by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] It’s a “green” day, with global equity markets mostly higher on the back of a strong Friday rally in the U.S.  Here is what we are watching this morning:

Tax bill update: The clouds have parted and it looks like passage is likely.  Various tweaks were made to placate wavering senators and it looks like it will gather enough votes to pass, even with Sen. McCain (R-AZ) missing a vote due to cancer treatment.  Although no one seems to expect the House to object to the bill, we could still see a close vote there.  But, in the end, we expect the president to have a bill to sign by mid-week.

From where we sit, this bill appears to have been put together in a hurry and thus there will be surprises.  If political conditions were normal, fixes to problems would occur in the coming years.  However, that won’t be likely given the partisan nature of the country at present.  In fact, if the Democrats take back Congress at the mid-terms, look for all sorts of new tax bills that would raise marginal rates on the upper income brackets to be sent to the president for the sole purpose of triggering vetoes.  Still, at least until 2020, the tax bill will be the law of the land.

What’s next?  President Trump is scheduled to announce his National Security Strategy at 2:00 today.  The main elements will be to call China a “strategic competitor” and accuse the PRC of pursuing policies of “economic aggression” against the U.S.  It appears to us that the administration is now shifting from domestic policy to foreign policy and will focus on trade.  This makes sense; the president has used much of his political capital on the repeal of the ACA and taxes.  He will likely lose on the first but win on the second.  On trade, the White House has greater powers to act without Congress but there may be bipartisan support for trade restrictions.  Americans have become increasingly jaded about globalization; we are paying close attention to this issue because we believe that globalization and deregulation have been the keys to continued low inflation.  These factors expand and flatten the aggregate supply curve and thus lead to lower inflation at every equilibrium.  If these factors are reversed, there is the potential for rising future inflation.  Although we are probably early in the process of changing policy on trade, impeding trade will likely boost inflation.

Global politics: In Chile, Sebastián Piñera, the conservative billionaire former president of the country, has won re-election.  Local equity markets have been rallying on expectations of his victory.  In Austria, the People’s Party and the Freedom Party, a right-wing and far right-wing party, respectively, have formed a coalition and will rule the country.  Protests developed on the news.  So far, the EU and other European leaders are showing caution with the new government.  The Freedom Party has ties to the National Socialists and the EU put sanctions on Austria when it joined the government in 2000.  In South Africa, the ANC is holding party nominations.  Markets are hoping that Cyril Ramaphosa, a business leader running on an anti-corruption platform, will win against Nkosazana Dlamini-Zuma, the current president’s ex-wife who is running as a continuity candidate.

North Korea: On Friday, we discussed the recent execution of a high-ranking member of the North Korean military.  Although disloyalty was signaled as the reason, we pondered whether military leaders were grumbling because Kim Jong-un was shifting resources away from the military to the civilian sector of the economy.  One item we neglected to note was that on November 13^th a North Korean soldier defected by running through the DMZ.  He was shot and wounded by North Korean border troops but was brought to safety by allied forces.  While treating the soldier, doctors discovered dozens of parasitic worms, some as long as 11”, in his digestive track.  Although such infestations are commonly found among defectors, mostly because North Korean agricultural practices use human waste as fertilizer which spreads the parasites, we would expect better treatment for the military as they were given priority in resources under Kim Jong-il.  Another clue emerged over the weekend; in a long article in the NYT, there was a discussion of how well soldiers and scientists tied to the missile and nuclear program are treated.[1]  Kim Jong-un may be shifting resources to the nuclear program at the expense of the conventional military.  This would make sense.  The U.S. expanded development of its nuclear capabilities in the 1950s as a lower cost way of deterring the Soviets.  North Korea may be working from the idea that a nuclear program will be cheaper than conventional military forces and as a result is allowing some diversion of resources to the civilian sector.  Finally, in a speech to the Atlantic Council last week,[2] SOS Tillerson noted that the U.S. assured China that if U.S. troops land in the North to secure the nukes, American forces would leave once their work is complete.  We suspect that China, South Korea and the U.S. are quietly making plans to secure North Korea if there is a coup or a fall of the Kim regime.  The cited report suggests the U.S. will rely on China and South Korea to secure the country while American Special Forces secure the nuclear warheads.

