Markets Are Profoundly Unhealthy Now

By Michael E. Lewitt, Special Contributor, Money Morning

February 1, 2015

2014 was the best of times and the worst of times in financial markets. Stocks rallied, of course, while bond yields and commodity prices plunged. In 2014, the S&P 500 gained 13% while the yield on 10-year Treasuries dropped from 3.03% to 2.17%, and the price of oil collapsed by 50%.

And the all-important U.S. dollar rallied as other major currencies such as the euro and the yen plunged. Investors looking for a consistent message from markets had to look elsewhere.

In January 2015, a similar theme spooled out in a completely different way…

The S&P 500 lost 3% – its worst performance in a year – while Treasuries had their best month in five years, as interest rates plunged to record lows around the world. In fact, yields on government bonds in many places are negative, a profoundly unhealthy phenomenon.

Crude oil dropped for the 7th month in a row, something it did during the 2008/9 financial crisis, even after a manic rally on Friday, January 30. The U.S. dollar continued to rally for the 7th month in a row and had its best month since May 2012.

Here's what January's action means for the rest of 2015…

Pundits like to talk about the "January indicator" which, according to the Stock Trader's Almanac, holds that, as January goes, so goes the year 89% of the time from 1950 to 2013. Of course, that rule didn't hold in 7 of those years, this is the third year of a Presidential election cycle (when the market usually goes up), and on the other side of the ledger the S&P 500 has never rallied 7 years in a row (2015 would be the 7th consecutive year of gains).

In other words, basing one's investments on these types of statistics is a fool's gambit. What an investor needs to do it look at the facts.

And the facts are grim. Stocks are trading at extremely high valuations against a backdrop of slowing economic growth and rising global financial and geopolitical instability. And bond markets are sending truly alarming signals about the state of the global economy.

A Look Through the "Buffet Goggles"

Let's start with stock valuations. Warren Buffett's favorite valuation measure, the ratio between the total value of all S&P 500 companies and U.S. GDP, is currently at twice its historical average. The Shiller Cyclically Adjusted P/E Ratio, which measure stock values over a rolling 10-year period, is at 1.7x its historical average.

And the forward price/earnings ratio of the S&P 500, which is based on reported earnings that are artificially inflated by many factors (most importantly massive stock buybacks funded with low cost debt), is currently 16x versus an historical average of 14x (and therefore, because earnings are artificially inflated, less overstated than it is). In other words, stocks are very expensive.

An Alarming Number of Bonds Are Sporting Negative Yields

Now let's look at bonds. Ten-year Treasuries are now yielding 1.67% and the iShares 20+ Year Treasury Bond ETF (TLT) returned 9.8% in January. As crazy as it seems, this ETF is still something to buy because the 10-year yield is likely heading below 1.50% and could easily trade in the 1.0% to 1.25% range. The 30-year Treasury yield is trading at a record low of 2.22% and is likely heading under 2.0%.

The scary thing is that U.S. interest rates are still much higher than the rest of the world. Five year German bunds – the European benchmark – are negative and some $3.6 trillion of government bonds around the world are now sporting negative yields.

Investors should make no mistake about it: this is profoundly abnormal, unhealthy, and unsustainable, and a sign that something is seriously wrong with the global economy. And for that reason, it is a big mistake to think that stocks can continue to rise in such an environment.

For that reason, I recommend that investors should buy ProShares Short S&P 500 ETF (NYSEArca:SH) shares. This will rise if the stock market falls, which I expect it to do soon.

The Millstone Holding Down Global Growth

Next, let's look at global financial stability – or instability. The world is currently home to more than $100 trillion of debt. The problem is that the global economy can't generate enough income to pay the interest on this debt or pay it back.

Why is that? Because the money that was borrowed wasn't invested in the types of productive assets that generate income such as new businesses, new technologies, and innovation.

Sure, some of the money was invested in those things, but not nearly enough. Instead, most of the money was invested in non-productive assets such as housing and consumption. As a result, the world was left with too much debt and too little ability to handle it.

All of this debt is making it increasingly difficult for economies to grow. This is why the recovery from the financial crisis has been one of the most disappointing on record. And after several quarters of reasonably impressive growth, the U.S. – the only country in the world that is showing any strength – is stumbling again.

Last week, we learned that gross domestic profit only grew at 2.6% in the fourth quarter of 2014, roughly half the pace over the summer (which was itself overstated by statistical anomalies). For all of 2014, GDP only grew at an average rate of 2.4%, nothing to write home about. While consumer spending was strong in the fourth quarter, businesses pulled back.

First-quarter 2015 growth is also looking sluggish. The truth is that it is very difficult for heavily indebted economies to grow quickly and the U.S. economy is heavily indebted in both the public and private sector. Add the crushing weight of over-regulation, taxes, and Obamacare and you have a structural problem that can only be addressed through policy changes.

Geopolitics Are Playing an Corrosive Role

Finally, let's turn to geopolitics. Russia has increased its aggression in the Ukraine in the face of seeing its economy crumble as a result of the oil price collapse. This poses a direct threat to europe that can only be ignored for so long. The Middle East remains a powder keg.

China continues to advance its interests in the South China Sea and elsewhere. A rare bright spot was President Obama's visit to India last week, but overall global instability is rising and poses a threat to markets.

Against that backdrop, therefore, nobody should be surprised that stocks fared poorly in January. The real surprise is that they did so well in 2014.

Last week was particularly ugly with the Dow Jones Industrial Average (INDEXDJX:.DJI) losing more than 500 points or 2.9% to close at 17,165.95 while the S&P 500 (INDEXSP:.INX) dropped 57 points or 2.8%. The Nasdaq Composite (INDEXNASDAQ:.IXIC) index shed 123 points, or 2.5%, to 4635.24. A number of large companies such as Microsoft Corp. (Nasdaq:MSFT), Procter and Gamble Co. (NYSE: PG), Pfizer Inc. (NYSE: PFE) reported earnings that were hurt by the effects of the strong dollar.

This is a trend that will continue as 33% of S&P 500 earnings come from outside the U.S. Energy companies are also reporting lousy results, which should come as no surprise. Energy giant Chevron Corp. (NYSE:CVX) reported a 30% drop in earnings and announced it was cutting spending and eliminating its stock buyback program (which has been running at $5 billion a year).

Wall Street strategists are now lowering their earnings estimates for the S&P 500 to take into account the effects of lower oil prices and the higher dollar. This should place additional downward pressure on stocks.

According to Bloomberg, investors have lost $393 billion in energy stocks and bonds so far, something that wasn't factored into the optimistic reports about the positive effects of lower oil prices on consumers.

Here's a little bulletin: when the world's most important commodity experiences collapses in price by more than 50% in a period of just six months, it isn't good for anybody – not for consumers (who aren't just consumers – they are also investors, businessmen, and active members of a broader economy), investors or markets. And the reason is that lower oil is a symptom of something much more serious – the weak global economy that I described above.

Prepare for Tough Times Ahead

Through that lens, lower oil should be seen as a major warning sign that both the market and the economy are in for tough times.

