Risk On/Risk Off Face-off

Doug Nolan

The DJIA rose 11 straight sessions (“longest streak since the Reagan administration”) to end the week at a record 20,822. The S&P500 gained 0.7% this week (up 5.7% y-t-d), its fifth consecutive weekly gain. The Morgan Stanley High Tech Index’s 0.5% rise increased y-t-d gains to 11.5%. Already this year the Nasdaq Composite has gained 8.6%. The Nasdaq100/NDX added 0.3% this week (up 9.9%). Bullish analysts continue to point to strong market momentum.

It’s an unusual backdrop where “Risk On” powers a U.S. equities markets melt-up, while safe haven assets trade as if “Risk Off” is lurking right around the corner. Ten-year Treasury yields declined 10 bps this week (to 2.31%) to the lowest level since November 29th. UK yields sank 14 bps (to 1.08%) to lows since October. Gold added $22 this week to $1,257, trading to the high since the election. Silver jumped 2.0% to $18.41, increasing y-t-d gains to 15%. The yen gained 0.6% this week, increasing y-t-d gains versus the dollar to 4.3% (and near a key technical level).

Elsewhere, it appears some favored trades are performing poorly – with popular longs lagging and popular shorts outperforming. The financials continue to lag, while the out-of-favor Utilities surged 4.1% this week. Defensive stocks outperformed this week, while “Trump reflation” wagers underperformed. Low beta outperformed high beta. The small caps underperformed again this week. Meanwhile, the Treasury bond bears are running for cover. All in all, it would appear Market Dynamics continue to frustrate many hedge fund strategies.

At this point, Europe remains at the epicenter of The “Risk On”/“Risk Off” Face-off. Major European equities indices reversed lower into this week’s close. After trading to the highest level since 2015, Germany’s DAX index dropped 1.6% during Thursday’s and Friday’s sessions. Italian equities fell 2.2% this week, and Spanish and French equities posted modest declines. The European Bank Stock Index (STOXX 600) dropped 3.2% this week, trading to the lowest level since early-December. Notably, Italian banks sank 5.8% this week, boosting y-t-d losses to 10.4%.

Through the eyes of the global bond market, something just doesn’t look right. And while this week’s Treasury and gilt yield declines were curious developments, the real action continues to unfold in Europe. German bund yields declined a notable 12 bps this week to 0.18%, the low since December 29th. Even more intriguing, German two-year sovereign yields sank 14 bps this week to a record low negative 0.96%.

The French versus German two-year sovereign spread traded as high as 49 bps this week, the widest since the tumultuous summer of 2012. This spread widened 11 bps for the week (to 43bps), and has doubled thus far in February. The Italian to German 10-year spread widened 12 this week, back to a two-year high 201 bps. The Spanish to German 10-year spread surged 18 bps this week to a seven-month high 151 bps. After beginning the year at 37 bps, the French sovereign Credit default swap (CDS) traded Thursday above 70 for the first time since August 2013.

Markets clearly fret approaching French elections (first round April 23, second May 7). National Front candidate Marine Le Pen is widely expected to win the first round but then lose in May’s two candidate runoff. After Brexit and Trump, markets this time around are less willing to take things for granted. Le Pen is running on a far right platform that includes exiting the EU, returning to the French franc and adopting various “France First” measures. Having watched post-Brexit and post-Trump non-turmoil, perhaps French voters will disregard what has become routine fearmongering.

While markets see a Le Pen Presidency as a relatively low-probability (Citigroup says 20%), there is recognition that such an outcome would be highly market disruptive. Many would view a National Front upset as the beginning of the end of the euro monetary experiment.

February 23 – Reuters (Brian Love and Michel Rose): “France's presidential race took a new turn on Thursday as independent Emmanuel Macron raised the curtain on a partnership with veteran centrist Francois Bayrou to help him beat the far-right's Marine Le Pen. ‘Political times have changed. We cannot continue as before. The National Front is at the gates of power. It plays on fear,’ Macron said… Opinion polls appeared to show the 39-year-old Macron, a political novice who has never held elected office but who has soared to become a favorite to enter the Elysee, was already benefiting from the new-born alliance announced on Wednesday.”
French (to German) bond spreads narrowed Wednesday on prospects for a Macron/Bayrou alliance to counter Le Pen. This development, however, didn’t slow the melt-up in German bund prices or, for that matter, the rally in Treasuries, gilts and safe haven bonds more generally. And it didn’t stop a sell-off in European bank stocks that seemed behind the late-week underperformance in U.S. and global financial stocks.

A Friday Reuters headline caught my attention: “Global Stocks Fall, Bond Markets Rally as Trump Optimism Pauses.” I have a difficult time with the notion of “Trump optimism” fueling international equities. Rather, it’s too much “money” (liquidity) chasing highly speculative markets in stocks, bunds, Treasuries, gilts, JGBs, corporates and EM debt. This same fuel has been behind gold and silver’s 9% and 15% y-t-d gains.

It’s a Theme 2017 that markets are unprepared for what would be a surprising change in the global monetary backdrop. I expect both the BOJ and ECB to at some point this year begin developing strategies for significantly reducing QE liquidity injections. Clearly, the Germans are contemplating a year-end conclusion to ECB QE operations.

