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

[Posted: 9:30 AM EDT]

It’s Monday in late August, the last one of summer.  Global equity markets moved full circle overnight.  Here is what we are watching:

The trade war:  We were in the midst of writing Friday’s comment when China announced its retaliation against the most recent U.S. tariffs.  This action was not completely unexpected.  China had signaled that it would retaliate to the most recent tariff increase.  However, it became clear that President Trump was incensed; in a series of tweets, he lashed out at China and the Fed.  In what was perhaps the most momentous action, the president indicated that he planned to force U.S. companies out of China.  The powers the president is invoking, the International Emergency Economic Powers Act of 1977 (IEEPA), has generally been used for geopolitical events, not trade conflicts.  However, even if the president can’t actually force companies to leave, the political pressure to draw down operations in China will be enormous.  After the market closed on Friday, the White House announced additional tariff measures on Chinese goods, effectively putting levies on all Chinese imports.  There were some voices suggesting that these actions looked a bit like the president was pulling his punches.  Apparently, the president agreed with this analysis, indicating that he wished he had been tougher.

Equity market reaction on Friday was swift; stocks fell hard despite a rather supportive speech from Chair Powell.  As is often the case, the White House does tend to be attuned to market developments and we have seen a series of comments designed to walk back some of the negativity.  First, Economic Director Kudlow and Treasury Secretary Mnuchin both signaled that the president isn’t going to order American firms out of China.  Second, the president stated that he got a call from Chinese officials indicating they wanted to talk, giving the impression that Beijing is caving.  Chinese officials have disputed this account.  This attempt to ease worries is a hallmark of this administration; they are clearly conscious of the reaction of various constituencies and react rather quickly to adverse feedback.  Still, in the long run, it’s hard to make everyone happy.

Here is our take on the developments.  From the time of Trump’s election, we framed his administration as a dynamic tension between the right-wing establishment and right-wing populists.  The president won the election mostly because he ran as a populist, promising to deglobalize by restricting immigration, balancing trade and ending the offshoring of jobs.  However, given his background, there was a case to be made that in office he would govern as an establishment figure, and he mostly did from the inauguration until February 2018.  Regulations have been aggressively curtailed and taxes, especially on capital, were cut.  He did keep pressing for a border wall and deployed restrictions on immigration.  Although deglobalization was clearly a priority, it looked further down the list from the concerns of the establishment.  Until February 2018, action on trade was mostly symbolic; there were tariffs on steel, but nothing broad.  However, in Q1 last year, Trump began actively moving on broader sanctions on China and Mexico.  Nevertheless, even with these moves, it was still difficult to see whether these actions were merely for show or if there was really a march toward serious trade restrictions.

China’s initial reaction to Trump appeared to be to offer small changes that would give the U.S. president actionable headlines, e.g., large purchases of grain.  For a while, this policy appeared to be working.  However, USTR Robert Lighthizer had bigger ideas.  He wanted changes in China’s trade regulations that would be written into law, including intellectual property reforms.  Last May, it looked like a deal was to be made.  However, China made it clear that it would make promises but viewed changes to law as an infringement on sovereignty.  China’s position is disingenuous—in general, trade law does restrict sovereignty and is really the essence of such law.  Lighthizer wasn’t willing to accept that outcome; China decided it wasn’t willing to accept what it appeared to have agreed to, and relations have slowly deteriorated…until last week, when the deterioration accelerated.

The recent yield curve inversions have led to analysis by strategists, including us, about the state of the economy and when a recession might occur.  So far, the state of the economy is weakening, but still okay.  However, as we thought about the situation this weekend, we were reminded that since the 1960s recessions have tended to have two sources, policy error (mostly monetary) and geopolitical events (1973-75, 1990-91).  This escalation of the trade war may be putting us into the second category.  The problem with the geopolitical recessions is that history isn’t much of a guide because each event is unique.  The 1973-75 recession was mostly due to the oil shock—the rapid increase in gasoline prices shook consumer confidence.  In June 1973, crude oil traded at $3.56 per barrel; by January, it was up to $10.11, at a 284% rise.  Assuming $55 per barrel now, that would be like $156.19 per barrel in Q1 2020.  In October 1973, the Conference Board’s consumer confidence index was 107.5; 15 months later, it was 43.2.  The 1990-91 recession was triggered by the Persian Gulf War.  Oil prices rose then as well but the fears about war reduced consumer confidence from 113.0 in December 1989 to 55.1 by January 1991.

