Friday, July 7, 2017

Weekly Commentary: Wonderful Monetary Policy and Beautiful Deleveragings

“Generally speaking (depending on the country), it is appropriate for central banks to lessen the aggressiveness of their unconventional policies because these policies have successfully brought about beautiful deleveragings. In my opinion, at this point of transition, we should savor this accomplishment and thank the policy makers who fought to bring about these policies. They had to fight hard to do it and have been more maligned than appreciated. Let’s thank them.” Ray Dalio, July 6, 2017

I find his choice of words inflammatory, but I guess when you’re worth $16.8bn (Forbes) you can write what and how you please. In past CBBs I took strong exception with Ray Dalio’s “beautiful deleveraging” thesis. Data these days speak incontrovertibly to the fact that from a systemic standpoint there has been a huge accumulation of additional debt – at home and globally. The notion of deleveraging is a myth. It is the unprecedented inflation of “money” at the very foundation of global finance that is real. As for “wonderful monetary policy,” at best the jury’s still out. I’ll be shocked if we look back in five or ten years and tag this period’s monetary management in a positive light.

Dalio is somewhat of an enigma. Highly intelligent and hugely successful in the markets ($160bn hedge fund empire), he is one of this era’s foremost “deep thinkers”. I enjoy reading his analysis and share his concerns for social and geopolitical instability. But I see flawed monetary management - and resulting Bubbles/busts and wealth redistribution/destruction - as a major agent to these instabilities. Dalio sees “wonderful monetary policy” as a positive force, while I see radical policy experimentation with disastrous consequences.

It’s what Dalio doesn’t address that I find most intriguing: How much financial sector leverage has accumulated over the past nine years of near-zero rates and unprecedented central bank market liquidity injections and backstopping? How has the expansion of global financial sector leverage (including central bank balance sheets and speculative leveraging) distorted traditional indicators of systemic stability – such as corporate and household debt, debt service capacity and market risk premia.

Monetary policy and associated financial leveraging have significantly reduced debt service burdens for going on a decade, in the process lessening overall debt growth for households and businesses alike. I would also argue that Trillions of liquidity injections into the markets have flowed into real economies, again working to mitigate private-sector debt accumulation. The massive inflation of central bank and government balance sheets has indeed improved the outward appearance of private-sector finances. This has superficially “brought about balance sheet repairs” for traditional weak-link household and corporate borrowers. I’m just not convinced these remain the most germane structures for gauging global Bubble systemic fragilities.

Dalio has been a hedge fund “risk parity” pioneer. “Risk parity is a portfolio allocation strategy based on targeting risk levels across the various components of an investment portfolio… Risk parity considers four different components: equities, credit, interest rates and commodities, and attempts to spread risk evenly across the asset classes. The goal of risk parity investing is to earn the same level of return with less volatility and risk, or to realize better returns with an equal amount of risk and volatility…” (Investopedia).

Few strategies have so greatly benefited from nine years of radical monetary management. A portfolio of diversified asset classes (most notably equities, bonds and corporate Credit) - all enjoying simultaneous central bank-induced price inflation - has been a huge and surefire winner. The more leverage the better. And, importantly, no drag on performance from hedging or de-risking during recurring bouts of market instability, not with the inherent market “hedge” from managing a diversified portfolio with a significant bond component. It’s just been the best of all worlds.

“Wonderful Monetary Policy” has ensured that any successful strategy is inundated with financial inflows. Dalio’s Bridgewater has seen assets under management swell to $160 billion. Hundreds of billions more have gravitated to similar strategies. The proliferation of diversified multi-asset class strategies (leveraged and otherwise) has been a powerful force behind the synchronized inflation of prices for securities and corporate Credit across the globe. As central banks prepare to remove aggressive stimulus, I would expect many strategies that have enjoyed long (nine years!) and consistent success to now face significant challenges.

July 7 – Bloomberg (Dani Burger): “Hawkish signals from central bankers have punished stocks and bonds alike in the past week. Also punished: investors who make a living operating in several asset classes at once. They’ve been stung by the concerted selloff that lifted 10-year Treasury yields by 25 bps and sent tech stocks to the biggest losses in 16 months. Among the hardest-hit were systematic funds who -- either to diversify or maximize gains -- dip their toes in a hodgepodge of different markets all at the same time. Losses stand out in two of the best-known quant strategies, trend-following traders known as commodity trading advisers, and risk parity funds. CTAs dropped 5.1% over the past two weeks, their worst stretch since 2007, according to a Societe General SA database of the 20 largest managers. The Salient Risk Parity Index dropped 1.8%, the most in four months.”

Dalio: “Central bankers have clearly and understandably told us that henceforth those flows from their punch bowls will be tapered rather than increased—i.e., that the directions of policy are reversing so we are at a) the end of that nine-year era of continuous pressings down on interest rates and pushing out of money that created the liquidity-fueled moves in the economies and markets, and b) the beginning of the late-cycle phase of the business/short-term debt cycle, in which central bankers try to tighten at paces that are exactly right in order to keep growth and inflation neither too hot nor too cold, until they don’t get it right and we have our next downturn. Recognizing that, our responsibility now is to keep dancing but closer to the exit and with a sharp eye on the tea leaves.”

Fascinating analysis. “Central bankers have clearly and understandably told us that henceforth those flows from their punch bowls will be tapered… that the directions of policy are reversing… Our responsibility now is to keep dancing but closer to the exit and with a sharp eye on the tea leaves.”

The problem is that tea leaves reading “head for the exits” risk inciting a stampede. These fund complexes and speculative strategies have become gigantic within an overall marketplace structure more vulnerable than ever. In what will now be a common theme, who will take the other side of the trade when the enormous “risk parity” crowd moves to de-risk. Who will have the wherewithal to step up and buy when asset prices across the board come under pressure? How quickly will perceived low-risk strategies face major redemptions when performance turns sour? This has become a systemic issue, recognizing the massive flows into equities, bonds and corporate Credit – with the ETF complex surpassing $4.0 TN of assets. There has never been anything similar to trend-following (speculative) finance so dictating market dynamics.