And that is what January's stock market action is telling us. Bond and commodities markets have been signaling for months that the global economy is in trouble. Last month, stocks finally caught up.

Janet Yellen is going to have to pull another rabbit out of her hat to keep stock prices levitating in the year ahead, and she is quickly running out of rabbits.

The Bravado of Borrowers

By: Peter Schiff

Tuesday, February 3, 2015

Last week a scene unfolded in Athens, largely unnoticed by American eyes, that provided all the visual and metaphorical symbols needed to define the current state of the global economy. Hollywood's best screenwriters couldn't have laid it out any better.

Tiring of being told by self-righteous foreigners to pay for past borrowing with current austerity, the Greek people had just elected the most radically left-wing government in recent memory, whose stated goal was to tell their creditors that they were not going to take it anymore. The leadership of the victorious Syriza Party, a collection of mostly young Marxist and Trotskyite academics, had promised the Greek people a clean break from the past and an end to years of economic malaise.

Although their plan seemed fundamentally contradictory (telling foreign creditors to butt out even while courting more aid), Syriza nonetheless appealed to a frustrated electorate through their dynamism and optimism.

To show that they were not just another upstart coalition that would co-opt the status quo once elected, Syriza leaders adopted the posture, vocabulary and clothing of revolutionaries. Throughout his campaign, Alex Tsirpas, the new prime minister, refused to wear a tie, thereby eschewing the most potent symbol of traditional power. When sworn in as prime minister, also with an open collar, he dispensed with the "hand on the bible" ceremony and instead invoked the spirit of fallen Greek Marxists. Since the election Syriza leaders have hot toned down their rhetoric as many predicted they would. Could it be that they actually meant what they said?

Syriza's fiery attitude has put Greece on a collision course with northern European leaders who face the political necessity of requiring Greece to repay previously delivered bail out money. In this context the first meeting between Yanis Varoufakis, the newly installed Greek Finance minister and Jeroen Dijsselbloem the Dutch representative of the so-called "troika" of lenders (The European Central Bank, the International Monetary Fund, and the European Commission), was bound to produce some drama. The meeting exceeded expectations on that front. But how it looked was perhaps more important than what was said.

In a room packed with cameras and reporters, Varoufakis strode in not just tieless and open collared, but with his shirt shockingly untucked. He ambled to his chair, and sat slouching backwards with his legs crossed like a poker player barely able to contain the glee of a winning hand. His expressions were effusive, satirical, and defiant. All he lacked were sunglasses and a couple of groupies to complete the rock star persona. To his right sat the stiff necked, buttoned-down Dutchman, who in in the words of Colonel Kurtz appeared like "an errand boy, sent by grocery clerks, to collect a bill."

The two agreed on seemingly nothing. Dijsselbloem insisted that the new Greek government live up to the austerity and repayment commitments, and Varoufakis said that the Greeks would no longer negotiate with the creditors who he believed were responsible for his country's destitution. When there was really nothing left to say, the meeting came to an abrupt end and the two executed a painfully awkward handshake. Dijsselbloem, seeming annoyed, avoided eye contact with his counterpart and left the room without looking back. On the other hand, Varoufakis, seemingly enjoying the moment, shrugged his shoulders and smiled for the cameras, as if to say "What's up with the stuffed shirt?"

What could explain these contrasting attitudes? Shouldn't the creditor, the one lending the money, and the party who will be asked for more, be in the power position? Shouldn't the borrower be in position of supplication? If you thought that, you don't understand the current way of the world.

Based on the ascendancy of Keynesian "demand side" economics it is the borrower who is considered the key driver of growth. The theory holds that if the borrower stops borrowing they will also stop spending. When that happens they believe the entire economy collapses, dragging down both lenders and borrowers in the process. From that perspective, the bigger the borrower the greater his importance, and the more leverage he has with the lender. This is like the old adage: "If you owe the bank $10, that's your problem. But if you owe the bank $10 million dollars, that's the bank's problem."

Syriza knows that northern European leaders are terrified at the prospect of disintegration of the EU and the stability it provides. The goal of maintaining open and essentially captive markets for German manufacturers was the prime reason that pried open Berlin's wallet in the first place. But Syriza also understands the power that debtors have in today's world. Default leads to liquidations, which in turn leads to deflation, the biggest bugaboo in the Keynesian night gallery of economic fears. After years of bailouts of banks, corporations, and governments, debtors know that no one is ready to risk another Lehman Brothers type collapse on any level.

The bar of "Too Big to Fail" has gotten progressively lower. If Greece can repudiate its debts, the temptation for larger indebted nations like Italy and Spain to do the same will be ever greater.

This understanding fuels not only the swagger of the Greek finance minister but also the attitude of the world's largest debtor, the United States of America. Although the $1 Trillion dollar plus annual budget deficits have been cut significantly in recent years (thought the national debt has exploded beyond $18 trillion), I believe the reduction is largely a function of the asset bubbles that have been engineered by the Fed's six year program of quantitative easing and zero percent interest rates. Any sustained economic downturn could immediately send the red ink back into record territory. But flush with his victory speech/State of the Union address, President Obama has adopted a bit of the Varoufakis bravado.

President Obama's newly unveiled 2015 budget includes almost $500 billion in new spending; effectively dispensing with the token austerity that Washington had imposed on itself with the 2011 "Sequester." In my opinion, the U.S. has virtually no hope of paying for all of our spending through taxation, the budget busting proposals should be viewed as a message to our foreign creditors that we plan on borrowing plenty more, and that we expect that they will keep lending for as long as we want.

From a global economics perspective the United States is like Greece writ very, very large.

Much like the Northern European countries, the major exporting nations around the world are terrified that their economies would be shut out of U.S. markets if their currencies were to strengthen against the dollar.

I believe this has allowed America to approach its finances with impunity.

But this confidence may be leading to trouble. If the new Greek government keeps following its current course, it may ultimately be shown the door of the Eurozone. Although a "Grexit" may ultimately pave the way for a real Greek recovery, the Greeks themselves should have no illusions about how painful this journey may be. Without the purchasing power of the euro and the largesse of the creditors supporting them, the Greeks may find themselves with a basket case currency that delivers far lower living standards.

If Greek government employees thought austerity was bad when it was imposed from Brussels, wait until they see how bad it's going to be when imposed by Athens. In fact, no Greek recovery will be possible until the newly elected Marxists become unapologetic capitalists.

When the Swiss National Bank decided to abruptly reverse course on its euro peg, the world should have been treated to a fresh lesson at the finite nature of creditor patience. While this message may have been lost on most observers, sooner or later this reality will sink in. When it does, the shirts will be tucked, the ties will be fastened, and knees just may start bending.

