by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]The summer doldrums are upon us.  Financial markets are very quiet this morning in front of tomorrow’s ECB meeting and press conference.  Here is what we are watching this morning:

The ECB:  The EUR has been rising recently, in part due to expectations the ECB will begin the process of withdrawing stimulus.  We expect Draghi to offer a very slow path of tapering with lots of comments suggesting that the Eurozone recovery remains fragile and that policymakers must be careful to avoid tightening too quickly.  We do expect signaling that a plan for tapering QE and the eventual path of ending balance sheet expansion will be detailed in September.  Overall, the EUR has been strengthening and the risk is that traders have overestimated the pace of stimulus withdrawal.  However, if our read for tomorrow’s meeting is accurate, the EUR should maintain recent gains.  Anything that signals faster withdrawal of stimulus will lead to further currency strength.

Sanctions on Venezuela:  The Trump administration is reportedly considering sanctions on Venezuela if the Maduro regime decides to rewrite the country’s constitution.  The fear is that a new constitution would move Venezuela to a Cuban-style government, dispensing of contested elections and ensuring that Maduro and the Chavistas will be permanently in power.  The key threat is the U.S. will ban Venezuelan oil exports to the U.S.  Venezuela generally provides around 0.6 mbpd, or about 8% of U.S. gross oil imports.  Although we expect the U.S. oil market to be able to handle the loss of this oil, it may cause some short-term disruptions.  Venezuela mostly sells heavy, sour oil to the U.S. because American refineries have the ability to refine such crude oil.  If Venezuelan imports are disrupted, some refineries may scramble to find heavy, sour oil and we may see a temporary decline in refinery operations.  The sanctions will hurt Venezuela more than the U.S. but our oil infrastructure won’t be completely unscathed if sanctions are introduced.

GCC backs off:  The WSJ[1] is reporting that the GCC has revised its demands that Qatar must meet to see the current blockade lifted.  Specifically, it looks like Al Jazeera will not be forced to close and some clerics sympathetic to the Muslim Brotherhood will be allowed to remain in Qatar.  Although Qatar has not reacted warmly to this overture so far, we suspect that pressure from Turkey and the U.S. led the GCC to ease its demands.  We would not expect the same parties to lean on Qatar to accept the new “principles” as opposed to demands, from the GCC.  The U.S. does need the GCC to work together to combat Iranian designs for the region and this recent dispute between the GCC and Qatar doesn’t support U.S. policy.

Off to taxes:  After the legislative failure to deal with the ACA, the party is mostly moving on to taxes, primarily corporate taxes.  The first issue will be whether we simply see cuts in rates or if broader reform is enacted.  We suspect the president, who would like to see some major legislation signed before year’s end, will opt for simple cuts which could be done faster.  However, it’s likely such cuts, which will probably increase the deficit, won’t be given permanent status.  The House GOP would prefer broader reform which could then yield permanent tax cuts.  However, broader reform will require spending cuts or reduction in tax expenditures to make the tax rate declines revenue neutral and negotiating such changes will slow the process down.  We are leaning toward reductions in the tax rate and higher deficits.

 

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[1] https://www.wsj.com/articles/qatars-critics-scale-back-demands-in-diplomatic-bid-1500441047

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Although global equity markets are steady to lower this morning, there is a lot of action in the forex markets.  The dollar is sliding on a combination of lower expectations for Fed policy tightening and the lack of policy progress from the Trump administration.  Here are the news items we are tracking this morning:

GOP Senate healthcare dies:  Senate Majority Leader McConnell’s efforts to craft a replacement bill for the ACA fell apart overnight as he could not round up 50 GOP votes to pass a bill.  This is a deep blow to McConnell’s leadership.  There are reports he will now move to a straight ACA repeal, but our sources indicate this vote can’t occur as part of the reconciliation process and thus needs 60 votes, ensuring defeat.  If this is true, all the GOP senators would vote for it but the repeal will never reach the floor because the Democrats can filibuster it.  Why is this important?  It suggests the GOP can’t govern.  This is actually a characteristic we are seeing across the U.S. political landscape.  Two-party systems are forced coalitions.  There are wide divergences in the positions among various groups within parties (we believe these divergences will eventually lead to a realignment of the parties in the coming years).  When a party is out of power, these divergences tend to be papered over in the interests of returning to power.  However, once in power, these different groups believe they are the “real Democrats” or the “real Republicans” and they push a narrow agenda that, shockingly, fails to gain a majority.  The GOP is clearly divided and these divisions killed the healthcare effort.  Now the worry is that these divisions will not only prevent tax reform and infrastructure spending, they may not even get the debt ceiling increase accomplished without drama.   If the GOP can’t get legislation passed, it weakens the outlook for change.  We believe that is showing up today in dollar weakness; after all, if fiscal spending isn’t coming and investor sentiment weakens, the Fed won’t raise rates as much as expected.  On Friday, we will release our new Asset Allocation Weekly; its focus is on the dollar.

OPEC drama:  Oil prices have jumped this morning on rumors the Saudis are planning to cut oil exports.  We may actually see reductions but only because air conditioning demand in the Saudi summer is driving up consumption.  On the downside, Ecuador announced it will no longer comply with its 26 kbpd pledged cut in output because is simply can’t afford the loss of revenue.  Although Ecuador’s defection, by itself, won’t be a major factor in weakening prices, it may encourage other defections which would be a problem for the cartel.  We still expect the Saudis to make strenuous efforts to prop up oil prices into next year’s Saudi Aramco IPO (expected now in Q4 2018) which should prevent a sustained price decline.  In addition, dollar weakness is a major supporting factor for oil prices.

China crackdown continues:  Chinese banking regulators have instructed some lenders to lower the rates they offer on wealth-management products (WMP), which have become alternative investment products due to low deposit rates  As the PBOC tightened the money supply, lenders have raised the rates on WMP to a 17-month high in a scramble to acquire lendable funds.  The PBOC tightened the money supply to support deleveraging.  The banks are trying to offset the PBOC’s efforts via WMP funds.  The risk for the banks is that lowering rates on WMP will deprive them of lendable funds which will slow lending and economic growth.  And, households may again increase their attempts to move funds offshore in search of higher returns.  For years, China has abused the household sector through financial repression; this has led to rising real estate prices and the search for higher returns in overseas markets.  China has been trying to stem the currency outflow through a number of regulatory tactics but the best way to keep the money at home would be to offer higher domestic financial returns to the household sector.  Unfortunately, the more the household sector earns, the less the banking and business sector earns.  Policymakers have generally been captured by the business sector and thus have based their economy on household financial repression.

The RBA turns hawkish:  Although the Reserve Bank of Australia didn’t move on rates, in the minutes from its July 4^th policy meeting, the bankers suggested a policy goal of a “nominal neutral cash rate” of 3.5%, which would imply a 200 bps rise in rates is in the offing.  It is unclear if policymakers are really intending to lift rates this aggressively, but in an environment of increasing dollar disappointment, even offhand comments that suggest potential tightening lead to currency strength. The AUD has jumped to its highest levels since May 2015 on this news.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It was another quiet weekend.  Here are the news items we are tracking this morning:

China economy:  GDP, somewhat predictably, came in a bit stronger than expected, at 6.9% (y/y%).   It’s important to remember that China can generate any growth number it wants as long as it has debt capacity.  Total social financing, the broadest measure of lending, rose 14.7% in June (y/y%).  Recent media reports indicate that the housing boom is exhibiting signs of overheating;[1] we noted that property investment rose 8.5% in H1, above last year’s 6.9% rise over the same period.  Orders from Chairman Xi to the State Owed Enterprises (SOE) to reduce their debt levels does suggest that the Chinese leadership is aware it is creating a debt problem.  The tradeoff, however, is daunting; it’s about impossible for China to grow at the above rate and simultaneously deleverage.

Xi prepares for October:  The PRC holds its annual leadership meetings in late October and this is a special one because it will announce Chairman Xi’s nomination for a second term.  Over the weekend, the party announced that Sun Zhengcai was being replaced as Party Secretary of Chongqing.  Sun was considered a possible successor to Chairman Xi in five years so removing him from power and indicating he is under investigation (effectively ending his political career) at least allows Xi more power in building his own Standing Committee of the Politburo and may be an early ploy to give Xi a third term which would be the first chairman to have more than two terms since Mao.  In the Chinese political system, the second term is usually the most important for a leader because in the first term, his rivals usually pick some of the members of the Standing Committee to maintain their influence.  In the second term, the chairman gets more leeway in building his own Standing Committee.

