by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT]

Global equity markets are generally higher this morning.  The EuroStoxx 50 is up 0.4% from the last close.  In Asia, the MSCI Asia Apex 50 closed up 0.1%.  Chinese markets were higher, with the Shanghai composite up 0.2% and the Shenzhen index also up 0.2% from the prior close.  U.S. equity index futures are signaling a higher open.

After a busy week, it’s been a quiet Friday so far.  We wonder how history will deal with the end of Mayor de Blasio’s campaign.  Here is what we are watching this morning:

Misjudging Trump:  We have been getting questions from readers about U.S. Iran policy.  So, here is our response.  It is starting to look like Iran has concluded that President Trump is a bully who will back down when his bluff gets called.  Yesterday, Iran’s foreign minister, Javad Zarif, suggested that a military attack on Iran would trigger “all-out war.”  This is a clear and strong threat.  Throughout its history since the Iranian Revolution, Iran has generally been cautious in foreign affairs.  Although it underwrites audacious acts (e.g., bombing of U.S. troops in Beirut, Khobar Towers bombing in Saudi Arabia), these are usually carried out by proxies or in ways that provide plausible deniability.  In the attack on the Saudi oil infrastructure, Iran tried to follow the same script, with the Houthis immediately taking responsibility.  However, unless the Houthis are hanging out in southeastern Iran or southern Iraq, it probably wasn’t their doing and Iran had to know that it would be hard to maintain that ruse.

After the U.S. failed to respond militarily to the downing of a U.S. drone, the leadership of Iran appears to have concluded that the White House is reluctant to engage Iran militarily.  The U.S. response to the attacks last weekend has done nothing to suggest this assumption is wrong.  So far, the U.S. has responded to what is probably the most significant act against the Carter Doctrine since Iraq annexed Kuwait with sanctions and threats of a military buildup.  This isn’t to say that sanctions haven’t been effective; they have had a major impact on the Iranian economy.  But, between the harsh sanctions and the lack of a diplomatic path, Iran has decided to up the ante.

One of our “go-to” tools in analyzing foreign relations and the reactions of presidents is to use Mead’s Archetypes.  Regular readers are familiar with the four major ones.  We note that these are merely archetypes as no president is a pure reflection of any of the four but all lean toward one.  So, here is how we think each archetype would react to last weekend’s events:

1. Jeffersonian: A Jeffersonian president would be angry that the U.S. was still even in this part of the world, but since we are there we should talk to allies and formulate a response. Military action would be a reluctant and last resort.  This president would not have responded to the drone downing.
2. Wilsonian: The drone downing would have triggered a strong military response. This recent escalation would have led to an ordinance being already in the air.  Although this type would try to avoid escalation, its actions usually end up leading to a broader conflict.
3. Hamiltonian: Always a realist, a Hamiltonian president would be trying to pull out of the Middle East, concluding that China was the real issue and shale oil has made the extensive U.S. commitment to the region unnecessary. However, this president, faced with the problem at hand, would likely attempt to escalate carefully, bombing highly visible but mostly symbolic areas in Iran, e.g. old oil fields that are in decline, secondary industrial sites, etc.  In other words, it would send a signal that the U.S. isn’t happy, but also trying to avoid hitting anything that would lead to escalation.  This archetype would have attacked after the drone downing.
4. Jacksonian: This response would have been identical to the Jeffersonian response. These two types are the most isolationist of the four.  However, if honor is violated, the response is the most aggressive.  So, what would this president react to?  The spilling of American blood or the harming of innocents.  The response to such events would likely be swift and disproportionate.

We characterize President Trump as Jacksonian.  In WWII, Jacksonians were America First supporters…until Pearl Harbor.  Then, they wanted to annihilate Japan and Germany.  If Iran escalates further and an American is killed, or if Iran’s actions kill children, Trump will likely shift to aggression that is stronger than Tehran expects.  However, as long as the escalation avoids these two outcomes, we expect Iran to increase its belligerence, and probably get away with it. As a result, oil markets are probably underestimating the level of risk.

Brexit:  A thaw is developing.  Although a deal is still a ways off, the two sides are clearly trying to come up with a way to reach an accommodation on the Irish border issue.  We have seen the GBP rally on hopes of a deal.  If an agreement is forged, we could see a much larger rally in the currency.

A deal of sorts with China:  Our base position on China is that the U.S. has concluded Beijing is a strategic competitor that will not fold itself into the U.S.-led order.  Because of this a slow decoupling and increased competition is in our future.  However, that doesn’t mean an intermediate deal cannot be struck.  We note the Trump administration has exempted a large number of Chinese goods from tariffs.  U.S. agricultural interests are talking to China as well.  These actions might lead to a limited deal that would improve market sentiment.  At the same time, Michael Pillsbury, a Hudson Institute analyst and key informal advisor to President Trump, has warned the U.S. will dramatically ramp up pressure on China if a trade deal isn’t struck soon.  Pillsbury characterized the current U.S. tariffs against China as “low” and warned they could go as high as 100%.

Monetary policy:  The Fed has conducted open market operations for the fourth consecutive day. The PBOC cut its benchmark lending rate for the second straight month, but only by 5 bps to 4.20%.  The BOJ, on the other hand, cut its purchases across the yield curve in an attempt to steepen it.  We doubt the BOJ can continue this action for long without triggering a strengthening JPY.

India: Prime Minister Modi announced a surprise tax cut that will slash the effective corporate rate to 25.17% from the current 34.94%, putting it on par with many other fast-growing Asian countries.  New manufacturing firms will face an even lower rate.  Indian stocks are surging on the news, but Indian bonds are down on concerns about the fiscal deficit.

Russia:  President Putin has again been forced to back down a bit with his political repression, as he faces strong public outcry over the police beating and jailing of aspiring actor Pavel Ustinov during a protest last month.  The actor was released on bail today.  Putin still has a strong grip on power, but popular discontent is rising and has the potential to destabilize the country.   

Saudi Arabia:  There are reports that the crown prince is “bullying” wealthy Saudi families into large purchases of the Aramco IPO to bolster the price.  Such action is further evidence that the Salman family effectively is “taxing the rich.”

