Daily Comment (May 8, 2019)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Risk-off continues. Tensions with Iran are increasing. South Africa holds elections today. Here is what we are watching:

The Iran issue: SoS Pompeo abruptly canceled a meeting with German Chancellor Merkel and made an unannounced visit to Baghdad.[1] According to reports, he made the detour due to renewed but unspecified threats from Tehran. The U.S. would likely want to base troops and other assets in Iraq if action against Iran is being considered. However, this might be difficult as Iran is deeply imbedded in Iraqi politics. Iran indicated that it may reduce its level of compliance on the nuclear deal due to U.S. actions unless Europe can guarantee that Tehran continues to have access to global markets.[2] France has indicated that if Iran does reduce its nuclear compliance and resumes nuclear enrichment activities then Europe would re-impose sanctions.[3] Tensions with Iran are clearly increasing; the sudden detour by Pompeo has the look of preparations for some sort of action. To some extent, this problem details dissonance within the Trump administration; on the one hand, the president’s instincts are to reduce American involvement in the world, including the Middle East. On the other, his Jacksonian tendencies lead him to react strongly to perceived threats. The concern is that he may be being led into a conflict by hawkish advisors.[4] Oil prices are steady this morning. Although the Iran news is supportive, U.S. inventory levels in the API data showed a build. Oil has been behaving as a risk-on asset and is likely following equities lower.

China trade: Apparently, China did reverse numerous positions that were previously established, leading to the administration’s response.[5] It seems highly probable that tariffs will be increased on Friday. The more hopeful outcome is that China returns to what was previously accepted and the U.S. pulls back on sanctions. However, doing that and saving face will be difficult. We suspect Lighthizer is pressing China hard on monitoring the agreement and building in further sanctions if the agreement’s terms are not met. This position is likely an anathema to China, which has a long history of accepting terms and then ignoring them.[6]

The chances of a significant trade rupture are increasing, mostly because both sides seem to underestimate the potential impact.[7] We believe China’s position is weaker than it perceives; we note defaults are increasing[8] and recent trade data showed weaker exports.[9] At the same time, tariffs would likely lead to rising inflation and may force the Fed into raising rates. Thus, risks are increasing.[10]

The Fed: Vice Chair Clarida appears to have reversed his comments suggesting a prophylactic cut in rates might be wise in the face of weaker inflation and, instead, adopted the language of Chair Powell, suggesting that low inflation was likely due to “temporary factors.”[11] Clarida is considered a top-flight economist and we would be somewhat surprised to see him toe the party line if he didn’t really believe it. Unfortunately, his recent comments seem to suggest a reversal from his earlier stance. One possibility? It may be that Powell is asserting the Fed’s independence and is intent on keeping policy steady to show the White House that it cannot be bullied into a rate cut. It is possible Clarida would be willing to accept that position even if his economic analysis suggests the Fed should cut rates.

Brexit: The May government has indicated that the U.K. will participate in the upcoming EU elections,[12] obliquely confirming that cross-party talks on Brexit have likely failed.[13] There are increasing risks that May will be forced to step down, triggering either general elections or a hard Brexit Tory PM to replace her.

Venezuela: The U.S. lifted individual sanctions against a Venezuelan general who changed his allegiance from Maduro to Guaido.[14] Caracas has ended a rigid program of tiered exchange rates, mostly because foreign reserves have reportedly dropped to $8.5 bn and most of this is in gold.[15] Meanwhile, SoS Pompeo and Russian Foreign Minister Lavrov are scheduled to talk in Sochi later this month in a likely bid to ease tensions over Venezuela.[16]

South Africa elections: Although Cyril Ramaphosa will almost certainly win today’s poll, his party, the ANC, is suffering from widespread corruption.[17] Ramaphosa is considered an honest candidate, but the bigger issue is increasing disillusionment with democracy itself. This condition increases the chances of a coup or a call for dictatorship. If unrest widens in South Africa, it could be bullish for precious metals, especially platinum.

Odds and ends:The U.S. has decided to implement tariffs against Mexican tomatoes.[18] The U.S. had accused Mexico of dumping tomatoes on the U.S. market, beginning a formal investigation in 1996. The investigation was suspended on a regular basis ever since. Separately, China has begun construction on a third aircraft carrier, one that appears larger than the two it currently has, which are based on a Soviet platform.[19] This would be China’s first full-sized flattop. Lastly, we’re seeing more trouble for crypto currencies as a reported $41 mm was stolen from Biance, a crypto-exchange.[20]

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