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

[Posted: 9:30 AM EDT]

Welcome back!  Three-day weekends are great, but now we get to pile five days of work into four!  Trade worries continue to weigh on risk assets.  Brexit appears to be reaching some sort of resolution.  Hurricane Dorian dominated the weekend news flow.  Here are the details and other items we are watching:

Trade: On Sunday, a new set of tariffs went into effect.  Although it will take a few weeks, we may start to see it show up in the inflation data by November.  The focus has now shifted to meetings between trade negotiators later this month.  Both sides are struggling to figure out when to hold talks and who should participate.  If Liu He doesn’t make the trip, it will suggest the meetings are simply window dressing.  The U.S. has a 5% bump on $250 bn of Chinese exports due to come into effect on October 1 (from 25% to 30%) and a 15% increase on December 15 for the remaining $200 bn in imports.  There is hope that these may be delayed or reduced, but the lack of consensus on either side makes adjustments difficult.  On a hopeful note, China’s retaliation doesn’t really go into full effect until December.  At the same time, China has important party meetings in early October, and there is no way the Xi government can be seen as caving to U.S. demands before those meetings.

Meanwhile, China is taking steps to adjust to the effects of tariffs.  Additional stimulus is being planned, although the scale remains relatively constrained mostly due to concerns about debt capacity.  We note that the CNY has been allowed to quietly weaken.  While the currency fixes have been steady, the PBOC isn’t making much of an effort to force the market rate to the fix, suggesting it is allowing the currency to offset some of the impact of the tariffs.

China is also opening new fronts in the public relations battle.  In a press release denying that it stole smartphone camera technology from a Portuguese company, Chinese telecom giant Huawei Technologies (002502.SZ, 3.19) tried to turn the tables by claiming the FBI is harassing and threatening Huawei employees to get them to turn against the company.  It also said the U.S. has launched cyberattacks against it.  Given the continued U.S.-China trade war, growing concerns about China’s digital warfare capabilities and the Trump administration’s more aggressive use of offensive cyberwarfare operations, we actually think the accusation rings true.  If so, it is probably a good example of how the administration is conducting a full-court press against China, which bodes poorly for any near-term cooling of tensions.  In another sign of Chinese pushback against the U.S., the Ministry of Public Security touted its efforts to restrict fentanyl shipments since May.  After President Trump demanded Chinese action to help deal with the U.S. opioid crisis, China could have taken some additional steps as a show of good faith.  By pushing back instead, China seems to be signaling that it’s done making concessions, at least for now.

The global economy continues to suffer the effects of the trade conflict.  Chinese PMIs over the weekend were stable but didn’t improve.  The rest of the world, on the other hand, is struggling.

China: Vice premier and Politburo member Hu Chunhua told a meeting of top officials last week that surging pork prices – resulting mostly from an epidemic of swine fever that has decimated pig herds – have become a “major political risk.”  To get control over prices, Hu called for greater financial support for pig farmers and setting pork production targets for each province, though outright price controls can’t be ruled out.

Brexit: The situation with the U.K. and Brexit is getting as complicated as determining who is in the NFL playoffs three weeks before the end of the season.  Here is the rundown:

1. MPs move to kill hard Brexit. The “rebel alliance” of MPs within the Tories is joining forces with opposition groups to vote on a bill that would prevent PM Johnson from leaving the EU without an agreement.  In case a deal with the EU isn’t reached, the bill requires Johnson to ask the EU for an extension until January 31, 2020.  The bill requires an extraordinary measure, the so-called “Standing Order 24” that allows MPs to debate important matters.  This debate and subsequent vote can only occur if the Commons Speaker, John Bercow, gives permission.  It is widely expected that he will grant the debate.  The odds of passage are high, but it would need to move quickly through the House of Commons and House of Lords to become law by early next week when Parliament shuts down.
2. If passed, what does Johnson do? The most aggressive action would be for Johnson to call for new elections.  By calling new elections, Parliament would be dissolved immediately and the delay bill will be dead.  But, there is a catch.  For a sitting PM to dissolve Parliament and call snap elections he needs a 66% vote; a mere majority won’t do it.  Of course, if Johnson loses the delay bill and can’t muster enough votes to call elections, he will be mortally wounded politically.  A vote of no-confidence could follow.
3. No-confidence may be the plan. Labour’s Corbyn has been pining for a general election but it isn’t obvious he would win.  K. politics has become jumbled in the Brexit process, with the two leading parties split.  In other words, the Tories and Labour are both divided over this issue, which would argue that new party arrangements are called for.  We would expect Johnson to make Brexit the key part of his platform in a new election to thwart the effect of the Brexit Party; some Tory MPs would likely defect to another party, putting their seats at risk.  Meanwhile, it isn’t obvious where Labour would fall on this issue.  Former PM Blair rightly warns that Labour is falling into an “elephant trap” and would likely lose a general election.  Complicating matters further is that Labour has just released a radical economic platform that may be too extreme to win a majority.  Johnson could easily move an election away from Brexit and toward Corbyn.  New elections are risky for all parties, but it may be the only way to break the current gridlock.  If elections are called, we would expect them before the Halloween exit deadline.

