by Bill O’Grady and Thomas Wash

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

It’s official—Randal Quarles is likely the newest Fed governor: The Trump administration formally nominated Quarles for the chair vacated by Dan Tarullo.  His name has been in the media for several weeks, so the actual news wasn’t a surprise (since the GOP controls the Senate, his approval is a virtual lock).  In fact, the surprise is that it took this long to make it official.  It seems the administration wanted to fill all three openings at once; however, it was struggling to come up with a third candidate who would represent the community banks (it is widely expected that Marvin Goodfriend will also be nominated soon).  We expect Quarles to be bank friendly; he has supported lower capital requirements and has mostly represented the industry in his private law career.  He has also supported rules-based monetary policy, although there isn’t a lot of evidence that this is a core belief that would turn him into a hawk.  Overall, we look for moderate voting pattern from Quarles until proven otherwise.

U.S. to move unilaterally on North Korea: The WSJ is reporting[1] that the administration is unilaterally tightening sanctions on the Hermit Kingdom and targeting Chinese companies and banks that do business with the Kim regime.  The Treasury is specifically going after offshore dollar accounts held by North Korea with the cooperation of Chinese companies.  We have doubts that these moves will make much difference but it does suggest the White House is in no hurry to engage North Korea militarily.  The same paper has an interview with Robert Gates on how he would address the North Korean problem; as one would expect, it relies on China to bring the Kim regime to heel.[2]  There’s a lot to like in the Gates proposal.  One thing we would add—if China fails to deliver, the U.S. would support strategic nuclear weapons in Japan.  Nothing would get China’s attention faster.

 

War games: The U.S., Japanese and Indian navies are holding exercises in the Indian Ocean.  The People’s Liberation Army Navy has been sending an increasing number of warships into the Indian Ocean, raising India’s concerns.  Sea lanes are a critical part of China’s “one belt, one road” trade route goal and India is a potential road (or better, “sea”) block to completing this goal.  India has historically focused on its northern border with China as a security threat (India’s primary threat remains Pakistan), but is now realizing that the PRC’s rapidly improving blue water navy means it is now facing a southern naval threat as well.  India’s response appears to be to team up with the U.S. and Japan to constrain China.  We note that Australia has traditionally participated in these exercises but pressure from China led the country to withdraw from the games.  The fact that China’s economic influence is affecting how Australia manages its participation in regional security is a worry.

Rising U.S. oil exports: The FT[3] is reporting that an influential study says the U.S. will be exporting more oil than most OPEC members by 2020.  Surging U.S. production and changes in trade regulation are expected to boost exports to perhaps four times the current level by the aforementioned year.  According to the report, U.S. exports could reach 2.3 mbpd by 2020, which would exceed the exports of all OPEC members except for the UAE, Iraq and Saudi Arabia.  The U.S. is rapidly becoming a supply threat to OPEC and, over the longer term, lower oil prices are probably inevitable.  However, in the near term, the Saudi IPO will likely keep prices mostly in the $45 to $55 price range.

The battle for bitcoin: Although this issue is well known among the cryptocurrency cognoscente, there is a rapidly rising ideological split in the bitcoin community.  The issue, simply put, is whether the cryptocurrency should evolve into a payment system that would be used by mainstream corporations and the financial system or whether it should be a libertarian alternative to precious metals.  When bitcoin was created, to protect it from cyber-attacks, the design put a ceiling on the number of transactions the blockchain (the distributed ledger of transactions) could process.  As bitcoin has become more popular, this limit has slowed processing times and processing fees have increased.  This has made bitcoin less popular as a medium of exchange; simply put, a credit card within the banking system is looking more attractive as a means of payment.  To create bitcoin, “miners” process algorithms using large computers; the miners want to solve the problem by boosting the size of each blockchain.  The other proposal, supported by the developers of the bug-proof software, is to move some of the ledger data off the blockchain to be managed outside the network.  A compromise is possible.  The miners could get a partial increase in the blockchain size in return for moving some of the data off the main network.  The key date is August 1.  On that day, the majority of miners must adopt a new protocol called “SegWit.”  If they don’t, it is possible that two versions of bitcoin could begin circulating.  Although bitcoin remains a bit of a sideshow in the financial system, a breakdown could have unexpected effects in the financial system.  We will continue to monitor this issue.[4]

