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

[Posted: 9:30 AM EDT] The employment data, discussed at length below, was disappointing, with payrolls coming in weak.  The bullish headline was that the unemployment rate fell to a new cycle low; in fact, a 16-year low.  Sadly, that occurred because the labor force fell by a whopping 429k, offsetting a 233k decline in employment.

The president did remove the U.S. from the Paris Accord.  There is much commentary on this issue.  Our read is that the accord is mostly for show; there is no enforcement mechanism beyond international shaming and the goals are self-set.  Anytime an agreement can have nearly all the nations of the world join is one that either (a) isn’t going to change very much, or (b) is being enforced by the economic and military power of the hegemon.  The Paris Accord falls under the first type.

However, the signaling is important.  The U.S. is forgoing any element of leadership on climate change as the president makes it abundantly clear that his mantra of “America First” is, and remains, the key element of his administration.  There is much punditry suggesting that this hands global leadership to China.  If only…instead, this is further evidence that we are skidding rapidly to a “G-Zero” world in which there is no global leadership.  Could China use this issue to expand its global influence?  Perhaps.  But the litmus test would be whether China is willing to cut its growth to 3% in order to take leadership on climate change.  We strongly suspect that scenario isn’t likely.

This is what global leadership looks like:

This chart shows the U.S. goods trade balance as a percentage of GDP, starting in 1860.  Note that from the 1870s until the 1970s, the U.S. tended to run trade surpluses.  But, as part of our superpower role, we have to provide dollars to the world for global trade, meaning that we will be required to expand our trade deficit in order to provide global liquidity.  In the last decade, we ran a goods-trade deficit that reached 6% of GDP.  This was done to accommodate China’s development.  Is there any other nation in the world willing to make such sacrifices for global growth?  Is there any other nation willing to suffer the destruction of industries to global competition that is structured to generate trade surpluses at America’s expense?  Is China prepared to take similar actions to reduce carbon emissions?

For the foreseeable future, there is no obvious replacement to U.S. leadership.  That’s why Trump’s decision is so unsettling.  In reality, we expect businesses, along with state and local governments, to continue to take steps to reduce carbon emissions.  As we noted yesterday, insurance companies and investors are demanding such changes from business.  In addition, the chances of policy reversal in the next administration is likely.  The key change here, as we noted above, is the signal that the U.S. is reducing its global responsibilities.  For our regular readers, this comment isn’t a shock; this is a theme we have been highlighting for years.  But it is possible that historians years from now will cite this event as a bright line that signals the change in American policy.  Just like the U.S. decision not to join the League of Nations, America is letting the rest of the world know that they will need to find their own way.

U.S. crude oil inventories fell 6.4 mb compared to market expectations of a 3.0 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 1.0 mb sale of oil out of the Strategic Petroleum Reserve.  This is part of a $375.4 mm sale (or 8.0 mb) done, in part, to pay for modernization of the SPR facilities.  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 7.4 mb, which is a larger draw than forecast.

As the seasonal chart below shows, inventories are usually well into the seasonal withdrawal period.  This year, that process began early.  Although the actual level of stockpiles remains quite high, we are seeing stock declines at a rather rapid pace.  Assuming a similar drop from this year’s peak of 566.5 mb at the end of March, we will end up at 505 mb by late September.  In fact, the current level of inventories has already declined more than the seasonal trough, which is supportive.

Based on inventories alone, oil prices are overvalued with the fair value price of $37.69.  Meanwhile, the EUR/WTI model generates a fair value of $48.80.  Together (which is a more sound methodology), fair value is $45.14, meaning that current prices are above fair value but the deviation has been steadily closing in recent weeks.  Using this model and assuming a steady €/$ exchange rate and a 505 mb trough in oil inventories, fair value for oil would be $47.25.  Overall oil market sentiment has become rather bearish as a number of wirehouses have cut their price forecasts.  Thus, a test of the lower end of the trading range, around $45, would not be a great surprise.  However, we are seeing solid inventory liquidation and, if the dollar weakens, a recovery from these lower levels may be in the offing.

