November 17, 2014 7:34 pm

Bonds: Anatomy of a market meltdown

Tracy Alloway and Michael Mackenzie

Fall in Treasury bond yields left investors asking if world’s safe haven needs shoring up

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Legend has it that a young man once asked the financier J Pierpont Morgan what the stock market was going to do. “It will fluctuate,” Mr Pierpont is said to have replied.

Had the young man asked Mr Pierpont about today’s US Treasury market – where the US government sells trillions of dollars worth of bonds to a wide range of investors – he may have received a very different response.

For decades, the US Treasury market has been a bedrock of global finance. While stock markets are prone to sudden price swings, such episodes in the vast and easily-transacted world of Treasuries have been far rarer – giving the market an exceptional reputation for orderly trading.

That reputation took a big hit last month.

On October 15, the yield on the benchmark 10-year US government bond, which moves inversely to price, plunged 33 basis points to 1.86 per cent before rising to settle at 2.13 per cent. While that may not seem like much, analysts say the move was seven standard deviations away from its intraday norm – meaning it might be expected to occur once every 1.6bn years.
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For several minutes, Wall Street stood still as traders watched their screens in disbelief.

Electronic pricing machines, which now play a bigger role than ever in the trading of Treasuries, were halted and orders cancelled by nervous dealers as prices see-sawed.


The events have sparked a financial “whodunnit” as investors, traders and regulators seek to understand what happened – and to determine whether October 15 was a unique event or a harbinger of further perilous trading conditions to come.
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“We’re all looking for a chief reason because clients want to understand the impetus behind market volatility,” says Reggie Brown, head of exchange-traded fund trading at Cantor Fitzgerald.

Among US regulators’ concerns is whether a tougher regulatory climate for big banks, coupled with the inexorable rise of electronic trading, has fundamentally altered how the $12.4tn government bond market functions. The answer has profound consequences for the conduct of Federal Reserve policy and how the US funds its national debt.
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For the Fed, the resilience of the Treasury market will be a consideration as it begins to raise interest rates. Analysts say the risk of a highly volatile market reaction suggests the central bank will move in measured steps when it begins to raise borrowing costs, which many expect to begin next year.
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One worry is that the US Treasury market might have suffered a pronounced loss of support for prices – or “liquidity” in financial parlance – due to changes that have swept over Wall Street including the rise of computer-driven trading. Some draw parallels with the “flash crash” that hit stock markets in May 2010, which eventually spurred efforts to reform the wider equity market.

James Angel, associate professor at Georgetown University, says the US Treasury market should be regulated in a different way now that it has embraced electronic trading.

“When people use computers to provide prices across markets it [liquidity] can be withdrawn in a heartbeat,” he says. “How much market liquidity really exists under this type of market structure and what changes should be made are the questions for regulators.”

Unlike other bond markets, US Treasuries are viewed as being open for business for the entire global trading day. They also enjoy safe-haven status during times of tension. The immense size of the market means investors can easily express opposing views about the direction of interest rates by buying or selling the government debt.

Any indication that the market can suddenly shut down with little warning raises troubling questions about how the nature of trading has changed in recent years. Electronic systems are more visible to the whole market, so trades tend to be smaller than those that take place in private telephone conversations between dealers and investors.

A recent gathering of US Treasury officials and key representatives of dealers and investors, known as the Treasury Borrowing Advisory Committee, held in a Washington hotel, revealed “a wide variety of views regarding the potential drivers of the intraday volatility” on October 15. Members of the TBAC include JPMorgan Chase, RBS, Morgan Stanley, BlackRock, Pimco, Citadel, Brevan Howard and other major players in the Treasury market.
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A number of US regulatory agencies are looking at last month’s Treasury market mayhem. An official at the Federal Reserve Bank of New York told the Financial Times: “In the course of our normal market monitoring we regularly explore and assess market developments.”

Timothy Massad, chairman of the US Commodity Futures Trading Commission, which regulates interest rate futures trading at the Chicago Mercantile Exchange, said that the agency’s initial view was that the market had functioned reasonably well given the high number of trades.

“Let me just add, that’s based on our preliminary look. New evidence might come to our attention that suggests otherwise.”

When dawn broke on a grey October 15 in New York, traders and investors had plenty of reasons to be nervous. Concerns over the spread of Ebola and weakening economic activity in Europe and China were weighing heavily – helping to push bond yields lower as investors sought the refuge of US Treasuries.

The scuppering of AbbVie’s £32bn deal to acquire Shire left many big hedge funds nursing heavy equity losses and may have contributed to the rapid repositioning that would eventually engulf markets.
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When US retail sales for September flashed across news screens at 8:30am and confirmed the first monthly decline since January, concern mounted among investors that the US economy could well be softening. For investors who had positioned themselves for a strengthening economy that would propel the Fed to raise interest rates before 2017, it was a painful reversal of sentiment. Many had placed record bets on interest rates moving higher via futures contracts listed on the CME.
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With many hedge funds and money managers already suffering a poor year, their offside wagers on interest rates and other failing trades now required emergency action. What subsequently unfolded, according to traders, was a series of massive positions being liquidated and dumped on to the market.

One hedge fund manager recalls being bewildered by subsequent events: “What on earth was charging through the market to want volume at such a price and why, in response to that catalyst, did the electronic marketplace just take any and all liquidity away?”

By 8:45am, liquidity began noticeably deteriorating, and the process accelerated after 9:30am, according to data from Nanex, a market research firm. By 9:33am, the yield on the 10-year Treasury had sliced through the critical 2 per cent level, causing many who had bet on rising yields finally to capitulate and close out their negative bets by buying back US government debt and various interest rate futures contracts.

In September, hedge funds had established a record net “short” position in interest rate futures according to CFTC weekly data. Between the end of September and the week ending October 21, this big bet shrunk from 1.27m contracts to just 217,000, reflecting more than $1tn of notional exposure being cut.

“The elephant tried to squeeze through the keyhole,” says John Brady, managing director at RJ O’Brien, a futures broker in Chicago.


