Daily Comment (September 20, 2017)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Markets are very quiet in front of the FOMC meeting.  We get the results later today at 2:00 EDT, with a press conference about 30 minutes later.  Here is what we are watching:

The UN speech: On the surface, the president’s speech at the UN was more bellicose than we expected.  The populist right was giddy; the centrist establishment was horrified.  However, below the surface, we saw the speech as pure Andrew Jackson.  As we have discussed before,[1] Jacksonian foreign policy rejects the globalist vision of policy, be it for the sake of business (Hamiltonian) or spreading American values (Wilsonian).  Instead, it is based on supporting American sovereignty and supporting American interests first.  At the same time, it is heavily invested in honor—the U.S. supports its allies but will react with overwhelming force against threats.  Jacksonians reject the concept of limited war.  This model of foreign policy, along with its more isolationist model, Jeffersonian policy, disappeared during the Cold War.  It is clear the administration views North Korea and Iran as significant enemies.  On the other hand, it seems willing to give more room to China and Russia.  Although we expected a less aggressive speech, the content was no surprise.  Thus, the potential for conflict in North Korea is elevated but, as we have noted before, there are no mobilization actions that one would expect if a conflict is imminent.

The Fed: Expectations are high for a beginning to the balance sheet runoff.  We expect the Fed to stop reinvesting when bonds mature, initially allowing $5 bn per month to exit the balance sheet and eventually raising this to $50 bn.  The dots plot will be of particular interest.  Currently, fed funds futures put the odds of a December hike at virtually 50%.  Thus, if the dots suggest the next rate hike isn’t coming until 2018, we could see some dollar weakness develop.  This topic will likely be addressed in the press conference if it isn’t clear in the dots, which could lead to some volatility later in the day.

Another Russian bank in trouble: B&N Bank, one of the top five lenders in Russia, is reportedly in trouble and may need a bailout.  This would be the second major bank in Russia in the past few months to require nationalization.  Earlier, the Bank of Russia bailed out Bank Otkritie.  To some extent, both banks have gotten into trouble by purchasing dodgy loans in smaller banks that were closed by the financial authorities.  What is going on in Russia looks much like the Savings and Loan Crisis in the U.S. in the 1980s.  The Bank of Russia is trying to consolidate the banking system and is encouraging larger banks to buy the smaller ones.  However, the small banks apparently were in more trouble than they thought.  We don’t expect these bank failures to become systemic; instead, the Bank of Russia will simply nationalize these bad banks.  The risk comes from the potential for a forced expansion of the money supply, which would lead to higher inflation.

Catalan independence vote: The WSJ reports that the Spanish police have arrested 13 officials associated with the planned October 1st referendum for Catalonia secession.  The Spanish government has stated that the referendum is illegal and has vowed to stop it by any means necessary.  The government’s decision to crack down on officials will likely bolster support for the referendum within Catalonia.  So far, the EU has refrained from intervening, apparently viewing it as an internal Spanish matter.  However, the referendum can also be framed as a human rights issue and the EU’s failure to mitigate the tensions between the Spanish government and Catalonia could possibly undermine its reputation as a defender of human rights.  If the problem festers, it could have a bearish effect on the EUR.

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[1] See WGR, 4/4/2016, The Archetypes of American Foreign Policy: A Reprise.