Last updated: February 5, 2015 12:59 pm

Dollar bulls face jobs report test

Michael Mackenzie

Dollar trade-weighted index

One constant of the new year has been a strengthening US dollar, until now.
The broad global currency weakness against the dollar faces a test when the latest US employment figures are released on Friday. Ahead of this closely watched report, the dollar’s ascent during January has slowed — with the euro recovering back above $1.14 from below $1.11 — while the world’s reserve currency has also slipped versus the yen, sterling and Canadian dollar.
The hefty appreciation of the dollar since last summer has been built on two major planks, the first being expectations of a stronger US economy propelling the Federal Reserve towards a tightening of policy in the coming months, while the second has been slowing global growth prompting easing by other central banks — notably in Japan and the eurozone — that results in sharply weaker currencies.
Since November, a host of central banks have eased policy and sought stimulus via a depreciating currency, with Australia being the latest example this week. That has certainly boosted the dollar, but of late the bond market has questioned whether the US central bank will start tightening policy by the middle of the year.
Last week’s Federal Open Market Committee meeting left that question open, with the onus on key economic data such as the monthly jobs report. Signs of oil prices stabilising and conjecture over the timing of Fed tightening have sparked some trimming of bullish dollar bets this week.
“The dollar’s momentum has weakened on the talk that the US may not hike this year,” says Marc Chandler, strategist at Brown Brothers Harriman.

Renewed dollar strength, at least in the near term, requires a solid jobs report for January and one that is accompanied by evidence of rising wages.

“Payrolls are one of the most important data points for the month,” says Jens Nordvig, global head of foreign exchange strategy at Nomura Securities. “The Fed clearly tried to sound optimistic on the economy and keep a June rate rise on the table. The market doesn’t believe it.”

While economists expect the addition of 230,000 new jobs for January, down from the past four-month average of 284,000, the pace of wage gains during January looms as the key factor for currency traders and investors.

The December jobs report was marked by a surprise drop of 0.2 per cent in earnings that resulted in an annualised rise of just 1.7 per cent for workers. During prior business cycles, wages have expanded at a yearly rate of around 4 per cent, and the relative absence of better pay for workers has helped cap interest rates.

“A rise in earnings would mean the rate hike story is back on for this year,” says Mr Chandler.

Another weak month of earnings is seen pushing the Fed towards delaying rate rises until later this year, more in line with the bond market’s current expectations.

Anthony Karydakis, chief economic strategist at Miller Tabak & Co, says little or no rebound in wages during January “would leave a pocket of concern to the Fed, as the softness in wage growth has been a key missing part in the context of the ‘solid’ improvement in labour markets that the FOMC mentioned in its statement last week”.

A delay in Fed rate rises towards the end of the year may well pressure the dollar as traders with a short-term horizon trim bullish bets. Net bets on the US dollar rising remain close to all-time highs, according to US futures positioning data, and such crowded trades are vulnerable to sudden shifts in sentiment.

Recent sharp changes in currencies, such as a 10 per cent slide in the Canadian dollar over a six-week period, can swing back abruptly and catch out traders riding the positive momentum of the US dollar.
“People complain when there is little volatility,” says Mr Nordvig, and there is currently a lot of potential for surprises in the currency market he adds.

But the difference in the growth performance of the US and other key economies favours owning the dollar over the long haul, many argue.

Alan Ruskin, strategist at Deutsche Bank, says the recent appreciation of the dollar against the backdrop of lower US interest rates bodes well for the currency’s prospects. “The theme of global disinflation has encouraged many central banks both to ease policy and become more tolerant of foreign exchange weakness to help reflation,” he says.

In turn, Mr Ruskin says modest expectations for tighter policy from the Fed are a boon for the dollar as the outlook for the US contrasts sharply with the rest of the world.

Also propelling the dollar higher has been the attractiveness of higher US bond yields relative to the eurozone and Japan.

Mr Nordvig expects lift-off for US interest rate policy in September and such a prospect means the dollar will remain in favour.

The dollar’s long weakening run began in 2002 and ended during 2011, but only started breaking out last year.

“Once the trend changes, a currency gains its own momentum. We still see a longer term dollar uptrend for another year or more,” says Mr Nordvig.

Germany will have to yield in dangerous game of chicken with Greece

'You cannot keep on squeezing countries that are in the midst of depression,' says President Barack Obama, lining up with the Greeks

By Ambrose Evans-Pritchard

5:33PM GMT 02 Feb 2015

The threat of a stand-off between Greece and its international creditors poses the biggest risk to the global economy, George Osborne warned on Monday

The Chancellor shakes hands with Greek finance minister Yanis Varoufakis outside No11 Downing Street on Monday Photo: EPA
George Osborne has warned that the escalating showdown between Greece and the eurozone has become the “greatest risk to the global economy”.
In this the Chancellor is right. North European politicians assert with remarkable insouciance that EMU is now strong enough to withstand the effects of contagion if Greece is forced out of the euro, and some say it may even emerge stronger. This is courting fate.
It is true that QE by the European Central Bank has anaesthetised the bond markets. Yet Grexit would covert the eurozone into a fixed exchange rate system overnight, a sort of 'ERM3' in the words of Morgan Stanley. Portugal would be a sitting duck. Whether Europe’s leaders could stop the EU itself from disintegrating after such a breach of political solidarity is an open question.
Mr Osborne pointedly refused to take sides, and came very close to rebuking the EMU authorities for carelessness after his meeting with the Greek finance minister Yanis Varoufakis.
“I urge the Greek finance minister to act responsibly but it’s also important that the eurozone has a better plan for jobs and growth. We have got to make sure that in Europe, as in Britain, we choose competence over chaos.”

In Washington, President Barack Obama tilted even further towards the Greeks. “You cannot keep on squeezing countries that are in the midst of depression. When you have an economy that is in freefall there has to be a growth strategy and not simply an effort to squeeze more and more out of a population that is hurting worse and worse.”

This should be a cautionary warning to Brussels, Frankfurt and Berlin that they do not have a green light from the rest of the world to do as they like with Greece – however irritated they may feel by the provocations of Alexis Tsipras. There are larger diplomatic and strategic matters at stake.
The European Central Bank must move with particular care. Eyebrows were raised over the weekend when two ECB members threatened to cut off support for the Greek banking system if the new Syriza government walks away from its Troika bail-out obligations on February 28.
There is near universal agreement that such action would precipitate a systemic banking crash in Greece, lead to full-blown default and force the country’s ejection from the eurozone with days. Greece would have to impose capital controls, nationalise the banks and reintroduce the drachma in short order.
Delayed data show that ECB support for the banks has reached €54bn. It is surely rising very fast since capital flight has accelerated to almost €1bn a day, leading to an offset from the ECB through the Target2 payments system.
Finland’s governor, Erkki Liikanen, was categorical. “Some kind of solution must be found, otherwise we can't continue lending."

