Fed Steps Into Repo Market to Control Soaring Rates

New York Fed adds $53 billion into the banking systems via repurchase agreements after the benchmark fed-funds rate moved outside its target range

By Nick Timiraos and Daniel Kruger


The Federal Reserve Bank of New York bought repurchase agreements after strains surfaced in the short-term financing market. Photo: brendan mcdermid/Reuters 


For the first time in more than a decade, the Federal Reserve Bank of New York took steps Tuesday to relieve pressures that were pushing short-term interest rates higher than the central bank wanted.

Strains developed Monday in short-term financing markets that suggested the central bank could lose control of its federal-funds rate, a benchmark that influences borrowing costs throughout the financial system.

Bids in the fed-funds market on Tuesday morning reached as high as 5%, according to traders, well beyond the central bank’s target range, which is 2% to 2.25%.

The Fed moved Tuesday morning to put $53 billion of funds back into the banking system through transactions known as repurchase agreements. After the moves, the New York Fed said the effective fed-funds rate, or the midpoint of transactions in that overnight market, stood at 2.25%, up from 2.14% on Friday.

The pressures that had sent the fed-funds rate higher were related to shortages of funds for banks, stemming from rising government deficits and the central bank’s decision to shrink its securities holdings in recent years. Its reduced holdings have soaked up funds in the financial system, crimping liquidity.

The Fed is likely to continue to provide funding to ensure the smooth operation of the repo market for some time to come, although it isn’t clear how long that might be, saidGennadiy Goldberg,a fixed-income strategist at TD Securities.

“I think they’re going to be playing this one by ear,” he said. “This is in every way, shape and form an emergency measure.”

The Federal Reserve’s rate-setting committee began a two-day policy meeting on Tuesday at which officials are likely to lower the fed-funds range by a quarter-percentage point to cushion the economy from a broader global slowdown, a decision unrelated to recent funding-market strains.

The New York Fed hasn’t had to conduct such a transaction since 2008 because during and after the financial crisis, the Fed flooded the banking system with reserves when it purchased hundreds of billions of dollars of Treasurys and mortgage-backed securities in an effort to spur growth after cutting interest rates to nearly zero.

It has been draining reserves from the banking system since 2014, when it stopped increasing its securities holdings. The declines accelerated after the Fed began shrinking its holdings in 2017. Reserves have declined from $2.8 trillion to less than $1.5 trillion last week.

The Fed stopped shrinking its asset holdings last month, but because other Fed liabilities such as currency in circulation and the Treasury’s general financing account are rising, reserves are likely to grind lower in the weeks and months ahead.

The strains in funding markets this week have been driven by several factors.

First, reserves have been declining. Second, brokers who buy and sell Treasurys have more securities on their balance sheets due to increased government-bond sales to finance rising government deficits.

Then on Monday, these strains were aggravated by a series of technical factors. Corporate tax payments were due to the U.S. Treasury, and Treasury debt auctions settled, leading to large transfers of cash from the banking system.

Meanwhile, postcrisis financial regulations have made short-term money markets less nimble than they used to be. This didn’t matter as much when the banking sector was awash in reserves and could absorb the kind of swings witnessed this week.

“The issue here is not that the level of reserves is structurally too low. We’ve reached the level where the market doesn’t respond to temporary deposit flows as efficiently or fluidly,” saidLou Crandall,chief economist at financial-research firm Wrightson ICAP.

Monday’s tax payments and debt settlements “drained money from the system, and there was no cash sitting on the side waiting to come in,” said Mr. Crandall.

Banks are holding on to reserves because they don’t think they can part with them and still continue to conduct the normal operations of a bank, such as cashing checks, approving mortgages and allowing companies to draw on letters of credit, Mr. Goldberg said. “Even small confluences of events will start to have outsized effects,” he said.

What happens in this narrow sector of the financial market can be important because funding spikes create the risk of sudden and disorderly efforts by market participants to reduce debts given the lack of cheap and predictable short-term financing.

“This sort of thing can lead to substantial pullbacks, and that can create very unpredictable dynamics in markets,” said TD Securities’ Mr. Crandall.

Scott Skyrm,a repo trader at Curvature Securities LLC, said he had seen cash trade in the repo rate as high as 9.25% Tuesday.

“It’s just crazy that rates could go so high so easily,” he said.

On his trading screens, Mr. Skyrm said he could see traders with collateral securities that they were trying to exchange for cash. The rates they were offering would start to rise until an investor with cash available to trade would start to accept their bids, gradually driving repo rates down until investors had exhausted their cash, he said. Then rates would resume their climb.

While there are technical factors to explain why cash would be in high demand this week, including corporate tax payments, the settlement of recently issued Treasury securities and the approach of quarter-end, they didn’t seem to explain the “crazy market volatility,” Mr. Skyrm said.

“It seems like there’s something underlying out there that we don’t know about,” Mr. Skyrm said.

Forget trade war, a 20% move implies real war

By: Izabella Kaminska


This was the early-market response to news that Saudi oil facilities had been struck by a suspected Iranian/Yemeni rebel drone strike:




As the FT noted:

Oil prices rose as much as 20 per cent to above $71.00 a barrel — the biggest percentage spike in almost three decades — as markets reopened after an attack on Saudi Arabia’s oil infrastructure at the weekend cut more than half the country’s production.

That’s one of the biggest moves in Brent prices in dollar terms in a single session in a very long time, if not ever.* And for the commodity markets that’s a big deal. Huge, in fact.
Traders on the winning side of the bet will be laughing all the way to the bank right now. But there’s going to have been some serious fallout on the other side. We don’t know the extent to which natural producer hedgers and systematic funds will have been hit, but it’s likely that in the days and weeks to come some extraordinary details will emerge about the bloodbath that took place on the back of that single move.

The key point to remember about the commodity-oriented fund world is this: ever since Trump took over and started threatening Chinese trade wars, the “smart” money has become overly focused if not obsessed by the narrative that global demand will be hit by tariffs and a slowdown in trade. This has led to massively bearish sentiment in the oil futures market over the past year.

And yet, those obsessing about the impact of “trade wars” may have simply missed the wood for the trees. Specifically, that trade wars are irrelevant if there’s a chance the world will go to war.

That may sound hyperbolic but we think it’s essential that someone bluntly states matters for what they are.

And herein lies the contrast between real-world markets and virtual gambling markets. In bitcoinland a 20 per cent move means nothing at all. In commodity markets, it’s a potential signifier that we’ve reached the point of no return in terms of conflict acceleration.

What analysts should be noting now is not the scale of economic loss from Brexit or continued Chinese trade wars, but the degree to which wartime conditions have never favoured free-market norms. To the contrary, in such circumstances, economies turn repressive, protectionist and domestic-production oriented. They also become energy security obsessed.

The UK might be a basket case in many Brexit-related ways but the one thing it’s genuinely got over much of Europe is energy security (at least for as long as it’s got the Scots). And while US/China trade wars are likely to hurt the relevant economies more than help them, the fundamental Trump card held by the US remains... you’ve guessed it... energy security.

*We’re checking if it’s a record, but our data only goes back so far, and one always has to account for the first Gulf war which took place during a time when oil prices were a little less free than they are today, so comparatives are difficult.

The Geopolitics of Iran’s Refinery Attack

By George Friedman


A Yemeni rebel group aligned with Iran took credit for a drone attack against Saudi Arabia’s main oil refinery this weekend. The range, payload and accuracy of the attack, as well as the sophistication of the operation, suggest that the Houthis had a lot of help from their patron nation.

