Flight to safety

Have regulators created a new type of financial monster?

Clearing houses pose new perils for the global financial system




GRIMSTAD, NORWAY, is an unlikely setting for financial-market shenanigans. But the fishing town is home to Einar Aas, a trader who took huge bets on Scandinavian energy markets. His 15 minutes of infamy came in September 2018, when his bets went spectacularly wrong. Unable to cover his losses, he blew a €114m ($133m) hole in the capital buffers of Nasdaq Clearing, which handled his trades. Other members of the clearing house—mostly banks and energy-trading companies—were called upon to replenish its buffers.

The affair sent shivers down regulators’ spines everywhere. In the midst of the global financial crisis in 2009, leaders at the G20 summit in Pittsburgh decided that the chaotic world of derivatives needed to be made safer by ensuring that they were centrally cleared. A decade later the notional value of all derivatives outstanding globally stands at a trifling $639trn, of which 68% are centrally cleared through a handful of clearing houses. Collectively these institutions contain one of the biggest concentrations of financial risk on the planet.

Regulators fret most about a murky subset of derivatives: those that are traded over the counter by dealers and investors, rather than on exchanges. The notional value of these OTC derivatives is $544trn, of which 62% are centrally cleared (see chart). That is up from just 26% before the crisis. The share will rise further: traders who avoid clearing houses will soon be financially penalised by new rules.




All this raises a queasy question: does central clearing, which was meant to make the system safer, come with new risks of its own? To answer that you have to understand Mr Aas’s fiasco better and peer into the complex cascades of liability that clearing houses manage.

A call like Mr Aas’s is rare. Before trading through a clearing house, the parties must post an “initial margin”. When Lehman Brothers defaulted in 2008 a British clearing house, LCH, was able to cover all Lehman’s trades with its initial margin. If bets are souring, clearing houses can demand extra “variation margin”. Mr Aas posted a further $42m as markets moved against him. But when he failed to meet another margin call on September 10th, his positions were liquidated. Nasdaq had to dip into its default fund—a pool of money collected from its members.

Nasdaq’s Scandinavian clearing house is tiny compared with the biggest, like LCH, which clears more than half the global market for interest-rate swaps, or ICE, which dominates clearing for credit-default swaps. The optimistic view is that had Mr Aas been a smaller fish, or the pond bigger and more liquid, Nasdaq might have been able to find buyers for his positions.

Some regulators are unwilling to brush off the episode quite so easily. In a letter in March to Randal Quarles, the American Federal Reserve’s chief bank regulator, Paul Tucker, a former deputy governor of the Bank of England, expressed alarm that a single trader could wipe out two-thirds of the default fund of a clearing house—albeit a relative tiddler. It augured badly for giant institutions, he argued.

Clearing houses can work as intended only if no one believes they can fail. Their purpose is to sit between market participants. If a hedge fund buys $100m-worth of Apple shares from an investment bank, say, and the transaction is centrally cleared, it is the clearing house that guarantees the bank gets its $100m and the fund get its shares. For simple transactions this is a small role. Cash-equity trades are settled within two days. The risk that a party goes bust before settlement is minimal.

Now suppose the fund wants to buy an option—say, the right to buy $100m-worth of Apple shares at today’s price in a year’s time. The price it pays—the premium—will settle quickly, but the parties’ ongoing exposure will vary during the year. If Apple’s share price rises sharply before its end, the right to buy those shares at the old price becomes more valuable. If the bank holding the shares goes bust before the year is out, the clearing house will be on the hook. The longer the time between execution and settlement, the bigger this credit risk. It is magnified when products are highly leveraged, as options generally are.

That is still better than the alternative—a bilateral trade, in the industry argot—in which the bank and fund face each other for the life of the option. This requires each to keep tabs on the other’s creditworthiness, which is hard when they do not know each other’s positions. If the fund wanted to close its position early, for example, it might sell an offsetting position to another bank. It would then appear to each bank that the fund was exposed to movements in Apple’s share price, though in reality its risks would cancel out. If its trades had been centrally cleared, that would be obvious to everyone. This lack of transparency played a big part in the financial crisis—hence regulators’ desire to shift from bilateral to central clearing.

The trouble is that central clearing creates new risks. Incentives are skewed when the risk of default is spread across a group, making a weak counterparty everybody’s problem. Market participants may become less choosy about their counterparties. And most clearing houses are for-profit entities. Their profits rise with transaction volume, but losses for bad trades are largely borne by their members. That is a standing temptation to lower standards.

Skimpy margin requirements or shallow default funds increase the chance that the default of a big member would leave a clearing house with large unmatched positions. It would then have just four possible sources of capital: its owner, usually an exchange; its members, usually investment banks; its customers, mostly investment funds—or, in extremis, the taxpayer.

Each has problems. It is unclear that owners could be obliged (or could afford) to cover much. If a big burden were to fall on members, they too might be forced to default, or decide to cut their losses and walk away. If a clearing house looked likely to call on its customers’ margin, they might pre-emptively step back, closing positions to reduce their margin requirements and perhaps starting a market panic. And financial regulators are rightly determined that taxpayers should not be landed with the bill for another financial crisis.

Clearing houses have collapsed before. In 1974 a Parisian house was felled by members defaulting on margin calls when sugar prices plummeted. In 1983 one in Kuala Lumpur came to grief when palm-oil futures crashed. But only one has been deemed too big to fail. After global stockmarkets crashed in 1987, the Hong Kong Futures Exchange clearing house collapsed and regulators shuttered the stock exchange while the government and city-state’s largest banks arranged a bail-out.

A clearing-house collapse now would have far bigger repercussions. In his March letter Mr Tucker said that a clearing house that could not withstand a member’s default could be a “devastating mechanism for transmitting distress across the financial system”. Central counterparties, he said, were “super-systemic”.

The shift to central clearing has been most pronounced in interest-rate derivatives, but is visible in other categories, such as credit derivatives, too. And it will continue. According to research by Citibank, an American investment bank, from September 2020, when margin requirements for uncleared trades come fully into force, investors may have to post three or four times as much margin when trading bilaterally as when using a clearing house.

Regulators have reduced the risk that derivatives will cause as much disruption as they did a decade ago. But they have created a new group of institutions that are too big to fail. Without certainty about where a clearing house in distress can seek capital, its members and customers will be more likely to behave in ways that mean it needs that capital. Rules intended to protect taxpayers may have the paradoxical effect of putting them back on the hook.


So Much for the Trump Put

Doug Nolan


So Much for the “Trump Put.”

May 31 – Bloomberg (Felice Maranz): “President Trump’s promise to impose tariffs on goods until Mexico halts a flow of undocumented immigrants is being panned by analysts and economists… Here’s a sample of the latest commentary: MUFG, Chris Rupkey: ‘If you are going to turn the world upside down with these America First trade sanctions against imports from China, car imports from Europe, and now immigration from Mexico, you risk turning the economy upside down… Keep your eye trained on stock market valuations as the magnitude of the decline will tell you when investors have had enough and are rushing to the safety of cash in an increasingly dangerous and uncertain world.’ Cowen, Chris Krueger: ‘In the space of a few hours last night, Trump overturned all we thought we understood about the near term direction of the Administration’s trade strategy’… The president ‘unveiled a one-two punch that we believe will make USMCA extremely hard to pass in both Mexico and the U.S.’ ‘When Tariff Man returned on a rainy Sunday (May 4) to announce tariff escalations on China, we detected a consensus that this was merely a negotiating tactic… In the 27 days that have followed, no public talks have been held and the tariff escalation for goods in-transit along with China’s escalation on $60 billion in U.S. exports is hours away.’ AGF Investments, Greg Valliere: ‘These tariffs break new ground’ …because ‘they’re political, a punishment to Mexico for not stopping the surge of immigrants from Central America.’ He listed five ‘enormous implications’: Damage to USMCA ratification process; potential that a ‘slumbering’ Congress may awaken; Trump may not be finished with new tariffs, triggering higher prices for products…; Trump doesn’t seem to be listening to advisers, appears unconcerned by market and economic damage; Federal Reserve may now be forced to cut rates, but that may not be enough to reverse the damage.’”

