Derivatives Story 2014

by Doug Noland

October 10, 2014

Increasingly, it looks like "risk off" and big trouble.

At this point, I’ve seen sufficient market evidence to posit that the global financial Bubble has serious fissures. Emerging market currencies, bonds and equities are in trouble. Commodities are in trouble. The global leveraged speculating community appears close to, if not already in, trouble. Geopolitics is full of trouble. Global “risk off” liquidity issues are becoming a bigger issue – and are now being transmitted to U.S. securities markets through liquidity-challenged sectors such as small cap equities, corporate Credit and surging prices for risk protection. Corporate credit default swap (CDS) prices this week surged to multi-month highs. The VIX stock market volatility index jumped to an eight-month high. Moreover, this week’s bludgeoning in the over-loved and over-owned technology sector could have pushed some to the edge. Examining it all, the unfolding backdrop has me pondering previous vulnerable Bubbles along with the soundness of global derivatives markets.

And whenever I’m about to dive into analysis of the esoteric derivatives marketplace, I always think back to an early CBB, the fictional “Little Town on the River.” I’ll attempt a brief summary.

“It had for years been a sleepy little place. The expense and limited availability of flood insurance discouraged building and commerce along the river’s edge. There was a long history of occasional flooding that wreaked havoc. But a few years without a significant flood created greater appeal for what had evolved into an extraordinarily profitable insurance business. The newfound availability of insurance encouraged some to build along the waterfront. Others, always hoping to live and work near the river, bid up asset prices. The town’s banks began doing brisk business. And with the Little Town enjoying a simultaneous economic renaissance and drought, writing flood insurance became a booming enterprise. Additional players led to only cheaper insurance, which stimulated more building, more “wealth” creation (asset inflation) and a resulting full-fledged economic boom. And, as “luck” would have it, drought persisted. Over time, the hugely profitable insurance market attracted major speculative interest. All types of “investors” joined the fray, writing policies or taking ownership interests in the insurers, booking easy profits all along the way. Local “banks” became big players. Each year saw concerns for a bout of unexpected rain dissipate a little more. And with a thriving, highly-liquid reinsurance marketplace, players were elated to write as much insurance as they could possibly sell. Why not cash in on fabulous wealth gains, operating comfortably without traditional reserves that would protect against future damage claims. The well-crafted plan was to immediately offload risk in the reinsurance market in the low-probability event of torrential rains.”

In my unsuspecting Little Town, the availability of cheap flood insurance fueled a major boom. And Reflexivity played a major role in spurring self-reinforcing Bubble Dynamics. Cheap risk insurance fostered building and risk-taking, which stoked a generalized economic boom (replete with distortions and maladjustment), with bullish perceptions regarding the soundness of the economic and financial sectors stoking asset prices. Yet when torrential floods finally – inevitably - arrived, the crowd that had speculated on insurance contracts raced to the reinsurance marketplace. Risk players were either unwilling or unable to write more reinsurance – not with the harsh realities coming into greater focus and greed abruptly transforming to fear. Market dislocation ensured those that had been writing insurance – and had accumulated huge risk exposures – faced potential insurance claims without the financial wherewithal to cover major losses. Panic in the dislocated insurance markets then provoked fear and dislocation in the real economy. When the eventual flood arrived, it was a complete wipeout. In hindsight, the booming financial sphere (risk insurance marketplace) ensured that enormous unappreciated risk accumulated throughout the real economy.

I posted my original “A Derivative Story” back in March 2000. While it highlights some of the key concerns I had at the time with the booming derivatives marketplace, there were also some key real world differences. Importantly, no individual or group sought to control the weather.

While the prices and quantities of risk insurance had major impacts on risk-taking in both the financial and economic spheres, flood insurance market dynamics didn’t impact the amount of rainfall. In the “real world,” the scope of risk-taking and derivatives trading does have a profound impact on market behavior and the amount of accumulated underlying market risk.

In the world in which we operate, the greater the amount of financial insurance written, the greater the risk that market dynamics at some (“black swan”) point might incite market illiquidity, dislocation and panic. This had been made readily apparent in 1987 (“portfolio insurance”), 1994 (“IOs,POs” and interest-rate derivatives), 1997 (SE Asian currency derivatives), 1998 (LTCM derivatives leverage and Russian currency derivatives) and 1999/2000 (Nasdaq and tech stock derivatives).

Some fourteen and a half years ago I just felt there was overwhelming evidence that the Federal Reserve needed to take a more aggressive approach in overseeing what had become a dangerous proliferation of financial risk insurance. The Fed did the very opposite. Our central bank instead adopted a more heavy-handed stance with respect to market intervention. The derivatives marketplace rested upon the (specious) premise of liquid and continuous markets.

So the Fed essentially promised the marketplace it would ensure liquidity and guard against market panic and dislocation. We learned absolutely nothing, as derivatives then played an integral role in the mortgage finance Bubble and resulting 2008 financial and economic crisis.

I’m not planning on writing “Derivatives Story 2014.” But if I change my mind, my Little Town would have experienced some radical changes since 2000. Today, interest rates on local savings accounts are a goose egg. Economic activity is bustling. There may not be much building or capital investment, but consumption, services and finance are booming. Reminiscent of 2000, there’s lots of exciting new technologies. There’s certainly lots of money slushing around. Asset prices and confidence are really high. The flood insurance market is bigger and more sophisticated than ever.
Yet the biggest change from 2000 is that everyone has faith in the central authority’s capacity to control the weather. And with central control over flood risk and zero deposit rates, local savings have inundated all types of new vehicles and instruments profiting from the risk markets. You’d have to be a moron to settle for a near-zero return when central control now protects the community from flood and myriad risks. Enlightened policies from central control amount to the greatest financial innovation in the history of the community. Today, it is possible for virtually everyone in our town to participate in unprecedented wealth creation.