The GBP fell on the turmoil to historic lows but hasn’t collapsed.  Despite the concerns, so far, there is enough uncertainty to prevent either a strong relief rally or a meltdown.  But, as we have described above, there is enough that can go wrong that the risks of a volatile move in either direction are elevated.  For now, investors should remain cautious.

Hong Kong: The situation remains grim.  There were massive demonstrations over the weekend, with water cannons spewing blue water (a new twist on the tactic, making demonstrators easier to identify for arrest) and lots of tear gas.  The Chinese government’s Hong Kong and Macau Affairs Office continues to assert itself amid the continuing anti-China political protests in Hong Kong.  Today the office said the protests are looking more like the “color revolutions” that have toppled governments in Eastern Europe and the Middle East.  It also warned that it has the legal power to declare a state of emergency in the city, and outlined several steps it might take to get control over the situation, including the possible introduction of “patriotic education” into Hong Kong schools.  The office is still focusing on threats to diffuse the crisis, but the risk of a disruptive crackdown can’t be dismissed.

Argentina: Over the weekend, the government imposed capital controls in an effort to contain its latest debt and currency crisis.  Under the controls, residents aren’t allowed to buy more than $10,000 of foreign currency per month.  The peso jumped on the news, but it’s not yet clear whether its recent plunge will resume.

Italy: In another nail-biter in European politics today, Italy’s left-wing Five Star Movement will conduct an online poll of its members on whether to approve a deal with the center-left Democratic Party for a coalition government.  The deal is generally expected to be approved, but if it fails it would add to the sense of political chaos in Europe and weigh on assets ranging from the euro to Italian stocks and bonds.

Japan: Prime Minister Abe said he will reshuffle his cabinet on September 11.  Reports indicate most key players in the cabinet will keep their jobs, but Economic Revitalization Minister Toshimitsu Motegi may be promoted to foreign minister to reward him for his work negotiating the new trade deal with the United States.

Australia: In order to break China’s near monopoly on rare-earth and other critical minerals, the Australian government said it will support more than a dozen private-sector mining projects centered on those materials.

German regional elections: Germany held regional elections in two former East German states.  The AfD made a strong showing but the CDU did win the most votes.  Both the hard-left and the SPD had weak showings.  Overall, the results avoided the most unsettling outcome (an AfD majority), but also showed that the centrist parties are still struggling to gather votes.

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

[Posted: 9:30 AM EDT]

It’s the last business day of “cultural summer” (the autumn equinox doesn’t occur until September 23), but the summer season generally ends with Labor Day.  Trade optimism continues to buoy equities.  There are elections in Germany over the weekend.  Hurricane Dorian is bearing down on the Atlantic Coast of Florida.  Here are the details and other items we are watching:

China trade:  Optimism abounds but the evidence of progress is rather thin.  There are reports that trade negotiators are maintaining “effective communication” but it isn’t clear what exactly that means.  Both sides appear to be trying to look reasonable and seem to be seeking a way to reduce tensions.  However, underneath all the happy talk are increasingly long odds that the negative impact of the trade tensions can be avoided.  Here are few items of note:

1. The CNY dropped sharply in August, its biggest monthly fall in 25 years. Although the usual reaction to tariffs is currency depreciation, we expect the PBOC to resist further sharp declines.  First, Chinese firms are holding around $500 bn of dollar-denominated debt and CNY weakness increases the cost of debt service.  Second, fears of currency weakness tend to lead to capital flight in China; there are reports that authorities in China are increasing their efforts to contain outflows.
2. There has been a timing problem with trade tensions. Recall Q4 2018…equity markets were declining, in part on trade concerns, which led Presidents Xi and Trump to declare a temporary ceasefire.  One of the factors that led to this easing of tensions was that China had passed its party meetings.  China has informal meetings in August (which have just concluded) and major party gatherings in the first week of October.  It’s difficult for any Chinese leader to concede anything to foreigners until these meetings have passed.  This year is particularly sensitive because it is the 70^th anniversary of the founding of the communist government on the mainland.  Chairman Xi is slated to give a major policy speech on October 1 to commemorate the event.  Giving that speech while making concessions to the U.S. is just about impossible.  Thus, we may have meetings between negotiators next month, but we would not expect any breakthroughs unless the U.S. completely caves, which looks highly improbable.
3. Although reports of contacts continue, both sides are preparing for more of the worst. China is said to be measuring its exposure to U.S. technology firms as it prepares a “blacklist” of unreliable U.S. trade partners.  The Trump administration is considering a plan to reduce taxes by the amount raised by the tariff levies.  If the U.S. were planning to pull back on tariffs, it would not need to create a mechanism to recycle the revenue.
4. Nazak Nikakhtar, the acting chief of the Commerce Department bureau reviewing U.S. company license applications to trade with Chinese telecom firm Huawei (002502.SZ, 3.06), has mysteriously resigned in order to return to the more junior position she previously held elsewhere in the department. The licenses to trade with Huawei have become an important bargaining chip in the U.S.-China trade dispute.  As an inducement to China, President Trump has promised the licenses would be issued, but none have been granted to date.  Nikakhtar’s curious decision to step back to a lower-level role suggests there was something about the process that she found unpalatable.
5. Pain from the trade war is rising. S. businesses complain their Chinese operations have been adversely affected by the trade war and are warning that the conflict is hurting their overall business.  The Peterson Institute has a fine summary of the impact we have seen from the trade war.
6. Although the process is slow, it does appear that some operations are moving out of China. India is attempting to become a destination for this outflow.  However, there is scant evidence that production is coming back to the U.S., a goal of the administration.
7. There is a risk that the trade war could trigger a financial event, most likely in China. Two items caught our attention, in addition to the aforementioned level of dollar debt held by Chinese firms.  First, the PBOC is trying to contain potential problems in smaller banks that could be at risk to the slowing economy.  Second, the Chinese youth, unlike their parents, are spending heavily and racking up debt to maintain their lifestyle.  They could be vulnerable to a decline in growth.  Although the Xi government would appear to be able to absorb more pain than the Trump administration, one must be careful not to overestimate Chinese resilience.  At the same time, as noted in point two, the odds of a deal before mid-October are very low.

German local elections:  Germany will hold state elections in Brandenburg and Saxony on Sunday, 9/1.  The AfD is making a strong showing; if the CDU loses, it could undermine Merkel and her successor, AKK.  In addition, a poor showing might tempt the Social Democrats to exit the grand coalition and bring down the government.

Hong Kong:  The municipal police have arrested several high-profile democracy activists on charges of instigating unlawful demonstrations.  Those arrested include Joshua Wong, a key leader of the “Umbrella Movement” in 2014, and Agnes Chow, a leader in Wong’s group, as well as two elected officials and the former head of a student union.  Wong and Chow were later released on bail, but the arrests are seen as a warning for anyone trying to organize further protests like those that have been going on all summer.  More ominously, two other well-known activists were attacked and beaten by masked assailants, suggesting the government could still be using organized crime figures – or at least their tactics – to intimidate demonstrators.  After the Hong Kong government’s refusal yesterday to grant a permit for another big demonstration on Saturday, its organizers officially cancelled it, but other democracy and anti-China activists are calling for unsanctioned protests.  The potential for miscalculation and violence remains high, which will likely continue to be a cloud over the Hong Kong economy and assets.

In a report that should dispel hopes that Beijing will make concessions to the Hong Kong protestors, Hong Kong Chief Executive Carrie Lam evidently proposed a formal withdrawal of her controversial extradition bill this summer, but Chinese officials rejected the idea.

Brexit:  Courts in Scotland and Northern Ireland have both declined to issue an immediate injunction against Prime Minister Johnson’s plan to suspend Parliament in order to prevent legislation that would block a no-deal Brexit.  Instead, both courts have scheduled hearings on the matter next week, but legal experts suggest the suspension is a prerogative of the prime minister that is not subject to review.

Otherwise, the game of chicken is on.  PM Johnson is pressing for talks with the EU to damp down the outrage over closing Parliament.  The opposition is considering a no-confidence vote, even picking up some Remain Tories, but that requires getting behind a caretaker government led by Jeremy Corbyn, a distasteful option.  The EU shows little sign of changing anything; Ireland remains upset with the U.K. over the backstop.  Again, as we noted yesterday, despite all the turmoil, the GBP is holding its own, suggesting that we may be seeing a short-term bottom in the currency.

Japan:  In its budget request for the fiscal year starting April 1, the Defense Ministry proposed converting a destroyer into Japan’s first post-World War II aircraft carrier, and buying U.S.-made F-35B jet fighters to arm it.  The proposal is consistent with Prime Minister Abe’s drive to revamp the country’s pacifist constitution and adopt a more muscular, independent approach to national defense.  As they continue to push for the U.S. to step back from its traditional role as global hegemon, President Trump and his administration will likely applaud the possibility that Japan could soon be able to shoulder more responsibility for its own defense.  However, it’s important to remember that a future carrier could also allow Japan to project power in ways that might be at odds with U.S. interests, such as pressuring South Korea over the disputed Dokdo islands.