May 31 – Bloomberg (Michelle Jamrisko and Enda Curra): “Prospects for a U.S.-China trade deal just became even more remote after President Donald Trump whacked tariffs that could rise to 25% on Mexico until that country stops immigrants from entering the U.S. illegally. ‘A U.S.-China trade deal will be even less likely,’ said Khoon Goh, head of research at Australia & New Zealand Banking Group… ‘At the end of the day, what’s the point of doing a deal if the U.S. can just impose tariffs arbitrarily?’ Investors are already bracing for a prolonged economic stand-off between the world’s two biggest economies. One potential beneficiary of the impasse was likely to be Mexico as companies considered shifting supply chains away from China toward lower-cost markets closer to American consumers. The latest escalation of Trump tariffs threatens that process.”

May 31 – Bloomberg (Michael Sin): “‘Trade policy and border security are separate issues. This is a misuse of presidential tariff authority and counter to congressional intent,’ U.S. Senate Finance Committee Chairman Chuck Grassley (R-Iowa) says… ‘Following through on this threat would seriously jeopardize passage of USMCA.’”

May 31 – Bloomberg (Michael R. Bloomberg): “President Donald Trump’s approach to trade policy had set new benchmarks of incoherence and irresponsibility even before his threat to impose escalating tariffs on imports from Mexico — but this latest maneuver takes the cake. The administration plans to harm businesses north and south of the border, and to impose additional new taxes on U.S. consumers, not to remedy a real or imagined trade grievance but to force Mexico to curb migration to the U.S. This is a radical and disturbing development. The administration is invoking a law that allows it to impose emergency economic sanctions. It’s safe to say that Congress never envisaged that those powers would be used in a case like this.”

According to CNBC reporting (Kayla Tausche and Tucker Higgins), the President’s Mexico tariff move was “spearheaded by advisor Stephen Miller.” That the decision was made despite opposition from both Treasury Secretary Mnuchin and Trade Representative Lighthizer is only more troubling to the markets (and the world more generally). Has the President “gone off the rails”? CNBC: “The surprise decision to announce the tariff plan came as Trump was ‘riled up’ by conservative radio commentary about the recent surge in border crossings… As the tariff plan was formulated, top advisors, including Vice President Mike Pence, who was traveling, and Larry Kudlow, who was undergoing surgery, were away.”

“‘Unreliable’ Trump Throws Markets Into Tizzy as Traders Scramble,” read a Friday afternoon Bloomberg headline. With the S&P500 index wobbling just above the key 200-day moving average, traders had been looking for a supportive tweet. Who would have expected it to be the President to nudge markets toward the cliff’s edge? Meanwhile, increasingly anxious currency traders hit a landmine, as the Mexican peso was slammed 2.4% in Friday trading (2.9% for the week). Mexico’s S&P IPC equities index dropped 1.4%. As if awakening to how incredibly uncertain the backdrop has become, gold surged $21 this week. Seemingly experiencing nightmares of global depression, WTI crude collapsed 8.7% for the week.

For a day, dramatic threats of Mexico tariffs almost took the spotlight off the rapidly escalating China-U.S. trade war. Almost.

May 31 – New York Times (Alexandra Stevenson and Paul Mozur): “The Chinese government said on Friday that it was putting together an ‘unreliable entities list’ of foreign companies and people, an apparent first step toward retaliating against the United States for denying vital American technology to Chinese companies. China’s Ministry of Commerce said the list would contain foreign companies, individuals and organizations that ‘do not follow market rules, violate the spirit of contracts, blockade and stop supplying Chinese companies for noncommercial reasons, and seriously damage the legitimate rights and interests of Chinese companies.’”

This is turning serious. The “Unreliably Entities List” follows reports earlier in the week that China is preparing to restrict the export of rare earth minerals. Friday from the New York Times: “As China Takes Aim, Silicon Valley Braces for Pain.” Another Friday headline, “U.S. is Dependent on China for Almost 80% of Its Medicine,” played into the narrative that the trade war is suddenly appearing much more complex and ominous than previously envisioned. China clearly has the capacity to play hardball; preparations have commenced.

May 29 – Reuters (Ben Blanchard, Michael Martina and Tom Daly): “China is ready to use rare earths to strike back in a trade war with the United States, Chinese newspapers warned… in strongly worded commentaries on a move that would escalate tensions between the world’s two largest economies… In a commentary headlined ‘United States, don’t underestimate China’s ability to strike back’, the official People’s Daily noted the United States’ ‘uncomfortable’ dependence on rare earths from China. ‘Will rare earths become a counter weapon for China to hit back against the pressure the United States has put on for no reason at all? The answer is no mystery,’ it said. ‘Undoubtedly, the U.S. side wants to use the products made by China’s exported rare earths to counter and suppress China’s development. The Chinese people will never accept this!’ the ruling Communist Party newspaper added. ‘We advise the U.S. side not to underestimate the Chinese side’s ability to safeguard its development rights and interests. Don’t say we didn’t warn you!’”

I’ll assume the Mexican tariff issue is resolved relatively soon, while the trade war with China appears poised to be a major and protracted problem. As I’ve highlighted in previous CBBs, this confrontation comes at a tenuous juncture for China’s financial system and economy. The assumption – for the markets and, apparently, within the administration – has been that fragilities would incentivize Beijing to play nice and succumb to a deal.

The Trump administration pushed aggressively, and the deal blew apart. And the longer conciliatory tones go missing from both sides, the more likely it is that the Rubicon has been crossed. This significantly increases the likelihood that China is heading into a crisis backdrop, with Beijing enjoying a larger-than-life “foreigner” “bully” to blame, berate and villainize before a population with expectations perhaps as great as the challenges they now confront.

What could be the most consequential story of the past week received little press attention in the U.S. – and maybe even less in China.

May 28 – Bloomberg: “Is it the start of a new era for China’s $42 trillion financial industry, or a one-time shock that will be quickly forgotten? Five days after the first government seizure of a Chinese bank in 20 years, investors are still grasping for answers. The takeover of Baoshang Bank Co. -- announced with scant explanation on Friday night -- left China watchers guessing at whether it marks an end to the implicit backstop for banks that has served as a linchpin of the country’s financial stability for decades. Regulators have said they’ll guarantee Baoshang’s smaller depositors, and while they’ve warned some creditors of potential losses, they haven’t said what the final payouts could be or given public guidance on whether the takeover will be a blueprint for other lenders. Complicating matters is the fact that Baoshang has been linked to a conglomerate under investigation by Chinese authorities.”

It’s a testament to the incredible growth of China’s banking system (from about $7 TN to $40 TN since the ’08 crisis) that Baoshang, with its mere $80 billion of assets, is one of a very large group of “small banks.” Along with most “small” Chinese banking institutions, Baoshang tapped the “money” markets for much of its gluttonous financing needs. It issued institutional negotiable certificates of deposit (NCD) and aggressively borrowed in the interbank lending market. The first Chinese government bank seizure in 20 years is further notable for Beijing’s decision to impose losses on some Baoshang creditors. While retail depositors are to receive 100% of their funds, corporate and financial creditors face painful haircuts.

