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

[Posted: 9:30 AM EST] The big news overnight came from the U.K. where the Supreme Court ruled that Parliament must move on Brexit before an Article 50 declaration can be made.  Although this decision is being portrayed as a setback for PM May, it isn’t exactly a huge shock.  A number of legal experts warned that the referendum alone would not be enough to pass constitutional muster and the court confirmed this opinion.  Interestingly enough, Scotland and Northern Ireland MPs won’t participate in this vote as decided by the court.

It doesn’t appear that the results of the referendum will be reversed by Parliament.  MPs have made it clear that they will support the outcome of the referendum.  However, taking the decision to Parliament will, to some extent, remove some of May’s power over the process of Brexit.  Those wanting a “hard Brexit,” especially favoring strict immigration restrictions, may be frustrated.  A number of MPs have indicated that they want to offer amendments to any bills granting May the power to declare Article 50.  Most of the proposed amendments would soften immigration restrictions and press for fewer trade restrictions with the EU.  In other words, the amendments will push for a “soft Brexit.”

It is suspected that May will quickly offer a short bill for Parliamentary approval.  However, it will be difficult for her to limit amendments.  The more amendments that are considered, the greater the likelihood is that the Article 50 declaration will be delayed.  It is also more probable that she will lose control of the process and be forced into a softer Brexit stance.  May has proven to be a leader that controls the process; if the Parliamentary vote forces her to lose control of how Article 50 is executed, political turmoil will likely rise.  This fear probably explains why the GBP is weaker this morning.  In general, the softer Brexit proves to be, the more bullish it is for the GBP.  Thus, news of the Supreme Court’s decision is arguably bullish for the currency but the political tensions it could raise lifts uncertainty and is consequently being taken as bearish, at least for now.

As we noted yesterday, the president formally killed TPP yesterday by pulling the U.S. out of the treaty.  Although there is much media wailing about this action, in reality, TPP was dead a long time ago.  Secretary Clinton had promised not to enact it if she won the presidency; essentially, neither candidate supported TPP or its European twin, TTIP.  Although all the evidence suggests that Trump is going to be more protectionist than previous presidents, one really can’t hang TPP on him.  After all, if President Obama had really thought it had a chance, he could have rammed it through the lame duck session of Congress.  Given the backlash against globalization, there was little chance it would have passed through the legislature anyway.

Bloomberg, citing BOJ sources, suggests that the Japanese central bank is committed to maintaining a zero percent 10-year JGB even as inflation rises.  There has been speculation that the BOJ would set a higher target for the long-dated sovereign in Japan as inflation rose.  Essentially, the BOJ has given up control of its balance sheet.  It is reasonable to assume that the higher inflation rises, the more the 10-year yield would rise in an unfettered market.  Capping the yield, in theory, will require more buying as inflation rises.  Expanding the balance sheet is a quiet method of keeping downward pressure on the Japanese currency.

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

[Posted: 9:30 AM EST] It was a rather tumultuous weekend with the incoming administration sparring with the media over a number of issues.  Those factors are being hashed out in the media so we won’t focus on them.  However, what we are paying attention to is the impact on financial markets.  The dollar is sharply lower this morning; some of this weakness is probably due to the fact that there was so little in the weekend comments from the new government on trade and tax policy.  The inaugural speech was clear that the U.S. will be adjusting its superpower role, something we discussed in the 2017 Geopolitical Outlook under the idea that the U.S. is shifting from a mostly benevolent hegemon to a malevolent superpower.  The speech puts the world on notice that U.S. foreign policy will be about boosting U.S. growth even at the potential expense of foreign growth and stability.

This, by itself, is a major shift in U.S. policy.  It essentially marks the end of how the U.S. has managed the world since 1944.  Although American policy has been successful (the primary goal was to prevent WWIII, which we did accomplish), it hasn’t been cheap.  The U.S. has been forced to increase the size of government (there is no such thing as a small government superpower), expand domestic and foreign surveillance (the U.S. had one intelligence agency at the end of WWII; now, 17), suffer through a series of status quo wars and run persistent trade deficits to ensure adequate global dollar liquidity.  These costs were significant and the burdens were not equally distributed.  Trump’s broad policy, it seems, is to lower these costs and redistribute the burden.

