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

[Posted: 9:30 AM EST] The big news item over the weekend was the passing of Fidel Castro, the revolutionary leader of Cuba.  The immediate impact of his death on markets will be rather small; as Fidel’s health weakened over the past decade he turned over the day-to-day running of the government to his younger brother, Raul.  Still, Fidel was an important factor in the Cuban government.  Raul, at 85 years old, is expected to retire in 2018.  Thus, we will be seeing a change in power in Cuba.  We don’t expect a wholesale reversal of socialism in Cuba but, without Fidel, we would expect to see a softening of what were often rigid socialist policies under Fidel.

Cuba’s geopolitical importance is that it is near the key U.S. port of New Orleans.  For much of U.S. history, this city was the most critical port for the U.S. economy.  This port was the terminal point for the massive American river system that includes the Mississippi, Missouri, Ohio, Illinois and Arkansas Rivers.  If a foreign power could impinge on New Orleans, it would effectively bottle up the agricultural and material wealth of the U.S.  Controlling Cuba was key to keeping New Orleans safe; that was part of the reason for the Spanish-American War.  When Castro ousted Batista in the early 1950s, the importance of New Orleans had diminished as other forms of transportation were created.  But, when Cuba fell under Soviet influence, Fidel became a significant threat.  The 1962 Missile Crisis almost led to a nuclear exchange that may have been a disaster.  Fidel survived 11 U.S. presidents and was a pain for almost all of them.  Thus, his death will likely lead to an easing of tensions.

Of course, one of the reasons why Cuba might be more malleable is due to the economic collapse of one of its key supporters.  The Saturday NYT had a long report about the newest refugee crisis as Venezuelans are taking small watercraft to island nations in the Caribbean and flooding across the Brazilian and Colombian borders.  The Venezuelan economy is in near collapse and, according to this report, the lack of food is driving Venezuelans to leave their homeland.  Venezuela needs higher oil prices to have any chance for economic recovery, although the distortions caused by the late Hugo Chavez are also a major handicap to the economy.

There has been great hopes for an OPEC deal, but the cartel is still struggling to allocate production cuts.  The key sticking point remains between Saudi Arabia and Iran, although there is disappointment that Russia appears only willing to freeze production.  What is especially galling about Russia’s behavior is that its production is at record levels, meaning OPEC cuts will boost Russia’s market share.  At this point, an OPEC deal hinges on whether the Saudis can live with giving up market share to Iran, Iraq and Russia, which it is also essentially fighting in Syria.  If the kingdom needs higher prices more than it needs geopolitical influence in the Middle East, it will be forced to make what are effectively unilateral cuts in output.  That outcome may be more than the Saudis can stomach.

Finally, in case you missed it, one of our favorite China analysts, Michael Pettis, had an op-ed in the WSJ last week in which he discussed the key role of the U.S. in global trade.  Most importantly, he discussed how the U.S. has been willing to run persistent trade deficits by providing the reserve currency.  This has allowed the global economy to expand and has supported globalization.  Pettis makes it clear, and we agree, that the Chinese economy is in no position to take over America’s role in the global economy.  The last election has also made it clear that the U.S. citizenry is tired of the role of importer and consumer of last resort.  Although Pettis holds out hope that some sort of restructuring is possible, a more likely outcome is a reversal of globalization.

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

[Posted: 9:30 AM EST] Uncertainty continues to plague the European Union as a result of growing populist movements.  Today, Turkish President Recep Tayyip Erdogan threatened to allow refugees to enter Europe after the European Parliament voted to stop talks regarding Turkey’s admission into the EU.  Turkey has received a lot of criticism from the EU for its brutal crackdown following the failed coup earlier this year.  If Erdogan were to carry out this threat it would strengthen populist movements throughout the EU.  Populist leaders such as France’s National Front Leader Marine Le Pen, who plans to immediately withdraw France’s membership from the EU if elected, have exploited peoples’ frustrations with slow economic growth and growing immigration.  If populism were to take hold throughout Europe it could lead to the end of the European Union.