Switching back to the real world, I’ll excerpt from Federal Reserve Bank of Richmond’s Jeffrey Lacker and John Weinberg’s excellent and timely op-ed in Wednesday’s Wall Street Journal:

The Fed’s Mortgage Favoritism – When the central bank buys private assets, it distorts markets and undermines its claim to independence… Some will say that central bank credit-market interventions reflect an age-old role as ‘lender of last resort.’ But this expression historically referred to policies aimed at increasing the supply of paper notes when the demand for notes surged during episodes of financial turmoil. Today, fluctuations in the demand for central bank money can easily be accommodated through open-market purchases of Treasury securities. Expansive lending powers raise credit-allocation concerns similar to those raised by the purchase of private assets. Moreover, Federal Reserve actions in the recent crisis bore little resemblance to the historical concept of a lender of last resort. While these actions were intended to preserve the stability of the financial system, they may have actually promoted greater fragility. Ambiguous boundaries around Fed credit-market intervention create expectations of intervention in future crises, dampening incentives for the private sector to monitor risk-taking and seek out stable funding arrangements.

For “A Derivative Story 2014” purposes, I’ll focus on Lacker’s Fed “actions in the recent crisis bore little resemblance to the historical concept of a lender of last resort. While these actions were intended to preserve the stability of the financial system, they may have actually promoted greater fragility. Ambiguous boundaries around Fed credit-market intervention create expectations of intervention in future crises…”

From a macro analytical perspective, it’s such an incredibly fascinating environment. Again falling back to old favorite analytical tools, let’s ponder “economic sphere” versus “financial sphere” analysis. In the economic sphere, there has been for a while now evidence of excessive liquidity abundance. General asset inflation and a booming technology sector come first to mind. Securities and asset prices have inflated spectacularly over recent years to record levels. Accordingly, my analytical challenge has been to identify the underlying source of finance – the monetary disorder – fueling the destabilizing asset inflation and Bubbles. And this is where it gets really interesting.

Traditional “financial sphere” bank lending and Credit expansion metrics just do not equate with the type of Credit growth required to fuel systemic asset inflation and securities market booms.

Household debt expanded at a 1.6% rate in 2013 and about 3% during this year’s first half. Even with booming corporate and federal borrowings, Total Non-Financial Sector Debt expanded just 3.8% last year and about 4% during 2014’s first half. And while bank lending has picked up, the tepid expansion of this traditional source of finance in no way can explain the liquidity deluge behind Tech Bubble 2.0 and Stock Market Bubble 3.0. If I only had a dollar for every time I’ve heard a Fed official or bullish pundit say it can’t be a Bubble because there’s not the type of leverage consistent with Bubbles.

Truth be told, there is a tremendous amount of leverage. We know that the Fed’s balance sheet (“Fed Credit”) has inflated $3.6 TN, or 400%, in about six years. Fed Credit is up an incredible $1.6 TN, or 58%, in just two years. Yet this critical source of system leveraging is supposedly coming to an end soon. Which leads me to my bigger concern: leverage that we do not know – that lurks unrecognized and unappreciated. And my thoughts continually come back to my Little Town and A Derivative Story. These days I really worry about global derivatives markets – and part of the reason I worry is that the marketplace is convinced there’s no reason for worry. Global policymakers – central control – have it all under control. Market risk is not an issue.

So here’s how I see it. Fed market assurances coupled with the ballooning/leveraging of its balance sheet was instrumental in an unprecedented expansion of derivatives-related leverage. “Ambiguous boundaries around Fed credit-market intervention” did “create expectations,” in the process distorting the derivative markets like never before. The cost of financial insurance collapsed across all financial classes all over the world – U.S. and global equities, corporate Credit, European periphery debt, EM stocks and bonds, and “developed” and “developing” currencies. Importantly, global central bank backstops created “too big to fail” distortions in markets for financial institution credit risk around the world. And with central control having eradicated so-called “counter party risk,” there was at that point nothing to hold back a derivatives market speculative feeding frenzy.

I see derivatives as integral to the “global government finance Bubble,” the “Granddaddy of all Bubbles,” thesis. Central (bank) control distortions “promoted greater fragility” – absolutely no doubt about it. Indeed, fragility and inevitable instability have arrived. It appears the Global Bubble has been pierced.

The global “reflation trade” is imploding. WTI crude sank 4.4% this week to $85.82. Natural gas dropped 4.5%. Heavily leveraged balance sheets – abroad and at home – in the energy and commodities universe are increasingly suspect. The ability of EM economies to service external debt is becoming an increasing concern. Ongoing currency market instability is causing losses and de-risking/de-leveraging in various derivative “carry trades.” The global leveraged speculating community is close to some serious problems. Losses would be met with redemption notices and forced liquidations. And with lots of players all crowded into similar trades, things could quickly topple into a panic for the exits. Such a circumstance would quickly crack wide open serious shortcomings in derivatives trading, in the securities markets and for leveraged participants in these markets.

How “crowded” is the bullish technology trade? And, more importantly, how sound is the underlying finance that has been fueling Tech Bubble 2.0? Few at the time appreciated how the nineties technology boom was being financed by unstable Bubble finance – industry and Telecom debt, speculative Credit, derivative-related Credit and myriad sources of finance that would so quickly evaporate come the reversal of speculative flows and the bursting of the Bubble. 

I believe the increasingly vulnerable leveraged speculator community would now like to reduce exposure to the high-flying tech space. And I would also suggest that a reversal of “hot money” from technology would mark a very important liquidity inflection point for Tech Bubble 2.0.

And if you have de-risking in tech combining with de-leveraging in currencies, de-risking/de-leveraging in commodities and EM, and de-risking in corporate Credit – wow, rather quickly you have all the necessary makings for a very problematic “risk off” market backdrop.

There is absolutely no doubt that buoyant derivatives markets have promoted epic risk-taking – in finance, in securities markets, in asset and commodities markets, in real economies globally.

