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

[Posted: 9:30 AM EDT] Here are some of the news items we are following this morning:

PM May calls snap election: Reversing her earlier stance, Theresa May has called for a general election on June 8.  The previously scheduled election wasn’t due until 2020, but there are rising tensions that will come from Brexit and the Tories lead Labour by 21 points and will likely lift that margin in Parliament significantly.  Snap elections have become quite rare; the last voluntary early election was October 1974.  In 1979, an election was called after the Labour government lost a no-confidence vote.  May will need two-thirds of Parliament to actually get permission to dissolve the government.  It looks like that will be a formality.  Given that May took control of the government without an election (she took over for David Cameron when he resigned following Brexit), winning an election would give her a more solid mandate.  It would also allow her to jettison her predecessor’s policies and put forward her own goals for government.  The GBP initially fell on the announcement but has rebounded strongly since; a stronger mandate would be bullish for the currency as it would give May a stronger bargaining position with the EU.

Special election in Georgia: There will be a special election today in Georgia’s sixth Congressional District to replace Tom Price, who resigned the seat to become HSS Secretary.  It is generally a strongly red district (Price won it by 23 points in 2016), but it does appear that Democrat Jon Ossoff, a former congressional staff member, will win the most votes.  To win the seat, the winner must garner a majority.  If no candidate gains a majority, a runoff will be held.  There are a number of viable GOP candidates that are splitting the Republican electorate and so it is highly unlikely any of them will threaten Ossoff in the first round.  However, Ossoff would be quite vulnerable in the second round.  Thus, if the Democrats are going to flip the seat, they probably have to do so in the first round.  Although losing the seat won’t change the House, it will be a political embarrassment to the White House.

French elections: The polls are turning into a four-candidate race, with Macron and Le Pen still holding in the mid-20s but Mélenchon (hard-left) and Fillon (conservative) approaching 20%.  Undecided voters are still running as high as 20% in some polls so it is possible that the expected Le Pen/Macron second round could have another combination.  The NYT[1] reports that Russia is being accused of actively trying to sway French voters; the Kremlin seems to be supporting Fillon and Le Pen.  Both are considered right wing and anti-EU.

New BOJ board members: The Abe government named two new members to the BOJ, replacing two whose terms had expired.  Takehiro Sato and Takahide Kiuchi are leaving the BOJ; both are hawkish.  They are being replaced by Goushi Kataoka and Hitoshi Suzuki, both from the private sector.  The former is considered quite dovish while the latter is more neutral.  Thus, the composition of the board is considerably less hawkish.  This should be a bearish factor for the JPY.  Given the recent strength in the currency, we would look for this rally to stall and reverse based on the news.

More on Quarles: Yesterday, we noted that there are strong indications that President Trump will nominate Randal Quarles to governor of the Federal Reserve, filling one of the three open spots on the FOMC.  Quarles is being appointed to a specific role at the central bank, one concerned primarily with regulation.  His views on regulation appear consistent with David Tarullo, who had unofficially taken on this role and recently resigned.  He does not favor increasing bank capital but does want to give regulators specific powers to liquidate banks, even those considered “too big to fail.”[2]  However, the surprise from Quarles may come on monetary policy.  He is, apparently, a proponent of rules-based monetary policy, suggesting that discretion-based policies politicize the central bank and lead to policy mistakes.  Although that is true, going to rules won’t necessarily protect the central bank from politicization either; the rules don’t come down from Mount Sinai but are made by people with political agendas.  In addition, no rule can cover all circumstances and people will be likely to intervene even in a rules-based environment.  Based on his stance, we would likely score him as a two-star hawk with a tendency toward a single-star hawk.

Oil prices: Yesterday’s WSJ[3] carried a report that OPEC’s largest producers are targeting oil prices at $60 per barrel.  Bloomberg reported today that Saudi exports have fallen to 6.95 mbpd, the lowest level since May 2015.  Compliance has been high among the cartel members.  The report carried this interesting quote, “They [the Saudis] need this price [$60] for the IPO of Saudi Aramco.”  Although current stockpiles and dollar strength don’t support prices at current levels, it is clear that the kingdom, in what can best be described as “window dressing,” is propping up the price of oil for this IPO.  This move will give U.S. shale producers an opportunity to boost output and take share from the cartel, at least until the IPO is priced next year.  What happens after that could be problematic but, for now, OPEC action will be supportive.  We have serious doubts that $60 can be reached unless the dollar tumbles because the inventory overhang looks to be with us for a while.

