Daily Comment (May 25, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Friday!  Here is what we are watching this morning:

Capping oil prices: On the eve of the first summer holiday, gasoline prices are becoming an issue.  The recent rise in crude oil prices has taken gasoline higher.  Although higher gasoline prices are a natural consequence of higher crude prices, perhaps no other price has greater visibility and political impact.  The president has tweeted against high oil prices in the recent past and now the issue is starting to have some political implications.[1]

There have been three reasons behind the recent rise in oil prices.  First, OPEC + Russian output discipline has been solid.  We believe Saudi Arabia has held production steady to support its IPO of Saudi Aramco, which we expect sometime next year.  Second, supply was curtailed further by falling output from Venezuela.  The potential for additional sanctions on Iran has boosted bullish sentiment.  Third, the dollar was weak for most of last year; most of the time, there is an inverse correlation between the dollar and oil.  The weaker dollar acted as a bullish factor for oil prices.

These factors have been reversing.  OPEC has enjoyed the rise in prices but has been disappointed with the loss of market share caused by the surge in U.S. shale production.  It does not want to cede market share indefinitely.  Consequently, the cartel is looking to boost production.[2]  Second, the dollar has been rising, mostly due to expectations of tighter monetary policy.  We note that the dollar is still expensive on a parity basis and history suggests rising deficits will pressure the dollar going forward.  Thus, we don’t expect the dollar to rise over the long run but, until the FOMC is set to “pause,” the dollar will tend to be underpinned by policy divergence.

The political fallout should not be underestimated.  President Trump has two policy levers at his disposal to bring down gasoline prices.  First, he can release oil from the Strategic Petroleum Reserve.  Although this oil is held for emergencies, in fact, previous presidents have tapped it to curb price increases.  Second, he can use his “tweet” bully pulpit to pressure OPEC into raising production.  Given that the Saudis have been actively trying to cultivate good relations with the president, it looks like this is the direction the kingdom wants to go in anyway.

We have been bullish on oil prices for several months.  Given the above factors, a more neutral position is probably warranted.  That doesn’t mean oil prices are heading to the basement.  Geopolitical risk remains elevated and we expect U.S. refiners to ramp up output for the summer driving season.  But, a pullback into the low $60s would not be a huge shock.

No summit: We were surprised by the president’s decision to walk away from the summit with North Korea but we do agree that Beijing was likely behind the breakup.  China has been afraid the U.S. would make an ally out of North Korea and, given the Koreas’ almost natural opposition to China, Chairman Xi had reasonable concerns that Kim could be turned.  Thus, he moved to ease sanctions on North Korea and we saw a near about-face in North Korea’s rhetoric.  The White House made some unforced errors, too.  John Bolton’s talk of the “Libya model” was a mistake, although it is also probable that Bolton wasn’t thrilled with the summit anyway.

The key issue is, “now what?”  We see two consequences from the summit’s cancellation.  First, trade negotiations with China will likely become hostile again.  It appeared the White House was pulling its punches in trade talks with China, likely hoping Beijing would assist the U.S. in negotiations with North Korea.  Now that the summit is canceled, we would expect the Navarro/Lighthizer hardline wing to return to the forefront.  Second, the risk of military action against North Korea will likely increase in the coming weeks.  If it occurs, it will tend to lift flight to safety assets.

Backdoor bonds: The EU is working on a proposal to create “sovereign bond-backed securities” (SBBS), which would create a securitized bond composed of the government debt of the various EU nations.  The stated reason for the creation of these instruments is to create a bond that European banks could buy in lieu of their national government bonds and reduce the odds of the “doom loop” that occurs during crises.  However, this probably isn’t the real issue.  One of the reasons the EUR can’t compete with the USD for reserves is that there is no single sovereign bond that is backed by the full faith and credit of the Eurozone.  Thus, if a nation wants to hold EUR as reserves, it has to pick a single country bond to invest in.  That reduces the attractiveness of the EUR.  Creating a securitized debt instrument with “all” the bonds in the Eurozone could be a substitute for the lack of a Eurobond (defined as a single full faith and credit instrument).

The Germans saw through the ruse.  Germany’s finance minister, Olaf Scholz, slammed the plan, correctly pointing out that if such a securitized instrument was viable the private sector would have already created it.  Germany has vehemently opposed any attempt to mutualize Eurozone debt, worried that higher spending nations (read: Italy) would borrow heavily against the credit of Germany and force the Germans to fund Italy’s spending in the case of a crisis.  This little dust up tells us that the mandarins within the EU still pine for a unified Eurobond.  

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[1] https://www.politico.com/story/2018/05/25/trumps-gas-prices-midterms-570916

[2] https://uk.reuters.com/article/us-global-oil/oil-prices-fall-as-opec-and-russia-weigh-output-boost-idUKKCN1IQ03C?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosgenerate&stream=top