Too dicey

Betting on bitcoin prices may soon be deemed illegal gambling

Regulators increasingly think crypto-derivatives are unsuitable for retail investors




ON SEPTEMBER 24TH the price of a single bitcoin, the best-known cryptocurrency, fell by $1,000 in 30 minutes. No one knows why, and few people cared. There have been similar drops nearly every month since May. Yet for one obscure corner of the market, it mattered.

Exchanges that sell “long” bitcoin derivatives contracts, with which traders bet that prices will rise without buying any coin, soon asked punters for more collateral. That triggered a stampede. By the end of the day $643m-worth of bitcoin contracts had been liquidated on BitMEX, a platform on which such contracts trade. Bets on other cryptocurrencies also became toxic.

Crypto-derivative products, which include options, futures and more exotic beasts, are popular. More than 23bn have been traded so far in 2019, according to Chainalysis, a research firm. But tantrums such as last month’s have put them in regulators’ cross-hairs. Japan is considering stringent registration requirements.

Hong Kong bars retail investors from accessing crypto funds; Europe has had stiff restrictions since last year. Now the Financial Conduct Authority (FCA), a British watchdog, is proposing a blanket ban on selling crypto-derivatives to retail investors. A consultation ended on October 3rd. Its decision is expected in early 2020.

It would take an earthquake for the FCA not to press ahead. In the real world, importers buy derivatives as a defence against slumps in their domestic currency. But crypto-monies are not legally recognised currencies. They do not reliably store value, rarely serve as a unit of account and are not widely accepted. Peddlers of crypto-derivatives, the FCA says, cannot claim their wares are needed for hedging purposes.

That explains why most such derivatives are marketed as investment products. Yet they are not tempting places to park savings. The assets they track are hard to value: virtual monies promise no future cash flows. Prices across cryptocurrencies are strongly correlated, suggesting that demand does not stem from usage or technological advances. Instead it responds to hype (for which Google searches are a proxy; see chart). Thin trading means that prices differ widely between crypto-exchanges, making them a poor reference for derivative contracts. Illiquidity also amplifies swings: bitcoin is four times more volatile than risky physical commodities.




The FCA thinks crypto amateurs fail to understand all this. It estimates that investors in Britain made total losses of £371m ($492m) on crypto-derivatives from mid-2017 to the end of 2018 (net profit was £25.5m, but was mostly captured by the largest investors). Two other features can make losses catastrophic: leverage (platforms typically allow derivative traders to borrow between two and 100 times what they put in) and high trading costs. The FCA thinks its mooted ban could reduce consumer losses by up to £234m a year.

Insiders disagree. “This is a knee-jerk reaction,” says Jacqui Hatfield of Orrick, a law firm. “Crypto-derivatives are just as risky as other derivatives.” A ban could mean consumers invest directly in unregulated cryptocurrencies instead. Exchanges could relocate. In any case, says Danny Masters of CoinShares, which sells crypto vehicles, the regulator should not be choosing which technology thrives or fails.

Yet it is part of the FCA’s mandate to protect consumers against predators. Nearly $1bn in virtual coins were stolen from crypto-exchanges and infrastructure last year, 3.6 times more than in 2017. Such thefts hit the value of derivatives. Manipulation is also rife. “Retail investors are diving in a pool of sharks,” says David Gerard, a bitcoin sceptic. As regulators close in on market abuse, defenders of crypto-derivatives are swimming against the tide.

What a Power Struggle in Beijing Might Look Like

The president won’t fall completely, but his authority could wane.

By Phillip Orchard

 

On Oct. 1, 2019, exactly 70 years since Mao Zedong stood in triumph at the gates of the Forbidden City and declared the creation of the People’s Republic of China, Chinese President Xi Jinping was doing his best imitation of the great helmsman. Dressed in a black tunic identical to the one worn by Mao in his famous portrait at Tiananmen Gate, Xi echoed Mao’s boasts that only the Communist Party of China is capable of protecting China from foreign exploitation. Xi, like Mao, then inspected the People’s Liberation Army – though, this time, instead of American tanks captured by Mao’s forces from the nationalists in 1949, Xi reviewed an extravagant parade of new indigenous weapons systems, including new hypersonic missiles and intercontinental ballistic missiles meant to keep the U.S. at bay.


The message of the meticulously choreographed affair was obvious: The CPC has vanquished the ghosts of the century of humiliation and transformed China into a unified emerging power – and Xi has the unquestioned mandate from heaven to carry forward the project of national rejuvenation started by Mao. But those with a stake in Beijing’s opaque power politics may have been watching for more subtle messages: A curious choice of words in Xi’s speech, or the unexpected presence of a certain official on the rostrum with Xi, or a quiet shift in state propaganda themes – anything that would hint that, as was often the case with Mao himself, Xi’s grip on power was not so absolute.

Some were likely disappointed; the ceremonies were clearly tailored to the purpose of deifying Xi, with state media crowning him the “people’s leader” – a title not used since Mao. Still, in recent months, the frequency of supposed hints of discontent with Xi has picked up again, both among those who believe he is too much like Mao and those who believe he is not enough like Mao. Given China’s socio-economic pressures, along with the trail of purged rivals and discarded norms Xi left behind as he consolidated power, it’d be naive to assume the president is immune to challenge altogether. So it’s worth asking: What might a major power struggle look like?
 
Reading the Tea Leaves
Power struggles in China typically spill into the public sphere with thumb-biting and coded taunts rather than bare-knuckle brawls. The media is too tightly controlled, and the risks of open speculation too high, for the case to be otherwise. Observers are typically stuck parsing sodden tea leaves for clues about unrest beneath the surface. Still, as in any country, rival factions in China have incentives to find ways to weaken each other in the public eye and use the state’s megaphones to build popular support for their objectives. And since state propaganda, official speeches and personnel moves are so carefully scripted, and thus so pregnant with symbolism, even small deviations from established trends can carry enormous meaning. Silence can also be deafening.

