"Whatever They Want" Coming Home to Roost

Doug Nolan

Let's begin with global. China's yuan (CNY) traded to 6.9644 to the dollar in early-Friday trading, almost matching the low (vs. dollar) from December 2016 (6.9649). CNY is basically trading at lows going back to 2008 - and has neared the key psychological 7.0 level. CNY rallied late in Friday trading to close the week at 6.9435. From Bloomberg (Tian Chen): "Three traders said at least one big Chinese bank sold the dollar, triggering stop-losses." Earlier, a PBOC governor "told a briefing that the central bank would continue taking measures to stabilize sentiment. We have dealt with short-sellers of the yuan a few years ago, and we are very familiar with each other. I think we both have vivid memories of the past."

The PBOC eventually won that 2016 skirmish with the CNY "shorts". In general, however, you don't want your central bank feeling compelled to do battle against the markets. It's no sign of strength. For "developing" central banks, in particular, it has too often in the past proved a perilous proposition. Threats and actions are taken, and a lot can ride on the market's response. In a brewing confrontation, the market will test the central bank. If the central bank's response appears ineffective, markets will instinctively pounce.

Often unobtrusively, the stakes can grow incredibly large. There's a dynamic that has been replayed in the past throughout the emerging markets. Bubbles are pierced and "hot money" heads for the exits. Central banks and government officials then work aggressively to bolster their faltering currencies. These efforts appear to stabilize the situation for a period of time, although the relative calm masks assertive market efforts to hedge against future currency devaluation in the derivatives markets.

If policymakers then lose control - market pressures prevail - those on the wrong side of (now outsized) derivative hedges are forced to aggressively sell/short the underlying currency. This type of self-reinforcing selling can too easily foment illiquidity, dislocation and currency collapse. As I highlighted last week, for a list of reasons such a scenario would have devastating consequences for China - and the world.

As I've noted in previous CBBs, the current global environment has some critical differences compared to China's last currency instability episode in early-2016. Global QE was ramped up to about a $2.0 TN annual pace back then, versus today's QE that will soon be only marginally positive. Buoyed by zero rates, sinking bond yields and rising equities prices, global speculative leverage was expanding - versus today's problematic contraction. China's Credit system and economy were significantly more robust in 2016. EM, in general, was still enveloped in powerful financial and economic expansion dynamics. Moreover, the global trade and geopolitical backdrops have deteriorated dramatically since 2016.

October 26 - Bloomberg: "Investors are turning up the temperature on Chinese policy makers, who were already feeling the heat. That may cause the government to resort to even tighter controls on money flowing in and out of the country, according to Citi economists. Net foreign exchange settlement by banks in China on behalf of their clients -- a proxy for capital flows -- was negative in September for a third straight month, according to… the State Administration of Foreign Exchange. At -110.3 billion yuan, purchase of foreign currencies was the most since December 2016. An escalating trade war with the U.S. has contributed to souring investor sentiment and put downward pressure on China's currency, which Friday came within striking distance of a 10-year low against the dollar. It's fallen 9% over the last six months. Measures taken by the People's Bank of China this month to support the economy as the outlook has darkened… haven't helped the exchange rate."

October 26 - Bloomberg (Alfred Liu and Benjamin Robertson): "China's finance ministry has warned the country's state-owned financial assets need further protection from mismanagement, following the release of new data on the size of their balance sheets. Total assets of state-owned financial enterprises amounted to 241 trillion yuan ($34.6 trillion) in 2017, according to a report published by China's Ministry of Finance… Their liabilities were 217.3 trillion yuan last year… 'While we are gradually upgrading the management of state financial assets, we have to be aware that there are still institutional and structural contradictions and problems,' said Liu Kun, China's finance minister… 'The mission of preventing massive risks remains tough.'"

A disorderly breakdown of the Chinese currency has the potential to be one of the most destabilizing developments for global finance and the world economy in decades. I am not confident that Chinese officials have the situation under control. At the same time, there is no doubt that Chinese finance and financial institutions have inflated to previously unimaginable dimensions. And it appears Beijing is increasingly cognizant of unfolding risks. This likely explains why officials appear less inclined than in the past to push through aggressive fiscal and monetary stimulus. A key aspect of the bullish global thesis (Chinese stimulus on demand) is due for reassessment.

The Shanghai Composite rallied 1.9% this week. It was difficult for global markets to sense anything more than fleeting relief, suspecting the "national team" was hard at work. Markets throughout Asia were under pressure. Hong Kong's Hang Seng index fell 3.3%. Major indices were down 6.0% in South Korea, 6.0% in Vietnam, 4.3% in Taiwan, 3.2% in Thailand, 2.8% in Malaysia, 2.8% in India and 1.2% in Philippines. Japan's Nikkei 225 index sank 6.0%, with the TOPIX Bank Index's 4.7% drop boosting y-t-d declines to 17.1%.

Asian bank weakness is a primary Systemic Contagion Link globally. Europe's STOXX 600 bank index fell 3.5% this week, increasing 2018 losses to 24.0%. Italian banks were down another 3.9% this week (down 28.2% y-t-d). Deutsche Bank dropped 11.4% this week (to an all-time low). Deutsche Bank (senior) credit-default swap (CDS) prices rose 11 bps this week to 156 bps, the high since early July. Many of the big global banks saw CDS prices rise this week to near one-year highs. Curiously, Goldman Sachs CDS rose seven this week to 79 bps, an almost 19-month high. The U.S. bank equities index (BKX) sank 5.0% this week, and the Broker/Dealers dropped 4.8%.

In a further indication of heightened global systemic risk, German bund yields sank 11 bps this week to 0.35%, the low since September 4th. With Italian yields declining only four bps (to 3.45%), the spread to bunds widened seven bps to 310 bps. Portuguese yields dropped 11 bps to 1.96%, and Spanish yields fell 17 bps to 1.57%. UK 10-year yields sank 19 bps to 1.38%, the low since August.

It certainly has all the appearance of bond markets beginning to discount ramification of the bursting of the global Bubble. WTI crude declined another $1.52 to $67.62, a two-month low.

The dollar index increased 0.7% to 96.412, near a 16-month high. The British pound declined 1.9%, the Norwegian krone 1.6%, the Swedish krona 1.6%, the New Zealand dollar 1.4%, the South African ran 1.3% and the euro 1.0%.

October 26 - Bloomberg (Jacob Bourne): "Inflation expectations are tumbling in the U.S. bond market, suggesting traders are worried that the Federal Reserve's monetary policy is becoming too tight -- potentially by a quarter-point -- amid the slide in equities. The five-year breakeven rate, which represents bond investors' view on the annual inflation rate through 2023, dropped Friday to 1.88%, the lowest since January."

The headline for the above article was "Inflation Bets Are Tanking, Showing Bond Traders See a Tight Fed." Ten-year Treasury yields did drop 12 bps this week to 3.08%. But the overarching issue is escalating systemic risk associated with a faltering global Bubble - and not a "tight Fed." The Fed would prefer to remain "data dependent." The early read on Q3 GDP came in at 3.5%, with Personal Consumption growing at a 4.0% rate (strongest since Q4 '14). A number of Fed officials this week downplayed U.S. stock market weakness.

I'm not at all sure Fed officials appreciate their predicament. The global Bubble is bursting, yet the U.S. economy at this point maintains a decent head of steam. Bond markets are quickly adjusting to the changing global backdrop. Treasuries have had more of a domestic focus but that has begun to shift. And having shown resilience until recently, junk bonds (HYG) have now declined 1.1% over the past two weeks. With yields jumping this week to a two-year high, junk bond funds suffered net outflows of $2.364 billion.

October 26 - Bloomberg (Adam Tempkin): "One of Wall Street's go-to shelters in times of trouble is showing cracks as broad concerns pile up. Bouts of selling have hit bonds backed by mortgages, auto loans and credit card payments -- typically havens during periods of stress -- amid the carnage in financial markets this month. Certain sectors of so-called securitized loans are 'experiencing some headwinds,' said Neil Aggarwal, senior portfolio manager and head of trading at Semper Capital. 'A combination of rates, earnings, and global concerns are having an ongoing impact.' The debt class usually does better than corporate bonds during market turmoil because the securities are linked to consumer payments, rather than company performance, and typically have cash cushions to absorb initial losses. But recent weakness highlights how the sector may be unable to shrug off the chaos enveloping other assets."