February 23 – Reuters (Francesco Canepa): “Germany's central bank posted its smallest profit in more than a decade in 2016 as it set aside more money against potential losses on the bonds it is buying as part of the European Central Bank's stimulus programme… The Bundesbank recorded a net profit of 399 million euros, the lowest since 2004 and a sharp drop from the 3.2 billion euros bagged in 2015… Commenting on the results, Bundesbank president Jens Weidmann said it was right for the ECB to discuss closing the door to a further policy easing in the future.” February 23 – Bloomberg (Carolynn Look and Manus Cranny): “Investor expectations for an interest-rate increase by the European Central Bank in 2019 aren’t totally unjustified as downside risks to the economic outlook recede, according to Bundesbank President Jens Weidmann… Accelerating inflation and a strengthening economic outlook have fanned a debate in the 19-nation euro area about the appropriate degree of stimulus as central banks prepare for a policy shift. While officials including Weidmann are arguing that the time to talk about an exit is coming closer, ECB President Mario Draghi contends that record low rates and a 2.28 trillion-euro ($2.4 trillion) quantitative-easing plan are still necessary to produce a sustained pickup in inflation… While Weidmann conceded that the ECB is right to keep monetary policy accommodative, he criticized the Governing Council’s decision to extend QE through the end of 2017. ‘I was not very supportive of that step… The monetary-policy stance that I would have been willing to accept is less expansionary than the current one.’ One can certainly ask ‘when we might slow down monetary policy and whether the ECB Governing Council shouldn’t make its communication more symmetrical beforehand, for instance by not only pointing to the fact that monetary policy could be even more expansionary.’”
Angela Merkel appears increasingly vulnerable heading into October elections. Responding to criticism from a Trump advisor, Merkel this week commented: “We have at the moment in the euro zone of course a problem with the value of the euro. The ECB has a monetary policy that is not geared to Germany, rather it is tailored from Portugal to Slovenia or Slovakia. If we still had the D-Mark it would surely have a different value than the euro does at the moment.”

February 23 – Reuters (Francesco Canepa): “Exclusive: ECB seeks to lend out more bonds to avert market freeze – sources: The European Central Bank is looking for ways to lend out more of its huge pile of government debt to avert a freeze in the 5.5 trillion-euro short-term funding market that underpins the financial system, central bank sources told Reuters. The ECB has bought more than a trillion euros ($1.06 trillion) of euro zone government bonds in a bid to shore up economic growth and inflation in the euro zone… By doing so, it has taken away the key ingredient for repurchase agreements, or repos, whereby financial firms lend to each other against collateral, typically high-rated government bonds such as Germany's… Germany, the only large euro zone country with a top-notch credit rating, is where the problem is at its most severe.”
Will the Merkel government and Weidmann Bundesbank finally craft a more aggressive strategy for reining in Mario Draghi? Securities financing markets are already under heightened strain, as ECB purchases ensure an ever-dwindling supply of German debt in the marketplace. Again this week, there was talk of heightened stress and dislocation in the crucial “repo” marketplace. And while German influence over the ECB has waned throughout Draghi’s term, the Bundesbank holds a commanding position over the (by far) most dominant securities in the euro zone: “AAA” German debt. At this point, there’s a case to be made that German bunds are more critical to global securities funding, leveraged speculation and derivatives markets than even Treasuries.

ECB policymaking is increasingly at odds with German interests. I hold the view that German officials have more power to impose their will than is appreciated in today’s complacent markets. Perhaps it was no coincidence that Mr. Weidmann publicly voiced comments critical of ECB policy concurrent with a dislocation in bund trading and associated “repo” market stress. Moreover, I wouldn’t suggest owning risk assets anywhere in the world if European securities financing markets begin to malfunction.

Here at home, perhaps the markets will begin questioning the new Administration’s priorities (along with the ability to get those priorities through Congress). The markets are bullishly positioned in anticipation of a string of tax cuts, deregulation and infrastructure spending. I’m not sure how encouraging markets should find White House chief strategist Steve Bannon’s “three buckets” - “national security and sovereignty,” “economic nationalism” and the “deconstruction of the administrative state,” along with his comment “…one of the most pivotal moments in modern American history was [Trump’s] immediate withdraw from TPP. That got us out of a trade deal and let our sovereignty come back to ourselves.” It’s also worth mentioning that President Trump spent more time at CPAC trumpeting military buildup than offering details for tax reform and deregulation.

February 24 – Reuters (Emily Stephenson and Steve Holland): “President Donald Trump said he would make a massive budget request for one of the ‘greatest military buildups in American history’ on Friday in a feisty, campaign-style speech extolling robust nationalism to eager conservative activists. Trump used remarks to the Conservative Political Action Conference (CPAC)… to defend his unabashed ‘America first’ policies. Ahead of a nationally televised speech to Congress on Tuesday, Trump outlined plans for strengthening the U.S. military… and other initiatives such as tax reform and regulatory rollback. He offered few specifics on any initiatives, including the budget request that is likely to face a harsh reality on Capitol Hill… Trump said he would aim to upgrade the military in both offensive and defensive capabilities, with a massive spending request to Congress that would make the country's defense ‘bigger and better and stronger than ever before.’ ‘And, hopefully, we’ll never have to use it, but nobody is going to mess with us. Nobody. It will be one of the greatest military buildups in American history…’”

Trump, the Dollar and Trade – What’s Ahead



President Donald Trump’s early statements on international trade and currency valuations left many concerned about rocky times ahead: After winning the election, Trump continued to accuse key U.S. trading partners of unfair practices, following up on comments he made during the campaign. By making one of his first acts as president calling the Taiwanese president, Trump seemed to call into question the “one-China” policy (which entails diplomatic, official recognition of China, with an unofficial relationship with Taiwan), in an apparent snub to the mainland.

