Daily Comment (June 21, 2021)

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

[Posted: 9:30 AM EDT] | PDF

Happy Monday, the day after the summer solstice.  Days will get shorter from here!  We are watching the destruction waged by TS Claudette that moved through the Southeast over the weekend.  The storm is on its way back to the Atlantic.  We are getting a reflation trade bounce this morning, although we have little faith it will hold.  Our coverage begins with the Iranian election.  A deeper dive into Fed policy follows.  There was a surfeit of political news from Europe, which we cover next.  China news follows.  Our international roundup comes next; economics and policy follow, and we close with pandemic news.

Iran Presidency:  As expected, Ebrahim Raisi won the presidency easily.  It was mostly rigged, as the Guardian Council eliminated nearly all the candidates and two conservatives withdrew from the race on Thursday.  Turnout was below 50% of voters, which does undermine his legitimacy.  Raisi is something of Ayatollah’s Khamenei’s executioner; as a prosecutor, he has overseen hundreds of executions.

The focus now shifts to talks on the U.S. returning to the nuclear deal.  There is an element of a “Nixon to China” moment.  Only an Iranian hardliner can make a deal with the U.S. because that person has political cover.  A moderate would be criticized by the conservatives.  In addition, Ayatollah Khamenei likely wanted a hardliner like himself to get credit for the lifting of sanctions.  Of course, there is the awkwardness that Raisi is under U.S. sanctions.

When Obama made the deal, it appears he saw it as an opening gambit to eventually give Iran the role of regional hegemon.  This would finally allow the U.S. to move on from the Middle East and focus on the Far East.  Obama assumed Clinton would win in 2016 and negotiate a broader agreement.  When Trump won, the Arab states and Israel moved quickly to isolate Iran and were successful.

As we move closer to a resumption of the agreement, its flaws will only be highlighted.  The U.S. would like a broader agreement that would include curtailing Iran’s missile program and its support of proxies throughout the region.  There is little chance Iran will give that up.  Iran wants assurances that a new administration won’t again withdraw from the agreement.  Since the Iran deal isn’t a treaty (which requires a two-third’s majority in the Senate), there is no guarantee a new administration wouldn’t withdraw again.  Although we suspect that the U.S. will return to the agreement, it probably won’t matter all that much.  Only nations like China and Russia will invest there, because any other nation knows that in 2024 the deal could be off.  There is fear in the oil markets that the return of the Iran deal will be bearish due to increased supply.  Any price weakness from that news isn’t likely to last.

The Fed:  The repercussions of the change in the FOMC’s tone continue to affect financial markets.  On Friday, after we published, St. Louis FRB President Bullard delivered a rather hawkish interview on CNBC.  As we noted on Thursday, the dots plot pretty much ended the Fed’s earlier narrative of no hikes through 2023, and no amount of discussion by the Chair at his press conference could undo the damage.  The market’s reaction has been swift and unmistakable.  The reflation trade is being unwound.  Commodities are under pressure, stocks fell, and the dollar appreciated.  Perhaps the most profound change has been in fixed income, where the yield curve flattened rapidly.

First, the 10-year/2-year spread:

(Source:  Bloomberg)

Next, the 10-year/5-year:

(Source:  Bloomberg)

Although we are still a long way from inverting, the decline is unmistakable.

Meanwhile, the LIBOR futures are not yet factoring in rate hikes but are rapidly moving to a neutral position.

The two-year deferred Eurodollar futures have added 30 bps to the implied rate over the past week.  Our model that incorporates the economy with Eurodollar futures suggests that short-term interest rate futures have not begun to build in tightening but are moving in that direction.

What happened here?  It appears that Powell was trying to engineer a regime change at the Fed, shifting from an exclusive focus on inflation suppression to a greater consideration of full employment.  The dispersion of the dots plot would argue that Powell has a rebellion of sorts on his hands.  At the same time, we note that not all members of the FOMC have turned hawkish; Minneapolis FRB President Kashkari is still calling for a steady policy through 2023.

