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

[Posted: 9:30 AM EST] Yesterday’s market action was a good example of what we expect to see at least through the summer.  As we have noted since the election, President Trump needs to manage two constituencies, the right-wing populists (RWP) and right-wing establishment (RWE).  Although there is some overlap in policy, there isn’t all that much.  The RWP want lots of high paying, low skilled jobs and support trade impediments, immigration restrictions, entitlement protection and regulations designed to support their primary goal.  The RWE want continued low inflation, which requires deregulation, free trade, open borders and entitlement reforms.  Trump really can’t govern without placating both wings.  If he only focuses on the RWE, he risks losing the White House in 2020 to a left-wing populist.  If he only focuses on the RWP, he will struggle to get any legislation through Congress.

When the president seems to focus on the RWP, equities tend to drift, interest rates fall, gold rises and the dollar weakens.  When the president pays attention to the RWE, equities rally, interest rates rise, gold prices slip and the dollar strengthens.  If we expect the president to vacillate between these two constituencies, it means that markets will remain choppy.  At this point, we don’t really expect either side to “win out.”  Instead, we expect more of the same going forward.  However, markets do eventually adjust.  At some point, the markets will establish a verdict on who this president mostly represents.  We don’t know when this will occur but suspect it will be sometime this summer.

On Feb. 20, EU finance ministers must approve Greece’s fiscal plans in order to disburse €7.0 bn in aid.  The IMF has been pressing the EU to write off some of Greece’s debt, indicating that continued austerity is becoming politically impossible to sustain.  The IMF position seems to be that Greece needs even tougher reforms but will be rewarded with debt forgiveness.  The EU (read: Germany) opposes any such debt forgiveness; in fact, German Finance Minister Schäuble said yesterday that if Greece can’t meet its obligations, it should consider Grexit.  At the same time, the EU is less insistent on reforms.  Essentially, EU leaders want to settle a Greek deal before elections are held in the Netherlands, Germany and France (and maybe Italy) this year.  If a Greek bailout is still being discussed during elections, it may be impossible to agree to anything because supporting Greece is politically unpopular.  We expect a deal to get done by the 20^th but, if it isn’t, conditions in Europe could deteriorate and the EUR could weaken.

The IEA is reporting that OPEC has achieved its best compliance in cartel history, achieving 90% of its promised cuts.  The Saudis, showing their seriousness, cut production more than promised.  The 11 members of OPEC that received a quota cut production by 1.1 mbpd to 29.9 mbpd.  This strong performance is lifting prices this morning, offsetting a massive increase in U.S. commercial crude oil stocks last week.

President Trump and General Secretary Xi spoke on the phone yesterday.  Xi insisted that no direct talks would occur until the incoming U.S. president reaffirmed the “one-China” policy, which President Trump did.  This does appear to be a retreat from the earlier controversy over the congratulatory phone call from Taiwan president Tsai Ing-wen shortly after the election.

Finally, the White House announced it is demoting the position of chairman of the Council of Economic Advisors (CEA); the council is a three-member committee that was formed by President Truman.  Usually filled by academic economists, it is responsible for publishing the Economic Report to the President and Congress.  The White House is required, by statute, to submit this report 10 days after submitting the fiscal budget.  It is unclear why President Trump has decided not to fill this committee; it does require Congressional approval and he simply may not want another fight.  It would be difficult to find a reputable academic economist that would support trade barriers and thus, he may not want the internal dissention, although he doesn’t seem to have a problem with internal conflict.  It’s quite likely Trump believes that he has enough economic firepower with Peter Navarro, Gary Cohn and Wilber Ross.  Still, it will be interesting to see who authors the Economic Report to the President this year.

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

[Posted: 9:30 AM EST] Although U.S. equity markets have been generally moving sideways for the past couple of weeks, there have been some interesting developments.  Here are a few items of note:

Greece should leave the Eurozone: In its latest report on Greece, the IMF displayed this sobering chart:

Since the 2008 Financial Crisis, Greece’s GDP level is now about 25% below where it was at the onset of the downturn.  The Eurozone has recovered.  Although the Asian Economic Crisis in the late 1990s was just about as bad in its first year, these nations rapidly recovered.  The U.S. did worse during the Great Depression but a sharp recovery developed after year four and had nearly fully recovered by year seven.[1]  Greece, as the chart shows, has declined and subsequently flatlined.  In the case of the U.S. and Asia, reflation was the key factor behind their recoveries.  Both Asia and the U.S. had fixed exchange rates in the 1990s and 1930s, respectively; the former was due to dollar pegs and the latter was due to the gold standard.  The IMF forced Asian nations to either devalue or float their currencies which led to sharp depreciation that supported recovery.  President Roosevelt’s decision to devalue the dollar compared to gold led to a recovery in the U.S.  Greece cannot use currency depreciation to reflate because of its membership in the Eurozone.  So, barring a German-led reflation in the Eurozone, Greece cannot reflate within the Eurozone.  Greece leaving the Eurozone, by itself, isn’t a big deal for the single currency or the EU.  It’s a small economy and its troubles are well known.  The risk is that Greece leaves and thrives, leading bigger nations, such as Italy and Spain, to consider Itexit and Spexit.  That would create all sorts of turmoil in the EU and the Eurozone.  Greek leaders, seeing this IMF chart, have to at least consider their options about staying in the Eurozone.