Especially in our zero short-term financing rate environment, all varieties of derivative strategies have made it too easy to leverage up and chase yields and market returns. What’s your bogey? A pension fund client that requires a 9% annual return? Well, there is a bevy of derivative products easily structured to fulfill your needs. The amount of leverage is a plug variable. If spreads narrow, simply employ more leverage. And there’s no reason these days to fret leverage. The Fed promises not to raise rates much – if at all (global deflation!). Besides, if leverage or shaky markets do start to become a worry, there’s cheap derivative insurance available to calm nerves. How much of the seemingly insatiable appetite for higher-yielding securities over recent years has been due to demand from leveraged derivative strategies? Has that leverage been a key source financing a Bubble?

If I were to write a final chapter for “Derivatives Story 2014,” I’d have the local flood insurance market having expanded to communities everywhere: same players, same strategies, same bullish market perceptions and the same faith in central control. And they’d all have written boatloads of cheap flood and risk insurance – and sold lots of related “investment” products - across the universe, believing that significant losses, if they were ever to occur again, would surely be a localized problem. And in my prosperous Big Town, they’d hear about the rain and flood and losses in some distant communities. But that has nothing to do with our town, right? Actually, doesn’t it make our prosperity all the more appealing? It does, right?

Meanwhile, away from all the public exuberance, in the dark caverns of the reinsurance market things start to get a little dicey. The price of reinsurance is surging and there’s newfound fear of marketplace liquidity issues.

martes, octubre 14, 2014



Free exchange

Unproductive production

Weakening productivity is casting doubt on the sustainability of China’s growth

Oct 11th 2014

THE growth of China’s economy is staggering: it produced $9.5 trillion-worth of goods and services in 2013, nearly three times more than in 2007. But has that growth come simply from deploying more labour and capital? Or did total factor productivity (TFP)—the efficiency with which those two inputs are used—also increase? China’s future growth hinges on the answer.

A period of high growth does not necessarily involve a rise in productivity. The more people there are in employment, and the more factories and roads there are for them to use, the bigger an economy will be. But those workers and roads may not be put to good use. As long as the amount by which labour and capital grow outpaces any fall in productivity, GDP will still increase.

Growth of this sort, however, can last only so long. Neither labour nor capital are infinite. In the long run, improving the productivity with which they are used is the magic ingredient for any economy, the only path to sustainable growth. Hence the concerns about China. A series of estimates published this year have all suggested that productivity is flagging.

At the pessimistic end of the range is Harry Wu, an economist who has devoted much research to the shortcomings of China’s official economic data. He finds that since 2007 TFP has actually been a drag on the economy, denting growth by about 0.9 percentage points a year. At the more optimistic end, researchers at the World Bank think TFP added nearly three percentage points a year to growth from 2000 to 2010—but even they reckon that is 40% lower than in the 1990s.

In between these two estimates are Jianhua Zhang, Chunxia Jiang and Peng Wang, two of whom are with the People’s Bank of China. They conclude that productivity increased just 1.5% a year between 1997 and 2012.

As these diverging estimates suggest, overall productivity growth, despite being central to economics, is frustratingly difficult to pin down. It cannot, after all, be seen. When comparing two workers with the same job in the same company, it is easy to determine which one produces more. For economies, such apple-to-apple comparisons are not possible. Instead, economists get at TFP by subtracting the change in capital and labour deployed from the change in overall output. The difference (known as the Solow residual, after Robert Solow, the economist who pioneered this method) reflects the contribution of productivity to growth. In this way, the unseen becomes visible.

But the process requires several accounting somersaults. Assumptions are needed about, among other things, the size of the capital stock, the rate of capital depreciation and the level of workers’ education. Mr Wu does not trust official GDP figures and so constructs his own. Because his estimate of average annual growth for 2008-12 (6.5%) is dramatically lower than the official figure (9.3%), his calculations yield a negative Solow residual. Productivity, in other words, appears to have gone into reverse.

This conclusion looks too gloomy. For one thing, there are problems with Mr Wu’s own numbers. He relies on a selective sampling of official data and applies far-reaching yet apparently arbitrary adjustments to them, assuming, for instance, that reforms in the 1990s added only 1% to services growth. Many other economists see problems with Chinese data—lumpy growth figures are often smoothed, for instance—but not enough to justify such extensive revision, especially during the past decade when there has been a proliferation of data from China’s trading partners that can be used to verify the Chinese numbers.

But even the more sanguine estimates from the World Bank and the researchers at the central bank reveal a worrying trend in terms of TFP. It may still be positive but it has slowed, and quickly at that. All agree that a massive accumulation of capital, rather than any improvement in the efficiency with which it is used, has become the dominant engine driving China’s GDP.

In search of lost growth
How worrying is this? Some slowdown in productivity is only natural after three decades of rapid growth. The World Bank calculates that the reallocation of both labour and capital from farms to factories and from state-owned firms to private enterprise accounted for nine-tenths of TFP’s contribution to growth in 2000-10. But as the private sector grows and ever more workers flood to the cities, the returns from this are bound to diminish.

There is another, more worrying factor behind the deceleration in productivity, however: bad lending and investment decisions. Financial development, handled well, should promote growth by improving the allocation of resources. But the researchers from the central bank find a strongly negative correlation in China between growth in lending and in TFP. That is an indication that state-owned banks, which still dominate China’s financial sector, are not disbursing enough credit to the country’s most deserving companies. And the economy is consuming more and more capital. China’s incremental capital-output ratio (ICOR), a measure of how much investment it takes to achieve each percentage point of growth, rose to 5.4 in 2012 from 3.6 over the preceding two decades, according to the World Bank. Japan, South Korea and Taiwan were far more efficient during their high-growth phases, with ICORs of 2.7-3.2.

Perhaps this should not be surprising. The Chinese government has warned about overcapacity in scores of industries from steel to textiles. Heavy capital spending gins up growth when factories are built, but it also shows up in the data as weak productivity if the factories are only partly used. Nevertheless, it is still alarming. The Communist Party has long pledged to make China’s economy more efficient. The data on TFP show that it is struggling to do that. Accumulating productive capacity is easier than putting it to productive use.

