Plausible Bubbles Abound

Doug Nolan

They finally did it – 25 bps, for the first rate increase since 2004. Surely it’s the most dovish Fed “tightening” ever. Indeed, it was really no tightening at all. One has to go all the way back to 1994 for the last time the Federal Reserve commenced a true tightening cycle. That episode proved so destabilizing that the Federal Reserve assured the markets that they’d learned their lesson. And this (dovish and market-pandering) mindset was fundamental to the little baby step rate increases that ensured no tightening of financial conditions throughout the historic 2002-2007 mortgage finance Bubble inflation.

This week’s policy move will be debated for years to come. Lost in the debate is how the Fed (along with global central bankers) found itself stuck at zero for seven years (with a $4.5 TN balance sheet) and then saw it necessary to move to raise rates in the most gingerly, market-pleasing approach imaginable.

Traditionally, tightening cycles are necessary to counter mounting excess, including ill-advised lending, speculating and investing. Rate increases back in 1994 exposed what had been a dangerous expansion in speculative leveraging, derivatives and market-based Credit (at home and abroad). With the “bond” market in disarray and Mexico at the precipice, the Greenspan Fed turned its attention to bolstering the markets and non-bank Credit more generally.

Market-based Credit is unstable. This remains the fundamental issue – the harsh reality – that no one dares confront. I would strongly argue that long-term stability in a Capitalistic system requires sound money and Credit (hopelessly archaic, I admit). Over the years, I’ve tried to differentiate traditional finance from unfettered “New Age” finance. The former, bank lending-dominated Credit, was generally contained by various mechanisms (including the gold standard, effective currency regimes, bank capital and reserve requirements, etc.). This is in stark contrast to the current-day securities market-based global financial “system” uniquely operating without restraints on either the quantity or quality of Credit created.

A few data points from the Federal Reserve’s “Z.1” report illuminate why the Credit system had turned fragile back in 1994. After beginning the decade at $6.39 TN, Total Debt Securities (my compilation of Treasuries, Agency Securities, Corporate Bonds and Muni Debt) surged $2.94 TN, or 46%, in four years to end 1993 at $9.33 TN. For comparison, over this period bank (“Private Depository Institutions”) Loans actually declined $169 billion (Total bank Assets rose $137bn to $4.9 TN). Importantly, Total Debt Securities as a percentage of GDP jumped from 113% to 135% in four years, while bank Loans to GDP declined from 57% to 44% (bank Assets 84% to 71%).

Fast-forward to 2014 and securities-based finance completely dwarfed bank loans. Total Debt Securities had inflated to $21.11 TN, or 172% of GDP. At $6.32 TN, bank Loans had increased only marginally to 51% of GDP. It’s worth noting that Equities as a percentage of GDP ended 2004 at 154%, up from 1994’s 86%. Total (Debt & Equities) Securities, at $40 TN, ended 2004 at a then record 326% of GDP. This compares to 1994’s $16.2 TN, or 222%.

The 2008 crisis exposed the incredible leveraged that had accumulated over a protracted period of Fed-induced easy money. It’s my view that Fed policies were used specifically to reflate the securities market Bubble in 1998 and then again in 2001-2002. This then precluded the Fed from adopting real tightening measures throughout the mortgage finance Bubble period that would have risked financial crisis.

Importantly, market-based finance did not equate to freer markets. Indeed it was the exact opposite. Policies at the Greenspan Fed evolved from actively supporting the securities markets and promoting speculation to desperate measures to sustain the Bubble. Dr. Bernanke arrived at the Fed in 2002 with an inflationist ideology to use “helicopter money” to reflate Credit and securities market Bubbles. Ironically, market-based finance became the most powerful tool for central bank manipulation - so powerful that the central planners at the Chinese communist party rushed to adopt securities-based finance.

Post-mortgage finance Bubble reflationary measures inflated the global securities Bubble to historic extremes. Here at home, Total Securities ended 2014 at $74.54 TN, or 430% of GDP. Debt Securities ended the year at $38.3 TN, or 221% of GDP, with Equities at $36.2 TN, or 209% of GDP.

There’s no precedence for such a globalized monetary fiasco, though there are a number of historical episodes that provide valuable insight. John Law’s introduction of paper money in France (1716-1720) and the resulting “Mississippi Bubble” is one of my favorites. The basic flaw in Law’s inflationist theories was his focus on the “medium of exchange” attribute to the exclusion of money’s critical role as a “store of value.” Pertinent as well, when confidence in Law’s financial scheme began to wane, he devalued competitive hard currencies in a desperate attempt to sustain demand for his scheme of paper money and securities. Bernanke, Draghi, Kuroda, Yellen and their central bank colleagues inflate central bank Credit as a “medium of exchange” for securities market inflation and apparently don’t contemplate the “store of value” dilemma that has torpedoed inflationism’s grand illusions throughout history.

The late-twenties period provides invaluable insight: The extreme divergence between the trajectory of commodities and securities prices. Benjamin Strong’s 1927 “coup de whiskey” (Draghi’s 2012 “do whatever it takes”). Policymaker confusion about the nature of inflation. How new technologies, a prolonged investment boom and booming global trade fostered confounding price instabilities. The critical issue of productive vs. non-productive Credit. How the Fed sought to promote capital investment, yet the allure of a speculative securities market Bubble proved too powerful. How there was little understanding of how securities market leverage had fostered acute market, financial and economic fragility. 
Especially late in the boom, the Fed was in no way in control of either inflation or the flow of finance through the markets and real economy. How everyone was determined to hold their ground, yet the ground gave way beneath them.

“In order to believe you should raise rates for financial stability reasons, you have to believe that there’s a serious problem of over-confidence – of bubble formation. And it seems to me that most of the plausible bubbles are no longer plausible bubbles at this point. Perhaps you could have said there was a bubble element in the high-yield bond market at some point, but you certainly can’t say that today. Perhaps you could have said that about emerging markets at some point. You can’t say it today. Perhaps you could have said it about commodities at some point. You can’t say that today. So the notion of raising rates today as a prophylactic against financial instability seems quite odd. I think we’re much more likely to have problems that come from under-confidence in financial markets than problems that come from over-confidence in financial markets.” Former U.S. Treasury Secretary Larry Summers speaking with Bloomberg’s Tom Keene, December 15, 2015

Unfortunately, Plausible Bubbles Abound. Junk bonds are merely the Periphery of a historic Bubble throughout corporate Credit and debt securities more generally. Troubled EM markets are merely the Periphery of a historic Credit Bubble throughout Latin America, Eastern Europe and Asia, certainly including the runaway mega Chinese Bubble (at the Core). 
Commodities are merely the Periphery of a historic global speculative Bubble, with financial assets at The Massive Core.

And the dilemma for John Law, for the late-1920s period, during 2007 and again these days: easy money policies meant to support a faltering Periphery work generally to exacerbate excess at the Bubble’s Core. As an analyst of Bubbles, the great challenge is to try to recognize when trouble at the Periphery, rather than supporting excess at the Core, begins to lead to risk aversion, de-leveraging and a tightening of financial conditions at the vulnerable Core.

It was a tricky week. To have such an important policy announcement two days prior to a year-end “quadruple witch” options expiration added complexity. The Fed basically gave the markets exactly what they were expecting, providing reason enough to rally. This rally, right before expiration, was fueled by an unwind of hedges and bearish positions. Yet it wasn’t long before deteriorating fundamentals trumped the Fed’s dovish rate increase. I have not agreed with the conventional thinking that global instability has been mainly about the Fed. So I don’t subscribe to analysis that sees the Fed now reducing uncertainty and engendering stability.

The Brazilian real declined 2.7% this week. Brazilian stocks sank 3.0%. Devaluation saw the Argentine peso collapse 36%. Argentina’s Merval equities index sank 10.8% this week. Crowded trades and a proliferation of derivative trading ensure some big bear market rallies. But the bursting of the EM and commodities Bubbles runs unabated. It’s as well worth noting that the yen gained 1.1% against the dollar Friday when the BOJ surprised the market with expanded stimulus measures but disappointed by not boosting QE.

December 18 – Wall Street Journal (Aaron Back): “Bank of Japan Governor Haruhiko Kuroda may have thought he was giving markets an early Christmas present. But investors reacted like they were finding coal in their stockings. The BOJ was widely expected not to make any adjustments to its easing program on Friday. So when headlines hit that it was making moves—extending the maturity of its government bond portfolio and introducing a new stock buying program—reaction was ecstatic. The Nikkei 225 surged by over 2% in minutes. But as traders read through the text of the BOJ statement, elation gave way to befuddlement. Japanese stocks ended the day down 1.9%. The new measures don’t amount to extra easing by any significant degree.”
Until recently, markets remained sanguine in the face of downward pressures on commodities as well as general global consumer and producer price indices. After all, “do whatever it takes” central bankers would be compelled to increase QE to reach their so-called “inflation mandates”. Regarding QE and the global drive to increase inflation, it’s been “If it’s not working just do more of it.” And speculative markets have absolutely loved the QE bonanza. At some point, however, central bankers had to face the reality that QE is highly destabilizing – and not all that effective. First it was the ECB. Now the BOJ. Reality is beginning to set in. “Do whatever it takes” has limits, especially when it comes to QE. Suddenly, the bursting EM and commodities Bubbles appear a lot more problematic.