View the complete PDF

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT]

The FOMC meeting turned out hawkish.  Other central banks were active today. Trade negotiators from China begin talks in the U.S. today.  Here is what we are watching this morning:

Hawkish Fed:  The FOMC did cut rates by 25 bps but nearly everything else about the meeting was disappointing for the doves.  The dots plot suggests this will be the last easing that is consistent with the recent easing being more of a mid-course correction instead of being the beginning of an easing cycle.  The dots chart below suggests this will be the last rate cut, a position more in line with a correction than an easing cycle. In fact, based on the 2019 dots, 10 members would either hold rates at the current level or increase them by 25 bps.  Additionally, next year, the board is nearly equally divided on one more cut or raising rates.  The divergence between the FOMC and the markets are stark, not to mention the goals and aspirations for monetary policy from the White House.

Perhaps even more disturbing is the increasing number of dissents. George (KC FRB) and Rosengren (Boston FRB) did not want to cut, while Bullard (STL FRB) wanted a 50 bps reduction (although no dot reflect that desire).  It is becoming clear that Chair Powell is unable to bring the committee to a consensus on policy.  This inability will make it difficult to move policy in either direction.  Simply put, additional easing will require strong evidence that the economy is weakening.  In the press conference, Powell expressed little concern about the repo problems, which is also a bit unsettling, especially since the NY FRB has conducted repo operations again this morning, making this the third consecutive day of such actions.

Market reaction was swift; treasury yields, especially in the short end, jumped, flattening the yield curve.  The dollar appreciated and gold prices fell.  Equities did manage to rise, likely on a positive economic outlook from the FOMC.  The bottom line: the FOMC isn’t poised to aggressively cut rates unless the situation changes.  History tells us that by the time the evidence is clear that the situation has changed, it will be too late to avoid a recession.

Other central banks:  The Bank of Japan kept its monetary policy unchanged, as expected, but Governor Kuroda promised to consider further loosening in October.  With the Fed and other major central banks loosening policy, Kuroda’s statement amounts to an effort to talk the yen down, but it doesn’t seem to be working.  So far today, the yen is up some 0.5% against the dollar.  Also, The Bank of England kept its benchmark interest rate unchanged at 0.75%, as anticipated.  It also warned rates could go either up or down in the event of a no-deal Brexit, but many policymakers say a cut to stimulate demand would be more likely than a hike to support the pound and reduce inflation pressure.

U.S.-Japan Trade:  Economic Revitalization Minister Nishimura said the new U.S.-Japan trade deal will be ready to sign at month’s end.  In a sign of what the UK may face in any post-Brexit deal with the U.S., Nishimura admitted that the government would have to provide additional support to farmers and small businesses that would be impacted by the deal.

Growth prospects downgraded:  The OECD has reduced its forecast for global growth, calling for growth in 2019 at 2.9%, the lowest since 2009.  The group warns that if trade tension remains high, sluggish growth will extend into 2020.

Brexit:  There is some movement in addressing what may be the most contentious element of exiting the EU, the border with Northern Ireland.  PM Johnson is floating the idea of creating a special economic zone for Northern Ireland, which looks a lot like an early EU plan that would put the trade border on the Irish Sea.  More importantly, the Unionist parties appear to be softening their stance on this issue; previously, they had opposed such measures.  Creating a trading zone probably can’t be accomplished before Halloween, but the Leavers would probably accept an extension if a way forward can be made on the Irish border issue.

Israel:  The elections failed to yield a path to a coalition, as a result we will have one of two outcomes.  Either we will see a “national unity government” where the two leading parties form a government, or new elections will be called.  So far, the opposition Blue and White Party has rejected forming a national unity government, meaning elections may be coming next.

Saudi Arabia:  SoS Pompeo made the strongest statement on this issue to date, calling the weekend’s missile and drone attack an “act of war.” The Saudis held a press conference yesterday and all but implicated Iran for the attack.  However, there is little evidence that President Trump has much interest in a military response.  The reaction thus far has been to increase sanctions against an already heavily sanctioned Iran. Pompeo is working to build a coalition against Iran and work within the auspices of the U.N.  Reports suggest the White House is analyzing other alternatives, but it does appear the appetite for kinetic action is quite low.

President Trump campaigned changing America’s hegemonic role, offering to step back from being the “global policeman.”  The lack of a military response to this attack is clear evidence that he is doing what he said he would do.  However, the U.S. isn’t fully in control of the situation.  Iran can continue to escalate; if the only response is sanctions, the mullahs will likely conclude they can act with impunity and engage in additional actions.

Odds and ends:  Commercial land prices outside of Japan’s major cities have posted their first annual rise in 28 years. Congressional leaders reached a deal on a stopgap spending bill that would preclude a new government shutdown through late November.

Energy update:  Crude oil inventories rose 1.1 mb compared to an expected draw of 2.0 mb.

In the details, U.S. crude oil production was unchanged at 12.4 mbpd.  Exports fell 0.1 mbpd while imports rose 0.3 mbpd.  The rise in stockpiles was mostly due to falling refinery demand (see below).

This chart shows the annual seasonal pattern for crude oil inventories.  As we approach the end of the spring/summer inventory withdrawal, we are starting the autumn rebuild period at a sizeable deficit.  Without aggressive increases in stockpiles, we will likely continue to lag seasonal patterns which, on its own, is bullish.

The most important information from this week’s data is that we appear to be starting the autumn refinery maintenance season.

The drop in refinery utilization will likely continue for the next four weeks; utilization should begin to rise by mid-October.  During this period, inventories usually rise.  However, the usual seasonal rise will depend on Saudi production.

Based on our oil inventory/price model, fair value is $68.30; using the euro/price model, fair value is $48.23.  The combined model, a broader analysis of the oil price, generates a fair value of $54.54.  We are seeing a clear divergence between the impact of the dollar and oil inventories.  Given that we are into the maintenance season, we would normally expect inventories to rise.  However, with the Saudi outage, we may see inventories remain constrained, thus prices may find some support from constrained inventory growth.  We note that after claiming oil supplies will be restored by the end of the month, the KSA is seeking to import petroleum products from other nations and for customers it has promised to supply with oil, it is offering less valuable grades.  Oil prices rose on this report. We remain highly skeptical that Saudi Arabia will be back on line by month’s end.

