Daily Comment (June 27, 2017)

by Bill O’Grady, Kaisa Stucke, and Thomas Wash


Here are the news items we are watching:

Draghi the hawk?  ECB President Draghi gave a speech overnight where he offered a rather upbeat assessment of the Eurozone economy.  He suggested that growth is picking up, headwinds are abating and inflation is likely to rise.  Despite these improvements, he argued for continued monetary stimulus.  The financial markets are taking the speech as a precursor to eventual policy tightening; the EUR is up sharply this morning and commodities are rebounding off of recent lows.

Trump administration warns Syria: Late yesterday, the White House issued a press statement warning Syria that another chemical weapons attack would invite a response from the U.S. and the Assad regime “would pay a heavy price” if it uses these weapons.  The U.S. is suggesting that it has intelligence that Syria was taking steps to deploy these weapons.  Such public warnings coming directly from the White House are unusual; normally, this type of warning would have been sent from the Defense Department or State Department.  It would appear the president is taking a personal interest in this situation.  If Assad defies the U.S. there would almost certainly be a response given the White House statement, which could lead to a situation of Iran and Russia against the U.S.

Filling the Fed Governor vacancies: The administration has apparently decided that it wants to announce all three vacant Fed governor positions at the same time.  Randal Quarles and Marvin Goodfriend appear to have the inside track on two of the positions but the remaining position traditionally goes to a community banker to offer some representation from small banks on the FOMC.  The Trump administration is facing a similar problem to what the Obama administration faced—Fed rules require divestiture of ownership in most cases and that is an unattractive requirement.  So far, three candidates have withdrawn their participation because they didn’t want to sell their interests in their bank affiliations.  The delay in filling these spots reduces the administration’s influence on the FOMC and it would behoove them to act sooner rather than later.

The Italian job: Yesterday, we noted that Italy bent EU banking rules to bail out two banks with taxpayer funds while protecting bondholders.  The backlash has now begun in earnest.  Germany is apparently furious with Italy’s behavior and is pressing Brussels to tighten rules to prevent bondholders from being protected while taxpayers are hit with the bailout.  Germany’s concern is that, eventually, the Eurozone will have a unified banking system and it doesn’t want its taxpayers to be bailing out bank bondholders in other countries.  Italy argued that the failure of the two banks would not bring systemic risk to the Eurozone and thus could be resolved using Italian regulations.  The real problem was that most of the senior bondholders were ordinary depositors who were sold the bonds as savings alternatives.  The political fallout from liquidating the bondholders before the taxpayers would have been a major problem.  We will be watching for whether Germany can force the EU to close the loophole Italy used for this bailout.  If Germany can, future bank failures will tend to put senior bondholders at risk.  At the same time, bank failures always run the risk of becoming unexpectedly systemic and it seems unrealistic for Berlin to expect that Eurozone nations will allow a small bank to implode their national financial systems.  We still expect the Eurozone to eventually shrink due to the inconsistencies between Germany’s goals and the inability of much of the Eurozone to achieve Germany’s position.

May has a government: Yesterday, PM May officially built a coalition of the Tories and the Democratic Unionist Party (DUP) of Northern Ireland.  It’s mostly a marriage of convenience and may not last.  The DUP, first and foremost, received money; Northern Ireland is going to get an additional £1.0 bn in extra spending over the next two years.  The agreement could potentially upset the delicate peace process in this area of the U.K.  Currently, Northern Ireland has some degree of self-governance (devolution), but only if the Catholics and Protestant parties can agree (the DUP represents the latter).  The DUP was able to place strongly unionist language in the coalition agreement which will not sit well with the Catholic parties.  It is possible that London will need to take over the government in Northern Ireland if the two groups can’t agree.  The other problem is that the DUP is a “soft Brexit” party; although it did support Brexit last year, it does not want a hard border with Ireland as would be necessary if the Brexit agreement with the EU is strict.  Thus, the DUP could rebel if the May government pushes a hard Brexit policy.  On the other hand, this coalition may force May into a softer position on Brexit which could lead to a backbench revolt within the Tories.  Finally, the DUP is a socially conservative party that holds many positions the Tories find distasteful.  All this leads us to believe that this government may not have staying power.

Growing tensions with China: Axios is reporting that the White House is becoming jaded with China.  The hope was that by offering trade concessions China would ratchet up pressure on North Korea.  The realization is setting in that Beijing isn’t ever going to put enough pressure on Pyongyang to stop its nuclear weapons program.  This was apparently the reason for inviting Indian PM Modi to Washington.  India is a geopolitical rival to China and the optics of the warm embrace won’t be lost on Chinese leaders.  It should be noted that Reuters reported yesterday that the U.S. plans to place China on its global list of worst offenders of human trafficking and forced labor.  The State Department compiles this report but there are leaks that indicate SOS Tillerson has decided to put China into “Tier 3,” the lowest grade, suggesting it is among the worst offenders.  In the 2016 report, Tier 3 nations included Iran, Russia, Sudan, Syria, Venezuela, North Korea, et al.  If this leak is true, it will anger China and suggest deteriorating relations.

View the complete PDF