May 29 – Reuters (Cheng Leng, Zheng Li and Andrew Galbraith): “Chinese regulators have issued instructions for the repayment of debts owed by China’s beleaguered Baoshang Bank that could see larger debts facing haircuts of as much as 30%, two sources with knowledge of the matter told Reuters. According to oral instructions detailed by the sources, regulators will guarantee the principal but not the interest on interbank debts between 50 million yuan and 100 million yuan. Debts of more than 5 billion yuan ($723.47 million) will have no less than 70% of their principal guaranteed, the sources said. For debts between 100 million and 2 billion yuan, regulators will guarantee no less than 90% of principal, and for debts of 2 billion yuan to 5 billion yuan, no less than 80% of principal will be guaranteed.”

May 31 – Bloomberg: “Holders of bankers’ acceptances worth more than 50m yuan ($7.2m) issued by Baoshang Bank will be repaid at least 80% of the principal, said people familiar with the matter. Investors were told on Friday that while they will be repaid 80% initially, they may still have recourse to the rest of the repayment as regulators progress in resolving Baoshang’s finances…”

Beijing has moved to invalidate the implicit 100% state guarantee of all large bank liabilities – deposits, NCDs, bankers’ acceptances, interbank loans, etc. Such a critical issue should have been decisively addressed years ago - certainly long before China’s Bubble inflated in “Terminal Phase” excess. Now, with the colossal sizes of China’s banking system and money market complex - coupled with rapidly expanding problem loans - a banking crisis would add Trillions (U.S. $) to the central government’s debt load. Bank losses will have to be shared by the marketplace, a prospect few to this point have been willing to contemplate. Going forward, investors will increasingly question the perceived “money-like” attributes of safety and liquidity for Chinese financial instruments.

Baoshang is part of an organization controlled by a Chinese tycoon under criminal investigation. While not a typical bank, its vulnerable financial structure is typical of scores of Chinese financial institutions whose breakneck growth was financed by cheap loans readily available for all from China’s booming (“shadow”) money market. Reminiscent of America’s GSE experience, it was all made possible by implied government guarantees Beijing was for too long content to empower. Beijing has now moved to adjust the rules of the game, with major ramifications for China’s fragile historic Bubble – right along with world markets and the global economy more generally.

May 28 – Bloomberg (Ina Zhou): “Pressure is building in a corner of Chinese lenders’ offshore debt after the nation’s first government seizure of a bank in about two decades. Loss-absorbing bonds, known at Additional Tier 1 instruments or AT1s, plunged across several small lenders on Tuesday after a sell-off on Monday. Huishang Bank Corp.’s 5.5% AT1s sank by a record 3 cents on the dollar Tuesday, while Bank of Jinzhou Co.’s 5.5% note fell most since July and China Zheshang Bank Co.’s 5.45% bond had the steepest drop in a year.”

The Shanghai Composite jumped 1.6% this week, while China’s currency was down only slightly (.07%). Superficially, it was easy to dismiss the Baoshang seizure as “no harm, no foul.” Thank the PBOC.

May 29 – Reuters (John Ruwitch and Simon Cameron-Moore): “China’s central bank made its biggest daily net fund injection into the banking system in more than four months on Wednesday, a move traders saw as an attempt to calm the money market after the rescue of a troubled bank. The government announced its takeover of Baoshang Bank on Friday… Worries that Baoshang’s plight might herald wider problems among China’s regional banks had driven money market rates higher, until the People’s Bank of China (PBOC) delivered a mighty infusion of cash on Wednesday.”

The PBOC’s $36 billion Wednesday injection raises a crucial question: What will be the scope of liquidity needs when a major bank finds itself in trouble - when escalating systemic stress begins fomenting a crisis of confidence? It’s worth noting that Chinese sovereign CDS jumped six bps this week to 59 bps, the high since January. Overnight repo and interbank lending rates rose, along with Chinese corporate bond yields. According to Bloomberg, issuance of negotiable certificates of deposit slowed sharply this week. Chinese finance is tightening, an ominous development for a fragile Bubble.

This is where the analysis turns absolutely fascinating – and becomes as important as it is chilling. The PBOC is at increasing risk of confronting the same predicament that other emerging central banks faced when their Bubbles succumbed: in the event of a mounting crisis of confidence in the stability of the financial system and the local currency, large central bank injections work to fan market fears while generating additional liquidity available to flow out of the system. “Everyone has a plan until they get punched in the mouth.”

Markets ended the week pricing in a 95% probability of a Federal Reserve rate cut by the December 11th meeting. Ten-year Treasury yields sank 20 bps this week to 2.12%, falling all the way back to the lows from September 2017 (2.57% 30-yr yield to pre-2016 election level). German bund yields dropped nine bps to a record low negative 0.20%. Swiss yields fell five bps to negative 0.51%, with Japanese JGB yields down two bps to negative 0.10%. I view the ongoing global yield collapse as powerful confirmation of the acute fragility of Chinese and global Bubbles.

If President Trump is determined to squeeze rate cuts out of the Federal Reserve, he made impressive headway this week. This CBB began with, “So Much for the Trump Put.” As for the “Beijing put,” a $36 billion PBOC liquidity injection was indiscernible beyond Chinese markets. Investors in U.S. securities would be wise to anticipate zero favors from China.

As such, markets are left with the “Fed put.” For the most part, U.S. stocks, equities derivatives and corporate Credit have been comfortable banking on the Federal Reserve backstop. But with things turning dicey in China, risk aversion is gaining a foothold.

Investment-grade funds saw outflows surge to $5.1 billion the past week (“most since 2015”). Corporate spreads and CDS prices have begun to indicate liquidity concerns. With the “Fed put” now in play, there are important questions to contemplate: Where’s the “strike price” – what degree of market weakness will it take to compel the Fed to move – and, then, to what effect? Markets, after all, have already priced in aggressive rate cuts. It could very well require some “shock and awe” central banking to reverse markets once panic has begun to set in. And it’s as if global safe haven bond markets are anticipating a bout of panic in the not too distant future.

The politics of hope against the politics of fear

Ten ways to build an alternative to the siren song of the strongman

Martin Wolf



Charismatic politicians entice disillusioned people into giving them support. Some of those politicians are would-be despots. Others are scoundrels. Yet their siren songs are enticing. How then should politicians of the centre right and centre left and those who support them respond?

They must recognise they are in for a huge fight. A massive financial crisis, with a bitter aftertaste, undermined confidence in almost all elites. Moreover, as Jonathan Swift wrote, “Falsehood flies, and truth comes limping after it.” What would Swift have made of our media?

Yet liberal democracy survived the great challenges of the interwar years and the cold war. As Torben Iversen and David Soskice argue in Democracy and Prosperity, the stabiliser is widely shared prosperity. Without that, all is lost, especially when belief in democracy has waned (see charts).

So how is hope to be renewed?

First, leadership matters. Democratic politics is not just about buying votes. It is about persuading people. Donald Trump may be an inexperienced politician. He may also be a widely detested person. But he knows how to motivate his supporters, because he knows how to tell a good story. A politician without a story will lose. Great politicians are always storytellers, from Pericles of Athens to Franklin D Roosevelt.

Second, competence matters. It matters far less, at least in the short run, for the demagogues of right or left. Theirs is an oppositional politics, even when they are in power. Competence is less demanded. But politicians of the centre need to know — and show they know — what they are doing. That is particularly important so soon after leaders of this kind made big mistakes, the most important being the belief that financial markets are stable and those engaged in them know what they are doing. Such errors proved disastrous.