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[1] https://www.wsj.com/articles/u-s-prepares-to-act-alone-against-north-korea-1499707831?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top-stories

[2] https://www.wsj.com/articles/what-would-gates-do-a-defense-chiefs-plan-for-north-korea-1499697227?tesla=y

[3] https://www.ft.com/content/96df15aa-65b7-11e7-8526-7b38dcaef614?emailId=5964507e4c37ad0004e739fb&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[4] https://www.bloomberg.com/news/articles/2017-07-10/bitcoin-risks-splintering-as-civil-war-enters-critical-month

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Monday!  It’s officially mid-summer as baseball’s All-Star Game will be held tomorrow.

Global markets are rather quiet this morning.  Here are the headlines:

G-20: The U.S. is becoming steadily isolated in the world as per the design of the Trump administration (and, to be fair, this process predated this administration).  For example, the final communiqué noted free and fair trade, but there is really no way to accurately describe fair trade.  Fair trade is a euphemism for trade barriers.  We have been discussing this issue for nearly a decade—the U.S. public is tired of the burdens of hegemony and this weekend’s meeting is further evidence that the administration is responding to that fatigue.  Although there is brave talk among the rest of the group about making policy, in reality, without the U.S., the world order would have to be restructured and there is no power on earth that can fill that role at this time.  Our initial take on the meeting with Putin was a draw; the Russians appear no closer to getting sanctions lifted and President Trump faces a new controversy over Russian involvement in the presidential election.  On the other hand, his pre-meeting speech in Poland appeared to be a hit.  It should be noted that there has always been tension over how one defines “the West.”  It is either an intellectual concept or a matter of national origin.  In the former definition, anyone from anywhere who agrees with free markets, open borders, deregulation and globalization is a member.  The latter requires the social and cultural membership in the European project.  Although the first definition is usually considered the dominant one, the latter one has never gone away.  It is now becoming stronger and thus the idea of stronger nationalism is becoming more important.  That issue was evident in the meeting.

Yellen this week: On Wednesday and Thursday, Chair Yellen will speak before Congressional committees in what we used to call the Humphrey-Hawkins Testimony.  We expect her to lay the groundwork for balance sheet reduction and at least one more hike this year (and maybe two).  This could be her last testimony of this kind as her term will be near expiration during the next one.

Oil prices remain soft: Oil prices failed to hold early overnight gains as OPEC indicated it will not consider further cuts at its meeting on July 24.  There is talk about capping Nigerian and Libyan output.  As we noted last week, the data suggest that prices are a bit cheap here but we aren’t looking for anything beyond a trading range market for now.

IS loses Mosul: Iraqi and allied troops have mostly eliminated IS fighters from Mosul.  Although a great victory, pictures suggest it came at a horrific cost.  IS still controls areas in the region but it has lost a major urban center and is thus becoming a smaller threat.  On the other hand, the vacuum that the IS collapse will bring is perhaps an equally vexing problem.  The next battle for the region will involve powers filling these gaps that used to be under IS control.

Grains up on dry, hot weather: The mercury is expected to top out at 97° today, with drought conditions in place in the spring wheat areas.  This is boosting grain prices.  This time of year, prices tend to swing every four hours as the NWS releases new maps.  Still, this hot weather will likely have some negative effect on crop yields; how much damage is dependent on how long the hot weather lasts.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy employment day!  The employment data is covered in detail below but the snapshot of the data is supportive.  Payrolls rose 222k compared to forecasts of 178k; we also saw a 47k upward revision, making the report robust.  The unemployment rate came in at 4.4% versus expectations of 4.3%, mostly due to a rise in the labor force and increased participation.  Wage growth remains sluggish at 2.5%.