One prominent example: Following the death of Premier Zhou Enlai in 1976, with Mao effectively on his own death bed, the infamous Gang of Four (including Mao’s wife) used state media to accuse acting Premier Deng Xiaoping of counterrevolutionary activities, betraying the power struggle raging behind the scenes. Deng, of course, came roaring back after Mao’s death and was promptly rehabilitated in state media, which in time announced the gang’s arrest long after purging them from state propaganda.

Despite the arrival of the information age, little has changed. If anything, Xi’s embrace of a cult of personality, which was frowned upon by Deng, has made problems somewhat easier to detect. When Xi is at the center of nearly everything produced by state media organs, any sudden downtick in official adulation over the president becomes very conspicuous. In late 2017 and early 2018, for example, state media made it clear that Xi was effectively untouchable. Sure enough, at the epochal 19th Party Congress in November 2017, Xi was enshrined in the party’s constitution and succeeded in stacking the Politburo with loyalists. Three months later, at the National People’s Congress, Xi eliminated presidential term limits and, arguably more important, pushed through a staggering reorganization of the machinery of the state.

But cracks began to show. In July 2018, for example, several prominent portraits of Xi in cities across China, as well as one portraying Xi’s father, Xi Zhongxun, as the real architect of the success of Shenzhen, disappeared. The Shaanxi Academy of Social Sciences abruptly announced the end of a highly touted research project into Xi’s time as a student in a rural village during the Cultural Revolution. And the Xinhua News Agency published an article criticizing former Chinese leader Hua Guofeng for cultivating a Mao-style cult of personality – a veiled critique of Xi. For several weeks in late July and August, amid rumors of a coup, Xi disappeared from the front pages of the People’s Daily altogether. Around this time, two of Xi’s most powerful loyalists, propaganda chief Wang Huning, who oversees the effort to deify Xi, and Vice President Liu He, responsible for several contentious issues, including trade negotiations with the U.S. and SOE reforms, also disappeared from the front pages.

If Xi was ever truly threatened, he quickly bounced back and by September was once again monopolizing the media’s attention. But hints of discontent have continued. For example, ideological divisions between Deng advocates (including Deng’s son) and Xi supporters were laid bare in the run-up to the 40th anniversary of Deng’s reform and opening. Xi’s speeches and state propaganda subsequently changed, emphasizing more than before the notions of ideological purity and loyalty to party leadership – and threatening to impose autarky and take the country on a new “long march” if that’s what unity required. But while in 2017, every high-profile speech he made spurred ritualistic demonstrations of loyalty and support among key officials, now they are perfunctory and scarce, even among the president’s closest allies, some of who have remained silent. Perhaps most conspicuous, Xi has repeatedly pushed back the Fourth Plenum of the 19th Central Committee, suggesting concern about exposing the party’s internal divides. Last month, Xi mentioned “struggle” 56 times in a single speech – reviving a theme favored by Mao at the height of intra-party battles in the 1960s and 1970s.
 
Implications
There’s a risk of reading too much into these sorts of things, of course, and of measuring Xi’s control against unrealistic expectations. Some hints could go either way. Does the lack of high-profile purges this year, for example, suggest that Xi is immune to backlash, or simply that there are no potential rivals left worth targeting? If criticism of Xi’s policies increases, does that mean the opposition is more emboldened, or that Xi is confident enough to allow for the level of honest debate needed to avoid the policy pitfalls inherent to an echo chamber? Are tightened capital controls that target private sector tycoons politically motivated or merely meant to fight corruption and rein in reckless financial speculation?

Ultimately, divining the motivation behind certain choices is perhaps less important than understanding the nature of the choices themselves. Right now, Xi has only bad options.

He can’t, for example, micromanage the economy more than he is without prolonging trade tensions with the West, scaring off foreign investment, risking a credit crisis and 
creating a fracture along China’s historical fault line between the interior and the coasts. But he can’t push reform or liberalize too much without abandoning Beijing’s favored tools for staving off an existential socio-economic crisis. And as the global economic slowdown intensifies, the next few years are likely to make disagreement over things like reform and opening an order of magnitude more intense.

Absent a worst-case economic scenario, it’s hard to imagine Xi abruptly falling from power. The Communist Party has probably wrapped its own legitimacy too tightly in Xi’s cult of personality to avoid falling with him. During his first term, moreover, Xi’s sweeping purges smashed up traditional factions, took down extraordinarily powerful figures and their proteges, and reconfigured critical patronage networks that now have him at the center. Xi also took tight control of the PLA, the guarantor of CPC rule.

But even if his formal position is bulletproof, Xi’s real authority – over policy direction, over personnel choices at the next Party Congress in 2022, over lucrative patronage networks – could theoretically be taken from him. And this could prove deeply problematic by, say, reviving crippling factional struggles and leading to paralysis in a crisis. After all, Xi’s consolidation of power in his first term wouldn’t have happened without widespread recognition among Chinese leaders that the turbulent waters ahead necessitate a strongman at the helm. The CPC’s embrace of Xi’s dictatorship may now be causing as many problems as it was intended to solve. But so too would paddling in opposite directions midstream.

China’s 70 Years of Progress

Much of the West, as well as Asia, continues to assume the worst about China – a habit of mind that could have catastrophic consequences. As Albert Camus once wrote, “Mistaken ideas always end in bloodshed, but in every case it is someone else’s blood."

Keyu Jin

jin19_HowHweeYoungPoolGettyImages_jinping70celebration


BEIJING – The celebration of the 70th anniversary of the founding of the People’s Republic of China on October 1 will be an exuberant affair, involving glitzy cultural events, an extravagant state dinner attended by Chinese and foreign luminaries, and a grand military parade in Tiananmen Square. And, at a time of high tensions with US President Donald Trump’s administration, it will be imbued with an extra dose of patriotic enthusiasm. But while China has much to celebrate, it also has much work to do.

