** Our sense of the Fed’s current crisis management thinking – and we can only imagine what hours are being put in — is that the Fed is not thinking of YCC as a liquidity tool to currently put to use, but are instead still extremely focused on moving forward with additional alphabet facilities to target a smoothing of market functioning.

** We understand many Fed officials have been frustrated with the dealer/banks and that the massive repo operations have not been reaching to where the liquidity is needed. But, on the other hand, there looks to be an accumulative calming across most of the markets in the wake of the QE purchases, the flood of repo, and the string of new targeted facilities and swap lines. So we still expect more of what could be best described a market functioning targeted vehicles, among them:

** The one at the top of the Fed menu, we believe, is a reworked version of the 2008 Term Asset-Backed Securities Loan Facility (TALF), in which the Fed purchased newly originated asset-backed securities. There is no way of knowing with certainty, but we believe its likely reincarnation will entail a fine tuning to reach a targeted small to medium sized business sector, and with perhaps looser credit ratings than just AAA paper. Whatever its final form, a TALF or a similar vehicle will require Treasury authorization and a credit backstop, either from Treasury through its Exchange Stabilization Fund or from Congress in one of the huge fiscal stimulus bills storming across Capitol Hill (the original TALF was funded through TARP money).

Tim Duy's Fed Watch:

The Fed may have to act again before the next meeting, like Monday morning. Although last week some Fed officials like St. Louis Federal Reserve President James Bullard floated the idea that the Fed simply moved up the March rate hike, such comments shouldn’t be taken too seriously (the blackout period couldn’t come soon enough).
There is just too much uncertainty for the Fed to try to hold off on further easing and a strong argument for delivering more easing sooner than later. Given low inflation low and market expectation that it falls further, the low-risk, high-reward policy position argues in favor of additional easing.
Realistically, the Fed should be discussing just taking rates to zero and getting very far out ahead of the data but they tend not to react that quickly. Bond markets are telling them to do it. I don’t have a strong argument for gradualism in this environment. If you take rates to zero, you maximize the odds of getting ahead of the weakness. If you can’t get ahead of the weakness, you are going to zero anyways. In either case, once you get back to the zero bound, then you need to look at QE, yield curve control, forward guidance, liquidity provisions, etc.

Global attention on the newly dubbed “Covid-19” virus has been focused on ground zero of the epidemic in China, and on monitoring pockets of super-spreaders such as in Singapore.

But the virus has proven an enormous source of concern also in Japan, given its proximity to China, and the strong interrelationship between the number two and number three economies of the world.

** The first source of concern in Tokyo is over the potential for the spread of the Covid-19 virus itself: out of the 32 million visitors to Japan in 2019, a whopping 30% are estimated to have come from China. **

** And from an economic perspective, the virus fallout is coming on the heels of a severe downturn already at the end of the year in activity, as evidenced in declining industry production levels, a buildup in inventories, and a downturn in private consumption. **

** But cynically speaking, the virus may provide political cover for Japan’s Prime Minster Shinzo Abe in distancing what is an increasingly sharp slowdown from the impact, primarily, of the government’s well telegraphed, but still controversial, VAT tax hike last October 1 from 8% to 10%. **

That respite for Abe, however, may prove short-lived, as local economists increasingly eye the possibility that Japan may enter a recession in the not too distant future.

** Saudi Arabia is unlikely to press for large-scale near term output cuts of up to 1 million barrels per day when the OPEC Joint Ministerial Monitoring Committee meets this week, but it will support a more cautious collective cut in the OPEC+ output of around 500,000 barrels per day as the most prudent response to the impact of the Chinese coronavirus outbreak on crude oil demand.

** And as of today, Saudi officials are also likely to seek a delay on a decision whether to bring forward to February the scheduled March OPEC+ Ministerial meeting until there are at least some clearer indications of how sustained the drop in crude demand will prove to be, and if others are indeed willing to take action, however small, as the new Saudi Energy Minister has repeatedly advised that everyone was in this together.

** There is a concern also in signaling a panic – a fear voiced by Russian oil officials – and which might elevate expectations for the deeper output cuts Saudi oil officials are for now very reluctant to commit to when it is still unclear how sustained the drop in crude demand will be.