Mexico and Japan also came in for criticism for alleged manipulation of currency and trade regimes.

Even Germany was put in the cross hairs for carrying a perceived trade surplus deemed too large.

But more recently, in a phone call with China President Xi Jinping, Trump walked back any threat to abandoning the one-China policy. Then, his meeting with Japan’s Prime Minister Shinzo Abe last week seemed to suggest more cooperation than confrontation. That followed an announcement by Japan’s Government Pension Investment Fund, the world’s biggest, that it would invest in U.S. infrastructure projects that could create hundreds of thousands of American jobs. Still, trade tensions with Mexico and elsewhere remain unresolved.

To better understand how recent events could affect the U.S. dollar and international trade, Knowledge@Wharton spoke with Franklin Allen, an emeritus professor of finance at Wharton who is also a professor of economics and finance at Imperial College in London, where he is executive director of the school’s Brevan Howard Centre for Financial Analysis.

Knowledge@Wharton: I’d like to discuss the U.S. dollar, which could be used as a lens, in some ways, for analyzing some of the key issues in world markets. The value of the dollar, of course, has big implications for world growth, and very importantly, emerging market dollar-denominated debt. Also, many people view the dollar as a bit of a proxy for how the U.S. is performing overall, including the new administration. So, if people lose faith in the dollar, they might sell the dollar off and buy gold, or other currencies, or other investments.

At the same time, if the dollar appreciates too much, that can affect the level of growth here in the U.S. There was a recent Financial Times article that said if the U.S. dollar went up by 10%, that could knock a half percentage point (0.5%) off of GDP growth. There are a lot of pointers in the direction of the dollar getting stronger, such as: economic growth has been pretty strong, and it looks like it’s going to get stronger; especially if the administration passes a stimulus package. They’re also talking about deregulation, lower corporate and personal taxes and corporate tax forgiveness. All these things could put upward pressure on the dollar. The stock market has been doing well — that seems to draw money in and increase the dollar. And of course, the Fed has been talking about wanting to raise interest rates — that makes for a stronger dollar.

On the other side are the politics. President Trump has been talking about an interest in a weaker dollar. He is also saber-rattling about trade with some of the U.S.’s major trading partners; Mexico, China, Japan, Germany and other euro countries.

Given all of that, there’s a lot of contradictory stuff. What’s your view of the landscape? How important is it to look at the dollar, to figure out what’s happening in the world, and what’s likely to happen going forward?

Franklin Allen: I think it’s fairly important. I don’t think it’s hugely important, but it’s certainly one of the important things. Probably, the main driver is the difference in interest rates around the world, for the short run, at least. And, how things like a stimulus package, and so on, will play into that. If [the U.S.] does pass a big stimulus package, then my guess is that the Fed will raise rates faster than they otherwise would have done, and that will have an effect. We’ll see whether that gets passed; what the timing of that is, how the expectations for that play out.

The other thing, which I think is important, is what happens in the other countries, in terms of interest rates. In particular, in the Eurozone; whether that continues to stay where it is, or whether the growth that started to emerge leads to some ending of the quantitative easing, and raising of rates going forward. All of those, I think, will be very important for where the dollar ends up.

I think the trade policy of Trump will also play an important role. We’ve seen, clearly, some aggressive moves against Mexico, in particular, but also towards Germany, and to a lesser extent, maybe Japan. And then, of course, the big one is China. That’s been a little bit on the back burner, with everything that happened after he was elected; in particular, the call from the president of Taiwan, and the issue about the “one-China” policy, and whether it would be continued.

Hopefully, the talk [February 9] between President Xi and President Trump will mean that now that issue is off the table and we can focus on trade. I think there are lots of things going on, as your introduction indicated. But I would stress, most of all, the interest rate movements, and also the trade movements.

Knowledge@Wharton: One key thing is that if the dollar were to appreciate quite a bit, then there are a lot of emerging market countries out there that have a lot of dollar-denominated debt. We know that in the past, the Asian financial crisis of the late 1990s, and the Latin American crisis of the early 1980s — the dollar had a role in those problems. They had a lot of dollar-denominated debt, which suddenly became very expensive when they had big devaluations of their currencies. Could you talk about the risks in emerging markets right now?  
Allen: I think that potentially, is something to worry about. The key issue is the extent to which they have dollar-denominated income from exports, and various other sources, to offset their dollar debt. I think it’s the net positions, rather than the gross positions, that are important there.

A country like South Korea, I think it’s less of a problem than some of the other countries which are borrowing in dollars…. I would say there’s wide variation in that. But I think that’s something people need to keep an eye on over the next year or two.

Knowledge@Wharton: We’ve seen that President Trump is very concerned about trade with Mexico…. There’s talk of putting some kind of tax, or tariff, on imports. I’m wondering what effect this would have, both on Mexico and the U.S., and as a chilling effect on trade in general?

Part of what I’ve read suggests that it won’t be very effective, because the dollar may just adjust in a way that would have a zero-net effect in the long run.

Allen: That’s what people have argued, but that’s in an ideal world that it would adjust.