Eric Hunsader, Nanex chief executive, says the scale of the shift in US Treasury prices may have prompted the “market-makers” who usually support trading of the debt to retreat: “The speed of the move was abnormal and trading systems lack historical data for such episodes that can provide them with some guidance.”

When the day drew to a close nearly $1tn worth of cash Treasuries had changed hands, illustrating the intensity of the rush for the exit. Such huge volumes also show liquidity was available, but was possibly difficult to obtain at prices deemed reasonable by investors on the day and amid rapidly fluctuating markets.

The head of trading at a major dealer-bank says: “Once volatility shows up, you don’t want to make a mistake in a fast market and so you always see dealers pull back from providing prices.”

Compounding such pressures are changes that have transformed Wall Street since the financial crisis, with the big banks who once dominated Treasury trading now under tougher balance sheet constraints thanks to regulation and a newfound aversion to risk.

This trend has encouraged greater electronic trading and a migration of experienced traders from dealers to hedge funds and asset managers, leaving a younger generation of traders manning Treasury desks at big banks. Many of these have never experienced the gung-ho pre-crisis days when banks were more willing to make bets on the market.

“The appetite to take on a position is lower than it was pre-new regulation,” says Greg Gurevich, managing partner at Maritime Capital Partners, adding that compensation structures “do not reward the trader to take risk that may ultimately cost the trader his or her job”.

The two main electronic trading venues for US Treasuries are run by Nasdaq’s eSpeed and Icap’s BrokerTec. In recent years these platforms have opened up to a range of broker-dealers and high-frequency traders. These firms do not underwrite US Treasury debt sales and are often viewed as opportunistic – providing prices when they spot a quick profit and then retreating when trading turns tricky.

Customer orders are now transacted and almost instantaneously hedged, or offset, by computer systems – a type of automation that works well when trading is orderly but rapidly breaks down when the situation changes. At such moments, turning off the machines becomes a necessity. This contributed to the downdraft in liquidity on October 15.

“Dealer-banks don’t really position in bonds,” said one head trader at a large US bank. “They basically act as a pass-through to places like BrokerTec and eSpeed or match off their client flow.

The market-makers in this new market are not obligated to be there when everyone’s selling.”

The worry is that even the highly dependable US Treasury market may suffer from sudden droughts in liquidity because big banks have been barred from “proprietary” trading. The “prop traders” could take the other side of huge customer demand to buy or sell bonds.

“If the Street – for balance sheet, risk appetite and regulatory reasons – can’t provide a speed bump between buyers and sellers such as hedge funds and asset managers, then the Treasury market will experience a lot more jumps in trading,” says one trader.

As the market becomes increasingly driven by electronic trading, more rules may be required to help deal with sudden violent swings, similar to the adoption of circuit breakers in stock markets.
Prof Angel says: “The Treasury market is a freewheeling world where trading is not formalised like that of an exchange and where the use of circuit breakers can help steady activity.” These kind of curbs matter for markets that increasingly trade electronically and also influence other financial areas, such as derivatives and futures.

A broader consequence of last month’s turmoil may be that Fed rate rises will be more likely to take the form of a series of slow steps, rather than big moves that run the risk of sparking turmoil in the bond markets, according to analysts.

For the US Treasury, which is responsible for making sure budget deficits and maturing debt are refinanced smoothly, further episodes of turmoil could well impair the market’s ability to underwrite government debt efficiently, says Michael Cloherty, analyst at RBC Capital Markets.

Mr Cloherty says the US Treasury market has altered structurally and lacks the depth to absorb easily surprises in Fed policy and changes in market sentiment. This trend has gathered pace as the central bank has become a major owner of Treasury debt through its emergency bond-buying programme, further limiting liquidity.

He adds that any sign that the Treasury market’s liquidity has declined would cast a shadow over investor confidence – and may ultimately raise the cost of selling government debt.

Says Mr Cloherty: “Investors know they can trade large amounts of Treasuries and any erosion of confidence in the market’s liquidity has long-term consequences.”


Additional reporting by Gregory Meyer


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Investors fear fresh ‘value at risk shock’

The backbone of Wall Street’s risk management is a dauntingly complex mathematical model with the deceivingly banal name of “value-at-risk,” writes Tracy Alloway.
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VaR models have been a key component of the risk management toolboxes of big banks and funds for decades – despite being criticised for failing to predict the large losses incurred during the recent financial crisis.

The models attempt to forecast how much money firms could lose from trading – within a certain timeframe and probability – by overlaying historic market movements with statistical analysis. Firms typically place internal trading limits based on their VaR estimates, meaning that if they breach the figure they may have to curb trading and, in extreme cases, sell off positions.

With the shockwaves of late 2008 now gradually receding, and a period of low market volatility taking its place, these VaR models have been indicating that the risk of investors sustaining large losses is very low.

That means investors may be subject to a so-called “VaR shock” in the event that volatility returns to markets.

Some market participants say this is exactly what happened on October 15, when an abrupt repositioning across Wall Street resulted in dramatic swing in the price of US Treasuries.
As yields dropped, the models deployed by active traders and the computer algorithms used by automated market-making machines – both of which tolerate far less volatility than in the past – began buying more Treasuries in order to stem their losses.

Lower risk appetites at the biggest banks have “created the effect of reducing liquidity in trading securities . . . particularly during periods of stress,” Fitch Ratings said in a report on the day’s events. “This was demonstrated by the inability to trade fixed-income.”

The rating agency estimates that the trading VaR of the major US banks had fallen about 66 per cent between the end of 2010 and mid-2014.

While post-crisis reform efforts have encouraged banks to factor in “stressed VaR” models that incorporate more turbulent events into their capital requirements, concerns remain that the risk management tools could end up having the perverse effect of sparking market mayhem rather than helping to prevent it.

“VaR-based analysis leads to self-reinforcing loops,” a group of banks warned in a presentation to the US Treasury weeks before October 15. “An unexpected increase in volatility might come from broad-based selling of assets wanting to de-risk in front of a turn of policy.”


Up and Down Wall Street

Falling Oil Prices: The Downside

While consumers should gain from cheaper gasoline, the decline in oil prices could have a negative impact on the overall U.S. economy.

