by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s a slow news morning.  Columbus Day is being celebrated, which means the Federal Government and Treasury market are closed.  Equities are open.  Here is what we are tracking this morning.

A Turkish spat: Turkish financial markets have been roiled this morning after both the U.S. and Turkey limited travel visas.  The proximate cause was the arrest of a Turk employed by the U.S. Consulate.  However, it is important to put this action into context.  Turkey has been aggressively arresting Americans working or living in Turkey, claiming they were part of last year’s coup.  The key actor in this event is Fethullah Gulen, a Turkish Muslim leader living in Pennsylvania.  Gulen has built a broad, and mostly moderate, Islamic movement in Turkey that was ultimately designed to undermine the secular Turkish state.  President Erdogan and Gulen were initially allies but had a falling out in recent years.  Erdogan believes Gulen was behind the 2016 coup attempt and wants the U.S. to extradite him for trial.  So far, the U.S. has refused.  Thus, Erdogan is arresting Americans or Turks working for Americans as a way to create “hostages” he can trade for Gulen.  Worries about deteriorating relations are pushing the Turkish lira lower this morning.  We expect tensions to remain elevated on this issue as we don’t expect the U.S. to send Gulen to Turkey.

Pressure builds on North Korea: The WSJ reports that more than 20 nations have reduced operations with North Korea as the U.S. steps up economic and financial sanctions.  Although the consensus of analysts is that North Korea will never relinquish its nuclear weapons program, President Trump has managed to unify nations against the regime.  Economic pain may work to start talks; however, there is no clear roadmap as to what goals could be salvaged at this point.  The stated position of the U.S. is that Pyongyang must give up its nuclear weapons, while North Korea’s starting point is world recognition that it is a nuclear power.  Clearly, these are not compatible goals.  But, talks might yield a workable outcome short of war.  One possibility is that North Korea gets to keep its nukes but allow supervision to ensure the program doesn’t get larger, i.e., a freeze.  For now, the president’s comments suggest the march to war is more likely.

Counter-protests in Catalonia: Large rallies were held in Barcelona over the weekend where Catalonians who oppose independence called for the province to remain in Spain.  Polls have suggested that the independence movement is a minority in the province and there is an argument that PM Rajoy overreacted; allowing the referendum to go forward and fail would have been a stronger outcome than using force to prevent it.  Canada’s experience with Quebec separatism bears this out.  We have seen Spanish assets rally after initially declining on the idea that support for independence may not be enough for Catalonia to declare independence.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy employment data day!  We cover the release in detail below but the quick view is the report is mixed; payrolls actually declined but the unemployment rate did, too.  The data was affected by weather events.  The dollar rose on the news and Treasury yields rose as well, while equities eased modestly.  Here is what we are watching this morning:

PM May is in trouble: The FT is reporting that up to 30 Tory MPs are pushing for PM May to resign.  They are being led by Grant Shapps, a former party chairman.  The broader party leadership is trying to suppress the rebellion, worried that the leadership challenge could lead to a no-confidence vote and new elections.  If elections are held, it is quite possible that Labour could win.  The GBP continues to slide on fears that political turmoil will stall potential rate hikes and the possibility of a Corbyn government.

Madrid continues to tighten its grip on Catalonia: Spain’s constitutional court has suggested Catalonia can’t declare independence and the head of the province’s police force has appeared in court under investigation for sedition.  Some large businesses in Catalonia have indicated they would quit the province if independence is declared.  In the end, independence usually requires applying one’s claims through force.  Catalonia doesn’t have the military resources to separate.  When a region finds itself in this situation, it usually petitions other nations to support its goal.  For example, the emerging U.S. benefited greatly from French support during the American Revolution.  The South may have been able to successfully secede if the British had come to its aid.  We don’t see any outside power willing to go to war with the rest of Spain to bolster Catalonian independence.  The bigger problem is that Madrid will now have a restive province that will sullenly defy Spain at every turn.  Madrid should have used the Canadian model; allow the vote to go on but shower Catalonia with “goodies” to sway the average voter that staying in Spain was a better deal.  PM Rajoy is winning the battle but setting up for a long-term war that should have been avoided.  This problem is weighing on the EUR.