View the complete PDF

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT]

Markets are stable this morning after a wild day in the overnight lending market.  The Israeli elections did not yield a clear result.  The FOMC meeting concludes today.  Here is what we are watching this morning:

The funding problem:  We have received many inquiries on the state of the money markets.  Yesterday, the money markets were roiled by an apparent funding shortage which sent repo rates soaring.

Bids for fed funds reached the 5% level, well in excess of the upper limit of the fed funds target, currently at 2.25%.  For the first time since the onset of QE, the New York FRB conducted overnight  repo operations; the NY FRB was authorized to purchase up to $75 bn of collateral to inject cash into the system with about $58 bn being drawn.  In an unsettling development, the “plumbing” didn’t work initially, and the operation was delayed by about 25 minutes.  The fact that this facility hasn’t been used in over a decade is probably the reason for the delay; it’s possible that a number of people on the NY FRB’s desk had never been involved in such an operation.

However, before we jump into all of that, a bit of history is in order.  The Fed used to routinely intervene with repurchase operations before the financial crisis.  When banks were in the settlement period at the end of the month, banks with excess reserves would lend them to other banks that were lacking.  Occasionally, spikes in fed funds occurred; around holidays, a bank somewhere would find itself short of reserves and by the time they came to the Fedwire, most banks were closed and the ones that were not could lend at a penalty rate.  Usually, the next day, the Fed would conduct repo operations to buy securities and put liquidity back into the system.

Then QE happened, and the traditional way that money markets operated was changed.  The banks were flooded with reserves, so the Fed could no longer guide the policy rate by adjusting the level of bank reserves.  Instead, it began paying interest on reserves and that Interest on Excess Reserves (IOER) rate became how the policy rate was set.  There is no incentive for a bank to lend reserves below that rate, so the IOER has become the effective floor for interbank reserve lending.

Free reserves are total reserves less required reserves and other borrowings from the Federal Reserve.  Other borrowings are very small, so, for practical purposes, free reserves are excess reserves.  As the chart shows, excess reserves in the banking system are $1.386 trillion.  So, at first glance, it seems odd that a shortage would develop.

Here is what we think is happening:

1. Perhaps the most interesting part of this issue is the inability of entities to turn securities into cash. Essentially, that is what a repurchase agreement (repo) is.  This sort of transaction is the lifeblood of finance.  When entities would rather have cash than earn interest on that cash, that signals a problem.
2. As the charts above shows, there are ample reserves in the aggregate banking system, but there seems to be a problem of serious maldistribution.  It appears the major banks are holding the bulk of the excess reserves and seem unwilling to lend them.  The big banks complain that they are holding these large reserves due to regulation.  Given that regulators have a goal of making the large banks safe, the banks seem content to hold high levels of cash and earn IOER, which is currently around 2.10%.  Even with the possibility of risk-free profit at unusually high spreads, banks with reserves did not rush in to take advantage of the spreads.  This means (a) they are inept, (b) they need the reserves more than the profits or (c) they don’t trust the counterparties.  We lean toward “a, b” but if “c” is the issue, we have a bigger problem.
3. The major media is reporting that a combination of tax payments, Treasury borrowing and other liquidity draining activities were the proximate cause of the shortage. Although these events probably contributed to the cash crunch, the amounts don’t seem strikingly large. Thus if these were the culprit, available liquidity is really tight and the Federal Reserve has a serious problem and needs to start re-expanding the balance sheet.
4. An overlooked factor in all of this is dollar strength. Even though the dollar is excessively valued relative to inflation, and in some cases, unit labor costs, the dollar continues to be buoyed.  Although the spreads against other nations’ interest rates are usually trotted out as a factor supporting the dollar, the persistence of dollar strength appears to be more like a dollar shortage.  In other words, foreign borrowers that have financed in dollars are struggling to acquire dollars to service debt.   A side issue is that the attack on Saudi Arabia may have played a role as well.  Usually, the KSA funnels around $400 mm per day into the U.S. money markets from oil sales, but with the sudden halt in oil production, it is highly possible that the kingdom is actually doing repos to generate cash to meet its dollar obligations.
5. The level of Treasury debt/Fed’s balance sheet has fluctuated over the years but has ranged between 6x to 12x. After QE, the ratio plunged to about 5x, and has fallen as low as 4x.  However, the combination of rising Treasury borrowing and a shrinking balance sheet have pushed the ratio to a bit more than 6x.  The historical record would suggest this is not an alarming level, but it is possible that in our current environment, the ratio may need to be below 5x for the money markets to have enough liquidity.  In other words, the world changed after 2008 and the Fed doesn’t know for sure what are the proper level of reserves.  However, it is looking rather obvious that they are too low.

6. Another thought. Over the past four decades policymakers generally have relied heavily on monetary policy to guide the economy.  Discretionary fiscal policy has been used occasionally, but only in emergencies when presidents can prod Congress to act.  The problem with monetary policy is that it works through the financial system and its primary tool of stimulation is lending, with refinancing being secondary.  However, if the real problem is excessive debt, monetary policy is simultaneously helping and exacerbating the problem.  It’s a bit like a drunk trying to postpone the hangover by continuing to accept cocktails.  At some point, the debt must be addressed; it’s the job of the political system to assign the cost of adjustment.  What policymakers would likely prefer is to use inflation and financial repression to force the adjustment on creditors over a long glide path.  Although, inflation can’t be triggered by monetary injection alone (yes, Milton Friedman was wrong); inflation needs reregulation and deglobalization to work, and financial repression needs reregulation of the financial system to force savers to accept negative real rates.  We believe this process is underway, but progress is very slow (the last time we dealt with a debt overhang was the Great Depression and it wasn’t really resolved until we had the fiscal expansion with war spending).  In the meantime, events may preclude addressing the debt overhang at a measured pace.
7. So, bottom line, should we be worried? Yes, but it is hard to figure out what exactly to be worried about.  It is difficult to see how we are on the cusp of a domestic banking crisis.  As noted above, banks seem to have plenty of reserves.  Fear itself, along with zealous regulation, may be prompting reserve hoarding and that may be exacerbating the problem.  But, for whatever reason, there appears to be a dollar shortage and the Fed can address that by reflating its balance sheet.  It probably will also be more aggressive in repo operations, perhaps even establishing a standing facility.  However, these events suggest that even though the overall economy may not necessarily need lower rates, the financial system is in desperate need of cash and the Fed, as the global lender of last resort, should probably be cutting rates more aggressively.  Still, given the Fed’s history, they don’t tend to act on these “plumbing” issues until a crisis develops.  We will continue to monitor this issue and will be the first to admit that it is devilishly complicated.  Nevertheless, two things do stand out; first, caution is warranted and second, the Fed should get aggressive in easing.  A historical analog might be the 1998 LTCM crisis; Greenspan made a sharp emergency fed funds cut to flood the money markets with dollars.  It prevented a crisis but it probably led to the last upleg in the tech bubble in equities.

