by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy end of quarter day!  Q3 comes to a close today and next week we begin the march to Q4.  Markets are quiet at quarter end.  Here is what we are watching:

Social media and Russian bears: For the past several weeks, Facebook (FB, 168.73) has spent time in the proverbial barrel, facing rising criticism for facilitating the circulation of information that appears to have come from Russia.  Yesterday, it was Twitter’s (TWTR, 16.85) turn.[1]  The social media companies are arguing that they are merely facilitators of media and should not be held accountable for the information that others put on their platforms, even if it comes from foreign governments or terrorist groups.  There are two problems with that argument.  First, as anyone who uses these social media platforms notices, advertisements and articles start appearing on your phone or desktop that seem tailored to your search patterns or what you read.  By design, social media companies are not neutral but instead support a user’s bias, which suggests a level of power to persuade that is potentially quite powerful and prone to manipulation.  Second, if one’s platform can be used for nefarious activities and the facilitator argues it can’t control the content, it opens itself up for regulation.  This is where broadcast media found itself in the 1950s and 1960s and led to “fairness clauses” and the FCC.  Information technology has been able to operate in a permissive regulatory environment for decades but if the social media platforms can become conduits for manipulation then regulation is much more likely.[2]  Part of what makes tech firms so profitable is the revenue per employee[3]—the heavy use of technology and algorithms eliminates the need for workers.  However, it is apparent that the social media firms have been unable to screen for foreign sources, fake accounts and social media bots that would probably require human oversight to discern.  Regulations that would force increased hiring would weaken the profitability of these companies.  This is an issue that bears close watching in the coming years.

A nuclear dyad?  It appears North Korea is working to add a second nuclear delivery method to its arsenal.  According to 38 North, North Korea is investing in infrastructure to build a sea-launched ballistic missile.[4]  If North Korea does develop submarine launching capabilities, it will give the country a credible “second strike” capacity, meaning it could retaliate against a nuclear strike by a foreign power.  Although this is an unwelcome development, we do note that it would also create conditions of Mutual Assured Destruction (MAD) which, paradoxically, tends to stabilize nuclear power relations.  A nation that is a nuclear monad faces a “use it or lose it” decision if it thinks it will be attacked.  Thus, it has to be more open to using its nuclear weapons under threat.  On the other hand, a nation with a nuclear dyad (or, in the case of the U.S. and Russia, a triad) can credibly signal to an attacker that although you may destroy our nation, be assured that we will counter with an equally devastating follow on attack…or, MAD.  Currently, North Korea either has, or is near, a nuclear monad.  So, if it believed the U.S. was preparing to attack, it would be severely tempted to strike first; although it knows that it would be hit with a devastating attack (Gen. Powell called it “turning North Korea into a briquette”), at least it didn’t come to that fate without launching its own nukes.  However, if North Korea had a dyad, it would likely be less “hair trigger” in using its nuclear weapons.  This assumes, of course, that North Korea eventually adopts the behavior patterns exhibited by all the current nuclear powers.  We suspect it would, not because we have faith in the Kim regime but because this is what game theory suggests would happen and the history of the Cold War shows it works.  In other words, the U.S. and U.S.S.R. avoided nuclear holocaust not because of the content of their characters or rationality but because they were locked into an equilibrium that made it stupid to behave otherwise.  Even China under Mao eventually followed the same path.  Simply put, a nuclear North Korea is terrifying but we may be approaching a balance of terror that characterized the Cold War, which was frightening but remarkably stable.

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[1] https://www.axios.com/twitters-reality-check-on-russian-election-meddling-2490707290.html?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top-stories

[2] https://www.axios.com/the-walls-close-in-on-tech-2473228710.html

[3] http://www.businessinsider.com/top-tech-companies-revenue-per-employee-2015-10/#2-google-1154896-per-employee-11 and http://www.visualcapitalist.com/top-20-tech-companies-revenue-per-employee/

[4] http://www.38north.org/2017/09/nampo092817/

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Financial markets are mostly quiet today.  There is a modest reversal of recent trends as the dollar eases a bit, but long-duration bonds are continuing to weaken.  Here is what we are watching today:

Tax talk: The GOP leadership sketched out the tax plan.  Tax reductions tend to excite equity markets.  Since the late 1960s, there is a broad inverse correlation between the highest marginal tax rate and equity values.

