June 18, 2015 4:10 pm

A bloated US Federal Reserve prepares to shape up

Gillian Tett

The balance sheet should shrink to a more normal size after seven or eight years

Amid another wave of feverish speculation about US interest rates Janet Yellen, chairwoman of the US Federal Reserve, confirmed on Wednesday what most observers suspected: US central bank will not raise the crucial Federal funds rate this month.
But she also suggested that the Fed hopes to act soon, possibly as early as September (assuming, that is, that events in Greece do not create a wider crisis). Little wonder, then, that market traders are now braced for a sticky summer; the Fed has not raised rates for almost a decade.
As investors watch the calendar, they should not lose sight of something else: namely that rate rises are not the only hot issue on the Fed’s agenda right now. Far from it. Behind the scenes, a second argument is under way about how the Fed will unwind the extraordinary technical experiments it has launched since 2008. And, while this second discussion may not appear as thrilling as the speculation about dates, it too could end up being crucial.
There are at least two important issues at stake. The first is the question of what the Fed plans to do with the assets sitting on its balance sheet. Until the onset of the 2008 financial crisis, these totalled about $1tn, mostly in the form of government bonds. The balance sheet has since increased to more than $4tn.
The Fed has indicated that it plans to shrink that bloated balance sheet to a more normal size within a decade. And, when the US central bank does so, it could use this process as a second tactic to raise rates, alongside the usual rise in the Fed funds rate.

After all, if it were to sell the bonds it holds, this would cause prices to fall — and yields to rise (in effect reversing what happened during quantitative easing).
However, Fed officials seem divided on whether this would be a good idea. Most of those at senior level seem very wary of taking this second route since the realm of activist balance sheet management sits in something of an intellectual vacuum.

This is because, although extensive research has been conducted on the link between the Fed funds rate and the real economy, nobody quite knows what might happen if the central bank tried to raise rates by selling assets. So, rather than spook the markets by taking a potentially unpredictable step, most Fed officials would prefer to shrink the balance sheet “naturally”, by letting the bonds mature without replacing them.
But the problem is that these assets will not expire smoothly. The Fed’s models suggest that the balance sheet should shrink to a more normal size after seven or eight years. But the projected pattern of decline is jagged; a third of the Treasuries mature in 2018. So one question now subject to fierce debate is whether the Fed will be forced to embrace balance sheet activism just to avoid market shocks.
The second, related, issue is what happens to the funds that private banks have parked as spare reserves at the central bank in recent years. In the five years before the 2008 crisis, these “reserves” were tiny, just $11bn on average each day, partly because the Fed did not pay interest to banks.
But by 2014 the reserve balance had risen to $2.6tn and the Fed pays 25 basis points of interest.

This has in effect introduced what central bankers call a “corridor” policy system: instead of the system revolving around just one rate (that is, the Fed funds), there is now a second rate too. This pattern is not unusual: central banks in places such as the UK or Canada have used a corridor approach for many years. But the Fed has never attempted this before, and officials are still trying to work out the implications.
Currency investors were looking for signs of lift-off in interest rates this week, but Fed chair Janet Yellen wants the US central bank to tread very carefully. Roger Blitz, FT currencies correspondent, spoke to Stephanie Flanders, chief market strategist for Europe at JPMorgan Asset Management, about the Fed’s message.

Take the issue of so-called “reverse repurchase agreements”. The Fed recently introduced this tool in the hope of finding innovative ways to shrink the balance sheet. But though some Fed officials think it will help ease the transition, others fear it will undermine the money market fund sector if a wider market panic erupts (with, say, Greece), and do not want to expand it in any way.
Either way, as the debates bubble on, the one thing that is clear is that these seemingly arcane details about financial plumbing can matter deeply. So it is no surprise that Ms Yellen stressed on Wednesday that, if you want to understand monetary policy now, you have to take a long-term view.

When future historians write the story of finance in this decade, the current feverish debate about whether rates rise in September or December may appear a mere footnote in the great battle to make the Fed more “normal” again.

Greece and the euro

Down but not yet out

The costs of Grexit still outweigh the benefits for both Greece and the euro área

Jun 20th 2015

SINCE the euro crisis erupted five years ago, the possibility of “Grexit” has been a recurring nightmare. It is looming again, as large as it did in 2012, when Greece was ultimately kept in the fold by a second big bail-out from the IMF and other euro-zone governments. Negotiations over the release of the remaining rescue funds have virtually broken down, as a new Greek government dominated by the radical-left Syriza party continues to balk at the reforms its creditors are demanding. The chances of a deal when euro-zone finance ministers met on June 18th (after The Economist had gone to press) looked slim. Yet Grexit looks no better an option now than it did three years ago.

The Greek population overwhelmingly wants to stay in the euro and the government led by Alexis Tsipras says it does too. This is understandable, since leaving the monetary union would be a bloody business rather than a surgical operation—or so the IMF predicted in 2012. The reintroduction of the drachma would entail the forcible conversion of all domestic assets and liabilities to the new currency, which would immediately plunge by 50% against the euro, the IMF estimated, gutting bank deposits and other savings. As the drachma fell, pushing up import prices, inflation would surge to 35%, it reckoned, while the toll on GDP would be a decline of around 8%. Even the smallest of transactions would become difficult, it pointed out: after the short-lived Czech-Slovak monetary union broke up in 1993 it took six months to introduce new banknotes.

Is the likely outcome still as grim? Unlike the situation in 2012, advocates of Grexit point out, the euro area’s economy is growing, which should help it withstand the turmoil Grexit would bring.

Before this year’s setbacks Greece was running both a primary budget surplus (ie, before interest payments) and a current-account surplus, enabling it to cope without new loans. The default on foreign debts that would precipitate Grexit (or would become unavoidable since the burden of the euro-denominated liabilities would soar in devalued drachma terms) could also be seen as an advantage, resolving once and for all the seemingly oppressive burden of public debt, which is now close to 180% of GDP. Once the initial shock had been absorbed, Greece could benefit from the boost to competitiveness devaluation would bring.

This scenario, however, underestimates the damage Grexit would do to the Greek economy.

Confidence would be shattered in the long term as well as the short, since Greece would struggle to regain any semblance of trust. There would be endless wrangles with the IMF and other euro-zone governments, which would be nursing big losses on their loans to Greece. That would unsettle private investors, who would also worry that without pressure from official creditors, the Greek government would revert to the bad policies and poor governance that lie at the root of the country’s misfortunes.

