President Putin’s recent moves in the Middle East—to shore up Bashar al-Assad’s regime in Syria through deployment of combat aircraft, equipment, and manpower and build-out of air-, naval-, and ground-force bases, and the agreement in the last week with Iran, Iraq, and Syria on intelligence and security cooperation—could contribute to Russian efforts to combat the myriad negative pressures on Russia’s vital energy industry.
Live by Energy…
Energy is the foundation of Russia, its economy, its government, and its political system. Putin has highlighted on various occasions the contribution Russia’s mineral wealth, in particular oil and natural gas, must make for Russia to be able to sustain economic growth, promote industrial development, catch up with the developed economies, and modernize Russia’s military and military industry.
Even a casual glance at the IMF’s World Economic Outlook statistics for Russia shows the tight correlation since 1992 between GDP growth on the one hand and oil and gas output, exports, and prices on the other (economic series available here). According to the IMF’s 2015 Article Iv Consultation-Press Release and Staff Report, published August 3, oil and natural gas exports comprised 65 percent of exports, 52 percent of the Federal government budget, and 14.5 percent of GDP in 2014. Including their domestic contribution, hydrocarbons represent ~30 percent of GDP.
While oil and natural gas are crucial to Russia, Russia’s crude and natural gas are crucial to its neighbors on the Eurasian landmass. Russia supplied about 30 percent (146.6 bcm) of Europe’s natural gas in 2014, and about 25 percent of its crude (3.5 mmbbl/day) in 2013. Russia’s oil and natural gas are also important to its Asian and Central Asian neighbors.
It is not only the commodities that make Russia crucial, but its massive land-based infrastructure for their distribution throughout the Eurasian landmass. As Tatiana Mitrova, head of the oil and gas department, Energy Research Institute, Russian Academy of Sciences, pointed out regarding natural gas in The Geopolitics of Russian Natural Gas:
“Russia has a unique transcontinental infrastructure in the heart of Eurasia (150,000 km of trunk pipelines), which also makes it a backbone of the evolving, huge Eurasian gas market (which could include Europe, North Africa, the Commonwealth of Independent States (CIS), Caspian Sea region, and Northeast Asia). Control over the transportation assets in this region together with vast gas reserves make Russia the key element of this new market.”
The land-based oil distribution network is smaller, but also important. The 4,000 km Druzhba pipeline delivers about 1 mmbbl/day of crude to Europe—about 30 percent of total shipments to Europe. In the Far East, Rosneft shipped 22.6 million tons of crude to China in 2014 through the East Siberian Pacific Ocean (ESPO) pipeline.
The Russian government continues to seek to extend and expand the natural gas distribution infrastructure—into Europe, with various proposed pipeline projects (Nord Stream 2, Turkish Stream 2, 3, and 4, South European Pipeline), and into China, with two large pipeline projects, Power of Siberia Pipeline (to supply China from East Siberia), and the proposed Altai pipeline (to supply China from West Siberia).
…Death by Energy
In the last few years, the threats to Russia’s energy industry have multiplied and intensified. They pose an existential threat to the industry and therefore to the Russian economy:
- The revenues Russia can earn from its crude and natural gas exports face intense pressure. The Saudi decision to let the market set prices and to pursue market share, has led to steep declines in crude and petroleum product prices. The decision also has impacted natural gas export prices negatively, since, for Russia’s long-term supply agreements, they wholly or partially are indexed to oil prices. The transition in Europe to hybrid natural gas pricing models (which take European spot hub prices into account) also has pressured natural gas pricing. (Natural gas data from Gazprom).
(Click to enlarge)
Adding to the revenue pain, natural gas export volumes have been falling, according to Gazprom (which has a monopoly on pipeline exports), as have domestic volumes within Russia:
(Click to enlarge)
It is therefore not surprising that the aforementioned IMF Article Iv Consultation-Press Release and Staff Report projected sharp declines in 2015 and 2016 from 2014 levels for oil export revenues ($109.8 billion and $96 billion respectively) and natural gas export revenues ($12 billion and $14.3 billion respectively).
(Click to enlarge)
Since these IMF projections are based on $60.1 and $65.8 per barrel prices in 2015 and 2016, oil export revenues will undershoot these pessimistic IMF projections, as crude prices are projected to stay below $60 through 2016 (EIA estimates for Brent are $54.07 and 58.57 in 2015 and 2016 respectively).
- The U.S. and European Union’s decisions to impose—and maintain—sanctions on Russia after its invasion and annexation of Crimea and invasion and informal annexation eastern Ukraine will pile more pressure on the Russian energy industry. They include bans on financing for and the supply of critical equipment and technology to important Russian energy projects. Novatek and its partners Total and Chinese National Petroleum Company still lack $15 billion of the $27 billion needed to finance the Yamal LNG plant. Denis Khramov, Russia’s deputy Minister of Natural Resources, said September 28 at a conference in Russia’s Far East that Rosneft and Gazprom are delaying some offshore drilling by two to three years because of sanctions and low oil prices. The sanctions are also impeding Gazprom’s ability to develop the Chayandinskoye and Kovyktinskoye fields in eastern Siberia, from which it plans to supply natural gas to China under the bilateral $400 billion, thirty year deal signed in 2014.
- Following the Russian invasion of Crimea and eastern Ukraine, The European Union is now even more determined to reduce its dependence on Russia for natural gas and to force Gazprom submit to EU competition rules. Europe has sought and continues to seek alternatives Russian natural gas (among them, U.S. LNG and Iranian pipeline and/or LNG). The European Commission, the European Union’s executive body, has refused to bless Gazprom’s proposed 55 bcm/year Nord Stream 2 natural gas pipeline project, citing existing surplus Gazprom pipeline capacity into Europe and insufficient future demand for Russian natural gas. Also, the EU Commission in April charged Gazprom with violating the EU’s anti-trust laws for anti-competitive practices and unfair pricing in Central and Eastern Europe. If found guilty, Gazprom could face substantial fines of around $1 billion. Even if Gazprom avoids fines and manages to reach a settlement with the EU, as it hopes to do, its European market share and pricing will remain under pressure into the future.
- The emergence of the U.S., along with Canada, as powerful crude, NGL, and natural gas producers is also a major concern for the Russian economy. This has transformed the U.S. from a market for Russian crude and natural gas (via LNG) to a global competitor. If, as seems increasingly likely, the ban on crude exports is lifted, U.S. crude will compete with Russian crude in several key markets. It would also force foreign suppliers to seek other markets for all or part of the exports they previously sent to the U.S. This in turn would intensify competition among these crude exporting countries for share in those markets. In regard to natural gas, its explosive output growth in the U.S. undercut Gazprom’s rationale for its Baltic LNG project (10 mtpa), turned the U.S. into a major (potential) LNG competitor in global LNG import markets, and, via the U.S. toll- and Henry Hub- pricing model, weakened Gazprom’s ability to insist on oil-indexed, long-term contracts.
Saving Russian Energy (and Russia) through the Middle East?
Putin’s moves in the Middle East could help Russia address the impact of these threats to the Russian energy industry. They potentially enhance the attractiveness of Russian crude and natural gas supplies compared to those from Saudi Arabia and its Gulf Arab allies.