The Establishment Strikes Back, Part I: Jim Baker is a senior member of the GOP establishment.  He has held numerous jobs in the Reagan and the G.H.W. Bush administrations, including Secretary of State, Secretary of Treasury and Chief of Staff.  He has been joined by Hank Paulson, also a former Treasury Secretary, and George Shultz, a former Secretary of State and Treasury Secretary, to suggest “a conservative climate change solution” in the form of a carbon tax.  The populist right doesn’t believe there is a human cause to climate change and although this group faces broad derision for its stance, it is quite possible that there are other important factors outside human activity that affect the climate.  Solar activity is a well-documented factor that has an impact on earth climate, for example.  Still, Baker and his cohorts make a solid case.  If humans could be having an impact it makes sense to take steps to limit carbon emissions as a cautionary form of insurance.  And, if we are going to limit carbon, it should be done in the most economically effective manner, which is a carbon tax.  This is a much better plan than the current myriad of market-distorting regulations that are currently in place.  Baker goes even further with his plan.  He also suggests that the proceeds of the tax be distributed back to households as a form of “carbon dividend.”  Although this is something of an economic cul-de-sac, it is important politically; one of the reasons right-wing populists oppose the global warming argument is that they fear the elites will determine that global warming is real and middle class households should pay in the form of higher energy costs so the elites can go to Davos.  The carbon dividend would undermine that argument and, at the same time, change prices enough to affect behavior.  The third leg of their program is also critical; Baker proposes a carbon border adjustment.  Exports from the U.S. to nations without a carbon tax would receive a rebate and imports would have their carbon content taxed (woe to OPEC!).[2]  What makes this plan interesting politically is that it (a) could overcome the objections of the right-wing populists via the carbon dividend, and (b) undercuts the left, both establishment and populist, who have been afraid of a carbon tax and have instead used the less-effective approach of regulation.  Can Baker, et al. sell this plan?  If they can, it may be a signal of a détente of sorts between the right-wing establishment and the right-wing populists, laying the groundwork for further cooperation and the formation of a stronger coalition.

The Establishment Strikes Back, Part II: There is growing concern about fiscal deficits coming from tax cuts and fiscal spending.  Some analysts are suggesting the Federal debt could add another $9.4 trillion over the next decade if Trump’s plans are enacted.  We tend to think these concerns are overblown; the U.S., for example, won’t default on its debt.  However, that isn’t to say we have no concerns about fiscal spending.  Our biggest concern is whether there are enough public investment projects available that would actually generate a positive return for the economy.  Would a new airport in St. Louis be nice?  Yep!  Would it make any airline want to put a hub in St. Louis and improve the efficiency compared to the current airport?  Probably not.  Some public investments are winners—the interstate highway system was a clear one.  The National Parks are probably net winners too.  We doubt most urban light rails will boost growth.  The same is true for defense spending; until you need it, it’s mostly dead spending.  Thus, the key should be the return from the public investment relative to the debt service.  Still, there does appear to be a growing unease in Congress over fiscal spending and debt, which may make it harder for Trump to enact all his plans.  Without fiscal spending, the argument for dollar strength is seriously undermined; this is an issue we are watching closely.

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[1] It should be noted that the U.S. economy promptly dropped in 1937 after Roosevelt attempted to balance the fiscal budget and the Fed raised rates.

[2] https://www.wsj.com/articles/a-conservative-answer-to-climate-change-1486512334?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam and

https://www.nytimes.com/2017/02/07/science/a-conservative-climate-solution-republican-group-calls-for-carbon-tax.html?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam

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

[Posted: 9:30 AM EST] We are seeing the dollar rise this morning along with U.S. equity futures.  There isn’t a lot of news to indicate a reason for the rise in the greenback.  Perhaps the best explanation is that the drop we have seen in the dollar over the past two weeks has mostly been a technical correction.  Momentum indicators, such as the moving-average convergence/divergence indicator and the stochastic indicator, became overbought, suggesting that the market had gotten ahead of itself.  Since mid-January, we have seen the market move from overbought to oversold, and chart traders have probably concluded that the short trade has reached its limit.  Although the dollar is overvalued based on inflation differentials, expectations of tighter monetary policy (Dallas FRB President Harker suggested yesterday that March could be a “live meeting”), fiscal expansion and tax reform (the big one being the border adjustment) all point to a stronger greenback.