Geopolitical recessions are tougher to time and, in the current case, there is still a chance of a resolution.  However, we don’t see how either side can easily walk back the current turmoil despite today’s optimistic comments.  The escalation of the trade conflict is increasing the likelihood of recession and, perhaps more troubling, is changing the calculus of estimating the downturn.  In other words, obsessively watching for traditional signs of recession may be less effective if we are going to experience a geopolitically induced downturn.

Complicating matters is the notion that the president seems to believe that being tough on trade is a positive factor going into 2020.  It might be, but winning reelection during a recession is a rare accomplishment, last done by Calvin Coolidge.  It’s still not too late to pull back the trade issue, but trade restrictions do appear to be a core belief of President Trump.  And, in his defense, the China issue does need some sort of resolution as the status quo was running out of runway.  However, presidents who do hard things are usually not rewarded for their actions; President Carter’s appointment of Paul Volcker probably saved the U.S. economy but cost him the election.  This is the risk that President Trump seems to be accepting.

So, where are we now?  The remaining elements of the establishment wing of the administration, Mnuchin and Kudlow, are trying to keep trade talks in place and are talking up the economy.  The populists, especially Peter Navarro, are pressing for greater confrontation.  The president tends to vacillate between the two positions depending on his read of the political situation.  So, uncertainty will continue, but this path may end up leading us into a downturn.

The G-7:  This summit may go down in history as the one where it was no longer possible to paper over the differences between world leaders.  President Trump was at odds with other members; President Macron, in a “stick in the eye” move, invited Iran’s foreign minister to stop by.  Macron did give President Trump a “heads up” at a private lunch on Saturday afternoon.  Still, the move by Macron could not have sat well with SoS Pompeo and NSD Bolton.  PM Johnson got nowhere with the EU and now insists he won’t pay the £39 bn “divorce bill.”  This G-7 meeting was clearly difficult, but that isn’t to say nothing was accomplished.  President Trump indicated that a U.S./Japan trade deal is near completion.  This announcement came after President Trump and PM Abe disagreed over recent missile launches from North Korea.  In addition, France and the U.S. did come to a compromise on the former’s recent tech tax.

Jackson Hole:  In addition to Powell’s speech, BOE Governor Carney made headlines calling for a new reserve currency to replace the dollar.  The problems with having a national currency as the global reserve currency are nothing new.  Keynes saw the flaw at the Bretton Woods meetings in 1944 and the Triffin Dilemma emerged in the 1960s.  The problem essentially is that as the world economy grows, the demand for the reserve currency grows with it, forcing the reserve currency nation to constantly expand its current account deficit to supply the world with its currency.  This widening current account deficit distorts the economy of the reserve currency and puts us in the position we are now—the drive to deglobalization is, in part, due to the demands of supplying the reserve currency.  However, moving to a multi-lateral reserve base solves nothing; for the reserve system to work, some nation must be willing to be the global importer of last resort.  Otherwise, there will be a lack of global liquidity. The U.S. was generally willing to play that role during the Cold War because it became part of the system of communist containment.  However, the end of the Cold War and the massive expansion of China have put tremendous pressure on the dollar reserve system; the 2008 Financial Crisis was partly due to foreign nations dumping their saving on the U.S. financial system and demanding safe assets, which expanded mortgage lending.

Can a new system be developed?  Only if global nations are willing to give up monetary sovereignty.  The real solution is not a basket of currencies, but a global central bank that would manage the supply of the global reserve currency.  The battle for control of this entity would be epic.  Carney isn’t wrong in his concerns, but his solution won’t work.

