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

[Posted: 9:30 AM EST] It’s Veteran’s Day—thanks to all those who served.  The cash Treasury markets are closed but the futures are trading.  Equities are open all day.

BREAKING: Vice Chair Fischer said this morning that policy rates will rise more slowly and less high than in previous cycles.  This statement will be dollar bearish, Treasury and equity bullish.  However, in reading the speech, it isn’t clear if his statements reflect the election of Donald Trump.  Fischer’s speech is on the international impact of Fed policy; if trade is impeded, these international effects will change. 

It has been quite a week, to say the least.  Although it is early, there is a definite shift in market expectations.  We appear on the cusp of reflation.  President-elect Trump has figured out that no amount of stimulus will lift prices and reap the full benefits of growth until trade is restricted.  Thus, we have seen a sharp swing in Treasury yields.  Even though we would expect a retreat in yield during the next recession, it is likely that the secular bond bull market that began in the early 1980s is coming to a close.

The chart above shows the 10-year T-note yield from 1921.  Perhaps the most important issue to remember is that when the last secular bear market began after the lows were made in 1945, the next peak took 36 years.  It took eight years before yields doubled.  Although the regulatory environment is different, it takes a while for bond yields to reach really high levels.  Still, the tailwind for financial assets that this bull market represents is noteworthy.

Surprisingly, the other winner has been Britain.  The GBP swooned after Brexit and the selling accelerated after PM May indicated she was going to start the process of exiting the EU in February.  However, President-elect Trump has indicated he wants to rekindle the “special relationship.”  In addition, Trump has shown a special affinity for Brexit and views his own election as a continuation of the Brexit sentiment.  If the U.S. and U.K. press ahead with improving relations, it will give PM May leverage in her negotiations with the EU.

The chart above shows the GBP/USD exchange rate.  Note the sharp decline around Brexit and in October when the Article 50 announcement was made.  Over the past week, we have seen a steady rise in the exchange rate on hopes that Trump will have warmer relations with Britain than Obama had.

The Iranian government claims its oil production hit 3.9 mbpd last month, up 0.2 mbpd.  Outside sources dispute this number, suggesting Iran’s output was mostly steady with September.  Iraq also claims its production was 4.8 mbpd, about 0.2 mbpd higher than outside sources report.  It does seem that OPEC producers are trying to ramp up output in front of the November 30^th meeting in order to claim a larger market share, which should mean that if production cuts materialize, the cuts will come from a higher base for individual nations.  These announced increases, even if they are exaggerated, will tend to weigh on oil prices.

There will be much to sort out in the coming weeks as all of us try to determine what the Trump election means for markets, the economy and society.  However, we feel pretty confident that reflation is underway.  How the markets and the Fed react to this phenomenon remains to be seen.  But, the steady decline to low inflation, which has been a consistent part of the landscape for over 35 years, is changing and it will mean a different world from what we have been accustomed to.  We believe it is manageable, but it will be different.

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

[Posted: 9:30 AM EST] The Trump rally continues this morning; so does the bond selloff.  Like all analysts, we are still trying to figure out how the Trump administration will govern.  To some extent, we are seeing a bit of “hope and change” being projected on the markets with assumptions of regulatory rollback and tax cuts for all.  Because Trump’s plans are not detailed, it is easy to cast hopes that many favorable changes will emerge.  There will obviously be significant changes but probably not as much as the current euphoria suggests.

Still, one trend that does seem to be emerging is that Trumponomics will likely be a combination of policies that could be profoundly stimulative.  Trump does appear to be planning a large fiscal stimulus that will include infrastructure spending coupled with tax cuts and tax reform.  The usual problem with such policies, beyond the expanding deficit, is that some of the stimulus is lost to imports.  However, if you couple the fiscal stimulus with trade barriers, there is less leakage and more growth.  Of course, there is a downside (isn’t there always!); the more trade is restricted, the greater the potential for inflation.  The Fed will likely react to rising inflation, although the degree of the reaction will be dependent on the composition of the FOMC.  The issue of Fed independence is critical to how strongly the central bank reacts.  If it reacts strongly, we could get a “Volcker dollar.”  If the Fed is restrained by political pressure, the dollar still rallies but not nearly as much as if rates remain accommodative.