10/13/2014 03:41 PM

The Last Days of Kobani

A Decisive Battle in the Fight against Islamic State

Photo Gallery: The Fate of Kobani

Turkey stands by doing nothing while US bombs have been unable to slow down Islamic State fighters: The battle for Kobani has revealed the West's helplessness in the face of radical jihad. Worries of a massacre are growing.

It's an eerie quiet that descends when the guns periodically go silent. Even the swallows can be heard.

Two dozen men in baggy trousers stand silently on the rooftop of the mosque in Yatiretepe, a Turkish farming village on the Syrian border. They peer through ancient binoculars in an effort to see what's happening just across the border in their hometown of Kobani, a city under siege. They carefully follow every exchange of fire and every street battle, full of concern for their relatives still in the city.

Every few minutes the Syrians look up to the sky but the approaching fighter jets remain invisible. Suddenly, the roar becomes deafening and the mosque's rooftop begins to shake for the ninth time on this Friday morning. A boom can be heard in the distance and then, very close by, a deafening explosion. The men cheer as a black column of smoke billows over Kobani.

Below, in the mosque's courtyard, women sit and clap approvingly between newly dug graves and slumbering children. They've turned the mosque into a soup kitchen and several hundred Syrians have taken refuge here. Nasar, 28, claps the loudest. The thin, anxious mother of four fled Kobani 24 days ago. She has almost given up hope of one day being able to return to her home. She wipes tears from her eyes and says she takes pleasure from every detonation, but admits that they also make her afraid. Nasar's husband and brother are still in Kobani and she hasn't heard anything from either in days. Less than a kilometer away, the men continue fighting to defend the city. It is the decisive battle.

It all began with the refugees, tens of thousands who fled across the border into Turkey within just a few days. Now Kobani is a full-fledged battlefield. A few thousand people are still there -- fighters and civilians -- surrounded by the Islamic State's (IS) terrorist army, a force which often beheads its prisoners. It's a war that can be watched from just a few kilometers away and is being broadcast live around the world. It is so close, yet so far away.

The Next Srebrenica?

The fate of the Kurds in Kobani is thus more than just a further chapter in an eternal Syrian civil war whose death toll will soon reach 200,000. The town is of crucial symbolic importance in the battle against the Islamic State and could become emblematic of its failure -- a new Srebrenica, a place where the world looks on as a massacre takes shape that is not only foreseeable, but also preventable. At stake is no less than the credibility of what has become an international battle against the Islamic State.

As Nasar's husband and brother continue to fight in Kobani, Turkish tanks stand in position on hills just across the border from the city, like oversized elephants perched on a ridge. They have been motionless for days now. The Turkish army has spent weeks watching as IS jihadists seize one neighborhood after the other in the besieged city just across the border.

"As horrific as it is to watch in real time what's happening in Kobani, it's also important to remember that you have to step back and understand the strategic objective," United States Secretary of State John Kerry said last Wednesday.

It seemed like an expression of helplessness in the face of the IS advance. But what else could he have said? Could he have said that Turkey, the decisive partner in the coalition against IS, doesn't want to actively participate? And that it instead wants to use the jihadists to keep the Kurds, potential allies in the US-led coalition, at bay? That, at least, would have been truthful.

The situation in Kobani reveals the fundamental problem in the battle against IS: Each participant seems intent on waging its own war. It is rarely the case that interests clash as clearly and openly as they have between the West, Turkey and the Arab allies in this conflict.

The Turkish government wants, on the one hand, to topple Syrian leader Bashar Assad -- but on the other is at pains to prevent a Kurdish autonomous region from taking shape in Syria.

The Turkish government's primary opponent remains the Kurdistan Worker's Party (PKK), and it would prefer to allow IS to overrun Kobani than to provide aid to its nemesis.

Meanwhile, the sole aim of the US and its allies is to fight IS without being drawn into a ground war -- and are prepared to accept the possibility that Kobani might fall to the jihadists.

A Threat to Turkey's Stability

Victory in Kobani would be a triumph for the Islamic State because it would deliver proof that the terrorist militia can't even be stopped by an alliance led by a superpower like the United States. It's even possible that developments in Kobani will determine whether the US-led coalition remains intact and prevails in the battle against IS.

If the city falls into the hands of the jihadists, Kobani would also become a disaster for Turkey, for the peace process between Ankara and the PKK and for the entire country's stability.

"IS fighters are coming by the thousands, with tanks, but mainly on foot from the south, from the east, there are more and more," the man calling himself the "foreign minister" of Kobani shouts into the telephone. "It's like in the 'Lord of the Rings' and we can't stop them," he says. "They run, shoot, run, shoot -- they don't even care if they die." Just one day earlier, the foreign minister had been more optimistic, expressing his satisfaction over the air strikes. On Thursday alone, 14 had taken place, with fighter jets circling over the city, bombing vehicles, buildings and IS positions.

But last Friday, despair had gained the upper hand. IS has buttressed its campaign by dispatching troops to Kobani from every corner of its self-declared "caliphate" -- from Raqqa, Deir al-Zor, al-Bab and even from Iraq -- to capture the city and demonstrate that they are prevailing against the rest of the world. Around 9,000 jihadists, and possibly more, are matched up against an estimated 3,000 Kurdish fighters in the city. The IS forces are also better armed. Whereas the Kurds must get by with Kalashnikovs and a few vintage bazookas, IS is equipped with tanks, modern machine guns, mortars and what appear to be endless supplies of weapons and fanatic fighters.

A Trial Run of an Independent State?

As a former importer of canned tropical fruits from Indonesia, Ibrahim Kurdu, in his mid-50s, has a modicum of international experience -- enough to become foreign minister of the "Canton of Kobani". That's the name given to this virtually autonomous zone on the Turkish border. It has become a kind of trial run for statehood, with a police force and tax authority in addition to ministers for youth, sport, culture and tourism.

