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

[Posted: 9:30 AM EST] The weekend’s news flow seemed to be all about the president-elect.  Perhaps the most interesting was an interview in the Hollywood Reporter[1] with Steve Bannon, the incoming president’s chief strategist.  Bannon outlined his policies and it dovetails with our read on him and the incoming administration.  Bannon describes himself as an “economic nationalist.”  He views himself and the incoming administration as similar to Andrew Jackson, a position with which we would agree.  His goal is to support the working class who have mostly been on the negative side of globalization and deregulation.  In particular, he appears to want to create a coalition similar to Roosevelt’s.  This coalition was a combination of center-left establishment and right-wing populists.  Bannon’s appears to be comprised of center-right establishment and right-wing populists.  However, we have serious doubts that the center-right can accept the goals of the right-wing populists.  We have noted Ralph Nader’s book, Unstoppable, which called for a political coalition of populists on the left and right.  Although still a long shot, the likelihood of such an outcome is probably higher than it’s been for a while.  We continue to closely monitor comments from Sen. Sanders with regard to the president-elect’s policies.

A WSJ article[2] today highlights the uneasy relationship between the center-right and the right-wing populists.  Here is a good quote:

One group, which appeared ascendant in the closing weeks of the campaign, largely rejects mainstream economic thinking on trade and believes eliminating trade deficits should be an overarching goal of U.S. policy.  That camp views sticks—tariffs on U.S. trading partners and taxes on companies that move jobs abroad—as critical tools to reverse a 15-year slide in incomes for middle-class Americans.

The opposing camp is closer to the traditional GOP center of gravity on taxes and regulation and includes many policy veterans staffing the transition team and advising Vice President-elect Mike Pence.

Those advisers have long championed supply-side economics and reject the hard-line position on trade that one side’s gain must come at the other’s expense.  By offering more carrots—slashing red tape and taxes to make the U.S. the top destination for businesses—they say stronger growth would obviate any need for trade protectionism.

If the latter group wins, we will probably get a fairly standard issue plan of deregulation, tax cuts and pressure on the FOMC to raise rates.  Trade protectionism will be token, if at all.  If this side wins, we would expect Trump to be popular on Wall Street but probably a one-term president.  If the first group wins out, the economy will be much different; trade barriers will rise, reregulation will occur and tax cuts will be modest at best.  This outcome would be unpopular for Wall Street but wildly popular in the “flyover zone.”  At this point, it’s unclear who will win.  But, for the most part, this is one of the key issues.

In foreign news, Chancellor Merkel has made it official.  She will run for another term.  At this juncture, she will likely win in next autumn’s elections.  On the other hand, if there has been any trend it’s that betting on the establishment has been a poor wager.  It also appears that the Italian referendum is in trouble.  The FT notes that Chairman Xi was actively wooing Pacific nations in light of the Trump win, the end of the “pivot” to Asia and the end of TPP.

Finally, oil prices are higher again this morning in anticipation of an OPEC deal.  This lift is flying in the face of a stronger dollar and the massive inventory overhang.  We expect a deal of sorts to be made.  We also suspect it will be far short of what is necessary to boost prices and will disappoint the markets.  If we are right, prices will trend toward $50 per barrel into Nov. 30^th and pull back in the wake of the meeting.  Overall, however, oil prices are mostly in a $40 to $50 trading range; we expect that to hold.

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[1] http://www.hollywoodreporter.com/news/steve-bannon-trump-tower-interview-trumps-strategist-plots-new-political-movement-948747

[2] http://www.wsj.com/articles/inside-donald-trumps-economic-team-two-very-different-views-1479643204

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

[Posted: 9:30 AM EST] It was another quiet night with lots of political speculation and some news.  Gen. Michael Flynn was apparently offered National Security Advisor, and Sen. Jeff Session has been offered Attorney General, according to the AP.  Meanwhile, in the markets, we are seeing some moderation in recent trends, which looks more like position-squaring in front of the weekend.