Iran:  There is apparently growing sentiment in Iran that it will be forced to acquiesce to talks with the U.S. because President Trump might win a second term and the Iranian economy probably won’t be able to withstand another five years of sanctions.  If this is the case, Iran will probably try to ramp up its disruptive actions in the Middle East to improve its bargaining position.  The risk, of course, is that it overreaches and triggers a military response.  Of course, hawks within the administration would support escalation; we note that Israel is uncomfortable with U.S. and Iranian talks.  This situation is bullish for oil until talks ensue.

Odds and ends:  Ridesharing firms are deploying a massive lobbying effort to thwart attempts by legislators that would make it more difficult to treat their workers as independent contractors.  There is evidence that wealthy Americans are cutting back their spending, perhaps signaling a loss of confidence.  Argentina suffered a three-notch downgrade by Standard and Poor’s.  The country’s long-term foreign debt now carries a CCC rating.  ECB hawks are pushing back against Mario Draghi’s planned easing expected next month.  There are increasing reports that businesses are simply unable to find workers in some markets, a reflection of tight labor market conditions and a growing lack of mobility among American workers.

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

[Posted: 9:30 AM EDT]

Risk-on has returned on trade optimism.  Italy has a government.  Brexit thoughts.  Fifty-year T-bonds?  Here are the details and other items we are watching:

China: Equity futures rebounded after China indicated that it would not retaliate against the latest U.S. tariff increases.  That news raised hopes that there may be a cooling in trade tensions.  China also indicated it “hopes the U.S. will create conditions necessary for September talks.”   We have our doubts that this lack of retaliation is a breakthrough.  China is running out of items to apply tariffs to and is probably considering measures other than trade to retaliate.

For example, China indicated yesterday that it would extend its “social credit” system to monitor and manage foreign companies.  The social credit system is an evolving program in China that measures the behavior of Chinese citizens on a number of different scales and assigns them a number that can affect school entries, loans, government services, etc.  By moving to a similar system for companies, Beijing is working to structure a program where it can reward firms for doing what China wants, and punish them for bad behavior, on a systemic basis.  To some extent, all nations monitor firms that operate in their countries, both foreign and domestic.  However, this overt scoring system has Orwellian overtones and is raising concerns among foreign firms operating in China.  In the current environment, it would be expected that China might reward U.S. firms that rebuff American government efforts to enforce trade sanctions.

The Chinese government is reportedly studying the extent to which Chinese technology companies are dependent on U.S. suppliers.  The research apparently aims to gauge whether those firms could withstand further shocks from the U.S.-China trade war.  It could also be used to plan for weaning the companies off their dependence on U.S. technology.  In sum, it’s the kind of thing you would expect to see in an intensifying trade war and a splintering of the global economy into regional spheres.

The Xi government is moving to adapt to a less integrated world by changing its focus on internal growth, especially emphasizing its major cities.  This is something of a reversal of the policies of recent years which tried to boost growth in China’s interior through direct investment and lending.  The tension between the faster growing and more cosmopolitan coastal regions and the interior have been a feature of Chinese history for centuries.  Typically, China can be rich and divided or poor and united; this policy reversal will likely lead to the former.

Hong Kong: The municipal police department has turned down a permit request for a major new anti-China protest on Saturday near the Chinese government’s liaison office.  The permit request was submitted by the Civil Human Rights Front, which has organized some of Hong Kong’s biggest protests over the last four months.  This event was to commemorate Hong Kong’s rejection of electoral restrictions that Beijing wanted to implement.  Although permit refusals aren’t unheard of in Hong Kong, this one has the potential to stoke anger and prompt an unsanctioned, violent demonstration over the coming weekend.

Japan: Bank of Japan board member Hitoshi Suzuki warned in a speech today that any move by the central bank to cut interest rates further would do more harm than good.  Suzuki warned that financial institutions might try to mitigate the pain of lower rates by charging fees on household deposits, as has happened in Europe, and he said that could cool consumer sentiment.  He also said excessively low interest rates could discourage banks from lending, which would offset the benefit of any policy easing.

South Korea: The finance ministry’s proposed budget for the next fiscal year would boost spending by a whopping 8%, even after considering the stimulatory supplementary spending added to this year’s budget.  The stimulus, which is its biggest since the Global Financial Crisis a decade ago, is designed to counter the headwinds from weaker economic growth abroad and the U.S.-China trade battle.