Even if the global warming scare were a hoax, we would still need it

China is the low-carbon superpower and will be the ultimate enforcer of the COP21 climate deal in Paris

By Ambrose Evans-Pritchard

Wind turbines

China is covering its northern plains with wind turbines Photo: Alamy

Chinese scientists have published two alarming reports in a matter of weeks. Both conclude that the Himalayan glaciers and the Tibetan permafrost are succumbing to catastrophic climate change, threatening the water systems of the Yellow River, the Yangtze and the Mekong.

The Tibetan plateau is the world’s "third pole", the biggest reservoir of fresh water outside the Arctic and Antarctica. The area is warming at twice the global pace, making it the epicentre of global climate risk.
One report was by the Chinese Academy of Sciences. The other was a 900-page door-stopper from the science ministry, called the “Third National Assessment Report on Climate Change”.
The latter is the official line of the Communist Party. It states that China has already warmed by 0.9-1.5 degrees over the past century – higher than the global average - and may warm by a further five degrees by 2100, with effects that would overwhelm the coastal cities of Shanghai, Tianjin and Guangzhou. The message is that China faces a civilizational threat.

Whether or not you accept the hypothesis of man-made global warming is irrelevant. The Chinese Academy and the Politburo do accept it. So does President Xi Jinping, who spent his Cultural Revolution carting coal in the mining region of Shaanxi. This political fact is tectonic for the global fossil industry and the economics of energy.

Until last Saturday, it was an article of faith among Western climate sceptics and some in the fossil industry that China would never sign up to the COP21 accord in Paris or accept the "ratchet" of five-year reviews.

They have since fallen back to a second argument, claiming that the deal is meaningless because China will not sacrifice coal-driven growth to please the West, and without China the accord unravels since it now emits as much CO2 as the US and Europe combined.

This political judgment was perhaps plausible three or four years ago in the dying days of the Hu Jintao era. Today it is clutching at straws.

Eight of the world’s biggest solar companies are Chinese. So is the second biggest wind power group, GoldWind. China invested $90bn in renewable energy last year and is already the superpower of low-carbon industries. It installed more solar in the first quarter than currently exists in France.

The Chinese plan to build six to eight nuclear plants every year, reaching 110 by 2030. They intend to lever this into worldwide nuclear dominance, as we glimpsed from the Hinkley Point saga.

Home-grown energy is central to Xi Jinping's drive for strategic security. China's leaders know what happened to Japan under Roosevelt's energy embargo in the late 1930s, and they don't trust the sea lanes for supplies of coal and liquefied natural gas. Nor do they relish reliance on Russian gas.

Isabel Hilton from China Dialogue says the energy shift has reached a point where Beijing has a vested commercial interest in holding the world to the Paris deal. “The Chinese think they can dominate low-carbon technologies,” she said.

This is why they feel confident enough to forge ahead with a cap-and-trade system for carbon emissions in 2017, covering more CO2 than all of the world's 40 existing schemes put together.
China is changing fast. The energy intensity of Chinese GDP is in freefall as Xi Jinping tries to wean the economy off primitive metal-bashing and move up the technology ladder.

The "tertiary sector" has jumped from 42pc to 51pc of the economy since 2007, taking the baton as the Party starts to tackle vast swathes of excess capacity in steel, cement and shipbuilding.

It comes at a time when the cost curve for renewables has fallen far enough to make the post-carbon switch economically painless. "The average cost of global solar was $400 a megawatt/hour worldwide in 2010. It fell to $130 in 2014, and now it has fallen below $60 in the best locations.

Almost nobody could have imagined this six years ago," said Mark Lewis from Barclays.

China installed a record 23 gigawatts (GW) of windpower in 2014. It did so because wind is quick and cheap. Lazard calculates that the "levelized cost" of unsubsidized onshore wind has dropped 61pc globally, thanks to smart software, better blades and higher turbines that catch the sweet spot. It thinks wind now undercuts coal and gas, and by a wide margin in optimal spots.

Specifically, the levelized cost has fallen "well below" coal in Jilin, Jiangsu and Zhejiang with new turbines, according to a study by the North China Electric Power University.

Whether China's coal use has already peaked is a hotly disputed subject. The country's coal association says consumption dropped 4.7pc in the 12 months to October, but this may be a blip.
The economy has just been through a recession. It is now recovering. Car output jumped from 1.3m in July to 2.2m in November. Infrastructure spending is up 18pc as fiscal stimulus kicks in.

Yet peak coal is in sight and it is a fair bet that the country will achieve peak CO2 emissions long before the target date of 2030.

The key point is that only 60pc of China's coal is used for power plants, compared with 90pc in the US. The rest is burned in gruesomely toxic home boilers or in small workshops, and this where the sledgehammer is falling. Beijing is phasing out coal boilers within the city limits.

Greenpeace says China has shut down 18GW of old coal plants, and is likely to shut another 60GW by 2020. These are the worst polluters, mostly "subcritical" plants below 50 megawatts.

Cleaner ones are being built. The latest "high efficiency low emission" (HELE) facilities cut CO2 by 25pc-33pc.

It is true that regional governments took advantage of newly-devolved powers to approve another 155 plants for 123GW this year, alone equal to Brazil's annual use. Horrified officials in Beijing are trying to reverse course. The expansion makes no sense since coal thermal plants are already running at below 50pc of capacity.

Greenpeace, which first revealed this planning frenzy, doubts that many of these plants will ever be built, and if they are built, up to $110bn will go up in smoke on stranded assets. There will never be enough demand for their electricity. It will be a repeat of the steel fiasco. The Communist Party has surely learned its lesson by now.

Coal, oil and gas companies and their investors should assume that China's leaders meant what they said in Paris, and therefore that the balance of political power in the world has swung towards drastic reductions in fossil fuel use, and that negative net CO2 emissions by 2070 is on the cards.

Hedge funds and finance houses are already acting on this inference. Goldman Sachs thinks the mix of tougher rules and vaulting technology is so potent that global emissions will peak in 2020, much earlier than widely supposed.

One front-runner is the LED lightbulb, which cuts power use by 85pc compared win incandescent lights. Goldman expects it to win 95pc of the global market by 2025.

Electric and hybrid vehicles will reach sales of 25m by then, driven by plunging battery costs and tightening car emission rules in China, Europe and the US. Goldman says these curbs are nearing the point where car producers will stop investing in the internal combustion engine.

That is when the switch to electricification will become a stampede.

In the end, the sums are dizzying. Abyd Karmali from Bank of America says the low-carbon economy is worth $5.5 trillion a year and the Paris deal will now "turbocharge" an investment blitz.

Barclays has told clients to prepare for a ratchet of tougher climate rules needed to stay within the "carbon budget" of 2,900 gigatonnes and stop global temperatures rising more than two degrees by 2100. This implies a carbon price of $140 a tonne by 2040.

It also implies $45 trillion of spending on decarbonisation over the next quarter century, with forfeited revenues to match for coal, gas and coal companies, many doomed to slow run-off.

Barclays estimates that crude oil demand will fall to 72m barrels a day by then, half Opec assumptions.

This switch will not "cost" anything in macro economic terms. Such a zero-sum thinking overlooks the catalytic effects of technology leaps, and it overlooks the paradox of destruction.

The Second World War lifted the global economy out of a low-growth liquidity trap by flattening excess industrial capacity and harnessing a glut of static savings. This was the launchpad for the rebuilding boom of the 1950s and 1960s.

We are in a similar 1930s low-growth trap today. The world savings rate is a record 25pc of GDP. It is the root cause of our malaise. So even if global warming were a hoax, we would need it to make our great economic escape.

The German philosopher Hegel had a term for such historical twists. He called it the Cunning of Reason.

The Fed's Extremely Dovish Hike - Key Takeaways

- After seven years, the Fed finally ended its zero-interest-rate policy.
- Behind the 25 basis points hike, there are other key takeaways to consider, including the size of the Fed's balance sheet and the upcoming reverse repurchase agreements.
- Don't assume that just because the Fed raised rates, you'll be earning more on your deposits.
Finally! Seven years after cutting the federal funds rate to essentially zero, the Federal Open Market Committee showed the world that indeed rates won't stay at zero forever. What follows are some key takeaways from Wednesday's announcement:

Maintaining the Size of the Balance Sheet

In my recent article, "These Charts Are Screaming 'Bear Market'," I showed the following chart, which I believe is key to understanding the driving force behind the 2009 to 2015 bull market.

The size of the Fed's balance sheet has been highly correlated with rising stock prices since the 2009 bottom. As the balance sheet rises, stocks tend to rise. As the balance sheet levels off, stocks seem to level off. From my perspective, the more important news than the 25 basis points hike can be found at the bottom of the Fed's press release in the following paragraph:
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions".
What does this mean? By reinvesting its principal in agency and Treasuries securities, the Fed will keep its balance sheet relatively stable. This, in turn, means the Fed's balance sheet, which could easily have acted as a major headwind for stocks, will possibly be less of a headwind for the time being. I will address why I used the word "possibly" in a bit.