  • Regime changes need different economic paradigms. The Phillips Curve dominated the Fed in the 1960s and 1970s.  It is important to remember that Paul Volcker adopted monetarism by targeting the money supply and allowing fed funds to find their own level.  Had he announced 19% fed funds in January 1981, he probably would not have survived. However, by saying the focus was on the money supply, it was the “market” that set the rate.  This is obviously disingenuous (there is nothing sacred about a money supply target), but it gave him cover for doing something controversial.  Powell has tried to change the regime by talking about an inflation target over a cycle and by a fully employed labor market.  But he has never defined what these terms mean.  By doing so, he hoped to give the FOMC maximum flexibility.  By failing to set parameters, it was never clear when goals were close to achievement.  So, when it came time to “stare down” the current spike in inflation, he apparently didn’t have the tools to sway a majority of the FOMC members.
  • Earlier chairs never had to deal with the transparency that is now in place. We know from biographies that earlier Fed Chairs faced criticism.  But then again, the disagreement wasn’t so public in the past.  Thus, markets were forced to estimate the degree of dissension.  For example, if Greenspan had dots in the late 1990s, it probably would have looked like he was facing a rebellion.  After all, several members, including Janet Yellen, wanted to tighten credit.
  • We suspect Powell lacks the theoretical credibility to sway the members. He isn’t an economist.  Although that may not be necessary for much of the job, in this circumstance, the lack of intellectual credibility is damning.  To note, he has very good relations with Congress.  He consults with members regularly and is well-liked.  Yet, when a Chair is standing up against orthodoxy, he must show he can argue the point.  Volcker was able to credibly argue for money supply control.  Greenspan could delay rate hikes in the late 1990s by arguing that productivity gains would keep inflation suppressed.  Powell lacks credibility in this area, and when the economic orthodoxy (Summers, Dudley, and El-Erian) constantly warns that the Fed needs to address rising inflation, Powell is unable to craft a response.  He is apparently unable to control the committee either.

Although commentators correctly point out that the Fed actually hasn’t “done” anything yet, this is misleading.  The flattening of the yield curve and the rise in Eurodollar futures rates will affect borrowing costs and potentially slow the economy.  Is the orthodoxy right?  It depends on the path of inflation.  If inflation is transitory, the Fed has made a mistake; the current turmoil is unwarranted.  If inflation expectations are rising, then tightening is the correct action, and we can expect the dots to steadily build in rate hikes.

For markets, the reflation trade—weak dollar, strong commodities, small caps over large caps, value over growth, and international over domestic—is in question.  There are still elements that argue for reflation; it’s not just the Fed that drives the trade.  Nevertheless, the Fed’s shift will lead to a recalibration of the position.

The EU:  Local elections show a recovery of the center-right, Sweden’s PM facing a no-confidence measure, and the DUP leader resigns.

China:  Germany is reluctant to oppose China, and the world is overly dependent on Taiwan for semiconductors.

International roundup:   New sanctions on Russia, North Korea is threatening the U.S., and Brazil is dealing with drought.

  • President Biden’s meeting with President Putin seems to have gone remarkably well. This is due, in part, to skillfully reducing expectations to the point where almost anything short of a blowup was seen as a success.  It also seems that Biden has no illusions about getting along well with Putin, and therefore, both nations can pursue their interests on a clear-eyed basis.  So, no great reconciliation, but a position where each party understands the other.
  • Last week, we noted North Korea was probably facing severe food shortages if not famine. Almost on cue, Kim Jong Un is getting belligerent.  When facing a crisis such as this, Pyongyang often threatens its neighbors in order to extract aid.
  • Brazil is dealing with a crippling drought, said to be the worst in 90 years. Hydroelectric power is being curtailed, and crops are threatened.

Economics and policy:  Tech remains under regulatory scrutiny, and a global tax deal may be unveiled by the end of June.

COVID-19:  The number of reported cases is 178,528,742 with 3,867,050 fatalities.  In the U.S., there are 33,542,382 confirmed cases with 601,825 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 379,003,410 doses of the vaccine have been distributed with 317,966,408 doses injected.  The number receiving at least one dose is 177,088,290, while the number of second doses, which would grant the highest level of immunity, is 149,667,646.  The FT has a page on global vaccine distribution.

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