Government funding: The Treasury will run out of spending authority by Friday unless Congress moves to approve spending.  Although we expect a deal to be reached, there will be added tensions because of the tax bill.  We look for the Democrat leadership in Congress to try to extract some support for DACA.  A shutdown just before Christmas would be in bad form and both parties will probably try to avoid it, but the potential exists.  If a shutdown occurs, look for Treasuries to rally.

Gold loses its luster: Bloomberg[3] reports that hedge funds are leaving the gold market, moving to equities and cryptocurrencies.  To some extent, cryptocurrencies are a potential replacement for gold; if one is uncomfortable with fiat currencies, the chance to own bitcoin has allure.  It can be traded anonymously and can be held in such a way that government and taxing authorities don’t know you have it.  And, unlike gold, it can be easily transferred without the weight of gold (at least in theory—in reality, the infrastructure to move cryptocurrencies is rather clunky as reports surface of traders taking days to execute a transaction).  At the same time, the security of cryptocurrencies is still uncertain; we may be only one security crisis away from a debacle.  At least with gold, one who has it can touch and feel it.  Even with the advent of a second futures contract (it now trades on the CBOE and CME), we still view price action as a bubble.

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[1] https://www.nytimes.com/interactive/2017/12/15/world/asia/north-korea-scientists-weapons.html?emc=edit_mbe_20171218&nl=morning-briefing-europe&nlid=5677267&te=1

[2] https://www.nytimes.com/2017/12/17/us/politics/tillerson-north-korea-china.html?emc=edit_mbe_20171218&nl=morning-briefing-europe&nlid=5677267&te=1

[3] https://www.bloomberg.com/amp/news/articles/2017-12-15/-nobody-cares-about-gold-as-hedge-funds-seek-thrills-elsewhere?__twitter_impression=true

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] 

Tax bill update: Although the conference committee has finished its work, it’s going to be something of a nail-biter to passage.  Sen. Rubio (R-FL) has indicated he will vote against the current version unless the child tax credit is increased.  It is unclear if Sen. Corker (R-TN) will oppose this measure as he did when the Senate version was passed.  Sen. Flake (R-AZ) may not be on board and Sen. Lee (R-UT) has now indicated concerns.  In addition, Sen. McCain (R-AZ) is in the hospital due to complications tied to his cancer treatment and Sen. Cochran (R-MI) has been undergoing treatment for a variety of maladies and has missed a few votes recently.  VP Pence has changed his travel plans; he was scheduled to visit the Middle East but is staying around in case his vote is needed to break a tie.  Although the financial markets appear confident that a bill will pass, the chances for delay are probably higher than acknowledged.  If the votes aren’t there, negotiators could wait until next year but the GOP’s loss of Alabama earlier this week would further complicate passage.  This isn’t a done deal yet and if the bill fails we would expect a pullback in equities.

EU agrees on Brexit: The EU has confirmed that “sufficient progress” has been made on Brexit talks to proceed to the next stage of negotiations.  This news should be considered a boost for PM May, although the praise she was given by EU leaders may make her less popular at home.  Interestingly enough, the GBP has been steadily weakening on this news which isn’t what we expected.  It is possible this outcome was already discounted and with that confirmation we are seeing liquidation (buy rumor, sell fact).  If this is the case, the weakness should be short-lived.

A Chinese satellite ground station in North America: China has quietly built a satellite ground station in Nuuk, Greenland, which is on the southwestern coast of the large island.[1]  China is building an alternative to the U.S. GPS system called “Beidou.”  Although both are used by civilians, the primary reason for their existence is for military purposes.  The new station will be used for gathering military data.  China has designs on the Arctic; as the polar caps melt, it allows for faster shipping over the pole and China clearly doesn’t want to be dependent upon Canadian and U.S. forces for navigation.  China has promised Greenland, Denmark and the Faroes “full access” to the data, but we have serious doubts that sensitive information will be shared.

It should be noted that China has been investing in Greenland for some time; Jiangxi Copper (SHA, CNY 16.97) has had an exploratory project there since 2009.  However, it wasn’t until 2013 that Western media realized this investment had occurred.  Anne-Marie Brady, a leading expert on Chinese polar aspirations, says that China tends to domestically boast of its Arctic activities but downplays them to the foreign press.  This sort of encroachment shows China’s increasing reach and also America’s diminishing influence.

The curious case of EUR/USD basis swaps: Recently, the swap rate between the EUR and USD over three months has widened significantly.

