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

[Posted: 9:30 AM EDT] It’s an August Monday.  Equities are under pressure again this morning and risk assets, in general, are weaker.  Here is what we are watching:

China and the dollar: For the third consecutive day, the PBOC fixed the CNY/USD exchange rate above 7.  Although this reference rate was a bit stronger than Friday’s level, it suggests PBOC policy is more about stabilizing the exchange rate at a point weaker than 7 (the higher the rate, the weaker the CNY).  There are two reasons why the PBOC probably isn’t letting the CNY sink lower.  First, there is the constant problem of capital flight.  During previous periods of CNY weakness, foreign reserves fell as Chinese investors moved money out of the country to protect themselves from a depreciation.

This chart shows foreign reserves and the CNY/USD exchange rate.  The CNY began to weaken in early 2014.  From 2014 to late 2016, the currency weakened nearly a full CNY and foreign reserves fell by nearly a trillion dollars. Some of the decline in reserves was due to valuation changes but there were notable levels of capital flight.  China has measures to prevent capital flight but, as the data shows, regulators’ ability to prevent it is limited.  The second issue, as we noted last week, was the high level of dollar-denominated debt in the private sector.  There are reports that private Chinese companies are being forced to sell off foreign assets because they face a shortage of dollars.  There is some debate among analysts as to what this dollar shortage means.  One possibility is that the above chart’s $3.1 trillion of dollar assets is not liquid or is already committed.  In other words, these companies may be facing a real dollar shortage and China may be in bigger trouble than it appears.  The second explanation is that China has ample dollar reserves but doesn’t want to spend them on the private sector.  Allowing (forcing?) private companies who splurged on foreign buying (which may have been related to capital flight) may be in Beijing’s best interest.  The leadership may want to discourage Chinese companies from buying assets overseas and warn foreign lenders that lending to private Chinese companies, even big ones, is riskier than it looks.  We tend to think the second explanation is more likely.  There has been a clear bias toward the state-owned enterprises (SOE) under Chairman Xi, and “starving” the private sector’s demand for dollars while allowing access for the SOEs would fit that partiality.  Still, the reason there is a debate at all is due to the opaque nature of China’s reserve management; it is possible that the first explanation is correct and, if it is, China could be quite vulnerable to market volatility.

China’s lending slows: Chinese lending in July came in weaker than expected.  Total loan growth slowed under 13% as the PBOC tries to rein in lending.

The slowdown highlights the problem Chinese authorities are facing, something similar to what the U.S. saw in 2011-13.  Although monetary policy itself suggests easing, regulatory constraints are hampering the transmission process.  Essentially, the entities that China wants borrowing from aren’t doing so and the firms that need the liquidity are being restricted.  For example, components of private financing, or “shadow banking,” are down for the year.

In other words, China wants to see more borrowing but only by certain borrowers.  If this bias continues, monetary stimulus will likely disappoint.

Authoritarians under pressure: Hong Kong remains a tinderbox as protests continue.  Air traffic was halted due to unrest as thousands of demonstrators flooded terminals.  Protests continue in the city as well.  Beijing is escalating its rhetoric, calling it “terrorism,” which may be laying the groundwork for a military crackdown to restore order.  Meanwhile, there were massive protests in Moscow, dwarfing those of previous weeks.  Although the bulk of the unrest remains in Moscow, there is evidence of smaller actions elsewhere.  One source of trouble for Putin is a disappointing economy.  With Hong Kong, the protests there could trigger a Tiananmen-style response.  If that occurs, capital flight would soar and relations with Taiwan would harden.  In terms of Russia, we expect Putin to remain in control but the fact that protests are happening at all suggests his power is under pressure.  In another interesting sidelight, a massive munitions explosion last week apparently caused a radiation leak, raising speculation that the blast involved a nuclear cruise missile project.  If so, this is yet another setback in Russia’s military technology.

Italy: It is still unclear whether the government will fall, but the uncertainty isn’t helping Italy’s perilous financial situation as it faces credit downgrades.  Salvini had to deny that his party wants to exit the Eurozone; such talk would lead to further capital flight and more downward rate pressure on German Bunds.

