this forecast doesn’t include the recent employment data.  We are concerned about the softer residential investment and weak government spending but, overall, the data for Q2 suggests a good recovery, at least so far, and should lift H1 growth levels.  At the same time, this solid data should support the FOMC in raising rates on the 14^th.  Fed funds futures put the odds of a rate hike at the next meeting at just above 90%.  Interestingly, the odds of a hike in September remain around 35%, while we see a greater than 50% chance of a third hike this year at the December meeting.

View the complete PDF

____________________________________

[1] The Economist has nicknamed her “Theresa Maybe.”

[2] https://www.ft.com/content/dd033082-49e9-11e7-a3f4-c742b9791d43 (paywall)

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

[Posted: 9:30 AM EDT] Although financial markets are quiet, there is a lot happening in the news.  Here is what we saw as important:

President Trump ready with two Fed governor nominations: The president, according to numerous media reports, is prepared to fill two of the current three vacancies on the FOMC.  Randal Quarles, a former Treasury official, is said to be the selection to replace Tarullo, who was acting as the governor with the regulation mandate.  His public statements suggest he would likely roll back regulations on the banks and his appointment would be welcomed by the financial services industry.  The other selection is Marvin Goodfriend, an economics professor at Carnegie Mellon; he has broad experience working as a researcher in monetary policy.  Media reports touted comments he has made critical of QE and his support of a “rules-based” policy for setting rates as evidence that he would be a hawkish “offset” to Yellen.  However, deeper research suggests this is a facile analysis of his broader work.  Goodfriend opposed QE mainly because he was much more supportive of negative interest rates.  Of course, the major problem with negative rates is that they create a positive return for cash.  Thus, negative rates should trigger massive cash hoarding if the rates become negative enough.  His solution to this problem would be to devalue cash by having the central bank no longer exchange 1:1 currency for reserves.  In other words, the value of cash held would be allowed to adjust as well.  We remain unsure how this would work in practice but suffice it to say that to suggest Goodfriend is a hawk is probably a misjudgment.  In fact, his views appear radical enough to suggest we may be installing the next Kocherlakota.

Terror attacks in London: Again, the U.K. was the target of another attack over the weekend.  IS has claimed responsibility but we don’t yet know how involved the group was in the attack.  It isn’t clear why London was the target unless terrorists groups want to undermine the May administration.  Although these attacks are clearly not on the scale of 9/11, they are effective insofar as they terrorize.  Thus far, these attacks have had little effect on financial markets and, in fact, the more often they occur, the more markets become inured to them.

Thursday is a big day: On Thursday, former FBI Director Comey is expected to testify before Congress, the British hold elections and the ECB holds its regular meetings.  The Comey testimony runs the risk of further distracting the administration from tax reform, health care, etc.  In the U.K., the polling spread remains in the single digits, with the latest poll showing the Conservatives holding a 7% lead, although some polling from late last week showed the race as a dead heat.  We still expect the Tories to win but a narrow victory would defeat May’s reason for calling snap elections, which was to build a larger mandate to negotiate Brexit.  Finally, the ECB may begin hinting about tapering and rate increases.  If so, the EUR may get a boost.

The PRI in Mexico squeaks out a win: A quick vote count in the state of Mexico gives the governorship to Alfredo del Mazo, the candidate of the ruling PRI.  The last count shows the PRI up 32.3% to 31.3%.  This election was seen as a harbinger for next year’s national elections.  The PRI has ruled the state of Mexico for 88 years and so a loss here would suggest that the leftists under Andres Manuel Lopez Obrador[1] might win the presidency.  We caution that this final vote hasn’t been tabulated so the PRI may still lose this state.

Qatar isolated: Bahrain, Saudi Arabia, Egypt and the UAE, among others, have severed diplomatic ties to Qatar.  Diplomats are being sent home.  The severing nations are angry with Qatar for their supposed ties to Iran and its support of the Muslim Brotherhood.  Less than two weeks after the president’s visit to Saudi Arabia, the anticipated coalition against Iran and terrorism appears to be fracturing.  We note the U.S. operates out of the Al Udild Air Base in Qatar; the base is used for air operations against IS.  So far, we don’t know if operations will be disrupted due to this diplomatic spat.  Religious authorities in Saudi Arabia are accusing the leadership of Qatar of religious illegitimacy.  Conspicuous in its absence is Pakistan.  The Pakistanis have been cool to the Saudis’ tensions with Iran and any sort of conflict with Iran would be problematic without Pakistan’s support.  Overall, we have seen such tensions before, although not to this degree; in fact, the actions being implemented are commonly part of war.  Thus, this is an issue that bears watching.

