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

[Posted: 9:30 AM EDT] One question we have been getting for the past couple of months is, “How can the equity market keep rising in the face of all this political turmoil?”  The standard answer is that financial markets focus on the economy, market fundamentals, etc. and only turn to political events when they become significant enough to affect these factors.  Sometimes the impact is immediate; 9/11 is an example.  Other times, there is a cumulative effect where enough things happen over time to “suddenly” change sentiment.  Equity market action before the S&P downgrade of the U.S. debt rating in 2011 is a good example of the cumulative effect.  That is what yesterday looked like.  It appears financial markets have concluded that the president’s political woes are becoming big enough to stall his otherwise mostly market-friendly agenda and may become serious enough to weaken confidence.

We do note that, based on the history of new GOP presidents, we are approaching a period of weakness.

This chart shows the performance of the S&P 500 on a weekly close basis, indexed to the first Friday of the first trading week in the year of the election.  So far, we have been closely tracking the average for newly elected Republican presidents.  Note that there is general euphoria into roughly August of the year after the November elections; from there, we see weakness, which may reflect disappointment in the fact that all that was promised won’t occur.

Although the chart suggests this pullback is a “head fake,” we are concerned that the rally seen in the average may not occur.  In any case, this initial rally is “aging out” and there is more potential downside than upside.  Thus, a broader decline may be in the offing, perhaps in the 10% range.

Meanwhile, Deputy AG Rosenstein appointed Robert Mueller as special prosecutor to investigate alleged Russian ties to the Trump campaign and its administration.  In the very short term, this is good news for financial markets.  It will shift the focus from the White House to Mueller and, perhaps, allow the administration to move on its agenda.  However, this is only a short-term respite.  Special prosecutors can dig a long time.  Mueller is a friend of Comey; he is considered a dogged investigator and incorruptible.  He will not be cowed by pressure.  And, at 79, he has nothing but his reputation to defend.  According to reports,[1] FBI agents were expressing “jubilation” at the appointment.

The president responded by saying he wants a quick investigation to prove he has no ties to the Russians.  If there are none, Mueller’s confirmation will be accepted by both sides of the aisle.  It should be noted that Rosenstein made this appointment independently of the White House[2] and the decision was not universally appreciated.  We view this as Rosenstein signaling his independence from the administration.  There are reports that Jared Kushner wanted to “counterattack.”[3]  He was overruled by the rest of the staff and the president.  Also yesterday, a potentially damaging report emerged in the WP[4] which indicated that House Majority Leader Kevin McCarthy (R-CA) said in a closed door meeting among GOP Congressmen that “there are two people I think Putin pays, Rohrabacher (R-CA) and Trump.”  This conversation apparently took place a month before the election and Speaker Ryan (R-WI) stopped the conversation and swore members to secrecy.  This comment may have been in jest but, even in humor, this revelation, if true, doesn’t look good.

Political scandal isn’t just a U.S. issue.  In Brazil, it is being reported that President Temer was recorded discussing payments to buy the silence of the former legislative speaker Eduardo Cunha.  Cunha is serving a 15-year sentence for corruption; almost a third of Temer’s cabinet is under investigation for corruption.  Temer has denied the allegations but if the recording is proven to be true then he will be in deep trouble.  The Ibovespa fell 1.7% and the Brazilian real plunged 10% from Tuesday’s high.

U.S. crude oil inventories fell 1.8 mb compared to market expectations of a 2.8 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 the seasonal withdrawal phase has begun.  We also note that, as part of an Obama era agreement, there was a 0.7 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 2.5 mb, which is fairly close to expectations.

As the seasonal chart below shows, inventories usually are just starting their 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 515 mb by late September.

Based on inventories alone, oil prices are overvalued with the fair value price of $34.27.  Meanwhile, the EUR/WTI model generates a fair value of $46.73.  Together (which is a more sound methodology) fair value is $42.71, meaning that current prices are above fair value but the deviation has been steadily closing in recent weeks.  We note that OPEC looks like it will keep production cuts in place into next year.  That probably keeps oil in a range of $55 to $45, basis WTI.  If the problems in Washington either undermine confidence in the U.S. economy or prompt the FOMC to back away from its tightening stance, the dollar could weaken and that may be the most bullish factor for oil.