Decertifying Iran: It appears the White House is planning to decertify the nuclear deal with Iran, forcing Congress to deal with the issue.  However, it also appears that the president won’t recommend new sanctions.  This will allow the White House to express its displeasure with the Obama-era agreement without triggering a crisis.  The president may not be able to avoid it.  Once Congress gets control of the policy, there is no guarantee they won’t push new sanctions to his desk, forcing him to either break the current deal or defy his own party.  In addition, it is highly unlikely that Europe or Russia will cooperate on new sanctions, meaning the U.S. will be implementing the action unilaterally.  About the only way the U.S. can make unilateral sanctions stick is if the American financial system is involved.  Of course, if the nuclear deal ends, we would expect Iran to rapidly move to acquire a nuclear weapon which increases the potential of further destabilization in the Middle East.  The White House is trying to weave a middle path—it wants to express its displeasure with Iran, which is a way to gain “points” politically without causing a crisis.  It’s a risky move because we doubt the president wants to go to war in the Middle East.

Quarles confirmed: The FOMC gained a new governor (finally!) as Randal Quarles was confirmed yesterday.  He will take over Dan Tarullo’s role as guiding bank regulation.  Quarles is expected to be much more bank friendly, especially compared to Tarullo.  As a voter, he will probably be moderate to hawkish.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Financial markets are very quiet again this morning in front of the employment data on Friday.  Here is what we are watching this morning:

Fed chair decision: President Trump has distilled a short list for replacing (or, perhaps, reappointing) the position of Fed chair.  Below is what the prediction markets are signaling.

Bettors are putting their money on Warsh.  He does meet many of the assumed criteria of the president.  He is a Republican with private sector experience.  He is young and well connected, coming from the elite establishment, and has been a Fed governor.  He is not an economist.  It is the latter point that gives most analysts and Fed watchers pause.  He hasn’t written much, but what he has published has been skewered.[1]  In his defense, Chair Bernanke did speak well of Warsh but mostly in his work as a liaison between various parties during the Great Financial Crisis.  At the same time, Warsh might be the most compliant Fed chair Trump could appoint.  Most of the other candidates would likely support Fed independence, but it is possible Warsh would be more inclined to please the White House.  In watching the debate over who should be Fed chair and how that person would react in terms of policy, there have been persistent comments made that the combination of a new Fed chair and fiscal stimulation in the form of tax cuts could lead to a 1980s dollar bull market.  That outcome is possible.  However, there is another possibility that is almost never discussed, probably because most commentators were not even zygotes when that other outcome occurred, which is the combination of fiscal expansion and loose monetary policy, personified by Fed Chairs Arthur Burns and G. William Miller, that led to a significant dollar bear market.  If Warsh is willing to be the most pliable chair, he could get Trump’s nod.  If Warsh doesn’t win, we are leaning toward Jerome Powell, a current governor.  He is a Republican but we would characterize him as a moderate on policy, sort of another Yellen.

The Iran deal: There are numerous reports this morning that Trump may not certify Iran’s compliance to the nuclear deal.  We do note that Gen. Mattis, his SOD, has indicated he believes Iran is complying.  Part of the problem is that there has always been a lack of consensus about what the Iran deal means.  On the surface, it is a limited pact that probably prevents Iran from developing a nuclear weapon—nothing more, or less.  However, during the process of negotiating the deal, the Obama administration seemed to believe that it might be the first step in normalizing relations with Iran.  This is hugely important.

