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

[Posted: 9:30 AM EDT] BREAKING NEWS: The Atlanta FRB announced that Raphael Bostic has been named as the new president, replacing the retiring Dennis Lockhart.  Bostic will take over the bank on June 5.  He was a housing official in the Obama administration and his academic work is mostly on the housing market.  He is currently a professor at USC.  He also spent time as an economist at the Federal Reserve in Washington.  He did his undergraduate studies at Harvard and has a Ph.D. from Stanford.  The Atlanta FRB will be a voting member of the FOMC in 2018.

There is a lot of impending news this week.  Here is what’s on tap:

The FOMC: The Fed meets Tuesday and Wednesday and is virtually certain to raise rates by 25 bps to a range of 75 bps to 100 bps.  With that outcome well telegraphed, the focus will move to the progression of future rates.  Therefore, the dots chart will take on unusually high significance when it’s released on Wednesday.  It is quite possible that the text of the release will read much more hawkish than the press conference; Yellen is more dovish than the committee and if the projection is three more hikes this year, and maybe three to four next year (all 25 bps), she will probably try to suggest that such an outcome isn’t necessarily her position.  If we get a negative financial market reaction (higher interest rates, weaker equities), we will be watching to see if the Fed is subjected to Twitter criticism from the Oval Office.

President Trump and Chancellor Merkel meet: The two leaders meet on Tuesday as the latter comes to the U.S. for a visit with the new president.  The Trump administration has been highly critical of the German government’s positions on immigration and trade.  The NYT reports that Merkel is bringing executives from several large German firms that have operations in the U.S. to show how German companies are major American employers.  Merkel has a generally good record of handling strongmen; she parries President Putin well and managed Italian President Berlusconi when he led Italy.

Dutch elections: Elections will be held in the Netherlands.  Geert Wilders will likely win the most seats but won’t be able to form a government.  Building a government without the most popular party will tend to undermine its mandate.  We will be watching to see if the polls underestimate the popularity of populists as we saw in the U.K. and U.S. elections.  An interesting side note developed over the weekend when the Dutch government banned a Turkish diplomat from visiting the country to rally support for an upcoming referendum on the Turkish constitution that would give the president (currently Recep Erdogan) sweeping powers.  President Erdogan called the Dutch “Nazis” for not allowing his representative to rally support.  Dutch officials were concerned about unrest just before their elections as civil disorder would likely lift support for Wilders, which is something the current government wants to avoid.  Both Erdogan and Wilders are trying to use the incident to boost their respective electoral chances.

The BOE and BOJ meet: These two central banks hold meetings on Thursday.  The BOE is facing increasing pressure to raise rates as the U.K. economy outperforms.  The BOJ has been toying with allowing a modest rise in the 10-year JGB, which is pegged to zero by the Japanese central bank.  We don’t expect much movement from either bank.

Article 50: U.K. PM May is working to dispense with two amendments from the House of Lords, one that would unilaterally guarantee the rights of EU citizens working in the U.K. and the other granting a meaningful vote on the final agreement.  If she can garner enough support for a “clean” bill in the House of Commons, Article 50 could be activated as soon as tomorrow.  That would begin the 24-month process for the U.K. to exit the EU.

G-20 Summit: The G-20 will hold a leaders’ summit in July in Hamburg.  On Friday, foreign ministers will meet in Bonn as a pre-meeting.  Although the leaders’ meeting will gain more press, actual work is done at the pre-meetings so the leaders can mostly sign off on things.  Russia is expected to use the forum to expand its influence.  The weekend media had several “where’s Rex” reports, suggesting U.S. Secretary of State Tillerson has been mostly sidelined.  If that is the case (and we have doubts), the U.S. could find itself at a disadvantage at the July gathering.

In other news, there are reports that Chairman Xi may visit Mar-a-Lago next month on April 6 and 7.  According to reports, there are no golf outings planned.  The U.S. wants China to rein in North Korea; China wants to keep trade open.  This could be a very important meeting for the global economy and for stability in the Far East.  The weekend FT reported a “civil war” in the administration between the economic nationalists (Bannon and Navarro) and the establishment (Cohn and Mnuchin).  The president seems to support internal strife among his staff but all indications still signal that the nationalists are dominant.  Finally, the CBO is expected to score the new GOP replacement for the ACA.  Given the high number of critical comments about the office, it looks likely that it won’t get a favorable score (which means that it will either increase the deficit or the number of uninsured Americans).  The level of opposition in the Senate to the Ryan replacement is very high and thus we may see an ACA repeal but there is no obvious replacement.

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

[Posted: 9:30 AM EST] Happy Jobs Day!

The February jobs report was generally positive, with payroll easily beating estimates at 235k compared to the forecast of 200k.  Wage growth was pretty strong, coming in line with expectations at 2.8%.  Equities have responded positively to the data, whereas bonds fell sharply this morning.  The report shows support for a fed increase next week and if this trend persists we expect the fed to meet its prediction of three rate hikes this year.