This chart shows the swap rate between euros and dollars for three months.  These swaps are generally used to hedge against currency moves.  Thus, if European borrowers need dollars, they issue dollar-denominated commercial paper.  The buyer who buys the paper now has dollar risk.  The swap eliminates that currency risk.  The borrower servicing the debt in dollars may decide to also hedge. The sudden shift is probably due to two factors.  First, if there is a dearth of dollars at year-end, when some buyers want to hedge, it can drive up the rate (negatively widening the swap).  Note that there were squeezes in 2011, 2015 and 2016, although the current one is much stronger than the last two, which suggests something is in play other than seasonal factors.  The second reason this may be happening is that U.S. firms with dollars offshore may have been the usual buyer of this dollar-denominated paper.  They would have less need to hedge and thus could absorb the paper without pressuring the swap rate.  But, if those firms are expecting a repatriation holiday from the tax bill, they may be reluctant buyers and thus there is a dollar-funding squeeze.

Interestingly enough, for European buyers, U.S. 10-year T-notes are now carrying a negative yield if the paper is fully hedged.  If they borrow U.S. dollar three-month LIBOR at +1.61%, plus local LIBOR (-39 bps) plus the EUR/USD swap rate, the hedged rate is around -63 bps.

We watch this rate because it can signal financial stress.  As the chart above shows, in 2008, the spread widened dramatically as global borrowers tried to secure dollars.  Paradoxically, the Treasury downgrade in 2011 caused similar worries.  We think the current widening is probably due to seasonal factors and tax concerns, but we will continue to monitor markets to see if there is some other factor affecting the swap rate.

Another North Korean execution: It has been confirmed that Vice Marshall Hwang Pyong-so, a senior DPRK military figure, has been executed.  He was in charge of the General Political Bureau, which oversees the military.  South Korean intelligence indicates the bureau is under “audit”; Hwang was said to have been punished for an “impure attitude” toward the Kim regime.  What is important here is that there could be growing dissent between Kim and the military.  It should be noted that Kim’s father, Kim Jong-il, strongly supported the military.  His successor son has been trying to rebalance the relationship to boost the civilian economy, which could be leading to tensions within the regime.

In addition, it should be remembered that military leaders everywhere are acutely aware of the weaknesses and limitations of their forces.  There is a natural tendency for military leaders to overestimate the strength of an opponent.  On the other hand, civilian leaders, charged with selling military action to the populous, tend to overestimate their own forces and underestimate the enemy.  Very few civilian leaders indicate at the onset of war that the conflict will be long and bloody with an indeterminate outcome.  That’s why PM Churchill’s promise of “blood, sweat and tears” was so remarkable.  Instead, civilian leaders typically promise quick and painless victories.  It is quite possible that the North Korean military views Kim Jong-un’s actions as impetuous[2] and was trying to encourage him to lower the tone of his rhetoric or maybe even entertain talks with the U.S.  Kim may be trying to rid the military of these “impure thoughts” because he doesn’t trust them or because he doesn’t want to hear words of caution.  At the same time, this execution may signal internal dissent within North Korea.  If Kim continues to march toward a conflict, especially if there is another nuclear test, the military may decide a coup is in order.

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[1] https://tools.wmflabs.org/geohack/geohack.php?pagename=Nuuk&params=64_10_30_N_51_44_20_W_region:GL_type:city

[2] This trait may run in the family.  See WGRs: North Korea and China: A Difficult History, Part 1, 10/16/17; Part II, 10/23/17; and Part III, 10/30/17.  Note how Chinese military leaders viewed the military “prowess” of the current leader’s grandfather, Kim Il-sung.

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Markets are mostly quiet this morning, although there has been a lot of news over the past 24 hours.  Here is what we are watching:

Central banks: The Fed began the discussion (which we discuss at length below) but the BOE, ECB, PBOC and SNB were all active today.  The PBOC raised Chinese borrowing costs in apparent response to the FOMC’s rate increase, although the pace of the changes were less.  The seven-day and 28-day repo rates were lifted 5 bps, and the one-year rate was raised by the same amount to 3.25%.  The BOE, as expected, left policy unchanged but did indicate it is prepared to raise future rates.  The ECB also left policy unchanged; Draghi’s press conference is occurring at the time of this writing and the general tone is dovish.  Perhaps the biggest surprise came from the SNB, which indicated that the Swiss central bank is prepared to allow inflation to exceed its official target.  The CHF dipped on the report.  Overall, it appears the European central banks are more than willing to allow the Fed to raise rates without similar responses, suggesting they are either comfortable with the exchange rate levels or are actively seeking depreciation.

