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

[Posted: 9:30 AM EST] Happy Fed Day!  The FOMC completes its first meeting of the year with a new slate of voters.

This shows the 2017 voters on the FOMC.  The red ‘X’ represents permanent voters.  The 2016 regional bank presidents who won’t vote this year are St. Louis FRB President Bullard, Kansas City FRB President George, Cleveland FRB President Mester and Boston FRB President Rosengren.  Bullard and Rosengren were very dovish, while George and Mester were hawkish.  This year’s average is about the same as last year as the dovish Chicago FRB President Evans and moderate Minneapolis FRB President Kashkari join two hawks, Philadelphia FRB President Harker and Dallas FRB President Kaplan.

As a reminder, the Mankiw rule would suggest the Fed needs to raise rates.  The Mankiw rule model attempts 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, 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 3.79%.  Using the employment/population ratio, the neutral rate is 1.21%.  Using involuntary part-time employment, the neutral rate is 3.03%.  Using wage growth for non-supervisory workers, the neutral rate is 2.01%.  We know that the FOMC tends to support Phillips Curve models of the economy, which suggests there is a relationship between wage growth, inflation and unemployment.  What we don’t know is which of these four models holds the most sway.  However, we suspect the wage growth variation might be the most supported; if so, the Fed does need to start moving rates higher.

The implied LIBOR rate from the two-year deferred Eurodollar futures is projecting a 1.76% rate into the future.

The election of President Trump led the markets to reverse policy expectations and rapidly build in rate hikes.  For most of last year, this indicator was suggesting that slow economic growth and continued low inflation would lead the Fed to raise rates very slowly; in fact, last July, this indicator was signaling a fed funds of 60 bps two years from now.  The interest rate markets expect the new president to boost economic growth and inflation, leading the U.S. central bank to raise rates significantly compared to last summer.

Despite the Fed’s statutory independence, it is under the sway of political influence.  The administration, as we have recently noted, has been arguing that the dollar is too strong.  One of the key components of dollar strength is the divergence in monetary policy between the U.S. and the other major nations’ central banks.  If Trump can badger Yellen into not raising rates as rapidly or as far as the market expects, the dollar will likely weaken.  The risk is that financial markets will begin to build in inflation expectations, which will bring higher rates on long duration assets (which are more sensitive to inflation and less to monetary policy) and could lead to P/E contraction in equities.

What will Yellen do?  Will she cave into what we see as growing pressure on the Fed to be dovish?  Or will she press the Fed’s independence and move rates higher as the interest rate markets suggest she will?  Her history suggests she leans dovish; however, she has publically indicated she opposes fiscal expansion at this stage of the business cycle.  It is too early to tell, but one of the stories shaping up for 2017 may be Trump versus Yellen.  We might get our first clue today.  Although fed funds futures only expect about a 15% chance of a rate hike, we will be closely watching to see what the statement looks like because a hawkish tone could be an indicator that the FOMC is prepared to deal with opposition from the White House on monetary policy.  At present, fed funds futures are not expecting a hike this year until May; the odds for March are near 35%.  The Fed could tee up a hike for March with a hawkish statement.

We are watching a couple of geopolitical items.  First, there has been a notable increase in fighting in eastern Ukraine.  We suspect that Putin is testing the West to see if it will react to further encroachment.  We don’t expect the Trump administration to push back against Russia; any resistance will need to come from Europe.  Although western European nations probably won’t do much, we do note that Poland has a mutual defense pact with Ukraine and if Poland were to send material support and then get attacked by Russia, it could trigger an Article 5 “collective defense” declaration.  Second, the Greek economic and financial crisis is brewing yet again.  Greece and its creditors are in negotiations over bailout support.  Athens has balked at creditor conditions for the next round of disbursements and the creditor nations, many facing elections this year, are loath to give into Greek demands for relief.  PM Tsipras is trying to hold onto a fractious coalition that only holds a five-seat majority.  If the government fails, it would mean another European election this year and add to political uncertainty in the EU.

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

[Posted: 9:30 AM EST] There was a lot of political news overnight but it didn’t have much impact on financial markets.  However, this morning, Peter Navarro, the director of the newly formed National Trade Council, told the FT that Germany is using a “grossly undervalued” exchange rate to “exploit” the U.S. and its EU trading partners.  The EUR rose on the news, indicated by the red arrow on the chart below.