There is not much new to report on the G-20.  We expect a contentious meeting where the differences between the emerging American policy of exiting the hegemonic role collide with the rest of the world’s terror at realizing the U.S. world order of the past 72 years is coming to a close.  It should be noted that this retreat has been underway since 2008 and President Trump is merely making the case more clearly, but the American public, painfully aware of the costs of hegemony but inured to the benefits, has simply had enough of supporting the world.  We note that Japan and the EU have apparently negotiated a new trade deal.  This will be interesting to watch—how does a trade deal work between two parties that are running export-promoting policies?  In addition, trade rests on the U.S. providing global security.  Who will guarantee the sea lanes between Japan and Europe?  China?  Overall, we don’t expect much out of the G-20 other than clarity that the world is changing rapidly.

U.S. crude oil inventories fell 6.3 mb compared to market expectations of a 2.5 mb draw.

This chart shows current crude oil inventories, both over the long term and the last decade.  We have added the estimated level of lease stocks to maintain the consistency of the data.  As the chart shows, inventories remain historically high but they are declining.  We also note that, as part of an Obama era agreement, there was a 1.4 mb sale of oil out of the Strategic Petroleum Reserve.  This is part of a $375.4 mm sale (or 17.0 mb) done, in part, to pay for modernization of the SPR facilities.  We note that sales have reached 13.1 mb this year, which likely means we should see these sales end in the coming weeks.  International agreements require that OECD nations hold 90 days of imports in storage.  Due to falling imports, the current coverage is near 140 days.  Taking that into account, the draw would have been 6.7 mb, which is an even more impressive draw.

As the seasonal chart below shows, inventories are usually well into the seasonal withdrawal period.  This week we saw an acceleration in the decline.  Some of this was likely due to weather disruptions caused by Hurricane Cindy.  Still, we have already seen a larger than normal seasonal decline and the seasonal trough isn’t usually hit until mid-September.  Thus, we should see further stock withdrawals over the next couple of months.

Based on inventories alone, oil prices are overvalued with the fair value price of $40.27.  Meanwhile, the EUR/WTI model generates a fair value of $52.55.  Together (which is a more sound methodology), fair value is $48.61, meaning that current prices are well below fair value.  Currently, prices are below our expected trading range; we view oil prices as attractive on a short-term trading basis.  Yesterday’s DOE data was bullish.  The drop in prices is therefore a worry because markets that fail to positively react to bullish data usually face further selling.  We do expect oil prices to rise in the coming weeks, simply because the fundamentals are supportive.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s a fairly quiet morning, typical of mid-summer.  Here are the issues we are watching:

Fed minutes: Most of the media recaps focused on the reduction of the balance sheet.  As we have noted in the past, in theory, this action shouldn’t be a big deal.  Most of QE ended up sitting harmlessly in the banks as excess reserves.  Simply put, the funds from QE were injected into the banking system and then simply sat.  Thus, taking them away shouldn’t have much of an impact.

As this chart shows, excess reserves are almost 13x more than required reserves.  Since tapering began, the level of excess reserves has started to decline but still remains high.  Therefore, removing some of these reserves probably won’t prevent loans from being given.

The bigger concern is the psychological impact of shrinking the balance sheet.

This is a chart we have shown for a while with a new twist; we assume the Fed will begin its process of reducing the balance sheet in September and follow the plans previously released.  Obviously, if the balance sheet affected equity markets in a mechanical fashion, a bear market is looming.  We don’t think this is the case.  We believe that the impact of QE on equities was to reassure investors that the Fed wasn’t lacking tools to stimulate the economy.  If investors are confident about continued economic growth, the impact of balance sheet contraction shouldn’t be a big deal.  However, since we have never seen anything like this before, it is difficult to quantify the risk factor.

Buried in the minutes were concerns expressed about the “increased risk tolerance” of investors as a reason for tighter policy.  As we have noted before, the Fed has lost control of financial conditions.  Until the late 1990s, the Fed could affect financial stress via changes in fed funds.  That relationship broke down in the late 1990s.

