by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] We are seeing stronger equities, weaker bond prices and a stable dollar this morning.  Here’s the news we are following:

The FOMC: The Fed statement didn’t offer too many surprises.  It did admit that inflation is running below target but didn’t elaborate about the future path of inflation.  As expected, rates were left unchanged and the Fed indicated that balance sheet reduction would begin “relatively soon.”  Fed funds futures have now removed any more rate hikes this year, essentially indicating that balance sheet reduction will become the path of tighter policy.  The biggest market reaction came from the dollar, which fell sharply in the wake of the statement.  The greenback has stabilized this morning.

A new Sino-Indian War?  China and India fought a border war in the Himalayas in the early 1960s and the dispute has mostly been simmering ever since.  Although China and India really don’t want a war, partly because the ability to fight a war at the elevations involved is a deterrent, we are seeing a rise in tensions.  The issue is China’s decision to extend a gravel road in the disputed region between China, Bhutan and India, which has led India to boost troop strength in the area.  Under normal circumstances, we would expect mostly a war of shouting and then negotiations.  However, conditions have changed.  Chairman Xi is preparing for important party meetings in late October that will install new members of the Standing Committee of the Politburo.  This is his chance to surround himself with a “cabinet” aligned with his interests.[1]  Looking weak will undermine Xi’s ability to select his own supporters.  Meanwhile, Indian MP Modi has been pushing a nationalist agenda and cannot be seen backing down.  Finally, this conflict is escalating at a time when U.S. influence is waning and thus the ability for the U.S. to step in and stop the squabble has lessened.  As a result, what should normally be a local problem could become something more troublesome.  If a war breaks out, it would be bearish for risk assets of both China and India.

The end of LIBOR: The London Interbank Offering Rate (LIBOR), the benchmark for some $350 trillion of financial products, will be phased out by 2021.[2]  U.K. regulators are moving to scrap the current system, which is based on a rate set by a survey of large British banks in London.  The rate-setting process has been proven to be prone to manipulation and thus regulators want to change the current system.  In the U.S., LIBOR is really the overnight interbank rate and we expect some similar rate to replace the current LIBOR quote.  However, there may be some confusion until a new benchmark develops.

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[1] In China’s political structure, the first term of a new president is usually hampered by a Standing Committee that is packed with allies of former presidents.  In the second term, the sitting president gets to select more of his own allies.  Thus, unlike what we usually see in the West, a Chinese leader can become more powerful in the second term than in the first.

[2] https://www.bloomberg.com/news/articles/2017-07-27/libor-to-end-in-2021-as-fca-says-bank-benchmark-is-untenable-j5m5fepe

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Good Wednesday morning!  It’s Fed day.  Other than that, we continue to see the major U.S. equity indices quietly make new highs.  Good earnings and nothing earthshattering coming from Washington are playing a role in lifting equity values.  Here are the news items of interest today.

Fed day: There are two factors to watch for in today’s statement.  First, although we don’t expect the FOMC to actually begin balance sheet contraction today, we do expect them to signal strongly that it will begin in September.  Our take on balance sheet adjustment is that the doves on the committee are selling the hawks on the idea that reduction is tightening.  In reality, it shouldn’t be the case as most of the balance sheet sat innocently on commercial bank balance sheets as excess reserves.  Thus, reducing those reserves a bit probably shouldn’t affect the economy significantly.  Therefore, if Chair Yellen can convince the hawks that balance sheet reduction is tightening, it should lead to fewer rate hikes.  The problem for Yellen is the possibility that balance sheet cuts will actually act as a tightening by undermining investor confidence.  We don’t think this will be the outcome, but it is possible.  Second, we will be watching for comments surrounding inflation.  The FOMC has continually suggested that the weakness in inflation has been due to a succession of one-off events.  We suspect this simply isn’t the case; deregulation, globalization and the subsequent suppression of labor costs are keeping inflation down.  What isn’t part of this equation is monetary policy.  Really, since probably the early 1990s, monetary factors have become mostly irrelevant to inflation (but not to asset prices).  Unfortunately for the Fed, they have a mandate for inflation and probably have no tools to achieve that mandate, at least not under current conditions.  Thus, if they admit that inflation remains low and perhaps for structural reasons, it begs the question as to why raise rates at all?  The best answer is to prevent “irrational exuberance” in the asset markets.  But, that means the Fed would be targeting equity values as policy, a “third rail” in the Fed’s relations with Congress.  To recap—we look for no rate change and no balance sheet reductions, but signaling for reductions to commence in September.