South Koreans have taken to the streets after the Constitutional Court upheld the legislature’s impeachment vote of President Park Geun-hye.  Park was accused of using her office to benefit colleagues.  She will be the first president to be impeached from office in South Korea.  Protests in response to the court decision were swift and have turned violent, with at least two deaths and several injuries reported.  Park’s removal from office comes at a peculiar time in which tensions between North and South Korea have risen.  In addition, her administration was an ally to the U.S. and it is unclear whether this favor will carry over to the next administration.

Elections for her replacement will take place on May 6, with the early favorite being Moon Jae-in, who narrowly lost to Park in the 2012 election.  Moon has supported the idea of a “balanced diplomacy” in which Korea maintains its relationship with the U.S. while also increasing its ties with China.  He also supports building a relationship with North Korea.  It is unclear how Moon would handle the deployment of THAAD, an anti-missile system to counter aggression from North Korea.  In the wake of North Korea’s recent missile launches, China has been vocal about its displeasure with THAAD being built so close to its border.

In Europe, a leaked report from Madrid shows that Spain could lose an estimated 1 billion euros in exports as a result of a hard Brexit.  News of the possible economic consequences of Brexit on the Spanish economy is not surprising but probably a bit exaggerated.  The proximity of the two countries to one another make them convenient trading partners, although it is worth noting that the pound’s relative strength to the euro has benefited Spanish goods and made Spain a popular travel destination for many Brits.  Therefore, it is not surprising that Spain would try to push for better terms for the UK.  That being said, the recent depreciation of the pound has yet to have a negative impact on the Spanish economy as its GDP expanded 3% year-over-year in Q4.

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

[Posted: 9:30 AM EST] Equity markets remain relatively calm as the ECB decided to leave its monetary policy unchanged.  During a press conference, Mario Draghi stated that even though risks have become less pronounced, global factors are still a threat to the overall stability of the Eurozone.  We believe his statement could be referring to a possible breakup of the Eurozone as well as an increasingly isolationist U.S.  Draghi also stated that even though the inflation forecast increased from 1.3% to 1.7%, the change was largely due to expected rises in energy prices.  He pointed out that core inflation still remains low, although the risk of deflation has more or less dissipated.  In a retort to his critics who criticized the asset purchase program, Draghi pointed to stronger employment numbers as evidence that his policies are having the desired impact.  The euro has remained unchanged, trading at about 1.057, suggesting Draghi’s statements are more or less in line with market expectations.

Although we believe political risks have decreased in recent weeks, we are still skeptical of the reliability of polls.  As mentioned in prior reports, populists can overcome unfavorable poll numbers due to a very loyal and motivated supporter base.  As a result, populist candidates like Geert Wilders in the Netherlands and Marine Le Pen in France may be able to pull off upsets in their respective elections.  A win by Geert Wilders on March 15 could give Marine Le Pen a major boost in April as her supporters will try to replicate populist success in France.  If either Le Pen or Wilders are able to pull off a win, it will likely have a negative effect on European equities as it could substantially increase the likelihood of a Eurozone breakup.  The purchase of German bonds could help hedge against currency risks in the event of a Eurozone breakup.

Earlier this morning, the American Healthcare Act, the Republican replacement to the Affordable Care Act, has cleared its first hurdle by making it out of the House Ways and Means Committee.  Despite this victory, the bill is still unlikely to become law in its current form due to bipartisan opposition in Congress.  The American Healthcare Act, also known as Trumpcare/ Ryancare depending on where you read, has received criticism from Democrats for not doing enough for low-income households and Republicans for not completely repealing Obamacare.  Although we are pessimistic about the bill’s chances of making it out of Congress, if Trumpcare/Ryancare were to become law it could be bearish for equity markets, particularly for healthcare equities.

The price of Brent Crude and WTI has dropped substantially after U.S commercial crude oil inventories rose 8.2 mb, well above the forecast rise of 1.4 mb.

Oil inventories have reached a new record high.  As the seasonal chart below shows, we will likely see inventories hit new highs in the coming weeks.

Seasonally, stockpiles are mostly following their usual seasonal pattern.

This chart shows the indexed inventory pattern for the past five years along with this year’s indexed data.  As the chart shows, we are mostly in line with seasonal behavior.  Inventories will tend to rise into the middle of next month and then begin their seasonal withdrawal period.

 

Based on our oil/euro inventory price model, the fair value for oil is $34.04.  Comparing oil prices to the euro yields a fair value of $37.91, and we are down to $29.33 using only oil inventories.  Yesterday’s hard break in prices appears to be the realization that, despite OPEC’s efforts, inventories are not falling enough to justify current prices.  We do expect to see refinery operations rise in the coming weeks which should help ease the growing overhang.  But, as the seasonal chart shows, we still have another five to six weeks of potentially bearish stockpile data.  Further weakness in oil is likely.