Brexit: There is growing talk that MPs may not be able to stop PM Johnson from a hard Brexit if he is determined to go that path.  It is starting to look like the available measures of no-confidence will probably backfire and may deny MPs any role in halting a sudden exit.

Argentina: In a sign that populism may be returning to Argentina, Alberto Fernández of the Peronist party won the nationwide primary election over the weekend by a far larger margin than expected.  Fernández, whose wife is former president Cristina Fernández de Kirchner, received 47.0% of the vote, while the current pro-business president, Mauricio Macri, won just 32.7%.  Investors probably fear the return of the Peronists’ radical, unorthodox economic policies under Fernández and Kirchner, so Argentine assets will likely come under pressure in the coming days.

Deep thoughts: With fond memories of Jack Handey, here are some broader items that caught our attention over the weekend:

1. The waning superpower problem: The FT ran a long thought piece about what happens to the world if the U.S. becomes less involved. We have been discussing this issue for some time; our take is that Americans were sold the policy of containing communism to foster participation in the hard work of hegemony.  But, in reality, containing communism was only a small part of freezing other global conflicts worldwide.  When communism fell, most Americans believed we could end the hegemonic role without realizing that a world without a hegemon is a world at risk of WWIII.  We found the comment section from the aforementioned FT article to confirm that position.
2. Other kinds of inflation: Although price inflation remains sticky, firms will try to maintain margins in other ways. Showrooms may have fewer sales staff; dining rooms may be less clean.  Sizes may shrink.  If tariffs bite, we would expect more tactics like this to maintain margins and price levels.
3. The long expansion: One characteristic of this expansion is that most of the benefits have accrued to a few major metropolitan areas. Much of the rise in growth has not found its way into the rest of the country.  That may be starting to change.  As the cost of living in the supercities becomes onerous, there are reports that some areas of the country are seeing a secondary boom as people leave the “hot” areas for parts of the country that are more affordable.  If this is the beginning of a trend, policymakers will likely try to support it by keeping policy more accommodative.

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

[Posted: 9:30 AM EDT]

Happy Friday! Equities are giving back some of yesterday’s stronger gains.  The Italian government is near a collapse.  U.K. economy disappoints.  U.S. holds off on tech decisions.  And, five decades ago today, the famous album cover photo of Abbey Road was snapped.  Here is what we are watching today:

Italian troubles:  Making good on earlier threats, Deputy Prime Minister and League leader Matteo Salvini withdrew his party from government, and called for new elections.  Despite Salvini’s actions, new elections are not inevitable.  Italy’s president, Sergio Matarella, actually decides if the government will fall, and he might decide to give other parties the opportunity to form a new government.  The legislature is in recess for the summer (after all, it is Europe) and the president probably won’t want to take this action while lawmakers are away.  In addition, the body is working on budgets and bringing new elections at this time could delay that process.

We see two important takeaways from Salvini’s move.  First, as we noted yesterday, this action probably spells the end of the world’s only “Nader coalition,” one described by Ralph Nader in his book Unstoppable,[1] which is a coalition of right-wing and left-wing populists.  Although Nader’s idea of this coalition seems reasonable, the reality is that the differences between the two sides may simply be unworkable.  If so, a coalition between an elite group with a populist group is more likely; perhaps the most enduring one in U.S. politics was engineered by Franklin Roosevelt, who tied left-wing elites to right-wing populists.  This coalition dominated U.S. politics from 1940-65.  Since then, both elite groups have had looser ties with populists, but in reality, the right-wing and left-wing elites have governed as a minority coalition (at least in terms of economic policy) with ties of convenience to populist groups.  This is why we have seen the White House consistently shift between parties.  Second, the move by Salvini is roiling Italian financial markets.  The spread between German bunds and Italian bonds blew out this morning with German yields declining on flight-to-safety buying.  Salvini has been confrontational with the EU and if the government falls and he leads the next one, the odds of the conflict escalating increases.