The relief achieved through defaulting on government debt would be minimal. Even though public debt is high as a share of GDP, the interest that Greece is paying is very low, at 3% of GDP this year, helped by a deferral of payments on most of its loans from the euro zone’s rescue fund until 2022. In all its borrowing from European creditors, Greece is already benefiting from debt relief in the form both of maturity extensions (some loans stretch out until the 2050s) and ultra-low interest rates.

Indeed if Greece left the euro it could find itself paying more interest on its debt, even though its remaining loans would have become far smaller as a share of GDP.

A cheaper currency would boost exports and tourism, but the benefits could easily be frittered away in higher inflation, especially as the central bank would be unlikely to enjoy genuine independence. In any case, Greece no longer needs to enhance its competitiveness with a devaluation since it has already achieved an “internal devaluation” through a sharp fall in wages. What is more, because exports make up an unusually small share of the economy, the gain from a devaluation would be limited.

Grexit would still be troubling for the rest of the euro area too. The direct cost to euro-zone governments of a Greek default would be higher than in 2012, because they have since lent the country more money. Arguably, this would simply be recognising reality and would at least stop them throwing good money after bad. However, they could well find themselves having to provide large amounts of aid to Greece, if Grexit led to a humanitarian disaster.

A particular worry in 2012 was that Grexit would unleash a domino effect whereby panic in the bond markets pushed one country after another into default. This scenario, which has informed the Greek government’s bargaining strategy, is now less convincing. Although the difference in yield between safe German Bunds and the bonds of other vulnerable countries in southern Europe has recently widened slightly, this year’s Greek drama has largely been confined to Greece (see chart). It helps that just days before the Greek election in January, the European Central Bank (ECB) announced a programme of quantitative easing, which involves buying lots of euro-zone government debt.

Moreover, the European Court of Justice affirmed this week the ECB’s (unused) policy of throwing a lifeline to governments under siege in the markets through unlimited purchases of their bonds.

 That has prompted some to argue that removing the perpetual troublemaker would make the euro zone stronger. By demonstrating that those who do not abide by the rules can be shown the door, the theory runs, Grexit would spur fiscal prudence and structural reform among the remaining members. In contrast, if Mr Tsipras faced down Greece’s creditors, anti-austerity movements such as Podemos in Spain would take heart.

The euro area may therefore seem to have good reason to countenance the upheaval of Grexit, but it would still be a risky move. Crucially, it would debunk the idea that membership of the euro was irrevocable. That would turn the single-currency club into just another fixed-exchange-rate system that might be vulnerable to speculative attack.

On balance, then, the costs of Grexit still outweigh the benefits for the euro area as well as Greece. There are sound economic grounds for both sides to compromise and strike a deal.

Whether strident politics in Greece and the creditor countries will allow that to happen remains an open—and pressing—question.

06/19/2015 10:46 AM

The New Kingdom

Saudi Arabia's Contradictory Transformation

By Bernhard Zand

During his reign, King Salman Bin Abdulaziz Al Saud has created a new leadership role for Saudi Arabia. But his changes are filled with contradictions -- and may only make the region more unstable.

This article is the first in a two-part series about the state and future of the most influential country in the Middle East. Check back next week for part two.

Saudi Arabia's rulers don't attach great importance to being called "king." There are many kings in the world. The Saudi rulers prefer to call themselves the "Custodians of the Two Holy Mosques," a reference to Mecca and Medina. It sounds modest, but it denotes a claim to power that extends well beyond the kingdom.

Mecca and Medina are the two holiest places for Muslims, where people from all continents come together, from Bosnia to North America, Nigeria to Malaysia. In 2010, 12 million people attended the large and small pilgrimages, and the numbers are predicted to rise to 20 million soon. This means that the Grand Mosque requires constant expansion.

The footprint, which is already big enough to accommodate St. Peter's Basilica several times over, is now being more than doubled in size. Entire mountains are being removed to expand a building symbolizing the glory of Islam - and of the House of Saud. The new wing is named after the deceased King Abdullah and its next extension, already in the planning stages, will bear the name of his successor, Salman Bin Abdulaziz Al Saud.

The new king has been in office for less than half a year. Given the enthusiasm he brings to his work, he seems to want to go down in history as one of the greatest kings since Saladin. It was he, the first "Custodian of the Holy Mosques," who united Muslims in the 12th century, drove out the Crusaders and captured Jerusalem.

In less than five months, Salman has realigned his kingdom -- and laid claim to a leadership role in the Middle East. Traditionally, Saudi kings have concealed their power instead of displaying it. They used their oil wealth to support friendly groups and regimes, and they created a network of preachers who spread their radical version of Islam around the world.

Now the once secretive realm acts without restraint. In Egypt, it provides financial support to the generals who have once again seized power. It fosters armed groups in Libya, Syria and Iraq. In Yemen, the kingdom has begun a war against the Huthi militias allied with its rival, Iran. No one, perhaps not even Israel, fears Iranian hegemony in the Middle East more than Saudi Arabia.

Riyadh's role in the Arab world is similar to Berlin's in Europe -- but unlike German Chancellor Angela Merkel, the king has few hesitations. Apart from its size, wealth and ambition, one wonders, can Saudi Arabia fulfill its new king's expectations?
It remains unclear whether this leadership has a vision for bringing peace to the Middle East and whether it can transform a country that is dependent on oil exports into a modern economy. It is also remains to be seen whether it can liberalize its archaic system of rulership and break the power of its religious leaders.

The New Generation

Before becoming king, Salman Bin Abdulaziz spent 50 years as the governor of Riyadh, and then became the country's defense minister. He didn't even wait until the burial of his predecessor, Abdullah, to start transforming the kingdom. On the evening of Jan. 23, his first as king, he dismissed influential members of Abdullah's staff, and within weeks he had replaced several cabinet ministers.

Three and a half months later, he rearranged the line of succession.

In doing so Salman who, at 79, is not much younger than his predecessor, sickly and, as visitors report, "often digressing," initiated a long-awaited generational change in Saudi Arabia. More than two-thirds of the population is younger than 30. King Abdullah was 90 when he died, and the average age in his cabinet was 65.

All Saudi rulers since 1953 have been sons of the founding king, Abdulaziz, known as Ibn Saud.