This is not some nebulous issue going unexplored by market players. There are, however, three key aspects to this issue that are unknowable – and have, to this point, been easily dismissed in the exuberance of a central bank-administered marketplace: First, how much leverage has been employed throughout the securities markets – in the U.S. and globally? Second, how much embedded leverage has accumulated in global derivatives markets? And third, what is the scope of market risk that has (or expects to be) offloaded to dynamically hedged derivatives trading strategies (that will be forced to sell into declining markets to hedge exposures)?

And a few thoughts on Dalio’s, “The beginning of the late-cycle phase of the business/short-term debt cycle, in which central bankers try to tighten at paces that are exactly right in order to keep growth and inflation neither too hot nor too cold, until they don’t get it right and we have our next downturn.”

I have issues with such analysis. “Central bankers” trying to get things “exactly right”? The next downturn comes when they “don’t get it right”? Well, let’s not lose sight of the reality that central bankers are nine years into an unprecedented reflationary experiment. To this point, rightly or wrongly, they’ve orchestrated historic securities and asset market inflation. Yet central banks will at some point lose control of the global financial Bubble, at which time they will have fully lost control of inflation and growth dynamics. The notion that this continues so long as they “get it right” really suggests that central bankers must remain pro-Bubble.

It’s these days not difficult to explain how the structure of the U.S. household balance sheet appears in good shape (net worth approaching $100 TN!). The structure of the corporate balance sheet is surely solid as well, at least from the perspective of strong earnings and cash-flow. With rates so low and markets abundantly liquid, it’s easy to argue that the federal government balance sheet, while having ballooned massively, remains quite manageable. Conventional analysis, then, views the entire structure of the greater U.S. balance sheet as solid and immune to crisis dynamics.

Yet traditional analysis misses the prevailing vulnerability that emanates from this most unusual of Credit and Speculative Cycles: The Structure of Global Financial Market Risk. Central banks inflated an unprecedented market Bubble, slashing rates, adding Trillions of liquidity and repeatedly intervening to stem fledgling “Risk Off” Dynamics. Perceptions of low risk have over years stoked the accumulation of unprecedented systemic risk (including price, liquidity, Credit, counterparty, policy, economic, social, political, geopolitical and so on)

Over nine years, this has led to deeply embedded market misperceptions, perhaps most importantly that risk assets enjoy money-like attributes of liquidity and safety. Moreover, that central banks will ensure rising asset prices. These misperceptions have spurred Trillions of flows, with a major chunk jumping aboard the equity and fixed-income bull markets via the ETF complex.

Within the leveraged speculating community, hundreds of billions flowed into “risk parity,” CTAs (“a CTA fund is a hedge fund that uses futures contracts to achieve its investment objective”) and other trend-following strategies. Meanwhile, zero rates and central bank control over securities markets have ensured a derivatives boom like no other – derivatives to leverage securities, to employ international “carry trade” speculations, to exploit Credit spreads, to write myriad variations of market “insurance,” to hedge risk and to implement about whatever strategy imaginable.

I would posit that global market Bubbles today rest tenuously upon the false premise that central banks can get it right when it comes to managing market risk and liquidity. In reality, central banks have created an Unsustainable Market Structure with increasingly acute latent fragilities. It’s impossible to “get it right,” because Bubbles are by their nature unsustainable.

Today’s global Bubble works only so long as securities values continue to inflate. Market inflation is dependent upon unrelenting central bank stimulus and backstops. It will all falter badly in reverse. And all the “money” that has chased central bank-induced market returns – from “risk parity” to corporate bond and equity index ETFs to derivatives strategies – creates vulnerability to an abrupt shift in perceptions, followed by illiquidity and market dislocation.

Markets this week were again showing indications of vulnerability. Global yields remain on the rise. German bund yields jumped 11 bps to an 18-month high 0.57%. French yields rose 13 bps to 0.94%. The largest yield spikes, however, were at the “periphery.” Italian and Spanish 10-year yields surged 19 bps to 2.34% and 1.73% - with Italian yields near two-year highs.

It’s also worth noting that emerging bond markets faced increased selling (EM bond ETF down 1.3% this week). Local EM bond markets were under heavy selling pressure. Ten-year yields surged 28 bps in Turkey, 21 bps in Indonesia, 21 bps in Russia, 22 bps in Colombia, 12 bps in Brazil and 11 bps in South Africa. Dollar-denominated EM bonds were not spared. Yields rose 20 bps in Turkey, 19 bps in Argentina, 13 bps in Brazil, 12 bps in Mexico, 15 bps in Colombia and 10 bps in Russia.

July 6 – Bloomberg (Liz McCormick and Lananh Nguyen): “With yields surging across major economies as more central banks hint at joining the Federal Reserve in tightening policy, strategists are pointing to a likely loser: emerging-market currencies. The fallout is already being felt in the foreign-exchange market as investors eye the end of an era of unprecedented stimulus. An MSCI index of emerging-market currencies hovered near a seven-week low Thursday as yields on Treasuries and bunds rose to fresh highs. In 2006, the last time investors braced for steeper borrowing costs in the biggest economies, the index lost almost 5% of its value in a span of weeks, while developing-market stocks plunged.”

When it comes to Market Structures vulnerable after nine years of runaway global monetary stimulus, look no further than EM. Despite all the corruption, fraud, political turmoil and nonsense that one would anticipate from a prolonged period of egregiously easy “money,” finance has nonetheless flowed lavishly to EM (with its relatively high-yielding debt markets and growth opportunities). Over recent months, with blow-off dynamics enveloping risk markets worldwide, huge flows gravitated to EM. Much of this “money” was intermediated through the ETF complex. How much was purely trend-following?