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[1] http://www.politico.com/magazine/story/2017/05/18/trumps-worst-nightmare-comes-true-215153

[2] https://www.nytimes.com/2017/05/17/us/politics/robert-mueller-special-counsel-russia-investigation.html?hp&action=click&pgtype=Homepage&clickSource=story-heading&module=a-lede-package-region&region=top-news&WT.nav=top-news&_r=0

[3] ibid

[4] https://www.washingtonpost.com/world/national-security/house-majority-leader-to-colleagues-in-2016-i-think-putin-pays-trump/2017/05/17/515f6f8a-3aff-11e7-8854-21f359183e8c_story.html?hpid=hp_hp-top-table-main_transcript-6pm%3Ahomepage%2Fstory&utm_term=.2121d3dac6c0

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

[Posted: 9:30 AM EDT] The political problem du jour is that former FBI Director Comey apparently kept memos and notes of his meetings and phone contacts with President Trump.  This is standard practice in bureaucracies.  Writing “memos for the file” is a way to preserve one side of a conversation that can be retrieved in case of a dispute.  In a disagreement under normal circumstances this practice leads to a battle of the memos, where two people describe the same event in different ways, questioning whether either person perceived what actually happened.  However, in this circumstance, the president is at a serious disadvantage.  He tends to treat each day as a new one and never seems to feel bound by what has been said or done before.  We fully expect the White House to dispute Comey’s recollections of what transpired.  Unfortunately, it will be the word of a careful lawyer against a president who is anything but careful.  It will be difficult for the president to defend himself against what is likely to be a steady revelation of damaging allegations.

We still hold that we are a long way from impeachment.  It is important to note that impeachment will always be a political act.  Although it is reserved for “high crimes and misdemeanors,” the founders left such crimes undefined.  It is hard to fathom that the party that controls Congress would impeach a president from the same party unless there were obvious treason involved.  There is some talk that Trump could be removed via the 25^th amendment.  This covers a president who becomes incapacitated in office and becomes unable to discharge the duties of that office.  Only a majority of the president’s cabinet is required to trigger a 25^th amendment ouster; if the president rejects this finding, Congress would have to approve his removal from office by a two-thirds majority.

Again, we are still a long way from this happening.  However, the fact that this is even being discussed in the major media does show how far things have devolved.  Shortly after the Comey memo news hit the press, S&P futures fell hard and have not recovered.  We also note the dollar is under continued pressure this morning.  The financial markets are becoming aware that, at a minimum, much of the agenda that boosted confidence and lifted financial markets is in grave danger of not coming to pass.  We will see some level of deregulation but major changes to taxes, infrastructure spending and even trade policy may be stalled.

On Friday, voters in Iran go to the polls to select a president.  Hassan Rouhani, the incumbent, is in what appears to be a tight race against the hardliner Ebrahim Raisi.  Although there are others running, the race will mostly be between these two.  Rouhani is considered the reformer, although only in the framework of Iranian politics.  The more radical reformers, who want to curb the power of the Supreme Leader, have all been removed from politics with many in prison or under house arrest.  Raisi is the favored candidate of the Iranian Republican Guard Corp (IRGC) and is rumored to be supported by the Supreme Leader, the Grand Ayatollah Khamenei.  The big issue in the campaign is the continued poor performance of the economy and widespread corruption.  Rouhani is probably best suited to rid the economy of corruption; the fact that he hasn’t had much luck in this area is because the corruption comes from the most powerful in Iranian society.  Raisi is accusing Rouhani of either being ineffective against corruption or complicit.

It appears that the major problem in the Iranian economy is the heavy involvement of the IRGC which uses businesses to support its members.  Essentially, the IRGC skims funds from businesses and employs its members in these businesses.  The hardline clerics appear to be part of this system and thus corruption will likely remain a dampener on Iranian economic activity.

What makes this election critical is that the Supreme Leader is 77 years old, and there are rumors he suffers from cancer.  If he dies within the next few years, the president will play a role in selecting his successor; in fact, the president may become the next leader.  Thus, the election on Friday is important to the future of Iran and the path of stability in the region.

