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

[Posted: 9:30 AM EST] Donald Trump has released a pair of memos that lay out a plan to cut down on illegal immigration into the United States.  The memo expanded the definition of criminal aliens from those who have committed serious crimes to those who have been convicted of any criminal offense.  The change is designed to increase the number of immigrants who are considered priorities for deportation.  The White House plans to use all of its resources to enforce immigration laws, in addition to hiring 10,000 immigration agents to assist with the process.  This new immigration order does not come as a surprise as President Trump campaigned on tackling illegal immigration.

There have been concerns that an increase in the crackdown of immigrants could have a negative impact on the U.S. economy as many industries such as hospitality services and construction rely on them for labor.  It is worth noting that this is not the first time the U.S. has taken such strong measures against immigrants.  In 1954, Dwight Eisenhower deported many undocumented immigrants through “Operation Wetback,” which sought to forcibly repatriate Mexican immigrants. At this time, we don’t believe there will be an immediate impact on the economy, but the president’s aggressive approach suggests that our relationship with Mexico may worsen.  Secretary of State Rex Tillerson and Homeland Security Secretary John Kelly will meet with Mexican officials today and tomorrow to discuss law enforcement cooperation, border security and trade.

In other news, German yields have fallen to a record low due to concerns that Marine Le Pen, the anti-establishment candidate, could win the French election.  As mentioned in our previous reports, polls suggest that she should make it out of the first round of voting.  Popular opinion suggests that she could lose in the second round, but we are a bit more optimistic about her chances.  Le Pen, insistent on Frexit, has led many to look at German bonds as a hedge against currency risk.

Despite Le Pen’s pugnacious rhetoric, her strategy to leave the European Union has been vague.  Earlier in the year, she stated that if elected she would spend her first six months creating a basket of “shadow European currencies” that would be pegged to the reinstated franc.[1]  It is unclear how she plans to structure the basket or whether she plans to maintain a relationship with the European Union after the currency is dropped.  All things considered, we believe that Frexit could lead to the breakup of the Eurozone.

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[1] https://www.wsj.com/articles/marine-le-pen-centers-presidential-run-on-getting-france-out-of-eurozone-1484735580

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

[Posted: 9:30 AM EST] Even with a three-day holiday weekend to work with, there isn’t a ton of news this morning.  The president did appoint a new National Security Director and the pick is being well received.  European and Asian PMI data (see below) generally came in above the expansion line of 50 and above forecast.  Equities remain higher; the dollar is up, gold and Treasuries are lower and oil prices are stronger.

Although Greece was facing a deadline yesterday, the Eurozone blinked and agreed to extend talks for an adjustment in bailout payments.  In return for lowering payments from Greece, the Eurozone wants legislation to enforce structural economic reforms.  The good news here is that the Eurozone has decided not to foster a crisis in a politically uncertain year.  However, this agreement is really more of “delay and pray” by creditors.  The simple truth is that Greece isn’t able or willing to pay; creditors must either negotiate the workout or consider other forms of collateral capture (in the 19^th century, invasion might have been an option).

French polls show that National Front Leader Le Pen is gaining momentum.  Polls continue to show she will win the first round and lose the second but, given how poorly the polling industry performed in the U.K. and U.S., we still think that a Le Pen win in May isn’t out of the question.  On this news, French bond yields rose relative to Germany.

Bill Gates made headlines over the weekend with a provocative interview in Quartz[1] in which he recommended that firms that automate should pay a tax for the jobs they eliminate.  Although such proposals aren’t new, this coming from one of the “godfathers” of the tech revolution is news and suggests that Silicon Valley may be realizing that the unfettered introduction of new technology into the economy may have negative effects that need to be addressed.  Essentially, a “robot tax” is a tax on capital.  It would be quite difficult to create a tax that would have a positive effect on fiscal revenue and at the same time not severely undermine investment.  Still, it isn’t hard to see that this tax would make automation more expensive and may lead some firms to simply add people.  We will be watching this idea to see if it gains any traction.  Although the stories aren’t directly related, the NYT[2] has a long read on how technology is reducing the number of workers needed in oil exploration and drilling.  The reduction of jobs in this area due to the expansion of technology could be thwarted if a tax is implemented on the jobs lost through automation.

Finally, we have been watching China’s capital flight for a while now.[3]  Due to a combination of declining investment opportunities, General Secretary Xi’s campaign against corruption, environmental degradation and the desire for political freedom, wealthy Chinese citizens have been steadily moving money out of China.  Much of it has found its way into U.S. and European real estate, although we are seeing investment broaden.  Capital flight has caused a steady decline in foreign reserves and prompted the government to tighten restrictions on foreign investment.  Reuters is reporting that Chinese conglomerate Dalian Wanda’s purchase of Dick Clark Productions is on hold because the firm can’t get permission to move $1.0 bn out of the country to consummate the deal.  This would be the largest transaction so far that has failed due to Chinese investment restrictions and may dampen other investment areas in the West, mostly real estate.