Before the end of WWII, when President Roosevelt met with King Ibn Saud on the Bitter Lake aboard the U.S.S. Quincy, the U.S. established itself as the enforcer of stability in the Middle East.  The U.S. has significant military assets in the region and has acted as “offshore rebalancer” to intervene in various conflicts to prevent any regional power from becoming dominant.  This position ensured a free flow of oil from the region and denied the Soviets a warm water port.  However, with the end of the Cold War and the onset of shale production, the U.S. has been reconsidering the balancer role.  The whole concept of “pivoting” to the Far East required the U.S. to pivot away from the Middle East.  Thus, if the U.S. isn’t going to maintain that role, who should get it?  The Obama administration seemed comfortable with giving that to Iran.  Such a decision sent shock waves through the neo-conservative wing of the GOP who are focused on the security of Israel.  And so, the election of Trump has led to a Sunni recovery in the region.  At the same time, the Trump administration has essentially viewed the Iran nuclear deal with a broader mandate—that it should be designed to contain Iran and reduce its regional influence.  Thus, rejecting the nuclear deal isn’t just about the strict reading of the treaty; it’s a reversal of unstated Obama-era policies to abandon the region to the tender mercies of the Persians.  So, strictly speaking, Mattis is right…Iran is meeting its obligations.  But to say that ignores the broader context, which is who will keep the Middle East stable?

Debt forgiveness for Puerto Rico?  President Trump suggested that Puerto Rico’s debt could be written off.  Although we do expect a restructuring, the comments did surprise and Budget Director Mulvaney is trying to walk them back.  We note that it seemed to have an impact on the island’s debt prices.  As the chart below shows, this representative GO bond has seen its prices fall by almost half since mid-September.

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[1] http://economistsview.typepad.com/timduy/2017/01/was-kevin-warsh-really-a-fed-governor.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Financial markets are very quiet this morning.  Because it’s quiet, let’s take a look at Europe:

Catalonia, Spain and the EU: Every nation is a construct.  It is built on a social contract that offers various public goods in exchange for membership.  First and foremost, states offer protection from outside threats.  A nation that cannot protect its citizens from outside invaders has a difficult time demanding allegiance.  Second, it also must create internal conditions that make membership attractive.  These include public goods like security, which include policing protections for life and property, and usually some socialization from the vicissitudes of life.  These can include old age pensions, unemployment insurance, health insurance, price protections for basic life staples, etc.  Third, most states also support social goods, such as parks, the arts, etc.

It is not uncommon for divisions within nations to develop.  Regional, ethnic or religious differences can trigger aspirations for separation.  For the most part, modern democracies manage these differences in two ways.  Most democracies are federal; they offer some degree of local autonomy to deal with regional differences.  Laws are usually put in place to protect some degree of religious and ethnic freedom.  Usually, the combination of federalism and legal protection is enough to manage internal differences and maintain a nation.

However, these mechanisms are imperfect and there are numerous examples of internal divisions becoming so acute that civil conflict develops.  The history of Europe shows floating borders.  Our first example is the map of Europe in early 800 AD.  Notice that most of central and eastern Europe were tribal.

By 1200 AD, various nations, kingdoms and principalities were starting to emerge.

Three hundred years later the remnants of the Byzantine Empire were gone, replaced by a group of nations in the Balkans.  France was starting to develop.  Note that the Iberian Peninsula was five nation states, including Aragon, which is much of modern-day Catalonia.

Below is a map of Europe at WWI.

Note that many of the various principalities and kingdoms were absorbed into large empires.  This consolidation occurred for two reasons.  First, powerful groups conquered these areas to build large nations.  Second, war was common in Europe and smaller nations found they had more protection by banding together to form empires.

Finally, this map shows Europe today.  In the aftermath of two world wars, Europe once again became a continent of smaller nations.  Europe has generally been stable despite these smaller states because the continent outsourced its defense to the U.S. under the guise of NATO.  In comparing this map to earlier maps, one cannot help but notice that the Balkans, who were united under the nation of Yugoslavia, have seen significant devolution into a series of small nations.  Why should France, Germany, Spain, Italy, et al. not see a similar breakdown?