It’s the actual policy measures that are unknown.  We note that this morning the U.S. formally exited TPP; TTIP is also essentially dead, meaning the U.S. won’t be the global pivot for trade rules.  Greg Ip had a report in the WSJ over the weekend suggesting that Trump doesn’t want a broad-based tariff.  Instead, he wants to be able to wield the threat of trade restrictions to encourage foreign firms to build plants and equipment in the U.S. and, at the same time, discourage U.S. firms from doing the same abroad.[1]  That may mean he will reject the Ryan corporate tax reform that includes border adjustments.  These adjustments will reduce the president’s power to affect investment changes.  Instead, Trump has been calling for a large cut in corporate tax rates.  Interestingly enough, without the border tax adjustment, the tax cuts will likely lead to lower government tax revenue.  Trump seems to be signaling a general disregard for deficits.[2]

This leads us to this morning’s market action.  Is the weaker dollar a sign that investors are concluding that Trump’s policies won’t be as dollar bullish as originally thought or is this mere profit-taking (“buy on the election, sell at inauguration”)?  We suspect it is more the latter.  Trump’s policies appear to be reflationary; in other words, he wants to pump up nominal GDP growth.  Under normal circumstances, that should lead to dollar strength as rising nominal growth usually leads to higher interest rates.  For now, we are assuming that the Fed will raise rates faster if inflation rises quicker than expected.

However, that thesis assumes the FOMC will react to higher inflation by tightening monetary policy.  We would not be surprised to see President Trump try to cajole the Fed into maintaining steady rates when faced with rising inflation.  Most of us have spent our careers during a period of central bank independence and support for inflation control.  However, that hasn’t always been the conduct of policy.  Under Fed Chairs Arthur Burns and William Miller, the Nixon and Carter administrations (especially the former) pressed the Fed to maintain easy money in the face of rising inflation.  Carter did reverse that policy with the appointment of Paul Volcker; we note that Carter was a one-term president.  Simply put, we would not be completely shocked to see Trump appoint doves to the two open governor positions and press the Fed to keep rates low despite rising inflation and wages.  If that is the outcome, we are looking at a dollar bear market.  For now, we don’t think this is the most likely outcome but it is one we are watching closely.

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[1] http://www.wsj.com/articles/trump-on-trade-peace-through-strength-1485086400 (paywall)

[2] This is generally not unique; the party that holds the White House tends to be less concerned with deficits and becomes fiscally hawkish when out of power.

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

[Posted: 9:30 AM EST] Happy Inauguration Day!

As President Obama exits the White House and President Trump takes control, the new administration will begin to settle in.  One of the characteristics of any new president and his team is that nearly all the members of the incoming administration are going to face a level of scrutiny they have never experienced before.  There is probably nothing one can do to fully prepare for the experience.  In their former lives, they have usually been accomplished leaders who have developed their own opinions and beliefs.  In most circumstances they can offer their thoughts freely because, for the most part, their opinions don’t change policy.  However, once in a senior advisory or cabinet position, their opinions take on importance.  In watching these transitions over the years (the fifth in my professional life), it is fairly common to hear direct statements that create a media frenzy.  A good example of this was when Paul O’Neil, the first treasury secretary serving G.W. Bush, said 27 days into his term that the U.S. really didn’t always follow a strong dollar policy.  In his previous role as head of Alcoa (AA, 35.42), such statements were unremarkable.  As treasury secretary, they matter a lot.

Thus, investors should be mindful that it takes about six months on the job for an official to recognize the gravity of their role.  After this time period, market-moving comments become less frequent.  In fact, their goal is to reach the level of obfuscation often attributed to Alan Greenspan who reportedly said, “I know you think you understand what you thought I said, but I’m not sure you realize that what you heard is not what I meant.”  So, between now and summer, one should be prepared for seemingly aggressive statements that may move markets but may not reflect policy.

China’s GDP came in on expectations which is no surprise because the number is regularly massaged to meet or slightly exceed target.  We do note that outflows from China appear to have slowed in December but we suspect this is temporary.  The government has been progressively tightening regulations on outflows which have had some impact.  However, history does suggest that Chinese investors eventually figure out ways to evade regulations which will lead to higher outflows later this year.

As a reminder, the Chinese New Year begins on Jan. 28, with the official holiday running from Jan. 27 to Feb. 2.  China effectively closes during this period.  In the Chinese Zodiac, it is the Year of the Rooster.

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

[Posted: 9:30 AM EST] The ECB decided to keep its interest rates low as well as maintain its quantitative easing program.  During a press conference, Mario Draghi expressed his willingness to extend the current monetary policy as growth within the European Union is still relatively slow.  He also stated that he believes growth is imminent and that those who would like him to increase rates should be more patient, stating “as the recovery firms up, real rates will go up.”  This comes in response to critics from Germany who believe rising inflation is imminent.  Reports show that inflation in Germany rose 1.7% annually, a three-year high, as the Eurozone jumped from an annual change of 0.6% in November to 1.1% in December.  Since the rise in inflation has largely been attributed to oil prices, Draghi stated that there is no data to support the idea that underlying inflation has risen significantly enough to justify a rate hike.

