Daily Comment (April 23, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It was a very busy weekend.  This morning, 10-year T-note yields briefly touched 3.00% and remain near that level.  The dollar is higher on somewhat soft European PMI data.  Here is what we are watching this morning:

North Korean thaw: Kim Jong-un said his nation would close its nuclear test site and suspend its long-range missile launches but didn’t go so far as to give up his nuclear arsenal, at least not immediately.  In one sense, this is a big deal; the NY Times[1] speculated this may signal an end to the current leader’s signature policy, “byungjin,” which is essentially a “guns and butter” approach to the economy.  Instead, North Korea would allow the civilian side of the economy to prosper by allocating it more resources than the military side.  If true, this signal alone is important because it suggests Kim has enough confidence in his control of the military that he can reduce its resource base.

However, like all complicated issues, this one comes with caveats.  First, the nuclear test site has probably been compromised.  Mount Mantap, the site of six nuclear tests, may have suffered enough damage to threaten leakage if another test occurs there.[2]  Although North Korea has other test sites, this one is clearly the favorite.  We would not be shocked to discover that China has pressured North Korea to stop testing at Mount Mantap.  At the same time, we doubt North Korea has completed enough tests to reliably believe it can build a working warhead, so the agreement to suspend tests is important.  Second, a suspension of missile tests can end quickly.

George Friedman at Geopolitical Futures[3] argues that North Korea is shifting from a “ferocious, weak and crazy” strategy to a “ferocious” strategy.  Kim acknowledged that North Korea is now a nuclear power, thus the weak part of the original strategy is no longer operative.  And, nuclear powers cannot be unpredictable; it invites pre-emptive attacks.  The concessions will offer both the U.S. and North Korea room to bargain but we would not expect North Korea to immediately give up its nuclear weapons program.  But, a runway for integration into the world economy would bolster North Korea’s economy.  The key unknown is Kim’s views on markets.  His grandfather and father saw markets as a threat but it appears Kim does not.  Thus, North Korea may be opting for a Chinese model of development.

Europe visits the White House: President Macron and Chancellor Merkel are visiting the White House this week.  We expect each of them to suggest that allies don’t fight over trade (which really isn’t true—Reagan did with Japan and Germany) and that the U.S. should not simply jettison the Iranian nuclear deal.  President Trump and President Macron seem to get along well on a personal level which might help discussions.  However, we still view the chances that the Iranian deal gets scotched as elevated.  SOS nominee Pompeo will likely not be recommended by the Senate Foreign Relations committee this week but will probably still get the position by a narrow margin in the Senate vote.  His appointment would add another Iran hawk to the administration.

China rumblings: There were four items of note on China.  First, Treasury Secretary Mnuchin tried to lower the temperature on trade tensions with China over the weekend.  At the spring IMF meetings, Mnuchin met with PBOC Governor Yi Gang and informed the Chinese official that he is interested in visiting China.  It appears China was open to talks.  In discussions at the IMF meeting, Mnuchin expressed optimism that a trade conflict would be avoided.  Second, President Xi and PM Modi of India have announced they will hold informal talks on Friday and Saturday of this week.  India and China have a contentious mountain border and the former has looked at the one-belt, one-road project with trepidation, fearing encroachment by China into South Asia.  China has allied itself with Pakistan, India’s arch-enemy.  Although India has improved ties with the U.S., concerns about the stability of American policy may be prompting Modi to seek accommodation with China.  Third, the Pakistani press[4] is reporting that China is “ready to provide security guarantees for the one-belt, one-road project.”  At this point, China doesn’t have the military infrastructure to back such claims.  However, we note that the U.S. didn’t either when it unveiled the “Monroe Doctrine.”  Simply making the claim is important if no outside power challenges the claim.  Fourth, the EU is claiming that China is using criminal groups to avoid VAT in Europe.[5]

Global tensions: Greece is reporting that Turkey has been increasing incursions into Greek airspace and waters recently.[6]  Greece was given islands near Turkey at the end of WWI, which was also the end of the Ottoman Empire.  It appears that Turkish President Erdogan is trying to rebuild at least part of that fallen empire.  He is also encroaching into Iraqi and Syrian territory and the threats to Greece are part of that posture.  In the same region, widespread protests were reported in Armenia.  The former president, Serzh Sargsyan, had to step down due to term limits.  He then took the role of prime minister and transferred all the power of the presidency to his new role.  Anger over Sargsyan’s ploy to extend his rule has led to the unrest.  Widespread protests also continue in Iran.  Much of the unrest is due to deteriorating economic conditions.  A drought is leading farmers to demonstrate against Iran’s water allocation policies.  The nuclear deal was partly done to improve the economic lot of Iranians.  However, lingering sanctions and uncertainty about the future path of the nuclear deal have tempered economic growth.  If President Trump does kill the nuclear deal, Iranian leaders will likely welcome that outcome because it would allow them to blame the U.S. for their economic woes.  The nuclear deal raised expectations that have not been met; reinstituting sanctions would reduce those expectations.

U.S. aluminum prices fall: There are reports that the administration may ease sanctions on Rusal (HKD 0486, 1.52) after its controversial leader, Oleg Deripaska, offered to step down as president.  The news has led to a drop in U.S. aluminum prices.

Saudi scare: Over the weekend, there were reports of massive gunfire in Riyadh.  Although there were unconfirmed rumors of a coup attempt, the official report was that a drone had strayed near the Royal Palace, triggering a wave of anti-aircraft fire.  There were unconfirmed reports King Salman was moved to a secure bunker in the capitol.  At this point, it is unclear if this incident was anything more than the official version of the story.  Clearly, the oil markets are unconcerned as prices are slumping this morning.  We will be watching in the coming days to see if there are any reports of arrests.  However, even if the official version is correct, the reaction observed in Riyadh does suggest that security forces are on elevated alert.

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[1] https://www.nytimes.com/2018/04/21/world/asia/north-korea-kim-jong-un-nuclear-tests.html

[2] https://www.washingtonpost.com/world/after-six-tests-the-mountain-hosting-north-koreas-nuclear-blasts-may-be-exhausted/2017/10/20/ccdfa016-b50d-11e7-9b93-b97043e57a22_story.html?utm_term=.bc0f2e110390

[3] https://geopoliticalfutures.com/north-koreas-strategy-halting-nuclear-program/ (paywall).

[4] http://paktribune.com/news/China-ready-to-provide-security-guarantees-for-the-One-Belt-One-Road-project-280601.html

[5] http://m.scmp.com/news/world/united-states-canada/article/2142760/eu-suspects-tax-fraud-chinas-gateway-europe-state?amp=1&__twitter_impression=true

[6] https://www.nytimes.com/2018/04/21/world/europe/greece-turkey-islands.html