Whether or not that will happen in practice, I think, is still something that we don’t have a good sense of. I think if [the Trump administration does] something like that with Mexico, then it will potentially cause big problems because so much of world trade now is on supply chains.

Really, a lot of what’s happening in Mexico is supply chains. If they get disrupted, then people can be very reluctant to invest in those kinds of things again. That could potentially have a very big effect.

I guess it’s tied up with how they want to renegotiate the NAFTA agreement; and I think we still don’t have too much idea what exactly their tactics on that one are going to be. There’s also the [border] wall, and paying for the wall, and all those issues bubbling away underneath some of these things. So, I think it’s going to be a while before we know how that plays out. But it is potentially disruptive, not just for Mexico, but for many other countries where people are using them as part of a supply chain.

Knowledge@Wharton: China was a real whipping-boy for President Trump during the campaign. He talked about China’s currency being undervalued. Some analysts and critics said, well, that was true years ago, but it actually isn’t the case now. Although it is true, I think, that the Chinese currency has been depreciating somewhat against the dollar more recently, but probably for good, fundamental reasons. Can you talk about your view of how accurate the relationship between the dollar and China’s currency is now, and how much merit there is to what the administration has been talking about, regarding China?

Allen: My own view on the RMB-dollar exchange rate is that it depends a great deal on the capital account flows, as well as the current account flows. I think too much of the discussion focuses on the current account flows, and the deficit that the U.S. has with China. But what we’ve seen, as your question indicates, is that in fact in recent months there has been a weakening of the RMB as the dollar strengthened. So, the notion that they’re manipulating it is somewhat valid, but they’re manipulating to keep it valuable, rather than to keep it undervalued. I think that is, to a large extent, because of capital flows coming out of China. As long as that continues, it’s likely to be weak.

What we have to see is how capital account convertibility plays out in China. They’ve said they’ll do it, but the time frame is very important. And, as long as there’s money coming out in the kinds of quantities that there are, I think they’ll be reluctant to do it any time soon. So, my own view is that that’s the big issue on the RMB-dollar exchange rate.

Knowledge@Wharton: Also, with Japan, there’s been some jawboning by President Trump about the currency differences. And then, perhaps coincidentally, there was an announcement by Japan that it was willing to make certain investments in the U.S. that would create hundreds of thousands of jobs. What are the merits of the argument that Japan is still — I say ‘still,’ because this was an argument that goes back to the 1980s — manipulating its currency against the U.S. dollar?

Allen: They do intervene more than most countries in the foreign exchange market, but I think this is more to smooth the movements, rather than to have a fundamental effect. The one major achievement of Abenomics was to move the exchange rate so that the yen did effectively devalue against the dollar. But I think that they really are trying to stimulate the economy, and that this was a side effect, rather than the main reason for doing it.

I would say that they aren’t manipulating their currency, and that the charges that the Trump team is making are not particularly valid, with respect to Japan.

Knowledge@Wharton: I think back when Japan first instituted some of those changes, under Abenomics, that the International Monetary Fund (IMF) actually gave them the blessing to go ahead and do that.

Allen: Yes. I think the view was, they’ve had such a bad time for such a long time, that we should give them a free pass on that. But it’s an interesting one, because Brexit basically does the same thing for the pound. The pound has devalued substantially, and the economy’s now doing quite well — partly as a result of that, I think. So, these movements in exchange rates are driven by a wide range of things, and I think that the notion that countries are doing these things on purpose is probably not a valid one, in most cases.

Knowledge@Wharton: The final case I wanted to chat about is Germany. I didn’t expect to be talking about Germany until President Trump came out and accused them of undervaluing their currency, which, of course, is the euro, which, of course, most of the continent uses. There have been criticisms that Germany has benefited from a relatively low euro, because it’s a big exporter, one of the biggest in the world. And so, if it had its own currency, that currency would have gone up a lot. And that would have balanced out its trade with the rest of the world.

But also, Germany has been criticized for not spending more within the EU to take some of those gains, and to spread it around, as it were, and try to stimulate the rest of the EU.

But in any case, Germany doesn’t totally control the euro. So, what’s going on when you actually go head-on against Germany, and accuse it of manipulating its currency?

Allen: I think this is one of the most interesting questions — not just in this aspect, but also, of course, if you look at some of the other things that the Trump administration has been stressing. Like, spending at least 2% of GDP on defense for NATO members. Germany is also one of the biggest violators of that. They’re having a tremendous amount of pressure put on them, I would say.

In terms of the economic aspect, I guess I would be more sympathetic to them in the sense that the euro is not controlled by them. That’s controlled by the European Central Bank (ECB).

And I would think, if they could do anything, they would want the ECB to raise rates. They’ve been complaining bitterly about the penalty that German savers have been facing because of the low interest rates the ECB is setting. And, of course, if they were to raise interest rates, the euro would probably appreciate significantly. So, I think it’s a misplaced charge.

My own view on, should they be spending more? I guess that’s a sort of a macroeconomic view, based on inflexible prices, and whereas there’s some merit to that in the short run, in the long run, I don’t think it’s particularly valid. The one thing we know is that Germany has been running surpluses, in the long run, for many decades now. They’re incredibly competitive. People love their goods. And so, whatever the exchange rate is, they seem to do well. So, I think in this case, the issues raised by Trump are not particularly valid.