It appears that the recent U.S. operation in Yemen had a bigger target—Qassim al-Rimi, the head of al Qaeda in the Arabian Peninsula.  He apparently survived and is now taunting President Trump.  Operations to remove leaders from terrorist groups have been part of the war against these groups since 9/11.  However, this action in Yemen does bear watching.  There has been growing speculation that the U.S. is taking a tougher stand against Iran and there is a temptation to view the proxy war in Yemen as a Saudi/Iranian conflict.  Specifically, National Security Advisor Flynn has been openly hostile to Iran, saying “the days of turning a blind eye to Iran’s hostile and belligerent actions” have come to an end and he has also blamed Iran for Houthi actions against U.S. allies, Saudi Arabia and the UAE.  Although there are elements of a proxy war, the overall conflict is local.  Yemen has struggled to unify for years.  In fact, from 1967 to 1990, Yemen was divided into North Yemen and South Yemen.

There are echoes of this division in the current conflict; in fact, the Houthi military actions are more tribal in nature.  Still, our worry is that the Trump administration could be lured into a quagmire in Yemen as a way of indirectly attacking Iran.  Simply put, escalating the conflict in Yemen would probably be a distraction and “winning” (an undefined outcome at this point) would not significantly undermine Iran.

China’s foreign exchange reserves fell by $12.3 bn in January, a bit more than forecast.

This chart shows China’s forex reserves since 2000.  They peaked in mid-2014 and have steadily declined ever since.  We have seen the level dip under $3.0 trillion, which, being a large round number, is psychologically significant.  However, as the chart shows, the recent decline is simply part of a longer trend.  Why are reserves falling?  One of the key reasons is that the PBOC is trying to prop up the value of the CNY.  Without support, the Chinese currency would be weaker.  Second, falling reserves could signal capital flight; as Chinese citizens move their assets out of China, it lowers the nation’s reserves.  China has been clamping down on capital flows which may account for the slower drain of reserves but the overall trend is probably lower.  Is this necessarily a bad thing?  Not completely.  The buildup of reserves reflected a deliberate policy to use export promotion for development.  If China is restructuring toward consumption, then this level of forex reserves is probably unnecessary.  If, however, the drop in reserves is mostly due to capital flight, then it is a worry because it suggests that Chinese investors are unhappy with developments in the Chinese economy and political system.

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

[Posted: 9:30 AM EST] It was a mostly quiet weekend, at least quiet based on the standards of the new administration.  Super Bowl weekend has become something of a national holiday in the U.S. and last night’s game was one for the ages.  So, even with injunctions and tweets, most of the focus was on the game and the caloric treats that accompany.[1]

Still, there were some articles of interest.  One of the key political battles we have been watching is what we have framed as the “Ryan v. Bannon” match.  Ryan represents the traditional GOP positions favoring low tax rates, balanced budgets (which, by arithmetic, require cuts in government spending), free trade, globalization and deregulation.  Bannon represents the right-wing populists who favor deglobalization, including immigration and trade restrictions, along with defense and infrastructure spending, with little to no regard for deficits.

This battle will have numerous iterations, one of which surrounds corporate tax reform.  The Ryan wing wants to cut the highest marginal rate and allow for all investment to be deducted from taxable revenue (ending depreciation) and expand the base of the tax by ending the deduction on interest payments.  However, the key revenue offset comes from a “border adjustment,” which would tax imports but leave export revenue untaxed.

This border adjustment is complicated and fraught with uncertainty.  If it works as planned, the obvious lift in import prices would be offset by a stronger dollar.  Over time, the adjustment would give an incentive for firms (foreign and domestic) to source investment and production in the U.S., which would boost U.S. employment but also likely lead to retaliation from foreign nations.  The Tax Policy Center estimates that by 2026 the net effect of corporate tax reform will reduce tax revenue by $890.7 bn; if the border adjustment isn’t included, this number rises to $2.07 trillion.[2]  For establishment members of the GOP, the rise in deficits is unacceptable.

However, President Trump has already indicated he is less concerned about the deficit, suggesting that defense spending alone should rise regardless of tax revenue.  He has also vacillated about the border adjustment; on the one hand, if it brings investment into the U.S., it would be favorable.  On the other, it does reduce his flexibility to unilaterally impose trade barriers on nations he feels aren’t fairly trading with the U.S.  We note Reuters is reporting that Kevin Brady, the head of the House Ways and Means Committee, is suggesting he is willing to make adjustments to the program.  Once this horse trading starts, the whole purpose of the tax reform, which is to lower the rate and broaden the base, becomes a mere tax cut, which would lower the rate as exceptions are made to the border adjustment.