Finally, although the Macron election has led pundits to suggest that populism is in retreat, we see three items that suggest this sentiment may be overly optimistic.  First, last Friday, the Austrian coalition failed which will likely bring new elections soon.  New elections will give the populist Freedom Party another chance to gain control of Austria.  The party is leading in the polls but no party commands a majority.  Even in new elections, the Freedom Party may not win; the decision to break the coalition came from the center-right People’s Party, who is gambling it can pull enough supporters from the Freedom Party to gain a majority.  It is worth noting that the People’s Party seems to have concluded that in order to win the path to power requires becoming populist, meaning the policies of globalization and deregulation are in trouble.  Second, the Dutch, who turned away the populists in elections earlier this year, still haven’t been able to form a government, showing that the right-wing populists there may not be a majority but it is a large enough voting bloc to prevent the other parties from forming a government.  Third, in Greece, a general strike is being held today to protest against austerity.  Centrist policies that support austerity remain unpopular in the southern tier of Europe but are being forced upon them; at some point, a pushback appears inevitable.

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

[Posted: 9:30 AM EDT] Another controversy…the Washington Post[1] reported late yesterday that President Trump revealed highly classified information to the Russian foreign minister and ambassador.  Although not illegal (the president essentially can determine the distribution and classification of information), the decision to share the intelligence is potentially reckless.  The sources of the information appear to be from deeply imbedded moles within ISIS and from a Middle East source.  The decision to share the information will likely put these resources at risk; the WP story indicates that the president revealed the city controlled by ISIS that generated the information.  U.S. intelligence agencies did not reveal this information with close allies so the action is troublesome.  Although the official stance of the administration is that nothing was revealed, it is notable that Tom Bossert, the assistant to the president on homeland security and counterterrorism, soon placed calls to the CIA and NSA to warn them of the breech.  If nothing was revealed, it seems odd that Bossert would have notified the two primary U.S. intelligence agencies of what occurred.

There are two issues that concern us about this report.  First, if this turns out to be a serious mishandling of critical information, other nations will stop sharing intelligence with the U.S.[2]  In fact, it is highly possible that U.S. intelligence agencies will be less open to sharing intelligence with the White House, fearing the security of the information.  Second, it’s important to remember that while there is a lot of information the government “classifies,” there is some information that is much more important than others.  In general, the “sources and methods” is often more important than the information itself.  This may be one of those cases.  The information seems to relate to the laptop ban on some international flights; it appears quite likely that some terrorist group has figured out how to put a bomb on a laptop that is difficult to detect.  The fact that laptops haven’t been banned on U.S. flights suggests that either (a) TSA’s methods can screen these bombs, or (b) (the more likely scenario) the laptop bomb is so sophisticated that they can’t be mass produced and thus the terrorist group wants to create a greater sense of terror than attacking an international flight would probably bring.   If the president’s actions inadvertently reveal a path to sources and methods, it would seem reckless.

Here is where this action may start to affect financial markets.   Political events tend to be “tail” risks.  In other words, they are the sort of things that are difficult to predict, and if predicted, are difficult to determine their market effects.  At a minimum, a White House that seems unable to avoid constant controversy will eventually undermine market confidence.  Financial markets have put a good deal of faith into this president; the sharp rally in equities and the dollar strength we have seen since his election are a testament to the hopes that this administration would cut taxes, boost infrastructure spending and lift growth.  Instead, we are seeing precious political capital squandered in unnecessary errors that distract policymakers from moving on the agenda the markets expected.  Perhaps the “canary in the cage” is the dollar.

The line on the chart shows the dollar index over the past nine months.  We have placed a horizontal line from the election to now.  The dollar has essentially given up all of the post-election gains even though the FOMC appears on a path to at least two, if not three, more rate hikes this year.  If other markets begin to conclude that the administration isn’t going to get anything accomplished, we may see similar moves in other markets as well.

This doesn’t mean the White House can’t recover.  However, the current path is raising the chances that this administration will be unable to formulate policy which will be disappointing to investors.  At the same time, the economy is holding up, earnings are solid and rates remain manageable.  There is nothing that signals an immediate problem for equities.  Unfortunately, the political situation is becoming more of a headwind when investors were anticipating a tailwind.  That could become problematic as the year continues.