Knowledge@Wharton: What do you think is going to happen to the dollar over the next year or two, given pressures I mentioned, at the outset, that suggest that the dollar would go up, at least somewhat? And then, the opposite pressures, at least so far, of the new administration, suggesting they want a softer dollar, and also kind of saber-rattling against our trading partners, when it comes to the currency, in the hopes of improving the U.S. trade position.

Allen: I think a lot of things are already priced in, that you’ve discussed. The one thing that we do definitely know is that forecasting exchange rates is one of the most difficult things to do.

And there are not many people that can do it very well, and I’m certainly not one of them. I wouldn’t be surprised if the dollar strengthened, but I also wouldn’t be surprised if it weakened. I think there’s just so many things that can happen, in terms of the Trump program, that can make it move either way. There are some trade issues that we haven’t seen play out very much yet, particularly with China.

But there are also a number of other things, like security issues, and so on, and how Congress reacts.

What they do about these border taxes that we talked about, and so forth. There are just so many things. It would be very difficult to project what’s going to happen.

Knowledge@Wharton: Is there’s anything else you want to bring up in connection with all of this?

Allen: This issue about the border tax — of making exports non-taxable, and imports non-deductible — is potentially a big thing. Republicans seem to be pushing that hard in Congress, but it’s not quite clear what Trump thinks about it. But that could drastically change a number of things. One would be the dollar, but also, the relative positioning of firms will change quite a lot, I think, if anything like that happens. We’ll see whether it does. How the World Trade Organization will react to that is also up in the air, I would say. But I think that’s a big issue.

Knowledge@Wharton: When you say it could bring big changes for firms, could you describe, just in broad strokes, what some of them are?

Allen: Well, the exporters, like Boeing, and so forth, are going to do wonderfully well. And the importers, like Walmart, are going to do pretty badly, in terms of their taxes. So, that’s one aspect.

Whether or not it will change how they proceed, in terms of importing less and exporting more, I think, is an open question. I’m not sure how much of the effect there will be.

Trump, Islam and the clash of civilisations
The hostility to Muslims is finding adherents across the western world
by: Gideon Rachman

Donald Trump’s travails with his “Muslim ban” make it easy to dismiss the whole idea as an aberration that will swiftly be consigned to history by the judicial system and the court of public opinion. But that would be a misreading. The ban on migrants and refugees from seven mainly Muslim countries was put together clumsily and executed cruelly. But it responded to a hostility to Islam and a craving for security and cultural homogeneity that is finding adherents across the western world — and not just on the far right.

Even if Mr Trump’s ban is withdrawn or amended, it will probably be just the beginning of repeated efforts — in the US and Europe — to restrict migration from the Muslim world into the west.

There certainly should be no doubt about the radicalism of the thinking of some of Mr Trump’s key advisers. Michael Flynn, the president’s embattled national security adviser, and Steve Bannon, his chief strategist, believe that they are involved in a struggle to save western civilisation. In his recent book, The Field of Fight, General Flynn insists that: “We’re in a world war against a messianic mass movement of evil people, most of them inspired by a totalitarian ideology: Radical Islam.” Mr Bannon holds similar views. In a now famous contribution to a seminar at the Vatican in 2014, he argued that the west is at the “beginning stages of a global war against Islamic fascism”.

The fact that Mr Trump’s closest advisers believe they are engaged in a battle to save western civilisation is a key to understanding the Trump administration. It helps explain why the president, in his inaugural address, pledged to defend the “civilised world” — not the “free world”, the phrase that would have been naturally used by a Ronald Reagan or a John F Kennedy.

This tendency to conceive of the west in civilisational or even racial terms — rather than through ideology or institutions — also helps explain the Trump team’s sympathy with Vladimir Putin’s Russia and hostility to Angela Merkel’s Germany. Once the west is thought of as synonymous with “Judeo-Christian civilisation” then Mr Putin looks more like a friend than a foe. The Russian president’s closeness to the Orthodox church, his cultural conservatism and his demonstrated willingness to fight brutal wars against Islamists in Chechnya and Syria cast him as an ally. By contrast, Ms Merkel’s willingness to admit more than a million mostly Muslim refugees into Germany make America’s alt-right regard her as a traitor to western civilisation. President Trump has called the German chancellor’s refugee policy a “catastrophic” error.

Through his Breitbart news service, Mr Bannon forged close ties with the European far-right, who share his hostility to Islam and immigration. The belief that the west is engaged in a mortal struggle with radical Islam clearly animates Marine Le Pen, leader of France’s National Front, who recently argued that: “Washington, Paris and Moscow must form a strategic alliance against Islamic fundamentalism . . . Let us stop the quarrels and unnecessary polemics, the scale of the threat forces us to move fast, and together.”

These views are not confined to the political extremes in France. François Fillon, the centre-right’s candidate in the presidential election, recently published a book called, Conquer Islamic Totalitarianism, which contains the Flynn-like declaration that: “We are in a war with an adversary that knows neither weakness nor truce.” Pierre Lellouche, France’s former Europe minister, has also just brought out a book called War without End, which argues that Islamism is the 21st-century equivalent of Nazism.

Far-right parties with a Trumpian view of Islam are also prospering in the Netherlands and in Germany. The Freedom party led by Geert Wilders is set to top the polls in next month’s Dutch elections — although it is unlikely to enter government. In Germany, the Alternative for Germany party has surged in response to the refugee crisis, and is likely to become the first far-right party to enter the country’s parliament since 1945. Some in the British government believe that hostility to immigration from the Islamic world — more than Europe — lay behind the discontent that triggered the Brexit vote last year.

