Desperate Britain Forced To Import Russian Gas From Sanction-Targeted Project

We said two days ago that it’s been a tough week for anybody who needs to heat their home or put gasoline in their cars in Britain. The litany of negative events and mishaps includes extremely low temperatures, the shutdown of the Forties pipeline due to a hairline crack and an explosion at one of the Europe’s biggest gas hubs in Austria, which further tightened UK supplies.

As we noted, the price of gas futures surged by the most in 8 years. The timing of the gas hub explosion, as we head into Winter, couldn’t have been worse either.

However, adding insult to injury, the UK lacks gas storage capacity and the web of interconnections that link markets across Continental Europe. And…Centrica is closing the nation’s biggest storage site after more than 30 years. The question was, where could the UK secure alternative supplies, as we noted.

It takes about two weeks to bring LNG from Qatar, the U.K.’s biggest supplier of the super-chilled fuel. Only one tanker, the Bu Samra, is confirmed as arriving in the U.K. this month. The first tanker from Russia’s Arctic plant Yamal LNG may also head to Britain and would arrive in about five days, according to shipping website sea-distances.

The photo below shows Russian President, Vladimir Putin, personally giving the order to begin loading the first export shipment of Yamal LNG onto the world’s first icebreaking LNG carrier, the Christophe de Margerie.

The destination of the LNG carrier was expected to be Asia, but will actually be Britain, even though the British government backed US sanctions against the project. Indeed, Novatek, which operates Yamal had to perform “financial gymnastics” after the US Treasury cut it off from western financing in 2014. To overcome this challenge, the company converted the funding of the $27bn project into euros and secured a $12bn loan from Chinese banks. As the Financial Times reports.

British homes are set to be heated over the new year with gas from a Russian project targeted by US sanctions, as the shutdown of a key North Sea pipeline slashes domestic output and sends utilities and traders scrambling for supplies. The first tanker of liquefied natural gas from the Yamal LNG project in Russia’s Arctic, which was opened by President Vladimir Putin last week, is making its way to the Isle of Grain import terminal in Kent as UK gas prices soar.

The shipment of the super-chilled cargo to the UK, which was originally expected to go to Asia, will be cheered in the Kremlin, where the Yamal LNG project has been held up as evidence that it can withstand western sanctions. Moscow has insisted that Europe will remain reliant on Russia for gas. The UK government has taken a tough line on Russian sanctions since Moscow first intervened in Ukraine nearly four years ago, and Theresa May, prime minister, has stepped up criticisms more recently, accusing Moscow of meddling in elections and attempting to “weaponise information” to undermine the west.

As the FT notes, it’s not unusual for the UK to import small volumes of Russian gas by pipelines through other European countries, however, the arrival of the Christophe de Margerie LNG tanker will be the first Russian delivery to arrive by ship. Neither the UK or EU sanctions specifically target Yamal LNG, although they have targeted finance and technology for other Russian energy projects in the wake of Russia’s annexing of Crimea in 2014. The FT quoted an unnamed official close to the Russian energy ministry saying that the UK’s decision to back US sanctions, including ones targeting Yamal LNG, looks like “someone biting the hand that feeds him”. So, given the embarrassing position the UK has found itself in, what is its response? According to the FT.

Britain’s Department of Business, Energy and Industrial Strategy (BEIS), which has argued that gas supplies will still be ample this winter because of the UK’s import capacity, emphasised that 80 per cent of the gas consumed in the UK is domestic or bought from Norway or Qatar. BEIS said that it was up to the market to decide what gas to import. The LNG cargo has been bought by the London-based trading arm of Malaysia’s Petronas, which did not respond to requests for comment. “Whether this liquefied natural gas shipment is eventually consumed in the UK is down to the market,” BEIS said. “But we can only benefit from having a diverse range of supplies.”

So, using a third party gives the UK leeway to say, essentially “It’s not me, Guv’nor”, to use the cockney vernacular.

The FT asked an analyst at the respected Wood Mackenzie consultancy for his opinion.

Frank Harris at Wood Mackenzie, an Edinburgh-based energy consultancy, said that the shipment demonstrated that the UK was now reliant on a market-based import model for its gas supplies. “There’s great flexibility in that model, but ultimately you’re competing with other countries on price for supplies,” Mr Harris said.

Having been loaded last Friday, the Christophe de Margerie is currently sailing past the northern coast of Norway. As commentators are pointing out, it could still be redirected if someone is willing to pay a higher price for its gas. The way the UK’s luck has gone recently, that’s probably a pretty good bet.

 

Huge Hub Explosion Sparks Surge In UK NatGas Prices

It has been a tough week already for those that heat their homes in Britain (and those that trade Natural Gas). Following extreme weather warnings and the forties pipeline crack shutdown, an explosion at one of the Europe’s biggest gas hubs further tightened supplies sending gas futures prices up by the most in 8 years.

As Bloomberg reports, gas futures rose the most in more than eight years in Britain, which already is struggling to absorb the impact of a crack that shut down a North Sea pipeline network. After snow fell for two days in London, cooler-than-normal temperatures spread from the Alps to Scandinavia, raising demand for heating fuels.

An explosion at around 9am at Austria’s main gas pipeline hub, left one person dead and 18 injured, according to police.

The facility about 50 kilometers (31 miles) northeast of Vienna transports the equivalent of a 10th of Europe’s gas demand.

Fire engines, ambulances and a rescue helicopter have reportedly been deployed to the area, and all work has been halted at the site.

"Eighteen people are injured and one is dead," police chief Markus Haindl said, as quoted by Sputnik.

 

 

He added that "technical problems" caused the explosion, and that there was "no indication of terrorism."

Several media outlets previously put the number of people injured at around 60.

”It is the worst possible time for a big gas hub to burn, since capacity is needed ahead of the winter and it changes the expectations of how much gas there will be available,” said Arne Bergvik, the chief analyst at Swedish utility Jamtkraft AB.

 

“If weather turns colder and capacity is unavailable, it will absolutely drive up power prices.”

Britain felt the threat most acutely, since it lacks the gas storage sites and web of interconnections that link markets across continental Europe. As Bloomberg concludes, U.K. is more vulnerable than normal this winter because Centrica Plc is closing the nation’s biggest storage site after more than 30 years. The Rough facility was able to meet as much as 10 percent of peak winter demand but that is now much reduced as it pumps out its last remaining fuel.

It takes about two weeks to bring LNG from Qatar, the U.K.’s biggest supplier of the super-chilled fuel. Only one tanker, the Bu Samra, is confirmed as arriving in the U.K. this month. The first tanker from Russia’s Arctic plant Yamal LNG may also head to Britain and would arrive in about five days, according to shipping website sea-distances.

“Gas demand is at above average levels because of the cold snap,” he said by email, estimating the shortfall of supply from the Forties outage at about 10 percent of average winter demand. “If outages persist, prices will remain high for some time.”

The Central Bank Bubble: How Will It Burst?

Alberto Gallo of Algebris Investments steps up to take his shot at the $64,000 (more like trillion) question in a report published this week “The Central Bank Bubble: How Will It Burst?”

Gallo manages the Algebris Macro Credit Fund described as “an unconstrained strategy investing across global bond and credit markets, and with lead responsibility for Macro Strategies” on the company’s website.