Draghi also appears to be cautious of possible global risks that may affect the economic outlook of the EU.  He declined to comment when asked how he thinks Brexit and a Trump presidency might affect growth within the EU.  His lack of clarity is understandable as no one is sure what policy measures Donald Trump will implement or what a deal between the U.K. and EU will look like.  Trump’s call for a possible tariff on German cars along with Theresa May’s statement that she is willing to leave the EU even without a plan make forecasting Eurozone growth relatively complicated.  Draghi’s decision to stay on the current path while leaving the door open for an extension of quantitative easing is probably a safe option.

In other news, Donald Trump is set to take office tomorrow without most of his cabinet, leading many to question how effective Trump will be in his first 100 days in office.  As Trump is less established than his predecessors, he may have a harder time pushing through some of his agendas.  The longer it takes for him to get his cabinet in order, the harder it will be as the Democrats will look to undermine him.  Despite these concerns, many believe he should have most of his cabinet in place by the end of the month.

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

[Posted: 9:30 AM EST] President-elect Trump caused a stir yesterday when he suggested that he doesn’t want a strong dollar.  Some of the commentary we saw suggested that this is nearly “unprecedented.”  That’s not really the case.  Since the dollar began floating under Nixon, presidents have, on occasion, discussed the dollar or had key cabinet members, normally the treasury secretary, try to “jawbone” the dollar.  Nixon was comfortable with dollar weakness.  His treasury secretary, John Connally, told European leaders soon after the collapse of Bretton Woods that the dollar is “our currency but it’s your problem.”  President Reagan initially cheered the stronger dollar as he saw it as confirmation of his policies and he wanted to contain inflation.  However, by his second term, he became concerned about the dollar’s impact on manufacturing so he had his treasury secretary, Jim Baker, organize the Plaza Accord, which was a joint effort by the G-5 to weaken the dollar.  In 1987, after the dollar had declined, Baker, angry at Germany over its policies, threatened to push the dollar lower.  Some have suggested this was a contributing factor to the 1987 Stock Market Crash.  President Clinton’s first treasury secretary, Lloyd Bentsen, openly called for a stronger yen.

The “modern” policy on the dollar was developed by Clinton’s second treasury secretary, Bob Rubin.  Rubin simply said that the U.S. should always support a “strong dollar,” irrespective of how it is actually trading, and at the same time let markets set the exchange rate.  This policy really had no content in terms of the level of the exchange rate.  What it did do was take the exchange rate out of policy discussion and end the practice of using oral intervention to move exchange rates.  Early in President George W. Bush’s administration, his treasury secretary, Paul O’Neil, suggested the dollar was too strong.  The currency plunged and he was forced to backtrack into the Rubin policy, suggesting that if U.S. currency policy changed, he would “rent out Yankee Stadium” to let everyone know.

Since O’Neil’s comment, every subsequent treasury secretary has fallen back on the Rubin dollar policy.  Trump’s comments could be signaling that the Rubin policy may be coming to a close.  If the incoming president decides to start commenting on the level of the dollar, instead of making innocuous comments about the “strong dollar,” it will lead to much higher exchange rate volatility.  It may encourage other nations to make similar comments.  The benefit of Rubin’s policy was that it toned down the rhetoric in the currency markets.  If the policy is being jettisoned, volatility will tend to rise.

At the same time, it is important to note that Trump’s policies appear to be quite bullish.  Tariffs implemented by the reserve currency nation tend to strengthen its currency because it reduces the supply available on world markets.  If the border adjustments are part of corporate tax reform, that is dollar bullish.  If tax reform encourages repatriation of corporate liquidity held overseas, that is dollar bullish.  And, if infrastructure spending and tax cuts boost the economy, it will likely lead to tighter monetary policy (this may be the most interesting issue to watch this year) and, again, a stronger dollar.  Simply put, Trump may try to talk the dollar down but his policies will tend to move the dollar in the opposite direction.

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

[Posted: 9:30 AM EST] The big news item over the long weekend was U.K. PM May’s indication that she is leaning toward what is being called a “hard Brexit.”  In general, a “soft Brexit” would mean the U.K. leaves the EU but the terms are such that not much changes.  In other words, financial institutions in London could still easily access EU markets and there would be a mostly unimpeded flow of EU member citizens across the U.K. border.  A “hard Brexit” is quite different—there would be a return to a stringent U.K. border and the free movement of EU members would no longer be in place.  If this is the U.K.’s definition of Brexit, the EU will almost certainly put up trade barriers on the U.K. and financial institutions in London will probably need to shift into one of the EU financial centers.

