Will the ECB live up to investor expectations?

Market Questions is the FT’s guide to the week ahead




When Mario Draghi speaks on Thursday, the market will be hanging on his every word. Eurozone bond markets have staged a powerful rally since the European Central Bank chief indicated last month that a fresh round of easing measures is on the way to combat stubbornly low inflation and a flagging economy.

Investors are betting heavily on interest-rate cuts — possibly as early as this week — and a revival of bond purchases, known as quantitative easing, later in the year. If a July rate cut fails to materialise, Mr Draghi’s forward guidance will be crucial: he is widely expected to add the words “or lower” to the ECB’s projection that rates will remain at their current level until next summer.

Anything less could disappoint markets, according to Marchel Alexandrovich, senior European economist at Jefferies. “People have been trading on the assumption of more QE before year-end and maybe jumping a few steps ahead,” he said.

Currency traders have also set a high bar for Mr Draghi, according to analysts at Nomura.

“We think the euro will trade weakly into the ECB meeting, but disappointment risk is relatively high and a knee-jerk rebound is possible in the short term,” they wrote.

Even so, investors seem convinced the ECB will roll out the big guns later in the year. According to a survey by Bank of America Merrill Lynch, more than 60 per cent of fund managers expect more bond buying by the end of the year. That belief is likely to continue weighing on bond yields.

“I don’t think Draghi will close the door to anything,” Mr Alexandrovich said.

“Whatever happens at the July meeting, more easing is coming.”

Tommy Stubbington


Will economic data keep ‘trolling’ the Fed

The US central bank has shifted in a decidedly more dovish direction over the past month, moving from signalling that interest rates are on hold to hinting heavily that the first rate cut in nearly a decade may be on the cards at its upcoming meeting. The problem is that the economic data has been challenging that view ever since the Fed’s shift.

Last month’s employment data thumped economists’ forecasts when reported at the start of July. The core inflation rate then accelerated and last week US retail sales data were unexpectedly buoyant, indicating that the engines of the economy are still going strong.

“Retail sales crushed it,” said Tom Porcelli, chief US economist at RBC Capital Markets. “In other words, the Fed is poised to cut rates even in the face of very sound economic fundamentals in place.”

Investors still believe the central bank will cut rates on July 31 — a conviction strengthened by chair Jay Powell’s dovish testimony to Congress earlier this month — but if data remain strong over the coming week, some doubts may begin to creep in. The biggest releases in the coming five days are Markit’s purchasing managers indices for services and manufacturing, home sales, durable goods orders and jobless claims. The week culminates in the first estimate for overall economic growth in the second quarter.

The pace of growth is expected to slow from the surprisingly rosy first quarter, but another batch of buoyant data might embolden the Fed’s hawks and force investors to reassess their view that several rate cuts are coming.

“By cutting rates now, [the Fed] risks having no firepower if the economy actually turns down and goes into recession,” said Chris Rupkey, chief financial economist at MUFG. “ ‘Save the rate cuts for a rainy day’, is what consumers are telling the Fed. ‘We don’t need them.’ The Fed says they listen; let’s see if that’s the case.”

Robin Wigglesworth 


 


Will the world economic outlook improve?

The International Monetary Fund is due to issue an update to its World Economic Outlook on Tuesday, providing clues about the state of the world economy following a downbeat assessment of global growth in April.

In its last release, the IMF highlighted the drag that trade tensions have had on growth, and said monetary policy remained somewhat restrictive, as it cut forecasts for 2019 and 2020. Since then, ructions between the US and China have remained unresolved, and new US trade war fronts have opened up with Mexico, India and the EU — but the Fed has shifted to signalling the start of a rate cutting cycle.

“Central banks are shifting toward monetary easing, as they aim to cushion a global slowdown sparked by trade tensions,” said analysts at BlackRock. “This policy pivot should help stretch the [economic growth] cycle.”

Three months ago, the IMF pinned hopes for a rebound on a “precarious” boost from emerging markets, expecting an end to crisis conditions in Argentina and Turkey and a stabilisation in China’s growth rate.

Argentina’s economy has indeed improved, while Turkey emerged from three quarters of contraction in May. China’s economy, however, grew at its slowest rate in nearly 30 years despite being buoyed by domestic consumption.

With a mixed bag of signals to digest, analysts are not expecting a major shift in the Fund’s July update. A consensus forecast of economists polled by Bloomberg points to global growth of 3.3 per cent in 2019 — right in line with the IMF’s previous estimate.


Siddarth Shrikanth

The U.S. vs. China

In A Newly Bipolar World, Europe is Caught in the Middle

By Matthias Gebauer, Peter Müller, Marcel Rosenbach, Michael Sauga and Bernhard Zand

U.S. President Donald Trump, left, and Chinese President Xi Jinping

The trade war between the United States and China is increasingly creating a bipolar world. As U.S. President Donald Trump and Chinese President Xi Jinping prepare to meet at the upcoming G-20 summit, Europe is facing an increasingly tense dilemma: Which side should it choose?

United States President Donald Trump began the week before last on a golf course in Virginia. He was unhappy. On Twitter, he complained about London Mayor Sadiq Khan. The two men have a deep, mutual dislike for one another. "Khan is a disaster," Trump wrote, "will only get worse." In an interview, he complained about Congress, arguing that its members are, "more difficult than frankly many of the foreign leaders. Because they have their own views, you never know exactly, but they have their own views."

Last Tuesday, he launched his 2020 re-election campaign and peppered his speech with attacks on the media ("fake news"), his opponents generally ("angry left-wing mob") and the Democrats overall: "They want to destroy our country as we know it."

