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

[Posted: 9:30 AM EDT]

Good morning! Risk assets are rising again this morning.  Central banks make a splash; gold continues to march higher.  Trade conflict with China remains front and center. Here are the details:

Central bank surprise:  The Reserve Bank of New Zealand, the Reserve Bank of India and the Bank of Thailand all moved to lower rates; the first two lowered rates more than forecast and the Bank of Thailand’s cut was unexpected.  Central banks around the world are becoming increasingly accommodative and these three banks are adding to the policy stimulus.  All the banks involved suggested that escalating trade tensions were having a negative impact on their respective economies.  As global trade war grinds on, we expect more countries to utilize monetary policy in order to defend their economies through weaker currencies. As the reserve currency, the US dollar will likely face upward pressure as capital flight will lead to many foreign investors seeking dollar denominated assets to hedge against inflation risk. As a result, there will likely be more pressure on the Federal Reserve to further cut rates and possibly resume balance sheet expansion.

All that glitters:  Gold is becoming increasingly popular with central banks.  Data from the World Gold Council indicates that gold demand in H1 was at a three year high with central banks buying 374.1 tons. This is the largest purchase for a “semester” in the 19-year history of the data series.  The PBOC and the Central Bank of Russia led the buying, with the Central Bank of the Republic of Turkey and National Bank of Kazakhstan also increasing their holdings.  The ECB has ended its agreement to limit gold purchases, which will likely lift central bank purchases going forward.  Exchange-traded product demand rose as well, while bullion sales actually contracted (this buyer is price sensitive).  What’s driving central bank behavior?  Uncertainty surrounding the reserve currency and falling opportunity cost from low (and increasingly negative) nominal interest rates.  Gold prices continue to lift this morning.

China trade:  Although factions in the White House continue to argue that a trade deal is possible, it is starting to dawn on pundits that this trade spat has broader ramifications.  For China, caving to U.S. demands is probably politically impossible.  This morning’s CNY fixing was just below 7.0 CNY.  It is becoming clear that China has likely decided that it won’t be able to strike an agreement with the Trump administration that isn’t designed to cripple its economy and contain its rise.  We have been watching a steady movement for a return to fixed exchange rates; supply side economist calls for a “return to the gold standard” is probably more about a return to fixed exchange rates.  Judy Shelton’s[1] comments seem to suggest that position.  China’s leaders believe that the “beginning of the end” for Japan’s rise was the Plaza Accord.  In 1985, the dollar was historically strong and the U.S. strong-armed Japan and Germany to work in concert with the U.S. to weaken the greenback.  By 1990, the Japanese economy peaked, and it has been stagnant ever since.  Beijing fears that Washington has designs on a similar program with the same outcome.[2]  Unlike Japan, economic stagnation in China would probably cause an epic political crisis.  Although the U.S. would probably struggle to achieve the same degree of cooperation it engineered nearly 35 years ago, it could likely achieve the same outcome by changing Fed policy.  Meanwhile, the U.S. courts have given increased power to U.S. regulators to seize records of foreign banks if those banks have corresponding accounts with U.S. banks.  VP Pence indicated the U.S. might use the Global Magnitsky Act to sanction Chinese officials over the Uighur internment camps, a move that will infuriate Beijing.

China’s foreign reserves in July fell $15.5 bn, about in line with expectations.

This data will be closely watched next month to see how China is using its foreign reserves to manage the CNY exchange rate.

One other interesting item of note on China.  There are reports that private companies are finding it difficult to get paid promptly, leading to the creation of an informal commercial acceptance market.  Although the PBOC is conducting policy easing, it appears that banks are mostly lending to state owned enterprises, likely for two reasons.  First, state support reduces credit risk and second, the banks may be perceiving a “nudge” from the government to support the state-owned sector.  These factors appear to have caused dearth of working capital and has led companies to accept IOU’s for receivables.  This development also suggests worries about the economy; after all, the banks probably earn a larger spread by lending to the private sector, so this news probably is signaling stress in the Chinese financial system.

Kashmir:  Both Pakistan and China warned India about its takeover of its area of control in Kashmir, which, up to now, had been granted a high level of autonomy.  We will have more to say on this issue in an upcoming WGR.

A recession in Germany? A weaker than expected industrial production report sparked fresh concerns that the German economy could be headed for recession. The chart below shows that industrial production is down 5.14% from the prior year.

The industrial production reports suggest that weak demand for autos and slowing economic growth may be weighing on the German economy. As an export-driven economy, Germany relies heavily on the rest of the world to consume its excess production, therefore it is very vulnerable to global shocks. In fact, the slowdown in China may also be weighing on the Germany economy, as China represents a large market for German cars. The weakness in industrial production has led many to suspect the German economy may have contracted in the second quarter.

Brexit:  The twists in the Brexit saga continue to develop.  Sinn Fein holds seven seats in the House of Commons, but it has never put MPs in these seats because it won them by arguing for abstention.  Sinn Fein is the political wing of the Provisional Irish Republican Army, and holds the second largest set of seats from Northern Ireland.  The DUP, a part of the government, is a key member of the current ruling coalition.  Its policy of abstention is designed to protest the legitimacy of the government it was elected to; it wins the seats in elections but refuses to participate in the government’s activities.  If Sinn Fein wanted to bring the current government down, all it would have to do is seat MPs and refuse to join the government.  It would be a minority from that moment on.  Politically, it would rally the Tories because it would look like Irish radicals were scheming against the party.  However, if Sinn Fein called on its MPs to resign, by-elections would be held and if the party was willing to cede these seats to a coalition of Remainer candidates, they would probably win these districts.  That would likely push the current government into minority status, triggering new elections.

Another twist is that Boris Johnson is hinting that if he lost a no-confidence vote, he may simply refuse to stand down, or push the vote past Halloween, thus crashing the U.K. out of the EU.  There is some speculation that the Queen might intervene and remove Johnson from office, likely spurring a constitutional crisis of epic proportion.  We assume the Queen would prefer to avoid such an outcome at all costs, but the fact this potential outcome is even being discussed indicates just how far conditions have diverged from what one would consider normal.

