Daily Comment (August 15, 2017)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Markets are calming down.  Here’s what we are tracking this morning:

North Korea blinks: According to numerous reports, the military leadership of the Democratic People’s Republic of Korea (DPRK) offered plans to Kim Jong-un for a missile test around the U.S. territory of Guam.  After reviewing the plans, the “young marshal” decided to postpone any attacks.  There has been a definite cooling of tensions since rhetoric intensified last week.  As noted before, the U.S. military has not mobilized for an extended attack.  U.S. military leaders have been stressing the need for diplomacy.  South Korea’s president indicated that “only the Republic of Korea (South Korea) can make the decision for military action on the Korean Peninsula.”[1]  Although President Moon is partially correct in his assessment, in that the U.S. can’t dictate a ground war on the peninsula, an attack on Guam would lead to a U.S. response regardless of South Korea’s position.  Still, as tensions ease, we are seeing a reversal of risk trades—the dollar is higher, gold and Treasury prices are falling and equities are improving (today’s retail sales data, shown below, have accelerated these trends).

The next North Korea?  Iranian President Rouhani indicated today that his country could quit the nuclear deal “within hours” if new U.S. sanctions are imposed.  Recently, the U.S. has applied unilateral sanctions on six Iranian companies for their work on Iran’s ballistic missile program.  The Trump administration argues that Iran’s missile tests and development violate the 2015 nuclear deal; Iran denies that their conduct bars such activity.  If relations between the U.S. and Iran continue to deteriorate and the nuclear deal ends, we expect Iran to rapidly move to build a deliverable weapon.  This outcome would be quite negative.  First, Israel will likely view this as an existential threat and could strike Iran with its own (so far undeclared) nuclear weapons.  Second, even if military action doesn’t occur, a nuclear Iran will very likely create a nuclear arms race in the region and, given the instability of these regimes, the chances increase for either a nuclear accident or a rogue government with a nuke.  The Iran nuclear deal probably was nothing more than “kicking the can down the road.”  However, the end of “can kicking” has its own problems and it isn’t clear that the U.S. has the bandwidth to handle increasing problems in the Far East and the Middle East simultaneously.  Additionally, we would fully expect the Putin regime to take advantage of American distraction if conditions in the Middle East deteriorate.

Germany signals to the ECB: German Finance Minister Schäuble indicated today that the European Central Bank’s ultra-loose monetary policy would come to an end in the “foreseeable future.”  However, he also indicated that rates would remain low.  Germany has not been comfortable with ECB monetary policy for some time and monetary policy is probably too loose given the strength of the economy.  The EUR has been appreciating this year due to a combination of tighter ECB policy expectations, an overvalued dollar and disappointment that dollar bullish policies (e.g., border adjustment tax, infrastructure spending, etc.) expected when Trump was elected have failed to materialize.  It should be noted that Schäuble’s comments were made at a campaign rally; Germany, a net saving nation, feels it is being unfairly penalized with low interest rates.  So, his comments were well received.

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[1] https://www.ft.com/content/2de5c7ce-815f-11e7-a4ce-15b2513cb3ff?emailId=599271a28146910004bcb96f&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22 (paywall)