Commerce delays:  The Commerce Department has decided to delay its decision on granting exemptions for companies wanting to buy equipment from Huawei (002502, CNY 2.83).  What seems to be occurring is that the U.S. wants China to buy U.S. agricultural goods, and China wants the U.S. to ease restrictions on Huawei.  However, both want the other side to make the first move, perhaps in order to show the other side “caved”.  In the 7^th grade, similar disputes are either resolved by each party having a hand on what the other wants and releasing each good on the count of “3,” or by bringing in a third party to hold both goods in “escrow” and releasing each after both sides hold up their end of the bargain.  Apparently, the U.S. and China haven’t experienced these resolution measures.  The decision’s delay is probably behind today’s equity market pullback.

CNY fixing:  For the second straight day, the PBOC has fixed the CNY above seven CNY/USD.  Although Chinese officials are preventing the currency from weakening further, they are also clearly giving up on the previous ceiling at seven.[2]  Meanwhile, the White House jawboning for a weaker dollar continues; next week’s WGR will discuss the potential for a shift in the global forex regime.

Hong Kong:  Tensions remain very high.  China has singled out Julie Eadeh, a U.S. consulate official, for meeting with protest leaders.  Chinese official media is suggesting that the meeting is clear evidence the U.S. is influencing the protesters.  Protests are planned for this weekend; the U.S. has issued a travel warning.  Although the Trump administration has been mostly quiet about the protests, it is clear Chinese officials feel they need to paint the protesters as being influenced by foreigners to frame the protests are unpatriotic.

Global Economic Growth:  Japan and the United Kingdom, which typically represent the two biggest non-U.S. stock markets in the broad international indexes, today both reported their second-quarter economic growth.  Japan’s gross domestic product beat expectations with an increase of 0.4%, as trade headwinds were offset by rising corporate investment.  In contrast, the United Kingdom’s GDP unexpectedly declined 0.2%, marking its first contraction since late 2012.  The U.K. decline, which is driving sterling downward today, came in large part because pre-Brexit stockpiles built up in previous quarters have started to be consumed.

Global Oil Market:  The International Energy Agency cut its forecast for this year’s global oil demand for the third time in the last four months.  After demand in January through May increased at its weakest rate since 2008, the IEA now expects demand in all of 2019 to be up just 1.2 million barrels per day.  The cut in the forecast mostly reflected slowing economic growth around the world and the worsening U.S.-China trade war.  Separately, officials in Tokyo are hinting that Japanese naval forces may be sent to the waters off Yemen in order to help protect oil shipments through the Persian Gulf without unduly antagonizing Iran.  In another interesting development, Iranian oil traders have found themselves being wooed by Western intelligence agencies and surveilled by Iranian officials as the former tries to figure out how Iran is smuggling oil, and the latter tries to prevent the information from getting out.  Additionally, British private guards are being pulled from Persian Gulf shipping on fears they could be captured by Iran and used as potential bargaining chips.

Japan-South Korea:  As a sign that the Japan-South Korea dispute over World War II reparations is still not resolved, the South Korean Environment Ministry said yesterday it would tighten radiation checks on coal ash imports from Japan.  That comes after some positive news yesterday, when Japan approved the export of a key chemical to South Korea.  Although the dispute is likely to remain relatively contained, perhaps the worst aspect of it is that it shows how countries are now using protectionist trade measures as their weapon of choice in international disputes.

Turkey:  Sources say several high-level officials at the central bank have been removed from their posts, just weeks after President Erdogan sacked the previous governor because he “wouldn’t follow orders.”  The move is a sign that Erdogan’s effort to take control over monetary policy goes deeper than originally thought.  It also points to the kinds of developments that might become more common as other leaders – including U.S. President Trump – work to dismantle the independence of their central banks.  Attacks on central-bank independence raises the risk of politically motivated interest-rate cuts, higher inflation and a depreciating currency. However, the lira has responded little to today’s news so far.