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

[Posted: 9:30 AM EST] Populist candidates in both France and the Netherlands are seeing their polling numbers deteriorate.  In France, Marine Le Pen is holding at around 26% support, which is a statistical dead heat with Emmanuel Macron.  She was leading by up to seven points last month.  Mostly her support has held around 25%, but Macron has seen his numbers improve to close the gap.  Second round polls continue to show that Le Pen will gain about 42% of the vote, not enough to win the election.  In the Netherlands, Geert Wilders’s Party of Freedom has slipped to second place at 23%, behind the center-right People’s Party for Freedom and Democracy, led by Mark Rutte, at 25%.  Wilders was polling in the mid-30s in early January.

In light of Brexit and the Trump win, there are concerns about the reliability of polling.  The last Brexit polls were 48%/46% in favor of remain; the outcome was 52%/48% in favor of leaving.  The RealClearPolitics average poll two days before the U.S. election was 46.8% for Clinton and 43.6% for Trump.  The actual outcome was 48.2% for Clinton and 46.1% for Trump.  The poor performance of the polls seems to be due to a number of factors.  The demise of land lines has made telephone polling more difficult and sampling errors appear to be higher. There is also some evidence of preference falsification, where voters may tell pollsters they are voting for a candidate they actually don’t intend to vote for.

While there is great concern about the French vote, Macron holds a 30-point margin over Le Pen in runoff polls.  Although we saw an eight-point swing with Brexit, a 30-point swing to give the vote to Le Pen would be massive.  Again, we wouldn’t necessarily count Le Pen out; after the initial vote next month, we could see conditions change in the runoff.  Macron is essentially running as a candidate without a party.  He is somewhat inexperienced and could make a political mistake.  But, from where we are now, it seems more likely that Le Pen will not win the presidency.  If she loses, we would expect a short-term rally in the EUR.

The Dutch elections are more certain.  Although Wilders could still win a plurality, none of the other parties will be willing to join him to create a government.  Still, if his party gets 30% of the vote, it will either force a “grand coalition” of center-left and center-right parties or force the center-right to cobble together a coalition of small conservative parties.  Either situation will likely be unstable and lead to ineffective governments.

All this suggests the Eurozone will continue to deal with high levels of political uncertainty going into the German elections in the fall.  We would not be shocked to see the current Italian government fall.  Given the high level of dissatisfaction in Italy with the Eurozone, an election there could lead to a serious disruption of the single currency.  So, for now, we expect the EUR to struggle due to political conditions.

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

[Posted: 9:30 AM EST] In Washington, the wheels of policy continue to move forward.  The GOP has offered its first swing at replacing the Affordable Care Act (ACA).  It keeps many of the more popular measures, such as pre-existing condition coverage and child coverage up to age 26.  It does jettison the individual coverage mandate, replacing it with a 30% penalty to renew coverage if allowed to lapse.  All the taxes surrounding the ACA would be repealed.  Two popular proposals, including a national market for insurance (allowing policies to be sold across state lines) and malpractice reform, failed to make it into the bill because these measures would require a filibuster-proof majority in the Senate.  This new version would be part of budget reconciliation, which only requires a majority in the Senate.

We place low odds that this proposal will pass in its present form.  We expect the Democrats to oppose the measure since it reverses the bill the party passed under President Obama (the ACA).  But there isn’t all that much unity in the GOP for the bill either.  This new version is strikingly similar to the ACA and that won’t be lost on most observers.  Still, some movement on health care will allow Congress to move forward on a budget and tax policy.

China’s forex reserves rose modestly in February to $3.005 trillion, up from $2.998 trillion, a $6.92 billion rise.  This is the first rise in reserves in eight months.  China has tightened rules on foreign investment, which has thwarted a number of overseas mergers and acquisitions.  The rise in reserves could be signaling that these measures have had some effect, although we note that the Chinese New Year also fell mostly in February, which may have distorted the measure.  Still, the rise in reserves does give the Xi regime some breathing room and may ease pressure on the government to add additional measures to restrict outflows.

The Reserve Bank of Australia left rates unchanged, as expected.  The AUD rose modestly on the news.  The ECB meets on Thursday; although no change in policy is expected, the markets will pay close attention to forward guidance.  The Eurozone economy is showing signs of improvement and inflation has lifted, although the latter has mostly been a function of rising oil prices.  If the ECB’s guidance remains unchanged, we could see the EUR weaken.