Financial conditions have now begun to meaningfully tighten at the "Core." I suspect de-risking/de-leveraging dynamics have begun to unfold throughout U.S. corporate Credit. There are also indications of tightening liquidity conditions in securitized Credit. These are important developments.

October 26 - Bloomberg (Suzy Waite and Nishant Kumar): "Hedge funds using computer-driven models to follow big market trends have been whiplashed as volatility has spiked, among the biggest casualties of a stock rout that has accelerated worldwide. Funds known as commodity trading advisers, or CTAs, have traditionally shielded investors during market selloffs such as the global financial crisis, especially when mathematical models show a clear or pronounced trend. But this time, they've been unable to navigate sharp reversals in asset prices… 'It's a bloodbath out there across almost every strategy with very few exceptions,' said Vaqar Zuberi, head of hedge funds at Mirabaud Asset Management… 'CTAs have been caught by a double-whammy with rising rates and equities plummeting,' said Zuberi. 'There's only one exit and everyone is trying to exit now because the models are telling them to do so.' Computer-driven hedge funds were already headed for their worst year ever before this month's volatility…"

As an industry, hedge funds were already struggling for performance prior to the recent bout of "Risk Off." Many funds have seen 2018 gains quickly morph into losses. There is now the distinct risk of escalating losses into year-end spurring significant industry outflows. This dynamic elevates the odds of a destabilizing de-risking/deleveraging dynamic.

Treasuries provided somewhat of a hedge against equities losses this week. Yet, overall, markets have been particularly uncooperative to popular "risk parity" hedge fund strategies. Leveraged portfolios of stocks, government securities and fixed-income are not experiencing the diversification benefits they've enjoyed for most of the past decade (or two). Losses and general performance volatility will force these strategies to deleverage, with negative consequences for liquidity across various markets.

With de-risking/deleveraging gaining momentum globally - and some of the big global "banks" under pressure - it's reasonable to begin contemplating counter-party risk. And anytime markets start indicating waning liquidity and dislocation risk, my fears return to the derivatives markets. How much market "risk insurance" has been sold by strategies that plan on hedging this risk by selling into declining markets? Stated differently, what is the risk that derivatives "insurance" "dynamically (delta) hedged" by quant models could erupt into self-reinforcing sell programs, illiquidity and market dislocation?

October 26 - Financial Times (Alfred Liu and Benjamin Robertson): "Mario Draghi has pushed back against the wave of political attacks on the world's central banks, warning that the rising pressure could lead to lower growth and undermine a vital line of defence against future financial crises. Speaking just hours after he was criticised by Italy's deputy prime minister as 'poisoning the climate' against Rome, the European Central Bank president called on legislators around the world to instead 'protect the independence' of rate-setters. 'The central bank should not be subject to . . . political dominance and should be free to choose the instruments that are most appropriate to deliver its mandate,' Mr Draghi said in a thinly-veiled rebuke to his native country."

I see things similarly as the great statesman, the ailing Paul Volcker: "A hell of a mess in every direction." The stock market is only a few weeks past all-time highs, yet the finger-pointing has already begun in earnest. The Powell Fed cautiously raising rates just past 2.0% is certainly not responsible for the world's problems. A decade of central bank-induced monetary inflation, well that's a different story. More than a couple decades of central bank experimentation and inflationism, now you're on to something. It was always going to Come Home to Roost. That's the harsh reality that no one was willing to contemplate.

Draghi: "The central bank should not be subject to… political dominance and should be free to choose the instruments that are most appropriate to deliver its mandate."

It's ridiculous to bestow a small group of global central bankers the power to do Whatever They Want in the name of delivering on some arbitrary index level of consumer price inflation. To create $14 TN of "money" and unleash it upon global securities markets is undoubtedly history's most reckless monetary mismanagement.

Inevitable Blowback has commenced. "The dog ate my homework." "The inflation mandate made us do it." With a full year remaining in his term, Draghi won't be sharing Bernanke's good fortune. This whole historic monetary experiment will be unraveling while he's still on watch. But, then again, the Trump administration already has its scapegoat. Perhaps the whole world will blame Chairman Powell - or the man that appointed him.

Following a terrifying trajectory, things somehow turn more disturbing by the week. Political travesty has degenerated into a surreal quagmire. And to see this degree of division and hostility at this cycle's boom phase should have us all thinking carefully about what the future holds. As a nation, we are alarmingly unprepared. And it's back to this same issue that's troubled me for a number of years now.

Bubbles are always mechanisms of wealth redistribution and destruction. Akin to central banking, they can inflict immeasurable harm and somehow deflect culpability. As we've already witnessed as a society, they wreak subtle - and, later, more overt - havoc. And the current astounding Bubble has been on such an unprecedented global scale. Harsh geopolitical fallout is unavoidable. For me, it's been scary for a while. It's just more palpable now. We'll see if the midterms can provide an impetus for a market rally. If not, this has all the appearances of something that could turn sour quickly.


The world economy looks dependent on booming America

What will happen when its growth slows?

IT HAS been a nervy few days for financial markets. A sell-off in bond markets, prompted by monetary tightening in America, this week infected global stockmarkets, too. The S&P 500 share-price index fell by over 3% on October 10th, its worst day in eight months. Markets in Shanghai hit their lowest level for nearly four years the next day; those in Japan and Hong Kong closed around 3.5% lower.

At first glance, the sell-off seems odd. The world economy is still growing briskly enough: this week the IMF only slightly trimmed its forecast for world GDP growth for 2018, from 3.9% to 3.7%. But investors are right to fret. Whereas acceleration was synchronised across much of the world in 2017, the global economy’s expansion now looks increasingly unbalanced.

Two divides stand out. The first is between emerging markets, which are suffering from particularly volatile financial conditions, and advanced economies. The cause of this divergence is a strong dollar, which is making emerging markets’ debts that are denominated in the currency costlier to service. The latest casualty is Pakistan. On October 8th it announced that it would seek an IMF bail-out, which is expected to amount to $12bn. It joins the ranks of other emerging markets in distress, notably Argentina, which has negotiated a record $57bn credit line from the IMF, and Turkey.

Sustained falls in emerging-market currencies and stocks have been painful for investors. Several countries have raised interest rates to stem capital outflows. Yet the damage to the real economy has for the most part been confined to those with large current-account deficits, such as Argentina. From a global perspective, the bigger worry is China. Authorities there are trying to reduce leverage in the financial system at the same time as American tariffs are squeezing their exports. The currency is under pressure; growth expectations are being lowered.

The second divide exists within the ranks of advanced economies. Rich countries seem to be gently slowing, with one big exception: America. There, growth has sped up dramatically, exceeding an annualised rate of 4% in the second quarter of 2018. America is the only large advanced economy in which the IMF projects activity will expand more quickly this year than it did last year.

This acceleration is because of President Donald Trump’s tax cuts. In September the unemployment rate fell to 3.7%, the lowest since 1969; wage growth is slowly but surely rising.

Rampant demand is pushing up interest rates. The Federal Reserve has raised short-term rates by two percentage points since it started tightening monetary policy in 2015. This week Mr Trump described the Fed’s policy as “crazy”. The yield on ten-year Treasury bonds has risen by more than in most other rich countries (see chart). It now stands at over 3.2%, higher than at any time since 2011.

America first

These different growth paths could yet separate further, because many of the immediate economic risks threaten countries other than America. One emanates from Italy, where bond yields are also rising rapidly—and not because of a robust economy. Instead, an extravagant budget put forward by its populist coalition government has sparked a confrontation with the European Commission and reignited fears about the sustainability of the country’s huge public-debt burden. The spread between yields on Italian and German ten-year bonds now stands at around three percentage points, its widest in over five years. Those rises will chill the Italian economy. Rising yields have not so far spread beyond Italy’s borders, but further increases could mean that crisis engulfs the euro zone again. Such fears will do no favours to European business confidence, which has already softened this year.

Another threat is a rising oil price. In September the price of Brent crude surpassed $80 per barrel for the first time since 2014, driven in part by falling Venezuelan supply and the prospect of American sanctions on Iran. It now stands at around $82. Costly fuel used to threaten the American economy. Today, however, it spurs investment in shale rigs. That gives America a natural hedge against oil-price shocks, even though, in the short term, limited pipeline capacity might mean investment responds only slowly.

