Gary Cohn, Now the Leading Candidate to Succeed Yellen as Fed Chair

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Updated, July 11, 2017 at 6:45pm

Breaking: Gary Cohn is now the leading candidate to succeed Yellen as the world’s most important central banker…

President Donald Trump is increasingly unlikely to nominate Federal Reserve Chair Janet Yellen next year for a second term, four people close to the process told Politico.

Yellen’s Job is Cohn’s if he wants it, and he would win Senate confirmation easily, one Republican close to the selection process told Politico.

National Economic Council Director Gary Cohn is now the leading candidate to succeed Yellen as the world’s most important central banker, these people said. Yellen begins two days of congressional testimony on Wednesday, and her own future in the job may come up in questioning.

You have to go back to the 1970s to see a non-economist Fed Chair, we’ve been telling clients all year – we believe Trump wants a practitioner, NOT another academic who’s never taken professional risk.  G. William Miller was Fed Chair under President Jimmy Carter, the last Chair outside academia to run the world’s most powerful central bank.

Yellen’s Legacy Has an Impact on Markets

Gold prices plunged again Friday, now 7% off their June highs, while the gold miners GDX sits 12% lower over the same period.  What’s going on?

As central bankers from the U.S., Canada, Europe and Asia have turned more hawkish (publicly discussed pulling back accommodation) – bond yields have surged while gold has plunged.

“If we were not to withdraw accommodation, the risk would be that the economy would crash to a very, very low unemployment rate and generate inflation.  Then the risk would be that we would have to slam on the brakes and the next stop would be a recession.”

Bill Dudley, New York Federal Reserve Bank – July 2017

Implied Probability of Deposit Rate Hike from the ECB*

July: 66%
June: 20%

*OIS swaps, looking out over the next 11 months to June 2018.  Most of this move higher occurred after Mario Draghi’s speech last week.  Banks like HSBC are anxiously adjusting their outlook, now forecasting 10-yr German bund yields will hit 90bps (53bps today – 22bps in June)) by year-end.  The breadth of that kind of sell off brings back memories of Jean Claude Trichet’s ECB.  Their 2011 rate hike was judged by most market participants as a disaster – pulling back accommodation into a deflation storm.

“We’ve not only reached full employment mark – we’ve exceeded it by a fair amount.  If we delay too long, the economy will eventually overheat, causing inflation or some other problem.”

John Williams, San Francisco Federal Reserve Bank – July 2017

In our opinion, President Trump is in Fed chair Yellen’s head – legacy in on her mind.  With Yellen’s term up in February and receiving no visibility on a White House re-appointment – Yellen has been digging in.  She’s taking this opportunity to pen a few pages in the history books.   After years of gross over-accommodation – an easy money gravy train pumping up asset bubbles – Yellen’s Fed is singing a far different tune today.  If she goes out – the Yellen Fed wants the world to know in their last 9 months of service, they tried to let some air out of the balloon.

Fed Chair Yellen on Capitol Hill, July 12-13

Federal Reserve Chair Janet Yellen has been making the case – strong hiring will feed through to higher wages and price pressures over time.  She will explain her views on the labor-market and the Fed’s colossal balance sheet (levered 77-1 see below) when she delivers semi-annual testimony to Congress next week. She speaks to the House Financial Services Committee on July 12 and the Senate Banking Committee on July 13.

Short Positions in Gold Futures and Options*

July: 96k
June 63k
May: 51k
April: 41k

*CFTC data, highest since January 2016 – signals that global central banks are shifting ever closer to pulling back economic stimulus helped boost bearish bets on the gold to the highest in almost 18 months.

U.S. 2 Year Bond Yield

US 2s new

A hawkish turn by the Fed has two year bond yields at 6 year highs.  Government bonds globally have lost nearly $350B in recent weeks under the bond sell off siege.

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To add fuel to the fire, this week’s ECB minutes (European Central Bank) hint toward coordination with Yellen’s FOMC.  The “financial conditions” targeting narrative we laid our in our Bear Traps Report (in June) is picking up believers, moving toward a consensus view.