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[1] https://qz.com/911968/bill-gates-the-robot-that-takes-your-job-should-pay-taxes/?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam

[2] https://www.nytimes.com/2017/02/19/business/energy-environment/oil-jobs-technology.html?emc=edit_ee_20170220&nl=todaysheadlines-europe&nlid=5677267

[3] See WGR, 7/16/2012, The Mystery of Chinese Capital Flight.

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

[Posted: 9:30 AM EST] Equity markets are lower this morning.  We suspect two issues are weighing on sentiment.  First, the two left-wing candidates in France, Socialist Benoit Hamon and hard-left Jean-Luc Melenchon, are holding talks that may lead one of these candidates to drop out of the race.  Hamon is the candidate from the established Socialist party, while Melenchon used to be a member of that center-left group but found it too centrist and started his own party.  Polls show that neither would make it into the second round runoff, most likely against National Front Leader Le Pen.  Latest polls show Le Pen winning 26% of the vote and winning the first round.  Emmanuel Macron, the leader of the breakaway party En Marche!, is getting 19.5% of the vote, while Republican Party François Fillon is third with 18.5%.  Fillon has been hit by a corruption investigation alleging he paid family members to work for him but they did no actual work.  Most polls suggest that Le Pen will lose against either Fillon or Macron in the second round.

However, it should be noted that, combined, Melenchon and Hamon are polling at 25%; if either drops out and can sway those supporters to stay with the remaining candidate, Le Pen will be running against a leftist candidate.  Given the deep unpopularity of the Socialists, if Hamon is the remaining candidate, Le Pen may very well win.  Melenchon may fare better against Le Pen but he is calling for a 100% marginal tax rate on incomes in excess of €360k.  That may prove to be unpopular enough to give Le Pen the presidency.

The chart below shows the spread between German and French 10-year sovereigns.  The average spread runs around 35 bps (with French rates usually exceeding German rates).  The spread has nearly doubled as elections loom.  The first round will be held on April 23; if no candidate attains a majority in the first round (and none have since the 5^th Republic was formed in 1958), a second round is held between the two top performers.  That round would be held on May 7.  The polls show that Le Pen’s support peaks at 35% to 40% against either Fillon or Macron.  However, no polls have been run against the leftist candidates so the markets are justifiably concerned about a Le Pen win if the leftists join forces.  Although negotiations do raise this possibility, we suspect that Melenchon and Hamon won’t be able to reach an agreement.  They have sharp differences and it’s difficult to see either stepping down.  If they do come to a deal, the risks of a Le Pen win in the second round probably rise.

The other issue weighing on sentiment is that it looks like the Ryan corporate tax reform is failing to gain traction; the sticking point is the border adjustment tax, which is proving to be quite unpopular.  Without this provision, it doesn’t appear that the tax change would be revenue-neutral unless the cut is inconsequential.  We suspect the White House would be more than happy to see deficits but much of the Congressional GOP won’t agree with deficit increases.  Much of the equity and dollar rally has rested on corporate tax cuts; if these can’t get passed, it will be bearish for both equities and the dollar.

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

[Posted: 9:30 AM EST] We continue to watch the drama in Washington.  What we find most interesting is that equity markets continue to churn higher despite the turmoil.  We believe there are two reasons for the continued strength.  First, earnings are continuing to edge higher and thus prices should rise so long as multiples remain steady.  So far, the issues in the capitol haven’t led to a loss of confidence.  Second, as we have discussed regularly, we see the Trump administration as the populists against the establishment, or “Bannon versus Ryan.”  As conditions deteriorate, Ryan is winning.  Flynn’s departure and reports of investigations of Russian ties to the Trump campaign will likely pressure the Bannon wing, which seems supportive of Russia.  If the Bannon wing weakens, the void will be filled by the establishment, meaning the Trump presidency evolves from a champion of populist change to a traditional Republican center-right administration.  That means more focus on deregulation and tax cuts, less on trade and immigration restrictions.  Until Trump’s troubles affect the GOP’s ability to pass tax cuts and deregulation, equity markets will remain supported.

Chair Yellen’s comments yesterday were upbeat about the economy.  The Fed raising rates into economic strength isn’t a bad outcome for equities, although it is bearish for fixed income.  She didn’t lay the groundwork for a March hike but made a clear case for at least two hikes, and likely three, from June into December.

With the release of CPI, we can update our Mankiw Rule models.  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 3.75%.  Using the employment/population ratio, the neutral rate is 1.47%.  Using involuntary part-time employment, the neutral rate is 3.00%.  Using wage growth for non-supervisory workers, the neutral rate is 1.95%.  All these models support rate hikes by the FOMC; we suspect that the doves on the committee are focusing on the employment/population ratio, which would call for around three to four more rate increases to achieve policy neutrality.