Reports from the OPEC meeting are mixed.  On the one hand, all the comments from the meetings seemed quite optimistic.  However, there is a noticeable lack of substance coming from the meetings.  Iran and Iraq both want a deal as long as they can produce as much as they want.  Nigeria and Libya want exceptions due to persistent unrest in these countries.  Russia wants a deal as well, but has indicated its contribution will be to freeze production levels at current record levels.  As is usually the case, OPEC will put together a deal if the Saudis are willing to shoulder most of the burden of market share loss.  For the most part, the Kingdom does not want the swing producer role.  The unknown here is whether financial conditions have deteriorated enough for the Saudis to accept the market share loss for higher prices, knowing full well that American shale producers, bolstered by a Trump presidency, will likely keep raising production on the back of higher prices.  Our expectation is that we get a widely trumpeted agreement with little substance.  If so, expect some market disappointment in oil, but probably not a drop much more than $40.  However, we are growing more concerned about the dollar’s strength, which, thus far, has not weakened oil as much as we would normally expect.  To some extent, the dollar rally is putting more pressure on OPEC to make a substantive deal.

With the release of CPI data, we can update our versions of the Mankiw rule model.  This 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 by 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 3.50%.  Although this rate is well above fair value, it dropped 5 bps over the past month on the dip in core CPI.  Using the employment/population ratio, the neutral rate is 1.13%, down 17 bps.  Using involuntary part-time employment, the neutral rate is 2.73%, down 14 bps.  And, for the new model using yearly wage growth, the neutral rate is 1.71%.  To some extent, the Mankiw models, based off the Phillips Curve, do suggest that the FOMC is behind the curve but the degree of stimulus has actually eased over the past month.  Thus, the case for a rate hike has weakened to some extent.  However, we don’t expect this will change the expectations for a December hike.

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

[Posted: 9:30 AM EST] In terms of market and economic news, it was a fairly quiet night.  Chair Yellen gave testimony before the Joint Economic Committee of Congress.  The prepared remarks were, for the most part, unremarkable.  There was no mention of the new president which, for Yellen, is probably prudent.  Until policies are actually enacted, there is no point in joining the speculation.

Meanwhile, speculation abounds about Trump’s cabinet and what will actually occur with stimulus and such.  The WSJ suggests that Trump may be leaning toward an infrastructure bank, which would probably have less impact than direct spending.  However, it is worth remembering that Trump appears to be a more “shoot from the hip” sort of manager.  He probably hasn’t completely made up his mind.  What appears to be going on now is an attempt by the populists among his advisors and friends to make major changes that were popular with the working class voters (trade impediments, immigration reform, major infrastructure spending), whereas the establishment center-right is trying to focus Trump’s precious political capital on tax reform and deregulation.  We suspect Trump will continue to allow the two sides to fight each other before making a decision on where he leans.  Thus, the current lack of clarity will likely be with us for another week or so.

The BOJ proved its mettle overnight; last month, the bank indicated it was changing its policy.  Instead of targeting a steady expansion of its balance sheet, it indicated instead that it would simply target the 10-year JGB at 0% and buy all the bonds necessary if yields rise above that level.  It worked like it was designed today; as the 10-year approached zero, the BOJ indicated it was in the market.  Yields promptly eased.  This program probably makes more sense and would become quite powerful if coupled with fiscal spending.

A cautionary tale is emerging from Europe.  Since the end of WWII, the U.S. has effectively demilitarized Europe.  After being the source of two world wars, the U.S. decided that the only way to ensure the continent wouldn’t do so again was to take over its security.  European militaries have, to a greater or lesser extent, atrophied over the years.  The further removed we are in time from this decision, the more current leaders have forgotten why this policy was implemented in the first place.  All that is seen now are the costs; the benefits of not fighting a land war in Europe (or, God forbid, a nuclear one) are mostly forgotten.  President-elect Trump has indicated he considers NATO questionable and thinks Europe should be responsible for its own defense.  Roderich Kiesewetter, a foreign policy spokesman for Merkel’s conservative coalition, suggested today that Europe may need its own nuclear deterrent if the U.S. is no longer willing to protect it through NATO.  If Europe remilitarizes, it would reduce some of America’s military burdens, but the cost would be that we may not be able to control European defense policy.  Although it seems inconceivable that Europe could behave in a belligerent manner, given the Cold War history, the first half of the 20^th century offers a stark lesson as to what Europe is capable of.