The first 30 years of rule by the Communist Party of China (CPC) are judged harshly, owing to the disastrous Great Leap Forward and the Cultural Revolution. But these were not lost decades. On the contrary, major strides were made in modernizing China: local and national power grids were established, industrial capacity was strengthened, and human capital rapidly improved.

As a result, China’s human-development indicators, on par with India’s 70 years ago, surged ahead. From 1949 to 1979, the literacy rate rose from below 20% to 66%, and life expectancy increased from 41 to 64 years. All of this set the stage for Deng Xiaoping’s program of “reform and opening up,” which unleashed China’s rapid economic growth and development over the last 40 years.

Today, China’s to-do list remains long, but its leaders are working consistently to check off agenda items, from reducing inequality and reversing environmental degradation to restructuring the economy. If they are to succeed – thereby solidifying China’s development model as a viable alternative to Western-style liberal democracy – they will need to deliver on two key imperatives in the coming years.

First, China needs to reach high-income status. So far, China has relied on the massive size of its markets and rapid output growth to raise incomes. But these forces only take an economy so far, and China’s institutions, technology, and prevailing mindset remain more closely aligned with today’s $10,000 per capita income than with the $30,000 level to which the country aspires.

Second, China must ensure that the Belt and Road Initiative (BRI) is a success. This means implementing an inclusive program of cost-effective, environmentally sustainable infrastructure construction that does not result in unsustainable debts.

Neither of these goals will be easy to achieve, especially given a challenging external environment. While China revels in its birthday celebration, the outside world – beginning with the United States – is worrying about China’s aspirations to become a global leader in technology and in geopolitical terms.

When a large ship sets sail, its wake will agitate other boats, no matter how skillfully it is steered. And yet China faces the daunting task of keeping other countries calm as it sails on. This will require, above all, open, frank, and consistent communication between China and the outside world.

But the onus is not entirely on China; Western leaders also must be receptive to the country’s efforts. China has long promised the world a “peaceful rise.” Unlike the nineteenth-century US, it has no Monroe Doctrine, which attempts to guarantee its sphere of influence, and claims no “manifest destiny” to expand its territory at all costs. In fact, since Deng, all but one of China’s border disputes have been settled through peaceful negotiations. It took China 11 years to negotiate, inch by inch, its borders with Russia.

Yet much of the West, as well as Asia, continues to assume the worst about China – a habit of mind that could have catastrophic consequences. As Albert Camus once wrote, “Mistaken ideas always end in bloodshed, but in every case it is someone else’s blood. That is why some of our thinkers feel free to say just about anything.”

To avoid falling into the trap of war, Western political and intellectual leaders must not blindly believe those who assume that confrontation with an ascendant China is inevitable. If any historical experience should be brought to bear, it is that of near-misses and miscalculations – reminders of how easily a standoff can become a calamity.

Past incidents – such as the 1999 bombing of the Chinese embassy in Belgrade by NATO forces, or the 2001 collision of US and Chinese aircraft off Hainan Island – have been settled through negotiation. But, given rising antagonism toward China, there is no telling whether leaders would manage to replicate that outcome were a similar incident to occur today.

The first 70 years of CPC rule brought rapid development, but ultimately only modest prosperity. Now, China must shift its attention to raising incomes and implementing the BRI effectively. These goals can be achieved only in a peaceful, stable context. China’s leaders understand that. But they still must convince the West that they do.


Keyu Jin, Professor of Economics at the London School of Economics, is a World Economic Forum Young Global Leader.

The $5tn diaspora: Dimon’s lieutenants take top roles

JPMorgan Chase alumni flex the network as Scharf moves to Wells Fargo

Robert Armstrong in New York


Former lieutenants of Jamie Dimon, second from left. Top roles at other financial institutions include, left to right: Jes Staley of Barclays, Matt Zames of Cerberus and Bill Winters of Standard Chartered © FT montage / Bloomberg


The appointment of Charlie Scharf as chief executive of Wells Fargo is not just a crucial turning point for the troubled San Francisco bank. It also represents further consolidation of the most powerful professional network in global finance: the JPMorgan Chase executive diaspora.

Former JPMorgan executives now lead banks with assets totalling some $4.7tn. Add in JPMorgan itself, where Jamie Dimon is into his 14th year as chief executive, and the sum reaches $7.4tn.

In the UK, Barclays is run by Jes Staley, who previously ran both JPMorgan’s asset management and investment banking divisions, and Standard Chartered is led by Bill Winters, who also did a stint leading the JPMorgan investment bank. In the US, in addition to Wells, PNC Financial, the eighth-largest bank in the country, is run by Bill Demchak, who ran JPMorgan’s structured finance and credit businesses.

Mr Scharf’s JPMorgan career culminated with his leadership of the retail banking division from 2004 to 2012, before he become chief executive of Visa and then BNY Mellon.

The Dimon network does not stop at the banking industry. Frank Bisignano, former JPMorgan chief operating officer, is the chief executive of First Data, the payments company that was sold to rival Fiserv for $22bn in January. Matt Zames, another former chief operating officer, is president of the private equity company Cerberus. Ryan McInerney, now president of Visa, once ran consumer banking at JPMorgan.

Investors and analysts give much of the credit to Mr Dimon’s own management skills. “The skills he teaches, the qualities he looks for, if I was [Wells’ chair] Betsy Duke or head of another search committee, I would look right to JPMorgan,” said Tom Brown, a longtime bank investor and commentator. “The highest praise I can give someone is that they make complicated issues simple, and Jamie and Charlie [Scharf] are so much alike in that way.”

Certainly, the credentials of any JPMorgan alum are burnished by the outstanding performance of JPMorgan shares, which have almost tripled over the past 10 years, far outpacing all other big US banks. The bank did not go through the near-death experiences that convulsed so many rivals during the financial crisis.

