Daily Comment (January 30, 2019)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Fed Day!  U.S. equity futures are higher this morning in light of some solid earnings reports.  Here is what we are watching this morning:

Fed meeting: The FOMC ends its two-day meeting today.  Although we won’t get new dots or forecasts, Chair Powell begins his new policy of press conferences after each meeting.  No action on rates is expected, but we will be watching for any hints on future policy (are risks “balanced” and will rate hikes be removed from the statement or contain the usual “gradual” language?).  In addition, the markets will be looking for any flexibility on the balance sheet.  We expect a mostly neutral statement; it would be a surprise to see them turn hawkish but it would also be a surprise to see them move toward a clear dovish stance.

Trade talks: Talks with China begin today and, so far, trade is being kept separate from the Huawei (002502, Shenzhen, CNY 3.32) issue.  China is offering protection for foreign investors[1] and is also preparing a timeline of reforms to address structural trade concerns.[2]  Although we doubt this will satisfy USTR Lighthizer, it will likely be enough for the president.  While we think U.S./China relations are on a deteriorating path, as we noted yesterday, both Chairman Xi and President Trump need peace this year.[3]  Thus, we remain optimistic that some sort of deal will be negotiated.

Venezuela: Conditions are deteriorating further in Venezuela.  The courts, firmly under the control of Maduro, have frozen opposition leader Guaido’s banks accounts and have prevented him from leaving the country.[4]  Maduro did indicate he was willing to “negotiate” but it is unclear who would mediate.  In response to the freezing of Guaido’s assets, the U.S. is giving Guaido control of some Venezuelan government accounts held by the U.S. at the NY FRB.[5]  The situation is a mess and oil prices are rising on fears that oil production from Venezuela will fall further.  Saudi Arabia has indicated it has no plans to offset any decline in output from Venezuela; in fact, the Saudi oil minister indicated the U.S. should use the SPR if shortfalls develop.[6]  The Saudis believe they were wrong-footed on the Iran sanctions issue and are making it clear it won’t happen again.[7]

Brexit: Things got rather weird yesterday.  Parliament rejected a series of proposals but did approve a non-binding measure to avoid a hard Brexit.  And, they approved an amendment that sends PM May back to Brussels to negotiate a different border agreement in Ireland.[8]  However, May was not given any specific instructions as to what the border agreement should look like.  It isn’t that there was no direction; May was told that Parliament doesn’t want a hard Brexit and the Euroskeptics don’t want an Irish border solution that effectively keeps the U.K. in the EU with few of the benefits.  This outcome isn’t really possible.[9]  The EU has made it clear that it won’t renegotiate the current agreement.[10]  With such uncertainty, it would seem the most logical outcome would be to delay Article 50; however, that solution is a problem for the EU because it holds EU Parliamentary elections in May.  If the U.K. is still in the EU, Britain would seemingly participate in these elections even though it wants to leave.  Although there is universal desire to avoid a hard Brexit, the chances of stumbling into one remain elevated and not fully discounted by the market.

Our parity model suggests fair value for the GBP/USD exchange rate is 1.65, which means we would have a much stronger pound in the absence of Brexit.  We assume a hard Brexit would lead to a rapid drop in economic output and yield an exchange rate of 1.10.  Thus, if a deal ends up with the U.K. leaving but maintaining most of the benefits of the EU (or not leaving at all), then we get 1.65.  The current exchange rate should indicate the market’s estimate of the odds of either outcome.  So, if P = good Brexit and 1-P = bad Brexit, then (P*1.65) + ((1-P)*1.10) = current exchange rate.  Solving for P at current exchange rates would indicate the market thinks there is about a 40% chance of a good Brexit and a 60% chance of a hard Brexit.

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[1] https://www.scmp.com/economy/china-economy/article/2184138/china-rushing-through-overseas-investment-reform-unprecedented

[2] https://asia.nikkei.com/Economy/Trade-War/China-to-kick-off-trade-talks-with-timeline-for-structural-reforms

[3] https://www.wsj.com/articles/as-china-trade-talks-begin-trump-faces-pressure-to-make-a-deal-11548808477

[4] https://www.washingtonpost.com/world/the_americas/venezuelan-officials-seek-to-block-us-supported-opposition-leader-juan-guaido-from-leaving-the-country-freeze-his-assets/2019/01/29/1a4791a0-232c-11e9-b5b4-1d18dfb7b084_story.html?utm_term=.453c43ca259c&wpisrc=nl_todayworld&wpmm=1

[5] https://www.nytimes.com/2019/01/29/us/politics/venezuela-bank-accounts-guaido-pompeo.html?emc=edit_mbe_20190130&nl=morning-briefing-europe&nlid=567726720190130&te=1

[6] https://www.wsj.com/articles/saudis-not-rushing-to-respond-to-venezuela-oil-ban-11548794233

[7] https://www.youtube.com/watch?v=gqzA1VOiC-M

[8] https://www.washingtonpost.com/world/europe/brexit-theresa-may-tells-a-divided-parliament-she-wants-to-reopen-talks-with-eu/2019/01/29/66ebca3a-1fe9-11e9-a759-2b8541bbbe20_story.html?utm_term=.4dc5921db939&wpisrc=nl_todayworld&wpmm=1

[9] https://www.ft.com/content/8ecf0b4c-2328-11e9-8ce6-5db4543da632?emailId=5c512e3432bcbc000472fcc1&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[10] https://www.nytimes.com/2019/01/29/world/europe/brexit-theresa-may-eu-irish-border.html?emc=edit_mbe_20190130&nl=morning-briefing-europe&nlid=567726720190130&te=1 ; https://www.ft.com/content/75f24764-23c9-11e9-8ce6-5db4543da632 ; and https://www.ft.com/content/390709e2-23de-11e9-8ce6-5db4543da632