This chart comes with a plethora of caveats.  The rise in the S&P that correlates with the drop in tax rates is true as far as it goes, but a lot of other factors led to the bull market that developed, including falling inflation, a secular bull market in bonds, deregulation, globalization, etc.  In addition, the biggest positive market impact from tax cuts mostly comes from the early cuts, which were substantial.  Moving from 39% to 35% on the highest marginal rate is nothing compared to moving from 70% to 30%.  Still, it makes sense that the equity markets have a positive reaction to the thought of tax cuts, especially corporate tax cuts, which will boost after-tax net income for corporations.  As we noted yesterday, we are not going to invest a lot of time and effort into discussing tax changes until we get closer to a final draft.  As a note of caution, the politics of tax reform are devilish because there are winners and losers and the latter try to prevent changes from occurring.  There are reports that the president is cool to the proposal.[1]  Senator Hatch (R-UT) has indicated he may draft his own tax plan.  Senator Corker has suggested that taxes are much harder than health care.[2]  It’s going to take months for anything to happen on taxes and what eventually emerges may or may not be favorable.

U.S. to send “strategic assets” to South Korea: The WP reported[3] that the U.S. is sending strategic assets to South Korea, although what exactly is being sent wasn’t noted.  We would expect strategic bombers and attack submarines capable of launching missiles to be sent.  Of course, sending nuclear weapons would be a significant signal to the North.

Navarro demoted: Peter Navarro, Director of Trade and Industrial Policy, now reports to David Cohn instead of directly to the president.  This is a win for the establishment wing of the GOP.

Iraq threatens the Kurds: The official results of the Kurdish referendum showed over 92% voted for independence.  Baghdad is threatening to invade the Kurdish region and has shut down Kurdish airspace in response.  Although we doubt an invasion is imminent, the threat of military action in the northern oil fields is lifting oil prices this morning.  The Kurdish situation is quite complicated; we expect all the surrounding nations to try to use the Iraqi Kurds to their own benefit.  On the one hand, playing the regional powers off each other increases the chances that a Kurdistan state will emerge.  On the other, if a state does develop, it will be wholly dependent upon the sponsoring power.  We continue to watch Turkey closely.

Catalonia votes (maybe): Catalonia is promising to hold a referendum on independence on Sunday.  The national government is threatening to use the national militia to prevent voting from occurring.  The Rajoy government is making a hash of this vote; polls suggest most Catalonians want to remain in Spain so allowing the vote to occur would be a politically savvy choice.  By acting in such a ham-fisted manner, Rajoy is boosting tensions.  Europe has a number of simmering independence movements which could undermine the Eurozone over time.

Japan’s snap elections: PM Abe dissolved parliament before the Oct. 22 elections in Japan.  The PM is hoping to solidify his already two-thirds majority because the opposition socialists are in deep disarray.  However, a surprise challenger has emerged as Tokyo Governor Yuriko Koike has formed a party called the “Party of Hope” to challenge the PM.  The Democratic Party, the official opposition party, has indicated it won’t compete in the Oct. 22 vote, allowing its candidates to run in the new party.  If she were to win, Koike would be the first female PM in Japanese history.  It’s not clear how Koike’s policies would differ from Abe’s, but any change from Abe might end the Abenomics experiment.  A stronger JPY may result.

Energy recap: U.S. crude oil inventories fell 1.8 mb compared to market expectations of a 2.5 mb increase.

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.  The impact of Hurricane Harvey is starting to diminish as refinery operations recover.  We also note the SPR fell by 0.8 mb, meaning the total draw was 2.6 mb.

As the seasonal chart below shows, inventories fell this week.  It appears we have started the inventory rebuild period sooner than normal this year due to the hurricane.  The key will be the path of refinery operations.

Refinery operations have recovered strongly; history suggests that the trough in maintenance ends about mid-October.  Although we could see a pullback over the next couple of weeks, if operations remain elevated it would be supportive for crude oil demand and prices.