In the selection of crude and natural gas suppliers, security is a key consideration for importers. Wary of U.S. naval power, the Chinese, for example, prefer pipeline natural gas supplies over seaborne LNG supplies. Importers therefore must take into consideration the potential threats to transport. In this critical area, Russia enjoys a decided advantage over Saudi Arabia and the Gulf Arab producers, which depend on sea transport through the Persian Gulf and the Red Sea to ship their oil and LNG.
Each of the three routes from these two bodies of water passes through a “choke point” (from the Red Sea, through the Suez Canal to Europe and through the Mandeb Strait to Asia, from the Persian Gulf through the Strait of Hormuz). By adding an airbase to their military presence in Syria, the Russians—coordinating with Iran, Syrian President Assad, and eventually possibly Iraq—would have the capability to disrupt shipments from Persian Gulf and Red Sea terminals.
Russia’s export channels are less susceptible to disruption. With the exception of LNG exports to Asia from Sakhalin, Russia sends natural gas to its customers via pipeline. About 70 percent of Russia’s seaborne oil exports are susceptible to choke points (shipments from two ports on the Gulf of Finland through the Baltic Sea to the Atlantic and one port on the Black Sea through the Turkish Strait/Bosporus to the Mediterranean), while 30 percent are not (pipeline shipments to Europe and ESPO pipeline shipments to the port of Primorsk near Vladivostok).
Putin’s moves also are strengthening Russia’s influence with OPEC. Russia already has extensive and close ties with Iran and Venezuela, and is now laying the basis for such ties with Iraq. Putin has aligned Russia with OPEC’s have nots–the members lacking financial resources to withstand low crude prices for an extended period and that have objected to Saudi policies (Iran, Iraq, Angola, Nigeria, Libya, Algeria, Ecuador, and Venezuela)—against the haves (Saudi Arabia, Kuwait, the UAE, and Qatar). He has continually supported Venezuelan President Maduro’s calls for an emergency OPEC meeting on prices and his efforts to persuade Saudi Arabia to reverse its policy. Most recently, in the beginning of September, Putin told Maduro that the two countries “must team up to shore up oil prices”.
In addition, Russia’s deputy prime minister in charge of energy policy, Arkady Dvorkovich, in the beginning of September made comments that, in tone and substance, mocked Saudi policy, saying that “OPEC producers are suffering the ricochet effects of their attempt to flush out rivals by flooding the world with excess output,” expressing doubt that OPEC members “really want to live with low oil prices for a long time,” and implying that Saudi policy is irrational.
Indeed, Russia can be seen as maneuvering to split OPEC into two blocs, with Russia, although not a member, persuading the “Russian bloc” to isolate Saudi Arabia and the Gulf Arab OPEC members within OPEC. This might persuade the Saudis to seek a compromise with the have nots.
A strategic alliance with Iran and Iraq offers Putin two more potential avenues to pressure the Saudis. They can test Saudi determination to defend their market share at any price and its wherewithal financially to do so. Iran claims it can raise crude output by one million barrels within six or so months of the lifting of sanctions. The Saudis may be calculating that Iran must first rehabilitate its oil fields and that Iran, cash poor, cannot do so quickly. If this is the case, Russia could step in, offer Iran financing, and force the Saudis to contemplate prices staying lower longer than they anticipated and therefore continuing pressure on their economy.
Russia also could cooperate with Iran and Iraq to take market share from Saudi Arabia in the vital Chinese market.As a recent Bloomberg article pointed out, Saudi Arabia, Iran, Russia, Iraq and other countries are vying intensely for sales to China, the second largest import market and the major source of demand growth in coming years. Coordinating their pricing and consistently offering the Chinese prices below the Saudi price, they could seek to win market share. Such a price war would pressure the competitors’ currencies.
Since the Russians allow the Ruble to float, Iran maintains an informal and unofficial peg for its Rial to the US$, and Iraq has indicated it is willing to adjust its peg if necessary, while the Saudis are committed to the Riyal’s peg to the US$, Russia, Iran, and Iraq would have any advantage over Saudi Arabia. To the extent that Iran and Iraq allowed their currencies to adjust, Russian, Iranian, and Iraqi revenues in local currency terms would not decline as much as Saudi revenues fixed in US$ (and might even increase) as their currencies depreciated.
Each of these opportunities offers the possibility to address the pressures on the Russian energy industry. However, Putin will have to play his cards carefully. Played heavy-handedly, he could intensify fears in Europe of excessive dependence on Russian energy supplies and awaken such fears in China. This could lead the Europeans and Chinese to search for other suppliers. In addition, mismanaged confrontation with the U.S. and Europe in and over Syria could lead to broadening and strengthening of economic and financial sanctions. Moreover, neither Iran nor Iraq will want to become overly dependent on Russia, which lacks the resources they need develop their energy industries.
Finally, the opportunities assume Putin’s gambits in Syria and with Syria, Iran, and Iraq in intelligence and security cooperation will succeed. And this, given the Soviet experience in Afghanistan and Putin’s experience in eastern Ukraine, is far from certain.
As oil prices are now hovering around $45 per barrel, the entire oil and gas industry is looking forward to the next OPEC meeting, due to be held on December 4 this year in Vienna. On October 14, non- OPEC member Mexicoconfirmed its participation in a technical meeting organized by the cartel on October 21 in Vienna to which seven other non-OPEC members were also invited.
“We are going with a technical delegation to receive information and exchange it with other producers. But Mexico will not take part in any reduction in production volume,” said Mexico’s Energy Minister Pedro Joaquin Coldwell. The meeting was held last Wednesday and was attended by representatives of five countries: Russia, Brazil, Kazakhstan, Colombia and Mexico. The main agenda of the meeting was to exchange different market views and create a common strategy in response to the current market conditions and low oil prices.
What exactly happened at the meeting?
Venezuela has been the most vocal OPEC member when it comes to the issue of raising oil prices by altering the cartel’s production levels. During the technical meeting between OPEC and non-OPEC members, Venezuela proposed that OPEC must resume its policy adopted in 1980s of fixing the oil price. It suggested a possible ceiling price of $88 per barrel which would naturally require OPEC to reduce its current production levels. In addition, Venezuela also proposed another technical meeting of this kind to be held during the upcoming Dec 4 meeting.
“We are concerned about the depletion of reservoirs and about the decline of production. We are talking here about an equilibrium price to sustain the production,” said Venezuela’s Oil Minister Eulogio del Pino in response to his nation’s stand on the OPEC production levels. Although it was agreed that a similar meeting would be held again after December 4 for assessing the global oil markets, Venezuela’s proposal of reducing the production levels for setting a specific ceiling price was not even discussed.
With Russia and other non–OPEC members refusing to stand by Venezuela, the meeting re-iterated OPEC’s policy of sticking to its production levels instead of reducing them. Although Venezuela has received support from other OPEC members such as Ecuador and Algeria to some extent, the OPEC leaders dismissed any further speculations on production cuts.
With this firm stand, it is possible that we might witness the formation of two blocks within OPEC during the next December 4 meet in Vienna. One, led by Venezuela, Ecuador, Libya and Algeria that would want to reduce production levels and the other led by Saudi Arabia, UAE and Kuwait that would stick to the current strategy of defending market share. Iran may have a neutral stance as, although it ‘urged’ the other OPEC members to reduce their combined production to maintain a ceiling of $70-$80 per barrel, Iran would itself be ramping up its production levels to regain its lost market share, once the western sanctions against it are lifted.