Trump ♥ Yellen?  It has been widely expected that the president is planning to replace Chair Yellen in February, with Gary Cohn as the lead candidate.  That is probably still the most likely outcome.  However, Trump is, at heart, a soft money guy…he wants low rates and easy credit conditions.  That is, by the way, a common position with presidents.  Establishment Republicans represent the creditor class; they are hard money types.  Thus, when one hears “rules-based policy,” that really means, “higher interest rates, tight money.”  After all, for a creditor, easy money is an anathema.  As a lender, I would get paid back in less valuable dollars.  There may be one of two things going on here.  First, Trump may be leaning toward replacing Priebus with Cohn, meaning that he may decide his next best alternative is Yellen.  Second, Trump wants a soft money Cohn and is beginning the signaling process to let Cohn know that if he wants the chair job, he needs to be a soft money guy.  Otherwise, he will stay with who he has now, a dove.

North Korea and ICBM: The WP[1] is reporting that North Korea could cross the ICBM threshold as early as next year, two years sooner than earlier estimates.  There are still two hurdles North Korea faces to directly threaten the U.S.  First, it must manage to build a warhead capable of reentry.  The stresses of leaving space and entering the atmosphere are formidable but there are clear indications that the country is working on it.  Second, North Korea hasn’t proven it has built a miniaturized bomb that can be put on a missile.  So far, all we have seen from the Hermit Kingdom are nuclear devices, which are essentially lab experiments.  A missile-deliverable bomb may still take a while to achieve.  But, it is clear that the U.S. is not saying anything to deter North Korea from its path toward directly threatening the U.S.

Macron mediates peace in Libya: Libya’s two main rival leaders, Fayez al-Sarraj and Khalifa Haftar, have agreed to a ceasefire and promised to hold elections next year.  The former is the UN-backed PM of the official government of Libya, while the latter is a military leader that controls much of the eastern part of the country.  This action is important on a number of levels.  First, peace coming to Libya would be a bearish factor for oil as we would expect Libyan oil production to recover.

Libyan production could reach its pre-crisis levels of 1.5 mbpd.  Most recent production estimates are around 0.8 mbpd, so the additional oil would be difficult for the market to absorb.  There are still issues to be resolved.  Al-Sarraj is the UN-selected PM but has little power.  Militias control much of western Libya’s oil and may not be impressed with this deal.  Second, peace in Libya might reduce the flow of refugees into Europe, which would be supportive for the European economy (at least in the short run).  Italy is a bit miffed that Macron has acted as mediator.  Libya was an Italian colony and it still believes it should have the most European influence in the country.  Macron is showing, again, that he is a disruptive actor in Europe.

The EU acts against Poland: The EU is opening an investigation into Polish legislation that would change the court system.  We doubt this will stop the ruling party in Poland from moving forward on this legislation but Poland could find itself increasingly isolated from the EU.  In the end, after Brexit, that might not matter much.

Dovish talk from the Reserve Bank of Australia (RBA): The RBA Governor Lowe indicated today that, due to low inflation, he remains “comfortable” with low policy rates.  The AUD has been strengthening recently on expectations of better growth, but continued low inflation readings will likely keep the RBA from raising rates in the near term.  We do view the AUD as undervalued and would not expect the RBA statements to lead to a reversal in recent trends.

Iran vs. U.S.: The U.S.S. Thunderbolt fired two bursts of machine-gun fire at an Iranian naval vessel that approached at a very fast pace.  The Iranian warship came within 150 yards of the U.S. ship before the American vessel opened fire.  According to reports, these provocative acts have been increasing recently.  We suspect the Iranians (and, for that matter, the Russians and the Chinese as well) are testing the new U.S. administration for its reaction to these provocations.

