by Bill O’Grady and Thomas Wash

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

ZTE relief? In a surprise announcement, President Trump tweeted that he is seeking some sort of relief for the embattled company.  ZTE (ZTCOF, 2.26, delayed) is under a rather harsh penalty from the Commerce Department for breaking Iranian sanctions.  Under U.S. rules, the company would not be able to access U.S. components for its devices.  According to reports,[1] President Trump was contacted by Chairman Xi who asked for help on this issue.  This action does appear contrary to the general direction of trade policy toward China but is probably also part of the administration’s broader negotiating stance.  In other words, the president may be using ZTE relief to accomplish other parts of his trade agenda.  We note that a high-level Chinese trade delegation is arriving in Washington on Friday, led by Vice Premier Liu He, a key member of Xi’s governing team.

This event highlights an element of this administration’s behavior.  Simply put, the president’s negotiating style is personal and improvisational.  He doesn’t over prepare and likes flexibility.  This characteristic makes for great risk but also has the potential for breakthroughs.  The North Korean negotiations are a case in point.  It may turn out that the talks with Kim end up as a disaster, leading to war.  At the same time, they might also lead to a new relationship and dramatic lessening of tensions.  Previous administrations have been very cautious in their dealings with Pyongyang and have gotten nowhere.  It is possible that Trump’s negotiating style is what is needed to move the discussion forward.

A similar trend may develop on trade.  The bellicose tone may morph into a workable trade deal that improves the global financial system and extends this business cycle.  It could also devolve into a trade war.  It is clear that Trump has gotten the world’s attention.  But, it is hard to know exactly what the result of these talks will be at their conclusion.  For financial markets, this is really hard because part of the markets’ role to discount the future.  The future is always uncertain but when a negotiator vacillates between war and peace, it increases the difficulty.  However, if Trump is offering Xi an “olive branch” on ZTE and it reduces trade tensions, it will be bullish for risk assets.  In order for Trump to do that, he will likely need a high-visibility “deliverable” to bolster his political fortunes.

Iran: Iranian officials are visiting nations that still remain in the nuclear deal.[2]  For now, it looks like the non-U.S. participants will remain in the agreement, although they will likely face the threat of secondary sanctions from the U.S.; National Security Advisor Bolton suggested this in the Sunday talk shows.[3]  For now, we expect the deal to hold but, eventually, Iranian hardliners will use the rupture to retake control of the government and at least threaten to restart uranium enrichment.  In the short run, oil prices have benefited from the risk of a decline in Iranian supplies.  Those supplies are probably not at risk for the moment.  We do note that China has opened an oil futures contract denominated in CNY.  Reports indicate that volume has increased in light of the sanctions.[4]  Although transacting in CNY will reduce the risk of dollar-based sanctions, it also reduces the value of Iranian oil as the CNY isn’t broadly convertible and China limits foreign ownership of Chinese financial assets, a key element of the reserve currency system.  Thus, Iran would be limited to buying Chinese goods and services.  Still, one of the rules of sanctions is that the more nations that participate in the sanctions effort, the better they work and thus, if the U.S. stands alone, the impact of sanctions is lessened.

Italian government: According to reports, the two major populist blocs, the Five-Star Movement and the League, are making progress toward forming a government.  Although the key sticking point, the prime minister position, hasn’t been resolved, they have put together a policy platform that includes a basic national income for the poor, a reversal of pension reforms and a flat tax of 15%.  Although the fiscal plan may meet the technical constraints of the Eurozone, it clearly doesn’t meet the spirit of structural reforms that the Eurozone has been asking of Italy.  A populist Italy will eventually threaten the fiscal rules of the Eurozone and, unlike Greece, Italy’s economy is large enough to threaten the integrity of the single currency bloc.  European equities have eased on the news while probably supporting modest EUR appreciation this morning.

Indonesia terror attack: It appears a set of bombings in Indonesia was executed by a family that had recently returned from Syria, reportedly[5] with ties to an Islamic State group.  Two Christian churches were targeted.  There have been fears among counterterrorism experts that the demise of Islamic State would lead to its followers spreading into other parts of the world and carrying out attacks in their new countries.  There was also an attack in Paris,[6] a knifing that may have been inspired by Islamic State, although the ties are not as clear as the Indonesian incident.

Iraqi elections: Although results are preliminary, it appears the radical cleric Moqtada al-Sadr was the winner of parliamentary elections over the weekend.  Turnout was very low, around 45%, which may have contributed to his win.  Results suggest his party won 54 out of 329 seats, which means he will need to build a coalition in order to govern.  The expected winner, current PM Haider al-Abadi, came in third.  Al-Sadr is an interesting candidate because he is considered an Iraqi nationalist—he opposes both the U.S. and Iran.  Although a Shiite cleric, his relations with Iran are mixed and we suspect Tehran is not happy about his win as it will complicate relations between the two countries.

Hawkish Mester: Cleveland FRB President Mester indicated that better growth likely means she will support more rate hikes than she has in the past.  She is a voter this year and this stance increases the odds of four hikes this year.

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[1] https://www.wsj.com/articles/trump-in-tweet-says-working-with-chinese-president-xi-to-keep-zte-in-business-1526225831 ; https://www.washingtonpost.com/news/the-switch/wp/2018/05/13/trump-pledges-to-help-chinese-phone-maker-zte-get-back-into-business/?utm_term=.deb75d6f11f8

[2] https://www.rferl.org/a/iran-china-russia-nuclear-deal-zarif-trump/29223723.html?wpisrc=nl_todayworld&wpmm=1

[3] https://www.reuters.com/article/us-iran-nuclear-rouhani/rouhani-says-iran-may-remain-part-of-nuclear-accord-idUSKCN1IE0BY ; https://www.politico.com/story/2018/05/13/bolton-pompeo-trump-iran-sanctions-584206

[4] https://www.reuters.com/article/us-iran-nuclear-china-oil/chinas-crude-oil-futures-boom-amid-looming-iran-sanctions-idUSKCN1IF0SD

[5] http://www.bbc.com/news/world-asia-44101070?wpisrc=nl_todayworld&wpmm=1

[6] https://www.washingtonpost.com/world/europe/paris-police-respond-to-knife-attack-media-report-2-dead/2018/05/12/8fdf41e6-5623-11e8-a6d4-ca1d035642ce_story.html?utm_term=.2bb6f41e6179&wpisrc=nl_todayworld&wpmm=1