Hong Kong:  As the city’s ongoing anti-China protests turned violent again yesterday, Hong Kong police used water cannons against the demonstrators for the first time.  In one skirmish, an officer even used his gun to fire a warning shot into the air.  In the meantime, Hong Kong Chief Executive Carrie Lam reportedly met over the weekend with a range of politicians, academics and business people who urged her to make concessions to the demonstrators, but there are no signs of such a move yet, and Hong Kong’s economic activity and assets continue to face headwinds from the situation.  Of course, the Hong Kong economy also continues to suffer from weakening economic growth abroad and the U.S.-China trade war.  New data today shows Hong Kong’s exports in July were down a sharp 5.7% year-over-year.

European Union:  Officials connected with the European Commission are considering ways to simplify and soften the Eurozone’s government debt rules so that they put less pressure on countries struggling with an economic downturn.  Although Italy isn’t mentioned as a reason for the move, the measure would likely help ease tensions between the EU and Rome.  It could even help undermine the populist League party of Deputy Prime Minister Matteo Salvini, which would probably be positive for Italian assets.

Middle East:  It appears that Israel may be engaging in widespread attacks on Iranian proxies in Lebanon, Syria and Iraq.  So far, Israel has only confirmed action against Syria on a base that Israel believes was launching drone strikes on its territory.  What we may be seeing here is Israel taking advantage of Iran’s current problems caused by sanctions.  Iran’s economy is under severe pressure from sanctions and this is undermining its ability to maintain its network of proxies across the region.

Negative interest rates:  The use of negative rates, or NIRP, has been controversial, to say the least.  Europe has been the most aggressive in deploying negative rates.  For the most part, European banks have been reluctant to inflict negative rates on depositors, fearful of disintermediation and political repercussions.  German politicians are considering legislation that would make negative deposit rates illegal.  This is a profoundly bad idea.  The most likely response from banks would be to simply refuse to accept deposits.  Although the academic community is somewhat sympathetic to NIRP, in practice, it’s really a divine message that monetary policy is exhausted.

Mexico:  The Mexican government reached a preliminary deal with four private energy firms to resolve a dispute over a major new natural gas pipeline from Texas to Mexico.  Under the agreement, Mexico would no longer have to pay stepped up transport fees over time, as in the original contract.  Instead, the transport fees would essentially be leveled.  Mexico would pay higher fees for the first 10 years of the pipeline’s operations, but it would realize savings afterward.  The deal is likely to keep concerns alive about the sanctity of contracts under the populist government of President Andrés Manuel López Obrador.

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

[Posted: 9:30 AM EDT] Happy Friday!  It’s quiet this morning in front of Chair Powell’s presentation.  Here is what we are watching:

BREAKING: China to levy tariffs on another $75 bn of U.S. exports.  Bonds and gold rally, while equities, oil and copper decline.  Oil, soybeans and auto exports were specifically targeted.

Powell:  Between the minutes and a series of interviews suggesting a wide disparity of views, there is growing sentiment, which we tend to share, that Chair Powell will struggle to bring the committee to make aggressive rate cuts.  We suspect his speech today will try to create a narrative that will support future action.  A set of variables could be established as guideposts; three possibilities might include persistently low inflation, global economic weakness or the dampening of investment from the trade war.  Another key idea to remember is that Powell doesn’t necessarily have to make the members of the committee happy, he merely needs their votes.  The members know that if Powell can’t sway the committee and he resigns, then the White House may press for a new chair who is an ideologue.  Thus, the committee members may grudgingly accept rate cuts to avoid turmoil.

Recession worries: Although the media coverage of any White House often sensationalizes divisions and concerns within the executive branch, recent reports of concerns about the economy probably have an element of truth.  Worries about the economy, especially in the year before the election, have been evident in most administrations.  We have seen earlier governments attempt to tag the Fed with blame if the economy slumps; again, nothing unusual here.  Presidents Johnson, Nixon, Reagan and Bush (H.W.) all engaged in attempts to sway monetary policy.  We lived through an unusual détente since Clinton where the White House and the Fed left each other alone.  That informal peace accord has clearly ended and we have returned to the earlier tensions.