“JPMorgan being JPMorgan definitely helps,” said Jeffrey Harte, an analyst Sandler O’Neill. “Managers could focus on running their businesses during the crisis when others were in survival mode.” He cites strategic consistency and an emphasis on accountability in both good times and bad as hallmarks of the Dimon regime.

Several industry insiders note that JPMorgan’s outsize influence is not without precedent, pointing out how executives at Citigroup in the 1980s and 1990 went on to play important roles at other institutions. One of these was Mr Dimon himself. The list also includes Richard Kovacevich, who went on to lead Wells Fargo.
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Not everyone thinks that the enthusiasm for executives who have worked under Mr Dimon is entirely benign. “Whenever we have a hero, we develop cultures around that — look at Silicon Valley and Steve Jobs, and everyone walking around in black turtlenecks. There is definitely too much emphasis on the persona and not enough on the leadership behaviour,” said Lindred Greer, faculty director at the Sanger Leadership Center at the University of Michigan.

Dave Ellison, who runs a portfolio of financial stocks at Hennessy Funds, thinks that the world of banking has become too cosy. “These boards of directors is a moneyed club — they all know each other . . . I was hoping Wells Fargo would take a chance on someone new, someone out of the box who would shake things up.”

The world of very low rates and increasing technological competition requires that banks think in new ways, Mr Ellison said. “But here is another case where they are bringing in someone else who is in the club, rather than taking a chance on someone new.”

Masters of the universe

The rise of the financial machines

Forget Gordon Gekko. Computers increasingly call the shots in financial markets




THE JOB of capital markets is to process information so that savings flow to the best projects and firms. That makes high finance sound simple; in reality it is dynamic and intoxicating. It reflects a changing world. Today’s markets, for instance, are grappling with a trade war and low interest rates.

But it also reflects changes within finance, which constantly reinvents itself in a perpetual struggle to gain a competitive edge. As our Briefing reports, the latest revolution is in full swing. Machines are taking control of investing—not just the humdrum buying and selling of securities, but also the commanding heights of monitoring the economy and allocating capital.

Funds run by computers that follow rules set by humans account for 35% of America’s stockmarket, 60% of institutional equity assets and 60% of trading activity. New artificial-intelligence programs are also writing their own investing rules, in ways their human masters only partly understand. Industries from pizza-delivery to Hollywood are being changed by technology, but finance is unique because it can exert voting power over firms, redistribute wealth and cause mayhem in the economy.

Because it deals in huge sums, finance has always had the cash to adopt breakthroughs early.

The first transatlantic cable, completed in 1866, carried cotton prices between Liverpool and New York. Wall Street analysts were early devotees of spreadsheet software, such as Excel, in the 1980s. Since then, computers have conquered swathes of the financial industry.

First to go was the chore of “executing” buy and sell orders. Visit a trading floor today and you will hear the hum of servers, not the roar of traders. High-frequency trading exploits tiny differences in the prices of similar securities, using a barrage of transactions.

In the past decade computers have graduated to running portfolios. Exchange-traded funds (ETFs) and mutual funds automatically track indices of shares and bonds. Last month these vehicles had $4.3trn invested in American equities, exceeding the sums actively run by humans for the first time. A strategy known as smart-beta isolates a statistical characteristic—volatility, say—and loads up on securities that exhibit it. An elite of quantitative hedge funds, most of them on America’s east coast, uses complex black-box mathematics to invest some $1trn. As machines prove themselves in equities and derivatives, they are growing in debt markets, too.

All the while, computers are gaining autonomy. Software programs using AI devise their own strategies without needing human guidance. Some hedgefunders are sceptical about AI but, as processing power grows, so do its abilities. And consider the flow of information, the lifeblood of markets.

Human fund managers read reports and meet firms under strict insider-trading and disclosure laws. These are designed to control what is in the public domain and ensure everyone has equal access to it. Now an almost infinite supply of new data and processing power is creating novel ways to assess investments.

For example, some funds try to use satellites to track retailers’ car parks, and scrape inflation data from e-commerce sites. Eventually they could have fresher information about firms than even their boards do.

Until now the rise of computers has democratised finance by cutting costs. A typical ETF charges 0.1% a year, compared with perhaps 1% for an active fund. You can buy ETFs on your phone. An ongoing price war means the cost of trading has collapsed, and markets are usually more liquid than ever before.

Especially when the returns on most investments are as low as today’s, it all adds up. Yet the emerging era of machine-dominated finance raises worries, any of which could imperil these benefits.

One is financial stability. Seasoned investors complain that computers can distort asset prices, as lots of algorithms chase securities with a given characteristic and then suddenly ditch them. Regulators worry that liquidity evaporates as markets fall. These claims can be overdone—humans are perfectly capable of causing carnage on their own, and computers can help manage risk.

Nonetheless, a series of “flash-crashes” and spooky incidents have occurred, including a disruption in ETF prices in 2010, a crash in sterling in October 2016 and a slump in debt prices in December last year. These dislocations might become more severe and frequent as computers become more powerful.

Another worry is how computerised finance could concentrate wealth. Because performance rests more on processing power and data, those with clout could make a disproportionate amount of money. Quant investors argue that any edge they have is soon competed away.

However, some funds are paying to secure exclusive rights to data. Imagine, for example, if Amazon (whose boss, Jeff Bezos, used to work for a quant fund) started trading using its proprietary information on e-commerce, or JPMorgan Chase used its internal data on credit-card flows to trade the Treasury bond market. These kinds of hypothetical conflicts could soon become real.

A final concern is corporate governance. For decades company boards have been voted in and out of office by fund managers on behalf of their clients. What if those shares are run by computers that are agnostic, or worse, have been programmed to pursue a narrow objective such as getting firms to pay a dividend at all costs?