U.S. crude oil inventories rose 5.3 mb compared to market expectations for a 1.0 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, seasonally, we should see inventories tend to stabilize into the end of November and decline into year’s end.  This week’s rise worked against that seasonal pattern and suggests we are seeing importers catch up from this summer’s tropical storm disruptions.

Based on inventories alone, oil prices are overvalued with the fair value price of $37.97.  Meanwhile, the EUR/WTI model generates a fair value of $43.10.  Together (which is a more sound methodology), fair value is $39.53, meaning that current prices are above fair value.  The divergence from fair value is due to hopes of an OPEC deal that would boost prices.  Saudi Arabian officials indicated today they are hopeful a deal will be done, which lifted prices this morning.  However, the current strengthening dollar and rising inventories make it clear that OPEC really needs to make credible cuts at the Nov. 30^th meeting.  If it fails, oil prices could fall into the high $30s.

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

[Posted: 9:30 AM EST] After a day of profit taking, the previous trends have returned; the dollar is up as are Treasury yields.  Gold prices are lower.  Oil prices are giving back some of their large gains from yesterday as the API data showed a larger than expected build in stockpiles.  The official DOE data is out at 10:30 EST.

The media remains focused on President-elect Trump’s transition.  We are watching this too but with some degree of restraint because, at this juncture, it’s a bit like what’s going on in baseball.  In the latter, this is “hot stove” season, where trades are made and free agents are soon to follow.  Baseball writers are floating all sorts of trade packages and tracking down rumors of deals.  Although it’s great sport, it will be a bit of time before actual transactions occur.  The same is true for the new administration.  Names are being floated about; a great deal of electronic ink is being deployed in commentary.  But, the “decider,” Trump, has been rather quiet about his choices.  Until people are actually named to positions, we are not going to comment about his choices and the impact on policy.

It appears we are seeing a battle within the transition team between the populists and the establishment.  The latter does seem to be trying to sway the new president into a traditional center-right package of tax cuts and hard money.  For example, David Malpass, an economic consultant with supply side leanings to the Trump campaign, is on the tape this morning calling for the Fed to create a plan to shrink its balance sheet.  We suspect this would lift long-term interest rates; how much rates would rise depends on a number of factors but, barring a recession, it is difficult to see how this would lower rates.  Similar talk has emerged about appointing hawks to the two open Fed governor positions.  The establishment wants the new administration to focus on tax cuts and deregulation.  Fiscal spending, trade restrictions and immigration curtailment would be, at best, back burner concerns for the establishment and probably not enacted.  The populists could probably live without hard money and tax cuts but really want to see infrastructure spending, immigration control and trade impediments.  Our read is that if the establishment wins, Trump will likely face a primary challenge by a populist in 2020, and the Democrats won’t make the same 2016 mistake and will run a candidate from the Warren/Sanders wing of the party.

Meanwhile, we are seeing the dollar strengthen.  What is occurring in China is especially notable.

This chart shows the CNY/USD exchange rate (inverted scale).  The Chinese yuan is making new lows this morning.  Such weakness will likely trigger Trump’s campaign promise to declare China a “currency manipulator.”

We are also seeing rising rates abroad.

This chart shows the yield on the 10-year German sovereign.  After falling into negative territory for the first three-quarters of the year, we are seeing a sharp rise in rates.  In our standard bond model, a 100 bps change in this yield adds 23 bps to the U.S. 10-year T-note.