North Korea issues warning? Last night, North Korea said that leader Kim Jong Un supervised the launch of two short-range ballistic missiles. The missile launch was likely a warning to the US over its plan to hold joint military exercises with South Korea.  At this time, it is unclear whether President Trump will condemn the launch, but if the past is any guide to the future, it is likely that the President will downplay it.

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[1] Shelton is being considered for a FOMC governor position.

[2] Adding to that concern is that Robert Lighthizer played a key role in the negotiating team that led to Japan’s “voluntary” auto export curbs to the U.S.

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

[Posted: 9:30 AM EDT] Good morning! Risk assets are getting a bounce this morning.  Trade conflict with China remains front and center. Here are the details:

Currency manipulator:  The Treasury has officially designated China a “currency manipulator.”  This designation isn’t as big a deal in reality as it appears.  First, China barely fits the guidelines for this designation.  The designation requires a current account surplus in excess of 2%; China is just above that level.

As this chart shows, China’s current account surplus relative to GDP is just above 2%.  In reality, China was an egregious violator from 2005 to 2009 but has become less so since.  Second, a nation in violation has to be actively intervening in the currency market; China has, but to prevent the CNY from depreciating.  So, yes, China is intervening but in a way to weaken its competitiveness, not raise it.  The third factor is the trade deficit with the U.S.   In this area, China is a clear problem.

So, what happens now?  The Treasury will ask the IMF to investigate China’s trade and currency practices to establish the degree of manipulation.  Then, in a year, if the allegation of manipulation is verified, then the U.S. and China will enter negotiations to remedy the problem.  If the talks fail, sanctions will be imposed.

To put a fine point on this action, nothing will likely come of it.  First, the manipulation China is engaging in is actually weakening China’s ability to export.  The IMF isn’t likely to find in America’s favor.  Second, given all the sanctions and tariffs already in place, it’s hard to see how China can be changed by additional tariffs.

So, why the fuss?  Of course, yesterday, the PBOC simply allowed the CNY to fall in the natural direction it would tend to move with the threat of sanctions.  However, this morning, the PBOC did come in and signal support for the CNY, raising hope that a full-blown currency war can be averted.  The PBOC’s action has lifted risk assets this morning, easing fears that China would simply allow its currency to fall precipitously.  However, this narrative probably isn’t accurate.  China isn’t lifting the CNY to help the U.S.  Instead, it is doing so for its own interests.  First, Chinese non-banks (generally Chinese non-financial companies) have huge dollar-denominated debt outstanding.  Currently at $501 bn, this debt represents 13.5% of total emerging market dollar-denominated debt.  If the CNY depreciates, it raises the debt service cost for dollar-borrowers.  Second, a weaker CNY in the past has triggered capital flight.  Although China has extensive capital controls, they are not completely effective, and a falling currency tends to encourage wealthy Chinese to find ways to evade them.

Devaluation has other ill effects.  Other nations that compete with China won’t allow a weaker CNY to undermine their exports; if China were to take definitive action to depress the CNY, it would likely cause a global dollar appreciation.  In addition, currency depreciation is counter-productive to China’s long term economic restructuring.  The net effect of a weaker currency is to depress household consumption.  That’s because it raises import prices and reduces the real income of households.  A weaker CNY benefits the bloated investment sector at the expense of households.

So, if all this is true, why the designation?  The optics suggest a narrative of action and often in politics the illusion of action is beneficial.  The Trump administration is targeting China, in part, because of the huge trade deficit with the U.S.  But, there is a bigger issue; the White House is slowly discovering that when you provide the reserve currency to the world, the rest of the world has an incentive to acquire your currency through trade.  Tariffs tend to be ineffective in this environment, in part, because nations can depreciate their currencies to offset the tariff.  What the president really wants, we think, is a return to fixed exchange rates.  Once fixed, the U.S. can force the cost of adjustment to foreigners via trade impediments.  But, the only way to achieve fixed exchange rates is to either (a) deploy capital controls, or (b) remove the Fed’s independence and make maintenance of the exchange rate the sole policy goal.  We are betting on (b), despite protests.

Where does this end?  We don’t see either leader caving.  Although China’s position is inferior (in a trade war, the surplus nation is always in a worse position—a good historical example is the Great Depression, which severely affected the U.S., the China of its day), the real question is which society can endure the most pain?  President Trump faces voters in November 2020.  An economy in recession a year prior has been a consistent indicator that an incumbent will lose.  In a full-blown trade war, easy monetary policy might not be enough to prevent a downturn.  But, our view is that President Trump doesn’t believe tariffs are bad for the U.S. economy and thus has no fear of a trade conflict.  On the other hand, although President Xi faces pressure as well, he is president for life.  In the short run, Xi can likely inflict more pain on his citizens than President Trump.  In the long run, that may not be the case.  If the U.S. thwarts China’s rise, the unrest could topple the CPC.  For financial markets, the risks are rising.

China-Hong Kong:  After Hong Kong was paralyzed yesterday by more anti-Chinese political demonstrations and its first general strike in 50 years, the Chinese government’s Hong Kong and Macau Affairs Office today issued a new, thinly veiled threat of intervention.  A spokesman for the office warned the protestors not to “misread the current situation [or] mistake restraint for weakness.”  When asked if the People’s Liberation Army of mainland police might be sent into Hong Kong, the spokesman merely said the government wouldn’t allow anything to threaten the country’s political system.  The spokesman also reiterated China’s recent line that the United States has secretly been instigating the unrest in the city.

Persian Gulf:  The U.K. has decided to join the U.S. program to protect shipping in the Persian Gulf.  Given that the U.K. wants to leave the EU and will need to cleave to the U.S. in the future, this action makes sense.

A no-confidence vote:  Labour leader Corbyn has threatened a no-confidence vote to prevent a no-deal Brexit.  The problem for Corbyn is that it isn’t clear if Labour would win an election because the key issue is Brexit and the Labour Party is divided on this topic.  Instead, we might see a broad Remain coalition of Liberal-Democrats, Scottish nationalists, the Greens and independent MPs from Labour and the Conservatives.