Mnuchin speaks: Yesterday, Treasury Secretary Steven Mnuchin granted interviews to the media and indicated that tax reform won’t happen soon and that the U.S. will maintain the “strong dollar” policy.  As we noted before, this policy isn’t designed to actively boost the dollar but to avoid exchange rate volatility by threatening to intervene to sway the currency.  The dollar lifted on the news as it seemed to suggest that the Rubin strong dollar policy would remain in place.

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[1] https://www.nytimes.com/2017/04/17/world/europe/french-election-russia.html?emc=edit_mbe_20170418&nl=morning-briefing-europe&nlid=5677267&te=1

[2] Our position, for what it’s worth, is that this stance doesn’t work in the real world.  Regulators are captured by those they regulate and institutions that are too big to fail are too big to orderly liquidate.  Assumptions that the government has the power to protect the financial system even from the failure of very large banks embolden banks to take risks and regulators to give too much room to operate for banks on the basis that they can address any crises.  Instead, the goal, IMO, is better served by forcing banks to hold more capital.

[3] https://www.wsj.com/articles/saudi-arabia-iraq-kuwait-aim-for-60-a-barrel-oil-price-1492176010

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

[Posted: 9:30 AM EDT] Erdogan narrowly wins: In Turkey, it appears that voters have approved major changes to the political system by a 51% to 49% margin.  There were reports of widespread voter irregularity and the opposition has announced it will formally protest the vote.  The new laws will dramatically boost the power of the presidency, changing it from a mostly ceremonial, non-partisan post to an executive presidency with wide powers.  The parliament will see its powers reduced, requiring supermajorities to open investigations on any of the president’s deputies or ministers.  The president will effectively be able to govern by decree and can dissolve the parliament at will.  He will also be able to appoint deputies, ministers and some judges without legislative oversight.

The new powers won’t go into effect until the next president is elected; elections are not scheduled until November 2019.  Although a spokesman for Erdogan said that he isn’t planning snap elections to take advantage of these new powers, it seems unlikely that he will wait that long.  The president can serve two consecutive five-year terms but can sit for a third if elections are called before the second term ends.

We will be watching for two signals.  First, will the opposition’s voter fraud charges have any impact, and second, assuming the first matter fails, will the opposition accept the results without political and social unrest?  On the first point, we doubt the charges will stick.  There were numerous media reports suggesting uncertified ballots were counted.  This could be a form of ballot box stuffing, but we doubt Erdogan will take these charges seriously.  On the second point, given how close the vote was, we would expect some degree of tensions.  We doubt these issues will have too much effect on financial markets.  European powers have indicated some unease over the results, but the threat of a refugee flood will likely quell these concerns.

North Korea: It was the 105^th birthday of the founder of the DPRK, Kim Il-sung.  Such occasions usually bring some sort of tests to show North Korea’s prowess.  Although it does appear the country is preparing a nuclear test, it opted for a missile launch which apparently exploded on takeoff.  While incompetence should never be discounted, there was some speculation in the analyst community that U.S. cyber efforts may have played a role.  VP Pence is in South Korea and reiterated the line about the “end of strategic patience.”  We also note Bloomberg^[1] is reporting that President Trump is considering a “sudden strike” on North Korea, although the preferred policy is for China to undermine the Kim Jong-un regime.  With steady escalation, Robert Litwak of the Woodrow Wilson International Center for Scholars describes the situation as “the Cuban missile crisis in slow motion.”^[2]  Although the financial markets have not done much with the North Korean situation (the JPY would likely be weaker if a war was imminent because Japan would almost certainly be a target), the odds of escalation are probably higher than before.  North Korea is getting closer to a deliverable nuclear weapon and no amount of sanctions appear able to deter that steady progress.  At some point, the U.S. will either need to attack North Korea to slow or stop its progress, negotiate a slowdown or live with a nuclear Kim regime.  The second option is preferred but also the least likely.