In other news, the recent ransomware attacks appear to be tied to North Korean hackers.  Although the clues are not conclusive, a number of cybersecurity officials suggest that there is evidence pointing to North Korea.  Apparently, the WannaCry virus used tools that North Korean hackers used against other targets in the recent past.  At the same time, it should be noted that although this code isn’t commonly used, it could have been copied by a criminal organization or another state with hopes of pinning it on the Hermit Kingdom as cover.  Still, if the North Koreans were involved, it will tend to make it easier to put sanctions on them with wider support.

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[1] https://www.washingtonpost.com/world/national-security/trump-revealed-highly-classified-information-to-russian-foreign-minister-and-ambassador/2017/05/15/530c172a-3960-11e7-9e48-c4f199710b69_story.html?utm_term=.f059dc318ad3

[2] Concerns over sharing intelligence have been rising since Trump was elected.  http://www.haaretz.com/israel-news/1.764711

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

[Posted: 9:30 AM EDT] Financial markets are quiet, although we are seeing a strong rally in crude oil (see below).  Here are the themes we are following this morning.

BREAKING: Edouard Philippe has been named PM of France.  He is a member of the Republican Party, suggesting the newly inaugurated President Macron is leaning right.  Philippe could be replaced after legislative elections next month.

Hack attack: On Friday, reports of a ransomware attack in the U.K. emerged.  They rapidly mushroomed, with some 200k computers compromised worldwide.  The U.K. health service was severely affected, car plants in France were forced to close and numerous areas of the Russian economy were struck.  Reports suggest that whoever is behind the attacks isn’t making a mint—the NYT reports that, so far, they have made about $33k.[1]  Fortunately, the attack does appear to be a bit amateurish.  For example, a researcher in Britain noted that a “kill switch” was imbedded in the code.  He activated it and slowed the spread of the virus.  Nevertheless, there are some bigger issues that have been revealed by this attack.  First, we have allowed the software industry to be held faultless for its bugs.  This was a legal decision made to allow the firms, when in their infancy, to grow rapidly.  If they were liable for the damages wrought from software that had security flaws, the growth of the internet and microcomputers would not have occurred as quickly as it did.  We saw similar legal decisions in other industries.  In the early days of railroads, the burden of safety was on the parties crossing tracks, not on the railroads.  This fostered faster growth of railroads at the cost of public safety.  Over time, as the railroads became established, the laws changed and rail crossings became clearly marked with gates to reduce the odds of crashes at rail crossings.  We may be reaching that point now.  If a software firm could be sued for putting out bad software, it would be more careful.  Second, a system that has multiple entry points is vulnerable.  Phishing attacks work because the hacker is betting on one mistake.  In a large entity, the odds that one inadvertent opening of an attached file is worth taking.  Third, software companies have to take steps to encourage users to update systems.  The concern about updating systems is that often the company decides to make “improvements” in the underlying software that the user may not want.  New isn’t always improved.  And so, there is always a fear that if one updates their software, they may get an unwelcome change in the “look and feel” of the software.  Hence, there is a reluctance to update which means critical security patches are not downloaded.  Fourth, the idea that software companies can orphan software, at least for security purposes, has to be abandoned.  The money the company made by selling the software didn’t expire—neither should the obligation to maintain its security.  The bottom line in all of this is that the tech industry is sitting on mountains of cash—being allowed to sell a defective product without ramifications, perhaps appropriate in the early days of technology, is becoming difficult to defend and thus a change in the legal landscape is probably coming.

North Korea launches missile: Over the weekend, North Korea launched a new “medium long-range” ballistic missile which it claims can carry a heavy nuclear warhead.  Analysts monitoring the launch say this test represents a major improvement in North Korean missile technology.  The Hwasong-12 is an improvement; on the other hand, it doesn’t appear to be capable of intercontinental flight.  This missile is probably a threat to Japan and Southeast Asia but not to the U.S. mainland.  Sadly, the technology does show progress toward an ICBM.