United States-Japan-South Korea: In an exceedingly rare development, the South Korean government has summoned the U.S. ambassador in Seoul and demanded that the U.S. butt out of the Japan-South Korea dispute over Tokyo’s behavior before and during World War II.  That dispute itself is a symptom of the U.S. backing away from its traditional role as global hegemon.  Along with Seoul’s failure to give the U.S. advance warning of its recent withdrawal from an intelligence-sharing program between Japan-South Korea, the castigation of the U.S. ambassador amounts to a significant slap in the face that would have been hard to imagine at the height of U.S. hegemony a couple of decades ago.

Italy: We have a government!  President Sergio Mattarella offered Giuseppe Conte a renewed term as prime minister with the support of the center-left Democratic Party and the left-wing, anti-establishment Five Star Movement.  If Conte is confirmed by the parties, it would leave former Deputy Prime Minister Matteo Salvini and his right-wing populist League party out of power.  The move is positive for Italian assets, in particular, and European assets, in general, but we remain skeptical that the two new coalition partners can maintain peace among themselves for very long.  However, there was a clear relief rally in financial markets.

Italian bond yields fell sharply, and the spread against German bunds narrowed.  This news does reduce the risk of a Eurozone crisis emanating from Italy, at least for the time being.

Brexit: Yesterday, we reported on Queen Elisabeth approving PM Johnson’s request to prorogue Parliament until mid-October in a bid to shorten the time between their return and the Brexit deadline.  This action will make it very difficult for Parliament to block the U.K. exit from the EU.  This move by the PM seems to increase the odds that there will be a “hard Brexit,” a crashing out of the EU.  To paraphrase Sherlock Holmes, the “dog that didn’t bark” is the GBP.  It did weaken a bit but did not make new lows on the news.  There are a couple of reasons why.  First, it’s possible the currency is so cheap that it may not have much room to decline further.

This chart shows our purchasing power parity model, which values exchange rates based on relative inflation.  As the chart shows, the pound is deeply undervalued, approaching two standard errors below fair value.  Although we have speculated that we might test the 1985 lows, putting the GBP around $1.09, the lack of selling on what should be bearish news may be signaling the worst is over.  Second, the markets may be taking a more nuanced view of Brexit; although there will be disruptions, they may not be as dire as predicted and being short here, at such a “cheap” level, could leave one vulnerable to a short-covering rally.  It’s still too early to tell, but if the exchange rate holds in the face of this current turmoil then we may be reaching a bottom.

Argentina: With the country on the verge of its ninth sovereign default, Finance Minister Hernán Lacunza said the government will ask its creditors to accept delayed repayment on some $101 billion of debt.  The request would apply to approximately $7 billion of short-term local debt, $50 billion of long-term private debt held mostly by foreigners and $44 billion of debt from the IMF.  Lacunza claimed the move was driven merely by liquidity issues, rather than a solvency problem, but the debt may actually be untenable given the steep drop in the peso since President Macri’s primary election defeat in early August.

Century bonds?  Treasury Secretary Mnuchin indicated yesterday that the Treasury is considering ultra-long bonds.  Given the low level of interest rates, issuing such bonds makes sense.  But, an added benefit from this move is that it would likely steepen the yield curve.

Odds and ends: Mnuchin also indicated that his department is not considering dollar intervention at this time.  Chairman Xi is planning to deliver a major address in early October to mark the 70^th anniversary of Mao’s takeover of mainland China.  GOP senators would like to open hearings on Bill Dudley’s op-ed to question whether the Fed is acting to affect election outcomes.  Recent polls suggest that more voters are seeing economic deterioration compared to expansion, an ominous sign for President Trump’s re-election.

Energy update: Crude oil inventories fell 10.0 mb compared to an expected draw of 2.3 mb.

In the details, U.S. crude oil production rose to a new record, up 0.2 mbpd to 12.5 mbpd.  Exports rose 0.2 mbpd, while imports declined 1.3 mbpd.  Refinery operations fell 0.7%.  The large drop in stockpiles was mostly due to the decline in imports.

This chart shows the annual seasonal pattern for crude oil inventories.  Seasonal factors clearly fell hard this week and are now well below the seasonal trough.  However, the summer driving season is rapidly coming to a close, so further inventory declines of significance are unlikely.

Based on our oil inventory/price model, fair value is $64.93; using the euro/price model, fair value is $50.22.  The combined model, a broader analysis of oil prices, generates a fair value of $54.51.  We are seeing a clear divergence between the impact of the dollar and oil inventories.  Given that we are nearing the end of the summer driving season, the bullish impact of inventories will likely diminish in the coming weeks.  A sideways to lower price path is the most likely outcome.