We have recently noted the growing political polarization of the country.  This chart shows that it even affects views on the economy.

This chart measures perceptions of the economy by voters in Wisconsin based on political party.  Note that during the 2012 elections, Republicans were far more despondent about the economy than Democrats.  The recent flip is notable and has probably affected some of the well documented improvement in the survey data.  What is also interesting about the data is that Democrats seldom become overly bearish on the economy, whereas GOP voters seem to have rather violent mood shifts in their outlook.  We do want to note that this is only one state but it does reflect national data, although the shifts are less pronounced.  If GOP voter hopes become dashed due to the lack of progress on taxes and other fiscal measures, we could see a reversal in the survey data.

President Trump has indicated that he is likely to select Randy Quarles to the FOMC for the top regulator post.  The Dodd-Frank bill created a role on the FOMC for a governor dedicated to regulation.  This post was never officially filled, but the recently retired David Tarullo had informally filled the position.  Quarles is considered a moderate and was a Treasury undersecretary in the Bush administration.

On Good Friday, the BLS released the consumer price index for March.  The data came in surprisingly soft.  On a yearly basis, the core rate fell 20 bps to 2.0% while the overall rate dipped 30 bps to 2.4%.

Lower inflation did affect the Mankiw Rule model results.  The Mankiw Rule models attempt to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative.  Mankiw’s model is a variation of the Taylor Rule.  The latter measures the neutral rate by core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy.  Potential GDP cannot be directly observed, only estimated.  To overcome this problem with potential GDP, Mankiw used the unemployment rate as a proxy for economic slack.  We have created four versions of the rule, one that follows the original construction by using the unemployment rate as a measure of slack, a second that uses the employment/population ratio, a third using involuntary part-time workers as a percentage of the total labor force and a fourth using yearly wage growth for non-supervisory workers.

Using the unemployment rate, the neutral rate is now 3.45%.  Using the employment/population ratio, the neutral rate is 1.22%.  Using involuntary part-time employment, the neutral rate is 2.65%.  Using wage growth for non-supervisory workers, the neutral rate is 1.35%.  Outside of the unemployment rate, the labor market data was soft.  Coupled with weaker than expected inflation data, two of the variations have us approaching policy neutrality.  Weak wage growth and a stagnant employment/population ratio would suggest the FOMC is roughly one hike away from achieving a balanced policy.  This may be what the dollar and Treasury markets are concluding.

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[1] https://www.bloomberg.com/news/articles/2017-04-16/mcmaster-rules-nothing-out-as-trump-team-mulls-north-korea-moves

[2] https://www.nytimes.com/2017/04/16/us/politics/north-korea-missile-crisis-slow-motion.html?rref=collection%2Ftimestopic%2FCuban%20Missile%20Crisis%20(1962)&action=click&contentCollection=timestopics&region=stream&module=stream_unit&version=latest&contentPlacement=1&pgtype=collection

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

[Posted: 9:30 AM EDT] In a wide-ranging interview, President Trump roiled the markets late yesterday by admitting that (a) China is not a currency manipulator; (b) the dollar is too strong; and (c) Chair Yellen might be invited to stay at the FOMC.  Point (b) was the market-moving news; since Bob Rubin was Treasury Secretary during the Clinton administration, the White House has hewed to a “strong dollar” policy.  Essentially, this policy was designed to end the practice of currency manipulation by the government.  For the most part, the U.S. has allowed the dollar’s level to be set by market forces.[1]  Earlier, the Trump administration signaled that the Rubin dollar policy was coming to an end and active discussion of the dollar’s level was possible.  The president’s position that the dollar is “too strong” suggests the administration would like to see it weaken.

This policy of “oral intervention” is often effective in the short run.  Whether it has a long-term effect depends on two factors.  First, is the jawboning followed up with policies that change the fundamentals for the exchange rate?  And second, what is the valuation of the currency when the jawboning takes place?  Currently, on a relative inflation basis, the dollar is expensive relative to the JPY and EUR.  For the most part, the dollar’s strength since 2014 has been a function of tighter monetary policy.  In fact, based upon the current level of the two-year T-note, the EUR/USD rate should be closer to parity.  It appears to us that the exchange rate markets are waiting to see how much more U.S. monetary policy tightens and whether other central banks are coming close to ending their overly easy policies.  A president suggesting that he wants a weaker dollar does, at least in the near term, signal the potential for a weaker currency.  However, we would also note that most presidents prefer dollar weakness on hopes it might boost growth.  Even President Reagan, who supported dollar strength initially, reversed course on currency policy in his second term.