ECB, BOJ meet this week:  We don’t expect any surprises from the BOJ.  Market speculation suggests that ECB President Draghi will try to ease expectations of policy tightening by signaling the pace of balance sheet reduction will be very slow.  Although we don’t disagree with this goal, we do have doubts that Draghi can pull it off.  As former Fed Chair Bernanke discovered, once markets become fixated on easy policy forever, even the most modest of stimulus withdrawal can have surprising effects.  With Eurozone interest rates still negative in some countries, any hint of tapering will likely be a factor; we believe the most sensitive asset class will likely be forex, meaning any signal of tightening will appreciate the EUR.

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[1] https://www.nytimes.com/2017/06/15/opinion/chinas-real-estate-mirage.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] The CPI data came in weaker than expected, sending the dollar and Treasury yields lower.  We examine the data in the context of policy using our Mankiw model variations below.  Outside the inflation numbers, here are some of the other news issues we are tracking this morning:

More trouble for Donald Jr.:  It appears that there were other persons that met with Donald Trump, Jr., Paul Manafort and Jared Kushner.  Reports this morning suggest that there was also a lobbyist who was a former Soviet counterintelligence officer with suspected ties to Russian intelligence.  Whether this additional person is important or not isn’t really the problem.  The problem is that as new information continues to drip out, the administration is forced to deal with the Russian problem constantly and this is burning political capital that isn’t being used for other policy goals, e.g., deregulation, tax cuts, infrastructure rebuilding, etc.

Abe’s support declines to critical levels:  A new poll shows that Japan’s PM Abe’s favorable ratings have dropped to 29.9%, the lowest since he took power for a second time in 2012.  He has been hit be a couple of scandals.  Although Abe’s term won’t expire until September 2018, such low ratings will tend to undermine his ability to push through policy changes.  If Abe falls, it is probably bullish for the JPY, as it will appear that Abenomics has failed and the experiment of aggressive BOJ QE, fiscal spending and deregulation didn’t resolve Japan’s problem and thus, nothing will work.  That would likely lead to expectations that the BOJ will have to lift its extremely accommodative monetary policies because they will appear to have failed.

The debt ceiling:  While the Senate continues to work through its vacation on health care, the debt ceiling clock continues to tick closer to “midnight.”  Bloomberg[1] is carrying a report today suggesting that the Treasury is dusting off old Obama administration procedures to deal with potential default, including a program to prioritize paying interest on Treasuries while delaying other spending.  The Obama plan would pay interest on the Treasury debt, Social Security, veterans benefits and entitlements, roughly in that order.  All other spending would likely be delayed and the longer the crisis extends a higher probability some entitlement payments might be delayed as well.  The markets seem to be comfortable that nothing bad will happen; credit default swap prices for 5-year T-notes is running around 22 bps.  At the peak of the last debt ceiling crisis in 2011, they almost hit 70 bps.  Although there is probably no good reason for this issue to become a crisis, the constant distractions in the White House may lead to the U.S. stumbling into a problem here due simple management failure.  We will report on the 5-year CDS periodically for signs of concern.

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[1] https://www.bloomberg.com/news/articles/2017-07-14/trump-may-have-to-use-obama-s-secret-debt-plan-worrying-markets

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Here’s what we are watching today:

Yellen, Round 2:  There was nothing in Yellen’s testimony that differed from her opening statement which the markets took as dovish.  Our comments yesterday appear to be mostly confirmed; the FOMC is shifting to emphasizing balance sheet reduction and less focus on rate hikes, which is being taken as bullish by financial markets.  Upon further reflection, the FOMC seems to be tying rate changes to inflation and balance sheet contraction to the economy.  If this is the case and inflation remains below target but labor markets continue to be tight, balance sheet reduction could begin as early as autumn.  If this impression is what the Chair wanted to signal, we shouldn’t see any deviation from yesterday’s discussion.  On the other hand, if the market’s impression was flawed, the Chair may signal otherwise.  Although it’s rare for this adjustment to occur, Chair Greenspan did make that change when he felt the markets overestimated his position.  We don’t expect that today.