Gallo sets the scene as follows.

Most investors are still playing the game, and in the same direction. We estimate there are currently around $11tn in negative-yielding bonds and over $2tn in strategies that explicitly or implicitly depend on stable volatility and asset correlations. If low interest rates and QE have been the lever pushing up prices of dividend and coupon-paying assets, central banks are the fulcrum.

This fulcrum is slowly shifting: the ECB has just announced a reduction in its bond purchase programme, the Bank of England is likely to hike this month – even in the face of economic weakness –the Fed will likely hike rates again in December, and the PBoC has recently warned of asset overvaluation.

One of our favourite parts of the report is “The Magic Money Tree” infographic which explains how QE has benefited a plethora of investment strategies and created the current bubble to end all bubbles.

Now Gallo is obviously savvy because he doesn’t nail his colours to the mast on one factor which will prick the central bank bubble. Instead he offers four scenarios. The first threat is a rise in inflation, which he summarises as follows.

1. Inflation: after nine years of low-flation, the probability of a sudden rise in inflation is increasing, as job markets get tighter, globalisation leaves way to protectionist policies and liquidity reaches job-creating small and medium businesses as banks re-start lending.

Wage inflation aside, Gallo believes China could continue to export inflation based on a more resilient than expected Chinese economy. Gallo believes that China may have sufficient policy options to smoothly deflate its credit bubble. While we might disagree, it is a possibility.

The second threat to the central bank bubble is…central bankers.

2. Central bankers themselves: central banks appear to have shifted their tone to worry increasingly about financial stability. There are good reasons to do so. We are many years into a global synchronous expansion, and there will be little monetary policy ammunition to fight a new slowdown, with interest rates near record lows and $20tn in global central bank balance sheets. In some countries, like Japan and Switzerland, central banks have grown their balance sheets to sizes similar to their respective economies. The good news is some central banks are trying to curb stimulus before their mandate ends. The Federal Reserve is poised to raise rates again in December, the Bank of England will likely hike, the ECB has announced a reduction in purchases and the Bank of Canada has hiked too. The bad news is that markets have so far largely ignored this reduction in stimulus.

It makes sense…central banks created the bubble via QE and ZIRP/NIRP, so reversing that strategy might prick their own bubble.

The third threat is another merry band of miscreants.

3. Politicians: central bank QE has not only lowered yields and boosted asset prices. It has also artificially suppressed volatility. Yet volatility may come back as the consequences of rising inequality in the distribution of wealth, opportunity and natural resources across the world. The last decade has been great for billionaires, not so good for Main Street. Inequality of wealth and opportunity in developed economies has fuelled anti-establishment protest votes like the ones for Brexit or President Trump. Other populist parties are on the rise in Continental Europe and Scandinavia. In turn, domestic populism and nationalism in developed countries can increase commercial conflict and protectionism - see for instance the potential withdrawal from NAFTA, or the EU-UK tariff threat - as well as exacerbate militarism and geopolitical conflict. Populism has historically fuelled government spending and fiscal stimulus, higher taxes and aggressive redistribution policies, which could all re-price overvalued assets and/or target assets used as a store of value. 

We have nothing to add.

4. The market: rising growth, low inflation and low interest rates have proven a boon to global markets. There are now $20tn in central bank assets globally, and around 10% of global sovereign debt is yielding negative. Investors have been buying equities for yield and bonds for capital gains, and have been selling volatility explicitly or positioned in strategies that are implicitly short volatility. These assume a stable volatility and correlation among the price of assets. For example, risk-parity strategies assume a negative correlation between risky assets, like stocks, and "risk-free assets", like U.S. treasuries. But what happens if both decline together, and short volatility investors become forced to unwind their portfolios?

Exactly, this is what we’re waiting for, but what is the catalyst? Nobody knows.

If we were forced to guess what will prick the bubble, we would probably place more emphasis on China than the Algebris report does. However, putting aside what causes it, we share Gallo’s view on some of the key mechanics which will be “in play” when a crisis unfolds.

What will the next crisis look like?

The over $2tn in explicit and implicit short-volatility strategies could be the spark, similar to sub-prime for credit markets in 2008, which was $1.4tn. However, a future crisis would be very different from 2008. Growth in passive investing vehicles and in the mismatch between assets they buy and liabilities they issue, lack of risk-free assets and growing collateral chains, diminishing trading liquidity due to higher capital requirements for dealers point to more fragility in financial markets.

It"s perfectly set up, if we only knew when.

*  *  *

Full report below...

The World"s New Reserve Currency? Everything You Need To Know About PetroYuan

Earlier this week, we pointed out that the "PetroYuan" is on the verge of becoming reality with Graticule"s Adam Levinson noting that the birth of a yuan-denominated oil contract will be a “huge story” in the fourth quarter, and will be a “wake up call” for investors who haven’t paid attention to the plans.

As a reminder, nothing lasts forever...

Judging by the interest in the topic, investors are less informed than many believed and so the different teams within Société Générale Cross Asset Research examine what this contract would mean for the global oil markets and for the internationalisation of the yuan - if it gets off the ground.

 

Part 1 The proposed yuan-denominated crude oil futures contract

• Why is a yuan-denominated Chinese crude futures contract interesting to think about?  Why is it potentially significant?


• Would yuan-denominated Chinese crude futures affect the physical markets?


• Has China actually proposed changing its crude buying from USD to yuan?


• What about the crude producers and exporters?


• How much non-USD crude trade currently exists?


• If small volumes don’t change how the oil market operates, how big would the volumes have to be to make a difference?


• Is there another commodity that trades in multiple currencies at different exchanges that we can learn lessons from?

Part 2 Another step towards currency internationalisation?

• Why does China want to introduce a yuan-denominated crude oil futures contract? 


• How can the yuan succeed in becoming a reserve currency?


• What does the status of an international currency mean for the yuan?


• What will an internationalised yuan mean to China’s FX reserves?

*  *  *

Part 1: The proposed yuan-denominated crude oil futures contract

In November 2013, the Shanghai International Energy Exchange (INE) was established. Fully owned by the Shanghai Futures Exchange, the INE began efforts to offer an alternative crude oil futures contract to the global oil markets. After four years, these efforts are continuing. The proposed contract is for medium sour crude oil, is physically deliverable, and – most significantly – would be denominated in yuan.

We begin with the oil markets.

Why is a yuan-denominated Chinese crude futures contract interesting to think about? Why is it potentially significant?

Such a contract would be a tool that would make it possible for crude exporters selling to Chinese refiners to hedge their sales in yuan. This could help any future effort by China to import crude using yuan; on the other side of the coin, it could also help any future effort by various crude exporters to sell crude in a currency other than USD. 

In the abstract, the potential volumes are large, which is why this is worth thinking about.  China is the world’s biggest crude importer, with net imports in January-July 2017 of 8.4 Mb/d (and trending higher); the second biggest crude importer is the US, with net imports of 7.2 Mb/d in January-July 2017 (and trending lower). 

To put this into context, according to the IEA, in 4Q17, global product demand will be 98.5 Mb/d and global crude demand will be 82.2 Mb/d (including refinery runs and direct burn).  Crude trade is much less, at 42.4 Mb/d in 2016, according to the BP Statistical Review; this excludes crude that is produced and consumed in the same country. In other words, Chinese net crude imports account for over 10% of the global crude market and almost 20% of global crude trade. 