By Randall W. Forsyth           

Nov. 15, 2014 1:17 a.m. ET

 
Last week saw a significant reduction in global warming in Beijing. No, not the agreement to reduce carbon emissions reached by President Barack Obama and Chinese President Xi Jinping. Rather, it was the icy interchanges between the world’s leaders gathered in China’s capital for the Asia-Pacific Economic Cooperation conference that seemed to induce a virtual polar vortex over the proceedings.

Even the warm gesture of draping a shawl over the shoulders of China’s first lady by Russian President Vladimir Putin was coolly received, as he was seen as being a bit too hot to trot for this venue, which was far more chilly than chill.
 
While critics contend that the environmental pact will do more to restrain U.S. economic growth than Chinese carbon emissions and global warming, an unmistakable deflationary cold front has been spreading across global markets. The blast from the slide in commodities is being felt across other sectors, in currencies, credit, and equity markets.
 
According to the conventional wisdom, this ought to be the most salubrious of situations. To use the cliché, the drop in prices at the gasoline pump translates into a tax cut for the consumer. (The identity of this single, solitary consumer is a closely guarded secret, although pundits apparently have access to his or her mind-set and motivations.) In a piece emblazoned with the headline “THE BARREL STIMULUS,” in all caps, in case you might have missed it, last Friday’s New York Times quotes a corporate chieftain who declares “if oil prices stay between $75 and $95 a barrel, we would see the kind of stimulus package that the Federal Reserve or Congress could never do.”
 
This, however, ignores the revolution in domestic oil production that has been loudly trumpeted as making the U.S. energy independent, a hyperbolic claim to be sure. But U.S. crude-oil production has ramped past nine million barrels a day, a pace not seen in decades, a result of advances in technology, such as hydraulic fracturing, combined with the massive capital that has been pumped into the sector.
 
This shift at the margin from America being mainly a consumer to a producer of oil has been a plus for the U.S. economy. So, at the minimum, the reduction of this plus is a minus for this sector, notwithstanding the windfall for consumers—a point made previously in this column in the past month, both in the print (“Down an Oily Slope,” Oct. 13) and online editions (“Watch Out for Falling Oil,” Oct. 15).
 
In her latest MacroMavens missive, Stephanie Pomboy cites a report from the Manhattan Institute stating that “without the $300 to $400 billion yearly increase in output from oil and gas production, [economic] growth would still be negative.” Since U.S. oil production started to surge in 2012, the longstanding inverse relationship between the economy and crude prices has shifted, she points out with her usual perspicacity.
 
“Lower oil prices are now a net negative,” she continues. The New Normal is that “the hit to domestic energy producers is greater than the benefit of lower prices to energy consumers.” That also is the conclusion of an analysis from a major institutional investor group (whose name dare not be divulged in print). Putting pencil to paper, or more likely keyboard to spreadsheet, the group reckons that the drop in prices at the pump initially will boost real U.S. economic growth by 0.25%. Without further declines, however, that boost will fade.
 
Lower oil prices will then exert a larger, more sustained drag on the economy as they flow through to the energy sector. Some 30% of U.S. shale-oil production is noneconomic at current prices, the group calculates. And, unlike traditional oil production, shale plays require a continual, high level of investment to maintain output. The reduction of this spending could be a drag of 0.5% on real gross domestic product growth—twice the benefit to consumers.
 
In nominal terms, the drop in oil prices makes this more acute. This group estimates that there would be a “material hit to income growth of 1% to 1.5%” measured in current dollars. And current dollars are what many of these highly leveraged oil producers need to service their substantial debt. As our colleague Michael Aneiro describes in this week’s Current Yield column, the high-yield bond market is heavily populated by energy companies, which availed themselves of copious credit to fund the expansion that has produced the sector’s growth.
 
EVEN IN THE U.S. STOCK MARKET, the drop in oil prices has been felt. Microsoft  (ticker: MSFT) on Thursday overtook ExxonMobil (XOM) as the second-largest company in terms of market capitalization. (They both are, of course, behind Apple  (AAPL) at the top of the leader board, where it extended its steady ascent with 1% daily rises in the last three sessions of the week.) And to cope with lower prices, Halliburton  (HAL) is reported to be seeking to buy rival Baker Hughes            (BHI.)
 
Those two big oil-services players didn’t wait for the International Energy Agency to release its report contending that oil—on Thursday, U.S. benchmark crude fell below $75, to a four-year low—could keep sliding into the first half of 2015. “It is increasingly clear we have begun a new chapter in the history of the oil markets,” the IEA said.
 
That also is apparent to Putin, who said on Friday that Russia is preparing for a “catastrophic” drop in oil prices. Venezuela also is reeling from the slump in petro revenue, while producers of other energy commodities around the globe also are feeling the pinch. Glencore  (GLEN.UK) will temporarily shut its Australian mines for three weeks to cope with a market that is “awash with coal,” The Wall Street Journal reports.
 
The surfeit of coal and oil are a result of the investment booms in recent years to meet what was thought to be insatiable demand for energy, especially from China. Ultralow interest rates engineered by central banks helped provide cheap capital to fund projects. And, as the old saying in the commodity pits goes, the cure for high prices is high prices; they eventually spur increased supply to meet demand, sometimes too successfully.
 
Combined with the effect from the rising dollar, these falling prices, especially for fuels, are evidencing themselves in a sharp drop in import prices—down some 1.3% in October, the Labor Department reported on Friday. It cuts both ways, however; prices of U.S. exports dropped 1% last month.
 
While cheaper fuel might be a windfall for consumers, they don’t seem to be heading to the mall to spend it. Overall retail sales rose 0.3% last month, reversing September’s similarly sized decline. But Steve Blitz, chief economist of ITG Investment Research, notes that department-store sales fell 0.3% last month after plunging 1.1% in September. He argues that, while higher fuel prices pinch discretionary spending, lower ones allow consumers to spend in tandem with incomes, which slog along at a 2% growth rate. More to the point, says Pomboy, “bubble-scarred U.S. consumers are taking any unexpected windfall as an opportunity to save.”
 
