"Good Things Could Happen"

By Molly Schwartz, cross-asset strategist at Rabobank

President Trump spoke with reporters yesterday aboard Air Force One, saying that the US is “meeting with Iran” and that “good things could happen”—with the “could” doing some heavy lifting. What the “good things” are, or when they “could happen,” is still TBD. The other alternative is that “if they don’t work out, [the US] will go back to very strong military action.” That, of course, is dependent on whether or not these talks are actually happening (or at least happening with the people who matter) which Iran currently denies.

We heard announcements over the weekend that Trump was “pausing” strikes on Iran. But that doesn’t mean that Iran has paused strikes against its neighbors. Indeed, Jordanian and Israeli military forces both claimed to have intercepted drones in Jordanian airspace early yesterday morning, while sources from Saudi Arabia said that they intercepted drones launched by Iran-backed militias operating in Iraqi territory.

Markets, however, were seemingly unmoved. Brent crude oil futures traded sideways around $90/bbl after gapping lower on the open, while US rates were similarly sluggish. However, the US yield curve continues to flatten, now at 22bp down from recent heights of 73bp, seemingly poised to flatten further as short-term inflation and Fed hike expectations rise. Re-escalated tensions last week led to a sharp spike in 2-year breakeven yields, up more than 21bp from July 23, back to 2.16%. Meanwhile, the US OIS curve signals investor expectations of a hike by the September FOMC meeting, and more than two full Fed hikes by March of next year.

Trump is not taking a note from Warsh with regard to his philosophy on limiting communication on monetary policy, also making his stance on interest rates and the Fed very clear yesterday. Predictably, Trump re-emphasized that he thinks “rates should be lowered,” but qualified that “you need a consensus from people,” highlighting that “Warsh is great, but he has a board.” The tone came across as softer than that he used when speaking of Warsh’s predecessor (perhaps giving Warsh some wiggle room to hold rates (or hike?)), but the bar for softer rhetoric in this instance is on the floor.

In his recently published FOMC preview, Talking about hikes, Rabobank’s Philip Marey writes that hikes are not part of his own Fed forecasts. Still, he expects plenty of chatter around them, both in markets and within the FOMC itself. He points to Kevin Warsh’s desire for a “good family fight” and the possibility of dissents in favor of hikes at the upcoming decision.

While Kevin Warsh does technically need a consensus to come to an interest rate decision, the current composition of the FOMC still appears to favor the doves. A look at where members generally sit on Bloomberg’s Hawk-Dove spectrum suggests an even five-to-five split, with the remaining Board members clustered closer to the middle. However, that headline balance overstates the hawks’ practical position. Warsh sits firmly on the dovish side and, as Fed Chair, has additional influence in shaping the policy discussion and building consensus. More importantly, the voting arithmetic is tilted in the same direction: five of the dovish members are voters, while only two of the more hawkish members currently have a vote, with the others either non-voters or alternates. So, unless the hawks can bring centrists with them, the balance of votes is likely to remain firmly with the doves, raising the bar for hikes even further.

That said, hikes are not entirely off the table. While energy prices have fallen by around $10/bbl from last week, a full-scale re-escalation and persistent disruptions to the Strait of Hormuz, and the Bab el-Mandeb Strait, could fuel inflationary pressures in the US. Marey writes that “if inflation expectations become unanchored…we may have to pencil in a hike later this year and push the rate cuts further into the future.”

On the other side of the Atlantic, Brussels is still grappling with the prospect that “cold shoulders” and civil discourse are not always the most effective strategies, not only when dealing with an adversary like Russia, but also when trying to wrangle EU members to make any decision. The EU’s proposed sanctions package against Russia failed to pass last week after Greece refused to sign off unless a carve-out was made to allow Greece to continue to transport Russian LNG.

EU officials were furious. According to the Financial Times, one EU official said that “this approach does not work any more” while another lamented that they “don’t want to hear anyone talk about ‘solidarity’ any more.” Still, as Trump put it, “good things could happen.”

Perhaps that means Greece eventually signs off on the sanctions package; perhaps it means a more durable de-escalation further down the line.

For now, though, markets are left trading the gap between what could happen and what has actually happened.