So was the ECB’s vice-president Vitor Constancio. Greece currently enjoys a “waiver”, allowing its banks to swap Greek government bonds or guaranteed debt for ECB liquidity even though these are junk grade and would not normally qualify. This covers at least €30bn of Greek collateral at the ECB window. "If we find out that a country is below that rating - and there's no longer a (Troika) programme - that waiver disappears," he said.
These esteemed gentlemen are sailing close to the wind. The waiver rules are not a legal requirement. They are decided by the ECB’s governing council on a discretionary basis. Frankfurt can ignore the rating agencies if it wishes. It has changed the rules before whenever it suited them.
The ECB may or may not have good reasons to cut off Greece – depending on your point of view – but let us all be clear that such a move would be political. A central bank that is supposed to be the lender of last resort and guardian of financial stability would be taking a deliberate and calculated decision to destroy the Greek banking system.
Even if this were to be contained to Greece – and how could it be given the links to Cyprus, Bulgaria, and Romania? – this would be a remarkable act of financial high-handedness. But it may not be contained quite so easily in any case, as Mr Osborne clearly fears.
I reported over the weekend that there is no precedent for such action by a modern central bank. “I have never heard of such outlandish threats before,” said Ashoka Mody, a former top IMF official in Europe and bail-out expert.
“The EU authorities have no idea what the consequences of Grexit might be, or what unknown tremors might hit the global payments system. They are playing with fire. The creation of the euro was a terrible mistake but breaking it up would be an even bigger mistake. We would be in a world where anything could happen.

“What they ignore at their peril is the huge political contagion. It would be slower-moving than a financial crisis but the effects on Europe would be devastating. I doubt whether the EU would be able to act in a meaningful way as a union after that.”
In reality, the ECB cannot easily act on this threat. They do not have the political authority or unanimous support to do so, and historians would tar and feather them if they did. The ground is shifting in Paris, Rome and indeed Brussels already.
Jean-Claude Juncker, the European Commission’s president, yielded on Sunday, accepting (perhaps with secret delight) that the Troika is dead. French finance minister Michel Sapin bent over backwards to be accommodating at a meeting with Mr Varoufakis. There is no unified front against Greece. It is variable geometry, as they say in EU parlance.
Greek bonds and equities rallied on Monday on reports that Greek leader Alexis Tsipras has agreed to uphold Greece’s debts after all. He did no such thing.
He very specifically said Greece would pay the IMF (never in doubt) and the ECB. What he left out was the bulk of the debt owed to the EMU bail-out machinery in its various forms.
How this will end is anybody’s guess. With goodwill on both sides, you could imagine a deal along the following lines:
The Troika is renamed the Love Brigade. Greece’s primary surplus for coming years is cut from 4.5pc to 2.5pc of GDP, moving closer to fiscal neutrality and creating some leeway for Syriza’s social welfare programmes (not that expensive).
To pay for this, the debt could be stretched out until 2055 – a date already circulated before – with the average interest rate cut by around 1.5 percentage points.
Chancellor Angela Merkel could agree to this without having to admit to the Bundestag that German taxpayers have lost a lot of money (bailing out German banks in Greece) or having to submit the losses as a line-item in the annual budget.
Syriza would have little difficulty calling this debt relief. There would be no more extend-and-pretend loans shovelled onto Greece. All would have a face-saving way out. The cost would be trivial compared with the huge sums already wasted.
Yet such happy formulations overlook the furious passions ignited by six years of depression in Greece and the raging battle under way to wrest control over the economic levers in Europe and to overthrow the contractionary regime that has pushed the whole currency bloc into a deflationary vortex.
Joschka Fischer, the former German foreign minister and vice-chancellor, says the Syriza victory is really a “Greek burial” for the broader German strategy of belt-tightening and austerity for Europe. If I may quote him at length:
“Not long ago, German politicians and journalists confidently declared that the euro crisis was over; Germany and the European Union, they believed, had weathered the storm. Today, we know that this was just another mistake in an ongoing crisis that has been full of them,” he wrote for Project Syndicate.

“Even before the leftist Syriza party’s overwhelming victory, it was obvious that, far from being over, the crisis was threatening to worsen. Austerity – saving your way out of a demand shortfall – simply does not work. In a shrinking economy, a country’s debt-to-GDP ratio rises rather than falls, and Europe’s recession-ridden crisis countries have now saved themselves into a depression, resulting in mass unemployment, alarming levels of poverty and scant hope.”

“Warnings of a severe political backlash went unheeded. Shadowed by Germany’s deep-seated inflation taboo, Chancellor Angela Merkel’s government stubbornly insisted that the pain of austerity was essential to economic recovery; the EU had little choice but to go along. Now the backlash has arrived.

“It does not take a prophet to predict that the latest chapter of the euro crisis will leave Germany’s austerity policy in tatters – unless Merkel really wants to take the enormous risk of letting the euro fail.
"There is no indication that she does. So, regardless of which side – the troika or the new Greek government – moves first in the coming negotiations, Greece’s election has already produced an unambiguous defeat for Merkel and her austerity-based strategy for sustaining the euro.

“Simultaneous debt reduction and structural reforms, we now know, will overextend any democratically elected government because they overtax its voters. And, without growth, there will be no structural reforms, either, however necessary they may be.

“That is Greece’s lesson for Europe. The question now is not whether the German government will accept it, but when.”

So who really holds the trump cards here?

What Is Plan B for Greece?
Kenneth Rogoff
FEB 2, 2015

Greece and EU flags

TOKYO – Financial markets have greeted the election of Greece’s new far-left government in predictable fashion. But, though the Syriza party’s victory sent Greek equities and bonds plummeting, there is little sign of contagion to other distressed countries on the eurozone periphery.
Spanish ten-year bonds, for example, are still trading at interest rates below US Treasuries.

The question is how long this relative calm will prevail.
Greece’s fire-breathing new government, it is generally assumed, will have little choice but to stick to its predecessor’s program of structural reform, perhaps in return for a modest relaxation of fiscal austerity. Nonetheless, the political, social, and economic dimensions of Syriza’s victory are too significant to be ignored. Indeed, it is impossible to rule out completely a hard Greek exit from the euro (“Grexit”), much less capital controls that effectively make a euro inside Greece worth less elsewhere.
Some eurozone policymakers seem to be confident that a Greek exit from the euro, hard or soft, will no longer pose a threat to the other periphery countries. They might be right; then again, back in 2008, US policymakers thought that the collapse of one investment house, Bear Stearns, had prepared markets for the bankruptcy of another, Lehman Brothers. We know how that turned out.
True, there have been some important policy and institutional advances since early 2010, when the Greek crisis first began to unfold. The new banking union, however imperfect, and the European Central Bank’s vow to save the euro by doing “whatever it takes,” are essential to sustaining the monetary union. Another crucial innovation has been the development of the European Stability Mechanism, which, like the International Monetary Fund, has the capacity to execute vast financial bailouts, subject to conditionality.
And yet, even with these new institutional backstops, the global financial risks of Greece’s instability remain profound. It is not hard to imagine Greece’s brash new leaders underestimating Germany’s intransigence on debt relief or renegotiation of structural-reform packages. It is also not hard to imagine Eurocrats miscalculating political dynamics in Greece.
In any scenario, most of the burden of adjustment will fall on Greece. Any profligate country that is suddenly forced to live within its means has a huge adjustment to make, even if all of its past debts are forgiven. And Greece’s profligacy was epic. In the run-up to its debt crisis in 2010, the government’s primary budget deficit (the amount by which government expenditure on goods and services exceeds revenues, excluding interest payments on its debt) was equivalent to an astonishing 10% of national income.
Once the crisis erupted and Greece lost access to new private lending, the “troika” (the IMF, the ECB, and the European Commission) provided massively subsidized long-term financing.