Based on inventories alone, oil prices are undervalued with the fair value price of $50.62.  Meanwhile, the EUR/WTI model generates a fair value of $66.61.  Together (which is a more sound methodology), fair value is $61.20, meaning that current prices are well below fair value.  If the Fed does continue to tighten policy and the dollar recovers, it will tend to undermine oil prices, although we would note that oil has been underperforming the dollar’s weakness.  Thus, the adverse impact of a stronger dollar on oil should not be material. 

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[1] https://www.axios.com/the-gops-nightmare-scenario-2490500624.html?utm_medium=linkshare&utm_campaign=organic

[2] http://thehill.com/blogs/blog-briefing-room/352762-corker-tax-reform-will-make-health-care-reform-look-like-a-piece-of

[3] https://www.washingtonpost.com/world/more-us-strategic-military-assets-to-south-korea-to-deter-the-north-seoul-says/2017/09/28/4062cc7e-a416-11e7-8c37-e1d99ad6aa22_story.html?utm_campaign=New%20Campaign&utm_medium=email&utm_source=Sailthru&utm_term=.827469c5adb0

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] The primary features of this morning’s trade are rising interest rates and a stronger dollar.  Chair Yellen is becoming increasingly hawkish; so far, equity markets are holding their own.  Here are some of the news items we are tracking:

BREAKING: German FM Wolfgang Schäuble has indicated he is willing to give up the finance ministry and lead the CDU/CSU in the Bundestag.  Schäuble is a stalwart in the Merkel government and so this move was not expected.  This action may show that Merkel is struggling to build a coalition and needs the finance mandate to woo potential coalition partners.  Initial market reaction has been bearish for the EUR as Schäuble leaving the government suggests disarray.  At the same time, it is possible the FDP is pressing Merkel for the finance ministry as a condition of joining the government.  The FDP leans anti-Eurozone and would call for a hard line against the southern tier.  Thus, an FDP finance ministry would probably be bullish EUR.

Initial tax plan to be unveiled today: A rough outline of tax reform is expected to be revealed today.  Although there will be many electrons dedicated to parsing out the details of what is released, investors shouldn’t get overly concerned about what is seen today because if a deal is struck it probably won’t look like what is proposed today.  We do expect to see a marginal cut in personal rates; corporate taxes will be adjusted lower with credits reduced.  The basic method of tax reform is to lower the rate and broaden the base.  The former is self-evident; the latter means getting rid of deductions and credits designed to steer behavior.  The problem with broadening the base is that one party’s wasteful tax expenditure and sop to special interests is another party’s critical tax relief that is elemental to the continuation of Western civilization.  We continue to pay attention to this issue but won’t go into detail until later when (or if) a real program emerges.

Yellen the hawk: In a speech yesterday, Chair Yellen reiterated the message of the Fed, indicating a path of rate hikes and balance sheet reductions.  We had expected Chair Yellen to use the latter to stall action on the former.  However, she is apparently moving to keep the two policy items separate, suggesting she doesn’t see balance sheet reduction as a removal of accommodation.  We tend to agree with her that reducing the balance sheet, by itself, won’t affect the economy much.  Although the Fed argues that expanding the balance sheet lowered long-duration yields by reducing the term premium, we suspect that falling inflation expectations, not an expanded balance sheet, caused the term premium to decline.

This chart shows the expectations of a rate hike at the December meeting, derived from fed funds futures.  Current expectations for a hike are around 70% and have increased significantly.

Why has Yellen turned hawkish?  It is important to note that Yellen came of age during the 1970s and policymakers who did their academic work in this period are more inclined to fear inflation.  It may be that she is planning on leaving in February and worries that the next Fed chair will be a dove and thus wants to remove stimulus while she can.

This chart shows the past four tightening cycles and the current cycle, shown in gray, along with the Chicago FRB National Activity Index.  A reading above zero in the latter index indicates above-trend growth.  Note that the economy was significantly stronger in past tightening cycles.  The only argument for tightening with this level of economic growth is that the policy rate is below a rate consistent with equilibrium (on-trend) growth, which seems to be a stretch.  The bottom line here is that further Fed tightening will increase the risk of a policy mistake.