Sympathy for the Bannon-Flynn-Trump view of Islam extends beyond the US and Europe. A belief that their nations face an elemental threat from radical Islam is also an animating force on the rightwing of Indian and Israeli politics.

Even if Mr Trump loses the battle over his executive order on refugees and immigration, he is likely to return to the fray with further measures. That is because his closest advisers and many of his strongest supporters will remain driven by a deep suspicion of Islam and a determination to stop Muslim immigration.

There will also, almost inevitably, be further jihadist attacks in both the US and Europe that will feed this fear and hostility. Meanwhile, the long-term demographic trends that create pressure for migration from Muslim countries to the US and Europe will only increase in the coming years. The population of impoverished, largely Muslim, north Africa is much younger than that of Europe, and growing fast.

The polemic over Mr Trump’s “Muslim ban” will not be an isolated event. On the contrary, it is a foretaste of the future of politics in the west.

Make Big Banks Put 20% Down—Just Like Home Buyers Do

Financial CEOs say capital requirements are already too high, but the facts suggest otherwise.

By Neel Kashkari

There’s a straightforward way to help prevent the next financial crisis, fix the too-big-to-fail problem, and still relax regulations on community lenders: increase capital requirements for the largest banks. In November, the Federal Reserve Bank of Minneapolis, which I lead, announced a draft proposal to do precisely that. Our plan would increase capital requirements on the biggest banks—those with assets over $250 billion—to at least 23.5%. It would reduce the risk of a taxpayer bailout to less than 10% over the next century.

Alarmingly, there has been recent public discussion of moving in the opposite direction. Several large-bank CEOs have suggested that their capital requirements are already too high and are holding back lending. As this newspaper reported, Bank of America CEO Brian Moynihan recently asked, “Do we have [to hold] an extra $20 billion in capital? Which doesn’t sound like a lot, but that’s $200 billion in loans we could make.”

It is true that some regulations implemented after the 2008 financial crisis are imposing undue burdens, especially on small banks, without actually making the financial system safer. But the assertion that capital requirements are holding back lending is demonstrably false.

How can I prove it? Simple: Borrowing costs for homeowners and businesses are near record lows. If loans were scarce, borrowers would be competing for them, driving up costs. That isn’t happening. Nor do other indicators suggest a lack of loans. Bank credit has grown 23% over the past three years, about twice as much as nominal gross domestic product. Only 4% of small businesses surveyed by the National Federation of Independent Business report not having their credit needs met.

If capital standards are relaxed, banks will almost certainly use the newly freed money to buy back their stock and increase dividends. The goal for large banks won’t be to increase lending, but to boost their stock prices. Let’s not forget: That’s the job of a bank CEO. It isn’t to protect taxpayers.

So if capital requirements aren’t the problem, why does it feel so hard to get a loan today? I can speak from firsthand experience. Last year my wife and I decided to buy a house. We applied for a loan with a bank where I have been a customer for many years. I assumed that my long record with the bank and our good credit would make it easy. With the required 20% down payment, we were prequalified for a mortgage with a rate of 3.375% fixed for the first 10 years. That was an attractive rate, suggesting capital was not holding back lending.

The prequalification was easy. Then the frustration began. The mortgage banker asked for myriad documents: bank statements, 401(k) statements, brokerage statements, tax returns, W-2s, insurance records and so on. That all seemed reasonable, but as the weeks rolled on, the requests for more documentation kept coming. After a month or so, I couldn’t believe what I was being asked for. Despite having all the records of my on-time monthly rental payments in my checking account, the bank demanded a copy of my lease and to speak with my landlord.

The banker called me to apologize, admitting that the requests were ridiculous but saying that there was no reasoning with the underwriting department. As we waited, we began to wonder if we wanted to buy the house at all. Wouldn’t continuing to rent be so much easier?

In the end, the bank funded the loan. I felt bad for the underwriters, who seemed unable to exercise judgment or use common sense. The impression I got was that people at the bank were simply paralyzed by fear—that they might make a mistake, that regulators would be breathing down their necks.

I have spoken to many borrowers at other banks, and they tell me similar stories. It has become needlessly difficult for qualified borrowers to get loans. But again, the problem isn’t the capital requirements—it’s everything else.

Capital is the best defense against bailouts. Although capital standards are higher than before the last crisis, they are not nearly high enough. The odds of a bailout in the next century are still nearly 70%. Large banks need to be able to withstand around a 20% loss on their assets to protect against taxpayer bailouts in a downturn like the Great Recession, according to a 2015 analysis by the Federal Reserve. Unfortunately, regulators have taken it easy on the large banks, which today have only about half of the equity they need.

There is a simple and fair solution to the too-big-to-fail problem. Banks ask us to put 20% down when buying our homes to protect them in case we run into trouble. Similarly, taxpayers should make large banks put 20% down in the form of equity to prevent bailouts in case the financial system runs into trouble. Higher capital for large banks and streamlined regulation for small banks would minimize frustration for borrowers. If 20% down is reasonable to ask of us, it is reasonable to ask of the banks.

Mr. Kashkari is president of the Federal Reserve Bank of Minneapolis and a participant in the Federal Open Market Committee.

The European Unraveling?