Third, citizenship matters. A democracy is a community of citizens. The sense of what is owed to — and expected from — citizens is the foundation of successful democracies. Without the idea that citizens come first, there can be no national community. In modern democracies, the welfare state is a practical expression of citizenship. But so are policies that give all citizens a chance to participate in — and benefit from — economic life. Foreigners can usefully participate, too. But immigration must always be managed if it is to be judged fair and politically acceptable.




Fourth, inclusion matters. It is striking that on one well-known measure, the “gini coefficient”, inequality of market incomes is not in fact particularly high in the US. But inequality of disposable incomes (after taxes and spending) is relatively much higher. This outcome, then, is a policy choice.

Fifth, economic reform matters. As Paul Collier argues, in The Future of Capitalism, and Colin Mayer, in Prosperity, we need reform of taxation and of the corporation if we are to create a society that is economically successful and more inclusive. Particularly important are taxing rents and promoting greater competition. As Jonathan Tepper and Denise Hearn argue, in The Myth of Capitalism, the decline in competition is a large concern. This does not justify a socialist economy: we know that does not work. It does justify better markets.

Sixth, the local matters. Interestingly, this is a theme of both Collier’s book and of a new book, The Third Pillar, by Raghuram Rajan, former governor of the Reserve Bank of India. Both talk about communities. Devolving decisions, while also giving communities the means to revitalise themselves, must be part of a good new politics.



Seventh, public services matter, even if people usually dislike paying the taxes needed to support them. What is most demanded varies across countries. But the libertarian idea of a minimal state that leaves all this to the free market is not only unworkable, but incompatible with democracy. Politicians of the centre have powerful arguments in their favour when they defend the public services on which people depend.

Eighth, managed globalisation and global co-operation also matter. No country is an island. We depend on ideas, resources, people, goods and services from other countries. This is true even for very large countries. The economic, political and moral arguments for stable and predictable rules governing these interactions is even stronger now than during and shortly after the second world war, when they were first brought together into a new global system. National sovereignty does matter. But it is not all that matters. This is even more true for management of the global commons. Co-operation among nations is not optional here. It is absolutely essential.

Ninth, looking ahead matters. We live in a world of large long-term upheavals — notably climate change, artificial intelligence and the rise of Asia. Good governments must look at what these things might mean for their peoples and the world. If democracies cannot do this sort of forward thinking, they will have failed. Certainly, the Chinese party-state will certainly argue just that.



Finally, complexity matters. The great American humorist, HL Mencken said: “For every complex problem, there is an answer that is clear, simple, and wrong.” That is what the charismatic demagogues offer. Expert advice can easily be wrong. But technocrats have reputations to lose. A politics that rests on popular anger and despotic whim is sure to fail. The only question is how.

The right response has to be a politics that bases hope on realism. That is the only sort of democratic politics worth doing. Will it succeed in today’s world? Possibly not. But trying to do the right thing is the only way to give the world the best chance of good outcomes.

The next to blow

Britain’s constitutional time-bomb

Brexit is already a political crisis. Sooner or later it will become a constitutional crisis, too



BRITONS PRIDE themselves on their “unwritten” constitution. America, France and Germany need rules to be set down in black and white. In the Mother of Parliaments democracy has blossomed for over 300 years without coups, revolution or civil war, Irish independence aside. Its politics are governed by an evolving set of traditions, conventions and laws under a sovereign Parliament. Thanks to its stability, Britain convinced the world that its style of government was built on solid foundations laid down over centuries of commonsense adaptation.

That view is out of date. The remorseless logic of Brexit has shoved a stick of constitutional dynamite beneath the United Kingdom—and, given the difficulty of constitutional reform in a country at loggerheads, there is little that can be done to defuse it. The chances are high that Britons will soon discover that the constitution they counted on to be adaptable and robust can in fact amplify chaos, division and the threat to the unión.

On June 10th, three days after Theresa May steps down as Conservative leader, the race to succeed her will formally begin. Some of the runners, including the favourite, Boris Johnson, vow that, unless the European Union gives them what they want (which it won’t), they will pull out of the EU on October 31st without a deal. The 124,000 members of the Conservative Party who will choose the next prime minister, an unrepresentative sample, to put it mildly, will thus take it upon themselves to resolve the question that has split the nation down the middle.

Worse, Britain’s supposedly sovereign Parliament has voted against just such a no-deal Brexit on the ground that it would do the country grave harm. There will doubtless be more parliamentary machinations to stop a no-deal Brexit or force one through. The constitution is unclear on whether the executive or Parliament should prevail. It is unclear how to even choose between them.

Behind this uncertainty lies the fact that Britain’s constitution is a jumble of contradictions scattered across countless laws, conventions and rules. As our Briefing this week describes, these can easily be amended, by a vote in Parliament or merely on the say-so of the controversial Speaker of the House of Commons—who this week vowed to stay in office in order to ensure that Parliament’s voice is heard. There was a time when most British lawmakers were mindful that playing fast and loose with the rules could undermine democracy. Perhaps that is why they used to practise self-restraint. But in recent decades, when liberal democracy seemed unshakable, Britain’s leaders forgot their caution. Instead, in a fit of absent-mindedness, they set about reinventing the constitution wholesale.

Under Tony Blair and David Cameron, the Westminster Parliament ceded power to assemblies in Scotland, Wales and Northern Ireland and to the people directly through referendums. These innovations were often well-meant and, in themselves, desirable. But nobody gave much thought to the consequences for the constitution as a whole.

The resulting mess has already stamped its mark on Brexit. The referendum endorsed leaving the EU but left the details for later. It provided a mandate for Brexit, but not for any of the very different forms Brexit can take. It is unclear how MPs should reconcile their duty to honour the referendum with the duty of each one of them to act in the best interests of their constituents. Other countries avoid that mistake. Ireland holds referendums, too. But Article 46 of its constitution is clear: the people vote on a change only after a bill has passed through the Dail with the details nailed down. Britain never thought to be so sensible.

Brexit is itself sowing the seeds of further constitutional chaos, by threatening the integrity of the union. In the elections for the European Parliament (see article), the Scottish National Party (SNP) won an increased share of the poll. Scotland voted Remain in the referendum, and the SNP’s leaders can understandably claim that they have just won an enhanced mandate to leave the United Kingdom. Yet, at least one of the Tory leadership candidates is ruling out any further referendums.

Breaking up the union would be a constitutional nightmare—if only because no process for secession is laid down. Merely choosing to hold a second Scottish referendum could be fraught. Mr Johnson is loathed north of the border. Plenty of English voters are calling for a second Brexit referendum. Mrs May told the SNP to wait until Brexit had been resolved. Legally, could Prime Minister Johnson hold the line against a determined Scottish campaign? It is unclear.

The very act of leaving the EU would also load the constitution with fresh doubts. The Charter of Fundamental Rights, which enshrines EU citizens’ rights in law, would no longer govern British courts. Some would-be Tory leaders, such as Dominic Raab, want to scrap domestic legislation that embeds those rights. If Parliament passed oppressive new laws, the courts might complain, but they could not stop it. Voters who moan about meddling European judges might start to have second thoughts. Cue calls for a British Bill of Rights and another fit of ill-considered constitutional innovation.

And that leads to a final worry. Britain’s ramshackle, easily amended constitution is vulnerable to the radicalised politics produced by three years spent rowing about Brexit. Jeremy Corbyn and his colleagues on the hard left could not be clearer about their ambitions to revolutionise Britain. It is naive to think they would focus on the economy and public spending, but leave the rules alone. A Labour government under Mr Corbyn—or, for that matter, a Conservative government led by a populist Tory—would be constrained only by its ability to get its way in Parliament. Labour has already called for a constitutional convention.