Women drivers in Saudi Arabia: On its face, this isn’t market-making news, although some are trying to spin it as such as it will increase the number of autos sold in the kingdom.  Perhaps…however, the big takeaway from this move is that the crown prince is steadily modernizing Saudi Arabia.  We have been hearing rumblings that the crown prince wants to weaken the grip of the Sunni religious establishment in Saudi Arabia, believing it has become an obstacle to the changes the kingdom will need to make in order to deal with the challenges of the next 20 years.  This action is important because, symbolically, it suggests that modernizers within the royal family are gaining the upper hand.

Populists on the march: Earlier in the week, Germany showed how populists are gaining ground in Europe.  The GOP primary in Alabama added to the evidence.  Sen. Corker (R-TN), an establishment stalwart, announced he won’t seek re-election next year.  Politico notes that former VP Biden is considering a run for president in 2020 as an anti-populist.[1]  The establishment center-left and center-right is taking a drubbing; this is a theme we have been monitoring for a long while, but the bottom line is that it could undermine investor confidence at some point in the future if it gains momentum.

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[1] To quote the movie Dodgeball, “It’s a bold strategy, Cotton…” https://www.youtube.com/watch?v=9HVejEB5uVk

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Financial markets are generally quiet this morning.  Here are the news items we are watching:

The German elections reverberate: Although Merkel remains chancellor, the German political landscape is shifting radically.  If the ruling coalition is made up of the CDU/CSU, FDP and the Greens, it will be the first three-party government in postwar German history.  And, even putting this coalition together is problematic.  The FDP would probably prefer to be in the opposition.  How the Greens will operate in a conservative government will be interesting.  The CDU/CSU is generally considered one party but it isn’t; the CSU, mostly representing Bavaria, has more of a Catholic Church influence.  Thus, it is more socially conservative than the CDU and tends to support social spending.  The rise of the socially conservative AfD is putting pressure on the more conservative CSU to break with the CDU.  If this were to occur, new elections would be difficult to avoid.  The uncertainty surrounding the German government is putting pressure on the EUR this morning for the second consecutive day.

The Kurds vote: We won’t get the official results from the Kurdish vote for a few days, but it seems highly improbable that the vote will not support independence.  Neighboring nations are threatening the Kurds; Iraq and Turkey are holding military exercises near the Kurdish region and Iran has been making threatening comments.  Turkey has also threatened to cut off Kurdish oil exports, which is one of the reasons oil prices have lifted.  The Kurds want independence but it is obvious that the only way they can get it is to gain the protection of a local power.  The more likely candidates would be Turkey or Iran.  Usually, Turkey would oppose Kurdish statehood but having a state dependent on Turkey might be attractive.

A declaration of war: Financial markets were rattled by comments from North Korea’s Foreign Minister Ri Su Yong, who indicated that President Trump’s recent statements to the UN were a “declaration of war” and North Korea reserves the right to shoot down any foreign warplanes that venture near the country, even if they are over international airspace.  Reuters is reporting that North Korea has boosted its air defenses on its eastern border.[1]  This sort of talk is unsettling but it should be remembered that North Korea has a long history of provocations.  These include the sinking of the ROKS Cheonan in 2010, the boarding and capture of the U.S.S. Pueblo in 1968 and the 1976 “Axe Murder Incident” where North Korean troops attacked an American and South Korean tree trimming operation in the Demilitarized Zone, killing two U.S. soldiers.  North Korea also downed a civilian aircraft, Korean Air Flight 858, in 1987.  After the U.S. sanctioned Kim Jong-un in July 2016, the official news agency declared it as “an act of war.”  The same occurred after South Korea withdrew from a joint industrial complex in February 2016.  The key point here is that provocative statements and actions are standard course for the DPRK; how the U.S. reacts is important, but North Korea declaring war isn’t unusual.

Yellen speaks: As noted below, Chair Yellen speaks today.  We will be watching to see if she adheres to the generally hawkish tone of the statement or if her own position is more dovish.  We expect her to hold to the hawkish line, which may be dollar supportive.