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

[Posted: 9:30 AM EDT] There were a couple of political items of note.  First, the White House announced the president will hold a Rose Garden gathering to announce his decision on the Paris Climate Accord.  Reports suggest he will take the U.S. out of the agreement, although there are conflicting news items indicating he hasn’t completely made up his mind quite yet.  Although there is much concern in the media about the action, we view it as mostly symbolic.  First, these major accords rarely meet their promises.  The ones that do are narrowly structured; for instance, the Montreal Protocol on CFCs worked because it was a specific gas and substitutes were available.  The Paris Climate Accord is much more general, thus we always expected widespread failure in reaching the stated goals.  Second, it seems to us that the private sector is already moving on this issue of reducing carbon emissions and government action may not matter all that much.  Insurers’ decisions to not cover risks affected by climate and firms needing to make long-term investment decisions that might be affected by a post-Trump reversal of environmental rules are not going to change based on what the president says later today.  In other words, a utility looking at a 30-year investment in generating capacity will probably still lean toward natural gas instead of coal, not knowing how regulation may change in the future.  Third, natural market forces lowering the costs of alternatives may make leaving the accord moot.

And, lest we forget, President Trump is mercurial; he may decide to stay in the accord.  We are expecting to hear from the White House at 3:00 EDT.  If the announcement is delayed, it may indicate how torn the president is over this decision.

PM May decided to skip a live debate yesterday evening, continuing a pattern where she is refusing to directly engage the other candidates.  Instead, she sent Home Secretary Rudd to represent her.  This was probably a bad move.  The lesser parties severely criticized the PM while Labour Party Leader Corbyn scored points by staying measured and avoiding direct attacks on May.  Polls continue to tighten, with the Tories’ lead falling to a mere 3%.  We are in the area of the margin of error; if the Conservatives lose, it will be bearish for the GBP and other U.K. financial assets.

One of the issues we are monitoring is the debt ceiling.  The debt ceiling is the limit on national debt that can be issued by the Treasury.  As a refresher, the debt ceiling was first created in 1917 during WWI.  Prior to the Second Liberty Bond Act of 1917, Congress had to approve the debt every time the government borrowed money for a specific appropriation.  War borrowing made this practice impractical so the new law set a limit on debt the Treasury could issue and Congress must lift the limit in order to issue more debt once the initial limit is reached.  It should be noted that the appropriations and budget are separate from the debt ceiling issue.  In effect, the debt issued is to fund government appropriations that have already occurred.

After a couple of incidents when the debt ceiling was reached, Congress passed the “Gephardt Rule,” which said that the debt ceiling would be automatically raised when a budget was passed.  This rule was repealed in 1995; since then, we have had periodic debt limit crises that have led to government shutdowns.  The first occurred in 1995-96.  The most famous incident occurred in the summer of 2011 which resulted in a downgrade of U.S. Treasury debt by S&P.  The sequester process emerged from this event.  Another shutdown occurred in 2013.  We have been currently working under a suspended debt ceiling that expired in March.

It initially appeared that the debt ceiling would become an issue in Q4, but the Trump administration has indicated that the Treasury will reach the current limit by August.

This chart shows the yearly change in net Federal receipts, smoothed with a six-month moving average.  Falling receipts is a concern; the past two recessions coincided with a sharp decline in revenue likely caused by falling incomes and profits.  The current problem is partially due to some taxpayers delaying asset sales in hopes of lower capital gains rates in the future.[1]

The GOP membership appears divided on the debt ceiling issue.  The Freedom Caucus is hinting that it may call for spending cuts to approve a rise in the debt limit.  Other members of the GOP, including the treasury secretary, are pressing for a “clean” rise in the debt limit.  The GOP leadership may be forced to woo Democrat Party votes in order to avoid default, but it is unknown what demands they will make on the White House and the establishment GOP for their votes.  We would not be surprised to see demands related to health care, for example.

Given the disarray within the Republican Party in Congress, we are worried that threats of default and a government shutdown are rising.  At best, this issue will begin to distract the administration and Congress from other pressing issues, such as health care, tax reform, etc.  At worst, we could face another government shutdown and the threat of another downgrade.  We will continue to monitor this issue as the summer unfolds.