Globally, the main coping mechanism is the currency market. Countries cut prices by lowering exchange rates to maintain market share. That is a zero-sum game in which any gains are at the cost of others, and probably ephemeral at that.
 
It’s a game of monetary musical chairs, too. As the Japanese yen continues to slide, hitting a multiyear low last week of more than 116 yen to the dollar, the Korean won remains under pressure as Hyundai (005380.Korea) struggles to compete with Japanese auto makers, such as Toyota (TM) and Honda (HMC.)
 
Countries in the rest of Asia and in Latin America have seen their currencies slump to keep pace in globally competitive marketplaces.
 
Meanwhile, China’s renminbi has appreciated even more than the dollar, a hindrance to that export-dependent economy, especially relative to Japan. With no love lost between those geopolitical rivals, could the exchange-rate shift between their currencies have contributed to pinched expressions between China’s Xi and Japanese Prime Minister Shinzo Abe at the APEC conference?
 
While the slide in pump prices didn’t bolster spending at department stores, it did boost consumer confidence, the University of Michigan reported on Friday. In particular, inflation expectations downshifted materially last month. That is especially important to Federal Reserve officials, who pay closer attention to such surveys than to market-based indicators, such as Treasury Inflation Protected Securities, according to JPMorgan’s chief domestic economist, Michael Feroli.
 
Indeed, according to the institutional investor’s research cited earlier, the key effect of low energy prices might be to stave off eventual Fed rate hikes, which the federal-funds futures market sees happening by the Sept. 17, 2015, meeting of the Federal Open Market Committee, according to the Website of the Chicago Mercantile Exchange. (However, the description of probabilities of Fed rate hikes cited here last week was incorrect, owing to a technical snafu at the CME.)
 
In sum, watch out for falling oil prices. Consumers initially may feel pleasure when it costs less to fill their gas tanks. But all those who have benefited from the U.S. oil boom, from producers to suppliers to oil workers earning a healthy paycheck, may be worrying, and eventually may be hurting.



Read This, Spike That

Is Stock Market Living on Borrowed Time?

LBO king Wilbur Ross and Prem Watsa, the “Warren Buffett of Canada,” have their concerns.

By John Kimelman 

Nov. 17, 2014 6:07 p.m. ET


The Standard and Poor’s 500 gained a mere 0.07% Monday, but any positive movement in the benchmark would have been enough to set yet another record close for the benchmark.

Earlier in the day, however, Wilbur Ross, Jr.., a shrewd investor known for turning around failed companies, went on CNBC to say that “markets are living on borrowed time.”

And an article in Street Authority profiled the cautionary views of V. Prem Watsa, the CEO of Fairfax Financial (ticker: FRFHF), a Toronto-based insurance holding company often compared to Berkshire Hathaway.

Watsa contends that stocks could suffer as economies enter into a period of deflation which will be aided by central bank money tightening. The executive is playing this theme through derivatives that pay off should consumer prices decline.

Like Watsa, Ross, in his CNBC appearance, also mentioned his concerns about deflation, as well as geopolitical risks as the catalysts can drive stock prices downward.

Thus far, the stock market has weathered various geopolitical concerns arising out of the Ukraine and the Middle East fairly well. But Ross told CNBC views that “I do think the big worries are geopolitical worries, that’s one of the things we’ve been very concerned with all year and I’ve some concern about deflation becoming anew problem.”

He added: “We have been a seller on balance, not because we think a terrible crash is coming but we need to sell opportunistically because we tend to have relatively large stakes in relatively thin securities so we have to sell when the markets are very strong.”

Meanwhile, the Street Authority piece does a nice job of profiling the contrarian views of Watsa, an Indian-born executive who hopes to profit grandly should stock markets head south.

“On the surface everything looks rosy,” writes Street Authority’s Jody Chudley. “Underneath, though, Watsa warns of serious trouble brewing. In Fairfax’s most recent investor conference call, Watsa referred to the fact that current levels of inflation are now at 60-year lows. That by itself is somewhat alarming, but remember that those low levels were reached despite the fact that the United States and almost the entire world has been engaged in easy-money policies on an unprecedented level.”

As Watsa sees it, once quantitative easing is completely ended, he says the United States and the entire world are in great danger of facing a long period of deflation. In fact, several countries in Europe are already facing a deflationary environment.

Deflation, the article points out, is bad for stocks because lower prices can translate to lower profits for corporations, which leads to cost-cutting, lays off and rising unemployment.

“To understand the severity of deflation and its effects on a market, simply look at Japan, which experienced a prolonged period of deflation, from 1990 through today,” Chudley writes. “If Watsa is correct, then investors should be reducing their exposure to equities immediately. I think that isn’t a bad idea even without deflationary concerns when you consider that the market is at all-time highs and is six years into a bull run.”

The article is bullish on shares of Fairfax Capital itself because it nearly $7 billion of cash and short-term securities ready to be invested in opportunities that might arise in a big market selloff. “Additionally, Fairfax owns more than $100 million in derivatives that are set to generate big profits should the consumer price index (CPI) decline -- which is what will happen in the event of deflation,” Chudley writes. “Those CPI-linked derivatives would be worth billions if deflation actually occurs as Watsa has forecast.”

Of course, it takes opposing views to make a market. And a thoughtful piece on the Reuters Website by columnist Anatole Kaletsky makes the case while stocks can continue to “melt up.” Interestingly, Kaletsky thinks that low inflation will remain a stimulus and not sink into a debilating deflation as Ross and Watsa fear.

His bullish arguments follow. “First and foremost, the worst financial and economic crisis in living memory has ended, and most parts of the world economy are enjoying decent, if unspectacular, growth. Second, economic and financial policies around the world, though far from perfect, are highly predictable and therefore unlikely to cause further market disruptions.

Third, technology is continually advancing and innovation is creating new products, services and processes that stimulate both investment and consumer demand. Finally, inflation is almost nonexistent, at least in the advanced economies, meaning interest rates are guaranteed to stay low for a very long time,” Kaletsky writes.