But despite recent expressions of frustration with the pace of negotiations by President Trump, Chinese sources still believe he very much cares about striking a first phase deal with China soon, and continue to believe, despite Commerce Secretary Wilbur Ross’ warnings to the contrary, that they have assurances the threatened December 15 tariffs will not be imposed if there is progress, but still no deal, by then.

As to the remaining hurdles to a deal, Chinese negotiators reiterate that the US must agree to roll back current tariffs in a trade agreement, and not just avert the upcoming tariffs scheduled for December 15. This rollback could be in several stages (presumably starting with last September’s tariff hikes), but however it is presented, Beijing wants a path to seeing all tariffs removed if the US is to “show sincerity” on its negotiating side.

Indeed, the complication for Beijing is that while President Trump has attempted to pull China into concrete commitments to multiple years of (unrealistically) ambitious agricultural purchases in this “phase one” agreement, there is no assurance in reality there will ever be a “Phase Two” to address some of China’s concerns about the existing tariff regime. So Beijing, we believe, has doubled down in pushing for a roadmap, at least, for the removal of all tariffs in this round.

All said, sources in China remain “cautiously optimistic” a phase one deal can be signed, but as we have written, not by December 15, but perhaps, if all goes well, they now expect it could happen before the advent of the Chinese New Year, on January 25 of next year.

*** And third, while it is early days to be sure, we think there is very likely to be a boost to German spending next year and in 2021, even if modest. Despite Berlin’s defiant insistence there is no case for deficit-financed spending in Germany, our sense is that the demand to loosen the “black zero” fiscal policies so central to Walter-Borjans and Esken’s winning leadership campaign enjoys a far wider support across the main political parties than assumed. Indeed, “black zero” is less an ideological constraint than a pragmatic calculation, the timing and eventual scale to a softer “guiding principle” in the interpretation of the fiscal brake driven to a large extent by the eventual impact of Brexit on the German economy. ***

President Donald Trump’s threat yesterday to hike tariffs “substantially” if there is no trade agreement with China soon, and press reports of pushback by hawks within the White House and Trump himself against Beijing’s demands that US tariffs be rolled back have raised concerns in markets over the status of current trade negotiations between China and the United States.

*** Despite those concerns, we continue to believe there will be a “phase one” deal signing, albeit most likely now in early December, and we would put the odds on that as high as 80-90%. Senior officials in Beijing, at least, believe they received assurances in a call on Friday that the US side would agree to remove tariffs imposed on each other’s products, “in different phases, after both sides make progress” in reaching a deal. ***

** In looking ahead, the message went on that if the two sides reach a phased trade agreement, China, will “consider removing” (meaning they will remove) extra tariffs on most US agricultural products, and “both sides” (meaning more importantly the US side) will give up additional rounds of tariffs threatened on each other for December 15.

** Not anticipated by markets, Beijing is also asking that in return for its lifting of the extra tariffs on US agricultural imports that it imposed in tit-for-tat escalations with the US, the US should consider removing equal amounts of tariffs that it imposed on Chinese products. That would be above and beyond a simple ceasefire on the December 15 tariff threats.

** In looking ahead, the message went on that if the two sides reach a phased trade agreement, China, will “consider removing” (meaning they will remove) extra tariffs on most US agricultural products, and “both sides” (meaning more importantly the US side) will give up additional rounds of tariffs threatened on each other for December 15.

** Not anticipated by markets, Beijing is also asking that in return for its lifting of the extra tariffs on US agricultural imports that it imposed in tit-for-tat escalations with the US, the US should consider removing equal amounts of tariffs that it imposed on Chinese products. That would be above and beyond a simple ceasefire on the December 15 tariff threats.

Chinese officials expect the following deal, barring an unlikely last minute “accident” in advance of Liu’s meeting this afternoon in the Oval Office with Trump (see SGH 9/30/19, “China: A “Mini-Truce,” with Major Tensions”).

** China will make “substantial” purchases of US agricultural products, and the US will not raise the existing tariffs on $250 billion of Chinese imports from 25% to 30% as threatened on October 15.