The FT is reporting that EU officials are looking into a process where sovereign debt across the Eurozone would be “bundled” into a new financial instrument and sold to investors.  Although officials in Brussels have been careful not to characterize this new instrument as a Eurobond, it could be an intermediate step toward the creation of such an instrument.  In theory, German, Italian, Spanish and other nation bonds would be bundled into an instrument; this process could modestly raise German borrowing costs but lower costs elsewhere.  We would look for Germany to oppose the measure but France and the southern tier nations to actively support the idea.

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[1] https://www.bloomberg.com/politics/articles/2017-05-31/rich-americans-may-hasten-a-trump-headache-raising-debt-limit

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

[Posted: 9:30 AM EDT] News flow was quiet overnight.  The biggest item came from the U.K. where a YouGov model projected a hung Parliament.  It showed the Tories losing 20 seats to fall to 310, while Labour would pick up 28 seats, capturing 257.  The required majority is 326 seats.  Other polling is mixed, with the most recent showing Conservatives with a 12% lead.  The betting markets continue to show May holding an 89% probability of winning.

The GBP slumped overnight on this news but has partially recovered its losses.  We still expect that May will prevail but probably not significantly improve her party’s current four-seat majority.  However, the underlying concern in all Western elections has been the trend of deep voter dissatisfaction.  Outsiders, candidates not considered part of the political establishment, have been consistently polling well everywhere in the West.  Brexit and the U.S. presidential election are clear indications of this pattern.  Even the French presidential election confirmed this trend; although the more populist Le Pen didn’t win, she did make it into the second round and French voters are betting that a young and mostly inexperienced newcomer with his own party is a better choice than the more established parties.

What is worrisome about the British election is whether voters will view PM May as enough of an outsider or take a chance with Jeremy Corbyn.  Although Corbyn’s policy positions appear radical enough to disqualify him, the fact that the polls have narrowed raise the possibility that voters are desperate for something new.  During the U.S. election, there was a famous op-ed called “The Flight 93 Election.”[1]  The report suggested that, like the passengers on that famous flight, American voters could either remain in their seats and crash (vote for Clinton) or charge the cockpit and elect a novice (vote for Trump) on the chance that he might be able to fly the plane.  In reality, the likelihood of a good outcome with a novice at the wheel is low but voting for the status quo was to accept a certainly bad outcome.  It is possible that British voters may make a similar calculation next Thursday.  If they do, we could see a hung Parliament or, perhaps even more shocking, a Labour-controlled government.

If we end up with a narrow Conservative win, which appears the most likely outcome, it will tend to weaken the May government’s mandate to negotiate with the EU.  However, financial markets will likely take this outcome in stride.  A hung Parliament or a Labour-led government would likely lead to a sharply weaker GBP and equity markets.  It will also continue the trend where Western voters seem inclined to take chances on their leaders due to an overall milieu of disenchantment.

Oil prices have remained under pressure this morning on worries about oversupply.  This weakness has occurred despite comments from Russian and Saudi officials indicating they are committed to recent output cuts.  We don’t think the weakness is due to OPEC action.  Instead, we think the market is really in a trading range and it looks like, in the short run, we are going to test the lower end of that range.

This chart shows the nearest crude oil futures price; we have placed a box on the chart that represents a range of $45 to $55 per barrel.  Over the past eight months, this range has captured most of the price range and we expect that range to hold in the coming months.  Since it doesn’t appear that the current weakness is due to anything specific, we expect the market to stay in this range for the foreseeable future.  Thus, if prices decline toward the lower end of the range, around $45, we would look for prices to stabilize around that level and recover.  On the other hand, we don’t see conditions that would lead to a sustainable breakout above or below this range for the time being.

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[1] http://www.claremont.org/crb/basicpage/the-flight-93-election/

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

[Posted: 9:30 AM EDT] Welcome back from the long weekend!  Here are the stories that caught our attention:

A break in Europe: Chancellor Merkel made headlines by indicating that, in the wake of the G-7 meeting, continental Europe must prepare to “go it alone” without the security support of the U.S. or U.K.  During his trip (and in an early morning tweet), the president called Germany “bad,” criticizing the nation’s trade surplus with the U.S. and its defense spending coming in below the 2% NATO target.  These are all legitimate concerns.  However, we fear it has been forgotten why we are in this position at all.  After WWII, the U.S. was not looking forward to fighting another war in Europe.  Thus, the U.S. created NATO, which America has dominated, and effectively disarmed the continent.  In other words, we purposely created conditions in which the Europeans spent less on defense and made them dependent on the U.S. for security.  Although this was an expensive policy, it did work.  So far, we haven’t fought WWIII on European soil.  If Merkel is true to her word, Germany should rebuild its armed forces.  Although this may be what the U.S. wants on the surface, Germany will be less likely to follow American foreign policy once it has a formidable military.  Such fears seem farfetched given the current state of European militaries, and they probably are in the short run.  In the longer run, however, a remilitarized Germany is a grave concern.