FOMC:  There is no doubt the Fed will cut rates by 25 bps today.  Everything else will probably disappoint.  We doubt the dots will signal further easing this year and we expect at least one dissent from the KC FRB.  Additionally, the press conference will likely be non-committal; do not expect any clarity on the aforementioned money market issues in the presser.  If we are right, the yield curve should flatten, gold will ease, equities will likely ease.

Oil:  The KSA says it will return to normal production levels by the end of the month.  We think this claim is wildly optimistic; we would expect, at best, 2.0 mbpd to 3.0 mbpd by the months end.  Both the U.S. and the KSA seem to believe that Iran is behind the attack, but seem reluctant to assign blame.  That’s because doing so will require action and neither the Trump administration nor the KSA seem to want a war with Iran.  BREAKING:  PRESIDENT TRUMP INDICATES HE WILL INCREASE SANCTIONS ON IRAN.  This decision shows his deep reluctance to engage Iran militarily.  This reluctance may encourage Iran to become even more aggressive.

Hong Kong:  Protestors are increasingly pressing the U.S. to support  its movement for democracy.  The White House has mostly been non-committal; if the president intervened in the situation, it would likely end any chances of a trade deal.  However, that isn’t stopping Congress from getting involved.  House bill 3289 has been introduced, titled the Hong Kong Human Rights and Democracy Act of 2019, would force the executive branch to judge if the two systems program is being upheld, and direct the White House to take action if China is deemed to have undermined Hong Kong’s democracy.  It is highly unlikely this will pass, but it does show that this issue could become a complication in trade negotiations.

Spain:  The country will hold elections again on November 10^th as Pedro Sanchez was unable to form a coalition government.  This will be the fourth election in four years, and highlights a political problem seen across Europe; deep divisions in society are making nations nearly impossible to govern.

View the complete PDF

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT]

After a wild day yesterday, markets are rather quiet.  The FOMC meeting starts today, the new Saudi energy minister is conducting his first press conference at 1:15, and Israel is holding elections.  Here is what we are watching this morning:

The aftermath of the Saudi strikes:  Here are three items we are following in the wake of the missile and drone attack on Saudi oil facilities:

1. The retaliation issue—although President Trump suggested the U.S. was “locked and loaded,” it appears he is not in a hurry to escalate the situation. Although the president says it “appears” Iran was behind the attack, he also indicates he does not want war.  In addition, the White House seems to be suggesting the U.S. is going to be led by Saudi Arabia’s decision on Iran.  Part of the reluctance is probably due to the lack of attractive alternatives.  It is hard to see how the U.S. could find additional economic sanctions (Iran is heavily sanctioned already), and mere sanctions would look like a weak response to a historic attack.  A blockade against Iran is an option, but how one determines when “victory” is achieved is difficult.  In other words, what would have to occur to lift the blockade?  Additionally, a blockade could put U.S. Navy vessels in harm’s way.  Limited airstrikes against the Iranian defense industry (to weaken its capacity to build missiles and drones) is probably the most likely response, but that action could escalate.  The president doesn’t want a war this close to an election that could spike oil prices and undermine his reelection chances.  Also, like his predecessors, he would really prefer less involvement in the Middle East.  However, as we noted yesterday, doing nothing or something less than a proportional retaliation runs the risk of ending the Carter Doctrine.
2. The negotiations issue—the Ayatollah Khamenei has announced that there will be no talks on any level with the U.S. This decision effectively ends any chance of a diplomatic solution.
3. The “how did this happen” issue—one of the unanswered questions is how did the Saudis not have adequate defense against this attack? The KSA’s defense spending ranks third in the world with total defense spending and first relative to the GDP, at 8.8%.  We haven’t seen much written on this issue, other than Russia’s offer to sell the KSA the S-400 system.  In our estimation, there are two potential reasons why the kingdom was unable to protect these key facilities from a combined drone and missile strike.  First, pure incompetence.  The leadership was more concerned with a terrorist or ground attack and simply didn’t consider this sort of strike.  Thus, the defense that was purchased was inadequate.  Second, the defense system was adequate but was disarmed by a cyber-attack.  If the answer is the first reason, it’s inexcusable.  If it’s the second, it’s terrifying because it means that missile defense systems are vulnerable.  We don’t know the answer to this issue but will continue to watch for information.

What now?  OPEC and Russia appear to be using this event to drain global inventories.  OPEC and Russia’s output policy has been designed to slowly reduce global stockpiles; with the KSA partially offline, the cartel appears to be using this situation to accelerate the process.  If so, this should keep a bid to oil prices.  We note that the KSA has already signaled to customers that October oil loadings will be delayed.  The risk of much higher prices is tied to the U.S. response to this attack.  At this juncture, the White House is exhibiting caution, which reduces the odds of a spike.

Venezuela heats up:  The situation in Venezuela has become a stalemate in recent weeks.  The U.S. has mostly exhausted economic sanctions and the Venezuelan economy is moribund, so additional measures probably won’t have much of an impact.  The U.S. has no interest in a military response.  However, we are seeing tensions rise between Colombia and Venezuela.  The former is accusing the Maduro regime of harboring guerrillas, and of planning bombings against Colombia’s capital, Bogota.  Leaders in the region are calling for the activation of the 1947 Rio Treaty, a mutual defense treaty among Latin American countries.  We will be watching to see if a group of nations in the region will build a military force to remove the Maduro regime.  Although Venezuela’s oil production has declined precipitously, Colombia does produce 0.9 mbpd and a conflict could reduce supplies in an already tight world.

Islamic State:  Secretive ISIL leader Abu Bakr al-Baghdadi issued an audio message urging his followers to redouble their fight against nonbelievers, and their efforts to build an Islamic caliphate, in spite of the group’s severe weakening and loss of territory.  The message is a reminder that ISIL hasn’t been completely destroyed, and that it will probably continue to pose a terrorism threat in the near term.