The Houthis are a Yemeni faction aligned with Iran. Indeed, Iran’s support runs deep. Last month, the ambassador the Houthis sent to Iran was accredited as a formal ambassador – rare for someone representing a faction outside the country’s formal government. It signaled that Iran regards the Houthis as a nation distinct from Yemen or that Iran recognizes the Houthis as the legitimate government of Yemen. Diplomacy aside, Iran is close to the Houthis, has the capability of fielding the kinds of drones used in the Saudi attack and providing targeting information, and has the motive to act in this way.

Understanding its motivation is critical. Iran is a country under tremendous pressure. It has built a sphere of influence that stretches through Iraq, parts of Syria, Lebanon and parts of Yemen. From Iran’s point of view, it has been constantly on the defensive, constrained as it is by its geography. It will never forget the 10-year war it waged against Iraq in the 1980s that cost Iran about a million casualties. It was a defining moment in Iranian history.

The strategy Tehran formed in response to this moment has been to build a coalition of Shiite factions to serve as the foundation of its sphere of influence and to use those factions to shape events to its west. The struggle between Iraq and Iran goes back to the Biblical confrontation between Babylon and Persia. This is an old struggle now being played out in the context of Islamic factionalism.

The Iranians’ sphere of influence may be large, but it is also vulnerable. Their control over Iraq is far from absolute. Their position in Syria is under attack by Israel, with uncertain relations with Russia and Turkey. Their hold on Lebanon through Hezbollah is their strongest, but it’s still based on the power of one faction against others. The same factional influence exists in Yemen.

Iran does not rule its sphere of influence. It has a degree of authority as the center of Shiite Islam. It derives some control from supporting Shiite factions in these countries in their own struggles for power, but it is constantly playing balancing games. At the same time, it is imperative for Iran not to let a Sunni power or coalition of powers form on its western frontier.

The farther west it pushes its influence, the more secure its western border and the more distant the threat of war becomes. Its strategy is forced on it by geopolitics, but its ability to fully execute this strategy is limited.

Iran’s problems are compounded by the United States, which has been hostile to the Islamic Republic from its founding with the overthrow of the shah. The American interest in the region, as opposed to the visceral dislike on both sides, is to prevent any single power from dominating the region. The historical reason used to be oil. That reason is still there but no longer defining. The geography of oil production has changed radically since the mid-1980s.

The United States has an interest in limiting the power of Islamist groups prepared to attack U.S. interests. In the 1980s, multiple attacks on U.S. troops in Lebanon caused substantial casualties and were organized by Shiite Hezbollah. After 9/11 the threat was from Sunni jihadists. The invasion of Iraq, followed by failed attempts at pacification, drove home the complexity of the problems to the Americans.

This has led the U.S. into something very dangerous in the region: a complex foreign policy, the kind that the region usually imposes on powerful outsiders. At the moment, the main concern of the United States is Iranian expansion. It is not alone. The Sunni world and Israel are in intense opposition to Iran. Turkey and Russia are wary of Iran but at the moment are content to see the U.S. struggle with the problem, while they fish in troubled waters. An extraordinary coalition has emerged with the support of the U.S., bringing together Israel, Saudi Arabia and other Sunni states under one tenuous banner.

This coalition is a threat to Iranian interests. The Israelis are attacking Iranian forces in Syria and exchanging mutual threats with Hezbollah. The Saudis and the United Arab Emirates are supporting anti-Iran forces in Yemen and conducting an air campaign. Iraq is under limited outside pressure but is itself so fractious that it is difficult to define what Iranian control or influence is. In other words, the Iranian sphere of influence continues to exist but is coming under extreme pressure. And Iran is aware that if this sphere collapses, its western border becomes once again exposed.

U.S. strategy has moved away from large scale American military involvement, which defined its strategy since 9/11. It has shifted to a dual strategy of using smaller, targeted operations against anti-U.S. groups in the Sunni world and economic warfare against Iran. This anti-Iran strategy follows from a broader shift in U.S. strategy away from the use of military power toward the use of economic power in places like China, Russia and Iran. The U.S. drive to end the Iran nuclear deal was less about fear of Iranian nuclear power and more about imposing a massive sanctions regime on the Iranian economy.

The sanctions strategy has badly hurt the Iranians. For a while, it seemed to threaten political unrest on a large scale, but that threat seems to have subsided somewhat. But the pain from sanctions constantly tightening and shifting, with unpredictable targets and methods of enforcement, has undermined the Iranian economy, particularly its ability to export oil. This, combined with the pressure it is facing from the anti-Iran collation the U.S. supports, has placed Iran in a difficult position.

It has already responded in the Persian Gulf, seizing tankers in the hopes of creating panic in the industrialized world. But this is not 1973, and the significance of a tanker war like the one that raged in the 1980s was not enough to spike oil prices or create pressure from Europe, Japan and others against the United States and its allies to release the pressure on Iran.

Iran now has two imperatives. It must weaken the anti-Iran coalition, protecting its allies in the region, and it must generate pressure on the United States to ease U.S. pressure on the Iranian economy. The weak link in the coalition is Saudi Arabia. Its government is under internal pressure, and it holds together its social system with money gained from oil sales. It is the part that is both vital to the coalition yet vulnerable to events. And nowhere is it more vulnerable than in Saudi oil revenue.

The strike at the Saudi oil refinery was well thought out on all levels. Not only did it demonstrate that the Saudi oil industry was vulnerable to Iranian attack but the attack significantly reduced Saudi oil production, inflicting real pain. It is not clear how long it might take to bring production back online, but even if it is done quickly, the memory will not fade, and if it takes time, the financial impact will hurt. It has imposed a price on the Saudis that others will note.

It is also intended to remind the Saudis and others that while in the past the U.S. had an overwhelming interest in protecting the flow of Middle Eastern oil, this is not a major interest of the United States any longer. Between massive American shale oil production and its reserves, the U.S. is not nearly as vulnerable as it once was to oil disruption. This also reminds U.S. allies in Europe and Asia that a dramatic shift has occurred. Where once all were obsessed with doing nothing to threaten oil supplies, now the United States is in a position to take risks that its allies can’t afford to take. The Iranians hope that with this attack they can split the American alliance over the oil issue.

That oil issue is also Iran’s problem. The U.S. has blocked sales of a substantial proportion of Iranian oil production as part of its economic war on Iran. In creating alarm over global oil supplies, the Iranians want to force U.S. allies to be more assertive in defying U.S. wishes on not only oil but other matters as well. The U.S. assurances of ample supplies played into the Iranians’ hands, causing major importers to start thinking about the U.S. position.

The attack on the refinery was both operationally skillful and strategically sound. It made the Saudis’ vulnerability and their weakest point manifest. It imposed a price on the Saudis for their alliance structure that, if it continues, they cannot pay. The attack also drove home to U.S. allies that their interest and the United States’ interest on oil diverge. Finally, and importantly, it will benefit other oil producers, particularly Russia, by potentially raising prices. And in American politics, anything that benefits Russia right now can be made explosive.

The United States cannot ignore the attack. As the greatest military power in the anti-Iran coalition, it is the de facto security guarantor. But if it strikes, it invites a response from the Iranians and resistance from its allies. If it does not strike, it weakens the foundations of the anti-Iran alliance and strengthens Iran. U.S. Secretary of State Mike Pompeo has recently alluded to the possibility that the U.S. was open to negotiations. The Iranians may have seen this attack as an important negotiating point.

It is difficult to see how the U.S. can respond without risking more attacks on Saudi Arabia. It is likewise difficult to see how the U.S. can avoid striking without losing the alliance’s confidence. Part of this will depend on how bad the damage to the refinery actually is. Part of it will have to do with the effectiveness of U.S. counterstrikes against drones in Yemen.