Most Britons seem blithely unaware of the test ahead. Perhaps they believe that their peculiar way of doing things always leads to stability. It is indeed just possible that their constitution’s infinite flexibility will permit a compromise that gets the country through the Brexit badlands. More likely, however, it will feed claims that the other lot are cheats and traitors.

Brexit has long been a political crisis. Now it looks destined to become a constitutional crisis, too. It is one for which Britain is woefully underprepared.

The Promise and Pitfalls of 5G: Will It Kill Cable?

Wharton’s Kevin Werbach and Jeffrey Reed from Virginia Tech discuss whether 5G technology will live up to its promise.




In December, the Federal Communications Commission will undertake the largest spectrum auction in U.S. history — putting 3.4 GHz of airwaves on the market to free up space for 5G communications. As the next generation in wireless technology, 5G promises to boost data speeds by up to 100 times, making them competitive with the fastest wired broadband networks. In April, the White House planted an official stake in the 5G race, with President Trump calling it a “big deal,” as it will change the way Americans work, learn, communicate and travel.

A lot of expectations are riding on 5G, for good reason. The technology offers “potentially gigabyte speeds over wireless, fast enough that for the first time wireless could be a competitive alternative for wired systems — like cable- and phone-based and fiber-based systems — for basic broadband access,” said Kevin Werbach, a Wharton professor of legal studies and business ethics who used to work for the FCC, on the Knowledge@Wharton radio show on SiriusXM.

5G also could usher in new innovations to supercharge the “internet of things” and mobile broadband applications, among others. “It is very important for the U.S. to adopt this technology early. And the reason is that it is going to form the basis for innovations in a variety of areas, such as smart grid and smart connected automobiles, and factories of the future,” said Jeffrey Reed, Virginia Tech professor of electrical and computer engineering and founding director of Wireless@Virginia Tech.

Case in point are past rollouts of 2G, 3G and 4G networks, which led to new applications like livestreaming after fully deploying. “My gut feeling is there are probably 5G applications that we will eventually have that we are not even thinking about today,” Reed said. Due to 5G’s reliability and low latency or delay, new future applications could include “being able to control, for instance, unmanned aerial vehicles, cars talking with other cars, and cars talking with people to avoid collisions. [Also,] cars planning a strategy together on how to deal with a traffic situation.”
A potential killer app for 5G is augmented reality (AR), Reed added. That means “being able to superimpose on your field of view augmentation that may explain the things around you,” he said. “That could have a very dramatic effect, impacting everything from tourism to education.” 5G can supercharge AR and virtual reality by placing “virtual items, virtual characters and augmented contextual information” in TV shows and movies or even projecting 3D holographic displays, according to the “5G and the Economics of Entertainment” report by Intel and Ovum.


But the cold reality is that a fully functioning 5G future still is a long ways away. “5G is called 5G because it is the fifth generation of wireless technology and so, obviously, there were four prior generations,” Werbach said. “These are things that evolve and develop and get implemented over a long period of time. They involve extensive standards work in the industry; they involve extensive deployment work.” Even the FCC’s plans took time. “All of these spectrum auctions for the high frequency spectrum to be used for 5G have been in the works for a long time,” he said.

What Is 5G?

5G is a wireless communications technology that is a big step up in connectivity — some describe it as a quantum leap — from 4G. It can use any band of spectrum but thrives in the extremely high frequency (EHF) range of 30 to 300 GHz, compared to today’s cellphones that are in much lower bands. “When you’re transmitting and receiving at very high frequencies, it is very efficient for carrying lots and lots of data,” said Gerald Faulhaber, Wharton professor emeritus of business economics and public policy and former FCC chief economist. “You can carry much, much more data than you ever could using our 4G phones.”

But a key drawback is that these signals travel only short distances. The wavelengths in this band range from 1 mm to 10 mm — the FCC’s December auction is called the millimeter wavelength auction — so these can’t reach very far and are easily degraded. “Very high frequency radio signals travel in direct, straight lines, and they attenuate very quickly,” Faulhaber said. In comparison, very low frequency 30 hertz signals can travel more than 10,000 km, or 6,200 miles. Lower frequencies also can better penetrate solid objects like buildings and walls.

Because millimeter wavelengths are short, they need more antennas to connect. “One of the things that 5G requires is a much denser network,” Werbach said. “You need many more nodes. That is partly how the capacity increases, which means either more towers or more cells in more places. You need equipment that is running on those cell sites, and then you need chips that go into people’s handsets and devices.” At least, the 5G antennas are small and can be installed easily on top of telephone poles and other locations, Faulhaber said.

Because it requires density, 5G mainly is feasible for more populated areas where many antennas can be placed close together. “The nature of the infrastructure is that it works in dense areas; it doesn’t work as well in other areas,” Faulhaber said. “Will there be 5G in [rural areas]? The answer is yes, but it won’t be over these high-frequency antennas. It will be basically where 4G is today, so you won’t get the high-capacity [service].”

This brings another challenge: the widening of the digital divide by geography. “It is a real problem,” Werbach said. “There are still too many Americans who don’t have broadband service and many more who have inferior quality broadband service.” The reality is it’s “harder and more expensive to provide wireless service and wireline service in rural and hard-to-reach areas.” While the FCC has set aside $20 billion to expand broadband access in rural areas, he said, the commission was short on details and where the funds would actually come from.


Telecom Investments

Telecom companies and other providers will have to invest billions to make 5G a reality — not only to buy more spectrum, but also to build out the infrastructure. Because it’s yet uncertain how much revenue 5G will bring, for now the most prudent path for telecom firms is to upgrade the capacity of their 4G networks by reclaiming airwaves allocated for 2G and 3G, as well as buying more spectrum, according to a report by McKinsey. (The lower bands can be used for 5G as part of the carrier’s network management plan, even though data capacity won’t be as good.)

But there will come a time when these tactics won’t be enough. Historically, data traffic rises by 20% to 50% a year, and 5G could put the traffic increases at the higher end of that range, the McKinsey report said. That means most telecom companies will have to embark on a “significant new build out” between 2020 and 2025. Also, to handle higher traffic, carriers have to install fiber in their wired networks, where wireless connects to the internet. “It’s rather ironic that the projected performance goals of 5G wireless will depend on the availability of wireline fiber,” an executive at telecom equipment maker Ciena said.

At least, 5G standards have been finalized by the 3GPP, an international group whose members work together to develop cellular standards. These are standards that networks must meet to be considered 5G. Carriers can’t just label their service 5G, which is a lesson AT&T learned when it was sued by Sprint for putting “5GE” on its service despite not using true 5G. AT&T reportedly settled the lawsuit, explaining that “E” stands for “Evolution.” A Verizon spokesman tweeted that “5GE” stood for “5G Eventually.”

5G ‘Hype’ and China’s Huawei

Telecom carriers have been trialing 5G. In April, AT&T said mobile 5G is live in parts of 19 cities, with more cities to come. In the same month, Verizon said 5G service has launched in parts of Chicago and Minneapolis, where typical early adopters experience download speeds of 450 Mbps and peak speeds of 1 Gbps. That is six and 14 times faster than the median fixed broadband speed of 72 Mbps respectively, according to a December 2018 FCC report. Verizon expects to deploy limited 5G in more than 30 cities this year. Last fall, it launched a limited 5G home internet service in four cities. Sprint is rolling out 5G in nine markets this year.

