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.

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