Japan:  As yesterday’s U.S.-China trade tensions prompted safe-haven buying and drove the yen higher, Japanese officials from the Finance Ministry, Financial Services Agency and Bank of Japan held an emergency meeting to decide how to respond.  Afterward, Vice Finance Minister for International Affairs Yoshiki Takeuchi said that if the currency moves start to hurt the economy or financial markets, then the government would take action, but only within the limits of its G7 and G20 commitments.  All the same, the government may also try to intervene secretly by directing its pension fund to buy more foreign assets.

Japan-South Korea:  As tensions continue to rise over Seoul’s demand that Japan provide reparations for its treatment of South Korea before and during World War II, today Japanese Prime Minister Shinzo Abe accused Seoul of violating the two countries’ 1965 compensation agreement.  In a more dangerous move, the South Korean military is reportedly considering military drills this month on a set of islands in the Sea of Japan that are claimed by both countries.

Australia:  The Reserve Bank of Australia today held its benchmark short-term interest rate at a record low of 1.0%, as expected.  The decision to hold rates steady came after two straight rate cuts, but the policymakers signaled further rate cuts may be needed to counter slower economic growth around the world, a weaker domestic housing market and subdued inflation.

Russia:  Following the U.S. withdrawal from the Intermediate-Range Nuclear Forces Treaty last week and the Trump Administration’s plan to deploy new short- and intermediate-rate missiles to Asia, Russian President Putin has vowed to match whatever new missiles the United States develops.  Putin also ordered increased spying on the United States in order to track its development of any new missiles.  Separately, the Chinese Foreign Ministry’s arms control department warned that China would take “countermeasures” against any U.S. deployment of new, ground-based, short- or intermediate-range missiles in the Asia-Pacific region.

North Korea:  The North Korean military has tested short-range missiles again for the fourth time in less than two weeks, as leader Kim Jong Un registers his displeasure over upcoming U.S.-South Korean military exercises and seeks to pressure the United States for concessions on its nuclear program.

Venezuela:  The United States announced a nearly total economic embargo on Venezuela yesterday, intensifying its effort to drive President Nicolás Maduro from office.  President Trump signed an executive order to freeze all the Venezuelan government’s assets under U.S. jurisdiction, prohibit any entity worldwide from transacting with it, and sanction any foreigners who provide support to it.

Negative interest rates:  UBS (UBS, $10.89) announced it will begin applying negative interest rates to large accounts.  With the entire yield curves of Germany and Switzerland in negative territory, banks have been effectively subsidizing depositors by merely holding their cash at a zero rate.  Banks have been avoiding applying overtly negative rates to depositors, in part fearing disintermediation of cash.  Given the size of UBS, Switzerland’s largest wealth manager, it is likely other banks will follow suit.  We will be watching closely to see if this trend spreads and the reaction of investors.

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

[Posted: 9:30 AM EDT]

It’s Monday, but far from a happy one.   Global equity markets are taking a beating while interest rates continue to decline.  Geopolitical tensions are rising in several theaters.  The U.S. is dealing with two mass shootings.  And, the Haj begins today.  Here are the details:

Trade wars:  Media reports indicate that nearly all the president’s advisors (Peter Navarro was the exception) did not want to see tariffs implemented on China.   As we have noted in the past, the president believes that the incidence of the tariffs falls on Chinese exporters and thus it is a “free tax” for the U.S.  Although this point is often disputed with great certainty by the media, in reality, it can work as the president suggests.  Without question, a tariff raises the price to a U.S. importer.  If the transaction were that simple, the president’s critics are correct.  However, the Chinese exporter, in order to maintain market share, may reduce his price to the level of the tariff.  In that case, the incidence falls on the exporter.  Or, the foreign nation may depreciate its currency by the amount of the tariff, offsetting the levy.  In that case, the incidence of the tax falls on U.S. exporters (the price of their goods increased due to a weaker currency) and on consumers in China (the cost of imports rises for those buyers).  In other words, it’s complicated.

However, China followed the textbook and this morning allowed the CNY to fall, as the currency broke seven CNY to the USD.  This was a level that markets assumed the PBOC would defend.  Instead, monetary officials simply allowed the currency to decline.  Although this action is consistent with international economic theory, Chinese officials tended to hold the line on this level due to worries about capital flight.  Although there have been conflicting reports, it appears China may be halting agricultural purchases.   In addition, China has disputed Trump’s claim over fentanyl exports.  Fears of a currency war are clearly undermining investor confidence.  At the same time, investors should be aware that the president could flip on this position at any time, as we saw with Mexico.  The hurdle for making a switch isn’t all that high.  All China would probably have to do is announce soybean purchases and make some show about seizing narcotics.  Although, doing so and not appearing to cave to the U.S. is tricky, especially in front of party meetings.  In addition, China is blaming the U.S. for not just the tariffs, but for unrest in Hong Kong; giving in to U.S. demands in this atmosphere looks unlikely.

India:  India appears to be moving to remove autonomy from Kashmir.   In the past few days, New Delhi has warned tourists to evacuate and has put the region on lockdown.   Communication links have been broken and local officials have been placed under house arrest.   The region has been a flashpoint in tensions between Pakistan and India, both who claim control over the districts.  The area, mostly Muslim, wants autonomy from both nations but neither are inclined to cede it to the other.  If India moves to absorb its area of control into greater India, local unrest will almost certainly escalate, and Pakistan could become involved.

Hong Kong:  There a no signs of cooling in Hong Kong.  A general strike, the first in 50 years, has been called for today and widespread protests occurred over the weekend.   Public transportation was disrupted over the weekend, and civil servants held protests against their government.

