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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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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