Trade:  Liao Min, China’s vice-minister of finance, is in route to Washington to begin preliminary trade talks.  USTR Lighthizer remains committed to a comprehensive trade agreement with China, something that China does not appear to want.  Again, this issue underscores the differences within the Trump administration on trade; the Lighthizer/Navarro wing want a broad agreement that will encompass not only trade but intellectual property and security, while the Mnuchin/Kudlow wing want a narrow agreement that only affects trade.  The president vacillates between the two camps.  In general, we watch Lighthizer; if he does not get his way, we would expect him to resign and if he does, we will get a narrow deal.  If he stays, we doubt China will agree to anything before the elections.  Meanwhile, the U.S. and Japan appear to be near a trade agreement.

Hong Kong:  Illustrating the negative impact of the continued anti-Chinese political protests, and the threat of a violent Chinese crackdown, private investors are reportedly pulling millions of dollars of gold out of Hong Kong.  The pullout not only reflects concerns that China could restrict capital outflow from the city, but also that protests at the municipal airport and other facilities could impede shipments.

Italian politics:  Just after the center-left and populist-left formed a government, former Italian PM Matteo Renzi announced he is leaving the center-left Democratic Party to create a new centrist group similar to what Macron has created in France.  His decision will weaken the current coalition, and could end up bringing down the government.  We are seeing a backup in Italian sovereign yields this morning.

Russia:  Another powerful Russian has floated the idea of amending the country’s constitution to allow President Putin to stay in power after his current term ends in 2024.  Sources close to the Russian leadership say Putin currently thinks he and his United Russia Party are strong enough that they don’t need to worry about the future yet.  However, the Russian oligarchs and others who have profited from the Putin regime are worried about losing their favored positions, so they’re laying the groundwork for legal changes that could keep Putin in power.

View the complete PDF

 

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT]

It’s Fed week, but the big news is that financial and oil markets are roiled by an attack on Saudi Arabia’s (KSA) oil infrastructure.  Here is what we are watching this morning:

The attack of the Houthis?  Houthis in Yemen have claimed a massive attack on Saudi Arabia’s oil infrastructure.  Here are the key points:

1. Initial reports indicated that 5.7 mbpd of crude production was lost, or about 58% of the KSA current output. Saudi officials have indicated that they expected to bring about a third of that production back early this week. However, recent reports suggest that outlook may have been overly optimistic.
2. The attacks appear to be strategically sophisticated as 19 different points of impact were reported. First, the processing facility at Abqaiq was struck.  This facility processes 7.2 mbpd of oil; therefore, even if Saudi fields continue to pump oil it can’t be exported until this facility is restored.  Second, 1.2 mbpd of the Khurais oil field was also damaged.  About 18% of the KSA’s natural gas production is offline, as is 50% of its NGLs that were affected.
3. Although the Houthis have claimed responsibility for the attack, there is a great deal of skepticism about this claim. Secretary of State Pompeo blamed Iran shortly after the attack.  Iran has categorically denied this claim.  Regional media sources claim the attacks came from Iraqi soil, which the Iraqis have denied.  The White House has released photos that suggest the attack came from the north or northwest, which are casting doubt on the Houthis’ claim.  In fact, the attack appears to be sophisticated enough that it probably exceeds the Houthis’ capability.  This factor alone increases the odds that this either came from Iran or from a close proxy.
4. We now will watch closely to see how the administration responds. President Trump indicated he was “locked and loaded.”  Iran may have misjudged the president, exhibiting a classic mistake that foreign nations have historically made about the U.S.  The Jacksonian streak that runs through American foreign policy has befuddled foreign adversaries before.  The Jacksonians appear to be isolationists and thus can be taken advantage of; the president’s decision to back away from an earlier missile attack may have emboldened Iran into thinking that it could get away with the escalation.  However, Jacksonians will defend their honor, thus a military response is likely if the president concludes that this act besmirches America honor.  As we note below, we still believe the president wants to avoid a military confrontation, but if he feels he is personally being challenged then all bets are off.
   1. At a minimum, this attack will end any chance of talks, at least in the near term.
   2. If Iran is implicated, it will be hard for Europe to continue to maintain the Iranian nuclear deal.
5. Here is our “back of the envelope” analysis of the oil situation. OPEC has been producing around 29.9 mbpd; its total capacity is about 34.6 mbpd.  Thus, at first glance, this problem appears manageable.  The loss of Saudi production is 5.7 mbpd but excess capacity is 4.6 mbpd.  Thus, the world only needs 1.1 mbpd, which could easily be filled from the OECD’s SPRs around the world.  However, it isn’t that simple:
   11. Although the KSA’s capacity is thought to be 11.5 mbpd, it is still likely that much of that oil would still need to flow through Abqaiq. Thus, a conservative estimate would have to assume that the KSA’s current full production is probably closer to 4.1 mbpd, at least initially.  We would expect some of that capacity to be restored in the near term, although full recovery may take months.
   12. If our back of the envelope analysis is correct, this action against the KSA cuts OPEC excess capacity by 7.4 mbpd.
   13. In addition, 1.6 mbpd of the cartel’s excess capacity resides in Iran. It is unlikely the U.S. will lift sanctions on Iran now as excess capacity is down 9.0 mbpd.
   14. Taking this all into account, a rough estimate is that OPEC can now produce around 26.6 mbpd. That means the world must find 4.4 mbpd of lost production.
   15. Essentially, the world oil market is now running without any buffer. For most of the history of the oil market, some producers have held production off the market to stabilize prices.  This offline capacity has acted to dampen price spikes when events occur.  The world mostly relies on the KSA for maintaining this buffer.  For the time being, that buffer is missing which means price volatility will rise.
6. The loss of a buffer turns our attention to the Strategic Reserves (SPR). The estimated operational drawdown capacity of the U.S. SPR is 4 mbpd.  It takes about 13 days from the time a presidential order is made until oil begins to reach the market.  The SPR has never had a sustained drawdown of this magnitude and thus, we don’t know for sure if it will work.  At the same time, given high U.S. production and rather elevated levels of commercial inventory, the likelihood of an extended supply shock is rather small…if consumers act rationally.  However, that is a heroic assumption.  The reason the OECD, through the auspices of the IEA, created the SPR system was to prevent hoarding.  In theory, in the case of a global supply shock, the IEA “coordinates” the SPR response.  Since the SPR system has never been tested on a drop of this magnitude, it is unclear if the IEA members will actually allow the IEA to coordinate the national SPRs.  In theory, the IEA could direct the U.S. to sell SPR oil to Paraguay to relieve a shortage there.  The idea that U.S. taxpayers would not have access to the oil they paid for so that Paraguay could avoid a price spike is politically unlikely.  The economic reasoning behind coordinating the SPRs is to discourage hoarding, but if the SPRs become mere national stockpiles, hoarding behavior is likely and the price spike could have legs.
7. This attack is a potential test of the Carter Doctrine. The Carter Doctrine states that the U.S. is prepared to use military force to defend its interests in the Persian Gulf, originally a response to the Soviet Union’s invasion of Afghanistan in 1979.  The U.S. response to Iraq’s invasion of Kuwait in 1990.[1]  It has even been claimed that the Carter Doctrine was used to justify the 2003 Iraq War.  If SoS Pompeo’s allegation that Iran was responsible for this attack, the Carter Doctrine would seem to argue that a military response against Iran is warranted.  It is certainly possible that the Houthis did launch the attack, but even so they likely procured the drones from Iran.  So, we could end up with one of two scenarios:
   1. The Carter Doctrine is enforced and we see military action against Iran—at least airstrikes against Iran’s defense industry, the part that makes drones, would be possible. A military strike would increase uncertainty surrounding oil supplies, at least in the short run, lifting the odds of escalation and pushing prices higher.
   2. The Carter Doctrine is not enforced—this would mean the doctrine is probably no longer operational and would signal a major change in U.S. policy. This decision would lower oil prices in the short run but increase the “normal” level of geopolitical risk in the market, putting a higher premium into oil prices.
8. Our expectation is that the White House, notwithstanding Pompeo’s claim and the president’s comment about “locked and loaded,” would prefer to avoid military action against Iran. Once engaged, it may be hard to contain the escalation and a sustained spike in oil prices could tip a slowing U.S. economy into recession.  Although the Trump administration is facing a decision on the Carter Doctrine, it has been on shaky ground for some time.  The Obama administration’s “pivot to Asia” was a clear signal that the U.S. just wasn’t as concerned about the Middle East.  The shale revolution reduced the need for the doctrine.  Still, it is important when a superpower pulls back from a stated policy.  Clear points of departure force other nations to change policy.  At a minimum, if the Carter Doctrine is defunct, Middle East oil supply becomes less secure.
9. The KSA is no longer a reliable swing producer. To some extent, this attack is “the big one.”  Anyone who has analyzed oil markets has always acknowledged the possibility of an attack on the KSA oil facilities.  Even after repairs and the return of production, forevermore, we will know that these facilities are not completely safe.
10. The timing of this attack was inauspicious. There are two problems.  First, CP Salman had just fired the leadership of the energy ministry and Saudi Aramco.  That means this crisis will be handled by the new, untested leadership.  This crisis would have challenged a seasoned staff, but the odds of a mistake are elevated with an untested group.  Second, the IPO of Saudi Aramco is in doubt; a company that faces these sorts of threats will face a significant discount.
11. Finally, a sustained spike in oil prices will further undermine global economic growth.