The Silk Road meeting: China held a large meeting for its “one belt, one road” investment program designed to recreate the Silk Road, which was a transit for goods to move from China to Europe.  The original road was on land; this one is designed for both land and sea.  As part of this program, China is building port facilities across Southeast Asia.  Not all nations are welcoming; India is not participating in the meetings and Russia is concerned about China’s growing influence in the overland part of the program which runs through the ‘stans, a region Russia views as part of its near abroad.  We view China’s program as a form of imperialism.  Unlike the U.S., which exercises its hegemony through the dollar as reserve currency and by acting as importer of last resort, it appears that China is trying to utilize its growing excess capacity by funding infrastructure in foreign lands.  This is a form of what the European powers did in the 18^th and 19^th centuries when they too found themselves with excess capacity.  They acquired colonies which became targets of exports; in other words, the colonies were forced to accept imports from the mother country which maintained employment in the colonizer.  It also offered a venue for mother country saving which would be protected from expropriation.  We note that China is furiously building a “blue water” navy to protect these investments.  Although the U.S. press is framing the Silk Road initiative as filling the void caused by the U.S. abandonment of free trade and the TPP, an outgrowth of “America First,” it is only partly that.  China would have needed to do this regardless of the existence of TPP.  However, the absence of TPP greatly enhances the likelihood of success.

OPEC + Russia extend deal: Although the rest of the cartel needs to agree, that is mostly a formality.  The fact that the Saudis and Russians have agreed to extend cuts into Q1 2018 is bullish for oil.  Oil prices are stronger this morning.  We continue to maintain that oil prices are in a range between $45 and $55.  We expect oil prices to move toward the top end of that range in the coming weeks.  This is good news for U.S. oil producers; effectively, OPEC + Russia is creating a price umbrella that offers price protection to expanded output.

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[1] https://www.nytimes.com/2017/05/13/world/asia/cyberattacks-online-security-.html (paywall)

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

[Posted: 9:30 AM EDT] Although the Comey situation continues to dominate the news flow, we are reaching the point where there isn’t really anything new.  So far, the financial markets are managing the situation calmly.

The U.S. and China announced a trade agreement.  On its surface, it doesn’t look like it will affect the overall trade deficit but it will boost two key constituents for the president—energy and agriculture.  The ban on beef exports will be lifted; the Chinese had implemented a partial ban after the “mad cow” scare 14 years ago.  It appears that the beef market has probably anticipated this action.

Prices jumped but have fallen off their highs.  In addition, the U.S. will be able to export LNG to China, although it isn’t obvious that this change will result in any major exports immediately.  China already has sources in Asia and the U.S. is still building the infrastructure for gas liquefaction.  One item left out was any language about the U.S. allowing Chinese firms to invest in the natural gas industry.  The U.S. also said it “recognizes the importance of the [one belt, one road] initiative.”  Negotiating a deal, even a modest one, shows that the administration can move forward on policy even amidst controversy.

China has been steadily tightening monetary policy and it’s starting to show up in the term structure.  The five-year/10-year yield curve has inverted, although we are not sure this really matters.  However, we are seeing a rapid narrowing of the one-year/10-year yield curve, which is probably more significant because it highlights the impact of policy tightening.

We have seen this curve invert before, in mid-2013, driven by a spike in the one-year rate.  However, the rise in the short rate was brief.  As the lower line on the chart shows, the curve in China is flattening.  In most economies, an inverted yield curve is a clear signal of future economic contraction.  As the chart shows, policymakers in China tend to back away from policy tightening once the curve moves to flatten; we wouldn’t be surprised to see similar behavior this time, either.  But, if the PBOC continues to ratchet rates higher, we will soon be approaching a level of concern.

Reuters is reporting that the administration is “weeks” away from appointing new governors to the FOMC.  Currently, there are three governor openings.  Appointing governors to the FOMC is perhaps the second most important appointment a president gets to make, overshadowed only by the Supreme Court.  Who gets these jobs will have an important impact on monetary policy.  The Bannon wing will likely want to appoint dovish governors, while the Cohn wing would lean toward hard money types.  Media speculation has trended toward hawks.  Since appointments are weeks away, the earliest any of these seats could be filled is autumn.  We do also expect both Yellen and Fischer to exit in Q1 2018, so President Trump will get to appoint up to five of the seven governors in his term.