Although we have seen this situation before, Greece is facing another crisis.  This time, the IMF wants Greece to receive some form of debt relief; although write-offs will eventually occur, the IMF would probably accept restructuring (extend maturities and reduce rates).  The EU (read: Germans) will have none of this and insist that Greece run a primary surplus^[1] of 3.5% of GDP.   This austerity is almost impossible for Greece to achieve but there is little political space for compromise with elections looming across northern Europe.  German Finance Minister Schäuble has made it clear that either Greece meets the EU’s demands or it can leave the Eurozone.  So far, when faced with this choice, the Greeks have caved.  But, at some point, leaving will become more attractive.  The risk for the Eurozone is that if Greece leaves and prospers, it will be difficult for Italy and Spain to stay.  If these nations leave, the Eurozone as we now know it is finished.  How it will evolve remains to be seen but the risks surrounding European investments will be elevated.

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[1] (Total fiscal revenue less (total fiscal spending minus interest payments))/GDP

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

[Posted: 9:30 AM EST] Happy Valentine’s Day!

For a mostly quiet market day there is a lot of news to digest.  Let’s get started!

Flynn out: Yesterday, when Kellyanne Conway suggested that National Security Director Flynn had the full support of the president, we suspected he was doomed.  We have all seen this vote of confidence just before someone gets ousted (most often in sports—when a general manager or owner gives a coach or field manager his “full confidence,” he is usually gone soon after).  We see two takeaways from this situation that affect markets.  First, Flynn’s short tenure and the circumstances of his resignation suggest a chaotic and mismanaged White House.  It isn’t unique to Trump; most new administrations have the air of confusion for at least three to six months.  However, given Trump’s lack of military or government experience, worries about his ability to manage the government are elevated and so this resignation adds to fears that the incoming president will struggle.  And, the more he seems unable to control his message or policy path, the less confidence the markets will have in his ability to get anything accomplished.  Second, Mike Allen at Axios has developed a useful taxonomy for the administration’s tensions when he describes it as the “confrontationalists” versus the “conformists.”  The former, which include Bannon, Conway, Sessions and Miller, want to confront the Washington system and make aggressive moves on both foreign and domestic policy.  We have characterized these members as populists.  The conformists are the Kushners, Preibus, Cohn, Mattis and Tillerson, who want to execute the president’s policies within the framework of Washington.  We have characterized this group as establishment.  Flynn was a confrontationalist and the replacement names would fall into the conformist category, so the former team is losing a position.

If one backs away from the noise surrounding Flynn, there are a couple of oddities.  First, Flynn would have known that his calls were being monitored.  He had deep experience in intelligence and should have been shocked if the conversations weren’t being taped.  The fact that he seemed to have multiple conversations does suggest that he, and his Russian counterpart, may have been consulting superiors.  Second, although the Logan Act could be in play, which makes it illegal for private citizens to negotiate for the U.S., in fact, private citizens are involved in these sorts of things all the time.  When a business leader talks to a foreign leader about investment in a foreign nation, there are potentially policy issues involved.  Few people have ever been indicted under the act and no one has ever been prosecuted.[1]  Thus, the threat of “blackmail” is probably not all that strong.  Think of it this way; if the Logan Act was strictly enforced, no new administration could make contact with foreign governments.  That doesn’t make much sense.

Instead, we suspect that Flynn was trying to create a policy that would be favorable to Russia in return for cooperation against IS.  This is likely a fool’s errand; Russia’s primary goal in the region is to boost its influence through supporting Assad and IS hasn’t been a serious threat to the Syrian leader.  It is quite possible that Mattis and Tillerson don’t support this deal with Russia and opposed Flynn trying to engineer it.  Clearly, Flynn putting the vice president in a bad light is a real problem, but what we may be seeing here is simply a fight over policy and the conformists won.

Our take has been that Trump needs to placate both constituencies.  The person that could prove to be the most powerful person beside the president is the one who shows him the path to this end.  It isn’t obvious to us who that person will be, although if we had to bet, we are watching Jared Kushner.  The equity markets and the dollar are rooting for the conformists.  They would represent establishment policy goals and support low inflation.

Yellen to Congress: The Fed chair goes to Capitol Hill for her semiannual testimony.  Currently, the fed funds futures put the odds of a March rate hike at 30%.  Although we don’t think the case for a rate hike is all that strong, we suspect Yellen would like the flexibility to raise rates in March even if the board decides to stand pat.  Thus, we would not be shocked to see a rather hawkish speech today even if the FOMC decides not to hike next month.