While traditional analysis would look first to U.S. economic fundamentals (including household and corporate debt, earnings, employment and inflation) for indications of underlying market vulnerability, I would point instead to Global Market Bubble Dynamics – while reminding readers that the current backdrop is distinct to previous Bubble experiences. As such, market indicators this week at the periphery – EM as well as European – were flashing heightened susceptibility to de-risking/de-leveraging and the potential for liquidity challenges. Considering the enormity of recent flows, perhaps EM will provide an early test for the thesis of Market Structural Vulnerabilities.

Here at home, 10-year Treasury yields rose eight bps to 2.39%. In equities, there was more of this choppy topping-action rotation away from tech/high-flyers and into financials/laggards. Corporate debt markets are beginning to feel the strain of rising global yields. High-yield bond funds saw another $1.1bn of outflows, though investment-grade corporates are still attracting large inflows. The high-yield ETF (HYG) traded near a two-month low. Commodities, as well, seemed to support the thesis of fledgling “Risk Off” and waning liquidity. With crude down almost 4%, the GSCI Commodities Index dropped 1.8%. Copper fell 2.4% and gold lost 2.3%. But it was wild trading in silver (down 7.2%) that might have provided a harbinger of more general market liquidity issues to come.

That Treasuries, equities, corporate Credit and commodities all seem to be indicating a (thus far subtle) shift in market liquidity, we can look to “risk parity” - and similar multi-asset class strategies that incorporate leverage – as a possible weak link in a Vulnerable Global Market Structure. And we’re supposed to savor this moment and pay a debt of gratitude to courageous central bankers? Strange world.

For the Week:

The S&P500 was little changed (up 8.3% y-t-d), while the Dow added 0.3% (up 8.4%). The Utilities declined 0.8% (up 5.4%). The Banks jumped 1.6% (up 5.8%), and the Broker/Dealers added 0.6% (up 0.6%). The Transports rose 1.4% (up 7.2%). The S&P 400 Midcaps were unchanged (up 5.2%), and the small cap Russell 2000 was little changed (up 4.3%). The Nasdaq100 increased 0.2% (up 16.3%), and the Morgan Stanley High Tech index added 0.2% (up 20.5%). The Semiconductors recovered 1.9% (up 16.4%). The Biotechs gained 1.2% (up 27%). With bullion sinking $28, the HUI gold index fell 3.7% (down 1.9%).

Three-month Treasury bill rates ended the week at 101 bps. Two-year government yields added two bps to 1.40% (up 21bps y-t-d). Five-year T-note yields gained six bps to 1.95% (up 2bps). Ten-year Treasury yields rose eight bps to 2.39% (down 6bps). Long bond yields jumped nine bps to 2.93% (down 14bps).

Greek 10-year yields were unchanged at 5.36% (down 166bps y-t-d). Ten-year Portuguese yields rose 13 bps to 3.16% (down 59bps). Italian 10-year yields surged 19 bps to 2.34% (up 53bps). Spain's 10-year yields rose 19 bps to 1.73% (up 35bps). German bund yields gained 11 bps to 0.57% (up 37bps). French yields jumped 13 bps to 0.94% (up 26bps). The French to German 10-year bond spread widened two bps to 37 bps. U.K. 10-year gilt yields increased five bps to 1.31% (up 7bps). U.K.'s FTSE equities index gained 0.5% (up 2.9%).

Japan's Nikkei 225 equities index slipped 0.5% (up 4.3% y-t-d). Japanese 10-year "JGB" yields were unchanged at 0.09% (up 5bps). France's CAC40 gained 0.5% (up 5.8%). The German DAX equities index rose 0.5% (up 7.9%). Spain's IBEX 35 equities index added 0.4% (up 12.2%). Italy's FTSE MIB index recovered 2.1% (up 9.3%). EM equities were mixed to lower. Brazil's Bovespa index declined 0.9% (up 3.5%), while Mexico's Bolsa increased 0.4% (up 9.7%). South Korea's Kospi fell 0.5% (up 17.4%). India’s Sensex equities index gained 1.4% (up 17.8%). China’s Shanghai Exchange added 0.8% (up 3.7%). Turkey's Borsa Istanbul National 100 index dipped 0.4% (up 28.1%). Russia's MICEX equities index rallied 1.8% (down 14.3%).

Junk bond mutual funds saw outflows of $1.155 billion (from Lipper).

Freddie Mac 30-year fixed mortgage rates jumped eight bps to 3.96% (up 55bps y-o-y). Fifteen-year rates rose five bps to 3.22% (up 48bps). The five-year hybrid ARM rate gained four bps to 3.21% (up 53bps). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed rates up nine bps to 4.10% (up 46bps).

Federal Reserve Credit last week declined $4.1bn to $4.427 TN. Over the past year, Fed Credit dipped $2.8bn. Fed Credit inflated $1.616 TN, or 58%, over the past 243 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt gained $8.2bn last week to $3.316 TN. "Custody holdings" were up $86.6bn y-o-y, or 2.7%.

M2 (narrow) "money" supply last week jumped $35.7bn to a record $13.546 TN. "Narrow money" expanded $708bn, or 5.5%, over the past year. For the week, Currency increased $2.1bn. Total Checkable Deposits surged $45.6bn, while Savings Deposits declined $10.9bn. Small Time Deposits were little changed. Retail Money Funds dipped $1.8bn.

Total money market fund assets gained $4.7bn to $2.627 TN. Money Funds fell $74bn y-o-y (2.7%).

Total Commercial Paper dropped $26.8bn to $946.8bn. CP declined $93bn y-o-y, or 8.9%.

