The other inversion

China is calm as growth slows. But is it complacent?

Though the trade war is hurting, officials are reluctant to unleash stimulus

HALF A DECADE ago, if you had asked economists which number—five or seven—described China’s GDP and which its currency, most would have answered this way: growth will remain strong at around 7% annually, and the currency will strengthen until it takes just five yuan and change to buy a dollar. One measure of the impact of Donald Trump’s trade war on China is the inversion of these digits. As American tariffs bite, economic forecasters think that Chinese growth next year will slow to five-point-something percent. The yuan, for its part, has slumped to more than seven per dollar.

Mr Trump has crowed about the success of his tactics. “China has taken a very hard hit,” he said on August 26th at a news conference after the G7 summit in France. “They want to make a deal very badly.” But a more accurate reading of China’s policy stance is one of surprising calm in the face of the economic slowdown and, by extension, of stiffer resolve in the trade dispute.

The toll of tariffs on China’s economy is becoming more visible. Although exports to America account for just a small share of overall GDP, the uncertainty has bruised corporate confidence. Investment spending is on track to increase this year at its weakest pace in at least two decades. Factory prices have veered into deflation, a bad sign for industrial profits.

Economists at Morgan Stanley, a bank, now forecast that Chinese growth will fall to 5.8% next year; previously they had expected 6.3%.

In the past, whenever growth looked set to slow sharply, Chinese companies could count on a stimulus package to revive it. But this time officials have been much more restrained in their response, partly because of concern about adding to China’s hefty debt burden. On August 26th the central bank had a chance to lower funding costs for banks, but it refrained, bucking the global trend towards lower rates. On August 27th the State Council, or cabinet, issued an underwhelming 20-point plan to promote consumption. Some analysts had been hoping for targeted tax cuts or subsidies; instead, it made small-bore promises, such as more 24-hour convenience stores.

The Chinese government’s lack of panic about the economic outlook should give Mr Trump pause. “Its leadership now looks committed to a strategy of toughing out trade tensions,” says Andrew Batson of Gavekal, a research firm. It helps that China has procured insurance in letting its exchange rate decline to 7.1 yuan per dollar, the weakest since 2008, offsetting some of the drag from tariffs.

But some think the calm is verging on complacency. Not only has China’s government refrained from stimulus, but it has become more hawkish about the property sector, the engine of its economy. In line with President Xi Jinping’s oft-repeated warning that investors should not speculate on housing, regulators have curtailed lending to developers and sworn off cutting mortgage rates. “We would view stabilising growth by choking credit to the property sector as analogous to performing cardiac surgery without blood pumps, oxygen and anaesthesia,” says Lu Ting, an economist with Nomura, a bank. In other words, things could get ugly.

Fed can ease the supply of credit but it cannot boost demand

Markets may be overestimating central bank’s ability to reverse tumultuous events

Joe Rennison

By lowering the cost of borrowing, the Fed is encouraging companies and households to lever up © Reuters

Many investors hope that the Federal Reserve has their back. The US central bank has consistently said it wants to keep the economic expansion going, offering assurance to fund managers looking to the Fed to alleviate some of the discomfort expressed in markets by dramatically lower bond yields and a contorted yield curve.

But such faith in the Fed’s power to reverse August’s tumultuous events may be misplaced.

The primary tool the Fed has at its disposal, after all, is to cut interest rates. This is like turning on a tap to let the water flow through, only instead of water the Fed is opening up the spigots for credit. By lowering the cost of borrowing, the Fed is encouraging companies and households to lever up.

But it is doubtful whether encouraging more credit to flow will do the trick. Borrowing costs have been at or near historic lows for over a decade and most companies are hardly struggling to borrow what they want, judging by the rapid growth of US corporate debt markets.

Boosting spending is the real challenge. And here, the Fed has less control. Capital expenditure by US companies has slowed; expected to rise just 3.5 per cent this year, according to Citi, a sharp drop from a 4.2 per cent projection just a few months ago. The most common reason given is uncertainty over public policy, and more specifically over the ongoing trade war.

July’s durable goods data released this week seemed positive on the face of it, but digging into the underlying numbers revealed a different story. Stripping out a surge in aircraft and parts, core capital goods orders were down 0.3 per cent on a year-on-year basis — the weakest reading for several years.