If the dollar is poised to fall, it would change our outlook for some markets.  Emerging markets have been unusually strong relative to the dollar, which may suggest that investors in these markets anticipated a reversal in the greenback.  Although dollar weakness is usually bullish for emerging markets, we would argue that much of that has already been discounted.  Commodities usually benefit as well.  As we note below, oil prices arguably have discounted some dollar weakness, too.  A weaker dollar tends to support large caps relative to small caps and that trade may have some room to move further.  But, it is too early to tell if yesterday’s weakness will stick.  After all, the FOMC is still expected to make at least two more hikes and the balance sheet will likely be trimmed, so a weaker dollar has to occur with tightening policy.  That might be a struggle.

The interesting issue surrounding the decision not to name China a currency manipulator is that Trump actually has already received the key response to naming a nation a currency manipulator, namely, bilateral negotiations designed to reduce the trade imbalance.  China does, in fact, manipulate its currency but in a way that is positive for U.S. trade; left to its own devices, the CNY would be much weaker.  By getting trade talks without naming China a manipulator, which would have been difficult based on the Treasury Department’s criteria, Trump has managed to get what he wanted anyway.

On the Yellen comment, we think it’s best to frame it relative to what we see going on in the White House.  Since the election, we have discussed this presidency as “Bannon v. Ryan.”  Bannon is losing ground fast.  Jared Kushner appears to be the president’s most trusted advisor, and he is steering Trump toward a conventional GOP establishment position.  This not only excludes the populists but also the Freedom Caucus, which is pre-Rooseveltian.  In other words, this is becoming a country club GOP administration.  That being said, the other characteristic of this administration is that it consists of mostly tactics with little clear strategy.  When the president cites “flexibility” we see the lack of clear goals.

If we are correct, it is good news for financial markets.  The inflation-generating policies that the populists want would weigh on stocks and bonds.  Instead, we will likely see “middle of the fairway” policies—the ACA mostly stays intact, modest tax cuts occur, trade impediments are mostly for show and the superpower role will remain intact.  On the other hand, the populists aren’t going away.  If this is the correct assessment of the trend, it will open the door for either a right-wing populist to mount a GOP primary challenge or, more likely, a “Bernie-crat” challenge from the left.  The latter assumes that the Democrat Party understands the populist-establishment dynamic, which is questionable.  So, we will continue to watch this development closely, but this is what we are seeing.

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[1] U.S. dollar policy has always been an odd configuration; the Treasury has the mandate for policy but the most effective tools for short-term exchange rate management are interest rates, which are the purview of the Fed.  The Treasury was mostly left with jawboning the markets, which isn’t a good long-term strategy.  Rubin decided that it made the most sense to say the U.S. wanted a strong dollar without defining what that meant.  That decision has left subsequent Treasury Secretaries to maintain the language without content.

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

[Posted: 9:30 AM EDT] SOS Tillerson is in Moscow as tensions are rising.  The White House is accusing the Kremlin of having prior knowledge of the sarin attack in Syria and attempting to cover up the attack.  Putin is suggesting that the U.S. is being “duped” by rebels into attacking the Assad regime.  It’s difficult to see how these talks have any hope of success.  We did mention yesterday that Tillerson met with European members of the G-7 in Italy.  The U.K., along with the U.S., called for Russia to abandon Assad; Italy and Germany, both facing refugee issues, were more cautious.

Yesterday, a tour bus carrying members of the Borussia Dortmund soccer team in Germany was attacked with three bombs.  One member of the team was reportedly injured.  The game was rescheduled for today.  Borussia Dortmund is one of the most popular teams in Germany; it appears this may have been a terrorist attack.