Moreover, the following sentence from the Fed's press release indicates further dovishness:
The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run" [emphasis added].
When combining the Fed's stance on its balance sheet with its stated belief that the strength of the U.S. economy will only warrant gradual hikes going forward, Wednesday's announcement was extremely dovish. The extreme dovishness was likely necessary for Janet Yellen to be successful getting everyone on board for a rate hike.

The Fed is Absolutely Not Data Dependent

For quite some time, the Fed has told us rate hikes will depend on the evolution of economic data. In other words, the Fed would be data dependent when determining whether to hike rates.

Specifically, two things lead me to believe this was hogwash:

First, as I detailed in my recent article, "These Charts Are Screaming 'Recession'," there has been a noticeable weakening in the U.S. economy. If the data wasn't strong enough to raise the federal funds rate at any point earlier this year, then the data is absolutely not strong enough to do so now.

In particular, the Fed has shown a special focus on labor market conditions. The words "labor market" were mentioned seven times in the Fed's five paragraph press release. According to the Fed, "The Committee judges that there has been considerable improvement in labor market conditions this year," despite the fact that the Fed's own "Labor Market Conditions Index," is down notably from year-ago levels and is dangerously close to dropping below zero, something that has preceded each of the past five recessions.

Data dependency doesn't appear to be the reason for this week's rate hike. But if the data didn't warrant a hike, why did the Fed hike? I believe Janet Yellen expressed the real reason for the Fed's decision, when, during Wednesday's press conference, she said the following:
One factor that we've talked about is the desirability of having some scope to respond to an adverse shock to the economy by lowering the federal funds rate. And so, it would be nice to have a buffer in terms of having raised the federal funds rate to a certain extent to give us some meaningful scope to respond".
I think the Fed is scared of what might happen if the economy were to enter a recession with rates still at the zero bound. In such a scenario, not only would the Fed lose a ton of credibility because financial market participants would see that indeed recessions and bear markets are possible with rates at zero, but the Fed would also lose its historically first line of defense against halting the negative impacts of a recession (or other adverse shock); that being a cut to the federal funds rate.

A Quick Word on the Dot Plot

I'm confident you will hear plenty about the Fed's dot plot over the coming days, while commentators debate the future path of rate hikes. Those readers wondering how credible the Fed's dot plot of fed funds projections are might be interested in a brief history lesson. First, here's a look at the Fed's dot plot on September 13, 2012:

Notice where participants thought fed funds would be at year-end 2013, year-end 2014, and shockingly, year-end 2015. Here we are at the end of 2015. Needless to say, the Fed was horrible at predicting what it itself would/should do.

Next, let's look at the dot plot on September 18, 2013:

At that time, 2015 projections, collectively, were way off. And looking ahead, I doubt those 2016 projections will, on the whole, be anywhere close to reality.

Last, let's look at the dot plot from September 17, 2014.

Just three months before the end of 2014, the majority of Fed members polled thought the federal funds rate would/should end up at 1% or higher by today. Furthermore, just 15 months ago, the overwhelmingly majority of those Fed members polled believed we would/should see rates at 2% or higher in 2016. The chances are pretty good that by this time next year, fed funds will still be a lot lower than 2%.

I don't plan to base my interest-rate assumptions on what the dot plot says.

Reverse Repurchase Agreements

I think it will take a number of weeks before financial market participants are able to fully gauge the impact of Wednesday's Fed announcement. Even though the size of the Fed's balance sheet will remain relatively flat, there is something else of importance that investors need to consider. In the Fed's "Implementation Note," also released on Wednesday, it announced that beginning December 17, "the Federal Open Market Committee directs the Desk to undertake open market operations as necessary to maintain the federal funds rate in a target range of 1/4 to 1/2 percent." This will include overnight reverse repurchase agreements, which will drain liquidity from the financial system in an amount limited "only by the value of Treasury securities held outright in the System Open Market Account that are available for such operations and by a per-counterparty limit of $30 billion per day."

As an aside, the Fed defines a reverse repurchase agreement as "a transaction in which the Desk sells a security to an eligible counterparty with an agreement to repurchase that same security at a specified price at a specific time in the future. The difference between the sale price and the repurchase price, together with the length of time between the sale and purchase, implies a rate of interest paid by the Federal Reserve on the transaction." When the Fed sells securities to its counterparties, it is draining liquidity from the financial system. How much liquidity are we talking about?

In addition to the 22 counterparties on the Fed's "Primary Dealers List," the potential size of the upcoming reverse repos made it necessary to create an expanded "Reverse Repo Counterparties List" that includes 65 counterparties. With 87 total counterparties, this means the theoretical limit for overnight repos is $2.61 trillion (87 multiplied by the $30 billion per-counterparty limit).

The exact amount of liquidity that will need to be drained from the system in order to keep rates at the Fed's target level is an open question. It could easily be measured in the hundreds of billions. Even though the Fed isn't planning to reduce its balance sheet anytime soon by permanently selling securities or letting securities mature and roll off, the Fed will be temporarily selling some of its securities during reverse repos. As the Fed notes, securities sold from the System Open Market Account (which holds assets acquired by the Fed) in reverse repos "continue to be shown as assets held by the SOMA in accordance with generally accepted accounting principles . . ." But make no mistake about it; although the Fed's assets may remain at elevated levels, the liquidity drain that will be happening could have negative consequences for the financial markets. An operation of this size is something new and we'll all just have to wait and see how things play out.

The War on Savers Is Not Over

For the past seven years, there has been an outright war against savers. One of the deflationary effects of the Fed's zero-interest-rate policy was the billions of dollars in lost interest income that millions of Americans would have earned on their deposits, and subsequently may have spent in various parts of the economy. There was a hope that once the Fed started raising rates, depositors might finally catch a break and see their rates go up. Sadly, initial indications are that this will not be the case at some of the nation's largest banks. Several banks, including JPMorgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC), PNC (NYSE:PNC), Citigroup (NYSE:C), U.S. Bancorp (NYSE:USB), and Bank of America (NYSE:BAC), among others, were quick to increase the Prime Rate they charge everyday people and small businesses on various types of loans. At the same time, CNBC reported that Wells Fargo indicated it will not be raising the deposit rate and a JPMorgan Chase spokesperson told CNBC "We won't automatically change deposit rates because they aren't tied directly to prime . . . We'll continue to monitor the market to make sure we stay competitive."

From the perspective of being a bondholder in JPMorgan, Wells Fargo, Citigroup, and Bank of America, I'm okay with this. A widening in the spread between loan rates and deposit rates is good for banks. With that said, from the perspective of being an everyday American who doesn't like being ripped off, what the banks are doing doesn't sit right. I assume the banks will be keeping a close eye on money market rates, some of which I suspect will be heading higher in the near future (and in some cases already have been). There will likely be plenty of people willing to shift their funds into money markets if banks decide not to compete on yield.


Wednesday's FOMC announcement was indeed a historic moment. It not only ended the zero-interest-rate policy that was a relic of the financial crisis, but it also marks the beginning of a historic liquidity-draining experiment that will play out in the weeks and months to come.

As I've mentioned before, I spent the past many months significantly de-risking my equity and high-yield bond exposure, raising cash for better opportunities on the horizon. I don't like picking up pennies in front of a potential steamroller. While it's too soon to tell if that's a steamroller coming into view, we do know that elevated asset valuations, a weakening economy, and an upcoming massive liquidity-draining experiment are reasons for elevated amounts of caution.

Good luck, and all the best in the New Year!

Markets Insight

Discovering the destructive force of excess capital

Corporate unease to intensify as easy money era fades
For examples of the strange spot the financial world is in, let us examine the desks of investment banks which help companies raise money.

Look left and it is megadeals, giant mergers and acquisitions, which need tens of billions of dollars sunk as foundations for corporate empires.

Look right, however, and the clients are miners and energy companies desperate for capital to pour into holes in the ground, dug when demand for commodities seemed insatiable. It’s boom times or the of end times, depending on which desk takes the phone call.

Into this environment has stepped the Federal Reserve, raising US interest rates for the first time in almost a decade. It isn’t the start of tighter monetary policy — that was October 2014 when the central bank ended its programme of bond purchases. Rather it is the first conventional step after several years without.
Still, compared with pre-financial crisis history, or the policy rate across the Atlantic set by the Bank of England, short-term interest rates at up to half a per cent still look like a dramatic attempt to stimulate the economy.
Two worlds also appear when we consider the Fed’s dual mandate to address jobs and prices.

The US economy has been adding more than 200,000 jobs a month for three years, and the unemployment rate has fallen from more than 10 per cent to half that, a level seen only briefly in the past four decades, during the dotcom and housing booms.

Meanwhile, expectations for US inflation — implied by the, admittedly, more limited experience of bond markets — were only lower in the more nervous moments of 2009. Janet Yellen, Fed chair, said on Wednesday the pace of future rate rises would be “gradual”, but the so-called “dot-plot” of Fed committee member forecasts indicates four increases next year, a more urgent schedule than market prices imply.

A final conundrum then, and a thread which runs through it all: cheap capital. Prices for high-yield bonds have been falling for a year-and-a-half as investors have reassessed the income they are prepared to accept to lend to the riskiest borrowers. Distress is real, particularly for oil and gas companies faced with tumbling prices for their product, and it is an open question how long banks will support businesses which lose money on each barrel of crude sold for less than $40.
Higher borrowing costs typically signal trouble ahead. Some companies will struggle to pay, or will simply be unable to refinance existing debt, and so default. Yet widespread failures still seem unlikely anytime soon, because less than a tenth of US high-yield debt outstanding comes due in the next three years, so great was the refinancing when money was cheap.