If this is the scenario, it will likely end secular stagnation for the U.S. but lead to much weaker global growth.  The boost to the U.S. economy will be profoundly popular with the populist classes, less so for the establishment, who will lose some of the benefits of globalization.  From a market perspective, we will likely see rising interest rates, a stronger dollar (the magnitude determined by Fed policy), stronger equities and weaker global growth and foreign markets (America First!).

Here is an interesting quote from Sen. Sanders.

Donald Trump tapped into the anger of a declining middle class that is sick and tired of establishment economics, establishment politics and the establishment media. People are tired of working longer hours for lower wages, of seeing decent paying jobs go to China and other low-wage countries…To the degree that Mr. Trump is serious about pursuing policies that improve the lives of working families in this country, I and other progressives are prepared to work with him. To the degree that he pursues racist, sexist, xenophobic and anti-environment policies, we will vigorously oppose him.

It isn’t much of a stretch to see the Warren/Sanders wing supporting much of what we have outlined above.  They won’t necessarily like the tax changes but will probably get behind the trade activity.  And, it should be noted that the president can do much on trade unilaterally.  Tax policy will be harder because it will need Congressional support.

In a surprise move, earlier this week, Indian PM Modi abolished the existing banknotes of INR 500 ($7.50) and INR 1000 ($15.00).  Thus, they are no longer legal tender, although they can be deposited into the banking system until December 30.  This is a big deal; 86% of the value of all cash in circulation is denominated in these bills.  This was done to undermine corruption and apparently prevent further counterfeiting.  He did say that new INR 500 notes will eventually be issued along with the creation of an INR 2000, probably with greater protections to prevent counterfeiting.  One of the potential outcomes from this decision could be an increase in gold demand.  India is the second largest consumer of gold, buying 848.9 metric tons of gold last year.  Uncertainty about the state of Indian currency might lead households to buy gold as a store of value, which is already a factor in gold demand.

U.S. crude oil inventories rose 2.4 mb compared to market expectations for a 1.5 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, inventories tend to stabilize into the end of November and decline into year’s end.  Refineries are coming back from maintenance, which boosts demand.  Still, inventories remain quite elevated.

Based on inventories alone, oil prices are overvalued with the fair value price of $39.89.  Meanwhile, the EUR/WTI model generates a fair value of $45.64.  Together (which is a more sound methodology), fair value is $41.96, meaning that current prices are above fair value.  Most likely, the divergence from fair value is due to hopes of an OPEC deal that would boost prices.   The IEA warns today that non-OPEC producers are raising production, suggesting that Brazil, Canada, Kazakhstan and Russia could raise output by up to 0.5 mbpd.  Given current OPEC output, cuts ranging from 0.8 mbpd to 1.3 mbpd will be necessary to bring output down to the target range of 32.5 mbpd to 33.0 mbpd.  With non-OPEC output rising, 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] In an upset perhaps even exceeding Truman/Dewey, Donald Trump, a real estate mogul with no military or government experience, defied polls and betting sites, winning the Electoral College vote last night.  Although there are still some states that have not officially declared their results, Trump has secured 276 electoral votes, exceeding the 270 needed to secure victory.  Here are our thoughts:

The Political Impact

The establishment is deaf: In our taxonomy of the American political system, we recognize two categories and four blocs.  These are the establishment category and the populist category.  Within the establishment, there are two blocs, the rentier/managerial and the entrepreneurial/ disruptor.  Populists break down into left-wing and right-wing populists.  After WWII, the Roosevelt coalition was built on the rentier/managerial and right-wing populists.  That coalition began to break down in the mid-1960s due to attempts to include the left-wing populists and the inability of the economy to cope with inflation.  The Reagan coalition was the establishment category; they all agreed on deregulation and globalization for economic policy and wooed the populists on social concerns.  This coalition was less stable than the Roosevelt coalition because it relied on center-right or center-left political leaders to sway populists (the so-called “base”) to their positions.  The 2008 Financial Crisis signaled the end of Reagan’s coalition.  We are still trying to figure out what will emerge.