On the geopolitical front, there may be a division developing between President Trump and other members of his administration.  The president has indicated he wants to talk; SoS Pompeo doesn’t seem to be on the same page.  Neither does John Bolton.  Overall, we would bet on the president; his long-term goal is to avoid entanglements in the Middle East and he wants a new deal with Iran but not regime change.  Any thaw with Iran would tend to weaken oil prices.  At the same time, Israel is stepping up attacks on suspected Iranian proxies in a bid to prevent Iran from arming these groups.  These attacks carry the potential for escalation.

President Andrés Manuel López Obrador is reportedly backtracking on his opposition to private-sector participation in the country’s energy sector.  Next year, according to a senior official, the government will once again allow private companies to bid for energy exploration rights in the Gulf of Mexico, and the president will allow state oil company Pemex to resume joint ventures with private companies, as provided for in a 2013 energy reform that the president has criticized.  Increased private-sector participation is probably essential to reversing Mexico’s continuing oil production decline, so the news is certainly positive.  However, López Obrador’s behavior to date still suggests some risk to property rights, the sanctity of contracts and private enterprise under his leadership.

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

[Posted: 9:30 AM EDT]

It’s midweek; halfway to Labor Day weekend!  Boris moves against Parliament, Parliament moves against Boris and we are reacting to the Bill Dudley op-ed. Here are the details and other items we are watching:

Brexit:  For the first time since 1948, PM Johnson has asked Queen Elizabeth to suspend Parliament on September 10, only a week after it returns from summer break, until October 14, which would severely limit the ability of the MPs to block a no-deal Brexit.  There are currently court challenges against the move in Scotland and former PM John Major has promised similar action in English courts.  By convention, the sovereign accepts the PM’s request for proroguing Parliament, although it is possible she might reject the suggestion.  The move increases the odds of a no-deal Brexit.  The GBP tumbled on the news.  The opposition in Parliament is trying to cobble together a response, which seems similar to what was used to delay Brexit at the end of March.  Meanwhile, the Johnson government is pushing for additional fiscal spending, which is normal if one is preparing for elections.

We note the move comes a day after Boris Johnson told German Chancellor Angela Merkel and European Commission President Jean-Claude Junker that he was willing to accept minor changes to the Brexit agreement if they agreed to changes to the Irish backstop.  This proposal was likely to assuage fears of a broader rewriting of the bill.  That said, by suspending Parliament, Boris Johnson’s Brexit agreement would likely force MPs to accept his agreement as-is or nothing at all.  As a result, the likelihood of a no-confidence vote and a no-deal Brexit is extremely elevated.  Following the news, the pound weakened significantly against the dollar due to growing uncertainty of Brexit.

The Dudley op-ed:  Bill Dudley, the former president of the NY FRB, penned an essay for Bloomberg where he suggested that the Fed should not accommodate the president’s trade policy, essentially acting as a governor against the trade war.  His concern is that by reducing rates to offset the negative effects of tariffs, the Fed is enabling the president’s trade policy.

As a private citizen, he has every right to express his opinion.  Additionally, he isn’t the first person to make such observations.  However, as a former member of the FOMC and permanent voter on monetary policy, the expression of his views is dangerous, even if he firmly believes them.

1. The Federal Reserve is an unelected body. Although the Fed governors are approved by the Senate, the regional bank presidents are not so there is limited democratic oversight of monetary policy.  The U.S. government does give power to unelected organs of government but limits their scope by giving them specific mandates.  The Fed has a relatively simple mandate, full employment and low inflation with fairly limited tools to meet these goals.  After 2008, the Fed veered closely into fiscal policy, but we do note that instead of simply recapitalizing the banks itself, which it had the wherewithal to do, Chair Bernanke insisted on the passage of TARP to ensure recapitalization had democratic legitimacy.  We let the Fed do a lot with its powerful tools, but with limited scope.  Tensions between the legislature, the executive and the Fed are nothing new, but Dudley’s recommendations would suggest that the Fed should take steps to thwart the desires of elected officials.  This may only be done within the strict limits of its mandate, not to simply stop a policy it may not favor.
2. Dudley’s comments as a former official are inappropriate because they will apply a political taint on the central bank. A theme that runs through populism is that the elites are a cabal that use the tools of government to support the goals and aspirations of the elite.  Populists of all stripes are, at best, jaded over free trade or, at worst, support autarky.  For a former central banker to suggest that the Fed should engage in behaviors that undermine an administration’s trade policy simply confirms to populists that the “game is rigged.”
3. A political taint for the Fed raises worries that yet another non-elected part of government is becoming politicized. For those in the political sphere, manipulating bodies like the Fed or the Supreme Court is fair game because their goal is to further their political aims.  That is what power is all about.  We create these apolitical bodies to limit the scope of political power, to make groups in government that can make decisions based on considerations other than simply political concerns.  When these apolitical bodies shift into policy advocacy, problems develop.  In general, one can either change the world or understand it, but you can’t do both.  If one decides to change the world, everything becomes a tool to meeting that goal.  If one decides to understand the world, they must avoid crossing over into altering the world, because at that point bias sets in.  Some have argued that we are political at heart and no one is unbiased.  We disagree, but the costs of being unbiased is that one cannot cross the line into advocacy.  History has shown periods when the Supreme Court appeared to venture into advocacy; once that occurs, faith in the court diminishes and its decisions can be seen as merely political.  Justice Roberts appears to be disappointing some in the political sphere for not moving toward their goals, but we suspect the chief justice is trying to uphold the integrity of the institution.  The concern now, in the wake of Dudley’s comment, is that decisions made by the Fed will be subject to political analysis.  In other words, Dudley may have inadvertently undermined the integrity of the Federal Reserve.