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[1] https://www.washingtonpost.com/world/national-security/north-korea-could-cross-icbm-threshold-next-year-us-officials-warn-in-new-assessment/2017/07/25/4107dc4a-70af-11e7-8f39-eeb7d3a2d304_story.html?utm_term=.59ce09a7c18c

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s another quiet summer trading day.  Here are the items making news:

The FOMC meeting begins later today: The Fed has created a problem for itself.  The U.S. central bank meets every six weeks (or eight times per year), but because it makes four meetings out of each year more important by issuing dots, economic forecasts and holding a press conference, the markets mostly ignore the meetings that don’t have those events.  This is one of those meetings.  Although the Chair and other FOMC members continue to warn us that all meetings are “live,” that perception isn’t going to change until they actually take significant policy action outside of the meetings with press conferences.  So, the Fed finds itself in a situation where it really only meets four times a year.  That probably isn’t enough for a major central bank.  The solution?  Either end the dots and press conferences altogether, add them to all meetings, or make a major policy change at a meeting without a press conference.  How does this affect markets?  The financial markets are mostly ignoring this week’s meeting and so we could see some volatility if the FOMC actually does something.  However, we view the likelihood that anything happens as very low.

German business—I’m so happy!  The German IFO index (see below) unexpectedly hit a new record high, with the July number reaching 116.0.  The monthly survey of some 7k firms operating in Germany is reaching “euphoria,” according to IFO Chief Clemens Fuest.  According to interviews with German firms, the recent rise in the EUR is being managed successfully which probably means further gains in the exchange rate are possible.  European equities lifted on the news.

Is shale drilling starting to slow?  One feature of the oil market has been the relentless rise in U.S. production.  Bloomberg[1] is reporting that Halliburton (HAL, 42.51) warned that exploration companies are “tapping the brakes.”[2]  Anadarko (APC, 44.21) fell sharply overnight after reporting a larger Q2 loss than expected.  The company announced a cut in its capital budget and its production forecast for next year.  If this becomes a trend among other companies, the price pressure coming from shale could ease.  This would be good for oil prices in the short run, even though it may not be helpful for oil equities, at least initially.

These charts show U.S. oil production with a long-term view on the left chart and production over the past 32 years on the right.  Note the lift in production since November 2016.  If that production begins to stall, we could see oil prices move higher.  We note that oil prices are higher this morning.

China prepares for war?  The WSJ[3] is reporting that China is increasing its military presence along its border with North Korea.  In some respects, this is merely an update to reports we have been hearing for some time about troop movement on the North Korean frontier.  However, the article did note some policy signals from Beijing.  China wants to avoid a flood of refugees and doesn’t want a hostile power aligned with the U.S. directly on its border.  Thus, the article hints that the People’s Liberation Army (PLA) is likely drawing up plans to invade North Korea to set up a safe zone so that refugees will move there instead of into China, and it also may be taking steps to secure the nuclear facilities.  Essentially, if the U.S. attacks, China wants to remove the Kim regime and establish another buffer government, one that can more easily be controlled by the U.S. and China.  The danger is that China is making it clear that if the U.S. intervenes militarily in North Korea, the Chinese will as well.  This could lead to a bigger war if both sides are not careful in their actions.

China and Russia hold joint naval exercises: The FT reports[4] that Russian and Chinese warships are holding exercises in Baltiysk, the home port of Russia’s Baltic fleet in the Russian enclave of Kaliningrad.  China is slowly expanding its naval “footprint” and joining up with Russia clearly gets the attention of the West.  The NATO frontier nations, especially the Baltic States, will be watching these exercises closely.