Our base expectation is that President Trump will need to placate both the GOP establishment and the populists to succeed.  This involves doing two things, finding common ground between the factions and figuring out the priorities of each side.  Thus, a trade of immigration reform for corporate tax reform that is less revenue-negative might work.  How Trump manages these competing interests will, to some extent, define his administration.  One thing we do expect, however, is that deficits will likely rise. We still expect both defense and infrastructure spending to increase over the next four years.

Other interesting news…Germany’s Finance Minister Wolfgang Schäuble indicated that the EUR is too weak for the German economy and blamed the ECB for this weakness.  As we have noted recently, we would tend to agree with this assessment.  However, Schäuble’s complaints are a bit disingenuous.  It’s true that Germany doesn’t control forex policy; that mandate does reside with the ECB.  However, Germany’s saving and investment policies lead to large trade surpluses and low inflation, which would lead to a stronger currency if the D-mark still existed.  One way Germany could address the overly weak EUR would be to boost its fiscal spending and raise inflation, addressing the currency distortion.

PM May of the U.K. may be facing a revolt within her own party as a group of Tory MPs broke rank and criticized her strategy before parliamentary votes for Brexit.  It is still unlikely that Parliament will reverse Brexit but, without solid support from her party, her bill to exit the EU might become larded with amendments and could lead to a hard Brexit without any trade deal.

Marine Le Pen has launched her campaign for president.  According to reports, she is following the Trump model, suggesting the nation is under attack from the EU and foreign influences that aim to undermine the French system and its economy.  Current polls suggest she will reach the runoff stage (the French electoral system requires a majority; if one does not emerge in the first round, a second round is held between the top two vote winners from the first round).  Due to scandal and disarray, the conservatives are falling in the polls and thus a populist win in France is a growing possibility.  The chart below shows the German and French 10-year sovereigns.  Note the spread is widening as French yields rise relative to Germany on worries about a populist president in France.

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[1] At the O’Grady household, it was flatiron steak tacos with red mole sauce; white chocolate cake for dessert.

[2] http://www.taxpolicycenter.org/sites/default/files/alfresco/publication-pdfs/2000923-An-%20Analysis-of-the-House-GOP-Tax-Plan.pdf

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

[Posted: 9:30 AM EST] It’s employment Friday!  We have a plethora of charts below but, in short, the report was rather mixed.  The payroll survey was surprisingly robust, rising 227k compared to expectations of +180k.  Wages were soft, with yearly average earnings rising 2.5%, less than the 2.7% rise expected and the 2.8% rise reported last month.  The household survey, on the other hand, was a bit of a dud.  The unemployment rate rose to 4.8%, up 0.1%, which was weaker than expected.  The rate rose because the labor force rose 76k while employment actually fell 30k.  Meanwhile, the participation rate rose to 62.9% from 62.7% and the employment/population ratio rose to 59.9% from 59.7%.  We do note that the BLS made benchmark revisions to the payroll survey and has made population adjustments which will affect the household survey going forward.  The revisions to payrolls increased hiring by 408k since 2012; although a big number in total, it’s only about 9k jobs per month.

The market’s initial reaction is that this report will slow the pace of monetary tightening.  We are seeing the dollar ease while equities and Treasuries are rising.  Still, with the revisions, this report is difficult to analyze and may simply be a “one-off.”  After all, it seems unusual that we would see such strong payroll data with falling wage growth.  For details, see below.

The BOJ and the markets had a showdown overnight as the 10-year JGB yield rose to 0.115%, above the central bank’s target of zero.  The general expectation is that the BOJ is targeting a range of -0.1% to +0.1%, so the rate had increased above the target.  Traders then waited…and waited for the BOJ to enter the market.  During the time of usual morning operations, the bank bought ¥452.4 bn of bonds; participants held this was too small and the yield jumped to 0.15%.  In the afternoon, the BOJ bought an additional ¥723.9 bn.  The JPY weakened and yields fell toward the upper end of the target range.  Although the stated purpose of the BOJ’s yield curve management is to lift growth and inflation, the forex markets are making the maintenance of a zero rate a key element to pricing the currency.  Essentially, if the BOJ doesn’t prove that it is willing to expand its balance sheet without limit to maintain a near-zero 10-year JGB, it appears traders will purchase JPY and lead to a stronger currency.

In a similar vein, two members of the ECB’s executive board, Benoit Coeure and Peter Praet, suggested that the central bank is not concerned about the recent rise in inflation because it is caused by rising oil prices.  Since the rise in oil prices is due to OPEC action and not demand, the bank should not end its accommodative policy because the lift in inflation is probably temporary.  Although this is the official reason, we suspect the ECB is worried about a stronger EUR and wants to counteract jawboning coming from the Trump administration that is designed to strengthen the Eurozone currency.

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