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[1] http://www.reuters.com/article/us-northkorea-missiles/north-korea-bolsters-defenses-after-flight-by-u-s-bombers-as-rhetoric-escalates-idUSKCN1C026A?il=0

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It was a busy weekend.  Here are the stories we are following:

Merkel slips: Merkel’s CDU/CSU won the election as expected, but underperformed expectations.  Her party took 32.9% of the votes compared to the last poll predicting a result of 34%.  However, most polls going into last week had her party at 36%, indicating a disappointing outcome.

The mainstream parties took a beating.  The Social Democrats lost votes to all the fringe parties, while most of the Conservatives (CDU/CSU) lost to the Free Democrats (FDP), libertarian, and the Alliance for Germany (AfD), populist-right.  Also note on the chart below that the AfD and the FDP took a large number of non-voters.  Populists are pulling disaffected voters into the polling booths as they now believe they have a choice.

The SPD has indicated it won’t join a coalition with Merkel again so the Chancellor will need to put together a government with the FDP and the Greens (the so-called “Jamaica option,” reflecting the flag colors of that island nation).

Because of Germany’s proportional electoral system, the seats in the Bundestag are now up to 709, meaning that a majority government needs 355 seats.  The CDU/CSU and the FDP only make up 326; the Greens are the only other coalition option for Merkel.

The fallout is that this will be a weak government.  Although Merkel’s nuclear power policy and support of green energy will give her some credit with the Greens, the rest of the conservative coalition’s policies will be opposed by the Greens.  The FDP generally opposes the Euro project which will undermine Merkel’s support because much of her own party is becoming increasingly Euro skeptical.  Thus, governing is going to require all of Merkel’s formidable political skills.   We would not expect a government to be officially formed until December.

The market impact is interesting.  German Bunds rallied, helping U.S. Treasuries to lift.  The EUR fell.  The German elections show what we are seeing across the rest of the West.  The center-left and center-right parties are losing support to the political extremes.  Everywhere, voters are pressing for something new.  We note over the weekend that the NYT carried a story about the growing strength of Jeremy Corbyn, who is dragging the British Labour Party to the extreme left.[1]  The continued surge of both right- and left-wing populism is a threat to the stability of financial markets.  In related U.K. news, Moody’s downgraded the U.K. to Aa2 from Aa1 due to Brexit and uncertainty about Britain’s debt reduction plans.

Japanese snap elections: Ending weeks of speculation, PM Abe will dissolve parliament on Thursday with elections mostly likely to be held on October 22.  Current polling puts Abe’s LDP well in the lead, with 44% support from voters and most of the opposition parties holding under 10%.  However, polls also report a high level of undecided voters, which carries its own dangers.   Abe is calling for increased fiscal stimulus (a usual election ploy) and a hike in the consumption tax to 10% from 8%, with the additional funding for daycare in a bid to boost birthrates.  We don’t expect Abe to lose but caution is warranted given the large number of election surprises over the past year.

Kurds vote: Iraqi Kurds are expected to vote to leave Iraq today.  Although Kurdish leaders have indicated they will press for secession within 48 hours of a vote to leave, we actually expect a long and drawn-out process.  Most of the Kurdish region’s neighbors oppose statehood and the Kurds themselves are bitterly divided between the more conservative Iraqi Kurds and the Marxist-leaning Kurds in Syria and Turkey.  Still, this vote exemplifies a risk that President Bush ignored when he invaded Iraq 14 years ago; Iraq was more of a construct than a country and democracy would likely lead to division.  Currently, Iraq is divided between Kurds, Sunnis who, for a time, flirted with IS, and Shiites, aligned with Iran.

Catalonia moves toward a referendum: PM Rajoy has declared the independence referendum, set for October 1, illegal and has arrested several Catalan independence leaders.  Thousands protested in Catalonia over the weekend, calling for the vote to proceed.  Rajoy probably overstepped by arresting leaders; polls suggest that support for independence is less than 50% and the referendum would likely fail on its own.  The PM’s harsh tactics may lead to more support for independence than would have otherwise occurred.