The Israelis do have “the bomb”: There was a report in the weekend NYT[2] that Israel was planning to detonate a demonstration nuke in the Sinai in 1967 if its forces were being overwhelmed.  This was to serve as a warning to the Arab states that the costs would be catastrophic if they tried to make good on their promise to “push Israel into the sea.”  The plan was never executed because the IDF won a quick victory in the 1967 Six-Day War.  On the 50-year anniversary of this conflict, the report reveals what Israel has refused to acknowledge, which is that it is a nuclear power.

The White House is pushing infrastructure: The White House seems to be preparing to unveil a plan to rebuild U.S. infrastructure this week.  It appears to rely heavily on local direction and money, with only modest federal involvement and funding.  Needless to say, state and local governments are less than impressed.  The idea of state and local government funding is a pre-1930s conception; it only works if the projects generate enough cash to service the debt drawn to pay for them.  Thus, toll roads and other service fees are required to build projects.  Although such constraints should lead to better projects, the public has gotten used to federal funding and it would be a shock to force car owners to rent or buy electronic pass units to drive around.  We note that the president is expected to unveil a partial privatization of the air traffic control system today.

View the complete PDF

______________________________________

[1] See WGRs: The Rise of AMLO: Part I, 3/13/17, and Part II, 3/20/17

[2] https://www.nytimes.com/2017/06/03/world/middleeast/1967-arab-israeli-war-nuclear-warning.html?emc=edit_mbe_20170605&nl=morning-briefing-europe&nlid=5677267&te=1

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

[Posted: 9:30 AM EDT] The employment data, discussed at length below, was disappointing, with payrolls coming in weak.  The bullish headline was that the unemployment rate fell to a new cycle low; in fact, a 16-year low.  Sadly, that occurred because the labor force fell by a whopping 429k, offsetting a 233k decline in employment.

The president did remove the U.S. from the Paris Accord.  There is much commentary on this issue.  Our read is that the accord is mostly for show; there is no enforcement mechanism beyond international shaming and the goals are self-set.  Anytime an agreement can have nearly all the nations of the world join is one that either (a) isn’t going to change very much, or (b) is being enforced by the economic and military power of the hegemon.  The Paris Accord falls under the first type.

However, the signaling is important.  The U.S. is forgoing any element of leadership on climate change as the president makes it abundantly clear that his mantra of “America First” is, and remains, the key element of his administration.  There is much punditry suggesting that this hands global leadership to China.  If only…instead, this is further evidence that we are skidding rapidly to a “G-Zero” world in which there is no global leadership.  Could China use this issue to expand its global influence?  Perhaps.  But the litmus test would be whether China is willing to cut its growth to 3% in order to take leadership on climate change.  We strongly suspect that scenario isn’t likely.

This is what global leadership looks like:

This chart shows the U.S. goods trade balance as a percentage of GDP, starting in 1860.  Note that from the 1870s until the 1970s, the U.S. tended to run trade surpluses.  But, as part of our superpower role, we have to provide dollars to the world for global trade, meaning that we will be required to expand our trade deficit in order to provide global liquidity.  In the last decade, we ran a goods-trade deficit that reached 6% of GDP.  This was done to accommodate China’s development.  Is there any other nation in the world willing to make such sacrifices for global growth?  Is there any other nation willing to suffer the destruction of industries to global competition that is structured to generate trade surpluses at America’s expense?  Is China prepared to take similar actions to reduce carbon emissions?

For the foreseeable future, there is no obvious replacement to U.S. leadership.  That’s why Trump’s decision is so unsettling.  In reality, we expect businesses, along with state and local governments, to continue to take steps to reduce carbon emissions.  As we noted yesterday, insurance companies and investors are demanding such changes from business.  In addition, the chances of policy reversal in the next administration is likely.  The key change here, as we noted above, is the signal that the U.S. is reducing its global responsibilities.  For our regular readers, this comment isn’t a shock; this is a theme we have been highlighting for years.  But it is possible that historians years from now will cite this event as a bright line that signals the change in American policy.  Just like the U.S. decision not to join the League of Nations, America is letting the rest of the world know that they will need to find their own way.

