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

[Posted: 9:30 AM EDT] Happy employment Friday!  We cover the data below, but the quick take is that the report is mixed.  The drop in the unemployment rate to 3.5%, a new cycle low, is impressive.  However, wage growth for non-supervisory workers fell to 3.5% from 3.6%, and the growth rate for all workers fell rather markedly to 2.9% from 3.2%.  The headline payroll number came in at 136k, a bit below expectations.  The data has triggered a risk-on trade, with interest rates rising amid stronger equity prices.  Here is what else we are watching this morning:

The economy and the Fed:  Yesterday’s ISM services data came in soft and added to concerns that the economy was coming under pressure.

This index is generally a coincident indicator and doesn’t signal recession until it crosses 50.  It also doesn’t have a long history, but the data is clearly in a downtrend.  Unlike the manufacturing index, the exports portion was a bit weak but most purchasing managers were reporting steady export orders.  Unfortunately, the subsector that showed the most profound weakness was employment, which has fallen from 56.2 in July to 50.4 in September.

Weaker economic data is raising expectations that the FOMC will accelerate rate cuts.  Vice Chair Clarida seemed to support this notion.  Hopes of easing likely led to yesterday’s equity market recovery.  However, the drop in the unemployment rate (see below) will make it hard for the Phillips Curve faction of the FOMC to agree to a rate decline.

Brexit:  PM Johnson’s plan for the Irish border fell with a thud in Brussels.  Although there hasn’t been an outright rejection yet, it is unlikely that the plan as it is currently constructed would get all 27 nations to agree.  Johnson has suggested he is open to other concessions but it isn’t obvious if they would be material.  Meanwhile, Johnson is working on Parliament to see if they will approve his exit proposal.  He might be closer than one would think.  To pass, there are three groups he needs to win over.  First, there is the matter of the 21 former Tories who he kicked out.  He needs all of them.  He needs all 9 DUP members.  To get over the line, he needs some defections from Labour.  There are a number of Labour MPs who come from Leave boroughs that might vote for Johnson’s plan.  In fact, this is the primary reason why Labour has not actually taken a position on Brexit; the party is divided, and Corbyn would lose MPs if he elects to support Remain.  If Johnson can get his deal passed and the EU rejects it, it appears to us that the U.K. will leave on Halloween.

Next week’s trade talks:  In light of market weakness, there is some speculation that the administration will at least agree to a truce.  That would entail a postponement of tariffs and at least a jump in Chinese agricultural imports.  However, a postponement without anything on intellectual property would look weak and it would be hard for the Trump administration to accept.  Additionally, China views the U.S. as an unreliable negotiating partner because, from their perspective, the administration changes its position after a deal has been made.  This charge is not exactly fair; instead, we suspect there is a high level of “strategic ambiguity,” where both parties say the same thing but mean something quite different.  In reality, we don’t think either side is willing to make the concessions necessary to make an arrangement but neither wants a “blow up” either.  There is also a narrative that Xi may simply wait out Trump and hope for a more compliant administration in 2020.  Beijing may want to rethink that position.

Masks off:  Carrie Lam will make it illegal to wear masks at protests.  We doubt these measures will have an immediate effect, but it will make it easier for the government to arrest protestors who otherwise will be vulnerable to tear gas.

Israel:  Prime Minister Netanyahu has agreed that if he is able to form a unity government with opposition leader Gantz, and if he is then indicted for bribery, fraud and breach of trust, as is widely expected, he will retain his title but give up his powers to an “interim premier.”  The coalition negotiations are currently deadlocked, but the deal could help move things forward.

India:  The Reserve Bank of India slashed its benchmark short-term interest rate to a nine-year low of 5.15%, from 5.40% previously.  That marked the fifth rate cut in a row as the economy has slowed due to heavy corporate debt on weak consumer confidence.  In fact, the RBI also cut its forecast of economic growth in the year ending in March 2020 to 6.1% from 6.9%.

Odds and ends: Civil disorder has developed in Iraq.  Although it appears to be driven by opposition to widespread government corruption, such unrest can be co-opted by outside actors (read: Iran) to disrupt oil flows or to mask attacks in the region.  Although the situation in Kashmir has not been in the news lately, warnings that the conflict could escalate have been issued, cautioning that the problem could go nuclear.  EU migration commissioner Avramopoulos warned that “irregular” crossings from Turkey into Greece are on the rise again.  That raises fears of a new immigration crisis that could give nativist, populist parties renewed energy despite recent signs they may be on the wane.  The risk of renewed political instability would likely weigh on Eurozone stocks and the EUR.  Finally, we are monitoring the impeachment inquiry, but until it has a direct effect on the financial markets our commentary on the issue will be limited.