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[1] https://www.nytimes.com/2017/09/23/world/europe/jeremy-corbyn-labour-conference.html?emc=edit_mbe_20170925&nl=morning-briefing-europe&nlid=5677267&te=1

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] There is much to discuss this morning.  Let’s get to it:

North Korea returns: After President Trump’s speech to the UN we have been waiting for a response from the Kim regime.  Overnight, we got our answer.  The Young Marshal offered a rambling response to Trump but, more importantly, suggested he is considering a thermonuclear test in the waters of the Pacific Ocean.  Non-underground testing of nuclear devices has become rare; the last one we could find was by China in 1980.  Underwater testing was usually done to evaluate the impact on naval vessels; if the test occurs near the surface it can disperse significant amounts of nuclear fallout in the water and create radioactive steam.  However, contamination is generally limited to the area around the blast.  Still, such a test would be a major escalation of tensions.  If the underwater test is a device offshore tethered to a barge (the usual method), it’s a problem but not a red line.  On the other hand, if the test is a warhead on a missile that is launched into the ocean and detonated, that would likely cross a red line and bring a military response from the U.S.  The Trump administration has unveiled new financial sanctions that could potentially raise pressure on Chinese financial entities dealing with North Korea.

There is no doubt that tensions are escalating and the bellicose rhetoric is pushing both leaders into corners that will be difficult to walk back from without losing face.  So far, financial markets are taking the news in stride.  As we have seen recently, most of the impact has been in the forex markets; the dollar has declined,[1] Treasuries are modestly higher and equities are mixed.  Although financial markets are concerned, there has been no discounting for war.  If a conflict does break out, we would expect a much larger downturn in equities; the duration and depth would be dependent upon the level of intensity and the outcome of a conflict.

German elections: Germans go to the polls on Sunday.  Current polling strongly suggests that Chancellor Merkel will remain in her role after the elections.  The latest polls show Merkel’s CDU/CSU holding a comfortable 14.5% lead over her nearest competitor, the Social Democrats (SPD).  There are two unknowns in this election.  First, Merkel will almost certainly need a coalition partner.  The current government is a “grand coalition” of the CDU/CSU and the SPD.  If the Free Democrats (FDP), a more libertarian party, get enough seats, you might see a CDU/CSU and FDP government.  This has been a traditional alignment in Germany.  A CDU/CSU and FDP coalition would probably take a harder line on the Eurozone issue as the FDP is much less enamored with the EU and the Eurozone.  Currently, polling suggests another grand coalition, meaning the status quo continues.  The second issue is the rise of the AfD, which is a right-wing populist party.  It is polling close to 11%, meaning it will almost certainly gain representation in the Bundestag.  No other party plans to join the AfD but its presence in the legislature will be a jarring development and highlights that, even in Germany, populism is gaining strength.

Kurdish referendum: On Monday, Iraqi Kurds are planning to hold a referendum on independence.  The Iraqi government, the U.S., Iran and Turkey all oppose the move.[2]  However, on the ground, the situation is more complicated.  First, the Kurds themselves are not unified.  The Syrian Kurds have closer relations with the Kurds in Turkey and are not all that close to the Iraqi Kurds.  The Syrian/Turkish Kurds are aligned with a leftist (neo-Marxist) movement of the Kurdistan Workers Party (PKK).  The Turkish government is much more concerned about a Kurdish state in Syria because it would have common cause with the Kurds in Turkey.  On the other hand, the Iraqi Kurds have been useful to Turkey.  A Kurdish state in Iraq would be deeply dependent on Turkey—oil pipelines from the Kurdish region transverse Turkey.  About 90% of Iraqi Kurdistan’s revenue comes from oil.  In addition, a Kurdish state split from Iraq narrows the “Shiite Crescent” that gives Iran influence from Tehran to Lebanon and reduces Iraq significantly.  Turkey isn’t comfortable with a Kurdish state on its border but it could be useful.  We expect the referendum to go forward and the vote to clearly favor independence.  From there, the negotiations begin.

May speaks in Florence: PM May is giving a speech in Florence today.  There is great anticipation over her comments because progress on Brexit has been slow and the clock is running.  She is expected to allow the EU and the U.K. to split in about 18 months, but it is thought that she will ask for a two-year transition period to prevent a “regulatory cliff” and chaos.  We doubt the EU will comply with her wishes; the EU wants to raise fears among others that leaving the EU is dangerous and costly.  The downside for the EU is that hurting the U.K. will harm the EU as well.  Moreover, the U.K. is arguably[3] the most competent military in Europe and NATO could become a less impressive force without full participation from the U.K. military.