Peter Navarro, President Trump’s head of the National Trade Council, again called out Germany for its massive trade surplus and accused the country of using the Eurozone as a cover for policies that triggered the growing surplus.  Although Navarro’s economic nationalism lies outside mainstream economic thought, we agree with his analysis of Germany’s policy mix.  Germany has effectively colonized the Eurozone through its saving and investment policies, creating conditions where other nations in the group, especially in the southern tier of Europe, cannot compete with German productivity.  Without the ability to depreciate their currencies, these states must either depress their labor costs through unemployment to improve competitiveness or rely on Germany to expand its economy to raise wages in Germany and improve the southern tier’s competitiveness.  Germany is forcing the former condition on the southern tier, which has been negative for their economies.  However, this inter-Eurozone condition has tended to weaken the euro, making it more competitive with the rest of the world.

What does seem to be lacking from Navarro’s analysis is a recognition of the dollar’s reserve status.  As the supplier of the reserve currency, the U.S. must run trade deficits because a surplus would effectively reduce the global money supply, cutting global economic growth.  If the Trump administration makes good on its promises to reduce the trade deficit, there will be fewer dollars available for the global economy and, very likely, a slowdown in the global economy.  We note today that the OECD is warning that the upswing in financial markets and surveys, by itself, won’t necessarily guarantee a stronger global economy.  The OECD is currently forecasting global GDP growth of 3.3% for 2017 and 3.6% for next year.  This is roughly average for the past decade.  The G-20 meets next week in Germany.  We will be watching to see how the Trump administration handles its first major international meeting.

Finally, in an update to this week’s WGR, North Korea has banned Malaysians in the country from leaving in response to the ouster of the North Korean ambassador from Malaysia.  This makes Malaysians in North Korea virtual hostages of the regime.

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

[Posted: 9:30 AM EST] There were two news stories of note over the weekend.  First, President Trump accused the previous administration of wiretapping his campaign.  This is a very significant charge, akin to Nixon’s “plumbers” breaking into the Democratic National Headquarters.  The FBI and the former Director of National Intelligence have denied the charges.  James R. Clapper, the former Director of National Intelligence, was on the Sunday news shows denying that any such activity took place.  Unfortunately, Clapper’s veracity is seriously in question given that he gave false testimony to Congress in 2013 related to the NSA’s program to capture phone data on U.S. citizens.

We don’t know whether this happened or not.  There was clearly some surveillance of the campaign tied to Russia; that’s why Michael Flynn is no longer in the White House.  However, we do know that any time spent by Congress or the White House investigating this issue is a distraction from fulfilling the president’s agenda.  And, since political capital is perishable, delays increase the odds that less will get done.

We have updated our election cycle chart.  The blue line in the chart below shows the rebased S&P 500 Index behavior for a new GOP administration.  The red line shows the current situation.  So far, the pattern is holding reasonably well.  In fact, the current level has gotten a bit ahead of itself recently.  Much of the surge is based on assumptions that the president will accomplish tax reform and deregulation.  If the administration finds itself bogged down by other issues and the agenda’s momentum stalls, it will be hard to keep the market up as we head into the latter half of the year.

The other issue is North Korea, which we will discuss in the most recent WGR to be published later today.  In our report, we take a look at the recent assassination of Kim Jong Nam, the older brother of the current leader of the Democratic People’s Republic of Korea, Kim Jong Un.  North Korea launched four ballistic missiles over the weekend, three of which fell in Japan’s exclusive economic zone in waters off the island nation.  The launch coincides with annual military drills that South Korea and the U.S. are about to conduct.  According to reports, North Korea is improving its missile technology and will, in time, be able to reliably reach the U.S. with an intercontinental ballistic missile.  The U.S. is considering deploying the Terminal High Altitude Area Defense (THAAD) system, which could shoot down any North Korean missiles that are aimed at South Korea or Japan.  It probably wouldn’t be able to shoot down a North Korean missile aimed at the U.S.  We note that the weekend NYT reported that the U.S. has tried to deploy cyberweapons to disrupt the North Korean missile program; although we have seen a series of failures in recent years, it is clear that progress is being made.

North Korea has become a nearly unsolvable problem.  Although the U.S. would probably prevail in a conventional attack against the Hermit Kingdom, the costs of war would be high.  South Korea would suffer tremendous damage and China may come to the aid of its ally like it did in the first Korean War.  Simply put, as long as North Korea isn’t a direct threat to the U.S., there is little stomach for triggering a costly war.  However, if North Korea sufficiently threatens the U.S., the cost calculus will change.  We continue to closely monitor conditions in North Korea.  So far, financial markets are taking this all in stride.  After all, if North Korea were an imminent threat, the Japanese yen would be collapsing.

Finally, we note that the CPC has been meeting in Beijing in anticipation of the important autumn meetings that will “re-elect” Xi Jinping to a second term.  Today, Li Keqiang, the premier of China (equal to a U.S. VP), lowered the GDP growth target to 6.5%.  That target is still quite lofty and probably unsustainable.

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