Overall, the attack is a new, significant risk factor for not just the oil markets but for the world economy.  It will take a few weeks to determine the significance of this weekend’s activities.

The problem of easing:  As we noted last week, ECB President Draghi’s easing plans were not universally supported.  It appears that at least nine members had some level of misgivings.  This week, Chair Powell has his turn to try to convince the voting members that a rate cut is necessary.  Although we have little doubt that a 25-bps cut is coming, we would not be surprised to see a hint of uncertainty surrounding future cuts.  The financial markets have reduced their expectations of future rate reductions; we might see more if the statement is balanced and does not lean toward further easing.

The chart on the left shows the implied three-month LIBOR rate, two years into the future; the implied rate comes from the Eurodollar futures market. The chart on the left shows the implied rate and the fed funds target on the lower lines with the spread on the upper line.  In general, the Fed tends to ease when the spread inverts.  We have seen a deep inversion recently but the backup in the implied rate would suggest that up to two rate cuts of 25 bps have been withdrawn from the markets.  Still, the implied LIBOR rate suggests that at least three more cuts are still coming.

Perhaps Powell’s biggest hurdle will be convincing the Phillip’s Curve adherents that they should cut rates.  To visualize Powell’s problem, we use the Mankiw Rule, a derivation of the Taylor Rule.  The Taylor Rule is designed to calculate the neutral policy rate given core inflation and the measure of slack in the economy.  John Taylor measured slack using the difference between actual GDP and potential GDP.  The Taylor Rule assumes that the Fed should have an inflation target in its policy and should try to generate enough economic activity to maintain an economy near full utilization.  The rule will generate an estimate of the neutral policy rate; in theory, if the current fed funds target is below the calculated rate, the central bank should raise rates.  Greg Mankiw, a former chairman of the Council of Economic Advisors in the Bush White House and current Harvard professor, developed a similar measure that substitutes the unemployment rate for the difficult-to-observe potential GDP measure.

We have taken the original Mankiw rule and created three other variations.  Specifically, our model uses core CPI and either the unemployment rate, the employment/population ratio, involuntary part-time employment and yearly wage growth for non-supervisory workers.  All four variations compare inflation and some measure of slack.   Here is the most recent data:

This month, all the variations’ estimated target rates rose substantially, a product of rising inflation and tighter labor markets.  All the models now suggest the Fed is too easy, although the employment/population variation is just above the current midpoint implied by the target.  Essentially, even the most easy variation would argue for steady policy.  Powell, likely on momentum alone, will be able to get a rate cut at the meeting but further cuts will likely require more persuasion.

The divergence of opinion about monetary policy is coming from two sides.  The first is the idea that the economy isn’t in all that bad of shape and cutting rates is not justified.  This is the usual problem with monetary policy and the business cycle.  Financial markets give the longest lead but tend to trigger false positives; waiting for the economic data to show a downturn in place usually means policymakers cannot move quickly enough to avoid a recession.  However, the fear is that easing when labor markets are tight might trigger inflation and thus the desire to hold steady will be notable.  The second idea is that monetary policy is exhausted and further stimulation must come from fiscal policy.  We are more sympathetic to this argument, but the problem is that the Western world’s legislatures are deeply polarized and (a) getting a fiscal package passed will be hard, and (b) getting a package passed that is actually effective may simply be impossible.