To be sure, he writes, minor corrections and panics are bound to happen. “Financial markets always move in boom-bust cycles, as greed alternates with fear. We saw this in early October, when Wall Street fell by 10% in three weeks and equity prices in Europe plunged by almost 20 percent in relation to the U.S. dollar. Such setbacks, however, actually reinforce the uptrend if the fears that triggered them turn out to be illusory — or less daunting than they first appeared.”

Only time will tell those aforementioned fears prove to be illusory or something quite real.

11/17/2014 05:41 PM

Putin's Reach

Merkel Concerned about Russian Influence in the Balkans

By SPIEGEL Staff

 
Russian President Vladimir Putin and German Chancellor Angela Merkel at the 70th anniversary of D-Day commemoration in June.
Russian President Vladimir Putin and German Chancellor Angela Merkel at the 70th anniversary of D-Day commemoration in June. REUTERS


Berlin has begun to see Moscow as an adversary rather than as a potential partner. The German government is concerned about efforts by Russian President Vladimir Putin to increase his influence in the Balkans. Stopping him, however, could prove difficult.

It is a fundamental principle of German foreign policy that talks are the best way to solve diplomatic problems. Such was the rationale behind Gernot Erler's recent trip to Moscow to speak with Russian parliamentarians about the ongoing Ukraine-related difficulties. Erler is the German government's Russia liaison and he has spent much of his political career working towards better relations between Germany and Russia. But his recent trip to the Russia capital was a painful one. There was no one in parliament who was willing to speak with him.

For Erler, the message was clear: Russia is no longer particularly interested in dialogue. That is true for simple parliamentarians just as it is for Vladimir Putin. The Russian president still, to be sure, speaks regularly with Angela Merkel. But the chancellor believes that what Putin says and what Putin does have long since diverged. Russian policy, says Erler, is currently following the "principle of organized unpredictability."

Foreign Minister Frank-Walter Steinmeier, who sought to establish a "positive agenda" with Moscow when he took office, is particularly frustrated. In recent weeks, Steinmeier has complained several times of significant breaches of trust perpetrated by the Russians and says he doesn't foresee relations with Moscow normalizing any time soon. Merkel is of the same opinion.

From the perspective of Berlin, Russia has gone from being a difficult partner to being an adversary within just one year. The effort launched in 2008 to tighten cooperation on a number of issues, one in which German leaders placed a great deal of hope, would seem to have come to an irrevocable end.

Instead, Berlin is now discussing ways in which it might be able to slow down Russia's expansionary drive -- particularly in the Balkans, a region in which some states are not entirely stable. Elmar Brock, a member of Merkel's conservative Christian Democrats (CDU) and the chairman of the European Parliament's Foreign Policy Committee, is also concerned about the region. "It is part of a broad strategic approach by Russia to 'infiltrate' the countries politically but mostly economically," he says.

Cold War recipes are coming back into fashion. It is time to begin thinking about a new "containment strategy," says one high-ranking diplomat. The reference is to the concept for curbing Soviet power that was first sketched out in a famous telegram sent in February 1946 by then-US Ambassador to Moscow George Kennan. It went on to become the foundation for Western policy in relations with the Soviet Union.

The Birth of 'Putinology'

Stefan Meister, a Russia expert at the German Council on Foreign Relations, agrees, saying that the West needs to focus on self-defense to a greater degree than it has thus far. One official at Merkel's Chancellery says that in some ways the situation is even more difficult than it was during the latter phases of the Soviet Union. Back then, the official says, Moscow at least adhered to agreements.

During the Cold War, Kremlinology was the word used to describe efforts to determine the true intentions of the Soviet leadership. That discipline has now been replaced by "Putinology," but the emphasis on speculation has remained. Even the chancellor, despite dozens of conversations with Putin, doesn't know how far the Russian president is willing to go in the current conflict with the West, or even whether he knows himself. She has spoken to Putin at least 35 times by phone since the beginning of the Ukraine crisis. She also requested a transcript of a speech given by Putin at the Valdai Club in Sochi four weeks ago. In it, the Russian president laid out his world view before journalists and political science experts. It is not a view that made Merkel more optimistic.

According to Putin's thinking, the US destroyed the international legal system and is attempting to establish a unipolar global order. He said that the so-called victor of the Cold War is trying to reorganize the world according to its own interests. Putin said that Washington is responsible for the rise of Islamist terrorism as well as the conflicts in Iraq, Syria and Libya.

Whereas the US cavalierly intervenes around the world, Washington reproaches Russia for doing exactly that, Putin said with a view toward Ukraine. "What Jupiter is allowed, the Ox is not," he said, referring to the Latin phrase often used to indicate a double standard. But the bear, he continued, "will not even bother to ask for permission." The bear, he said, is the "master of the taiga" and will not cede it to anyone. Putin then said that he doesn't intend to advance into other climactic zones. The taiga refers to the forested region stretching all the way across Russia, and the sentence from Putin's speech has now led Berlin officials to wonder where the taiga ends for Putin and where other climactic zones might begin. Observers have been keeping close track of the Russian president's comments in this regard, but a complete picture has yet to emerge.

Merkel would seem to have drawn her own conclusions. At a Monday lecture held by the German chancellor at the Lowy Institute for International Policy in Sydney, where she was following the G-20 summit in Brisbane, Merkel was clear about her view of Russia. "Truly, the Ukraine crisis is in no way a regional issue," she said. "It affects all of us." During the following discussion, she warned that the EU will not yield to Moscow like East Germany once did.

"Otherwise, one would have to say: We are too weak, be careful, we can't accept any others, we have to first ask Moscow if it is possible. That's how things were for 40 years; I never really wanted to return to that situation." She then made a particularly notable comment: "And that doesn't just apply to Ukraine. It applies to Moldova, it applies to Georgia. If the situation continues ... we'd have to ask about Serbia, we'd have to ask about the western Balkan countries."