Finally, there is Mr Trump’s trade war. America will eventually suffer from the distortive effects of rising tariffs, but it is not all that dependent on trade to fuel demand in the short term. Forecasts of the effect of existing tariffs on American growth and inflation predict only a small impact. The result is that the trade war so far also looks like an asymmetric shock—certainly as far as China is concerned.

The danger is that America’s outperformance pushes the dollar even higher, leading to more volatility in global finance and crimping growth in emerging markets. Yet America’s boom will not last for ever. Tax cuts will no longer provide incremental stimulus after 2019. Some forecasters fret that an end to the largesse, together with higher interest rates, may be sufficient to tip the country into recession by 2020. Analysts expect America’s economy, with its ageing population, to expand by less than 2% a year in the long run. That suggests that, unless productivity surges, a slowdown must eventually come.

The question then is whether the rest of the world can withstand, let alone make up for, an eventual slowdown in America. Not long ago, the consensus may have been that it could cope.

Now there is more to worry about.

Saudi energy minister Al-Falih speaks to TASS on OPEC+, oil prices and Khashoggi

TASS Editor-in-chief Maxim Filimonov and Saudi Arabian Energy Minister Khalid al-FalihTASS Editor-in-chief Maxim Filimonov and Saudi Arabian Energy Minister Khalid al-Falih

Saudi Arabia’s Minister of Energy Khalid Al-Falih is considered to be one of the most influential individuals on the global oil market. Traders, investors and officials keep close tabs on his comments, which can spark serious price changes to the world’s ‘black gold’. Al-Falih, who has worked his entire life in the oil sector, has gone through all corporate hierarchy levels of the Saudi Aramco oil giant and naturally, after having served as the company’s chief executive, he took over the leadership of the country’s oil sector.

Under Al-Falih, relations between Russia and OPEC started developing by leaps and bounds and resulted in a deal being reached between OPEC member-states and oil producing countries, which are not part of the cartel (OPEC+), and this made the situation on the oil market more predictable. It is also mainly thanks to Al-Falih’s efforts that Saudi Arabia has been actively working with the Russian Direct Investment Fund and its head Kirill Dmitriev. Al-Falih said RDIF is “an important bridge” between the two countries. 

In his interview with TASS, the Kingdom’s Minister of Energy Khalid Al-Falih spoke about what the future holds for the OPEC+ deal in 2019, whether oil prices in 2019 will surpass $100 per barrel, and whether Saudi Arabia will use oil as political leverage in the case of Saudi journalist Khashoggi, who went missing in Istanbul. In addition, he will also talk about working with the Russian Direct Investment Fund, and Saudi plans for investing into Russian companies, and a joint venture with Rosneft and meetings with Igor Sechin.​

TASS — Over the last year and a half, Saudi Arabia has been widely mentioned in the Russian media because of the OPEC+ deal, signed by OPEC and Russia that helped to stabilize the market quite significantly.  Are you happy with how this agreement has been working out so far and what was the main outcome for the global oil market from this deal? 
Khalil Al-Falih --Allow me to go back a few years back. At the beginning of this decade oil prices were $100 per barrel and many people thought that this was the new normal. Demand was growing, slower than now, but still growing, supply and demand in balance. But in reality the balance was due to outages in some countries due to geopolitical issues. High oil prices were hurting demand and we saw that demand slowing down considerably by 2014. It takes time for demand to respond, but it ultimately responds. We saw it in 1980s, in 2000s, we are seeing it now. In a period of 3-4 years after the price hike we see the demand response. And also, which is more significant, we saw the supply respond in a form of expensive oil from offshore and most notably from US shale coming on strongly. And ultimately the oil caused an oversupplied and unbalanced market. In 2013-2014 it was obvious to  us that market was not sustainable under those conditions. And as a result we saw the price crash from $100 to $25-30 per barrel.  

Consequently we started our discussions with our Russian colleagues, most notably there were discussions at the leaderships level in 2016 during the G20 meeting in China, where president Putin met with His Highness The Crown Prince.. And they agreed that Russia and Saudi Arabia needed to help the world to get out of the slump. Because the slump was hurting the world, not only the producers, but even the consumers, who were affected by the slowdown of industrial growth, inflation, negative interest rates. After that first meeting we met later. And not the two of us  agreed, but 24 countries in Vienna in December 2016 agreed to create the OPEC+ alliance to manage production . We did not shock the market by constraining supply.

We did it very gently. And the result was that by early this year the market was returning to balance. Excess inventories, which were very high and depressed the market, disappeared. We are now close to 5 year normal average of oil stocks. Supply and demand are close to each other, and the market is balanced. Of course, it helped producing countries like Russia and Saudi Arabia. But, also it helped consumers a lot. Returning the oil markets to balance was the lubricant for the global economy to return to the growth to the very healthy rate we are seeing now. All the parameters of the global economy are healthy. So, in a nutshell, we appreciate Russia’s role. What we want to do? This cycle is ending, and oil market will ultimately go through another cycle. We want to keep supply and demand balanced in the long term. In last three to four month we have coordinated with minister Novak to increase supply, because by May this year there was a lot of stress in the market about the shortage of oil, especially with sanctions and with reductions in some countries like Venesuela and Mexico . There were concerns, that there would be a shortage of oil. And if we continued the same policy that we had had in the previous 1.5 years, we would see the oil above 100 again. So we intervened.

We had discussions with minister Novak during the Saint Petersburg Economic Forum in May and we met in Moscow during the opening of the World Cup. Finally we agreed that it was  time to change the course. The policy of withdrawing supply has accomplished its mission, and now it is time to gradually release supply. We have managed to convince the OPEC+ group. And from June till now we see the market has relaxed. So we have proved to ourselves that we can work with Russia and keep the markets balanced whether there is the shortage or oversupply. So I want to emphasize that given the success of two years coordination between KSA and Russia, we need to establish the framework for the long-term coordination.

Oil market is always cyclical, and without cooperation that cyclicity  causes the severe volatility. And it is important to help moderate the volatility so that all participants and especially investors know that big producers like Russia and Saudi Arabia are working together to balance the markets. 

— When you talk about long-term stability what do you mean in particular? What will be the future of the OPEC+ deal given that the current deal expires at the end of the year? Do you plan to extend this agreement for the long term? 

We have started OPEC+ as a six month agreement. And we saw that six month is not enough to bring inventories down. Partially because US shale had continued to increase and partially because it took Russia almost four months to reduce its production by 300,000 bpd because there were many oil producing companies in Russia. So it took us some time to achieve that. But we extended the 6 months deal, and now it has been working for almost 2 years. In practice we only apply production reduction for Russia for 1.5 years, because for the last few months we agreed for Russia to produce as much as it can.

But nevertheless we want to sign a new cooperation agreement that is open-ended. That does not expire after 2020 or 2021. We will leave it open. And what we would like to do is continue for OPEC and non-OPEC to work together. And the difference is that there will be no fixed term for the agreement, which allows us to bring production up or down.

It should not have fixed production target. But it allows us to perform regular coordination and sharing information on what are our views on the market, supply and demand, how healthy the market is, what kind of intervention we need, if any,  and when. Another new aspect is to create a secretariat for OPEC+. For now there is no secretariat. Only OPEC secretariat both serves OPEC and OPEC+. For non-OPEC countries from OPEC+ we will offer to them to create a secretariat in Vienna to work closely with OPEC. Of course, if any of OPEC+countries wants to join OPEC, we have a process in OPEC to consider membership. But many countries expressed the desire to work closely with OPEC, but not to join OPEC. And we respect this approach.

Russia is one of those countries. But there are many variations on how to cooperate. The latest discussions we had in June showed that OPEC+ countries want to continue to work within a longer-term framework. 

— When do you expect to finalize this new deal? 

I hope, when we meet on Dec 7 in Vienna we will be able to sign it. 

— Will it be an open-ended agreement? 

Yes, it starts in January 2019 and it will allow us to intervene to rebalance the market in any appropriate time from January onward.

— And who do you believe will be the driving force for organizing this new secretariat? 

I think, Russia will have to take the leadership. Total non-OPEC participation is 20 mln bpd, but Russia’s alone gives 11 mln bpd. So obviously Russia is a heavy weight both in terms of production and in terms of political influence. So Russia’s leadership for OPEC+ is indisputable. That’s why I expect Russia would play a key role. Of course, we are keen to work with Mr Novak and Russian team to invite other countries from outside OPEC to join OPEC+. We have started some quiet contacts with some countries to join and hope we will succeed.