On a related note, the BOJ is considering further easing, which would require negative nominal interest rates.

On strike:  The United Auto Workers (UAW) is calling a strike against General Motors (GM, 38.86).  The union has instructed some 46k workers to walk off the job, the first action of this magnitude since 2007, when a UAW strike idled 73k workers.  The union is striking over the usual things, benefits and pay, but is also wanted to force the automaker to follow earlier contracts that forbid closing the plants except in an emergency.  Work stoppages have become increasingly rare since the 1980s.  Last year, nearly 500k workers were involved in stoppages.  Including this recent action against GM, the workers involved year to date is 372k.

The increase in labor actions is likely due to the long expansion.  We suspect the UAW leadership wants to make a deal now when the economy is still expanding because it will be much more difficult to press for higher wages in a recession.  In addition, UAW officials are facing investigations from the DOJ; a successful strike could keep the rank in file aligned with the current leadership.

Chinese economy:  The Chinese economy is slowing rapidly.  Industrial production growth fell to the lowest level since the Great Financial Crisis.

Fixed asset investment rose 5.5%, which was weaker than forecast, and retail sales growth eased as well.

All this suggests that China needs further stimulus to avoid additional economic weakness.  There is little doubt that the trade war is adversely affecting China’s economy more than the American economy; however, the issue isn’t so much the level of pain but rather the tolerance for it.  It is our position that Chairman Xi believes China has a higher pain tolerance and that Washington will blink first.

An interesting side note is that Chinese firms are divesting foreign assets, including those in the U.S.  It is unclear what is driving this divestment.  Some of it is likely coming from government pressure to reduce exposure abroad.  There is a desire from Beijing to curb capital flight.  Restrictions on investment are increasing and the change in the investing climate might be encouraging divestment.  But the bigger worry is that firms in China may be facing a cash crunch and they are divesting to build liquidity.  If the latter is the reason, it bodes ill for global growth.

United States-Japan:  In a joint statement that President Trump and Prime Minister Abe will release after their meeting in New York next week, the U.S. will promise not to hike tariffs on Japanese autos.  The leaders will also sign a new bilateral trade agreement.  Up until now, President Trump hasn’t definitively ruled out new tariffs against Japanese auto imports, so the move is a significant sign that the trade tensions weighing on so many other U.S. relationships probably won’t be a problem for Japan in the near future.

Hong Kong:  For the 15^th straight weekend, anti-Chinese protestors launched demonstrations and mass vandalism, underlining their view that Chief Executive Carrie Lam’s withdrawal of her controversial extradition bill was “too little, too late.”  In what may be a new tack by Beijing to fight the protestors and split the pro-democracy movement, editorials in three Chinese state-owned media outlets accused Hong Kong’s property tycoons of hoarding land and driving up real estate prices.  With tensions remaining, the risk of a crackdown by China is likely to continue weighing on Hong Kong’s economy and asset markets.

United States-European Union:  In the longstanding dispute over EU aerospace industry subsidies, the World Trade Organization approved a U.S. request to impose punitive tariffs against some European goods.  If implemented, the new U.S. tariffs could widen the trade war and further undermine confidence and investment in the EU.

Italy:  The new governing coalition of the populist, left-wing Five Star Movement and the center-left Democratic Party has filled out its cabinet positions, putting the traditionalist Democrats in an unexpectedly strong position.  For example, Roberto Gualtieri, a Democratic Party veteran and EU insider, has gotten the post of finance minister.  The new government is widely expected to loosen fiscal policy in an effort to boost the economy, just as the previous coalition between Five Star and the right-wing League sought to do, but the new government is likely to get substantially more leeway from the EU, which should help calm some of the volatility in Italian assets that was common over the last couple of years.  To illustrate how the new coalition might be more different in tone than in substance, the government allowed a charity ship with 82 rescued African migrants to dock in Italy over the weekend, but only after requiring it to first wait six days at sea while it negotiated with other EU countries to take some of the refugees.

United Kingdom:  Prime Minister Johnson today holds his first face-to-face talks on Brexit with the outgoing European Commission president, Jean-Claude Juncker, and the EU’s chief Brexit negotiator, Michel Barnier.  Johnson is not expected to present a detailed proposal for a new exit deal, but he may float some trial balloons, especially related to his thoughts on keeping Northern Ireland in a customs union with the EU.  There also seems to be some disagreement within Johnson’s cabinet as to whether a Brexit delay might be countenanced.

Tunisia:  Exit polls show outsiders won the first round of the country’s presidential election yesterday.  The top vote gatherers were apparently Kais Saied, a constitutional law professor unaffiliated with any party, and Nabil Karoui, a television tycoon imprisoned for tax evasion shortly before the balloting.  The current prime minister and other mainstream politicians were punished for their inability to improve economic growth and cut corruption since the country launched the “Arab Spring” reform movement in 2011.  If the results are confirmed, Saied and Karoui will face off in the final round of the election on October 13.

View the complete PDF

---

[1] Klare, Michael. (2004). Blood and Oil: The Dangers and Consequences of America’s Growing Dependency on Imported Petroleum. New York, NY: Henry Holt and Company.

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT]

Happy Friday!  It’s a quiet morning with equities continuing to lift on trade hopes.  Should we be worried about inflation?  The day after the ECB.  Here is what we are watching this morning:

Trade:  It looks like an “off ramp” may be emerging, an interim trade deal with China.  As we noted yesterday, the U.S. will delay increasing tariffs on Chinese goods by two weeks to avoid applying the hike on a major anniversary day for the PRC.  President Trump is signaling he might be ok with an interim deal.  Yesterday, we had dueling reports, with Bloomberg indicating that White House sources had said the U.S. was considering a rollback of tariffs and a potential trade peace deal with Beijing.  CNBC ran a report from the White House denying this was true.  China is softening its stance on importing agricultural goods.  If China begins significant purchases, and some buying has apparently commenced, we could see tensions ease.  There is growing talk that negotiators could focus more on the trade deficit, but leave the more contentious issues for later.