Ana Palacio

 EUprotest poland


MADRID – After years of intensifying fragmentation and tension, the European Union may be on the verge of losing its most precious assets: peace, prosperity, freedom of movement, and values such as tolerance, openness, and unity. Will Europeans unite in time to save them?
The danger facing the EU became starkly apparent last June, when the United Kingdom voted to leave. And Donald Trump’s election as US president has made matters far worse. The United States, Europe’s closest and most powerful ally – a crucial security partner and bearer of shared values – is now headed in a very different direction, and threatening to leave a shaken and divided Europe alone in a harsh world eager to tear it apart.
This might sound hyperbolic. Many in the US political class remain convinced – at least in public – that US foreign policy under Trump will be reined in by the more level-headed heavyweights in his cabinet, such as Secretary of Defense James Mattis and Secretary of State Rex Tillerson. “Don’t worry,” they say, “the worst will not happen.”
But, in my experience, the person who really counts is the one who has the president’s ear. And, so far, all signs indicate that Trump’s inner circle is driving policymaking. In fact, the pronouncements and executive orders of Trump’s first weeks in office convey a singular ideological perspective – the one long espoused by White House Chief Strategist Steve Bannon, an ultra-nationalist, acolyte of the Italian fascist philosopher Julius Evola, and long-time enabler of America’s white-supremacist “alt-right.”
As if to underscore his Rasputin-like influence, Bannon has now secured a seat on the National Security Council Principals Committee, which includes the secretaries of state and defense, but not the director of national intelligence or the chairman of the joint chiefs of staff. No surprise, then, that #PresidentBannon has been trending on Twitter.
Ordinarily, I would not pontificate on the structure of another country’s foreign-policy apparatus. But Trump’s is no ordinary US presidency, so we all have a responsibility to consider the implications of the White House’s ideological about face from traditional democratic and Western thinking for our own countries. For Europeans, this responsibility is particularly urgent, because America’s new driving ideology emphasizes the traditional Westphalian nation-state, with its insistence on sovereignty, strong borders, and nationalism.

The EU – built on the idea of strength, peace, and prosperity through cooperation – is anathema to it.
The problem for the EU is no longer the indifference that marked the worst elements of President Barack Obama’s approach to Europe. It is outright US hostility. Trump’s praise of Brexit, which emphasized the British people’s “right to self-determination,” and his belittling reference to the EU as “the Consortium” in his appearance with British Prime Minister Theresa May, underscores his hostility.
Europe is now stuck between a US and a Russia that are determined to divide it. What are we Europeans to do?
One option is to pander to Trump. That is the approach May took on her visit to Washington, DC, when she stood by silently as Trump openly declared his support for the use of torture at their joint press conference.
But, for the EU, such appeasement would be counter-productive. It is our values, not our borders, that define us. It makes little sense to abandon them, especially to ingratiate ourselves with a leader who has shown himself to be capricious and utterly untrustworthy.
Another option is to find a new savior – perhaps a country like China, which not only is America’s closest analogue, in terms of economic impact, but also has attracted substantial attention lately, owing to its president’s robust defense of globalization.
But we should beware of false messiahs. The global vision promoted by China focuses almost entirely on economic relations – precisely the soullessness that got the liberal world order into trouble in the first place. A sense of common purpose, not just the operation of the market, binds humanity together. Were it otherwise, the EU’s single market would have been enough to protect it from the existential threat it now faces.
The third option – and the only viable one for the EU – is self-reliance and self-determination.
Only by strengthening its own international positions – increasing its leverage, in today’s jargon – can the EU cope effectively with America’s wavering fidelity to its allies and the values they share.
Pursuing this option implies that the EU should push for progress in trade talks with Japan, negotiate an investment agreement with China, modernize the EU-Mexico Global Agreement, and position itself as a world leader on tax reform. Moreover, Europe should take greater responsibility for its defense, both by increasing spending and by pursuing continental cooperation aimed at using resources and capabilities more efficiently.
To address the migration challenge it faces, Europe should craft a policy guided by its values, as well as its security and economic interests. That means distinguishing between economic migrants and refugees, strengthening border controls, and boosting cooperation with third countries.
In all that it does, from this moment on, the EU must affirm and advance the values – openness, human rights, knowledge, and the rule of law – that have enabled Europe to recover, grow, and thrive for more than seven decades. French President François Hollande and German Chancellor Angela Merkel’s recent call for a “clear, common commitment” to the EU is a good start.
But such calls must now be backed by action. That may be difficult for the next nine months, as the Netherlands, France, and Germany hold national elections. It will be even more difficult if an extremist candidate in one or more of these countries achieves a surprise victory. But if Europe’s political center holds, as expected, the EU will be in a strong position to confront increasingly hostile external forces and move forward with purpose.

Something Rotten in the State of Russia?

By George Friedman and Jacob L. Shapiro

Geopolitical Futures’ forecast for 2017 says the following: “In hindsight, the coming year will be an inflection point in the long-term destabilization of Russia that we predict will reach a boiling point by 2040.” This may seem counterintuitive in light of the Russia hysteria following the US presidential election. Yet in the first six weeks of 2017, it is already possible to observe indicators that this forecast is on track.

These indicators fall roughly into four separate categories of instability: the distribution and prevalence of wage arrears, pressure on the Russian banking system, low-level social and economic unrest, and government purges. The map below summarizes these developments.