It may be tempting to see trouble for energy groups as disconnected, but remember that while production was enabled by technology, the cost of land, infrastructure and drilling was paid for by Wall Street with sales of debt and equity. When hedge fund manager David Einhorn toted up the numbers in May, he estimated the large frackers alone had spent $80bn more than they had received from selling oil.

The excess of capital leads to its own destruction, a glut of oil and gas which has helped to crash prices. It seems optimistic, however, to think the disruptive effects of cheap money haven’t been building elsewhere. In media for instance, Liberty Global and French rival Altice have used debt to roll up collections of cable and telecoms companies at the same time online groups Netflix, Amazon and Google are throwing money at production of original TV content.
In pharmaceuticals cash has flooded biotechnology upstarts, while Valeant has been conducting an experiment in the use of financial engineering as an alternative to research and development. The turning of the credit cycle then is less about the immediate effects of higher borrowing costs, but discovering the limits and consequences of seven years of cheap capital.
Which returns us to the question of big takeovers and deals, and suggests the motivation may not be so far removed from the troubled raw materials producers after all. The desperation is different — a need to grow when profits and sales have stalled — and is perhaps less acute, but it adds up to a very strange kind of boom.

The Ottoman caliphate

Straddling two worlds

Worldly, pluralist, hedonistic—and Muslim, too

ORHAN OSMANOGLU cradles a French handkerchief embossed with the letter H. “This is all I have left that’s my great-great-grandfather’s, the caliph’s,” he says. His family has fallen far since those illustrious days. Abdulhamid II lived in a palace, Yildiz, in the heart of Ottoman Istanbul; Orhan lives in a high-rise at the end of an Istanbul bus route. Europe’s royals flocked to caliphal functions, but when Orhan’s daughter married, Turkey’s present rulers stayed away. Worst of all, an Iraqi impostor has stolen the title his family bore for hundreds of years.

Abu Bakr al-Baghdadi’s barbaric outfit, Islamic State (IS), promises to restore the caliphate.

Does Mr Baghdadi know what he is talking about?

For 1,300 years the caliphs, or “successors”, prided themselves on developing the Islamic community the Prophet Muhammad left behind. The Ottoman Empire, which rivalled the Roman one in longevity, came to include not only the Middle East, but north Africa, much of the north Black Sea coast, and south-eastern Europe all the way to the gates of Vienna. Ruling from Istanbul, the caliphs kept polyglot courts, reflecting the multiple religions and races represented there. French was a lingua franca at the Ottoman court; Persian, Armenian and Arabic were also spoken.

The caliphs were far from doctrinaire. Abdulhamid II, who ruled from 1876 to 1909, was one of the more Islamist, but he loved music (forbidden by IS) with a passion. He grew up in a court where the princesses played a piano coated in gold leaf given by Napoleon III, and Layla Hanoum taught the princes the cello. On Thursday evenings he would accompany Sufi masters in reciting the dhikr (rhythmic repetition of the name of God), and his imperial orchestra would play Offenbach on the way back from Friday prayers at the mosque. At state banquets the orchestra would match each course to a different concerto, including some by “Pasha” Giuseppe Donizetti, Gaetano’s older brother, who was the court composer. The last caliph, Abdulmecid II, played the violin, entertaining a mixed audience of men and women at concerts.

Far from reading only the Koran and the Muslim Sunnah, Abdulhamid II had a taste for spy novels and Sarah Bernhardt, the greatest actress of her age, whom he brought several times to his private theatre. “In politics Abdulhamid was conservative,” says Suraiya Farooqi, a professor of Ottoman history at Istanbul’s Bilgi University. “In private, his tastes were distinctly Verdi.” The Ottomans paraded in the latest fashions, often imported from Venice.

Photographs in the vaults of the old Ottoman Bank show their clerks in pristine English frock-coats. In 1894 the governor of Smyrna, now Izmir, even banned the baggy trousers worn by mountain zeybeks (militias) because he found them uncouth.

In their efforts to emulate other European rulers, the caliphs commissioned Europe’s leading architects to design new palaces. Abdulhamid II’s father, Abdulmecid I, abandoned the Topkapi Palace, perched on the heights overlooking the city, and moved to the Dolmabahce, a neo-baroque edifice with marble steps that were washed by the waves of the Bosporus.

Passengers on liners sailing past could glimpse through the windows its crystal balustrades and its chandelier, the world’s largest, made in Birmingham. “The 19th-century caliph projected himself as a European emperor, like the Habsburgs or Romanovs,” says Mehmet Kentel, the head librarian at Koc University’s Research Centre for Anatolian Civilisations. Money was no object: Abdulhamid II’s descendants are seeking to recover a legacy, excluding his estates, that they estimate at $30 billion.

The iconoclasts of IS sledgehammer human likenesses; the last caliphs fashioned them.

Abdulhamid II appointed Pierre Désiré Guillemet, a French painter, and his wife to establish the empire’s first arts school, and Fausto Zonaro, an Italian, as his in-house palace painter.

Zonaro’s students included Abdulhamid II, whose paintings are still in the Dolmabahce. In “The Pondering” Abdulmecid II painted his wife Sehsuvar reclining, unveiled, reading Goethe’s “Faust” (pictured above). Another of his paintings, “Beethoven in the Harem”, depicts her unveiled again, playing the violin, with a trio that includes one of his Circassian consorts on the piano and a male accompanist on the cello. The setting, again, is continental, with European furnishings and a bust of Beethoven. Neither the orientalist fantasy of the harem nor the zealously segregated purdah of the capital of IS, Raqqa, are anywhere to be seen.

Nor was Western culture confined to the palace. Abdulmecid I hired two Swiss architects, the Fossati brothers, to renovate the Hagia Sophia—the former seat of the Patriarch of Constantinople that became a mosque and is now a museum—installing a gallery for non-Muslims to observe the worshippers below. They designed the country’s first opera house, its first university and new law courts, which are still in use. A Greek architect, Nikolai Kalfa, designed Abdulhamid II’s favourite mosque, Yildiz Hamidiye. So many playhouses, shadow-theatres and concert halls surfaced in the city that “The Encyclopaedia of Istanbul Theatres” fills three volumes. Despite traditional opposition to football, the last caliph’s son, Omer Faruk, was president of Istanbul’s premier team, Fenerbahce, while the city was under British occupation.

Under the 19th-century caliphs Istanbul became a metropolis of modernisation
Under the 19th-century caliphs, Istanbul became “a metropolis of modernisation”, says Philip Mansel in his book, “Constantinople: City of the World’s Desire, 1453-1924”, which spans the five centuries the Ottomans ruled the city. The first official newspaper, Moniteur Ottoman, appeared in 1831, first in French and then in Ottoman Turkish, as well as Greek, Armenian, Persian and Arabic. Abdulhamid II Westernised oriental concepts of time by erecting clocktowers across his empire, often at the entrance to mosques. He furnished Istanbul with an underground metro, the second in Europe. And he introduced the telegraph, an intelligence service and a rail network. The first Oriental Express steamed from Paris to Constantinople in 1889, almost two decades before the Ottomans completed their pilgrimage railway to Medina.

Ottoman attitudes to religiosity could be disarmingly liberal, too. The caliphs maintained multi-tier legal codes for their different communities. From 1839 Abdulmecid I revamped the legal system, introducing secular law alongside sharia. He gave non-Muslims equal rights with Muslims, abolished the right of the sultan to execute members of his court without trial, banned the slave trade and allowed the opening of taverns, which filled with European painters and composers on court stipends.

Diplomatic diaries from the time record caliphal scions enjoying a tipple, particularly of drinks that had not existed in the Prophet’s time and were therefore, according to more liberal readings, permitted. Mahmoud II was spotted sipping champagne at society balls.

Enjoying a tipple
Such practices were not aberrations. Drinking was a fundamental part of the pre-Ottoman early medieval caliphal courts, particularly Tamerlane’s, says Hugh Kennedy, a professor of Arabic at London University’s School of Oriental and African Studies, who is writing a book on their wanton ways. The greatest caliph of all, Harun al-Rashid (786-809), presided over an intellectual awakening and oversaw the translation of Greek Sophists in his House of Wisdom in Baghdad, but also partied with his debauched bard, Abu Nawwas, who composed drinking ditties as well as some of the Arab world’s finest classical verse. Drunken dervishes roam “The One Thousand and One Nights”, compiled during his reign.

Occasionally puritans howled. Caliph Walid II was killed in 744 after allegations he had organised drinking parties in Mecca. But dissolution was mostly taken as par for the course.

Selim II (1566-75), who conquered Cyprus and Tunisia, died in a drunken stupor, after smashing his head on his Turkish bath.
Abu Bakr al-Baghdadi: less Goethe and champagne

For all that, the caliphs could be profoundly reverential. They saw themselves as defenders of the multiple faiths that sought their protection, not just Islam. When Spain’s Christian rulers expelled their Jews, Bayezid, the then-caliph, sent boats to rescue them. Istanbul was an Armenian and Orthodox capital as well as an Islamic one. (In the Ottoman army, too, Iraqis fought alongside Albanians and Chechens.) Obedience was expected: Abdulhamid II is reputed to have slaughtered 30,000 Armenians to suppress a revolt around Adana, on the north-eastern Mediterranean. But those who proved docile and useful were welcome, whatever their origin.

