by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT]

Happy Monday!  It’s going to be a busy week.  The media will be mostly distracted with Mueller’s testimony.  Boris Johnson is set to become PM on Tuesday.  The ECB meets on Thursday with an outside chance of a rate cut.  China’s version of the NASDAQ opened with a bang.  And, GDP comes on Friday.  Here is what we are watching today:

Iran tensions: Last week, Iranian forces seized a British petroleum tanker; oil prices are higher this morning on fears of escalation.  The U.K., distracted with the PM change, is mostly marking time before deciding how to respond.  So far, the British are avoiding a military response.  It appears that a Royal Navy vessel tried to prevent Iran from seizing the tanker, but Iran was undeterred, a signal that Iran isn’t all that worried about escalation.  There was one interesting development—former Iranian president Mahmoud Ahmadinejad is arguing that Iran should negotiate with Trump.  He believes that Trump is breaking with America’s foreign policy tradition and might be willing to make a comprehensive deal.  Ahmadinejad is a controversial figure, to say the least.  He has a strain of anti-clericalism in his background and is beloved by the poor in Iran.  His comments suggest Iran may be more divided on the path forward than comments from government leaders may indicate.

China news: There is much to report.  Here are some items we are following:

1. For the seventh straight weekend, sections of Hong Kong were brought to a standstill by large demonstrations against the growing Chinese influence in the city. The demonstrations were reportedly the most chaotic yet, with police firing barrages of tear gas against the protestors.  In fact, some protestors went so far as to deface a Chinese central government office, spraying black paint over the official emblem on the building.  In an apparent effort to generate backlash against the protestors, Beijing has allowed images of that attack to spread on social media.  All the same, it’s not entirely clear whether there is a big risk of a violent crackdown by Beijing.  Reports last week said the central government’s evolving plan for the crisis excludes the use of military force, and the local authorities may have been encouraged by a pro-government demonstration of some 300,000 on Saturday.  Another interesting development is that police inaction against protests in some areas has led to speculation that some officers have been in collusion with the demonstrators, although it could simply be that the police are being spread thin by the continuing, widespread unrest.  We note that Chinese leaders will be meeting soon in Beidaihe for their summer retreat.  We suspect Xi will get an earful from former leaders on how to handle Hong Kong.
2. There is some movement on trade talks with the U.S. Although China continues to demand that tariffs be lifted as a precondition for talks, there are rumors of soybean purchases which may be a good faith effort on Beijing’s part to restart negotiations.  Meetings may begin before month’s end.
3. The governments of China and Cambodia signed a secret agreement in April giving the Chinese military exclusive rights to use part of a Cambodian naval base on the Gulf of Thailand, not far from a large airport being constructed by a Chinese company. Access to the naval base and airport would greatly enhance China’s ability to project power, enforce territorial claims, and protect economic interests in the region around the South China Sea.  Just as concerning, it appears to indicate a decision by the Cambodian government to place its bets on China as a preferred military and economic partner, reflecting the perils of U.S. disengagement in the area.  The move also follows China’s establishment of a military base in East Africa in 2017, and the building of heavily fortified, artificial islands in the South China Sea since 2014.  The Chinese military initiatives, coupled with the ongoing U.S.-China standoff over trade policy, continue to infuse an element of geopolitical risk into the markets.  China and Vietnam are dealing with a standoff in the South China Sea.
4. In an interesting reversal, Philippine President Duterte is demanding that the U.S. honor its mutual defense treaty after Chinese ships rammed a Filipino fishing boat. Duterte has flirted with improving relations with China and shunned the U.S. in recent years, but after finding that relations with China can be difficult he suddenly wants to invoke old friendships.  Although U.S. policymakers may be inclined to let Duterte suffer, this is actually a good opportunity for the U.S. to improve relations with the Philippines and close off the first island chain.
5. As further evidence that countries are emulating the United States’ weaponization of trade tariffs, China announced it will impose anti-dumping tariffs on stainless steel imports from the European Union, Japan, South Korea, and Indonesia. According to the Ministry of Commerce, those countries are selling stainless steel billets and hot-rolled stainless steel plates in China at prices below their cost of production.
6. China’s direct investment[1] in the U.S. is slowing, down over 90% since President Trump took office.
7. The U.S. is starting to go after China’s banks in enforcing sanctions. This action is a significant escalation of threats and could make any agreements, including the trade deal, nearly impossible.
8. China’s foreign investment is making its way into areas critical to Russia’s geopolitical interests. Belarus is getting support from Chinese investment.  For now, it’s all smiles between Putin and Xi, but tensions will almost certainly rise if China’s influence spreads to Russia’s near abroad.  China and Russia are natural enemies; China has been expanding its investment into the “stans” for some time and moving onto the European plain would eventually become a serious threat.
9. There is some evidence that S. trade policy is affecting supply chains that involve China.