This chart shows the relationship of the Chicago FRB Financial Conditions Index and fed funds.  The blue line measures financial stress, with a higher number indicating elevated stress.  Note that the two series were tightly correlated from 1973 into 1998.  Since then, the two have become almost completely independent.  We believe that the primary reason for the breakdown is transparency; from the late 1980s to the present, the Fed has become increasingly transparent and the more the Fed telegraphed its policy actions, the less policy activity affected stress.  Thus, when financial conditions deteriorated in 2007-10, the policy rate fell to zero and had to be held there before stress declined.  We note that NY FRB President Dudley suggested in a recent speech that the FOMC should be raising rates due to low levels of financial stress.  This could be considered a type of “controlled burn” by the Fed.  What is interesting is that if the relationship between fed funds and the above stress index had remained consistent since the 1973-98 period, then financial stress would be almost twice as low!  Thus, if the FOMC raises rates to lift stress, it will almost certainly overtighten.  This says nothing about the policy nightmare the Fed would face if it made the P/E a policy goal.

The takeaway from the minutes is that the FOMC is on a path of policy tightening and risks will rise over time.

The G-20: This promises to be a contentious meeting.  Merkel and Trump are not getting along.  The presidents of Russia and the U.S. will meet for the first time.  There is talk of trade wars over steel tariffs.  Given that expectations for this meeting are already low, it is hard to imagine there will be a disappointment.  Normally, G-20 meetings are snoozers.  We do expect some friction given all the tensions in the world, but the most likely outcome is that the meeting “won’t be that bad,” mostly because our expectations are so depressed.

North Korea: There isn’t much new to report.  The UNSC took up the issue yesterday.  As expected, Russia and China were reluctant to press hard on North Korea.  The U.S. is making military threats but there isn’t much evidence of mobilization.  As we have noted before, there are no good outcomes with North Korea.

Employment day tomorrow: Current forecasts call for non-farm payrolls to rise 177k, with an unemployment rate of 4.3% and average hourly earnings rising 2.6%.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Back to work!  Here are the items we are following this morning:

North Korea’s ICBM: Over the holiday, North Korea launched an ICBM that is at least capable of reaching Hawaii and Alaska and could hit much of Asia, along with northern Australia.  Although there is no official red line from the Trump administration, an ICBM that could hit the U.S. mainland is probably it.  As we discussed recently in our WGR series on North Korea,[1] there really aren’t any good options.  The South Korean government has offered a freeze of current technology in return for negotiations.  We doubt that will work because Kim Jong-un is convinced that without a deliverable nuke he risks the same fate as Saddam Hussein and Muammar Gaddafi.  The U.S. has discussed attacking missile sites pre-launch to ensure that the U.S. would not be hit.  However, North Korea has rolled out a solid propellant rocket that can be launched quickly, making that defense questionable.  As we noted, if the U.S. decides to go to war, Seoul is in range of North Korea’s massed artillery.  So far, the U.S. and South Korea have held joint missile exercises in response.  The situation in North Korea is becoming increasingly untenable and the risks of war are rising.  Does this mean war is a risk within the next few months?  Probably not, although the potential is rising given the pace of escalation.  So far, there isn’t clear evidence that North Korea can put a warhead on these missiles but most analysts expect that it’s only a matter of time.

The G-20 begins Friday: President Trump will visit Poland before the G-20 meeting in Germany.  Already, Chancellor Merkel has made harsh comments about Trump’s policies; this could prove to be a frosty meeting, at least with the Europeans.  The president is also expected to meet with Russian President Putin.  We doubt anything comes of it, although there is great concern about the meeting in the media.  Rarely do important decisions get made in brief meetings.

Qatar facing further isolation?  The GCC nations are considering expelling Qatar from the group.  The GCC made a list of demands to Qatar which it describes as “non-negotiable.”  The problem is that the more the GCC isolates Qatar, the more it will align with Turkey and perhaps even Iran.  The Trump administration remains divided on this issue, with SOS Tillerson calling for meetings and restraint while President Trump appears to be cheering on the GCC.  We expect this standoff to continue; if it escalates to military action, regional stability could be at risk.