But even if Greece’s debt had been completely wiped out, going from a primary deficit of 10% of GDP to a balanced budget requires massive belt tightening – and, inevitably, recession.

Germans have a point when they argue that complaints about “austerity” ought to be directed at Greece’s previous governments. These governments’ excesses lifted Greek consumption far above a sustainable level; a fall to earth was unavoidable.
Nonetheless, Europe needs to be much more generous in permanently writing down debt and, even more urgently, in reducing short-term repayment flows. The first is necessary to reduce long-term uncertainty; the second is essential to facilitate near-term growth.
Let’s face it: Greece’s bind today is hardly all of its own making. (Greece’s young people – who now often take a couple of extra years to complete college, because their teachers are so often on strike – certainly did not cause it.)
First and foremost, the eurozone countries’ decision to admit Greece to the single currency in 2002 was woefully irresponsible, with French advocacy deserving much of the blame. Back then, Greece conspicuously failed to meet a plethora of basic convergence criteria, owing to its massive debt and its relative economic and political backwardness.
Second, much of the financing for Greece’s debts came from German and French banks that earned huge profits by intermediating loans from their own countries and from Asia. They poured this money into a fragile state whose fiscal credibility ultimately rested on being bailed out by other euro members.
Third, Greece’s eurozone partners wield a massive stick that is typically absent in sovereign-debt negotiations. If Greece does not accept the conditions imposed on it to maintain its membership in the single currency, it risks being thrown out of the European Union altogether.
Even after two bailout packages, it is unrealistic to expect Greek taxpayers to start making large repayments anytime soon – not with unemployment at 25% (and above 50% for young people).
Germany and other hawkish northern Europeans are right to insist that Greece adhere to its commitments on structural reform, so that economic convergence with the rest of the eurozone can occur one day. But they ought to be making even deeper concessions on debt repayments, where the overhang still creates considerable policy uncertainty for investors.
If concessions to Greece create a precedent that other countries might exploit, so be it. Sooner rather than later, other periphery countries will also need help. Greece, one hopes, will not be forced to leave the eurozone, though temporary options such as imposing capital controls may ultimately prove necessary to prevent a financial meltdown. The eurozone must continue to bend, if it is not to break.


Say Goodbye to the 'Strong Dollar Policy'

By: Michael Pento

Monday, February 2, 2015

It is absurd to believe that the inhabitants of the Eccles building in D.C. promote a strong dollar policy. Printing $3.8 trillion dollars and keeping interest rates at zero percent for going on the seventh year can hardly be confused with a hard-currency regime. Merely pretending to cheer the dollar higher appears to be the Fed's method of operation.

But since World War II every administration likes to pledge their support for a "strong dollar policy".

However, the truth is this policy has only truly been practiced in the United States on very rare occasions. The courageous Fed Head, Paul Volcker, raised interest rates to the dizzying level of 20% in order to squeeze inflation out of the economy in the early 1980's. During his tenure the intrinsic value of the dollar increased and the economy thrived. This is because, contrary to what the Keynesians who currently run our economy believe, a strong dollar is great for America; while a weaker dollar is most efficient at destroying the purchasing power of savers.

A weak currency doesn't boost GDP or balance a trade deficit--a philosophy that governments and central banks now embrace with alacrity. Take Japan, which still has a 660 billion yen trade deficit two years after Shinzo Abe unleashed his all-out assault on the yen, which is down a staggering 40% against the dollar since January 2013. This, after a 50-year average trade surplus of 382 billion yen prior to his reign. And, in its 25th month of massive currency depreciation, Japan still finds itself in an official recession.

However, despite these facts Keynesian logic favors a currency debasement derby to the bottom. This is because they maintain that a weak currency stimulates exports, boosts manufacturing and leads to lower rates of unemployment. So with the dollar rising over 15% against the Euro and the Yen since July of 2014, it is no wonder we see a renewed fear of the stronger dollar, as it plays into their number one fear of deflation. We got the first hint of this from the U.S. Treasury Sec., as he explained that the current dollar strength is more the result of yen and euro manipulations, and less about the intrinsic dollar strength. Treasury Secretary Jack Lew said this in Davos Switzerland last week:

"The strong dollar, as all my predecessors have joined me in saying, is a good thing. It's good for America. If it's the result of a strong economy, it's good for the U.S., it's good for the world.

If there are policies that are unfair, if there are interventions that are designed to gain an unfair advantage, that's a different story."

We see multi-national companies playing right into this theme. These companies are now using the strong dollar to replace last year's harsh winter as their excuse for not making the numbers.

The plethora of companies that missed earnings this season are all blaming it on currency translation--leading to the new buzz phrase of 2015...Constant Currency. Constant Currency is when last year's earnings are re-translated to this year's rates to strip out the effects of currency dynamics.

First, we have the construction and mining equipment giant Caterpillar (CAT), who reported a lower profit that came in well below expectations. This was due primarily to the recent drop in the price of oil and lower prices for copper, coal and iron ore. But of course they had to mention "The strong dollar didn't help seems like when it rains it pours, and this is one of those days." Then, of course, the Caterpillar CEO urged the Fed to hold off on any rate hikes this year.

Procter & Gamble CFO Jon Moeller told CNBC that the strong dollar was the major factor in the company's disappointing earnings report last quarter. And we heard similar stories from 3M, Pfizer, United Tech and Amazon; just to name a few.

This appears to be a legitimate excuse, until you ask yourself--is the problem that the strong dollar is hurting their earnings, or is it that they no longer have a weakening dollar making it easier to beat the estimates. After all, I didn't hear these same companies offer this excuse when the weakening dollar was helping their profitability? Currency translations work both ways.

The truth is politicians and multinationals alike enjoy a weakening dollar because they don't have to work as hard. A weak dollar allows politicians to do what they do best--spend money without having to raise taxes. And a weak currency allows multinationals to appear more profitable, as they enjoy gains when stronger currencies are translated back to a weakening dollar. After all, how many times did we hear the term Constant Currency during the 2002-2008 timeframe for example, when the dollar was plummeting in value?

Keynesians cling to the belief that a weak currency is the corner stone for building a healthy economy. But I believe this fatuous notion is a ruse that stems from the necessity to find a justifiable excuse to give central banks carte blanche to monetize debt. For without an activist central bank aggressively printing money to purchase sovereign debt, interest expenses would soon spiral out of control--a falling currency is just an ancillary side effect of supplanting the free market for government issued debt.