PM May slammed again: U.K. PM May suffered a defeat in Parliament as lawmakers voted 309 to 305 to guarantee that Parliament will have a “meaningful” vote on Brexit.  May wanted the freedom to negotiate a deal without coming back to Parliament for approval.  This outcome will weaken her ability to negotiate a final agreement and raises the chances of a “hard Brexit,” or a potentially violent exit without a trade deal or an agreement on the status of regulation.  Interestingly enough, the MPs who voted for this outcome were the Remainers, who hope to stall the final outcome so long that the U.K. essentially never leaves.  The division on stay or remain is actually finely balanced and thus a final agreement that will make everyone happy is almost impossible.  Although May’s position is clearly weakened, there is no evidence the MPs are planning a no-confidence vote because they fear an incoming Corbyn-led Labour government.

Tax deal: It appears a final version of the tax bill has been negotiated.  Congress expects a score by tomorrow (it needs to not cause a deficit in excess of $1.5 trillion over a decade) and have it to the president’s desk by December 20.  This isn’t a done deal; Collins (R-ME) and Rubio (R-FL) both oppose the cut in the highest marginal rate to 37% but we do think that, in the end, they will cave.  Still, there is no margin for error and losing two senators will doom the legislation.  A side-note: there was a provision to end investors’ abilities to select lots for investment sales and would have required “first in, first out,” which would have been a hidden increase in the capital gains rate.  That provision has apparently been dropped.

The Fed: The FOMC did raise rates as expected.  The market’s take was modestly dovish.  The committee left its path of tightening unchanged; there were worries about the potential for a projection of four rate hikes in 2018, but that didn’t occur.

This is our dots chart history.  The most recent dot is dark blue.  The 2018 and 2019 dots are essentially equal to the September meeting.  It is a bit higher in 2020 but that won’t have a significant impact on the outlook toward policy.  The FOMC is clearly signaling that it would like a terminal rate of 3.00% for fed funds.

The vote was 7-2, with Minneapolis FRB President Kashkari and Chicago FRB President Evans voting against the rate hike.  Usually, that would have been profoundly dovish.  As a general rule, three dissents is the maximum and two dissents suggests the room to raise rates is limited.  However, both Evans and Kashkari will rotate off the voting slate and be replaced with more hawkish members in 2018.  Thus, their dissents were not all that dovish.

In terms of expectations, the unemployment rate is forecast to fall to 3.9%, which is down from September’s estimate of 4.1%.  Core PCE expectations were left unchanged.  For next year, GDP growth was bumped up to 2.5% from 2.1%.  Stronger growth and lower unemployment without inflation suggests the members believe the slope of the Phillips Curve must be nearly flat.  We tend to agree.

Overall, it was a modestly dovish report.  The reactions of the dollar, gold and Treasuries suggest markets were positioned for a more hawkish policy projection.  Yesterday’s inflation data confirms that, for whatever reason, price levels remain mostly stable.  We still expect a more hawkish FOMC next year based on the regional president voters and new governors.  But, the current path of policy tightening remains slow which is supportive of equities, Treasuries and gold, but bearish for the dollar.  This is the Fed that Jerome Powell will inherit.

Energy recap: U.S. crude oil inventories fell 5.1 mb compared to market expectations of a 2.9 mb draw.

This chart shows current crude oil inventories, both over the long term and the last decade.  We have added the estimated level of lease stocks to maintain the consistency of the data.  As the chart shows, inventories remain historically high but have declined significantly this year.  We also note the SPR rose by 0.2 mb, meaning the net draw was 4.9 mb.

As the seasonal chart below shows, inventories fell this week.  We are now well within the year-end seasonal draw.  As the new year starts, stockpiles will begin their largest seasonal build from early January into early April.

Oil prices fell yesterday due to rising gasoline stockpiles.  Although the rise in stocks was large, up 5.7 mb, this is the period during the year when gasoline stocks rise.

As the chart shows, gasoline inventories will likely rise into early February.  They are rising faster than normal and refining activity will likely decline if this pace continues, reducing oil demand.