View the complete PDF

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

[Posted: 9:30 AM EDT] Equity markets are mostly flat this morning after two sharp down days.  Johnson has a new Brexit plan.  The WTO approves U.S. retaliatory tariffs against the EU.  Here is what we are watching this morning:

Equity worries:  Equity markets have taken a bruising in the first two days of the quarter.  Worries about global growth are front and center, but other issues are important as well.  First, with Chinese negotiators coming to Washington next week, there is hope that at least a truce will emerge.  In fact, a narrative is developing that suggests President Trump will make a deal with China because he needs equities to rally and he needs a “win” amidst impeachment investigations and slowing growth.  Perhaps.  However, the president has suggested on numerous occasions that he views the trade conflict with China as politically supportive; in addition, there is growing support for confronting China in Congress.  Thus, if the administration takes a partial deal it might backfire.  Another point to consider is what China wants.  There is no doubt a trade war hurts both sides.  The issue isn’t who suffers the most but who has the greater ability to absorb pain.  China probably can win on this one; Xi runs a surveillance state and has much more control over his media.  China probably won’t accept anything other than a full removal of tariffs, something we doubt the U.S. will accept.  If the meetings next week don’t offer something to the markets, and tariffs are applied as scheduled, further weakness is likely.

Second, there is a worry that the Fed may react too slowly to problems in the economy, as it did in 2007.  We note recent speakers have struck an optimistic tone on the economy, which may make it more difficult to cut rates quickly.  It is hard for an institution that has relied on the Phillips Curve for decades to cut rates when unemployment is this low.  History shows, unfortunately, that policymakers tend to wait until the evidence is abundant to support easier policy.  Usually by that point, it’s too late.

EU tariffs:  The WTO has confirmed that Airbus (EADSY, 31.34) received illegal subsidies and gave the U.S. permission to apply $7.5 bn of retaliatory tariffs against EU products.  The USTR has drawn up a list of products he recommends to be taxed.[1]  In addition to these tariffs, President Trump will decide by November 13 if he will place tariffs on autos and parts that could be worth up to $100 bn.  EU leaders are quietly begging Congress to prevent this from happening.  Even though talks with China loom large, the potential that the trade conflict could shift to Europe doesn’t appear to have been discounted by the market; otherwise, we would likely see a much weaker EUR.

On the other hand:  All isn’t lost on trade.  Despite the impeachment proceedings, Congress does appear to be making progress on USMCA.  Getting that deal done would likely be positive for Canada and Mexico.

Johnson’s plan:  PM Johnson released his Brexit plan.  It’s rather convoluted, involving a customs border and a separate regulatory border.  So far, the EU has reacted cautiously, not because it thinks the plan has merit but because it fears Johnson will use rejection to argue that the EU will never agree to an acceptable plan and a hard Brexit is the real goal.  In our opinion, Johnson’s goal is to get new elections.  He would prefer not to have a hard Brexit but feels that is a better outcome than constantly extending the deadline.  What Johnson seems to want is Brexit followed by elections; if the U.K. is out of the EU, then the Brexit Party has no reason for existence and the Liberal-Democrats have no issue to run on.  Labour is hopelessly split and the Tories will likely romp to victory.  There is only one problem with this plan—if a hard Brexit proves to be the economic disaster that many have warned against, it’s hard to see how Johnson can win an election.  Whether or not these dire forecasts are correct is an empirical question, but therein lies the risk of where Johnson seems to be heading.  Of course, if everything breaks his way, an even better outcome is that the EU caves and accepts his plan, he pulls the U.K. out of the EU on time and is the conquering hero.  But, the aforementioned “Plan B” of leaving without a deal is also acceptable.

Hong Kong:  The city’s cabinet will meet Friday to approve using a colonial-era emergency powers law to get control over the ongoing anti-China protests.  One measure being considered would be a ban on publicly wearing the masks that protestors use to protect themselves from tear gas.  We suspect the government’s further clampdown will likely spawn more, not less, protests.

Turkey:  U.S. national security officials say Turkey seems to be preparing to send troops into northeastern Syria to attack the U.S.-allied Kurdish forces battling ISIS there.  If a large attack transpires, the officials say the U.S. may have to pull its remaining 1,000 or so troops out of Syria, potentially allowing ISIS to regroup.