Iran:  Iran has seized another petroleum tanker although it appears it may be a smuggler’s vessel.  Iran subsidizes its petroleum products and there is an active business in buying product at lower prices in Iran and selling elsewhere in the region.   A broader problem for the U.S. is that China is actively defying U.S. sanctions on Iran by smuggling oil from Iran.  Smuggling adds complications not only with Iran but with China as well.  Iran is indicating it is reducing its commitment to JCOPA; the more Iran goes down this path, the greater the odds Europe will be forced to shift to the U.S. position on Iran.

Brexit:  Boris Johnson appears to be preparing for a snap election due to the narrow nature of this coalition.  Polls in Scotland show a rise in separatist sentiment due to Brexit.

International Monetary Fund:  Leaders from the European Union over the weekend settled on Bulgarian economist Kristalina Georgieva as their candidate to replace Christine Lagarde as head of the IMF.  The Europeans have traditionally been afforded the right to name the IMF chief, while U.S. government names the World Bank head.  Perhaps the more interesting element of the decision is that it marks the second time in the last few weeks that French President Macron got his way with a major EU personnel decision.  At least for the moment, the French president seems to be in the ascendency, even as German Chancellor Merkel sees her power on the wane.

Russia:  For a second straight weekend, demonstrations against unfair municipal elections led to more than 1,000 arrests in Moscow alone.  Perhaps more important, authorities have reportedly started to investigate whether the anti-corruption group run by opposition leader Alexei Navalny has been using illegal financing.  Such investigations are often used to muzzle government critics in Russia.  Now that President Putin’s approval rating has fallen to a six-year low of 64%, the government may be getting desperate to nip any further political protests at the bud.  Although we doubt Putin’s regime is in any danger, conditions are not good in Russia.  Consumer debt is becoming an issue, massive, uncontrolled wildfires are occurring in Siberia, and in the Ukraine, the new leader there is making life difficult for Putin.

Japan-South Korea:  The South Korean government’s free-trade commission has fined four Japanese companies for rigging bids to supply South Korean automakers.  Although this could be just a run-of-the-mill action, it could also be retaliation for Japan’s decision last week to tighten its control over exports to South Korea.  South Korea is taking steps to reduce its reliance on Japan’s technology.  That move was retaliation over Seoul’s continuing demands related to Japan’s colonization of the Korean peninsula before and during World War II.  There are deep tensions between China, Japan and the Koreas going back centuries.  One of the keys to post WWII peace has been America’s ability to freeze these hostilities and force cooperation on the parties.  However, as the U.S. retreats from the world stage, these ancient disputes are becoming a problem again.  The tensions threaten the U.S. security arc in the region.  Interestingly enough, China is meeting with both Japan and South Korea in December to hold a security summit.  China may be trying to fill the security gap by calming tensions between Japan and South Korea.

The U.S. and South Korea are set to start military exercises today.

The NY FRB:  The New York Fed is the most important of the regional Fed banks.  It is the only one whose president is a permanent voting member and it executes the Fed’s activities in financial markets.  The president of this bank has often come from the financial services industry, but its current president is more of a policy wonk out of the San Francisco FRB.  John Williams has apparently fired two long-time high-ranking officials in a dispute over management priorities.  Although this may be nothing more than a leader wanting his own people in place, firing officials with front line experience over the past two decades appears a bit rash.

Middle East:  Congressional officials are trying to convince President Trump to keep American soldiers in Afghanistan.  The U.S. is trying to stop Turkey from invading northeast Syria, the home of Kurdish fighters who have been allied with the U.S.

 

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

[Posted: 9:30 AM EDT]

Happy Friday employment day!  We cover the data in detail below but the snapshot is generally in line with expectations.  Payrolls were 164k, nearly bang on forecasts of 165k, although revisions lowered payrolls by a net 32k.  The unemployment rate was unchanged at 3.7% when a 3.6% report was expected.   Wage growth was a bit stronger than expected (although the non-supervisory growth was steady) and the participation rate rose to 63.0%, a bit stronger than the 62.9% expected.  Here is what we are watching this morning:

Trade: So much for stability!  Midday yesterday, President Trump announced he would put a 10% tariff on $300 bn of additional goods.  The reason given was that China had not purchased grain as promised and was continuing to send Fentanyl into the U.S. In a press conference later in the day, the president suggested these tariffs might be temporary, which may mean if China buys grain and cuts narcotics exports, he may lift them.  Here is our take:

1. We doubt China will react well to this action. The Xi government has already indicated that a deal has to include the removal of all tariffs, which is unlikely.  It’s important to note that Chairman Xi will be heading off to Beidaihe   This seaside resort has been a long-time favorite of Chinese leaders going back to the Qing dynasty.  CPC leaders, both current and former, mingle and discuss issues.  We would expect Xi to find plenty of support to push back against the U.S.  After all, no nation likes to be bullied.  In addition, any criticism of Xi for poorly managing the relationship with the U.S. will likely be silent as Trump’s latest actions tend to confirm he is erratic and probably unmanageable.
2. As we have noted in the past, trade wars, like kinetic ones, usually occur because both sides miscalculate the actions of their opponent. We suspect President Trump is overestimating how damaging tariffs are to China and underestimating the impact on the U.S.  Chairman Xi is probably doing something similar.  In addition, we think President Trump continues to hold the position that the incidence of tariffs is falling solely on Chinese exporters.  Although it is occurring to some degree, a weaker CNY is offsetting some of the pain.  Additionally, some of the tax is falling on U.S. consumers and, as we note below, that effect will likely increase.  However, if the president believes the incidence isn’t affecting American buyers, he will tend to view tariffs as a “free tax” and have no compunction about continuing to apply them to China and others.  It should also be noted that S. trade negotiators knew the president was considering additional tariff measures before their most recent meetings with Chinese trade officials.
3. “Blinking” will be difficult for both leaders. It is hard to see how either side backs down without losing face.  If President Trump backs down, it will be a campaign issue.  If Chairman Xi backs down, he will face criticism for caving into foreigners.
4. China clearly can’t retaliate 1:1 simply because of the trade imbalance. So, look for other retaliation measures, e.g., harassing American foreign investment in China, perhaps the arrest of Americans in China or other penalties for American firms (regulatory raids, etc.).  We could also see European firms given preferential treatment to harm U.S. competitors.  Look for the “unreliable entities list” to reemerge to pressure U.S. firms to show allegiance to China instead of the U.S.  And, the most simple action is to weaken the CNY, which is already occurring.
5. There is another angle to the president’s surprise. In Chair Powell’s press conference on Wednesday, he mentioned international economic weakness repeatedly.  The new tariffs will almost certainly increase pressure on the Fed to cut more aggressively.  In a sense, the tariff announcement may have more to do with affecting monetary policy than trade policy.
6. Perhaps one of the unintended consequences of the additional tariffs is that the $300 bn of goods that will face the new tariffs are mostly consumer goods. Previous tariffs were mostly on intermediate goods and thus the price impact was not obvious to consumers or did it appear in the inflation data.  However, the new tariffs will directly affect consumers.  Retailer stocks fell hard on the announcement and merchants have been critical of the announcement.
7. And finally, there is one other issue to consider. The president could be following the Mexican playbook and decide not to implement the tariffs on September 1^st if China buys grain and cuts narcotics exports.  Since the tactic worked with Mexico, he may believe it will work with China as well.  Thus, there is a chance that nothing happens.