Those bleak numbers arrived shortly after another set of data showed the US factory sector in a rare period of contraction. IHS Markit’s US manufacturing purchasing managers’ index slipped to 49.9 this month, falling below its neutral level of 50 for the first time since September 2009.

Bill Dudley, former head of the New York Fed, put his finger on another potential problem this week, arguing that further stimulus from the central bank could have the effect of encouraging the Trump administration to open up new fronts in its trade battle with China. In that scenario, the private sector might be even less likely to spend and invest.

Still, investors are pricing in a near-certain chance of a rate cut by the Fed in September and there are cries for even looser financial conditions. Pimco’s US economist Tiffany Wilding said on Thursday that the Fed should slash rates more aggressively than the market currently anticipates.

The Fed might be the obvious candidate for coming to the aid of markets in distress but its desire to help is not the problem. Its ability is.

Fed Steps Into Repo Market to Control Soaring Rates

New York Fed adds $53 billion into the banking systems via repurchase agreements after the benchmark fed-funds rate moved outside its target range

By Nick Timiraos and Daniel Kruger

The Federal Reserve Bank of New York bought repurchase agreements after strains surfaced in the short-term financing market. Photo: brendan mcdermid/Reuters 

For the first time in more than a decade, the Federal Reserve Bank of New York took steps Tuesday to relieve pressures that were pushing short-term interest rates higher than the central bank wanted.

Strains developed Monday in short-term financing markets that suggested the central bank could lose control of its federal-funds rate, a benchmark that influences borrowing costs throughout the financial system.

Bids in the fed-funds market on Tuesday morning reached as high as 5%, according to traders, well beyond the central bank’s target range, which is 2% to 2.25%.

The Fed moved Tuesday morning to put $53 billion of funds back into the banking system through transactions known as repurchase agreements. After the moves, the New York Fed said the effective fed-funds rate, or the midpoint of transactions in that overnight market, stood at 2.25%, up from 2.14% on Friday.

The pressures that had sent the fed-funds rate higher were related to shortages of funds for banks, stemming from rising government deficits and the central bank’s decision to shrink its securities holdings in recent years. Its reduced holdings have soaked up funds in the financial system, crimping liquidity.

The Fed is likely to continue to provide funding to ensure the smooth operation of the repo market for some time to come, although it isn’t clear how long that might be, saidGennadiy Goldberg,a fixed-income strategist at TD Securities.

“I think they’re going to be playing this one by ear,” he said. “This is in every way, shape and form an emergency measure.”

The Federal Reserve’s rate-setting committee began a two-day policy meeting on Tuesday at which officials are likely to lower the fed-funds range by a quarter-percentage point to cushion the economy from a broader global slowdown, a decision unrelated to recent funding-market strains.

The New York Fed hasn’t had to conduct such a transaction since 2008 because during and after the financial crisis, the Fed flooded the banking system with reserves when it purchased hundreds of billions of dollars of Treasurys and mortgage-backed securities in an effort to spur growth after cutting interest rates to nearly zero.

It has been draining reserves from the banking system since 2014, when it stopped increasing its securities holdings. The declines accelerated after the Fed began shrinking its holdings in 2017. Reserves have declined from $2.8 trillion to less than $1.5 trillion last week.

The Fed stopped shrinking its asset holdings last month, but because other Fed liabilities such as currency in circulation and the Treasury’s general financing account are rising, reserves are likely to grind lower in the weeks and months ahead.

The strains in funding markets this week have been driven by several factors.

First, reserves have been declining. Second, brokers who buy and sell Treasurys have more securities on their balance sheets due to increased government-bond sales to finance rising government deficits.

Then on Monday, these strains were aggravated by a series of technical factors. Corporate tax payments were due to the U.S. Treasury, and Treasury debt auctions settled, leading to large transfers of cash from the banking system.

Meanwhile, postcrisis financial regulations have made short-term money markets less nimble than they used to be. This didn’t matter as much when the banking sector was awash in reserves and could absorb the kind of swings witnessed this week.