Abdulhamid II’s foreign minister for a quarter-century was Armenian, as were the architect of his palace and the designer, along with Jean-Paul Garnier, of the clocktowers that became his hallmark across the empire.

Sisli’s Darulaceze, the hospice for the homeless Abdulhamid II built in 1896, is easily missed. A highway zips past above the Golden Horn, too fast to catch the golden Arabic herald over the mahogany doors. But for those who pause there, the long courtyard shaded with cypress trees offers not just an escape from modern Istanbul’s frenzy but a time capsule of caliphal values. It contains a mosque to the south, and a church and a synagogue, with stars of David, to the north. Even as Orthodox Christians and Zionists were seeking to slough off Ottoman rule and govern themselves, the caliph was still building them holy places.

Ultimately, of course, the caliphate, along with eastern Europe’s other dynastic empires, the Habsburgs and Romanovs, was dissolved. After the first world war the British and French occupied Istanbul, along with all the caliph’s remaining Arab lands. Turkish nationalists under Mustafa Kemal, an army general, took the Anatolian rump that remained. Had Russia not fallen prey to its own revolution, its army too might have held eastern Anatolia.

By that point, the caliphs were powerless. In 1923 Mustafa Kemal abolished the Ottoman Empire, proclaimed a republic and made himself president. A year later he abolished the title of caliph. Even a titular role was too threatening for the republicans—and for the British, who feared that a Muslim revival in the Middle East might have repercussions for their rule in India. He stripped the imperial family of its Turkish nationality and possessions, took the Dolmabahce for himself and went on to proclaim himself “Ataturk”, father of the Turks.

Turkish history books ridiculed the country’s former leaders as anti-Western, anti-women, tyrannical and obscurantist. The family lived in penury, strewn across the world. Two became taxi-drivers in Beirut; another played the zither in Lebanese nightclubs. Only half a century later, in 1974, did Turkey let the first male relatives back. Mr Osmanoglu returned from Damascus, recovered his Turkish nationality in 1985, and opened an import-export business trading with bits of his forefathers’ former empire. When Hosni Mubarak was toppled in Egypt, thugs broke into the ports and pillaged his containers, leaving him bankrupt.

Recently, under the Islamist-leaning president, Recep Tayyip Erdogan, Turkey has seemed to relent a little. Textbooks are less derisive. State television sometimes shows interviews with members of the clan. Mr Erdogan is pushing the country to reconnect with its Ottoman past.

“Over the last decade people have begun to respect us more,” says Mr Osmanoglu. The day your correspondent met him he had come from Bursa, a four-hour drive away, where he had taken part in the opening of the mausoleum of Murad II, an ancestor who ruled in the 15th century, before the Ottomans had even taken Istanbul. Still, he worries about raising his profile too much, lest Mr Erdogan covet the caliphate for himself. “If the Christians can have their pope, why can’t we have our caliph?” asks the curator of Abdulmecid II’s study in the Dolmabahce.

Mr Osmanoglu has toyed with forming a political party, if only he had the money. The last Ottoman leader stood for election in 1922, he notes, winning office for the first time in six centuries by the people’s formal consent. Perhaps, he says, a little nostalgia for the family and the stability they brought the region remains.

In one of his last paintings, Abdulmecid II depicted a history tutorial. On the table lies a map of Rumelia, today’s Balkans. The tutor covers his face with his hand, too grief-stricken or embarrassed to account for its loss. A ginger-haired girl stares at the map and a boy in a starched collar, cravat and suit points at it, determined to win it back. Beneath the frame, the caliph has added the caution: “Forget those who have caused you personal problems, but don’t forgive the insult to your homeland.”

When Mustafa Kemal dissolved the caliphate, the guards sent to give the household their marching orders are said to have found the caliph in his study beside his easel, perusing volumes of his favourite magazine. It was La Revue des Deux Mondes, exemplifying the Ottoman knack for straddling two worlds that has created such problems ever since. Within 24 hours he had boarded the Orient Express at Stambouli station, heading west to Europe.

Is the “Easy Money Era” Over?

Justin Spittler

It finally happened.

Yesterday, the Federal Reserve raised its key interest rate for the first time in nearly a decade.

Dispatch readers know the Fed dropped interest rates to effectively zero during the 2008 financial crisis. It has held rates at effectively zero ever since…an unprecedented policy that has warped the financial markets.

Rock bottom interest rates make it extremely cheap to borrow money. Over the last seven years, Americans have borrowed trillions of dollars to buy cars, stocks, houses, and commercial property.

This has pushed many prices to all-time highs. U.S. stock prices, for example, have tripled since 2009.

• The Fed raised its key rate by 0.25%...

U.S. stocks rallied on the news, surprising many investors. The S&P 500 and NASDAQ both gained 1.5% yesterday.

The Fed plans to continue raising rates next year. It’s targeting a rate of 1.38% by the end of 2016.

So…is this the beginning of the end of the “easy money era?”

For historical perspective, here’s a chart showing the Fed’s key rate going back to 1995. As you can see, yesterday’s rate hike was tiny. The key rate is still far below its long-term average of 5.0%.

Josh Brown, writer of the financial website The Reformed Broker, put the Fed’s rate hike in perspective.

The overnight borrowing rate…has now risen from “around zero” to “basically zero.”

In other words, interest rates are still extremely low, and borrowing is still extremely cheap. We’re not ready to call the end of easy money yet.

• Cheap money has goosed the commercial property market…

Commercial property prices have surged 93% since bottoming in 2009. Prices are now 16% higher than their 2007 peak, according to research firm Real Capital Analytics.

Borrowed money has been fueling this hot market. According to the Fed, the value of commercial property loans held by banks is now $1.76 trillion, an all-time high.

The apartment market is especially frothy today. Apartment prices have more than doubled since November 2009. U.S. apartment prices are now 34% above their 2007 peak.

• Sam Zell is cashing out of commercial property…

Zell is a real estate mogul and self-made billionaire. He made a fortune buying property for pennies on the dollar during recessions in the 1970s and 1990s.

It pays to watch what Zell is buying and selling. He was one of few real estate gurus to spot the last property bubble and get out before it popped. In February 2007, Zell sold $23 billion worth of office properties. Nine months later, U.S. commercial property prices peaked and went on to plunge 42%.

Recently, Zell has started selling again. In October, Zell’s company sold 23,000 apartment units, about one quarter of its portfolio. The deal was valued at $5.4 billion, making it one of the largest property deals since the financial crisis. The company plans to sell 4,700 more units in 2016.

Yesterday, Zell told Bloomberg Business that “it is very hard not to be a seller” with the “pricing currently available in the commercial real estate market.”

Recent stats from the commercial property market have been ugly. In the third quarter, commercial property transactions fell 6.5% from a year ago. Transaction volume also fell 24% between the second quarter and third quarter., the largest online real estate marketplace, said economic growth is hurting the market.

Both commercial real estate transaction volume and pricing have showed signs of softening over the past few months…

It’s likely that what we’re seeing is the result of reduced capital spending due to some weakness in the U.S. economy, coupled with a highly volatile economic climate in China and ongoing financial issues in Europe.

• Zell is bearish on the U.S. economy…

On Bloomberg yesterday, he predicted that the U.S. will have a recession by the end of 2016.

I think that there’s a high probability that we’re looking at a recession in the next twelve months.

A recession is when a country’s economy shrinks two quarters in a row. The U.S. economy hasn’t had a recession in six years. Instead, it’s been limping through its weakest recovery since World War II.

Zell continued to say that the U.S. economy faces many challenges.

World trade is slowing. Currencies continue to be manipulated. You’re looking at the beginnings of layoffs in multinational companies. We’re still looking all over the world for demand…

So, when you look at those factors it’s hard to see where strength is going to come from. I think weakness is going to be pervasive.

Like Zell, we see tough economic times ahead. To prepare, we suggest you hold a significant amount of cash and physical gold. We put together a short video presentation with other strategies for how to protect your money in an economic downturn. Click here to watch.

Chart of the Day

The U.S. economy is in an “industrial recession”…

In recent editions of the Dispatch, we’ve told you that major American manufacturers are struggling to make money. For example, sales for global machinery maker Caterpillar (CAT) have declined 35 months in a row. In October, CAT’s global sales dropped by 16%...its worst sales decline since February 2010.

Today’s chart shows the yearly growth in U.S. industrial production. The bars on the chart below indicate recessions.

Last month, U.S. industrial production declined -1.17% from the prior year. It marked the 19th time since 1920 that industrial output dropped from a positive reading to a reading of -1.1% or worse.

15 of the last 18 times this happened – or 83% of the time – the U.S. economy went into recession.

Chinese business and the state

Another turn of the screw

The detention of Fosun’s boss shows that even China’s biggest tycoons are no longer safe from the regime’s crackdowns

THE three-year crackdown overseen by President Xi Jinping against corruption and other threats to the leadership of China’s Communist Party has taken aim at many targets: senior party figures and officials, the bosses of state firms, civil-rights activists, labour organisers and human-rights lawyers.