Financial Conditions are Driving the Gold Bus

Chi Fed Fin Con v GoldWe have an index of our 21 Lehman Systemic Risk Indicators, the Chicago Fed’s Financial Conditions Index is similar above.  Over much of the last five years – as financial conditions tightened, gold surged (see above).   On the other hand, in 2017 we’ve witnessed a regime change.  This year as the Fed has hiked rates twice – financial conditions eased – NOT tightened.  As long as financial conditions are NOT stressed – Yellen’s Fed has runway on the hawkish side to pull back accommodation.   Relationship to gold?  A year ago today there were close to $15T of negative yielding bonds on earth – this number is now well below $7T today.  As bond yields have surged – globally gold is far less attractive to hold – the macro impact on this metal has been profound.

Negative Yielding Bonds on Earth in July (in Trillions)

2017: $6.1T
2016: $15.1T

Bloomberg data

Fed Fund Futures, only Pricing in a 19% Chance of a September Rate Hike

Wall St. has unanimously read the Fed’s recent hawkish turn with focus on the Fed’s balance sheet, NOT rate hikes.  At a colossal $4.46T, most of Wall St’s economists see the Fed reducing the size of its SOMA* in September.  Wall St’s braintrusts like to hangout together, they typically think very much alike.  A year ago today, NOT one firm on the Street believed the Fed would touch the SOMA in 2017, or 2018 for that matter.  Today, they’ve moved up their expectations in a panicked hurry.

System Open Market Account (SOMA)

*The Federal Reserve System Open Market Account (SOMA) is a portfolio of U.S. Treasury and Federal Agency securities, foreign currency investments and reciprocal currency arrangements.

Central Bank Assets as a % of GDP

2007 to 2017

BOJ: 18% to 92%
ECB: 12% to 40%
BOE: 3% to 27%
FOMC: 7% to 23% (SOMA)

Bloomberg

Fed’s Balance Sheet (SOMA) and Funds Rate

SOMA3We must keep in mind, in February there was only a 17%  probability of a Fed rate hike in March (according to Wall Street’s economists).  This was before the Federal Open Market Committee (FOMC ) began shifting market expectations and ultimately tightened (hiked rates) in March.  Rule #1, more often than NOT – Wall St. gets the Fed wrong.   Today, the entire street has their eye on September SOMA reduction – rate hikes are (near) unanimously a December issue in terms of street expectations.   Our Bear Traps Report research team meticulously measures the breath of crowded trades on Wall St. – very often this is where alpha is found, going the other way.   

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Nasdaq 100 Volatility, Largest Premium over the VIX Since 2004

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Tesla $TSLA Drawdowns Since 2013

Feb 2016 -48%
Dec 2013 -38%
Aprl 2015 -36%
May 2014 -32%
Dec 2016 -31%
July 2017 -15%

Bloomberg

Nasdaq Volatility – Highest Since November, a Spectacular Divergence found in NDX vs S&P Realized Volatility

CBOE NDX Volatility Index vs VIX

This week, we’ve witnessed a strong correlation between Nasdaq and Rates (Treasuries). Keep in mind, this year the Nasdaq went up with U.S. government bonds as investors rotated from Trump trades into large capitalization growth stocks.  This Spring – as DC gridlock took hold – investors rushed into bonds and the Nasdaq 100.  Today, this rotation is now in full reverse mode.  See our The Bear Traps Report with Larry McDonald; Reflation Revival, Part I – June 21, 2017.  U.S. GDP and ISM data has come in above expectations.  At the same time, there is far more momentum in Washington than there was during the Comey (former FBI Director fired by President Trump) drama days of early May.  Over the last few weeks, the sell off in U.S. Treasuries and FAANG (Facebook, Apple, Amazon, Netflix, Google) equities has been spectacular.   Investors are rushing back into value stocks with energy names (XLE, XOP) up 7-9% from their recent lows.  Which begs the question, if oil (WTI) can make a move back up above $49 – where will Facebook FB trade?  $135?