Is Merkel in trouble?  Reuters is reporting that the three leftist parties in Germany probably have enough support to form a government.  Current polls suggest the SPD and Greens have about 38% support in the electorate; to form a government, the SPD would have to accept the hard-left Linke Party, which is seeing 10% support.  Given proportional voting rules, 48% would probably be enough to form a narrow majority in the Bundestag.  The key question is whether or not the SPD, a center-left party, could accept a coalition with the Linke.  The latter wants to pull out of NATO, is open to a new security agreement with Russia and wants the removal of all U.S. bases from Europe.  It also supports debt relief for European nations.  We suspect the SPD would rather join with Merkel’s coalition but would want a much larger profile in the new government.

Kim Jong-nam dies: According to numerous media sources, Kim Jong-un’s estranged older brother, Kim Jong-nam, has died in Malaysia.  Although unconfirmed, it does appear he may have been poisoned, supposedly by North Korean operatives.  The elder Kim had been critical of his sibling’s government; if he was assassinated, it adds to evidence of the brutality of the North Korean regime.

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[1] https://fas.org/sgp/crs/misc/RL33265.pdf

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

[Posted: 9:30 AM EST] On Friday, Fed Governor Tarullo announced his retirement.  Although his term ran until 2020, there was growing speculation he would leave.  He has undertaken the role of lead regulator, a position that Dodd-Frank created but was never filled.  It was expected that President Trump would fill the role and, when he did, Tarullo would resign.  There are a number of names swirling around as replacements.  David Nason, who was on Sec. Paulson’s TARP team, is thought to be the front-runner.  John Allison, former head of BB&T (BBT, 46.63), and Tom Hoenig, former KC Fed president and current FDIC chair, are also being considered.  Based on our scoring, Tarullo is rated a “5,”[1] making him a hard dove.  Although we don’t know how Nason would vote, we would expect him to be a moderate, making him a “3.”  Hoenig and Allison would likely be hard hawks, or “ones.”  Tarullo’s last meeting will be the March gathering, and his leaving changes the voting average from 3.5 to 3.3.  Simply put, Tarullo’s departure from the FOMC does make it a bit more hawkish.  Potentially, President Trump could turn the board more hawkish when he fills this slot.

Interestingly enough, Scott Alvarez also announced his retirement last week from the position of general counsel of the Federal Reserve.  His guidance has been to deregulate; we would look for Yellen to replace him with someone less inclined in this direction.

In addition to Tarullo’s position, two open governor positions remain on the FOMC.  The names being floated include John Taylor (yes, that John Taylor of the “Taylor Rule”), Kevin Warsh and Glenn Hubbard.  Although Taylor appears hawkish, we suspect he would be more moderate in practice.  We would rate him as a “2,” or a moderate hawk.  Warsh’s positions are a bit less clear but we would probably rate him a “2” as well; he is less of an academic in terms of monetary policy and more of a regulatory expert.  Hubbard is probably a “3”; he is a conservative economist but well regarded and cautious.  Any two of these three would tend to move the FOMC in a more hawkish direction.

Chair Yellen begins her semi-annual report to Congress tomorrow.  If the FOMC is considering a hike at the March meeting, we would expect her to begin preparing the markets for a move.  Presently, the market only has around a 35% likelihood of a rate hike next month.

Treasury nominee Mnuchin appears likely to be confirmed this evening.  Current speculation is that he is picking mostly establishment types for important deputy and undersecretary positions, including  Jim Donovan, who was part of the Romney campaign and a former Goldman partner (GS, 242.72), and Justin Muzinich, former Morgan Stanley banker (MS, 44.70) and policy director for the Jeb Bush campaign.  David Malpass looks poised to get a role at the Treasury as well.

In the populist/establishment box score, we note a long article in the NYT over the weekend on David Cohn, who is head of the National Economic Council and former Goldman Sachs COO.  The report was favorable for Cohn, seeming to suggest he has a steadying influence.  With Mnuchin’s confirmation and his expected selections, the establishment is filling seats which should give them a bigger voice around Trump.

Finally, there are rumors swirling that Gen. Michael Flynn, current National Security Advisor, may be on his way out as it appears he may have discussed lifting sanctions on Russia after the election.  Not only is this potentially illegal, he told VP Pence he didn’t discuss sanctions and Pence relayed that report to the media.  From a market perspective, this isn’t necessarily a market mover.  However, we mention it for two reasons.  First, Flynn probably rests in the populist camp and is undoubtedly a Jacksonian.  He is particularly negative on Iran and, if he is ousted, tensions with Iran may ease somewhat.  Second, it should be remembered that President Trump ran a popular reality TV show where he fired people.  It would not be out of character for him to move quickly against someone who has lost his favor.  That could be true for the entire cabinet.

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[1] We use a “1 to 5” scale, with 1 being the most hawkish and 5 the most dovish.