Would yuan-denominated Chinese crude futures affect the physical markets?

No, not at all. That’s not what this is about – there would be no impact on physical supply (like the example of natural gas – see below). In theory, if this were to happen, it would purely be about pricing. The global oil markets are denominated almost entirely in USD, so it is interesting to think about that landscape changing.

Has China actually proposed changing its crude buying from USD to yuan?

No. In recent years, there has been occasional general talk from China of moving away from the USD for purchases of crude oil and other commodities; however, we are not aware of any serious or concrete proposal on the table to start buying crude in yuan any time soon. That said, it is worth acknowledging that most Chinese crude buying is done by three large stateowned oil companies. Therefore, if it so chooses, the Chinese government certainly has the ability to push such an agenda; similarly, the government has the ability to push the use of INE crude futures for hedging crude in yuan.

What about the crude producers and exporters?

This is an important question to ask because it’s not just about what the Chinese want. As with any commercial transaction, both the buyer and the seller need to agree. In the case of crude oil, they need to agree on the volume, price, type and quality of crude as well as the delivery date and delivery location, among other things. However, the currency is almost always the USD – that is not a point of negotiation.

Over the years, including 2017, major crude producers such as Iran, Russia and Venezuela have talked about selling and exporting crude in non-dollar currencies. The reasons have been general geopolitical tensions with the US and Europe, and more specifically, oil-related sanctions; the use of non-dollar currencies may offer a way to circumvent oil-related sanctions, at least partially.  

Hypothetically, if China were to have serious talks with Iran, Russia and Venezuela about importing crude and paying in yuan, that would be important because it would add another dimension to the geopolitical analysis. If sanctioned countries could simply side-step the measures by selling crude in yuan or other non-dollar currencies, it would mean that the risk of supply disruptions and potential upside risk for oil prices would be reduced.

How much non-USD crude trade currently exists?

It is very difficult to make an accurate and confident estimate. Again, depending on the political context, talk of non-dollar crude trade from the countries mentioned above comes and goes, and sometimes some deals are done more for political and public relations purposes than for anything else. 

Our “guesstimate” is that such volumes probably amount to no more than 300-350 kb/d out of the 82.2 Mb/d global crude market noted above. For reference, to put that in terms of physical crude trade, 5 VLCC-size tankers each month carrying 2 Mb each would equal 333 kb/d. We would consider that, or its equivalent in smaller vessels, to be a generous estimate. We would consider 10 VLCCs or equivalent each month, or 666 kb/d, to be an extreme upside estimate but highly unlikely. This excludes barter arrangements and loans-for-crude deals. China lent Russia large sums of money after the global financial crisis in 2008-2009 in exchange for longterm crude supply deals; more recently, China had such an arrangement with Venezuela.

The bottom line, in our view, is that actual crude trade paid in cash but not using USD has never amounted to more than a few token cargoes. Importantly, when this does happen, the entire transaction and negotiation of the price is done in USD as usual, with pricing done the normal way; for example, both Urals and Dubai, which are key marker crudes in their own right, are priced as differentials to Brent. The only difference when a non-USD currency is used is that a last step is added, where the amount for the invoice is converted from USD into a different currency.

If small volumes don’t change how the oil market operates, how big would the volumes have to be to make a difference?

The question is really: what is the tipping point? How much non-USD crude trade does there need to be for the entire negotiation to take place in yuan, or rubles, or euros?  In other words, what does it take for price discovery and price formation to take place not in USD but in another currency?

The short answer is that we don’t know. But something on the order of 7-8 Mb/d of crude trade seems to be a sensitive level from a practical standpoint. How do we come up with this?  It’s simple: we are thinking about Saudi Arabia. Saudi crude exports have averaged 7 Mb/d through the first eight months of this year; in 2016, before the current OPEC cuts took effect, they averaged 7.6 Mb/d. The 7-8 Mb/d range works out to 16-19% of the 42.4 Mb/d global traded crude volumes.

Our view is that physical efforts to shift global crude trade away from US dollars seem doomed to failure unless the Saudis fully participate. Usually in matters of pricing, the other Middle East exporters follow the lead of the Saudis, so there is a “double whammy” effect and the volumes could start to increase quickly.

In this context, the warming relationship between Saudi Arabia and Russia becomes more interesting, too. Could the two countries cooperate on this in the same way they’ve cooperated on cutting production this year, in order to stabilise prices? Perhaps. That would add even more volumes because Russia is the second-biggest crude exporter in the world.  According to the BP Statistical Review, Russian crude exports averaged 5.5 Mb/d in 2016.

However, the geopolitics of oil quickly gets complicated. Why would the Saudis want to do something (like encourage non-USD crude trade) that would benefit Iran? This is always true, but is even more true now at a time when US-Iran tensions are ramping up and the US is threatening to re-impose oil sanctions on Iran. Also, why would the Saudis want to do something that would diminish the value of their currency, which is pegged to the USD, their huge USD reserves, and other USD-denominated assets?

If it would take the Saudis to make a real fundamental change in moving the oil markets away from a sole reliance on the USD to a multiple currency market, from a Saudi perspective, the arguments “against” are at least as strong as the arguments “in favour”. In short, we are sceptical of Saudi support for such a move.

Rather than support from Saudi Arabia or a cooperative effort between Saudi Arabia and Russia, a more realistic and higher-probability scenario would be a move to non-USD crude exports led by Russia on its own or perhaps a cooperative effort between Russia and Iran – with China being the key crude buyer, using yuan, in all the scenarios. Without the inclusion of Saudi Arabia and other Middle East exporters such as the UAE, Kuwait and Iraq, the volumes involved with Russia and Iran would be much less; this would make a fundamental change in oil price formation away from USD slower and more difficult but not impossible.

Is there another commodity that trades in multiple currencies at different exchanges that we can learn lessons from?

The answer to this question is yes and the best example is natural gas. The point of making this comparison is that ultimately different denominated prices in the same underlying commodity do not affect the physical balances but do influence trade flows, arbitrage and market analysis.

The US natural gas market is the largest regional market in the world (IEA estimates it alone represented 21% of total global gas demand) and is almost entirely priced in USD (AECO, Canada’s most liquid supply point, prices in CAD/GJ). The US LNG market (imports and exports) are also denominated in USD.

The global LNG market is heavily indexed to USD as well, but that is due to the dominance of oil indexation in long-term LNG sales agreements; the USD dominance of the global LNG market thus reflects the dominance of USD in oil prices.

In Europe (which represents 13% of total global gas demand according to IEA estimates), there are two main natural gas price points. In the UK, the National Balancing Point (NBP) – the hub of UK gas trading – is denominated in GB pounds and pence/therm. In the Netherlands, the hub of natural gas trading is known as Title Transfer Facility (TTF), and this contract is in euros and euro cents per MWh. Recently, there has been an observed shift in the dominance of these price points regionally; critically, this is a function of the physical characteristics of the market rather than the currency used or the exchange rate.