Of course humans could override this. For example, BlackRock, the biggest ETF firm, gives firms guidance on strategy and environmental policy. But that raises its own problem: if assets flow to a few big fund managers with economies of scale, they will have disproportionate voting power over the economy.

Hey Siri, can you invest my life savings?

The greatest innovations in finance are unstoppable, but often lead to crises as they find their feet. In the 18th century the joint-stock company created bubbles, before going on to make large-scale business possible in the 19th century.

Securitisation caused the subprime debacle, but is today an important tool for laying off risk.

The broad principles of market regulation are eternal: equal treatment of all customers, equal access to information and the promotion of competition.

However, the computing revolution looks as if it will make today’s rules look horribly out of date.

Human investors are about to discover that they are no longer the smartest guys in the room.

German scepticism of the ECB reveals a eurozone paradox

Berlin remains wary of being the paymaster for a ‘transfer union’

Tony Barber

Sabine Lautenschlaeger, former vice president of the Bundesbank, speaks during a farewell ceremony at the Geman central bank in Frankfurt am Main, on May 13, 2014. Lautenschlaeger recently joined the European Central Bank (ECB) as member of the Executive Board. AFP PHOTO / DANIEL ROLAND (Photo credit should read DANIEL ROLAND/AFP/Getty Images)
Sabine Lautenschläger, Germany’s representative on the ECB’s executive board, has resigned two years before her eight-year term is up © AFP


At the heart of Europe’s 20-year-old currency union lies a disturbing paradox. The beating heart of the eurozone economy is Germany. Yet, from the highest levels of policymaking to the lowest levels of the mass media, Germans are the most outspoken critics of the unconventional measures taken over the past decade to ensure the eurozone’s survival.

The paradox captured attention this week when Sabine Lautenschläger, Germany’s representative on the European Central Bank’s executive board, said she would resign more than two years before her eight-year term is up. This makes her the third German to resign from the ECB’s 25-member governing council, either wholly or partly because of disagreements with its policies, since 2011.

No representatives of the eurozone’s other 18 countries have ever resigned from the ECB council because of policy disputes. Germany’s dissent feeds concerns that Europe’s monetary union, rocked to its foundations in the sovereign debt and banking sector crises of 2010-12, is still not solid enough. György Matolcsy, central bank governor of Hungary, a non-eurozone country, even says: “The EU should admit the strategic error of the euro.”

In Germany, unhappiness with the ECB extends way beyond the rarefied realm of central banking. After Mario Draghi, the ECB president, announced the bank’s latest monetary stimulus measures on September 12, Helmut Schleweis, the head of the German Savings Banks Association, denounced the steps as “disastrous”. Bild Zeitung, Germany’s bestselling tabloid, likened Mr Draghi to a vampire sucking the blood of ordinary German savers.

Across the political spectrum, and across society, mistrust of the ECB’s actions is widespread. Chancellor Angela Merkel has lent quiet support to Mr Draghi and taken care not to make public criticisms of his initiatives. However, many politicians, economists, business leaders and media pundits display less restraint. The flood of attacks on Mr Draghi is submerging the once sacrosanct German principle that a central bank must be independent from political pressure.

Germany’s outlook reflects a certain reading of 20th-century history as well as the nation’s present-day circumstances. The hyperinflation of 1923 is a trauma never to be repeated. Fewer lessons are drawn from the disinflation and economic depression that propelled the Nazis to power in the early 1930s. German anxieties about inflation appear exaggerated, given that the eurozone’s average annual inflation rate since 2011 has been 1.1 per cent.

The ECB’s negative interest rates arouse indignation in Germany, where, it is argued, an ageing population needs decent returns on savings. However, the ECB’s measures benefit wealthy Germans by increasing the value of property, shares and other assets. Furthermore, the ECB’s unorthodox interest rate policies have handed a windfall to the German government by pushing sovereign bond yields to record lows.

With borrowing costs so cheap and the economy on the edge of recession, a chorus of voices is calling for Germany to loosen its fiscal strings and launch an infrastructure investment plan. Dieter Kempf, head of the BDI, Germany’s most influential business lobby, says it is time for the government to relax its insistence on balanced budgets. Bruno Le Maire, France’s finance minister, says: “Germany must invest and invest now. ”

The Christian Democrat-Social Democrat “grand coalition” that holds power in Berlin may one day take this advice. Its reluctance to do so reflects the view that Germany must set an example of budgetary prudence to other countries, mainly in southern Europe. Germany’s caution also illustrates a lack of firm direction at the heart of government. Ms Merkel is near the end of her long reign. Each ruling party senses that the CDU-SPD partnership — the third “grand coalition” out of four governments since 2005 — has outlived its usefulness.

Despite party squabbles, a consensus exists that Germany should not be lured into grand schemes of European integration that cast Berlin in the role of paymaster of a “transfer union”. Germany offered a lukewarm response to the proposals for deeper integration by President Emmanuel Macron of France.

At the ECB, the problem for Christine Lagarde, the IMF chief who will replace Mr Draghi on November 1, is that Germans are not the only critics. Nine ECB council members expressed opposition or reservations about the new measures at the September 12 meeting. They included the national central bank heads of Austria, France and the Netherlands, as well as Germany.

Independent experts have doubts, too. Ashoka Mody, a Princeton University economist, warns that the ECB’s measures could not only damage eurozone banks but have dangerous consequences if financial markets fear that heavily indebted governments will have to bail out the banks.

In principle, Europe’s central bankers and politicians can strike a bargain that balances tighter monetary policy and fiscal expansion. Without such a deal, the risk is that markets will focus on the eurozone’s faultlines and the ECB’s internal disputes.

As long as Germany is the odd man out, doubts about the eurozone’s stability will persist.

