Daily Comment (July 31, 2019)
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EDT]
Good morning! The FOMC meeting ends today. North Korea continues to fire off missiles. The baseball trading deadline occurs at 4:00 EDT today. Here is what we are watching this morning:
The Fed: Yesterday, we noted the scenarios for today’s monetary policy. To repeat, there is almost no chance the Fed won’t cut by 25 bps today. Instead, there are two factors that could offer insights into future actions. First, Powell’s language, especially in the press conference, will be important. The key word is “patient.” If the statement includes the word “patience,” it will signal that this rate move is a recalibration, suggesting the policy rate overshot its equilibrium level and the move was an adjustment. However, it won’t indicate that this cut is the start of a rate reduction cycle. If this is the outcome, markets will be disappointed and we could see equities decline. Second, there could be action on the balance sheet. The Fed might announce that it will end its balance sheet reduction six weeks earlier than planned. Although modestly supportive, this action would be a dovish signal.
We are starting to see more of monetary policy discussion being framed by exchange rate concerns. The ECB appears to be teeing up additional stimulus, including a deeper foray into negative interest rates and expanding QE. Some pundits are suggesting the Fed is being forced to move on rates to prevent further dollar appreciation. There is an element of truth to this charge. Central bankers and finance ministers have been careful not to couch their policy actions in terms of affecting exchange rates. In fact, in the unwritten rules of central banking, such discussions would be in bad form because they could open up a return to the 1930’s “beggar thy neighbor” devaluations that eventually led to a collapse in trade activity. However, in reality, much of the monetary stimulus came from currency weakness. After all, if you drive nominal rates below zero and you still can’t increase investment, what’s left? Export growth! Abenomics got most of this punch through a weaker yen, but because officials framed the actions as necessary for domestic growth, other central bankers essentially granted Japan a pass. President Trump doesn’t buy this ideology; he wants the Fed to cut rates by more than 25 bps to weaken the dollar.
At some point, this race to the bottom will end; one possibility is that we return to some sort of fixed exchange rate system but that might require central banks to focus solely on the exchange rate to set policy. But, before we get to some sort of resolution, continued attempts to weaken currencies is possible; the investor solutions are monetary assets, e.g. precious metals.
Trade: The first post G-20 meeting between U.S. and Chinese trade negotiators has come to a close. Not too much progress appears to have been made. China has agreed to buy some grain, but only to the extent consistent with “internal demand.” We also note that China is showing increasing interest in sourcing soybeans from South America. The U.S. will probably offer some tech relief but it is starting to look like both sides are digging in and awaiting the end of the next U.S. election cycle. This isn’t the worst outcome, which, specifically, would be a complete rupture of trade relations. In fact, the “slow walking” gives both sides a chance to adjust. The next round of face-to-face talks won’t take place until September.
North Korea: Kim doesn’t want to be ignored. As the U.S. and South Korea prepare for military exercises, for the second time in a week, Pyongyang has tested short-range missiles. North Korea has always been concerned about military exercises, fearing that they could be a pretext to invasion. Despite that fact that it hasn’t ever occurred, the worry is understandable. So far, the tests have not crossed any “red lines” such as entering Japan’s territorial waters or a long-range test that would threaten the U.S. We would not expect an overt threat to the U.S. from North Korea.
Brexit news: PM Johnson visited Wales yesterday and, much like what he experienced in Scotland, the locals weren’t all that happy to see him. Today, he visits Northern Ireland and will likely get a mixed reaction there as well. In fact, the issue of the Irish border may be the most intractable of all the hurdles of Brexit. Johnson faces another challenge—there is a special election in Wales today that could go to a Liberal Democrat. If so, Johnson’s coalition margin in the House of Commons will fall to one seat and increase pressure for a snap election.
Hong Kong: U.S. officials are watching the buildup of Chinese forces on the Hong Kong border with interest. So far, Beijing has been content to allow local officials to handle the unrest but we doubt that the Xi regime has infinite patience on this issue. Perhaps the most important reason why China has been reluctant to crack down on the protestors is it knows Taiwan is watching. A harsh crackdown on Hong Kong will make it difficult for Beijing to convince Taiwan’s citizens that unification will preserve its democracy. Reports that China is restricting tourist visits to Taiwan did catch our attention. If Xi concludes he cannot tolerate continued unrest in Hong Kong and uses the military to restore order, it may mean that unification with Taiwan can only be accomplished by force. And if that decision is made, it comes down to timing.
A softening on Iran? The Trump administration is apparently going to reissue waivers that allow foreign nuclear projects in Iran to continue. Iran hawks argued against the extensions, including NSD Bolton and SoS Pompeo. At the same time, the U.S. has formally asked Germany to participate in maritime security operations in the Persian Gulf. This request will be difficult for Germany to manage; on the one hand, it believes the U.S. has caused this crisis by leaving the JCPOA, so why should it work to fix a problem it didn’t cause. On the other hand, if they don’t participate, it looks like Germany is continuing to “free ride” U.S. security. After all, it is clearly benefiting from U.S. protection of Persian Gulf shipping.
 For details, see https://www.confluenceinvestment.com/wp-content/uploads/weekly_geopolitical_report_2_25_2019.pdf and https://www.confluenceinvestment.com/wp-content/uploads/weekly_geopolitical_report_3_4_2019.pdf