Ukraine:  While President Zelensky may be in hot water over the U.S. impeachment inquiry, that shouldn’t detract from his success in easing tensions with the pro-Russia separatists in eastern Ukraine.  This week, his government signed a deal with the separatists, Russia and EU monitors for a limited troop withdrawal and local elections in separatist-controlled areas as soon as Kiev gets control over its border with Russia.

Energy update:  Crude oil inventories rose 2.4 mb compared to an expected draw of 0.6 mb.

In the details, U.S. crude oil production fell 0.1 mbpd to 12.4 mbpd.  Exports and imports both fell 0.1 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.  This week usually signals the beginning of the autumn build season.  We have already troughed stocks but expect them to rise into early December.

The most important information from this week’s data is that we are now well into the autumn refinery maintenance season.

The decline in refinery utilization will likely continue for the next two weeks and should begin to rise by mid-October.  During this period, inventories usually rise.  However, the extent of the rise will depend on Saudi production.

Based on our oil inventory/price model, fair value is $66.51; using the euro/price model, fair value is $47.84.  The combined model, a broader analysis of oil prices, generates a fair value of $53.63.   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.  Reports that the KSA has lifted output to pre-attack levels has put further pressure on oil prices.   We also note that Iraqi PM Mahdi has imposed a 24-hour curfew in response to two days of large demonstrations against government corruption and high unemployment that have killed 18 people.

View the complete PDF

---

[1] Front and center are single-malt Irish and Scotch whiskies.

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

[Posted: 9:30 AM EDT] It’s another risk-off day so far this morning.  Residual worries about the economy continue to dominate.  Here is what we are watching this morning:

Reviewing ISM manufacturing:  As you are all aware by now, the ISM manufacturing data for September came in quite weak.  Here is the chart that most caught our attention.

The ISM asks purchasing managers a series of questions about the various parts of their business operations.  The group asks if conditions are better/the same/worse or higher/the same/lower on various aspects of their business.  The indexes that are printed are compilations of these questions.  However, the data about respondents is also available.  The above chart looks at export order responses.  Note the sharp rise in manufacturers reporting lower export orders and the plunge in firms reporting higher export orders.  This is a significant breakdown and puts the export orders index at 41.0, the lowest level since April 2009.  The trade war is having an increasingly negative effect on the economy.

The ISM data along with soft construction orders have taken the Atlanta FRB’s GDPNow forecast for Q3 GDP down 40 bps; the current forecast is 1.8%.

Brexit:  PM Johnson is expected to reveal his Brexit proposal, his “final offer.”  Rumors suggest he will call for customs checks on each side of the border, but inland (thus avoiding the “border” itself), with a time limit that will give both sides four years to actually work out a trade agreement.  We don’t see the EU accepting the deal; so far, it has rejected anything that has border controls.  By framing it as a final offer, Johnson will try to blame a hard Brexit on the EU.  We still think recent legislation will prevent a sudden Brexit, although it will require the EU to agree to another extension, which is likely to occur because the EU expects new elections and may hope that a new government might call off Article 50 altogether.  That scenario, however, is unlikely.  The most probable outcome is continued limbo; new elections probably don’t solve anything.  We expect that none of the parties would garner a majority in an election and any resulting government will be unstable.  The underlying problem is that the U.K. is nearly equally divided on this issue.  Remaining means a large part of the population believes they were denied their win in the first referendum, and leaving means that a large part of the population believes the country is making a huge mistake on a fairly small majority (at least considering the importance of Article 50).  In the meantime, we expect a stalemate—no exit on Halloween, new elections, inconclusive results.

More on repo:  The Fed is starting to grapple with the regulatory thicket that has led to the need for repeated repo operations to keep the money markets functioning.  First, as we suspected, the data shows that the large banks are holding the bulk of the cash in bank reserves.  The four largest banks in the U.S. held $377 bn of cash reserves at the end of Q2, well more than the remaining 21 banks in the top 25.  Large banks must meet a “liquidity coverage ratio” (LCR), assets that include cash and Treasuries.  However, the large banks are also required to meet intraday liquidity targets for which cash is the only asset that meets the regulation.  It looks like the requirements for safety have put a premium on cash and other liquid assets for the larger banks and the Fed has misjudged how much excess reserves the system needs to meet these requirements.  In other words, the repo crisis is starting to look like a regulation problem.  That doesn’t mean the regulations should be changed (after all, safety first, kids), but, given the regulations that are in place, the balance sheet needs to expand.  However, the Fed will likely be divided on expanding the balance sheet because it will appear to be another form of easing that may trigger an excessive response from the asset markets.  The other alternative is daily repo operations which is, at best, only a temporary solution.  We look for a balance sheet expansion but only after the Fed prepares the financial markets for the additional reserves.