Currency Watch:

The U.S. dollar index recovered 0.4% to 96.008 (down 6.2% y-t-d). For the week on the upside, the Brazilian real increased 0.8%, the Canadian dollar 0.7%, the Mexican peso 0.2%, and the Swedish krona 0.1%. For the week on the downside, the South African rand declined 2.3%, the Japanese yen 1.3%, the Australian dollar 1.1%, the British pound 1.0%, the South Korean won 0.9%, the New Zealand dollar 0.7%, the Swiss franc 0.6%, the Singapore dollar 0.4%, the Norwegian krone 0.3% and the euro 0.2%. The Chinese renminbi declined 0.36% versus the dollar this week (up 2.05% y-t-d).

Commodities Watch:

The Goldman Sachs Commodities Index dropped 1.8% (down 8.3% y-t-d). Spot Gold lost 2.3% to $1,213 (up 5.3%). In wild trading, Silver sank 7.2% to $15.425 (down 4%). Crude fell $3.91 to $44.23 (down 18%). Gasoline declined 1.0% (down 10%), and Natural Gas sank 5.6% (down 23%). Copper dropped 2.4% (up 6%). Wheat gained another 1.7% (up 31%). Corn rose 3.0% (up 12%).

Trump Administration Watch:

July 3 – Wall Street Journal (Kristina Peterson and Michelle Hackman): “Republican senators back home on recess this week are hearing from some influential critics of their health-law effort: GOP governors, many of whom are urging them to push back on the legislation because it would cut Medicaid funding. Governors of states including Ohio, Nevada and Arkansas, which stand to lose billions of dollars in Medicaid funding under the Senate bill, want senators to keep as much of that money as possible.”

July 1 – Financial Times (Demetri Sevastopulo, Tom Mitchell and Charles Clover): “China lashed out at the US… in protest at an apparent sea change in the Trump administration’s policy towards Beijing as the White House prepared to slap punitive restrictions on Chinese steel imports, agreed an arms deal with Taiwan, and sanctioned a Chinese bank. Cui Tiankai, the Chinese ambassador to Washington, criticised the $1.4bn Taiwanese weapons deal and what he called the ‘long-arm jurisdiction’ of the US in sanctioning Chinese companies… The deteriorating relations come less than 100 days since Mr Trump hosted Mr Xi at his Mar-a-Lago estate and said the leaders would have a ‘very great relationship’. Since then, the White House has become frustrated China was not doing enough to pressure North Korea to abandon its ballistic missile and nuclear programmes.”

July 2 – Time (Charlie Campbell): “The honeymoon, it appears, is over. On Sunday, Beijing warned the U.S. government that sending an American naval vessel into territorial waters it claims around the Paracel Islands in the disputed South China Sea was a ‘serious political and military provocation,’ in the latest of a slew of incidents that augur souring relations… Foreign Ministry spokesperson Lu Kang said… that China sent military vessels and fighter planes to ward off the USS Stethem, warning that approaching the Paracels, which are known as the Xisha Islands in China and are also claimed by Taiwan and Vietnam, ‘violated Chinese and international law, infringed upon China's sovereignty, disrupted peace, security and order of the relevant waters and put in jeopardy the facilities and personnel on the Chinese islands,’ according to the state-run China Daily newspaper.”

China Bubble Watch:

July 5 – Reuters (Yawen Chen and Ryan Woo): “China's services sector grew at a slower pace in June as new orders slumped, signaling renewed pressure on businesses after a pickup in May and pointing to a softening outlook for the economy… The findings reinforced analyst views that the world's second-largest economy is cooling after a strong start to the year, as Beijing cracks down on easy credit to contain a dangerous build-up in debt and defuse financial risks. The Caixin/Markit services purchasing managers' index (PMI) dropped to 51.6 in June from 52.8 in May…”

July 4 – Reuters (Shu Zhang): “China's central bank said… the shadow banking sector lacks sufficient regulation and the bank would give more prominence to financial risk controls. Compared with traditional bank lending, the opaque nature of shadow banking products make it easier for them to bypass regulatory requirements and provide credit to restricted areas, the People's Bank of China (PBOC) said in its annual China Financial Stability Report… The central bank will increase supervision over the rapidly growing asset management industry to curb shadow banking risks, it said.”''

July 4 – Reuters (Huileng Tan): “Growth in shadow banking in China is slowing due to coordinated government action to contain systemic financial risks, a development that will benefit banks, although it will also bring adjustment risks, Moody's… said… The ratings agency's analysis showed the effectiveness of coordinated measures by authorities by the central bank, the banking and securities regulators ‘to slow runaway growth in shadow banking.’ Actions included the central bank changing its monetary policy setting in the last quarter of 2016 to ‘moderate neutral’ from ‘moderate,’ which raised market funding costs and refinancing risks for banks, reducing the return from supporting long-term investments with short-term market funds, said Moody's.”

July 4 – Bloomberg: “China struck deal after deal to acquire companies abroad over the last few years. Now the bill is coming due. The nation’s top corporate dealmakers, including HNA Group Co. and Fosun International Ltd., must pay off the equivalent of at least $11.5 billion in bonds and loans by the end of 2018 -- a feat now complicated by government efforts to rein in their aggressive rush overseas. That figure represents just a fraction of the total debt of 1.1 trillion yuan ($162bn) that the Chinese companies have reported… The size of their obligations -- and whether they will be able to shoulder them -- has begun to worry global banks and investors now that Beijing has pressed companies to dial back their ambitions abroad.”

July 5 – Reuters (Thomas Escritt and Michelle Martin): “Ties between China and Germany are about to enter a new phase, China's president said, as he met the German chancellor before a G20 summit that is expected to highlight their differences with the United States on a host of issues. President Xi Jinping and Chancellor Angela Merkel pledged… to work together more closely on a range of issues… Trump's testy relationship with both China and Germany is pushing the two countries closer together, despite Berlin's concerns about human rights in China and frustrations over market access.”

