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

[Posted: 9:30 AM EST] The primary market theme this morning appears to be a broad reversal of the so-called “Trump trades” that have dominated the markets since the election.  We are seeing weaker equities globally and the dollar is weaker, while Treasuries and gold are doing better.  There are two factors that need to be separated from these markets moves.  First, a portion of this action is simply normal market adjustment.  The trend in the Trump trades has been pronounced and relentless.  Some market reversals for profit taking and position squaring make sense.  Second, one must determine where the interpretation of the Trump trades may have been in error.  The idea is that reversals that are merely “a pause to refresh” should be viewed as positioning opportunities.  Reversals based on mistakes may have more “legs.”

For example, it’s hard to see how trade restrictions will be bullish for bonds or stocks.  Deglobalization will tend to be inflationary, leading the Fed to raise rates and generally leaning against profit margins and growth.  Thus, the rise in bond yields make sense; the broad rally in equities less so.  This doesn’t mean that certain parts of the equity markets won’t do well.  Financials will be supported by regulatory relief and rising rates.  Energy should receive regulatory relief and the Ryan tax plan may tax oil imports, giving more support for domestic small cap equities.  Small and mid-cap stocks, due to their lower exposure to overseas markets, should outperform large caps.  However, populist policies favor equality over efficiency, which isn’t good for capital because it favors labor.  Thus, Trump’s policies may prove to be less supportive for the broad equity market, and consequently the fall in bond yields probably wouldn’t last and any weakness that develops in energy or financials may be a buying opportunity.

This chart shows the distribution of national income to capital and labor (the numbers don’t exactly add to 100 because we don’t include government’s share of national income).  From the late 1960s into the early 1990s, labor’s share averaged around 66% and capital about 28%.  Since the early 1990s, capital has been gaining share in each expansion cycle of the business cycle.  The current average share of labor in this expansion is around 61.5% compared to 36% for capital.  The deteriorating position of labor is probably behind the rise of populism.

Trump’s policies against trade are, in part, a bid to improve the labor share at the expense of capital.  These measures may not help all that much because, in a floating exchange rate environment, the dollar will likely rise to offset many of these measures.  This morning, for example, we are seeing a sharp drop in the dollar; although the dollar is technically overbought and due for correction, we expect Trump’s tax and trade policies to lead to dollar strength.  About the only way that the dollar’s rise can be stopped is if the Federal Reserve is badgered into holding rates steady.  We would not expect this outcome; thus, we see the dollar’s weakness as a technical correction, not a longer term change in trend.

Finally, as a side note, the Italian Constitutional Court rejected a request for a referendum on Renzi’s labor market reform.  This union-led request, if allowed, would have probably triggered new elections.  By rejecting the bid, the odds of an Italian election this year are reduced.

U.S. crude oil inventories rose 4.1 mb compared to market expectations of a 2.0 mb build.

This chart shows current crude oil inventories, both over the long term and the last decade.  We have added the estimated level of lease stocks to maintain the consistency of the data.  As the chart below shows, inventories remain elevated.

We won’t publish the annual seasonal pattern chart this week because, by design, the first week isn’t meaningful.  It will return next week.  We do note that the build is rather large this week which suggests OPEC cuts have not affected U.S. supply.  Of course, now that the cartel is officially reducing production, we should see a slower than normal build in the coming week.

Based on inventories alone, oil prices are overvalued with the fair value price of $41.79.  Meanwhile, the EUR/WTI model generates a fair value of $35.94.  Together (which is a more sound methodology), fair value is $36.05, meaning that current prices are well above fair value.  OPEC has managed to lift prices but maintaining these levels will be a challenge given the dollar’s strength and the continued elevated levels of inventories.

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

[Posted: 9:30 AM EST] There was a lot of political and geopolitical news overnight.  The most widely covered were reports that the Russians have compromising information about Donald Trump.  The 32-page report, published last night by Buzzfeed, makes a series of allegations, suggesting that the president-elect engaged in salacious behavior in Moscow, Trump campaign officials made numerous contacts with Russian officials and the Wikileaks were used to divulge information about Hillary Clinton and members of her campaign for “plausible deniability.”

It should be noted that these allegations circulated among the media well before the election.  They didn’t get a lot of traction because news organizations could not establish their veracity, but that doesn’t mean there isn’t an element of truth in them.  Russia’s two short-term goals are to get sanctions lifted and to rebuild influence in its near abroad.  Although it isn’t completely obvious that Trump would help in this area, Clinton was a known quantity and it was abundantly clear she would have bolstered NATO and pressed to keep sanctions in place.  Thus, trying to support Trump and undermine Clinton was a reasonable policy for Russia.

One of the more interesting sidelights of this affair begs the questions of why is this material coming out now and why did the intelligence agencies allow it to come to light?  It is plausible that the intelligence agencies are not happy with the incoming president and wanted to signal to him that they do have the ability to affect his presidency.  Trump holds a press conference at 11:00 EST this morning.  How he handles this issue will be worth monitoring.

Will this issue be enough to seriously undermine his presidency, leading to impeachment or resignation?  Probably not, but it should be noted that it might compromise his leadership to some degree.  It is important to remember that the establishment wings of both parties oppose many of Trump’s campaign promises.  Using this issue to prevent aggressive immigration reform or trade restrictions is not out of the realm of possibility.

At the same time, it should be remembered that foreign nations try to affect U.S. elections as a matter of course.  The fact that the Russians were so obvious about it suggests either a rather profound degree of incompetence or an indication that Putin’s personal loathing of Hillary Clinton got the best of him.  We note Politico is reporting that Ukraine was engaged in measures to support Clinton because it wanted a friendly person in the White House.  This support included reports that the country was investigating Paul Manafort for corruption in activities in Ukraine.  According to this source, Ukrainian officials are rapidly backtracking on these efforts in an attempt to build favor with the Trump White House.

China was in the news as well.  The military sent a strategic bomber near the Spratly Islands.  In addition, the Chinese Navy sent a flotilla of warships, including its lone carrier, the Liaoning, through the Taiwan Strait.  This show of force led the Taiwan military to scramble jets and send its own navy to surveil the Chinese vessels as they moved through the area.  China’s actions triggered Japan and South Korea to scramble warplanes earlier this week.  China’s increased aggression is coming as the U.S. prepares to transfer power and as Chairman Xi (who is speaking at Davos next week, the first Chinese president to speak to this group) is laying the groundwork for his second term, which will begin in November.

On the topic of China, the under-the-fold story in today’s FT reports that Chinese authorities are scrutinizing the bitcoin price surge.  According to the story, Chinese bitcoin exchanges are monitored for large transactions.  We suspect this is true.  However, smaller deals are not closely watched and thus bitcoin may have become the portal of choice for less affluent households to diversify their holdings.  Reuters is reporting that forex regulators are telling banks to keep their regulations surrounding capital exports secret and to let bank analysts know that any negative thoughts on the CNY should be “kept to themselves.”  SAFE, the Chinese regulator that manages forex, has been issuing oral regulations to conceal regulatory changes.  This forces banks to refuse transfer business that they may have performed previously, but the banks have to do so without indicating why.  These measures suggest that Chinese officials are very concerned about capital flight.

Finally, Bloomberg is reporting that Russia has started reducing oil production; as much as 148 kbpd of output may have been shut in.  Russia is notorious for reneging on production cut agreements, so the fact that it appears to have started the process (the Russians have promised cuts of 300 kbpd over the next few months) is remarkable and bullish for crude oil.

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