Based on inventories alone, oil prices are undervalued with the fair value price of $60.16.  Meanwhile, the EUR/WTI model generates a fair value of $63.83.  Together (which is a more sound methodology), fair value is $62.30, meaning that current prices are below fair value.  Overall, oil prices are within normal ranges of current fundamentals but we are neutral to bullish toward crude oil at this time.

The IEA’s quarterly update suggests that non-OPEC supply will rise 1.6 mbpd, with the non-OPEC Western Hemisphere supplying 1.3 mbpd of the increase.  The group is expecting demand to rise 1.3 mbpd, so the sharp drop in stockpiles seen in 2017 does not look likely to repeat unless OPEC cedes market share.  We are somewhat less optimistic on rising non-OPEC output compared to the IEA, but the report is bearish and accounts for today’s weakness in oil despite the large draw of crude oil reported by the DOE.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] It’s Fed Day!  Here is what we are watching this morning:

FOMC today: At 2:00, we will get a decision with certainty regarding a 25 bps rate hike.  We will also get new dots and forecasts, along with Chair Yellen’s last press conference at 2:30.  Usually, press conferences are important.  This one really won’t be because she will exit by February.  Thus, anything she says could be moot in less than two months.  The debate now is whether we will get three or four hikes next year.  At present, the financial markets only have two hikes discounted.

With the release of the CPI data we can upgrade the Mankiw models.  The Mankiw Rule models attempt to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative.  Mankiw’s model is a variation of the Taylor Rule.  The latter measures the neutral rate using core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy.  Potential GDP cannot be directly observed, only estimated.  To overcome this problem with potential GDP, Mankiw used the unemployment rate as a proxy for economic slack.  We have created four versions of the rule, one that follows the original construction using the unemployment rate as a measure of slack, a second that uses the employment/population ratio, a third using involuntary part-time workers as a percentage of the total labor force and a fourth using yearly wage growth for non-supervisory workers.

Using the unemployment rate, the neutral rate is now 3.07%.  Using the employment/population ratio, the neutral rate is 0.80%.  Using involuntary part-time employment, the neutral rate is 2.54%.  Using wage growth for non-supervisory workers, the neutral rate is 0.84%.  The fact that core CPI remains steady maintains the split within the variations.  If the proper measure of slack is unemployment or involuntary part-time employment, then the FOMC lifting rates is clearly proper.  On the other hand, if either the employment/population ratio or non-supervisory wage growth is the better measure, then further rate hikes are dangerous.  However, in the latter two variations—employment/population ratio or non-supervisory wage growth—there is still some room to raise rates before one achieves policy tightness.  Both models have a standard error between 100 to 125 bps.  So, roughly, taking the policy rate target to 1.75% to 2.00% would raise the risk of recession.  This is probably why the financial markets don’t expect fed funds to go above 2.00%.  We will recap the meeting in tomorrow’s report.

Alabama: In an upset, Doug Jones won the special election for the remainder of Jeff Sessions’s term, which ends in 2020.  Here are our takeaways:

• In the immediate term, this won’t matter a whole lot. As long as Congress gets the tax bill to the president before 2018, the GOP will maintain its two-seat majority for this key vote.  However, the election makes it abundantly clear that Congressional Republicans have to get this bill done before New Year’s.  If they don’t, it may be impossible to craft a bill that will placate both Bob Corker (R-TN) and Susan Collins (R-ME).
• Although losing this seat should make passing legislation even more difficult, we don’t know for sure how Doug Jones will vote. Will he follow the dictates of his caucus, reducing the chances of holding the seat in two years, or will he vote mostly as a Republican in a bid for re-election?  Despite last night’s outcome, Alabama remains a deeply red state and only a confluence of circumstances led to Jones’s win.  It may make no difference how he votes as to whether he retains the seat.  It is important to remember that the last time a Democrat won a Senate seat in the state, he changed party affiliation afterward.[1]  At the same time, it is reasonable to expect Jones to be more conservative than Dianne Feinstein (D-CA).
• The divisions in the GOP were laid bare by this election. The establishment/populist political division is something we have noted since 2014.  It affects both parties.  One of the characteristics we have noted about populist candidates is that they are often significantly flawed.  The political establishment is sort of a “finishing school” for political candidates.  Usually, establishment political figures “move up the ladder” through lower level office elections; large corporations perform similar grooming for their executives when they move up the organizational chart.  Populists tend to simply come into the political sphere due to popular anger; President Trump is a classic archetype.  Roy Moore did win offices but, in something of a political “hothouse” in Alabama politics, that didn’t expose him to the rigors of national political life.  Thus, his alleged activities that were highlighted in this special election campaign were simply not exposed by the local media.  Steve Bannon has become the de facto leader of the right-wing populists.  It appears that he, or his organization, lacks the ability to properly vet potential candidates.  Simply put, this loss was an “own goal” for the GOP; Luther Strange would have probably held the seat easily.  As a result, this is vindication for Senate Majority Leader McConnell (R-KY) and, to some extent, might be a welcome outcome to the GOP establishment.
• Although the GOP has struggled in recent elections, the Senate election calendar still strongly favors the Republicans in 2018. Twenty-three Democrats and the two independents who caucus with them are up for reelection next year, while only eight Republicans face elections.  A number of pundits are trying to argue that Jones’s win suggests Republicans everywhere are in trouble, but this is probably reading too much into a single election.  Roy Moore was a controversial candidate even before the recent allegations emerged.  If the right-wing populists put up a slate of similar candidates, similar outcomes are obviously possible.  But, this outcome should lead the right-wing establishment to “take the wheel.”
• Elections are becoming almost impossible to call. Polling before this election was literally all over the place.  The prediction markets, which have tended to be more reliable, missed this one by a mile.  We believe a major factor in recent elections is “preference falsification.”  In other words, respondents are simply lying to pollsters because they feel uncomfortable telling the truth.  A joke during the 2016 presidential election was, “How do you tell the pollster you are voting for Trump with your wife within earshot?”  The version during this election may have been, “How do you tell the pollster you are voting for Jones with your husband in the room?”  However, preference falsification doesn’t resolve the prediction market issue.  After all, lying simply means you lose money.  But, it may show that money distorts the market.  For example, we know that Remain looked likely to win in the Brexit vote, but the brokers noted in the aftermath that Remainers had put larger individual wagers on that side but there were more small-sized punters on Leave.  We may have seen a similar outcome here.
• Overall, Jones’s win will increase the odds of gridlock next year but, frankly, the financial markets will probably welcome that outcome because (a) the president can use executive orders and selective enforcement to deregulate, and (b) nearly all the concern was on taxes and, if that passes as we expect, anything after that is anticlimactic.

North Korea: SOS Tillerson told Pyongyang that he would be willing to talk “without preconditions.”  At the same time, the White House is reportedly asking China to ramp up sanctions and pressing for an oil embargo.  Given Tillerson’s tenuous position in the administration, his offer for talks may not have legs but it bears watching if North Korea takes him up on the offer.

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[1] Sen. Shelby won in 1992, then became a Republican in 1994.

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Market activity is quiet this morning, but we are monitoring a number of interesting news themes.

The Alabama Special: Special elections are being held in Alabama today to replace Jeff Sessions, who left the seat to become Attorney General.  Polling has been wildly divergent but the prediction markets are signaling a Roy Moore victory, although we have seen some weakness develop in the past 48 hours.  We assume Moore will win; how the GOP Senate leadership deals with this outcome remains to be seen.

Mixed reports from North Korea: First, the positive news.  The Manila Times[1] reports that U.N. envoy Jeffrey Feltman, the undersecretary general for political affairs, was in Pyongyang for five days of talks with North Korean officials.  Although no breakthrough occurred (in fact, official statements look like it was more of a rantfest by DPRK negotiators), there were two positive outcomes.  First, the fact that discussions occurred at all is a welcome development.  This is the first time in five years that anyone of this rank from the U.N. has been in North Korea.  Second, there were promises made to conduct more meetings.  Although there isn’t any evidence to suggest a softening tone from North Korea, the fact that they are interested in more talks is positive.  Second, the negative news.  The NYT reports that China is planning refugee camps on its border with North Korea.[2]  The article confirms temporary housing has already been constructed.  The fact that China is taking this step suggests that the Xi government is expecting some sort of crisis that will lead to a refugee problem.  It should be noted that this report emerged after China’s vice minister for foreign affairs, Zheng Zeguang, made an unscheduled visit to Washington last week to discuss the rising tone of confrontation between the U.S. and North Korea.  Although war is a constant worry, the Chinese may also be concerned about Kim Jong-un’s hold on office.  A refugee crisis could come from internal instability.