The Most Crowded Trade

by: Lyn Alden Schwartzer
Summary
 
- Being long the dollar and dollar-related assets (especially Treasuries at the moment) has been the most popular trade this year and for most of the past decade.

- We may be reaching a tipping point for the dollar, where a multi-year bullish trend reaches its apex and sets up for a reversal.

- Look for a weaker dollar in 2020. Nothing is for certain, but that's how the math seems to converge.
 
According to Bank of America Merrill Lynch, being long U.S. treasuries (TLT) has been the most crowded trade over the past four months into September.
 
This is a good cyclical play. When growth is slowing, back-tests show that going into the dollar and treasuries makes sense as a safe-haven trade.
 
However, that cyclical play is starting to run into a structural trend, where rising U.S. deficits are starting to matter. This is likely going to require a weaker dollar to fix, and the market is inherently self-correcting. It's largely a question of timing at this point.
 
I find very few investors that are bearish on the strength of the dollar (UUP) or bullish on anti-dollar bets like emerging markets (EEM). Being long the dollar and viewing dollar-denominated assets as a safe haven is today's most-crowded trade.
 
Deficit-Driven Liquidity Shortage
 
A significant chunk of U.S. economic outperformance over the past five years has been about fiscal stimulus.
 
In my opinion, this next chart is one of the most important visuals to be aware of over the next few years and I've included it in a few recent articles, because this isn't going away. The blue line is the U.S. federal budget deficit as a percentage of GDP. The red line is the unemployment rate. For the first time in modern history, the U.S. deficit is widening to a large deficit during a non-wartime non-recessionary period:
 
U.S. Deficits and Unemployment
 
 
Meanwhile, the Euro Area has focused on austerity. As a group, they have consistently reduced their budget deficits each year so that now, at under 1%, their debts are growing more slowly than nominal GDP.
 
 
Euro Area Government Deficit Chart Source: Trading Economics
 
 
For example, the United States (black dotted line, right axis below) grew its debt as a percentage of GDP from 62% to 106% over the past decade while Germany (blue line, left axis) decreased its debt as a percentage of GDP from 73% to 61%:
 
 
US vs German Government Debt to GDP Chart Source: Trading Economics
 
 
So, not only does the U.S. have massive unprecedented fiscal stimulus equal to about 5% of GDP during non-recession peacetime, but we're doing so from the highest base of debt-to-GDP that the U.S. has had since World War II.
 
On the other hand, U.S. monetary policy has been the reverse of its fiscal policy. The Bank of Japan and European Central Bank have locked rates at zero and performed quantitative easing at a far larger scale relative to GDP than the U.S. Federal Reserve. The Federal Reserve stopped quantitative easing in 2014, performed quantitative tightening for a brief time, and raised rates about 2.5% higher than its peers. On that front, the U.S. has been by far the most hawkish one. However, the big fiscal stimulus is what gave the Fed ability to be hawkish.
 
The result of looser fiscal policy and tighter monetary policy than its peers over the past five years has been stronger U.S. economic growth than the rest of the developed world while simultaneously having a strong dollar, but such a situation is temporary and likely getting close to its apex.

The United States has the largest twin deficit (government deficit/surplus + current account deficit/surplus) out of its developed peers, and higher than many of the BRIC nations:
 
Twin Deficits 
 Data Source: Trading Economics
 
 
 
This twin deficit doesn't matter in the short-term, but it matters significantly in the long-term.
 
As I'll describe below, the United States appears to be reaching a point where its debts and deficits are starting to matter, causing its monetary policy to reverse, and there are some specific catalysts to look for as it relates to timing.
 
The Market is Usually Self-Correcting
 
In late 2014, the Federal Reserve finished its third and final round of quantitative easing (QE), meaning they stopped "printing money" to buy U.S. government debt from institutions. This removed a significant source of liquidity and left the U.S. economy to stand on its own two feet.
 
Dollar liquidity is a tricky thing, because as the world reserve currency, it's the primary currency for lending to emerging markets, buying commodities, and has all sorts of offshore uses.
 
The dollar quickly rose higher relative to many other currencies as that round of quantitative easing ended. The blue line in the chart below is the Fed's balance sheet (when it's going higher, that's quantitative easing), and the red line is the trade-weighted dollar index. Once QE ended, the dollar shot up. It was then choppy for a while, but the beginning of QT gave it another kick back up:
 
 
Dollar vs QE and QT Chart Source: St. Louis Fed
 
A country can't have growing deficits and growing debt vs GDP forever without QE, but they can do it for quite a while until a catalyst brings them to a halt.
 
Ironically for the United States, a strong dollar tends to be that catalyst.
 
The following chart shows the percentage of U.S. privately-owned debt that is held by foreigners (blue line) compared to the trade-weighted dollar index (red line), with a few inflection points marked:
 
Dollar Strength vs Foreign Debt Chart Source: St. Louis Fed
 
 
As the chart shows, there's a historical inverse correlation between dollar strength and the percentage of U.S. debt that foreign sources hold. Whenever the dollar grows stronger, the U.S. private sector ends up having to fund more of its own government's deficits. Foreigners stop buying, and may even begin selling to stabilize their own currencies.
 
The major exception on the chart where the inverse correlation broke down was in the 1990's. There was a three-decade trend from the mid-1980's to 2014 where foreigners were funding an increasing portion of U.S. deficits. They went from holding about 15% of privately-held U.S. debt to 60% of it.
 
This was during a rise of globalization, and particularly the rise of China. That foreign buying reversed course in late 2014, and they are now down to about 45% ownership of privately-held U.S. debt.
 