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[1] https://www.bloombergquint.com/business/2017/07/24/anadarko-cuts-drilling-plan-as-oil-explorers-bow-to-price-slump

[2] https://www.bloomberg.com/news/articles/2017-07-24/frack-giant-halliburton-adds-1-billion-in-sales-during-recovery

[3] https://www.wsj.com/article_email/china-prepares-for-a-crisis-along-north-korea-border-1500928838-lMyQjAxMTE3ODI4NDkyMDQ0Wj/ (paywall)

[4] https://www.ft.com/content/1dfabf08-7076-11e7-93ff-99f383b09ff9?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56 (paywall)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s another quiet, summertime session.  Here are the items we are watching this morning:

OPEC meeting: The OPEC meeting is wrapping up with no new production cuts.  However, Saudi Arabia has promised to reduce its oil exports which is modestly positive.  As we noted last week, Saudi oil exports tend to fall in the northern hemisphere summer due to rising electricity demand in the kingdom.  Thus, the decision to “reduce” exports has more to do with the need for domestic energy.  It is a bullish move in the short run but we doubt exports will remain at summer levels once autumn comes.  In addition, Kuwait noted that the cartel may extend production cuts past Q1 2018, taking a page out of the central bank’s playbook of managing expectations.  Over the past decade, central banks have used the concept of “forward guidance” to steer policy expectations.  Kuwait’s comment hints that the cartel may be planning something similar.  Overall, the meeting was neutral to negative for oil prices; the market was hopeful that OPEC would announce further production cuts, but didn’t expect them.  If Saudi oil export cuts allow for a drop in U.S. oil inventories, it would be bullish for oil prices.

Venezuelan sanction threats get serious: The Trump administration is considering financial sanctions on Venezuela that would prohibit the Venezuelan state oil company, PDVSA, from making dollar transactions.  This would mean the country would be isolated from the U.S. financial system and the global reserve currency.  Since oil is priced in dollars, this would be a major blow to the country.  Although PDVSA could accept another currency, say, the EUR, the European banks would not want to risk U.S. sanctions and probably would not participate in PDVSA transactions.  This would leave Venezuela to the “tender mercies” of Russia and China, both major creditors of the Maduro government.  The U.S. has threatened the sanctions if the Maduro government goes ahead with making a new constitution.

The importance of “Mooch”: Last week, President Trump shook up his White House by appointing Anthony Scaramucci as communications director.  Known as “Mooch,” his appointment was vehemently opposed by Chief of Staff Priebus and Advisor Bannon.  On the face of it, this appointment shouldn’t affect markets directly so, normally, we wouldn’t comment.  However, this one may change the shape of things and thus requires some examination.  It appears that Priebus’s objection is mostly personal; he doesn’t seem to like Scaramucci and the appointment undermines Priebus’s authority since Scaramucci will directly report to the president.  The resignation of Priebus’s ally, Sean Spicer, further undermines the Chief of Staff.  Bannon’s distrust of Scaramucci is more due to his Wall Street ties.  Bannon fears that Trump has another establishment figure who will fall in line with Mnuchin and Cohn.  Here are some reasons we are watching this appointment with interest.  First, if Priebus resigns, and odds are high that he will, Cohn is the most likely replacement.  This might mean he won’t become Fed Chair and would reopen this position.  Kevin Warsh would be the likely leading candidate for Fed Chair (Warsh is probably a hawk).  Second, if Bannon decides he is isolated and the establishment has won, he too may resign and the populist cause is probably lost.  Thus, the Mooch appointment could be a big deal.

The sanctions bill: A bill putting new sanctions on Russia, Iran and North Korea is headed for the president’s desk.  Although there is much controversy surrounding Russia, most presidents don’t like foreign policy from Congress.  As with every bill, the president will have two choices; he can sign the bill and limit his ability to operate in foreign policy.  Or, he can veto the bill and raise concerns that he is unwilling to punish Russia and cause more headaches for the White House.  We suspect he will reluctantly sign the bill, especially because it also includes actions against Iran and North Korea.  At the same time, we want to reiterate that no administration wants foreign policy meddling from Congress.