Zuckerberg strikes back:  Last April, Facebook’s (FB, 175.81) CEO and founder, Mark Zuckerberg, suggested that the populist-left wanted to break up his company.  In comments to employees, he indicated he would fight such measures.  Senator Warren was the explicit target; she responded sharply to the comment.  How this all plays out remains to be seen; Facebook is an important medium for political ads, and it is possible the company could “tip the scales” to candidates with less interest in anti-trust actions against the firm.  We do note that Silicon Valley is getting behind Warren as her poll numbers improve.

Huawei:  Huawei (002502, CNY, 3.200) claims it has begun making 5G equipment without using U.S.-supplied components.  It is unclear how successful the firm has been with this action but if its claims are true then it would add to evidence that the tech world is dividing between China and the U.S., meaning nations will need to decide on which side they will ally.

Germans will be Germans:  As the ECB prepares to restart its quantitative easing program in November, the head of Germany’s Bundesbank, Jens Weidmann, warned that he would oppose all attempts to lift the limits on bond buying.  Currently, the ECB has given itself a limit of 33% of asset purchases, meaning the bank can only buy up to that limit with respect to a country’s government debt as well as debt in supranational and non-bank private sector debt.  The rule is designed to maintain some level of fiscal responsibility among member countries.

Mr. Weidmann’s comments highlight the growing dissent among central bankers in the Eurozone.  Rising trade tensions and sluggish growth have led a push for aggressive monetary easing to address these problems.  Ironically, Germany would likely benefit from monetary easing as the country has already contracted in two quarters within a year, and four quarters within the last five years.  Germany’s aversion to debt-fueled growth has added to market concerns of a prolonged slowdown, which have contributed to a drop in European equities.

Despite its reluctance to accept expanded monetary stimulus from the ECB, the German government has begun drawing up plans for a fiscal stimulus package if the economy were to approach recession.  The plan involves the government investing in projects that are designed to improve efficiency and boost confidence as well as stimulus in the form of tax write-offs and subsidies.  Although the stimulus plan is viewed as a safeguard in the event of a recession, it has been reported that parts of the plan have already been rolled out.

North Korea fires another missile: The launch came a day after the U.S. and North Korea agreed to resume nuclear talks.  The missile launch highlights the level of impatience that North Korea has in getting an agreement that would lead to sanctions relief.  Previous discussions about sanctions relief stalled in February after the president refused to remove all sanctions.  The U.S. has described the launch as provocative but has not formally withdrawn from the meeting.

Odds and ends:  Today marks the second anniversary of the Catalan independence referendum. In recognition of this day, thousands of protesters took to the streets to express their frustration.  Peru appears to be without a government as the president dissolved the legislature and the legislature appointed a new president.  Finally, a lesson in central banking—don’t tell people, especially depositors, not to panic.

View the complete PDF

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

[Posted: 9:30 AM EDT] Happy Q4!  Although there is a lot of news, not much is market-moving.  A poorly received bond auction in Japan has lifted bond yields around the world.  Here is what we are watching this morning:

China’s anniversary:  China held its 70^th anniversary parade.  There were lots of soldiers and military equipment, including a hypersonic missile.  During the parade, protests continued in Hong Kong.  There were reports that a protestor was shot with live ammunition; this is a serious escalation.  Now that the anniversary is past, we will be watching to see how Xi handles the Hong Kong situation.  We doubt we will see anything as blatant as the Tiananmen Square event.  Instead, we would expect a steady suppression of protests designed to slowly reduce the number of participants and make the protests appear to be tapering off.  We note that China has been moving security personnel and military groups toward Hong Kong.  Essentially, this buildup could be used to eventually stifle the uprising.  One thing to keep in mind is that China spends much more on domestic security than on its military.

We note that Xi’s speech had much to say about unity.  The Chinese state is trying to do something it has never done in its history, which is to have a strong economy that is unified.  Throughout its history, periods of strong economic growth have led to divisions between the outward-looking coastal regions and the interior.  When Mao unified the country, he did so by cutting off China from the world, which allowed him to tie the coast to the interior.  Deng’s economic reforms have led to economic divisions again that, so far, have not led to political divisions.  However, Xi’s behavior, including a massive crackdown on “corruption,” the suppression of the Uighurs and of religion, points to a leader trying to force unity on the country while maintaining growth.  If history is any guide, Xi will have to choose between a strong economy or a unified country.  Our best guess is that he will choose the latter if forced.  That would mean slower economic growth not just for China but for the world.  It is also worth noting that some of Xi’s “colleagues” may prefer the other option; perhaps this is why he spent his first term purging the party.  For now, we expect Xi to try to have both growth and unity, but that may not be possible.