July 1 – Reuters (James Pomfret and Venus Wu): “Chinese President Xi Jinping swore in Hong Kong's new leader on Saturday with a stark warning that Beijing won't tolerate any challenge to its authority in the divided city as it marked the 20th anniversary of its return from Britain to China… Xi said Hong Kong should crack down on moves towards ‘Hong Kong independence’. ‘Any attempt to endanger China's sovereignty and security, challenge the power of the central government ... or use Hong Kong to carry out infiltration and sabotage activities against the mainland is an act that crosses the red line and is absolutely impermissible,’ Xi said.”

Europe Watch:

July 3 – Bloomberg (Carolynn Look): “Euro-area manufacturing expanded at the strongest pace in over six years as factories across the region took on more workers to deal with surging orders. A Purchasing Managers’ Index climbed to 57.4 in June, up from 57.0 in May and above a June 23 flash estimate, IHS Markit said…”

July 3 – Reuters (Michael Nienaber): “Euro zone growth is stronger than expected and this will enable the European Central Bank to slowly normalize its monetary policy and end a ‘crazy situation’ of negative interest rates, German Finance Minister Wolfgang Schaeuble said… Senior German government officials have stepped up the pressure on the ECB to scale back its monetary stimulus of bond purchases and sub-zero rates as Germany heads toward federal elections and voters complain about meager savings returns… Speaking to voters… Schaeuble said that the euro zone was recovering surprisingly well and that the threat of deflation had vanished. ‘If we have more growth and if there is no threat of a deflation, then the ECB will -- it cannot do this fast because the problems in some countries in Europe are too big -- then it can slowly start to normalize monetary policy so that we can hopefully soon end this crazy situation of zero interest rates and negative interest rates,’ he said.”

July 4 – Reuters (Foo Yun Chee, Stephen Jewkes and Antonella Cinelli): “The European Union has approved a 5.4 billion euro ($6.1bn) state bailout of Italy's fourth-largest lender, Monte dei Paschi di Siena, taking the total amount of Italian taxpayer funds deployed to rescue banks over the past week to more than 20 billion euros. Outside Greece, Europe has not seen such big state bailouts since the aftermath of the global financial crisis, raising political concerns about the continued use of public funds to mop up losses at badly run banks despite the introduction of new EU rules designed to prevent this.”

July 4 – AFP (Daniel Bosque): “Catalonia will declare independence ‘immediately’ if a majority of the Spanish region's voters opt for independence in a Scotland-style referendum called for October, its ruling coalition said. ‘If the majority of votes are for creating a Catalan republic, obviously independence will have to be declared immediately,’ said Gabriela Serra, a member of the separatist coalition that governs Catalonia.”

Central Bank Watch:

July 6 – Bloomberg (Carolynn Look): “European Central Bank policy makers considered removing a pledge to increase their bond-buying program if needed when they met last month. As the likelihood of calls for unconventional policy measures to be stepped up had ‘clearly diminished,’ the Governing Council discussed removing the easing biases in their policy communication, an account of the June 7-8 meeting showed. While they ultimately opted only to change the wording on interest rates, ‘it was argued that the improved economic environment with vanishing tail risks, in principle, suggested also revisiting the easing bias with respect to the asset-purchase program.’ The account highlighted how nervous decision-makers are about the outlook for the post-crisis recovery as they edge cautiously toward the day they start unwinding their extraordinary measures.”

July 4 – Financial Times (Roger Blitz): “A week after European Central Bank president Mario Draghi rattled markets by declaring victory against deflation, Sweden’s Riksbank said that higher inflation expectations and an easing in external risks made further rate cuts ‘less likely than before’. Forecasts of a slow summer in markets have been disabused by a sudden shift from central banks towards normalising monetary policy. For investors, this has a number of implications. Bond yields are moving higher and the dollar is weakening against the euro, the Canadian dollar, the pound and other currencies whose central banks have signalled a shift in policy.”

July 3 – Reuters (Frank Siebelt): “The European Central Bank is working on moving away from its ultra-easy monetary policy, Jens Weidmann, head of Germany's Bundesbank and a member of the ECB's rate-setting body, said… Investors are watching for any sign that the ECB may reduce its stimulus, which includes massive bond purchases and ultra-low rates, after a hint in that direction by President Mario Draghi boosted the euro and government bond yields this week. ‘It will hopefully come and we're working on that, we're also discussing it,’ Weidmann, a long-standing critic of the ECB's bond purchases, told an audience at the Bundesbank's open days.”

July 4 – Bloomberg (John Ainger and Stephen Spratt): “European Central Bank data showed it fell short of its target for purchases of German bonds under its quantitative-easing program for a third straight month in June, while favoring French and Italian securities as it combats a shortage in the euro region’s benchmark sovereign debt. The ECB fell short of its implied buying target, as dictated by the capital key, by 304 million euros ($345 million) last month, following a shortfall of 277 million euros in May… The ECB has been fudging its own bond-buying guidelines, known as the capital key, with President Mario Draghi reiterating last in a press conference last month that the asset-purchase program has enough ‘flexibility.’”

July 2 – Financial Times (Claire Jones): “For years, Jens Weidmann was the unabashed hawk at the heart of the European Central Bank, the voice of German opposition to the unconventional monetary policies intended to save the eurozone from a deflationary death spiral. Now, an uncharacteristic period of reserve from the Bundesbank president has convinced his eurozone colleagues that he is mounting a quiet campaign to take over as ECB chief. Not all of them are happy at the prospect. Mario Draghi’s term as the ECB’s president is up in late 2019 and speculation is already rife that Berlin will push for Mr Weidmann — a close ally of Angela Merkel, the chancellor — to become its first German head.”