— Will the principles for OPEC+ be the same as for OPEC: one country – one voice? 

Yes, we ultimately want everybody to be on board. But my experience is that countries like Russia and Saudi Arabia with bigger scale and bigger impact ultimately carry more weight. It is not through voting and through formal process,but through convincing.  Because people know that if we agree to cut five percent , as we did, our volumes are huge. Our production cuts were close to 600,000 bpd every month through the duration of the agreement out of 1.8 mln bpd of total OPEC+ cut. So when we sit around the table, our voice carries more weight. The same with Russia, which cut 300,000 bpd out of 560,000 for total non-OPEC  cuts.

And all OPEC+ countries are very respectful of Russia. So I think we should not hang on voting and formal process, but focus more on alignment and objectives. Once you get the trust of other countries and understand  their objectives and you are serving those objectives with your actions, formal voting becomes irrelevant, most decisions are made by consensus very fast. This is how it works.

— You have mentioned that the new agreement will be signed in December. Do you have any objectives in mind already? Will you cut or increase the supply for a certain period?  And what will this period be? 

I think there are many uncertainties about 2019 that it is very premature for us to say what we will do.

The only certainty for 2019 is that we need to be ready to act promptly and effectively. You have got uncertainty with the demand for many reasons. There are trade frictions that affect major trading countries. You have developing countries like Turkey, Argentina, India, which have a lot of pressure on their currencies. As a result you have strong dollar and weak emerging economies. So potentially a world economic slowdown could hurt oil demand. And if demand is low, we know oil markets will respond. On the supply side we could have problems with disruptions of production. First, we have sanctions on Iran, and nobody has a clue what Iranians export will be. Secondly, there are potential declines  in different countries like Libya, Nigeria,  Mexico and Venezuela. If any of these countries’production is significantly impacted, it will have an impact on the balance in the market. Then there is uncertainty about the US shale oil. Also many people say that in 2019 there will be pipeline constraints on moving oil production in the US. So we need to be ready to look at the balance. And if supply is too long, we should be able to cut. If supply is short, we have to be able to respond. We would like to do it in a coordinated way. We do not want to confuse the market and surprise the market. 2019 is a very critical year to keep the market in balance , which  we have achieved after a lot of hard work, and we should not lose this hard work. If the Group [OPEC and OPEC+ – TASS] works together, we can quickly act to adjust production.

— In a worst case scenario with Iran do you have enough spare capacities in OPEC and OPEC+, and particularly in Saudi Arabia to fill this gap? 

Obviously, since June we increased our production a lot. We were at 9.9-9.8 (mln bpd) in April and May, and now we are at 10.7. At the same time our friends from Russia and UAE have increased production as well. So our spare capacities for the entire globe at the moments are much less today than they were back in the past. We have relatively limited spare capacities and we are using a significant part of them. For now we in Saudi Arabia have 1.3 mln bpd of spare capacity, UAE has assured me they have over 200,000 bpd remaining. But we do not know what is going to happen in other countries. We know Kazakhstan plans to increase production with Kashagan and Tengizoilfields., Brasil is expecting to increase production. And US shale could bring additional volume of oil. So it may happen that we may not need to use spare capacities. But if you have other countries to decline in addition to the full application of Iran sanctions, then we will be pulling all spare capacities.

— So do you think you have enough opportunities, and enough capacities to keep the oil market balanced, to avoid sending prices soaring to over $100 per barrel? 

I cannot give you a guarantee, because I cannot predict what will happen to other suppliers. Saudi Arabia now in October produces oil at the level of 10.7 mln bpd. I can say that we can go up, if necessary, to 12 mln bpd. This I can assure. But if 3 mln bpd disappears, we cannot cover this volume. So we have to use oil reserves. But it is very important for the world to support Saudi Arabia, because it is the only country that invest heavily in spare capacities. We invest tens of billions of dollars constantly to in-build capacity  we do not use, only in shortage situations. It does not work for us; money is parked as insurance for the rest of the world. Today we are using some of it, tomorrow we will be using most of it, if  disruptions in other countries will take place. We see there were disruptions in the past like Gulf War, but there were no shortages of oil because of our spare capacities. That requires us to continue our policy of investing. But Saudi Arabia needs to be appreciated and supported, recognized for doing very honorable duty for the rest of the global community. It is important for us to highlight that our production is likely to go up in the near future to 11 mln bpd on a steady basis. So we have to make a decision do we increase our total production capacities from currently 12 to 13 mln bpd. And this decision requires incremental investments from $20 bln to $30 bln. This is the capital cost for each one million barrels of additional capacity. 

— You say that the world should support and appreciate Saudi Arabia. But now we are weathering a difficult period of turmoil because of the case of the Saudi journalist that has disappeared in Istanbul. Some analysts, based on comments from the Saudi media, say that because Riyadh is unhappy with the treatment by the West in this case, Saudi Arabia could cut supplies by up to 0.5 mln bpd. What sort of response can you provide to these predictions? 

I think that rational people in the world know that oil is a very important commodity for the rest of the world. If oil prices will go too high, it will slow down the world economy and would trigger a global recession. And Saudi Arabia has been consistent in its policy. We work to stabilize global markets and facilitate global economic growth. That policy has been consistent for many years. We suffered in the past from political crises, this is not the first time.

This incident will pass. Of course, this is not my mandate to speak about it. Our government through political channels is addressing this issue. But Saudi Arabia is a very responsible country, for decades we used our oil policy as responsible economic tool and isolated it from politics. So lets hope that the world would deal with the political crisis, including the one with Saudi citizen in Turkey, with wisdom. And we will exercise our wisdom both in political and economic fronts. My role as the energy minister is to implement my government’s constructive and responsible role and stabilizing the world’s energy markets accordingly, contributing to global economic development.

— So can people relax? There won’t be a repetition of 1973, correct? 

There is no intention.

— Let’s then move on from global oil market issues to more specific matters regarding the Saudi oil industry. Saudi Aramco’s IPO was supposed to be one of the largest in modern financial history, but recently it was postponed. What were the reasons behind this decision? Were they only business reasons? Did you need to finalize planned M&As? Or are there some political reasons as well – say you want to avoid US legal risks, if you launch a listing on the NYSE? 
 First of all let me emphasise that when we  list in any particular jurisdiction the. world is wide open for us to choose where to list. We can list only in Saudi Arabia or we can choose another friendly safe jurisdiction. However the listing itself, regardless the venue has been deferred because of the reasons you know - Aramco is overly weighted on the upstream and it has to be re-balanced by building in its downstream, which is less developed. By far Aramco is the world’s largest upstream company with the production of around 14 mlnbpd of oil equivalent – oil and gas. And also the reserves of Aramco are by far the largest of any company in the world: 260 bln barrels of low cost high quality conventional oil. And we have over 300 TCF (trillion of cubic feets – TASS) of gas reserves. This is huge portfolio of reserves with huge potential of production, that will last at a very high level until the next century. But if you look at the downstream of Aramco it is significant, but is not at the same level as upstream. Our petrochemical portfolio also is not so large, and is not so strong in terms of technology and global reach. So the decision was made that Aramco needs to balance its portfolio, such that it also gives us more revenues from the downstream. If in the next oil cycle the prices for the upstream go down, the downstream will be able to create a very healthy return. As a result we look at the opportunities globally and domestically. One has been announced - - the aquisition of 70 percent of Sabic (petrochemical giant Saudi Basic Industries, owned now by Public Investment Fund, the national sovereign fund of Saudi Arabia– TASS). And this deal will take at least 18 months for closing the transaction, getting the regulatory approvals from antitrust agencies globally. Only after that we could share the  information about the financial benefits of the deal with the investors. We are looking at 2021 as potentially the year of IPO. If all goes well, IPO will be more successful in 2021 compared to 2018. 

— What other assets do you see for Aramco? And do you have any particular interest in including Russian assets into Aramco’s new downstream strategy? 

Aramco continues to grow, petrochemicals in particular. Sibur is an interesting company, we have talked  with Novotek (the main shareholder of Sibur)and Mr Mikhelson (Leonid Mikhelson, CEO of Novatek). There is a potential project in Jubeil (petrochemical JV with Aramco and Total in Saudi Arabia) for Sibur. Aramco has a target of 3 mln bpd to convert into chemicals, and part of it could be Russian oil, it does not   necessarily have to be all Saudi oil. So JV between Sibur and Aramco is one possibility. As well as buying equity in Russian companies, especially in the companies with technologies. Sabic will not be the last deal that Aramco does in chemicals. Aramco continues to look for the right companies. We are doing a lot of projects in many countries – Malaysia, China, and recently in India. But in addition to the mega projects we are looking for the large, medium and small companies to acquire.

