Daily Comment (December 9, 2019)

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

[Posted: 9:30 AM EST] Looking for something to listen to while shopping?  Episode #4 of the Confluence of Ideas Podcast is now available.  It’s all about the Equality/Efficiency Cycle.  Enjoy!

Happy Monday!  It’s a busy week, with the Fed and ECB meeting, elections in the U.K. and Algeria, and looming new China tariffs.  The WTO is close to being effectively closed.  Talks between Ukraine and Russia are being held in Paris this week.  Worries about repo are elevated.  Here are the details:


Central banks: The FOMC meets this week.  No change in policy is expected, although we will get new dots and forecasts and a press conference.  We would not expect any dissents.  It is also worth noting that we get the usual rotation of regional bank presidents in January.  Thus, Evans (Chicago), Bullard (St. Louis), George (Kansas City) and Rosengren (Boston) roll off and are replaced by Mester (Cleveland), Kashkari (Minneapolis), Kaplan (Dallas) and Harker (Philadelphia).  Taken as a group, they are (in our estimation) a bit more centrist than the 2019 roster.  If Waller and Shelton get approved this year, the Fed will be much more dovish in 2020.  Meanwhile, Legarde will lead her first ECB meeting this week since replacing Draghi.  Again, policy is expected to be maintained.  Legarde is planning the ECB’s second strategy review since it was created.

Elections: Boris Johnson continues to hold a double-digit lead in the polls with the vote looming on Thursday.  Johnson plans to move quickly to remove the U.K. from the EU, with 2020 being the year both parties negotiate their trade relationship.  Employers are beginning to realize that Brexit will mean a smaller pool of laborers; good news for workers, bad news for profits.  Meanwhile, elections are set in Algeria to replace the Abdelaziz Bouteflika; however, the candidates approved by the military regime are seen as status quo and therefore a low turnout is expected.  The vote probably won’t quell underlying tensions.

Trade: If a trade deal isn’t made with China, new tariffs will be implemented by the weekend.  We would not be surprised to see the taxes postponed.  Meanwhile, it appears the USMCA is close to ratification.  However, as the deal nears, business interests are worried that the measures taken to placate Democrats have reduced the attractiveness to business.  Mexican Foreign Minister Ebrard said his government would oppose any effort to have U.S. inspectors operating within Mexico to enforce the pact’s labor rules, but he welcomed the use of arbitration panels to resolve disputes over labor standards.

WTO: Tomorrow, the WTO will likely cease to be a functioning body.  The appellate court, which adjudicates trade disputes, has seven judges.  The U.S. has refused to approve new members.  The current court is down to three judges, the minimum for a quorum, and two judges’ terms expire tomorrow.  Thus, the WTO will no longer have the legal apparatus to judge trade disputes.  The U.S. has become jaded with the WTO.  At heart, the issue is about sovereignty.  All trade deals reduce sovereignty; a fully sovereign nation is an autarky.  However, the WTO, especially this court, makes judicial decisions out of the hands of the nations involved.  This structure does limit U.S. power and the Trump administration has been keen to increase American bargaining power by conducting bilateral trade arrangements.  At the same time, the loss of this appellate body means that nations will have no forum to bring disputes and power will now be the final arbiter instead of rules governing trade.  In one sense, that development will boost U.S. leverage with individual nations but tend to undermine the broader American strategy of building large trade coalitions.

Repo: Last September, the repo market seized up, leading to a spike in short-term interest rates.   Year-end will likely create similar conditions.  The Fed has rapidly expanded its balance sheet (but don’t call it QE!) to try to ensure ample liquidity, but worries remain.  Why is this happening?  There are three reasons.  First, post-crisis regulation has signaled to banks to be hyper-safe.  Although the official data would suggest banks are “swimming” in excess reserves, the banks are putting a premium on having liquidity, partly due to stricter regulations and partly due to stress testing.  Thus, even 10% overnight rates were not attractive enough to risk the wrath of regulators.  Second, the Fed decided to reduce the size of its balance sheet in an attempt to normalize monetary policy.  The FOMC was not sure what level of balance sheet was necessary after 2008; September offered a clue.  Simply put, the Fed cut its balance sheet too much.  Third, the BIS has indicated that hedge funds were aggressively using repo funding to leverage up rather mundane arbitrage trades to “juice” returns.  This led to excessive leverage.  The good news is that the Fed is well aware of the looming repo issue and has taken steps to address it.  The bad news is that we don’t know if the actions are sufficient.  Thus, there is a chance of a repeat of September or worse in the next three weeks.

Ukraine: Russia and Ukraine, along with Germany and France, are holding talks to deescalate tensions.  There are worries over whether the new Ukrainian president, Volodymyr Zelensky, is savvy enough to negotiate with Vladimir Putin.  The concerns are that Zelensky will cede too much to Putin; given that Ukraine is embroiled in the U.S. impeachment process and Germany and France seem interested in improving relations with Russia, Ukraine may not have much leverage in talks.  The IMF has tentatively approved a new $5.5 billion loan program for Ukraine, offering a vote of confidence for President Zelensky, a former comedian recently elected with a mandate to fight corruption, improve the economy and manage Russia’s incursions against Ukraine.  The next WGR being published later today will provide an update on the situation in the country and explain how final approval of the IMF loan has been in question because of Zelensky’s ties to a Ukrainian oligarch.

China: Beijing has ordered all government offices and public institutions to stop using foreign computer equipment and software within three years.  Analysts estimate up to 30 million pieces of hardware will need to be replaced under the initiative, with the vast majority swapped out by the end of 2021.  The order could become a headwind for a range of Western technology firms.

North Korea: Ahead of Kim Jong-un’s year-end deadline to resume U.S.-North Korean denuclearization talks, North Korea’s state-run media said on Saturday that the military had resumed testing long-range missile components.  The tests appeared to involve liquid-fueled engines.  With North Korea’s renewed provocations getting only minimal coverage in the Western media, there is an increased chance that the country will keep pushing to create an attention-getting crisis in the coming weeks and months.

Pensacola shooting: There was a shooting at a U.S. Naval base in Pensacola over the weekend.  The assailant was a Saudi national who was receiving training at the base.  Officials are investigating to see if there was a broader terrorist plotPresident Trump is attempting to downplay the Saudi connection, likely concerned it will weaken relations between the two nations; the Florida congressional delegation isn’t pleased.

Finland: The Social Democratic Party selected Transport Minister Sanna Marin as its new leader, setting up a parliamentary vote for her to become prime minister later this week.  All four parties in her ruling coalition are led by women, and three of them are in their 30s (Marin is just 34).  The question is whether they’ll be able to survive against the surging nationalist right.

Odds and ends: There were large protests in Hong Kong over the weekend.  Cement prices in China have jumped, suggesting the Xi regime may be pump-priming through investment as GDP slows.  Turkey and Libya have inked a deal to allocate maritime borders; the agreement overlaps other nations’ interests and is raising concerns in the Mediterranean.

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