Iran holds presidential elections on May 19.  Registration for this office began yesterday and it seems the conservatives are running Ebrahim Raisi for the presidency.  In the past, the conservatives have run a number of candidates that tend to dilute the vote, giving hope to centrists (liberals are pretty much excluded from the race).  There is growing speculation tht Raisi was handpicked by Ayatollah Khamenei.  If it is a two-man race, the current president, Hassan Rouhani, would face an uphill battle for reelection.  If Raisi wins, we may see Iran retreat from foreign investment which would slow its development and may hamper oil production.  We note that former president Ahmadinejad is making noise about running.  Khamenei could probably prevent him from running by having the Guardian Council disqualify him, but such a move would be unpopular with the poor in Iran who remember the former president fondly.  A more conservative Iranian president would be an unwelcome outcome for the U.S. and Sunni powers in the region.

In response to rising tensions between the U.S. and North Korea, Trump issued a stark warning via Twitter that the U.S. is prepared to act alone if China is unwilling to intervene in North Korea.  Rodong Sinmun, a state-run newspaper in North Korea, stated that Pyongyang has its “nuclear sights” focused on U.S. military bases in South Korea and on the U.S. mainland.  In our opinion, even though North Korea does have the capability to strike U.S. bases in South Korea, it is still unable to launch a missile that could land in the U.S.  Nevertheless, China has issued a statement that it is committed to the denuclearization of the Korean Peninsula.  In addition, the Global Times, a Chinese state-run newspaper, reported that Beijing is losing patience with North Korea and would consider cutting off oil exports if it continues to cause trouble.  This Saturday could prove to be a test for both Kim Jong Un and President Trump as North Korea celebrates the birth of the country’s founder, Kim Il Sung.  It is expected that Kim Jong Un will use the occasion to showcase the country’s military capabilities by launching another missile.  If this were to happen, President Trump is likely to respond militarily, further escalating tensions between the two countries.  We will continue to monitor this situation as it unfolds.

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

[Posted: 9:30 AM EDT] U.S. equity markets continue to meander; hopes for fiscal support continue to buoy equities but there are growing worries that the administration will fail to deliver.  Geopolitical issues are a concern as well.  Sean Spicer, the administration’s press secretary, seemed to add barrel bombs to Syria’s prohibited weapons.  Although this decision is clearly defensible, the persistent use of these bombs would almost certainly suggest that more U.S. strikes are in the offing.  We doubt the president has made this change in policy but we will be watching.  Anytime ordinance is in the air unexpected things can happen.  If any further U.S. action leads to a Russian casualty, escalation is likely.  In another part of the world, the Chinese media is reporting that the People’s Liberation Army has sent 150k troops to its border with North Korea.  There are unconfirmed reports that these troops are training to handle a refugee situation.  Given that Chairman Xi and President Trump have recently met, this buildup may be a signal that China is expecting some sort of military action against the Hermit Kingdom that, most likely, would lead to a flood of refugees heading into China.

Meanwhile, SOS Tillerson is on his way to Moscow after meeting with the G-7.  The group suggested that more sanctions against Syria are being considered.  We expect Tillerson to receive a rather chilly reception in Russia.

In Fed news, Chair Yellen suggested in a talk yesterday that the economy has exited crisis mode and her policy now is to protect the gains made.  This suggests less support for the economy but doesn’t necessarily suggest tightening policy.  Our most recent focus has been on inadvertent tightening; a rising dollar, increasing credit spreads, rising financial stress, etc.  None of these appear to be a problem now.  There are rumors that the administration may be close to nominating a FOMC governor, one to essentially replace the recently departed Daniel Tarullo.  However, no names have emerged so there may be a surprise coming.  The NY Post[1] is speculating that NY Fed President Dudley may have leaked non-public information to analysts, similar to behavior that led to the recent resignation of Jeffrey Lacker from his post as president of the Richmond FRB.  If Dudley were forced out, it would remove a major dove from the board.