The Fed has officially rejected Dudley’s comments, as it should, but the damage has been done.  Chair Powell was already facing a difficult task of conducting monetary policy under a constant barrage of criticism.  Now, Dudley’s comments can be used to frame unpopular monetary policy decisions as having a political agenda.

A rare occurrence:  Yesterday, the dividend yield on the S&P 500 rose above the yield on the 30-year T-bond.

The 30-year T-bond has a relatively short history; the first issuance occurred in 1977.  The only other time this occurred was in 2009 and was due to the collapse in equity prices.  This time, it was due to the drop in Treasury yields.

Conte returns?  The Five-Star Movement and the Democratic Party are close to coming to an agreement that would avoid new elections.  Under the new government, Guiseppe Conte would return as prime minister, with Five-Star’s Luigi Di Maio returning as his deputy, and co-deputy Matteo Salvini would likely be replaced by a member of the Democratic Party.

Last week, the parliament dissolved after the League Party decided that it no longer wanted to form a coalition government with the Five-Star Movement.  To say that the relationship between the two sides was rocky from the start would be putting it lightly as the two parties represent populist wings of opposite sides of the political spectrum.  Following the dissolvement of the coalition, Italian President Sergio Mattarella gave the parties the opportunity to form a government in order to avoid snap elections; within that time, the Five-Star Movement held talks with the Democratic Party.  In the event of an election, the co-deputy and League  leader Matteo Salvini, who helped initiate the procedure, is favored to take over as prime minister.  Optimism about a possible coalition between the Democratic Party and the Five-Star Movement has resulted in a rally in Italians bonds.

Big Tech project on hold: A plan to build an undersea cable that would link the U.S. and mainland China has been put on hold due to national security concerns.  The Justice Department has concerns over one of the Chinese backers, Dr. Peng Telecom & Media Group Co. (600804, CNY 6.81).  U.S. official involvement is another example of the growing distrust between the U.S. and China.

Russia-Turkey:  At the opening of a major airshow in Moscow yesterday, President Putin personally gave Turkish President Recep Tayyip Erdogan a tour of Russia’s newest stealth fighter jet, the Su-57.  Putin continues to take advantage of Turkey’s growing estrangement from the West (see our Weekly Geopolitical Report from August 5).  Ankara’s purchase of a Russian air defense system this summer prompted President Trump to prohibit any sales of the U.S. F-35 stealth fighter to Turkey, so Putin is now dangling the Su-57 and other aircraft in front of Turkey with the hope of pulling Ankara further onto Russia’s side.

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

[Posted: 9:30 AM EDT]

Good morning!  After several days of stomach-turning gyrations, things are rather quiet this morning.   Here is what we are watching:

Italy:  Today is the deadline day for the center-left and populist-left to try to cobble together a coalition.  The news is mixed.  On the one hand, it does appear that talks have progressed in a favorable manner.  However, the squabbling is continuing and still could upend a deal.  We are leaning toward a new coalition outcome, for no other reason than the League is so hated by the other parties that keeping it out of government is enough to hold a disparate group together.  A coalition that excludes the League will likely narrow the spread between Italian and German sovereign yields.  However, we would not expect it to hold together for more than a year.

Let’s talk:  After exiting the JCPOA in May 2018 and applying crippling sanctions on Iran, President Trump is signaling that he is open to a meeting.  Our read is that the more moderate elements in the Iranian political system are open to talking, but the hardliners are strongly opposed.  Iran’s response is that if sanctions are lifted, they will talk.  Which, for now, is a non-starter.

