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

[Posted: 9:30 AM EDT] As noted below, we have a full slate of Fed officials talking today.  We expect these speakers to generally confirm the Fed’s policy stance for at least two more hikes this year, with the potential for a third.  The most interesting member, Minneapolis FRB President Kashkari, has already made the media rounds; he had a dovish dissent to the move, arguing that there is no evidence of accelerating inflation or rising expectations.  Thus, in his analysis, there was no reason to move rates.  We would not expect such talk today.

The FBI director testified yesterday that there was no evidence of wiretaps on Trump party headquarters and did suggest that there was a broad investigation of Russian interference in the U.S. election.  We doubt this investigation will rise to the level of Watergate; however, it will act as a distraction to the administration.  Our position is that presidential political capital is at its peak on inauguration day and, like time decay on an option, is eroded until nearly fully diminished 18 months after the oath of office.  Despite this obvious pattern, presidents often squander their limited and perishable political capital on superfluous policy battles.  Health care is burning a lot of the president’s capital as are all the investigations which divert attention.

The financial markets have been focused on deregulation and tax cuts, sending equities and the dollar higher and bond prices lower.  However, we are starting to see the dollar roll over despite Fed tightening, in part because there is growing skepticism that the administration will be able to get tax reform in place.  Tax reform is one of the factors that has raised market sentiment and if the administration becomes bogged down in health care reform and defense against investigations, there simply won’t be enough bandwidth to get much of anything else accomplished.  This is an issue we are watching closely.

There was a French presidential debate yesterday.  Media reports suggest that the current presidential favorite, Emmanuel Macron, managed to avoid any major mistakes.  Although Macron is currently second in the polls to Marine Le Pen (Le Pen is at 27%, Macron at 23%), the polls all signal a Macron victory in the second runoff election.  Macron is relatively inexperienced and there were fears among Le Pen opponents that he would make a mistake at the debates and boost Le Pen’s chances for the presidency.  According to reports, Macron, though not spectacular, did avoid losing.  The EUR’s rally this morning is partly due to his better performance.

SOS Tillerson announced he will skip the NATO meetings next month to be with the president when General Secretary Xi visits the U.S.  His office also announced he will visit Russia later in April.  This sends the signal that the administration is focusing on the big nations and paying less attention to the smaller allies in Europe.  There is some fear that the U.S. is also indicating a greater affinity for authoritarian governments and paying less attention to democracies.  The charge of playing to enemies and ignoring allies was leveled at the previous administration as well.[1]  It should be remembered that one of the goals of creating the EU was to give Europe a platform on the world stage.  Henry Kissinger famously destroyed this idea with his comment,   “Who do I call if I want to speak to Europe?”  Europe still hasn’t solved this problem.  Simply put, the trend of U.S. administrations paying less attention to Europe has been underway for some time.

Finally, despite strong sentiment indicators, the Atlanta FRB GDPNow forecast is currently at an anemic +0.9%.

In the contribution data, consumption has declined 108 bps from the initial forecast and inventories have reduced the growth projection by 39 bps.

We are looking at a soft Q1 number.  Consumer confidence data suggests that consumption should improve in the coming months, although the relationship is not always consistent.

This chart shows real consumption expenditures with the Conference Board’s Consumer Confidence report.  In general, they do move together, although a case could be made that consumption led confidence in the early 1990s and in 2011.  In addition, consumption softened in front of the last two recessions despite elevated confidence.  The divergence between rising confidence and sluggish spending is something we monitor.  So far, this isn’t a major problem; however, it could develop into one if this situation persists.

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[1] https://www.theatlantic.com/international/archive/2016/12/obama-israel-kerry-allies/511796/

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

[Posted: 9:30 AM EDT] Although it has been a quiet morning, there was a lot of news over the weekend.  Here’s what we saw as noteworthy:

Mnuchin won’t disavow protectionism: The G-20 communiqué usually includes language supporting free trade and opposing protectionism.  Of course, in practice, there really is no nation that has completely open trade but some have more than others.  Instead, free trade is seen as an ideal; something that one should aspire to but realize that one will always fall short.  That wasn’t the outcome among the finance ministers at this weekend’s G-20 meeting in Baden-Baden.  The new U.S. treasury secretary, Steven Mnuchin, would not support such language.  Germany’s finance minister, Wolfgang Schäuble, suggested that Mnuchin has “no mandate” to settle on what U.S. trade policy is all about.  President Trump has made it clear that his administration intends to change America’s trade policy.  Since the end of WWII, the U.S. has steadily opened its markets to foreign nations as part of its reserve currency role.  Foreign nations have obviously taken advantage of this, implementing export promotion policies to achieve developed nation status.  Trump is suggesting that trade is the key factor behind the decline of the U.S. middle class and is determined to force nations to change their policies to boost American jobs.