Salman will be the last of these sons to rule the country, and his successor will be the first grandson. Salman dismissed his half-brother Muqrin as crown prince and replaced him with his nephew, Muhammad bin Nayef, 55. Both men are members of the influential Sudairi branch of the family, descendants of Ibn Saud and his favorite wife, Hassa bint Sudairi. The new crown prince was educated in the United States and is considered an energetic interior minister.

But Salman's most spectacular decision was to designate his son Mohammed as the second crown prince. The prince, who is about 30, is known to be quick-tempered and impulsive, but he apparently accepts the authority of his cousin, the first crown prince. Unlike the first crown prince, Mohammed bin Salman did not study in the West. He prefers Japan, where he spent his honeymoon. When he visited the United States a few weeks ago, President Barack Obama described him as "extremely knowledgeable" and "wise beyond his years." The Saudi Arabian press, which had been touting the king's son as a savior for months, was grateful for the Obama quotes.

The amount of power concentrated in the hands of the crown prince is unparalleled in the kingdom's history. As chief of staff, he controls access to the king. He heads the Council for Political and Security Affairs, and he also runs the state-owned oil company, Saudi Aramco, and the government investment fund.

In addition to these functions, the young crown prince is defense minister and, as such, has directed the Saudi Air Force bombardment of Huthi militia positions in Yemen for the last two-and-a-half months. The country has participated in military operations in the past -- as a US ally in the 1991 Gulf War, and as an ally of Egypt, Jordan and Syria in the 1967 Six-Day War -- but now the kingdom has forged its own alliance and initiated a war.

A Sniper Waits

The border with Yemen passes through the mountains in the far south of the kingdom, an hour's drive inland from the port city of Jizan. Abu Ubaid, a sniper, has been stationed at the Musharak outpost there since early April. He looks through his scope at a hillside covered with bushes, on the far side of the border. Sometimes a herd of goats passes through his field of vision, sometimes a goatherd follows behind, and sometimes he spots a pickup truck on the horizon. Then he sends a report to his post commandant, who passes it on to the air force. Abu Ubaid has not fired a single bullet yet in this war. "But I wouldn't hesitate a second to do so," he says.

The Saudi-led coalition began its air strikes on Yemen in late March. Its goal is to stop the rebellion by Huthi militias and force the quarreling factions to the negotiating table. It has been somewhat successful, in that some of the hostile factions are now scheduled to meet in Geneva for initial talks.

Still, in the 10 weeks since the bombing began, 2,000 civilians have been killed, entire blocks in the capital Sana'a have been destroyed and more than half a million people are now displaced.

The Huthis, however, have not been significantly weakened. In fact, last week rebels from Yemen even attacked army posts on the border and killed four soldiers, not far from the place where Abu Ubaid is stationed.

"Nevertheless, this campaign is the right thing to do," says Jamal Khashoggi, a journalist and one of the country's leading intellectuals. "The Yemen operation shows that we can lead and form alliances."

Khashoggi lives in Jeddah, the Red Sea port city that, with its freeways, skyscrapers and shopping malls, resembles Los Angeles more than the austere, conservative desert city of Riyadh. In the capital, women wear black abayas and family life revolves around the home and the mosque. Jeddah, on the other hand, has beach clubs and hip-hop music booming from cars driving along the waterfront promenade. Jeddah is hungry for life -- it is creative and its residents consider themselves more modern and cosmopolitan than their fellow Saudi Arabians in Riyadh. But they still don't get to question their king's claim to leadership.

Riyadh has neglected its responsibility in the Middle East for too long, says Khashoggi. "All we have done is complain when something went wrong. After the eruption of the Arab Spring, we thought that someone else would reestablish the old order for us." But now, he adds, the United States is withdrawing from the region and Iran is causing trouble from Lebanon to Bahrain, and from Syria to Yemen. This is why a new regional force is needed to keep order, says Khashoggi. "We are the ones who need to fix this broken Middle East."

In a much-noticed essay, he condensed his thoughts into a catchy formula: the Salman doctrine.

Khashoggi argues that the kingdom, lead by an energetic new head of state, is putting an end to the age of Arab mawkishness, realigning the region and, most of all, pushing back against Shiite Iran.

The war in Yemen, he says, is the first application of the Salman doctrine.

Years ago, Khashoggi proposed forming an alliance with Turkey to put an end to the civil war in Syria. "They laughed at me at the time, calling me 'General Khashoggi.' One person asked me whether we intended to liberate Palestine on the way home. No one is laughing today."

Under Salman, a similar alliance has just become a reality.

Khashoggi can't describe Saudi Arabia's strategic goal as a peacekeeping power -- or what this realigned Middle East should look like. It is clear, however, that Riyadh's rift with Tehran is deeper than ever. The kingdom may have consolidated its influence among the exclusively Sunni members of its military alliance, but its conflict with Iran has been exacerbated by the war in Yemen and it has deepened the religious divides running through the Middle East. This poses a problem for the rest of the world -- as long as Sunnis and Shiites, and their preeminent leaders in Saudi Arabia and Iran, are not talking to each other, there will be no peace.

As long as the Arab world remains one of the most backward regionsof the world, it will fail to emerge from its deep crisis. For that to happen, the sharp contrast between extreme wealth in the Gulf States and poverty in Africa will have to recede, along with the hopelessness in large portions of the Levant and the humanitarian disaster in Yemen and Syria.

So far, Saudi Arabia, which has a higher per-capita income than many European countries, had little reason to think about its economic model. Its leadership was not swept away by the Arab Spring, nor was it even challenged, like the regimes in neighboring Bahrain and Oman.

This was mostly because Saudi Arabia's rulers have distributed wealth across the country with patriarchal skill. The unspoken arrangement was that money bought obedience.

But this social contract has long been approaching its limits. The population, about 30 million today, is growing rapidly and could reach 45 million by 2050. At the same time, the price of oil has dropped from $140 (€124) to $60 a barrel in the last seven years. Shale oil is now being produced in North America, and Iran could return to the international oil market, making a sustainable increase in prices unlikely. Riyadh needs an oil price of about $100 to maintain a balanced budget.

The Future of Oil

The oil ministry is housed in an unassuming building in Riyadh, a utilitarian high-rise with a façade that emulates the pointed arches of Islamic sacred buildings. If the elevator shafts in the interior hadn't been made to resemble drilling rigs and the elevators to look like oil barrels, the building could just as well house a bank or a hospital.