“The issue here is not that the level of reserves is structurally too low. We’ve reached the level where the market doesn’t respond to temporary deposit flows as efficiently or fluidly,” saidLou Crandall,chief economist at financial-research firm Wrightson ICAP.

Monday’s tax payments and debt settlements “drained money from the system, and there was no cash sitting on the side waiting to come in,” said Mr. Crandall.

Banks are holding on to reserves because they don’t think they can part with them and still continue to conduct the normal operations of a bank, such as cashing checks, approving mortgages and allowing companies to draw on letters of credit, Mr. Goldberg said. “Even small confluences of events will start to have outsized effects,” he said.

What happens in this narrow sector of the financial market can be important because funding spikes create the risk of sudden and disorderly efforts by market participants to reduce debts given the lack of cheap and predictable short-term financing.

“This sort of thing can lead to substantial pullbacks, and that can create very unpredictable dynamics in markets,” said TD Securities’ Mr. Crandall.

Scott Skyrm,a repo trader at Curvature Securities LLC, said he had seen cash trade in the repo rate as high as 9.25% Tuesday.

“It’s just crazy that rates could go so high so easily,” he said.

On his trading screens, Mr. Skyrm said he could see traders with collateral securities that they were trying to exchange for cash. The rates they were offering would start to rise until an investor with cash available to trade would start to accept their bids, gradually driving repo rates down until investors had exhausted their cash, he said. Then rates would resume their climb.

While there are technical factors to explain why cash would be in high demand this week, including corporate tax payments, the settlement of recently issued Treasury securities and the approach of quarter-end, they didn’t seem to explain the “crazy market volatility,” Mr. Skyrm said.

“It seems like there’s something underlying out there that we don’t know about,” Mr. Skyrm said.

Forget trade war, a 20% move implies real war

By: Izabella Kaminska

This was the early-market response to news that Saudi oil facilities had been struck by a suspected Iranian/Yemeni rebel drone strike:

As the FT noted:

Oil prices rose as much as 20 per cent to above $71.00 a barrel — the biggest percentage spike in almost three decades — as markets reopened after an attack on Saudi Arabia’s oil infrastructure at the weekend cut more than half the country’s production.

That’s one of the biggest moves in Brent prices in dollar terms in a single session in a very long time, if not ever.* And for the commodity markets that’s a big deal. Huge, in fact.
Traders on the winning side of the bet will be laughing all the way to the bank right now. But there’s going to have been some serious fallout on the other side. We don’t know the extent to which natural producer hedgers and systematic funds will have been hit, but it’s likely that in the days and weeks to come some extraordinary details will emerge about the bloodbath that took place on the back of that single move.

The key point to remember about the commodity-oriented fund world is this: ever since Trump took over and started threatening Chinese trade wars, the “smart” money has become overly focused if not obsessed by the narrative that global demand will be hit by tariffs and a slowdown in trade. This has led to massively bearish sentiment in the oil futures market over the past year.

And yet, those obsessing about the impact of “trade wars” may have simply missed the wood for the trees. Specifically, that trade wars are irrelevant if there’s a chance the world will go to war.

That may sound hyperbolic but we think it’s essential that someone bluntly states matters for what they are.

And herein lies the contrast between real-world markets and virtual gambling markets. In bitcoinland a 20 per cent move means nothing at all. In commodity markets, it’s a potential signifier that we’ve reached the point of no return in terms of conflict acceleration.

What analysts should be noting now is not the scale of economic loss from Brexit or continued Chinese trade wars, but the degree to which wartime conditions have never favoured free-market norms. To the contrary, in such circumstances, economies turn repressive, protectionist and domestic-production oriented. They also become energy security obsessed.

The UK might be a basket case in many Brexit-related ways but the one thing it’s genuinely got over much of Europe is energy security (at least for as long as it’s got the Scots). And while US/China trade wars are likely to hurt the relevant economies more than help them, the fundamental Trump card held by the US remains... you’ve guessed it... energy security.

*We’re checking if it’s a record, but our data only goes back so far, and one always has to account for the first Gulf war which took place during a time when oil prices were a little less free than they are today, so comparatives are difficult.