However, we are seeing one interesting development on President Trump’s openness to a meeting.  Israel is getting nervous.  Although the leaders of the two nations have close and warm ties, Israel can’t help but notice that this U.S. administration is willing to engage in diplomacy that may put allies in a difficult position.  Japan is a case in point.  The U.S. is making it clear that it will tolerate North Korea’s nuclear and missile program as long as it doesn’t threaten the U.S. mainland.  That gives little comfort to Tokyo.  Israel rightly fears that its interests could be harmed if the U.S. and Iran make a deal.  We have noted recently that Israel has increased its military strikes in the region.  It’s possible it is taking these actions on concerns that if a deal between Iran and the U.S. develops, Iran will recover.  Thus, these strikes may be seen as opportunistic.

Trade:  The whipsawing on trade with China is dizzying.  After suggesting that his only regret about increasing tariffs was that he didn’t raise them enough, the president seemed to back off from his comments and, in Pavlovian fashion, equity markets rallied.  With all this volatility, it is hard to discern what path makes sense.  Here is one idea; the U.S. can either engage in a trade war with China or enjoy stronger economic growth.  However, it may not be possible to do both.

One of the items taught in the first week of an introductory economics course is the production possibility curve.  The point of the exercise is to show that, at full utilization, there is a trade-off in what can be produced.  Essentially, the curve illustrates the concept of opportunity cost; if an entity chooses a certain objective, it probably means that it will forgo other goals, which become a “cost” to that choice.  All presidents (or for that matter, all people) want to believe they are “inside” the curve, meaning they can get more than two goals.  The notion of “having it all” is about being inside the curve.  What we find in reality is that, most of the time, we are on the frontier and getting more of one thing means losing something else.  That is likely where we are on the trade issue with China.  If the goal of reducing our economic entwinement with China is to be fostered, it will almost certainly have a negative impact on U.S. growth, at least at first.  Reducing our ties to China may be a worthwhile goal, but it doesn’t come without costs.

Slow Germany:  German GDP contracted in Q2 by an annualized 0.3%.

The decline was modest but, as the chart shows, growth hasn’t exceeded 2% since Q4 2017.  Although, on its face, the data doesn’t look too bad, the underlying data is worrisome.  Final domestic demand, excluding inventory accumulation, fell 2.8%; simply put, the overall GDP number was boosted by strong inventories which won’t continue.  Despite these weak numbers, the head of the Bundesbank, Jens Weidmann, opposes new stimulus.  A slowing German economy will undermine overall EU economic growth.

Norway:  In spite of the relatively higher valuation of U.S. stocks, and prospects for a depreciating dollar, central bank officials managing Norway’s $1 trillion sovereign wealth fund have recommended removing the fund’s current over-weight position in European equities.  Instead, they recommend moving toward an index-weight allocation with about 19% of their equity holdings in Europe (from 34% currently) and 57% in North America (from 40% currently).

Japan-South Korea:  The U.S. Department of State has warned that last week’s decision by South Korea to exit an intelligence-sharing pact with Japan will endanger U.S. troops stationed on the Korean Peninsula.  The decision by Seoul was part of its ongoing dispute with Japan over its behavior before and during World War II.  For decades after the war, when the United States fully accepted its position as a global hegemon, it worked to keep that dispute under wraps in the interest of allied security.  The warning by the State Department shows the kinds of danger that could now arise as the United States steps back from embracing its role of hegemony.

Brexit:  PM Johnson didn’t change minds among the EU members.  Parliament is investigating ways to prevent a no-deal Brexit, but no one has found momentum for a single plan.  However, there is one glimmer of hope; a group has created a plan that would avoid the backstop but allow for checks on goods to flow.  According to this group, it has garnered interest.  If the backstop issue could be resolved, the potential for a non-disruptive Brexit would improve dramatically.

India:  Although we’ve talked a lot about President Trump’s pressure on the Federal Reserve, it’s important to remember that aggressively nationalist and populist leaders around the world are also impinging on their central banks’ independence.  The latest example is in India, where the Reserve Bank of India gave in today to Prime Minister Modi’s demand that it transfer $24.8 billion in dividends and “surplus capital” to the government.  Former RBI Governor Urjit Patel was sacked precisely for refusing this demand.  The raid on the central bank comes as reports suggest the government is getting cold feet on its planned $10 billion foreign currency bond.  In July, the Modi government said it would issue the bond in order to diversify its funding sources and take advantage of historically low interest rates.  However, with the influx of funds from the central bank, it now appears Modi could forgo the issue and avoid the negative consequences that might arise if the dollar continues to appreciate, in spite of our belief that it should be falling. India has traditionally shied away from foreign currency obligations, which has helped it avoid the financial crises that often plague emerging markets.

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