Therefore, it is my prediction that Yellen will not be able to raise rates and will soon have to adopt a very bearish stance towards the dollar. After all, a hawkish interest rate policy is untenable for a Fed that is now paralyzed with the fear of deflation, especially while the rest of the world is frantically printing money. Our central bank will not have the courage to allow the dollar's rise to continue. And, it is inevitable that Yellen and her comrades at the Fed will soon follow the lead of our Treasury Secretary in talking the dollar down. That may be music to the ears of multi-national corporations and our government; but will be the death knell for the middle class. 

Why U.S. Bond Yields Are Falling

by: Andrew Sachais            

Feb. 1, 2015 11:34 PM ET

  • U.S. bond yields drastically fell alongside a weak U.S. economic growth print on Friday.
  • Meanwhile, market-based inflation readings are similarly declining.
  • With both inflation and economic growth below Fed targets, U.S. government and corporate yields may continue to decline in coming months.
U.S. government and corporate bond yields continue to decline as weak economic growth and inflation measures push out expectations for a Fed Funds rate hike. Since January 2014, iShares Barclays 20+ Year Treasury Bond (NYSEARCA:TLT) is up over 36%, while iShares Core Total US Bond Market ETF (NYSEARCA:AGG) rose nearly 7%, as is seen in the chart below.

(click to enlarge)

On Friday, the U.S. economic growth figure came in below estimates, possibly giving the Federal Reserve reason to hold off on rate hikes in early 2015. In the fourth quarter, U.S. economic growth came in at an annual pace of 2.5%, below the previous quarter's reading of 2.7%. Since 2010, the economic growth figure fluctuated between 2.5% to 3%, as is seen in the chart below. This is well below the average rate of over 4% during the 1990's and early 2000's.

As economic activity has been slowed by exports because of a strong dollar, consumer spending due to tepid wage growth, and weak business investment, economic growth has failed to achieve "escape velocity" higher.

(click to enlarge)
Data provided by the Federal Reserve

Meanwhile, as energy prices fell and wages remain suppressed, market-based inflation expectations have broadly declined. The chart below is of iShares Barclays TIPS Bond (NYSEARCA:TIP) over iShares Barclays 7-10 Year Treasury (NYSEARCA:IEF). This indicator represents inflation expectations of investors, moving higher when inflation expectations rise.

Since July, the indicator has fallen over 6% to levels not seen since the financial crisis, signaling demand for hedging against future inflation with TIPS is low. Until oil prices find a bottom, and real labor wages begin to significantly move higher, investors are unlikely to fear inflation.

(click to enlarge)
Data provided by Trading View

Lastly, with both inflation and economic growth readings below Fed policymakers' desired targets, the U.S. lending rate will likely remain at current levels. Since 2009, the Fed's benchmark lending rate has been at 0.25%, as is seen in the chart below. During the Fed's January meeting, policymakers stated they liked the positive momentum economic data, but remained "patient" on changing policy until more recovery was under way. Below is an excerpt from the Fed's press release:
"The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate. The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. 
Inflation is anticipated to decline further in the near term, but the Committee expects inflation to rise gradually toward 2% over the medium term as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate. The Committee continues to monitor inflation developments closely. 
Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. However, if incoming information indicates faster progress toward the Committee's employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated," according to Trading Economics.

With both inflation and economic activity improving, albeit at a slower than anticipated pace, the Fed remains "patient" in tightening policy, avoiding potentially pushing the economy into another recession. The weak growth figure on Friday, and the steady decline in energy prices, investors are pushing out the expected time table of an increase in the Fed's benchmark lending rate. With expectations being pushed out, investors continue to buy bonds, which should lead to even lower U.S. government and corporate yields in coming months.

(click to enlarge)

Data provided by Trading Economics

02/02/2015 01:51 PM


It's Time To Compromise on Greece

By Dirk Kurbjuweit

Syriza supporters at a rally just before the leftist party won Greek elections a week ago. Getty Images

Syriza supporters at a rally just before the leftist party won Greek elections a week ago.

Syriza's victory in Greece makes it clearer than ever that a new approach is needed in Europe. Chancellor Merkel, in particular, must show flexibility in the search for compromise with Greek Prime Minister Tsipras. If they can't agree, Europe is in trouble.

Angela Merkel, it is often said, has a terrific feel for her people. That's why she is revered by German voters and that's why she wins elections. But what is true in Germany does not apply in Greece. The victory of Alexis Tsipras in elections one week ago is also a defeat for the German chancellor. The Greeks have elected a radical government in order to free themselves from German pressure.

Merkel, of course, could simply say that she's not responsible for the Greek people. German interests are her top priority: keeping the currency strong and ensuring that Berlin's coffers don't take a hit. But that's old thinking, nation-state thinking. Merkel herself played a role in the renationalization of politics in Europe. She thought she could get by without paying too much regard to sentiment in Greece. Now, though, the Greek people are out to settle a score.

The fact is that there is a political union in Europe, even if it lacks strong institutions. It is a union being created by the people. And now that the Greek people have chosen Tsipras as their leader, everyone has a problem. And it is a problem to which Merkel, first and foremost, must find a solution.

A Legitimate Government

It does no good to chastise the Greeks for this election. Tsipras may be shrill -- and of course the xenophobia and anti-Semitism of his coalition partner Panos Kammenos is detestable -- but both now comprise Greece's legitimate government. Other EU member states will have to learn to deal with them.

It also does no good to continue saying that the Greeks weren't economically mature enough for the euro, that the Germans have showed their solidarity in the form of bailouts and that the Greeks should have made a greater effort to overcome the financial crisis in their own country.

That's all correct, but it doesn't help so long as most Greeks see things differently. And they do. Sometimes public sentiment has a greater influence on politics than do facts.

Policies that at first seemed correct are proven wrong if they make the situation worse rather than better. And with Tsipras' election, the situation in Europe has deteriorated dramatically. Politicians across Europe will now need to take steps to improve it. Before that can happen, they will need to define their goals and strategies.

Flirting with Moscow and Beijing

If the situation escalates and Greece exits the euro, two major dangers lurk. One is that Tsipras will secure the money his country needs from Russia or China and he has already hinted at such a direction. Should he? The answer is no, because those who become financially dependent on Russia or China could soon become stooges of an authoritarian state. Even if Greece were to leave the euro zone, it would still remain a member of the EU, meaning Putin or Xi Jinping would then have a voice in Europe and in NATO. His opposition to further sanctions against Russia shows that Tsipras has no scruples on the issue.

The other danger is that Europe will become a laughing stock in the international community.

In parts of Asia and in the United States, there is greater economic growth than on the old continent. Europe can only win respect through its unity. Other countries eye the fight to save the euro as spectators who are not always well meaning. If Greece were to exit the common currency area, it would be perceived as a failure, especially for Merkel. A continent that is led poorly doesn't need to be taken particularly seriously by others.

That's why there need to be two goals -- for Greece to remain part of the euro zone and for the common currency to remain stable, as difficult as it might be to reconcile the two. The situation is difficult and there's no room in the debate right now for political know-it-alls. It is time for realpolitik, for small steps.

