Daily Comment (July 31, 2017)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy St. Ignatius of Loyola Day!  The weekend was news heavy—here’s what we are watching this morning.

A new Chief of Staff: Reince Priebus was removed from the Chief of Staff position at the White House late Friday.  Although it does appear he resigned the day before, his removal played out on national TV with him standing in the rain on the tarmac in Washington.  Gen. John F. Kelly moved from DHS to the Chief of Staff role and begins his job in earnest today.  There is much being discussed about the problems Kelly will face in trying to streamline the Byzantine organizational structure of the Trump White House.  From a market perspective, probably the most important signal this appointment sends is that Gary Cohn is the frontrunner for Fed Chair.  There was speculation that Cohn could become Chief of Staff if (or when) Priebus was removed.  Of course, if Cohn took that job, it reduced the chances that he would take the FOMC role.  With Kelly’s appointment, Cohn remains in the running.  Although we think odds still favor Cohn getting the Fed Chair position, it wouldn’t shock us if Trump decides to keep Yellen in place.  Yellen is a dove and Cohn would probably be more hawkish.  In addition, it should be noted that Priebus’s exit from the White House reduces establishment GOP influence.  The establishment GOP generally favors higher rates—establishment Republicans tend to be creditors who like low inflation, a strong dollar and higher interest rates.  Trump has made it clear he isn’t a hawk on monetary policy and thus may find Yellen is a better fit for his policy goals.  We still think odds favor Cohn to replace Yellen but the likelihood isn’t overwhelming.

On to taxes…maybe?  Congressional Republicans have signaled that with the failure to repeal Obamacare the agenda will move to tax reform.  However, the president continues to urge lawmakers to pass a repeal measure.  Each day that tax reform (or cuts) are delayed means more political capital is lost and reduces the odds that anything gets accomplished.  Lurking in the background is the debt ceiling.  The Freedom Caucus is apparently planning to trade spending cuts for permission to raise the limit; this may mean we could see a shutdown develop by late September or early October.

Another North Korean missile test: North Korea successfully launched another ICBM and, by all accounts, this one could reach the continental U.S. and maybe all the way to the Midwest.  The U.S. response was multipronged.  First, American B-1 bombers flew over South Korea, accompanied by South Korean F-16s.  Second, the South Koreans requested and the U.S. approved longer range missiles in South Korea.  Third, the U.S. is strongly considering additional sanctions against China to encourage China to pressure Pyongyang to restrain its behavior.  The North Korean problem is a major concern of ours as the U.S. is rapidly facing a binary choice of either accepting North Korea as a nuclear state or fighting a very costly war on the Korean peninsula.  Although the more likely outcome is the former, President Trump is capable of aggressive action.

The Russians toss U.S. diplomats: Russia didn’t initially respond to the Obama administration’s decision to remove some Russian diplomats and close two Russian facilities but, in light of recent sanctions, the Kremlin his decided to send 755 U.S. diplomatic personnel home.   Despite attempts by the president to improve relations, it appears that the trend of a new cold war with Russia has resumed.

The mess in Venezuela: The Venezuelan government held an election on Sunday to select a constituent assembly to create a new constitution.  The vote was rigged by design; voters only got to select the members of the assembly, not decide whether the constitution should be rewritten.  The government claims eight million Venezuelans voted, but independent observers think it was about half that level at best.  It is unclear where we go from here.  The Trump administration has threatened sanctions if the elections were held.  We are waiting to see what the U.S. will implement.  At a minimum, we expect the administration to restrict access to the U.S. financial system.  At worst, the U.S. could ban Venezuelan exports.  Given that Venezuelan crude oil is heavy and sour, there are few outlets for its oil.  China and Russia are especially nervous because they are significant creditors to the regime.  If the government falls, the incoming government may repudiate the debt.  We are seeing signs that the economic situation is becoming untenable.  Venezuela is having difficulty generating inflation because it can’t print enough banknotes.  The country imports its currency from foreign printers and, since they haven’t been paid, new currency isn’t coming in which is stabilizing prices.  In addition, the market for dollars has seized up in Venezuela as those holding greenbacks are hoarding them and won’t trade them at any price.  If Venezuela collapses, it may be short-term bullish for crude oil.

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