What does this decision mean for the future of OPEC and the oil industry?
“OPEC made it very clear months ago they will not interfere to control prices and it is the market that should do that,” said one of the OPEC delegates during the meeting.
It is quite clear that even Russia (which produced around 10.74 mb/day in September, a new post- Soviet Era record) is not interested in reducing its output and is competing directly with Saudi Arabia in markets like Europe and Asia, battling for market share.
On the one hand, the Saudis are offering discounts to customers in Asia, Europe and the U.S. On the other, Russia is competing hard with Saudi Arabia in Eastern Europe and China.
In any case, a potential OPEC cut in production levels would not be the complete solution to the problem of the global supply glut as the U.S. shale patch has nearly doubled its production, up by 4 million barrels per day between the year 2011 and 2015, arguably making them more responsible for the supply glut and current oil price crash.
Survival of the Fittest
In the end, it will come down to survival of the fittest. Players who have higher breakeven costs will be the ones who will blink first and thereby reduce their production levels. In the present scenario, the U.S. shale drillers, who have very high breakeven costs, are going out of business and we are already witnessing how U.S. production is falling every month since April. Still, oil prices remain below the $50 per barrel mark.
The ‘survival of the fittest’ also applies to Middle East oil producers, and especially to Saudi Arabia, the undisputed leader of OPEC. As widely reported by the media, the International Monetary Fund has warned that Saudi Arabia is now facing the possibility of going broke in the next five years, while the other Middle Eastern nations like the UAE, Kuwait and Qatar have foreign reserves that could last for almost twenty years. The desert kingdom is now facing a massive budget deficit of $36.8 billion according to its 2015 budget figures and is burning its foreign reserves at an alarming pace. Although Saudi Arabia is responding to this crisis by cutting spending, postponing several projects and by attracting foreign investment, is it doing enough to salvage the situation?
Many experts now believe that Saudi Arabia will eventually be compelled to cut its production levels as its rising budget deficit will leave the desert kingdom with no other option. And, with Saudi Arabia deciding to cut the production, we can expect oil prices to bounce back in the longer run. Until then, oil prices will continue to remain bearish and volatile. Although it is almost certain that OPEC will not change its strategy in its next meeting in Vienna, it is unlikely that it would maintain this stance for too much longer in 2016.
... but the pressure from simultaneously maintaining the riyal peg and preserving the standard of living for everyday Saudis has driven Riyadh back into the debt market in an effort to offset some of the pressure on the country’s vast store of USD-denominated petrodollar assets (see second pane below).
Meanwhile, the war in Yemen is also weighing on the budget and now, the Saudis are staring down a fiscal deficit that amounts to some 20% of GDP and the first current account deficit in years.
All of the above have caused to market to lose faith in Riyadh’s ability to keep the situation under control and now,S&P has downgraded the kingdom to AA- negative citing “lower for longer” crude and the attendant ballooning fiscal deficits.
* * *
We expect the Kingdom of Saudi Arabia's (Saudi Arabia's) general government fiscal deficit will increase to 16% of GDP in 2015, from 1.5% in 2014, primarily reflecting the sharp drop in oil prices.Hydrocarbons account for about 80% of Saudi Arabia's fiscal revenues.
Absent a rebound in oil prices, we now expect general government deficits of 10% of GDP in 2016, 8% in 2017, and 5% in 2018, based on planned fiscal consolidation measures.
We are therefore lowering our foreign- and local-currency sovereign credit ratings on Saudi Arabia to 'A+/A-1' from 'AA-/A-1+'.
Standard & Poor's is converting its issuer credit rating on Saudi Arabia to "unsolicited" following termination by Saudi Arabia of its rating agreement with Standard & Poor's.
The outlook remains negative, reflecting the challenge of reversing the marked deterioration in Saudi Arabia's fiscal balance. We could lower the ratings within the next two years if the government did not achieve a sizable and sustained reduction in the general government deficit or its liquid fiscal financial assets fell below 100% of GDP.
* * *
Of course this will only get worse should Riyadh decide to launch a sequel to "Operation Decisive Storm" in Syria and indeed, the IMF recently warned that absent higher oil prices, the Saudis could literally go broke in the space of five years:
Sharply lower oil prices have significantly affected the fiscal prospects of oil exporters across MENA and the CCA.1 The Brent oil price is projected to average $53 a barrel in 2015, down from almost $110 a barrel in the first half of last year. Exporters’ fiscal balances have turned from sizable surpluses to large deficits, with MENA and CCA export revenues dropping by $360 billion and $45 billion, respectively, this year alone.
For oil exporters, the main policy issue is fiscal adjustment and rebuilding buffers over the medium term. The Brent oil price is projected to recover only modestly to about $66 a barrel by the end of the decade, with MENA and CCA export receipts remaining $345 billion and $30 billion, respectively, below the 2014 level, even in 2020. In the absence of adjustment, fiscal balances will remain in deep deficit in most countries, with public debt ratios rising rapidly (red lines in Figure 4.2).
Even under the IMF baseline scenario, however, public debt ratios will continue to rise in many GCC and CCA exporters (blue lines in Figure 4.2). In a number of countries, mediumterm fiscal balances will fall well short of the levels needed to ensure that an adequate portion of the income from exhaustible oil and gas reserves is saved for future generations (Figure 4.3). Bahrain, Oman, and Saudi Arabia have medium-term fiscal gaps of some 15–25 percentage points of non-oil GDP, while conflict-torn Libya has a gap of more than 50 percent of non-oil GDP.
The large and sustained drop in oil prices has increased fiscal vulnerabilities in MENA and CCA oil-exporting countries. The issue of fiscal space has become critical as oil exporters decide how quickly to adjust their fiscal policies to the new reality of persistently lower oil prices. This box considers several alternative measures of fiscal space. A good starting point is the size of governments’ financial assets—commonly referred to as “fiscal buffers.” In general, countries with larger buffers can afford to maintain fiscal deficits further into the future, so as to reduce the impact of lower oil prices on growth. On current trends, however, all non-GCC MENA oil exporters are already projected to run out of liquid financial assets in the next three years (see Chapter 1). In, contrast, CCA oil exporters have at least 15 years’ worth of available financial savings,1 while GCC countries are split evenly between countries with relatively large buffers (Kuwait, Qatar, and the United Arab Emirates—more than 20 years remaining) and countries with relatively smaller buffers (Bahrain, Oman, and Saudi Arabia—less than five years).
As a refresher, here's BofAML's sensitivity analysis which shows how long Riyadh's SAMA reserves will last under various scenarios for crude prices and debt issuance:
One important takeaway from the above is that if the Saudis were to burn through their reserves it would represent a nearly $700 billion global liquidity drain as Riyadh dumps its USD-denominated assets. That would amount to a complete reversal of the petrodollar virtuous circle that's underwritten decades of dollar dominance and which has served to underpin the global economic order for as far back as most market participants can remember.
And while it's by no means a foregone conclusion that oil prices will remain "lower for longer" as the Saudis are to a certain extent the masters of their own destiny in that regard, one thing worth noting is that not only is Iranian supply set to come back online, but Tehran seems determined to supplant Riyadh as regional power broker. Both of those eventualities will have very real consequences for crude prices and thus for the future of The House of Saud.
So enjoy it while it lasts King Salman...