In our view, the 2017 bond market rally – which saw yields plunge from 2.62% in December to 2.12% on June 26th – supported the equity market surge, especially in the Nasdaq NDX.   Going on the 9th year of the equity bull market, it’s clear to us the 2017 explosion higher in the Nasdaq 100 NDX had a lot to do with the plunge in long duration bond yields.  The recent reversal in this trend has been profound.

Volatility Suppression

We must remember, global equities are off to their best start since 1998  – calm waters are sucking a lot of people in to complacency.  Too many players are in the same trade selling volatility, they’re stepping in front of a steamroller – trying to pick up a $1 bill.   Over the years, time after time we’ve seen this trade print money for weeks on end – only to give it all back in a few days.  The VIX, also known as the CBOE Volatility Index has plunged 21% this year – its smallest quarterly average since in eleven years.  We’ve also seen the least amount of one-day* surges in any first half year going back as far as 2005.

*Moves greater than 10% in one trading day

S&P 500 Smallest 1st Half Drawdowns

1995: -1.7%
2017: -2.8%
1964: -3.1%
1954: -3.6%
1963: -3.6%
2015: -3.7%
1985: -3.7%
1989: -4.2%
1961: -4.3%

Schaeffer’s Research

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Nasdaq 100 Volatility Premium over the S&P 500 VIX

NDX over VIX

You have to go back to 2004 to find this large a volatility premium.  Forty one stocks in the Nasdaq 100 NDX are up 30% or more in the first half of 2017, today’s volatility premium is spectacular.  As we start Q3, growth continues to lose leadership.   There’s a powerful growth to value rotation developing as the “reflation trade” has stormed back to life.   Looking at returns, the Nasdaq 100 futures vs S&P contract are near a ten week low.   This is a large problem for hedge fund positioning.

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Reflation Revival, Why is Wheat Trading like Tesla Equity?

Nas CRBIn Reflation Trade Revival mode, wheat is trading like Tesla equity.  The September wheat futures contract (MWU7) is up 50% since May 15th, 2017.   Energy stocks are as under-owned as any sector in the last decade relative to growth.  As a result, we’re seeing a colossal sector rotation back into value names (commodity sector equities) as cash hemorrhaging out of big tech (FAANG stocks).

As investors pile out of crowded tech trades – positioning risk is HIGHLY elevated at quarter-end when allocators tend to rebalance.  In the first twenty days of a new quarter, positioning alpha is 10x higher than average.  In other words, getting out in front of the rotation is more important than valuation – as capital flows out of highly concentrated trades it has to go somewhere in a bull market.  It’s a growth into value tsunami.

Reflation Revival: Rates, this Sell off in Bonds is a Beauty

10 Year U.S. Treasuries

21bps in the last five trading days, 2.13 to 2.34%
31 bps: Feb 26 – Mar 13: 2.31 to 2.62%
58 bps: Nov 4 – Nov 18: 1.77% to 2.35%

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Flash Crash in 10 Year Treasuries

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“A Shift from the FOMC: As the Fed has opened the door to using balance sheet reduction in lieu of rate hikes – bond bears are running for the hills. As we head into a busy week of Fedspeak, we believe capital gains are found by discounting the obvious and positioning for the unexpected. In a world full of crowded trades searching for alpha – these words ring more true today than in years past. As the wild mob is rushing for the exits, we want to be short bonds.”

Bear Traps Report, Monday June 26, 2017

CRB rerflation rivivalCommodities soared this week in a Reflation Revival, were you on board?

The U.S. economy slow down is not as bad as most feared. Q1 GDP came in better than initial estimates due to unexpectedly higher consumer spending and a jump in exports, beating expectations and providing a slightly more encouraging outlook for growth this year. Gross domestic product increased at a 1.4% annual rate instead of the 1.2% pace reported last month, the Commerce Department said in its final assessment for the period on Thursday.

Breaking: Inflation in Japan, Fastest since 2014

Consumer prices excluding fresh food advanced 0.4% in May from a year earlier, the fastest gain since December 2014, when the impact of a 2014 sales-tax hike is excluded (estimate 0.4% ).

Hawks at the BOE, BOC, ECB and FOMC

A hawkish turn from Janet Yellen and Mario Draghi have some now looking for a reflation trade revival. A focus on financial conditions. The prospect of four of the world’s five largest central banks moving to tighten policy at the same time is shocking traders after years of easing, with the dislocations in money markets also rippling through global bonds.