This week in Beijing, outside the trial of Pu Zhiqiang, a free-speech campaigner, diplomats and foreign journalists were among those manhandled by organised goons. Until now, however, one group of Chinese citizens had seemed immune from such harassment: the country’s self-made, private-sector billionaires.

But over the past week, Guo Guangchang (pictured), the chairman and majority shareholder of Fosun, one of China’s most successful and globalised private conglomerates, suddenly disappeared and then just as mysteriously reappeared, having apparently been held for questioning by the judicial authorities in the interim. No official explanation has been given for his detention. That such a thing can now happen to one of China’s most popular business figures—someone who accompanied Mr Xi on his recent state visits to Britain and America—should serve as a warning to investors that the regime’s crackdown may now start to menace private businesses.

On December 10th local press reports suggested that Mr Guo had been bundled into hiding by security officials as he got off a plane in Shanghai. Fosun claimed its missing boss was merely “assisting” the authorities with an investigation, but still asked for its shares briefly to be suspended from trading. That sent ripples across the globe, since Fosun now has billions of dollars invested in prominent firms and buildings in Europe and America. After a nerve-racking weekend, Mr Guo reappeared at an internal company conference on December 14th, but offered no explanation for his absence.

Fosun said that, in its directors’ opinion, the inquiry that its boss is helping with did not threaten any “material adverse impact” on the firm’s finances or operations. But if the company were to become the focus of any corruption investigation, the blow could be devastating. Although the firm has a history of sound management, it has splashed out to buy insurance companies and banks outside China, and spent a further fortune purchasing foreign firms—from jewellers to holiday-resort operators—with brands that it can peddle to the country’s rising middle classes. In a report issued on November 30th, Standard & Poor’s (S&P), a credit-rating agency, gave the firm its lowest grade in the category of “financial risk”.

It may turn out that Mr Guo was simply giving evidence to an inquiry into corrupt officials, and is not himself under any suspicion. Even so, the high-handed treatment of such a prominent business figure is worrying. It is not just a reminder of the lack of due process and transparency in China’s weak and politicised legal system; it also sends a message that the party can do what it likes, to whomever it likes.

T.J. Wong of the Chinese University of Hong Kong Business School points out that what he calls the “original sin” of Chinese private business provides a mechanism for the party leaders to take down any tycoon they choose to. Thanks to Mao Zedong’s destruction of capitalism and the rule of law, most private businesses got started in legal limbo. “A lot of assets did not have defined property rights, and tax rates were often negotiated,” notes Mr Wong. So even if an entrepreneur is not corrupt, there will be enough ambiguity in his past to paint him as a crook if that suits the leadership.

The risk posed by such an event is greater for investors in private firms than for those in state-backed companies. The guanxi (web of connections) of a state firm remains even if its boss is removed, but if the founder of a private firm is arrested, its guanxi may simply evaporate.

Already, this episode has jeopardised Fosun’s bids for Phoenix Holdings, an Israeli insurer; BHF Kleinwort Benson, a British merchant bank; and Hauck & Aufhauser, a German private bank. On December 14th S&P warned that “an extended investigation of Mr Guo could potentially have a negative impact on the company’s access to funding.” The next day Moody’s, another credit-rating agency, applied a “negative outlook” to the debt of Fosun International, the group’s main listed arm—that is, it gave warning of a potential downgrade of its rating.

China’s leading tycoons are now rushing to pledge loyalty to Beijing. This week Mr Xi hosts the World Internet Conference in Wuzhen, a pleasant river town in eastern China. Despite its name, the three-day event is not a celebration of the joys of the borderless internet. Rather, it is meant to promote China’s view of “internet sovereignty”, which Balkanises the web and throttles free speech.

Predictably, a rogue’s gallery of political leaders from illiberal states—Russia, Pakistan, Kazakhstan, Kyrgyzstan and Tajikistan—have confirmed their attendance. More to the point, so too have the founders of China’s top internet and technology companies, from Alibaba to Xiaomi.

Indeed, the clearest sign of the current pressures on the private sector comes from Jack Ma, Alibaba’s boss and the most visible of all Chinese tycoons. Mr Ma has long avoided political controversies, saying that he much prefers to date government than to marry it. So it came as a surprise when Alibaba confirmed recently that it was buying the South China Morning Post, a 112-year-old English-language paper in Hong Kong. The paper’s vigorous reporting of the city’s political protests has greatly upset Mr Xi’s censors, who have blocked such content from readers on the mainland.

Will Mr Ma prove the saviour of free speech in Hong Kong? “Trust us,” he says. But on December 11th, after securing Alibaba’s bid for the paper, the firm let it be known that its leadership stands firmly with the censorious mainland regime. Joseph Tsai, Alibaba’s vice-chairman (a sophisticated Taiwanese-Canadian with a Yale law degree), complained in uncharacteristically boorish language that Western media merely see China “through the lens that China is a Communist state and everything kind of follows from that.” An “independent” editorial team at the Post, he vowed, will present things “as they are”. But China is, in fact, a Communist state and, as the Fosun affair makes plain, things do very much follow from that.

Back from the 'Caliphate'

Returnee Says IS Recruiting for Terror Attacks in Germany

By Hubert Gude and Wolf Wiedmann-Schmidt

Photo Gallery: An IS Returnee Opens Up

Islamist extremist Harry S. wasn't in Syria for long. But during his stay there, he claims, Islamic State leaders repeatedly tried to recruit him to commit terror attacks in Germany.

Security officials believe he could be telling the truth.

It was an early summer morning in the Syrian desert, with not a cloud in the sky, when Mohamed Mahmoud asked those gathered around him: "Here are some prisoners. Which of you wants to waste them?"

Not long before, Islamic State (IS) had taken the city of Palmyra, and now jihadists from Germany and Austria were to participate in the executions of some of the prisoners taken in the operation. They drove to the site of the executions in Toyota pick-ups, bringing along an IS camera team in order to document the atrocity in the city of antique ruins. Even then, Mohamed Mahmoud was known to German security officials for his repeated propaganda-video calls to join the jihad. On that early summer day in Palmyra, though, he didn't just incite others. He grabbed a Kalashnikov himself and began firing. That day, Mahmoud and his group of executioners are thought to have killed six or seven prisoners.

The story comes from someone who was in Palmyra on that day: Harry S., a 27-year-old from Bremen. "I saw it all," he says.

Harry S. returned to Germany from Syria and is now in investigative custody. He has told security officials everything about the brief time he spent with Islamic State and has also demonstrated his readiness to deliver extensive testimony to German public prosecutors. He stands accused of membership in a terrorist group. His lawyer Udo Würtz declined to offer a detailed response when contacted, but said of his client: "He wants to come clean."

German investigators are extremely interested in the testimony of the apparently repentant returnee, even as they are likely unsettled by what he has to say.

A Vital Witness

Harry S., after all, is more than just a witness to firing squads and decapitations. He also says that on several occasions, IS members tried to recruit volunteers for terrorist attacks in Germany. In the spring, just after he first arrived in Syria, he says that he and another Islamist from Bremen were asked if they could imagine perpetrating attacks in Germany. Later, when he was staying not far from Raqqa, the self-proclaimed Islamic State capital city, masked men drove up in a jeep. They too asked him if he was interested in bringing the jihad to his homeland. Harry S. says he told them that he wasn't prepared to do so.

Harry S. was only in IS controlled territory for three months. Yet he might nevertheless become a vital witness for German security officials. Since the Nov. 13 attacks in Paris, fear of terrorism has risen across Europe, including in Germany, and security has been stepped up in train stations and airports. And the testimony from the Bremen returnee would seem to indicate that the fear is justified.

Harry S. says that, during his time in the Syrian warzone, he frequently heard people talking about attacks in the West and says that pretty much every European jihadist was approached with the same questions he had been asked. "They want something that happens everywhere at the same time," Harry S. says.

Harry S.'s path from the Bremen quarter of Osterholz-Tenever to the jihadists of Islamic State was not particularly remarkable. His radicalization was similar to many other young, directionless men from European suburbs, from the Molenbeek district of Brussels to Lohberg in Dinslaken. In Tenever, some of the residential towers are up to 20 stories tall.

The son of parents from Ghana, Harry S. grew up in "difficult conditions," according to a court file. His father left the family just as he was entering puberty. Even though Harry S. initially only managed to graduate from a lower tier high school in Germany, he dreamed of returning to his parents' homeland and working as a construction engineer.

There was even a brief moment when it looked as though he was going to get control over his life. But then, in early 2010, he and some friends robbed a supermarket, getting away with €23,500, and flew to the island of Gran Canaria for a vacation. It wasn't long before the authorities were on to them and Harry S. was sentenced to two years behind bars for aggravated theft.

A Dangerous Radical

In prison, he met a Salafist named René Marc S., the "Emir of Gröpelingen" -- a man who Bremen officials consider to be a dangerous radical. It didn't take long before prison officials noticed a "change in character" in Harry S. According to prison records, he converted to Islam and expressed "radical sentiments" about world events. After his release, the new convert visited the Furqan Mosque (which has since been shut down) in the Gröpelingen neighborhood of Bremen. At the mosque, he became part of a Salafist clique which sent at least 16 adults and 11 children to Syria in 2014.