Xi Jinping, China's president, visited a conference in Tajikistan the weekend before last, where Asian leaders congratulated him on his 66th birthday. Russian President Vladimir Putin gave him a cake, a vase and a box with Russian ice cream. "That's the most delicious one," Xi said.

On Thursday, Xi headed to North Korea, the first trip there by a Chinese president in 14 years. He said he was traveling to Pyongyang to strengthen the "strategic communication and exchange" with North Korea. If he was annoyed about anything, like the mass protests in Hong Kong, the growing international unease about Beijing's new might or the trade war with the U.S., Xi didn't show it. Unlike Donald Trump, that's almost always the case with him.

These two contrasting personalities will meet this coming weekend at a highly anticipated event: Together with other world leaders, Trump and Xi will be attending the G-20 Summit in Japan. It wasn't until last Tuesday that Trump confirmed in a tweet that there would be an "extended meeting" between him and Xi. Their showdown could overshadow all other summit events.

Because the two leaders represent something that hasn't existed since the end of the Cold War: an increasingly polarized world that is being split into two political and economic spheres. It comes as little surprise that the rivalry between the established and the rising superpower will be so openly displayed at a G-20 meeting for the first time. Its consequences won't only affect the two rivals, but all the participating nations -- countries that make up about 80 percent of the global economic output, two-thirds of global trade and two-thirds of the world's population.

Unlike the U.S.' conflict with the Soviet Union, however, its showdown with China didn't spark from an ideological or military rivalry, but an economic one. Washington believes it is being challenged by Beijing and, under President Trump, is pushing the two biggest national economies to de-couple from one another. It is gradually capping global production and delivery chains connected to China, chains on which almost all other countries depend.

A Problem, Not an Alternative

The Financial Times warned that the American-Chinese rivalry is the "most important geopolitical development of our era." It argued that it "will increasingly force everybody else to take sides or fight hard for neutrality " and that "it risks turning a manageable, albeit vexed, relationship (with China) into all-embracing conflict, for no good reason.

How are the industrialized nations, or the European Union, or Germany, to act in this conflict?

If another president was running the U.S., that question would be easy to answer. Europe shares its fundamental values and economic order with the United States, not with China, an authoritarian country. But Donald Trump, and his aggressive "America First" economic and tariff policies are posing a challenge not only to China, but also to the U.S.'s European allies and states like Canada, Japan and South Korea. All of these countries -- especially trade-dependent Germany -- have interests in China. The decision between Washington and Beijing isn't an alternative -- it's a dilemma.

At the moment, it's the U.S. government -- more than Beijing -- that is pushing the rest of the world to take a clear stance. Take Huawei: For months, Washington has been pressuring countries to stop working with the controversial Chinese network equipment supplier. In May, the administration added the company to an "entity list," a black list banning companies from working with Huawei without government permission. American companies like Google and the semiconductor company Intel have already announced that they would end their professional relationship with Huawei.

Over 140 Chinese companies in the electronics, aerospace, semiconductor and engineering sectors, are already on the list. Washington has deemed them to be threats to national security, and is seeking to make it more difficult for other countries and for companies with U.S. ties to work with them.

The U.S. Senate launched a hearing last Monday about a new package of tariffs that would affect $300 billion dollars worth of products. If it passes, almost all imports from China would be slapped with high duties. Both the Chinese and a majority of the affected U.S. companies are fighting back. Of the 50 companies invited to the hearing, 47 spoke out against the new tariffs.

Only two supported them. In a letter to Trump's China negotiator Robert Lighthizer, the American Chamber of Commerce warned that the new package of tariffs would "dramatically expand the harm to American consumers, workers, businesses and the economy."

The approach is reminiscent of Washington's strategy with Iran: You're either with us, or against us. And it is accompanied by undertones that haven't been heard in the U.S. for a long time: Kiron Skinner, the director of policy planning at the State Department, said the rivalry with China was "a fight with a really different civilization."

Beijing, which has been using access to its markets to apply political pressure for years, now sees itself as a victim of its own strategies. In the earlier stages of the Trump-initiated trade war, China acted more defensively. But now it is taking a sharper tack. In late May, Beijing announced its own black list of "unreliable" foreign companies and threatened to halt exports of rare earth metals, crucial raw material for the high-tech industry. State propaganda is preparing the population for tough times ahead: "No one, no force should underestimate and belittle the steel will of the Chinese people and its strength and tenacity to fight a war," Quishi, a Chinese political journal, argued.

Shifting Strategies

At the same time, Beijing is also adapting its policies to the new realities. Chinese leadership is encouraging entrepreneurs, engineers and scientists to gird themselves and strengthen China's own technology sector. "From China's perspective, the trade war is coming too early, because it remains dependent on U.S. components. But it is also seen as confirmation of its own strategy," says Max Zenglein of Berlin's Mercator Institute for China Studies (MERICS). Four years ago, Beijing drew up a master plan called "Made in China 2025" for 10 industrial sectors. Now, it is modifying that plan in a targeted fashion: In classic high-tech sectors like aircraft manufacturing, the party leadership is apparently willing to accept shortcomings, says Zenglein. "Semiconductor chips and artificial intelligence, on the other hand, are being clearly prioritized."

Xi Jinping's most important economic advisor and lead negotiator, Liu He, even sees the growing trade conflict as having a positive effect on China. "The pressure from outside will help us improve our innovation and own developments, so we can reform and open ourselves up faster, and so we can bring our growth to a higher level of quality." The nationalist daily Global Times in Beijing reported that a quote "by the German philosopher Friedrich Nietzsche: 'What doesn't kill us makes us stronger'" was being widely shared on the Chinese internet.