Solidarity Is the Right Course

This means that Germany must display forbearance. Germans have been forgiven for so much in their own history that they should also be capable of forgiving others. Despite mistakes made by the Greeks, solidarity remains the correct course. That's not to suggest that the Tsipras administration can ignore the treaties Greece has with the EU. Nor should there be a debt haircut, because Spain and Portugal would demand equal treatment and that would place an unbearable strain on the euro zone.

However, deferments and interest rate discounts are possible. No one should be too proud to talk about the possibility of concessions.

If Tsipras has an ounce of political understanding, then he knows that he can't demand too much from Merkel because she's obviously still accountable to German voters. And because the right-wing Alternative for Germany (AfD) party is waiting in the wings. Nothing would be worse than increasing the power of populists. If that is what Tsipras wants, then Europe has no chance.

Exactly 200 years ago, Europe's rulers succeeded at the Vienna Congress in balancing their interests, creating a halfway stable situation that lasted for decades, even though the temptation was great at the time to solve problems with weapons. The situation is much easier for European democrats today. Now they must show that they understand the concepts of diplomacy and compromise.

February 2, 2015, 11:35 AM ET

The U.S. Economy Will Soon See Its Best Years in a Decade, Forecasters Say

By Josh Zumbrun

The White House, Congressional Budget Office and Federal Reserve unanimously see the nation on the cusp of the best years for the economy in a decade or more.

In its latest round of economic forecasts, released Monday with the president’s budget, the White House sees the unemployment rate falling below 5% by the end of 2016, the lowest since before the recession. The White House sees growth of 3% this year and in 2016–the best back-to-back years since 2004 and 2005.

“The U.S. economy has substantial room for growth, although there are factors that could continue to limit that growth in the year ahead,” the White House report said. On the positive side, the report noted declining unemployment, support from Federal Reserve policy, and pent-up demand as consumers regain confidence after nearly seven years of economic doldrums. On the negative side, the report sees lingering effects of the credit crisis and continued weakness in European and Asian economies.

The White House’s economic projections have, at times, been too optimistic. In President Barack Obama’s first budget, for example, the White House projected much lower unemployment than private economic forecasters and the CBO. Forecasters and the CBO thought unemployment would still climb; the White House saw it declining. With hindsight, the administration was also much more optimistic than what actually followed, when unemployment climbed to 10%.

Yet in recent years, the White House forecasts have sometimes erred on the side of too much pessimism, particularly for the unemployment rate. Last year, the White House projected unemployment would average 6.9% in 2014. Instead unemployment averaged 6.2%, and ended the year at 5.6%.

Now the White House, CBO and Fed all see growth strengthening in coming years, and all see unemployment declining.

Their optimism in part reflects the economy’s steady momentum in recent years. Despite international turmoil, fierce budget battles and lingering scars from the financial crisis, the unemployment rate has steadily declined for more than five years. Economic growth has been both disappointingly slow but persistent.

The White House sees growth of 3% over 2015 from the fourth quarter of 2014 to the end of 2015. That compares with 2.9% for the CBO and forecasts between 2.6% to 3% for most Fed policy makers. By 2017, the White House sees 4.9% unemployment–better than the CBO’s forecast of 5.3%–but in line with Fed forecasts of between 4.9% and 5.3%.

One factor behind the White House’s upbeat outlook is the easing of the fiscal battles that defined so much of Mr. Obama’s first term. The budget deficit in 2014 was the smallest of Mr. Obama’s presidency and the White House now projects that budget cutting will not be an economic drag in the years ahead.

The White House’s economic forecast assumes that the president’s budget is enacted in full; an assumption that generally doesn’t work out. The policies hoped for in the budget this year include higher taxes on capital gains, comprehensive immigration reform, and an expansive package of infrastructure investment.

Two Ships Pass in the Night

By: Erik Swarts

Sat, Jan 31, 2015

Ships that pass in the night, and speak each other in passing, only a signal shown, and a distant voice in the darkness; So on the ocean of life, we pass and speak one another, only a look and a voice, then darkness again and a silence.

- Longfellow

For just the fourth time in the last fifty years, the S&P 500 yields more than 10-year Treasuries.

If one was to mine the data, in the three previous occasions where this had occurred, equities rallied sharply over the short-term and strongly performed over the next year - quickly closing the aberration that represented a particular extreme between these two markets.

  • June 1962: +14% 06/27/62 - 08/22/62 (1-year performance + 32%)
  • November 2008: +24% 11/20/08 - 01/06/09 (1-year performance +35%)
  • August 2011: +9% 08/09/11 - 08/31/11 52 (1-year performance +25%)
That said, we would strongly caution anyone looking for similar returns or bolstering their respective equity biases with this fourth occurrence. From our perspective, the fourth time may be the charm as these two massive trends pass quietly in the night, ending an epoch that first set sail in 1959 as Treasury yields began their long and steep journey to a secular peak in 1981.

S&P500 Dividend Yield versus 10-Year Yield

While the Trend-Trading-To-Win and passive investor zen masters might view current market conditions as testament to equity strategies that should continue to outperform, you only need to look at a long-term chart of both metrics to realize, the times they are a changin' - or historically speaking, perhaps sliding back to a market relationship that stood for nearly a century before 1959. To boot, when one considers the equity market drawdowns of the previous three occasions that elicited such condition, the current "downturn" appears more coincidental of juxtaposition - than actionable of signaling a market extreme in equities.

SPX weekly Charts, 1962, 2008, 201 and 2015

Overall, we view binary "signals" such as this as representative of market conditions that should not be compared to contemporary parallels for insights, such as Fed tightening cycles or recession and equity market impressions from an inverted yield curve. What they all have in common is probabilities and expectations entrenched over the past fifty years where yields were not exceptionally low and the Fed was not enacting or normalizing unconventional and extraordinary policy.

From a historical perspective of the equity and Treasury markets, we still view the closest parallel as the trough of the long-term yield cycle in the 1940's, where the Fed began to normalize policy after extraordinary support was extended to the markets with significant Treasury purchases by the Fed between 1942 and 1946. Our expectations remain that the U.S. equity markets will continue to come under pressure and normalize with policy (QE free), which should recalibrate risk and valuations as the Fed evaluates market conditions in its wake. Moreover, for those looking for guideposts in the road with the Fed allowing or telegraphing when their balance sheet will passively runoff, you'll notice that in the mid 1940's the equity markets revalued swiftly shortly after the Fed's balance sheet peaked - but before it started to decline. We suspect a similar dynamic this time around, which would likely further push back even a ceremonial rate hike by the Fed that some see occurring this year.

The Hand of the Fed

While 10-year yields have made their way back to where we expected they would last January - and we suspect they are currently completing the end of that move; from a relative performance perspective we would still favor long-term Treasuries relative to the S&P 500 this year, as these two ships pass, signaling one last time in the darkness.

CAPE versus 10-Year Yield Chart

Review & Outlook

Putin’s Ruble Gamble

The Kremlin cuts rates despite currency and inflation risks.