— You have expressed your interest in the Arctic LNG project. Do you have any particular terms?

I have attended the inauguration of Yamal 1 and it was very impressive just to see that Russian companies can operate in such difficult environment. It was also impressive to see president Putin, his vision, his leadership, his determination to open new frontiers for Russia. At that time we had initial understanding that we will look at the next project[Arctic LNG-2 - TASS].

Early indications are positive, reserves are there. We expressed interest, now what we have to do is to agree on the terms and negotiate them with Novatek. We hope to be the second largest investor in [Arctic LNG-2] after Novatek. We not only want to come in, we want to come in with the substantial stake. Hopefully our terms will be accepted. But regardless of what happens with [Arctic LNG-2], Aramco will be a major player in the global LNG market. That decision has already been taken.

— So when can we expect any decisions on the next project?

The sooner, the better. I think with Aramco the project will also benefit. We have good upstream and project management capabilities. Arctic climate is not our expertise, but we will learn very quickly.

— Aramco is also mulling over buying some oil and manufacturing services from Russian companies. Could you provide some details on that?

Thanks to Russian Direct Investment Fund we are looking at this opportunity. There is also PIF, with whom as partner we are looking to do this. PIF allocated 10 bln dollars for investment in Russia, out of which 1 bln are for oil and gas fields services. We are very close to invest into Novomet. And we are also looking to EDC. These are two companies we hope to invest. But this is not final.

— What is your general view of Russia’s investment climate? 

Extremely positive. I am very bullish on Russia. I think president Putin and Russian government are focusing on developing the country for the people, and they are doing it by working with the business community. You have friendly regulatory system, which promotes private business. My only complaint is that every time I go to Russia I need to get a visa, so my passport is running out of pages. But I say it in a friendly way, because it indicates the frequency of my visits to Russia. The more we see, the more we like.

— In July, you met with Igor Sechin from Rosneft. Do you have any projects with this company in the pipeline? 

We talked to Mr Sechin about  global cooperation. We will grow our downstream, and soon we will have over 10 mln bpd of downstream capacity. And there is no way we can supply it only with Saudi oil. We need other crude, and Russia is number 2 exporter after us. And Rosneft is the biggest Russian company. So swapping crudes and products is the natural area of cooperation. We have noticed that Rosneft and Lukoil have started to invest into refineries around the world. So together with Russian partners we could form joint venture with this refineries. We could supply oil to these refineries. Mr Sechin is also very important leader for the Russian industry, and having a constant dialog with him is a good for us.

Interviewed by TASS Editor-in-chief Maxim Filimonov and energy correspondent Iuliia Khazagaeva

Why is Democracy Faltering?

Kaushik Basu  

While technological progress has brought important gains, it has also left many segments of the population feeling vulnerable, anxious, and angry, fueling a crisis of democratic legitimacy. Though it is not immediately clear how we can confront this crisis, it is clear that business as usual won't cut it.

jair bolsonaro protest

NEW YORK – Jair Bolsonaro, the frontrunner for the Brazilian presidency, is a far-right, gun-loving, media-baiting hyper-nationalist. The fact that he would be right at home among many of today’s global leaders – including the leaders of some of the world’s major democracies – should worry us all. This compels us to address the question: Why is democracy faltering?

We are at a historical turning point. Rapid technological progress, particularly the rise of digital technology and artificial intelligence, is transforming how our economies and societies function. While such technologies have brought important gains, they have also raised serious challenges – and left many segments of the population feeling vulnerable, anxious, and angry.

One consequence of recent technological progress has been a decline in the relative share of wages in GDP. As a relatively small number of people have claimed a growing piece of the pie, in the form of rents and profits, surging inequality of wealth and income has fueled widespread frustration with existing economic and political arrangements.

Gone are the days when one could count on a steady factory job to pay the bills indefinitely. With machines taking over high-wage manufacturing jobs, companies are increasingly seeking higher-skill workers in areas ranging from science to the arts. This shift in skill demand is fueling frustration. Imagine being told, after a lifetime of body-building, that the rules have been changed and the gold medal will be awarded not for wrestling, but for chess. This will be infuriating and unfair. The trouble is that no one does this deliberately; such changes are the outcome of natural drift in technology. Nature is often unfair. The onus for correcting the unfairness lies on us.

These developments have contributed to growing disparities in education and opportunity. A wealthier background has long improved one’s chances of receiving a superior education and, thus, higher-paying jobs. As the value of mechanical skills in the labor market declines and income inequality rises, this difference is likely to become increasingly pronounced. Unless we transform education systems to ensure more equitable access to quality schooling, inequality will become ever-more entrenched.

The growing sense of unfairness accompanying these developments has undermined “democratic legitimacy,” as Paul Tucker discusses in his book Unelected Power. In our deeply interconnected globalized economy, one country’s policies – such as trade barriers, interest rates, or monetary expansion – can have far-reaching spillover effects. Mexicans, for example, do not just have to worry about whom they elect president; they also need to concern themselves with who wins power in the United States – an outcome over which they have no say. In this sense, globalization naturally leads to the erosion of democracy.

Against this background, the ongoing transformation of politics should not be surprising. The frustration of large segments of the population has created fertile ground for tribalism, which politicians like Trump and Bolsonaro have eagerly exploited.

Mainstream economics is founded on the assumption that human beings are motivated by exogenously given preferences – what economists call “utility functions.” Though the relative weights may differ, all individuals want more and better food, clothes, shelter, vacations, and other experiences.

What this interpretation fails to account for are “created targets” that arise as we move through life. You are not born with an essential drive to kick the ball through a goal post. But once you take to soccer, you become obsessed with it. You do not do it to get more food or clothes or houses. It becomes a source of joy in itself. It is a created target.

Even becoming a sports fan is similar. Nobody is essentially a devotee of Real Madrid or the New England Patriots. But, through family, geography, or experience, one might become deeply connected to a particular sports team, to the point that it becomes a kind of tribal identity. A fan would support players not because of how they play, but because of the team they represent.

It is this dynamic that is fueling tribalism in politics today. Many who support Trump or Bolsonaro do so not because of what Trump or Bolsonaro will deliver, but rather because of their tribal identity. They have created targets related to being part of “Team Trump” or “Team Bolsonaro.” This damages democracy by giving political leaders a license they did not have earlier. They can do what they want without being constrained by the will of the people.

It is not immediately clear how we can rectify these problems, protect the vulnerable, and restore democratic legitimacy. What is clear is that business as usual will not cut it.

The Industrial Revolution – another major turning point for humankind – brought massive changes in regulations and laws, from the various Factories Acts in the United Kingdom to the implementation of income tax in 1842. It also brought the birth of modern economics, with major breakthroughs by the likes of Adam Smith, Augustin Cournot, and John Stuart Mill.

But we are at a historical juncture where the subject of political economy deserves a rethink.

The dinosaur did not have the capacity for self-analysis and headed toward extinction 65 million years ago. We, too, run the risk of civilizational collapse. But, luckily we are the first species with the capacity for self-analysis. Therein lies the hope that, despite all the turmoil and conflict we see around us, we will ultimately avert the “dinosaur risk” and pull ourselves back from the brink.

Kaushik Basu, former Chief Economist of the World Bank, is Professor of Economics at Cornell University and Nonresident Senior Fellow at the Brookings Institution.

Gold Upleg Fuel Abounds

by: Adam Hamilton

- This young gold upleg is accelerating, greatly boosted by this month’s unexpected plunging stock markets. Abundant buying fuel remains to propel gold dramatically higher in coming months.

- Despite speculators’ record gold futures short covering on that drop, the lion’s share of that stage one gold-upleg-driving buying is still yet to come. And stage two gold futures long buying is barely starting.