Ibrahim Al-Muhanna, a close adviser to Oil Minister Ali Al-Naimi, occupies a large corner office. Unlike the minister, whose every word could affect billions of dollars on the commodity markets, Muhanna can speak more freely. Given that oil has always been a key element of Saudi policy, he is very knowledgeable about where the country is headed.

"The Americans are pulling out of the Middle East. If they leave behind a vacuum in the region, someone else will fill it," says Muhanna. Three countries could do that, he explains: Turkey, Iran or Saudi Arabia. The kingdom is the strongest of the three at the moment, he adds, because it has the largest number of allies.

Muhanna, in his mid-60s, has experienced so many wars and crises that he seems to be unfazed by the chaos in Syria, the disintegration of Iraq and Egypt's decline. His worldview has not changed, he says: Saudi Arabia will remain stable no matter how deeply the Middle East plunges into chaos. "We have been supplying the world with oil for the last 60 years. Europe's demand is declining and America has discovered its shale oil reserves, but our markets in China, India and Indonesia are growing." Saudi Arabia exports three-quarters of its oil to Asia today.

The oil ministry also faces generational change. The fourth-born son of King Salman is seen as a possible successor to the minister, who has been in office since 1995. The country has repeatedly announced and yet never followed through on its promise that it would fundamentally change its business model - oil for the world - and reduce its dependency on petroleum. The government still derives 90 percent of its revenue from oil exports.

To this day, Saudi Arabia has about 8 million foreigner workers, or almost a third of the population. Hardly anything would function without them. Until a few years ago, a majority of Saudi Arabians worked for the government, but now the kingdom can hardly afford such a large bureaucracy. Many young people are unemployed, while older citizens work in opulent government offices and palaces.

Most neighboring countries have modernized their economies and eliminated their dependency on oil. The United Arab Emirates focuses on logistics, aviation and trade, while Oman and Qatar promote tourism.

Saudi Arabia has abandoned beaches, magnificent deserts and ancient landmarks, but these attractions are hardly tapped or marketed. The country is investing billions of dollars in its infrastructure, and it plans to develop its industry and attract foreign companies. Still, these developments are in their early stages and there are substantial bureaucratic hurdles to overcome.

Saudi Arabia could remain dependent on oil for a long time to come.

"They have been talking about the end of the age of oil for decades," says Muhanna, the official in the oil ministry. "Yes, it will happen one day, but not in the next 10 or 20 years." The last drop of oil will come from his country, he says. It is a message of confidence, but not one of change.

The Poisonous Pact

On a spring day about three months after his accession to the throne, King Salman paid a visit to Diriyah, on the outskirts of Riyadh. Diriyah, the first capital of the Saudi nation, was designated a UNESCO World Heritage site five years ago. On the day of his visit, Salman announced that he intended to spend millions to rebuild the town's old mud-brick buildings.

The total budget for the project was $500 million. The government expected Diriyah to attract tens of thousands of visitors in two years, once the renovations have been finished.

About 270 years ago, in Diriyah, the Saud tribe formed an alliance with the clan of a man named Mohammed Bin Abd al-Wahhab. He was an influential preacher who declared anything that deviated from a strict interpretation of the Koran to be the work of the devil. He forbade the faithful from listening to music, worshiping saints or idolizing monuments. He was the founder of Wahhabism, the rigid state doctrine and "takfir" culture, which defines all those who do not abide by these rules as infidels and persecutes them. This is the poisonous theological core that ties Wahhabism to terrorist groups like Al-Qaeda and the self-proclaimed "Islamic State."

The pact remains the basis of the kingdom today. The Saud family represents its worldly establishment and Wahhabi ideology shapes the clerical elite. Not even the shock of the attacks of Sept. 11, 2001, given that 15 of the 19 attackers were Saudi Arabians, could shatter the alliance.

When Western politicians and human rights activists criticize the kingdom for not allowing Christians to build churches there or even openly display Christian symbols, Saudi diplomats often resort to a comparison. They say that their country is not a nation in the conventional sense. As the home of the two holy mosques, they argue, Saudi Arabia should rather be likened to the Vatican. This is the country's view of itself, and it tolerates virtually no dissent. Not only Christians, but members of Muslim groups whose interpretation of Islam differs from that of the Wahhabis must be very careful.

Any behavior that diverges from the consensus is strictly sanctioned, and gender segregation is a national policy. Nevertheless, young Saudi Arabians have begun to adopt a wide range of lifestyles.

As they travel the world, use the Internet and watch satellite TV, they begin to question why their country bans things that are permitted in other Muslim countries, like Egypt and Indonesia.

To allow diversity would mean taking leave of the unambiguity of Wahhabi doctrine, and would requires the courage to take on religious leaders. But King Salman has shown no inclination to shake the pact made in Diriyah -- on the contrary. His predecessor, King Abdullah, was a cautious reformer who promoted modernization of the education system and education for women. He fired two of the most radical legal scholars who had opposed reforms, one of whom had even advocated the murder of "amoral" TV producers. Salman rehabilitated both men.

He has appointed an archconservative as the head of the religious police, who are the guardians of Wahhabism. The number of executions has increased sharply under Salman. At least 90 people have been beheaded since the beginning of the year, or about as many as in the entire previous year. The draconian punishment of blogger Raif Badawi, sentenced to 10 years in prison and 1,000 lashes for "insulting Islam," was just confirmed.

An adviser to the former king says Salman wants to "enlarge the tent once again, so that everyone has a roof over his head." This tent, apparently, only welcomes people who, when it comes to the future, are only looking to the past.

A Rebel with Contradictions

A visit with Mohsen al-Awaji underscores how difficult and contradictory the rulers' pact with the Wahhabis is. One wall in the office of his house on the outskirts of Riyadh consists of 12 large screens. They transmit, in real time and from every angle, images of anyone approaching the house.

"I want to be prepared," Awaji says with a laugh, "when they come to pick me up again."

They have picked him up many times already, for as much as two or three months at a time.

Altogether, Awaji has spent several years in prison. Most recently, he was locked up for 11 days when the generals in Egypt drove the Muslim Brotherhood out of power.
Awaji, a bearded man with a fierce sense of humor, sympathizes with the Muslim Brotherhood, and he is not the only one in the kingdom who agrees with the group's demands. "We want an elected parliament, an independent judiciary and a more equitable distribution of income," he says. In one's dreams, he adds, one could even imagine the country turning into a constitutional monarchy one day.