But T-Mobile is calling out its rivals over their 5G hype. “I have the exact same 5G mmWave network equipment and software that AT&T and Verizon do, and there’s no way we would launch this for customers right now,” CTO Neville Ray wrote in a blog. The millimeter wave signal “doesn’t travel far from the cell site and doesn’t penetrate materials at all,” he said. Ray’s blog even embedded a moving image showing that millimeter waves can’t even go through a door. T-Mobile will bring 5G to market, he said, “when the technology is ready for everyday customer use.”

Telecom analyst Craig Moffett of MoffettNathanson echoed similar doubts on CNBC. “There’s zero chance that 5G is ubiquitous technology” by 2021, he said. “The promises around 5G being insanely fast are partly because the standards for 5G were set for insanely wide blocks of spectrum. But you can’t find insanely wide blocks of spectrum anywhere except in these kind of stratospherically high frequencies,” which has its own technical problems. He noted that China, which is surging ahead on 5G, doesn’t use millimeter wave but rather lower band spectrum below 6 GHz, while Europe is using a combination of the two.

Politics also influences U.S. carrier adoption of 5G. The government has security concerns about using 5G telecom equipment from China’s Huawei because of fears over spying. Huawei is the world’s largest maker of telecom equipment, including that needed for 5G. It became a colossus, and “a key reason for that is they produce very inexpensive equipment. It is much cheaper than [that of] their European competition,” Reed said. Huawei doesn’t have any U.S. competition, because infrastructure providers left the business about 20 years ago, he added.

Today, Europe and other parts of the world are customers of Huawei. Britain and Germany specifically are resisting pressure from the U.S. to stop using Huawei. Their carriers have used Huawei in their networks for years, so “for them, it is very difficult to say … ‘rip it all out and go find someone else,’” Werbach said. “They’re just not going to do it.” Added Reed: “Even though a security threat exists with Huawei, companies tend to look the other way to maximize profits, lower costs.” As for security, “that’s way down on their list,” Reed said.

Werbach explained that the U.S. can’t address these security concerns by merely saying it will not use this equipment. It has to be more proactive. “We need to invest in companies in the U.S. and bring trust around the world that, for example, the U.S. is not putting similar kinds of back doors into equipment made by U.S.-based service providers.”
Will 5G Replace Cable?

Even with 5G’s drawbacks, enthusiasm for it remains unabated. One big hope is that 5G could be a viable alternative to the wired broadband service provided by cable and telecom companies. “Could 5G … be the new single pipe into the home?” Faulhaber asked. But before one gets excited about competition bringing lower prices and better service, remember that the same companies currently providing wired broadband to the home are the ones launching 5G. “Guess who are the two dominant wireless operators that have … a big chunk of the spectrum in the service? AT&T and Verizon, who, of course, are also major wired broadband providers,” Werbach noted.

However, Werbach acknowledged that there potentially could be other players in 5G, such as T-Mobile, Sprint and Comcast. Indeed, T-Mobile and Sprint have been trying to convince regulators to let them merge because then they would have the heft to deploy 5G nationally. But The Wall Street Journal reported in April that the deal is unlikely to be approved as structured.

As for Comcast, Faulhaber pointed out that the cable giant already has installed plenty of Wi-Fi receivers, including in customers’ routers that other folks on its network can use to access the internet. “Xfinity Wi-Fi is all over the place and I would suspect we would see something like that with 5G,” he said. But Faulhaber also pointed out that Comcast has time to figure out a response to 5G since it won’t have to worry about competition from this new technology in the near future.

Comcast CFO Michael Cavanaugh put it this way at a recent conference: “The threat of 5G to our broadband business is not significant any time soon. That’s because [cable is] going to be the most economic way to deliver high-quality broadband, period.” Any cable rival will need “high capacity, high speed and … high reliability,” he said. “Between the different ways, different levels of spectrum and approaches to 5G, it’s really hard to see how there’s a path to any one of those being a broadly addressable solution for residential [broadband] in the U.S.”

My Best Growth Forecast Ever

The Trump administration's tax reform of 2017, which took effect in 2018, was viewed prospectively, and now retrospectively, as a contributor to US economic growth. But there was – and remains – a great deal of controversy over the size of the macroeconomic effects of the tax changes.

Robert J. Barro

barro3_Spencer PlattGetty Images_stock market

CAMBRIDGE – America’s real GDP growth rate of 3.2% for the first quarter of this year is impressive, as was the 3% average growth in 2018 (measured from the fourth quarter of 2017 to the fourth quarter of 2018). Since the end of the Great Recession – from 2011 to 2017 – the US economy grew by only 2.1% per year, on average. What accounts for the recent acceleration?

The tax reform of 2017, which took effect in 2018, was viewed prospectively, and now retrospectively, as a contributor to growth. But there was – and remains – a great deal of controversy over the size of the macroeconomic effects of the tax changes.

In January 2018, in the spirit of resolving some of the controversy, the Brookings Institution recruited Jason Furman (chair of the Council of Economic Advisers under President Barack Obama) and me to write a joint paper focusing on the prospective growth effects of the tax changes. No doubt Brookings thought that combining a liberal viewpoint (Furman’s) with mine (which I view as pro-market) would avoid political bias and thereby generate estimates closer than usual to the “truth.” I leave it to other observers to assess whether this bold attempt at consensus was successful.

Much of our analysis emphasized the tax changes for businesses, including a cut in the federal tax rate on corporate profits from 35% to 21% (for C corporations, which include the largest businesses) and a smaller reduction in the tax rate for pass-through businesses (partnerships, S corporations, and sole proprietorships). All businesses benefited from a move to full expensing for equipment, though this change did not apply to structures. Our research predicted a substantial long-term increase in capital accumulation, which would generate sizable gains in labor productivity and real wages. Real GDP growth was predicted to be higher over ten years by an average of about 0.2% per year. Thus, the predicted growth effect was moderate but long-lasting.

The other important change in the 2017 tax package was an almost across-the-board reduction in marginal income-tax rates on individual incomes. On average, the decline in the marginal tax rate was around 2.3 percentage points (adjusted downward from 3.2 points to take account of the reduced tax deductibility of state income taxes). By comparison, the average cut in marginal tax rates was 4.5 percentage points under President Ronald Reagan’s 1986 legislation; 3.6 points under President John Kennedy and President Lyndon B. Johnson’s tax cuts, passed in 1964; and 2.1 points under President George W. Bush’s 2003 reform. Furman and I estimated from previous research that President Donald Trump’s cut would propel GDP growth by a substantial 0.9% per year for 2018-19, but would not contribute to growth after that. Thus, the predicted growth effect was larger than that of the tax cuts for businesses in the short run, but smaller in the long run.

When we computed the overall boost to short-run GDP growth, we got an estimate of 1.1% per year for 2018-2019. When added to a baseline growth forecast of 2% (reflecting contemporaneous consensus views and recent history), our estimated incremental effect from the 2017 tax law implied a forecast of real GDP growth of 3.1% per year for 2018-19. Frankly, although there is doubtless a large element of luck here, this is the best growth forecast that I can recall ever making. Moreover, our forecast in early 2018 of incremental effects from the 2017 law contrasts with many economists’ predictions of recession.

As an aside, I have a bet with a famous Harvard colleague who has promised to eat his proverbial hat if 3% GDP growth persists over a longer period. I recall that the bet specified the period as the full two years – 2018 and 2019 – but he now remembers it as the three years from 2018 to 2020. I think I must be right, because I never forecasted high economic growth for 2020.

Of course, it is always possible to find reasons for why one’s forecast turned out badly. A currently popular argument of this type is that the Federal Reserve has turned out to be much more expansionary than one would have predicted. Similarly, expectations that a trade war with China and other countries would dampen economic growth – a particular concern of mine last fall – have brightened (though I remain worried on this score).