Brexit news: Boris Johnson is likely to be the new PM tomorrow.  He is already facing a cabinet crisis.  The current Chancellor of the Exchequer, Phil Hammond, and the Justice minister, David Gauke, announced they will resign if Johnson wins because they cannot support a hard Brexit.  Being politics, there is always someone willing to step in but what makes this disruption troubling is that, without an extension, the U.K. will leave on Halloween.  The time taken to build a cabinet is lost to either preparing to make a new deal or preparing for exit.

Budget news: Although the Speaker’s Friday deadline has come and gone, a deal looks close.  Essentially, the debt ceiling will be lifted without any serious spending cuts.  Such an agreement will be difficult for deficit hawks to accept but President Trump isn’t much for cutting spending and the GOP hardliners on spending don’t have the votes to kill the deal.

Pakistan’s in town: Pakistan’s president, Imran Khan, is in Washington today.  We would not expect much beyond a photoshoot.  The U.S. and Pakistan do have mutual needs.  The war in Afghanistan needs Pakistan’s support and the Pakistanis need U.S. economic help.  But, Pakistan’s primary worry is India and it wants a government in Afghanistan that it can trust to give it strategic depth.  The Taliban is seen as Pakistan’s best partner, so cooperation from Islamabad is going to be limited.

Abe wins: Japanese PM Abe’s party won a majority in the upper house over the weekend but not enough to push through constitutional changes.  Abe wanted a large enough margin to change Japan’s constitution which prevents offensive military action.

Ukraine: In the Ukrainian elections we previewed last week, pro-Western President Volodymyr Zelenskiy’s Servant of the People Party has apparently won an outright majority in parliament.  That could help give Zelenskiy the political capital needed to pursue a peace deal with Russia and the Russian-backed separatists who control parts of the country’s east.  In addition, it should help Zelenskiy with a number of initiatives important to the economy, such as combatting corruption, strengthening the rule of law, and easing the sale of agricultural land.

Spain: Socialist Party leader Pedro Sánchez’s prospects for forming a government have improved now that the leader of the Podemos Party, Pablo Iglesias, is no longer demanding a ministerial post in order to lend his party’s support.  Parliament will vote this week on whether to approve the Socialist government with Sánchez as prime minister.

Italy: The leaders of the ruling coalition, Deputy PMs Matteo Salvini and Luigi Di Maio, are expected to meet tomorrow to calm a row over the former’s acceptance of Russian political funding.  Italy is the only Western nation ruled by a “Nader coalition” of both left- and right-wing populists.  We have been watching to see how this government works since being in office.  The verdict so far is not so good, which may suggest that a Nader coalition doesn’t work in practice…or it may simply reflect the chaotic nature of Italian politics.

Bullard as Chair?  We were a bit surprised when St. Louis FRB President Bullard turned down a chance to become a Fed governor.  Instead, his director of research became the candidate for the job.  Perhaps Bullard turned down the job because he has higher ambitions; there are reports Bullard would “love” to become Fed Chair.  Bullard is a committed dove and would likely fit into what President Trump wants but he isn’t a “Trump guy” that would be more loyal to the president than to the Fed.  Still, for the president’s goals of easy monetary policy, Bullard would be a good pick…if the job were open.

Goodbye to float?  Float is the money that is made when a transaction is between destinations. Big banks have been working on a system of real-time payments; so has the Fed.  The big banks don’t want the competition, and small banks are terrified that the big banks will dominate them if they control payments.  Although the focus has been on whether the real-time payment system will be in private or semi-public hands, what we find most interesting is that the era of “free money” for banks may be coming to an end.

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[1] Direct investment is the purchase or building of physical assets in a nation.  Buying financial assets is considered portfolio investment.  Direct investment is considered a strong signal of confidence by foreign investors because the foreign entity is subjecting itself to the host nation’s legal system and the investment is always at risk of expropriation.