"We are a tribal society, which is why we need the royal family at this time. But it doesn't mean that we love them," he says.

Awaji's ideas are dangerous for the royal family, especially when he proclaims them on television, as he often does. Saudi Arabia is an absolute monarchy. The king has the final say on both foreign and domestic policy, and he appoints the members of the Shura Council, or Consultative Assembly. The clergy controls the judiciary.

Nevertheless, Awaji is also a part of the system, with all of its contradictions. He criticizes the royal family, and yet he is committed to the religious foundation on which the kingdom is based. "I am a Wahhabi," he says.

As a preacher, he has been collecting money since the 1980s for causes like the mujahedeen in Afghanistan and former Al-Qaeda leader Osama bin Laden. He now works on behalf of the authorities and convinces jihadists to turn themselves in to the police. He is a well-traveled businessman, someone Western diplomats meet to understand how Saudi Arabians think.

It's difficult to explain, even for Awaji, how this all fits together. He says that his countrymen, especially the sons of traditional families, are confused. "For years, they were told how honorable it was to embark on jihad against the infidels, against the enemies of Islam." There was the sharp reversal after 9/11. "Now we were suddenly supposed to keep our mouths shut when the US Apache helicopters pilots hunt young Iraqis like ducks. Now we are supposed to keep silent when the Persians and their agents persecute our Sunni brothers, use poison gas in Damascus, drop barrel bombs on Homs and drive them out of their homes in Sana'a?"

Al-Qaeda once capitalized on these types of contradictions, says Awaji, and "Islamic State" does the same thing today. Hundreds, perhaps thousands of Saudi Arabians have joined the terrorist group in Syria and Iraq, and now they are turning against the kingdom itself. In late May, suicide bombers attacked two Shiite mosques in the eastern part of the country, killing 30 people.

The king will have to overcome all of this one day, says Awaji. "Saudi Arabia is part of the international community, and that's a good thing. But this country was founded on a basis that is not the basis of the international community: that of pure Islam." He does not envy the new leadership its task. "I don't know how this contradiction can be resolved."

Translated from the English by Christopher Sultan

China shakes off deep slump as credit soars again

Forward-looking gauges of consumer confidence are rising at the fastest rate since 2007 in China as output picks up on almost every front

By Ambrose Evans-Pritchard

6:16PM BST 18 Jun 2015

Apartment buildings are seen behind a the ancient gate outside a temple in Beijing, China. Photo: AP
China’s housing market is roaring back to life in the biggest cities while local governments are issuing bonds at a blistering pace, the latest signs that the world’s second largest economy is finally pulling out of a deep downturn.
Output is picking up on almost every front as the effects of credit easing begin to feed through, with the ‘expectations’ component of consumer confidence soaring to the highest level since the glory days of 2007.
Rail freight, electricity use, and even sales of diggers and earthmovers are all recovering at last from recessionary levels.

The apparent inflexion point has major implications for the world’s commodity markets and for struggling resource economies in Latin America and central Asia that depend on feeding the dragon.
The China Activity Proxy published by Capital Economics – deemed more accurate than the official GDP data – suggests that the underlying growth rate slowed to 4pc in the first quarter.

This was the slowest pace since the 1990s, excluding the brief episode of the SARS epidemic in 2003.

The economic cycle has now clearly turned as authorities step up stimulus, clearly worried that efforts to clamp down on the shadow banking system and rein in excess debt may have gone too far for comfort.

The crucial shift is an expansion of the country’s debt swap plan, intended to clean up the Augean Stables of China’s local government finances. The regions have switched from bank lending to bonds, issuing $65bn in the first two weeks of June alone.

Mark Williams from Capital Economics said frees up borrowing for other purposes, even if the extra lending is disguised. “The value of these bonds is not included in the central bank’s measure of total social financing,” he said.

Fresh data from the National Bureau of Statistics showed that home prices in the “tier I” cities jumped 2.8pc in May, the largest one-month rise in over five years.

Property continued to lag in the rest of the country – with a glut of 4.3m unsold units still hanging over the market - but prices have at least stabilized after sixteen months of declines. The sharp contraction in sales earlier this year has given way to a new burst of optimism, with transactions up 15pc in May.

Bo Zhuang from Trusted Sources said the government’s attempt to navigate a “controlled slowdown” nearly went awry earlier this year as curbs on local government spending led automatically to fiscal tightening – what some called a “fiscal cliff”.

Cuts in the reserve requirement ratio – the central bank’s pain policy tool – merely offset the contractionary effects of record capital outflows. They did not add extra stimulus.

The result was an ugly squall, with a crash in fixed investment and several months of outright contraction in industrial output. It amounted to a minor shock that sent ripples the world. Lombard Street Research estimates that China’s real domestic demand plunged by 2.1pc in the first quarter.

Bo Zhuang said Beijing has now pulled a set of stimulus levers, reverting to the same ‘stop-go’ pattern of past years. The benchmark market lending rate (7-day repo) has dropped abruptly from 5pc to 2pc, flushing the market with liquidity.

The country is still in the grip of powerful deflationary forces, with excess capacity in steel, cement, chemicals, and swathes of manufacturing. Factory gate inflation remains stuck at minus 4.6pc and has been negative for 37 months.

Yet there is little doubt that the Communist Party has blinked once again, putting off the day of reckoning. “They want a correction without actually having to go through one,” said Patrick Chovanec, a China veteran at Silvercrest Asset Management.

Beijing is winking at a vertiginous stock market boom that has lifted the Shanghai composite index by 150pc over the last year, fuelled by margin debt that eclipses even the final blow-off phase of the Wall Street bubble in 1929.

Mr Chovanec said China’s leaders are now in much the same position as Japanese officials in the early 1990s when they discovered that it was already too late to escape the consequences of a credit bubble and systemic over-capacity.

“In the end, they will have to turn on the fiscal taps to prevent a collapse of GDP, just like Japan,” he said.


Up and Down Wall Street

Fed Rate Liftoff Unlikely to Gain Much Altitude

Downshift in “dot plot” shows FOMC is getting closer to market view that rates won’t be hiked much.