Infrastructure looks dead: The NYT reported over the weekend that a move to boost infrastructure spending has mostly fallen by the wayside.  The establishment GOP was never much in favor of spending on fears it mostly bolsters Democrat Party supporters; in addition, they didn’t want to raise the deficit or increase taxes to fund spending.  There has been some interest in public/private partnerships but those are limited to projects that generate a stream of income.  In a world with very low interest rates, if such projects were easily feasible, one would think they would have already been funded.  Allowing infrastructure spending to stagnate will potentially hurt the president in 2020 as his support of such a program was popular with the right-wing populists.

Capital flight discussed: Emily Badger had a column in yesterday’s NYT discussing the impact of foreign capital flight into local real estate markets.  The influx of foreign money has tended to raise prices in these select areas, boosting the wealth of existing homeowners but making it difficult for new buyers to afford housing in these areas.  The article mentions that China alone invested $153 bn in U.S. real estate last year (03/16 – 03/17), up 49% from the previous year.  We suspect the money coming in is price insensitive as it represents an “escape pod” for wealthy foreigners looking to secure a space in the U.S. in case of future unrest at home.  For the U.S., these inflows are a mixed bag.  The investment should be welcome but the concentration of buying does affect American buyers and can force U.S. citizens to live in regions that are not their first choice.

Manafort, Kushner, Trump (Donald, Jr.) testify today: The session before the Senate Intelligence Committee is closed and not under oath.  We don’t expect anything initially out of the testimony, although we do look for leaks to emerge in the coming days.  If there is anything to this Russian situation, this meeting will be the preliminary one.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Friday!  Here are the items we are following this morning:

Pardon me:  Numerous media reports indicate that the Trump administration is exploring pardoning options and ways to ring fence Special Counsel Mueller’s investigation.  There are overtones of Nixon in these comments.  First, seeking pardons when no one has reportedly done anything wrong suggests that there is fear that something illegal will be found.  Second, Special Investigators have wide latitude once an investigation gets underway.  Trying to restrict an investigation (or for that matter, pardoning protocol) gets into legal gray areas over the boundaries of presidential powers.  Of course, our concern remains focused on financial markets.  One of the patterns we have seen recently is that equities tend to maintain strength while other financial areas seem to be reacting to these issues.  For example, we have seen Treasuries strengthen in recent sessions after yields had backed up earlier in the month.  Our position on the dollar is that the greenback is overvalued because the forex markets rapidly discounted tightening Fed policy (see the Asset Allocation Weekly below for details).  However, it is possible that recent dollar weakness is also a reaction to the growing turmoil in Washington. The fact that the dollar appreciated yesterday despite a rather dovish press conference and statement from ECB’s Draghi suggests that factors other than monetary policy are underpinning dollar weakness.  Simply put, the political issues in Washington are not adversely affecting equities yet, but that doesn’t mean that other financial markets are not reacting to these events.

Brexit concerns:  The May government appears deeply divided over how to execute Brexit, reflecting Tory divisions that are similar to issues within the GOP here.  The populists want a “hard” Brexit that will restrict the ability of foreigners to work in the U.K. and loath to pay the EU “exit fee” for leaving.  The business wing of the Tories wants a “soft” Brexit that will maintain London’s financial pre-eminence which means that Brexit really isn’t much of a break with the EU.  Unfortunately for Britain, there are elements within the EU that see opportunity from Brexit and are goading the Tory negotiators toward a hard Brexit so as to bring much of London’s financial business to the continent.  Given PM May’s poor election performance, we suspect that her government is likely to face a no confidence vote at some point; the confusion we are seeing in negotiations may simply reflect the lack of an electoral mandate.

China v. India:  China and India fought over disputed parts of their border in the Himalayas in 1962.  Currently, the two states are facing off in the Doklam plateau, which is at the trisection of India, China and Bhutan.  China is building a road in an area claimed by Bhutan and the latter is asking for Indian assistance in enforcing its claim.  This border dispute is part of rising tensions between the two countries.  India has quietly opposed China’s “one belt, one road” initiative and has recently joined naval exercises with Japan and the U.S.  As the U.S. profile declines in the region, tensions between India and China are likely to increase as both powers jockey for regional influence.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equity markets continue their quiet rise to new records.  Here are the items we are watching this morning.