With the release of the CPI data, we can upgrade the Mankiw models.  The dip in the core CPI rate (see below) did affect the Mankiw Rule model results.  The Mankiw rule models attempt to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative.  Mankiw’s model is a variation of the Taylor Rule.  The latter measures the neutral rate using core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy.  Potential GDP cannot be directly observed, only estimated.  To overcome this problem with potential GDP, Mankiw used the unemployment rate as a proxy for economic slack.  We have created four versions of the rule, one that follows the original construction by using the unemployment rate as a measure of slack, a second that uses the employment/population ratio, a third using involuntary part-time workers as a percentage of the total labor force and a fourth using yearly wage growth for non-supervisory workers.

Using the unemployment rate, the neutral rate is now 3.29%.  Using the employment/population ratio, the neutral rate is 1.13%.  Using involuntary part-time employment, the neutral rate is 2.60%.  Using wage growth for non-supervisory workers, the neutral rate is 1.15%.  Although the labor market data for April improved, the fall in the core CPI rate offset most of those gains, leading to lower projected rates for all models.

What is notable is that for two of the variations, wage growth and the employment/population ratio, the FOMC is nearly at a neutral rate now.  The fact that policymakers appear driven to lift rates further suggests they are more concerned with either involuntary part-time employment or the unemployment rate.

Since the Great Financial Crisis, it has been unclear which measure of employment accurately characterizes the labor market.  Because the Fed was conducting very easy monetary policy, the debate was mostly academic; that isn’t the case anymore.  If the accurate measure is the employment/population ratio or wage growth but the Fed thinks either the unemployment rate or involuntary part-time employment is the correct indicator of slack, policymakers would run the risk of overtightening and risking a recession.

This chart shows the issue; this is the Mankiw model variation using wage growth.  The lower line on the chart shows the deviation from the neutral rate as projected by the model.  When the rate is below zero, policy is leaning toward accommodative.  Note the parallel lines on the lower part of the chart; these lines measure a standard error on either side of the neutral rate.  When the deviation is within the parallel lines, it suggests policy is mostly neutral.  Thus, based on wage growth, we are close enough to neutral policy that the Fed could stand pat until either wage growth accelerates or core CPI rises.

Thus, the coming months will be key.  If this model is the most accurate measure of slack then the Fed needs, at most, one more hike.  Policy would be tight at a fed funds target of 2.40%, so there is some element of tolerance that the economy should be able to manage.  Based on the dots chart, we would be at this level by the end of next year.  Simply put, we could be approaching a period where monetary policy shifts to a headwind.

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

[Posted: 9:30 AM EDT] Media attention remains on the Comey firing.  On this issue, there are three stories we view as notable this morning.

Deputy AG Rosenstein threatened to resign: The WP[1] is reporting that the deputy AG threatened to resign as the narrative emerging from the White House was that the president was simply following the recommendations of the DOJ.  This highlights an emerging characteristic of this presidency.  When things go well, the president takes full credit.  When something goes wrong, an underling is blamed.  It’s a far cry from President Truman’s “the buck stops here.”[2]  All presidents demand some degree of loyalty.  The same is true of all leaders.  An organization will struggle to perform its mission without some level of loyalty.  However, it cannot be the primary virtue because it can lead to abuses; loyalty to the organization becomes an excuse for the end justifying the means.[3]  President Trump appears to put great emphasis on loyalty and the decision to fire Comey is creating a narrative that the primary reason was concern that Comey was not loyal and could not be controlled by the White House.[4]

The optics of meeting with Russian officials looks like an “own goal”: The White House did not allow the U.S. press to cover Trump’s meeting with Russian Foreign Minister Lavrov and Russian Ambassador to the U.S. Sergei Kislyak.  However, the Russian media apparently did get a photo of the president and the two Russian officials.  Under normal circumstances, such meetings are not news—presidents meet with foreign officials as part of the job.  However, the timing of this one is unfortunate.