Why did the U.S. engage in this policy?  We believe for two reasons—to win the Cold War and promote global growth.  We wanted to build the Free World and we did so by allowing foreign nations to trade with us.  This gave other nations a steady source of demand; they created economies designed to export by suppressing domestic demand and restraining their currency’s appreciation.  The second reason is all about world growth in general, based on the idea that a world that trades with each other may be less likely to go to war.  To provide the currency of choice for trade, the U.S. must run a trade deficit; a surplus acts as a global contraction of the money supply.

In our opinion, Trump represents a clear break in this policy.  However, support for the financial side of American hegemony has been weakening for some time.  Free trade deals have become politically difficult to pass through Congress.  Even if Clinton had won the presidency, TPP and TTIP were dead.  It’s been so long since the U.S. has fought a world war that we have forgotten why these policies were put in place.  This G-20 event is further evidence that change is underway.

60 Minutes takes on HB-1 visas: Newsmagazine 60 Minutes opened last night with a story about a group of IT workers in California who were replaced with foreigners on HB-1 visas and were given incentives to train their replacements.  It’s the kind of report that gets attention and is part of middle class angst over trade.

Was Tillerson “snuck” in China?  While visiting China over the weekend, SOS Tillerson seemed to adopt language China has been supporting for some time.  These statements included terms like “mutual respect” and “win-win” cooperation.  This language issue is a classic example of strategic ambiguity.  For most American ears, terms like mutual respect are benign.  However, China interprets these as sphere of influence concepts.  In other words, mutual respect means China won’t interfere with U.S. relations in South and Central America and the U.S. will give China a free hand in the Far East.  Did Tillerson understand China’s take on this language?  It’s possible that given his newness to the job and the lack of support staff, he easily could be unaware.  Or, he may be preparing the world for a removal of U.S. power and the creation of regional hegemonies.  If we had to guess, we would go with Tillerson’s inexperience as the explanation.  The next point suggests why.

Trump is preparing to confront China on trade in early April: According to Axios,[1] Trump is planning to press Chairman Xi on trade policy with regard to autos.  U.S. automakers face a 25% tariff when they try to import into China.  In response, U.S. automakers build manufacturing in China but, to do so, they must undergo joint ventures with a Chinese firm that is, by law, the majority owner.  Chinese automakers face a 2.5% tariff when exporting to the U.S.  Why don’t we see more Chinese cars in the U.S.?  Mainly due to poor quality.  Chinese manufacturers haven’t mastered the techniques to meet Western quality standards.  However, China has been eyeing the U.S. market for some time and we would expect quality to improve.  According to Axios, Trump will make a series of demands that will include that China must build plants in the U.S.  They can be fully owned by Chinese firms but only if the U.S. firms in China are relieved from the joint venture rule.  In addition, profit repatriation will be limited.  This gives a flavor for how the president may be looking to negotiate on trade.

Greece spinning toward another crisis: Eurozone finance ministers are meeting today to reiterate that the Tsipras government needs to comply with all the terms attached to emergency loans.  Greece isn’t really prepared to meet all the demands, which include highly unpopular pension reforms.  Markets are ignoring this issue simply because Greece always seems to “blink.”  This is because there really is no solution to Greece’s debt problem other than default and Grexit.  Would a Greek exit be a big deal?  By itself, probably not, but if Greece leaves the Eurozone and thrives, it will tempt other big economies to do the same which would spell the end of the single currency as we now know it.

Article 50 on March 29: PM May has indicated she will begin the Brexit process by declaring Article 50 on March 29.  Assuming rationality, Brexit should not be a crisis; Britain will need the EU for trade and the EU needs Britain for defense and financial services.  However, the EU fears that if Britain gets too good of a deal then other nations may decide to exit as well.  Although these fears are not unfounded, it should be noted that the U.K. is a special case; it’s a big economy and it is well integrated into Europe.  Striking a deal makes sense and one should emerge if emotions are managed.

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[1] https://www.axios.com/axios-sneak-peek-2319878918.html?utm_source=The+Sinocism+China+Newsletter&utm_campaign=e55d7dcd71-EMAIL_CAMPAIGN_2017_03_20&utm_medium=email&utm_term=0_171f237867-e55d7dcd71-29661833&mc_cid=e55d7dcd71&mc_eid=e77499fecc

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

[Posted: 9:30 AM EDT]

Happy St. Patrick’s Day!