Therefore, in light of these worries, we have seen a number of trial balloons floated, including indexing capital gains taxes to inflation, a payroll tax holiday and other unspecified tax cuts.  To some extent, the problem is that the trade conflict with China was bound to have adverse economic repercussions.  It’s possible the president didn’t believe that, but his advisors should have been aware.  At the same time, presidents sometimes have a policy goal so important to them that they engage in that policy even though it adversely affects other goals.  It looks to us that President Trump deeply believes the trade regime established after WWII isn’t working for the majority of Americans and a strong case can be made that this is true.  Both sides of the populist wings have turned against trade and only the elites still believe in it (mostly because they benefit greatly from overall globalization, of which free trade is an element).  The problem for the president is timing.  He spent his “golden period”[1] deregulating and cutting taxes.  If these were the president’s most deeply held goals, then he did the right thing.  However, it appears to us that changing the postwar trade regime may be his most deeply felt goal; if so, he should have done that first.  If he had moved on trade immediately after winning the election, then we would likely be past the worst effects by now and the disruption of supply chains would not be threatening the business cycle.

Given today’s news out of China on tariffs, it seems unlikely that tensions can ease without one side caving.  China seems to be banking on the idea that the U.S. needs a deal more than it does because of looming elections.  The U.S. doesn’t appear open to backing down and the recent move to tie conditions in Hong Kong to a trade deal likely reduces the odds of a deal.  It is quite possible that the most effective policy to lift the economy in the short run would be a reduction in trade tensions.  The problem is that neither side appears open to a way out of this conflict.

G-7: The G-7 meets this weekend, with the members deeply divided.  As we noted yesterday, the host nation, France, has already indicated that it won’t deliver a communiqué.  Macron wants to talk about the fires in Brazil, while President Trump wants to talk about France’s recent tech company tax.  The EU would like to ease trade tensions with the U.S.  Although we don’t expect this meeting to have a major market impact, the divisions among the leading democracies are problematic and an indication of the deglobalization that is underway.

Italy: Parties were given until next Tuesday to form a government.  The center-left and populist-left parties are continuing to negotiate.  Although these parties have been at odds for a long time, the prospect of a government dominated by the populist-right is concentrating their efforts.  If the negotiations fail, it doesn’t necessarily mean immediate elections.  Instead, we could see the president of Italy install a caretaker government until the budget process is completed.

Brexit: PM Johnson continues to hear the same message from EU leaders: the backstop is necessary and negotiations are futile.  It is becoming difficult to see how a hard Brexit is avoided unless Parliament stops it from happening.

Champions: The EU is floating a plan to create a €100 bn sovereign wealth fund to create “European champions” in the technology space to compete with the U.S. and Chinese tech giants.  Although the sentiment makes sense, we have doubts that money is the problem.  After all, rates in Europe are below zero in many markets.  The key is allowing companies to “move fast and break things,” something Europe doesn’t seem too comfortable with allowing.

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[1] We consider the first 18 months of a president’s first term as the most important.  This is the period when a president can get the most accomplished and therefore one should try to move their highest priority goals through before the summer of the year before the election year.

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

[Posted: 9:30 AM EDT]

We cover the Fed minutes below!  The G-7 summit is this weekend.  Tensions between Japan and South Korea are rising.  Quietly, overnight, the CNY fell to an 11-year low.  Here is what we are watching:

The Fed minutes: There were three points that emerged from the minutes:

1. The members are divided. Although the two dissents made it clear that divisions exist, the issues appear to run deeper.  We know for sure that two members officially wanted to keep rates unchanged, but the minutes indicate that “several” wanted to maintain the target.  This means that either some of the regular voters (governors plus NY FRB president) reluctantly went along with the rate cut decision as long as it was framed as a “mid-course adjustment” or the hawks are centered among the regional bank presidents.  We suspect the former statement is probably more accurate.  At the same time, two participants wanted a 50 bps cut.  Given that Bullard came out favoring only 25 bps, we suspect Kashkari had a partner; if we had to guess, Daly probably wanted a larger cut.   Overall, if the majority are going along reluctantly, future rate cuts may be harder to generate than the market expects.
2. The financial stability faction is getting visibility. In our taxonomy of FOMC members, we divide the group into traditional hawks, doves and moderates, with a fourth faction called financially sensitives.  The first three still maintain the Phillips Curve as their guide but shade policy toward either greater worry about inflation (the hawks) or unemployment (the doves), or they try to balance between the two (the moderates).  The financially sensitives are a new breed that worry about policy causing valuation issues in financial markets.  The committee is currently dominated by moderates; we estimate nine members are in that group.  There are four doves (including nominee Waller) and two hawks.  The financially sensitive group numbers three.  If our analysis is accurate, the financially sensitives are especially eloquent in their presentations because they received a rather high level of mention in the minutes.  Or, its membership is growing and we may be underestimating the size of this group.  If this group is getting larger, policy will tend to become hawkish as equities rally (or, to put a finer point on it, when the VIX falls below 15).
3. Another surprise emerged in the discussion of the balance sheet. A “number” of participants suggested that QE worked so well it probably should have been deployed more aggressively.  It doesn’t appear this is a majority opinion, but it does look like this position was favored by a significant minority.  At the same time, the language seems to indicate that the FOMC has little interest in negative interest rates.

Overall, market reaction was somewhat mixed.  Equity markets took the news in stride.  The most hawkish reaction probably came from the dollar, which rallied after the report.  Bond yields also rose on the report.  Our take is that the minutes were a bit hawkish but the FOMC did try to leave itself room to adjust in the future.  The bottom line, though, is that Powell has his work cut out for him if he wants to take the committee to a more aggressive easing stance.

The financial markets have not changed their opinion in the wake of the report; the deferred Eurodollar futures are still signaling a serious inversion, and are projecting another 90 bps of easing over the next two years.

At the same time, the Mankiw Rule is suggesting that the last thing the Fed should be doing is cutting interest rates.  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 by 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, then the central bank should raise rates.  Greg Mankiw, a former chair 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, the estimated target rates all rose substantially.  Not only did inflation rise but the labor markets showed strength.  Three of the models, the ones using the unemployment rate, wages and involuntary part-time employment, all rose 20 bps to 40 bps and suggest the last thing the FOMC needs to do is ease.  Even the most dovish model, the variation using the employment/population ratio, rose by 20 bps and is flirting with neutral.  This analysis explains why so many members of the committee are reluctant to support an aggressive easing stance; the basic model that the Fed has used for years is calling for tightening.  Thus, the potential for disappointing the financial markets is elevated.

Jackson Hole: Now that the minutes are out of the way, the market’s focus will shift to the annual meeting in Wyoming.  Powell’s speech at Jackson Hole is scheduled for 10:00 EDT tomorrow, but the “festivities” begin today.  As our discussion of the minutes show, it will be very difficult to create a narrative for further easing that will sway the FOMC.  Greenspan would likely come up with some novel story to carry the day, but we can’t think of any other Fed chair who could pull this off.  Thus, the odds of disappointment are elevated.

South Korea v. Japan: The current spat between these allies centers around the issue of reparations surrounding the colonial period and WWII.  Japan argues that its previous actions have fully satisfied the responsibility for its past.  It’s unlikely that South Korea (or North Korea, for that matter) will ever fully absolve Japan for its past actions.  During the Cold War, the U.S. essentially forced these nations to work together as allies to contain communism.  However, with U.S. influence waning, old tensions are resurfacing.  South Korea has announced it will no longer share classified military information with Japan.

G-7 and Brexit: PM Johnson met with Chancellor Merkel yesterday.  Essentially, Merkel didn’t offer Johnson much, which suggests she would like to see the backstop issue resolved but that it is up to the U.K. to do that.  Johnson will meet with Macron next.  We are starting to see a realization among the pundits that the U.S. will be more than happy to make a free-trade deal with the U.K. after Brexit, but the outcome will likely make Britain a vassal state of Washington.  As noted yesterday, the G-7 won’t even try to issue a joint communiqué, an indication of the deep divisions within the world’s most significant democracies.