Polls are slipping: Quinnipiac released a poll[5] yesterday showing rising disfavor with the president.  This isn’t exactly news in that Trump hasn’t usually polled all that well.  However, one of the characteristics of the Quinnipiac polls is that they ask the same questions over a number of weeks so one can observe trends.  Here are a few interesting observations.  In handling the job as president, “strongly disapprove” has moved from 40% to 51% since late January.  The “favorable/unfavorable” responses have seen favorable deteriorate from 44% in late November to 35% now and unfavorable rise from 46% to 58%.  The “honest/dishonest” responses have dropped honest from 42% to 33% (November to now), while dishonest has risen from 52% to 61%.  On the question of leadership as “good/bad,” good has declined from 56% to 41% (November to now), and bad has risen 38% to 56%.  Perhaps the most troubling were the responses to whether “Donald Trump cares about Americans”; yes has fallen from 51% to 38% (November to now), while no has risen from 45% to 59%.  Why does this matter?  The ability to get legislation through Congress needs presidential leadership.  If members of Congress begin to view the president as a political liability, it becomes difficult to move legislation through Congress.  President Obama faced similar issues at the midterms of 2014; Democrat candidates didn’t want him campaigning with them.[6]  It’s also noteworthy that the Obama administration was unable to move major legislation through Congress after 2014 in part due to his unpopularity.  The more unpopular Trump becomes, the quicker his political capital will be depleted.  That means tax reform, infrastructure spending, etc. will not move forward.

Meanwhile, the Fed appears on a path toward at least two more rate hikes this year.  Boston Fed President Rosengren, a reliable dove, indicated yesterday that he sees three more hikes this year.  The financial markets haven’t discounted tightening of this magnitude so this could become a risk factor as the year wears on.

U.S. crude oil inventories fell 5.3 mb compared to market expectations of a 2.2 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 the seasonal withdrawal phase has begun.  We also note that, as part of an Obama era agreement, there was a 0.5 mb sale of oil out of the Strategic Petroleum Reserve.  This was 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 5.8 mb, which is even more below expectations.

As the seasonal chart below shows, inventories usually are at their seasonal peak and begin falling about now.  This year, the seasonal decline has started early.  Although inventories remain high, this seasonal level is consistent with July, meaning that we may be on the way to an easing of the inventory overhang.  Last year, we saw a roughly 45 mb draw from the April peak.  Assuming a similar drop from this year’s peak of 566.5 mb at the end of March, we will end up at 520 mb by late September.

Based on inventories alone, oil prices are overvalued with the fair value price of $33.71.  Meanwhile, the EUR/WTI model generates a fair value of $46.04.  Together (which is a more sound methodology), fair value is $42.04, meaning that current prices are above fair value but the deviation has been steadily closing in recent weeks.  We note that OPEC looks like it will keep production cuts in place into next year, which probably keeps oil in a range of $55 to $45, basis WTI.

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[1] https://www.washingtonpost.com/politics/how-trumps-anger-and-impatience-prompted-him-to-fire-the-fbi-director/2017/05/10/d9642334-359c-11e7-b373-418f6849a004_story.html?utm_campaign=newsletter_axiosam&utm_medium=email&utm_source=newsletter&utm_term=.64858ef5cc41

[2] https://qph.ec.quoracdn.net/main-qimg-edc462fee894f545efa2db00e65b86c9-c

[3] One of the best works on balancing loyalty in an organization comes from Herbert Simon. See: Simon, H.A. (1945). Administrative Behavior. New York, NY: The Free Press.

[4] https://www.nytimes.com/2017/05/10/us/politics/how-trump-decided-to-fire-james-comey.html?_r=0

[5] https://poll.qu.edu/national/release-detail?ReleaseID=2456

[6] http://time.com/3507165/alison-grimes-barack-obama-midterm-elections/

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

[Posted: 9:30 AM EDT] The story dominating this morning’s headlines is the Trump administration’s decision to fire FBI Director Comey.  There is much speculation surrounding what is going on with the decision; our focus will remain on the impact on financial markets.  So far, it hasn’t had much of an impact.  S&P futures are flat, Treasuries are modestly stronger and the dollar is mostly steady.  Here are a few of our thoughts:

FBI directors rarely survive their terms.