- That futures buying ultimately ignites the far larger stage three investment buying, which soon takes on a life of its own. The shock of that out-of-the-blue stock market plunge started attracting investors early.
Gold and its miners’ stocks have proven rare bastions of strength during recent weeks’ market carnage. They are powering considerably higher while nearly everything else burns. The markets’ major sentiment shift is accelerating a young gold upleg, which ought to grow much larger as speculators and investors continue returning. Their collective gold positioning remains very low, making for abundant gold upleg fuel.
October’s outperformance by gold and gold stocks has been impressive. As of Wednesday, the flagship US S&P 500 broad market stock index had plunged 8.8% month-to-date. That heavy selling was led by the market-darling mega tech stocks, pummeling the NASDAQ down 11.7% MTD! Stock investors are starting to pay the piper for getting far too complacent in bubble-valued markets, the reckoning is underway.
But contrarians prudently positioned in gold and its miners’ stocks have enjoyed large divergent gains as flight capital floods in. Gold has surged 3.4% MTD despite the US Dollar Index’s strong 1.3% rally. The long-forsaken gold stocks have nicely amplified those gains, refusing to get sucked into the maelstrom of heavy stock market selling. The leading HUI gold stock index has blasted 8.2% higher MTD, 2.4x gold’s upside!
While mid-October’s stock market plunge out of the blue jumpstarted gold, its young upleg was already stealthily underway. Gold bottomed at $1,174 in mid-August after getting pummeled by all-time record gold futures short selling by speculators. It quickly rebounded as high as $1,210 in late August, but drifted back down as low as $1,183 in late September. This anemic gold upleg was already 7+ weeks old in mid-October.

Though gold didn’t respond much the first day the S&P 500 plunged 3.3%, the next day’s 2.1% follow-on selling galvanized gold interest. It rocketed from $1,194 to $1,223 that day, a huge 2.5% rally that made for its biggest up day since late June 2016’s surprise pro-Brexit vote in the UK! Those massive gold gains propelled the HUI a huge 7.4% higher that day. Capital was deluging back into this moribund contrarian sector.
While the gold and gold stock gains in recent weeks were impressive, they remain quite small. From their respective mid-August and early-September lows, gold and the HUI were only up 5.0% and 13.9% as of the middle of this week. That’s hardly even upleg territory, a mere start. Gold’s last major upleg unfolded in roughly the first half of 2016. While it was on the smaller side by historical standards, it offers perspective.
Gold surged 29.9% higher in just 6.7 months, catapulting the major gold stocks as measured by the HUI 182.2% higher in largely that same span! So what we’ve seen in recent weeks is nothing compared to the last major gold upleg, let alone far-bigger previous ones. Today’s young gold upleg is only getting started. And with gold upleg fuel still abounding, odds are it and the resulting gold stock upleg will grow much larger.
Gold bull market uplegs usually unfold in the same telescoping fashion. They are initially ignited by gold futures speculators covering shorts. These traders are usually the only buyers at major lows following corrections when sentiment is hyper-bearish. They buy offsetting gold futures long contracts to close out their existing short contracts at profits. This short covering is the spark that first kindles major gold uplegs.
That short covering soon burns itself out, as short-side traders have relatively little capital compared to the other gold buyers. But it often propels gold high enough for long enough to entice long-side gold futures speculators to return. They command much more capital than the shorts, and their buying soon becomes self-feeding. The more gold futures contracts they buy, the more their peers start chasing that momentum.
That long-buying second stage eventually evokes gold uplegs’ third stage, the primary one and largest by far. All the gold futures buying extends gold’s rally enough to get investors interested in returning. They control vastly more capital than futures speculators, so once they start buying gold is off to the races in a major new upleg. Unlike short-lived gold futures buying, gold investment buying can run for many months on end.
Stage one gold futures short covering is the initial trigger that ignites stage two gold futures long buying. And all that futures buying together eventually jumpstarts stage three investment buying. As investors start to return to gold in a material way, gold’s upleg accelerates in a self-sustaining virtuous circle. The more capital investors pour into gold, the more it rallies. The more gold climbs, the more investors want to buy.
Today’s young gold upleg is starting to follow that usual three-stage pattern of fueling buying. And since vast amounts of gold futures short covering, gold futures long buying, and investment buying still remain based on current positions, this gold upleg is likely to power way higher before it eventually gives up its ghost. Gold looks exceptionally bullish today with upleg fuel abounding, portending much bigger gains to come.
What gold futures speculators and gold investors are actually doing and likely to do in coming months is discernable from two key datasets. The first is the weekly Commitments of Traders reports published by the CFTC, which detail speculators’ collective positions in gold futures on a weekly basis. The second is the physical gold bullion held in trust by the leading and dominant SPDR Gold Trust ETF (GLD).
We’ll start on the gold futures side, as that’s where gold uplegs’ stage one and stage two buying comes from. This chart shows large and small speculators’ total long and short gold futures contracts held, in green and red, respectively. Gold is superimposed over the top in blue.
Despite gold’s sharp rally when the S&P 500 plunged, the great majority of likely gold futures buying is still yet to come which is really bullish.
Gold’s woes that ultimately birthed today’s young upleg are recent. This classic contrarian investment actually fared pretty well from early 2017 to mid-2018, climbing higher on balance and holding above a rising support line for 17.4 months. Gold was trading at $1,302 in mid-June before enormous gold futures short selling erupted on a sharp USDX rally. That extreme short selling snowballed into a record shorting spree.
From mid-June to mid-August, speculators’ gold futures shorts skyrocketed a stupendous 156% or 156.4k contracts! That catapulted them to an extreme new all-time record high of 256.7k, as you can see above in red. That shattered the previous record of 202.3k from August 2015, which helped spawn that last major gold upleg in H1 ’16. Gold fell 9.9% in 2.1 months when that epic record short ramp was underway.
In early September, I wrote an extensive essay on those record gold futures shorts explaining why they were so darned bullish. There’s nothing more bullish for gold than extreme speculator shorts because of how short selling works. These traders reverse the normal trading order by first selling high before later attempting to buy back low. But speculators don’t actually have the gold futures they want to sell short.
So they must effectively borrow gold futures to short them. And these debts legally have to be paid back soon. Mechanically, gold futures shorts are repaid and closed by buying offsetting long contracts. Thus speculators’ excessive gold futures shorts are literally guaranteed proportional near-future buying! And the incredible leverage inherent in gold futures means this short covering often unfolds fast, over a couple months.
Back in early September, the minimum margin required for controlling each 100-troy-ounce gold futures contract was $3,100. This week it’s $3,400. At $1,200 gold, 100 ounces are worth $120,000. But a trader running at the margin limits can effectively buy or sell that much gold with crazy 35.3x leverage! In stock markets, the legal maximum has been 2x for decades now. At 35x, trading gold futures is extraordinarily risky.

For every 1% the gold price moves against traders’ positions, like rallying when they are short, they lose 35% of their own capital risked. A mere 2.9% gold rally would wipe out fully 100% of their capital at 35x leverage! And in mid-October on the S&P 500’s second big down day alone, gold surged 2.5%. That was driven by frantic speculators rushing to buy longs to cover their extreme near-record gold futures shorts.
The weekly CoT reports are current to Tuesday closes, but aren’t published until late Friday afternoons. So the latest available data on speculators’ gold futures positions when this essay was published was current to October 16th, the CoT week straddling that sharp 5.3% 2-day plunge in the S&P 500. Just as I warned in early September, speculators’ near-record short-side bets resulted in record short-covering buying.
That CoT week speculators bought to cover an astounding 48.1k gold futures short contracts! That was a new all-time record high, shattering the previous CoT-week record of 41.5k from March 1999. Covering of this magnitude is exceedingly rare. Out of the 1,033 CoT weeks since early 1999, only 11 witnessed short covering over 25k contracts. That frenzied short covering is why gold’s price exploded higher that day.
Remember major gold uplegs are initially ignited by stage one gold futures short-covering buying. And despite speculators panicking as stock markets plunged and covering nearly 1/5th of their near-record shorts in a single CoT week, their remaining shorts are still extreme. They were running way up at 205.0k in that latest CoT report, which would’ve been a record high before late July 2018. Much more covering is coming.
To just mean revert back down to mid-June levels before this summer’s record orgy of shorting, these elite traders still have to buy to cover another 104.7k contracts! That’s 2.2x what they did in that initial CoT week, and the equivalent of a huge 325.6 metric tons of gold still due to be bought from short covering alone. Short-covering buying out of extremes tends to unfold rapidly, over just a couple months or so.