What is clear is that the Iranians are playing a weak hand as well as they can. But they are also playing a hand that could blow up in their face. The geopolitics of this clear. The intelligence capability of each side in follow-on attacks is the question – as is how lucky all the players feel they are.

The Fed’s Tail-Chasing Problem

The Federal Reserve’s current policy reasoning could push rates sharply lower in response to remote risks

By Justin Lahart


An ounce of prevention is worth a pound of cure,’ said Fed Chairman Jerome Powell. Photo: Associated Press 


The U.S. economy is probably going to be fine, but the Federal Reserve looks likely to lower rates this week anyway.

There is some sense to that: With all the potential economic threats out there, the Fed worries that staying on hold could be riskier than cutting rates. But the danger is that the Fed is entering a spiral where increasingly remote tail risks will lead it to keep lowering rates until it has next to no rate cuts left to give.

With the unemployment rate near a 50-year low, consumer spending solid and inflation beginning to perk up, it seems incongruous at the moment to cut rates. But trade tensions, a slowing global economy and, now, last weekend’s attack on Saudi Arabian oil facilities, all count as reasons to worry.




Those worries are magnified by the fact that the Fed’s current target range for overnight rates, at 2% to 2.25%, is already quite low. That leaves it with little ammunition if it is confronted by a recession—indeed in the past the central bank has had to cut rates by around 5 percentage points in response to a recession.

As a result, the Fed arguably should be readier than usual to lower rates in response to threats, and stave off the possibility of recession, than it might be otherwise. Or, as Fed Chairman Jerome Powell put it in June, “An ounce of prevention is worth a pound of cure.”

Say there is a one-in-five chance that global problems lead companies to reduce employment in the U.S. or spook consumers into spending less. If overnight rates were now set at 5%, the Fed might be more comfortable waiting to see how the situation develops than it is now.

By this logic, however, as the starting rate goes lower, the Fed needs to get even more aggressive responding to remote but worrying possibilities. If policy makers cut rates at the conclusion of their meeting Wednesday and then cut rates one more time this year, as most economists expect, the Fed’s target range will be 1.5% to 1.75% at the start of 2020.

If the Fed then perceives a one-in-10 danger, should it cut rates in response? Where does it end? Rates could end up slipping toward zero even before an actual downturn materializes.

Investors warn gold miners to keep lid on ambitions

Fears 6-year price highs will stoke repeat of previous boom’s doomed investments

Henry Sanderson and Neil Hume


Investors want gold producers to keep a lid on costs and take a more conservative approach to executive remuneration © Bloomberg


Gold miners are facing pressure from investors to keep their animal spirits in check as the precious metal trades at its highest levels in six years.

As the industry gathers this week for its annual gold conference in Denver, some of the sector’s largest investors have warned gold miners not to repeat the mistakes of the past.

“We don’t want to see the poor decisions that we’ve seen in previous cycles,” said Joe Foster, a fund manager at VanEck in New York. “The emphasis will continue to be on more conservative management styles, in terms of debt and financial management.”

Gold miners have outperformed this year, rallying 31 per cent according to the VanEck Gold Miners Exchange Traded Fund. The gold price has risen 17 per cent to about $1,500 a troy ounce.

But investors are fearful that soaring gold prices will lead to a repeat of the last boom, which peaked in 2011 when they rose above $1,900 a troy ounce. Encouraged by bankers, miners splurged cash on ambitious deals and projects that ultimately destroyed value for investors when gold crashed in 2012.

“The big thing we’d like to see is for companies to grab the margin expansion from higher gold prices and return that to shareholders as dividends,” said Mark Burridge, managing partner and fund manager. “We don’t want to see a massive shift to growth.”

Investors also want gold producers to keep a lid on costs and take a more conservative approach to executive remuneration.

Shareholders’ Gold Council, a group backed by 19 investors including New York hedge fund Paulson & Co and Egyptian billionaire Naguib Sawiris, has found gold miners spend much more on salaries and general administrative costs than their peers in copper and iron ore.

If listed gold miners brought their spending in line with the rest of the mining industry, $13bn could be unlocked for shareholders, the group says.

“SGC believes that it is imperative for management teams and boards to immediately explore ways to reduce excessive spending levels,” it said.

That message appears to have been taken on board, at least by the largest companies in the sector. Gary Goldberg, head of Newmont Mining, the world’s biggest gold producer, will not be distracted by the high gold price.

“If I was an investor I’d be making sure people aren’t getting starry eyed with the gold price,” he told the Financial Times. “Making sure they are staying focused on the basics going forward.”

Mr Foster expects that sentiment to be shared by some miners at Denver. “Companies are no longer afraid to say they have a flat production profile,” he said. “If a company can sustain production for the foreseeable future and maybe grow margins by becoming more efficient — you’ll see that type of talk.”

While investors are justifiably wary of deals, many believe there needs to be a round of consolidation among the small and mid-cap producers.

According to bankers these companies should merge to improve returns, but in many cases entrenched senior management — who do not want to give up pay packages that stretch into the millions — are standing in the way.

“There are clearly some companies that should be paying more dividends but in other cases it makes sense for them to consolidate,” said George Cheveley, portfolio manager at Investec Asset Management.

Emerging market central banks most dovish since financial crisis

Monetary authorities are reacting to faltering growth

Steve Johnson




Emerging market central banks have turned more dovish than at any point since at least the global financial crisis, according to analysis of the language in 4,000 monetary policy publications.

The extreme pro-easing bias is remarkable given that banks, including those of Brazil, Russia, India, China, South Africa and Turkey, have already cut rates this year, suggesting the scope for further policy loosening should be narrowing.

Bank of America Merrill Lynch’s Emerging Monetary Mood Indicator, based on robotic scanning of keywords used in the publications of 11 big EM central banks, is at its more dovish extreme since the height of the crisis in 2009, based on a six-month moving average.

Based on single-month figures, the August reading — the latest available — was the most extreme since the depths of the dotcom crash in 2000.

“There are quite a few emerging markets where we are comfortable saying we think [central banks] will cut more than the market is expecting,” said David Hauner, head of EM cross-asset strategy and economics at BofA, who cited Russia, Brazil, China and the Czech Republic as examples.

“We don’t think the market is aggressively pricing in rate cuts. There is plenty of firepower out there. Real rates in emerging markets are still quite high,” he added.

Turkey has led the way among big EM central banks this year, slashing base rates by 750 basis points to 16.5 per cent, while India has cut by 110bp to 5.4 per cent. Since the start of 2017, Brazil has eased by 775bp to 6 per cent and Russia by 300bp to 7 per cent.

Monetary authorities are reacting to faltering growth, with the IMF forecasting that EM-wide growth will slow to a post-global financial crisis low of 4.1 per cent this year.

Tame inflation (outside of Turkey and Argentina) has given central banks headroom to ease. Mr Hauner said many countries “have got rid of the current account deficits that have constrained policy in the past, so they have more room to cut without their currencies exploding”. He argued the extreme dovishness should be supportive for EM equities and bonds, but be a potential drag on currencies.


Don’t Blame Economics, Blame Public Policy

Engineering and medicine have in many respects become separate from their respective underlying sciences of physics and biology. Public-policy schools, which typically have a strong economics focus, must now rethink the way they teach students – and medical schools could offer a model to follow.