Japan:  The country’s value-added tax officially rises to 10% today, from 8% previously.  While VAT hikes have derailed the Japanese economy in the past, today’s relatively smaller hike isn’t causing as much concern, in part, because it could be offset by a system of differentiated rates, cashback rewards and spending related to the upcoming rugby World Cup tournament.  Although the VAT hike is being taken well and Japanese equities remain firm, as noted above, the Japanese bond market is tumbling after the Bank of Japan said yesterday that it will slash purchases of longer term bonds in an effort to steepen the yield curve.  Meanwhile, the Government Pension Investment Fund said it will pivot toward buying more foreign debt.

Brexit:  PM Johnson has told the Tories that he expects to “know by the weekend” if he can get a Brexit deal done by the end of the month.  The issue remains the Irish backstop.  There are rumors that Johnson will propose customs clearance centers on both sides of the Irish frontier.  Johnson has denied the rumors; having customs on both sides of the border is a potential problem because the ones on the Northern Ireland side would become targets for the IRA.  We don’t think this is going to work.  If Johnson can’t sway the EU, then expect a delay in Brexit and new elections.  One interesting side note is that the U.K. apparently exports a significant amount of its trash to the Netherlands, where it is separated and some is incinerated and the rest recycled or landfilled.  If there is a hard Brexit, the Brits will have to handle their own rubbish, which could become a political problem for the Johnson government.

A cautionary tale:  For 24 hours last week, the U.S. shut down its air command center at the Al-Udeid Air Base in Qatar and shifted operations to South Carolina.  It was described as a drill, but the timing does suggest the U.S. has concerns about the safety of the base and is testing its backup plan.  This comes on reports that Saudi Arabia is trying to ease tensions.  So far, Iran has been playing “hard to get” with regard to a meeting with the U.S.

United States-North Korea:  The United States and North Korea said working-level talks on denuclearization will resume on Saturday.  The talks may show whether progress can start again now that hardliner John Bolton is no longer U.S. national security advisor.  If progress can be made, it would probably feed into the developing bullish narrative of reduced tensions in Asia.

Peru:  Frustrated with legislators refusing to pass his popular anti-corruption proposals, President Martín Vizcarra ordered the dissolution of Congress and new elections.  However, Vice President Aráoz declared the move illegal and had herself voted in as the new leader, potentially setting up a period of continued political uncertainty.

Odds and ends: Riots emerged on the Greek island of Lesbos, where a fire broke out in a refugee camp.  Although it hasn’t caught the attention of the media, refugee flows have been increasing recently.  Greece is working to improve conditions.  Italy has increased its budget deficit projections but will seek to avoid a conflict with the EU.  The WTO is warning that world trade is slowing and that this factor will likely weaken global growth.  The dollar share of world reserves has declined to its lowest level in six years; the JPY was the greatest beneficiary.  Finally, surveys are suggesting that banks are tightening credit conditions on smaller firms.

View the complete PDF

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

[Posted: 9:30 AM EDT] Happy Monday!  It’s the last day of the quarter and there is a lot going on.  Let’s dig in.  Here is what we are watching this morning:

Happy Anniversary!  The Communist Party of China (CPC) will hold major celebrations this week for the 70^th anniversary of the CPC’s takeover of the mainland.  Tomorrow, a large parade will be held.  Meanwhile, it was another weekend of protests in Hong Kong.  Chairman Xi has been trying to bring Hong Kong under Beijing’s control since coming to office.  Xi’s policy has been to homogenize China culturally; he has cracked down on Islam and Christianity, and clearly does not want any other social narrative but that of the CPC.  The actions in Hong Kong are affecting Taiwan’s view of the mainland and may make the island even more determined to remain separate from Beijing.  In other China news, PMIs came in better than forecast.

Capital issues:  Equity markets took a tumble on Friday on reports that the U.S. is considering delisting Chinese equities from U.S. financial markets.  The administration has denied the reports, but we note these ideas have been floating around Congress for some time.  As our recent WGRs[1] note, attacking the trade deficit from the current account doesn’t really work in a floating exchange rate environment.  But, attacking it from the capital account can be very effective.  Similar to the Baldwin/Hawley bill, which would force the Fed to ease policy to achieve a weaker dollar and allow the Fed to levy taxes on foreign Treasury buyers, delisting measures would affect China through the capital account.  China has a serious debt overhang and is likely considering something akin to debt/equity swaps to eventually resolve the problem.  Getting foreigners to “participate” would be a reasonable desire.  Delisting would dramatically reduce China’s ability to tap global financial markets and thus force the debt adjustment onto China.