Looming tariffs: Although most of the tariffs on China were delayed, some will go into effect September 1.  China warns that new tariffs will raise tensions and vows to retaliate.  The earlier mentioned drop in the CNY is likely part of the response.  In other China news, companies are reporting that pulling supply chains from China is apparently harder than it looks.

Italy: Salvini’s attempts to force new elections may not work out.  For the next two weeks, parties will try to form a government to avoid fresh elections.  The center-left and populist-left parties are trying to form a coalition and elections will not be necessary if they are successful.

The establishment strikes back: The left-wing establishment has never been on board with President Trump, while the right-wing establishment has had a mixed relationship.  Until February 2018, the president talked like a populist but his policies were in line with establishment goals—taxes were cut, especially on the upper income brackets, and there was a massive pullback in regulation.  However, since February of last year, the administration and the right-wing establishment have diverged on trade and immigration policy.  We are now seeing establishment “mouthpieces” becoming increasingly critical of trade and immigration policy.

Trouble on the farm: My former colleague at A.G. Edwards, Bill Nelson, used to conduct a farm tour that moved through the Midwest corn belts and reported up close and personal on the condition of the crops.  It was an arduous task and fortunately for Bill he doesn’t have to do that anymore.  Pro Farmer is currently conducting a tour and is bringing some USDA officials along for the ride.  Farmers have been upset with the USDA, which has been rather optimistic about the prospects for this year’s crop despite damage caused by an unusually rainy spring and early summer.  These rosy estimates have depressed prices and apparently angered farmers to the point where government officials have been threatened.  Federal Protective Service agents have been dispatched to investigate the incidents.  Farmers are also upset with the administration’s decision to grant ethanol waivers to refiners which reduce demand for corn.

Energy update: Crude oil inventories fell 2.7 mb compared to an expected draw of 1.4 mb.

In the details, U.S. crude oil production was unchanged at 12.3 mbpd.  Exports rose 0.1 mbpd, while imports increased 0.5 mbpd.  Refinery operations rose 1.1%.

This chart shows the annual seasonal pattern for crude oil inventories.  Seasonal stockpiles are stabilizing a bit below the usual seasonal trough.  The summer driving season is rapidly coming to a close, but crude oil inventories usually don’t rise until late September when refinery maintenance begins.

Based on our oil inventory/price model, fair value is $61.72; using the euro/price model, fair value is $50.45.  The combined model, a broader analysis of the oil price, generates a fair value of $53.60.  We are seeing a clear divergence between the impact of the dollar and oil inventories.  Tensions in the Middle East have lessened and we are heading into a weaker demand period; thus, weaker oil prices in the short run are likely.  We do note that Alberta will continue to constrain oil production, although producers are being given a higher production ceiling.

In other oil-related news, Russian oil companies are moving to price oil in euros.  Over the years, there have been nations that have attempted to move away from dollar pricing.  Both Iran and Iraq tried when they were under sanction.  Russia’s decision does make some sense; not using dollars might allow it to skirt U.S. sanctions, which tend to depend on intersections with the U.S. banking system.  However, we doubt this will begin a wholesale shift away from dollar pricing for oil simply because the purchasing power of the dollar is so strong now that not taking in dollars is expensive for most nations.  After Brexit, the U.K. will dramatically reduce its strategic oil reserve.  OECD nations are required to hold oil in reserve as part of a global strategic reserve system designed, in part, to weaken OPEC’s ability to embargo oil and drive the price higher.  However, the EU has stricter rules than the OECD regarding the level of oil required to be held.  When (if?) the U.K. leaves, it will reduce its strategic reserve to the OECD level, which will put around 50 mb out for bid.  This action could lead to lower Brent prices post-Brexit.  The U.S. and Venezuela have been engaged in backchannel talks.  According to reports, Diasdado Cabello has been leading the talks on the Venezuelan side.  A deal would be bearish for oil prices at some point, although it might take years before Venezuela’s oil industry recovers.  Sanctions on Iran are having an effect; reports indicate it is in the deepest recession since the Iran-Iraq War.

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