However, what is clear is that the populist classes won’t be satisfied with just social policies.  They want economic policies they favor, which will likely mean a retreat from globalization and deregulation.  Obama’s 2008 victory was completely misinterpreted by the establishment and the political pundits (and perhaps by the president himself).  In 2008, voters thought they were getting Bernie Sanders—instead, they got another establishment president.  Offered the same choice in 2012, they simply opted for the familiar.  However, the 2016 election was clearly a signal of revolt; Sanders nearly won and Trump shocked the political world by beating a well-funded and experienced group of GOP candidates.  We still believe that if Sen. Warren had run, she would have won decisively.  The electorate wants a populist that will create an economy to help the bottom 80% of households.  Expect to hear the pundits state that “this wasn’t Trump’s win but Hillary’s loss.”  We strongly disagree; although Clinton was a flawed candidate, the issue wasn’t her inability to campaign, it was that she didn’t have a message that resonated.  Remember, the electorate didn’t get what it wanted with Obama; it wanted a populist.  Instead, it got a center-left establishment figure from the rentier/managerial category.  Clinton’s decision to run as a continuation of Obama’s legacy was a mistake.

This is also why the polls and betting sites performed so poorly.  Polls can’t deal with preference falsification and betting sites are skewed by the size of the bets.  This is the third significant polling failure in the past six months.  Trump, Brexit and the Colombia referendum on FARC were all missed badly by the polling industry.

What do we get with Trump?  We believe a president has his greatest power in the first 18 months of his first term.  Once the midterms loom, the attention of Congress shifts and little gets done.  Usually, the president’s party loses power at the midterm (although this might not occur in 2018 due to the high number of Democrats up for election in the Senate) and little moves forward afterward.  We believe that immigration will top Trump’s agenda, with trade a close second.  Ending Obamacare will come next.  Fourth on the list will be fiscal spending with an emphasis on infrastructure.  Any openings on the Supreme Court will be filled with conservatives; there will be at least one opening and, given the ages of the justices, perhaps more.  These will consume political capital and attention.  Tax reform is down the list and will likely be less radical than currently proposed.  We would expect cuts in corporate taxes and no increases in tax rates on upper income households, but the cuts currently outlined probably won’t occur or will be less aggressive.  Elements of the GOP establishment will try to put tax changes at the forefront; we don’t expect their efforts to succeed.

Who is Trump’s cabinet?  Under normal circumstances, GOP figures would be lining up to take positions after being out of power for eight years.  However, Trump alienated much of the intellectual figures on the right.  Thus, he will have a smaller pool from which to derive his advisors.  For Secretary of State, former House Speaker Gingrich or Sen. Corker are likely choices.  Former Ambassador John Bolton is a possibility, although he would be out of step with Trump’s isolationist leanings.  Treasury will likely go to Steven Mnuchin, a vet of Goldman Sachs.  Defense will probably go to Sen. Sessions.  Lt. Gen. Flynn should get a national security post.  Former NYC Mayor Giuliani will likely become Attorney General.  Wilbur Ross could get Commerce Secretary.  Ben Carson or Florida Gov. Scott have been mentioned for Health and Human Services.  Harold Hamm is thought to have the inside track on Energy Secretary.  Myron Ebell has the inside on EPA, although he might be too controversial.  It isn’t clear who will get Chair of Economic Advisors.  Finally, there are reports that Reince Priebus could get Chief of Staff.

Overall themes of a Trump presidency: We look for “America First” to be the guiding principle.  As we will discuss in next week’s WGR, we expect Trump to be a Jacksonian (using Mead’s archetypes), which is essentially isolationist unless provoked.  Putin and Xi would be well advised not to make overt moves that make America look weak.  Russian planes that buzz U.S. warships risk being shot down and Iranian vessels that harass U.S. warships in the Persian Gulf will likely be sunk.  On the other hand, a steady encroachment into the South China Sea, Eastern Europe or the Fertile Crescent will be tolerated.  Trump will discover that trade barriers are a bit like “whack-a-mole,” in that putting tariffs on one state means other nations try to fill the gap.  Still, we expect trade barriers and “administrative guidance” against firms that have moved jobs offshore.  Technology and the substitution of capital for labor will likely become the best way to control labor costs.