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[1] http://nypost.com/2017/04/11/ny-fed-boss-may-have-blabbed-during-blackout/

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

[Posted: 9:30 AM EDT] Global markets are generally quiet this morning as investors try to discern how to handle President Trump’s new muscular exercise of foreign policy.  After reading and reflecting over the weekend, we offer our take on the missile strike against Syria.  First, this is a president that eschews consistency; although a number of analysts are trying to figure out if these attacks signal a “Trump Doctrine,” we suspect not.  Instead, it shows that personal issues matter.  It appears that the president was truly moved by video of the aftereffects of the sarin attack and reacted based on that feeling.  This sort of behavior is consistent with a Jacksonian view of the world.  Trump seemed to view the Assad gassing as a matter of honor and reacted accordingly.  Second, the military appointees are clearly influencing policy.  The strikes were designed to warn, not escalate.  Military leaders try to avoid “mission creep,” where a military intervention keeps expanding as civilian leaders try to accomplish ever larger goals.  The military prefers discrete events and this missile strike is a classic example.

We do note that the U.S. is sending a carrier group toward North Korea.  We doubt this is little more than a signaling exercise but that doesn’t mean it won’t be effective.  The U.S. doesn’t want war with North Korea but no president wants the Hermit Kingdom to acquire a nuke on their watch.  Thus, sending a signal to the Kim regime that there could be costs to its current policy is prudent.

The Trump/Xi meetings ended with little drama.  China did offer some modest concessions on finance and beef, and they set a plan to discuss trade over the next 100 days that may create conditions for a bilateral trade agreement.  In the meantime, China will likely adjust higher its allowed percentage of foreign ownership of financial firms and lift the ban on U.S. beef imports.  It also promised to buy more agricultural products.  China will want to avoid a trade war until the October CPC meetings.  After that, we will get a better look at China’s real trade policy.

The French polls have tightened, with the center-right Fillon and the hard-left Melenchon gaining ground.  There is a high number of undecided voters going into the first round of elections later this month and the surge of these two candidates show how divided the French electorate has become.  This election still holds the potential to upset Europe.  We also note that Greece and the EU have reached an agreement on its bailout program.  Now we will see if the Greek legislature will actually pass further unpopular reforms or bring down the government.

After the election, we argued that the fate of the Trump presidency rested on the poles of “Bannon v. Ryan.”  That is morphing into “Bannon v. Kushner” but the battle is the same.  The former represents the new isolationism, an attempt to return to a less globalized world.  The latter in both cases represent a world that is globalized and deregulated.  This is going to be a long war because even if the personalities are vanquished, the sides of the debate remain.  At present, Bannon is losing power; the establishment is steadily marginalizing him.  For investors, this is a good outcome because it means that inflation remains under control and margins should continue to be robust.  However, the forces of populism remain and even if the right-wing version gets quashed by the right-wing establishment, the left-wing version remains in the background.

In Sunday’s NYT,[1] Louis Hyman, a professor of economic history at Cornell, published an op-ed arguing that Main Street is mostly dead because it’s inefficient and so its return is not a likely outcome.  Although he makes some good points, we believe he is being a bit naïve.  Since the late 1970s, policymakers have bought into a “cult of efficiency” that Marx obliquely discussed.  Marx’s assertion was that, at some point, capitalism becomes so efficient and income inequality so profound that there isn’t enough consumption to absorb all the productive capacity the efficient capitalists create.  Marx thought that scenario would create a crisis for capitalism that would result in its collapse.  So far, that hasn’t been the case.  Nevertheless, that doesn’t mean that changes haven’t occurred.  Both the Roosevelts took steps to retard the efficiency of capitalism through regulation.  Hyman noted that we used to have “fair trade” laws that set minimum prices; a retailer could not put a price below a certain level meaning that the chain and the small independent business didn’t compete on price.[2]

Some of us represent capital, most labor, but all of us are consumers.  The economic model that Hyman says can’t return was actually good for capital and labor but bad for consumers.  The high inflation of the late 1960s and 1970s was a result of this model.  As consumers, we cheer foreign trade because it keeps prices low, but foreign trade is mixed for capital and labor.  We are less sure that Hyman is right; a return to a model that is less friendly for consumers is ultimately the goal of populism based on the idea that globalization and deregulation have been worse for labor.  Although we could argue the case, that is the perception and thus a return to an earlier model cannot be so easily dismissed.

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[1] https://www.nytimes.com/2017/04/08/opinion/sunday/the-myth-of-main-street.html (paywall)

[2] This is one of the reasons Sears (SHLD, 11.34) developed in-house brands like Kenmore and Craftsman; because these weren’t national brands, it allowed Sears the ability to undercut the national branded competition.