This vacillating of tensions is a reflection of internal disputes within the administration.  The Navarro/Lighthizer wing wants significant reforms forced on China.  The Mnuchin/Kudlow wing wants a more modest deal where everyone is declared a winner, which would be welcomed by the financial markets.  The key, of course, is where the president sits, and he tends to swing between the two camps.  The past few months have shown that when financial markets panic, the president reduces the tension.  But, fearing he will be seen as weak on China, he tends to then revert back to a hardline position.  China does appear to want a deal, but only one that would disappoint the Navarro/Lighthizer wing.  It is possible that re-election concerns could push the president toward the Mnuchin/Kudlow wing; however, the president does believe that the trade war with China is a political winner and therefore does not necessarily see the hardline position as a problem.  Our take?  We will probably get more of the same—the cycle we have been seeing will likely continue.

In other trade news, there is a concerted effort from the business sector to get USMCA through Congress.  There is still a high level of opposition in Congress to passing the trade treaty, but progress is being made.

ECB:  Market reaction to the ECB was rather interesting.  The first reaction was that the easing was less than expected—the EUR rallied, bond yields rose and European bank stocks rallied.  Then, traders decided that it was, in fact, a significant easing, and the EUR depreciated, bond yields fell and European banks stocks fell.  After a while, these positions reversed again.  So, what exactly happened?  Draghi did get some significant measures adopted.  But, opposition was strong, especially from the northern Europeans.  This opposition prevented a larger rate cut and higher levels of QE.[1]  German opposition to further easing will likely be formidable.  So, the market’s take is that this latest package may be the last of its kind for a while, and although Draghi was able to get some open-ended elements into the program, Christine Legarde will likely need time in her new office before she can build consensus to do more.  When markets believe a policy has been exhausted, there is often a reversal in trend; the trend in place may need a steady diet of whatever caused it and the trend begins to reverse if that diet becomes restricted.  Essentially, the verdict from the financial markets is that this package is it and thus further weakness in the EUR is less likely.

What about inflation?  The rise in core CPI has raised concerns that inflation may be brewing.  Although the fear isn’t baseless, we don’t expect a major inflation problem to develop.  If one looks at core CPI relative to the ISM Manufacturing Index, the rise we are seeing in the core rate is normal.

Since the turn of the century, the ISM Manufacturing Index tends to lead core CPI by about two years.  The rise we are seeing is “right on time” and we will likely see a rise to 2.5% into next year.  However, about a year from now, inflation should begin to decelerate and fall back below 2% into 2021.  Nevertheless, this rise in the core rate may slow the pace of easing. 

Brexit:  There is a chance that Hungarian PM Orban could come to Boris Johnson’s aid by refusing to agree with an Article 50 extension.  EU decisions require unanimity; a single vote of opposition can kill a deal.  If Orban decides to oppose an extension, Brexit will occur on Halloween.  Meanwhile, it is starting to look like the solution to the Irish problem is to put the EU/U.K. trade border at the Irish Sea, leaving Northern Ireland in the customs union.  The only way this can occur is with new elections; currently, the minority government is still aligned with the Northern Ireland Unionists.  But, if Johnson wins the next election without needing the Unionists, he will be free to deal with them as he sees fit.

Johnson and the outgoing European Commission president, Jean-Claude Juncker, will meet in Luxembourg on Monday.  The meeting marks their first face-to-face talk on Brexit, and with Johnson’s hint this week that he could be open to keeping Northern Ireland in a customs union with the EU, there is probably some chance of a breakthrough.  However, Johnson would have more leverage by dragging negotiations out further, and Juncker is merely a lame duck.  Therefore, the more likely result of the meeting may simply be that it will provide Johnson the opportunity to float more details on his Northern Ireland thinking and sound out Juncker for the EU’s likely reaction.

Meanwhile, Labour is holding party meetings and the Brexit issue is dividing their party as well.  So far, Corbyn has not put out a clear position on Brexit.  If he chooses to champion Remain, he will lose a large share of traditional union voters to the Tories.  If he opts for Leave, he will lose the young urban supporters to the Liberal Democrats.  At some point he will have to choose, but he clearly doesn’t relish having to do so.

France:  Transport workers are on a massive strike today in order to protest President Macron’s proposed pension reforms.  Public transport in Paris is reportedly at a standstill.

Argentina:  The International Monetary Fund is reportedly getting cold feet about releasing a $5.4 billion tranche of its bailout package for Argentina that is due this month.  In part, that’s because of President Macri’s call for creditors to “voluntarily” accept delayed repayment on more than $100 billion of the country’s debt.  In addition, officials worry that the likely winner in next month’s presidential election, Alberto Fernández of the populist Peronist Party, may take an even more radical step toward debt repudiation.  Sources say IMF officials may therefore postpone the disbursal until after the election.

South Korea:  Moody’s has warned that more than a dozen major South Korean exporting firms could have their debt ratings cut in the coming months because of a deterioration in their earnings amidst the U.S.-China trade war.  The companies are mostly in the technology and chemicals sectors.

Japan:  Sources say officials at the Bank of Japan are becoming more open to the idea of cutting the benchmark interest rate even further into negative territory, especially after yesterday’s decision by the European Central Bank to do just that and to launch a new round of bond buying.  The sources say the BOJ would try to focus any further cuts on shorter maturities in order to maintain an upward-sloping yield curve and help ease the pain for financial firms.  That would be especially important amid reports that banks are already considering imposing account maintenance fees on consumer deposits.  In its policy statement last month, the BOJ said it wouldn’t hesitate to take new easing measures if needed.  The earliest it would make such a move would be at its meeting in late October, since officials want to gauge the impact of a planned hike in Japan’s value-added tax on October 1.

Econ 101:  California is moving to deal with its lack of real estate supply by implementing rent control.  Discussing the likely outcome would be a good weekend assignment for someone taking intro economics.

Long bonds?  The Treasury is considering 50-year and maybe even 100-year bonds.  They should, in our opinion.  Yields are low and extending funding would be prudent.  Should investors buy such bonds?  That’s a different story…

View the complete PDF

---

[1] However, another constraint to QE is the fact the ECB is running out of sovereign bonds to buy.  To expand QE further, other instruments will need to be available for purchase, e.g., bank loans, corporate debt, perhaps equities.