Feb. 1, 2015 6:26 p.m. ET

   Photo: Getty Images

The Russian Central Bank’s surprise decision Friday to cut the policy interest rate to 15% from 17% shows that low oil prices and Western sanctions continue to inflict severe pain on the Russian economy. The cut comes only a month after December’s 6.5 percentage-point increase, but the problems that prompted a string of hikes, from 5.5% a year ago, haven’t abated.

The crisis was precipitated by the plummeting price of oil, on which the commodity-dependent Russian economy depends. American and European sanctions restricting Russians’ access to foreign exchange compound the pressure. The ruble has lost more than half its value against the dollar over the past year, and it slid further immediately after Friday’s announcement.

The central bank claims recent inflation will prove temporary and that financial markets have now stabilized, meaning Russia can afford the risks of a rate cut. We’ll see about that. Inflation rose to 13.1% year-on-year in January from 11.4% in December, and preliminary data released Friday pegged growth in 2014 at 0.6%, down from 1.3% in 2013.

More fundamentally, the Kremlin’s cronyism and corruption have already made the Russian economy a no-go zone. Standard & Poor’s acknowledged what everyone already knew when it downgraded Moscow’s debt to junk last week, and the other two main credit agencies peg it at barely investment grade. More than $150 billion left Russia last year, double the total for 2013.

Capital Economics estimates the bad-loan ratio could increase to as high as 12.5% of total loans from 6.6% today. Were that to happen, banks might require a capital injection of up to $35.6 billion, a sum equal to 5% of GDP, to meet regulatory capital levels. This would come after the falling oil price already deprived the Kremlin of some $180 billion in revenue.

The central bank’s rate cut suggests that Vladimir Putin is desperate to maintain the semblance of a growing economy, whatever the currency and inflation risks. That’s a major gamble—and an opportunity for the West if it will tighten sanctions while Russia continues to press its offensive in Ukraine. Geopolitical gifts don’t often fall into the laps of Western leaders, especially when dealing with ambitious autocrats. This is one to seize.

The Grand Strategy of Xi Jinping
Yoon Young-kwan
JAN 30, 2015

SEOUL – China spent much of 2014 seeking to revive a concept that Japan proclaimed seven decades ago, when it was an imperial power seeking to impose its will on the region: “Asia for the Asians.” But that effort may not end as badly for China as it did for Japan.
International relations tend to become destabilized by rapid changes in the distribution of power. Established powers’ resistance to their rising counterparts’ demands for a larger role in setting the global agenda fuel tensions and disrupt the existing world order.
That is precisely what has been occurring lately between China and the United States, and is the impetus for China’s “Asia for the Asians” policy. In November 2013, China shook the regional order by unilaterally declaring an air-defense identification zone (ADIZ) over a large swath of the East China Sea that includes disputed territory – notably the Senkaku Islands (known in Chinese as the Diaoyu Islands) that are claimed by China, Japan, and Taiwan.
This amounted to an escalation of China’s already assertive stance in the region, with Chinese President Xi Jinping routinely sending maritime-surveillance and fishery law-enforcement ships to the waters surrounding the islands, spurring protests in South Korea and Japan. The US, prompted by its allies’ anger, dispatched two B-52 bombers into the ADIZ.
Tensions continued to mount through early 2014, raising concerns about an “accidental war” between China and Japan, which would demand the involvement of Japan’s main ally, the US (as President Barack Obama confirmed on a visit to Tokyo last April). Add to that simultaneous tensions over China’s claims to South China Sea islands and atolls – claims disputed by the Philippines and Vietnam – and a clash between China and the US was beginning to seem inevitable.
Before long, however, the US had to turn its attention to Russia, which under President Vladimir Putin’s leadership has been seeking to recapture the Cold War-era Soviet Union’s geopolitical status.
With its regional authority apparently threatened by rising pro-European sentiment in Ukraine, Russia invaded and annexed Crimea and began supporting separatist rebels in eastern Ukraine, prompting the US and Europe to impose increasingly tough political and economic sanctions.
In this conflict, China has actually become something of a US ally. Though the conclusion of long-negotiated gas deals between Russia and China may seem to reflect a deepening of the bilateral relationship, China extracted an exceedingly low price from Russia for the gas that it will receive.
This, together with the fact that China has cut lending to Russia since the Crimea invasion, suggests that, in the longer term, the Chinese envision Russia as a natural-resource vassal, not an equal ally.
Chinese and American policies converged even more clearly on North Korea in 2014. Xi expressed his unwillingness to tolerate any unruly behavior – particularly concerning nuclear weapons – by the country’s unpredictable rulers. This drove the North, which depends on Chinese aid, to send diplomatic interlocutors to Japan, Russia, and even South Korea. But, following the United Nations General Assembly’s resolution on North Korea’s human-rights situation, the regime announced that it would hold its fourth nuclear test.
These power shifts are the result less of Russia’s expansionist ambitions or China’s military and economic rise than of America’s declining international leadership. With Obama unwilling – or unable, due to rising political partisanship at home – to take the lead in addressing crises like those in Egypt, Libya, and Syria, challengers to American primacy took heart in 2014, and US allies took fright. Global power must be allocated somewhere; if the US would not fill its leading role on the international stage, an understudy would have to step in.
But China’s recent shift away from muscle-flexing, and its confluence of interests with a US-led order, offers hope that it will not fuel large-scale regional instability this year. Indeed, China withdrew its jumbo oil platform from the waters of the disputed Paracel Islands last July, and it has been sending surveillance ships to the Senkaku Islands less frequently. Chinese officials have also become more willing to discuss the creation of a code of conduct for the South China Sea.
The most important element of China’s charm offensive is its effort to improve relations with Japan, initiated at a meeting between Xi and Japan’s Prime Minister Shinzo Abe on the sidelines of the recent APEC meeting in Beijing. The long-awaited climate deal that Xi struck with Obama at another peripheral meeting at the same event is no small step, either.
China’s new, more emollient diplomacy underpins a nuanced foreign policy. By offering generous economic incentives to its Southeast Asian neighbors, it has weakened their will to confront China in a coalition. Vietnam, for example, decided to “reset” its relations with China, and not to cooperate with the Philippines in waging a legal battle over China’s maritime claims.
Indeed, China has been shifting from hard power to soft throughout the region, and is using its economic power to challenge Western-dominated multilateral institutions. Specifically, China has decided to pour huge amounts of money into establishing new development institutions: the Asian Infrastructure Investment Bank, the Maritime Silk Road Bank, and the New Development Bank (created by the five major emerging economies, Brazil, Russia, India, China, and South Africa). Furthermore, Chinese Premier Li Keqiang recently offered $20 billion to finance infrastructure and development projects in the ASEAN countries.
With the US economy yet to recover fully from the global economic crisis, and American politics increasingly dysfunctional, there is a global power vacuum that China, with shrewd diplomacy and economic might, hopes to fill – beginning in Asia. This may not yet mean Asia for only the Asians; but it could mean a reduced regional role for the US – especially as America turns inward during the presidential election season that starts this year.