Financial markets were affected by the reports.

It makes sense that the administration would downplay the delisting news in front of this week’s anniversary (see below) and trade talks in mid-October.  However, we doubt this will be the last word on the issue.  As the aforementioned WGRs noted, the capital account would be an effective avenue to address deglobalization.  Restricting foreign access to U.S. financial markets is part of that process.  On a related note, China has been reducing its foreign direct investment, in part, due to worries over the trade deal and also due to some rather questionable investments.

European Union:  The European Parliament will hold confirmation hearings this week for incoming European Commission President von der Leyen’s slate of commissioners.  Several of her nominees are already in trouble because of financial conflicts of interest, and observers worry political bickering will push the process well beyond November 1.

Trouble for Johnson:  PM Johnson isn’t just struggling to deal with a difficult Parliament.  His wayward past is also bubbling up to hurt his ability to lead.  And, the DUP is cooling to the possibility of a trade deal that keeps Northern Ireland in the EU trading zone.

Repos continue:  The Fed carried out repos again this morning among increasing fears that the Federal Reserve may have given the NY FRB presidency to the wrong guy.  John Williams was appointed to the position in April 2018.  Williams had an illustrious turn as president of the San Francisco FRB and is a well-respected monetary and financial market economist.  His work on “R*” has shaped monetary policy for the past decade.  However, he is not a “market guy.”  Historically, the president of the NY FRB has had experience in the “plumbing” of the financial system.  Ed Corrigan and Bill McDonough had long experience on “the desk.”  Tim Geithner had broad international experience.  However, there was some departure from the streetwise presidents with Bill Dudley, and Williams had little financial market experience.  Complicating matters, last May, Williams fired two long-term veterans, Simon Potter, who had been at the NY FRB since 1998 and ran the markets desk since 2012, and Richard Dzina, who had been with the bank since 1991.  Reports suggest that Williams wanted to change the management structure of the markets desk and apparently decided these leaders were not helping that effort.  It is also important to note that the Fed hasn’t really had to conduct repo operations since 2009 when QE flooded the banking system with reserves.  There may be a lack of experience on the trading desk in the execution of these actions.  Although Williams’s academic work shows clear expertise in theoretical monetary policy, he may have a gap in understanding the actual operations of the financial system.  We suspect Williams will acquire this knowledge in due time, but the actions of the NY FRB have done little to inspire confidence.

Austria elections:  Sebastian Kurz’s party had a strong showing in this weekend’s elections, with the center-left and the populist-right losing support.  The Greens showed a dramatic improvement.  Kurz now has his pick of coalition partners.  He could return to the chastened populist-right to form a government, or break tradition and bring the Greens into government.   We will be watching to see how Kurz chooses because it could indicate how the political situations of other European nations may evolve.

Happy New Year!  Rosh Hashanah began yesterday evening and will end tomorrow evening.  We usually mark market performance on the Gregorian calendar, but here is a chart showing how we have done over the past year using the Hebrew calendar.

It’s been a good year for gold and bonds, but rather “meh” for stocks.

Saudi Arabia:  Fitch’s Ratings cut Saudi Arabia’s long-term, foreign-currency debt rating to A from A+, citing the increased geopolitical and military risks that became evident in the recent attacks on the country’s oil infrastructure.  Importantly, the agency said it saw a risk of further attacks that could hurt the country’s economy.

Odds and ends:  Protests continue in Moscow.  The Houthis are claiming a major victory against Saudi forces in Yemen.  Crown Prince Salman warns of “skyrocketing” oil prices if the world does not bring Iran to heel.  As one would expect given the turmoil, voter turnout in Afghanistan was light.

View the complete PDF

---

[1] See WGRS, Weaponizing the Dollar: The Nuclear Option, Part I (9/16/19) and Part II (9/23/19).

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

[Posted: 9:30 AM EDT]

Hurray for Friday!  It has been a tumultuous week as we approach the end of Q3.  Markets are generally quiet this morning.  U.S. economic data was a bit soft (see below).  There are two elections over the weekend, in Afghanistan and Austria.  The media is fully focused on the impeachment issue.  Here is what we are watching this morning:

BREAKING: Oil falls on reports that the U.S. has offered to remove all sanctions in exchange for talks.  Reports have not been confirmed by the White House.