It’s a quiet morning in what has been a busy week.  The only major news today is that Chancellor Merkel, who was due to visit earlier this week but was unable due to the snowstorm, is in Washington today.  Merkel represents the established liberal order which Trump has vowed to upend.  The meetings today could be interesting.

For the most part, economic expansions end for three reasons—inventory overhangs, overly tight monetary policy or a geopolitical event.  Technology has mostly eliminated the first reason; firms have become so adept at managing inventory that overhangs are less common.  The remaining two reasons have thus become more important.  Geopolitical events were mostly to blame for the 1973-75 recession (the OPEC oil embargo was due, in part, to U.S. support for Israel in the Yom Kippur War) and the 1990-91 recession (the Gulf War was the culprit).  The rest have been caused by overly tight monetary policy.

Currently, monetary policy appears accommodative—real fed funds remain negative and, by any measure of the Mankiw Rule (see today’s Asset Allocation Weekly below), policy is easy.  Thus, paying attention to the other mentioned factor, geopolitics, makes some sense.  And, when the lead headline in the FT says America’s “strategic patience” with North Korea has been exhausted, it makes us take notice.  Secretary of State Tillerson said today that the U.S. considers the military option “on the table” if North Korea continues to ratchet up its military threats.  We view this as a form of signaling.  The military option should always be on the table.  After all, if North Korea did something aggressive, like invade South Korea, the U.S. would almost certainly respond militarily.  By saying the military option is available is to suggest that there is some sort of red line, or trigger, that would warrant military intervention.  What might that be?  Evidence that North Korea has a deliverable nuclear warhead might be enough.

Since the end of WWII, nuclear weapons have evolved into more of a doomsday defense than an offensive weapon.  Essentially, a nation with deliverable nukes cannot be forced to unconditionally surrender.  If Hitler had had deliverable nukes, he probably could have forced the Allies to offer a peace deal or face the total destruction of Washington or Moscow.  If Pyongyang had a deliverable nuclear weapon, the likelihood of an invasion to overthrow the regime would decline significantly.  This is the lesson of Saddam Hussein and Muammar Gadhafi; without a doomsday weapon, your regime can be overthrown and you can face execution.

Threatening the North Korean regime will more likely than not spur Kim Jong Un to achieve a deliverable weapon.  However, it is unknown how exactly the U.S. will act if North Korea goes nuclear.  Two states have joined the nuclear club in recent years—India and Pakistan.  These didn’t appear to be a threat to the U.S. because the weapons are mostly pointed at each other.  Iran’s calculus was to have a program and get close to “break out” of getting a weapon without actually doing so.  Iran was able to use this brinksmanship to get most international sanctions lifted.  The reason Iran probably never moved to cross the nuclear line is that it wasn’t sure whether Israel or the U.S. would view this as an existential threat and attack its nuclear facilities.

North Korea’s “Young Marshall” is clearly trying to solidify his position; this is why he has been on a dramatic execution binge.[1]  This activity would suggest he feels insecure and may do something rash.  Managing this situation will require delicate diplomacy, which may not be forthcoming from this administration.  That doesn’t necessarily mean we are on the brink of war but it does suggest that the risks are rising.  Even if the conflict remains contained and conventional, it may lead to a recession if concerns rise enough.  Thus, we are closely monitoring the situation with North Korea for signs of escalation.

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[1] See WGR, 3/6/17, The Assassination of Kim Jong Nam.

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

[Posted: 9:30 AM EDT] Happy Ides of March!

There are two big events today—the FOMC meeting ends with an expected rate hike, along with new dots and a press conference, and the Dutch go to the polls.  The key issue for the FOMC is the path of future rate hikes.  The current base expectation is two more hikes this year after today’s rate change, which would put the year-end upper level of the target at 1.50%.  It should be remembered that the Fed now has a range of 25 bps for the target rate and does vary that rate within those bounds.

As this chart shows, most of the time the Fed keeps the rate near the mid-point of the range; assuming a hike of 25 bps today, the effective rate will likely be around 0.875%.

Another way of looking at policy is through the inflation-adjusted rate of fed funds.  The chart below looks at the effective fed funds rate less the yearly change in CPI.