Historically, NBP was the most liquid point and also the price structure included in European LNG sales contracts, making it the dominant global representation of the European market. Recently, however, TTF has seen an increase in liquidity (increased open interest) and has become increasingly reflective of the physical continental European market. Factors such as the higher carbon price in the UK, which has an impact on gas competitiveness/pricing within the regional power generation stack, the declining trend of the UK production profile, and the region’s increased dependence (seasonal switching) on the Interconnector pipeline between the UK and continental Europe have all contributed to the reduced ability of NBP to reflect the wider European market; hence the rise of TTF. Importantly, it is the changes in the physical market that have changed the competitive landscape among TTF and NBP, and it has little to nothing to do with the different exchange rates (although Brexit may have decreased NBP’s popularity).

The existence of varying price structures in the global natural gas market is a critical comparison to make for oil, which has the potential to see a rise in pricing in currencies other than the USD. It is important to emphasise that even with multiple price structures, global natural gas trading behaviour is dominated by physical market conditions. At the same time, there is sometimes an influence from fluctuations in exchange rates, making analysis of flows, arbitrage, and trading somewhat more complicated; however, supply and demand dynamics are not fundamentally affected.

Part 2: Another step towards currency internationalisation? 

Why does China want to introduce a yuan-denominated crude oil futures contract? 

The Chinese government wants the yuan to become an international currency. This means that it wants the yuan to be used widely in international transactions (a settlement currency), to be adopted as a pricing currency for goods and services in global markets (an invoicing currency), and to be considered as a store of value by international investors (an investing currency). The goal of internationalisation also goes hand in hand with the profile objective for the yuan to obtain a reserve currency status since these two are highly correlated. While it is currently unclear (or too early to discern) whether China is aiming for the yuan to become the reserve currency – dethroning the dollar – Chinese policymakers are certainly eyeing the yuan as one of the major reserve currencies.

China has been working much harder on this project since 2009. The process has moved at varying speeds depending on capital account pressures, domestic asset prices and growth considerations, but much progress has been made (see the timeline on the next page). A quarter of China’s exports and imports are settled in yuan, although most of them are still invoiced in other hard currencies.

The proposed yuan-denominated crude oil futures contract to be listed on the Shanghai International Energy Exchange (INE), fully owned by the Shanghai Futures Exchange, is another step on the road to promote internationalisation and erode the USD hegemony in the global financial system. While over the years, there have been some relatively small volumes of oil traded in non-USD currencies, including the yuan (as discussed in the oil section above), the value of oil is still priced in dollars. One of the main impacts of the proposed new crude futures contract, and presumably one of the intentions behind the proposal, is that by providing a yuandenominated financial hedging tool for crude oil, this will likely help to promote the appeal of the yuan as a pricing currency in global oil trade.

From the Chinese policymakers’ perspective, China should arguably have a bigger say in the pricing of commodities since it has become the biggest consumer of many of them. Also, the petro-dollar system seems to be a successful model to imitate: first, the yuan would be more widely accepted by natural resource exporters, and in turn, these exporters could invest their yuan revenues (as FX reserves) into yuan-denominated financial assets.

How can the yuan succeed in becoming a reserve currency?

To improve the yuan’s chances of becoming an international and reserve currency, the main areas of development would be strengthening the institutional framework, fully opening the capital account to foreign residents, allowing market forces to play a greater role and establishing and managing a policy framework that alleviates the risk of crisis over an extended period.

China technically joined the reserve currency club when the IMF added it to the SDR basket in September 2016. The narrow definition of a reserve currency is for currencies used for international trade and willing to be held by other central banks as part of their reserves. On these narrow criteria, China has achieved what few currencies have been able to do.

Realising “true” reserve status and supplanting or even meaningfully competing with the USD in the global financial system is a very high hurdle that will take time (maybe 10-20 years) and require further enhancements in various areas. A broader set of criterion (listed below) of a reserve currency highlights the enormous challenges that China faces:

Medium of exchange. Entities outside China would need to widely adopt the RMB for transactional purposes (i.e. trade settlement). The yuan trade/investment settlement, the offshore yuan market and the Belt & Road Initiative (BRI) would need to be promoted. China is making steady strides in this area, with now 25% of China’s cross-border transactions settled by yuan. According to the SWIFT, however, the yuan share in international payments has not been able to advance and has hovered around 2% since late 2014.

 

Store of value. Individuals, companies and central banks would need to have faith in the currency as able to preserve wealth. About 60 central banks now hold some RMB assets in their portfolios, but this amount only represented 1% of total global reserves at the end of 2016.

 

Liquidity and market access. To become widely accepted, a currency would need to have high liquidity with foreigners having unencumbered access to local financial markets. China has created numerous schemes for global investors to access its equity and bond markets, but it is only a start, with foreign investors’ share in onshore capital markets at merely 2%. Further liberalising the capital account for foreign residents would be a necessary condition.

 

Institutional framework. Ultimately, confidence in the legal, regulatory and policy framework would need to be paramount for foreigners to hold large quantities of the currency. The current (USD) and previous (GBP) dominant global reserve currencies already had these qualities before attaining their status.

In many ways, China is working in reverse order – pushing internationalisation before the others condition are in place. Critically, policy priorities would need to be reoriented. It will be a challenge for China to meaningfully challenge the USD’s dominance, but it is not insurmountable over the next 10-20 years provided China takes steps in opening up (full capital account convertibility), giving up control of markets and strengthening and improving transparency in its legal, regulatory and policymaking framework.

What does the status of an international currency mean for the yuan?

Before the reserve currency status can support the yuan, the yuan may have to continuously prove itself as a stable currency to boost its status as a reserve currency. We think that the fundamental factors of economic growth, debt risk and interest rate differentials will continue to play dominant roles in the yuan’s FX trends over the medium term.  
A quick check of the history of the four major currencies – the dollar, euro, yen and sterling – since the 2000s suggests a visible and positive correlation between a currency’s traded weighted performance and its share in global FX reserves. However, correlation does not necessarily mean causality, and the causality can go both ways.

For instance, in the case of the yen and sterling, however, changes in their valuations look to have led their changing popularity among global reserve managers. The strength of the yen between 2009 and 2013 did not attract significantly more reserve inflows right away, probably because of the lacklustre economic development at the time. Sterling only started to gain a share in global reserves in 2003 despite its persistent strength since late 1990s.

For the yuan, we observe that the pace of yuan internationalisation was faster during the phase of currency appreciation or stability and slower when the yuan depreciated. This came despite the continuous policy efforts.

For the past seven years, USD/CNY has moved surprisingly closely with US-China yield differentials, and in the past three years the correlation of CNY to broad dollar moves has increased. Contrary to popular belief, the CNY shows few idiosyncratic tendencies and rather behaves in a similar manner to other EM/G10 currencies.

No matter what happens, the correlation between the CNY and the USD could remain high. The simple fact is that the correlation across most currencies is high over the cycle given that many top-down macro factors tend to drive FX over the medium term. 

The CNY may, however, play an increasing role in leading currency cycles, just as the USD does now. This would mean an increasing importance of Chinese data, monetary and fiscal policy in affecting global currency trends.

What will an internationalised yuan mean to China’s FX reserves?

The project of yuan internationalisation comprises currency liberalisation, capital account open-up and domestic capital market deepening. Liberalising the currency implies that the central bank will intervene less and less in the currency market, and a relatively stable level of FX reserves is therefore most consistent with the goal of making the yuan an international currency. 