Russia says “nyet” to further cuts: Oil prices are weaker this morning after Russia indicated it would not support additional supply cuts.  This isn’t really a surprise.  If further cuts are coming, the Saudis will have to bear the loss of market share.  We continue to hold that oil prices are in a trading range; we are up from the bottom of the range but expect choppy markets as prices approach the high $40s.

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[1] See our recent two-part WGR series on The Second Korean War: Part I, 6/19/17; and Part II, 6/26/17.

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] N.B.  Due to the upcoming Independence Day holiday, the next issue of the Daily Comment will be published on July 5^th.  We want to wish you a happy and safe holiday!

We expect a quiet trade today; it’s a summer Friday, there’s a holiday looming, Canada is off today for Canada Day (Happy 150^th!) and markets have been rather choppy recently.  A pause to consolidate makes sense.  The key issue we are seeing is a rapid shift in policy expectations.  Although the Fed has been on a tightening path for some time (arguably since the onset of tapering), it appears the ECB, BOE and BOC are in the process of either ending stimulus or beginning to tighten.  Tight policy almost everywhere (the BOJ being the last holdout) hasn’t been a feature in the financial markets since 2007.  Thus, some concern is probably warranted.  However, as we note in this week’s AAW (see below), economic conditions generally would not indicate that a major selloff is in the offing.  Thus, if one occurs, it will probably come from something other than the economy.

Other news items of note:

A trade war brewing?  President Trump ran a campaign promising to restrict trade to boost U.S. growth and jobs.  According to Mike Allen at Axios,[1] the vast majority of Trump’s cabinet opposed deploying steel tariffs.  The report puts the vote at 22-3.  However, Trump was one of the three, thus the plan is expected to move forward.  Tariffs on steel could hit 20% and the report suggests that other items, including aluminum, semiconductors, paper and appliances, could be next.  Trade wars are tricky; it’s hard to avoid self-inflicted wounds.  Raising the price of steel will adversely affect consumers (automakers, for example) and bring inflation.  And, depending on the price elasticity, it can actually reduce demand to the point where domestic steel producers could be harmed.  For example, if the price rises to the point where automakers reduce their steel consumption and substitute carbon fiber or plastic, all could be worse off.  In addition, retaliation is always possible.  If the U.S. hits Chinese steel exports with a tariff, expect China to hit American exports to China, such as agriculture products.  This could get quite interesting.

Rising tensions with China: The issues with China are really a string of tit-for-tat headlines.  The U.S. has approved a $1.4 bn arms sale to Taiwan.[2]  China is building new military facilities in the South China Sea islands.[3]  The U.S. has cut off China’s Bank of Dandong from the U.S. financial system over ties to North Korea.[4]  The bank is rather small but the move is likely designed to send a clear signal to other Chinese banks about their business dealings with North Korea.  It is becoming apparent that the warm ties from earlier meetings between President Trump and Chairman Xi have dissipated.

The G-20: The world group meets next week but already it looks like it will generate lots of news.  Yesterday, we noted that Chancellor Merkel, the host of this gathering, will strongly oppose protectionism and isolationism and made no attempt to veil her displeasure with the U.S.  President Trump announced yesterday he will meet with Russian President Putin; there are reports the administration intends to surround Trump with staff to avoid any compromising images from developing.  These meetings are usually non-events, but this one may be full of “fireworks.”

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[1] https://www.axios.com/exclusive-trump-plots-trade-wars-2450764900.html?utm_medium=linkshare&utm_campaign=organic

[2] https://www.wsj.com/articles/trump-administration-proposes-1-42-billion-in-arms-sale-to-taiwan-1498770781

[3] http://www.reuters.com/article/us-southchinasea-china-islands-idUSKBN19L02J

[4] https://www.wsj.com/articles/u-s-to-sanction-chinese-bank-over-north-korea-financing-1498763996