Brexit Watch:

July 1 – Reuters (Andrew MacAskill): “British business leaders have been told to brace for the possibility that Prime Minister Theresa May's government may walk out of Brexit talks this year, according to the Sunday Telegraph. The move would be designed for ‘domestic consumption’ to show the government is negotiating hard with the European Union… The Sunday Telegraph said the briefing of business leaders by a senior May aide took place after last month's general election and the person has since left in the recent overhaul at the top of government.”

Global Bubble Watch:

July 2 – Wall Street Journal (Simon Nixon): “Central bankers around the world are grappling with a common problem: when and how to normalize monetary policy at a time of normal levels of economic growth, normal levels of unemployment but abnormal levels of wage growth that is keeping inflation lower than their economic models predict. Policy makers at the European Central Bank and Bank of England are facing political challenges that are making their task even harder. At the ECB, the political constraint is its own self-imposed rules setting limits on the size and scale of its quantitative easing program. To avoid getting foul of the European Union treaty prohibition on direct financing of governments by the central bank, the ECB limits itself to buying government bonds strictly in proportion to each eurozone member’s ECB shareholding and capping its ownership of any individual bond at 33%. As a result, its QE program will soon run into capacity constraints—starting as soon as this summer with Germany, Spain, Ireland and Portugal.”

July 6 – Bloomberg (Dani Burger): “Is this the dawn of a new era? Coordinated or not, signals from central bankers from Europe to Canada and the U.S. have roiled financial markets: The 10-year Treasury note yield jumped more than 20 bps, bund rates reclaimed 0.50% for the first time in 18 months… While a few days of trading doesn’t cement the fate of markets for months to come, the debate is heating up over whether the moves are fleeting, amplified in the short term by summer vacation-induced light volumes, or if they mark the start of the end of a decade of easy money.”

July 3 – Reuters (Huw Jones): “The rising influence of ‘open ended’ funds and the impact on developing economies if the investment flows were abruptly reversed remain a concern for global regulators, Financial Stability Board Chairman Mark Carney said… The rapid growth in the world's asset management sector since the financial crisis to $75 trillion assets by 2015, or 40% of the world's financial assets, has been a largely positive development, Carney told reporters. An issue of concern, however is around ‘open ended’ funds supplying a substantial proportion of cross border flows into developing economies… Carney said the concern comes at a time when liquidity, or the ability to sell at short notice to redeem investors, appears better than it is likely to be under stressed conditions. ‘The question is what will the consequences be when inevitably there is a period of sharp adjustment, reduced liquidity,’ Carney said.”

July 4 – Wall Street Journal (Henny Sender): “On the 20th anniversary of the Asian financial crisis it might be regarded as a fitting response to sceptics that emerging market equities have been one of the best performing asset classes so far this year. Two decades ago, no sooner had the first day of official festivities accompanying Hong Kong’s return to Chinese control finished, then the overvalued Thai baht swooned. Its drop was followed by a plunge in the Indonesia rupiah and South Korean won, while the Malaysian ringgit, and Hong Kong and new Taiwan dollar were all rapidly under pressure… And make no mistake — emerging markets are still vulnerable to rising rates. Almost $2tn in emerging markets bonds and loans come due by the end of 2018. Higher rates in the US would likely mean a stronger US dollar, making dollar debt that Asian companies more expensive to service. That may well usher in credit downgrades in emerging markets.”

July 6 – Bloomberg (Katia Dmitrieva, Erik Hertzberg, and Kristine Owram): “Toronto’s housing market is losing steam. A series of government measures and the prospect of higher interest rates boosted listings and sparked the biggest sales decline in more than eight years last month, the Toronto Real Estate Board reported… Average home prices rose just 6.3% to C$793,915 ($612,000), the smallest annual increase since January 2015. Toronto’s real estate market, mostly known for bidding wars and 20% price gains, is beginning to feel the effects of government rule changes that make it harder to get a mortgage.”

Fixed Income Bubble Watch:

July 3 – Wall Street Journal (Richard Barley): “Tiny hints from central banks about policy normalization shook markets up last week. They were also a reminder of the highly abnormal situation bond markets find themselves in, with little or no cushion for investors against rising yields. It is too easy to lose money in bonds. Returns on bonds come from two sources: the interest income that accrues to holders and changes in bond prices. But years of zero-interest-rate policy have drastically reduced the former, making the latter far more important. That shift is important, in that it has changed the way in which normally reliable bonds behave. Take Germany… The country’s benchmark 10-year bond pays a coupon of 0.25%, and at the start of last week was priced nearly close to par, with a yield of 0.25%. By the end of the week, it yielded 0.47%, but the bond’s price had dropped by around 2%...”

July 5 – Bloomberg (Robert Smith): “The US and European high-yield markets have delivered strong returns this year, but clouds are looming that threaten to make the second half of 2017 less straightforward. Bank of America Merrill Lynch’s non-financial high-yield indices returned 4.8% for US dollars and 3.7% for euros in the first half of 2017. However, the sheen came off both markets slightly at the end of these runs, with the US and euro indices having been up more than 5 and 4.1% respectively earlier in June. Two very different culprits caused these dips in performance, with a renewed slump in the oil price largely to blame for US weakness and talk of the ECB tapering bond purchases fuelling the European sell-off.”

July 3 – Reuters (Lauren Hirsch and Nick Brown): “The Puerto Rico power utility PREPA, laden with a $9 billion debt load, has filed for a form of bankruptcy, Puerto Rico's primary fiscal agent said… “

Federal Reserve Watch:

July 4 – Wall Street Journal (Nick Timiraos): “Federal Reserve officials have indicated there is a strong chance they will announce in September a decision to start shrinking the central bank’s portfolio of bonds and other assets, while putting off until December any further interest-rate increase. The moves would give officials time to assess how markets react to the balance-sheet reductions and to confirm their view that a recent slowdown in inflation will fade. Launching the balance-sheet plan in September also would afford Chairwoman Janet Yellen an opportunity to initiate it well ahead of any potential leadership transition.”