Indeed, Chinese policymakers have repeatedly expressed their commitment to making the yuan a more flexible currency, freer from direct currency interventions by the central bank. However, it is also a stated goal for the yuan to maintain relatively stability against a basket of China’s major trade partners’ currencies. These two goals are only compatible when there is no major depreciation (or appreciation) pressure on the yuan resulting from major outflow (or inflow) pressure. 

China’s FX reserves can recover this year after the $1tn drop over the previous 2.5 years because the yuan has managed to stabilise against the dollar and a basket of currencies. The yuan’s stability should be a function of 1) dollar weakness, 2) capital controls and 3) China’s stable growth this year. These three factors will likely be the main drivers of the trend in China’s FX reserves over the next few years. While there remains much uncertainty around the dollar, it seems that Chinese policymakers have honed the skill of capital controls. This ought to reduce the risk of sharp declines in FX reserves going forward.

In the meantime, we think the chance of China persistently increasing its FX reserves is also limited unless the weak dollar trend continues and accelerates. The relationship with the US is one factor, and domestically there will likely remain strong demand from Chinese households and corporates for investment diversification if China continues to rely on rapid debt growth and money creation to sustain its economic model (see Anatomy of China"s outflows). As the developments in 2015 and 2016 proved, such capital outflow pressure could outweigh the support from a decent current account surplus for the yuan.

What will the yuan’s internationalisation mean to global FX reserves?

China’s share of global reserve portfolios should increase over time. Depending on whether it achieves true reserve currency status in the eyes of foreign participants, that share will be either low (5%), high (25%) or very high (25%+). 

Emerging market central banks still need a significant amount of dollars to undertake intervention assuming their currency regimes are not fully flexible, and a precautionary stockpile is desired to manage balance of payments shocks. Against all EM currencies, except most notably the CEE euro bloc, the dollar is by far the most widely traded and liquid FX cross. Virtually all intervention is done in USD crosses, and one prerequisite for central banks to shift their anchor currency to the RMB would be CNY crosses that are tradable without underlying dollar transactions being required. For instance, while EUR/CNY is quoted and traded onshore through the CFETS, it requires dealers to facilitate the trade through two separate transactions (USD/CNY and EUR/USD). The sheer size of the Chinese economy, growing global financial linkages and increasing RMB trade settlement will see a shift in this direction over time, but it will be a very long and slow process. Products such as the proposed yuan-denominated crude oil futures contract will help to marginally speed up the progression. 

Reserves can be divided into two broad categories: precautionary and excess. The precautionary portion needs to be in liquid assets to meet demand for foreign currency/dollars on short notice and mitigate balance of payments stress. Currently, these are mostly held in US government bonds or deposits, followed by European bonds, then UK, Japan, Canada and Australia down the list. China is below these. Gold is liquid but somewhat lower on the scale compared to deposits or government bonds, so there are natural limitations to how much central banks would hold. 

The excess portion of reserves can be invested in anything, and central banks have an excess globally. Central banks have undertaken various diversification efforts over the past few decades, with the share of euros in global reserve portfolios for example having increased from 20% in 2002 to 27% in 2008 before falling back to 20% in 2016. Central banks have been more active in holding commodity currencies (CAD and AUD) over the past five years.  
Russia has been buying a lot of gold. To do this, it either sells existing USD or other currency holdings, or when it intervenes and accumulates dollars it then diverts the currency to gold instead of treasuries. If central banks have excess reserves or do not want to accumulate more dollars, they could hold gold instead. 

The proposed yuan-denominated crude oil futures contract reduces the need to use dollars for the transaction, but it does not change the outcome or address the fundamental question: do central banks want/need USD or yuan? They could have bought yuan previously. The proposed yuan-denominated crude oil futures contract does not make it an easier process. But for those countries subject to sanctions, it might be attractive. According to the 4Q16 IMF COFER report (link), foreign central banks held USD85bn in allocated reserves in the CNY (or 1% of global reserves). Total foreign holdings of Chinese bonds amounted to USD135bn, according to ChinaBond, suggesting the vast majority of holdings are from central banks.

If reserve manager allocations to the RMB doubled over the next five years, and if those inflows were spread out evenly over the period, they would amount to roughly USD6bn per quarter (or another USD100bn). While not insignificant, that is still a drop in the ocean compared to other balance of payments components. However, if reserve manager allocations reached the weighting of the JPY in allocated global reserves (4%), the inflows could be closer to USD500bn over five years. An allocation equivalent to the euro (around 20% of global) reserves could see nearly USD1.5trn in inflows.

It could be challenging for the CNY to reach a high weight if global reserves are not rising. In 2002-2008, when central banks were diversifying into euros, global FX reserves were rising sharply and a significant portion of the growth in reserves was due to China. During this period, central banks were buying dollars through intervention (in an attempt to keep their currencies weaker than otherwise) and with some of those newly acquired dollars they decided to diversify their holdings and buy euros. However, in the absence of a strong increase in global FX reserves going forward, it would present a significantly higher hurdle for reserve managers to diversify into the CNY. It would require active diversification out of other currency holdings (i.e. sell existing dollar assets) to acquire the CNY.

Ray Dalio Is Shorting The Entire EU

Authored by Raul Ilargi Meijer via The Automatic Earth blog,

A point BOE Governor Mark Carney made recently may be the biggest cog in the European Union’s wheel (or is it second biggest? Read on). That is, derivatives clearing. It’s one of the few areas where Brussels stands to lose much more than London, but it’s a big one. And Carney puts a giant question mark behind the EU’s preparedness.

Carney Reveals Europe’s Potential Achilles Heel in Brexit Talks

Carney explained why Europe’s financial sector is more at risk than the UK from a “hard” or “no-deal” Brexit. [..] When asked does the European Council “get it” in terms of potential shocks to financial stability, Carney diplomatically commented that “a learning process is underway.” Having sounded alarm bells about clearing in his last Mansion House speech, he noted “These costs of fragmenting clearing, particularly clearing of interest rate swaps, would be born principally by the European real economy and they are considerable.”

Calling into question the continuity of tens of thousands of derivative contracts , he stated that it was “pretty clear they will no longer be valid”, that this “could only be solved by both sides” and has been “underappreciated” by Europe . Carney had a snipe at Europe for its lack of preparation “We are prepared as we should be for the possibility of a hard exit without any transition…there has been much less of that done in the European Union.”

In Carneys view “It’s in the interest of the EU 27 to have a transition agreement. Also, in my judgement given the scale of the issues as they affect the EU 27, that there will ultimately be a transition agreement. There is a very limited amount of time between now and the end of March 2019 to transition large, complex institutions and activities…

If one thinks about the implementation of Basel III, we are alone in the current members of the EU in having extensive experience of managing the transition for individual firms of various derivative and risk activities from one jurisdiction back into the UK. That tends to take 2-4 years. Depending on the agreement, we are talking about a substantial amount of activity.” [..] “I wouldn’t want to use financial stability issues as leverage. I wouldn’t want them to be addressed in a bloodless technocratic way in the interests of all the citizens.”