Harry S. tried to make the journey as well. From Istanbul, he flew in April 2014 to Gaziantep, a large Turkish city near the border with Syria, but his trip came to a premature end. Turkish authorities arrested him and sent him back to Bremen, where he told police that he had wanted to help out in Syrian refugee camps. The authorities didn't believe him and confiscated his passport in an effort to prevent him from making another attempt. On Tuesdays and Saturdays, he was required to report to the local police station.

But the authorities were still unable to prevent the Salafist from traveling to Syria to join the war. Harry S. simply grabbed an acquaintance's passport and, with another Islamist from Bremen, traveled overland via Vienna and Budapest. This time, there were no police waiting for him at the border to Syria. Instead, he was met by smugglers who brought him across the border to an IS safe house set up for new arrivals from around the world.

Harry S., a large man with broad shoulders, was trained as a fighter in Syria. He claims to have been drilled in training camps together with 50 other men: sit-ups, hours of standing in the sun and forced marches lasting the entire day. Those who gave up were locked up or beaten. His Kalashnikov, it was driven home to him, should become like his "third arm" and he was told to keep the weapon in bed with him while sleeping.

Once he finished training, he says he was to become a part of a special unit, a kind of suicide squad for house-to-house combat. Harry S. claims that, during his brief time in Syria, he was never sent into battle -- but he claims to know many young men, including Germans, who died in battle. "Luckily, I managed to get away," he says.

Notorious German-Speaking Jihadists

The insights of the Bremen convert into Islamic State are of interest for security officials. Harry S. is the first returnee who can offer insight into the roles played by two notorious German-speaking jihadists who have joined Islamic State: Mohamed Mahmoud, an Islamist from Austria, and the former Berlin rapper Denis Cuspert (aka Deso Dogg). Rumors that they were recently killed in Syria have thus far not been confirmed by German officials.

Mahmoud initially attracted attention in Vienna for his radical Internet postings and spent four years in prison there. He then moved to Germany, where he founded a Salafist group called "Millatu Ibrahim" together with Cuspert. The association was banned by the German Interior Ministry three years ago, whereupon several members went underground, only to reappear as members of Islamic State in Syria and Iraq.

Harry S. met both Cuspert and Mahmoud in Raqqa. He sat together in a mosque with Cuspert and says the former rapper had just come back from the front. S. said his impression was that Cuspert was more important to Islamic State as the "hero" of propaganda videos used to attract Western recruits than as a fighter. Mahmoud, he said, had more influence and would hold ideology training sessions on Fridays in Raqqa. Mahmoud, Harry S. says, is "really dangerous," adding that he had never before met such a disturbed person. After the executions in Palmyra, S. says, Mahmoud was proud of what he'd done.

SPIEGEL was unable to confirm everything that Harry S. said. But many of the details he mentioned are consistent both with the findings of security officials and with the testimony of other terror suspects.

'Walked and Walked'

Plus, there is proof of the executions in Palmyra that Harry S. claims he saw. In the summer, Islamic State released a five-and-a-half minute video that was edited in some parts like a horror film. It was the first German-language execution video released by IS and it depicts two men kneeling between antique columns with Mahmoud and another Islamist from Germany standing behind them, weapons in hand. "Merkel, you dirty dog," Mahmoud calls into the camera. "We will take revenge." Then they shoot the prisoners in the head; a jihad hymn plays in the background.

Harry S. likewise makes a brief appearance in the video. Clad in camouflage, he carries an Islamic State flag across the picture. His defense attorney Udo Würtz says that his client didn't directly participate in the executions. "He is a lackey who allowed himself to be misled by the propaganda of IS and who misled himself."

Shortly after the executions in Palmyra, Harry S. began his journey out of Syria and back to Germany. He says he could no longer stand all of the violence. Despite his great fear that Islamic State could pursue and kill him as a traitor, he left secretly one evening and made his way to Turkey. "I walked and walked," he says.

When Harry S. landed in Bremen on July 20, the police were waiting for him -- with a warrant for his arrest.

Prof. Fekete About Gold and The Debt Society

By: Claudio Grass

GLOBAL GOLD: Prof. Fekete, it is a pleasure to have this opportunity to talk to you. You are a fierce critic of the current monetary system and a strong proponent of the gold standard, particularly the variety that combines with the Real Bills Doctrine (RBD) of Adam Smith which we shall get into later. We are very much interested to learn how this interest of yours started in the first place and what led you to believe in gold and Austrian Economics in general.

I have been a lifelong student of gold money which led me to Austrian economics. However, I find that the writings by Austrian authors such as Hayek and Mises on gold somehow deviated from Carl Menger's basic idea of marketability of goods in favor of the Quantity Theory of Money. For this reason, I find they did not address the nexus between gold and interest. I take pride in pioneering a new departure to develop a theory of interest based on the idea of marketability of goods (also known as hoardability) that puts this nexus right into the center. My own view is that gold and silver are the only monetary metals for reasons having to do with the fact that they are the most hoardable substances in existence. I also believe that if Menger had lived longer, he himself would have developed his theory of interest along the lines of indirect exchange of income and wealth that are an improved version of hoarding and dishoarding (direct exchange). As a matter of fact, here we are talking about the dual theory of the evolution of direct exchange (barter) into indirect exchange of goods and services (monetary economy). Essentially what we see is the direct conversion of income into wealth (and vice versa) evolving into indirect conversion. More specifically, direct conversion of income into wealth (hoarding) and wealth into income (dishoarding) is evolving into indirect conversion of income into wealth (selling bonds) and wealth into income (buying bonds).

GLOBAL GOLD: In an article you published last year you accused the United States of fraudulently defaulting on its international obligations payable in gold. Could you tell us more about this story?

There were two instances of default, one in 1933 under a Democratic president and again one in 1971 under a Republican president. Both were fraudulent in the sense that the U.S. Treasury did possess the gold in question that should have been paid out to meet claims. In particular, in 1933 the U.S. defaulted on its gold bonds. As a result, people were denied the facility of converting income into wealth and vice versa through buying and selling gold bonds. They still are.

GLOBAL GOLD: Let's talk about this in more detail after discussing the polarity among U.S. policymakers when it comes to the gold standard. I find this quite interesting. In the 1980's you joined the staff of California Congressman William E. Dannemeyer in Washington, D.C., to work on a plan proposing monetary and fiscal reform to the Administration of President George Bush Sr. This involved the refinancing of the entire debt of the federal government through issuing gold bonds (i. e., bonds paying both principal and interest in gold). Could you simplify for us how this would function? Do you believe that this proposal had any chance of ever being accepted?

A self-respecting, upright government should not issue irredeemable debt, which essentially is the debt that is only redeemable in irredeemable currency. The mechanism involved in issuing irredeemable debt is check kiting: it is a form of fraud and therefore a crime dealt with by the Criminal Code. It is a conspiracy between the U.S. Treasury and the Federal Reserve to defraud the general public. It will take a very long time for the U.S. to live down the infamy of robbing the rest of the world of its savings. Governments should not issue debt unless they can clearly see the revenues with which the debt can be retired. Contrary to some views, the gold standard is not designed to stabilize prices, which is neither possible nor desirable. It is designed to stabilize the interest rate structure which it has done admirably well over the one hundred year period between 1815 and 1913.

When the interest rate is changing capriciously, bond values change arbitrarily, thereby rewarding some without merit and penalizing others unjustly. It invites bond speculation which will feed upon itself. Gold bond financing of the public debt is not merely a matter of honor. It is also a matter of sound economics to avoid the vicious spiral of fast breeding debt.

In presenting the gold bond plan, Mr. Dannemeyer led a delegation of ten republican congressmen to the Oval Office in the White House in October, 1989. Present at the meeting also was the Secretary of the Treasury. Mr. Bush listened to the presentation attentively and then turned to his Treasury Secretary suggesting that the staff of Congressman Dannemeyer and the Treasury staff should get together to iron out possible wrinkles in the plan.

At that time, yes, we had high hopes that the Treasury was acting in good faith and the plan would get a fair hearing in academic circles and in the financial press, particularly after it became widely known that they are studying the proposal at the Treasury. Of course, we had no clue that the Treasury had a "better" idea: to conspire with the Federal Reserve to hatch Q.E.

A date for the meeting between the staffers was duly set, a day before which Mr. Dannemeyer's office got a call from the Treasury advising that "because of other urgent business" our meeting had to be rescheduled. A new date was agreed upon, a day before which another call from the Treasury came and we had to reschedule once again. This was repeated a few more times. I saw that the Treasury had no intention to take Mr. Dannemeyer's proposal seriously in spite of the President's wishes. It is not known whether President George Bush ever realized that he was double-crossed by his Treasury Secretary. I decided to pack my bags and return to my university to resume my teaching career. I did what I could. I could not knock down a brick wall with bare hands. But there is an interesting twist to end of this story.

GLOBAL GOLD: We are coming to that. Back in 1989 Alan Greenspan, the Chairman of the Federal Reserve Board went on a mission to Moscow to suggest uncannily to the Soviet leadership to refinance their foreign debt by issuing gold bonds to prevent the imminent collapse of the Soviet economy. Do you believe that if Greenspan's proposal had been accepted, it would in fact have prevented the Soviet Union from collapsing two years later in 1991?