So assume 7 more CoT weeks of speculators covering shorts on balance, which works out to 46.5t of gold per week. According to the World Gold Council’s definitive fundamental data, in the first half of 2018, total global gold investment demand averaged 21.9t per week. So speculators’ buying to cover alone could boost this by 2.1x over the next couple months! That will naturally propel gold considerably higher.
Eventually, gold will power high enough for long enough to convince long-side gold futures speculators to start buying again. As the higher green line above shows, they control a lot more capital than the short-side guys. While they wield that same extreme leverage, their buying is totally voluntary. They don’t need to first borrow in order to buy low then sell high. Their collective bets just bounced off a deep 2.7-year low.
Merely to mean revert back to their 52-week high of 356.4k long contracts, these speculators would have to buy another 119.4k from the latest CoT week’s low levels. That’s the equivalent of another 371.5t of gold. Stage two gold futures long buying by speculators generally unfolds over 3 to 6 months. Assuming the conservative latter gives us about 25 more weeks of buying on balance, averaging out to 14.9t per week.
That alone would boost baseline global gold investment demand from the first half of this year by 68%! And that’s not including that stage one short-covering buying. You better believe gold will power a lot higher from here if world investment demand swells by 2/3rds for a half-year or so on gold futures long buying. Massive gold upleg fuel remains on both the short and long sides of gold futures with current positioning.
When gold surged 29.9% higher to enter a new bull in the first half of 2016, speculators’ total shorts fell by 82.8k contracts while their longs soared by 249.2k. That made for 332.0k of total buying. Including this first CoT week of buying on that mid-October stock-market plunge, gold’s young upleg today easily has the potential to see at least 152.7k contracts of short-covering buying and another 129.3k of long buying.
That adds up to 282.0k contracts, equivalent to a colossal 877.1 metric tons of gold! World investment demand in H1 ’18 totaled just 570.1t for comparison. With the buying fuel for this upleg running around 85% of what drove early 2016’s 30%-ish one, this gold upleg should have no problem rallying over 25% from its mid-August lows. That would carry gold to $1,467, a major bull breakout above the previous $1,365 peak.
Nothing excites investors more than new bull market highs, which motivates them to chase the strong momentum. They allocate larger fractions of their vast pools of capital into gold, leading to sustained buying dwarfing anything the gold futures speculators can manage. This stage three investment buying is what makes gold uplegs awesome. All the futures buying leading into it is ultimately just a triggering mechanism.
This next chart looks at American stock investors’ capital flowing into and out of gold through the lens of that dominant GLD ETF. Unlike most gold fundamental data only available quarterly, GLD’s holdings are published daily. They offer a near real-time view into whether investors are buying or selling gold. I wrote a whole essay in late September explaining the mechanics of GLD and its importance to gold prices.
GLD’s mission is to track the gold price, but GLD shares’ supply and demand is independent from gold’s own. Thus, GLD’s managers have to equalize excess GLD share buying or selling pressure directly into physical gold itself or this ETF’s share price will decouple. So GLD effectively acts as a conduit for the vast pools of American stock market capital to slosh into and out of gold. GLD’s changing holdings reflect this.
When investors are buying GLD shares faster than gold is being bought, the GLD share price threatens to breakaway to the upside. GLD’s managers prevent this by issuing enough new GLD shares to satisfy the excess demand. Then they plow the resulting proceeds directly into gold bullion which boosts this ETF’s holdings. So rising GLD holdings mean investment capital is flowing into gold, which naturally bids it higher.
But the opposite happened in recent months as investors dumped GLD shares faster than gold was being sold. GLD’s share price would’ve failed to the downside if its managers hadn’t stepped in to sop up that excess supply. They raised the capital to buy back GLD shares by selling some of its gold bullion held in trust for shareholders. Thus, falling GLD holdings reveal investment capital flowing out of gold, pushing it lower.
GLD’s physical gold bullion holdings held for its investors peaked at 871.2 metric tons in late April, and started to shrink as stock investors pulled capital from gold. Strong stock markets and that extreme gold futures shorting-driven gold selloff contributed to the bearish sentiment and mass exodus. But that gold negative trend reversed sharply when the stock markets started plunging in mid-October, a major inflection.
Gold tends to rally when stock markets weaken, making it the ultimate portfolio diversifier. Between late April and early October, GLD’s holdings relentlessly dropped 16.2% or 141.0t. GLD’s capital outflows in Q3 ’18 were the worst by far since Q4 ’16 when Trump’s surprise election victory really goosed the stock markets and thus hammered gold. By early October, GLD had gone an incredible 2.6 months without any builds!
Remember the S&P 500 clawed to more all-time record highs in late August and late September, so gold was deeply out of favor with investors. Why prudently diversify small fractions of stock-heavy portfolios with counter-moving gold when stock markets seem to do nothing but rally indefinitely? But that trend reversed hard that very day the S&P 500 plunged 3.3% out of the blue in mid-October, GLD demand exploded.
As stock investors shocked from their euphoric and complacent stupor rushed to buy GLD shares, there was so much differential buying pressure it forced a major 1.2% holdings build! That was the largest in 6.7 months, and the first build at all since late July. One serious day of stock market selling was all that was needed for investors to remember gold. That differential buying pressure persisted in subsequent days.

GLD’s holdings enjoyed further 0.8% and 0.6% build days late that week and early the next, and have seen additional builds this week. This early stage three investment buying spawned by renewed fears that stock markets can fall too has already boosted GLD’s holdings by 2.7% or 19.5t in just a couple weeks. And while stock selloffs help initially ignite gold investment buying, it soon becomes self-feeding.
Investors love chasing winners, so buying begets buying. The more anything rallies, the more investors want to buy it. The more capital they deploy into it, the more it rallies. That last major gold upleg back in the first half of 2016 was also sparked by a stock market correction, with the S&P 500 retreating 13.3% in 3.3 months. As of this week, this latest stock market selloff was still a large pullback at 9.4% over 1.1 months.
That early-2016 correction bottomed in mid-February, as gold was just nearing $1,250. But once it had been ignited, that big differential GLD buying pressure continued until early July, ultimately pushing gold lots higher to $1,365. Most of that gold upleg happened after the stock markets had already bottomed and started marching higher again. The thing that killed that gold upleg was finally a new record high in the S&P 500.
Between mid-December 2015 and early July 2016, GLD’s holdings soared 55.9% or 352.6t higher which was a major driver of that 30%-ish gold upleg. To revisit those bull-to-date-high GLD holdings levels today, this ETF would have to add another 252.6t of gold to its holdings from its recent early-October low. So there’s again plenty of room for massive stage three gold investment buying to catapult this upleg far higher!
Investors were and remain radically underinvested in gold, it barely even registers in their portfolios any more. When GLD’s holdings sunk to 730.2t in early October, that was a deep 2.6-year low. American stock investors hadn’t been less deployed in gold since mid-February 2016 when gold’s last upleg was still young before powering much higher. Like gold-futures speculators, investors too are positioned for big buying.

So gold upleg fuel abounds today! Gold futures speculators still have massive stage one short-covering buying left to do, and have barely even started their also huge stage two mean-reversion long buying. And the big stage three investment buying that will ultimately follow the gold futures buying is already getting underway early. Such enormous buying likely coming will drive gold’s young upleg much higher.
And while it’s not strictly necessary beyond ignition, I suspect stock market weakness will persist and fuel even more gold investment demand. As I warned at the end of September when the S&P 500 remained near record highs, Q4 ’18 is the first quarter ever that would see Fed quantitative tightening run at its terminal $50B-per-month pace. I wrote an important essay detailing why that is this stock bull’s death knell.
To merely unwind half of the Fed’s $3.6T of QE-conjured money created in preceding years, QT would have to run at full steam for 30 months! These QE-inflated stock markets trading at bubble valuations are going to struggle greatly with QT underway. So October’s stock market weakness is likely the start of a major bear market, not a temporary correction before new record highs. That will greatly boost gold demand!
The gold miners’ stocks will really leverage gold’s coming gains as its young upleg grows. When gold’s last upleg surged 29.9% higher in the first half of 2016, that HUI major gold stock index skyrocketed an enormous 182.2% higher in roughly that same span! While that was extreme 6.1x upside leverage, 2x to 3x is common and expected. Gold stocks are already amplifying gold’s surge since mid-October by 2x.
The bottom line is this young gold upleg is accelerating, greatly boosted by this month’s unexpected plunging stock markets. Despite speculators’ record gold futures short covering on that drop, the lion’s share of that stage one gold-upleg-driving buying is still yet to come. And stage two gold futures long buying is barely starting. So abundant buying fuel remains to propel gold dramatically higher in coming months.