U.S. Bubble Watch:

July 5 – Wall Street Journal (Greg Ip): “If you drew up a list of preconditions for recession, it would include the following: a labor market at full strength, frothy asset prices, tightening central banks, and a pervasive sense of calm. In other words, it would look a lot like the present. Those of us who have lived through economic mayhem before feel our muscle memory twitch at times like this. Consider the worrisome absence of worry. ‘Implied volatility’ measures the cost of hedging against big market moves via options. When fear is pervasive, options are expensive so implied volatility is high. At present, implied volatility in bonds, stocks, currencies and gold sits near its lowest since mid-2007, the eve of the financial crisis… The economic expansion is now entering its ninth year and in two years will be the longest on record. The unemployment rate sits at 4.3%, the lowest in 16 years, suggesting the economy has reached, or nearly reached, full capacity.”

July 3 – Bloomberg (Sho Chandra): “American factories powered up in June at the fastest pace in nearly three years, with robust advances in production, orders and employment that indicate a firming in the economy, data from the Institute for Supply Management showed… Factory index rose to 57.8, highest since August 2014 (est. 55.3) from 54.9 in May…”

July 3 – Bloomberg (Will Davies): “It’ll take more than central bank tightening to shake volatility from its yearlong slumber, according to Goldman Sachs… A large shock such as recession or war is usually required. That’s generally been the case for the 14 similar low volatility ‘regimes’ since 1928, at least in equity markets, Goldman Sachs strategists Christian Mueller-Glissmann and Alessio Rizzi said. These periods on average lasted nearly two years, featured short-lived spikes and realized S&P 500 volatility was usually at or below 10.”

July 3 – Bloomberg (Elise Young): “Were it not for Illinois’s flirtation with a junk credit downgrade and New Jersey Governor Chris Christie’s luxuriating on a closed public beach, the budget woes of U.S. states might have assumed their annual spot in the dust bin of public-policy history. This year, spending strife is unusually widespread, with 11 states missing their July 1 fiscal-year deadlines... In a poor economy, states often freeze spending while lawmakers and the chief executive work out how to plug budget holes. This year’s standoffs, though, come amid record stock-market gains and low national unemployment.”

July 6 – Reuters (Howard Schneider): “The U.S. housing finance system continues to put taxpayers at risk in a market dominated by government-backed agencies, Federal Reserve Governor Jerome Powell said…, calling for further reform of an ‘unsustainable’ situation. A decade after doubts about the creditworthiness of mortgage-backed securities helped trigger the worst financial crisis since the Great Depression, systemic risk remains given the concentration of mortgages in Fannie Mae and Freddie Mac, he said. ‘We're almost at a now-or-never moment,’ Powell told a conference…, arguing that the window for political action on an overhaul of housing finance may not stay open for long.”

July 4 – MarketWatch (Rachel Koning Beals): “As car buyers’ obsession with bigger, pricier vehicles grows, so does their willingness to take longer to pay for them, says new analysis from The average auto-loan length reached an all-time high of 69.3 months in June. That’s 6.8% longer than five years ago… The average amount that buyers financed was hit with the biggest uptick for the year last month, at $30,945, or up $631 from May. The financing trend also lead to the highest monthly payments for the year, now averaging $517…”

Japan Watch:

July 3 – Reuters (Linda Sieg): “Prime Minister Shinzo Abe's Liberal Democratic Party suffered an historic defeat in an election in the Japanese capital on Sunday, signaling trouble ahead for the premier, who has suffered from slumping support because of a favoritism scandal. On the surface, the Tokyo Metropolitan assembly election was a referendum on Governor Yuriko Koike's year in office, but the dismal showing for Abe's party is also a stinging rebuke of his 4-1/2-year-old administration.”

July 3 – Bloomberg (Isabel Reynolds and Yuki Hagiwara): “Scandal-hit Japanese Prime Minister Shinzo Abe faces one of his biggest tests since coming to power in late 2012, after his ruling party lost to an upstart outfit in an election for Tokyo’s assembly. The Liberal Democratic Party lost more than half its seats to end up with 23, the lowest number ever in the capital, in a vote that could be a harbinger for national elections. Voter turnout was up about eight percentage points on the previous poll four years ago… Somber-faced party executives sat in silence at the opening of an extraordinary meeting on Monday morning to discuss the defeat.”

July 2 – Bloomberg (Yoshiaki Nohara, Masahiro Hidaka, and Toru Fujioka): “Haruhiko Kuroda shouldn’t serve another term as governor of the Bank of Japan because the central bank will need fresh ideas as it moves toward exiting years of unprecedented monetary easing, according to an adviser to the prime minister. ‘An exit will surely come up within the next five years and we need someone who can prepare for it,’ said Nobuyuki Nakahara, a former BOJ board member. ‘He will fall into inertia and struggle to come up with bold new ideas. It’s the same in the private sector when a corporate president stays too long,’ he said.”

July 2 – Reuters (Leika Kihara and Tetsushi Kajimoto): “Confidence among Japan's big manufacturers hit its highest level in more than three years in the June quarter, …adding to signs the recovery in the world's third largest economy is gaining pace. Big firms also saw the job market at its tightest in 25 years, offering policymakers some hope that companies may finally raise wages… The survey underscores the Bank of Japan's view that the economy is heading for a moderate expansion…”

July 3 – Bloomberg (Toru Fujioka, Keiko Ujikane, and Takashi Amano): “A change of leadership at the Bank of Japan would offer a chance to bolster public confidence in its ability to defeat deflation, according to an economic adviser to Prime Minister Shinzo Abe. ‘What’s important, especially this time, is whether we can undertake regime change,” Etsuro Honda said… ‘It should be someone who is refreshing enough and can renew people’s impressions with personal charm and sincerity.’”