The market effects were swift.  The following are intraday charts of various U.S. markets.

The S&P 500 fell over 60 points.

The 10-year T-note yield fell over 15 bps to decline under 1.90%.

The dollar weakened on ideas that a trade conflict would likely force the Fed to cut rates more aggressively.

This chart shows the 2-year T-note yield.  Like it’s longer duration “cousin” that yield fell sharply, confirming the comment on the EUR above.  In fact, the yield curve modestly steepened.

On the other hand, oil prices plunged on fears that a trade war will harm global economic growth.  We are seeing some recovery in oil prices this morning.

We also note that tensions between the U.S. and China remain high; SoS Pompeo criticized China at the ASEAN meetings in Bangkok, a clear indication of deteriorating relations.

Tories lose: In a by-election in Wales, the Liberal-Democrats won the seat, reducing the Tory-DUP coalition to a single seat.   The loss increases the odds of snap elections.  Labour continues to struggle, as it didn’t perform all that well.  The Liberal-Democrats ran on a platform to Remain in a district that voted to leave.  Perhaps the signal for this election is that the most important issue is the “should I stay or should I go” decision and not the traditional issues of fiscal policy, foreign policy, etc.  The risk of new elections could be that there is a swift realignment of the parties, where Remainers in the Labour and Conservative Parties move to the Liberal-Democrats and the traditional parties fall to minority status.

North Korea: There were more missile launches by Pyongyang.  Clearly, the Young General is trying to get the world’s attention.

United States-Russia: Today is the day that the United States has officially withdrawn from the Intermediate-Range Nuclear Forces Treaty of 1987, in which Washington and Moscow agreed not to develop, test, or deploy certain ground-based nuclear missiles that were seen as particularly dangerous and destabilizing.  The move, announced in February, follows the Russian deployment of a ground-based cruise missile in violation of the accord.  That violation was real enough, but we note that the immediate U.S. response didn’t have to be a complete withdrawal from the pact.  The U.S. side is apparently gambling that in order to free its hands to develop its own new weapons to counter a rising China, it would be worthwhile to sacrifice stability in Europe.  As we’ve already seen in the U.S.-China trade dispute, the Western Europeans are the main losers, at least in the immediate term.  Separately, President Trump has belatedly imposed new financial sanctions against Russia for using the nerve agent novichok in its effort to assassinate former double agent Sergei Skripal in England during March 2018.  Under law, the administration was required to impose those sanctions last year, but resisted until Congress recently raised pressure on it with a number of new Russia sanctions bills.

Afghanistan withdrawal: Due to an agreement with the Taliban, the U.S. will reduce its troop strength in Afghanistan by 5k.

Russia-Japan:  In another provocative move, Russian Prime Minister Medvedev today visited an island in the Pacific Ocean that is claimed by both Russia and Japan, resulting in a strong diplomatic protest by Tokyo.

United States-European Union: As we mentioned yesterday, it’s important to remember that while the overall global trade picture continues to slide, there are smaller-scale improvements from time to time.  Today, for example, the United States and the European Union will sign an agreement giving U.S. beef producers more access to the EU market.  The deal is a direct result of the Rose Garden meeting last summer between President Trump and European Commission President Jean-Claude Juncker.

International Monetary Fund: The European Union’s finance ministers will vote today on their candidate to succeed Christine Lagarde as head of the IMF.  The Europeans traditionally name the IMF chief, while the United States names the head of the World Bank.  Frontrunners for the IMF job include former Dutch Finance Minister Dijsselbloem, Finnish Central Bank Governor Rehn, Spanish Finance Minister Calviño, and Bulgarian World Bank executive Georgieva.  The unusual need for a vote reflects disagreement between Europe’s more affluent northern countries and the less developed southern nations.

 

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

[Posted: 9:30 AM EDT]

Good morning!   Markets are dealing with the aftermath of the Fed meeting.  China is slow-walking trade. The BOE met today.  Osama bin Laden’s son is believed to have died.  The MLB trade deadline big winner was Houston, with Atlanta coming in a close second.  Here is what we are watching this morning:

The Fed: The FOMC generally did what was expected—the fed funds target was reduced by 25 bps and quantitative tightening has ended.  However, beyond that, the financial markets view the Fed’s action as relatively hawkish.  First, Chair Powell characterized the policy actions as “a mid-cycle adjustment.”  This comment, coupled with confirmation later in the press conference, suggests that this rate cut doesn’t signal a new rate cutting cycle.  Instead, to use a historical context, it is more like 1995.  Essentially, the Fed has admitted it moved rates too high and is adjusting rates to a level better suited to current conditions.  Powell did suggest that yesterday’s cut may not be enough for current conditions, but if the financial markets thought this was the beginning of 100 bps of easing into early next year, that probably isn’t the case.