By Randall W. Forsyth           

June 17, 2015

Channeling the Wiz of Oz, many Federal Reserve officials say we shouldn’t pay too much attention to the so-called dot-plot graph of predictions for the year-end federal funds rate by central bank officials.
But to harken back to an obfuscator of another era, John Mitchell, President Nixon’s attorney general, watch what they do, not what they say.
Janet Yellen speaking after the Federal Open Market Committee meeting on Wednesday. Photo: Andrew Harrer/Bloomberg

To the surprise of nobody, the Federal Open Market Committee Wednesday gave no further indication in its directive on monetary policy when the initial liftoff in its key policy interest rate, the federal funds target, would take place. The comparison between the latest statement and the previous one in late April reveals little. The Fed’s key rate has been stuck in a range of 0-0.25% since the depths of the financial crisis in December 2008.
As Fed Chair Janet Yellen reiterated in her post-FOMC press conference Wednesday, liftoff should come sometime later this year. That is, if—and this is a big “if”—the policy-setting panel’s expectations for steady economic growth, improvement in the labor market, and convergence on the Fed’s 2% inflation target prove accurate. Policy, to use the tired term, is data dependent.
And that has been the conventional wisdom; that the initial quarter-point hike should take place either at the Sept. 16-17 FOMC meeting or the Dec. 15-16 confab. (While the FOMC also will get together on July 28-29 and Oct. 27-28, the September and December meetings will have updated economic projections and dot plots, plus a Yellen presser. The likelihood is the Fed won’t hike without the Fed Chair meeting the press to explain the move.)
But Yellen also noted in her presser Wednesday that, whether the FOMC moves in September, December or even next March, it doesn’t matter much. And as she repeats endlessly (mainly because the markets need to be reminded), the first Fed hike will depend on the data.
What’s vastly more important than when the Fed begins to lift rates is how much. And those dot-plot graphs implied the Fed will remain lower for longer than its previous graph indicated.
The Treasury market took due note. Yields on the crucial intermediate maturities—the so-called belly of the yield curve—fell sharply. The Treasury five-year note’s yield plunged 11 basis points, to 1.62% by late Wednesday afternoon from 1.73% just before the 2 PM EDT release of the FOMC’s statement and dot plots. To bond geeks, that’s a big move.
The dollar also backed off with the DXY —as the U.S. Dollar Index is familiarly known by its ticker—down 0.67% over that same time span. The currency market, along with the Treasury market, discerned the key message that the Fed will remain lower for longer than its oratory has implied.
Yellen also gave lip service to international considerations, acknowledging that a Greece default could roil global markets and thus wash up on U.S. shores, which is another reason for the Fed to be circumspect about hiking rates. And she took due notice of International Monetary Fund chief Christine Lagarde’s call to hold off on rate hikes this year without promising anything.
As for Yellen’s contention that the first rate hike will take place this year, the financial futures market agrees—but just barely. The January 2015 fed-funds future contract is priced nearly at a 0.38% target, which would be the mid-point of a range of 0.25%-0.5% and 25 basis points above the current target.
As Yellen noted in her presser, the dot plots indicated a downshift of about 25 basis points of what they illustrated previously in March. You can get the visuals for the June meeting here and the March meeting here. What you’ll observe is a tightening of the range of the dot plots toward lower levels.
Specifically, the mean estimate for end-2015 dropped to 0.5661% from 0.7721% in March, which is closer to the fed funds futures market forecast. For end-2016, the mean projection is down to 1.75% from 2.103% previously.
As for the futures market, it projects a 1.145% rate for the January 2017 fed-funds contract, close enough to the mid-point of a 1%-1.25% range for government work, but more than a half-point lower than the FOMC solons’ estimates.
The bottom line is the market is saying short-term interest rates will remain low for a long time. There may be a small increase by December, which is unlikely to have any meaningful impact. And in 2016, there could be three quarter-point hikes—which would lift the fed funds rate target to near its nadir of 1% after the rate cuts in the wake of dot-com collapse at the turn of the century.
The message of the markets continues to be interest rates will stay lower for longer than leading Fed watchers say. And longer than bullish stock market strategists expect as well. The Fed’s dot plot, moreover, is moving in the direction of the futures market.
So, watch what they do more than what they say. For when all is said and done, the Fed is likely to do a lot less than they say.

The Bloom Is off the BRICS  Michael J. Boskin.   JUN 17, 2015

brick wall

STANFORD – A few years ago, pundits and policymakers were predicting that the BRICS countries – Brazil, Russia, India, China, and South Africa – would be the new engines of global growth. Naive extrapolation of rapid growth led many people to imagine an ever-brighter future for these economies – and, thanks to them, for the rest of the world as well.
But now the bloom is off the rose. The economies of Brazil and Russia are contracting, while those of China and South Africa have slowed substantially. Only India’s growth rate has stayed up, now slightly exceeding China’s. Will the BRICS fulfill their former promise? Or are continued problems inevitable?
Given that low-income economies typically have little fixed capital (computers, factories, infrastructure) and human capital (education and training) per worker, they tend to have higher potential returns to capital investment. That means they can grow more rapidly than wealthier economies, until their per capita income catches up.
While China, India, and Brazil still have very large rural populations, they have made great strides in reducing poverty, with several hundred million people (the largest proportion in China), escaping it in the last few decades. And these countries’ middle classes are growing fast as well.
Rapid progress in the emerging economies has contributed to economic pessimism in Europe and North America. After all, the developing economies’ combined GDP now exceeds that of the advanced economies – a situation that would have been unimaginable a generation ago.
Moreover, the hundreds of millions of low-cost workers who joined the global labor force when China, India, and Eastern Europe opened their economies are still putting pressure on the wages of all but the most skilled workers in the advanced economies. As the Nobel laureate economist Paul Samuelson observed in 1948, international trade leads to factor-price equalization, with wages, adjusted for skill levels, equilibrating across countries.
But, for the BRICS, continued rapid progress may become more difficult. Experience shows that there is a point – usually when per capita income levels reach about $15,000-20,000 (roughly one-third the level in the United States) – when growth tends to slow. In recent decades, only a few economies – notably, South Korea, Taiwan, and Singapore – have managed to escape the so-called “middle-income trap” and continue to increase their prosperity.
Beyond the problems that almost all developing economies confront – for example, weak institutions and poor governance – each of the BRICS countries faces a unique set of challenges. For example, Brazil must contend with a recession, low oil prices, and an unprecedented corruption scandal at Petrobras, the state oil company. Given this, freer trade, such as with the NAFTA countries (Canada, the US, and Mexico), and more hospitable terms for foreign investment, especially in energy, should top President Dilma Rouseff’s agenda.
Russia, too, is feeling the pressure of lower oil prices, both on its current budget and in terms of its ability to pursue further energy-sector development. Compounding the challenge are the economic sanctions imposed by the US and Europe in response to President Vladimir Putin’s aggressive policies toward Russia’s immediate neighborhood. Finally, Russia has a staggering demographic problem, characterized by a shrinking population, life expectancy far below the advanced-country average, and a growing brain drain.
India, at least for the moment, has the best short-run economic conditions. Inflation, a major threat to the economy until recently, is down under the guidance of the Reserve Bank of India’s governor, Raghuram Rajan. And growth is projected at 7.5% for this year. But India’s fiscal position remains challenging, and the country’s population, which will soon overtake China’s, remains mostly rural and impoverished.
Despite the looming challenges, Prime Minister Narendra Modi has been slow to implement the promised economic reforms. Indeed, although he has made some small improvements in regulation, privatization, and cash transfers to the poor, bolder land and labor-market reforms remain elusive.
China, for its part, is attempting a difficult economic rebalancing, from an export-led to a consumption-based growth model. In poker terms, Chinese President Xi Jinping is attempting to pull an inside straight, gambling that a growing middle class will demand enough manufactured goods to prevent the economy’s immense excess capacity in basic industries from leading to widespread unemployment.
At under 40% of GDP – compared to at least 60% in advanced economies – Chinese household consumption certainly has space to grow. But China’s economy remains prone to considerable risks.
As occurred in Japan decades ago, China is starting to face lower-cost competition, such as from Vietnam; its stock market is frothy; and Xi’s anti-corruption program, though popular with ordinary citizens, has led to widespread uncertainty about the “rules of the game.”
Finally, South Africa’s problems reflect a loss of confidence in the government, endemic corruption, massive infrastructure needs, and restrictive labor-market and foreign-investment regulation. And, in terms of reform, President Jacob Zuma is not headed in the right direction.
The BRICS are – and always have been – subject to the same forces as other economies. But, although they have increased their dependence on market forces, their governments continue to dictate too many major economic decisions, increasing the risk of imbalances or even crises.
Their ability to develop institutions that support greater economic freedom, with more reliance on market competition and less on government, will likely be the main determinant of their long-term success.