Starting in 2015, right after QE ended in the U.S. and the dollar became strong, foreigners stopped buying U.S. treasuries. Almost all new U.S. debt issued in the past five years (about $3 trillion worth) has been bought by domestic sources (blue line below). Foreigners (green line) and the Fed (red) have not been buying at significant scale:
 
Federal Debt Holders Chart Source: St. Louis Fed
 
This is quite a lot of debt for domestic balance sheets to hold. The next chart shows the amount of U.S. government debt held domestically compared to U.S. GDP, indexed to 100 five years ago:
 
 
Domestic Debt to GDP Chart Source: St. Louis Fed
 
 
Basically, various institutions have increased their U.S. treasury holdings by 12.3% per year over the past five years compared to 4.1% annual nominal GDP growth over that time period.
 
Additionally, U.S. corporate profits peaked in 2014 right when the dollar index shot up at the end of QE. Pre-tax profits are down since then, and after-tax profits have gone sideways thanks to tax cuts.
 
 
Corporate Profits Chart Source: St. Louis Fed
 
 
This shouldn't be a big surprise, considering that the S&P 500 is a large component of this and as an index they get over 40% of their revenue from foreign sources. All of those foreign income sources translate into fewer dollars when the dollar is strong.
 
This dollar strength has put a lot of pressure on the global economy. Many emerging markets have high dollar-denominated debts, so a stronger dollar effectively raises their debts and puts financial pressure on them, which has caused some of the weaker ones (i.e. Argentina and Turkey this time around) to fall into a currency crisis, and to slow the growth of others.
 
In addition, dollar strength puts a lot of pressure on the United States. Total corporate profits are down, so a combination of tax cuts, share buybacks, and valuation improvements have contributed to continued equity growth. And as previously mentioned, the U.S. has been forced to fund its own deficits.

In other words, the combination of loose U.S. fiscal policy and tight U.S. monetary policy is starting to strain the global system. Argentina and Turkey popped first, everyone has been strained, and now some leaks are starting to show up in the United States.
 
Repo Issues
 
Most investors are aware that the overnight repo market has required Federal Reserve intervention every night for the past two weeks. Starting in mid-September, repo rates spiked, implying that banks don't have cash to lend to each other, and it required ongoing liquidity injections from the Fed to push back down:
 
Repo Rate Chart Source: Trading Economics
 
 
Some commentators in financial media were freaking out because the last time the repo market was this bad was in September 2008 when U.S. banks were afraid to lend to each other overnight due to the risk that one of them would announce bankruptcy the next morning. That was an acute liquidity crisis due to an insolvent banking system.
 
Other commentators were saying the repo spike was nothing, just temporary timing issues. Quarterly corporate taxes were due mid-month. The U.S. Treasury is sucking up a couple hundred billion dollars in extra debt issuance to refill its cash reserves following this summer's debt ceiling issue that forced the Treasury to draw down its cash levels.
 
Evidence shows pretty clearly that the issue is somewhere in the middle. It was not and is not an imminent bank collapse liquidity crisis, nor was it purely a one-time thing. Instead, five years of domestic institutions fully-funding U.S. deficits basically saturated the banks with treasuries and they have trouble holding more. Their cash reserves have run low.
 
In particular, large U.S. banks that serve as primary dealers have been filling up with treasuries and drawing down their cash levels ever since QE ended. This chart shows the percentage of assets at large U.S. banks that consist of treasuries (blue line) vs the percentage of assets that consist of cash (red line):
Bank Liquidity Bedrock Chart Source: St. Louis Fed
 
 
 
Primary dealers are the market makers for treasuries. They don't really have a choice but to buy the supply as it comes, and supply is starting to turn into a fire hose and foreigners aren't buying much of it.
 
The percentage of total assets held as treasuries at large U.S. banks is now over 20%, which is the highest on record.
 
Cash as a percentage of assets at those institutions is now down to 8%, which is right at post-Dodd Frank post-Basel 3 lows. They're pretty much at the bedrock; they can no longer continue drawing down cash and using it to buy treasuries. Cash levels can't (and shouldn't) go lower like they did in the 2000's because that's the type of leverage that led to the financial crisis back then and current regulations require banks to have more cash.
 
A lot of people are confused at how there can be too much supply of treasuries, because there is clearly investor demand for treasuries, especially long-duration treasuries that have performed very well this year.
 
However, most U.S. debt is short-term, and that sheer quantity of short-term debt has been pressuring the banks all year. Over the past few years, bid-to-cover ratios have been declining leading to some messy treasury auctions this year, and starting this spring, the federal funds rate has gone over the interest rate on excess reserves:
 
IOER-FFR Chart Source: St. Louis Fed
 
 
Clearly, this issue has been building for years and has accelerated throughout 2019, and September just happened to be when a couple extra pressures finally caused the system to reach its limit. It doesn't take a repo expert to see that it's not a repo-specific problem. It's a sovereign debt problem.
 
The Dollar's Apex is in Sight
 
As this liquidity squeeze plays out and global economic growth continues to slow, the dollar is still in an upward trend, but these trends historically can reverse very quickly:
 
Chart Data by YCharts

 
Unless the dollar weakens, foreigners are unlikely to resume buying U.S. treasuries at scale.
 
Even though U.S. treasuries pay higher rates than European or Japanese sovereign bonds, currency hedging eliminates that difference, so only investors daring enough to hold un-hedged U.S. treasuries can take advantage of that rate differential. This means that domestic institutions likely have to keep funding most the deficits of over $1 trillion per year, and primary dealers already clearly have a liquidity problem and are already holding a record amount of treasuries as a percentage of assets.
 
There are a few ways this can play out. The most likely outcome is that the Federal Reserve will begin expanding its balance sheet again by 2020 (or perhaps in this fourth quarter 2019) to relieve pressure from domestic balance sheets, which means that the Fed would essentially be monetizing U.S. government deficits. This would inject liquidity into the system, take some of the burden off of domestic institutions for absorbing all of those treasuries, and is likely to weaken the dollar which could allow foreign investors to step in and buy some more treasuries as well.
 
However, timing and details will be interesting.
 