Real fed funds rose over the past two years mostly due to a decline in inflation.  As oil prices have recovered, the level of real fed funds has declined which may be prompting the move to raise rates.  Compared to the core rate, real fed funds have mostly been steady at -1.50%.  Although the Fed tends to focus on core inflation, it should be noted that inflation expectations, measured by the TIPS spread, mostly track oil prices, meaning that the FOMC may be paying closer attention to oil prices.  This might explain the decision to move in March, which was not expected until about three weeks ago.  We look for a somewhat hawkish statement and dots chart today, with Chair Yellen diluting some of this hawkishness in the press conference.

In the Netherlands, polls close at 4:00 EDT.  We expect meaningful results around three hours after the polls close.  Although Geert Wilders is getting a lot of attention, there is little chance he will be the next PM even though he will likely win the plurality of the electorate.  The Netherlands political system has numerous parties and none of them have indicated they would form a government with Wilders.  Instead, we will be watching Wilders’s performance to gauge the degree of populist support in Europe.  Recent polls have suggested some softening of support; if this trend holds, he may receive less than the 20% expected.  However, the recent weakness may reflect preference falsification, a factor seen with Brexit and in the U.S. presidential election.  If we do see evidence of preference falsification, it may mean that Le Pen in France could do better than current polls suggest.

Finally, as Secretary of State Tillerson visits Japan, there is evidence that China is continuing construction activity on islands and shoals in the South China Sea.  Candidate Trump indicated during the campaign that China was doing this due to a lack of respect for President Obama.   Continued activity suggests that China doesn’t see the change in the White House as material.  We do note that Chairman Xi and President Trump will meet in early April.  We will be watching to see if this construction activity will be part of the discussions between the two leaders.

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

[Posted: 9:30 AM EDT] The two big news items since yesterday morning are from the U.K. and the CBO.  In the U.K., PM May won her battle for a clean Brexit bill, meaning that Article 50 can be declared soon. We look for the declaration to come by month’s end.  From the time of the declaration, negotiations have a two-year deadline, although there is a chance that the EU and Britain could decide to extend talks for another two years.  The GBP did slump on the news, which is more of a knee-jerk reaction given that this outcome was well expected.

Nicola Sturgeon, the leader of the Scottish National Party, is demanding a new referendum on Scottish independence, which was mostly expected.  There is some speculation that PM May is delaying the announcement of Article 50 until the end of March in response to Sturgeon’s call for another referendum.  Speculation had been high that May would announce as soon as today.  If Scotland tries to separate from the U.K. during the country’s negotiations to exit the EU, it will weaken the U.K.’s bargaining position.  May wants to establish a favorable trade deal with the EU but, if Scotland exits, the EU will have less incentive to deal with the remaining elements of the U.K. and will probably force the country to accept WTO rules.

Also from the U.K. this morning, Charlotte Hogg resigned from the BOE after it was disclosed that she failed to tell regulators that her brother worked for Barclays (BCS, $11.12).  She was appointed by the current governor, Mark Carney; because she came from industry instead of academia, she mostly deferred to Carney in voting.  This means that Carney will lose a reliable ally in conducting policy.  Given that recent decisions by the BOE have been non-controversial, in that voting hasn’t been close, we expect her exit to leave policy unaffected.  However, it does undermine the reputation of Governor Carney.

The CBO scored the new health care bill and it showed an increase in the number of uninsured but a reduction in spending.  These characteristics will probably allow the bill to pass in the House but we see a much more difficult time in the Senate.  We are seeing the usual railing against the CBO for its analysis.  Our take is that the body isn’t always right but it is generally fair.  One of our concerns is that the president is spending political capital on this issue which will make tax reform more difficult; the longer the health care issue consumes Congress, the less time there is for other legislation.

Reuters is reporting that Japan is sending its largest warship, the Izumo helicopter carrier, to a port tour across Southeast Asia starting in May.  The ship was commissioned two years ago.  Stops include Indonesia, the Philippines and Sri Lanka.  It will eventually join the U.S. and India for naval exercises in the Indian Ocean in July.  The vessel will be moving through waters claimed by the PRC; although this could be controversial, we don’t expect China to act aggressively against the Izumo.  Still, this is a show of force and does signal that Japan could have significant offensive capabilities if it decided to take such a role.

Finally, we are expecting a nor’easter for the Northeast and parts of the Mid-Atlantic states.  Chancellor Merkel has canceled her trip due to the weather event.  The FOMC is still meeting but some of the members may participate by teleconference.  Major snow events in New York have disrupted financial markets in the past.  We don’t expect too many problems but investors should be aware that New York may be less active today.

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