The flow of funds: Yesterday, the Federal Reserve released the Financial Accounts of the U.S., which was formally known as the “flow of funds” report.  It is a rich report with lots of interesting information.  We will have more to detail on this report in an upcoming Asset Allocation Weekly, but one chart we will show today is household net worth as a percentage of after-tax income.  As shown on the chart below, net worth has hit another new record, a reflection of elevated asset prices.  As the history shows, elevated levels are followed by corrections, mostly due to weaker equity markets.  Note that declines in the level of household net worth are closely tied to recessions.  At this juncture, none of our recession indicators are suggesting that a recession is imminent.  Thus, the chart confirms equity markets are elevated, but nothing more.

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[1] One question we have been getting recently is, “Why is the JPY a flight to safety currency?”  It’s a good question.  The best answer is that Japan, due to years of current account surpluses, has significant levels of overseas investments.  When crises hit, Japanese investors pull some of their money home, causing a rally in the JPY.

[2] The only regional power showing unabashed support is Israel.

[3] The French military is considered a close second.

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Financial markets are consolidating after yesterday’s Fed meeting, which we will discuss below.  The key takeaway is the dollar’s rally.  In the Asset Allocation Weekly published on Friday (see gray section below), we analyzed the case for a weaker dollar; it rests on the fact that the dollar is already overvalued as the currency markets discounted tighter Fed policy much earlier than other markets.  Still, it appears the Fed’s decisions yesterday did stall the dollar’s recent weakness.  Here is what we are following this morning:

Fed recap: The financial markets took a hawkish tone to the FOMC decision.  Market expectations had been for a tradeoff of balance sheet reduction in place of rate hikes.  In other words, Chair Yellen would placate the hawks on the committee by reducing the balance sheet instead.  However, that isn’t what was offered.  Instead, the FOMC has mostly maintained its plan to raise rates.

Yesterday’s average estimates are shown in the large light blue dots.  The forecasts from the FOMC members are mostly consistent with June.  In fact, they are a bit dovish in the out years.  However, market expectations had been shifting to no change in rates this year.  That estimation shifted sharply in light of the FOMC report.  Looking at the chart below, the black line shows the probability of a hike from fed funds futures relative to no change, shown in blue.  Note that expectations of a hike rose initially after the last meeting then steadily edged lower.  We have been seeing a steady shift in expectations toward a hike since early September and it jumped to over 67% in light of yesterday’s comments.  We will see if the June/September pattern repeats itself, or if the expectations hold for a hike in December.

The other issue worth noting is that inflation expectations haven’t changed.  The FOMC is still projecting a core PCE of nearly 2.0% by 2019 and throughout the rest of the forecast period.  Current core PCE is 1.4%.  The projected rate hikes with 2% inflation will bring the real rate to zero by the end of next year and positive thereafter.  However, if core PCE does not increase as expected and rates continue to rise, the projected rate of real fed funds will turn quite positive.  The red line on the chart below shows the projected path of real fed funds using the FOMC assumptions.  Usually an upward move of 400 bps from the low in the cycle triggers a recession.  Given that the low was established in early 2012 at near -2.0%, the projected path would put us dangerously close to recession territory.  Of course, the FOMC’s projection of inflation may end up being correct and the red line is too high by 40 bps; if that occurs, the concern is lessened.  However, we have little confidence that the Fed’s projections of inflation will be right as the track record is less than stellar.

An additional concern is the balance sheet shrinkage.  Although the jury remains out as to the actual impact of QE, the risks of a policy mistake rise if reducing the balance sheet ends up having the effect of tightening policy.  As we have seen in the above dots chart, promising is one thing—doing is another.  The FOMC may not tighten as much as expected; in fact, in 2014, the terminal rate was expected to reach 4%.  That expectation has clearly changed.  But, based on what we saw yesterday, the path of policy tightening still appears to be on track.