U.S. crude oil inventories fell 6.4 mb compared to market expectations of a 3.0 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.  We also note that, as part of an Obama era agreement, there was a 1.0 mb sale of oil out of the Strategic Petroleum Reserve.  This is part of a $375.4 mm sale (or 8.0 mb) done, in part, to pay for modernization of the SPR facilities.  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 7.4 mb, which is a larger draw 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 are seeing stock declines at a rather rapid pace.  Assuming a similar drop from this year’s peak of 566.5 mb at the end of March, we will end up at 505 mb by late September.  In fact, the current level of inventories has already declined more than the seasonal trough, which is supportive.

Based on inventories alone, oil prices are overvalued with the fair value price of $37.69.  Meanwhile, the EUR/WTI model generates a fair value of $48.80.  Together (which is a more sound methodology), fair value is $45.14, meaning that current prices are above fair value but the deviation has been steadily closing in recent weeks.  Using this model and assuming a steady €/$ exchange rate and a 505 mb trough in oil inventories, fair value for oil would be $47.25.  Overall oil market sentiment has become rather bearish as a number of wirehouses have cut their price forecasts.  Thus, a test of the lower end of the trading range, around $45, would not be a great surprise.  However, we are seeing solid inventory liquidation and, if the dollar weakens, a recovery from these lower levels may be in the offing.

View the complete PDF

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

[Posted: 9:30 AM EDT] There were a couple of political items of note.  First, the White House announced the president will hold a Rose Garden gathering to announce his decision on the Paris Climate Accord.  Reports suggest he will take the U.S. out of the agreement, although there are conflicting news items indicating he hasn’t completely made up his mind quite yet.  Although there is much concern in the media about the action, we view it as mostly symbolic.  First, these major accords rarely meet their promises.  The ones that do are narrowly structured; for instance, the Montreal Protocol on CFCs worked because it was a specific gas and substitutes were available.  The Paris Climate Accord is much more general, thus we always expected widespread failure in reaching the stated goals.  Second, it seems to us that the private sector is already moving on this issue of reducing carbon emissions and government action may not matter all that much.  Insurers’ decisions to not cover risks affected by climate and firms needing to make long-term investment decisions that might be affected by a post-Trump reversal of environmental rules are not going to change based on what the president says later today.  In other words, a utility looking at a 30-year investment in generating capacity will probably still lean toward natural gas instead of coal, not knowing how regulation may change in the future.  Third, natural market forces lowering the costs of alternatives may make leaving the accord moot.

And, lest we forget, President Trump is mercurial; he may decide to stay in the accord.  We are expecting to hear from the White House at 3:00 EDT.  If the announcement is delayed, it may indicate how torn the president is over this decision.

PM May decided to skip a live debate yesterday evening, continuing a pattern where she is refusing to directly engage the other candidates.  Instead, she sent Home Secretary Rudd to represent her.  This was probably a bad move.  The lesser parties severely criticized the PM while Labour Party Leader Corbyn scored points by staying measured and avoiding direct attacks on May.  Polls continue to tighten, with the Tories’ lead falling to a mere 3%.  We are in the area of the margin of error; if the Conservatives lose, it will be bearish for the GBP and other U.K. financial assets.

One of the issues we are monitoring is the debt ceiling.  The debt ceiling is the limit on national debt that can be issued by the Treasury.  As a refresher, the debt ceiling was first created in 1917 during WWI.  Prior to the Second Liberty Bond Act of 1917, Congress had to approve the debt every time the government borrowed money for a specific appropriation.  War borrowing made this practice impractical so the new law set a limit on debt the Treasury could issue and Congress must lift the limit in order to issue more debt once the initial limit is reached.  It should be noted that the appropriations and budget are separate from the debt ceiling issue.  In effect, the debt issued is to fund government appropriations that have already occurred.

After a couple of incidents when the debt ceiling was reached, Congress passed the “Gephardt Rule,” which said that the debt ceiling would be automatically raised when a budget was passed.  This rule was repealed in 1995; since then, we have had periodic debt limit crises that have led to government shutdowns.  The first occurred in 1995-96.  The most famous incident occurred in the summer of 2011 which resulted in a downgrade of U.S. Treasury debt by S&P.  The sequester process emerged from this event.  Another shutdown occurred in 2013.  We have been currently working under a suspended debt ceiling that expired in March.

It initially appeared that the debt ceiling would become an issue in Q4, but the Trump administration has indicated that the Treasury will reach the current limit by August.