Releasing the doves:  Michael Saunders, one of the more hawkish members of the Bank of England, said today that the BOE may need to reduce rates even if a no-deal Brexit is avoided because growth has been dampened due to the turmoil caused by the issue.  The GBP fell on the news.

Elections:  In the midst of instability, Afghanistan is holding elections this weekend. Islamic State (IS) has become increasingly active in the country, not only attacking the official state but also the Taliban.  According to reports, IS and al Qaeda officials have been in talks as well.  Overall, it is hard to see how elections can be conducted in such an atmosphere.  The sitting government, fearing the U.S. wants to pull out of the country and make a deal with the Taliban, likely wants a mandate that an election victory would grant it.  Look for terrorist acts and general insecurity this weekend.

Meanwhile, in Austria, Sebastian Kurz is poised to return to power as he leads the center-right to a likely win…but not a majority.  Kurz will need to build a coalition; polls suggest his People’s Party will gain about 35% of the vote.  He could join with the center-left Social Democrats to form a unity government, or the populist-right Freedom Party to create a conservative coalition.  Thus, the election itself has little drama, but the post-election coalition decision will be the real event.

Labor unrest:  The GM strike continues into its 11^th day, but it does appear that negotiations are coming to a close; however, the issues still needing to be resolved are the most difficult, so it would not be a surprise to see talks extend into next week.  Meanwhile, the Chicago Teachers Union has authorized a strike.  A teachers union strike in a major city tends to bring serious disruption as students (about 300k) have nowhere to go during the day.

Falling confidence:  Economic confidence in the Eurozone fell to over four-year lows as the industrial sector slows.

Although not necessarily at recession levels, the decline is pronounced and supports easier ECB policy.  The EUR is weaker on the news.

China trade:  China continues to buy U.S. agricultural goods, framing the purchases as a confidence-building measure rather than the fulfillment of a desperate need.  High-level talks are scheduled for October 10.

Impeachment talk:  Reflecting the many lines of inquiry that could be touched off by the White House whistleblower complaint, Kremlin spokesman Dmitry Peskov said Russia hopes the United States will not release the transcripts of calls between President Trump and President Putin.

Odds and ends:  The U.S. is sending a Patriot missile battery and 200 troops to Saudi Arabia.  Former VP Biden is proposing a financial transactions tax, likely in response to proposed wealth taxes from other Democratic party presidential candidates.  The German Bundestag voted to open talks with Albania and North Macedonia on EU entry.  The Census Bureau reports that large U.S. cities saw a decline in younger residents as Millennials and Gen-X exit cities for less expensive housing markets.  The Indonesian government is now facing a wave of student-led demonstrations.  The protests are targeted mostly against a new law being pushed by President Widodo’s conservative Islamic supporters, criminally banning sex and cohabitation outside of marriage.  In Egypt, the outbreak of political and anti-corruption protests that broke out last week look set to continue as protest leaders are calling for further demonstrations today.

View the complete PDF

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

[Posted: 9:30 AM EDT]

Markets are rather quiet this morning.  The IMF has a new leader.  The head of the DNI testifies today before the House and Senate Intelligence Committees.  The House testimony will be public, while the Senate will be closed.  We expect the media to remain focused on the impeachment issue.  Here is what we are watching this morning:

Impeachment update:  Before we start, we want to correct something we said yesterday.  We implied that we didn’t think the president would be impeached.  That’s not exactly what we meant.  We would not be surprised if the House impeaches the president but think the odds of a conviction in the Senate are near zero.

After another 24 hours, here are some additional thoughts on the impeachment issue:

1. Although we suspect this event will look more like the Clinton impeachment rather than the Nixon one, history doesn’t necessarily tell us very much. The fact that there are only two events in recent history means we simply don’t have enough of these circumstances to draw clear conclusions.  Our expectation is that these proceedings will probably help the president more than hurt him.  However, our confidence in that expectation isn’t all that solid.  To frame just how current conditions affect these events, imagine the Clinton impeachment in the #MeToo era.  Democratic Party senators would have been torn between trying to protect their party’s president and allowing him to get away with what was clearly an inappropriate relationship.  In other words, in the late 1990s, what President Clinton did was framed as an unfortunate dalliance.  In the current world, such actions, especially by older, powerful men against younger women, are not tolerated.  In today’s world, Clinton may have been removed from office.  So, we will have to play this one by ear because each one of these is unique.
2. Americans have little knowledge of the degree of corruption in Ukrainian politics. There have been chemical attacks on candidates.  Former leaders have been jailed.  The country elected a young comedian hoping he might be able to clean things up.  If we see Ukrainian officials testify before Congress, it will be quite a show.
3. Ukrainian President Zelenskiy will likely be making some apology calls to EU leaders over the coming week.