Beijing is feeding this technological ambition through an aggressive foreign policy, strengthening existing alliances and forging new ones, from Russia to Central Asia to the Middle East. Xi's trip to the G-20 Summit will be his fourth in June alone. Generally, he travels out of the country more often than his predecessor -- as well as his rival, Trump.

He also seems to be getting more flexible in his economic and trade policy when it comes to the EU and other countries. Although China has so far reacted to tariffs from the U.S. in tit-for-tat fashion, it has also selectively lowered duties on imports from other countries -- Canadian lobster, for example.

At the Silk Road summit earlier this year, which several European leaders traveled to Beijing to attend, Xi Jinping admitted that some criticism of China was completely understandable. He announced changes and the first are already being felt. For example, BMW is being allowed to take a majority stake in its Chinese joint venture, and German chemicals giant BASF has been given the go-ahead to build a factory without a local partner. Beijing has also agreed to decrease excess capacity in the steel industry and to withdraw a complaint with the World Trade Organization against anti-dumping tariffs levied by the EU.

The Europeans are noticing that China is yielding under pressure -- in part because it wants to avoid a two-front war against Washington and Brussels. At the EU-China summit in April, the Europeans threatened not to sign the final joint statement, a strategy that proved successful.

Ultimately, the Chinese agreed to clearer formulations that not only meant better access to the Chinese market, but allowed a political mechanism to monitor progress in establishing "fair competition" and a "level playing field" in trade.

Stuck in the Middle

Many G-20 countries share Trump's reservations about China, but are concerned that a trade war could destroy a world economic order that America played a large role in building. It boils down to scale: China cannot be compared to Iran or Japan, America's nemesis in the 1980s.

The U.S. and the Soviet Union once had a trade volume of $2 billion per year. Trade with China is currently $2 billion per day.

If the summit in Osaka doesn't end with an economic cease-fire, it could have dire consequences not only for China and the U.S., but for other countries as well. The Chinese market is more important for Germany's export-oriented industries than it is for the U.S. As early as last summer, over 40 percent of the German companies operating in China and more than half of the German companies operating in the U.S. began feeling the consequences of the tariffs.

Europe is stuck in the middle of the conflict. On one side, EU Trade Commissioner Cecilia Malmström has emphasized her commitment to multilateralism. "We expressly do not share Trump's approach. China is an economic rival for us, but not a political enemy," she said in an interview with DER SPIEGEL.

On the other hand, the EU has declared China a "systemic rival." European hardliners like former NATO Secretary General Anders Fogh Rasmussen argue that the trans-Atlantic alliance should be bound more tightly together in an effort to counter Beijing. France, an EU member, and the United Kingdom, an EU member for now, are also providing military support to the U.S. by having their navy ships conduct sea patrols in the western Pacific.

But a joint political and economic strategy to counter China would require Trump to respect America's allies and ultimately to stick to his word. Both are unlikely. Trump, for his part, is threatening his European and Asian allies with the same methods he is using against China. And even after a year of trade warfare, it remains unclear how the conflict with China will ultimately resolve itself.

It will, as is often the case, depend on which route will offer a more promising path for Trump's reelection: an agreement with his unequal rival, Xi Jinping, which Trump can sell as the "biggest deal of all time" -- or using China as a powerful bogeyman for the upcoming campaign. In the early 21st century, there would be no more powerful one.

Why are central banks fixated on inflation expectations?

Two metrics in particular are attracting the attention of Fed and ECB policymakers

Joe Rennison in New York


ECB president Mario Draghi, left, with US Federal Reserve chairman Jay Powell. After the ECB and Fed signalled earlier this month that they may be open to more accommodative monetary policies to support markets, inflation expectations jumped © AP


The European Central Bank and the US Federal Reserve have both opened the door to easing monetary policy, succumbing to fears about slowing global growth and fading inflation expectations.

In particular, two metrics have received a lot of attention: European five-year five-year swaps — typically written “5y5y” — and US break-evens. But what are they? What do they tell us? And why are central banks paying them so much attention?

Firstly, what is inflation?

In simple terms, it’s about prices rising for goods and services. That could be how much consumers pay at the supermarket for a loaf of bread or the cost of oil for industrial companies.

The effect of inflation is to reduce the purchasing power of money. Basically, goods cost more.

Central bankers typically try to keep inflation low but above zero, with both the ECB and Fed targeting a rate of about 2 per cent annually.

Current inflation is measured in a variety of ways. The Fed pays the most attention to the personal consumption index (PCE), tracking how much consumers pay for a range of household items. The ECB looks at the consumer price index (CPI), a similar measure that tracks price changes on a basket of goods and services.

Both measures have been lagging behind the central banks’ targets lately.





So why do we need these other measures of inflation?

Measures that collate recent data — such as PCE and CPI — are fine for giving policymakers a sense of what inflation is like now, but they do not offer insights into the outlook.

For that, investors and policymakers turn to 5y5y swaps and break-even inflation rates.

The 5y5y swap rate is a market measure of what five-year inflation expectations will be in five years’ time. It gives a window into how expectations for inflation may change in the future, which tells policymakers whether markets are convinced a central bank has the tools to keep the inflation rate within its set target.

The US 10-year break-even rate is slightly different. It measures what investors think inflation will be in 10 years’ time, derived from inflation-protected government securities. If inflation erodes the value of an investment, so goes the theory, then investors want to be paid more now to account for that. This “inflation compensation” is effectively what is represented in the break-even rate.

Why have these measures been getting so much attention?

Primarily because they have dropped so precipitously.

Earlier this month Mario Draghi, the ECB president, said he was taking the sharp move lower in 5y5y swaps “seriously”. The rate has fallen from 1.6 per cent at the start of the year to a low of 1.22 per cent this month.