MOST CRITICAL TIPPING POINT ARTICLES THIS WEEK - Oct 25th, 2015 - Oct 31st, 2015
RISK REVERSAL - WOULD BE MARKED BY: Slowing Momentum, Weakening Earnings, Falling Estimates
RISK REVERSAL - WOULD BE MARKED BY: Slowing Momentum, Weakening Earnings, Falling Estimates
GLOBAL RISK SIGNALS
The Financialization of the Economy
John Mauldin | Oct 28, 2015
Roger Bootle once wrote:
The whole of economic life is a mixture of creative and distributive activities. Some of what we ‘‘earn’’ derives from what is created out of nothing and adds to the total available for all to enjoy. But some of it merely takes what would otherwise be available to others and therefore comes at their expense.
Successful societies maximise the creative and minimise the distributive. Societies where everyone can achieve gains only at the expense of others are by definition impoverished. They are also usually intensely violent….
Much of what goes on in financial markets belongs at the distributive end. The gains to one party reflect the losses to another, and the fees and charges racked up are paid by Joe Public, since even if he is not directly involved in the deals, he is indirectly through costs and charges for goods and services.
The genius of the great speculative investors is to see what others do not, or to see it earlier. This is a skill. But so is the ability to stand on tip toe, balancing on one leg, while holding a pot of tea above your head, without spillage. But I am not convinced of the social worth of such a skill.
This distinction between creative and distributive goes some way to explain why the financial sector has become so big in relation to gross domestic product – and why those working in it get paid so much.
I came across this quote while reading today’sOutside the Box,which comes from my friend Joan McCullough. She didn’t actually cite it but mentioned Bootle in passing, and I googled him, which took me down an alley full of interesting ideas. I had heard of him, of course, but not really read him, which I think may be a mistake I should correct.
But today we are going to focus on Joan’s own missive from last week, which she has graciously allowed me to pass on to you. It’s a probing examination of how and why the financialization of the US and European (and other developed-world) economies has become an anchor holding back our growth and future well-being. Joan lays much of the blame at the feet of the Federal Reserve, for creating an environment in which financial engineering is more lucrative than actually creating new businesses and increasing production and sales.
There are no easy answers or solutions, but as with any destructive codependent relationship, the first step is to recognize the problem. And right now, I think few do.
What you will read here is of course infused with Joan’s irascible personality and is therefore really quite the fun read (even as the message is sad).
Joan writes letters along this line twice a day, slicing and dicing data and news for her rather elite subscriber list. Elite in the sense that her service is rather expensive, so I thank her for letting me send this out. Drop me a note if you want us to put you in touch with her.
The Financialization of the Economy
Joan McCullough, Longford Associates
October 21, 2015
Yesterday, we learned that lending standards had eased and that there was increased loan demand from institutions and households, per the ECB’s September report. (Which was attributed to the success of QE and which buoyed the Euro in the process.)
This has been bothering me. Because it is a great example of the debate over “financialization” of an economy, i.e., is it a good thing or a bad thing?
The need to further explore the topic was provoked by reading this morning that one of the larger shipping alliances, G6, hasagainannounced sailing cancellations between Asia and North Europe and the Mediterranean. This round of cuts targets November and December. The Asia-Europe routes, please note, are where the lines utilize their biggest ships and have been running below breakeven. So it’s easy to understand why such outsized capacity is further dictating the need to cancel sailings outright. G6 members: American President, Hapag Lloyd, Hyundai Merchant Marine, Mitsui, Nippon and OOCL. So as you can see from that line-up, these are not amateurs.
We have already discussed in the past in this space, the topic of financialization. But seeing as how the stock market keeps rallying while the economic statistics have remained for the most part, punk, time to revisit the issue once again. Is it all simply FED or no FED? Or is the interest-rate issue ground zero and/or purely symptomatic of the triumph of financialization over the real economy?
Further urged to revisit the topic by the seemingly contradictory developments of the ECB banks reportedly humming along nicely while trade between Asia and Europe remains obviously, significantly crimped.
Let’s make this plain English because it takes too much energy to interpret most of what is written on the topic.
Definition (one of quite a few, but the one I think is accurate for purposes of this screed):
Financialization is characterized by the accrual of profits primarily thru financial channels (allocating or exchanging capital in anticipation of interest, divvies or capital gains) as opposed to accrual of profits thru trade and the production of goods/services.
Economic activity can be “creative” or “distributive”. The former is self- explanatory, i.e., something is produced/created. The latter pretty much simply defines money changing hands. (So that when this process gets way overdone as it likely has become in our world, one of the byproducts is the widening gap called “income inequality”.)
You guessed correctly: financialization is viewed as largely distributive.
So now we roll around to the nitty-gritty of the issue. Which presents itself when business managers evolve to the point where they are pretty much under the control of the financial community. Which in our case is simply “Wall Street”.
This is something I saved from an article last summer which ragged mercilessly on IBM for having kissed Wall Street’s backside ... and in the process over the years, ruined the biz.
IBM is but one possible target in laying this type of blame where the decisions on corporate action are ceded to the financial community; the instances are innumerable.
You probably could cite the well-known example of a couple of years back when Goldman Sachs was exposed as the owner ofwarehouse facilitiesthat held 70% of North American aluminum inventory. And how that drove up the price and cost end-users dearly. (Estimated as $ 5bil over 3 years’ time.)
First link: NY Times article from July of 2013, talking about thewarehousingissue.
Well, here’s another from the same article which makes the point quite clearly:
... Boeing’s launch of the 787 was marred by massive cost overruns and battery fires. Any product can have technical problems, but the striking thing about the 787’s is that they stemmed from exactly the sort of decisions thatWall Street tells executives to make.
Before its 1997 merger with McDonnell Douglas, Boeing had an engineering-driven culture and a history of betting the company on daring investments in new aircraft. McDonnell Douglas, on the other hand, was risk-averse and focused on cost cutting and financial performance, and its culture came to dominate the merged company. So, over the objections of career-long Boeing engineers, the 787 was developed with an unprecedented level of outsourcing, in part, the engineers believed, to maximize Boeing’s return on net assets (RONA).Outsourcing removed assets from Boeing’s balance sheet but also made the 787’s supply chain so complex that the company couldn’t maintain the high quality an airliner requires. Just as the engineers had predicted, the result was huge delays and runaway costs.... Boeing’s decision to minimize its assets was made with Wall Street in mind. RONA is used by financial analysts to judge managers and companies, and the fixation on this kind of metric has influenced the choices of many firms.In fact, research by the economists John Asker, Joan Farre-Mensa, and Alexander Ljungqvist shows that a desire to maximize short-term share price leads publicly held companies to invest only about half as much in assets as their privately held counterparts do.”...
That’s from an article in the June, 2014, Harvard Business Review by Gautam Mukunda,“The Price of Wall Street’s Power”also cited in the Forbes article. This is the link; it is worth the read though you may not agree with parts of the conclusion:https://hbr.org/2014/06/the-price-of-wall-streets-power
The upshot to this type of behavior is that the balance of power ...and ideas... then migrates into domination by one group.
Smaller glimpse: Over-financialization is what happens when a company generates cash then pays it to shareholders and senior management which m.o. also includes share buybacks and vicious cost cutting. This is one way, as you can see, in which the real economy is excluded from the party!
Part of the financialization process also includes ‘cognitive capture’ where the big swingin’ investment banking sticks have the ear of business managers.