 Of course, the first FBI director, J. Edgar Hoover, served from the bureau’s founding in 1935 until his death in 1972.  Hoover was a controversial figure and after his death presidents wanted to regain control of the FBI.  Nixon initially appointed Patrick Gray as acting director following Hoover’s death.[1]  Later, Clarence Kelly was appointed to the position as full director.  Directors are given 10-year terms with the idea that they will be insulated from political influence; that hasn’t worked according to plan.  With his firing, Comey has now served the shortest term in the bureau’s history.

The FBI has great power; it is essentially the U.S. equivalent of MI-5, engaging in not only Federal policing but also domestic counterintelligence.  Hoover lasted as long as he did because presidents were afraid of the political fallout from removing him from office.  Any removal of an FBI director is fraught with risk.

The firing could become a significant distraction.  Concerns about Russian involvement in the presidential campaign is a story that simply won’t go away.  Our position is that election interference is nothing new.  The Soviets tried to keep Reagan from getting elected; recently, President Obama not only endorsed Emmanuel Macron but also recorded a message to French voters.  However, there is a line between trying to sway an election and influencing a government.  If government officials are compromised by a foreign power, the danger is immense.  Gen. Flynn resigned from the NSC over alleged Russian ties.  The FBI has an active investigation about Russian activity among officials of the Trump administration.  The attorney general had to recuse himself from any involvement in supervising the Russian investigation.  This story will remain a problem for the administration and absorb precious political capital, which will reduce the odds of accomplishing other goals, such as tax reform, infrastructure spending and trade policy.

The Nixon overtones are hard to quash.  Firing a figure that is conducting an investigation of one’s administration looks like a cover up.  That factor is going to be difficult to overcome.  One way to manage the story is to appoint a special prosecutor.  However, once that door is opened, it becomes impossible to control.  President Clinton’s special prosecutor started with Whitewater; it ended with Monica Lewinsky.  The key to whether a special prosecutor needs to be appointed will likely come from Senate Republicans.  If enough of them decide to press for this action, it will be hard for the president not to acquiesce.

At the same time, the situation doesn’t compare well to Nixon.  Although Trump is a political outsider, which Nixon was as well, Trump’s party controls Congress.  Nixon faced a Congress controlled by Democrats.  There were people in jail tied to the Nixon re-election campaign.  Nixon was involved in a cover up.  There isn’t clear evidence that the Trump administration has done anything wrong, although the investigation continues.

Comey was controversial.  His handling of the Clinton private server investigation was unorthodox.  He was clearly a man guided by his own internal compass, which makes him dangerous to power.  At the same time, his ability to manage investigations was questionable.  At last summer’s press conference, he laid out a case suggesting Clinton was guilty.  In our interpretation of his remarks, it seemed to be leading to an indictment but instead, in what appeared to be a surprise, he indicated that the FBI was not recommending that action.  The decision to “reopen” the investigation near the election was also controversial.  From a partisan standpoint, Republicans are not happy that Clinton wasn’t indicted; for Democrats, Comey turned the election to Trump.  Thus, he doesn’t really have a political constituency in Washington that would support him.

This process will be really difficult to handle.  By all accounts, the White House moved on this decision without much outside counsel.  Aides were caught off guard; Comey himself appeared shocked.  It almost appears the White House misinterpreted how this would be taken.  The administration may have thought that Comey’s own unpopularity would make the decision popular.  Instead, Democrats are pushing for a special prosecutor and Republican reaction has been mixed at best.  Now the White House has to appoint a new director who will come under tremendous scrutiny.  In fact, the AG usually recommends a new FBI director but Sessions cannot do so because of his Russian recusal.  All told, this situation will require a lot of attention.

The bottom line is that this problem will be a distraction.  At a minimum, it will take attention away from other priorities, such as tax reform, the ACA repeal, infrastructure spending, etc.  As these goals are pushed further into 2018, the less likely they are to be achieved.  We have consistently warned that political capital is a wasting asset.  By June 2018, it’s gone whether or not a president was able to accomplish anything.  As long as the economy avoids recession and earnings remain firm, the market fallout won’t be severe.  But, if weakness develops, one cannot expect fiscal and tax policy to ride to the rescue if the administration can’t bring this issue under control.

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[1] Mark Felt, a deputy director, was unhappy that he wasn’t appointed to the acting role and, as we recently discovered, was the famous “deep throat” of Watergate.