The 10-year US break-even rate has this year dropped from 1.98 per cent in April to a low of 1.62 per cent in June. When the Fed met in May several participants commented that if inflation expectations did not move higher soon then the rate could become anchored below the Fed’s 2 per cent target.

“If inflation break-evens don’t move back toward 2 per cent from here that really starts to incentive easing,” said Jon Hill, an interest rate strategist at BMO Capital Markets. “Inflation expectations matter for current inflation. You price to it today. It is concerning how low these levels have been.”

Are there drawbacks to these measures of inflation expectations?

Central bankers certainly prefer to focus on current conditions. Measures of expected inflation are predictions — and policymakers sometimes disagree with what the market is telling them.

Furthermore, inflation expectations see-saw a lot more than actual measures of inflation. The primary driving force lately has been the ongoing trade war between the US and China, with investors fearing it could dampen global growth.

After the ECB and Fed signalled earlier this month that they may be open to more accommodative policies to support markets, inflation expectations jumped. The 5y5y rate rose back up to 1.30 per cent while the 10-year US break-even rate hit 1.78 per cent.

Both measures are also susceptible to movements in the price of oil, given crude prices are a large input in how each is calculated. Rising energy prices typically correspond with rising inflation expectations, and vice versa.

“The correlation between break-evens and the spot price of oil is extremely high,” said Seth Carpenter, chief US economist at UBS. “You have to tell a completely convoluted story about why the current oil price should affect the growth rate of all prices ten years from now. It doesn’t make sense. That alone means you should very much downplay break-evens, if pay attention to them at all.”

Iran’s Miscalculation in the Strait of Hormuz

Iran is disrupting freedom of navigation at a critical chokepoint in the oil trade. That’s something the U.S. can’t accept for very long.

By Jacob L. Shapiro


On Friday afternoon, the Islamic Revolutionary Guard Corps seized two U.K.-affiliated oil tankers – the British-flagged Stena Impero and the British-owned Mesdar. After a couple of hours – and, according to Iran, a warning about environmental regulations – the Mesdar was released. The Stena Impero has not been so lucky. An IRGC statement on the Stena Impero said the ship had switched off its GPS system, was moving in the wrong direction in a shipping lane and had ignored repeated Iranian warnings. The statement stretches the bounds of credulity, considering that the Stena Impero was en route to Saudi Arabia and that maritime tracking data showed the ship making an abrupt change in course toward the Iranian island of Qeshm before its transponder was turned off at 4:29 p.m. U.K. time.

But a flexible sense of credulity is necessary in attempting to understand why Iran and the U.S., neither of which has an interest in fighting a war against the other, seem intent on hurtling down that path anyway.

According to Northern Marine, a subsidiary of the Stena Impero’s Swedish owner Stena AB, the Stena Impero’s sudden change in course was in response to a “hostile action.” The company said the ship was approached by unidentified small craft and a helicopter while in international waters. That does not square with the version of events offered by the IRGC, which claims the Stena Impero was violating international maritime law, or the head of Iran’s port authority, who was quoted by Tasnim News Agency as saying the Stena Impero was “causing problems” and was being routed to the Iranian port at Bandar Abbas.

However interesting Iran’s motivations and justifications may be, they ultimately do not matter a great deal; the reality is that Iran has seized a British-flagged ship in the Strait of Hormuz. This poses a double challenge to the United States, whose primary objective in the Middle East under the Trump administration has been to weaken Iran. By seizing a British-flagged ship (even if there were, as it appears, no British nationals aboard), Iran eschewed a direct confrontation with the U.S., preferring to confront a weaker U.S. ally. Indeed, Britain’s foreign secretary, while threatening “serious consequences” for Iran, also said the U.K. was not currently considering military options but was searching for a diplomatic solution to the situation. (The Telegraph reported that a British frigate, the HMS Montrose, had been dispatched to aid the Stena Impero but inconveniently arrived minutes late.)
 
A Severe Miscalculation
More broadly, however, Iran is attempting to show that it really can disrupt freedom of navigation in the Strait of Hormuz. Since 1945, the true global power and appeal of the United States have rested on its defense of the Strait of Hormuz. Iran has disrupted maritime traffic in the Persian Gulf in the past, most recently and notably in the late 1980s. But one critical thing has changed since then. Key U.S. allies depended heavily on oil from the Middle East in the 1980s; Turkey sourced 78 percent of its oil from the region, France 24 percent and the U.K. 10 percent. In 2018, those numbers were far lower – 7 percent, 4 percent and zero percent, respectively. With the exception of Japan, the countries most susceptible to the interruption of maritime traffic in the Strait of Hormuz are not countries the U.S. is as inclined to help – countries like India (which relies on the region for 50 percent of its oil), South Korea (62 percent) and, increasingly, China (21 percent).
 

 
As a result, this move is unlikely to have its intended effect. Tehran is desperately searching for leverage it can use to force the U.S. to ease the economic pressure on Iran. Breaking uranium enrichment restrictions laid out in the Iran nuclear deal has not done the trick, so now Iran is trying to show the U.S. and the world that, if it cannot catch a break, it will try to send the price of oil skyrocketing by blocking oil traffic out of the Persian Gulf. It is hard to characterize that as anything besides a severe miscalculation by Tehran. The U.S., especially under the current administration, will not feel pressured to ease up just because Iran has seized a ship or two. If anything, Washington will use that as justification for a much more aggressive approach to safeguarding maritime traffic in and out of the Strait of Hormuz, even if that benefits a country like China. The guarantor of freedom of maritime navigation isn’t much of a guarantor if it decides to pick favorites at a time like this.