10 Year Bond Yields in June

UK: 0.92% to 1.25%
US: 2.12% to 2.28%
Germany: 0.22% to 0.45%

Bloomberg

Hawkish Quotes from this Week

“some removal of monetary stimulus is likely to become necessary”

Bank of England’s Mark Carney

“deflationary forces have been replaced by reflationary ones.”

European Central Bank’s Mario Draghi

“rate cuts have done their job”

Bank of Canada’s Stephen Poloz

Bond Flash Crash

10s CrashLast week’s crowded long bond trade is unraveling quickly. A colossal seller kicked off a flash crash this morning. Positioning in long U.S. Treasury positions recently moved from very short to a crowded long – today bond bulls are running for the hills.

Deregulation Reflation

A Hidden $1T Stimulus: Trump could repeal enough regulations to give a $1 trillion boost to the economy, just ask Treasury Secretary Steve Mnuchin. We get into what’s going on behind the scenes in Washington. Much of the Dodd Frank re-write can be achieved with executive orders – this is a reflation boost in the wings.

New Shorts Became Longs in a Hurry

Net Treasury Positions

Student body left… Student body right.  U.S. Treasury bears in January became bulls in June, not they’re rushing to the exits.

U.S. President Donald Trump has said during his election campaign that he would cut banking regulation. The U.S. Treasury Department earlier this month proposed easing up on restrictions big banks now face in their trading operations. The financial industry is counting on President Donald Trump to soften that oversight by appointing more business-friendly board members to the Fed, shifting the balance of power from regulators to shareholders. This month, Treasury Secretary Steven Mnuchin recommended that stress tests be performed every other year and that banks maintaining a sufficiently high level of capital be exempt from exams.

“Reflation Bar is Too Low: Our thesis is clear – markets have moved from pricing-in far too much stimulus out of Washington to now under-estimating its reflationary potential. Once crowded reflation trades have been left in the dust bin – not even the cleaning lady will touch them. Congress has their back against the Wall with an eye on the 2018 mid-term elections – the GOP can ill afford go home empty handed. In December and January, we stressed tax reform was a 2018 story while the street was talking up a rosy hundred day kickoff. Now, the Street is way out in 2018, while we’ve moved the probability of 2017 tax reform / cuts up substantially.”

Bear Traps Report, Monday June 26, 2017

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Fed Now Targeting Asset Bubbles, Financial Conditions

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*FISCHER: HIGH ASSET PRICES MAY LEAD TO FUTURE STABILITY RISKS

Breaking News: The FOMC is Targeting Asset Bubbles – Financial Conditions

“To us, the Fed is targeting Financial Conditions, which is a circular feedback mechanism to the equity markets, given its overall construction. It’s as near to ‘bubble targeting’ as they can get, we recommend clients short bonds.”

Bear Traps Report, June 26, 2017

Bond yields spiked today on a hawkish turn from the Fed and ECB Tuesday.

Governor Stanley Fischer was not on the calendar today and this speech was just published on the Fed’s website. He sees a “notable uptick in risk appetites” that warrant “close monitoring” as “price-to-earnings ratios now stand in the top quintiles of their historical distributions, while corporate bond spreads are near their post-crisis lows.”

Back Up in Bond Yields, Copper, Iron Ore, and Oil

Reflation RevivalYellen’s Hawkish turn has helped fuel a global reflation revival.  Just when Wall St. threw in the Reflation towel, she started a comeback.

Yellen’s Legacy

We believe Chair Janet Yellen is setting up her FOMC exit strategy – if President Trump says “goodbye Janet” in February (Yellen’s term expires as Fed Chair) – she will protect her legacy on the way out in our view – focused on financial conditions, asset bubbles and balance sheet reduction.

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Hawkish Fedspeak Driving Yields Higher Today

Janet and MarioYields spiked today on a hawkish turn from Janet Yellen and Mario Draghi – Central bankers talked up removing accommodation while focused on asset bubbles.  Yellen even talked up risks we’ve stressed to clients in recent months- PIK Toggle Structures – extremely aggressive financing in the corporate bond market.