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

[Posted: 9:30 AM EST] It looks like we are getting a profit taking day across the financial and commodity markets, with Treasuries, oil and gold rallying, while the greenback takes a breather.  Equities are modestly higher.  We see a couple of items in play.  First, numerous markets have moved significantly in a short amount of time off the Trump win and may have overshot a bit.  Second, we may be in the early stages of discounting the second order effects; in other words, tighter monetary policy coupled with a stronger dollar will create a rather significant headwind for the economy down the road.  Consequently, until we actually see the degree of fiscal stimulus, the markets may have moved too far, too fast.  Still, we do think that the populist movement underway will undermine the current policy regime and ultimately lead to higher inflation.

In Syria, the Russians and Assad government have resumed air strikes against Aleppo.  The lone Russian aircraft carrier, Admiral Kuznetsov, has apparently made it to the coast of Syria and is assisting in the air campaign.  However, the Guardian reports that a MiG-29 crashed shortly after takeoff from the carrier; the pilot did bail out before the aircraft plunged into the sea.  It appears that the Assad regime, with Russian support, is moving to affect the situation in Syria during a period of distraction in the U.S.  In related news, President-elect Trump and Russian President Putin reportedly had a cordial conversation in the wake of the election.  Meanwhile, President Obama, in what is probably his last foreign trip, is in Europe letting leaders there know that the new president remains committed to NATO.  However, it should be noted that a large number of European nations are boosting their defense spending in light of the American election.

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

[Posted: 9:30 AM EST] The Trump market effect continues this morning; equities are flat to higher, but the most consistent market action has been in interest rates and the dollar, which continue to march higher.  Like everyone else, we are trying to determine the impact of Trump’s policies for the economy and markets.  At present, the focus seems to be on who is in key positions on his team.  Some establishment members are being paired off with populist insurgents and it isn’t clear if we are going to get a standard issue GOP agenda (tax cuts, deregulation) or a populist program (protectionism, deglobalization and reregulation).  The inside track seems to be for the standard issue program, because the Washington establishment knows how the system works and can get policies executed.  The populists don’t have that knowledge.  However, the Sunday papers make it abundantly clear that if Trump doesn’t execute at least some high profile populist goals, such as immigration control and trade impediments, then Trump shouldn’t bother with a second term and 2020 could bring us a left-wing populist.  This is going to be a “stay tuned” situation.

The Trump global effect also continues.  Francis Fukuyama had a good op-ed in the weekend FT in which he examines the rise of economic nationalism in the West.  Here is a salient quote from his piece:

The world today is brimming with economic nationalism. Traditionally, an open trade and investment regime has depended on the hegemonic power of the U.S. to remain afloat. If the U.S. begins acting unilaterally [ed. “America First”] to change the terms of the contract, there are many powerful players around the world who would be happy to retaliate, and set off a downward economic spiral reminiscent of the 1930s.

In the Sunday NYT Review section, Ruchir Sharma of Morgan Stanley had a solid analysis of the dangers of deglobalization.  Essentially, world growth slows, inflation rises and the dangers of war increase.  We are seeing emerging markets weaken in the face of Trump’s election.

The issue of monetary policy is less visible but equally important.  The Sunday NYT had a report on GOP desires to reduce the power of the central bank.  There is growing speculation that Janet Yellen could be replaced with John Taylor.  If he were to implement his Taylor rule for optimal interest rates, Haver Analytics calculates the fair value rate for fed funds at 1.78%.  Appointing Taylor would lead to a more mechanistic Fed and higher rates.  Wolfgang Münchau of the FT is suggesting that the consensus surrounding central bank independence is weakening.  This makes sense; in an era of reflation, it is consistent to force the central bank to accommodate fiscal spending (of course, we doubt John Taylor would join such a Federal Reserve—this is an example of the traditional vs. populist GOP).  In the meantime, expectations of policy tightening have increased.

The chart above shows the implied three-month LIBOR rate, two years deferred. Note the recent spike in the implied rate.  This puts the fed funds target at 135 bps two years from now, up about 35 bps from prior to the election.  Essentially, the election of Trump is acting as a policy tightening.

Finally, we do want to note that there are growing calls from left- and right-wing populists in Italy to reject the December 4^th referendum on government restructuring in Italy.  If the vote fails, PM Renzi will likely resign and the potential will rise for further financial problems in Europe.

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