Draghi remains dovish: The ECB president indicated that the Eurozone still needs “an extraordinary amount of monetary support.”  ECB policy has increasingly come under fire from German officials who want policy to tighten.  Draghi did acknowledge the Eurozone economy is improving but expressed concerns about continued low inflation.  On a related note, the ECB has been reluctant to buy Greek bonds until the current bailout is resolved.

A Greek scare: There were reports overnight that seemed to suggest Greece was preparing to default on its debt if a bailout deal wasn’t reached.  The EUR plunged on the news, but we have seen a recovery after Greek officials clarified that a default wasn’t being considered.

Italian elections: By February 2018, Italy will need to hold elections.  However, the major parties are considering early elections tied to a change in electoral law.  The proposal would be to use a proportional system similar to Germany’s that prevents any party that gathers less than 5% of the national vote from seating candidates in the legislature.  Although a proportional system would improve the stability of Italy’s political system, a vote could bring the populist Five Star party to power and raise fears about Italy’s commitment to the Eurozone.  Meanwhile, the NYT is reporting that the Russians are taking advantage of the Trump administration’s distractions elsewhere and building relationships in Italy.[1]  The aforementioned Five Star movement not only wants to hold a referendum on the Eurozone but also calls for closer relations with Russia and a reduction of American influence in Italy.

U.K. elections: Debates were held over the weekend and were essentially called a draw.  The polls are still tight; the latest show the Tories with a 6% lead over Labour, which is stable but close enough for discomfort.  If the polls remain this tight, the best we can hope for is that the Conservatives hold a small majority in Parliament.  This outcome would hamper May’s ability to negotiate exit conditions with the EU.  The second worst outcome would be a hung election where no party is able to cobble together a government.  The worst outcome for the financial markets would be a surprise Labour win.  In some respects, a Corbyn-led Labour Party win would send a clear signal to the world of the unpopularity of globalization and indicate that the post-Cold War “Washington Consensus” is probably finished.  Although we don’t expect a Labour win, the polling frankly bothers us because we wonder about preference falsification; Corbyn is a divisive political figure and we worry that he might have more support than people will admit to poll takers.

A second Korean War?  The U.S. is sending the U.S.S. Nimitz carrier group to northern Asian waters, perhaps joining the U.S.S. Carl Vinson and the U.S.S. Ronald Reagan.  It is possible that the Nimitz, which was originally scheduled to go to the Middle East, is going to relieve the Carl Vinson.  However, the U.S. tends to prefer to have three carrier groups in a region when it goes to war.  Having three groups makes it easier to conduct round-the-clock operations if a hot war erupts.  We suspect that SOD Mattis is putting the pieces in place for President Trump if he decides to attack North Korea.  We will have more to say on this issue in the coming weeks but the North Korean situation has evolved to a point where, if nothing is done, the Hermit Kingdom will be able to launch missile strikes on the U.S. itself.  We don’t see war as imminent (next six weeks) but the odds of conflict are rising.  Perhaps the carriers are the best clue—if three remain in place, it does indicate that the U.S. is moving to a war footing.  That signal may be designed to encourage the Kim government to the negotiating table or scare China into pressuring North Korea.  But, the stronger the signal the harder it is to “walk back.”

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[1] https://www.nytimes.com/2017/05/29/world/europe/russia-courts-italy-in-us-absence.html?emc=edit_mbe_20170530&nl=morning-briefing-europe&nlid=5677267&te=1

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

[Posted: 9:30 AM EDT] The GDP data (see below) came in much better than forecast and that is giving a bounce to equities this morning.  It’s a long Memorial Day weekend, which usually means the afternoon trade will become very thin and sluggish.