The German resigns:  Sabine Lautenschläger, the German representative and only woman on the ECB’s executive board, has resigned over recent easing actions by the ECB.  She was in her sixth year of an eight-year term.  Germany, along with other northern European nations, has become increasingly unhappy with the easy money policies of the ECB.  Draghi was able to force his will on the ECB, in part, because he has the intellectual “chops” to argue for his position.  It will be interesting to see how Legarde handles this growing hawkish opposition to easy policy.  It is possible that she will not be able to stand against it.  We will also be closely watching to see who Germany appoints to replace Lautenschläger.

More repo:  Like the cowbell, the financial system can’t get enough Fed repurchase operations.  The NY FRB will increase the size of the repo operations to $100 bn from $75 bn.  It appears that the Fed is focusing on the largest banks’ reserve hoarding as the reason for why there appears to be a scarcity of liquidity in the repo market.  If the large banks are, in fact, hoarding reserves, the key question then becomes, “why?”  We suspect it is regulation uncertainty causing this behavior, but will be watching to see if other reasons emerge.

United States-Japan:  At the UN yesterday, President Trump and Japanese Prime Minister Abe signed a trade deal that will cut Japanese agriculture tariffs and U.S. industrial duties.  However, the agreement is seen as limited.  It doesn’t appear to open up major new markets, nor does it produce major new momentum for the U.S.-China trade negotiations.

North Korea-South Korea:  Recent reporting suggests North Korea secretly annexed and occupied a small South Korean island near the countries’ maritime border, sparking a scandal for the South Korean government.  The government denies the islets are really South Korean territory, but reporters have found evidence that they were considered so in the past.

China:  Chinese buyers continue to lap up U.S. agricultural products.  At the same time, U.S. hardwood lumber exports to China have fallen 40% this year, after China’s imposition of 25% retaliatory tariffs on the product.  This helps explain why major timber REITs have fallen in price over the last year, while REITs as a whole have surged.  On another topic, the PBOC  auctioned 10 billion yuan of six-months bills in Hong Kong to shore up the yuan exchange rate.  The trade war has also affected global trade.  The Netherlands Bureau for Economic Policy Analysis has a World Trade monitor; for the first seven months of 2019, world trade contracted.

Energy update:  Crude oil inventories rose 2.4 mb compared to an expected draw of 0.6 mb.

In the details, U.S. crude oil production rose 0.1 mbpd to 12.5 mbpd, a new record.  Exports fell 0.2 mbpd, while imports fell 0.7 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.  For the past two weeks, we have seen small builds but, as the chart shows, the seasonal gap is still significant.  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 well into the autumn refinery maintenance season.

The drop in refinery utilization will likely continue for the next three 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 our oil inventory/price model, fair value is $67.53; using the euro/price model, fair value is $48.17.  The combined model, a broader analysis of the oil price, generates a fair value of $54.23.  We are seeing a clear divergence between the impact of the dollar and oil inventories.  Given that we are in the maintenance season, we would normally expect inventories to rise.  Prices will remain sensitive to Saudi output and tensions in the Middle East.

On the Middle East, conflicting trends are emerging.  The Kingdom of Saudi Arabia (KSA) is arguing that it’s oil production is recovering quickly, claiming it is producing around 8.0 mbpd, mostly from other fields and facilities that were not affected by the recent attacks.  However, it is not clear if the production has any use; if the oil can’t be processed to rid it of impurities and imbedded gasses, it can’t go anywhere.  So far, the KSA has been fulfilling its export requirements by using storage, but it is unclear how much longer it can maintain exports by draining stockpiles.  So far, markets are obviously giving the KSA the benefit of the doubt and pushing prices lower.

As the KSA supplies the oil market, calming supply fears, the U.S. continues to “turn the screws” on Iran.  The White House has barred senior Iranian officials from entering the U.S.  In addition, in the midst of trade talks with China, the U.S. has sanctioned Chinese firms that have conducted oil trade with Iran.  Tightening conditions probably increases the likelihood of a lashing out by Iran; even if there is another attack on the KSA, U.S. support for the kingdom may be tepid at best.  We view the geopolitics as bullish.

View the complete PDF