Sounds like Carney knows a thing or two that Juncker et al haven’t sufficiently thought through. The EU plans to move all – or most- derivatives clearing to the continent, but such a thing is anything but easy. That’s another very tangled web, and an expensive one to boot. Brussels probably wants to use the issue to put pressure on London in some way, but a hard Brexit might make that unlikely if not worse. Bloomberg from June this year:

EU Targets Derivative-Clearing Giants With Relocation Threat

“Today, a significant amount of financial instruments denominated in the currencies of the member states are cleared by recognized third-country CCPs,” according to the proposal. “For example, the notional amount outstanding at Chicago Mercantile Exchange in the U.S. is €1.8 trillion for euro-denominated interest-rate derivatives,” the commission said. “This also raises a series of concerns.”

The financial industry has lobbied hard against a location policy. The International Swaps and Derivatives Association said requiring euro-denominated interest-rate derivatives to be cleared by an EU-based clearinghouse would boost initial margin requirements by as much as 20% . The FIA, a trade organization for the futures, options and centrally cleared derivatives markets, has said forced relocation “could nearly double margin requirements from $83 billion to $160 billion.”

According to that Bloomberg piece, the notional amount outstanding of euro-denominated OTC interest-rate derivatives is some $90 trillion, 97% of which goes through the London Clearing House (LCH) based in .. well, you guessed it. Wikipedia:

LCH is a European-based independent clearing house that serves major international exchanges, as well as a range of OTC markets. Based on 2012 figures LCH cleared approximately 50% of the global interest rate swap market, and is the second largest clearer of bonds and repos in the world , providing services across 13 government debt markets.

In addition, LCH clears a broad range of asset classes including: commodities, securities, exchange traded derivatives, credit default swaps, energy contracts, freight derivatives, interest rate swaps, foreign exchange and Euro and Sterling denominated bonds and repos. LCH’s members comprise a large number of the major financial groups including almost all of the major investment banks, broker dealers and international commodity houses.

More details from Reuters, also in June:

Derivatives Body Warns EU Against Moving Euro Clearing From London

Shifting clearing of euro-denominated derivatives from London to the European continent would require banks to set aside far more cash to insure trades against defaults, a cost that would be passed on to companies, a global derivatives industry body says. [..]The London Stock Exchange’s subsidiary LCH currently clears the bulk of euro-denominated swaps, a derivative contract that helps companies guard against unexpected moves in interest rates or currencies.

Britain, however, is due to leave the bloc in 2019, putting it out of the EU’s regulatory reach. The International Swaps and Derivatives Association (ISDA), one of the world’s top derivatives industry bodies, said on Monday that a “relocation” in euro clearing to continental Europe would split liquidity in markets and reduce the ability of banks to save on margin by offsetting positions in the same liquidity pool.

Deutsche Bank has the world’s largest derivatives portfolio. Not all of it will be euro-denominated, but still. And I know it’s just notional amounts, but derivatives are not things one plays fast and loose with, lest the clearing becomes opaque and trouble starts.

Juncker better solve this thing. Oh, and this one too (yes, it’s quite fun to report on this):

Money Will Divide Europe After Brexit

As part of the transition period of around two years that she called for in her emollient Florence speech last month, Britain would continue to pay in to the EU budget to ensure that none of the member states was out of pocket owing to the decision to leave. These net payments of around €10 billion a year would fix the immediate problem facing the EU, the hole that would otherwise open up in its finances during the final two years of its current budgetary framework, which runs from 2014 to 2020.

[..] through its accounting procedures, the EU can and does commit it to spending that will be paid for by future receipts from the member states. What this means is that even after 2020 there will still be payments due on commitments made under the current seven-year spending plan. That pile of unpaid bills, eloquently called the “reste à liquider” (the amount yet to be settled), is forecast to be €254 billion at the end of 2020.

Estimates of what Britain might owe towards this vary, but taking into account what might have been spent on British projects it could be around €20 billion. On top of that – and the second main reason why the EU is holding out for more – the EU has liabilities, notably arising from the unfunded retirement benefits of European staff estimated at €67 billion at the end of 2016, which it is expecting Britain to share. Even taking into account some potential offsets from its share of assets, Britain may face a bill of between €30 billion and €40 billion on top of the €20 billion paid during the transition period.

The EU finances itself on the fly. It’ll have a €254 pile of unpaid bills in 3 years time. That is scary. Not for Brussels, but for its member countries. A hard Brexit, in which Britain may refuse to pay, is perhaps even scarier.

Anyway, once Juncker’s done with all that, he’ll have to move on to the next problem.

Derivatives is a big cloud hanging over Europe, but this one is potentially shattering.

Ray Dalio, manager of the world’s biggest hedge fund, is shorting, placing large bets against, anything Italian, and given Italy’s size and hence importance to the EU, his bets are effectively bets against Brussels.

Dalio’s Fund Opens $300 Million Bet Against Italian Energy Firm

Bridgewater Associates is adding to its billion-dollar short against the Italian economy. The world’s largest hedge fund disclosed a $300 million bet against Eni SpA, Italy’s oil and gas giant, data compiled by Bloomberg show. Bloomberg previously reported that Ray Dalio’s firm had wagered more than $1.1 billion against shares of six Italian financial institutions and two other companies.

This latest bet is the hedge fund’s second-largest against an Italian company, trailing only the $310 million against Enel SpA, the country’s largest utility. Eni’s majority holder is the Italian government via state lender Cassa Depositi e Prestiti SpA and the Ministry of Economy. The public involvement also is reflected in the government’s role in appointing the chief executive officer. Current CEO Claudio Descalzi has been at the helm since 2014 and was reconfirmed this year.

$1.1 billion against the banking system, $310 million against the main utility, $140 million vs pan-European insurer Generali and now $300 million vs the national oil and gas company, That adds up to quite a bit more than the Bloomberg graph says, but I’ll include it anyway.

Dalio doesn’t call the bluff of Italy, and this is not just like George Soros’ shorting the British pound in 1992, he’s calling out the entire EU and its financial system.

He’s saying I don’t believe you can keep up the charade.

He’s making a mockery of Mario Draghi’s “whatever it takes”.

So what are Rome, Brussels and Frankfurt going to do? They can’t ignore the no. 1 hedge fund forever. They will have to pump money into Italy, in large amounts. Merkel won’t like that, neither will her new coalition partner FDP, and the Bundesbank may start legal action.

Dalio’s located the Union’s achilles heel, which is not just that Italy’s insolvent (it’s not alone in that), but that there’s a gigantic theater production being performed to give everyone the impression that things are going just swimmingly, thank you. So Dalio’s said: how much for a ticket to the show?, and paid it. And now he’s inside.

Bridgewater didn’t enter that theater for nothing. $1.85 billion is not chump change for them. Intesa Sanpaolo CEO Carlo Messina may have said that Dalio will lose his bets, but according to the IMF Italy’s non-performing loans levels were €356 billion at the end of June 2016, which is 18% of total loans for Italian banks, 20% of Italy’s GDP and one-third of total Eurozone NPLs. Intesa Sanpaolo holds a nice chunk of that.

‘Whatever it takes’ may well be too much to take for the EU, and Draghi looks outsmarted, as do Juncker and Merkel. How many billions will it take for Dalio to go away? And then, who’s next, which hedge fund, which politician, which ECB chief? Coming soon to a theater near you.

Hard Assets In An Age Of Negative Interest Rates

Time is the soul of money, the long-view - its immortality.