At the end of the day, Iran simply cannot shut down maritime traffic through the Strait of Hormuz. It is trying to stoke fears that it is capable of doing so, but ultimately, Iran can’t keep the strait closed for any considerable length of time.

There is one more scenario to consider, which is that the Iranian government may be losing its monopoly on force in the Islamic Republic. Truth be told, the very existence of the Islamic Revolutionary Guard Corps, which is charged with defending not the state but the spirit of the revolution, has always meant that power in Iran does not lie solely with the Iranian government. But this particular Iranian government staked its legitimacy and its hopes for Iran’s future on the windfall it expected to flow from the Joint Comprehensive Plan of Action. Not only has the windfall failed to materialize – Iran’s economic situation is just as bad if not worse than at any time preceding the JCPOA. The Iranian government may not be calling the shots here. The IRGC may very well be taking things into its own hands, or, at the very least, providing cover for fed-up local officers or commanders tired of Iran’s inability to push back against the United States. It is also possible that the Iranian government likes the good cop-bad cop routine that the IRGC allows it to play. The opacity of Iran’s domestic politics right now makes it very difficult to know exactly how Iranian decision-makers are thinking about its grand strategy.
 
Unintended Consequences
As we have said before, the two countries with the least interest in a U.S.-Iran war happen to be the United States and Iran. But interests don’t always define how these sorts of situations play out. Consider that the United States announced this week that it was deploying 500 troops to an air base in Saudi Arabia to beef up its air defense systems. It was the presence of U.S. troops in Saudi Arabia after the first Gulf War in the early 1990s that sparked a rage so deep in a man named Osama bin Laden that he formed a group called al-Qaida, which attacked the U.S. and drew it into the Muslim world. In a sense, even that small and seemingly innocuous deployment set off a chain reaction that eventually resulted in the U.S. destruction of Iraq and, with it, the natural barrier to Iran’s expansion in the region.

The unintended consequences of these kinds of contingent events are always hard, if not impossible, to divine. The most likely scenario is that, like other recent activity in the Persian Gulf (the U.S. shooting down Iranian dronesEmirati tankers disappearing without a trace, mysterious mines being placed in broad daylight on Japanese oil tankers in the Strait of Hormuz), this incident will also be resolved. The U.S. will be content with maritime traffic continuing unimpeded and the Stena Impero set free, while Iran will be content with having made its point. Still, every time something like this happens, the risk of a wider conflagration rises – because that risk is defined not by broad historical forces but by the decisions and emotions of the sailors, airmen and soldiers involved. And who knows what future unintended consequence an event that will soon be old news might portend down the road.

For now, all we can do is wait and see whether and how quickly Iran will realize it has miscalculated – and how far the U.S. determines it must go in responding. We hardly think a real conflict is imminent – everything strictly “geopolitical” about this suggests it isn’t. But the hard, realpolitik interests that should be at work here also didn’t suggest that we’d have gotten this close in the first place. Iran disrupting freedom of navigation in one of the most important chokepoints for one of the most important resources in the world is not something the United States is going to accept for very long – and that may ultimately be more important than any other factor here.

Trump’s Lose-Lose Iran Strategy

As the Trump administration spins its wheels over Iran, the world is reminded of why the Obama administration and the Europeans went to such lengths to develop a new approach to dealing with the country. By resuscitating a failed strategy, Trump and his advisers are risking yet another catastrophic war in the Middle East.

Joschka Fischer

fischer158_MANDELNGANAFPGettyImages_trumpboltonovaloffice

BERLIN – One can only guess what US President Donald Trump hopes to achieve in Iran. Does he have designs on a “better” nuclear treaty than the 2015 deal from which he withdrew the United States? Are he and his advisers assuming that if they pile up enough demands, the regime will be forced to submit, or even abdicate? Or are they setting the stage for an attempt at regime change through military forcé?

In all likelihood, they themselves have no idea. That may be just as well, because none of the above is going to happen.

To be sure, Trump’s withdrawal from the Joint Comprehensive Plan of Action (JCPOA, as the 2015 nuclear deal is officially known) fulfilled one of his key campaign promises. The problem is that neither he nor his advisers seem to have considered what would come next.

One of the few constants of Trump’s approach to policymaking is its focus on winning the approval of his core bloc of supporters. Given that he also campaigned against America’s foreign entanglements, it is safe to assume that these voters do not want the US to launch another war in the Middle East. A military conflagration with Iran would result in even more casualties, and prove to be even less winnable, than the US-led wars in Afghanistan and Iraq.

For his part, Trump most likely wants to avoid war while still maximizing the pressure on the Iranian regime. The problem is that in the political environment of the Persian Gulf, the line between these two options is not particularly clear. Past experience shows that maximum pressure often creates the conditions for military confrontation.

Trump, unlike his hawkish national security adviser, John Bolton, claims that violent regime change is not one of the objectives of his Iran policy. Yet he is acting exactly as if the neoconservatives who led former US President George W. Bush into Iraq are still calling the shots.

This situation is all the more dangerous considering that US policymakers’ room to maneuver in the Middle East has shrunk significantly since 2003. Iran’s strategic position today is much stronger than it was then, precisely because the Iraq war toppled its foremost regional rival. And far from being isolated in the event of a military escalation, Iran would receive material and diplomatic support from both Russia and China.

At least since the fall of the Shah in 1979, Western policy toward Iran has been based on illusions. The West, led by the US, has long relied on economic sanctions to force the Iranian regime to alter its policies and behavior. But this approach, along with America’s many other mistakes in the region, has actually strengthened Iran. The country’s military forces or proxies now extend across Iraq, Syria, and Lebanon – all the way to the Mediterranean and Israel’s northern border. And though the Iranian economy is bending under the weight of sanctions, it isn’t breaking. And the security apparatus is showing no cracks whatsoever.

