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

[Posted: 9:30 AM EDT] | PDF

Good morning.  U.S. equity futures continue to trend lower this morning.  A resurgence in COVID-19 infections and worries about the economy and inflation have weakened investor sentiment.  Oil prices are sharply lower this morning, and bond yields are falling as well.  Our coverage begins with reports that the U.S. is accusing China of instigating the hack of Microsoft (MSFT, USD, 280.75).  German flooding is up next, followed by the OPEC+ deal.  We then move to a discussion of cryptocurrencies, economics and policy, and the pandemic update.  We close with China news and comments on Lebanon.

The Microsoft hack:  The U.S. is accusing the Chinese government of cooperating with organized crime groups in China to engage in widespread cyber-attacks, including last year’s infiltration of Microsoft.  This accusation isn’t coming from Washington alone; the EU, U.K., Australia, Canada, New Zealand, Japan, and NATO all agree on this point.  The governments accuse China’s Ministry of State Security (MSS) of employing criminal elements to carry out these attacks.  The U.S. is expected to reveal details of the attacks later today.  This accusation is notable.  Criminal groups in Russia have carried out numerous high-profile attacks recently, but the Kremlin has apparently taken great pains to avoid direct state sponsorship.  All Russia does, at this point, is provide safe harbor for cybercriminals. Tying the attacks to the Chinese government directly requires a state-to-state response.  At a minimum, sanctions will likely be applied to officials tied to MSS.  If Beijing maintains its “wolf warrior” diplomacy, we can expect an aggressive reaction against these charges.

German flooding:  The tragedy in Germany continues.  Floods, described as a “500-year” event, are affecting areas in western Germany.  New evacuation orders have been issued, even as some areas start the clean-up process.  Chancellor Merkel visited flood affected areas of Germany yesterday.  There is growing speculation that the intensity of the flooding, which may have been affected by climate change, might help the Greens in the September elections.  So far, polling isn’t showing this development, but the prediction markets suggest a modest decline in support for Armin Laschet, the CDU candidate for chancellor, who is also the premier of the flood-affected North Rhine-Westphalia region.  Although the Federal government issued warnings, state and local governments apparently didn’t issue evacuation orders, leading to high fatality rates.  Compounding the lack of action to protect lives, Laschet was seen laughing in the background during a press conference.  Although the Greens rose in popularity in the spring, that surge didn’t last.  Recent polling trends suggested that the CDU/CSU was likely going to maintain power.  This event and Laschet’s lackluster response could change that trend.

OPEC+:  Although an agreement was indicated last week, over the weekend, the oil cartel formalized the deal.  Oil production is scheduled to rise 0.4 mbpd per month, starting in August, for the next two years.  Oil prices have fallen hard this morning on the news.  It remains to be seen just how much new oil comes to market.  At the same time, rising COVID-19 cases threaten demand.  The combination of higher output and perhaps slower consumption is weighing on prices.

Cryptocurrencies:  Regulators are taking aim at “stablecoins.”  These coins are pegged to national currencies and are used by participants in cryptocurrencies to transact business.  For example, if traders wanted to take profits on a bitcoin position and didn’t want to trigger a traceable taxable event by putting the proceeds into the banking system, they could put the funds into a stablecoin.  In theory, if the stablecoin did what it says it does, simply holds reserves of USD for each stablecoin issued, this would not create a systemic risk issue.  However, it is hard to see how the provider of the stablecoin makes any money by acting in this fashion.  The fear is that stablecoins are runnable; in other words, the provider, to make money, is likely investing the reserves in some other financial asset.  The stability of the stablecoin is dependent on the holdings in its reserves.  Since there are no regulations in this arena, the temptation is to hold higher-yielding but less liquid assets on the assumption that all the holders won’t demand the national currencies simultaneously.[1]  The fear among regulators is that a run on stablecoins could end up affecting the financial system, as the coins may have been used as collateral for lending.  The numbers are not insignificant; Tether has $64 billion in assets, USD coin, $26 billion, and Binance (BND, USD, 280.01) USD, $11 billion.

• Although there has been a steady parade of proposals for crypto ETFs, the SEC has not approved any in the U.S.
• It appears the bitcoin mining has moved from China to Kazakhstan.

Economics and policy:  Infrastructure legislation reaches a critical moment, and the tight labor markets are colliding with the politics of immigration.