Market Issues

Watching the Fed: With fiscal spending likely and tax cuts possible, along with restrictions on immigration and trade barriers that will decrease efficiency, inflation becomes more likely.  As we have noted before, in our opinion, globalization and deregulation were key in containing inflation.  Although the latter should mostly remain in place, the former will come under threat.  The key issue is the reaction of the FOMC.  We have had an independent Federal Reserve since 1951, although one could argue that it was compromised by Nixon in 1971 and not restored until Volcker in 1978.  Trump has been critical of Chair Yellen.  It is probably safe to assume Trump would prefer accommodative policy (he just didn’t like it for Obama/Clinton).  There are two governor vacancies on the FOMC that Obama never filled.  Trump will likely fill these and, if/when he does, it will give us an idea of what sort of monetary policy he favors.  The GOP establishment would tend to favor hawkish policies; after all, they are creditors and prefer low inflation and higher rates.  However, Trump’s core supporters are populists who are debtors; they would like more accommodative policy.

Here is one of the key issues we will be closely watching—does the Fed lean against the inflationary impulses that will probably emerge from a Trump administration and risk the central bank’s independence?  Or, will it bend to Trump’s position and allow reflation?  Another way of putting it is this—will we get the Fed of the 1970s of Burns and Miller, or the Fed of the late 1970s of Volcker?  If it’s the former, bond yields will rise, the dollar will sink and commodity prices will increase.  If the Fed stands against these inflation impulses, the dollar will rise, bond yields will remain contained and commodity prices will fall.  Although the outcome remains to be seen, our first impression is that we will get a version of the Burns/Miller FOMC.  It’s what the bulk of the country wants.

In the short run, we are seeing spiking bond yields, a mixed dollar (commodity currencies are down sharply, the yen is higher, the euro is steady), a jump in gold and lower equities (but, off their worst levels of the session).  We will have more in the coming weeks on positioning but, initially, we view Trump’s policies as bond bearish (more fiscal spending) and neutral to bullish for equities (health care, materials and defense should shine).  Foreign investing is much more problematic if the U.S. becomes less trade friendly.  Commodity prices and the dollar will depend on the Fed.

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

[Posted: 9:30 AM EST] There isn’t much more we can add on the election at this point.  It appears the financial markets have discounted a narrow Clinton win, but we would still not be shocked to see Trump prevail.  We have been concerned about the reliability of polls and betting sites in this election due to political polarization.  There is a pretty good chance we will know the outcome when we publish tomorrow, although even that outcome isn’t certain.  Given that the financial markets expect a Clinton win, if she does meet expectations, we would not expect a major market reaction.  On the other hand, a Trump win will likely lead to a short, but sharp, equity selloff; most analysts put this in the 5% range.  We are less sanguine and would expect something closer to 10%.  However, the drop shouldn’t last too long.

We got a plethora of data from China overnight (see below).  We want to highlight a couple of items.  Exports (in USD) were weak, falling over 7%.

This chart shows the yearly change in Chinese exports along with the 12-month moving average.  Since January 2015, we have only seen two months with positive readings and the yearly average has been negative all year after steadily declining last year.  China’s export sector is suffering and it’s showing up in two other numbers, the exchange rate and reserves.

This chart shows the CNY/USD on an inverted scale.  As China’s exports began to falter last year, China has been guiding its exchange rate lower.

Foreign reserves have been weaker as well.

In October, China’s foreign reserves fell $45.7 bn.  As the chart shows, the pace of the decline has slowed to some extent, but most of that slowdown probably occurred due to tighter regulations on capital flight.  However, falling exports will tend to lead to a weaker currency and a steady decline in foreign reserves.  With less growth coming from exports, China will be forced to either live with slower growth or use other means to maintain growth.  This may mean more investment (and debt) or, with luck, rising consumption.  Although it may be too soon to tell, we do note that the Xi regime fired its finance minister, Lou Jiwei.  Mr. Lou was an outspoken reformist figure who supported economic restructuring.  Removing him could signal that Chairman Xi intends to maintain the investment model.  The firing was a surprise, although we do note he was approaching retirement age and it was highly unlikely he would have been reappointed.  The fact that Xi decided to fire him rather than allow him to retire suggests the leadership of the CPC wanted him removed, probably for a less independent replacement.

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