In response to Trump’s decision to renege on the JCPOA and re-impose sanctions, Iran has threatened to restart enrichment of weapons-grade uranium. Should the regime acquire nuclear weapons, the likelihood of an immediate war or nuclear arms race in the region – and the threat to Europe’s security – would be substantial.

Preventing such an outcome is precisely why the Europeans initiated nuclear negotiations with Iran in the early 2000s, following the US invasion of Iraq. But not until the arrival of US President Barack Obama did the overall Western strategy change. Now that Trump is reversing so much of the progress made during the Obama years, it is clear that Europe alone is too weak to prevent Iran from developing nuclear weapons.

It is worth remembering that in addition to its nonproliferation objectives, the JCPOA was also designed to reintegrate Iran into the international community. Like the Europeans, the Obama administration recognized that isolating Iran had not worked, and that another war in the region was not an option. By reversing course, Trump has sealed off the only viable path forward.1

Iran has been a distinct political and cultural entity for more than 2,000 years; it isn’t going anywhere. The only question is what role this ancient, proud civilization should play in the region and the wider world. Without a satisfactory answer to that question, the entire Middle East will remain unstable, and the risk of a war extending well beyond the region will continue to increase.

Since the US began its partial withdrawal from the Middle East under Obama, Iran, Saudi Arabia, and Israel have been fighting for regional domination. And, because the JCPOA raised the prospect of a US rapprochement with Iran, it did not alleviate the tension between these longstanding rivals. In the meantime, Iran has enhanced its position and extended its regional presence through the Syrian civil war and other conflicts. With the Saudis and Israelis already on tenterhooks, a restoration of the Iranian nuclear-weapons program would put the region on the cusp of a major war.

Significant diplomatic efforts will be needed to prevent Iran from acquiring nuclear weapons, and to formulate a constructive regional and international role for the Islamic Republic. But even then, stabilization of the region must come from within; the experiences of the past century have proven that.

By withdrawing from the JCPOA for no good reason, Trump has wandered into the Iranian maze. Soon, he could come to a fork where he will have to choose between losing face and launching a military confrontation. Either way, he will disappoint his loyal fans and make the Middle East – and the world – a far more dangerous place.


Joschka Fischer was German Foreign Minister and Vice Chancellor from 1998-2005, a term marked by Germany's strong support for NATO's intervention in Kosovo in 1999, followed by its opposition to the war in Iraq. Fischer entered electoral politics after participating in the anti-establishment protests of the 1960s and 1970s, and played a key role in founding Germany's Green Party, which he led for almost two decades.

The City and Brexit

London’s reign as the world’s capital of capital is at risk

Rival European financial centres are seeking to steal its Crown






















A WELL-KNOWN stockmarket sell signal is a company splurging on flashy new headquarters.

It might then be time to go short the City of London. From the Shard, the tallest building in the European Union, the view is of a crowded skyline of fellow concept skyscrapers. There is the Gherkin, the Cheesegrater, the Walkie Talkie and, rising in their midst, 22 Bishopsgate, which will be the Square Mile’s tallest and most capacious tower. The building frenzy is even accelerating. Londoners are waiting to hear if the 1,000-foot Tulip—with a design that many contend is more phallic than floral—will be approved.

None of this suggests a financial centre bracing for Britain’s departure from the European Union. But as soon as Theresa May, the prime minister, made leaving the single market a “red line” after the Brexit referendum in 2016, it seemed likely that the City would be sundered from its biggest foreign market. Regulators on both sides of the Channel scrambled to ensure business continuity and financial stability. British firms were asked to draw up contingency plans, including opening hubs in the EU27 (the EU minus Britain). For much of the City, Brexit happened sometime last year.

According to New Financial, a think-tank in London, 291 big financial firms have moved some activities or people to the EU27, or opened legal entities there. Many contingency plans were triggered before March 29th, when Brexit was supposed to have happened. About £1trn ($1.27trn) of the City’s assets has gone, says EY, a consultancy. That compares with perhaps £16trn of bank assets and securities. To London’s EU rivals, Brexit looks like a once-in-a-lifetime opportunity to grab business. A repatriated French banker says so many people have moved to central Paris that she often bumps into London friends. In the run-up to the extended deadline of October 31st, another wave of staff and their families will head off to new digs, offices and schools.

Some financial infrastructure is moving, as are whole classes of EU27 business. The London Stock Exchange has moved trading in European government bonds worth £2.4bn daily to Milan, for example. Amsterdam has gained more government-bond trading as well as trading in euro-denominated repurchase agreements.

The moves do not seem hasty. Though Brexit’s final form is unclear, only the softest of departures would keep Britain in the single market. And nothing short of that would safeguard “passporting” rights for City firms. These allow financial firms in any EU country to sell in any other and matter hugely in banking and asset management (and a bit less in insurance). In 2016, 5,476 firms based in Britain used 336,421 passports to sell in the EU. Around 8,000 firms in the European Economic Area, where much of the EU’s writ runs, used 23,535 of them to offer services in Britain.

Including asset managers, insurers and so on as well as banks, Britain provides a quarter of all financial services in the EU27. Scores of financial firms run their Europe, Middle East and Africa operations from London. American investment banks have as much as 90% of their European staff in London. In 2016, before the referendum, the City of London’s trajectory was better than that of New York as gravity shifted eastward to Asia, says William Wright of New Financial. “London is London as we know it, the world’s number-one or number-two financial centre, because the EU allowed it to become the financial centre of the euro zone,” says an EU27 official.