• Senate majority leader Schumer is trying to set close deadlines for the infrastructure measures. This is a time-worn tactic in legislation; put an artificial deadline in place, and the party in power tries to force legislators to compromise quickly.  There is another reason Schumer is moving so fast.  If he doesn’t get the bills done by August 9, the Senate is scheduled to go into recess.  This absence would give lobbyists the opportunity to work against the legislation for about a month and reduce the odds of passage.  Minority members are crying foul (also a time-worn tactic by the party out of power).  One item that has emerged is that the IRS enforcement source of revenue has apparently been killed.  This struck us as a questionable tactic.  It’s a bit like a city deciding to budget more revenue from traffic tickets.  Although we expect something to get done on infrastructure, the clock is running, and if it doesn’t pass by early August, the odds that part will fail increases.
• In the “dog that didn’t bark” category, we note that recent antitrust measures didn’t get much pushback from the GOP. This is likely an indication of just how populist both parties are becoming.
• In a related area, it is well known that friction in the labor markets is elevated. The opening to hires ratio is at record levels, for example.

We note a recent editorial in a Texas newspaper suggesting that immigration could fix this problem.  We also note that there has been a surge of arrests on the Mexican/U.S. frontier.  Soaring wages (our own Dave Miyazaki sent me a report of a fast-food restaurant offering $17 per hour in Frazer, CO) are a result.  The goals of populism, margin protection, and immigration are colliding here.  Business would like more workers to keep wages dampened and thus supports higher immigration.  Populists on the right oppose immigration in order to keep wages elevated.  Immigrants, seeing the higher wages, are clearly flocking to the border.  There is no doubt this is a crisis; the issue is who will bear the cost of the crisis, capital or labor.

• Related to the stablecoin discussion above, the Fed and other regulators are taking another swing at making money markets less runnable. The industry wants to “have its cake and eat it too,” which means it wants to have investors believe money markets are as safe as bank deposits with a higher yield.  In fact, they are not.  The issue is how “less safe” are they?  It is clear that in recent financial crises, money market funds proved to be “ground zero” as they proved runnable.  However, if regulators reduce the risk, they may also reduce funding for commercial paper and other short-term debt instruments.
• Although inflation worries are elevated, the drop in oil prices and the recent decline in lumber show that markets for commodities do eventually clear. In homebuilding, builders are trying to figure out how to price their product in the face of rising material costs.
• Markets are beginning to figure out that we are probably at peak growth, and the rate of change will slow from here.

COVID-19:  The number of reported cases is 190,526,225 with 4,091,672 fatalities.  In the U.S., there are 34,080,890 confirmed cases with 609,021 deaths.  For illustration purposes, the FT has created an interactive chart that allows one to compare cases across nations using similar scaling metrics.  The FT has also issued an economic tracker that looks across countries with high-frequency data on various factors.  The CDC reports that 390,100,605 doses of the vaccine have been distributed, with 337,740,358 doses injected.  The number receiving at least one dose is 186,038,501, while the number of second doses, which would grant the highest level of immunity, is 161,232,483.  The FT has a page on global vaccine distribution.

• As the U.K. officially reopens from pandemic lockdown measures tomorrow, infection rates are rising, and the PM and a few other cabinet members have gone into quarantine after being exposed to the virus. There are concerns that the U.K. may have moved prematurely.
• The U.K. is expanding its research on “long COVID,” the condition where those infected have lingering symptoms.
• Indonesia has become the world’s “hot spot” with new infections. The highly infectious Delta variant is rapidly spreading across the island nation, overwhelming the medical system there.
• China is mandating vaccines for both students and their families.
• The EU has caught up to the U.S. on vaccinations.
• Although U.S. infection rates are rising, hospitalizations and deaths are not as high as in earlier periods. Most of the hospital admissions are being reported in areas with low vaccination rates.

China:  China acts to quell inflation, and the U.S. acts to limit technology exports to China.

• Although there have been concerns that China would become a conduit for inflation, the country has, instead, taken aggressive steps to dampen price increases. The country has released strategic stocks to lower commodity prices, and companies are seeing margins fall as they absorb higher material costs.
• In further evidence that the policy of opposing China has become bipartisan, the Biden administration is continuing the Trump administration policy of blocking high-tech machine tools to China.
• Australia is providing financing to Telstra (TLSYY, USD, 13.94) to buy mobile networks in the small Pacific island states to prevent Chinese firms from purchasing them.

Lebanon:  Although it isn’t gathering much media attention, Lebanon is slipping into a massive crisis.  The exchange rate is plummeting, the government is in disarray, and now the head of the central bank is embroiled in a corruption scandal.  As conditions deteriorate, it would be reasonable to expect another refugee situation to emerge.

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[1] This is, of course, the business model of fractional reserve banking.  Until deposit insurance and regulation, bank failures were common.