Basically, a prediction such as the one for 3.1% GDP growth that Furman and I advanced in early 2018 should be viewed as a non-contingent forecast that can always be conditioned on (or explained away by) an array of unanticipated events. And, more generally, there is always a lot of uncertainty in annual GDP growth rates, which is why the accuracy of our forecast has to be viewed as reflecting a good deal of luck.

I take it as self-evident that faster economic growth is better than slower economic growth.

Underlying this sentiment is that millions of people benefit from higher growth rates, which are typically accompanied by higher wages and lower unemployment, which especially help the worse-off. Yet today, the antipathy toward the Trump administration is so intense that many people, including some of my economist colleagues, are rooting for lower economic growth just to deny Trump a political win.

I understand this viewpoint, but I still think that the direct benefits from a better economy outweigh this kind of political calculus. More to the point, the beneficiaries – which include most people and most voters – must favor faster over slower growth.


Robert J. Barro is Professor of Economics at Harvard and a visiting scholar at the American Enterprise Institute. He is the co-author (with Rachel M. McCleary) of The Wealth of Religions, forthcoming from Princeton University Press.

Trump and Duda close to deal on boosting US forces in Poland

Agreement would increase troop numbers and capabilities on Nato’s eastern flank

James Shotter in Warsaw


US troops in Zagan, western Poland. The US has 4,500 troops in the central European country, which could be boosted by a further 1,000 under the deal © EPA


Warsaw and Washington are close to a deal on an increased US military presence in Poland, which could be announced when Polish president Andrzej Duda visits his US counterpart Donald Trump next month, according to people familiar with the discussions.

The deal, the result of months of intensive negotiations between the two allies, would increase the 4,500-strong US presence in Poland — the linchpin of Nato’s eastern flank — by at least 1,000, they said.

The increased presence would go hand in hand with an upgrade in the capabilities of the US forces stationed in Poland, including a special forces component as well as the establishment of a state of the art joint training facility.

Alarmed by Russia’s renewed assertiveness, Polish officials last year launched a concerted effort to persuade the US to establish a permanent military presence in their country. Mr Duda suggested that a base could be called “Fort Trump” and Poland offered to provide up to $2bn towards funding it.

The deal between the two countries does not envisage a single Fort Trump-like facility, with the US reinforcements instead expected to be split between multiple bases. But officials speak of an “enduring” US presence in the central European nation.

The two sides are still haggling over details of the funding. The deal could be signed on June 12 when Mr Duda visits the US, although officials cautioned that it could also slip to September if final details took longer to iron out.

The two countries’ Nato allies are to be briefed on the plans before a final agreement is signed.

A Pentagon spokesperson said: “While it is premature to discuss the details at this time, we are looking to enhance our mutual interoperability and security in the region. Together with Poland, we are reaffirming our commitment to the Nato treaty and any ongoing discussions are pre-decisional.”

A deal on an increased US presence in Poland would be a boost for Poland’s ruling Law and Justice party, which has often clashed with Brussels over the past three years and has made closer ties with the US one of its strategic priorities.

It would also boost Mr Trump, who has made it clear he expects other Nato countries to play a bigger role in the burden-sharing associated with maintaining the alliance’s capabilities and has frequently criticised countries such as Germany for doing too little. Poland is one of just five Nato states that meet the bloc’s defence spending targets.

As well as the bigger US military presence, the two sides are expected to discuss a range of other security topics, including a recent Polish request for a quotation on the purchase of F-35A fighter jets, according to a person familiar with the plans. Polish officials are set to visit a US air base as part of the trip.

Also on the agenda is greater energy co-operation. Poland’s state-controlled energy group PGNiG has struck a number of deals with US liquefied natural gas groups in recent months, and as part of his trip, Mr Duda will visit an LNG facility in Louisiana.

Delegates will also cover nuclear co-operation. Warsaw is considering whether or not to build the country’s first nuclear power plant. US officials, including Rick Perry, energy secretary, have been lobbying on behalf of US group Westinghouse, according to people briefed on the discussions.

They will also discuss Poland’s desire for a visa waiver for citizens visiting the US.



Additional reporting by Sam Fleming in Washington

Stocks Have Had Enough Of The Bond Rally

by: The Heisenberg

Summary
 
- This week, the global growth scare went into overdrive.

- Bonds are on fire, thanks to a trade war that is no longer just a trade war, according to the likes of Ray Dalio.

- Stocks, it would appear, are in no mood to stomach any further trade escalations and would really appreciate it if the bond rally abated.
 

If there's one overarching theme that pervades almost all of the commentary I've read this week, it's that market participants have finally woken up to why recent escalations in the dispute between Washington and Beijing matter more than previous escalations.
 
Note that I didn't include the word "trade" before "dispute". That's because it's now clear that at least one party to this worsening quarrel has designs on curtailing the other side's economic development.

In other words, this isn't just about righting historical trade injustices or leveling the proverbial playing field.
 
If you don't believe me, just ask Ray Dalio, who on Wednesday said the following:
As I have explained for a while, the US-China conflict is much more extensive than a 'trade war.' It is an ideological conflict of comparable powers in a small world. It’s about 1) China emerging to challenge the power of the US in many areas and 2) these two countries having two different approaches to life­ - one that’s top down and one that’s bottom up.

Without weighing in on the multitude of normative questions that arise when one country cites "national security" and trade "fairness" to justify actions clearly designed to undermine another nation's global economic ambitions, suffice to say Beijing is fully apprised of the possibility that this isn't all about reducing the bilateral trade deficit. Over the past three weeks, Chinese state media has run accusatory commentary after accusatory commentary in an effort to lay bare what China believes is an increasingly nefarious crackdown.
 
Importantly, none of the above is debatable. I'm not expressing an opinion here. Indeed, that's the whole point. Over the past two weeks, analysts and traders have come to begrudgingly accept what experts (e.g., former government officials who have spoken to media outlets about the situation) have been saying all month. Namely that the Huawei ban, the Hikvision news and other prospective actions on the US side, and, on the Chinese side, overt nods to weaponizing (economically speaking) China's dominance over rare earths are all manifestations of a widening conflict that goes well beyond the Trump administration's desire to shrink the deficit.
The rare earths story has grabbed all manner of headlines over the past 48 hours. For anyone who wants a reasonably comprehensive take on the situation, you can find one here, but for our purposes, just note that what's critical for markets isn't so much the threat of China actually playing the rare earths card. On Tuesday and Wednesday, Chinese media effectively confirmed that Xi's visit to a rare earths processing plant earlier this month was intended to send a message. Part of that message involves simply reminding the US that China accounted for nearly 80% of global REE mine supply last year. But markets heard something more. Simply put, markets interpreted the rare earths news as just another indication that this dispute is spiraling further and further out of hand.
 
As Dalio put it in the same linked post excerpted above, "history shows that countries in conflict have seen that such conflicts can easily slip beyond their control." Ray means that in a broader (and scarier) sense, but sticking with markets, the concern now is that what was everyone's worst-case scenario is now the base case. It appears to be a foregone conclusion that at least some further escalations are coming, with the most well-telegraphed being tariffs on the remainder of Chinese exports to the US.
 