This chart shows the yearly change in net Federal receipts, smoothed with a six-month moving average.  Falling receipts is a concern; the past two recessions coincided with a sharp decline in revenue likely caused by falling incomes and profits.  The current problem is partially due to some taxpayers delaying asset sales in hopes of lower capital gains rates in the future.[1]

The GOP membership appears divided on the debt ceiling issue.  The Freedom Caucus is hinting that it may call for spending cuts to approve a rise in the debt limit.  Other members of the GOP, including the treasury secretary, are pressing for a “clean” rise in the debt limit.  The GOP leadership may be forced to woo Democrat Party votes in order to avoid default, but it is unknown what demands they will make on the White House and the establishment GOP for their votes.  We would not be surprised to see demands related to health care, for example.

Given the disarray within the Republican Party in Congress, we are worried that threats of default and a government shutdown are rising.  At best, this issue will begin to distract the administration and Congress from other pressing issues, such as health care, tax reform, etc.  At worst, we could face another government shutdown and the threat of another downgrade.  We will continue to monitor this issue as the summer unfolds.

The FT is reporting that EU officials are looking into a process where sovereign debt across the Eurozone would be “bundled” into a new financial instrument and sold to investors.  Although officials in Brussels have been careful not to characterize this new instrument as a Eurobond, it could be an intermediate step toward the creation of such an instrument.  In theory, German, Italian, Spanish and other nation bonds would be bundled into an instrument; this process could modestly raise German borrowing costs but lower costs elsewhere.  We would look for Germany to oppose the measure but France and the southern tier nations to actively support the idea.

View the complete PDF

_____________________________________

[1] https://www.bloomberg.com/politics/articles/2017-05-31/rich-americans-may-hasten-a-trump-headache-raising-debt-limit

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

[Posted: 9:30 AM EDT] News flow was quiet overnight.  The biggest item came from the U.K. where a YouGov model projected a hung Parliament.  It showed the Tories losing 20 seats to fall to 310, while Labour would pick up 28 seats, capturing 257.  The required majority is 326 seats.  Other polling is mixed, with the most recent showing Conservatives with a 12% lead.  The betting markets continue to show May holding an 89% probability of winning.

The GBP slumped overnight on this news but has partially recovered its losses.  We still expect that May will prevail but probably not significantly improve her party’s current four-seat majority.  However, the underlying concern in all Western elections has been the trend of deep voter dissatisfaction.  Outsiders, candidates not considered part of the political establishment, have been consistently polling well everywhere in the West.  Brexit and the U.S. presidential election are clear indications of this pattern.  Even the French presidential election confirmed this trend; although the more populist Le Pen didn’t win, she did make it into the second round and French voters are betting that a young and mostly inexperienced newcomer with his own party is a better choice than the more established parties.

What is worrisome about the British election is whether voters will view PM May as enough of an outsider or take a chance with Jeremy Corbyn.  Although Corbyn’s policy positions appear radical enough to disqualify him, the fact that the polls have narrowed raise the possibility that voters are desperate for something new.  During the U.S. election, there was a famous op-ed called “The Flight 93 Election.”[1]  The report suggested that, like the passengers on that famous flight, American voters could either remain in their seats and crash (vote for Clinton) or charge the cockpit and elect a novice (vote for Trump) on the chance that he might be able to fly the plane.  In reality, the likelihood of a good outcome with a novice at the wheel is low but voting for the status quo was to accept a certainly bad outcome.  It is possible that British voters may make a similar calculation next Thursday.  If they do, we could see a hung Parliament or, perhaps even more shocking, a Labour-controlled government.

If we end up with a narrow Conservative win, which appears the most likely outcome, it will tend to weaken the May government’s mandate to negotiate with the EU.  However, financial markets will likely take this outcome in stride.  A hung Parliament or a Labour-led government would likely lead to a sharply weaker GBP and equity markets.  It will also continue the trend where Western voters seem inclined to take chances on their leaders due to an overall milieu of disenchantment.

Oil prices have remained under pressure this morning on worries about oversupply.  This weakness has occurred despite comments from Russian and Saudi officials indicating they are committed to recent output cuts.  We don’t think the weakness is due to OPEC action.  Instead, we think the market is really in a trading range and it looks like, in the short run, we are going to test the lower end of that range.

This chart shows the nearest crude oil futures price; we have placed a box on the chart that represents a range of $45 to $55 per barrel.  Over the past eight months, this range has captured most of the price range and we expect that range to hold in the coming months.  Since it doesn’t appear that the current weakness is due to anything specific, we expect the market to stay in this range for the foreseeable future.  Thus, if prices decline toward the lower end of the range, around $45, we would look for prices to stabilize around that level and recover.  On the other hand, we don’t see conditions that would lead to a sustainable breakout above or below this range for the time being.

View the complete PDF

_________________________________

[1] http://www.claremont.org/crb/basicpage/the-flight-93-election/