Less Focus on the Fed’s Models – Advice the Pre-Lehman FOMC Should Have Heeded

We commend the Fed and Janet Yellen, making phone calls – talking to real risk takers (less academics) is a key to 21st century risk management.

Fed Chair Janet Yellen says the FOMC is “trying to think outside the box” and talk to more people both inside and outside the financial sector after missing signs leading up to last crisis in its economic models.   “Unfortunately, these insights were a little bit too late” last time, Yellen said Tuesday at event in London.

Financial Conditions Have Eased as the Trump FOMC has Hiked RatesFin ConIn our view, the FOMC is NOT comfortable with easing financial conditions as they hike rates.  The Fed is trying to do things now “in a more systematic way” and “talk to people in different pieces of the financial sector about all of the things that could conceivably go wrong that are not in our models”

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A Rush for the Exits

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*U.S. TECH STOCKS TUMBLE, PUSHING NASDAQ 100 INDEX DOWN 2.4%

A colossal sector rotation stole the headlines today, a sell-off in Big Tech shares ruined the wild party mood for stocks.

Since May 19, the Rotation

US Steel $X +18.5%
Banks $KRE +8.3%
Steel $SLX +7.4%
Russell 2000 $IWM +5.5%
S&P 500 $SPY +3.4%
Nasdaq 100 $QQQ +0.2%

Bloomberg data

Nasdaq, Worst Week of 2017

Apple (AAPL), Alphabet (GOOGL) Class A shares, Microsoft (MSFT), Facebook (FB) and Amazon (AMZN) — lost more than $100B in market value between the close on Thursday and the close on Friday.

For most of the day, only 3 stocks in the S&P 500 tech sector were in the green: IBM (IBM), Teradata (TDC) and Western Union (WU). Apple, Facebook, Amazon, Netflix, and Alphabet all traded more than 2 times their 30-day average volume.

Largest 5 Nasdaq Stocks

Valuation

Today: $2.9T
Before Election: $1.8T

Bloomberg

Big tech has led the equity market higher in 2017.  The S&P 600 is up 2% on the year (1.4% today) while Big Tech was 20% higher.

PowerShares QQQ Trust Series 1

Today, we witnessed the second highest notional trading volume since 2009, at nearly $14B.

FANG Rollover

Shares of Apple fell nearly 4%, while the other four companies fell more than 3%.

Stealing the show was a colossal macro centered rotation out of crowded Big Tech (FANG off 4%) into under-owned value (Steel and Energy names).  At one point today, U.S. Steel X was up 22% from last month’s lows.

Winners in Financials

Financials were also a rotation winner with names like Goldman Sachs GS breaking a four month down trend.

GS reverse

At one point last week, Goldman was 18% off this year’s high – big reversal this week.

Where Did the Money Flow?

Emerging debt ETFs saw the largest weekly inflows in more than four years of available data, adding $1.4 billion for the week ended June 7, equivalent to 3% of assets under management. This marks a 23rd straight week of inflows since Dec. 28 totaling to $12.3 billion, 28% as a share of assets.  – Bloomberg

Big Tech Rollover in the QQQs

QQQ volToday will mark a key sector rotation inflection point.  Market leadership is shifting from the loved to the un-loved.

Amazon Flash Crash

AMZN FlashQuants and algorithmic trading now make up over 30% of the volume across several of the major exchanges.  That’s up from less than seven percent five years ago.  What’s the only problem with a quant driven market?  At the first sign of trouble, the machines simply back away – air pockets are far more common today. 

Powerful Inter-Day Reversal

NVDA

We witnessed classic blow off top signals in multiple names today – always watch for the new high with a close below the previous day’s low on volume.  A beautiful NVIDIA candle blew out today – years from now this one will be remembered. 

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Russian Equities on Key Technical Level

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Media stories are countless – President Donald Trump has acted more friendly toward Russia and Russian president Vladimir Putin.  We must ask, why are Russian equities down 4% in 2017, 10% off their recent highs?  It’s clear, the stress the White House is experiencing over its relationship with Russia is weighing on Russian equities.  There were very high hopes  the Trump administration could be more willing to roll back sanctions placed on Russia in response to its actions against Ukraine (Circa 2014-15).