Ricardo Hausmann

hausmann76_g-stockstudio_getty images_professor and students

AMMAN – It is now customary to blame economics or economists for many of the world’s ills. Critics hold economic theories responsible for rising inequality, a dearth of good jobs, financial fragility, and low growth, among other things. But although criticism may spur economists to greater efforts, the concentrated onslaught against the profession has unintentionally diverted attention from a discipline that should shoulder more of the blame: public policy.

Economics and public policy are closely related, but they are not the same, and should not be seen as such. Economics is to public policy what physics is to engineering, or biology to medicine. While physics is fundamental to the design of rockets that can use energy to defy gravity, Isaac Newton was not responsible for the Challenger space shuttle disaster. Nor was biochemistry to blame for Michael Jackson’s death.

Physics, biology, and economics, as sciences, answer questions about the nature of the world we inhabit, generating what economic historian Joel Mokyr of Northwestern University calls propositional knowledge. Engineering, medicine, and public policy, on the other hand, answer questions about how to change the world in particular ways, leading to what Mokyr terms prescriptive knowledge.

Although engineering schools teach physics and medical schools teach biology, these professional disciplines have grown separate from their underlying sciences in many respects. In fact, by developing their own criteria of excellence, curricula, journals, and career paths, engineering and medicine have become distinct species.

Public-policy schools, by contrast, have not undergone an equivalent transformation. Many of them do not even hire their own faculty, but instead use professors from foundational sciences such as economics, psychology, sociology, or political science. The public-policy school at my own university, Harvard, does have a large faculty of its own – but it mostly recruits freshly minted PhDs in the foundational sciences, and promotes them on the basis of their publications in the leading journals of those sciences, not in public policy.

Policy experience before achieving professorial tenure is discouraged and rare. And even tenured faculty have surprisingly limited engagement with the world, owing to prevailing hiring practices and a fear that engaging externally might entail reputational risks for the university. To compensate for this, public-policy schools hire professors of practice, such as me, who have acquired prior policy experience elsewhere.

Teaching-wise, you might think that public-policy schools would adopt a similar approach to medical schools. After all, both doctors and public-policy specialists are called upon to solve problems and need to diagnose the respective causes. They also need to understand the set of possible solutions and figure out the pros and cons of each. Finally, they need to know how to implement their proposed solution and evaluate whether it is working.

Yet most public-policy schools offer only one- or two-year master’s programs, and have a small PhD program with a structure typically similar to that in the sciences. That compares unfavorably with the way medical schools train doctors and advance their discipline.

Medical schools (at least in the United States) admit students after they have finished a four-year college program in which they have taken a minimum set of relevant courses. Medical students then undergo a two-year program of mostly in-class teaching, followed by two years in which they are rotated across different departments in so-called teaching hospitals, where they learn how things are done in practice by accompanying attending (or senior) doctors and their teams.

At the end of the four years, young doctors receive a diploma. But then they must start a three- to nine-year residency (depending on the specialty) in a teaching hospital, where they accompany senior doctors but are given increasing responsibilities. After seven to 13 years of postgraduate studies, they finally are permitted to practice as doctors without supervision, although some do additional supervised fellowships in specialized areas.

By contrast, public-policy schools essentially stop teaching students after their first two years of mostly in-class education, and (aside from PhD programs) do not offer the many additional years of training that medical schools provide. Yet the teaching-hospital model could be effective in public policy, too.

Consider, for example, Harvard University’s Growth Lab, which I founded in 2006 after two highly fulfilling policy engagements in El Salvador and South Africa. Since then, we have worked on over three dozen countries and regions. In some respects, the Lab looks a bit like a teaching and research hospital. It focuses both on research and on the clinical work of serving “patients,” or governments in our case. Moreover, we recruit recent PhD graduates (equivalent to freshly minted MDs) and graduates of master’s programs (like medical students after their first two years of school). We also hire college graduates as research assistants, or “nurses.”

In addressing the problems of our “patients,” the Lab develops new diagnostic tools to identify both the nature of the constraints they face and therapeutic methods to overcome them. And we work alongside governments to implement the proposed changes. That is actually where we learn the most. In that way, we ensure that theory informs practice, and that insights gained from practice inform our future research.

Governments tend to trust the Lab, because we do not have a profit motive, but rather just a desire to learn with them by helping them solve their problems. Our “residents” stay with us for three to nine years, as in a medical school, and often take up senior positions in their own countries’ governments after they leave. Instead of using our acquired experience to create “intellectual property,” we give it away through publications, online tools, and courses. Our reward is others adopting our methods.

This structure was not planned: it just emerged. It was not promoted from the top, but was simply allowed to evolve. However, if the idea of these “teaching hospitals” was embraced, it could radically change the way public policy is advanced, taught, and put at the service of the world. Maybe people would then stop blaming economists for things that never should have been their responsibility in the first place.



Ricardo Hausmann, a former minister of planning of Venezuela and former Chief Economist at the Inter-American Development Bank, is a professor at the Harvard Kennedy School and Director of the Harvard Growth Lab.

The Fed’s About to Buy $1 Trillion Worth of Stocks

By E.B. Tucker, editor, Strategic Investor


I’m betting the Federal Reserve’s next move is buying $1 trillion worth of stocks in the open market.

Ten years ago, Fed governors rarely got airtime on financial media. Twenty years ago, we only heard from the chairman occasionally. These days, the Fed is all we hear about.

Most average investors still don’t know that there are 12 Fed banks. Each has a president.

However, the New York Fed is the only one that matters. It holds all the power.

It’s the New York Fed that bought trillions of dollars’ worth of U.S. Treasurys after the 2008 crisis.

Chart


The idea behind gobbling up Treasurys was to stabilize the U.S. government’s funding market.

Federal Reserve primary dealer banks bought up Treasurys during government auctions. They then flipped them to the Fed days later.

Normally, government revenues fall during a recession. With this scheme, congressional funding kept growing right through the downturn. Government rarely shrinks.

Here’s the problem… Like a dope fiend who swears he’ll ease himself off the hard stuff, the Fed and its enablers in Congress said they’d return the system to normal after it stabilized. The truth is, they will never turn the money system back over to the markets.

The Playbook

Create a policy with unintended consequences. Down the road, that new policy causes another crisis. Policy, unintended consequences, crisis… Repeat until the economic system explodes.

Crisis creating and crisis solving is profitable work. Sure, the brainiacs at the Fed aren’t getting rich.

They’re humble servants, of course.

The plan at the outset was to buy just enough Treasurys and mortgage-backed securities to stabilize the system. To get things back to normal.

The slightest tinge of withdrawal earlier this year was too much to bear. In the previous chart, you can see the Fed shrunk its colossal Treasury holdings by just a few hundred billion, or about 16%.

Last month, the Fed actually increased its debt buying for the first time since 2017. We didn’t see anything in the news about this. We also think it’s the initial step in QE4 (quantitative easing)… which is the Fed’s fancy term for printing more money.

Chart

Bond buying won’t be enough this time. Government revenues are at all-time highs. In fact, with 26% of the world’s sovereign debt trading with negative rates, demand for Treasurys doesn’t need help.

The last time the Fed also bought mortgage-backed securities, the intention was to stabilize the housing market. With mortgage rates near all-time lows at 3.58%, lower borrowing rates won’t help things much today either.

That’s why I think the Fed will buy stocks at the next sign of trouble… which could be soon.


Looking to the Future

Pretend today is September 4, 2021… two years into the future.

The Fed just wrapped up a program in which it bought $1 trillion worth of U.S. stocks.

In late 2019, the weight of crippling debts and a shrinking economy cracked the stock market.

Investors sold at any price to get what they could out of stocks.