But IS appears to be dead set on doing everything in its power to destroy this dwarf-sized state in the middle of its "caliphate." At the same time, given that Kobani fuels Turkish fears of a trans-national Kurdistan, the government in Ankara would also like to see it founder.

Most residents have already left Kobani and the Islamic State has since surrounded the city, even threatening to attack the border crossing, closing the last remaining escape route for those trying to flee the city. By the end of last week, the eastern and southern parts of Kobani had already fallen into the hands of its IS attackers, who have also seized the police headquarters and city administration building. A black IS flag flies above the southern part of the city atop Mishtanur hill -- which also provides a perfect vantage point for snipers.
But foreign minister Kurdu is still holding out in Kobani. "I've lost my home three times during the past two years," he says. "First I fled from Assad's army in Aleppo. Then Daesh conquered my village outside Kobani. Now they have seized my apartment in the south part of the city." "Daesh" is the Arabic acronym for IS, but the word is also used disparagingly because of its similarity to the Arab word for "trampling on" or "crushing". Kurdu's rapid-fire speaking style is punctuated by the sound of gunfire in the background. He says he doesn't know how long Kurdish fighters can continue to hold out against IS forces.

'If Turkey Doesn't Do Anything, We Will Fall'

"We lack everything -- munitions, medicine, bandages, food and water," he says. "Soon we won't have anything left. Please tell the world that we don't have much time. They should be attacking -- precisely and, more importantly, more often!" Kurdu shouts. He says that, at most, 150 fighters with the brigade created when the Free Syrian Army and Kurds joined forces remain in the city. Many have fled because they have nothing left with which to defend themselves.

"So far the Turks have blocked any help," he says. "Yesterday they even left our wounded lying on the border for hours until four of them died. If Turkey doesn't do anything, we will fall."

Kurdu has no illusions about what happens if the jihadists overrun the entire city. "They've been laying siege against Kobani for 25 days and if they succeed, they will exact terrible revenge," he says. A few hundred civilians are still holding out in their homes -- some out of fear, others out of spite because they don't want to flee the jihadists without at least putting up a fight. "They will massacre all of us," Kurdu says.

A few hundred Syrians are standing on the road to Suruç, the Turkish border town, gesticulating wildly. Moustaches dyed red and scarves wrapped around their heads, they say they are a form of civil defense, looking after the families living in tents, taking care of the injured and burying the dead. For a month now, they've been coming here every day, squatting in the dust, munching on sunflower seeds and rubbing their prayer beads. A portable TV sits on the roof of a car. The men say they have two questions and a plea. First: "When will the European Union finally intervene?"

Second: "Who do you Europeans want to deal with in the future -- the IS terrorist militia or us Kurds?" Finally, the appeal: "We Kurds are modern Muslims, not from the Middle Ages like the ones over there. We have built up an autonomous, self-administering government and, yes, we even hold elections."

What Turkey Wants

The United States has been waging an air war against the Islamic State militants for more than two months now, deploying cruise missiles, fighter jets and drones. So far, though, the campaign has done little to weaken IS.

"People need to understand we need a little strategic patience here," a Pentagon spokesman said last week. "This group is not going to go away tomorrow, and Kobani may fall. We can't predict whether it will or it won't. There will be other towns that they will threaten, and there will be other towns that they will take. It is going to take a little bit of time." The State Department's spokeswoman even found herself on the defensive recently when she was asked whether the air strikes had actually led to any ground gains. "Sorry … umm … well, I'll find these," she said as she unsuccessfully leafed through a stack of papers looking for examples.

The reality, though, is that sustained victories like the retaking of the Mosul dam succeeded only because they involved air strikes in coordination with troops on the ground. The Iraqi government in Baghdad flew an elite military unit to Mosul and it reportedly played a major role in the operation. But there has been little movement in other regions.

Kurdish peshmerga fighters in northern Iraq seem more interested in digging defensive positions than in retaking lost terrain. And while PKK fighters have now established a base in the Sinjar Mountains -- into which the Yazidis fled over the summer -- Islamic State is now threatening to block their supply lines.

Indeed, the jihadists don't appear to be paying much mind to an American plan which calls first for stabilizing the situation in Iraq by attacking IS leadership, headquarters, oil refineries, training camps and arms depots. While IS freedom of movement has been reduced, they haven't been significantly hampered.

IS Had Prepared for Air Strikes

Islamic State leaders followed the extended debate over whether the US would engage in air strikes very closely. They appear to have prepared for them, too. The terrorist army, already highly flexible when it comes to shifting units and setting up temporary bases, was careful to move its leaders out of their headquarters in places like the Governor's Palace in Raqqa in northern Syria this summer. Later it did the same in the cities of Al-Bab and Manbej.

Informants in Raqqa reported at the time that IS had cleared out its headquarters and removed its heavy military equipment from the city the night before the first massive attacks by the Syrian air force in July. In the end, the bombs struck only empty buildings or civilians like the visitors at a cattle market in al-Bab in September.

IS has also taken steps to protect itself against air strikes from the US-led coalition. Refugees from Jarabulus report that IS has "purchased homes from civilians at a good price so that no one will betray their whereabouts. They then take their things to those homes, right in the middle of residential areas. If a house full of munitions is hit, the neighbors will also get blown up, so everyone is afraid." In Mosul, by contrast, the jihadists are said to have planted their black flags on homes where residents have refused to pledge allegiance to Islamic State.

Lacking coordination with allies on the ground, air strikes are only moderately helpful. Which is why calls are growing in the United States for the deployment of ground troops. That, though, is the last thing President Barack Obama wants.

Still, when it comes to the fate of Kobani, the most important decisions are being made in Ankara.