June 18, 2015 7:53 am

Liquidity pitfalls threaten parched markets

Robin Wigglesworth in New York

Concerns exacerbated by widening mismatch at the heart of the market

Welcome to the desert. The financial industry’s great debate du jour is “liquidity”, specifically how parched it looks at the moment.
Liquidity is tricky to define, but essentially means the ease of trading a financial security quickly, efficiently and without moving the price too much. Traders and money managers differ on the extent, but almost everyone agrees that liquidity has deteriorated across nearly every market, a downturn some fear could exacerbate or perhaps even spark another financial crisis. While that may be far too shrill, there is clearly cause for some concern.
■ First of all, is it really that awful?

Well, it depends. As the charts from Citi (below) show, at first blush things don’t look too bad. In absolute terms, trading volumes in corporate bonds and government debt are for the most part climbing (UK Gilts are a notable exception), and equity trading — although sharply down from the pre-crisis peaks — has been picking up.

Moreover, the bid-offer spreads, or the difference between the price investors are willing to buy or sell a bond — a popular gauge of liquidity — aren’t too shabby. These charts from Deutsche Bank, JPMorgan and Citi show the bid-offer spreads for investment grade, high yield and Treasury bonds plus equities respectively.

■ So we shouldn’t be worried?

Unfortunately we probably should at the very least be perturbed. These first charts ignore the fact that in many cases these asset classes have swollen dramatically in size, or do not reflect other changes in the market structure.
Corporate bonds have generated the most concern, both for the increasing difficulty in trading the securities and the increasing prominence of retail money in the market since 2007.

Adjusting absolute trading volumes for the market sizes paints a very different picture, as the charts from JPMorgan and Deutsche Bank underscore.

A large part of the problem is investment banks being forced to trim their corporate bond market trading operations. Hampered by regulation and under pressure to shrink balance sheets, banks have eliminated their “proprietary” trading desks and scaled back their market-making operations, with the cuts especially heavy in corporate debt.

The chart below from JPMorgan Asset Management vividly shows the shrinkage and shifting composition of the “inventories” of bonds held on banks’ balance sheets.

Concerns have been exacerbated by the widening mismatch at the heart of the market. Mutual funds have become increasingly important players in corporate bonds, but their money comes from retail investors who can pull out whenever they want, even though the underlying securities their funds buy are increasingly illiquid. Citi’s chart below shows the scale.

■ Is the problem exclusively in the corporate bond market?

The illiquidity might be the worst there, but corporate debt is far from the only corner of capital markets affected. As the two charts from Citi and Deutsche Bank below show, the government debt markets are also becoming less liquid. Even the US Treasury market is looking somewhat wan.

Equity market liquidity is also in the doldrums, despite many bourses exploring new record highs this year. As JPMorgan’s chart illustrates, the average size of trades has plummeted in developed markets and failed to recover since. With the exception of Chinese stocks, emerging market liquidity is also fading.
In the developed world it is likely at least partly a result of big trades migrating to so-called “dark pools” — as the second JPMorgan chart shows — but the trend away from the major public exchanges is nonetheless striking.

The causes of these illiquidity phenomena are manifold, and vary from market to market. But Matt King, a senior strategist at Citi, argues that the one common thread is the dominance of central banks over markets.

The paradox, he argues, is that the extra money pumped into the global economy by central banks is leading to “herding” by investors, as they run in and out of markets in a uniform fashion, prodded by shifts in monetary policy.
“Unfortunately, it leads to a rather ominous conclusion,” Mr King writes. “The bouts of illiquidity will continue until central banks stop distorting markets. If anything, they seem likely to intensify: unless fundamentals move so as to justify current valuations, when central banks move towards the exit, investors will too.”

Op-Ed Columnist

Voodoo, Jeb! Style

Paul Krugman

JUNE 19, 2015

On Monday Jeb Bush — or I guess that’s Jeb!, since he seems to have decided to replace his family name with a punctuation mark — finally made his campaign for the White House official, and gave us a first view of his policy goals. First, he says that if elected he would double America’s rate of economic growth to 4 percent. Second, he would make it possible for every American to lose as much weight as he or she wants, without any need for dieting or exercise.
O.K., he didn’t actually make that second promise. But he might as well have. It would have been just as realistic as promising 4 percent growth, and considerably less irresponsible. 