The Fed stepped in to “stabilize” the stock market… to protect retirement accounts. To allegedly ensure that hard-working Americans could sell their 401(k) assets as needed without fear of losing a lifetime of effort.

It could call this program RAPSAF-1. That could stand for Retiring Americans Profit Security and Freedom. The “1” at the end designates its first foray into buying stocks to stabilize the markets. The financial press would trip over itself predicting when Round 2 would begin.

You might think this sounds crazy. It’s not crazy at all.

In July, Reuters quoted Larry Fink, CEO of BlackRock (the world’s largest asset manager), in a story in which he called on the European Central Bank to buy stocks. He said, “I’m a big believer that Europe needs to find ways to have the Europeans focusing on investing for the long term through equities.”

You might say, “That’s Europe, things are different.” But it’s important to remember how these radical policies become normal. Heavy hitters like Fink, who stand to make billions if the Fed buys stocks, begin talking about central banks buying stocks. Others join in. Before long, it doesn’t seem so radical.

The Swiss National Bank buys stocks. It owns over $90 billion worth of U.S. stocks.

The Bank of Japan buys stocks. It owns a full 4.7% of its stock market already. In the same Reuters article, Fink implies it should consider buying more, since many Japanese sit on extra cash in savings accounts. That means Fink wants you to stuff your savings in the stock market, preferably in one of his funds.

If the U.S. matched Japan’s central bank in buying nearly 5% of the stock market, that means about $1.5 trillion of Fed funny money injected into the market.

Remember, $2 trillion worth of Treasury buying sent U.S. interest rates to all-time lows. I don’t see why $1.5 trillion worth of stock buying couldn’t send price-to-earnings (P/E) ratios to all-time highs. (The P/E ratio measures how much investors are paying for each dollar of current profits.)

Today, the S&P 500 trades with a P/E of 19. Don’t get me wrong: With a slowing economy and mounting debt problems, that’s no bargain. That is, of course, if you’re looking to the past for guidance.

With a whale buying $1.5 trillion worth of stocks, P/E ratios could surge to 30. That’s 58% higher than today.

With savings accounts yielding 0%, Treasurys yielding little more than 0%, and real estate yielding in some cases less than the cost to maintain it… stocks could easily trade for 30-times earnings.

Remember, the Fed’s radical money experiments usually show up as a crisis response. If it ends up buying $1.5 trillion worth of stocks, the market might take a beating first.

That means a big drop in stocks might justify the Fed’s next radical move, which is becoming the world’s largest stock buyer. If so, many average investors will be scared out of stocks before the whale starts buying. Keep that in mind.

In my Strategic Investor newsletter, we talk about having a mix of high-quality, resilient stocks and cash. That’s a way to stay in the market, if stocks run higher, and still have enough cash set aside to take advantage of a market shock.

China’s ‘helicopter money’ is blowing up a bubble

Investment implications go far beyond the mainland’s markets

Arthur Budaghyan


An air show in Tianjin, China. Helicopter money discourages innovation and breeds capital misallocation, which reduces productivity growth © VCG via Getty Images



The escalation of the trade conflict between the US and China has raised the likelihood of greater stimulus by Beijing to prop up the economy. While China’s excessive debt isn’t news, investors must wake up to the reality of “helicopter money” — enormous money creation by Chinese banks “out of thin air”.

While this sugar rush may provide short and medium-term cover for investors, the long-term effects will exacerbate China’s credit bubble. China, like any nation, faces constraints on frequent and large stimulus, and its vast and still rapidly expanding money supply will produce growing devaluation pressures on the renminbi.

When a bubble emerges we are often told that this bubble is different. Many economists justify China’s credit and money bubble and continuing stimulus by pointing to the nation’s high savings rate. But this narrative is false. At its root is the idea that banks are channelling or intermediating deposits into loans. This is not how banks operate.

When a bank expands its balance sheet, it simultaneously creates an asset (say, a loan) and a liability (a deposit, or money supply). No one needs to save for this loan and money to be originated. The bank does not transfer someone else’s deposits to the borrower; it creates a new deposit when it lends.

In all economies, neither the amount of deposits nor the money supply hinge on national or household savings. When households and companies save, they do not alter the money supply.

Banks also create deposits/money out of thin air when they buy securities from non-banks. As banks in China buy more than 80 per cent of government bonds, fiscal stimulus also leads to substantial money creation. In short, when banks engage in too much credit origination — as they have done in China — they generate a money bubble.

Over the past 10 years, Chinese banks have been on a credit and money creation binge. They have created Rmb144tn ($21tn) of new money since 2009, more than twice the amount of money supply created in the US, the eurozone and Japan combined over the same period. In total, China’s money supply stands at Rmb192tn, equivalent to $28tn. It equals the size of broad money supply in the US and the eurozone put together, yet China’s nominal GDP is only two-thirds that of the US.

In a market-based economy constraints are in place, such as the scrutiny of bank shareholders and regulators, which prevent this sort of excess. In a socialist system, such constraints do not exist. Apparently, the Chinese banking system still operates in the latter.

There are clear downsides. Helicopter money discourages innovation and breeds capital misallocation, which reduces productivity growth. Slowing productivity and strong money growth ultimately lead to rising inflation — the dynamics inherent to socialist systems.

In the long run, more stimulus in China will entail more money creation and will heighten devaluation pressures on the renminbi. As we all know, when the supply of something surges, its price typically drops. In this case, the drop will take the form of currency devaluation.

As it stands, China’s money bubble is like a sword of Damocles over the nation’s exchange rate. Chinese households and businesses have become reluctant to hold this ballooning amount of local currency. Continuous helicopter money will increase their desire to diversify their renminbi deposits into foreign currencies and assets. Yet, there is no sufficient supply of foreign currency to accommodate this conversion. China’s current account surplus has almost vanished.

As to the central bank’s foreign exchange reserves, at $3tn they are less than a ninth of the amount of renminbi deposits and cash in circulation. It is inconceivable that China can open its capital account in the foreseeable future.

If China chooses the path of unrelenting stimulus, investors should recognise the long-term negative outlook for the renminbi. Continuous stimulus will beef up investment returns in local currency terms, but currency depreciation will substantially erode returns in US dollars or euros in the long run.

The investment implications go beyond Chinese markets. Market volatility over the past few months as the talk of stimulus picked up has given us a peek into the future. As the renminbi has depreciated by 12 per cent since early 2018, the pain has reverberated across Asian and other emerging markets. The MSCI Asia and MSCI EM equities indices have each fallen 24 per cent in dollar terms since their peak in January 2018. Long-term pressures could play out even more dramatically.

Fortunately, Chinese authorities recognise these issues. Yet they face an immense task of stabilising growth while containing credit and money expansion. This will be hard to achieve in an economy that has become addicted to credit creation.


Arthur Budaghyan is chief emerging market strategist at BCA Research.

Areas of concern

Parts of America may already be facing recession

Slowdowns in housing construction and manufacturing are ominous




IT CAN BE hard to know when isolated announcements become something more. Since last November General Motors has cut several thousand factory jobs at plants across the Midwest.

In early August US Steel said it would lay off 200 workers in Michigan. Sales of camper vans dropped by 23% in the 12 months ending in July, threatening the livelihoods of thousands of workers in Indiana, where many are made. Factory workers are not the only ones on edge.

Lowes, a retailer, recently said it would slash thousands of jobs. Halliburton, an oil-services firm, is cutting too.

In any given month, even at the height of a boom, more than 5m Americans leave a job; nearly 2m are laid off. Most of the time, however, overall employment grows. But not all the time.