Erdogan's Double Strategy

During a visit to Gaziantep last week, Turkish President Recep Tayyip Erdogan said, "For us, PKK is the same as ISIS. It is wrong to consider them as different from each other." Such a statement reveals a lot about Erdogan's worldview. In the eyes of the Turkish government and army, the Kurdish PKK guerilla group remains enemy No. 1. The sides had actually made some process toward reconciliation in recent years, a process that can be credited to a large degree to Erdogan, who pushed it forward during his many years as prime minister against resistance from the military.

But then Syrian Kurds took advantage of the civil war to build the quasi-state Rojava, comprised of three zones along the Turkish border including the "Canton of Kobani". Their aim is to establish a cohesive autonomous area, precisely the scenario the Turks would like to avoid.

In response, both government authorities and the Turkish military have spent the last three years providing support to all rebel groups in Syria. By doing so, Ankara hopes to both topple Assad on the one hand and keep the Kurds in check on the other.

Many observers have suggested that Erdogan could now curry favor with the Kurds were he to provide help for Kobani. There would appear to be at least two reasons for such an approach: He needs Kurdish votes in next summer's parliamentary elections; and it would allow him to maintain a peace process that is economically and socially important for Turkey. But Erdogan is doing exactly the opposite. He's using the situation in Kobani to blackmail the Kurds and the rest of the world.

Erdogan has stipulated that help for Kobani would only come were the Syrian Kurds to join forces with the anti-Assad opposition, dissolve their local administrations and agree to allow the Turkish army to march into the border areas to create a security zone. The Kurds, though, find such conditions onerous and view an advance into northern Syria by the Turkish military being akin to an invasión.

'If the City Falls, a Massacre Will Take Place'

Salih Muslim, the head of PYD, the Syrian Kurdish party, has spent weeks negotiating with Turkish government representatives. But he held his last meeting with them on Oct. 4. "They promised help -- at the very least a corridor our fighters could use to reach Kobani, but nothing happened. And I haven't heard anything from them since," he says, sounding weary. "We don't know how long Kobani can continue to defend itself. If the city falls, a massacre will take place that will be witnessed by the whole world." Muslim's wife too fought there until the end of last week.

"If the international coalition is unable to stop IS, then who will still be capable of defending themselves against the jihadists?" Muslim continues. "Will they attack Erbil in Iraq next or Kurdish cities in Turkey? The Islamic State is the enemy of all of humanity, but the Turkish government doesn't seem to grasp that."

Ankara's Dangerous Game

Erdogan is demanding that the West, especially the Americans, support his calls for a buffer zone. It's a proposal that US Secretary of State Kerry said his country would look at "very, very closely." But it sounded more like a polite brush off given that the buffer zone would have to be defended with troops on the ground fighting against IS and would also require the destruction of Assad's air defenses in order for it to function. Many view the buffer zone as a tactic used by Erdogan in an attempt to drag the Americans into a real war -- one whose scope would swiftly shift from fighting focused on IS to a battle against the regime in Damascus.

To achieve that goal, Erdogan seems even prepared to accept a massacre in Kobani. One senior Turkish official told the BBC: "There is no tragedy in Kobani as cried out by the terrorist PKK. There is a war between two terrorist groups." It appears that Ankara is betting that the fight for Kobani will weaken the Kurds to such a degree that, in the end, they will be left with no option but to keep quiet.

It's a cynical position and even German Chancellor Angela Merkel appears to see it as nothing less than that. On Wednesday, she remarked critically that one should be able to expect a NATO member to set the right priorities.

More importantly, though, it's a dangerous game, as evidenced by the violent protests last week in Turkey that resulted in the deaths of 30 people and the injury of another 360. A massacre in Kobani could bring an end to the peace process and drive the PKK back into guerilla warfare.

At the same time, Halil Karaveli of the Central Asia-Caucasus Institute warns of the "Pakistanization" of Turkey. He notes that a number of Islamic State fighters are of Turkish origin and will turn against their home country at some point or other. "These groups will unleash a disaster that the government will be unable to control," he warns.

But Ankara isn't acting as if it views IS as a true threat. Of course the opposite could also be true. The government's own security agencies have been warning about the possibility of IS attacks in Turkey for months now, and some fear that providing aid to defend Kobani might actually provoke IS to take retaliatory measures.

'We Were Ready to Go, But the Turks Refused'

Indeed, it is likely this cocktail mixing fear with pride, stubbornness with ignorance, that is driving Turkey to block any assistance for Kobani. Kurds from all over Turkey who have tried to travel to Kobani to support the fighters are being beaten back at the border. So too are hundreds of fighters with the very Syrian rebel coalitions that both Turkey and the United States have backed in the past. Their plan had been to march into Kobani directly across the border, with the backing of the Turkish army. "We were ready to go, but then the Turks refused," reports one Syrian commander.

It has also been reported that Massoud Barzani, president of the Kurdish autonomous region in Iraq, offered to send in his Peshmerga forces. But they would also require a green light from Turkey that Ankara has thus far refused to give. In addition, the Turkish secret service has detained around 200 of more than 1,000 civilians who left Kobani a week ago. They're being held in a gymnasium in the village of Aligör. Among them is Perwer Ali, one of the two spokesmen for the local government of Kobani.

"They told us we would be tried before a military court because, they claimed, we were PKK terrorists," Ali explains on a mobile phone that was smuggled in to him. "It is grotesque -- the people who were sent out (of Kobani) are those who can't even fight." By the end of last week, 158 refugees were still being detained in the gymnasium, including nine children and 33 women.

Meanwhile, IS continues to have a surprising degree of freedom of movement on Turkish soil. On Oct. 4, a plane operated by Turkish discount airline Pegasus landed at Hatay airport in the southern Turkish province of the same name. Among the passengers on board Flight PC 4180 were nine men, likely Uzbeks and a Saudi, all wearing the dark-green outdoor jackets, sandals and ankle-length pants favored by the radicals. No one stopped the group and not a single official at airport security asked any questions. They were able to leave the airport unchecked before climbing into a minibus and disappearing.