IEA bearish:  The IEA reported that OPEC compliance declined to 78% in June, down from a remarkable 95% in May.  The violators were Algeria, Ecuador, Gabon, Iraq, the UAE and Venezuela.  Saudi Arabia, Kuwait, Qatar and Angola remained compliant.  Because of this increase in cheating, the IEA suggests rebalancing will be further delayed.

SOS Tillerson in the Gulf:  The SOS left Qatar this morning on his way back to the U.S. after a tour of the region.  Tillerson is trying to calm tensions between Qatar and the rest of the Gulf Cooperation Council (GCC) nations.  We do note that Tillerson and Qatari officials signed an agreement on counterterrorism earlier in the week in a bid to respond to the GCC’s claim that Qatar was soft on terrorism.  The GCC indicated that the agreement “wasn’t enough” which suggests terrorism has little to do with the current disagreement; we suspect this is mostly about Al Jazeera.  The other GCC nations strongly dislike the news channel because it is an independent source of news that these nations can’t control.  It appears to us that the Saudis, after a warm set of meetings with President Trump, felt they had the backing of the White House to bring Qatar to heel.  Although the president seems to have sided with the Saudis, Tillerson and the rest of the national security apparatus appear to want this issue smoothed over.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] The Chair speaks: The text of Chair Yellen’s comments has been released in front of her testimony to Congress.  Market reaction is consistent with a dovish stance.  Here is the excerpt that is probably triggering the weaker dollar/stronger equities/stronger Treasuries/higher gold trade:

…based on our view that the federal funds rate remains somewhat below its neutral level—that is, the level of the federal funds rate that is neither expansionary nor contractionary and keeps the economy operating on an even keel. Because the neutral rate is currently quite low by historical standards, the federal funds rate would not have to rise all that much further to get to a neutral policy stance.

Essentially, Yellen is signaling that the path of rate hikes will probably be gradual; if we were allowed a question, it would be, “So how does this comment relate to the “dots” chart?”  We suspect that Yellen is signaling that she is at the lower end of the dots dispersion.  She also indicated that the reduction of the balance sheet will commence soon.

The balance sheet issue: We remain quite concerned about the balance sheet reduction.  Although the real impact of QE will be the subject of dissertations for the next decade, in our analysis, the primary effect was to bolster confidence.  In reality, the bulk of QE ended up on bank balance sheets as excess reserves.  Thus, removing these reserves shouldn’t have much of an effect, either.  However, given the unprecedented nature of this event, there is still the risk of unexpected outcomes.  We are noticing something interesting, though.  Yesterday, a five-star dove, Governor Brainard, said that she sees a “low cap” on interest rates but supports balance sheet reduction (similar to Yellen’s above quote).  It appears that there is near unanimity on the FOMC that reducing the balance sheet is a good idea and we suspect the doves are supporting this plan because it will divert the hawks from raising rates.  If it turns out that withdrawing QE is a non-event, the doves will win if the reduction slows the pace of rate hikes.

Cohn for Chair? Politico[1] has a long report suggesting Gary Cohn will likely be the next Fed Chair, replacing Yellen when her term expires in early February.  Cohn checks a number of boxes.  He is likely a moderate on policy, which will suit a “low interest rate” president.  Although the nationalists (Bannon, et al.) don’t really like Cohn and would like to see him back at Goldman Sachs (GS, 226.95), they would rather see him at the Fed than as chief of staff, another job he has been rumored to be heading toward.  He isn’t an academic economist, which is probably favored by a business president.  The hardline rules-based GOP members of Congress would not be all that pleased with a Cohn Chair, who has been a Democrat, but they would likely go along.  Although predicting a mercurial president is always tough, and reports suggest Trump isn’t focused on this issue yet, we do think this is probably Cohn’s job if he wants it.  And, if the administration is struggling (its political capital will be nearly depleted by Q1), exiting to the Fed might be a good career move.

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[1] http://www.politico.com/story/2017/07/11/trump-cohn-yellen-fed-240421