Tit-for-Tat Reprisals

Her concerns about the Balkans are justified. Last Wednesday in the United Nations Security Council, Russia surprisingly refrained from voting in favor of extending the EURFOR mission in Bosnia-Herzegovina. It was the first time it has abstained in such a vote. The reason Moscow gave was that the resolution contained language referring to the country's prospective accession to the European Union. At the same time, Russia expressed reservations about Germany's announced candidacy for the 2016 presidency of the Organization for Security and Cooperation in Europe (OSCE). Over the weekend, Putin also left the G-20 summit before its official conclusion, though he claimed that his premature departure was related to the long flight back home to Moscow.

What's more, the Kremlin last week expelled Sabine Stöhr, a long-time employee of the German Embassy in Moscow. In a statement confirming the expulsion of the German diplomat, the Foreign Ministry in Berlin said: "An employee of the German Embassy in Moscow has left the country due to a reprisal measure taken by Russian authorities. We regret this unjust course of action and have expressed our displeasure to the Russian government."

The reprisal was apparently taken in response to the case of a Russian diplomat in the general consulate in Bonn who was accused of spying. German domestic intelligence agents had been observing the diplomat for months and ultimately expelled him from the country. In similar cases in the past, Russia has abstained from retaliation. "This is a policy of pinpricks," said a source in the Foreign Ministry. "We don't know where it is leading."

On Monday, the Russian Foreign Ministry announced that several Polish diplomats have likewise been expelled, a move that also came in retaliation for the expulsion of Russian diplomats from Warsaw. The Russian Foreign Ministry said in a statement that "the Polish authorities have taken an unfriendly and unfounded step. In connection with that, Russia has undertaken adequate measures in response."

Apart from such tit-for-tat pettiness, Berlin has observed a broad new approach by the Kremlin in the Balkans. The focus, officials believe, is an attempt to prevent the region's further rapprochement with, or even accession to, the European Union. "RUS attaches great strategic importance to the Western Balkans," reads a Foreign Ministry analysis entitled: "Russia's Influence in Serbia."

The paper, which is classified as confidential, describes Moscow's efforts to link Belgrade closer to Russia. The endeavor goes beyond military cooperation and Russian deliveries of natural gas.

Moscow, the paper indicates, is engaging in "public diplomacy with clear pan-Slavic rhetoric" and enjoys high esteem in the population, not least because of its approach to the Kosovo issue.

"Putin's goal is to exert so much pressure on Balkan states that they either back away from EU membership or that, once they become members, influence EU resolutions in a pro-Russian manner," says EU parliamentarian Brok.

Russian Soft Power

The same holds true for Serbia's neighbor, Bosnia-Herzegovina. "One gets the impression that Russia is trying to gain influence over all of Bosnia-Herzegovina via the Serbian partial republic Srpska," says German Agricultural Minister Christian Schmidt, who recently made a visit to the region at the behest of Merkel. "That also makes the path of neighboring Serbia into the EU more difficult," he says.

The accuracy of Schmidt's assessment is demonstrated by a paper on "Russia's soft-power strategy" in the Balkans that was drafted for Putin by the influential Council on Foreign Relations in Moscow. The paper notes that: "In this region, which is traditionally tied to Russia, we cannot limit ourselves to investing in companies. We must spend money on infrastructure, and for the people there who see Russia as an alternative to Western power."

Putin would seem to have taken the advice to heart. The Russian Railways company, headed by Putin-ally Vladimir Yakunin, is currently refurbishing a 350-kilometer (217 mile) stretch of track in Serbia at a cost of three-quarters of a billion euros. Furthermore, the Moscow-based oil multinational Lukoil now owns 79.5 percent of the local service-station chain Beopetrol while Gazprom holds majority ownership of the country's largest natural gas supplier.

"Russian investments have improved the prospects of regions that were heavily damaged by the NATO bombardment in 1999," the paper reads. In Montenegro, Russia is the largest foreign investor, with Russians controlling one-third of all companies in the country.

The German government believes that Russia's approach in the region has been largely successful. The Foreign Ministry analysis notes that October's 70th anniversary celebration of Belgrade's liberation from the Nazis was moved up by four days to coincide with Putin's visit there. It was also accompanied by a large military parade for the first time in 30 years. The paper doesn't fail to mention that Serbian President Tomislav Nikoli awarded Putin the country's highest decoration during the visit. "Images of tight srb.-rus. bond (are) from our perspective (an) inappropriate signal at a moment when SRB should be emphasizing its EU orientation," the German Foreign Ministry paper pointedly notes.

One particularly odd meeting underscores the methods Putin uses to expand his influence in Serbia. One year ago, Nikoli received the head of the Moscow motorcycle club Night Wolves, Alexander Zaldostanov. Putin refers to Zaldostanov (alias: The Surgeon) as his "brother." The gang has made repeated headlines for its outspoken anti-Semitism and homophobia, stances that are consistent with attitudes widely held in Serbia.

Exerting Pressure Where Necessary

It is not easy for the German government to counteract the Russian offensive. "We can't become party to a bidding war," says Michael Roth, a state minister in the Foreign Ministry. "We have to continually make it clear to the Balkan states that accession to the EU is in their interests."

Angela Merkel has also sought to thwart Putin's efforts diplomatically. At a Balkans conference in the Chancellery at the end of August, she encouraged the gathered heads of state and government to commit to a pro-EU path. She has even shown a willingness to exert pressure as necessary. Moscow's effort to grant diplomatic status to a disaster control center Russia established in the Serbian city of Niš is one example. Merkel called Serbian Prime Minister Aleksander Vuči to urge him not to sign the agreement. Berlin was worried that the center might develop into a permanent center of Russian espionage.

Putin's efforts to expand his influence do not stop at EU borders. The German government believes Putin was surprised that Europe was able to come to a consensus on Ukraine-related sanctions -- particularly the fact that even an accession candidate like Montenegro backed the penalties. Now he is doing his best on influence policy-making in individual EU member states, particularly in Bulgaria.

The country has traditionally been closely allied with Russia and is almost completely dependent on Russian natural gas and oil. An internal report from the German Foreign Ministry notes that around 300,000 Russians have bought property in Bulgaria. Officials in the Chancellery are concerned that Putin could seek to instrumentalize the alleged interests of the Russian minority there. Berlin and Brussels are likewise worried that the Bulgarian government could succumb to Russian pressure and block future EU foreign policy initiatives even more often than it has done in the past.