The Geopolitics of Iran’s Refinery Attack

By George Friedman

A Yemeni rebel group aligned with Iran took credit for a drone attack against Saudi Arabia’s main oil refinery this weekend. The range, payload and accuracy of the attack, as well as the sophistication of the operation, suggest that the Houthis had a lot of help from their patron nation.

The Houthis are a Yemeni faction aligned with Iran. Indeed, Iran’s support runs deep. Last month, the ambassador the Houthis sent to Iran was accredited as a formal ambassador – rare for someone representing a faction outside the country’s formal government. It signaled that Iran regards the Houthis as a nation distinct from Yemen or that Iran recognizes the Houthis as the legitimate government of Yemen. Diplomacy aside, Iran is close to the Houthis, has the capability of fielding the kinds of drones used in the Saudi attack and providing targeting information, and has the motive to act in this way.

Understanding its motivation is critical. Iran is a country under tremendous pressure. It has built a sphere of influence that stretches through Iraq, parts of Syria, Lebanon and parts of Yemen. From Iran’s point of view, it has been constantly on the defensive, constrained as it is by its geography. It will never forget the 10-year war it waged against Iraq in the 1980s that cost Iran about a million casualties. It was a defining moment in Iranian history.

The strategy Tehran formed in response to this moment has been to build a coalition of Shiite factions to serve as the foundation of its sphere of influence and to use those factions to shape events to its west. The struggle between Iraq and Iran goes back to the Biblical confrontation between Babylon and Persia. This is an old struggle now being played out in the context of Islamic factionalism.

The Iranians’ sphere of influence may be large, but it is also vulnerable. Their control over Iraq is far from absolute. Their position in Syria is under attack by Israel, with uncertain relations with Russia and Turkey. Their hold on Lebanon through Hezbollah is their strongest, but it’s still based on the power of one faction against others. The same factional influence exists in Yemen.

Iran does not rule its sphere of influence. It has a degree of authority as the center of Shiite Islam. It derives some control from supporting Shiite factions in these countries in their own struggles for power, but it is constantly playing balancing games. At the same time, it is imperative for Iran not to let a Sunni power or coalition of powers form on its western frontier.

The farther west it pushes its influence, the more secure its western border and the more distant the threat of war becomes. Its strategy is forced on it by geopolitics, but its ability to fully execute this strategy is limited.

Iran’s problems are compounded by the United States, which has been hostile to the Islamic Republic from its founding with the overthrow of the shah. The American interest in the region, as opposed to the visceral dislike on both sides, is to prevent any single power from dominating the region. The historical reason used to be oil. That reason is still there but no longer defining. The geography of oil production has changed radically since the mid-1980s.

The United States has an interest in limiting the power of Islamist groups prepared to attack U.S. interests. In the 1980s, multiple attacks on U.S. troops in Lebanon caused substantial casualties and were organized by Shiite Hezbollah. After 9/11 the threat was from Sunni jihadists. The invasion of Iraq, followed by failed attempts at pacification, drove home the complexity of the problems to the Americans.

This has led the U.S. into something very dangerous in the region: a complex foreign policy, the kind that the region usually imposes on powerful outsiders. At the moment, the main concern of the United States is Iranian expansion. It is not alone. The Sunni world and Israel are in intense opposition to Iran. Turkey and Russia are wary of Iran but at the moment are content to see the U.S. struggle with the problem, while they fish in troubled waters. An extraordinary coalition has emerged with the support of the U.S., bringing together Israel, Saudi Arabia and other Sunni states under one tenuous banner.

This coalition is a threat to Iranian interests. The Israelis are attacking Iranian forces in Syria and exchanging mutual threats with Hezbollah. The Saudis and the United Arab Emirates are supporting anti-Iran forces in Yemen and conducting an air campaign. Iraq is under limited outside pressure but is itself so fractious that it is difficult to define what Iranian control or influence is. In other words, the Iranian sphere of influence continues to exist but is coming under extreme pressure. And Iran is aware that if this sphere collapses, its western border becomes once again exposed.