I've been over and over the various estimates of how an all-out trade war will mechanically impact growth and inflation (see here, for instance). And I've also spilled gallons of digital ink explaining that it is impossible to catalogue all of the second-order effects (e.g., how a trade-related selloff across equity markets could accelerate thanks to the liquidity-volatility-flows feedback loop, how a widening of credit spreads occasioned by risk-off behavior could have ramifications for an over-leveraged corporate sector, etc.). Some of those discussions are tedious. But there wasn't anything tedious or subtle about how expectations of further trade friction impacted markets on Tuesday and Wednesday, when traders witnessed bonds attempting to price in the assumed deleterious effect of a worst-case scenario on global growth.
There's little utility in documenting each and every notable highlight from the action across rates and bonds for this platform. There were myriad events worth flagging, including Aussie 10-year yields trading through the RBA cash rate, a similar situation in South Korea and German yields nearing record lows, and those who want the full treatment can read more in "Marking To Misery". But for the sake of brevity, US investors should simply note the fresh "since 2017" lows in US 10-year yields and, relatedly, the deepening inversion of the 3-month/10-year curve.
 
(Heisenberg)


Obviously, the 3-month/10-year inversion feeds into the "imminent recession" narrative, and Bloomberg ran an entire feature article on Wednesday about the prospect of 10-year yields sinking below 2%.
 
When you think about this, do note that what's changed lately is that breakevens have fallen sharply since late last month. All year long, casual observers pointed to the disconnect between equities and bond yields and insisted that "something had to give". Over that period, declining real yields were bolstering risk appetite, while rising breakevens (in tandem with crude prices) made a case for stabilizing growth expectations. Recently, however, breakevens have led the way lower for yields, and that isn't something stocks are prepared to stomach given what it says about growth.
 
(Heisenberg)

 
That's why you're seeing stocks now starting to "catch down" to bond yields. Goldman underscored the point in a note out Monday evening. "As breakeven inflation closely follows market measures of global growth, it has now taken the lead for the recent decline in US rates, which moved lower alongside equities", the bank wrote.
It's also worth noting that this isn't just down to oil. Sure, crude has sold off recently on global growth jitters (despite persistent supply concerns tied to Venezuela and Iran), but the rapidity of the drop in breakevens outpaces the declines in crude.
 
(Heisenberg)
 
 
You should also note that the convexity flows dynamic I've talked about in these pages a couple of times (and on my site ad nauseam) likely comes into play on a further rally down to 2.20% (or so) on 10s. Any further signs of weakness in the US economy will obviously exacerbate this situation.
 
All of that said, and while completely acknowledging that the standoff between Washington and Beijing now threatens to spiral, undercutting the global economy in the process, I would still note that even if things do continue to deteriorate, the recent bond rally has run a long way in a short period of time. Simultaneously, rampant expectations for Fed easing and bets on multiple rate cuts from, for instance, the RBA suggest many market participants are now expecting the worst for the global economy and believe this is going to be a one-way trade from here on out.

Although I wouldn't be totally surprised to see 10-year US yields below 2% in six months, I wouldn't be surprised to see them far higher than they are now either.
 
One thing is for sure: Stocks have had enough of the bond rally for now. Especially to the extent it's predicated on well-founded global growth worries.

The Third “Oil Shock” Is Coming

By: Nick Giambruno




Big Middle East wars are often catastrophic for global oil supplies.

This makes sense. The Middle East accounts for more than 40% of global oil exports. So a big conflict in the Middle East often triggers a big spike in the price of oil.

Take the 1973 “oil shock,” for example. Oil prices suddenly spiked… roughly quadrupling in a matter of weeks.

Today, we could be on the verge of an oil crisis even worse than that. That’s because regional tensions are growing in the Middle East. Specifically, the conflict between Iran and Israel – and their allies – is quickly getting worse.

As I’ll explain in a moment, this conflict could soon explode, causing a sudden spike in the price of oil.

But before that, let’s take a quick look at the first two oil shocks to see how this could all play out.

The First Two Oil Shocks

In 1973, Israel was battling Egypt and Syria in the Yom Kippur War. In response to U.S. support for Israel, the Organization of the Petroleum Exporting Countries (OPEC) placed an embargo on oil exports to the U.S. and several other countries. It also cut oil production.

This triggered the first “oil shock.” The price of oil nearly quadrupled. It jumped from around $3 per barrel to around $12.

The second “oil shock” started in 1979. It grew out of the Iranian Revolution and continued with the Iran-Iraq War, which was one of the bloodiest conflicts of the past 50 years.
Iraq and Iran were (and still are) two of the biggest oil exporters in the world… So it’s no surprise that the war rocked global energy markets.

The price of oil more than doubled, as you can see in the next chart.




There was also another, less dramatic price spike in the early 1990s. It happened after Iraq invaded Kuwait, triggering the first Gulf War. Oil shot up over 70%, as you’ll see in the next chart.




The Middle East is divided into two basic geopolitical camps. On one side, you have the U.S. and its allies, like Israel and Saudi Arabia. On the other side, Russia and its allies, like Iran and Syria.

You likely know that a bloody conflict has been raging in Syria for nearly seven years. It’s the most significant military conflict on the geopolitical chessboard today.

The U.S. side, working through its proxies, has been trying to overthrow Syria’s leader, Bashar al-Assad. Meanwhile, Russia and Iran have massively fortified his regime. Assad is still firmly in charge.

This has shifted the regional balance of power toward Iran. The U.S., Israel, and Saudi Arabia find that unacceptable. But at this point, a war is the only thing that could reverse the trend.

Team Trump Wants to Bomb Iran

Iran will almost certainly be the focal point of the Middle East’s next regional war. Many people think that war has already started.

Earlier this year, Israel launched its biggest military strike on Syria since the 1973 Yom Kippur War. This attack, and other recent ones, killed dozens of Syrian and Iranian soldiers.
I only expect the conflict to escalate from here.

Aside from what appears to be the start of an actual war, there have been numerous, unambiguous signs that the U.S. has Iran in its sights.

To start, Trump has staffed up on known war hawks. In April, he made John Bolton his National Security Advisor and Mike Pompeo his Secretary of State. Both have been eager to bomb Iran for years.

In early May, Rudy Giuliani, one of Trump’s lawyers and a longtime political ally, announced that Trump is “committed to regime change” in Iran.

A few days later, President Trump pulled out of the 2015 Iran nuclear deal. He also re-imposed economic sanctions on Iran.

The World’s Most Critical Oil Choke Point

Iran has the world’s third-largest proven oil reserves, or 10% of the world’s total. It exports about 2.4 million barrels of oil per day. China, India, and Europe buy most of it.

A war between Iran and Israel (and its U.S.-led allies) would wreak havoc on the oil market. That’s because Iran holds a very powerful card…

Iran could effectively shut down the Strait of Hormuz, the narrow channel connecting the Persian Gulf to global markets. It is the only sea route from the Persian Gulf to the open ocean.

Tankers moving oil from Iraq, Iran, Saudi Arabia, Qatar, Kuwait, and the United Arab Emirates all have to pass through the strait. That translates into roughly 35% of the world’s oil traded by sea.

Nearly $2 billion worth of oil passes through the Strait of Hormuz every day. It’s the most critical oil choke point in the world.

In the event of an all-out war, Iran would quickly shut down the Strait of Hormuz. It’s been blatantly clear about this.

Credible studies have shown that – in a best-case scenario for the U.S. Navy – Iran could seal off the Strait with sea mines and asymmetrical warfare techniques for at least a month before the U.S. could reopen it. The Pentagon itself has admitted as much.

If and when a war with Iran happens – even if there’s only a whiff of it happening – investors should expect the third and most dramatic oil shock.

Of course, we’re not cheering for a war, or the collateral damage that would inevitably come with it.

Nevertheless, the odds of a big war in the Middle East starting soon are high. That means a sudden spike in the price of oil is equally likely.

There’s a good chance of outsized returns and soaring dividends in select oil stocks in the weeks ahead. I recommend positioning yourself for big profits now… before the bullets really start flying.