And the business managers/special interest groups, in turn, have the ear of the federal government. See? The control by Wall Street is still there, but sometimes the route is a tad circuitous! The clandestine formulation of the TPP agreement is a perfect example of this type of dominance. (Congress shut out/ corporate lobbyists invited in.)
So the whole process goes to the extreme.Therein lies the rub: the extreme.
So that business obediently complies with the wishes of these financial wizards. Taken altogether, over time, our entire society morphs to where it assumes a posture of servitude to the interests of Wall Street.
An example of that? John Q.’s sentiment meter (a/k/a consumer confidence) is clearly known to be tied most of the time to the direction of the S&P 500. Which of course, is aided and abetted by the foaming-at- the-mouth Talking Heads who pretty much .... dictate to John Q.how he is supposed to be feeling.
Forty years on the Street, I am still agog at the increasing clout of the FOMC to the extent where we are now hostages to their infernal sound bites and communiqués. Another example of the process of creeping financialization? I’d surely say so!
This is not an effort to try and convict “financialization” as indeed it has its place.When it is used prudently. Such as to facilitate trade in the real economy! Sounds kind of Austrian, eh? You bet. The simplest example of this which is frequently cited is a home mortgage. The borrower exchanges future income for a roof via a bank note.
And so it goes. Financialization humming along nicely, facilitating trade in the real economy.
Unfortunately, along the line somewhere, it got out of hand. Which is where the World Bank comes in.
Does the above sound familiar? Right. Too much financialization crimps growth.
That’s when we turn to the above-referenced World Bank table. Which shows the latest available worldwide statistics (2014) on domestic credit to private sector % of GDP.
Okay. Maybe we oughta’ read this bit from the World Bank before we get to the US statistic:
... “Domestic credit to private sector refers to financial resources provided to the private sector by financial corporations, such as through loans, purchases of nonequity securities, and trade credits and other accounts receivable, that establish a claim for repayment. ...
The financial corporations include monetary authorities and deposit money banks, as well as other financial corporations ...
Examples of other financial corporations are finance and leasing companies, money lenders, insurance corporations, pension funds, and foreign exchange companies.” ...
Clear enough. Again, the IMF suggests that 80 to 100% of GDP is where it gets dicey in terms of impact on growth:
In 2014, the US ratio stood at 194.8. In 1981 (as far back as the table goes), our ratio stood at 89.1.
For comparison, also in 2014, Germany stood at 80.0; France at 94.9. China at 141.8 and Japan at 187.6. Which is suggestive of what can be called “over-financialization”. So what’s the beef with that, you ask?
For all the reasons mentioned above which led to increasing dominance by the financial sector on corporate and household behavior, the emphasis leans heavily towards making money out of money. Which I’d like to do myself. You?
But when massaged into the extreme which is clearly, I believe, where we find ourselves now ... at the end of the day,we create nothing.
By creating nothing, the economy relies on the financialization process to create growth. But the evidence supports the notion that once overdone, financialization stymies growth.
“ ... The whole of economic life is a mixture of creative and distributive activities. Some of what we “earn” derives from what is created out of nothing and adds to the total available for all to enjoy. But some of it merely takes what would otherwise be available to others and therefore comesat their expense.Successful societies maximize the creative and minimize the distributive.Societies where everyone can achieve gains only at the expense of others are by definition impoverished. They are also usually intensely violent.” ...Roger Bootle quoted here:http://bilbo.economicoutlook.net/blog/?p=5537
In short, corporate behavior is dictated by Wall Street desire which in turn results in a flying S&P 500. Against a backdrop, say, of a record number of US workers no longer participating in the labor force.
So instead of cogitating the entire picture and all of its skanky details, we haveso farbeenwilling to accept a one-size fits all alibi for stock market action where financialization still dominates; the only choice is what financialization flavor will trump the other: “FED or no FED”.
I now wonder if when Bootle said a few years back ...“they are usually intensely violent”, if this wasn’t prescience. Which can be applied to the current political landscape in the US where the financialization of the economy has so excluded the average worker ... that he is willing to put Ho-Ho the Clown in the White House. Just to change the channel. And hope for relief.
As you can see, I am trying very hard to understand how as a society we got to this level.
"In face of the US harassment, Beijing should deal with Washington tactfully and prepare for the worst. This can convince the White House that China, despite its unwillingness, is not frightened to fight a war with the US in the region, and is determined to safeguard its national interests and dignity. Beijing ought to carry out anti-harassment operations. We should first track the US warships. If they, instead of passing by, stop for further actions, it is necessary for us to launch electronic interventions, and even send out warships, lock them by fire-control radar and fly over the US vessels."
Update: According to reports in on Monday evening, the USS Lassen has indeed sailed within 12 nautical miles of China's islands in the Spratlys.
As WSJ notes, "an American defense official confirmed Monday that the U.S. Navy ship navigated through the waters around at least one of the land masses to which China lays claim within the Spratly chain of islands in the South China Sea, crossing an area that China maintains is part of its sovereign territory."
WSJ also reiterates that this isn't likely to be a one-off event. As noted below, most "experts" believe that in order for this to be effective from a deterrence standpoint, the US will need to step up the patrols, presumably in an effort to prove to Beijing that the Pentagon is "serious", whatever that means in this context.
The ball is now squarely in China's court. The PLA has already promised to "stand up and use force" in the event its territorial sovereignty is violated. The question now is whether Beijing will back down and concede that "sovereignty" somehow means something different with regard to the islands than it does with respect to the mainland or whether Xi will stick to his guns (no pun intended) and take a pot shot at a US destroyer.
For anyone who might still be somehow unaware, the US is currently in a superpower staring match with both Russia and China. The conflict in Syria has put Moscow back on the geopolitical map (so to speak), creating an enormous amount of tension with Washington whose regional allies have been left to look on in horror as Russian airstrikes and an Iranian ground incursion dash hopes of ousting President Bashar al-Assad.
Meanwhile, in The South China Sea, Beijing has built 3,000 acres of new sovereign territory atop reefs in the Spratlys and although the reclamation effort itself isn’t unique, the scope of it most certainly is and Washington’s friends in the South Pacific are crying foul.
Beijing has continually insisted that it doesn’t intend to use the islands as military outposts, but the construction of runways and ports seems to tell a different story and so, Washington felt compelled to check things out over the summer by sending a Poseidon spy plane complete with a CNN crew to the area. Once the PLA spotted the plane the situation escalated quickly with the Chinese Navy telling US pilots to “Go Now!”
After that, an intense war of words developed with Defense Secretary Ash Carter insisting that the US would sail and fly anywhere it pleased and Beijing assuring the US that sailing within 12 nautical miles of the islands would prompt a harsh response from the PLA.
For weeks, the US was rumored to have been planning a freedom of navigation exercise in the Spratlys which, as we’ve pointed out several times this month, amounts to sailing by the islands just to see if China will shoot.
Now, according to CNN, Obama has given the green light and the ships may sail within 24 hours:
The US navy is poised to start freedom of navigation operations in the South China Sea in a high-stakes effort to push back against Chinese territorial claims over artificial islands in the disputed waters.
In a move that will enrage Beijing, the USS Lassen, a guided-missile destroyer, will sail inside the 12-nautical mile zones of two man-made islands — Subi and Mischief reefs — that China has built in the contested Spratly Island chain. A senior US defence official said it would sail through the area in the early hours of Tuesday morning.