That futures buying ultimately ignites the far larger stage three investment buying, which soon takes on a life of its own. But the shock of that out-of-the-blue stock market plunge started attracting investors back to gold early. They remain radically underinvested in gold, with huge buying to do to reestablish some normalcy in portfolio allocations. Weaker stock markets will accelerate this overdue shift of capital back into gold.

A European IMF

The New Face of the Eurozone Bailout Fund

The erstwhile bailout fund known as the European Stability Mechanism may soon be granted far-reaching new powers, including the kinds of functions currently possessed by the IMF. But there's a hitch.

By Christian Reiermann

The ESM bailout fund may soon become Europe's answer to the IMF.

One of Europe's most promising startups can be found in an unassuming low-rise in Luxembourg City's Kirchberg district. Despite its rather pallid surroundings, it has all the characteristics of a promising new company: dynamic growth, international staff, bright prospects and tons of money. It even has its own gym.

Eight years ago, just five people worked for the company's predecessor, which was located a few streets away. Today, though, it has 180 employees on the payroll and they deal with hundreds of billions of euros. They hail from 43 countries and speak two dozen languages.

In contrast to other business models of other startups, though, this place is not focused on identifying and attacking new markets. On the contrary, their mandate is defense. They are tasked with defending the eurozone and the euro against turbulence. And soon, even more people are set to join the staff. After all, this startup is adding to its portfolio of expertise.

The startup operates under the acronym ESM, which stands for European Stability Mechanism: But it is more commonly referred to as the euro rescue fund.

The finance ministers of the 19 eurozone member states, who make up the ESM's board of governors, have been discussing for months how the organization should be further developed.

They have big plans.

The board of governors would like to see the ESM become a European version of the International Monetary Fund (IMF). To achieve this, the ESM would have to be given new powers to better monitor euro countries' fiscal policies. The organization would also be expected to play a bigger role in bank bailouts -- not exactly an unimportant responsibility should a new financial crisis arise. And last but not least, the ESM would be empowered to better assist governments that find themselves in a tight spot. The board of governors hopes such reforms would bolster the rescue fund such that it could even handle a situation such as that developing in Italy, where the government is pursuing a heedless fiscal policy that has for the first time pushed a large European country to the brink of bankruptcy.

Strict Conditions

The fact that the ESM has come to play such a central role in European fiscal policy has to do with its own success. The organization and its predecessor, the European Financial Stability Facility (EFSF), have helped five eurozone member states grapple with the consequences of the financial crisis. Tens of billions of euros were loaned to Greece, Ireland, Portugal, Cyprus and Spain -- either because investors no longer wanted to provide these countries with follow-up loans, or because they simply lacked the money to save their own banks.

The billions of euros made available by the ESM, of course, were linked to strict conditions, including fiscal belt-tightening, social system reform and labor market liberalization. By now, every country that received an EFSF or an ESM bailout has completed the program. The last to do so was Greece, in August. The countries still have debts to pay back to the ESM, but each has different conditions regarding how quickly that must happen.

From his corner office on the second floor, Klaus Regling, the German head of the ESM, takes stock after eight years of crisis and his satisfaction is obvious. "No one can imagine us not playing a role in the future," he says. There was a time when that wasn't true. At first, Regling, who was also a founding member of the ESM's predecessor organization, EFSF, thought his job would be to coordinate an emergency response and then close up shop after a few years. Several years later, when the ESM was given permanent status, Regling was still planning to put the ESM into a kind of hibernation once the euro crisis was over, including massive staff cuts.

That is not, however, how things have turned out. Regling and his superiors, the financial ministers of the eurozone, have changed their thinking. "Fire departments, after all, don't lay off their people just because nothing's burning," he says.

The first step is that of transforming the ESM into a kind of European replacement for the IMF. The IMF played a central role in Greece during the crisis, but there were often clashes over the best way to help the country. In the future, the IMF does not intend to participate in state bankruptcies in Europe.

Graphic: The European Stability Mechanism
To enlarge graph click here

For the ESM to function as a European IMF, the organization is to be granted oversight rights to look over the individual finances of eurozone member states. Should a new crisis crop up, the ESM would be armed with additional control and enforcement rights.

Alarm Bells

The ESM is better equipped for this task than any other European institution. It's in regular contact with financial markets and knows much more quickly than, say, the European Commission when a eurozone member state's creditworthiness is in danger.

Communication with the markets takes place in a couple of different ways. First of all, the ESM invests its on-hand capital -- some 80 billion euros. Secondly, and much more importantly, the organization issues bonds, which generates the money necessary to help distressed governments out of financial jams. The bustling atmosphere at the organization's office in Luxembourg City is like that of the trading floor at an investment bank. Everyone is sitting in front of computer screens full of numbers, symbols and graphs that are constantly updating. Some of the traders have decorated their workspace with the European flag.

One of the ESM's new tasks is ringing the alarm bells early when there are signs of an approaching crisis. The ESM possess a deep knowledge of the financial situations of former crisis countries, in part because analysts tag along when donor state representatives visit those countries' capitals. The organization also knows a lot about larger member states like Germany and France, Regling says. "But if, purely hypothetically, something were to happen in, say, Austria or Malta, we would currently be at a loss." To fulfill its role as an early-warning system, the ESM must recruit experts on all member countries.

ESM head Klaus Regling
ESM head Klaus Regling

A larger staff is also needed for the ESM's second area of operation. In the future, the plan is for the ESM to provide financial backing for the European mechanism for the resolution of failing credit institutions. For this, Regling needs banking experts.

The ESM will also receive a set of new financial instruments geared toward helping ailing countries quickly. A precautionary line of credit is in discussion that could be extended to countries not yet in acute need but which require help to calm wary investors.

Expanding Workforce

In a paper for the Eurogroup, as the board of eurozone finance ministers is known, the ESM also proposes another instrument. It would provide short-term liquidity assistance to countries that have temporarily run out of money because they have unfairly landed in speculators' crosshairs. "These funds would be paid out without a big fuss, and the country wouldn't have to subject itself to a complete adjustment program," the paper reads.

Still, the countries in need of such aid would have to fulfill a number of conditions and requirements.

In the future, the ESM could also help to stabilize sluggish economic cycles in individual member states. To do so, the paper suggests empowering the organization to grant a line of credit to countries who experience an asymmetric shock. With a fresh injection of cash for the ESM, a government could, for example, quickly bolster demand. Such an instrument is necessary, Regling says, because the European Central Bank (ECB) can't intervene with lower interest rates. The ECB, after all, controls monetary policy for the eurozone on the whole, not for individual countries.

To manage these new ambitions, Regling will have to expand his workforce. "Were the ESM to get all of the new assignments that are currently being discussed, we would have to increase our staff from 180 to 250 in the coming years," he says.

The flood of potential new competencies is not without risks and side effects. There's plenty of money available: At the moment, the ESM has only loaned out a hundred billion euros of the half a trillion at its disposal. But at the same time, Regling's people are worried that politicians could saddle the ESM with too much responsibility.

The Money Everyone Needs

One thing that is particularly difficult is financially safeguarding the resolution mechanism for failing banks. To do so, Regling must set aside 60 to 70 billion euros of his overall budget. That sum would no longer be available for the other instruments, warns an internal ESM paper that Regling sent to the finance ministers of the eurozone member states. In addition, the paper noted, the ESM's own creditworthiness could be damaged.

Moreover, it's still not entirely clear who has the power to decide when funds are released. Some member states want to give Regling carte blanche to decide when to spend money on a bank bailout. But representatives of the German government, including Finance Minister Olaf Scholz, insist that German constitutional law means that Berlin must be granted veto power. The dispute is ongoing.

Not everyone's happy about the expansion of the ESM's list of duties. Representatives of the European Commission, in particular, are very keen to not see their own authorities curtailed, particularly when it comes to analyzing a country's financial well-being.

The most recent effort to hinder a transfer of power to the ESM is the insistence by the Commission that such a thing cannot be done because the rescue fund isn't an official EU agency. That is true: The ESM is a structure established solely by eurozone member states. But the Commission's argument is disingenuous. The executive body knows only too well that there will be no majority in the foreseeable future in favor of enshrining the ESM in EU law.

Regling can afford to view the political wrangling with equanimity. After all, he controls the money everyone needs. "It's not about strengthening the ESM," he says. "Our job is to strengthen the euro."