Powell did note that the rate cut was also tied to the perceived decline in “neutral rate” which does indicate the Phillips Curve model still has some influence on members of the FOMC.  He mentioned global concerns and the trade conflict as well.  Although these issues do offer a potential path for future easing (e.g., weaker overseas growth could trigger additional rate cuts), these factors probably are less important than they appear.  The dissents tend to undermine these other issues as having an effect on future rate moves.

Specifically, there were two dissents.  KC FRB President George’s dissent was no surprise. She is a traditional hawk that would rely on the Phillips Curve for guidance.  Given that labor markets remain tight, it is consistent that she would oppose the action.  Boston FRB President Rosengren’s dissent is far more interesting.  He is what we would characterize a “financially sensitive” voter; his opposition to a rate cut is based on the idea that it would lead to excessive risk taking in the financial markets.  We examined this class of voter in an earlier AAW.  In general, what we found was that when the 12-week moving average of the VIX was below 20, this class of voter tended to support rate hikes.  And so, the recent drop in the VIX probably explains Rosengren’s dissent, which was telegraphed.   With two dissents, the odds of further rate cuts will be challenging.

Financial markets reacted by treating the action as hawkish.  Gold prices fell, the dollar jumped, the yield curve flattened and equities slid.  To some extent, the reaction was probably a bit excessive but it is clear the financial markets wanted more and are now bringing back the risk of recession.   President Trump was critical of the easing, suggesting it was inadequate.

Interestingly enough, the two-year deferred Eurodollar futures implied rate didn’t change.  Although the spread compared to fed funds narrowed because of the cut, the projection of fed funds two years from now is still on pace for the 1.65% level (or a ceiling rate of 1.75%), meaning that three more rate cuts remain imbedded in financial markets.

In the final analysis, if Chair Powell wanted to move more than what we saw yesterday, he hasn’t convinced enough members of the committee to follow him.  There were two significant clues for the Fed from the actions of the financial markets.  The first is the yield curve.  If the financial markets viewed the easing as stimulative, the yield curve would have steepened.  The fact that it flattened is a clear indication the financial markets believe the Fed move and the consequent signaling was inadequate.  The second is strengthening of the dollar.  Given the dollar’s current high valuation, a policy change to easing should have led to a weaker greenback.  The fact it rallied suggests the action was taken as non-stimulative.  We should also note that the Fed’s modest action is occurring in a backdrop where the ECB is considering more aggressive actions and the BOJ is looking at allowing the JGB’s to fall into deeper negative territory.

The White House has been increasing its focus on the exchange rate markets, in our opinion, because the president has figured out that currency depreciation blunts the impact of tariffs.  Although the Treasury has exchange rate policy in its mandate, it has limited tools to affect the rate.[1]  As we have been discussing, the White House appears, at least to us, to be moving toward undermining Fed independence in order to fix the dollar’s exchange rate lower.  Interestingly enough, now Congress is getting involved.  Senators Baldwin (D-WI) and Hawley (R-MO) have introduced a bill that calls for a weaker dollar.  It is starting to look a little like 1985 and the run-up to the Plaza Accord.

The BOE:  The Bank of England left policy rates unchanged but did reduce U.K. growth forecasts due to the uncertainty surrounding Brexit.   The GBP rose modestly on the news.

Iran:  The U.S. has applied personal sanctions to Javad Zarif, Iran’s foreign minister.  This action will make it more difficult to begin negotiations.  However, the U.S. has also granted waivers to foreign nations participating in Iran’s civilian nuclear projects.

Trade talks:  China’s negotiating tactics have shifted to stalling as it appears officials are considering the status quo to see if anything changes after the elections.  China isn’t pleased with this characterization.   The Trump administration is restraining comments on the situation in Hong Kong, fearing that siding with the protestors might set back trade talks.  China is apparently moving on grain purchases, preparing to import from the U.S.

In what may be a new front in the U.S.-China trade dispute – or at least a new sore point – U.S. authorities have indicted a Chinese aluminum magnate on charges that he sidestepped anti-dumping duties on millions of pallets of aluminum brought into the United States from 2011 to 2014.  The U.S. attorney for the central district of California said Liu Zhongtian’s “rampant criminality” not only posed a threat to U.S. industry, livelihoods, and investments, but also artificially inflated the value of his Hong Kong listed China Zhongwang Holdings (1333.HK, 3.44).  More broadly, the U.S.-China trade dispute continues to weigh on manufacturing throughout the Asia-Pacific region.  As shown below, the latest Markit purchasing managers’ indexes show factory activity continued to decline during July in Japan, South Korea and Taiwan.

Hong Kong:  The commander of the Chinese military garrison in Hong Kong has warned that the city’s increasingly violent political protests are “absolutely impermissible.”  In addition, the People’s Liberation Army released a video showing how the Hong Kong garrison is training to suppress mass protests.  The speech and video are being taken as a warning to Hong Kong’s anti-Chinese protestors that the military is itching to clamp down on them.  As a clamp down starts to look more and more likely, we would expect increasing economic disruption in Hong Kong and further headwinds for Chinese and Hong Kong assets.

Japan-South Korea:  The Japanese government is preparing to take South Korea off its list of export destinations enjoying eased trade rules as early as tomorrow.  The move is in retaliation to South Korea’s continued legal maneuvering to gain compensation for its treatment by Japan before and during World War II.  The move would require Japanese exporters to obtain licenses before they export a wide range of chemicals and electronic goods to South Korea, compared with the controls that have already been imposed on just three chemicals.  No licenses have been granted for exports of those three chemicals, seriously crimping South Korean computer chip manufacturers.

United States-Japan-Brazil:  In spite of the overall global trend toward protectionism and trade disputes, there are some small signs of cooperation, too.  For example, U.S. Trade Representative Lighthizer will meet today with Japanese Economic Revitalization Minister Toshimitsu Motegi to accelerate work on a U.S.-Japan free-trade deal.  Separately, Brazilian Economy Minister Paulo Guedes said yesterday that Brazil and the United States are now officially in negotiations for a deal.