China has repeatedly warned that it would not tolerate any effort to violate what it considers its territory. Earlier this month, a senior Chinese naval officer said the People’s Liberation Army would hand a “head-on blow” to any foreign forces that violated Chinese sovereignty. His comments came after the Financial Times reported that the US was poised to launch its operations.
The manoeuvre will mark the first time since 2012 that the US navy has sailed through the 12-nautical mile zone surrounding any islands claimed by China. It is aimed at demonstrating that Washington does not recognise any territorial claims over artificial islands in the South China Sea.
It's also worth noting that should the US manage to get away with this without sparking a shooting war with the Chinese, it now looks as though Washington is leaning toward making this a regular patrol. Here's a bit of color from Reuters out over the weekend:
A range of security experts said Washington's so-called freedom of navigation patrols would have to be regular to be effective, given Chinese ambitions to project power deep into maritime Southeast Asia and beyond.
"This cannot be a one-off," said Ian Storey, a South China Sea expert at Singapore's Institute of Southeast Asian Studies.
"The U.S. navy will have to conduct these kinds of patrols on a regular basis to reinforce their message."
But China would likely resist attempts to make such U.S. actions routine, some said, raising the political and military stakes. China's navy could for example try to block or attempt to surround U.S. vessels, they said, risking an escalation.
Here are the latest visuals from Subi and Mischief (the two islands mentioned above):
Not to put too fine a point on it, but this borders on the insane. Here we have both Washington and Beijing risking an outright military confrontation over what amount to a couple of sandcastles and while there's probably some truth to the contention that China has plans for the islands that go beyond growing plants, building lighthouses, and raising pigs, it's not as though the PLA is going to invade The Philippines so at the end of the day, this looks like another example of what Vladimir Putin recently suggested is evidence that the world is losing its collective mind.
JAPAN - DEBT DEFLATION
EU BANKING CRISIS
MACRO News Items of Importance - This Week
GLOBAL MACRO REPORTS & ANALYSIS
US ECONOMIC REPORTS & ANALYSIS
CENTRAL BANKING MONETARY POLICIES, ACTIONS & ACTIVITIES
In August 2015, IBM learned that the SEC is conducting an investigation relating to revenue recognition with respect to the accounting treatment of certain transactions in the U.S., U.K. and Ireland. The company is cooperating with the SEC in this matter.
Big firms to post first decline in both earnings and sales since the recession
Quarterly profits and revenue at big American companies are poised to decline for the first time since the recession, as some industrial firms warn of a pullback in spending.
From railroads to manufacturers to energy producers, businesses say they are facing a protracted slowdown in production, sales and employment that will spill into next year. Some of them say they are already experiencing a downturn.
“The industrial environment’s in a recession. I don’t care what anybody says,” Daniel Florness, chief financial officer of Fastenal Co., told investors and analysts earlier this month. A third of the top 100 customers for Fastenal’s nuts, bolts and other factory and construction supplies have cut their spending by more than 10% and nearly a fifth by more than 25%, Mr. Florness said.
The weakness is overshadowing pockets of growth in sectors such as aerospace and technology.
Industrial companies are being buffeted on multiple fronts. The slump in energy prices has gutted demand for drilling equipment and supplies. Economic expansion is slowing in China and major emerging markets such as Brazil, which U.S. companies have relied on for sales growth. And the dollar’s strength also has eroded overseas profits.
The drag on earnings and sluggish growth projections for next year come as the Federal Reserve considers raising interest rates for the first time in nine years, and could add momentum to those in favor of postponing any rate increase until next year.
Profit and revenue are falling in tandem for the first time in six years, with a third of S&P 500 companies reporting so far. Analysts expect the index’s companies to book a 2.8% decline in per-share earnings from last year’s third quarter, according to Thomson Reuters.
Sales are on pace to fall 4%—the third straight quarterly decline. The last time sales and profits fell in the same quarter was in the third period of 2009.
Much of the anticipated decline stems from the hard-hit energy industry, where sales are expected to drop by more than a third from a year earlier and profits are likely to plummet 65%, Thomson Reuters says, based on analysts’ estimates. Basic-materials companies face a 17% drop in profits, and industrial sales are expected to decline more than 5%.
United Technologies Corp., which makes Otis elevators and Carrier air conditioners, said it expects profits to be flat or down in three of its four operating segments next year, despite strength in its U.S. operations. Chief Financial Officer Akhil Johri told investors last week that the Otis division’s sales in China fell 19% in the third quarter as commercial construction slumped.
Other companies voiced similar concerns. “If you look at kind of the broad industrial-production index, you see industrial production sequentially coming down,” said Fredrik Eliasson, chief sales and marketing officer at railroad operator CSX Corp.
CSX is scaling back some operations in response to declining coal shipments as power plants switch fuels, eliminating nearly 500 jobs in Corbin, Ky., and Erwin, Tenn. In the current quarter, the company plans to reduce its average head count by 2% from the third-quarter level.
U.S. manufacturing production rose in September at its slowest pace in more than two years, the Institute for Supply Management reported earlier this month. Economic activity at 11 industries tracked by the group contracted during the month, while just seven reported growth. Meantime, manufacturers told ISM that customer inventories remained high, contributing to a slowdown in new orders.
Some investors and analysts worry that companies accustomed to boosting earnings by cutting costs, repurchasing shares and refinancing debt will soon have to face the reality of worsening sales. “The ability of corporations to take a 1% to 2% revenue line [gain] and turn it into 5% to 6% profit growth is waning,” said Charlie Smith, chief investment officer of Fort Pitt Capital Group. “They’ve run out of rabbits to pull out.”
Still, cost-cutting continues. Companies from Twitter Inc. and Biogen Inc. to Wal-Mart Stores Inc. and Monsanto Co. have announced job cuts in recent weeks. That could boost the U.S. unemployment rate, which ended September at 5.1%, its lowest point since April 2008.
“Things are definitely a bit shakier than they were several months ago,” said Joseph LaVorgna, chief U.S. economist at Deutsche Bank. But, he added, “the U.S. is fundamentally in decent shape.”
Indeed, low fuel prices have boosted U.S. car sales and buoyed airlines’ results, and the U.S. construction market remains robust. And, even among manufacturers, the aerospace industry is doing well. Technology giants Amazon.com Inc. and Microsoft Corp. posted strong results on Thursday, as did Google parent Alphabet Inc.
Such strength suggests that the broader economy is unlikely to succumb to the industrial sector’s gloom, especially given robust profit margins, said Jeremy Zirin, chief U.S. equity strategist for wealth management at UBS. “The broad mosaic of data suggests that the U.S. economy is still doing OK,” Mr. Zirin said. “This isn’t a very bullish view, it’s just saying things aren’t as bad as feared.”
Others worry that the slowdown is spreading to consumer businesses. Wal-Mart recently warned its sales this year are likely to be flat, down from projection of as much as 2% growth, and cut its earnings forecast for next year as it raises wages. The retailer blamed the strong dollar for the weakening sales growth.
And truckload carriers have warned that they aren’t witnessing the usual uptick in retailer demand as the holiday season approaches, thanks to stubbornly high inventories, said Alex Vecchio, a transportation analyst at Morgan Stanley. “Transportation companies are typically a leading indicator, and our data is not good,” Mr. Vecchio said.