This is the conundrum the EU faces.  The EU is attempting to consolidate Europe into a loose, single federal entity; however, within European nations, there are growing efforts for self-determination.  It’s not just Catalonia…Scotland has been flirting with independence, Czechoslovakia divided into two states and Belgium has been on the brink of division for years.  The EU has generally tried to discourage the breakup of current nations within Europe, but the trends on the ground appear to be moving in the direction of increased local control.

So, how does Madrid keep Barcelona in Spain?  Truncheons and rubber bullets may have won a temporary stay but at the cost of looking desperate.  How does London keep Edinburgh in the U.K.?  If we revert to our first paragraph, it would seem that the key is being able to offer internal and external security along with an environment that supports economic growth and an attractive culture.  Suppression doesn’t work forever.  If Europe faced a significant external threat and the U.S. wasn’t there to protect it, the drive to self-determination would likely be stifled.  However, in the absence of an external threat, self-determination and the trend for devolution appear difficult to suppress.  In other words, if nations want to hold together, making membership attractive is probably the most effective way, in the long run, to maintain territorial integrity.  If Europe continues to devolve, interestingly enough, the economic benefits of being in the Eurozone rise, as would the development of a Eurobond.  If the EU continues to insist that nations stay together, it may be creating conditions that weaken the benefits of joining the single currency.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It was a violent weekend.  Here is what we are watching:

The mess in Catalonia: Catalonia did hold an independence referendum over the weekend in the midst of a strong central government crackdown.  Latest media reports suggest over 760 people were injured in clashes with central government riot police.  The vote overwhelmingly supported independence (over 90%) but that was mostly the result of anti-independence groups telling their supporters not to vote.  We are seeing a weaker EUR this morning, due in part to the chaos caused by this vote.  It gets even more complicated; PM Rajoy leads a conservative minority government that governs with occasional support from the liberal and center-left parties.  The opposition will be less likely to cooperate with Rajoy in the aftermath of his heavy-handed response.  So, it is quite possible the government will fall because of this event and Spain could be looking at new elections.

A massacre in Las Vegas: In a shooting somewhat reminiscent of the University of Texas massacre in 1966,[1] Stephen Paddock, a local resident, began shooting randomly from the 32^nd floor of a local casino/hotel into a crowded music festival.  At the time of this writing, 50 people have died and over 400 are injured.  Although this event probably won’t have a major market impact, it is a horrific event and our thoughts and prayers go out to the victims.

“Save your energy, Rex”: The Sunday NYT reported[2] that the U.S. was in direct communication with North Korea, raising hopes that negotiations were actually making progress.  There have been reports for months that the U.S. was engaged in backchannel talks with North Korean officials; for the Secretary of State to openly reveal that such talks were underway was a hopeful sign.  However, in a series of tweets, President Trump essentially undercut any discussions.  How could any North Korean negotiator take Tillerson’s promises with any degree of certainty? We do note that there is a North Korean holiday coming on October 10^th and there are expectations that the Kim regime will use the event to launch another missile test.  Trump’s comments raise the likelihood that a conflict occurs.  We still believe the odds remain low (>15%), but they are increasing.

Fed talk: President Trump is turning his attention to the three (and soon to be four) open Fed governor positions. Current Governors Jerome Powell and Kevin Warsh are said to be the leading candidates for Fed Chair.  Powell is a moderate on policy.  Warsh’s public statements have been hawkish but he isn’t an economist and our read is that he is more of a political operator than an independent voice on policy.  Thus, if the president wants a dove, Warsh can do that.  There are reports that Warsh may favor increased political oversight of the Fed; although central bank independence is accepted wisdom, in reality, independence is a function of anti-inflation policy.  For years, central banks were expected to accommodate fiscal policy and all central banks serve at the pleasure of some political master.  But, if we start to see a retreat from independence, the chances of reflation rise.

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[1] https://en.wikipedia.org/wiki/University_of_Texas_tower_shooting

[2] https://www.nytimes.com/2017/09/30/world/asia/us-north-korea-tillerson.html