Where’s Boris?  He was in Northern Ireland yesterday.  Just like what we saw in Wales and Scotland, his reception was rather cool.  Northern Ireland hasn’t had a local government because none of the parties can form a government so the area’s affairs are being run from Westminster.  Although Johnson’s coalition is dependent on the DUP for support, Johnson argued he would be an impartial arbitrator in establishing local government.  To a great extent, the Irish border is probably the most contentious issue with Brexit; if Ireland were unified, exiting the EU would be much easier.  The Republic of Ireland is considering plans to establish border controls on its soil to protect the EU’s trading area.

Germany says nein:  The U.S. has asked Germany to participate in protecting Persian Gulf shipping.  Germany has indicated it won’t act unless it is an EU wide effort.  The U.S. isn’t pleased.

Energy update:  Crude oil inventories fell 8.5 mb, well more than the 2.5 mb expected.

In the details, U.S. crude oil production rose 0.9 mbpd, recovering from the hurricane induced curtailment.  Exports fell 0.4 mbpd but import declined 0.7 mbpd.  Refinery operations fell 0.1 mbpd.

This chart shows the annual seasonal pattern for crude oil inventories.  The decline seen over the past few weeks now puts the level below the usual seasonal trough in September.  This decline in stockpiles is supportive for prices.

Based on our oil inventory/price model, fair value is $62.23; using the euro/price model, fair value is $51.84.  The combined model, a broader analysis of the oil price, generates a fair value of $54.73.   We are seeing a clear divergence between the impact of the dollar and oil inventories.  If President Trump is successful in bringing the dollar lower, it would be bullish for oil prices.

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[1] In reality, the Treasury’s mandate on forex is something of a holdover from the days of fixed exchange rates.  In that period, the Treasury, working on behalf of the executive branch, would manage negotiations with other nations on the level of the exchange rate and instruct the Fed to take actions to maintain the peg (in an earlier period, against gold, later against other pegged rates).  Under floating rates, the Treasury has limited tools to intervene to adjust the currency and can “jawbone.” However, monetary policy has a much larger impact.

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

[Posted: 9:30 AM EDT]

Good morning!   The FOMC meeting ends today.  North Korea continues to fire off missiles.  The baseball trading deadline occurs at 4:00 EDT today.  Here is what we are watching this morning:

The Fed: Yesterday, we noted the scenarios for today’s monetary policy.  To repeat, there is almost no chance the Fed won’t cut by 25 bps today.  Instead, there are two factors that could offer insights into future actions.  First, Powell’s language, especially in the press conference, will be important.  The key word is “patient.”  If the statement includes the word “patience,” it will signal that this rate move is a recalibration, suggesting the policy rate overshot its equilibrium level and the move was an adjustment.  However, it won’t indicate that this cut is the start of a rate reduction cycle. If this is the outcome, markets will be disappointed and we could see equities decline.  Second, there could be action on the balance sheet.  The Fed might announce that it will end its balance sheet reduction six weeks earlier than planned.  Although modestly supportive, this action would be a dovish signal.

We are starting to see more of monetary policy discussion being framed by exchange rate concerns.   The ECB appears to be teeing up additional stimulus, including a deeper foray into negative interest rates and expanding QE.   Some pundits are suggesting the Fed is being forced to move on rates to prevent further dollar appreciation.  There is an element of truth to this charge.  Central bankers and finance ministers have been careful not to couch their policy actions in terms of affecting exchange rates.  In fact, in the unwritten rules of central banking, such discussions would be in bad form because they could open up a return to the 1930’s “beggar thy neighbor” devaluations that eventually led to a collapse in trade activity.   However, in reality, much of the monetary stimulus came from currency weakness.  After all, if you drive nominal rates below zero and you still can’t increase investment, what’s left?  Export growth!  Abenomics got most of this punch through a weaker yen, but because officials framed the actions as necessary for domestic growth, other central bankers essentially granted Japan a pass.  President Trump doesn’t buy this ideology; he wants the Fed to cut rates by more than 25 bps to weaken the dollar.

At some point, this race to the bottom will end; one possibility is that we return to some sort of fixed exchange rate system but that might require central banks to focus solely on the exchange rate to set policy.  But, before we get to some sort of resolution, continued attempts to weaken currencies is possible; the investor solutions are monetary assets, e.g. precious metals.

Trade:  The first post G-20 meeting between U.S. and Chinese trade negotiators has come to a close.  Not too much progress appears to have been made.  China has agreed to buy some grain, but only to the extent consistent with “internal demand.”  We also note that China is showing increasing interest in sourcing soybeans from South America.  The U.S. will probably offer some tech relief but it is starting to look like both sides are digging in and awaiting the end of the next U.S. election cycle.  This isn’t the worst outcome, which, specifically, would be a complete rupture of trade relations.  In fact, the “slow walking” gives both sides a chance to adjust.  The next round of face-to-face talks won’t take place until September.

North Korea:  Kim doesn’t want to be ignored.  As the U.S. and South Korea prepare for military exercises, for the second time in a week, Pyongyang has tested short-range missiles.  North Korea has always been concerned about military exercises, fearing that they could be a pretext to invasion.  Despite that fact that it hasn’t ever occurred, the worry is understandable.  So far, the tests have not crossed any “red lines” such as entering Japan’s territorial waters or a long-range test that would threaten the U.S.  We would not expect an overt threat to the U.S. from North Korea.

Brexit news:  PM Johnson visited Wales yesterday and, much like what he experienced in Scotland, the locals weren’t all that happy to see him.  Today, he visits Northern Ireland and will likely get a mixed reaction there as well.  In fact, the issue of the Irish border may be the most intractable of all the hurdles of Brexit.[1]  Johnson faces another challenge—there is a special election in Wales today that could go to a Liberal Democrat. If so, Johnson’s coalition margin in the House of Commons will fall to one seat and increase pressure for a snap election.