Of course, oil’s 2017 headwinds have played a key role here, much of Russia’s economic activity is centered around crude.  Energy is by far the largest sector weight in the RSX.  It’s no secret, Russia is one one of the world’s largest non-OPEC producers.

Russian Equities

RSX newOnce up 86% from the January 2016 lows, Russian equities have lost 10% from their recent highs.  Down 4% on the year but stull up 14% since the election of Donald Trump – in line with the S&P 500.  This descending wedge above speaks to a key technical level Russian equities are dancing on – we’re about to see a significant move…

Price to Book Value: iShares MSCI Russia Capped ETF 

2017: 0.78x
2016: 0.67x
2015: 0.72x
2014: 0.51x
2013: 0.71x
2012: 0.85x
2011: 0.80x
2010: 0.75x
2009: 0.41x
2008: 1.9x
2007: 3.1x

Bloomberg, Bear Traps Report data

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A Real Political Crisis in Brazil

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*BRAZIL GOVT ALLIES SAID TO SEEK TEMER RESIGNATION: GLOBO
*TEMER UNLIKELY TO FINISH HIS TERM IF ALLEGATIONS TRUE
*TEMER LOST CONDITIONS TO NEGOTIATE PENSION REFORM
*BRAZIL ’21 EUROBONDS SLUMP MOST ON RECORD AMID POLITICAL CRISIS

 

We spoke to our analysts in Washington overnight – we’re in contact with our relationships on the ground in Brazil.  Setting up client calls today:

Brazil Erupts as Tapes Could Ruin Temer Presidency

In Cooperation with Analysts at ACG Analytics

Globo news, an internationally respected Brazilian network and news franchise, is reporting that the Chairman of JBS, the world’s largest meat company, has taped weeks of conversations with President Temer involving pay-offs to prevent imprisoned house speaker Eduardo Cunha from testifying in the Operation Car Wash scandal.

Brazilian equities have surged over the past year as Temer’s administration forged on an ambitious reform program that cheered investors. Brazilians, however, are overwhelmingly opposed to his austerity measures and the president’s approval rating hovers at around 11%.

Equities in Brazil

ewz newUp 132% from the January 2016 bottom, stocks in Brazil have priced in a ton of political goodwill.  The EWZ is set to open at the $34.20 – $34.50 level, below the two year trend line above in red.

We believe the administration’s economic team is highly concerned the crisis will impact their reform agenda. The government has been positioning their long awaited, and very controversial pension reform proposal to the lower house of Congress.  Equity prices / valuations are very dependent on completion / passage of these reforms.

Credit Risk Rising

Brazil 2021 newIn our view, credit risk will surge focused on Brazil’s government bonds if the reforms collapse.

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The JBS CEO Josely Batista reportedly taped Termer ordering the executive to “keep up” the payments in one of the recordings, which are said to be damning throughout.

Several weeks of recordings have reportedly been delivered to the
Attorney General’s office while opposition lawmakers are calling for the president to resign immediately.  If this occurs, the Brazilian Constitution requires that elections be held within ninety days.

Dollar – Real Heading North

real new

Technically, the real is moving to far weaker ground – a print above 3.21 shifts the currency into a new bear market.

Per our friends at ACG Analytics, if Temer resigns or otherwise leaves office the Brazilian Constitution requires elections within ninety days.  Brazil had been emergencing from it’s worst recession and consensus had been slowly but appreciably growing for Temer’s market based economic reform agenda.

From ACG Analytics in Washington

The corruption crisis in Brazil has left scorched earth where there
were political parties.  Initial thoughts include increased attention toward Mariana Silva, a candidate of the left who surged in the 2014 elections but ultimately missed the second round vote.  If she is not tainted by scandal, her stock certainly goes up.  Brazil’s small but vocal hard right will receive attention as its calls for “cleansing” Brazilian politics through the instatement of military rule could resonate in some quarters.

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