The fundamental problem from a Western standpoint is the fact that the desire for escalation and the ability to do so is not divided equally. Putin appears prepared to promote Russian interests in his neighborhood economically, politically and, if necessary, militarily. The West doesn't have much to offer in response -- and it is completely unwilling to go to war for Ukraine or Moldova. Even the economic sanctions against Russia are controversial in Germany and elsewhere in the EU.

Bolting the Door

Critics of Moscow, such as Andreas Schockenhoff, the deputy head of Merkel's conservatives in German parliament, believe that the sanctions must be maintained until the costs become too great for Putin. But even during the last round of EU sanctions, Merkel had difficulty convincing skeptics, such as Italian Prime Minister Matteo Renzi and Hungarian Premier Viktor Orban to agree to the penalties. She was thus particularly upset by recent comments by the EU's new foreign policy chief, Federica Mogherini, calling the effectiveness of sanctions into question.

During a recent meeting of current and former state ministers in the Foreign Ministry, several participants likewise criticized Berlin's strategy, saying that more concessions must be made to the Russians. Social Democrat politician Klaus von Dohnanyi, for example, argued that Russia must be allowed a zone of influence in its immediate neighborhood.

The resulting image these days is of a Berlin that is at once impotent, alarmed and perplexed -- perhaps one reason that Germany's frustrated foreign minister, for lack of better alternatives, has committed to staying the current course. "Even if you have been frustrated and unsuccessful 100 times," Steinmeier recently told a confidant, "diplomacy means that you still have to open the door the 101st time."

The question, however, is whether the other side hasn't already long since bolted the door.


By Nikolaus Blome, Susanne Koelbl, Peter Müller, Ralf Neukirch, Matthias Schepp and Gerald Traufetter


Editorial

Warning Signs From Commodity Prices

By THE EDITORIAL BOARD

NOV. 15, 2014
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Commodity prices have fallen nearly 15 percent since late June. Credit Monica Almeida/The New York Times 


For many consumers and businesses the recent drop in commodity prices has provided a tidy windfall — one analyst estimated that the typical American household would save $400 a year thanks to lower gasoline prices. But the tumbling price of fuels, metals and other commodities is also sending a warning about the global economy.

Over all, commodity prices have fallen nearly 15 percent since late June, according to a Bloomberg index. Last week, the price of crude oil dropped to a four-year low, about $74 a barrel, down from about $107 a barrel in June. The prices of metals like copper, platinum and silver have also fallen sharply since the summer.

The decline can partly be explained by economic changes taking place in China. In the last two decades, the country has been gobbling up the world’s coal, iron ore, copper, oil and other commodities to build new cities and fuel its booming economy, which grew at an average pace of nearly 10 percent a year for three decades. But that growth rate has now slowed, and with it China’s demand for raw materials. This year, the country will grow at 7.4 percent, according to the International Monetary Fund.

The world had anticipated China’s economic transition, but it was much less prepared for stagnation in Japan and in much of Europe.

In Japan, a sharp increase in a sales tax earlier this year has hurt consumer spending. And Prime Minister Shinzo Abe has largely failed to boost business investment and draw more women into the labor force, two changes he had promised as part of a plan to revive his country’s weakened economy. The Bank of Japan recently expanded its bond-buying program, but bigger government policy changes will be needed to revive Japan’s economy in 2015.

In Europe, government officials and central bankers in the 18-country eurozone have been slow and timid in boosting their economies, even though inflation is less than 0.5 percent and the unemployment rate is more than 11 percent. The European Central Bank should be buying government bonds to pump more money into the economy, a policy known as quantitative easing. But it has been reluctant to do so because German officials are opposed to the policy, which they think would serve to transfer wealth from strong euro nations to weaker ones. It should come as no surprise that the eurozone grew at just 0.2 percent in the third quarter of this year, according to data released on Friday.

The big losers in all this are nations that depend on commodity exports, like Russia, Brazil and Iran. Some of these countries, particularly Russia and Iran, already have substantial economic problems because of Western sanctions and government mismanagement. Brazil’s economy was slowing before the decline in commodity prices, and it faces a difficult 2015. President Dilma Rousseff, who recently was re-elected by a narrow margin, needs to diversify Brazil’s economy by investing in infrastructure and making it easier for entrepreneurs to start businesses.

The drop in prices, however, has been good for the United States, which is growing faster than other industrialized economies. Lower oil prices in particular will provide a much needed stimulus to consumers, particularly lower-income Americans who spend a larger percentage of their incomes on fuel; analysts say cheaper fuel has helped raise retail sales in the United States.

But America’s economy could struggle in the coming year if Europe and Japan slip into another recession. About 25 percent of all American exports went to those two markets in the first nine months of the year.

The economic recovery from the financial crisis was uneven and disappointing. Now, in many countries, it is stalling.

Catalonia’s future

Voting in their hearts

The Catalan “vote” on November 9th will do little to resolve the future either of the region or of Spain

Nov 15th 2014
LLEIDA
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MANUEL MOLINS remembers being called a “Catalan dog” after Spain’s civil war in the 1930s. But the 93-year-old had his revenge on November 9th, when he voted for the region’s independence in Lleida, one of Catalonia’s four provincial capitals. “Catalonia is important for Spain, but they treat us badly. If they didn’t, I might think differently,” he said. Mr Molins’ vote brought no consequences.

He was one of 1.9m Catalans (out of 6.3m who were eligible) to vote for independence at a mock referendum called by the region’s president, Artur Mas. The turnout of 37% was hailed as a triumph by Mr Mas and a resounding failure by his opponents.

The vote ends the game of legal cat-and-mouse between Madrid and Barcelona in which the constitutional court has twice banned Mr Mas’s attempts to hold an official, if non-binding, vote. The polls show widespread support in Catalonia for a referendum on independence similar to the one that was held in Scotland on September 18th, even among many who are against secession. But Spain’s prime minister, Mariano Rajoy, refuses to allow one.

