This time last week, I was enroute to Mississauga to drop my bike off at the starting location for this year’s Princess Margaret Cancer Foundation ride. The 209 kilometers covered that weekend with dozens of my CIBC colleagues was as uplifting and inspiring as it was challenging. There is something about gathering with thousands of cyclists, listening to stories of loss and recovery and then hearing that starting call. The other wonderful feature of the weekend ride was how the noise from geopolitics and market pundits was tuned out. Alas, on Monday it was time to return to the office and the real world – ready for this so-called agreement between the US and Iran and the first FOMC meeting chaired by Donald Trump’s appointee, Kevin Warsh. In contrast to how we got what we wanted from last weekend’s record-setting ride; Trump didn’t exactly get what he wanted from this week’s events.

Let’s start with the 14-point agreement, or memorandum of understanding (MOU), that the US e-signed with Iran on Wednesday night. I’m not going to dive into all 14, but in reviewing them it appears that Iran read Trump’s “Art of the Deal” and went one chapter better. In addition to getting $300 billion in a reconstruction and economic development fund, all US economic sanctions against Iran will end and the US will take steps to unfreeze Iran’s frozen or restricted funds. Iran agrees to neither procure nor develop a nuclear weapon but may continue to develop its nuclear program for civilian energy purposes. And it agrees to “make arrangements using its best efforts” to allow commercial vessels to pass through the Strait of Hormuz. The US agrees to remove its naval blockade. 

In essence, the agreement takes us to a situation which is a hybrid of where we were prior to the US attacking Iran and prior to Trump ripping up the previous nuclear agreement with Iran under the Obama administration. The price tag? Global economic dislocations, Middle East energy sector infrastructure degradation, higher inflation, much smaller US weapons inventories and increased uncertainty as to the economic outlook. The jury is going to be out for a long time as to whether this price was reasonable for what Trump or the American economy got and it’s important to stress that this MOU doesn’t exactly have a high probability of holding together over the coming 60 days. And Iran’s strategy with respect to the Strait has the potential of being copied in other regions.

Ally and I have been providing this exact message to clients this week and I made reference to this on BNN Bloomberg this morning. Have markets cheered on this “agreement”?  Absolutely, though the resumption of hostilities between Israel and Lebanon overnight and the scrapping of US-Iran peace talks in Switzerland caused some apprehension. It’s also important to note that most of the broader equity indices have not found enough juice to push back to recent record highs. The main exception was the Dow Jones, which hit a new intraday high above 61,800 on Tuesday.

Of course, crude oil prices have dropped sharply in response to the announced agreement, though this is really just an extension of a retracement that was reflecting weaker global demand exactly because of the effects of the war. As the above chart shows, Brent crude futures fell to below US$77/barrel on Thursday – the lowest level since March 2nd. Compared to the high of US$126.41 at the end of April, this is indeed a huge pullback and is going to calm a lot of drivers out there. When filling up at our local gas station tonight, the young lad breathed a sigh of relief that regular unleaded was back below $2 a liter! Yet, as Ally and I are reminding clients, Brent was trading below US$60 at the start of the year, and we are still up more than 30% from then – or around 60% on an annualized basis. Probably not what Republicans wanted going into the mid-terms.

As bad as this might be, at least the US economy is still delivering strong results. True, there have been no major cracks showing up in the data. Labour market conditions remain decent and, despite a sizable decline in consumer confidence, Americans are still spending ahead of their means. Retail sales rose by 0.9% in May, which was almost double street expectations and even if we strip our vehicles and gas station sales, there was a 0.8% gain. Employment growth in May was ahead of forecast as well and even though the weekly unemployment insurance claims figures have moved higher since the start of April, at 226,000 we are only back to levels at the beginning of the year. Unfortunately, with demand holding up and cost pressures still being felt from Iran war misstep, inflation has climbed and looks to be getting entrenched in other segments than just energy.

Enter Mr. Warsh. This freshly minted Fed Chair was supposed to bring Trump nothing but lower rates. Surely the new chair could look through things like higher inflation and a growing economy and deliver Trump what he wanted. This is a classic example of reading the candidate’s resume before giving them the job. Kevin Warsh is different from former Fed Chair Powell on a number of fronts (press conference likability being one of them) and key among them is his hawkish stance on inflation. Joe Biden never told Powell and the FOMC to stand pat on rates, even though the inflation numbers were screaming to them to hike, but he still stalled. Trump is calling for lower rates, but Warsh and crew delivered not only a no-change verdict on rates this week but signaled a greater tendency towards raising them before the end of the year. If you want to know why stocks fell back after the Iran deal was announced, it is because of the hawkish tilt at the Fed.

This is not to say that the Fed is going to raise rates this year, but unless demand conditions dramatically weaken or inflation nosedives, the options for rate cuts are slim to none. For the bond market, this means one thing. Short-term yields are going to be anchored and perhaps rise, while the perceived relaxation of hostilities in the Middle East and lower energy prices suggest that individuals and businesses will trim inflation expectations, allowing longer-term yields to decline. That is exactly what is playing out, as you can see in the above chart, where I show the US 2yr and 30yr government bond yields over the past year. Since the end of February, the 2yr yields have climbed 0.8% against a half-percent rise in the long bond yield. The narrowing in the gap between both yields is a caution flag for us. Not necessarily in terms of investing in longer-term bonds, though Ally and I still think that trade is premature.  The risk is that as the US yield curve flattens, this is yet one more headwind for the economy.

The good news is that the new Fed Chair is an inflation hawk.  He loves price stability and is probably more grounded in that base belief than a portrait of the president on the wall of his office. Now, this might simply be a display put on to generate credibility in the financial community for the new driver of the car. I beg to differ. Aside from the many structural reforms he might bring to the Fed, a defiance in favour of leaning towards one of the central bank’s mandates (price stability) versus the second mandate of maximum employment might help the US bond market at a time when fiscal discipline has flown out the window.

In terms of the portfolio, the fact that Trump didn’t get what he really wanted this week means that the odds of deterioration in US economic fundamentals still remain higher than those of an acceleration in growth. And because it is precisely that acceleration that has fueled stocks in recent weeks, we need to be focused on shifts. Neither are we naïve to the risk that the US-Iran agreement ends up getting dismantled like the UFC claw on the White House south lawn. When the gas station attendant started looking happy that gas prices were heading back to December levels, I had to tell him not to get too excited. You can’t always get what you want.

On behalf of the Pyle Wealth Advisory team, have a wonderful weekend.     

Andrew Pyle