Hard assets are forever, even when destroyed by the cataclysms of history.

It is the outlook that perpetuated the most competent and powerful aristocracies in continental Europe, well up through World War I and, in certain prominent cases, beyond; it is the mindset that has sustained the most fiscally serious democratic republic in the Western world, that of Switzerland (as demonstrated in this article).

In this view, the stewardship of money, formerly known as “banking,” is a serious matter of serious wealth management and not a weird-science lab experiment of investment products ultimately designed for hedge fund managers’ tax arbitrage schemes.

More than ever the focus on hard assets is a dire call to arms given the deformed market culture of central banking monetary magic. Despite the early promise of the Trump presidency to reinvigorate the economy, the United States remains mired in economic stagnation built up over so many years of debt-driven policies, easy-money policies, and the ZIRP fiasco fostering a bizarre-world situation in which the actual economy is doing poorly while the market is soaring. In such an environment, the allure of the centuries’-old tried and true has never had more appeal.

In a word, the hard asset vision is about building wealth outside the stock market. It refers to three main strategies overall: 

1) land ownership and/or farmland, forestry and agriculture

2) gold, other precious metals, and certain base-metal commodities, and

3) The (Old Masters/Classic Modern) art market.

Where this last is concerned, we mean art as investment and not art-as-commerce, such as that which contaminates today’s insipid and overpriced world of ‘Balloon-Dog’ bad art. The auction world of Rembrandt and Picasso; of El Greco and Gerhardt Richter has been on a tear, is smashing records, and cannot be ignored as an excellent safe-haven vehicle, as outstanding works of art traditionally always have been.

To begin with, physical gold and precious metals remain an investment enigma despite being market-leading performers for the past seventeen years. Gold is a must-have portfolio asset amid the aggressive debt levels and monetary debasement that have so unhinged the market. Silver, for its part, in addition to its prestige status, also has innumerable industrial applications and throughout the precious-metal bull market since 2000.

Russia, in this context, is leading the charge in the long-view outlook. For the past three years, the Bank of Russia has been the world’s number one stacker of gold, and, thus far in 2017, has taken the lead position among international central banks in buying the commodity.

At its current pace, Moscow will unseat China for the number five spot of gold-holding nations by the first quarter of 2018.

Currently, the gold-to-GDP ratios of the world’s leading powers are: Russia 5.6%; the Euro Zone 3.6%; the U.S. 1.8% and China 1.5%.

Yet countries buying up gold versus investors who do so are two different worlds. Ninety-five percent of the world’s gold is held as a wealth store.

In other commodities, zinc and copper have been the big movers. Zinc, the key galvanizing agent, claimed the status of the best performing metal last year. Copper began its resurgence in 2017, and in late August of this year, a host of commodities broke out of multi-month consolidation patterns. Nickel and cobalt are also coming into the spotlight as metals essential to the rapidly growing lithium ion (Li-ion) battery sector.

The art world lags not too far behind that of precious metals in terms of history’s preferred storehouses of value as protection against uncertain times. Art as investment has long been a favored strategy of the European elite since, effectively, the High Middle Ages and has never gone out of style. In modern times, the phenomenon of an ever-growing collectors’ base and less supply of museum quality works has been accepted as a meaningful way to protect investors’ cash during economic difficulty. Though continually eclipsed in the media by the brasher contemporary art market, Old Masters (and Classic Modern—the great 20^th century works) have shown stable, often spectacular, results over the past ten years with both categories reaching record-breaking highs.

Art, to be a safe haven, must be an investment and not a whim - just as it was for the Liechtenstein family who acquired Leonardo da Vinci’s Ginevra de Benci so many centuries ago. In the wake of the World War II near-bankruptcy of that eponymous principality (whose monarchs were not and are not supported by taxes), that painting was the first of the major, big-ticket art sales of the 20^th century, when it was sold to Paul Mellon and The National Gallery of Art in Washington DC. Ginevra continues to hang there today (and to date, is the only Leonardo painting in possession of the United States).  While the average investor may not be in a position to store wealth in a Renaissance master or a Picasso, there are always the underrated gems or the new discoveries that can and will bring in the most unexpected of windfalls decades down the line.

Finally, farmland is seen by many as an excellent addition to a precious-metal portfolio. As Jim Rogers predicted in early September, fortunes will be made in agriculture “and when an industry breaks full faith, even mediocre people make a lot of money” in that sector. Hard asset investors continue to include farmland in their portfolios “for a combination of income generation, diversification and inflation-hedging”. Historically, farmland, like forestland in continental Europe or Latin America, has been a unique asset class demonstrating low-correlation to traditional asset classes, and which performs well as inflation rises.

Cash reserves, land as cash, the endless applications of Nature’s resources to industry; the prestige, privacy, and long-term value of beautiful art: such has been the outlook of the hard-asset philosophy.

Today, that cult of independently-minded investors will laugh all the way to the bank - precisely by avoiding the paths laid out, and so horribly deformed, by those very banks.

Banks To London Employees: "Don't Panic"

With Brexit officially a go, banks in Britain are scrambling to undo months of verbal damage, and reassure their London employees over possible Brexit disruptions, a potential shift in jobs to continental Europe, and also talking down warnings made in recent months about leaving the City, some in now dashed hopes of getting a Brexit revote.

It now appears that many of those "threats" were hollow and as Reuters reports, investments banks such as Goldman and Nomura were among those who sent messages to employees in London as they work out how to keep serving clients across the European Union without spooking staffers, prompting employee defections to more hospitable employers. Richard Gnodde, CEO of the European arm of Goldman Sachs, stressed that no big changes were imminent even though he said last week that the Wall Street bank would begin by moving hundreds of staff as part of its "contingency plans" for Brexit. It seems a lot can change in one week.

"All of this work leads us to conclude that although Brexit may well bring some changes to our footprint, a lot will continue to operate as it does today," he said in a voicemail sent to all London employees" phones last Friday.

Morgan Stanley also informed employees in Europe that no decisions had yet been made on changes for when Britain departs. Rob Rooney, CEO of Morgan Stanley International, was blunter in updating staffers on the work of a committee comprising senior leaders at the bank which has been making Brexit contingency plans for over a year. "As prudence would dictate, we have been preparing for a worst case scenario, in which we would need to establish a more significant entity within the EU 27," Rooney said in a memo to staff on Wednesday seen by Reuters. "We continue to monitor the situation closely and, when appropriate, will take the necessary decisions and begin to execute on our plans."

Cited by Reuters, Gnodde said Goldman Sachs could make long-term decisions only after May"s two years of negotiations to exit negotiations to exit the EU were complete. "We also understand that you will have many questions regarding the implications of Brexit," he said. "We are sensitive to those concerns, and want you to know that we will share any information on changes that will impact our European footprint as quickly as we can."

Fearing they could lose top-performing staff, banks are treading carefully as they contemplate moving London-based workers to continental centers such as Frankfurt, Paris and Luxembourg, or paying them off and hiring employees locally.

In a similar message by Japan"s Nomura, the bank said in a message to staff on Wednesday that although it had been actively planning for Brexit, no final decision had been made on either location or timing of any new European entity, according to a source familiar with the matter.