Other central banks demur: Reserve Bank of Australia (RBA) Governor Lowe indicated that his central bank is not necessarily prepared to follow the Fed in raising rates.  BOJ Governor Kuroda indicated the same thing.  In general, we have seen veiled “beggar thy neighbor” currency policies throughout the world since 2008.  Although no central banker wants to directly say his/her nation is deliberately trying to weaken a nation’s currency, they also don’t seem to welcome depreciation.  In light of recent dollar weakness, it appears that other central bankers are likely to avoid the hint of hawkishness that would prevent their currencies from weakening.  In later parts of Lowe’s comments, he did warn that rates would need to rise, but that sentiment was lost when he indicated a tightening Fed wouldn’t necessarily trigger tightening from the RBA.

China downgraded: S&P downgraded China’s sovereign debt to A+ from AA-, five months after Moody’s cut China’s rating to A1 from Aa3.  Both cited high debt levels for the downgrades and changed their outlooks to stable after the adjustments.  In reality, China’s sovereign debt is not widely held outside of China so this downgrade won’t mean anything significant to interest rates.  Nevertheless, the downgrade does come at an inopportune time for General Secretary Xi with the CPC Congress next month.

SEC hacked: The SEC reported that its EDGAR reporting system was hacked last year and information gained may have been used for insider trading.  Essentially, hackers would have gotten advance information of official filings before the public, which would have been quite valuable.

South Korea at odds: President Trump, PM Abe and South Korean President Moon are expected to meet on the sidelines at the UN General Assembly this week.  Trump and Abe have been pressing for military action against North Korea.  Moon does not want this to happen.  Essentially, Moon fears that South Korea would face the brunt of a retaliatory attack from North Korea if the U.S. tries to militarily neutralize Kim’s nuclear and missile program.  Moon is probably correct.  North Korea has massed artillery along the 38° parallel and would likely strike Seoul with a devastating conventional barrage.  Worse yet, North Korea has a large arsenal of chemical weapons that would cause massive casualties.  Thus, South Korea is more willing to live with a nuclear-armed North Korea and wants its own nuclear weapons to act as a deterrent.  This solution is much less attractive to the U.S. and Japan.  The latter two are not threatened by North Korea’s conventional forces but are at risk to nuclear weapons on missiles.  We don’t know to what lengths Moon would go to prevent an American attack on Pyongyang; would he not allow U.S. troops in South Korea to engage in a conflict, or close South Korean airspace and sea boundaries to U.S. military assets?  It is hard to see how the U.S. could conduct effective operations against the North without South Korean cooperation.  At the same time, it is hard to see how President Trump would stand down and not protect the U.S. from a rogue nuclear power just because South Korea objects.  We note the White House has announced the president will make a statement on North Korea this afternoon.  We will await his comments.

Energy recap: U.S. crude oil inventories rose 4.6 mb compared to market expectations of a 3.0 mb increase.

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.  Hurricane Harvey affected the energy market data again this week; the effects should continue for several more weeks.

As the seasonal chart below shows, inventories did turn higher again this week, affected by the aforementioned hurricane.  We have started the inventory rebuild period sooner than normal this year.  Oil imports continue to recover, rising 0.7 mbpd, and domestic oil production rose by 0.157 mbpd, adding supply to the market.  However, refinery capacity utilization jumped 5.5% to 83.2%, an increase in consumption of 1.0 mbpd.  If this refinery recovery continues, the rapid increase in oil stockpiles should begin to dissipate.

Based on inventories alone, oil prices are undervalued with the fair value price of $50.02.  Meanwhile, the EUR/WTI model generates a fair value of $67.10.  Together (which is a more sound methodology), fair value is $61.30, meaning that current prices are well below fair value.  If the Fed does continue to tighten policy and the dollar recovers, it will tend to undermine oil prices, although we would note that oil has been underperforming the dollar’s weakness.  Thus, the adverse impact of a stronger dollar on oil should not be material.

OPEC meets: The cartel is scheduled to meet tomorrow and is considering extending production cuts well into next year.  Saudi Arabia has already announced it will delay its IPO of Saudi Aramco until 2019, likely because low oil prices will reduce the valuation of the company.  We expect the cartel to extend cuts, but would also anticipate less compliance as time passes.

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