I’ll get to Jeb!onomics in a minute, but first let me tell you about a dirty little secret of economics — namely, that we don’t know very much about how to raise the long-run rate of economic growth.
Economists do know how to promote recovery from temporary slumps, even if politicians usually refuse to take their advice. But once the economy is near full employment, further growth depends on raising output per worker. And while there are things that might help make that happen, the truth is that nobody knows how to conjure up rapid productivity gains.
Why, then, would Mr. Bush imagine that he is privy to secrets that have evaded everyone else?

One answer, which is actually kind of funny, is that he believes that the growth in Florida’s economy during his time as governor offers a role model for the nation as a whole. Why is that funny? Because everyone except Mr. Bush knows that, during those years, Florida was booming thanks to the mother of all housing bubbles. When the bubble burst, the state plunged into a deep slump, much worse than that in the nation as a whole. Taking the boom and the slump together, Florida’s longer-term economic performance has, if anything, been slightly worse than the national average.
The key to Mr. Bush’s record of success, then, was good political timing: He managed to leave office before the unsustainable nature of the boom he now invokes became obvious.

But Mr. Bush’s economic promises reflect more than self-aggrandizement. They also reflect his party’s habit of boasting about its ability to deliver rapid economic growth, even though there’s no evidence at all to justify such boasts. It’s as if a bunch of relatively short men made a regular practice of swaggering around, telling everyone they see that they’re 6 feet 2 inches tall.
To be more specific, the next time you encounter some conservative going on about growth, you might want to bring up the following list of names and numbers: Bill Clinton, 3.7; Ronald Reagan, 3.4; Barack Obama, 2.1; George H.W. Bush, 2.0; George W. Bush, 1.6. Yes, that’s the last five presidents — and the average rate of growth of the U.S. economy during their time in office (so far, in Mr. Obama’s case). Obviously, the raw numbers don’t tell the whole story, but surely there’s nothing in that list to suggest that conservatives possess some kind of miracle cure for economic sluggishness. And, as many have pointed out, if Jeb! knows the secret to 4 percent growth, why didn’t he tell his father and brother?
There is, of course, a term for basing a national program on this kind of self-serving (and plutocrat-serving) wishful thinking. Way back in 1980, George H.W. Bush, running against Reagan for the presidential nomination, famously called it “voodoo economic policy.” And while Reaganolatry is now obligatory in the G.O.P., the truth is that he was right.
So what does it say about the state of the party that Mr. Bush’s son — often portrayed as the moderate, reasonable member of the family — has chosen to make himself a high priest of voodoo economics? Nothing good.

Heard on the Street

Dollar Daze Not Over for Inflation

Low inflation levels look likely to persist, with businesses having little ability to raise prices.

By Justin Lahart

June 18, 2015 12:22 p.m. ET

Services prices, excluding energy-services prices, were up 2.4% in May from a year earlier. A Wyoming barber shop is seen here.Services prices, excluding energy-services prices, were up 2.4% in May from a year earlier. A Wyoming barber shop is seen here. Photo: Dan Cepeda/Associated Press

Someday inflation will pick up. But someday won’t happen for a while longer than some companies might hope.

The Labor Department on Thursday said its consumer-price index rose 0.4% in May from April, leaving it flat with a year earlier. The core CPI, which excludes food and energy to better capture inflation’s underlying trend, rose by just 0.1%, putting it up 1.7% annually.

A big part of why core inflation remains so low is the pressure the dollar has put on import prices.

Even though the greenback has weakened over the past few months, it is still 17% higher than it was a year ago against the Federal Reserve’s trade-weighted basket of other major currencies. Within the CPI, prices for core goods were down 0.3% from a year earlier last month.

The dollar’s strength should continue to feed into consumer prices for some time yet. Consider imported components that first get contracted for, then get built, then spend time on a boat and then get put together in the U.S. Moreover, weakness in China’s economy may prompt Chinese companies to step up exports, putting more pressure on import prices.

Service prices, which aren’t as affected by currency moves as goods are (prices for haircuts in Italy don’t affect U.S. barbers), are showing more heat. Excluding energy services, they were up 2.4% in May from a year earlier. But the pace of gains in service prices has been steady—they have been gaining about 2.5% annually for the past four years. So even though the job market has been getting a lot better lately, boosting consumers’ spending power, businesses’ ability to raise prices is still seriously limited.

For financial markets, low inflation is mostly a reason to cheer, since it will keep the Fed from raising rates too swiftly. But investors also need to be on the lookout for companies that are facing rising costs. These could be in for a serious squeeze.

The Next Move in Bonds has Big Implications

By: Trading On The Mark

Thursday, June 18, 2015

This is a follow-up to our February post in which we identified the conditions for treasury bond prices to decline into support and treasury yields to rise into resistance. Both of those moves appear to be nearing completion, making this month a candidate for reversal in bonds and yields.

On a monthly chart, the CBOE 30-year Treasury Yields Bond Index (TYX) is recognizing the first Fibonacci-derived resistance target at 30.92, and the high of the month was capped by a harmonic line of the channel we have drawn. From here, we believe the most likely scenario is for yields to test lower, and our main target area is between 19.00 and 20.75.

Treasury 30 year yield (TYX) - Monthly
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A direct move from the current yield rate down to the lower target area probably would coincide with a similarly direct upward move in bond prices to produce a higher high. On our monthly chart for U.S. 30-year Treasury Bond futures, below, that would coincide with the support areas holding near 147^14 and/or the lower channel boundary.

US 30 Year Bond Futures - Monthly
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On the other hand, if yields were to rise into the higher resistance target shown on the chart near 34.89, that would correspond with greater pressure being put on support in bonds. A breach of the lower edge of the bonds channel would be a significant piece of evidence against the prospect of another higher high in bonds. Such a development would lead us to move our alternate scenario to the forefront - the scenario in which bonds make a low nearby and rally to form a lower high in 2016 or 2017.

Some big moves are coming up in bonds as well as equity markets, and we are keeping our subscribers abreast of these developments with addititional charts and analysis on weekly and even daily time frames. We'd like to offer SafeHaven readers some exclusive charts and analysis that can help you catch the summer trades. Visit this page to let us know you would like us to send you some samples! Readers who request it this week will also receive an updated post with more detailed information on near-term treasury bond targets.