** We continue to get no indication, however, that the 25% tariffs will be rolled back, yet – note that this has not been a demand we have heard from Beijing for a very limited cease-fire – nor do we have indication that there will be any assurances at this point from the US over the threatened next round of December 15 tariffs.

The prospects for a narrow, “skinny” truce are still alive, barely – even with the latest sanctions from the US on 28 Chinese technology firms over human rights, the salvo from China’s beloved US National Basketball Association on Hong Kong, and, most importantly, indications that some internal deliberations over elements of the “Equitable Act” restrictions on investments from and into China are, despite “denials” by the White House, very much alive . If the mini-truce that was lubricated by increased Chinese purchases of US soybeans before this week’s talks does indeed materialize, the most likely result, sources say, will be for Beijing to make a limited commitment to purchase major US agricultural products that are not below last year’s modest numbers. In return, the US must agree not to hike tariffs on $250 billion of Chinese goods, and the two sides could then agree, if all goes well, to sign an interim bilateral trade agreement in November.

As to the upcoming round of talks, Chinese negotiators maintain they do not hold out great prospects for reaching an “interim agreement.” But markets may nevertheless take solace at a mini-truce that would see a continuation of an increase in the purchase of agricultural products by Beijing, in exchange simply for an agreement by the White House to refrain from hiking tariffs on $250 billion of Chinese imports on October 15 from 25% to 30%, as currently threatened. That certainly appears to be a low bar for that mini-truce to be struck.

** As to last week’s vice-ministerial level meetings, sources in Beijing note that there was little progress on any substance in those talks, but enough goodwill was established between the two sides to pave the way for Vice-Premier Liu He to visit Washington in October, as hoped, for the 13th round of talks. From what we understand, preparations are being made now for the principals’ meeting between Liu, US Trade Representative Robert Lighthizer, and Treasury Secretary Steven Mnuchin for the week of October 6.

First, the easiest quick fix to the ending stress would be a third downward tweak to the spread of the Interest on Excess Reserves rate over the bottom end of Fed Funds range by at least 5 basis points. So we assume it is almost certain the formal policy statement from the Federal Open Market committee will include an implementation note that the IOER will be cut by a larger 30 basis points, putting the rate at 1.80%, relative to the highly likely 25 basis point cut in the target range for federal funds to 1.75%-2%.
We are hesitant to fully buy into the argument of the expanded balance sheet being announced today. We do not hold any strong conviction one way or another on this front, but we would wonder whether the FOMC will be more inclined to address the short term funding stresses through a further expansion of repo operations to whatever scale required rather than outright purchases and an expansion of the overall balance sheet. It feels like it would be too rushed for the FOMC to jump straight into an expansion of the balance sheet today without a longer lead time to fully work out the fine tuning details and to prepare and explain that is a technical adjustment and not an additional statement of further easing in monetary conditions.

A 25 basis point rate cut is all but certain to be announced this coming Wednesday afternoon when the Federal Open Market Committee concludes its two-day September meeting. Now the overhang of the shock attack and disruption to Saudi Arabia’s oil output is certain to add to the growing sense of uncertainties and risk probabilities hanging over the FOMC’s deliberations. Whether the 2019 median comes in at no more rate cuts after this Wednesday, or perhaps just showing one more cut feels almost beside the point; in any case there is likely to be enough rate dots showing still one more easing beyond the expected rate cut on Wednesday is on the table. Equally, the rate dot projections further out will carry even less real information, though it is probably safe to assume the medians will not be as gloomy as the market pricing. The rate dots for 2022, for instance, may prove to show a clearer bifurcation of the Committee projections, with nearly half showing a return to rate hikes, perhaps even beginning in 2021, while an equal near half showing an extended period of a flatlined policy rate.

Since Bank of Finland Governor Olli Rehn delighted markets in mid-August in calling for the European Central Bank to overdeliver on expectations with an “impactful and significant” stimulus package at its upcoming rate setting meeting on September 12, no less than five of his fellow Governing Council members have publicly come out against a package next week that would include a resumption in the ECB’s Asset Purchase Program.