Hong Kong:  U.S. officials are watching the buildup of Chinese forces on the Hong Kong border with interest.  So far, Beijing has been content to allow local officials to handle the unrest but we doubt that the Xi regime has infinite patience on this issue.  Perhaps the most important reason why China has been reluctant to crack down on the protestors is it knows Taiwan is watching.  A harsh crackdown on Hong Kong will make it difficult for Beijing to convince Taiwan’s citizens that unification will preserve its democracy.  Reports that China is restricting tourist visits to Taiwan did catch our attention.  If Xi concludes he cannot tolerate continued unrest in Hong Kong and uses the military to restore order, it may mean that unification with Taiwan can only be accomplished by force.  And if that decision is made, it comes down to timing.

A softening on Iran?   The Trump administration is apparently going to reissue waivers that allow foreign nuclear projects in Iran to continue.  Iran hawks argued against the extensions, including NSD Bolton and SoS Pompeo.  At the same time, the U.S. has formally asked Germany to participate in maritime security operations in the Persian Gulf.  This request will be difficult for Germany to manage; on the one hand, it believes the U.S. has caused this crisis by leaving the JCPOA, so why should it work to fix a problem it didn’t cause.  On the other hand, if they don’t participate, it looks like Germany is continuing to “free ride” U.S. security.  After all, it is clearly benefiting from U.S. protection of Persian Gulf shipping.

 

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[1] For details, see https://www.confluenceinvestment.com/wp-content/uploads/weekly_geopolitical_report_2_25_2019.pdf and https://www.confluenceinvestment.com/wp-content/uploads/weekly_geopolitical_report_3_4_2019.pdf

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

[Posted: 9:30 AM EDT]

Good morning!   The FOMC meeting begins today.  The GBP continues its slide.  Here are the details:

The Fed: Although there is almost no chance the Fed won’t cut by 25 bps tomorrow, we are watching for two items.  First, Powell’s language, especially in the press conference, will be important.  The key word is “patient.”  If the statement includes the word “patience,” it will signal that this rate move is a recalibration, suggesting the policy rate overshot its equilibrium level and the move was an adjustment.  However, it won’t indicate that this cut is the start of a rate reduction cycle. If this is the outcome, markets will be disappointed and we could see equities decline.  Second, there could be action on the balance sheet.  The Fed might announce that it will end its balance sheet reduction six weeks earlier than planned.  Although modestly supportive, the action would be a dovish signal.

Regardless of what happens tomorrow, we doubt the White House will be happy about it.  The president wants a weaker dollar and he wants the Fed to engineer that outcome.  If the reserve currency nation attempts to restrict trade, its currency will appreciate.  This is because there is always demand for the reserve currency and the most effective way to acquire it is to run a trade surplus with the reserve currency nation.  The best way to prevent the currency from appreciating is for the reserve currency nation’s central bank to peg an exchange rate and adjust its balance sheet to ensure the peg holds.  This is what Switzerland’s central bank, the Swiss National Bank (SNB), has been doing relative to the EUR for the past few years.  However, such a policy essentially ends central bank independence; the SNB’s policy is completely subsumed to exchange rate policy.

Trade:  Although talks are underway, there is little movement toward a grand resolution.  As we noted yesterday, China appears to be buying some U.S. grain.  The U.S. is offering unspecified relief on tech exports.  However, beyond these two actions, not much else is happening.  As the U.S./China trade spat continues, companies have been moving supply chains out of China.  They haven’t brought production back to the U.S. but are going to other low labor cost areas, e.g., Vietnam.  This development has caught the attention of USTR Lighthizer who is now calling out Vietnam for its trade surplus with the U.S.

For those wondering if a new president would lead to a change in trade policy, we doubt it.  In fact, it may become more protectionist.  Elizabeth Warren’s recent comments on foreign policy are classic Jeffersonian (which leans isolationist) and her trade policy would probably be more protectionist than Trump’s.  What this suggests is that the president’s foreign and trade policy may be less about him and more about the direction the country is headed.

Brexit:  PM Johnson visited Scotland yesterday and got a chilly reception.  He has told the EU that he won’t engage in talks unless the EU agrees to change the current agreement, which the EU has indicated isn’t going to happen.   As the odds of a no-deal Brexit increase, the GBP is continuing to spiral lower.

A peek inside China’s foreign reserves:  For the first time ever, China has released some details about its foreign exchange holdings.  The data isn’t up-to-date (the last data available is 2014).  But, it does show the State Administration of Foreign Exchange (SAFE) reduced its dollar holdings from 79% in 2005 to 58% by 2014.  It shifted to EUR and other currencies, along with gold.

Health care transparency:  Economists have debated the problem of health care costs for some time.  Although measures to open the industry to competition should reduce costs, there are specific structures in the industry that defy standard market remedies.  It is almost impossible to comparison shop for treatment because it is difficult for the average consumer to evaluate quality.  And, even if one wanted to shop around, getting accurate price information is devilishly hard.  The Trump administration has proposed measures to disclose price information; the fact the hospital industry is upset with the proposal suggests it probably would undermine its profit structure.

Japan:  The Bank of Japan today held its monetary policy unchanged, with its benchmark short-term interest rate at -0.1%, its ceiling for 10-year bond yields at 0% and its pace of government bond buying at 80 trillion yen.  However, in a sign that the BOJ is ready to join the other major central banks that have been loosening policy, the officials also vowed further monetary easing without hesitation “if the momentum towards our price stability objective is at risk.”

Hong Kong:  The deputy leader of Hong Kong reportedly apologized for the way the city’s police force responded to last week’s incident in which thugs from criminal gangs beat anti-Chinese demonstrators.  That sparked a protest by police officials, possibly pointing to cleavages within the municipal government regarding how to handle the ongoing political protests.

Venezuela:  Although President Nicolás Maduro still publicly embraces socialism and castigates capitalism, the government is quietly embracing free markets in an apparent last-ditch effort to help the economy and stay in power.  Private business owners say rules banning hard-currency transactions have not been enforced recently, importing has been freed, and many price controls have been dropped.  The reporting says the economy is rapidly dollarizing, while inflation has fallen from more than 100,000% last year to an expected level of several thousand percent this year.

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