America may or may not be lurching towards a recession now. For the time being employment and output continue to grow. But in the corners of the economy where trouble often rears its head earliest, there are disconcerting portents.

Recessions are synchronised declines in economic activity; weak demand typically shows up in nearly every sector in an economy. But some parts of the economic landscape are more cyclical than others—that is, they have bigger booms and deeper slumps. Certain bits tend to crash in the earliest stages of a downturn whereas others weaken later. Every downturn is different.

Those caused by a spike in oil prices, for example, progress through an economy in a different way from those precipitated by financial crises or tax increases.

But most recessions follow a cycle of tightening monetary policy, during which the Federal Reserve raises interest rates in order to prevent inflation from running too high. The first rumblings of downturns usually appear in areas in which growth depends heavily on the availability of affordable credit. Housing is often among the first sectors to wobble; as rates on mortgages go up, this chokes off new housing demand. In a paper published in 2007 Edward Leamer, an economist at the University of California, Los Angeles, declared simply that “housing is the business cycle”. Recent history agrees.

Residential investment in America began to drop two years before the start of the Great Recession, and employment in the industry peaked in April 2006. Conditions in housing markets were rather exceptional at the time. But in the downturn before that, typically associated with the implosion of the dotcom boom, housing also sounded an early alarm.

Employment in residential construction peaked precisely a year before the start of the downturn. And now? Residential investment has been shrinking since the beginning of 2018.

Employment in the housing sector has fallen since March.

Things may yet turn around. The Fed reduced its main interest rate in July and could cut again in September. If buyers respond quickly it could give builders and the economy a lift. But housing is not the only warning sign. Manufacturing activity also tends to falter before other parts of an economy. When interest-rate increases push up the value of the dollar, exporters’ competitiveness in foreign markets suffers. Durable goods like cars or appliances pile up when credit is costlier.

In the previous cycle, employment in durable-goods manufacturing peaked in June 2006, about a year and a half before the onset of recession. This year has been another brutal one for industry. An index of purchasing managers’ activity registered a decline in August. Since last December manufacturing output has fallen by 1.5%. Rather ominously, hours worked—considered to be a leading economic indicator—are declining. Some of this is linked to President Donald Trump’s trade wars, which have hurt manufacturers worldwide. But not all. Domestic vehicle sales have fallen in recent months, suggesting that Americans are getting more nervous about making big purchases.

In some sectors, technological change makes it difficult to interpret the data. Soaring employment in oil industries used to be a bad sign for the American economy, since hiring in the sector tended to accompany consumer-crushing spikes in oil prices. But America now produces almost as much oil as it consumes, thanks to the shale-oil revolution. A recent fall in employment and hours in oil extraction may be a bad omen rather than a good one. By contrast, a fall in retail employment was once unambiguously bad news. But retail work in America has been in decline for two and a half years; ongoing shrinkage may not signal recession, but the structural economic shift towards e-commerce.

Other signals are less ambiguous. In recent decades employment in “temporary help services”—mostly staffing agencies—has reliably peaked about a year before the onset of recession. The turnaround in temporary employment in 2009 was among the “green shoots” taken to augur a long-awaited labour-market recovery. Since December it has fallen by 30,000 jobs.




Even if America avoids a recession, the present slowdown may prove politically consequential. Weakness in some sectors, like retail, is spread fairly evenly across the country. But in others, like construction or, especially, manufacturing, the nagging pain of the moment is more concentrated (see map). Indiana lost over 100,000 manufacturing jobs in the last downturn, equal to nearly 4% of statewide employment. It is now among a modest but growing number of states experiencing falling employment: a list which also includes Ohio, Pennsylvania and Michigan.

Those four states, part of America’s manufacturing heartland, suffered both early and deeply during the Great Recession. In 2016 all delivered their electoral-college votes to Mr Trump, handing him the presidency. The president’s trade war might have been expected to play well in such places. But if the economic woe continues, voters’ faith in Mr Trump is anything but assured. Choked states might well turn Democrat-blue.

It’s Official: The World’s Third Oil Shock Is Underway…

By Nick Giambruno, chief analyst, The Casey Report



The world’s next oil shock is playing out exactly as I predicted…

On Saturday morning, tensions in the Middle East escalated after drones attacked two major oil facilities in Saudi Arabia.

The strikes knocked out more than half of Saudi Arabia’s crude oil output… and 5% of the world’s oil supply. The Houthi movement in Yemen, which is at war with Saudi Arabia, claimed responsibility. The U.S. government, however, has blamed Iran.

In any case, this attack is unprecedented and makes escalating actions almost inevitable. I think it’s only the beginning.

If you thought this attack was disruptive, understand that it’s only a tiny example of what could really happen in the case of a full-fledged war with Iran, which grows more likely by the hour.

If you’ve been reading the Dispatch, this shouldn’t come as a surprise at all. I’ve been saying that the chances of war with Iran are higher than ever…

And when it happens, it will have tremendous consequences for the price of oil.

We’re seeing this play out just as I predicted. The attacks sent the global oil markets into chaos… and crude oil prices are up 14% today as I write.

And I saw it coming a mile away. Today, I’ll show you everything you need to know about the rising tensions with Iran – including what Iran could do next…


Tensions Flaring

You see, about a year ago, I warned readers of my newsletter, The Casey Report, that the next big war in the Middle East was coming. And I showed them why it would focus on Iran.

But let me give you a quick refresher of what’s going on…

Tensions in the Persian Gulf region were already near a boiling point as U.S. sanctions choked Iran’s economy. But Iran hasn’t taken this economic strangulation lying down. It has a few cards to play, too.

Let me explain…

Things have been heating up around a key waterway in the Middle East – the Strait of Hormuz.

Six oil tankers were attacked near the Strait and the Persian Gulf, and the U.S. government blamed Iran.

Iran then shot down a $120 million U.S. drone. It claims the drone was flying in its airspace.

In response, Trump approved airstrikes against Iranian targets. It would have started a full-scale war… but Trump pulled back at the last minute.

And those are just a few of the skirmishes that are now making headlines. In short, tensions between the U.S. and Iran are flaring.

But Iran holds a powerful card… because it controls the Strait.

Oil’s Most Important Chokepoint

The Strait is a narrow strip of water that links the Persian Gulf to the rest of the world. It’s the most important oil chokepoint in the world.

Five of the world’s top 10 oil-producing countries – Saudi Arabia, Iran, Iraq, the United Arab Emirates, and Kuwait – border the Persian Gulf. The Strait of Hormuz is their only sea route to the open ocean… and world markets.

Every day, nearly 19 million barrels of oil pass through the Strait of Hormuz. That translates into roughly 33% of the world’s oil traded by sea. It’s over $1.2 billion in value every single day.

That’s part of the reason why big Middle East wars are often catastrophic for global oil supplies.

After all, almost 40% of global oil exports comes from the Middle East. Take a look:

Chart

As you can see, shutting down the Strait is Iran’s next powerful option in this conflict. And the investment implications are huge…


The Next Oil Shock

If Iran shuts down the Strait of Hormuz, it would cause the largest oil supply shock the world has ever seen.

And that will cause a huge price shock.

A “price shock” is when the price of something rises so quickly that businesses cannot react.

Two classic examples are the First and Second Oil Shocks.

The First Oil Shock happened in 1973.

A regional war in the Middle East caused the price of oil to nearly triple. It triggered a massive gas shortage in the U.S.… and a lot of panic.

Drivers sat in lines stretching for blocks, waiting to fill up their gas tanks. Some gas stations closed.

Others operated by appointment only. Rationing was introduced.

The Second Oil Shock came in 1979. Crude prices nearly tripled again… also caused by conflict in the Middle East.