The big news overnight was that the Conservatives’ lead in U.K. polls has evaporated to a mere 5%, down from 20% a couple of weeks ago.  The election will be held in less than two weeks, on June 6^th.  May called for early elections due to strong polling and disarray in the Labour Party.  There is no evidence that that order is being restored to Labour; today, Corbin (the Labour Party leader) blamed U.K. foreign policy for terror attacks in Britain.  That isn’t a mainstream view.  So, why is the lead narrowing?  This may reflect a broader theme of disenchantment with the establishment in Britain.  First, they voted in favor of Brexit, and second, in what would be the ultimate snub, we are seeing a surge in the polls for a party whose leader is considered wildly outside the mainstream.  If Labour were to win, it would be profoundly bearish for the GBP and British equities.  We do note that the betting sites still show a 90% probability that May will prevail.  But, she really needs a landslide to help her negotiate the best deal possible from the EU.  A narrow win will tend to undermine her bargaining position.

President Trump made headlines in Europe for a number of actions, including an apparent stiff-arming of the leader of Montenegro, Filip Vujanović, refraining from confirming his support of Article 5 of the NATO charter (the one on collective defense) and calling the Germans “bad” for running trade surpluses with the U.S. and threatening to apply tariffs to German vehicles.  Regarding collective defense, although there is great concern about this issue, it should be noted that the U.S. still has a sizeable military presence in Europe and would certainly defend the continent if it were attacked.  The lack of confirmation is worrisome, but it is likely designed to boost European defense spending and not signal a U.S. pullback…at least not yet.

Although the German press is apparently up in arms about being called “bad,” it should be noted that the quote, initially reported in Der Spiegel, was not attributed and may have come from a third-hand source.  Administration sources did try to walk back the comment, suggesting the president didn’t mean the German people but instead the trade situation.

Although the president’s comments may have been undiplomatic, he actually has a point.  First, Germany does run a persistent trade surplus with the U.S.

On a rolling 12-month total, the German trade surplus with the U.S. is nearly $64 bn.  The EU surplus is $146.6 bn, with Germany representing 44% of the surplus.  As we detailed in our recent WGR series on trade, Germany runs a domestic policy designed to generate saving; essentially, they export this saving to the world and import demand.  This is the root cause of the problems in Europe.  At least the U.S. has the protection of a floating exchange rate where a weaker dollar can blunt some of Germany’s policy.  The nations of the Eurozone have no such protection.

It’s not just a U.S. issue.  German policy has led to a massive current account surplus.

Its surplus runs 7.6% of GDP, well above norms that suggest anything over 3% is a deliberate policy designed to “beggar thy neighbor.”

This chart shows German imports and exports scaled to GDP.  Exports represent 47% of Germany’s GDP.  It does also import 40%.  However, note that with the onset of the Eurozone in 1999, trade surpluses have become persistent.  In effect, Germany is treating the Eurozone much like 19^th century European powers treated colonies—a venue to absorb excess output.

So, the president does have a point.  German policy is designed to export and it probably can’t continue without significant political repercussions, e.g., trade restrictions from outside the Eurozone, and a breakup of the Eurozone itself.  His expression of displeasure was inartful but isn’t untrue.  Germany would be better off if it absorbed some of its domestic saving in higher public or private consumption.  However, we don’t expect that policy to change anytime soon.  Thus, rising trade conflicts are likely, both outside and inside the Eurozone.

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

[Posted: 9:30 AM EDT] The FOMC minutes held no surprises—barring a sudden downturn in the data, the next rate hike will come on June 14.  Dallas FRB President Kaplan gave a speech in Toronto yesterday and indicated that he expects two more rate hikes this year; thus, if they do move next month, as expected, there would only be one more hike this year.  As we have noted in the past, the key issue for policymakers is the correct measure of economic slack.  If it’s the unemployment rate, the Fed needs to raise rates into the 4% range to achieve neutrality.  If it’s the employment/population ratio or wage growth for non-supervisory workers, then the fed funds target is near neutral now.