Leveraged Speculation Watch:

July 4 – Wall Street Journal (Laurence Fletcher): “After the presidential election last year, many hedge-fund managers called the U.S. a great moneymaking opportunity. It turns out Europe is the place to be. Bets on stocks in Italy, France and Spain—long laggards compared with the U.S.—have given some global hedge funds returns of more than 20% so far this year. The average hedge fund has managed only 3% through May, according to… Hedge Fund Research.”

Geopolitical Watch:

July 5 – Wall Street Journal (Jonathan Cheng): “The U.S. warned North Korea that it is ready to fight if provoked, as Pyongyang claimed another weapons-development breakthrough following its launch of an intercontinental ballistic missile a day earlier. The regime, having demonstrated its capacity to reach the U.S. with a missile, …touted another achievement of the test launch: It claimed that its missile warhead—the forward section, which carries the explosive—can withstand the extreme heat and pressure of re-entering the earth’s atmosphere.”

July 4 – Reuters (Jack Kim and Christine Kim): “North Korea said… its newly developed intercontinental ballistic missile (ICBM) can carry a large nuclear warhead, triggering a call by Washington for global action to hold it accountable for pursuing nuclear weapons. A spokeswoman for the U.S. Defense Department said it had concluded that North Korea test-launched an ICBM on Tuesday, which some experts now believe had the range to reach the U.S. state of Alaska as well as parts of the mainland United States. U.S. Secretary of State Rex Tillerson said the test, on the eve of the U.S. Independence Day holiday, represented ‘a new escalation of the threat’ to the United States and its allies, and vowed to take stronger measures.”

July 5 – Wall Street Journal (Farnaz Fassihi, Gordon Lubold and Jonathan Cheng): “The U.S. and Russia clashed at the United Nations Security Council over how to respond to North Korea’s nuclear-weapons program, a confrontation throwing into doubt U.S. hopes for an international diplomatic solution to the burgeoning crisis. The standoff between diplomats… came just two days before President Donald Trump and Russian counterpart Vladimir Putin plan to hold their first meeting during the summit of the Group of 20 leading nations in Germany, raising the stakes for both leaders as well as China, which will attend the international gathering.”

July 5 – CNBC (Cheang Ming): “Strategic ties between Russia and China were appraised in glowing terms as Chinese President Xi Jinping wrapped up a two-day state visit to Russia, concluding with at least $10 billion in agreements. Xi, who met with Russian President Vladimir Putin during the trip, told Russian media that relations between the two countries were currently at their ‘best time in history.’ The Chinese president also said Russia and China were each other's ‘most trustworthy strategic partners,’ Xinhua reported.”

July 5 – Financial Times (Heba Saleh and Simeon Kerr): “The four Arab states that have imposed an extraordinary embargo on Qatar, on Wednesday lambasted Doha for its ‘negative’ response to their demands in a sign that the month-long diplomatic crisis is deepening. After meeting in Cairo to discuss the dispute, the foreign ministers of Saudi Arabia, the United Arab Emirates, Bahrain and Egypt said Qatar’s response showed ‘a lack of seriousness in dealing with the roots of the problem’ and a ‘failure to appreciate the dangers in the situation’. Adel al-Jubeir, Saudi Arabia’s foreign minister, warned that additional steps against Doha could be taken at the appropriate time."

July 6 – Reuters (Rodi Said and Dominic Evans): “The head of the Syrian Kurdish YPG militia said… that Turkish military deployments near Kurdish-held areas of northwestern Syria amounted to a ‘declaration of war’ which could trigger clashes within days. Turkey's Deputy Prime Minister Numan Kurtulmus retorted that his country was not declaring war but that its forces would respond to any hostile move by the YPG, which he described as a small-scale army formed by the United States.”

July 5 – Associated Press (Gerry Shih and Muneeza Naqvi): “China has insisted India withdraw its troops from a disputed Himalayan plateau before talks can take place to settle the most protracted standoff in recent years between the nuclear-armed neighbors, who fought a bloody frontier war 55 years ago. India must pull back its troops ‘as soon as possible’ as a precondition to demonstrate sincerity, foreign ministry spokesman Geng Shuang told reporters… His comments came after weeks of saber-rattling in New Delhi and Beijing, as officials from both sides talk up a potential clash even bloodier than their 1962 war that left thousands dead.”

July 2 – New York Times (Sheera Frenkel): “The attack had the hallmarks of something researchers had dreaded for years: malicious software using artificial intelligence that could lead to a new digital arms race in which A.I.-driven defenses battled A.I.-driven offenses while humans watched from the sidelines. But what was not as widely predicted was that one of the earliest instances of that sort of malware was found in India… Security researchers are increasingly looking in countries outside the West to discover the newest, most creative and potentially most dangerous types of cyberattacks being deployed. As developing economies rush to go online, they provide a fertile testing ground for hackers trying their skills…”

July 1 – Reuters (Pavel Polityuk): “Ukraine said… that Russian security services were involved in a recent cyber attack on the country, with the aim of destroying important data and spreading panic. The SBU, Ukraine's state security service, said the attack, which started in Ukraine and spread around the world…, was by the same hackers who attacked the Ukrainian power grid in December 2016. Ukrainian politicians were quick to blame Russia for Tuesday's attack, but a Kremlin spokesman dismissed ‘unfounded blanket accusations’.”

Friday Evening Links

[Reuters] Wall Street climbs after jobs data as tech, financials rise

[Bloomberg] Cross-Asset Quants Are Facing Their Worst Losses in a Decade

[Bloomberg] Oil Posts Weekly Decline as U.S. Drillers Resume Expansion

[CNBC] Money is rushing into ‘the most dangerous trade in the world’