Not only is President Erdogan trying to shore up his political fortunes with looser monetary policy, but he is also responding to popular anger over Syrian refugees, by pushing them out of the country.  The problem is that the plan would relocate some 700,000 of the refugees to Syrian territory that Ankara aims to seize from a U.S.-allied Kurdish group.  U.S. and Turkish military forces have in the past almost come to blows over Turkey’s desire to attack the Kurds, so the new plan again raises the risk of a confrontation.

Finally, in late breaking news on Turkey, China apparently negotiated a $1.0 bn swap arrangement with the Central Bank of Turkey, likely a move to shore up Ankara’s foreign exchange reserves.  This action is further evidence that Turkey is being pulled out of the West’s orbit.  Our latest WGR has analysis of the situation in Turkey.

Australia:  As more evidence that cybersecurity is now perhaps the key skillset for Western defense leaders, the new chief of the Australian Security Intelligence Organization will be Mike Burgess, the former head of the military’s top cyber defense agency, who had advised the government to bar Chinese telecom firm Huawei (002502, CNY 2.83) from the country’s new 5G communications network.  As a reminder, the U.S. government announced last month that Michael Gilday, the three-star head of the Navy’s Cyber Command, will be promoted over several four-star colleagues to be the new Chief of Naval Operations.

Russia:  Today marks 20 years since President Boris Yeltsin picked Vladimir Putin to be Russia’s prime minister, launching two decades of Putin’s effort to stabilize the Russian economy, rebuild its military and eventually make it a more assertive global power again.  Radio Free Europe today has a useful review of Putin’s years in power.

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[1] Nader, Ralph. (2014). Unstoppable: The Emerging Left-Right Alliance to Dismantle the Corporate State. New York, NY: Nation Books.

[2] Readers should note that the higher the exchange rate, the weaker the CNY.

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

[Posted: 9:30 AM EDT]

Good morning! Markets are relatively quiet this morning after an impressive reversal in the equity markets yesterday.  We are seeing a backup in bond yields in the past hour on reports Germany may finally be considering fiscal expansion.  Here is what we are watching today:

China news:  For the first time since 2008, the “official” CNY/USD exchange rate was fixed at a level above 7, although it has been trading above that level intraday for the past few days.  Markets are not taking the news too badly because the fixing was stronger than the market was trading, suggesting the PBOC will probably be coming in to support the current level in the coming days.  At the same time, the currency weakening also reflects a slowing economy.  The weaker CNY will likely trigger similar currency declines across Asia.  Currency weakness will tend to help lift economic growth by boosting trade.  Right on cue, China’s trade data for July was stronger than forecast as exports rebounded and imports fell.  Exports to Europe unexpectedly increased while the drop in imports is consistent with a slowing economy.

News on trade was mixed.  China did indicate it was still willing to meet early next month while U.S. trade negotiators draw up a list of goods for tariffs.  It’s hard to see how talks can progress if the tariffs are expanded.  However, news that China was willing to meet contributed to yesterday’s equity rally. China continues to threaten to restrict rare earth exports, which would raise trade tensions.  China is also warning other nations against restricting their imports of Chinese technology.  The U.S. is preparing to ban Huawei (002502, CNY 2.83) technology purchases by the U.S. government.

Although there wasn’t much news from Hong Kong, Chinese officials continue to blame the U.S. for the tensions.  We haven’t seen any evidence that the U.S. is actively supporting the unrest, but it is a strongly held belief among the authoritarian governments that the “color revolutions” are U.S. backed.  That’s a much more comforting notion than believing that citizens aren’t happy.  Beijing is increasing its threats to intervene in Hong Kong if the unrest continues.

Earlier this week, we noted a BIS report that showed China’s dollar-denominated debt was significant, and thus limited the use of currency depreciation as a tool against tariffs.  The details suggest the risk is elevated because over 20% of the dollar lending has occurred in real estate.  If a weak CNY triggers a debt crisis in China, problems in the politically sensitive real estate sector could force Beijing to back down to U.S. demands.

Japan-South Korea:  Although tensions remain high regarding Seoul’s demand for reparations over Japan’s behavior on the Korean peninsula before and after World War II, there are signs the dispute may be cooling.  Japan today approved the export of a key chemical to South Korea, after imposing new export controls over it and other products last month.