In terms of the expected balance sheet reduction, the FOMC is considering a plan that would set limits on the amount of bonds that would be allowed to “roll off” each month.  If there were more bonds that reached maturity than the limit, those would be reinvested.  Over time, the limits would be raised to allow for more bonds to roll off.  This appears to be a very gradual approach likely designed to reduce potential market volatility.  We expect more details to emerge as we approach year’s end.

Although we don’t have any details yet, we are assuming that the Fed is probably going to target a balance sheet roughly around 10% to 12% of GDP.  We expect that, at most, the Fed would reduce the balance sheet by about $50 bn per month; with 4% nominal GDP growth (growth has been around 3.7% since 2011), the balance sheet will stabilize around 2021 at around $3.6 trillion.

U.K. PM May is reportedly “furious” at information leaked to the U.S. press about the recent terrorist bombing in Manchester.  The NYT published pictures of evidence that seem to show a well-crafted bomb.  The bomb suggests a broader conspiracy; so far, seven people have been detained, including the bomber’s brother and father.  According to reports, May intends to confront President Trump on the leaks and then return to Britain, returning early from the G-7 meeting.  The most recent polls show a widening of the Tories’ lead, to 14% from 9% prior to the terrorist event.  PM May was Home Secretary under PM Cameron and is considered strong on security.

Oil prices have slumped this morning despite OPEC agreeing to a nine-month extension of its current output agreement.  The market narrative is that oil prices are lower on disappointment that new cuts were not announced.  We doubt that’s the case.  This look more like classic “buy rumor, sell fact” market action.  Overall, the extension is supportive for oil prices but the recent rally has put oil prices in the middle of our expected range, meaning some price consolidation is plausible.

U.S. crude oil inventories fell 4.5 mb compared to market expectations of a 2.0 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 0.4 mb sale of oil out of the Strategic Petroleum Reserve.  This is part of a $375.4 mm sale (or 8.0 mb) done, in part, to pay for modernization of the SPR facilities.  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 4.9 mb, which is well below expectations.

As the seasonal chart below shows, inventories are usually just starting their seasonal withdrawal period.  This year, that process began early.  Although the actual level of stockpiles remains quite high, we are seeing stock declines at a rather rapid pace.  Assuming a similar drop from this year’s peak of 566.5 mb at the end of March, we will end up at 510 mb by late September.

Based on inventories alone, oil prices are overvalued with the fair value price of $34.32.  Meanwhile, the EUR/WTI model generates a fair value of $48.17.  Together (which is a more sound methodology), fair value is $43.87, meaning that current prices are above fair value but the deviation has been steadily closing in recent weeks.  We note that OPEC looks like it will keep production cuts in place into next year, which probably keeps oil in a range of $55 to $45, basis WTI.

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

[Posted: 9:30 AM EDT] Financial and commodity markets are very quiet this morning.  U.S. equity futures markets are mostly steady, the dollar is becalmed and there is a modest bid for Treasuries.  There was some important news overnight.  Here are the high points:

Moody’s downgrades China: The U.S. credit rating agency downgraded Chinese sovereign debt from Aa3 to A1.  In the previous rating, Chinese debt was considered “high quality and very low credit risk.”  The agency describes the new rating as “upper-medium grade and low credit risk.”  The reason for the downgrade is Moody’s estimation that debt levels are high and growth is slowing.  Initially, Chinese markets weakened on the news but recovered after the initial shock.  In China, there are essentially two groups fighting over this issue.  One group wants to address the debt issue by restructuring the economy away from investment and toward consumption.  This action will likely reduce growth but would, paradoxically, improve wellbeing as more funds end up with households.  The other group is wedded to growth at all costs and wants to keep investment high even if it requires more debt.  President Xi must balance these two groups; there is no clear favorite, although, like his predecessors, he tends to lean toward the latter.  The Moody’s decision will tend to strengthen the hand of the former group.  In reality, this is a warning.  In the near term, China will likely be able to maintain decent growth and social stability.  However, at some point, China will need to restructure its economy or face either a major social breakdown or years of Japanese-style stagnation.

Britain raises terror threat level to “critical”: In the British warning system, this level means that an attack is expected imminently.  Previously, the level was “severe,” meaning an attack is highly likely; most of the time, this is the government’s threat level.  Until yesterday’s increase, the level had been severe for 998 days.  So far, financial markets are taking the terrorist event in stride.

