What to Worry about Today: The Fed

Outlook:

We are getting signals to go long the dollar against everything except the pound and euro, even the yen and Swiss franc. Coming right after a sell signal, the jumpiness is unnerving. No sooner do we deduce that all the good news is already priced in when something else comes along to provide a new factor. The Fed minutes seldom deliver that new factor and as noted above, we think it made a horrific error naming the stronger dollar as a risk factor for the US economy. There will be Consequences.

If the Fed were to retreat a little, presumably yields and the dollar would retreat, too. With so many new Fed members and a new chairman, a little incoherence is likely, but hardly normal. While the Fed doesn’t dictate to the regional Fed presidents and they quite often go their own way—Yellen was outspoken and a straight-shooter when she was at the San Francisco Fed—but somehow they mostly managed to deliver a somewhat balanced set of viewpoints. Today we get St. Louis Pres Bullard, considered by some to be dovish (although the St. Louis Fed itself has a long history of being hawkish). Oh, dear.

At a guess, hot-spots like Brexit and Italy are going to drag on, and on, and on. Eleventh hour doesn’t begin to describe it because players keep resetting the clock. That leave two major players on the stage, the US and China. Last week The Economist noted the weird situation of China being the only major country still loosening credit and boosting growth with easy money—when it can hardly afford such a stance, given already existing over-indebtedness. At some point China will face a rock and a hard place, and the yuan will have to go. China escaped being named a currency manipulator in the latest Treasury report, but at some point and soon, it’s likely to throw in the towel. That will set off Trump and depending on the timing, bring on the 25% tariff, now scheduled for January, much sooner.

If we assume the Dems take the House in the mid-terms on Nov 6, that new tariff on Chinese imports could come on Nov 7, whereupon the currency war could be on. This scenario is as likely as any other. Be prepared.

Better Data: We wrote last week about how the average Joe can’t afford to buy a new house. Turns out there was a simpler way to express it with fewer words, and here it is, from those fine statisticians at ScotiaBank. It’s named “housing affordability.” A picture is worth a thousand words. Chart courtesy of The Daily Shot, which published another chart showing subprime mortgages basically vanished in 2009. The percentage of very high risk loans was 42% in 2006 and has fallean to 24% in 2017.

And it’s not going to get better. New starts fell more than forecast in Sept, down 5.3% to 1.201 million units and Aug was revised downward, too. The South got a drop of 13.7% to a, 3-year low, with blame going to the hurricane. Building permits fell 0.6 percent to a rate of 1.241 million units for the second month of decline. By sector, multi-family starts crashed 15.2% and single family starts fell 7.6%. 

Left Field: Oil economist Jim Williams offers a splendid summary of the US-Saudi tiff (www.energyeconomist.com). Here it is in full, with permission: 

Saudi Risk

Saudi journalist Jamal Khashoggi entered Saudi Arabia's consulate in Istanbul on October 2 and never reappeared through the doors he entered. Current speculation is that the Saudis will say that they intended to arrest him and bring him to Saudi Arabia, but things got out of hand with his interrogation.

For years he worked for the Saudi media and even served as an advisor to Saudi intelligence, but got cross-ways with the government. First for a column criticizing President-elect Trump in 2016 and more recently for defending Saudi women's rights activist Loujain al-Hathloul. He left Saudi Arabia for the U.S. in 2017 and with a green card has been working for the Washington Post for about a year. That raised his profile which was already high in the West. Had he not relocated to the U.S. and worked for the Washington Post his disappearance would probably not risen to the level of a major event putting a strain on relations with the U.S. and other Western nations.

Secretary of State Mike Pompeo met with Saudi Arabia's King Salman and Crown Prince Mohammed bin Salman (MbS) in Riyadh yesterday and is in Turkey today. Both King Salman and MbS told Pompeo that they did not authorize the assassination. For all we know that may be the case and it could be a kidnapping to return Khashoggi to Saudi Arabia that went wrong. Even if it was intentional, the most likely outcome is that the blame will be placed on a scapegoat providing some deniability at the highest levels.

In the mid-term election cycle there is strong reaction against the Saudis on both sides of the isle. This poses threats to many contracts for military equipment and a possible retaliation from the Saudis. It also poses a threat to the U.S. Iranian policy the greatest supporter of which is Saudi Arabia.

Here are the oil risks as we see them:

1. The Saudis, who increased oil production over 100,000 b/d to 10.5 million b/d in September, could announce a cut, increasing prices in the last three weeks before the mid-term elections. This has been hinted, but Democrat control of the House and/or Senate increases risks for the Saudis of the cancellation of sales of military equipment. If canceled, there would be a shift toward China and Russia and greater influence in the Gulf. Protection of shipping in the Persian Gulf by U.S. and its allies has helped stabilized oil prices for decades. The military option is a real but longer term risk.

2. The House and Senate could pass the NOPEC bill (No Oil Producing and Exporting Cartels Act). It basically makes oil exporting countries subject to the Sherman Act which is the cornerstone of U.S. antitrust law. It has had several resurrections. President Bush threatened to veto it and a President Obama opposed it even though he had voted for it as a Senator. If the NOPEC bill passed both house and was approved by President Trump it risks greater and more frequent price fluctuations.
   
   If OPEC members do not "collude" to control productions and therefore prices, they will behave as individual oil producers. That means they will produce all the oil they can as long as the price exceeds their lifting (marginal) cost. That means OPEC members, think Saudi Arabia, will no longer go to the expense of maintaining spare production capacity.
   
   

   

   
   
   Spare capacity, estimated at 1.34 million b/d by the EIA, is already under stress with lower production from Iran and Venezuela. Libyan production is now at about a million barrels per day, but could easily be subject to another interruption. Nigerian production remains subject to periodic interruptions in the delta. With no spare capacity, supply interruption, which are frequent (see charts on the right) would lead to greater price fluctuations.
   
   Greater price movements could result in less stability in the OPEC countries leading to more supply interruptions. Also, the lack of spare capacity would provide additional support to prices just based on the fear of an interruption.

3. U.S. legislators might argue that we are no longer dependent on OPEC exports or soon could be, and that the U.S. need not worry about Saudi oil. For that argument to be effective the U.S. would have to be isolated from the entire international market. Even if the U.S. became a net exporter of oil and petroleum products, which requires an increase of 2.5 million b/d in production, domestic prices would still move with international prices. During an international shortage, the higher price would still impact U.S. consumers. Furthermore, without international spare capacity, prices would be more volatile than they have been historically.

4. Without U.S. and military support for the Arab nations in the Persian/Arab Gulf, Russia and China will fill the gap. The Saudis would drift away from the rapprochement with Israel causing greater instability in the Middle East and North Africa.

Conclusion

While we join the world in condemning the death of Jamal Khashoggi, there is a high risk to changing overall policies toward Saudi Arabia. The oil price risk is clear but it could lead to a less stable Middle East, increase the probability of Iran completing development of nuclear weapons and the loss of even more lives.  The threat of instability in Saudi Arabia along with the threats of sanctions and NOPEC legislation will continue to support instability and higher prices.

This is an excerpt from “The Rockefeller Morning Briefing,” which is far larger (about 10 pages). The Briefing has been published every day for over 25 years and represents experienced analysis and insight. The report offers deep background and is not intended to guide FX trading. Rockefeller produces other reports (in spot and futures) for trading purposes.

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