In the area near Kobani as well as other sections of the Turkish-Syrian border, there are currently several posts where Kurds are on the lookout for IS fighters. At the end of September, they picked up two Belgians and one Frenchman of Arab origin near Kobani who wanted to enter Syria to join forces with the jihadists there. After their arrest, the three explained how they had traveled by plane via Istanbul without having been asked why they wanted to fly to Sanliurfa, a city located near Kobani.

Is Turkey Aiding Radical Islamists?

As early as the beginning of September, a discovery in Iraq triggered tensions between Ankara and Washington. IS munitions found there were manufactured by MKE, a Turkish state-owned defense company. The revelation fueled suspicions that Turkish authorities may be providing direct support to IS -- with or without the government's approval.

Other incidents also suggest a close relationship between Turkish government authorities and radical Islamists. For example, an official with the Turkish relief organization IHH, considered to be close to the government, died on Sept. 22 during the first US air strikes in Syria, targeting accommodations belonging to the Nusra Front. The same organization had repeatedly helped jihadists make their way to Syria via "humanitarian border crossings."

With its silent aid for the radicals, the Turkish government has damaged its own Kurdish policies given that Erdogan did more for the Kurds in Turkey during his time in office as prime minister than any other leader of Turkey. He was the first leading Turkish politician to seek a solution to the conflict, and his government has been conducting peace talks with imprisoned PKK leader Abdullah Öcalan for the past two years. Now the drama surrounding Kobani poses a threat to those negotiations. If a massacre occurs, Öcalan has signalized, it will mean the end of the process.

Last week, thousands of Kurds in Turkey took to the streets to demonstrate their solidarity with the people of Kobani and to register their protest against the government in Ankara. For the first time in many years, six Turkish provinces issued curfew orders and soldiers patrolled the streets. The scenes evoked the period during the early 1990s when the conflict between the military and the PKK devastated the entire region.

At the same time, PKK has also made little effort to deescalate the situation. Radical Kurds view the current developments as an opportunity to stray from the moderate course of recent years and to instead push forward the idea of establishing their own Kurdish state. "The AKP (Erdogan's Justice and Development Party) is now at a crossroads," warns Mustafa Karasu, a high-ranking PKK member. He says the party will have to enter into an alliance with the Kurds or else the war with the Kurds will become worse than it has ever been. The tenor of the PKK-aligned media is already growing shriller. "The Jews may have had to experience Hitler's genocide," wrote the daily Yeni Özgür Politika, but in the end their own state arose out of the ashes.

Nazmi Gür, a member of the Turkish national parliament and foreign policy spokesman for the Kurdish HDP party, says: "An end to the negotiations would be a catastrophe, a nightmare that could threaten to become a regional conflagration."

"Fear? What Do We Have to Fear?"

Back on the pistachio farm-lined road to Suruç, with the Syrian civil defense force. A man who calls himself Mehmet jumps into his dented Fiat and speeds over the fields straight towards Syria. "Fear?" he asks, "What do we have to fear? We're as good as dead anyway." And those who are as good as dead, can challenge death. Young men on Honda motorcycles with torn jeans and pleather jackets drive next to Mehmet. They say they had to flee to Turkey to take care of their families but that their brothers and sisters are fighting in Kobani. They come to a stop less than 500 meters (1,640 feet) from the border. They want to see what's happening.

Mehmet's friend Kerim, 25, pulls a mobile phone out of his jacket and dials his brother's number in Kobani. His brother answers and Kerim begins shouting impatiently into the phone, wanting to know what his brother is seeing. "Tell me, now!" Kerim orders in Kurdish. The young men listen and then begin to hoot and holler and pat each other's shoulders. Kerim's brother told him about the drama that unfolded a few minutes earlier near a market square in Kobani. It's a story that can't be confirmed. He claims a young female Kurdish fighter cut the head off a captured IS fighter with a knife.

Years ago, many women joined up with Syrian Kurdish militias fighting in Kobani. They received military training and provide the ultimate culture shock for the jihadists. At least one of the women has been decapitated by IS. Another, the mother of two small children, blew herself up in the middle of a crowd of IS attackers last week. Well prior to the attack, one of her female comrades had announced, "We will defend our city, even if we have to die."

By Fiona Ehlers, Katrin Elger, Juliane von Mittelstaedt, Maximillian Popp and Christoph Reuter

Up and Down Wall Street

Stock Market Slides Down an Oily Slope

Energy stocks and Putin’s Russia get clobbered, but U.S. GDP might rise a bit. Techs take a beating, and investment pro Louise Yamada thinks the technical damage to the overall market will take some time to repair.