Now that status is at risk. “Before the [Brexit] debate began in 2015 it never crossed anyone’s mind that we would have to move financial services for Europe out of London,” says Bernard Mensah, president of Europe and the Middle East at Bank of America Merrill Lynch. “It was as if the British court system suddenly stopped working.” For the hundreds of small companies doing business with the EU27, the removal of passporting and uncertainty over what will replace it is an existential threat, says John Liver, global head of regulation at EY.

Financial services account for 6.5% of Britain’s economic output and 11% of its tax revenue.

The sector and its ecosystem of lawyers, consultants, lobbyists and the like employ 2.2m people, not only in the wealthy centres of the Square Mile, Canary Wharf and Edinburgh but also in places like Cardiff and Bournemouth.

Yet Britain’s negotiators have treated the industry as a sideshow. The government took the view that the City is strong enough to cope, and made little effort to keep passporting, which would have meant blurring Mrs May’s red lines. Nor did it press hard for “mutual recognition”, in which the EU would accept Britain’s rules as a basis for future trading as long as they did not diverge too much. The City is likely instead to be left with “equivalence”, a piecemeal status that the EU sometimes grants to third countries.

About half of the City’s business is domestic, a quarter from the EU27 and a quarter with the rest of the world. At worst the City could lose a quarter of its business and some of its non-EU international activity. Few City veterans expect things to get that bad. If regulators work together, equivalence could be made to function well.

Yet the obstacles are not merely technocratic. The EU would like to use Brexit to force much City activity to relocate to the European mainland. A row has broken out over plans from the European Securities and Markets Authority (ESMA) to stop EU investors trading stocks in London—a blatant land grab, say City folk. In May the Bank of England fulminated against “EU colleagues” who, it said, were scaremongering about Brexit in meetings with a foreign bank to lure it to the continent.

But EU regulators had become concerned that London’s clout impinged on the bloc’s financial and economic sovereignty well before the Brexit referendum. In 2011 the European Central Bank (ECB) tried to force British clearing houses handling huge volumes of euro-denominated financial products to move into the euro zone, only to be defeated four years later when the EU General Court said it lacked powers to make them do so. In the middle of the ECB’s gambit, the decision by LCH.Clearnet, Europe’s dominant, London-based clearing house, to raise margin requirements on some Italian and Spanish government bonds was seen by some in the EU27 as a hostile act.

Monetary sovereignty

A paper by economists at the Bank for International Settlements underlines the City’s centrality to EU financial operations. About half of all the €2.6trn ($3trn) of euro-area bonds bought by the ECB’s asset-purchase programme came from institutions outside the euro zone.

Banks in Britain were the main facilitators of bond sales. That EU regulators have spotty control over activities core to the bloc’s banking stability becomes troubling post-Brexit, they say. “If I have one heart I rely on and it’s inside me, that’s fine,” explains Olivier Guersent, director-general of the European Commission’s unit for financial stability, financial services and capital markets union. “But if I am reliant on a mechanical heart outside me, I become shaky.”



“How do you manage a financial crisis if the bulk of your financial services are provided by a third country?” adds Robert Ophèle, chairman of the Autorité des marchés financiers, France’s stockmarket regulator. Suppose the EU wanted to impose a blanket ban on shorting the shares of banks, he says (some countries restricted shorts during the crisis in 2008-09). In the EU, Britain could not easily refuse.

For its part, once it has left the EU Britain will no longer be able to block the forced relocation of financial activities to the euro zone. City folk fret about four areas in particular: clearing; share trading; risk management; and “delegation”, in which firms set up office in one EU country while their funds are managed in another.

Few rule out a fresh attempt to force euro-denominated clearing to relocate. In the meantime Eurex Clearing, LCH’s main EU27 rival, is trying the carrot rather than the stick. A new revenue-sharing model has helped increase its market share in euro-denominated interest-rate swap clearing (measured in notional amount outstanding) to 15%, from under 1% at the start of 2018. “Banks have flicked a switch in our favour where they easily can,” says Erik Müller, the firm’s boss.

As for share trading, in late May ESMA partially backed down and said that EU fund managers could continue to trade 14 stocks in London that trade overwhelmingly there now. But that leaves 6,186 more that, in the event of a no-deal Brexit, EU-registered investors will be able to trade only on exchanges in the EU27.

Regarding delegation, in 2017 ESMA published guidelines aimed at stopping European financial centres making “sweetheart” deals to lure financial firms from the City. It warned national regulators to watch out for firms that follow EU rules and locate there but keep managing their portfolios from Britain. Stopping EU funds from being run by City-based stockpickers would strike at the heart of the active asset-management model. Though ESMA appears to have backed off for now, risk management is still in regulators’ sights. The ECB sees “back-to-back” operations—doing business in the EU27 but shifting the risk to London using internal trades—as a ruse to minimise relocations.

After the referendum global banks made grids to help them decide where in the EU27 they might open new offices or expand their business, says a lawyer in London. Criteria such as size, tax and regulation were colour-coded red, green and amber. Then they examined the red and orange squares—and ruled everywhere out. “Frankfurt was seen as boring; Amsterdam, Luxembourg and Dublin were too small; Madrid and Milan had tax and regulation problems; and Paris was a nightmare for employment law,” says the lawyer.

Nevertheless, London’s rivals are doing their utmost. Paris is touting its size, cultural richness, financial-markets tradition, derivatives talent and proximity to London. François Hollande, France’s president until 2017, had declared in campaigning that his “true enemy” was finance. But Emmanuel Macron is more welcoming. Labour-market reforms and the abolition of the wealth tax have helped. And dinner with him is a big lure, bankers say.