Fed minutes later today: Although most FOMC minutes are a bit of a yawn, the most recent ones have been closely monitored not only for clues on the path of future interest rates but also on balance sheet management.  We expect quiet markets going into the release of the minutes at 2:00 EDT.  We note that the current fed funds futures projection of a rate hike at the June 13-14 meeting is 100%, so any surprise would be a dovish one.

The Trump budget: We are not spending a lot of time on the recently released Trump budget because it has almost no chance of getting approved.  But, there are a couple of issues the budget does highlight that are worth examining.  First, when the decision is made to hold the two major middle-class entitlements, Social Security and Medicare, untouched, the budget is a battle over defense spending and everything else.  If the decision is made to raise defense spending, then everything else is going to be reduced unless revenue is raised through some form of revenue enhancement, either overt tax increases or less obvious reforms that reduce tax expenditures.  Until the major middle-class entitlements are addressed, this is the problem budget officers face.  Second, the growth problem is a real issue and if anyone has the answer to this one they can expect heroic treatment from future historians.

This chart shows the quarterly change in GDP, annualized, with the 10-year average of the data and the 3% growth line.  Since the early 1950s, economic growth has tended to hold around 3%.  It’s only been since the lackluster recovery from the Great Financial Crisis that growth has been persistently sluggish.  The current 10-year average is a mere 1.4%, although the average is affected by the deep drop in growth in 2008.  Getting growth back to 3% is key; it’s not clear how exactly to do that.  Our take is that the key to depressed growth is deleveraging.  If one wants to boost growth then reducing the debt load, mostly on households, is critical.  This isn’t the only issue but, in our opinion, it’s the most important factor.

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

[Posted: 9:30 AM EDT] A deadly terrorist attack occurred in Manchester, U.K. last night as an apparent suicide bomber exploded a bomb outside a concert venue as a concert was ending.  At present, 22 have died and over 50 were wounded.  IS has taken responsibility for the attack.  The effect on financial markets was small, although it may become an issue if (a) there are follow up attacks, and/or (b) if it affects the Tories’ lead in the polls.

EU negotiators and Greece failed to reach an agreement on debt relief despite seven hours of talks.  Nothing has really changed; the IMF and Greece want debt relief and the Northern Europeans don’t want to give them any.  We look for a patch to get Greece through the summer and then serious talks that will involve debt forgiveness will be likely after the German elections this autumn.  The good news is that this issue shouldn’t affect markets; the bad news is that we doubt Germany will be any more open to debt forgiveness after the election and Greece will eventually have to face exiting the Eurozone.

EU negotiators finished talks on Brexit and have given negotiators a mandate to extract maximum costs for legacy promises, while also requiring Britain to offer broad EU citizen rights to those living in the U.K.  This looks to us as an opening position for talks but if these are the actual demands of the EU then we expect the U.K. to simply walk away from talks and live without trade access to the EU beyond what is proffered by WTO rules.  A “hard” Brexit will be quite damaging to the U.K. economy; it’s hard to imagine the London financial district surviving in its present form.  At the same time, an EU without Britain is one that loses its most potent military and thus will be vulnerable to Russian intrusions.  The EU is worried that if it doesn’t take a hard line on the U.K., other nations may decide to exit the EU, too; at the same time, too harsh of a stance may end up being a loss for both sides.

Oil prices fell overnight but have worked their way back to unchanged.  We expect the Saudis to “do whatever it takes” to keep prices propped up.  However, there are reports that the Trump administration is considering selling off half of the nation’s SPR, or about 344 mb of oil, which would seriously undermine OPEC efforts to keep prices high.  After the warm meetings the president just had in Riyadh, it seems unlikely that this proposal will have legs.  But if it does, it would be a negative for oil prices.

Finally, we are seeing a major spike in bitcoin prices.

It isn’t clear what is causing this parabolic move in the cryptocurrency.  Sales against yen are rising but that may be due to reports that the currency is gaining wider acceptance as a medium of exchange.  In some respects, cryptocurrencies have all the benefits of gold with less downside; it can be transmitted electronically and is weightless!  However, it isn’t obvious that the blockchain is completely immune to hacking.  Still, this rally does have the look of a mania and may have become the instrument of any “fear trades” in the market.

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