You can see what happened to the oil price during both oil shocks in the next chart.

Chart

I would expect the Third Oil Shock’s effect on the oil price to be at least as severe as the first two shocks. Recall that oil prices nearly tripled both times.

In today’s prices, that would likely mean oil shooting to around $200 a barrel…

A Golden Opportunity

However, the market doesn’t appreciate how close we are to a war yet.

Yes, the price of oil is rising, but this is just the beginning.

In this environment, you want to own the highest-quality oil stocks. That means two things:

1) Companies that have done well during turbulent times in the past.

2) Companies that aren’t heavily exposed to trouble in the Middle East.

As Middle East supply disruptions cause oil prices to skyrocket around the world, companies that fulfill these criteria will be your ticket to profits.

So if you haven’t yet, now’s the time to get in.

Three JPMorgan metals traders charged with market manipulation

US prosecutors allege ‘massive, multiyear scheme’ to defraud customers

Henry Sanderson and Neil Hume in London


US prosecutors have charged three JPMorgan metal traders with a “massive, multiyear scheme” to manipulate markets and warned they were continuing to probe higher echelons at the largest US bank.

Michael Nowak, head of precious metals trading, was charged on Monday along with two colleagues, Gregg Smith and Christopher Jordan, on federal racketeering charges normally used to take down organised crime syndicates.

The indictment alleged that the three traders engaged in “widespread spoofing, market manipulation and fraud” while working at JPMorgan, which along with HSBC dominates global flows of gold and silver trading.

They placed orders they intended to cancel before execution in an effort to “create liquidity and drive prices toward orders they wanted to execute on the opposite side of the market”, it said.

The case will increase scrutiny over global precious metals markets and the dominance of large banks such as JPMorgan, with prosecutors indicating more senior executives and other banks are under investigation.

“We’re going to follow the facts wherever they lead,” said Brian Benczkowski, assistant attorney-general. “Whether it’s across desks or upwards into the financial system.”

The Dodd-Frank financial reform law of 2010 imposed criminal penalties for spoofing, the practice of duping other market participants by entering and rapidly cancelling large orders.

This was the first time that federal racketeering charges have been applied in a spoofing case, a derivatives lawyer said.

Mr Nowak, who joined JPMorgan in 1996, is on leave from the bank, according to a person familiar with the matter, as is Mr Smith, a precious metals trader. JPMorgan declined to comment. Mr Nowak’s lawyers at Skadden, Arps, Slate, Meagher & Flom said Mr Nowak had “done nothing wrong” and they expected “him to be fully exonerated”. Mr Smith and Mr Jordan could not immediately be reached for comment.

Between 2008 and 2016, the traders sought to take advantage of algorithmic traders by placing genuine orders to buy or sell futures, some of them so-called “iceberg orders”, that concealed the true order size, the indictment alleged.

At the same time they placed one or more orders that they intended to cancel before executing, so-called “deceptive orders”, on the opposite side, which were fully visible to the market, the indictment alleged.

“By placing deceptive orders, the defendants and their co-conspirators intended to inject false and misleading information about the genuine supply and demand for precious metals futures contracts into the markets,” the DoJ said.

The DoJ alleged the three men named in the indictment placed deceptive orders for gold, silver, platinum and palladium futures contracts on exchanges run by the CME Group, including the Nymex and Comex exchanges.

In addition, the men also allegedly defrauded JPMorgan’s own clients who had bought so-called “barrier options” by trading precious metals futures contracts “in a way that sought to push the price towards a level at which the bank would make money”, Mr Benczkowski said.

Barrier options are contracts that pay out if the underlying asset breaches a pre-determined price level.

A former JPMorgan trader, Jonathan Edmonds, pleaded guilty to charges of spoofing last November. Another former JPMorgan precious metals trader, Christian Trunz, pleaded guilty in August.

A third trader, Corey Flaum, who worked with Gregg Smith at Bear Stearns before it was acquired by JPMorgan, also pleaded guilty in July, Mr Benczkowski said.

Gold bugs and retail investors have fixated for years on JPMorgan’s precious metals business and its influence over gold and silver markets. “It’s no surprise to me,” said Ted Butler, an independent analyst and persistent critic of the bank’s role in metal markets.


Additional reporting by Gregory Meyer in New York

The Real Loser From the Oil Price Jump Is China

Nation is already dealing with an inflation spike and weak manufacturing margins

By Nathaniel Taplin



Higher oil prices are no longer an unalloyed negative for the U.S., but they are for the world’s largest crude importer: China.

The country is already dealing with a vicious outbreak of African Swine Fever that has pushed the price of pork, its staple meat, up over 40% on the year. Inflation is running at its hottest since 2013, excluding the volatile Chinese New Year holiday period. And amid the ongoing trade war with the U.S., August data released Monday showed investment, retail sales and industrial growth all slowing further—the latter to its weakest in 17 years.

For much of the past year, cheap oil has eased the pain for beleaguered Chinese consumers and businesses. Following Saturday’s attacks on Saudi Arabia, though, the Brent benchmark on Monday has risen about 10% to $65 a barrel. And it could stay elevated for a while, even as Saudi Arabia brings some production back online—in part because investors are now reevaluating the risk of more disturbances in the Middle East. Brent futures show investors betting that oil prices won’t fully move back down to where they were on Friday until next summer, even with the global economy widely expected to weaken further.
.
All of this will make shoring up sagging Chinese growth even more difficult. China has managed to dull the impact of U.S. tariffs with a cheaper currency. Pricier oil, on top of out-of-control food prices, makes devaluing the yuan even riskier than it already was. Beijing’s recent move to exempt new purchases of U.S. pork and other agricultural products from tariffs should be viewed primarily in the context of China’s increasingly alarming domestic food prices rather than softening trade tensions.

Expensive oil makes looser monetary policy riskier too. Analysts widely expect an imminent cut to rates on a key central bank lending facility that underpins China’s new benchmark lending rate. But policymakers remain trapped between a weakening economy and too-pricey food and housing. House prices are still up over 10% on the year, and growth in housing investment actually accelerated to a four-month high in August.

The outlook for Chinese growth is weaker than ever. Given the constraints, though, modest rather than overwhelming 2015-style policy stimulus is probably the best investors can hope for.

A gas station in north China's Hebei

Gold And Backwardation, A Dangerous Mix

by: Austrolib
Summary
 
- Backwardation is a phenomenon in the futures market where spot prices are higher than for future delivery. Usually futures are in contango, where futures sell at a premium to spot.

- Backwardation happens when there is a shortage of a commodity, usually from seasonal factors like prior to a harvest. It is quickly resolved through arbitrage or an increase in supply.

- But what if backwardation happens not because of higher demand to hold a commodity now, but because of lower demand to hold dollars into the future?

- This could theoretically happen if and when dollar interest rates go negative, cheapening futures relative to spot because dollars are taxed.

- Only much higher rates across the yield curve can pull commodities futures out of backwardation in that case.

 
The mechanics of an eventual crack-up boom continue to be put into place. Last week, Alasdair MacLeod at Goldmoney made the case from a futures market perspective. What does a crack-up boom look like numerically in the futures market? His answer: It looks like permanent backwardation across all commodities. How does this theoretically happen? His answer: Negative dollar interest rates. Here I’d like to go into how this actually works, conceptually.
 
First of all, let's define terms. Backwardation is when the spot price for a commodity is more expensive than for delivery of that commodity in the future. The closer to the present, the more expensive the contract. Contango is the opposite, when spot is cheaper than a futures contract and the farther out in time you go, the more expensive the contract. Contango is normal.
 