In terms of his analysis of the euro, we tend to agree with him.  Here is our parity model of the euro, using German and U.S. consumer inflation.

Purchasing power parity uses relative inflation to value exchange rates.  The theory is that in a freely floating environment, the exchange rate should move to equalize prices between nations.  So, if cars in Canada are cheaper than in the U.S., Americans would buy Canadian cars but the demand for Canadian dollars would rise as a result and the exchange rate would appreciate to eventually equalize the exchange rate-adjusted prices between the two countries.  Simply put, the lower price levels are in a nation, the stronger its exchange rate.  In reality, it’s only a guide to exchange rate valuation.  For example, not all goods in a consumer price index are tradeable, so relative inflation rates are not perfect proxies for exchange rate valuation.  Trade isn’t frictionless, so deviation in the price of goods can persist even if tradeable.  And, financial factors, such as interest rates, may overwhelm inflation.  However, at extremes, the measure has some value.

The model suggests the D-mark is trading almost two standard errors from the forecast, or around 18% undervalued relative to the dollar.  There have only been two other periods when the dollar has been this strong relative to the D-mark, in the mid-1980s and at the turn of the century.  Eventually, the exchange rate reversed.

Navarro’s claim that Germany manipulates its currency also has merit (although technically it’s Europe’s currency, in reality, Germany effectively controls it because of its economic dominance over the Eurozone).  Germany has traditionally suppressed consumption and boosted saving, macroeconomic policies designed to bring trade surpluses.  Until the introduction of the euro, Germany was typically prevented from expanding its trade surplus due to D-mark appreciation.  However, now that it uses the euro, its European trading partners can’t use depreciation to remain competitive.  Since the euro was introduced, Germany’s current account (trade surplus plus official and private remittances) has ballooned.

These charts show Germany’s current account (the vertical line shows the introduction of the euro) and the Eurozone and German trade accounts with the U.S.  Clearly, Germany and the Eurozone run persistent trade surpluses with the U.S. and the German current account has swelled since the introduction of the euro.[1]

Here are the complications in Navarro’s comments.  First, the Treasury has the mandate for currency policy.  If multiple voices start commenting on exchange rates, it will make it tricky to determine what the administration’s currency policy actually is.  Second, the U.S. runs trade deficits because this is how the system is designed.  As long as we are the reserve currency, other nations in the world have an incentive to adopt the same policies as Germany (and many do, including China, South Korea, Japan, etc.).  The U.S. does benefit from being the reserve currency; we receive goods from the world and give dollars back that are held as savings.  In fact, if these reserves are not immediately spent, those dollars are recycled back into the U.S. financial system in the form of investment, often in Treasuries.  This means that foreigners give us stuff and also help fund our deficit in return for dollars; The Economist describes this condition as writing checks that nobody cashes.  The downside?  If one competes in an industry facing import competition, there is a fair chance one will not be working at some point.  It’s hard to compete in a globalized world.

It appears the administration is figuring out that its goals of reducing the trade deficit and boosting jobs in the U.S. could be thwarted by a strong dollar.  In fact, the controversial border adjustment in the GOP House corporate tax reform bill won’t be inflationary if only the dollar appreciates.  So, the administration is finding itself at cross-purposes.  On the one hand, it wants to create more jobs in the U.S. and is targeting import reduction as a policy to achieve that goal.  However, as long as the dollar is the primary reserve currency, other nations will take steps (e.g., currency depreciation) to maintain import flows into the U.S.  In fact, the more barriers we erect, the more aggressive foreign nations will become because the dollar is still the best currency to use for global trade.

Perhaps the most important person in this whole debate is Chair Yellen.  If the Fed turns more hawkish on fears of inflation and fiscal expansion, the dollar will tend to appreciate.  As we continue to say, we will be watching very closely to see how the president reacts to Fed tightening.  If the Fed faces a strongly negative reaction from the administration, the dollar may not rally much from here.  Of course, the lack of monetary tightening, a weaker dollar and trade impediments are a recipe for inflation and higher interest rates, especially on long-duration assets.

So, the FOMC meets tomorrow.  Current expectations for a rate hike are only at 13%; in fact, they don’t exceed 50% until June (all based on fed funds futures).  This suggests the markets are not expecting an overly hawkish statement.  Stay tuned…

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[1] For a deeper look at this issue, see this week’s WGR.