Frankfurt, for its part, emphasises its banking clout—it is home to the ECB and has long been Germany’s banking capital—plus regulatory and political predictability. It lies tenth in the Global Financial Centres Index (GFCI), a ranking of competitiveness. That is well above Paris, at 23rd. Germany’s government has chipped in by allowing banks to hire and fire far more readily.



To some banks Frankfurt’s refusal to make “crazy” deals is preferable to Paris’s newfound flexibility. As the head of Brexit preparations for an American investment bank tells it, French officials asked “what would you like?” and offered to change national law. The bank thought they might reverse things for someone else and went elsewhere. Though it has made strides, France has still to establish a long record as a reliable home for international finance, acknowledges a government adviser.

Staff have been mutinous about leaving London. For its way of life, Paris is the clear winner. In some of Frankfurt’s elegant suburbs the population is so elderly that “you’re the youth policy”, quips the European head of an American investment bank. All the same the German city has won the most banking business, attracting 44% of bank moves, according to New Financial. Paris has attracted a wide range of financial firms; Dublin and Luxembourg are popular with asset managers; Amsterdam is favoured by trading firms and market-infrastructure providers.

Sell signals

The shifts that have happened so far are just the start, however. According to the French government adviser, banks are placing smallish bets across Europe, and are likely to reconcentrate their EU27 activities once the dust settles. For London, the harm could be substantial.

Warning signs are already in evidence. The number of initial public offerings in London has fallen of late, with the total value in 2018 down 23% compared with 2017. Frankfurt, by contrast, had one of its best years in terms of issue volume since the turn of the century. London kept its top spot in the GFCI in March 2018 but was beaten by New York this year.

Catherine McGuinness of the City of London Corporation, the municipal body that governs the Square Mile, says that more business is moving away than is visible in banks’ announcements. She fears more will leave than are legally required to. Asian institutions in particular are flummoxed by the Brexit chaos. Nomura, a Japanese investment bank, no longer counts London as its global wholesale hub and will soon slash staff there. American investment banks, which particularly value passporting, are among the most critical of Brexit’s harm to financial services. In a decade, under even a soft Brexit, London will no longer be the financial centre it once was, Jamie Dimon, the boss of JPMorgan Chase, recently said.

“How much of the City’s international position relies on single-market access to the EU has not yet been tested,” says Mr Wright. Capital flows can quickly shift course if market infrastructure or regulation change. A case in point are so-called venues, where fixed income, currencies and commodities (FICC) trade. MiFID 2, a huge piece of new European regulation, regulates venues for the first time, creating greater scope for European regulators to try to bring FICC liquidity onshore.

Over the next decade London could see business trickle away to EU27 capitals, New York and, increasingly, Asian financial centres. The situation is highly unpredictable, says Mr Mensah of Bank of America Merrill Lynch. “The City grew organically over a long period of time, so there is no blueprint to dismantle bits of it while avoiding unintended consequences.”

Yet the City is not a passive observer of its fate. Britain’s time zone, between New York and Asia, and common-law system are powerful advantages—as are a willingness to experiment, global approach, cultural allure and deep hiring pool. And even if it loses some of its EU-related business, optimists think that revenues from the rest of the world will grow faster.

One way to safeguard the City would be for Britain to become a rule-taker, hewing to European financial regulation. But British regulators (and especially the large insurance industry, which has less EU27 business) reckon it is too big and important to be lashed to the EU. Following the EU’s more dirigiste and inflexible rule book after Brexit could hobble it relative to New York and Asian financial centres, they say. What is more, in future EU regulators could set out to harm London deliberately. European officials know where the compromises are between British priorities and, say, French ones, says Jonathan Hill, Britain’s former EU commissioner in charge of financial services. “They know precisely how to send Exocets into London.”

Hence another possibility: to embrace a buccaneering future. Brexiteer politicians’ conception of “Singapore-on-Thames”—slashing regulation, lowering capital standards and corporate taxes, and prioritising competitiveness—is often compared to the 1980s Big Bang. Though it is unclear how Britain could emulate a city state, EU negotiators take the risk seriously.

The Bank of England and the FCA are pressing for a compromise. Under “stylish regulation” Britain would return to a more outcomes-based system, guided by six principles, including openness to the rest of the world, sensitivity to business models and promoting competition.

As for equivalence, Andrew Bailey, the FCA’s chief executive, says Britain will need to see what framework the EU27 offers. “We are a global financial centre so we need to see if the price is worth paying.” Mr Bailey reckons that unless the EU27 follow Britain towards principles-based regulation, they will have little chance of developing more vibrant capital markets or bigger financial centres. And in private, officials express doubts as to whether EU27 countries really want outsized quantities of financial risk shifting to European capitals.

Such confident views are typical of the City. Yet there is more than a whiff of complacency. Passporting is not all the City is losing: also gone is its reputation for political stability and predictability. British governments of all stripes have long supported financial services. But Brexit’s toxic politics changed that. Mrs May earned a reputation for being hostile to the City. Boris Johnson, her probable successor, said “fuck business” in pursuit of a hard exit.

The shadow chancellor, John McDonnell, has recently begun courting the City. But the Labour Party’s plans, which include heavy taxes on the rich, giving a tenth of big firms’ equity to workers and nationalising utilities and rail, are viewed with dread. Mr McDonnell is rumoured to be plotting retroactive capital controls and clawbacks of bankers’ compensation from the crisis—though he insists that strong economic growth under a Labour government would mean no need for capital controls.

Some hear echoes from history. In the 18th century Amsterdam’s financiers used to lead the world, but they lost faith in the city’s future under Napoleon and moved to London. For a financial hub facing the twin threats of an acrimonious Brexit and a hard-left government, that is a lesson worth heeding.