Backwardation is abnormal, and is corrected by an increase of supply, or price increases by people playing futures arbitrage.
 
Why is contango normal? Because a supplier delivering a commodity in the future allows that supplier to keep his dollars in the present and earn interest on those dollars. That interest is reflected in the higher price for a futures contract the farther into the future you go.
 
Backwardation is abnormal because it means that the demand for a commodity at a certain time is high enough to counteract interest earned on dollars held. Those with a supply would gladly sell in the present to buy that cheaper futures contract and earn the difference. If supplies are short though, backwardation persists until supplies are replenished.
 
Backwardation from the Commodity Side
 
Seasonal backwardation is normal in consumable commodities. It is always a temporary phenomenon where a premium for spot is caused by a physical shortage of a given commodity at a certain time as explained above, for example, immediately before the seasonal grain harvest. This is resolved by the harvest, because then there are present supplies for futures traders to sell while buying the futures contract and profiting on the spread, lowering present prices and raising future prices.
 
This returns the market to contango, where it usually stays until another temporary shortage may arise for whatever reason. There is nothing troubling about this and it happens in cycles.
 

 
Backwardation from the Dollar Side
 
Here's where Macleod adds his critical twist. He asks, what if backwardation is coming not from the commodity side of the equation like a wheat shortage before harvest, but rather from the dollar side of the equation? In other words, not from a positive desire to hold wheat now, but from a negative desire to hold dollars into the future? These are mirror images of the same phenomenon numerically at least, but the latter is in an "evil twin financial universe" if we can call it that. Here's why.
 
Contango, the normal situation in commodities markets, is generally caused by the logical desire to hold dollars for as long as possible. For, say, gold delivered in 2025, the seller gets to hold on to the dollars paid for that contract for 5 years. The interest he can earn on those dollars is reflected in the premium usually demanded for later deliveries.
 
But when we suddenly introduce negative interest rates, there is an unnatural disincentive to hold dollars for longer created by central banks trying to pump asset prices. The longer you hold dollars when rates are negative, the more money you lose. The premium turns into a discount against shorter deliveries, with the highest-priced contract being the most immediate delivery available. And voila, backwardation.
Here is the crux of it. Macleod says the following in his latest piece, and this is the paragraph I want to focus on:
If the Fed introduces negative dollar rates, then distortions of time preference will take a catastrophic turn. All financial markets will move into backwardation, reflecting negative rates imposed on dollars. Remember, the only conditions where backwardation can theoretically exist in free markets are when there is a shortage of a commodity for earlier settlement than for a later one. Yet here are backwardation conditions being imposed from the money side.
 
Let’s work this out step by step. We will use gold here, but it applies for any commodity, because they are all traded in dollars. Let us assume that in order to counter the next recession, the Federal Reserve pushes the fed funds rate to -4%. Let’s now make two assumptions and see what happens logically. First, let’s assume a negative yield curve between the 5Y and the fed funds rate, which is what we have now. The 5Y yield is at 1.39%, and the fed funds rate is at 2.12% currently. That’s a negative spread of 73 basis points.
 
So assuming the same spread, fed funds rate of -4% puts the 5Y at -4.73%. The COMEX offers gold delivery currently out to 2025, about 5 years, so if 5Y yields are –4.73% and overnight is -4%, if you are a seller of gold futures for 2025 you lose 4.73% a year multiplied by 5 for that contract. That’s a total loss of 23.65% over the 5-year period due to the negative interest rates imposed on dollars.
 
However, if you sell a contract for delivery in one month (let's use 1M rates as a proxy for the fed funds rate) you lose only 4/12, or 0.33%. Obviously, in that case, gold for delivery in 2025 would be about 24% cheaper than gold deliverable in one month.
 
Can arbitrage be made over this spread to return the market to contango? Let's consider. Can a speculator make a profit buying gold deliverable in 5 years and selling gold deliverable in 1 month?
 
No, because he's going to lose 24% on gold deliverable in 5 years with negative interest rates.
 
He can only speculate about making money on this move if he is betting on higher interest rates down the road. There is no risk-free arbitrage here as there is with wheat once the harvest comes in and backwardation becomes contango. Plus, there is no such thing as a gold shortage because gold does not get consumed like, say, wheat does. More gold supply does not alleviate the backwardation. Only higher dollar interest rates can possibly do that.
Therefore, in a negative yield curve situation with overnight rates at -4%, everyone tries to buy gold now, raising the dollar price across deliveries and locking the market in backwardation from the dollar side - NOT the gold side. Other commodities fall in terms of gold and rise in terms of dollars.
 
The result when enough traders realize what's going on, is the crack-up boom across the entire commodity complex as the entire commodities futures market warps into backwardation due to negative dollar interest rates.
 
But what if the yield curve is positive? Let’s say the fed funds rate is -4% again. The highest the spread between the 5Y and overnight rates has gone is about 300bps, so let’s assume rates on the 5Y of -1%. What happens then? That means for gold delivered in 5 years, the seller of that contract loses 5% (1% a year multiplied by 5). The seller of 1-month gold loses -4%/12, or .33%. Gold is locked in backwardation whether the yield spread is positive or negative.
 
What could even theoretically stop this process to put gold back in contango? The only possible answer is higher dollar interest rates across the board. How much higher? Let’s say yields on overnight rates are still -4%, and yields on the 5Y move up to 1%. What would be the highest spread between them in history, but let's stick with this. Then sellers can earn 5% on 5Y gold (1% a year), lose 0.33% selling one-month gold. That's a spread of 5.33% down the delivery line, theoretically putting 5Y gold at a 5.33% premium. Unless, of course, the price inflation rate is higher than 5.33%. In that case, a seller of 5Y gold would still lose money in real terms and the premium for 1-month gold remains. Still backwardation persists.
 
The only thing that can take the gold market out of backwardation from negative rates is much higher interest rates across the board with a yield spread substantially higher than the price inflation rate. If, say, rates on the 5Y were 20% like they used to be in 1980, and one-month rates at 0%, then we have a 100% gain waiting 5 years for gold, and no loss for buying it in a month. That could do it, depending on the rate of price inflation and if the loop hasn’t spun out of control by that point. Price inflation would have to be below 20% a year for the market to return to contango in that case.
The big problem is, once the futures market gets locked into backwardation from negative rates, the fear Macleod expresses is that at that point, everyone starts plowing into commodities fast and price inflation explodes, making it much harder to reverse the backwardations. The Fed will not have much time to reverse the situation once it starts, if doing so is even possible without destroying the incredibly leveraged global economy.
 
Conclusion
 
Negative dollar interest rates are an absolute disaster waiting to happen. If it ever does happen, once we start to see nominally negative rates in the United States, the danger of a crack-up boom becomes very real. The only cure would be to jack up dollar interest rates very quickly to rates higher than the inflation rate. This was possible in the late 1970s and early 1980s when rates actually did go to 20%.
 
Debt was so much smaller back then. But this time, the wave of bankruptcies across corporate and sovereigns would break records.
 
The entire German and Swiss yield curves are already below zero. It’s not causing backwardations in commodity markets though because commodities are priced internationally and settled in dollars, the reserve currency, not euros or Swiss francs. But a systemic shock to Europe could lead the Fed to introduce negative rates in the world’s reserve currency if the European Central Bank and Swiss National Bank go there first. If that happens, duck and cover.
 
You can either hope this doesn’t happen and assume the Fed understands the threat of backwardation from the dollar side, and therefore won’t introduce negative rates under any circumstances. Or you can prepare for it, assuming they will.