A U.S./U.K. trade deal:  Brexit supporters argue that if Britain is free from the EU, it will be able to rapidly negotiate free trade deals across the world, giving a boost to the U.K. economy.  British officials have been discussing a deal with Washington.  SoS Pompeo supported this idea, suggesting he would “have pen in hand” to sign a measure quickly.   We have no doubts this is true.  However, British leverage in talks with the U.S. will be nil and the agreement they get will likely be heavily in America’s favor.  We would expect the U.S. to gain wide access to Britain’s agricultural industry, and finance would come under severe pressure.  Additionally, the British may have no choice other than to accept the terms.

Trouble in Italy:  Tensions within Italy’s ruling coalition continue to worsen, as League members in the Senate helped push through the approval of an Italy-France train link that the Five Star Movement has long opposed.  Disagreements over issues like tax cuts, regional governance, and relations with the European Union have increased the odds that Italy’s experiment with populist government may not last much longer.  Deputy PM Salvini is threatening to pull out of the current ruling coalition if the Five Star Movement doesn’t give into his demands for policy changes and a reshuffling of the cabinet.  The news has lifted Italian bond yields (in a context of falling global yields) and is raising worries about further tensions with the EU.  We have watched this coalition with great interest because it is the only working “Nader coalition” of right- and left-wing populists.  If this government fails, it will suggest that such coalitions are unstable and probably can’t function as governments.

Venezuela:  The U.S. has widened sanctions on Venezuela, implementing a near full embargo on the country.  In response, the Maduro government has withdrawn from talks with the opposition currently being held in Barbados.  Russia has now become the sole supplier of gasoline to Venezuela; it is unclear how the Maduro regime is paying for this product.  Most likely, Russia is supplying gasoline for geopolitical leverage.  Having such leverage over a country in the Western Hemisphere will be highly valued by Russian President Putin because it could help him meddle in regional affairs and keep the United States off balance.  We therefore expect Putin to continue his efforts to keep Venezuelan President Nicolás Maduro in power.  The action by Russia puts its firms at risk of secondary sanctions from the U.S.

Iran:  While Iran keeps harassing oil shipping in the Persian Gulf, new reports illustrate how the effort is sometimes imposing collateral damage on the regime’s few allies.  For example, even when Iran seizes a ship carrying cargo for the United Kingdom, the vessel might be crewed by Indian sailors.  When it seizes a British-owned ship, it might be carrying oil for China.  The risk of angering allies could potentially help mute Iran’s provocative action in the region.

Islamic State:  A report by the Pentagon’s inspector general says the pullout of U.S. military assets in Iraq and Syria is allowing Islamic State militants to regroup and regain their ability to mount attacks.

Food security:  The U.N. is warning that climate change is exacerbating soil erosion and shifting growing areas and seasons in such a fashion that food supplies may be threatened.

Energy update:  Crude oil inventories unexpectedly rose 2.4 mb compared to an expected draw of 3.0 mb.

In the details, U.S. crude oil production rose 0.1 mbpd, to 12.3 mbpd.  Exports fell 0.6 mbpd while imports rose 0.6 mbpd.  Refinery operations jumped 3.4%.

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 week’s rise wasn’t a complete surprise as, at some point, imports were going to reflect a full return from hurricane disruptions.

Based our oil inventory/price model, fair value is $61.35; using the euro/price model, fair value is $50.72.  The combined model, a broader analysis of the oil price, generates a fair value of $53.64.   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.  Recession fears are acting as a bearish factor for oil prices as well, overcoming worries about geopolitical disruptions.

In other oil news, prices have rebounded from a sharp selloff on two items.  First, the perceived “pause” in China/U.S. trade tensions led to some buying and second, reports the Saudis were considering measures to shore up prices lifted bullish sentiment.  On a different note, Bahrain is reporting that it was hit with a cyber-attack that penetrated important infrastructure.  Iran is the likely attacker.

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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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