The U.K. establishment supported the Remain campaign.  With Brexit, they were leaning toward the soft option.  But May, reflecting the goals of the core Leave constituency, wants the hard option, which means the reestablishment of secure borders.  The EU likely won’t tolerate that decision and will treat the U.K. as an outside power, meaning new trade deals will need to be created.  May has also made clear that she is preparing to leave the EU whether or not there is a trade deal in place with the EU bloc.  Despite her apparent leaning toward a hard Brexit, she has stated that any deal made between the EU and the U.K. will need approval from both houses of Parliament.

The GBP slid on the news over the weekend, falling below $1.200 on fears that a hard Brexit will weaken the U.K. economy, but has since rallied due to the level of clarity provided.  We have seen a reversal in the pound this morning, which is likely due to short covering.  Although fears of a hard Brexit are reasonable, there is evidence that supports the notion that the financial markets, especially the exchange rate, have already discounted much of these concerns.  The chart below shows a simple purchasing power parity model of the USD/GBP relationship.  Purchasing power parity is a way of valuing exchange rates.  Also known as the “law of one price,” it assumes that the exchange rate will adjust to differences in prices between two nations.  Thus, if the cost of living is higher in one nation compared to another, the former will have a weaker exchange rate to ensure the costs of goods between the two nations are equal.  In practice, the method is far from perfect.  To work perfectly, all goods would need to be equivalent between nations and shipping costs would be zero.  Some goods are simply impossible to trade; they are either services that can’t be exported (e.g., haircuts), or impractical for trade (e.g., cooked to order meals).  To calculate parity, we create a ratio of CPI between the U.K. and the U.S.  This clearly isn’t a perfect match; the inflation indexes between the two nations have different baskets with different weights, reflecting the buying patterns in each nation.

Keeping these weaknesses in mind, we have found that parity models are useful at extremes.

Note on this chart that when the exchange rate’s deviations near or exceed two standard errors, a reversal often occurs.  This doesn’t mean that the pound won’t remain weak in the near term; given worries about Brexit, we would not be surprised to see additional declines.  However, it should be noted that this is the weakest the GBP has been against the dollar since the Volcker dollar in the mid-1980s.  We would not be surprised to see the GBP recover soon after Article 50 is declared later this quarter.

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

[Posted: 9:30 AM EST]   Happy Friday the 13th!

Outside of the Chinese trade data (see below), there wasn’t a lot of news. The number from China came in a bit soft as exports fell 6.1% from last year in USD terms. For China, the weaker trade data does create a dilemma. On the one hand, the drag on growth from a narrower trade surplus could, at least in theory, be offset by fiscal spending, rising consumption or investment. The first and third options would not be preferred, whereas the middle option, rising consumption, could weigh on net exports even more because it usually follows from rising consumption as imports increase. The other option is to depreciate the CNY to improve competitiveness. The Chinese are actually trying to stabilize the currency as capital flight has been putting downward pressure on the CNY. We note that bank regulators in China are putting additional restrictions in place, forcing banks to keep their foreign ledgers balanced which will make it more difficult to move money out of the country. It appears that if a bank finds that outflows are larger than inflows, it can’t facilitate the movement out of China. The moves being made by China are looking increasingly desperate and we don’t think they will work over time.

Meanwhile, Fed officials are becoming increasingly hawkish. The general consensus is that the Fed will raise the fed funds target at least twice this year and maybe three times. Chair Yellen held a town hall yesterday. Although nothing of consequence seemed to emerge, she did sound quite optimistic about the economy. Today’s WSJ notes an unusual level of “harmony” among Fed officials about moving rates higher. Over the past two weeks, five of the 12 regional FRB presidents have suggested that we should see two to four hikes this year. The report contrasts information gleaned from the recently released Fed meeting transcripts from 2011 which show a high degree of dissention among the FOMC and the measures that Chair Bernanke was forced to take to contain dissention.

We note that both St. Louis FRB President Bullard and Philadelphia FRB President Harker are calling for shrinking the Fed’s balance sheet. Although Bullard continues to call for only one hike this year, consistent with his narrative that the Fed shouldn’t be in the business of projecting policy, the fact he is also suggesting a reduction in the balance sheet clearly signals a hawkish bias. Harker suggested that once the fed funds target reaches 1%, the Fed should begin reducing the balance sheet by ending the reinvestment process and, over time, actually start selling down the balance sheet. It is unclear how that would affect financial markets. Regular readers are familiar with this chart:

The chart shows a model for the S&P 500 based on the Fed’s balance sheet.  From 2009 into mid-2016 the S&P mostly tracked the asset side of the Fed’s balance sheet.  However, since last summer, equities have started outperforming model, suggesting that equities have shifted from focusing on monetary policy to other factors, mostly likely economic growth and fiscal policy.  In theory, shrinking the balance sheet is a form of policy tightening; if this occurs as the FOMC is raising the fed funds target, it could easily amplify the policy tightening effect.  This is a factor we will be monitoring in the coming months.

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