The stock market rally is continuing to rise to new highs.  President-elect Trump’s proposals to increase infrastructure spending and tax cuts along with business deregulation have been met with optimism about possible economic growth.  A lot of this growth in optimism can be attributed to beliefs that he is more flexible than most people gave him credit for during the election.  He has recently softened his stance on climate change, Obamacare and immigration.

There is still uncertainty within the oil markets as Russia has only committed to an output freeze and Iran is looking for an exemption.  As a result of this uncertainty, Saudi Arabia has pulled out of “non-OPEC” meetings.  Even though it is widely perceived that an agreement will be reached before November 30, there is growing pessimism within the market.

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

[Posted: 9:30 AM EST] U.S. stock futures moved mostly sideways after reaching a record high over the past two days.  There was little additive news to the macro and political news that have carried the U.S. reflation trade recently.  President-elect Trump gave an interview to the NYT yesterday and commentators generally agreed that his tone has softened from the harsher campaign rhetoric.  A WSJ article suggested that Romney is Trump’s top pick for Secretary of State.  Markets rallied modestly on the news as his policies are expected to be market-friendly.  Two other major personnel decisions are still undecided, although Steven Mnuchin is seen as the most likely candidate for Treasury Secretary and James Mattis for Defense Secretary.

The probability of a December Fed hike was around 85% after the election, but has crept up slowly and has now reached 100% (the likelihood is actually 100.2%).  The chart below shows the level of market expectations for a hike next month.  The market is expecting a 25 bps move, with a very small likelihood that it might move even more (represented by the 100.2% probability).  These expectations follow the strong market rally and comments from several Fed officials indicating their openness to a December hike, including Chairwoman Yellen, who acknowledged that a rate hike may be coming “relatively soon.”

Oil moved lower this morning as participation from Iraq and Iran in an OPEC production cut was left unresolved.  Although Saudi Arabia is still the largest producer in the bloc, pumping 31% of OPEC output, Iraq and Iran have gained market share following the end of sanctions and war.  Iraq is currently the second largest producer of the bloc, pumping 13.5% of the group’s output, while Iran is third with 10.8% of production.  Both countries would also like to expand production.  Their reluctance to cut production means Saudi Arabia would have to shoulder a larger portion of the quota.

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

[Posted: 9:30 AM EST] Equities continue to move higher in the post-election environment.  This rise is coming in the face of virtual certainty that the FOMC will raise rates next month.  We may be starting to see a shift in market sentiment away from the focus on monetary policy toward economic growth.

This chart shows a model of the S&P 500 using the Fed’s balance sheet as the independent variable.  Since 2009, the relationship has been quite close; the mostly sideways market seen since 2014 is consistent with tapering.  However, since the middle of the year, we have seen equities persistently exceed the upper band of the model.  Either equities are overvalued (fair value based on this model is 2029) or the relationship is starting to break down.  We are leaning toward the latter.  Both presidential candidates were calling for fiscal expansion with Trump’s admittedly vague promises expected to be larger than Clinton’s.  If we are shifting toward economic growth and away from policy, it means the FOMC may be able to raise rates and have less impact on equities than the past few years would have suggested.  On the other hand, equities may become more sensitive to economic growth and if there are delays in fiscal expansion or we fail to see growth pick up, equities could be vulnerable to weakness.  In the near term, however, hopes are high that Trump and a GOP Congress will be able to move on policy changes.

We do note that President-elect Trump gave a statement yesterday in which he indicated the U.S. would formally remove itself from the TPP group.  Japanese PM Abe indicated that TPP is “meaningless” without the U.S.  We would agree.

Meanwhile, optimism surrounding OPEC remains elevated.  Nigeria was the most recent cartel nation to comment on the proximity of a deal.  However, in the past hour, oil prices have begun to slide.  We have probably reached a price point that OPEC must now deliver.  If they fail to negotiate a credible deal, oil prices will be vulnerable to a sharp decline.  Given the EUR/WTI relationship since 2012, a 1.06 €/$ exchange rate translates into a WTI price of $35.80.

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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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