U.S. strategy has moved away from large scale American military involvement, which defined its strategy since 9/11. It has shifted to a dual strategy of using smaller, targeted operations against anti-U.S. groups in the Sunni world and economic warfare against Iran. This anti-Iran strategy follows from a broader shift in U.S. strategy away from the use of military power toward the use of economic power in places like China, Russia and Iran. The U.S. drive to end the Iran nuclear deal was less about fear of Iranian nuclear power and more about imposing a massive sanctions regime on the Iranian economy.

The sanctions strategy has badly hurt the Iranians. For a while, it seemed to threaten political unrest on a large scale, but that threat seems to have subsided somewhat. But the pain from sanctions constantly tightening and shifting, with unpredictable targets and methods of enforcement, has undermined the Iranian economy, particularly its ability to export oil. This, combined with the pressure it is facing from the anti-Iran collation the U.S. supports, has placed Iran in a difficult position.

It has already responded in the Persian Gulf, seizing tankers in the hopes of creating panic in the industrialized world. But this is not 1973, and the significance of a tanker war like the one that raged in the 1980s was not enough to spike oil prices or create pressure from Europe, Japan and others against the United States and its allies to release the pressure on Iran.

Iran now has two imperatives. It must weaken the anti-Iran coalition, protecting its allies in the region, and it must generate pressure on the United States to ease U.S. pressure on the Iranian economy. The weak link in the coalition is Saudi Arabia. Its government is under internal pressure, and it holds together its social system with money gained from oil sales. It is the part that is both vital to the coalition yet vulnerable to events. And nowhere is it more vulnerable than in Saudi oil revenue.

The strike at the Saudi oil refinery was well thought out on all levels. Not only did it demonstrate that the Saudi oil industry was vulnerable to Iranian attack but the attack significantly reduced Saudi oil production, inflicting real pain. It is not clear how long it might take to bring production back online, but even if it is done quickly, the memory will not fade, and if it takes time, the financial impact will hurt. It has imposed a price on the Saudis that others will note.

It is also intended to remind the Saudis and others that while in the past the U.S. had an overwhelming interest in protecting the flow of Middle Eastern oil, this is not a major interest of the United States any longer. Between massive American shale oil production and its reserves, the U.S. is not nearly as vulnerable as it once was to oil disruption. This also reminds U.S. allies in Europe and Asia that a dramatic shift has occurred. Where once all were obsessed with doing nothing to threaten oil supplies, now the United States is in a position to take risks that its allies can’t afford to take. The Iranians hope that with this attack they can split the American alliance over the oil issue.

That oil issue is also Iran’s problem. The U.S. has blocked sales of a substantial proportion of Iranian oil production as part of its economic war on Iran. In creating alarm over global oil supplies, the Iranians want to force U.S. allies to be more assertive in defying U.S. wishes on not only oil but other matters as well. The U.S. assurances of ample supplies played into the Iranians’ hands, causing major importers to start thinking about the U.S. position.

The attack on the refinery was both operationally skillful and strategically sound. It made the Saudis’ vulnerability and their weakest point manifest. It imposed a price on the Saudis for their alliance structure that, if it continues, they cannot pay. The attack also drove home to U.S. allies that their interest and the United States’ interest on oil diverge. Finally, and importantly, it will benefit other oil producers, particularly Russia, by potentially raising prices. And in American politics, anything that benefits Russia right now can be made explosive.

The United States cannot ignore the attack. As the greatest military power in the anti-Iran coalition, it is the de facto security guarantor. But if it strikes, it invites a response from the Iranians and resistance from its allies. If it does not strike, it weakens the foundations of the anti-Iran alliance and strengthens Iran. U.S. Secretary of State Mike Pompeo has recently alluded to the possibility that the U.S. was open to negotiations. The Iranians may have seen this attack as an important negotiating point.

It is difficult to see how the U.S. can respond without risking more attacks on Saudi Arabia. It is likewise difficult to see how the U.S. can avoid striking without losing the alliance’s confidence. Part of this will depend on how bad the damage to the refinery actually is. Part of it will have to do with the effectiveness of U.S. counterstrikes against drones in Yemen.

What is clear is that the Iranians are playing a weak hand as well as they can. But they are also playing a hand that could blow up in their face. The geopolitics of this clear. The intelligence capability of each side in follow-on attacks is the question – as is how lucky all the players feel they are.