FOMC: The FOMC meeting begins today and ends tomorrow with new forecasts, an updated dots chart and a press conference—and, with almost 100% certainty, a rate hike.  The key component we will be watching is the dots chart, which will likely signal at least three, and perhaps four, rate hikes for 2018.  We may see two dissents to a hike from Minneapolis FRB President Kashkari and Chicago FRB President Evans.  One of the key factors is the voting rotation next year.  We will get four new regional bank president voters and this group will be more hawkish than the 2017 group.  The table below shows the voting roster for this year and next year along with an estimate of what the FOMC will be at mid-year.  We also include our estimate of the participants’ policy stances, with five being most dovish, three being moderate and one being most hawkish.  The overall current FOMC is moderately hawkish, with an average of 2.81.  The 2017 voting roster was a 3.20 average, a moderately dovish policy stance and clearly more dovish than the overall average.  The 2018 voting roster average falls to 2.50, much more hawkish than the current roster.  The last column of the chart shows what the FOMC might look like by mid-year.  We are assuming the Richmond FRB will install Thomas Barkin as its new president (we assume he will be at least somewhat hawkish given the “DNA” of that bank).  We also assume Mohammad El-Erian as vice chair along with John Taylor and Marvin Goodfriend as governors.  With those appointments, the FOMC would be even a bit more hawkish.  This increases the odds of four hikes next year.

Tax bill update: The current plan is to have a bill to the president by December 22.  Still, there are gaps on a number of issues, including the corporate AMT and SALT.  The momentum to get something done is very strong and we do expect that a bill will be signed by the president.  At the same time, because it is being rushed, a plethora of distortions and loopholes will emerge and we have doubts that there will be legislative “energy” to address fixes.  The administration is moving to shift its focus to welfare reform and infrastructure in 2018.

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[1] http://www.manilatimes.net/new-hope-defusing-tensions-korean-peninsula/367943/ and https://www.wsj.com/articles/amid-north-korea-tensions-a-narrow-diplomatic-window-opens-1513010394

[2] https://www.nytimes.com/2017/12/11/world/asia/china-north-korea-border.html?_r=1

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] It was a quiet weekend in front of an active week.  Here is what we are watching this morning:

NYC bombing: This is a developing incident but early reports suggest a pipe bomb or similar device was detonated near Times Square.  According to early reports, there are four non-life threatening injuries and a man is in custody.  At least three subway lines have been shut down.  We saw the typical market reaction—equities suffered a mild selloff and Treasuries rallied.  This doesn’t appear to be a major situation, at present, and if there are no follow-on incidents we would expect the flight to safety buying to reverse in the later hours of the morning.

Central bank week: The ECB, Fed and BOE all meet this week.  The FOMC is expected to raise rates 25 bps on Wednesday.  We will get new economic forecasts and dots plots; it will also be Chair Yellen’s last scheduled press conference.  No action is expected from the ECB or the BOE, although the latter may set the stage for another rate hike.

Alabama special election: Although polling suggests Democrat Party candidate Jones is gaining ground, the prediction markets are solidly indicating that GOP candidate Moore will win easily.

If the prediction markets are correct, in the short run, it’s a bonus for the GOP as it holds the Republicans’ narrow majority.  The long-run implications may be less sanguine as one would expect the Democrats to use the controversy surrounding Moore as a way to boost their chances at the mid-terms.

Tax bill: Conference committee negotiations continue this week.  The president will offer his “closing arguments” on Wednesday.  Passage of something is likely but the final package could be rather muddled.  The haste to put the bill together will almost certainly yield some unexpected outcomes, both positive and negative.  But, until the final bill emerges, projections of what it will do are highly susceptible to error.

Negative nominal interest rates remain: The FT[1] reports there are $11.2 trillion of financial instruments with negative nominal yields, the highest reading since August.  Although the FOMC is clearly tightening U.S. monetary policy, this data shows the effect of accommodative policy in Japan and Europe.  These negative rates are keeping U.S. long-duration interest rates lower than they would be otherwise; therefore, we should see the negative nominal rate number ease when the ECB begins to reduce accommodation.  This outcome may have a modestly bearish impact on long-duration U.S. debt.

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[1] https://www.ft.com/content/0217091e-af9f-3884-96b1-0071016392ae