It is not known whether Greenspan was aware of Mr. Dannemeyer's gold bond initiative. Be that as it may, he is a smart man and certainly very knowledgeable about gold. It is quite possible that it has been decided at the highest level that the economic collapse of the Soviet Union was not in the interest of the U.S., and Greenspan fully believed that gold bond financing of new Soviet credit could be used to prevent that from happening. It is characteristic of the man's duplicity that he did not go public with his message saying: "what is sauce for the goose must also be sauce for the gander".

I think that if the Soviet Union had issued gold bonds in 1989, it would have changed the course of history. Instead, the financial markets had to do without gold bonds for 56 years between 1933 and 1989 and there was a great pent-up demand for gold bonds from insurance companies, pension funds and other financial institutions. Gold is the ultimate extinguisher of debt and, as such, it has no substitute. In particular, no irredeemable currency can ever measure up to gold as the ultimate extinguisher of debt.

Other countries could have successfully issued gold bonds to take advantage of the latent demand for them. But the U.S. Treasury retained veto power over such plans. If put into effect, they would have created discomfort in Washington during the time frame between 1933 and 1971 due to the breach of faith with creditors.

If a Soviet gold bond issue could have been successfully floated, and the Soviet authorities would have let it ride on its own success without default, then it is in my opinion, that this extension of peresztroika to economics would have saved the skin of the "the Evil Empire" and the example thus set would have saved the world economy from the disaster resulting from the collapse of the international monetary system.

GLOBAL GOLD: Could we argue the same for the global financial crisis? Could we have avoided the 2007/2008 financial turmoil, or was the financial system bound to go through that paralyzing crisis regardless of what the politicians could or would do?

The problem in 2007 was that by then it had dawned on the world that the American banking system was insolvent. This was partly a consequence of the deliberate relaxation of capital ratios that banks were supposed maintain. The banks understated their liabilities and overstated their assets in their balance sheets by wide margins. The various derivatives representing insurance against the collapse of bond values picked up the sorry state of the American banking system and the cost of insurance spiked. In fact, the spike signaled the onset of the great financial crisis.

GLOBAL GOLD: Back in 2011 you published an open letter to Texas Congressman Dr. Ron Paul with the title: DON'T LET BERNANKE WRECK THE AMERICAN ECONOMY WITH HIS Q.E. EXPERIMENT! Some analysts and economists argue that the economy has improved based on recently released data thanks to the successful implementation of Q.E. What would you say to them?

The serial Q.E.'s made the condition of the economy worse, not better. Bond speculators got a powerful backwind to help their effort to bid up bond prices. Interest rates were further suppressed, and more capital was destroyed. The crisis has deepened further. Q.E. helped them to front run the Fed in the bond-buying race, and so to reap risk-free profits on their bond-purchases.

GLOBAL GOLD: You made some interesting suggestions in an article a few years back on European currencies. Europe is sinking in a massive debt crisis involving Greece but also several other more important countries. In your opinion, is there a way out from the quagmire?

I am a firm believer that there is. All the banks in Europe have to be recapitalized on a gold basis. Bank capital in the form of irredeemable bonds is quicksand on which it is impossible to build a sound financial system.

GLOBAL GOLD: On the other end of the world, Russia, China, and India are amassing great amounts of physical gold. Do you think that they are heading towards a gold standard?

No, I don't think so. The gold standard to them is the same as holy water is to the devil. The governments of these counties are out and out socialist. Socialists do not believe in the gold standard because a true gold standard imposes the obligation on banks and governments to meet their liabilities by paying out gold. The gold standard is a thoroughly decentralized system, the very antithesis of central planning. It delegates power to ordinary people who can successfully veto wasteful government welfare/warfare spending, as well as any unjustified relaxation of bank credit across the board by withdrawing gold coins against bank notes and bank deposits. Russia, China and India use gold for propaganda purposes that have nothing to do with sound money. The hints they drop about gold are disingenuous, and therefore we should question their motivation to accumulate more gold. It's as Virgil said: "Timeo Danaos et dona ferentes" or 'beware of the Greeks bearing gifts"

GLOBAL GOLD: What is the connection between the gold standard and Adam Smith's Real Bills Doctrine? Could you please clarify the difference between the two for our readers? Which of the two would be more important to rehabilitate in the present monetary system? Or, perhaps, is it already too late?

As a sidenote, this a bit of background about Adam Smith's Real Bills Doctrine: Adam Smith argues that the money market acts as its own self-liquidating system and clearing house. Bank notes are exchanged for goods, goods in process or services, and accordingly represent their real value. Credit is not part of this transaction, as real bills become the means of payment for the trade taking place. Accordingly, there cannot be a situation of excess money supply or inflated nominal values. The market will clear itself as the excess money returns to the issuer.

Adam Smith's RBD can be restated by saying that it makes the bill market the clearing house of the gold standard. The gold standard is not viable without a clearing house where bills of exchange representing various stages of production and distribution of semi-finished goods on the way to the ultimate gold paying consumer are discounted and cleared. No rehabilitation of the gold standard is possible without prior rehabilitation of real bills. I don't think it is too late to rehabilitate the gold standard, provided that the RBD is rehabilitated first

GLOBAL GOLD: You once mentioned that the gold price is headed for extinction. Someday, perhaps fairly soon, no one will quote you an asked price for gold. No amount of irredeemable paper dollars will buy a gram of gold because no seller will part with it unless he can clearly see how he could replenish his holdings. Could you elaborate on this?

The gold futures markets routinely quote gold for delivery in the nearby future at prices that are at a premium to prices for on the spot delivery. The technical term for this condition of the market is contango, the exact opposite of backwardation under which spot gold sells at a premium price to future gold. The economic law behind this fact is specific to gold. It is fundamental for understanding the dynamics of gold trading. It signifies the scarcity of spot gold relative to gold futures. No one will ever sell gold spot without clearly seeing how he will be able to replenish his depleted inventory. The spread between the price of gold futures for nearby delivery and the price for spot gold delivery is called the gold basis. The gold basis is a fundamental indicator, which is even more important than the gold price itself, because, unlike the latter, it is not falsifiable.

GLOBAL GOLD: You were the first to call attention to the historic fact that all gold future markets were inexorably marching towards permanent gold backwardation. Why is permanent gold backwardation such an important, not to say frightening, event? Are you suggesting that this event, in and of itself, is more important than the fraudulent default of the U. S. Treasury in 1933 and again in 1971?

Yes, I am suggesting exactly that. The question is whether or not holders of the U.S. Treasury debt have a way to extract themselves from their losing position and, if they can, to what extent they can do so. When the gold basis goes and stays negative, it will be a globally significant event, heralding the advent of permanent gold backwardation. The advent of permanent gold backwardation is still in the future, but inevitable.

I wish to note here that the basis for all agricultural commodities behave cyclically. For example, the basis for wheat reaches its low (possibly negative) just before harvest. It indicates the shortage of wheat that can be immediately delivered. It reaches its maximum representing full carrying charge after the wheat harvest is brought in and put in storage. Thereafter, the wheat basis declines as stores are brought down during the remainder of the crop year.

The behavior of the basis for agricultural commodities is in marked contrast with that of the gold basis. The gold basis is declining from its maximum that is equal to the full carrying charge. This means that that virtually all the gold above ground is available for delivery. That situation occurred back in 1971 when gold futures trading started on the Winnipeg Commodity Exchange in Canada. After that, the gold basis exhibited a steady decline until 2000 when it reached zero for the first time ever. This was a watershed-event in economic history. All readily deliverable gold was gone. Academia has completely ignored the saga of the gold basis. In particular, it failed to study the question whether the gold basis could go and stay negative, and if so, what the consequences would be.

As it turns out, since 2000 the gold basis has exhibited a pattern of sporadically going negative.

But so far it has always bounced back. Similar warning signals have also been flashing, such as the negative gold lease rate. Technically this is not yet permanent gold backwardation, and it is a matter of debate how the situation will evolve from here on.

Points that bear watching are: 1. The flight of gold from the Occident to the Orient, thereby reversing the opposite trend that had prevailed over several centuries; and 2. The increasing scarcity of cash gold in the markets, especially in the approved warehouses of COMEX, and the persistent premium prices available to holders of mature gold futures contracts upon delivery.
This I consider as bribe money as it would persuade holders of gold certificates to cease from collecting their gold.

ABOUT: Professor Antal E. Fekete is a renowned mathematician and monetary scientist with many ideas and contributions in various fields. He is an expert on the central bank bullion sales and hedging and their effects on the gold price and the gold mining industry. With his essay "Wither Gold?" he won the first prize in the international currency essay contest in 1996, sponsored by Bank Lips, which was founded by the renowned Swiss Banker, Ferdinand Lips. Lips was an expert on gold and gold markets and therefore known as the "Pope of Gold". One of his famous publications is his book "Gold Wars: The Battle Against Sound Money As Seen From A Swiss Perspective". Today Prof. Fekete devotes his time to writing and lecturing on fiscal and monetary reform with special regard to the role of gold and silver in the monetary system.