ECB, BOJ lean dovish:  The BOJ came out overnight with nothing that wasn’t unexpected.  It is clear the bank won’t reach its inflation targets anytime soon, so it extended its deadline, making it the sixth time this has occurred under Abe.  The JPY weakened a bit on the news but since it was mostly anticipated, the forex move was modest.  The ECB has released its statement, which is almost identical to its last one.  The statement was taken as dovish by the markets.  In the press conference, Draghi remained dovish, suggesting that the ECB hasn’t laid out any plans for QE tapering.  Even though his opening comments and answers to questions were clearly dovish, the EUR rallied, European stocks fell and European sovereign yields rose.  However, we have seen a reversal in these prices after Draghi reiterated that tapering hasn’t been discussed.  Market behavior suggests that traders are focused on ECB balance sheet management.  Draghi is clearly keeping his “cards close to the vest” on revealing when tapering will begin.  Our view on market action suggests that it might be impossible for the ECB to avoid a “taper tantrum” once ECB QE ends.  Perhaps the most interesting market action is the EUR; the currency weakened after the statement then rallied during the presser.  It appears to us that the currency markets have concluded the dollar is going down, most likely because the ECB will eventually act to reduce stimulus.

U.S./China trade talks stall:  Negotiators for both nations quickly reached an impasse at trade talks.  The Trump administration is taking the position that the bilateral trade deficit with China is a serious problem that can only occur due to unfair Chinese policies.  Commerce Secretary Ross said, “If this were just the natural product of free-market forces, we could understand it, but it’s not.  So, it’s time to rebalance in our trade…”  Evidence of the differences between the two parties emerged when the U.S. canceled a scheduled news conference which was set for the two parties to reveal concrete proposals on trade.  It appears to us that China has no intention of changing its trade policies and its plan to deal with this trade spat is endless negotiations.  That would have worked before; although previous administrations clearly didn’t like the bilateral trade deficit, they understood that the superpower role necessitated a U.S. trade deficit.  The Trump administration, in our analysis, is preparing to withdraw from that role which ends the need for persistent U.S. trade deficits.  Thus, implementing trade barriers and ignoring the WTO are consistent with this position.  America’s more isolationist trade policy is a significant threat to the Chinese economy. 

Poland’s judicial crisis:  The Polish government has already increased control over the media, restricted public meetings and taken other steps.  Now, it is taking direct aim against the independent judiciary.  The populist Law and Justice Party has introduced bills that would force all the judges to resign, save those appointed by the aforementioned party.  Other bills would give the government greater control in appointing judges.  The EU has indicated that the actions against the judiciary, coupled with other moves, may mean Poland would no longer be considered a “democracy” by Brussels.  If this determination were to be made, it could lead to Poland losing its vote in the EU Parliament.  In one sense, this isn’t a big deal; it isn’t clear how much sovereign impact the EU Parliament has anyway.  However, calling Poland a non-democracy might trigger the decision to leave the EU, leading to Polexit.  Although there isn’t much discussion of Poland leaving the EU, the party in power will strongly oppose outside pressures and may conclude that being outside the EU will strengthen Poland’s sovereignty.  Another nation leaving the EU would seriously undermine the union.

The naming of a new Saudi Crown Prince looks like a coup:  Major U.S. media[1] are publishing reports that detail how the former Crown Prince Nayef resigned from the post and was replaced by his cousin, the former Deputy Crown Prince Salman.  We will have much more to say on this in future WGRs but we mention it here because it shows that the potential for leadership instability is rising in Saudi Arabia.  If instability rises, we would expect oil prices to rise.

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[1] https://www.nytimes.com/2017/07/18/world/middleeast/saudi-arabia-mohammed-bin-nayef-mohammed-bin-salman.html?hp&action=click&pgtype=Homepage&clickSource=story-heading&module=first-column-region&region=top-news&WT.nav=top-news&_r=1