Scenario 1) No U.S. Recession
 
If the Federal Reserve shifts from temporary open market operations "TOMO" to permanent open market operations "POMO" to permanent organic balance sheet expansion (QE by another name), it could address the issue for now.
 
Many investors assume that we would need a crisis scenario for the Fed to re-start QE, but as I showed with bank liquidity hitting bedrock and no end to U.S. debt issuance in sight, the Fed is likely to expand its balance sheet gradually simply due to liquidity pressures. They used to expand their balance sheet gradually prior to the global financial crisis anyway, so this would be a resumption of that but from a much higher starting point.

In a mild scenario, we could see the dollar leveling off and then weakening due to Fed easing, which could help some emerging markets show signs of life. It would give U.S. corporations some currency tailwinds for once rather than headwinds like they've had. In this case, I'd want to be positioned in emerging markets.
 
Vanguard has a good valuation/growth breakdown of the S&P 500 (VOO) and emerging markets (VWO) via their ETFs:
 
VOO vs VWO 
 Table Source: Vanguard
 
 
Emerging markets have higher 5-year growth rates and much lower valuations. They would be my top choice in a weakening dollar environment.
 
As a recent data point, when the DXY dollar index dropped from about 100 to 90 in 2017, the MSCI emerging markets index soared over 37% in dollar terms. Lower debt burdens gave them a burst of earnings growth and then strengthening currencies added onto it for dollar-based investors.
 
However, I don't particularly like just owning an emerging market index due to how heavily weighted they are in China. I prefer analyzing individual markets based on growth, valuations, sector composition, stability, currency fundamentals, and debt levels. I'm optimistic about forward equity returns for Chile, Russia, India, South Korea, Taiwan, and a few others, especially if we get further sell-offs this quarter. I don't have a strong conviction either way on China at this time.
 
One of my favorite emerging market stocks at the moment is Sberbank (OTCPK:SBRCY) as a small position as part of a diversified portfolio. Many investors underestimate how resilient the company is, it has a single-digit P/E ratio, and it offers a very high dividend yield with a modest payout ratio.
 
I would have a moderate outlook on gold (GLD) in dollar terms in this scenario. It would benefit from a weaker dollar and lower U.S. interest rates, but without a recession it wouldn't get a fear trade. I'd be a buyer at current levels.
Scenario 2) U.S. Recession
 
In a more severe scenario, Fed dovishness and liquidity injections aren't enough to keep things going and the U.S. begins encountering recessionary conditions in 2020. We could have some rough earnings numbers for these last two quarters of 2019 (the one that just ended, and the next one), leading into ongoing weakness in 2020.
 
Recessions significantly reduce U.S. tax revenue:
 
Government Tax Receipts Chart Source: St. Louis Fed
 
 
If we have a recession in the coming year, it'll be the first one where the government is already running an annual deficit at 5% of GDP before the recession even begins, which could make for some very interesting situations. We could easily blow a $500 billion hole in the budget as a low-end estimate, and depending on any stimulus measures the government takes, the range of numbers goes up from there. Annual deficits could balloon from over $1 trillion to over $1.5 trillion or upwards of $2 trillion.
 
The amount of QE by the Fed to monetize U.S. deficits would likely be larger than many investors realize, just looking at it mathematically. I'd expect at least 20% dollar devaluation in the coming years, if not more.
 
In this scenario, I consider it highly probable that gold would do especially well. I also think emerging markets, while they would likely be in for a volatile time, would do better than most investors assume at these valuation levels and with a weaker dollar, and would come out strong on the other side of any sell-offs. The night is darkest just before the dawn, in other words.
 
Most investors have it in their minds that emerging markets necessarily do bad when the U.S. has a recession. The sample size for this, however, is just three. There have been only three U.S. recessions since the MSCI emerging markets index was created in the late 1980's. During the "big one" in 2007-2009, emerging markets were a bloodbath but for context, they went into that global crisis with record high valuations and high expectations, not low valuations and low expectations like we have now.

Look how emerging markets held up during the two quarters surrounding the flash crash of 4Q2018 compared to the S&P 500, even without a weaker dollar:
 
Chart Data by YCharts
 
At these valuations, although I'd expect to see an emerging market draw down in a U.S. recession scenario, I'm optimistic about emerging markets coming out strong on the other side and would be a buyer of corrections, and particularly of select countries. Especially because, this time around, a weaker dollar is on the table and that would relieve some of their debt pressures like they enjoyed in 2017.
 
Final Thoughts
 
Summing this all together, there are multiple ways this can play out, but mathematically they all seem to require a lower dollar, one way or another.
 
It has been a longstanding belief that U.S. government debt and deficits are a far-off problem and don't really matter, but we are starting to run into tangible effects from treasury bill oversupply and in the coming years this will be a factor to work around. I classify U.S. debt/deficits as one of my four economic bubbles to be aware of.
 
The dollar has positive momentum at the moment, so it could trend higher in the short-term, but the higher it goes, the more it dooms itself by increasing the likelihood and timeline of a large U.S. recession and the associated debt monetization. Diversification is the safest way to play it. Traders may want to watch it for now, and be prepared to take advantage when/if the dollar strength turns over.
 
As far as I can tell, most of the dollar bulls who expect a much higher breakout in the dollar underestimate the damage that a strong dollar self-inflicts on the United States economy, which would then likely self-correct via a recession and major deficit monetization. The strong dollar reduces foreign corporate income and forces U.S. institutions to fund the U.S. government deficit, and after five years of doing this they are nearly tapped out and with flat dollar-denominated profits. Any major dollar breakout would likely be brief, self-correcting, and unpleasant.

I am including gold and emerging markets (with an emphasis on certain countries) in my portfolio, and which asset class will do better between the two will depend on how events unfold. I also have dry powder in the form of cash-equivalents and short-term bonds to add to my foreign or domestic equity allocation should we get a big equity sell-off later this year or in 2020.