Daily Comment (April 28, 2017)

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] Markets were fairly quiet overnight.  The biggest mover was the EUR, which rose after Eurozone CPI came in at 1.9%, a bit higher than forecast.  The financial markets are starting to discount a reduction in stimulus from the ECB, although Draghi’s comments yesterday suggest he is pushing back against any idea that stimulus is about to be removed.  However, the ECB does not have a growth mandate; it is designed, like the Bundesbank, to focus on inflation and the exchange rate and so rising inflation should boost the likelihood that tapering will begin later this year.  Although we have been favorable toward the dollar for some time, further strength is based on much more tightening by the FOMC and fiscal stimulus in the form of tax cuts and infrastructure spending.  It is unclear if or when the fiscal actions will be forthcoming and so the dollar could become vulnerable to weakness in the coming months, especially if the ECB begins to withdraw stimulus.

Yesterday, the president suggested in media interviews that a conflict on the Korean peninsula is possible.  Although we don’t think such an event is imminent, we are watching developments closely.  Earlier this week, all 100 senators came to the White House for a classified briefing on North Korea.  Comments afterward were underwhelming, suggesting little new information was discussed.  The president did make some waves by suggesting the South Koreans should pay for the recent deployment of the THAAD missile system.  This has actually been an issue for years; on numerous occasions in the 1970s, Congressmen suggested that Germany should pay for U.S. soldiers stationed there.  The U.S. exercise of hegemony has generally been rather “light touch” compared to the British colonial system.  The U.S. used its own resources to freeze conflict zones in Europe, the Middle East and the Far East.  However, it has been argued that Nixon’s decision to exit the gold standard in 1971 and create a “dollar-Treasury” reserve standard effectively forces foreigners to partially fund the U.S. fiscal deficit through the process of holding Treasuries as part of the dollar reserve currency system.[1]

President Trump has been alluding to a more overt “billing” of allies for American security.  In last year’s 2017 Geopolitical Outlook, we described this as the “Malevolent Hegemon” model.  So far, he hasn’t made any radical moves but he has clearly signaled that they may be coming.  The erroneous reports earlier this week that the U.S. was pulling out of NAFTA would be an example of such malevolence.  At first, Trump was skeptical of NATO but that appears to have changed.  So far, the malevolent hegemon has been mostly bluster but that could change.

Perhaps the most effective way to address hegemonic concerns is through a weaker dollar.  The best path to a weaker dollar is probably a relatively dovish FOMC.  Given recent retirements and anticipated term expirations, President Trump could fill five of the seven governor positions.  We reported earlier that Randal Quarles was the expected selection for Vice Chair of supervision, but he may have hit a snag.  Fed rules require that no two Fed governors can come from the same Federal Reserve district.  Quarles appears to be from Utah, in the San Francisco district, which is currently represented by Chair Yellen.  CNBC reported earlier this week that Gary Cohn might be a candidate for the chair to replace Yellen, which might free Quarles to be appointed in early 2018 when Yellen is expected to step down.  However, in order for Cohn to ascend, who is from NY, Vice Chair Fischer would also need to resign.  This rule may force the administration to look into the “dark hinterlands” of the Midwest and Southwest for candidates.  Kevin Warsh and Thomas Hoenig were also mentioned in the article.  Warsh would probably be a moderate on policy but Hoenig is a notorious hawk.  Adding Hoenig to the board would likely be dollar bullish.

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[1] Hudson, M. (2003). Super Imperialism: The Origin and Fundamentals of U.S. World Dominance (2nd ed.). London, England and Sterling, VA: Pluto Press.  First edition published in 1972 by Holt, Rinehart and Winston.