COMMODITY CORNER - AGRI-COMPLEX
THESIS - Mondays Posts on Financial Repression & Posts on Thursday as Key Updates Occur
FRA Co-Founder Gordon T. Long discusses the Austrian School of Economics with John Butler and how its methodologies can be applied to the current global economy. John Butler has 18 years’ experience in the global financial industry, having worked for European and US investment banks in London, New York and Germany.
Prior to launching the Amphora Commodities Alpha Fund he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London, where he was responsible for the development and marketing of proprietary, systematic quantitative strategies for global interest rate markets. Prior to joining DB in 2007, John was Managing Director and Head of European Interest Rate Strategy at Lehman Brothers in London, where he and his team were voted #1 in the Institutional Investor research survey. In addition to other research, he publishes the Amphora Report newsletter which appears on several major financial websites
THE AUSTRIAN SCHOOL OF ECONOMICS
“It is the no free lunch school of economics.”
The Austrian school believes that economics systems are ultimately information systems. Some of those systems use information more efficiently and effectively than others, and in particular systems of which authorities of various kinds meddle with the market. Authorities may do this by extracting capital from the market via tax rates or even by manipulating the money of that market through some sort of artificial interest rate policy.
“From the Austrian schools point of view, anything that impedes the free price information flow of an economic system will result in a sub optimal economic outcome.”
Without the rule of law, without the ability to strongly enforce property rights, without the ability to prosecute fraud, and various other legal frameworks; the Austrian economic model cannot work.
“Our goal is to make sure economic information flows as efficiently as possible within a solid legal structure.”
HOW THE AUSTRIAN SCHOOL CAN BE APPLIED IN INVESTING
Austrianism teaches us that the future is unpredictable. The economy is made up of the billions of people in the world, with each person making transactions almost every day. Each decision is an individual’s choice, and each decision, even the decision not to spend your money has some effect on the economy.
“Austrian school provides you a way to identify distortions, a powerful way that is caused by a fiscal and monetary policy set such as interest rate or fiscal policy manipulation. Austrians are able to look at these policies and be able to see how they are impacting the investment environment. This gives you a sense of where the distortions are. In theory you get an idea of where you should be overweight and underweight from an investor’s point of view.”
CURRENT EVENTS AMPHORA IS FOCUSED ON
“Currently we are seeing a general overvaluation of risky assets that has been caused by truly an unprecedented set of highly expansionary monetary and fiscal policies throughout most of the world.”
Income growth has not kept up; assets are expensive relative to incomes. So the correct strategy is not simply to short assets, which is dangerous; but if indeed they do look for ways to stimulate aggregate demand more directly rather than through the banking system.
The correct strategies to have today are those that will perform if incomes begin to catch up to asset prices, it could be asset prices declining towards incomes or vice versa. It is impossible to know which one is going to happen, but it is highly likely looking forward that a conversion of the two will happen.
POSSIBILITY OF NEGATIVE NOMINAL INTEREST RATES
“Policy makers have become almost pathological; they have a relentless attitude to make their policies work.”
“Problem with this is, once you get to this point, you can no longer question your original set of assumption. Austrian school of economics knows that the original sets of Keynesian assumptions that have gone into forming this unconventional and aggressive policy mix are themselves flawed. We are on this course where if it were left to run itself, policy makers will operation in these counter-productive directions because they will not question whether their assumptions are wrong.”
“Banning cash will prevent people from making even the simplest transaction in their own neighborhoods; it will lead to complete riot and chaos.”
“Putting a ban on cash is a terrible idea. It is terrible for them and for the economy as a whole. Sadly, with the way things are going, policy makers are going to teach everyone a very hard lesson about blindly accept anything the bureaucracy tells you to do.”
CENTRAL BANKS ROLE IF ASSET CORRECTION OCCURRED
“If you do get a major correction in asset markets that causes collateral problems in financial markets, the policy makers are out of options. The only thing they could do is begin capital controls”
Prevent investors being able to freely liquidate or withdraw funds from their existing investments. This of course is very anti-capitalist, very inti-market. It goes directly against everything that a free enterprise economy should stand for; but when you follow these policies you will eventually get to a dead end.
FRA Co-Founder Gordon T. Long interviews Leland miller, the president of the china beige book international and discusses financial repression in the context of the Chinese economy. He describes himself as a Lifelong china watcher who decided to do something about the complete lack of data in china.
“One of the things that the china beige book plans to do is to give people a real picture of not just the growth dynamics, but also the labor market, the credit dynamics, the macro implications of Chinese growth, indications of future Chinese demand, implications of commodity markets around the world, we try to give the people a much better picture on what’s actually happening instead of just relying on official data and press release”.
Leland describes the Chinese reform as a reversal of financial repression and this repression in the context of the Chinese economy is the oppression of consumers and households by state organizations through its economic systems.
“It means reversing this long time economic model, where the state will profit through the economic system at the expense of the consumers and household, and one of the things that the new leadership is intent on doing in order to create consumption is to empower consumers, so they spend more and stop empowering state organizations which are fuelling the overcapacity and the massive debt bubble”.
What should investor know about china?
He explains the biggest misconception concerning the Chinese economy is believing the GDP tells you much about how china is doing.
“It is a broad, blunt indicator that doesn’t measure productive growth or credit dynamics”.
On some of the challenges of getting reliable data in china, Leland explains that he and his team had to ask Chinese firms and consumers on ground what is happening in the country, and set up a number of polling units across sectors in order to get reliable and accurate information.
Economic trends in china
“For years we have been talking about the Chinese slowdown; it’s inevitable, despite the fact that the economy has been slowing”.
He goes on to explain that although the market sentiment has gone from optimism to “Armageddon” in recent months, the actual data is at odds with these sentiments. As a result of china’s economic slowdown, there is great vulnerability among emerging markets. Now, the reason for this is that for years these markets have relied on china’s demand without factoring the likelihood of a decline or certainty of a decline in china’s demand.
On China’s view of America, Leland has this to say
“The Chinese look at America as a model that they are interested in taking pieces from; they like the dynamism of the economy and the global status. On one hand, they see us as a model to learn a lot of things from but also as a serious threat that is looking to constrain their inevitable and ultimate rise”.
Something occurred in the banking system in September that required a massive reverse repo operation in order to force the largest ever Treasury collateral injection into the repo market. Ordinarily the Fed might engage in routine reverse repos as a means of managing the Fed funds rate. However, as you can see from the graph below, there have been sudden spikes up in the amount of reverse repos that tend to correspond the some kind of crisis – the obvious one being the de facto collapse of the financial system in 2008:
You can also see from this graph that the size of the “spike” occurrences in reverse repo operations has significantly increased since 2014 relative to the spike up in 2008. In fact, the latest two-week spike is by far the largest reverse repo operation on record.
Besides using repos to manage term banking reserves in order to target the Fed funds rate, reverse repos put Treasury collateral on to bank balance sheets. We know that in 2008 there was a derivatives counter-party default melt-down. This required the Fed to “inject” Treasury collateral into the banking system which could be used as margin collateral by banks or hedge funds/financial firms holding losing derivatives positions OR to “patch up” counter-party defaults (see AIG/Goldman).
What’s eerie about the pattern in the graph above is that since 2014, the “spike” occurrences have occurred more frequently and are much larger in size than the one in 2008. This would suggest that whatever is imploding behind the scenes is far worse than what occurred in 2008.