*** We believe, despite the frayed consensus within the Governing Council, that a bond buying program in perhaps the 20-30 billion euros per month range was nevertheless included in the options presented on Tuesday to ECB officials for consideration in the run-up to the final stimulus decision next week. ***

*** The first course of action next week, and where there is clearly far greater consensus, remains on the interest rate side, where we believe the proposed options include a cut of 10 or 15 basis points in the ECB’s currently negative 0.4% benchmark deposit rate. While a handful of analysts may expect, or hope for, a larger 20 basis points cuts, we do not understand that to be on the table. ***

That cut will be accompanied as expected with “mitigating measures,” or tiering, to exempt some bank deposits from the deeper punitive rates and soften the blow on the Eurozone banking sector. We suspect that tiering will be limited – after all negative rates are not the core issue ailing Eurozone banks – and could be tied to metrics that would ensure that the banks that do receive relief are in turn doing their part in lending money out into the system.

Indeed, in a meeting on Saturday in Zhongnanhai that was attended by China’s highest leadership, President Xi Jinping, from what we understand, characterized the President’s latest round raising of the rate of tariffs on almost all Chinese imports as a sign of “hysteria” and “desperation.”

Trump, Xi said, cannot be allowed to bully China, and unless his administration was to fully accept Beijing’s three principles, there would be no bilateral agreement between the two countries.

The first of those principles, as a reminder, is the removal of all the Trump administration tariffs on Chinese exports to the US.

Having said that, after Friday’s fireworks, Xi added there was no need to immediately escalate again with further additional tariffs – at least not yet.

In the meantime, he instructed Premier Li to convene a meeting on Saturday afternoon to go over a series of further countermeasures against the US, if needed.

** The same sources, however, expect that Trump will go ahead and impose the 10% tariffs, as threatened, on some Chinese exports on September 1 – and that will be a problem for Beijing. For Beijing’s part, the imposition of any new tariffs, no matter how it is packaged, would violate the consensus reached behind closed doors between Trump and China’s President Xi Jinping on the sidelines of the June 28-29 G20 summit in Osaka, Japan. As such, it will elicit a response.

** Assuming the 10% tariffs are imposed on September 1, even if there is some movement on Huawei, China, from what we understand, will adopt “two-part countermeasures, including tariffs and non-tariffs,” in response. On the non-tariff side, Beijing will, for starters, “severely” control the export of rare earth materials to the United States (see SGH 8/12/19, “China: Trade Retaliation Plans”). In addition, and much more visible to the markets and farm states dear to Trump’s re-election bid, Beijing will continue its suspension of large-scale purchases of agricultural products from the United States if tariffs are imposed – even if there is, as expected, some limited movement on Huawei.

Three weeks ago, China’s State Council reviewed and approved the National Development and Reform Commission’s (NDRC) plans for major industrial production output, as well as the joint NDRC/Ministry of Commerce plans for commodity imports and exports for the second half of 2019.

*** Perhaps of greatest immediate relevance to markets, both the NDRC and MOC planning is now predicated on the assumption that President Donald Trump will indeed impose the 10% tariffs on roughly $300 billion of Chinese exports to the US, as threatened, on September 1. ***

*** As such, from what we understand, three departments have recommended that the central government cease purchases of agricultural goods from the US — entirely — should that next round of tariffs, as now expected, be imposed. ***

*** Furthermore, China would significantly curtail exports of rare earth materials to the US and impose 25% price hikes on those that do go out, should the Trump administration proceed with its 10% tariff threat. And should Trump then escalate the tariffs from 10% to 25%, the proposal is to cut rare earth exports to the US entirely. ***

By this point, most all senior sources canvassed in Beijing do not expect a trade agreement with the US to be reached at all in 2019.

And in response Beijing has, for starters, yet to confirm it will stick to the agreed plan after the brief July meeting in Shanghai between US Trade Representative Robert Lighthizer, Treasury Secretary Steven Mnuchin, and Vice-Premier Liu He to hold low level discussions through August that would be followed by a meeting of the principals again in early September. While that may still end up the case — after all talking is better than not talking — expectations that these meetings will proceed have for now only been confirmed by the US side.