By Randall W. Forsyth

Oct. 11, 2014 1:12 a.m. ET

Praise John from whom oil blessings flow,” went a spoof of the Doxology, a traditional English hymn of praise sung by students at the University of Chicago more than a century ago to one of that institution’s main benefactors, John D. Rockefeller.
Oil, of course, has been the basis of the family’s considerable fortune, so it was more than a bit ironic that its $860 million philanthropic foundation, the Rockefeller Brothers Fund, last month announced that it would divest itself of investments in fossil fuels.
Had the foundation dumped the stocks at the time of the announcement, it would have been a canny bit of market timing. The Energy Select Sector SPDR exchange-traded fund (ticker: XLE)—whose largest component just happens to be ExxonMobil (XOM), the descendant of Rockefeller’s Standard Oil—is down about 9% since then and off more than 15% from its recent peak in late June.
That coincided with the stunning slide in crude-oil prices, which last week met the common definition of a bear market with declines of 20% or more. West Texas Intermediate dipped to $83.59 a barrel, the lowest since mid-2012, while Brent crude broke through $90, to as little as $88.11, the lowest since December 2010.
The slump obviously is a bane to the big oil companies, oil-service companies, and especially the exploration-and-production outfits. But it isn’t seen as big a boon as in the past for the rest of the economy, despite the hoary notion that a price drop at the gas pump equals a tax cut for consumers.
According to an estimate by a major institutional investor (expressly not for attribution), the drop in energy prices might boost U.S. gross domestic product about 0.3%. But that’s only about half of the fillip that was seen prior to the vast expansion of North American oil production, which has been a positive for U.S. growth in recent years. Thus, there are also minuses from lower prices, especially for high-cost oil producers funded by hefty debt.
Meanwhile, the dollar’s surge is diluting the drop in oil prices for consumers in other countries, who pay for petroleum in their depreciating currencies. For instance, the 20% bear market in Brent translates to only about a 15% decline in euro terms. (To be sure, when the euro was strong, it mitigated the rise in oil costs.)
And the vise is especially tight for oil-producing countries that have seen the value of their currencies tumble in tandem with their petrol profits. It couldn’t have happened to a nicer guy than Vladimir Putin, with the Russian budget dependent on oil staying over $100 and the ruble already under pressure from sanctions over Ukraine.
For investors, the corresponding big break in oil stocks is reminiscent of the action of financial stocks in 2006, says Louise Yamada, who heads the eponymous Louise Yamada Technical Research Advisors. That is, the financials peaked and faltered months ahead of the broad market averages, which topped in October 2007 as the first distant rumbles of the financial crisis were being felt.
Indeed, she writes in her monthly missive to clients, “energy appears to us technically in a structural decline.” Expanding on that in a phone chat, she says that the sector suffered a breakdown in relative strength after six years of waning strength, relative to the rest of the market. And after a spate of basically sideways movements, a number of energy stocks have suffered spectacular spills, including Anadarko Petroleum (APC), which she notes has tumbled from about $110 to under $90.
The waning relative strength of the energy sector was but one of the discordant notes sounded as the major averages were setting records, as did the Dow Jones Industrial Average and the Standard & Poor’s 500, or new cyclical highs, as did the Nasdaq Composite, not so long ago. Most prominent has been the laggard performance of small-capitalization stocks, a mostly All-American cohort thought to be a redoubt from the upheavals abroad. The iShares Russell 2000 exchange-traded fund (IWM) last week nevertheless entered official correction territory and is 13% below its 52-week high.
Louise also points to the rising numbers on the 52-week lows list, which exceed the tallies seen during pullbacks in 2013 or 2012, but are approaching totals from the 2011 selloff. Finally, the most attractive sector—technology—also is getting caught in the downdraft. (Ever the lady, Louise recalls the ribald description of this process by my illustrious predecessor in this space, but asks that it not be repeated.)
Techs got blasted on Friday after a revenue warning by Microchip Technology  (MCHP) sent its shares plunging 12.3%, which clobbered the Market Vectors Semiconductor ETF (SMH) by 6.6%. Even old tech such as Intel INTC  (INTC) was smacked 5% and Microsoft (MSFT), 4%, on Friday.
Google (GOOGL) took a 3% hit and entered correction mode, although Apple (AAPL) held the $100 a share level as Carl Icahn presses for more share buybacks.
Louise thinks that, in the stock market’s current oversold condition, there could be intermittent rallies. After all, Wednesday was the Dow’s strongest day of 2014, and Thursday was the worst. But she would be suspicious of any pops. The technical damage inflicted on the market, she adds, will take some time to repair.
By themselves, the bungee-jumping moves, with harrowing drops interspersed with big, one-day upward bounces, don’t say much, she says. More importantly, the false breakouts in the major averages contrasted with the breakdowns in various groups. Even sectors that would be expected to rally—transportation stocks amid declining fuel costs, defense stocks amid rising geopolitical tensions—have failed to participate.
At a minimum, it’s not time to buy the dips blindly. With investors having given back some $1.5 trillion in wealth in U.S. stocks in the past month or so, according to Wilshire Associates, their ability or willingness to do so may also be rather diminished.
The clear message running through all of the global markets, from equities to commodities to currencies and bonds, has been slowing growth and disinflationary pressures. In addition to the selloff in stocks on Wall Street and well beyond, and the slump in oil, this is being evidenced in the strength in the dollar and the further descent in bond yields.
Treasury yields dropped to their lows of 2014 last week, with the benchmark 10-year note falling to 2.30% and the 30-year long bond hovering just above the 3% level. The declines came in tandem with those in European bond markets after German economic indicators showed a much sharper slowdown than expected, indicating that the Continent’s strongest economy is possibly teetering on the brink of recession.
The slide in bond yields also got a push from the minutes of the Federal Open Market Committee’s September meeting, which showed a sensitivity to the restraint exerted by the dollar’s rise. Markets inferred that to mean eventual hikes in the federal-funds target would be pushed farther back into 2015, which spurred Wednesday’s one-day-wonder rally.
The interest-rate futures and options markets—where the real bets on Fed policy are laid, as opposed to paper forecasts—already had been moving in that direction before the FOMC minutes were released on Wednesday. And while the consensus of economists calls for the first increase in the fed-funds rate—from the current 0% to 0.25% target set back in December 2008 at the depths of the financial crisis—to take place in the first half of next year, the market continues to think differently.
Based on the futures market, there’s only a 36% probability of a rate hike at the July 28, 2015, FOMC meeting. Only by the Sept. 17, 2015, gathering is a rate hike deemed better than even money—a 57% probability, according to the CME’s calculation.
Even with the receding likelihood of an early Fed hike, the Dow Jones Industrial Average ended the week in the red for 2014. And that’s before earnings reports for the third quarter mostly have started rolling in.
While companies have engaged in the usual tack of lowering profit targets to make them easier to beat, Barclays analysts think that estimates haven’t been adjusted enough to reflect the head winds, including the dollar’s rise and economic weakness overseas. More importantly, they don’t think that guidance for 2015 will be positive.
Capital spending, one of the hopes to spur growth, might also disappoint. Energy accounts for 27% of capital expenditures, and with the slump in oil prices, the Barclays analysts say they will be “listening closely” to commentary about future capex. So will investors, for this and other clues about the future, which suddenly seems far less certain.