What’s even more interesting is that the spike-up in reverse repos occurred at the same time – September 16 – that the stock market embarked on an 8-day cliff dive, with the S&P 500 falling 6% in that time period. You’ll note that this is around the same time that a crash in Glencore stock and bonds began. It has been suggested by analysts that a default on Glencore credit derivatives either by Glencore or by financial entities using derivatives to bet against that event would be analogous to the “Lehman moment” that triggered the 2008 collapse.
The blame on the general stock market plunge was cast on the Fed’s inability to raise interest rates. However that seems to be nothing more than a clever cover story for something much more catastrophic which began to develop out sight in the general liquidity functions of the global banking system.
Without a doubt, the graphs above are telling us that something “broke” in the banking system which necessitated the biggest injection of Treasury collateral in history into the global banking system by the Fed.
The last time we observed one of our long-standing favorite topics (first discussed in early 2009), namely the global USD-shortage which manifests itself in times of stress when the USD surges against all foreign currencies and forces even the BIS and IMF to notice, was in March of this year, when we explained that "unlike the last time, when the global USD funding shortage was entirely the doing of commercial banks, this time it is the central banks' own actions that have led to this global currency funding mismatch - a mismatch that unlike 2008, and 2011, can not be simply resolved by further central bank intervention which happen to be precisely the reason for the mismatch in the first place."
Furthermore JPM conveniently noted that "given the absence of a banking crisis currently, what is causing negative basis? The answer is monetary policy divergence. The ECB’s and BoJ’s QE coupled with a chorus of rate cuts across DM and EM central banks has created an imbalance between supply and demand across funding markets. Funding conditions have become a lot easier outside the US with QE-driven liquidity injections and rate cuts raising the supply of euro and other currency funding vs. dollar funding. This divergence manifested itself as one-sided order flow in cross currency swap markets causing a decline in the basis."
To which we rhetorically added: "who would have ever thought that a stingy Fed could be sowing the seeds of the next financial crisis (don't answer that rhetorical question)."
All this was happening when the market was relentlessly soaring to all time highs, completely oblivious of this dramatic dollar shortage, which just a few months later would manifest itself quite violently first in the Chinese devaluation and sale of Treasurys, and then in the unprecedented capital outflow from emerging markets as the great petrodollar trade - just as we warned in November of 2014 - went into reverse. In fact, there are very few now who do not admit the Fed is responsible for both the current cycle of soaring volatility, or what may be a market crash (as DB just warned) should the Fed not take measures to stimulate "inflation expectations" (read: more easing).
In any event, since March we have received numerous requests for follow-up of where said funding shortage is now. So here are the latest observations on the current level of the global dollar funding shortage as measured by the Dollar fx basis, courtesy of JPM:
The dollar fx basis declined further over the past two months. The 5-year dollar fx basis weighted across six DM currencies declined to a new low for the year and the lowest level since the summer of 2012 during the euro debt crisis.
In other words: the USD funding shortage is even worse than it was when we looked at it in March, it still is a function of conflicting central bank liquidity flows, and while not as bad as it was at its all time worst levels in late 2011, it is slowly but surely getting there with every passing week that the Fed does not ease monetary conditions.
A brief history of the three key periods of global USD-funding shortfalls:
The first episode immediately after the Lehman bankruptcy coincided with a US banking crisis that quickly became a global banking crisis via cross border linkages. Financial globalization meant that Japanese banks had accumulated a large amount of dollar assets during the 1980s and 1990s. Similarly European banks accumulating a large amount of dollar assets during 2000s created structural US dollar funding needs. The Lehman crisis made both European and Japanese banks less creditworthy in dollar funding markets and they had to pay a premium to convert euro or yen funding into dollar funding as they were unable to access dollar funding markets directly.
The second episode of very negative dollar basis took place during the Euro debt crisis. The sovereign crisis created a banking crisis making Euro area banks less worthy from a counterparty/credit risk point of view in dollar funding markets. As dollar funding markets including fx swap markets dried up, these funding needs took the form of an acute dollar shortage. European banks and companies that had dollar assets to fund had to pay a hefty premium in fx swap markets to convert their euro funding into dollar funding. Those European banks and companies that were unable to do so, were forced to liquidate dollar assets such as dollar denominated bonds and loans to reduce their need for dollar funding
The third phase of very negative dollar basis started at the end of last year. Monetary policy divergence has for sure played a role during the end of 2014 and the beginning of this year. The ECB’s and BoJ’s QE has created an imbalance between supply and demand across funding markets. Funding conditions have become a lot easier outside the US with QE-driven liquidity injections raising the supply of euro and yen funding vs. dollar funding. This divergence manifested itself as one-sided order flow in cross currency swap markets causing a decline in the basis. And we did see these funding imbalances in cross border corporate issuance
More from JPM:
Similar to the beginning of this year, the decline in the dollar fx basis is raising questions regarding shortage in dollar funding. This is because the fx basis reflects the relative supply and demand for dollar vs. foreign currency funds and an even more negative basis currently points to more intense shortage of USD funding relative to the beginning of the year.
Figure 5 shows that the current negativity of the dollar fx basis represents the third major episode since the Lehman crisis. Before the Lehman crisis the fx basis was remarkably stable hovering around zero as funding markets were well balanced. After the Lehman crisis, funding markets experienced persistent imbalances with an almost structural shortage of dollar funding.
This is how it looks now:
In all, continued monetary policy divergence between the US and the rest of the world as well as retrenchment of EM corporates from dollar funding markets are sustaining an imbalance in funding markets making it likely that the current episode of dollar funding shortage will persist.
What does this mean in simple terms? Think back to what David Tepper said several weeks ago on CNBC when, contrary to popular opinion, he admitted he was bearish on risk assets mostly as a result of the "reserve streams" going in two different ways. This is precisely what the dollar shortage as quantified by the negative dollar basis is telling us: the policy divergence between the "tight" Fed and the ultra loose ECB and BOJ is starting to reach extreme levels, and will likely continue until the basis blows out to its theoretical limit of -50bps as set by the Fed-ECB swap line.
At that point either the Fed will be forced to admit it was beaten by the market, and either cut rates (to negative) while perhaps unleashing even more QE to offset the monetary imbalance with the rest of the world, or it will once again engage in even more swap lines with foreign central banks as the dollar funding shortage moves beyond simply synthetic and into an actual shortage of USD "bills" all in electronic credit format of course, because as we further explained last week, it is simply impossible to satisfy all global USD-denominated claims.
Gordon T Long is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. Of course, he recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.
THE CONTENT OF ALL MATERIALS: SLIDE PRESENTATION AND THEIR ACCOMPANYING RECORDED AUDIO DISCUSSIONS, VIDEO PRESENTATIONS, NARRATED SLIDE PRESENTATIONS AND WEBZINES (hereinafter "The Media") ARE INTENDED FOR EDUCATIONAL PURPOSES ONLY.
THERE IS RISK OF LOSS IN TRADING AND INVESTING OF ANY KIND. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.
Gordon emperically recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, he encourages you confirm the facts on your own before making important investment commitments.
Information herein was obtained from sources which Mr. Long believes reliable, but he does not guarantee its accuracy. None of the information, advertisements, website links, or any opinions expressed constitutes a solicitation of the purchase or sale of any securities or commodities.
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