Mr Mas relied on separatist volunteers to man the polling booths, though opponents still want to know why police did not prevent taxpayers’ money and public buildings being used. Mr Mas may be taken to court for disobeying the constitutional court. Madrid is wary of creating a separatist martyr, but Spain’s sluggish courts would take years to decide whether to fine him or ban him from public office.

Yet he was the obvious winner on November 9th. He honoured his promise to hold a vote and gained increased power over a separatist movement that he has struggled to control. He cocked a snook at Madrid, warming the hearts of many Catalans who see Mr Rajoy’s Popular Party (PP) government as aggressively centralising. It is impossible to know how many voters were taking aim at the PP, which usually wins only 13% of Catalan votes, and how many really wanted independence. Nor does anyone know how abstainers would vote in a real referendum. Opinion polls suggest a vote could go either way.

The immediate future is murky and quarrelsome. Mr Mas is calling for a formal referendum. Mr Rajoy will not give him one. So the Catalan president threatens to call a snap regional election instead, as a form of plebiscitary vote on independence. But that needs agreement with his rivals in the separatist camp and could break up his Convergence and Union (CiU) coalition, which has ruled Catalonia for 27 of the past 34 years.

Doing a deal with his main rival, the separatist Catalan Republican Left (ERC), will be tricky. ERC leads in the opinion polls and is well-placed to wrench power from CiU. Much depends on whether Mr Mas and the ERC’s leader, Oriol Junqueras, care more about an independence vote than about their parties. Negotiations are expected to revolve around Mr Mas’s preferred option of separatists running on a single list. A plebiscitary election would probably see the junior partner in CiU, the Catalan Democratic Union, split away. Mr Mas’s broad-based Catalan Democratic Convergence Party would also have to position itself clearly for independence.

Mr Rajoy’s government hopes the November 9th vote has released some steam from the separatist pressure cooker. It is waiting to see if Mr Mas and Mr Junqueras fall out. ERC has withdrawn support from Mr Mas’s minority government, so it will be hard to pass a budget for next year. In the rosiest of scenarios for Madrid, Mr Mas would forget about an early election and govern with the support of Catalonia’s moderate socialists, who propose a federalist reform of Spain’s constitution, for another year or two.

A darker scenario sees Mr Mas calling an election and losing resoundingly to ERC. Mr Junqueras threatens a unilateral declaration of independence. The consequences, for Catalonia and for Spain, are unforeseeable but potentially highly damaging. “Even an orderly break-up of the country would pose risks to the national economy; much more so a disorderly break-up,” says Fitch, a ratings agency.

A plebiscitary election would force Catalan voters to think hard about the pros and cons of rupture. Chief among the risks is that, with Madrid against, Catalonia might be forced out of the European Union. Dolors López, the PP boss in Lleida, points out that around 30% of local farmers’ income comes from Brussels handouts. Benefits from independence would include more tax revenues generated in wealthy Catalonia being spent there.

Many would like Mr Mas and Mr Rajoy to sit down and talk. The two leaders claim to be ready. But meaningful dialogue requires them to show more flexibility. With a general election expected at the end of 2015, both men could be out of office by next Christmas. Real dialogue may have to wait until after that.


Heard on the Street

U.S. Margins Defy Doom of Profits

Profit Margins Keep Widening, Confounding Forecasts. Here’s Why That’s Set to Continue

By Justin Lahart

Updated Nov. 17, 2014 1:45 p.m. ET



Alongside the inevitabilities of long-term interest rates picking up and inflation firming, one of the most obvious things that was going to happen over the course of this year was a narrowing of profit margins. So much for that.

Indeed, with third-quarter earnings advancing at around twice the pace of a sales gain of just 5.3%, profits as a share of revenue for companies in the S&P 500 look to now stand at 10.1%. That is the widest profit margin in the 22 years of data S&P Dow Jones Indices has on hand. A longer-dated measure—after-tax corporate profits as a share of gross domestic product—last year reached its highest level since 1929.

A big reason margins have continued to widen is wage gains—or more aptly, a lack of them.

Average hourly earnings continued to grow weakly in October, and were up just 2% from their year-earlier level, according to the Labor Department. That is even though companies have been hiring over the past year at a faster clip than economists expected, with the unemployment rate falling to 5.8% last month from 7.2% a year earlier.

Another reason margins are so high is that companies have been slow to spend. Commerce Department figures available through the first quarter show investing in new equipment relative to private industry output was low compared with prevailing levels before the recession. While there has probably been some pickup since then, companies remain reluctant to spend on longer-term projects without an immediate payoff.

Hourly wages aren’t rising very quickly, one of the factors contributing to persistently strong profit margins. Bloomberg News


The argument that margins must narrow goes something like this: Demand has reached the point where companies can’t meet it without hiring more workers, and the job market has reached a point where workers are in a stronger position to bargain for higher wages. So companies’ labor costs are heading up. And if they’re smart, they’ll spend more on labor-saving equipment that will help them boost productivity, and mitigate future labor cost increases.

Of course, this was also last year’s argument that profit margins were set to narrow. And 2012’s.

Today’s wide profit margins probably owe a lot to changes in the investing climate. Those other two mysteries—persistently low interest rates and inflation—have led to profound changes in what many investors look to stocks for.

With bonds offering little in the way of yields, for example, income-focused investors have turned increasingly to stocks. They are more apt to reward managers who generate and return cash to shareholders over managers who are looking to reinvest and grow. Moreover, low inflation lowers the risk for companies of not investing heavily in growth and seeing rising prices overwhelm the spending power for future revenue.

To that, add still-painful memories of the financial crisis and the growing clout of activist funds. So it’s easy to see why companies are reluctant to take chances that might damage margins and anger investors. That is the case even if those riskier moves have potentially big payoffs over the longer haul.

Eventually, things will change. Companies will no longer be able to keep labor costs at bay, interest rates and inflation will rise, and investors’ focus will swing back toward growth. But as the persistence of wide profit margins has shown, eventually can be a long time coming.