Banks are enacting two-stage contingency plans for Brexit. The first involves relatively small numbers of jobs to make sure the requisite licenses, technology and infrastructure are in place, while the next requires longer-term thinking on what their European business will look like in the future. This is when bigger moves might take place.

According to Reuters, the British Bankers" Association and the City of London Corporation, which runs the financial district, said in statements it is crucial that after the conclusion of the talks banks retain as much access to the single market as possible.

They both also said that Britain should announce a staggered departure from the EU that would allow British-based banks to prevent market disruption.

Regulatory and banking experts working for the City of London and lobby group TheCityUK are drawing up proposals for a "mutual recognition" system.

Under this, the EU and Britain would broadly accept firms in each other"s financial markets because their home regulatory systems apply similar standards. The aim is for London-based banks to keep serving continental clients, although skeptics say mutual recognition is largely untested globally and would struggle to win approval within the EU.

That said, perhaps in this particular case London banks are more worried than they should be: after all, with banks in Europe hurting and few actively hiring (Deutsche Bank"s "no bonus" policy will hardly prompt massive demand for lateral moves), with the buyside aggressively cost-cutting, and hedge funds shuttering left and right despite all time highs in global stocks, just where are the "panicked" bankers going to go?

What If Hillary Had Won?

Via ConvergEx"s Nicholas Colas,

Counterfactual analysis is a useful way to consider the world we actually inhabit.  To that end, today we ask “What if Hillary Clinton had won the Presidency on November 8th?”

Where would financial markets be trading today, and how does that differ from the reality we see on the screen?  The S&P 500 is up 6.6% since Election Day (11/8/16).  Our best guess is that US stocks would have rallied 2% after a Clinton win as the uncertainty of the election lifted, so the differential of 4-5% is the actual “Trump rally”. The real differences come when you look at interest rates.  The 10 year yield on Election Day was 1.86%.  Now, it is 2.47%.  Had Secretary Clinton won, it might not have even risen to 2.0% given that it was rarely over that level in pre-election 2016.  

The key lesson from this exercise in “What if...”: US stocks don’t seem to fully reflect the power of the “Reflation trade” priced into Treasuries. The push-pull of that dynamic (better earnings vs. higher rates) should drive volatility higher in the weeks to come.

What if the South had won the US Civil War?  That is the subject of an essay by Sir Winston Churchill, published in 1931 as part of a collection titled “If It Had Happened Otherwise”.  By his estimation, the British Empire would have ended up acting as a go-between for a fractured “Un-United States” and eventually all three would have merged into an “English Speaking Association”.  The power of that alliance would have prevented World War I by driving a wedge between the combatants of continental Europe and the world today would be very, very different. For Churchill fans, here is a good description of how he got the idea while on a trip to the US in 1929.

Counterfactual history – imagining alternative outcomes to important events – is part analysis and part fantasy.  At its best, it can illuminate how watershed moments shift the sands in the hourglass.  Some events are clear demarcation lines in world history, and the talented historian (Churchill being first among equals in that camp) can do much with this contrivance to illuminate just why they mattered in the first place.

Today we will use counterfactual history in its smallest form and simply ask “Where would capital market prices be today if Secretary Hillary Clinton had won the 2016 US President election?”  One of our senior options traders asked me that question this morning, and I thought it was a neat way to parse out just how much (and where) the “Trump rally” has changed investor perceptions.  It has been 78 days Americans went to the polls, and since then financial asset prices have changed in the following ways:

• The Dow Jones Industrial Average is up 8.6%, from 18,333 (close on 11/8/17) to now.


• The S&P 500 is 6.6% higher, closing at 2140 on Election Day.


• The 10 Year Treasury yield has moved from 1.86% to 2.47%, and the price return on +20 year US sovereign debt is negative 9.8% since the US election.


• The CBOE VIX Index is substantially lower, closing today at 11.1 after ending the day on November 8th at 18.7.


• The best performing S&P Large Cap sector YTD is Materials, up 5.7%. The best performing sector over the last 3 months (the round number that comfortably brackets pre- and post-election action) are the Financials, up 18.2%.  Materials and Industrials are roughly tied for second, up 11.3/11.6%.


• US mid caps and small caps have comfortably outperformed domestic large caps, with 3 month returns of 10.5% and 13.1% respectively versus 5.6%.


• Correlations between asset classes and sectors have declined dramatically and remained lower this month.


• The US dollar has strengthened modestly against the euro since Election Day ($1.10 to $1.07), remained constant against the British pound ($1.25) and strengthened notably against the Japanese yen (103 to 114).


• Earnings expectations from Wall Street analysts have not fundamentally shifted since the Election, with bottom-up estimates for the S&P 500 at $133/share.

So how would things be different if Secretary Clinton had won?  A few thoughts:

The S&P 500 would likely have rallied, but not as much as it has. The logic here is simple: the election was sufficiently contentious that US equities were likely to bounce higher once a winner was announced and the loser conceded.  That closing VIX on Election Day at 18, high for post-Financial Crisis US equity markets, tells you that.

Moreover, a Clinton win would have preserved the gridlock-prone status quo that had existed in Washington for the last 6 years, during which time US equities generally did quite well.  Average S&P 500 returns during that time were 12.8%.

Our best guess is that US stocks might be 2 percent higher if Hillary Clinton had prevailed on Election Day.  No real science there – just a quick poll among some of the senior people on our desk.  There wasn’t much of a range in their responses; everyone said 2 percent.

Everyone I asked also agreed that long term yields would be lower. The US 10 Year Treasury yield rarely broke 2% during 2016 until the Election was over, and since Secretary Clinton was the odds-on favorite for the entire campaign season it is reasonable to think it would not have done so after her win.

The fact that yields now trade between 2.3-2.5% is therefore purely a function of expectations for higher inflation and/or greater debt issuance due to President Trump’s proposed policies of lower taxes and increased infrastructure spending.  Loosely known as the Trump “Reflation trade”, this is one area where a Clinton victory would have generated a very different outcome.  Even if you believe a Democratic victory would have sparked a relief rally equivalent to the one we actually got, I doubt you would have pegged the 10 year to yield 2.5% in January 2017.

Sector correlations and performance would likely have been quite different as well. Materials and Industrials wouldn’t be leadership groups; most likely Technology (which has underperformed over the last 3 months by 100 basis points) would have been the workhorse sector as it has been for much of the last 6 years.  And forget Financials…  Those would have been held back by a flatter yield curve.

As we have noted in prior briefings, correlations have fallen since Election Day as well.  Average sector correlations now run 50-60%, versus the 70-90% of the last 6 years.  Chalk that up to the direct and indirect effects of a Trump win, with markets discounting a new set of winners in a Trump administration versus a more status quo environment under a President Hillary Clinton.

The upshot to this mini-counterfactual is the dichotomy between equity and bond market performance. 

Fixed income markets are essentially in a new world; US stocks, by comparison, are in only a slightly better position. 

The “Trump rally” has only been worth 4-5% when compared to our “What if” Clinton scenario. 

Realistically, it should either be more (if bond markets are right about a breakout in inflation/corporate pricing power) or less (with higher rates pressuring equity valuations in the absence of greater earnings power).

And so we come to the conclusion that equity markets will show more volatility in the weeks to come since this philosophical tug of war has only just begun.