Before we get started…

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In addition, you will have the opportunity to meet and talk with George and Meredith, GPF analysts Jacob L. Shapiro, Kamran Bokhari, and Antonia Colibasanu, and several of the other panelists. Our elite list of speakers includes Harald Malmgren, former adviser to four presidents; Theodore Karasik, senior adviser to Gulf State Analytics; Ariel Cohen, director of the Center for Energy, Natural Resources, and Geopolitics; and Stephen Blank, senior fellow at the American Foreign Policy Council… with more to be added to the event page  in the coming weeks.

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Show Me the Money

The bottom part of the Russia map shows wage arrears as reported by region. “Wage arrears” is a fancy term for workers not being paid. In December 2016 (the last month for which Russia’s Federal State Statistics Service has data), total wage arrears amounted to 2.7 billion rubles (roughly $46.4 million in USD).

The regions with the largest wage arrears can be divided into two categories. The first is port regions. Primorsky region, whose capital Vladivostok is Russia’s largest port on the Pacific, has by far the worst incidence of wage arrears. It accounts for 21.2% of the country’s total. The area where it is the second most prevalent is Siberia (in places like Irkutsk and Novosibirsk).

The importance of these wage arrears is not their size in absolute figures. It is where Russian workers are not getting their paychecks. Russia’s economy is highly regionalized. More than a fifth of Russia’s wealth is generated in Moscow and its surrounding areas. The central government keeps the Russian Federation together by redistributing wealth to interior regions.

The first places to expect economic trouble are port and interior regions. The port regions will struggle because trade is the oxygen that port cities need to breathe, and Russia’s main export, oil, is facing prolonged low prices. The interior will struggle because the central government will have less money to allocate. This forces a lose-lose choice between austerity and cutting military spending

The wage arrears map is an indication that GPF’s model for Russia is accurate. If the model is accurate, the probability of the forecast coming to fruition greatly increases.
Russia’s Banking System

The decline in the price of oil has had a predictably negative effect on the Russian banking system. Incidents of Russian depositors applying for deposit insurance have increased markedly.

Some regions are suffering from banking crises. In Tatarstan, for example, the region’s leading bank suspended operations in December, depriving both individual depositors and businesses of access to funds. This led to workers not being paid and to bankruptcies. It also required intervention from the central government.

The above map identifies regions where over 100 banks have had their licenses revoked. By itself, this indicator does not present a clear picture. Russia’s banks could be under severe pressure. The fact that the main fund used by Russia’s Deposit Insurance Agency has decreased in value by 75% in two years gives this argument some weight. Russia could also be cleaning up its banking system and shutting down banks involved in illegal or irresponsible activity. In view of the other negative indicators about the current state of Russia’s economy, the former is a more likely explanation.
Protests in the Countryside

The logical consequence of economic difficulty is social unrest. The world is not always logical, but in this case, what logic would dictate appears to hold true. Small-scale protests have been observed throughout the Russian countryside. Small incidents have also occurred in major cities like Moscow and St. Petersburg. The map plots areas where protests have been observed.

It is important to note two things. First, none of these protests have indicated any sort of wider national organization. Second, they are relatively small (often in the low hundreds). They are important, but they should not be over-exaggerated. The Russian countryside is not singing the songs of angry men, nor is it close to doing so.

There are, though, concrete signs of dissatisfaction bubbling to the surface. These are tangible indicators of frustration with salary cuts, unpaid wages, and social services reduced by Moscow. These small events are the canary in the coal mine and spell trouble down the line for the Russian government.

The remaining two items on the map show political and security purges ordered by President Vladimir Putin. Russian media have described these moves as a “major political reshuffle.” That is a euphemism for what it really is.

The point of a purge is to get rid of potential challengers and install loyalists in their place. On Feb. 6–7, two governors from Perm and Buryatia regions were forced to resign. Vedomosti, a leading Russian-language business daily, reported that additional resignations and removals are expected in the regions identified in the map.

Unlike wage arrears, these purges are not confined to any one geographic area. Some are in Siberia to the east, some are in the regions toward the Caucasus, and others are in the immediate vicinity of Moscow. That Putin feels unsure enough of his own position to carry out these kinds of political changes reveals a great deal about the position in which he currently stands.

Presidential elections are coming for Russia. They will likely be held in 2018 (though there have been rumors they could happen in 2017). Like President Xi Jinping in China, who is using “anti-corruption” as a pretense to remove rivals ahead of his reappointment at this fall’s Communist Party Congress, Putin is securing his political position in the name of fighting corruption.

The purges are not limited to governors who have significant powers in the Russian Federation’s political system. Putin has also removed generals from the Interior Ministry as well as the Ministry of Civil Defense, Emergencies and Elimination of Consequences of National Disasters. These ministries are responsible for forces that are used to control domestic social order and quell protests. Ensuring the loyalty of such ministries is essential and must be done before serious problems emerge. A total of 16 generals have been removed, according to RIA Novosti, and two of those were also removed from military service.
Writing on the Wall?

This report is not meant to be alarmist. It is not GPF’s forecast that the Russian Federation is in danger of imminent collapse. None of these data points by themselves indicate that GPF’s forecast has been confirmed. They simply highlight Russia’s underlying weakness and explain why Putin, who just a few months ago was strutting on the world stage, has gone somewhat quiet. Important things need to be done at home. This is where Moscow’s focus is right now, and in choosing that focus, GPF and Russia have something in common.